Ecuador - Fourth Development Banking Project

Document of The World Bank FOR OFFICIAL USE ONLY FILE COPY Report No.2414b-EC ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT May 31, 1979 Projects Department Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency amounts are expressed in Ecuadorian Sucres (S/) and US Dollars (US$) December 31, 1978 US$1.00 = S/25 S/1 = US$0.04 S/190009000 = US$40,000.00 GLOSSARY OF ABBREVIATIONS AID US Agency for International Development ATA Average Total Assets BCE Banco Central del Ecuador BNF Banco Nacional de Fomento BEV Banco Ecuatoriano de la Vivienda CAF Corporacion Andina de Fomento CFN Corporacion Financiera Nacional CMSU Capital Markets Study Unit COFIEC Ecuatoriana de Desarrollo S.A., Compania Financiera ERR Economic Rate of Return First Loan First Development Banking Project, Loan 721-EC FONADE Fondo Nacional de Desarrollo Fourth Loan The proposed Fourth Development Banking Project Loan IDB Inter-American Development Bank IESS Instituto Ecuatoriano de Seguro Social IFC International Finance Corporation INEC Instituto Nacional de Estadistica y Censo JM Junta Monetaria JUNAPLA Junta Nacional de Planificacion y Coordinacion Economica LRM Ley de Regimen Monetario MFF Mecanismo de Fondos Financieros OMC Capital Market Office PPA Project Performance Audit Second Loan Second Development Banking Project, Loan 930-EC SB Superintendencia de Bancos Third Loan Third Development Banking Project, Loan 1359-EC UPP Urban Poverty Project  FOR OFFICIAL USE ONLY ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT TABLE OF CONTENTS Page No. I. THE INDUSTRIAL SECTOR . ....................... . ....... . 1 A. General ...... .................................... 1 B. Manufacturing Sector **so . ..... ..... ..*. . ........ . 1 Industrial structure and recent trends ............ 2 Industrial policy ..... ........................... 4 Outlook and prospects for industrial growth ...... 6 II. THE FINANCIAL SYSTEM .................................. 7 A. Institutions and Regulations ............... ...... 7 Junta Monetaria ............................. ............ ............ 7 Central Bank ... ..................... ... . . . ............ 7 Superintendency of Banks ......................... 7 Financial institutions .. e......................... 7 Public financial institutions .................... 8 Financial funds mechanism ......... ............... 8 Banks and financieras ............................ 8 Operations, instruments, and markets ............. 10 Foreign exchange risk ........................ so 10 Interest rates and commissions ........ ........... 10 B. Recent Performance of the Financial System ... ..... 12 Intermediation .............................................. 0..... 12 Sources of credit .... ............ ................ 13 Distribution of credit ... #.............. 15 The financial structure of financial institutions. 15 Financial structure of corporations .............. 19 Stock exchanges ................ . .......................... 22 Bank Group involvement in the financial system ... 22 Issues and outlook . ............ . . . ..................... . 25 Capital Market Study Unit ........... ............ 26 This report is based on the findings of a mission composed of Messrs. T. Hutcheson and J. Calderon-Rossell of the Industrial Development and Finance Division, LAC Regional Office which visited Ecuador during October/November and January/February, rThis 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.|  TABLE OF CONTENTS (Continued) Page No. III. THE PROJECT ... ........................ ............... 27 A. Previous Loans . ................. .......... ...... 27 B. Objectives ...... ................ .................. 28 C. Participating Institutions .......... ............. 29 Corporacion Financiera Nacional .............. . .... 29 COFIEC ............................................ 34 New Financieras .................................. 39 D. Use of the Loan ...... ............................ 42 IV. THE LOAN .............................................. 46 A. Borrower and Terms ............................... 46 B. Allocation ..................... .................. 46 C. Free Limits, Economic Rate of Return ............. 46 D. Interest Rates ................................... 47 E. Fee for Foreign Exchange Risk .............. ...... 47 F. Subloans ....................................................... 48 G. Disbursement and Procurement ..................... 48 H. Project Benefit and Risks .... .................... 48 V. AGREEMENTS AND RECOMMENDATIONS .... .................... 50 ANNEXES 1. BCE - Capital Markets Study Unit - Program of Studies 2. CFN - Declaration of Policies and Procedures 3. COFIEC - Declaration of Policies and Operating Procedures 4. Table 1. Industrial Structure Table 2. Some Parameters of the Manufacturing Sector Table 3. Manufacturing Sector Classified by the Number of Employees Table 4. CFN - Balance Sheets Table 5. CFN - Income Statements Table 6. COFIEC - Balance Sheets Table 7. COFIEC - Income Statements Table 8. Eight Financieras: Comparative Structure of Balance Sheets Table 9. Summary Analysis of Subloans Approved under Loan 721-EC and Loan 930-EC Table 10. Summary Analysis of Subloans Approved under Loan 1359-EC 5. Estimated Schedule of Disbursements of the Proposed Loan 6. Selected Documents and Data Available in the Project File Map  I. THE INDUSTRIAL SECTOR 1/ A. General 1.01 The emergence of oil production in 1972 and the subsequent increase in international petroleum prices imparted unprecedented dynamism to the Ecuadorian economy. Compared to GDP growth of 5.5% p.a. in 1960-70, the growth rate in 1970-78 averaged 8.5% p.a. While the oil-based boom in Ecuador peaked in 1974, growth declined only slightly and still averaged 7.1% p.a. in 1975-78. Thus by 1977 Ecuador had achieved a GDP per capita of US$800 although its small population and skewed income distribution continued to restrict the domestic market for many products. 1.02 The period of the petroleum-induced boom is currently coming to a close. Already in 1978 Ecuador economic growth has fallen to 5%; however, the growth perspectives in the medium and long term are good. For these perspectives to become a reality, constraints on Ecuador's potential should be removed and strong incentives to use this potential more efficiently be designed and implemented. The most obvious immediate measure is that of increase in domestic prices of petroleum and its products, which are currently far below international prices. The effect of this measure would be to provide the Government with additional revenue from exports permitting it to resume necessary exploration for oil. In addition, the capital-intensive bias of industrial production should be removed in order to provide more employment opportunities than in the past. This could be achieved only by restructuring the present investment incentives and by using the exchange rates as an incentive for exports. B. Manufacturing Sector 1.03 In line with overall economic expansion, industrial growth was high during the 1970s and accelerated in recent years. Manufacturing value added growth averaged almost 10% p.a. (measured in 1970 prices) and was substan- tially above GDP growth after 1975. Virtually all subsectors participated in this expansion, stimulated by fast growth of incomes in the wake of the country's transformation to a petroleum-based economy, a favorable investment climate resulting from beneficial government policies towards the private sector, financial stability and, to a certain extent, the emergence of the Andean Common Market. 1.04 Industry's share in GDP remained nearly unchanged during 1970-77 (at 17.5%) but abstracting from the fast increase in the petroleum sector, the share of industry showed a constantly growing trend. The sector's con- tribution to employment is slightly smaller but still substantial, accounting 1/ A detailed discussion of the Ecuadorian economy and of its manufacturing sector is available in the Report 2373-EC, Development Problems and Prospects of Ecuador (yellow cover) of February 9, 1979 on which this section is based.  - 2 - for about 13-15% of the total labor force. Estimates of the overall increase in industrial employment during 1970-77 range from 50,000 to 67,000 jobs. Industrial structure and recent trends 1.05 Despite its rapid growth, manufacturing remains at a relatively early stage of development. Traditional activities such as food processing, textiles and wood processing accounted in 1970-75 for 55% of value added whereas chemicals, non-metallic minerals and metals contributed just about one-third of value added. The share of consumer goods in manufacturing value added increased slightly during 1970-77 whereas that of intermediate goods declined and the small share of capital goods remained virtually constant (Table 1). 1.06 The average size of industrial firms has remained small. Artisan's workshops and small-scale industries 1/ (i.e., firms employing less than 7 persons) account for about 67% of industrial employment but just somewhat above one-third of value added. Medium- and large-size firms, about 1,,500 in 1977, are also small by international standards: in 1975 only about 150 firms employed more than 100 persons and only 11 firms had more than 500 employees. 1.07 Growth in labor productivity in manufacturing was 3% p.a. during 1970-74 thus exceeding the increase in labor costs (about 1% p.a. in real terms). However, after 1975 emerging shortages for skilled labor and increased labor union activity resulted in accelerated increases in labor costs (about 7.5% p.a. in constant terms) which have probably overtaken productivity gains. 1.08 The expansion of industry has been associated with even faster growth of import requirements for capital goods but also for current inputs and even consumer goods. During the 1970-77 period, capital goods imports increased nearly 10 times in current US dollars terms and imports of current inputs in- creased about 4 times, which is above the increase in industrial output. Medium- and large-scale firms import nearly one-half of their current inputs. While large import requirements are to be expected in a country of Ecuador's size and stage of industrialization, the excess of domestic over international inflation, the maintenance of an increasingly over valued exchange rate, exoneration from duty of many industrial inputs, other investment incentives and accelerating labor cost increases have made it profitable for Ecuadorian firms to mechanize and to rely increasingly on imported equipment and materials, to the detriment of using domestic resources, including labor (para. 1.11). 1.09 Industrial exports experienced a remarkable increase, from less than US$20 million in 1970 to about US$290 million in 1977, when they accounted for about 10% of the gross manufacturing output and nearly 21% of total exports. 1/ The legal definition of "small-scale industry" in Ecuador (firms with no more than US$200,000 in fixed assets excluding land and buildings) includes most medium-sized firms as well.  - 3 - While two thirds of the increase in industrial exports was due to substitution of processed cocoa for raw cocoa exports, fish products (for animal and human consumption), wood products and electrical appliances also scored important increases. The duty-free access of some Ecuadorian products to the Andean Common Market contributed also to the export increase, but exports to the subregion grew less than exports to the rest of the world. Table 1: STRUCTURE OF MANUFACTURING VALUE ADDED (Percentages) 1970 1974 1977 Consumer Goods Food, Beverages, Tobacco 34.2 34.7 35.2 Clothing, Footwear 0.6 0.9 0.9 Furniture 1.1 1.7 1.7 Paper, Printing 9.3 9.2 9.0 Chemicals - Final Products 10.4 11.5 11.4 Other 3.3 3.1 2.9 Subtotal 58.8 61.1 61.1 Intermediate Goods Textiles, Leather 13.4 13.2 13.3 Wood 3.5 2.6 2.5 Chemicals - Intermediate 8.0 6.8 6.8 Non-metallic Minerals 4.4 4.5 4.5 Basic Metals 1.4 1.3 1.3 Subtotal 30.7 28.4 28.4 Capital Goods Machinery, Equipment 10.4 10.5 10.5 Total Manufacturing 100.0 100.0 100.0 Source: Report 2373-EC.  - 4 - 1.10 While the manufacturing sector in Ecuador has shown rapid expansion in recent years, it faces a number of limitations that are likely to acquire increasing importance in the wake of a period characterized by declining petroleum exports and the reappearance of a foreign exchange constraint. Major limitations faced by the manufacturing sector include insufficient development of institutional and physical infrastructure (particularly power supply but also transport and telecommunications), limited size of the domestic market, limited availability of financing for firms with less than first-class credit ratings, particularly small firms, and a system of industrial incentives and protection that has contributed little to increase industrial efficiency. Industrial Policy 1.11 The Government has stimulated industrial development through fiscal investment incentives, tariff protection and to a lesser extent, export promo- tion. Fiscal incentives are among the most generous in Latin America and include import duty exemptions or rebates for capital goods and intermediate products and partial income tax exemptions for reinvested profits. They have been recently increased for operations in specified locations outside the two main urban areas (Quito and Guayaquil) in an effort to give stronger stimulus to industrial development in relatively underdeveloped regions. In addition, firms qualifying under the "List of Special Investments" (LID) receive full exemption from income taxes for 10 initial years (irrespective of whether they reinvest profits), higher export tax credits and additional personal tax allowances for employees. 1.12 Industrial protection is mainly granted through the tariff system; the use of quantitative controls on non-competing imports has been restricted in order not to interfere with adequate supplies for industry. Nevertheless, Government entities and firms receiving fiscal incentives are expected to "buy local" insofar as the goods required are domestically produced. Nominal tariffs on imports used to be higher, but since the 1974 tariff reform, moderate (i.e., zero to 20-30 percent) rates have applied to imports of machinery and equipment and raw materials whereas tariffs on consumer goods are in the 50-70% range and approach 200% for some items, e.g., private automobiles. Also, a 30% surcharge is levied on imports of non-essential consumer goods but also on imports of some industrial inputs produced locally. The dispersion in nominal rates (including the surcharge) between industrial inputs and finished products can result in effective protection as high as 100-150% (and much higher in a few cases). In addition, prior import deposits ranging from 10-30% of CFI value have been in effect since 1975. 1.13 Export promotion policies emerged in the early 1970s. Exports other than agricultural raw materials and crude petroleum receive a tax credit ranging from 7-15% of the FOB value of exports depending on the export value reached in the preceding year. Firms operating under the LID scheme receive an additional 3% export tax credit. The Government established special export financing facilities for both pre- and post-shipment financing and a temporary admission system ("internaclon temporal"), allowing all exporters temporarily to import duty-free those goods incorporated into exports.  - 5 - 1.14 While industrial investment partly induced through fiscal incentives has made a significant contribution to output and employment growth, and to modernization and diversification of industry, the incentives have stimulated capital- and import-intensive forms of production, to the detriment of fuller use of Ecuador's resource endowment primarily consisting of labor and natural resources. The interaction of tax incentives and tariff protection has resulted in high returns and the emergence of oligopolistic structures mainly in import-substituting industries which, in the absence of incentives and protec- tion, might have been avoided. Finally, investment incentives have produced a loss of fiscal revenue which, while still limited in relation to overall fiscal receipts, has been substantial. 1.15 The Government is currently in the process of modifying industrial incentives, tying them to criteria such as generation of value added, linkages with the rest of the economy, foreign exchange earnings or savings, and the composition of ownership of industrial firms, among others. The intended modifications will remove some of the shortcomings of the existing system but others remain to be tackled. The Government might consider in this context restricting import duty reductions for capital goods and intermediate products, granting special incentives for employment expansion and for increased use of domestic raw materials, and providing relatively larger incentives to small- scale firms. There should also be a strict time limitation on investment incentives. 1.16 In contrast to investment incentives and protection, export incen- tives have not been excessive and do not appear to go beyond mitigating the cost disadvantages sustained by Ecuadorian producers. Export-related tax credits in 1970-77 averaged 11% of manufactured exports, less than in many other Latin American countries with higher industrial export potential, and probably less than the cost disadvantage faced by Ecuadorian manufactured exports. However, the existing criteria for allocating the export incentives has resulted in the bulk of export tax credits going to semi-processed goods and goods exported to the Andean Common Market (where they are duty-exempt) whereas newly exported products to international markets have received little or no incentive, at least in initial stages, as tax credits depend on exports in preceding years. The export incentive scheme should therefore be made more rational, by dropping the size of exports in preceding years as a yardstick for the level of incentive, replacing it by the value added incorporated into the product and possibly eliminating the incentive for exports to the Andean Group. 1.17 The Bank has maintained an active dialogue with the Ecuadorian authorities on industrial policy, inter alia, on the basis of the findings of an industrial sector mission in 1976, which also pointed out the high priority of agroindustrial and other resource based sectors. The Bank intends to intensify these discussions not only in the context of the proposed loan under which the financieras would continue to apply economic analysis to subprojects (para. 3.03), but also using the findings and recommendations contained in the report of the recent economic mission. In addition, a follow-up industrial sector mission is planned for the second semester of 1979 to examine i.a. the group of large capital-intensive projects being  - 6 - contemplated (para. 1.19) and to further analyze and make recommendations on industrial policy. In 1980, on the basis of this analysis, the Government and the Bank would conduct a review of industrial policy issues. Outlook and prospects for industrial growth 1.18 Accelerated industrial development to enhance the sector's contribu- tion to output and employment growth and to strengthening the balance of payments is one of the Government's major objectives. The strategy calls for industry to replace petroleum as the leading sector when the latter's poten- tial starts declining. Attaining these aims would require a development effort based on intensified utilization of Ecuador's substantial natural resources in agriculture, fisheries, forestry and non-metallic minerals, supported by policies aimed at improving the productive structure of the industrial sector and at removing price distortions in factor and product markets. 1.19 The Govenment is currently promoting several agroindustrial projects (e.g., sugar refining, production of edible oils and alcohol), forestry based projects and a substantial expansion of cement production which are likely to contribute to an improved overall industrial structure and growth. On the other hand, the Government also plans to set up several large-scale, techno- logically complex industries such as integrated iron and steel production, automotive production and petrochemicals which are very capital intensive and generate relatively little employment while requiring a skilled labor force. Achievement of economies of scale in such projects would require substantial exports to third markets as efficient sizes widely exceed domestic and Andean Common Market demands. Thus, there is a danger that some of these projects might not become competitive. 1.20 Future industrial growth will continue to be largely determined by overall economic expansion which is expected to decline from the very high rates sustained during the early and mid-1970s. In line with the projected growth of domestic income and expenditure, domestic demand growth for indus- trial products is forecast to be about 5.5% p.a. during 1978-85. Demand for domestically produced goods will also depend on the extent of import substi- tution which, at the aggregate level, is likely to be very small or even negative. With increasing manufactured exports reaching 16% of output in 1985, the overall growth of manufacturing during 1978-85 would be about 6% p.a. 1.21 Estimated investment requirements for industrial expansion during 1978-85 could be in excess of US$335 million (in current prices) on annual average. Assuming that the share of domestic resources in the financing of industrial investment could be increased from the current level of 60% to an average of 75% by 1985, close to US$110 million p.a. would have to be obtained from abroad, a target that appears attainable. However, should the Government go ahead with large-scale projects in basic industries, total investment requirements during the period would increase by at least US$2.1 billion. The Government intends to obtain financing for these project mainly from abroad both through equity and long-term credit.  - 7 - II. THE FINANCIAL SYSTEM A. Institutions and Regulations Junta Monetaria 2.01 The monetary and financial policies of Ecuador are established by the Junta Monetaria (JM) and executed by BCE. The aim of these policies is to establish and sustain monetary, credit and exchange conditions favorable to the orderly development of the country. In accordance with those policies, JM determines capital and reserve requirements, interest rates and commissions, and portfolio ceilings. JM also regulates the issuance of securities and capital flows into and out of Ecuador. Central Bank 2.02 In administering the monetary and financial polices of JM, BCE performs the classical operations of a Central Bank. BCE, however, is more active in open market operations than most other Latin American central banks. Also, BCE participates in the Ecuadorian credit market, particularly in development financing (para. 2.07). Superintendency of Banks 2.03 The supervisory body of the financial system is the Superintendency of Banks (SB), an autonomous, technical institution directed by a Superintendent and exercising a broad control over financial institutions, including finan- cieras. 1/ In general, SB supervises and controls the assets and liabilities of the financial institutions (including contingent liabilities), memorandum accounts, administration, the procedures of the Board of Directors, security and prudence with which business is conducted, the observance of laws, regula- tion and policies and any other matters prescribed by the Superintendent. Also, SB determines the accounting practices that financial institutions must follow. In addition, it authorizes the establishment of new banking institu- tions although financieras are authorized by the Ministry of Finance based on a SB report. Financial institutions 2.04 In addition to supervisory bodies mentioned above, the financial system is made up of 26 banking institutions (24 private and 2 government- owned); I bank of cooperatives, 8 financieras (7 private and I government- owned), 11 mutual savings banks, 23 insurance companies, 2 stock exchanges, the Ecuadorian Social Security Institute (IESS), a warehousing firm, and several foreign exchange houses. While banks and financieras lend to industry, agriculture and commerce, the housing and real estate sector is 1/ Financieras are financial institutions that cannot accept deposits from the public and that lend funds to productive sectors.  - 8 - mainly financed by mutual saving institutions, commercial banks and the government-owned Ecuadorian Bank of Housing (BEV). Insurance companies invest mainly in securities. IESS, in addition to providing health care, makes loans to its affiliates and the public sector and invests funds in the financial system. Exchange houses and the warehousing firms are special financial institutions operating in the exchange market and in short-term financing with merchandise guarantees, respectively. The Bank of Cooperatives is a special banking institution providing a very limited amount of credit to small productive operations, consumers, services, and commerce through credit cooperatives. The stock exchanges in Quito and Guayaquil promote trading of stocks and of public and private bonds. Public financial institutions 2.05 The credit operations of the National Development Bank (BNF), also owned by government, are basically oriented to serve agriculture, forestry, fishery, livestock and training, although it also provides funds for industry, in particular small scale industry. BNF is the largest financing institution both in terms of its 63 branches throughout the country and its capital. In 1963 the government transformed the former Securities Commission into a financiera--Comision de Valores - Corporacion Financiera Nacional--basically to serve the financial needs of industry. Currently this corporation is the largest financiera in the country (para. 3.14). As of 1978 its name was changed to Corporacion Financiera Nacional (CFN). 2.06 Official and semi-official financial institutions such as CFN must, according to the Monetary Law (LRM), coordinate their own policies with the monetary, credit, and exchange policies executed by BCE. Moreover, these institutions are subject to the regulations and instructions of JM regarding the issuance of securities and their credit and investment operations. In the exercise of this authority BCE controls the amounts and timing of CFN's bond issues (para. 3.20). 2.07 Financial Funds Mechanism. In addition to the public institutions mentioned above, the Financial Funds Mechanism (MFF), a discount window of BCE, was established in 1973. Administered by the Operations Department (GDO) in BCE, MFF complements the financing operations of the private financial sector by promoting specific programs of the Government. In 1974, the National Fund for Development (FONADE) was created and has become an important source of financing for MFF programs. Currently, those programs include: agriculture, small industry, small fishery, and small and medium tourism projects. MFF programs are approved by JM who also regulate amounts and terms of the loans. Banks and financieras 2.08 The general banking law of Ecuador classifies banks as commercial, mortgage and savings banks, although most of them operate in all three capacities. Each section of the bank is subject to different regulations. Banks are the only financial institutions authorized to receive demand deposits, but are not authorized to invest in non-financial operations. In general the banking law is more restrictive and specific than the financiera law. Financieras and banks are also subject to different requirements regarding capital, leverage, reserves, maximum claims and portfolio growth as shown below:  Financieras Commercial Banks CAPITAL Subscribed: 50% of authorized S/20 million in Quito capital but not less and Guayaquil and S/10 than S/10 million. million elsewhere. Paid-in: 50% of subscribed 50% of subscribed capital but in full capital but in full in 1 year. in 1 year. LEVERAGE Total Liabilities: < 10 times paid-in < 15 times paid-in capital + reserves. capital + reserves. Investments and Loans: < 10 times paid-in > 0.7 times demand capital + reserves. deposits, but > 0.5 times demand deposits + time deposits. RESERVES a/ 33% of demand deposits, including deposits with a maturity of 30 days or lower (August 2/78). Maximum claims 25% of paid-in 10% of paid-in capital + on a sinRle capital + reserves. reserves. borrower Maximum None 16% per year (February 78) portfolio growth a/ Although financieras need not have reserve requirements deposited in BCE they must have reserves of at least 10% of total liabilities. Although regulations regarding leverage and acceptance of demand deposits favor commercial banks, the absence of reserve requirements, less stringent regulations regarding minimum capital, higher maximum claims on a single borrower, and the absence of regulations regarding portfolio growth favor financieras. These advantages and the significant growth of the economy explain the formation of six new financieras since 1975 1/. 1/ Financiera Andina, Financiera del Austro, Ecuatoriana de Financiamiento, Financiera de Guayaquil, Financiera Iberoamericana, and Financiera Nacional.  - 10 - Operations, instruments, and markets 2.09 The financial operations and instruments available in the Ecuadorian system are in general similar to those known elsewhere. In the cases of financiera bonds, these may be of general or specific guarantee; only the former have been issued as yet by Ecuadorian financieras. The monetary stabilization bonds or the participation certificates of BCE used in open market operations are tax-free. The capital market, as opposed to the money market, is still in its infancy. The depth and scope of the market are still limited and as a result long-term instruments are not easily traded which reduces the liquidity of bonds. As a consequence financieras have been issuing bonds usually with a legal or informal agreement to repurchase at par, thereby reducing the market risk of the bonds. Therefore, yields are sustained at the coupon rate which is low compared with recent inflation rates and the alternative of buying liquid, tax-exempt bonds. This practice does not provide incentives for long-term resource mobilization and in addition institutions are subject to a permanent risk that could jeopardize their liquidity position. Mortgage bonds, issued so far only by banks, are now traded at discount to improve the yield for the buyer. Foreign exchange risk 2.10 Foreign currency denomination of loans by Ecuadorian financial institutions is not permitted except when arising from international transac- tions. Denominations of transactions in foreign exchange among local residents is effectively prohibited. The only legal tender for payments within the country is the Sucre (S/), the Ecuadorian currency. In practice this means that domestic financial institutions cannot pass along to the final borrower the foreign exchange risk on the institution's foreign borrowing. This restriction does not prevent local institutions from guaranteeing loans by foreign banks or serving as intermediary for opening letters of credit where the borrowers' obligation to the foreign institution is denominated in foreign currency. Interest rates and commissions 2.11 The maximum nominal interest rate for lending in Ecuador is 12% p.a. (Table 2). Adding allowable commissions of 2%, 3%, and 4% p.a. for loans with more than 3 years, 5 years, and 8 years maturity respectively, yields rates of 14-16% p.a. on medium- and long-term loans (including Third Loan funds) compared to inflation averaging 12% p.a. 1/ In addition, the effective rate on mortgages is currently about 16% p.a. and interest rates on foreign loans guaranteed by local financial institutions (including letters of credit) are set at LIBOR (or US prime rate) plus 4%-6% p.a. Loans under the Bank Agri- cultural Credit Loan are made at 11% for smaller farms and 14% for the larger farms. In contrast, loans from the Financial Funds Mechanism (MFF) are offered at only 9% p.a. and export promotion loans, at only 8% p.a. 1/ For a discussion of the Bank's role in Ecuador's move to.these positive interest rates, see paras. 2.24-2.27.  - Li - Tabla 2: TZST PATES AND COI*aSSICNS (as of April 1978) IlNST =rONS .4*ouaL Indi- Provtnces Privateo BN1 PrivNcS Saying, Endi- viduals & municipal 0 P e & A T I O N 5 Bankg Coop. Bank ?I n.n.cieras pmLk. vidu&ls through Central govern tns finsncial Gove and ocher i'etitucion public and smi-public Institutions I. LandinB 12% * 12% 11% Overdrafts ,n 8 81 FOPc *- 8% Agriculture & Livestock - 9% - Smail Induscry ad Arrisans - 9% COmarce - 12% To ENAC (National Zncarprise of Markaeing and Warehousing) - 41 Financial. Funds Mechanism */ 9Z 9% 9% 9% FinanciAl Funds Maechanism Livestock Davelopsen Program, in credits above 5/625,000 12% 12% 12% L.% II. Central 3 ak: 3S 5% Advences and rediscounts b/ - - - 12S Agriculture, fishery and artisanry 6% 3% tndustry 71 4% I/ 7% Coumarer 10% 10% FOPPX 4% Zxtraordinary Advances 7% Advances for Reserve Requiremnts 12% financial Funds Mtachanim Radiscounts 31 3% 31 3% Rediacounts for Livestock Developmnt Progrsn, credits below S/625,000 4% 4% 4% 41. LAdiscounts for Liventock Development programs, credits above Sf625,000 771 7 7% 7r Bankr' s Acceptancss Agriculturs. Fishery and Arti3snry 7r Industry, purchase of national raw mactrial 7% Industry 8% Commrca 9 Advances over Future Exports 6% (rs-liquidacion in case of no-*xports US) Z;l. Borrowling Savings 6% 7r Deposits itch a maturity of 31.- 180 days 7% 8% 181 360 8% 97 > 360 9% 10% SortgageS, 3over41enG Pledge and other bonds, liabilities issued by corporad on L2Z D.veLopmeat bonds 41 COMMXSSIONS OF 508f OPETAIONS a) Loans for agric, lture, mining, fishery tadustry and tourias with macurity of 3 5 years 2 Z2% 2. 2% 5-8 3% 3% 37 3% B "462 4S 4' 4% b) For mortage Lending baed on specific bonds Issue: 0.5% more than (a) c) Guarantees 4% _ , 4% Source: 3CE */ Includes specific progras in agriculture, livestock, agribusiness small industry and couriss. S/ In cases of operations outside Quico and Guayaquil, the Interest rates for private banks are Z7. less than for thosa reported and 1% for the Cooperatives B3nk and cha National Development Bank. c/ Small Industry.  - 12 - 2.12 Rates offered to savers also vary considerably. Savings accounts and certificates of deposit yield 6%-10% p.a. CFN bonds with 10 years nominal maturity (but with a legal guarantee to be repurchased at par on sight) yield 8%. Government and Monetary stabilization bonds of 30-day to 180-day maturity yield around 11% tax free. Ten-year mortgage bonds without repurchase guarantee have a 12% nominal rate but currently are yielding around 14%. COFIEC bonds (with no legal guarantee to be repurchased but in practice supported at par) yield 12% p.a. These wide variations among both lending and mobilization rates result in correspondingly wide variations of margins depending on the source, use and maturity of the operation. CFN has margins of 6%-8% when funding long-term loans with its bonds. Banks in contrast currently have a margin of only 2% on mortgage loans. COFIEC, so long as it is able to maintain the price of its bonds at par, has a margin on its long-term operations of up to 4%. Financieras and banks when using MFF resources have a 6% p.a. margin when these funds can be obtained. Foreign resources for short- and medium-term guarantees and letters of credit operations which are easily obtained enable the institution to earn up to 4% p.a. Financieras under the Agricultural Credit Loan have margins of 3% p.a. and 6% p.a. depending on the size of the borrower. B. Recent Performance of the Financial System Intermediation 2.13 The proportion of credit to GDP at around 40% shows (Table 3) the relatively low level of intermediation compared to more industrialized countries. Moreover this ratio failed to rise as could be expected during the period of rising real income. Only in 1977 did the level of intermediation exceeded that of 1970 as a result of further participation of official banks, mainly BCE, and financieras in the credit market (para. 2.15). 2.14 The current structure of interest rates and commissions, although a considerable improvement on the past, has not yet given the financieras or other institutions sufficient incentive to intermediate long-term resources. Because of high inflation (averaging 12% p.a.), large emissions of tax-exempt, short-term monetary stabilization and government bonds yielding 11%, and long- term mortgage bonds at 14% p.a. or more, it would be difficult for financieras to issue bonds at less than 14% p.a. Thus financieras lending at 14-16% would have at most a 2% margin on long-term operations, far less than the 4% margin on easily available foreign short- and medium-term resources or the 6% margin on MFF resources. Finally, lending rates are not flexible enough to fully reflect credit, business, and purchasing power risks. Thus, a fundamental rationalization of the interest rate structure is needed (para. 2.28).  - 13 - Table 3: GNP, SAVING AND CREDIT (S/million, current prices) Saving % a/ Credit Credit Year GDP Saving a/ GDP Credit Saving a/ GDP 1970 34,275 3,524 10.3 12,797 3.6 0.37 1971 40,247 3,798 9.4 13,497 3.6 0.34 1972 47,102 4,876 10.4 15,629 3.2 0.33 1973 63,575 9,988 15.7 19,010 1.9 0.30 1974 93,583 18,132 19.4 28,560 1.6 0.31 1975 108,246 19,155 17.7 36,839 1.9 0.34 1976 130,183 25,909 19.9 46,641 1.8 0.36 1977 153,812 27,636 18.0 61,901 2.2 0.40 Source: Junapla, BCE and SB. a/ Gross National Saving, excluding depreciation. Sources of credit 2.15 The proportion of credit granted by financial institutions changed during 1970-1977 basically as a result of the establishment of new financieras and the growth of CFN and COFIEC. Financieras intermediated 13.1% of total credit in 1977 compared to 6.9% in 1970 (Table 4). Credit provided by the private financieras outgrew that provided by CFN although the maturity of those credits is mainly short-term as opposed to longer term financing provided by CFN. In the banking sector the shifts in intermediation were even more dramatic. Since the oil boom, especially in 1974, official banks have become one of the major sources of credit with 44.1% in 1977 of total bank credit, while private banks intermediation has been substantiallly reduced since the early 1970s. The operations of the BNF substantially increased in 1973 and 1974 while BCE has become a major source of credit both to the public and to financial institutions. At the same time BCE drew resources from the financial system reallocating them to different lending programs such as MFF. During 1977 overall net credit from BCE was substantially lower than in the previous two years, reflecting an effort to withdraw resources from the system. Recognizing the effect that this withdrawal had on financial institutions, however, BCE increased its overall credit operations both to private banks and financieras but even more so to government-owned financial institutions. This stop-gap policy prevented sharp contraction of credit but merely resulted in reshuffling resources among financial institutions. A better policy of JM would have been to liberalize interest rates, eliminate tax exemptions of public bonds, and control the monetary system through open market operations.  - 14 - Table 4: SOURCES OF TOTAL CREDITa/ (S/ million) Institution 1970 1971 1972 1973 1974 19.75 1936 1977 Central Bank 3181.1 2762.1 3091.9 3095.8 6189.8 10029.0 13015.8 17745,3 National Development 677.5 762.8 807.8 1507.6 3640.6 4000.1 4578.7 4734.2 Bank Ecuadorian Housing - 19.5 99.4 70.0 144.64 387.3 368.1 904,8 Bank Total Offical Banks 3858.6 3544.4 3999.1 4673.4 9975.0 14416.4 17962.6 23384.3 Total Private Banks 8053.8 9079.4 10541.6 12888.2 15667.6 19087.7 23981.2 29512.6 Bank of Cooperatives n.a. n.a n.a n.a .55.8 71.6 86.2 149.9 TOTAL BANKS 11912.4 12623.8 14540.7 17561.6 25698.4 33575.7 42030.0 53042.8 CFN n.a. n.a. n.a. 484.9.b! 1233.3.b/ 1361.3.b/ 2259.9b/ 30-36.6c/ Private Financieras n.a. n.a. n.a. 963.2d4 1305.04' 14394/ 1766. 5073.6P/ TOTAL FINANCIERAS 884.8-/ 873.2e/ 1087.9-t 1448.1 2538.3 2800.3 4025.9 8110.2p-/ Mutual Savings Inst. n.a n.a n.a n.a 323.0 462.8 585.4 748.8 TOTAL 12797.2 13497. 15628.6 19009.7 28559.7 36838.8 46641.3 61900.8 Sources: a/ SB and BCE b/ CFN, Boletin Estadistico No. 6 c/ Based on growth of total portfolio d/ COFIEC e/ Portfolio pj Preliminary n.a. not available  - 15 - Distribution of credit 2.16 The sectoral distribution of credit disbursements during 1977 shows (Table 5) that commerce had the highest volume of credit (39.9%) followed by industry (28.4%), and agriculture and livestock (13.4%). This indicates that most credit is still oriented to financing working capital. Basically, the concentration of credit to commerce is because, notwithstanding the growth of the financieras, banks, which lend almost exclusively to the commercial sector, are still the main source of credit (86.5%). BCE also contributed substantially to financing commerce; half of its total credit (48.4% ) was to this sector. Financieras, however, mainly finance industry. Based on this distribution of credit (1977), private banks and private financieras have more widely diversified portfolios than CFN and BNF which, in line with their objectives, have portfolios concentrated in industry, and agriculture and livestock, respectively. The financial structure of financial institutions 2.17 The financial structure of financieras and private banks is shown in Tables 6 and 7. The major difference between them is determined by regulations concerning capital, leverage and reserves (para. 2.08). Banks, however, are operating at the maximum permitted leverage while financieras are still well below their maxima. In part this is because as of December 1978, there were six private financieras with three or less years of operations; and because CFN still could expand its operations further. 2.18 In relative terms private financieras have a higher liquidity position than private banks. CFN, however, has lower liquidity than private financieras mainly because it partially finances long-term loans with short- term resources. Private financieras and banks, on the other hand, appear to be using long-term resources partly to finance short-term operations. Another major difference between these institutions is their volume of contingent assets and liabilities, mainly guarantees. Private financieras are guarantee- ing substantial amounts of foreign medium- and short-term loans. When contin- gent assets are added to short-term loans, private financieras have 92% of their portfolios in these operations, a higher percentage than private banks. The acceptance and letter of credit operations of private financieras are also very similar to private banks. In contrast, CFN and to a lesser extent COFIEC appear to be the only major sources of long-term lending, yet their short-term loans and contingencies are also significant. The role of CFN, however, for intermediating long-term domestic resources has also been limited (para. 3.20). In return on investment, both private financieras and private banks show a similar performance 1/. In contrast, CFN's return has been lower (para. 3.28). 1/ The lack of comparable income statements from banks does not allow an analysis of the differences in actual interest rates and administrative expenses between financial institutions. However, based on the number of operations and average loan sizes, financieras probably have lower admin- istrative costs, per sucre lent, than banks.  Table 5: DISTRIBUTION OF CREDIT BY INSTITUTfON AND SECTOR - 1977 INSTITUTION (S:CToR Commerce Z % Industry % Z Agriculture I X Other-/ % X Total % and Livestock Central Bank 8990.5 35.9 48.4 4162.9 24.4 23.5 3520.3 31.9 19.8 1471.6 18.2 8.:' 17745.3 29.5 100% Nationtal Develop- 338.3 1.4 7.1 346,0 2,0 7.3 4049.9 36.7 85.5 4734.2 7.9 100% ment Bank Private Banks 14446.9 60.3 49.0 7173.6 42.1 24,3 2860.0 25.9 9.7 5032 62,3 17.1 29512.5 49.1 100% Tqtal Banks 23375.8 97.6 45.0 11682.6 68.5 22.5 10430.2 94.6 20.1 6503.6 80.5 12.5 51992.0 86.5 100% CFN c/ 230.8g' 1.0 7.6 2690.4 15.8 88.6 42.5 0.4 1.4 72.9 0.9 2.4 3036.6 5.1 100% H Private Financiecas 351.5 1.4 6.9 2671.8 15.7 52.7 551.8 5.0 10.9 1498.5 18.6 29.5 5073.6 8.4 100Z 8110.2 13.5 100% Total yinancieras 582.2 2.4 7.2 5362.2 31.4 66.1 594.3 5.4 7.3 1571.4 19.5 19.4 TOTAL 23958.0 100.0 39.9 17044.8 100.0 28.4 11024.5 100.0 18.3 8075.0 100.0 13.4 60102.2 100.0 100% Source: SB and BCE. a/ Excluding Ecuadorian Housing Bank which lent in this period S/852.5 million for housing, 94.2% of its total operation add mutual savings institutions which lent S/669.8 million for housing (90.0% of total credit), S/34.7 niillion for professional buildings (4.7%), S/38.3 iiiillion for land purchases (5.1%) and $1.0 million for equiipm,ent and furniture (0.1%). b/ includes fishery, training, construction, and other loans not classified elsewhere. c/ Based OLI percentages oc dtstributton ^f approved credits during 1963-76.! d/ Includes credit to restaurants and hotels.  - 17 - Table 6: CONSOLIDATED STATEMENT OF FINANCIAL INSTITUTIONS December 1977 (S/ Million) Private Financieras CFN Private Banks ASSETS a % Cash 279.9 5.9 197.8 3.2 9878.1 21.0 Loans 977.3 20.7 3736.5 59.7 13844.0 29.5 Short-term 743.2 15.8 1220.4 19.5 11030.6 c/ 23.5 Long-term 234.1 5.0 2516.1 40.2 2813.4 cl 6.0 Equity investments 72.1 1.5 996.7 15.9 117.9 0.3 Other securities 27.2 0.6 65.2 1.0 1020.0 2.2 Acceptances 91.4 1.9 - - 951.8 2.0 Letters of credit 895.4 19.0 373.9 6.0 7657.0 16.3 Operations in process of collection 83.1 1.8 115.3 1.8 1231.6 2.6 Rediscounts 202.8 4.3 n.a. - 850.7 1.8 Other assets 99.0 2.1 15.0 0.2 2242.3 4.8 Equipment and furniture 18.6 0.4 33.1 0.5 271.8 0.6 Real estate 135.1 2.9 36.3 0.6 538.0 1.1 Deferred assets 28.1 0.6 98.9 1.6 298.4 0.6 TOTAL ASSETS 2910.1 61.7 5668.8 90.6 38901.6 82.8 Contingent 1803.3 38.3 586.1 9.4 8086.5 17.2 TOTAL 4713.4 100.0 6254.9 100.0 46988.1 100.0 a/ Financial statements are shown based on SB reporting requirements for financieras, although CFN does not have to follow them. b/ Private banks statements are as of December 1976, however, the structure in 1977 was not substantially changed but final figures were not yet available. c/ The portfolio of short- and long-term loans of private banks is not known, it was estimated that this would be at least similar to the distribution of short- and long- term credit granted in the Deriod.  - 18 - Table 7: CONSOLIDATED STATEMENT OF FINANCIAL INSTITUTIONS December 1977 (SI million) Private b/ Financieras CFN Private Banks- LIABILITIES AND EQUITY.2J Short-term 225.3 4.8 1208.9 19.3 13374.6 28.5 Long-term 656.7 13.9 1925.3 30.8 4953.6 10.5 Acceptances 91.4 1.9 - - 951.8 2.0 Letters of credit 895.4 19.0 373.9 6.0 7657.0 16.3 Bonds 185.7 3.9 728.6 11.6 4293.7 9.1 Other 131.6 2.8 222.6 3.6 4755.4 10.1 Headquarters 1.6 - - - - - Deferred Credits 41.5 0.9 - - 566.0 1.2 EQUITY 680.9 14.4 1209.5 19.3 2349.4 5.0 Capital (paid-in) 511.8 10.9 1136.1 18.2 1447.6 3.1 Total reserves and profits 169.1 3.6 73.4 1.2 901.8 1.9 Reserves 86.5 1.8 - - 579.6 1.2 Accumulated profits 12.3 0.3 - - 63.0 0.1 Profits 70.3 1.5 73.4 1.2 259.2 0.6 Total Liabilities and Equity 2910.1 61.7 5668.8 90.6 38901.6 82.8 Contingent 1803.5 38.3 586.1 9.4 8086.5 17.2 TOTAL 4713.4 100.0 6254.9 100.0 46988.1 100.0 ROI 10.3% 6.1% 11.0% a/ Financial statements are shown based on SB reporting requirements for financieras, although CFN does not have to follow them. b/ Private banks statements are as of December 1976,-however, the structure in 1977 was not substantially changed but final figures were not yet available.  - 19 - 2.19 Examining the average loan size (Table 8) and the distribution of credit by loan size (Table 9), it is evident that CFN provides credit for large operations. Although private financieras lend larger amounts per loan than banks, still their loan size is smaller than CFN's average. This difference of loan size between banks and financieras results from the clien- tele each type of institution is serving and the assets they are financing (Table 10); financieras lend more for fixed assets than banks. However, excluding contingent operations, financieras have a maturity distribution of credit similar to that of private banks (Table 11), partly explained by the newness of most financieras, the difficulty to mobilize long-term resources (para. 2.14) and a very open financieras regulation (para. 2.08). 2.20 Table 8 also shows that the number of large loans by financial institutions is very low, even in the case of CFN. Therefore, most of the loans in Ecuador are relatively small. In addition, using the legal defini- tion of small industry which may include firms with total assets around S/20 million, it is likely that some small firms at the upper end of the asset range are receiving substantial amounts of credit. However, many small firms are not able to obtain enough credit, particularly long-term credit, to satisfy their needs. Financial structure of corporations 2.21 Examining the financial reports of corporations published by the Superintendence of Companies, the supervisory body of stock companies, it is evident that liabilities, especially short-term liabilities (Table 12), of these firms have been increasing from 57.8% of assets in 1974 to 62.8% in 1976. Equity financing, therefore, has been reduced proportionately. A detailed examination of those liabilities reveals that loans from non-related parties were only 44.7% in 1976, which means that financing from equity and loans of shareholders still accounts for approximately 55% of total assets. Because of the opportunity to capitalize on high, although declining returns on investment, corporations and shareholders prefer to reinvest in their own firms as opposed to invest in other financial instruments, thereby reducing funds for intermediation through the financial system. The need for capital for further expansions and recent trends in indirect financing 1/ show an increasing demand for intermediation by financial institutions, in particular of long-term resources. 2.22 Manufacturing companies have a similar financial structure to corporations in other sectors (see Tables 12 and 13). However, total indirect financing is higher in manufacturing firms, especially of short-term resources. This is due to the needs for working capital financing in the sector and the sophistication of management in relation to other sectors. In 1976, loans 1/ Debt financing except from stockholders.  -20- Table 8: AVERAGE LOAN SIZE BY SECTION AND INSTITUTION (1977) (S/Thousands) Agriculture Commerce Industry and Cattle Other Total Central Bank 296.4 534.4 154.0 482.5 484.8 National Development Bank 50.8 382.8 95.3 - 94.6 Private Banks 113.5 261.1 149.4 80.7 124.9 Total Banks 170.8 323.0 123.5 99.4 161.0 CFN a/ - 12735.4 - 4833.3 12491.0 Private Financieras 1440.5 1608.5 1365.8 1356.2 1486.1 Source: SB and BCE a/ Based on percentages of approved credits during 1977 excluding export credit and other special loans. Table 9: DISTRIBUTION OF CREDIT BY LOAN SIZE (1977) (Percentages) National Deve- Amount Number Size of Loan CFN a/ lopment Bank Private Banks Central Bank (S/ thousands) Amount Number Amount Number Amount Number Amount Number < 500 0.5 10.0 36.7 97.2 51.2 95.4 85.1 86.1 500 - 4500 16.7 57.3 4500 - 25000 37.7 27.9 63.3 2.8 48.8 4.6 14.9 13.9 > 25000 45.1 5.8 - 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: SB and BCE a/ Based on credit approved during 1963-1977.  -21- Table 10: TYPE OF ASSETS FINANCED BY FINANCIAL INSTITUTIONS (Percentages) Private Private CFN a/ Financieras b/ Banks b/ Machinery and Equipment 60.9 n.a. n.a. Buildings 15.3 n.a. n.a. Other 2.3 n.a. n.a. Fixed Assets 78.5 27.8 (28.8) c/ 9.4 Working Capital 21.5 72.2 (71.2)jc/ 90.6 TOTAL 100.0 100.0 100.0 a/ Based on approved credit during 1963-1976. b/ Mission estimates. c/ COFIEC figures Table 11: DISTRIBUTION OF CREDIT BY MATURITY (1977) Maturity Private National Private Central (years) CFN a/ Financieras Development Banks Bank ________ ___________ Bank ( 1 3.8 89.1 (49.0) c/ 41.0 89.1 100.0 1-5 ) 24.2 10.9 (51.0) c/ 32.0 4.5 - > 5 ) 72.0 27.0 6.4 - TOTAL 100.0 100.0 100.0 100.0 100.0 Source: SB and BCE a/ Based on credit approved during 1963-1977. b/ Estimates from consolidated statement of financial institutions Table 5, excluding contingent operations. c/ COFIEC figures.  - 22 - (except from stockholders) were 55.7% of total financing while in other sectors this percentage was 44.7%. Therefore, there is still need for more credit, especially long-term credit, as 69.1% of long-term resources used by firms are contributions of shareholders either in the form of equity or loans. The availability of long-term resources has been limited due to the lack of mobilization of these resources by financieras (para. 2.14). Stock exchanges 2.23 The combined operations of the Quito and Guayaquil stock exchanges have been growing at an average rate of 23.4% p.a. in the period 1973-76. In 1977, however, the growth was exceptionally large, 149.4%, reaching a trading volume of S/7,878.4 million, mainly due to the open market operations of the BCE (S/861 million of monetary stabilization bonds, and S/2,003.6 million in government bonds for deficit financing). As a result, 85% of the total trade on the exchanges in 1977 was in public securities, while only 15% of trade was in securities of the private sector, mainly bonds. The volume of stocks traded in the same year was insignificant (0.3%). Bank Group involvement in the financial system 1/ 2.24 Bank Group operations in the financial system of Ecuador began in 1969 with an IFC investment of US$251,371 in COFIEC. This was followed in 1971 with a US$8.0 million loan divided equally between the COFIEC and CFN. Since then the Bank has made two other loans of US$20.0 million and US$23.0 million to CFN and COFIEC although in the Third Loan US$3.0 million were also allocated to the six new financieras for a total of US$26.0 million. 2.25 In the IFC investment and the First Loan the Bank's basic objectives were to stimulate growth of the industrial sector through long-term financing of the foreign exchange costs of subprojects and to assist the institutional development of the two financieras. At the time of the Second Loan it was realized that more attention needed to be given to the efficiency of the sub- projects being financed and thus the financieras began using an economic rate of return (ERR) analysis of subprojects (para. 3.02). By the time of the Third Loan it bad become evident that the financial climate was such that financieras could do little more than channel foreign funds to their clients. The structure of interest rates did not permit them to mobilize sufficient funds domestically to make progress toward a third Bank objective--helping the industrial sector shift from undue reliance on short-term loans to long- term finance of industrial projects. 2.26 Discussions of the interest rate issue had begun prior to the First Loan at which time the Bank was able to convince the government of the neces- sity to raise the maximum interest rate from 10% to 12% in order to permit financieras to be financially viable. Although the increase was recognized at the time as only a first step toward interest rate reform, under the Second Loan an additional commission of only 1%, and only on Bank funds, could be obtained. Extensive discussions at the time of the Third Loan resulted in 1/ For a general discussion of the three existing Bank loans see paras. 3.01 - 3.05.  - 23 - Table 12: LIABILITIES AND EQUITY OF CORPORATIONS (S/ million) 1974 1975 1976 Short-term liabilities 14888.1 27.9 25664.0 39.8 34179.0 39.2 Long-term liabilities 15962.5 29.9 14020.9 21.8 20566.0 23.6 Total liabilities 30850.6 57.8 39684.9 61.6 54745.0 62.8 Equity 22593.1 42.3 24733.2 38.4 32423.0 37.2 Liabilities + equity 53443.7 00 64418.1 100 87168.0 100 LOANS FPROM NON-RELATED PARTIES Short-term 6587.3 12.3 18494.5 28.7 25514.8 29.3 Long-term 6752.6 12.6 8625.5 13.4 13438.6 15.4 13339.9 24.9 27120.0 42.1 38953.4 44.7 Return on investment* 95.1% 51.0% 46.9% * The high ROI was mainly due to oil companies. Source: SuperintendencY of companies.  - 24 - Table 13: LIABILITIES AND EOUITY OF MANUFACTURING CORPORATIONS (Sl million) 1974 1975 1976 Short-term liabilities 6288.6 35.1 8970.6 37.7 12955.6 40.4 Long-term liabilities 3877.4 21.7 5018.3 21.1 6935.6 21.6 Total liabilities 10166.0 56.8 13988.9 58.7 19931.2 62.1 Equity 7734.2 43.2 9825.3 41.3 12148.5 37.9 Liabilities + equity 17900.2 100 23814.2 100 32079.8 100 LOANS FROM NON-RELATED PARTIES Short-term 3190.9 17.8 8290.1 34.8 11970.6 37.3 Long-term 2803.3 15.7 4121.4 17.3 5888.7 18.4 5994.2 33.5 12411.5 52.1 17859.3 55.7 Return on investment Profits/Equity 22.7% 15.3% 15.5% Profits/Average equity - 17.1% 17.1% Source: Superintendency of Companies.  - 25 - government's recognition that the 12% ceiling on interest rates regardless of loan maturity gave financieras no incentive to mobilize long-term domestic resources whose cost at that time was also around 12%. Therefore, in late 1976 the JM established a schedule of commission applicable to long-term lending of 2%-4% p.a., depending on loan maturity (para. 2.11). Although this new commission structure partially removed a major obstacle to long-term resource mobilization and lending and helped the financieras maintain their profitability, it was not able to compensate for other difficulties (para. 2.14). 2.27 These developments led the recent Project Performance Audit of the first two loans 1/, (which nevertheless dealt with certain Third Loan issues) to conclude that, while the Bank had been successful in helping finance effi- cient industrial subprojects and in building up two strong, mature institu- tions, it had been less successful in helping to improve financial intermedia- tion. A further conclusion was that the Bank should broaden its discussions with government on capital market development rather than focus narrowly on interest rate issues. Indeed, it had been recognized already in the Third Loan that the new commission structure was only one step toward capital market development and therefore the Government agreed with the Bank on setting up a Capital Market Office (OMC) to recommend additional reforms. Disagreements within Ecuador concerning under whose auspices OMC should function prevented its establishment. The Capital Market Study Unit (CMSU) being established in BCE in connection with the Fourth Loan would fulfill the objectives of the OMC (para. 2.29). Issues and outlook 2.28 The financial system of Ecuador has been growing as a result of the expansion in the economy, the stability in the country, and the intervention of the monetary authorities. Nevertheless, there is still room for improvement and several issues related to a market oriented policy need to be studied in order to determine where reforms may be required, especially: - The liberalization of interest rates and commissions, and possible reductions in the margins allowable on the guarantee of short and medium-term foreign loans to increase intermediation of long term domestic resources, and efficient resource allocation. - The transfer of foreign exchange risk to final borrowers to increase competitiveness of, and reduce risks to, financial institutions; - The regulations governing financieras and banks to allow both types of institutions to compete on an equal footing in the financial market, centralizing also the authorization of both new banks and new financieras in SB; 1/ A recent completion report and Project Performance Audit Report on the first two Loans concludes that the Bank's institution building efforts were successful.  - 26 - The desirability of reducing the direct role of BCE in the credit market and in the intermediation of financial resources; The desirability of removing tax exemption from stabilization bonds and government bonds; The conditions under which additional financieras could be allowed, including an analysis to determine if one specializing in small-scale industry is needed; and - The statistical information regarding the financial system, in particular related to flow of funds accounts, issues of bonds and other securities, trading operations, classification of credits, standardization of financial reports. Capital Market Study Unit 2.29 In order to examine these and other issues related to the development of the capital market, BCE is formally establishing CMSU. Wholly within BCE, CMSU, would be appropriately staffed with professionals having the experience and qualifications to conduct studies leading toward reforms of law, regula- tions and practices governing financial institutions. Preliminary agreements regarding an initial program of priority studies (Annex 1) has been reached. BCE would afford the Bank a reasonable opportunity to comment on the terms of reference for the preparation of the priority studies as well as the draft of such studies. After completing each study, BCE would propose any needed changes to the appropriate authorities for final decision. Each study would contain a detailed program for implementing its recommendations.  - 27 - III. THE PROJECT A. Previous Loans 3.01 In three previous Bank loans US$47.6 million in Bank funds have been committed through CFN and COFIEC to help finance 84 subprojects (see Annex 5, Tables 9 and 10). The financieras have applied Bank funds to a well-diversified set of subprojects but the resource-based subsectors--food products; textiles; clothing; footwear; wood products; and non-metallic minerals--predominated (65% of the first two loans and almost 85% of the Third Loan). Most subproj- ects have been for import substitution; lending for export subprojects has been almost negligible because of inadequate incentives and lack of competitiveness of many manufacturing subsectors. With inflation and industrial growth the average subproject and subloan size averaged US$4.7 million and US$1.1 million under the Third Loan. The average maturity of subloans under the three loans has been around 8 years because, notwithstanding longer terms permitted,by the Bank, neither financiera lends for more than 10 years. Although possible under the loan and project agreements no equity investments have been with Bank funds. Around 10% of Bank funds went to small-scale enterprises, although this was not a specific objective of these loans, as the lack of an extensive branch network has prevented the financieras from lending to large numbers of small enterprises. In view of their need for credit and tendency to be more labor intensive, the Bank has begun preparation of a separate small-scale enterprises project in Ecuador in which a large number of financial inter- mediaries are likely to participate. 3.02 Both institutions under all three loans have used about 40% of Bank funds for loans to new firms. These also tend to receive larger subloans than expansion projects and indicate the financieras' fairly aggressive and promotional stance. The Completion Report found that the financieras' clients were more profitable, grew faster and had a higher proportion of long-term resources than other firms. The willingness to lend substantial amounts to new firms has enabled the financieras under the Third Loan to place about 30% of Bank funds outside of Quito and Guayaquil, the major poles of economic activity. Nevertheless, the financieras occasionally used Bank funds under the first two loans for projects of well-established firms which probably could have obtained alternative resources. For this reason a maximum use of Bank funds by a single firm of US$3.0 million was established under the Third Loan. It was also recognized that the higher interest rates being set would tend to encourage larger firms to obtain foreign financing, if available. 3.03 Under the Second Loan the financieras began applying an economic rate of return (ERR) analysis to their larger Bank-financed subprojects, thereby becoming the first financieras to do so among Bank-assisted institu- tions. 1/ Under the Third Loan the ERR analysis was extended to larger non- Bank subprojects as well. This analysis has allowed financieras to select 1/ Under guidelines developed for calculating the ERR by Bank-assisted institutions, the values of all tradable inputs and outputs are adjusted by the use of border prices at the official exchange rate.  - 28 - efficient subprojects typically having an ERR estimated ex ante at well over 20%. The Completion Report on the first two loans concluded on the basis of an ex post analysis of subprojects financed under the Second Loan that, while both costs and benefits were underestimated because of inadequate allowance for inflation, rates of return were in line with appraisal estimates. The prevalence of high returns on Bank-financed subprojects probably resulted from the high proportion of subprojects in the resource-based subsectors where Ecuador's comparative advantage lies. 3.04 In part because the number of new jobs created by investment in expansion projects tends to be underestimated and because of inappropriate industrial incentives, the cost per job created in Bank-financed subprojects is estimated at around US$50,000. Although the rate of return analysis shows that these projects have been efficient, the high cost per job suggests that the financieras could make greater efforts to search out more labor intensive projects. The need for such efforts has been discussed with the financieras at negotiations and the Bank would require special justification for projects that are highly capital intensive. The general problems of incentives for capital intensive activities would be taken up as part of the Bank's dialogue with the government on industrial policy (para. 1.17). 3.05 Six new financieras have begun operation since 1975. Under the Third Loan, new financieras that met a series of conditions were to become eligible to use, in the aggregate, up to US$3.0 million in Bank funds. These conditions turned out to be overly strict and in 1978, at the govern- ment's request, Third Loan arrangements were modified to allow the new finan- cieras to participate on a limited basis through CFN. The new arrangement is expected to become effective shortly. B. Objectives 3.06 Building on the achievements and experience of the first three loans (see paras. 2.24-2.27 and 3.01-3.05), the Fourth Loan would continue the shift in focus begun under the Third Loan toward overall capital market objectives. To this end it would aim at the following objectives: (a) to stimulate development of the Ecuadorian capital market to enable financial institutions to mobilize and channel efficiently larger amounts of medium- and long-term resources to worthwhile projects; (b) to encourage financieras to intermediate additional medium- and long-term resources for financing efficient investment projects, in particular those of the industrial sector; and (c) to promote competition in mobilization and channelling of long- term resources and wider dispersion of Bank funds by opening participation in the Fourth Loan to new financieras. 3.07 In order to help fulfill these objectives the BCE has agreed with the Bank to establish the CMSU responsible mainly for conducting studies and recommending reforms'to promote further developments of the Ecuadorian capital  - 29 - market (para. 2.29). In order to broaden the impact of the Fourth Loan on the capital market, to stimulate healthy competition among all financieras, and to help orient the new financieras toward long-term resource mobilization and lending, the six existing and any additional new financiera could partici- pate in the Fourth Loan. C. Participating Institutions 3.08 CFN and COFIEC, because of their size, experience, and previous relationship with the Bank, would participate from the outset of the proposed Fourth Loan and would use the bulk of Bank funds. New financieras aiming at becoming medium- and long-term oriented institutions and being accepted by the Bank could also participate. The following sections outline the organi- zation, operations, and prospects of CFN and COFIEC individually and of the new financieras as a group, including the way they may be accepted for parti- cipation (para 3.58). Finally the probable use of Bank funds is discussed. Corporacion Financiera Nacional 3.09 CFN, Ecuador's oldest and largest financiera is wholly owned by the government, but operates mainly with the private industrial sector of the economy. Although having considerable autonomy, its nine-member Board, seven of whom are Ministers of State, ensures that its policies and operations are in accordance with the Government's development strategy. 3.10 Management and staff. CFN is headed by a general manager, whose authority is further delegated to a deputy general manager and to departmental and divisional managers. Even at the fourth and fifth echelon, personnel is competent and morale is high. Because of its strong management, CFN has been able to absorb a doubling of assets in real terms since 1975 when the current structure was fixed, with only a 50% increase in professional employees (to 152). 3.11 Policies. CFN has conducted its operations in accordance with its Declaration of Policies and Procedures (Annex 3), but various weaknesses in the Declaration have come to light. The Declaration does not firmly limit CFN's total exposure (investment in shares plus loans and guarantees) to a single firm. As of December 31, 1977, CFN's exposure to a large sugar refinery in extreme difficulty, amounted to S/1,058.5 million, 88% of CFN's equity. Excessive exposure to this firm, now almost wholly owned by CFN, resulted from explicit direction from the government not to allow the firm to fall into bankruptcy. This event demonstrates that an outright limit on investments of this kind would not be a feasible form of protection for a public financial intermediary such as CFN, especially as CFN's recognized administrative competence makes it the logical choice to serve as the govern- ment's agency for investing in industry. Moreover, this kind of situation could arise in the future with several large government-sponsored enterprises in the steel, automotive, petrochemical, and cement subsectors (para. 1.19). Therefore, during loan negotiations, the Bank obtained agreement from CFN and the government that any loan, guarantee, or equity investment in a single  - 30 - firm, or group of related firms, whose combined amounts would result in CFN exceeding its normal exposure limit (not more than 20% of equity) or which fail to meet normal appraisal criteria of financial and economic viability would be made only through a mechanism that adequately protects CFN's equity. This mechanism would provide for complete separation of legal responsibility of funds, transactions, and risks from CFN's ordinary operations. By June 30, 1980, CFN would prepare a program for disposing of the sugar firm, and any other existing assets that result in excessive exposure. 3.12 Appraisal. CFN subjects all projects which it finances (including non-Bank financed ones) to a thorough appraisal covering technical, managerial, financial and economic aspects. Nevertheless, CFN has financed projects of doubtful financial prospects when the government strongly promoted the project. Careful economic analysis of projects is becoming more critical because high protection and tax incentives (paras. 1.11 and 1.12) can convert economic- ally inefficient projects into financially profitable ones. CFN recognizes that its appraisals, while comprehensive, occasionally have given insufficient attention to border prices in the calculation of the economic rate of return (ERR), and it is taking steps to strengthen subprojects' economic analysis and integrate it better with other aspects of appraisal. CFN also recognizes that appraisals of proposed equity investments need to include an explicit consider- ation of the marketability for those investments. In the light of these efforts to strengthen its appraisals, CFN would continue to calculate an ERR on all projects receiving more than US$500,000 equivalent from CFN or US$150,000 in Bank funds. 3.13 Supervision. Systematic follow up of its portfolio is a CFN strong point. Typically, CFN supervises each year about one half of its clients who are up-to-date with their payments. Clients who are in arrears are supervised several times per year. Supervision and appraisal are conducted by separate departments partly for internal control reasons. In the course of the Third Loan CFN prepared a supervision manual to guide the junior staff members assigned to routine supervision. Supervision of firms in which CFN has equity participation is done through representation on the firms' board of directors. 3.14 Disbursement and procurement. CFN enforces strict conditions for disbursement including carefully drawn up timetables for disbursements. Its policy is to make final commitment to the subproject rather late in the cycle attempting to avoid delays in disbursements. During execution of the Third Loan a manual was developed to further strengthen disbursement procedures. While relying mainly on the subborrower's self interest to ensure appropriate procurement decisions, CFN insists on the subborrower's examining alternatives and his decisions are checked for reasonableness of price and technical adequacy by engineers on CFN's staff. 3.15 Resources. Through 1977, roughly half of CFN's resources have come from long-term loans and equity (Annex 4, T-4). Of the former, all but a small fraction are foreign loans. CFN raises large amounts of domestic  - 31 - resources, 13% of the total, through tax exempt bonds repurchasable at sight. Like other financieras, CFN has been very much affected by the tight credit market in 1976-77 and was able to raise less in domestic resources than anticipated as BCE restrained their issuing bonds in order to reserve the market for its own and government bonds. Equity increases were also below projections. This has resulted in CFN's liability structure becoming progress- ively shorter term; in 1974-77 about two-thirds of its increment in total assets were financed with short-term liabilities. 3.16 Bank funds made available to CFN under their previous loan make up around 12% of its long-term foreign loans. CFN's component of the First Loan and a Fisheries Loan (555-EC) are fully disbursed and mostly repaid. CFN's US$9.4 million portion of the Second Loan is fully committed, the remainder is expected to be disbursed by March 31, 1979, the closing date. From effective- ness, in August 1977, through December 1978 CFN committed US$8.8 of the US$13.0 million available under the Third Loan and US$5.4 million have been disbursed. Full commitment is expected by April, 1979. 3.17 Operations. In the period 1975-1977 CFN maintained a rapid growth in total assets, increasing them by over 50% in real terms. Its most important lending activity is industrial lending, mostly long-term. In 1977 over half of CFN's assets were in this category. CFN's lending is spread among a large number of subsectors, but food products, textile and non-metallic minerals have received the largest proportions. About 60% of lending in 1977 was to firms located around the two major poles of economic activity, Quito and Guayaquil, but CFN's lending was less concentrated in those cities than was current indus- trial activity. In 1977 CFN made 97 industrial loans averaging around US$500,000 per loan. 3.18 Use of the Third Loan. CFN's distribution of Bank subloans by sector financed under the Third Loan (Annex 4, T-10) is similar to the distribution of non-bank financed subloans. For administrative reasons CFN prefers to minimize the number of Bank subloans and therefore tends to use Bank funds for its larger subprojects. In order to prevent undue concentration of Bank funds, CFN agreed it would not normally commit more than US$3.0 million of Bank funds to single firm, but the Bank waived this restriction in one case of a large textile project that had exhausted alternative sources of finance. This limit would be strengthened and extended to all participating financieras under the Fourth Loan (para. 4.06). As in the past, CFN has financed only about 1/4 of total subproject costs net of short-term working capital, so that US$8.8 million of Bank funds thus far committed have helped to finance more than US$34.0 million in investment. 3.19 Letters of credit and guarantees. Two of the fastest growing components of CFN's activity are letter of credit and guarantee operations. Their growth resulted from a decision in 1975 to offer these operations as a complement to and in strict connection with its long-term lending. These operations channel foreign short- and medium-term finance to CFN's client firms. In 1977 these two categories made up around 15% of CFN's assets (including contingencies).  - 32 - 3.20 Equity investments. In 1977 about 15% of CFN's assets were invested in equities of 47 firms of which 30 were in operation, 17 profitably. Aggre- gate profits of the profitable firms were slightly greater than the aggregate losses of the rest, but only two firms of the six in which CFN had invested more than US$1.0 million were operating profitably so that the portfolio as a whole was a considerable drag on profitability. These results reflect both the newness of several of the firms as well as some questionable investment decisions. In recognition of the doubtful quality of several of its invest- ments, notably the sugar refinery (para. 3.11) and a tuna fishing operation (now being liquidated), CFN wrote down the value of its equity portfolio by 14% in 1977. When the process of improving portfolio yield permits, CFN plans to issue a form of participation certificate to mobilize additional savings for investment in industrial equities. 3.21 Accounting practices and audit. CFN follows accounting practices accepted in Ecuador within the regulations of SB. These practices did not allow it to follow its agreement under the Third loan to write off foreign exchange losses arising from foreign borrowings as they occur. Rather, these losses are accumulated as a deferred charge, amortized over the life of the loan, thereby diluting the impact of these losses on profits. Although the appropriateness of this reporting practice would be studied by the CMC, with the likely assistance of SB, the Bank would accept under the Fourth Loan, the current Ecuadorian accounting practices. CFN's accounts are satisfactorily audited and no recent report has had any qualification. 3.22 Loan portfolio quality. Excepting the sugar firm, CFN's loan portfolio is satisfactory, reflecting good supervision, adequate guarantees and CFN's willingness to bring suit to recover its loans. Arrearage decreased from 29% of portfolio in December 1977 (most of which was the sugar firm) to 16% in December 1978. Exposure to firms in arrears more than 3 months was 30% of portfolio in December 1977 (the sugar firm making up 21% of portfolio). In light of the composition of CFN's portfolio, the obligation of CFN under the Third Loan to increase provisions for losses from 1.0% to 1.5% of portfolio by December 1978 was waived on the understanding that it would propose a new formula acceptable to the Bank and that an appropriate mechanism would be used for large, risky projects in the future (para. 3.11). 3.23 Profitability. The use of the new commission structure on long-term loans has led to an improvement in the profitability of CFN's loan portfolio. Nevertheless, the large amounts invested in the equity portfolio yielding only 5% held CFN's 1977 income as a percent of average total assets (ATA) to 8.9% considerably below the yield of the remaining portfolio, 9.6%. Administrative costs declined proportionally because of efficient management and economies of scale and reached 2.1% of ATA. Nevertheless, net income continued to decline (in relation to ATA) at 1.4% and the return on equity was only 6.5% in nominal terms, minus 5.2% in real terms, in line with results in recent years (Annex 5, Table 5). Preliminary estimates of 1978 operational results show a continuation of those trends with nominal return on equity dropping to 3.9% and the real return to minus 6.2%.  - 33 - 3.24 These unsatisfactory levels of net income would in the future be improved by the use of a mechanism for large government projects because low-yielding investments, promoted by the government, would not affect CFN's accounts. Profitability would also be improved by efforts to develop a control system to indicate which operations were or were not yielding adequate net income. CFN also needs to sustain its newly adopted policy of charging the maximum commissions allowed by JM. At negotiations, CFN confirmed its agreement to incorporate into its policy statement explicitly the goal of earning sufficient net income to at least maintain its equity in real terms. Adoption of this change in the policy statement would be a condition of disbursements to CFN. 3.25 Financial condition. CFN has continued to improve its budgeting and cash management procedures although in late 1977 it had to temporarily delay some disbursements for liquidity reasons. This arose because of a surge of redemptions of CFN bonds on which it has a contractual obligation to repurchase on demand. An increase in these bonds and other short-term borrowings has led to a progressive fall in the current ratio from 0.97 in 1975 to 0.71 and 0.78 in 1976 and 1977 respectively (Annex 4, Table 4). Nevertheless, CFN, like other financieras, would have access to BCE discounting in a liquidity emergency that could be caused by massive bond redemptions. 3.26 Rather more serious is CFN's exposure in 1978 to US$130.0 million in foreign exchange risk, expected to rise moderately again in 1979. This risk arises because of CFN's decision, due to the lack of alternative resources, to use large amounts of foreign funds even though under current regulations it cannot pass along the foreign exchange risk to final borrowers. The only foreign loans on which CFN bears no foreign exchange risk are Bank loans as the government accepts the risk on these resources. CFN has begun to use the system of guaranteeing foreign loans which effectively passes the risk to the borrower, but this system cannot provide long-term resources as can borrowing in its own name for relending. Therefore, as a priority matter (para. 2.29) the CMSU will study changes in regulations to permit domestic financial institutions to pass on the exchange risk of foreign borrowings. Until these changes occur, CFN is somewhat protected by the government's agreement under the Second and Third Loans to replace any reduction in capital resulting from exchange rate charges. Under the Fourth Loan the Government agreed to a stronger protection of CFN's exposure by which it would fully reimburse total foreign exchange losses according to the amortization schedules of the loans on which those losses occur. In addition CFN in agreement with the Bank would prepare a study by June 30, 1980 to establish reasonable limits for foreign exchange exposure and a program for reducing current exposure to within such limits. 3.27 Prospects. Disbursements for industrial loans, CFN's predominant line of activity, should increase by 7% p.a. in real terms in 1978 and by 8% p.a. in 1980 and 1981 as the political situation becomes clearer. Equity investments should be about 20% as large as loan disbursements (not including investments that might be carried out through the trust fund). According to the new equity investments strategy paper under discussion, CFN will increase efforts to assure itself of the long range financial soundness of its invest- ments. Because of the expected slow down in new loan and equity disbursements, CFN's long-term portfolio would increase only slowly in real terms even though expanding by about one-third in nominal terms.  - 34 - 3.28 As in the past, the bulk of CFN's resources will come from foreign loans and increase in equity. CFN estimates resource requirements of approx- imately US$190 million over the 1979-81 period. Of this total, a new govern- ment capital contribution (US$20.0 million expected in 1979) and retained earnings would provide about 23%. A US$30.0 million loan from IDB complemented by US$15 million of co-financing under that loan and US$16 million co-financing with the Bank's Third Loan (expected to be signed soon) would provide another 32%. The remaining gap would be filled by other foreign commercial bank lending, bond issues, and approximately US$18.0 million from the Fourth Loan. 3.29 Actions to be undertaken by CFN in connection with the Fourth Loan should lead to significant improvements in its financial performance. The use of a mechanism to protect CFN from large risky projects would lead both to a sounder portfolio and a better return on equity. Net income would also improve with the cumulative effect of the higher commissions on long-term lending that CFN began to apply in 1977. This result would be reinforced by the recent change in policy under which CFN now charges the maximum commissions permitted by Resolution 927-76. CFN's provisions for losses, already over 1.2%, of portfolio should remain adequate under a new formula satisfactory to the Bank of maintaining provisions in different proportions for different categories of assets within the portfolio. 3.30. The exposure of CFN to excessive foreign exchange risk would also be dealt with. Eventually, as a result of a CMSU study and subsequent action by the monetary authorities, CFN and other financial institutions could be able to pass on to final borrowers the foreign exchange risk of foreign borrowings. Moreover, on the basis of a study, CFN would undertake a program, in agreement with the Bank, to reduce, after 1979, foreign borrowings on which it does not have an exchange risk guarantee from the government. In the interim, the government has strengthened its agreement to compensate CFN for foreign exchange losses. Improvements in the capital market should also permit CFN to decrease the importance of its bonds with a repurchase guarantee, thereby reducing a source of liquidity risk. 3.31 As a result of these actions, CFN would be able to increase its leverage substantially, which could be desirable in order to further improve its return on equity. CFN's projections do not show the need at this time for an increase in the debt to equity ratio above the 6:1 agreed with the Bank under the Third Loan. Nevertheless, in light of some uncertainty about the size and timing of future capital contributions, CFN will be permitted to increase its debt to equity ratio to 8:1 immediately. If needed, and as CFN is successful in reducing its foreign exchange exposure and in substituting bonds without a repurchase guarantee to those with the guarantee, CFN would be able to further increase its debt to equity ratio to the legal limit, 10:1. COFIEC 3.32 Ownership and organization. COFIEC is one of the most widely held companies in Ecuador having over 400 shareholders. Its 15 member Board of Directors representing both local and foreign shareholders sets overall policy, but delegates to an executive committee power to approve loans up to  - 35 - S/18.0 million. Authorization of loans up to S/10.0 million and all day-to-day management responsibility resides with the President. Heading each of COFIEC's regional offices in Quito and Guayaquil is a Regional Manager. Central functions such as legal representation and treasury are located in Quito but report directly to the President. COFIEC has continued maturing institution- ally during the Third Loan and shows more clearly delineated responsibilities, separation of central administration from Quito regional functions and an improvement in the quality of staff who have grown in their jobs. Although decision making is still rather centralized, responsibilities are delegated much more now than in the past. COFIEC's entire organization has taken a new esprit, in a way symbolized by its move from unattractive quarters into handsome new buildings in both Guayaquil and Quito. 3.33 Total staff has continued to grow rapidly but mainly in support positions; professional staff has increased little. COFIEC has carried out continuous upgrading of its employees and has sent them to courses in Venezuela, Mexico, and the Bank's Economic Development Institute. This has helped to strengthen term lending operations and project appraisal, althiough more training in these areas still needs to be done to enable the Guayaquil office to engage more heavily in term lending. 3.34 Policy statement. COFIEC conducts its operations within the frame- work of its Policy Statement (Annex 3). The Statement sets the limits on the exposure to a single borrower at the legal maximum, 25% of equity and prohibits COFIEC from taking any foreign exchange risk in its foreign borrowing. Although making progress, COFIEC has not yet been able to bring its short- and medium-term operations within the limit of four times equity as its Policy specifies (para. 3.48). A new agreement reached at negotiations limits aggregate investment in, and lending to, firms controlled by COFIEC's principal stockholders to no more than 200% of equity in line with a similar restriction on the new financieras. Adoption of a modified Policy Statement reflecting this limit would be a condition of disbursements to COFIEC. 3.35 Appraisal. Subprojects submitted for approval under the Third Loan show improved and thoroughly satisfactory appraisals. By agreement that will be continued under the Fourth Loan COFIEC calculates the ERR as part of their appraisal on all projects receiving more than US$500,000 equivalent or more than US$150,000 in Bank funds. Even the few Bank-financed subprojects handled by the Guayaquil staff were adequately appraised--a considerable improvement over the past. The improvement in appraisal quality is a reflec- tion of the training program for its staff that COFIEC has undertaken. 3.36 Supervision. COFIEC combines supervision and lending in the same administrative unit. Always devoting considerable and effective supervision efforts toward clients in arrears, COFIEC has recently become more systematic in its supervision of other clients as a result of a program agreed with the Bank. In 1977 COFIEC conducted a full or partial supervision of about one half of its clients not in arrears and virtually all of those in arrears. It maintains more informal contact with all borrowers at regular intervals.  - 36 - 3.37 Disbursement and procurement. Procedures for disbursement and procurement remain adequate. COFIEC relies on the sub-borrowers' self-interest in obtaining the most adequate and economical machinery and equipment for the subprojects it finances. These judgements, however, are reviewed by COFIEC's staff who also ensure that the sub-borrower has canvassed alternatives. 3.38 Resources. COFIEC's medium- and long-term resource availability was considerably below expectations. Both bonds outstanding and long-term loans fell almost 50% short of projections for 1977. The failure to obtain long-term loans resulted mainly from the government's decision not to guarantee a cofinancing loan for the private financieras and to delays in the effective- ness of the Third Loan. The shortfall in bond sales was due to increased competition from public sector bonds issued to finance the government deficit and from monetary stabilization bonds. Short-term funds from foreign commercial banks for letters of credit and acceptances were used less than expected in 1977 as COFIEC attempted to lengthen maturities of its operations. Increases in equity out of retained earnings were about on target. To maintain growth and profitability COFIEC resorted to guarantees of medium-term loans of foreign commercial banks to its clients. Recently, it has some success in obtaining longer terms for these guarantees, up to 5 years, which in the past had been almost exclusively of less than one year. 3.39 Operations. The growth of the nominal value of COFIEC's portfolio has been roughly in line with expectations but because of more rapid inflation, real growth was lower. Since 1974 COFIEC's portfolio has increased 10.4% p.a. in real terms, although growth slowed down after 1976, when the last increase in fresh capital from stockholders took place. Reflecting the difficulty in obtaining term resources, the real value of COFIEC's loan and equity portfolio hardly increased, although the use of COFIEC's own resources for long instead of short-term loans, encouraged by the new structure of commissions (para. 2.26), led to some lengthening of its average maturity. In the future, as the CMSU is successful in stimulating reforms in the Ecuadorian capital market that makes it easier for financieras to raise long-term funds, COFIEC should have less dificulty in maintaining a basic orientation toward long-term lending. 3.40 The sectoral distribution of COFIEC's portfolio remained quite stable with manufacturing receiving about 60% and agriculture 15% while the remaining 25% went to other sectors as in the past. Use of funds under the first three Bank loans followed the pattern of manufacturing and tourism activities financed with other resources. COFIEC's US$10.0 million allocation under the Third Loan was committed within 8 months of loan effectiveness for 11 manufac- turing projects. Four of the sub-borrowers using 44% of total commitments were new firms, a high percentage, but typical of COFIEC's use of previous loans. Because of a lack of adequate incentive for manufactured exports only 20% of subloan amounts went to exporting or mixed exporting-import substituting projects. COFIEC's efforts to decentralize credit led to about 1/3 of its subloans amounts going to projects located outside of the established poles of economic activity, Quito and Guayaquil (see Annex 4, Table 10). 3.41 Accounting practices and audit. COFIEC maintains its accounts in accordance with practices generally accepted in Ecuador within the regulations set down by SB. These practices allow for counting stock dividends as income and COFIEC does so rather than follow more conservative practices (as does CEN) of recognizing only cash dividends. CMSU would examine this lack of  - 37 - uniformity in treatment and recommend a single standard for all financieras (Annex 1). COFIEC's accounts are satisfactorily audited and recent reports have had no significant qualification. 3.42 Portfolio quality. At December 31, 1977 arrears were only 3.5% of total portfolio, a smaller proportion than earlier years, and a smaller propor- tion than most financial institutions in Ecuador. Portfolio affected by arrears of more than three months was only 6.5%. In general, the portfolio has improved considerably. Under the Third Loan COFIEC agreed to maintain net provisions for losses (net of an amount of recognized losses not yet written off), equal to 0.8% of portfolio by December 1978, but met this target earlier. 3.43 Profitability. Continuation of high rates of inflation has made it difficult for COFIEC to earn an adequate real return on invested capital. The nominal rate of return on equity over the last four years was 16.8%, but the real return was only 4.5%, far below the opportunity cost of capital in Ecuador and less than COFIEC's clients typically earned on investment projects. A gradually falling gross spread resulting from a faster rise in interest cost than interest income and constant administrative costs and taxes as a percent of ATA led to a proportional decline in net income (Annex 5, Table 7). The new higher commissions on long-term loans had hardly any effect on total profitability by 1977 but are beginning to have an impact in 1978 as COFIEC has increased new long-term operations, and should eventually lead to an improvement in profitability. 3.44 Financial condition. COFIEC's management of its liquidity and cash budgeting have improved considerably after the establishment of a central treasury. A well trained new treasurer instituted a number of modern cash control procedures that have resulted in more effective use of liquidity. Although moderately reducing its current ratio from 1.4 in 1976 to 1.3 in 1978 (Annex 4, Table 6), COFIEC is now able to maintain consistently its desired levels of compensating balances on its foreign credit lines. The debt to equity ratio has increased but is not inherently excessive (para. 3.47). 3.45 Prospects. COFIEC's management expects for the next three years a higher growth rate (31.9% p.a.) of total loan portfolio than the rate (12.7% p.a.) of the 1975-1978 period. Despite this high expected growth of total loan portfolio, the growth of total assets and guarantees wQuld be lower (15.4% p.a.) than in the past (27.9% p.a.), mainly due to a slower growth in equity investments (2.8%) and guarantees (6.4%). The high growth rate of total lending operations is based on the assumption that in the past increases in total loans were constrained by the lack of long-term resources--a constraint now to be relate under the Fourth Loan. Considering uncertain demand and a slowdown in economic growth, however, it is likely that loan increases would be lower than expected. In addition, competition from new financieras may also prevent COFIEC from attaining its targets. Although the growth of long- term loan portfolio is expected to be 50% higher in 1980 and 1981 than in the 1975-1978 period, in 1979 only short-term loans would be substantially increased due to the scarcity of long-term resources. 1/ 1/ A new law authorizing financieras to engage in machinery and equipment leasing should open up new opportunities for COFIEC and other financieras.  - 38 - 3.46 Despite COFIEC's efforts to obtain alternative long-term resources, partially due to capital market conditions, the Bank remains COFIEC's major source for long-term financing. In 1978 loans from the Bank were almost half of long-term liabilities. COFIEC's management is expected to increase Bank long-term funds up to almost two-thirds of total long-term liabili- ties. The incentive-allocation mechanism (para. 3.61) would encourage further increases of alternative domestic resources, mainly bonds. This mechanism could help to sustain the growth rate of bond issues at the 41% p.a. rate of the 1975-1978 period. Equity is expected to grow at a slower pace (17% p.a.) than in the past (23.3% p.a.) because substantial capital increases are not foreseen. The incentive-allocation mechanism would also encourage COFIEC to increase its capital. Secondary sources of credit for financing industry would be Eximbank funds and financial certificates to be issued in the future. For short-term operations COFIEC would continue to rely on commercial bank loans, including letters of credit and guarantees financed by foreign banks. 3.47 In 1978 the debt-equity ratio of COFIEC reached 9.4:1 above the ratio of 8:1 agreed with the Bank during the Third Loan and it is expected that it would remain around the same level for the next three years. 1/ COFIEC met the target for increasing its provisions for losses and is expected to have no trouble in maintaining these at 1% of its portfolio. Considering that COFIEC has become a mature, sound, and well-managed institution, an increase to a 10:1 debt-equity ratio, the ratio allowed by law and considerably less than banks are allowed, would not significantly increase the riskiness of the institution. In addition, a higher leverage could also help to increase COFIEC's profitability (16% return on average equity in 1977) allowing it to attract additional capital increases and therefore making available resources for long-term financing. Agreement on the 10:1 debt-to-equity ratio and maintenance of net provisions for losses at 1% of portfolio was reached at negotiations. 3.48 COFIEC also agreed under the Third Loan to limit its short- and medium-term operations to four times equity, but, in spite of considerable efforts and as a result of the scarcity of long-term resources, the demand for short-term financing, availability of foreign lines of credit, the margin for guarantees, and competition from new financieras, COFIEC's ratio of short- and medium-term operations to equity was in December 1978 at 5.3:1. In the next three years COFIEC estimates that it would not be able to reduce this ratio. The purpose of this limit to increase COFIEC's orientation towards long-term financing was partially fulfilled but keeping within the limit turned out not to be feasible in the recent Ecuadorian context. Considering the many limita- tions of the Ecuadorian capital market, the limit on short-term operations has been revised. First, this limit is related to total portfolio rather than to equity. Second, the measure focuses on limiting the short-term operations as medium-term financing is a necessary component of many projects and should therefore be encouraged. Third, the limit has to be applied flexibly enough to take into account the constraints in the financial market. 1/ Under the Third Loan, COFIEC's debt-to-equity ratio could be increased to 10:1 under certain conditions which COFIEC was not able to fully meet due to constraints outside its control.  - 39 - Furthermore, COFIEC's policy should be flexible enough to allow it to respond to the demand of its clients who could seek the services of other financial institutions. COFIEC needs to provide a mixture of services (short, medium and long term), in particular to its clients in order to keep its segment of the market. Based on these considerations, agreement was reached at negotia- tions that COFIEC would limit its outstanding short-term operations (loans, acceptances, refinanced letters of credit and guarantees with a maturity below 3 years) to 50% of its total portfolio, including guarantees by the end of 1979 and to 40% by the end of 1980 and thereafter. New financieras 3.49 Ownership and sponsorship. The six new financieras that could participate in the proposed Fourth Loan (para 3.58) draw their sponsoring groups from various segments of the Ecuadorian society. Three are notably regional groups, two from Guayaquil, one from Cuenca, the third city of Ecuador. One of the two larger new financieras is sponsored by a commercial bank although through minority shareholdings; the other is supported by groups of Quito and Guayaquil businessmen not hereto associated with the financial sector. One of the newer financiera's shareholders come from among entre- preneurs with trading ties to Spain. Several have foreign shareholders but all are majority owned by Ecuadorians. CFN has minority shareholdings in four of the six. 3.50 All six new financieras are organized on conventional lines, roughly modelled on COFIEC, with a Board of Directors, Executive Committee and a strong President or General Manager in charge of administration. Because the staffs are small, administrative procedures are somewhat informal but all show a basic bifurcation of functions into a "credit" department in charge of promoting, evaluation and supervising loans and an "operations" department covering accounting, loan administration, disbursements and resource mobilization and short-term operations in general. All have drawn management, staff, or both from CFN and even more from COFIEC as well as from Citibank and international organizations such as IDB and CAF. Staff have also been recruited from university faculties and commercial banks. In general, the quality of the managements and staffs are good with one or two exceptions where low salaries may be a problem. One of these financieras, however, is soon to undergo a change of management which can be expected to take steps to obtain adequately qualified professionals. 3.51 Policy statements. Statements of policy are found only in the financieras' Statutes and consequently are quite broad. None provide for any restriction on exposure to a single client other than the legal maximum of 25% of equity. None of the new financieras have any foreign exchange exposure, but a formal prohibition on any significant exposure would be established. New financieras would agree to limit the aggregate of investments in, and lending to, firms controlled by the financieras' principal shareholders to no more than 200% of equity. Adoption of a Policy Statement satisfactory to the Bank including these two limits would be a condition of disbursement to any new financiera.  - 40 - 3.52 Appraisal and supervision. All of the new financieras have staff members with some exposure to long-term lending and project evaluation although some institutions are much stronger than others in this respect. All partici- pating new financieras would calculate an ERR on all subprojects using more than US$150,000 in Bank funds or more than US$500,000 in other medium- and long-term funds. Reviewing subprojects would allow the Bank to help the new financieras to apply proper project appraisal techniques. To this end the first two subprojects from each new financiera and any subproject requiring more than US$250,000 in Bank funds would require Bank approval. CFN has also entered an understanding with the Bank to give assistance in subproject appraisal to any new financiera that requests it. 3.53 The new financieras are also aware of the need to maintain close contact with clients after the loan is disbursed and have established suitable procedures for following up on their current short- and medium-term lending. As a condition of participation in the Fourth Loan, a new financiera would have to satisfy the Bank that modifications needed for supervision of long-term lending would be introduced and that the new financiera would use appropriate procurement practices at a minimum for Bank-financed subprojects but in the longer run on all projects. Control of disbursements is adequate. 3.54 Resources and operations. Thus far, because of their recent emergence, the new financieras have operated only with equity resources and short- and medium-term foreign commercial bank lines of credit. The amount of equity they have attracted is notable, however. By December 1977 their combined equity totaled US$16.7 million, slightly exceeding that of COFIEC. Foreign short- and medium-term resources totaled almost US$60.0 million equivalent, also in excess of COFIEC's (Annex 4, Table 8). Financiera de Guayaquil had begun to use BCE rediscount lines actively and had signed a subsidiary loan agreement to use Bank livestock loans. 3.55 This resource mix has determined the pattern of operations in which the new financieras have engaged. Most lending is on short- and medium term; 80% of loan amounts are due within one year. Foreign bank credit lines are used for opening letters of credit and for guaranteeing short- and medium-term loans. The exception to this pattern is Financiera del Austro which has made several long-term loans with its equity and, for lack of resources and demand, has engaged in fewer letters of credit and guarantee operations. As a condition of participation in the Fourth Loan, each new financiera would agree on a program to progressively limit their short-term operations. This program would be reinforced by the incentive-allocation mechanism for Bank funds (para. 3.61) and by reforms of the Capital Market, which would orient finan- cieras to increase medium- and long-term operations (para. 2.28, Annex 1). 3.56 Within the constraints imposed by resource availability, each new financiera has a somewhat different orientation. Financiera del Austro as its name implies intends to specialize in lending to the southern provinces around its home city of Cuenca. Financiera de Guayaquil will concentrate on the Costa region and will therefore dedicate a fairly high proportion, but less than half, of its activities to agriculture and livestock raising. Ecuatoriana de Financiamiento, on the other hand, will finance exclusively manufacturing aiming mainly at the Guayaquil market. The three remaining financieras are based in Quito. The newest of the six, Financiera Andina, has not yet settled upon a strategy but the background of its management, drawn largely from CFN,  - 41 - would indicate plans for an aggressive and much larger financiera. Promoting trade with Spain and financing agroindustry and food processing are to be the focuses of Financiera Iberoamericana. Financiera Nacional, the largest and oldest of the six, aims at a balance between Quito and Guayaquil with some operations in other regions as well. Its objectives are closest to those of COFIEC with which it expects to engage in head-to-head competition. These differences in location and orientation have incorporated additional customers into the financieras' market. 3.57 Financial condition. Good management, close oversight by SB and their very newness has resulted in an absence of financial problems for the new financieras. Loans in arrears are a negligible percentage of their portfolios. The high percentage of short-term operations which are easier to collect is also a factor in this good portfolio quality. Some financieras have begun the practice of making explicit provisions for losses. Others, while recognizing the need to make provisions for losses eventually, reasonably prefer to capitalize them in order to postpone writing off provisions against profits during the first three years when profits are not taxable. Even the financieras in full operation have maintained fairly high liquidity while some of the newer ones are still holding a substantial portion of their equity liquid while they start to operate. The three larger financieras, Ecuatoriana de Financiamento, Financiera Guayaquil, and Financiera Nacional have increased their leverage fairly rapidly but are still within the legal maximum of 10:1, a limit that is more restrictive than in many other Latin American countries. Of the new financieras in operation by 1977, all appear to be adequately profitable with the exception of Financiera del Austro whose lack of debt resources and low leverage have not permitted it to spread administrative costs over a large enough volume of operations, resulting in a negative real (although positive nominal) rate of return. Financiera del Austro's low profitability, however, is being corrected by growth in operations. The Bank would receive periodic information on the financial condition of each new financiera to enable it to monitor the financiera's progress and detect any problems that might develop. 3.58 Procedures for Participation. Under the proposed Fourth Loan a two-stage procedure for participation by new financieras would be estab- lished. First, to be eligible for a review by the Bank in order to be considered for participation, a new financiera would have to meet the following conditions: (i) a paid-in capital of US$2.0 million equivalent; (ii) a portfolio containing at least five medium- and long-term operations; and (iii) a debt-to-equity ratio of no more than 7:1 I/ Second, the Bank would review the eligible new financieras in order to evaluate the following points: 1/ A financiera showing the ability and a strong interest in orienting itself to medium- and long-term operations could be reviewed ever if it were in excess of this limit.  - 42 - (i) the financial and economic condition of the finance; (ii) the adequacy of its management, staff and administrative procedures for medium and long-term operation; (iii) its prospective capacity to prepare, evaluate and supervise investment projects; (iv) the experience of the financiera in the limited participation under the Third Loan; and (v) the ability and willingness of the financiera to enter into and carry out a program to progressively orient its operations toward medium- and long-term lending and investment. Eligible new financieras would be reviewed not later than June 30, 1980 and additional reviews, if needed, would be conducted during regular supervision missions. When found acceptable a new financiera would have access to Bank funds upon effectiveness of its Project Agreement with the Bank along the same line as those of CFN and COFIEC. Three or four new financieras may participate under this arrangement. D. Use of the Loan 3.59 The Fourth Loan of US$40.0 million would be used to fill part of a financing gap remaining after considering identified long-term resources of the eight financieras over the three-year period 1979-1981 estimated at US$56.5 million (Table 14). The expected financing needs are based on preliminary estimates presented by the financieras that were adjusted because of several factors. First, the estimates of both CFN and COFIEC did not fully reflect the uncertainty in demand for industrial investment and credit resulting from the current fluid political situation. Second, CFN's estimates did not take into account the use of a mechanism for large, risky projects. Third, the new financieras each tended to estimate a continuation of the high growth rates in operations of their initial year or two. I'aking account of competition between them and with the established financieras, much slower growth than they esti- mated seems likely even though they may reasonably expect to outperform the two older financieras in percentage terms. Finally, the financieras' projec- tions did not reflect the additional mobilization of long-term resources that should result from the incentives offered by the mechanism for distri- bution of bank funds (para. 3.61). 3.60 Allowing for these adjustments, the eight financieras would make use of US$164.9 million in long-term funds over the three-year period 1979-1981. This would imply an aggregate growth in long-term loans of 15% p.a. (around 4.0% p.a. in real terms assuming an inflat:Lon rate of 11% p.a.) which seems reasonable in the light both of their own processing capacity and of the growth of industrial investment, even allowing for some decline in the high growth rate of the immediate past (para. 1.05). Over the three-year period, 40% of funds would come from domestic sources and 60% from foreign sources. Of the former, equity would provide US$28.0 million, and bonds, US$7.4 million.  - 43 - Foreign loans would include US$30.0 million from IDB, US$16.0 million of cofinancing originally negotiated in connection with the Third Loan, US$15.0 million of cofinancing associated with IDB loan, and the US$12.0 million undisbursed portion of the Third Loan. The remaining financing needs would be partially filled by the Fourth Loan of US$40.0 million and additional domestic resources to be mobilized as a result of the incentive-allocation mechanism for the Fourth Loan. 3.61 In order to stimulate the financieras to mobilize and lend long-term resources, Bank funds would be distributed in proportion to the financieras' mobilization of domestic medium- and long-term resources and the efficiency with which they process subprojects to be financed under the Fourth Loan. 1/ This mechanism would determine a maximum amount, or quota, of Bank funds that financieras could use which will vary over time as the financieras draw it down through commitments of Bank funds or build it up by further mobilization. Table 15 indicates the proportions of World Bank funds that financieras would be allowed to use based on each one of those resources mobilized after December 31, 1978. It is to be noted that a financiera's resource mobilization establishes only a maximum amount that it can use; how much it actually uses depends upon its efficiency in identifying, preparing and processing subprojects. In order to stimulate efficient subproject processing, the aggregate maximum quota is set slightly higher (US$43.4 million) than the proposed loan amount. Based on past experience and the availability of other resources, CFN may be expected to use about US$18 million, COFIEC on the other hand would use around US$14 million. The new financieras may find difficulty in using more than some US$8.0 million as they will be in the midst of establishing new appraisal procedures (Table 16). The use of this incentive-allocation mechanism would therefore result in the financieras mobilizing around four dollars in domestic medium- and long-term resources for each five dollars of the Fourth Loan. 1/ The principle of allocating Bank funds in proportion to other long-term operations of the financieras was endorsed by the recent PPA of the First and Second Loans.  - 44 - Table 14: GAP ANALYSIS a/ (S/million) 1979 1980 1981 Total Long-term industrial financiera loans 911.0 1,079.0 1,274.5 3,264.5 Equity investments 318.5 283.7 255.8 858.0 Long-term loans and equity investments 1,229.5 1,362.7 1,530.3 4,122.5 Long-term resources 1,193.5 782.0 734.5 3,210.0 Gap to be financed (36.0) 580.7 795.8 1,412.5 US$56.5 Financing of the gap: - Fourth Loan US$40.0 - Additional mobilization of resources due to incentives (See Table 15) US$13.8 - Other US$ 2.7 a/ Net of amortization of loans  -45- Table 15: INCENTIVE-ALLOCATION MECHANISM FOR DISTRIBUTING FOURTH LOAN FUNDS (S/million) Expected quota Maximum quota based on origi- Additional Original a/ Proport- b/of Bank funds nal estimates mobilization financieras ionality based on origi- plus additional of resources Resources estimates factor nal estimates mobilization due to incentives Bonds c/ 185 2/1 370 570 100 Equity 700 1/2 350 430 160 Domestic long- term industrial loans - 1/1 - 85 85 TOTAL 885 - 720 1085 345 US$43.4 US$13.8 a/ Estimates of increments of promoted resources from December 31, 1978 to December 31, 1981. bl/ Number of Fourth Loan dollars for each dollar of other promoted resources. c/ Without legal obligation to repurchase on demand. Table 16: EXPECTED DISTRIBUTION OF FOURTH LOAN BY FINANCIERA Financiera S/million .1S$million CFN 450.0 18.0 COFIEC 350.0 14.0 New financieras 200.0 8.0 TOTAL 1000.0 40.0  - 46 - IV. THE LOAN A. Borrower and Terms 4.01 The proposed loan of US$40.0 million to be granted to the Republic of Ecuador would be channelled through the BCE as the government's fiscal agent, to CFN, COFIEC and new financieras who become eligible. BCE would act on the government's behalf in handling disbursements to, and repayments of, the participating financieras. Bank funds would be made available to qualifying industrial enterprises, privately or publicly owned, for financing direct foreign exchange costs of investment in fixed assets or associated permanent working capital, through either loans or equity investments. The proposed loan would be repayable within 15 years on a composite amortization basis including three years of grace. The terminal date for submission of sub- projects would be June 30, 1982 and the closing date for disbursements, June 30, 1983, after which the Ministry of Finance would prepare an evaluation of the project. B. Allocation 4.02 The proposed loan would be,allocated to the respective financieras on a first-come, first-served basis up to the maximum amount of funds each financiera could commit in proportion to its mobilization of domestic resources (para. 3.61). Whenever the Bank deems necessary but before allowing commitment of more than one half of the loan amount, or before December 31, 1980, the Bank and Borrower would review the allocation mechanism to ensure that its basic purpose--to give all eligible financieras fair access to Bank funds, while encouraging them to mobilize other medium- and long-term resources--was being achieved. Any needed adjustment would be made by the Bank after exchan- ging views with the Borrower. C. Free Limits, Economic Rate of Return 4.03 The following free limits were agreed to assure Bank review of a reasonable portion of subprojects from each institution and to afford the Bank opportunity to conduct a dialogue with the new financieras concerning appraisal techniques.  - 47 - Free Limits (US$ millions) Financiera CFN 1.50 COFIEC 1.25 New financieras 0.25 (after the first two subprojects of each new financiera) An economic rate of return would be calculated on all subprojects receiving more than US$150,000 in Bank funds or more than US$500,000 in other medium- and long-term funds. Although no minimum cut-off point for the ERR has been estab- lished, the Bank would continue to review the adequacy of ERR calculations, including those calculated on free-limit subprojects and would ask for a more detailed economic justification of any subproject with an ERR of less than 10%-12%. D. Interest Rates 4.04 Interest rates would be governed by the current legal maximum of 12% plus commissions of 2-4% p.a. authorized by JM Resolution 927-76. Thus, the maximum rate on subloans would be 14-16% p.a. depending on their maturity. These interest rates and commissions could be altered only after a study by the CMC and with the Bank's concurrence. On this basis, the typical loan with original final maturity of more than 8 years would bear interest of 16% p.a. and the average interest rate on all subloans would be around 15.5% p.a. Even at the inflation rate over the past three years of 11.7% and even more at the expected rate of inflation in 1979-82 of around 11% p.a., the proposed interest rates would be significantly positive in real terms. E. Fee for Foreign Exchange Risk 4.05 Based on the perceived risks of fluctuations among the currencies the Bank disburses the Government of Ecuador, through the BCE, would charge a fee of 2.3% p.a. for accepting the risk of borrowing in the Bank's basket of currencies at 7.9% p.a. and relending to the financieras in Sucres at 10.7% p.a., including a 0.50% p.a. administration fee for BCE. The proceeds from the exchange risk fee and all foreign exchange gains and losses would be handled through a special account in BCE to determine the adequacy of the fee. The proposed interest rate and foreign exchange risk fee would give the financieras spreads of 3.3-5.3% p.a. on Bank funds which is reasonable in the light of the lower spreads on complementary, domestically mobilized resources and the erosive effect on equity of continued inflation.  - 48 - F. Subloans 4.06 The financieras would set subloan conditions according to the financial requirements of the individual subprojects but all subloans would provide for maturities of no more than 15 years and for grace periods of no more than 3 years. Furthermore, to prevent undue concentration of Bank funds in a few firms, no firm or group of related firms would be able to borrow more than US$3.0 million under the Fourth Loan or have outstanding more than US$5.0 million under this and any previous Bank Loan. G. Disbursement and Procurement 4.07 Procedures for disbursement and procurement would be according to standard practice for previous Bank Loans. Disbursements would be made for 100% of the direct foreign exchange costs of the financieras' subloans.and would be fully documented. Loan documentation would establish clearly the obligation of BCE when dealing with the financieras to make all conversions between Sucres and the currencies disbursed by the'Bank at the rates of exchange that fully protect the financieras from the exchange risk on Bank funds. H. Project Benefits and Risks 4.08 A prime benefit of this project is the establishment of the CMSU to study and propose reforms of the Ecuadorean capital market. C2MSU would be the focus for Bank dialogue with Ecuadorian authorities on capital market issues and should lead to long range benefits. Ecuador has an extraordinary savings potential for its income level and stage of development; to the extent reforms based on CMSU studies are successful in enabling the financieras to mobilize these savings and channel them to efficient projects, the overall efficiency of investment would be enhanced. Furthermore, granting access to Bank funds in proportion to other long-term resources mobilized would give the financieras additional incentive to engage in this necessary task. Likewise the partici- pation of the new financieras should lead to a dispersion of Bank funds to a larger group of firms and in time should increase the absorptive capacity of Ecuador for long-term lending. The risks in this venture are those inherent in creating any new organization particularly those related to management and staffing of the CMSU. For this reason, formally establishing the CMSU was made a condition of Board presentation. 4.09 An additional benefit of the project would be the establishment of a mechanism to protect CFN from the risks of managing, on its own account, a series of large, government-sponsored projects that would involve it in excessive exposure, or that would not meet normal appraisal criteria. The use of an appropriate mechanism for this type of project would allow the government to make use of CFN's unique financial and administrative abilities in carrying out these projects while enabling CFN to maintain its currently sound financial condition.  - 49 - 4.10 The economic benefits of the proposed project would be similar to those of the three previous Bank Loans. Approximately 80 subprojects with an average use of Bank funds of around US$500,000 each would be financed (a substantial increase in number due to the inclusion of the new, smaller financieras) which would have an ERR of over 20% (para. 3.03). 1/ Most subprojects continue to be in the resource-based food, beverage, textile, and forest products subsectors. Although few subprojects would directly create sufficient jobs to meet the UPP guideline for Ecuador, they would create employment through both backward and forward linkages. Based on experience, Bank funds would be used to help finance around US$160 million in total investment. 1/ See Annex 4, Table 10 for ERR's of Third Loan subprojects.  - 50 - V. AGREEMENTS AND RECOMMENDATIONS Agreements 5.01 During negotiations, agreements were reached or confirmed on the following: (a) With the Government, on: (i) the use of a mechanism to protect CFN when financing large, risky projects (para. 3.11); (ii) full reimbursement of CFN's L-uture foreign exchange losses (para. 3.26 and 3.30); (iii) maintenance of interest rates and commissions (para. 4.04); (iv) fee to be charged through BCE for absorbing the foreign exchange risk (para. 4.05); (v) final evaluation of Fourth Loan (para. 4.01); (vi) procedure for participation by new financieras (para. 3.58); and (vii) other terms and conditions of the Fourth Loan (para. 4.01 to 4.10). (b) With BCE on a program of studies for CMSU (para. 2.29 and Annex 1). (c) With the Government, CFN, and COFIEC on: mechanism for allocation of funds including review thereof (paras. 3.61 and 4.02); (d) With CFN and COFIEC on: (i) new limits on debt-to-equity ratios (paras. 3.31 and 3.47); (ii) free limits and calculation of ERR (para. 4.03); and (iii) provisions for losses (paras. 3.22, 3.29 and 3.47). (e) With CFN, on: (i) incorporation in its policy statement of a net income objective (para 3.24); (ii) preparation of a program to dispose of existing assets that represent excessive exposure (para. 3.11); and  - 51 - (iii) preparation of a study to determine maximum exposure to foreign exchange risk and of a program of implementation thereof (para. 3.26 and 3.30). (f) With COFIEC, on: (i) limitation on short-term operations (para. 3.48); (ii) incorporation into its policy statement of a prohibition on excessive exposure to stockholders (para. 3.34). 5.02 The following would be conditions of Loan effectiveness: (a) Signing of a Fiscal Administration Agreement, satisfactory to the Bank, between the Borrower and BCE; and (b) Signing of Subsidiary Loan Agreements, satisfactory to the Bank, between the Government and BCE, and between BCE and either CNF or COFIEC. 5.03 The following would be conditions of disbursement: (a) to CFN: adoption of modifications to its policy statement (para 3.24); (b) to COFIEC: adoption of modifications to its policy statement (paras. 3.34 and 3.48); (c) to any new financiera: (i) signing of its Project Agreement with the Bank and its Subsidiary Loan Agreement with BCE; and (ii) adoption of a Policy Statement satisfactory to the Bank (para. 3.51). Recommendation 5.04 With the above agreements, the proposed project would constitute a suitable basis for a Bank loan of US$40.0 million to the Republic of Ecuador on the terms and conditions listed in Chapter IV.  - 52 - ANNEX 1 ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT BANCO CENTRAL DEL E;CUADOR Capital Market Study Unit - Program of Studies DRAFT The Banco Central del Ecuador, (EBCE) in order to promote the development of the Ecuadorian capital market will establish a Capital Market Study Unit (CMSU) appropriately staffed and qualified to carry out studies leading toward reforms of laws, regulations and practices concerning financial markets. Regarding the Fourth Development Banking Project the CMSU will carry out the following specific studies, according to the schedule indicated below: No. Subject Completion Date Desirability of further liberalization of December, 1979 ceilings on interest rates and commissions with the purpose of increasing saving inter- mediation and therefore improving the efficiency of allocating resources, encouraging borrowing and lending long-term resources, in particular of domestic resources. 2 Denomination and recognition of financial December, 1979 obligations in foreign currencies, allowing financial institutions dealing in foreign currencies to directly transfer foreign exchange risk to final borrowers. This could reduce the volume of guarantees that financial institutions are performing and probably could reduce administrative costs of these loans which ultimately are paid by the ultimate borrower. The transferability of the foreign exchange risk however should be in parallel to the liberalization of domestic rates for increasing competition, intermediation and yields of domestic funds vis a vis foreign funds. The study should also include recommendations about the maximum foreign exchange risk that financial institutions could be allowed to undertake as a policy decision of the institution itself attending to the nature of its operations, efficiency for serving its customers and the risk acceptable to the owners of the institution.  - 53 - ANNEX 1 No. Sublect Completion Date 3. Examination of the role and scope of different June, 1980 financial institutions operating in the Ecuadorian financial system, in particular of financieras and the securities exchanges. The study should basically recommend either a specialization of functions by each type of institution or that a single type of institution be allowed to perform all financial services. Based on the final outcome of the study appropriate related regulations should be recommended allowing either specialized or general institutions to have an equal footing to fairly compete for avail- able resources and operations. The study should also include a re-examination of public financial institutions and their compliance with the same regulations, practices and authorities as those applied to private financial institutions. The role of the Central Bank in granting credit directly to the public should also be re-examined. In connection with this study, recommendations should be made regarding policies and procedures concerning supervision and control of financial institutions and operations. 4. The characteristics of the financial instruments and June, 1980 operations in the financial system of Ecuador should also be examined, including Government and Central Bank bonds and any other tax-exempt bonds, in order to promote mobilization of resources, and other financial operations. An analysis should focus specifically on the impact that tax-exempt bonds have on the financial market of the country. 5. Improvements in the statistical information December, 1980 regarding the financial system, in particular related to the following: - Accounting standards and practices of financial institutions. - Flow of funds accounts. - Information regarding securities outstanding and trading operations in the securities exchanges, including distributions by volume, amounts, maturities, yields and other characteristics of the financial instruments. - Reporting requirements from financial institutions and operations, including both borrowing and lending operations.  - 54 - ANNEX I CMSU staff will present to the respective authorities immediately after the completion date, of each study its conclusions and recommendations. Included in each study should be any proposed changes in regulations and a detailed programming for implementation of the recommendations after approval. CMSU will give the Bank opportunity to comment on those studies, including at the preparation stage, during realization and at the completion date. In order to assist CMSU in carrying out this program of studies, consultants and outside experts may be employed.  - 55 - ANNEX 2 ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT COMISION DE VALORES - CORPORACION FINANCIERA NACIONAL Declaration of Policies and Procedures (as amended through June 14, 1977) The Board of Directors of the Comision de Valores - Corporacion Financiera Nacional (the Corporation), by virtue of the powers conferred upon it by its enabling legislation, establishes the following policies and procedures which will guide the financial activities and investments of the Corporation. I. Objectives (a) The fundamental objective of the Corporation will be to assist in the economic development of the country by providing financial assistance to productive enterprises of the private and public sectors and by supporting economic infrastructure projects of the public sector. In addition, the Corporation will stimulate the develop- ment of the capital market as an instrument for channelling private savings into productive activities (Amendment adopted by the Board of Directors on June 4, 1973). II. Investment Policies (2) The Corporation will base its investment decisions on sound economic and financial criteria and will finance only technical viable enterprises with good prospect of economic and financial return. (3) Although its operations will be oriented principally to the financing of the manufacturing sector, the Corporation may also finance fisheries, tourism, agro- industrial projects, and non-traditional exports. In no case will the Corporation finance commercial activities or real estate operations. (4) The Corporation will finance the establishment or expansion of enterprises when these are, or can reasonably be expected to be, adequately organized and managed.  - 56 - ANNEX 2 (5) In selecting projects, the Corporation will take into account the general economic development plans and policies of the country. Consequently, priority will be given to projects which have some of the following features: use of national raw materials; significant use of manpower; saving or earning foreign exchange by exporting or import substitu- tion; production of goods to meet national or foreign demand; participation of a significant number of shareholders; possi- bilities for training personnel in technical and management matters; and the possibility of development of related industries. In harmony with the foregoing, the Corporation will avoid financing enterprises which depend on excessive governmental protection for their profitability, resulting in a negative economic benefit for the country and consequently leading to an uneconomic utilization of national resources. (6) When a project conforms to the technical, economic and financial criterial for an investment by the Corporation and is of particular importance for the economic development of the country, but does not arouse sufficient interest in the private sector, the Corporation may undertake it, even if it involves 100% financing by the Corporation. However, the aim of the Corporation, as in the case of normal investments, will be to sell its participation when the project has reached an adequate development and when circumstances permit it to do so on satisfactory terms. (7) In the case of projects which require large investments, the Corporation will seek financial cooperation from other entities, whether national, inte!rnational or foreign. III. Type of Financing (8) The Corporation will provide the following types of financing: (a) short-, medium- and long-term loans; (b) investment in share capital. by direct participation, purchase options, underwriting, etc.; (c) guarantees related to the purchase of machinery and/or equipment; (d) rediscounting of loans grarnted by private banks, the National Development Bank, the Cooperative Bank, and private financial corporations to small industries as established by the Law of the Comision de Valores- Corporacion Financiera Nacional; and  - 57 - ANNEX 2 (e) other financial operations which are in accordance with the objectives and policies of the Corporation. (9) The Corporation's loans will be principally for the purchase or construction of fixed assets. Notwithstanding, the Corporation may also finance technical assistance and permanent working capital and, exceptionally, seasonal working capital. (10) With its special resources for this purpose, the Corporation shall finance pre-investment studies of projects of the public or private sectors, or of those which can be cariied out by the Corporation itself. IV. Diversification of Investments (11) With the purpose of maintaining a reasonable level of risk, the Corporation will diversify its investments. (12) The Corporation normally will not grant financing to the same enterprise for an amount greater than 20% of its capital and free reserves, financing being understood as investing is the share capital of the firm or the granting of loans or guarantees. In the case of projects considered essential for the country's economic development, the Board of Directors may authorize loans which exceed the above mentioned limit. On the other hand, the Corporation normally will not provide financial assistance for amounts smaller than S/200,000, except in the case of rediscounts mentioned in sub-paragraph (d) of Section 8, or in the case of pre-investment studies (Amendment approved by the Board of Directors on June 4, 1973.) V. Turnover of Investments (13) As the projects in which the Corporation holds shares reach an adequate state of development, and with the double purpose of freeing resources for new financing and of stimulating widespread ownership of securities, the Corporation will sell its shareholdings, when it can do so on satisfactory terms. In the sale of its investment, the Corporation will not only take into account its own interests, but also those of the other shareholders and of the enterprises themselves. VI. Relations with Enterprises Financed (14) The Corporation does not intend to acquire management control of the enterprises it finances. Consequently, the Corporation normally will not take up more than 25% of the share capital of the enterprise financed, except in the case of projects undertaken by the Corporation in  - 58 - ANNEX 2 accordance with the stipulations of point 6 of this Decla- ration, or, as a result of arn underwriting undertaken with the expectation that the shares remaining for its account will not exceed the said limit. Notwithstanding, in cases of jeopardy, the Corporation may take whatever measures it deems necessary to protect: its interests. (15) In accordance with usual banking practice, the Corporation will require its borrowers to provide and to maintain adequate security in its favor; to keep accounting records which reflect their financial situation in accordance with generally accepted accounting principles; and to supply the Corporation with whatever information it may reasonably require to establish the status of their operations and financial situation. The Corporation will exercise the right to inspect the enterprises it finances, as well as their accounting records. (16) All information furnished to the Corporation by applicants or clients will be treated by it as strictly confidential. VII. Financial Practices (17) The Corporation will conduct its operations in such a manner as to assure the maintenance of the value of its capital and of adequate liquidity. The Corporation will charge interest, fees and commissions for its financing and services in such a way that they yield an adequate return on the capital employed. (18) The Corporation will remain reserves in accordance with sound financial practice. These reserves will be sufficient to cover the risk of loss related to the size of its port- folio and the status of the projects financed. (19) The Corporation will maintain a reasonable level of administ- rative expenses, consistent with the scope and volume of its operations. (20) The Corporation considers that the total of its liabilities, including guarantees, in whatever form, should maintain an adequate relationship with its own capital and free reserves. Consequently, the ratio of liabilities to capital and reserves will not exceed 6:1. (21) The Corporation will maintain an adequate structure in the maturities of the credits it grants so that the relation between the balance outstanding of short- and medium-term operations and the consolidated capital and reserves of the Corporation and any financial subsidiary of the Corporation, shall not exceed 4 to 1.  - 59 - ANNEX 2 VIII. Procedures (22) The Corporation shall maintain the following funds, each with separate accounting and independent resources: (a) Fund for Industrial Investments; (b) Fund for Small Industry; (c) Fund for Pre-investment; and (d) Fund for Export Promotion. (23) In accordance with its investment policies and to protect its resources, the Corporation, prior to any financing, shall evaluate projects in relation to the market, technical and financial feasibility and the economic benefit for the country. (24) The Corporation will not limit itself to evaluating projects which are presented for its consideration. The Corporation, by itself or with the help of consultants when circumstances require it, will identify, study and promote industrial, agro-industrial, fishery and tourism projects of significant benefit for the economy of the country. (25) Procedurally, with respect to matters involving its Directors, officials and employees, the Corporation will abide by the stipulations of Article 50 of its Constitute Law. (26) The Corporation will maintain accounting and statistical records which accurately reflect its operations and financial status in accordance with generally accepted accounting principles and practices. The Corporation will employ the services of a firm of independent auditors of recognized technical and professional competence, who will examine annually the account of the Corporation and give an opinion on the financial statements of the institution. (27) The Corporation will maintain a balanced technical- administration management organization, with high level personnel which will enable it to carry out market, technical, economic and financial evaluations of the projects it finances, as well as to follow up its investments. (28) As part of the follow-up operations, the Corporation, when it deems it necessary and when personnel availability permits it, will provide technical assistance to borrowing enterprises through the preparation of problem identifica- tion and guidance reports, so that these enterprises may contract the specialized technical assistance that may be necessary.  - 60 - ANNEX 3 ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT ECUATORIANA DE DESARROLLO, S.A. (COMPANIA FINANCIERA) Declaration of Policies and Operating Procedures (Approved by the Board of Directors on November 27, 1968 as amended through March 8, 1977) The Board of Directors of COFIEC declares that the following guide- lines on policies and procedures will govern its operations and that modifi- cations thereof or departures there from will only be adopted by the Board after adequate opportunity has been given to all its members to review and discuss the proposed changes or departures. 1. COFIEC is a development finance company designed to assist in the economic development of Ecuador, in particular the industrial sector of the economy and such related fields as agriculture and cattle raising. To this end, it will pursue an aggressive policy to promote, finance and otherwise assist productive enterprises. 2. COFIEC will make its investment decisions only on the basis of sound investment criteria and standards. 3. Subject to the criteria set forth in paragraph 2 and 9 hereof, COFIEC will select projects on as broad a geographical basis as possible. 4. COFIEC will, as appropriate, make use of the entire range of forms of investment. It will give particular attention to its client's needs for equity financing and will provide such equity to the extent consistent with sound financial practice. 5. COFIEC's principal objectives is the supply of medium- and long-term financing. Accordingly, COFIEC will increase progressively and as rapidly as its circumstances permit, the proportion of its resources which are devoted to such financing. 6. COFIEC will diversify its financing (except for temporary investment of liquid funds in short-term securities) among different types of industries and different types of financing. (a) COFIEC will not normally commit t:o any single enterprise in whatever form, including loans, share capital, guarantees, or any combination thereof, an amount greater than 20% of COFIEC's paid-in share capital, free reserves and unappro- priated surplus.  - 61 - ANNEX 3 (b) COFIEC will not commit to any single enterprise in the form of equity more than 15% of COFIEC's paid-in share capital, free reserves and unappropriated surplus. (c) The aggregate of COFIEC's equity investment will not exceed the sum of its paid-in share capital, free reserves and unappropriated surplus. Exceptions to rules (a) and (b) may be made only after special considera- tion of each case by the Board, and will be confined to enterprises with particularly sound financial prospects. 7. COFIEC will refrain from taking a controlling interest in an enter- prise or any other interest which would give it primary responsibility for management of an enterprise, except that in the case of jeopardy the Board of Directors may take such actions as may be necessary to protect COFIEC's interest. COFIEC will not normally take up more than 25% of the voting shares of any single enterprise, except as may be temporarily necessary in connection with an underwriting commitment undertaken in the expectation that the ultimate investment will be within the limit cited. 8. COFIEC will conduct its operations in such manner as to assist in the growth of a capital market in Ecuador and, to improve facilities for marketing securities, will seek opportunities to underwrite securities, and will revolve its own portfolio whenever it can do so on satisfactory terms. In selling its investments, it will pay due regard not only to its own interest but also those of the other participants in the investment and to the interest of the enterprise whose shares are involved. 9. COFIEC will finance only private and mixed ownership enterprises which are soundly managed and which appear, on careful economic, financial and enginering investigation, to be economically viable and technically feasible. 10. COFIEC will not ordinarily make loan commitments to any one client for an amount less than the Sucre equivalent of US$20,000 for existing enter- prises and US$40,000 for new enterprises. 11. COFIEC will not make loans to enterprises which are in arrears in their tax payments or on payments of their social security contributions. 12. COFIEC will build up a technically competent staff, capable of carrying out the responsibilities which COFIEC's objectives imply (including staff skilled in engineering, financial and economic analysis) and able to provide services to clients which those objectives call for. COFIEC will develop and maintain adequate systems of project appraisal and follow-up and end-use supervision of its investments. Specific and periodic reports prepared in exercise of this control function will constitute the basis for periodic reviews of the investment portfolios by its Board of Directors.  - 62 - ANNEX 3 13. COFIEC's operating expenses will be maintained at a minimum con- sistent with the scope of its activities and with the volume of its operations. 14. In accordance with normal business practice, COFIEC will require its borrowers to provide and to maintain adequate security, to keep records and accounts in accordance with sound accounting practices and to furnish whatever information on their operations and accounts COFIEC deems desirable. COFIEC will take the right to inspect the enterprises it finances as well as their operations and accounts. Business secrets and other information supplied by applicants or clients will be treated as confidential. 15. COFIEC will conduct its operations in such a manner as to maintain the value of its capital and secure a satisfactory profit. It will build reserves consistent with sound financial practice; these will include reserves for bad debts and investment and, in addition, supplementary reserves. Its dividend policy will be consistent with the foregoing. 16. COFIEC will not carry the foreign exchange risk on external borrow- ings, which it must repay in foreign exchange. It will pass the risk on to its clients or find other suitable means to cover it. 17. Neither COFIEC nor any financial subsidiary of COFIEC will not incur, assume or guarantee any debt if, after incurring or assuming such debt, the total amount of it then incurred and outstanding exceeds an amount equal to 8 times the aggregate of and any financial subsidiary of COFIEC the paid-in capital, free reserves and unappropriated surplus of COFIEC. 18. The outstanding balance of operations with original maturity of less than 5 years of COFIEC and any financial subsidiary of COFIEC shall not at any time after December 31, 1978 exceed 4 times the paid-in capital, free reserves and unappropriated surplus of COFIEC and any financial subsidiary of COFIEC. 19. The maturities of COFIEC's assets will correspond with, or be shorter than, the maturities of its liabilities. 20. The Board of Directors of COFIEC will direct the operations of COFIEC in such a way as to assure uniformity in the application of the policies and guidelines set forth herein. In order to assure the imple- mentation of this policy by the Executive Committee, the Board will, at each meeting, review the decisions of the Executive Committee in the interim. 21. COFIEC will have its books and accounts audited annually by a firm of reputable, independent public accountants.  -63 - ANNEX 4 T-1 ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT Industrial Structure Current SI million Percent 1970 1974 1977 1970 1974 1977 Industrial Value-Added 5,671 12,803 25,749 100.0 100.0 100.00 Food, Beverages & Tobacco 1,942 4,448 9,061 34.2 34.7 35.2 Textiles & Clothing 796 1,808 3,653 14.0 14.1 14.2 Wood & Wood Products 255 557 1,094 4.5 4.4 4.3 Paper & Printing 527 1,175 2,335 9.3 9.2 9.1 Chemicals & Products 1,042 2,337 4,661 18.4 18.3 18.1 Non-metaliic Minerals 251 572 1,161 4.4 4.5 4.5 Basic Metals 80 171 332 1.4 1.3 1.3 Metal Products; Machinery & Equipment 591 1,343 2,714 10.4 10.5 10.5 Other 187 392 737 3.3 3.1 2.9 Source: BCE  ECUADOR STAFF APPIAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT Some Parameters of the Manufacturing Sector 1974 1975 --S/ million-- -S/ million--- New New No. of Em- Fixed Invest-! No. of Em- Fixed Invest- Firms ployees Assets ments Firms ployees Assets ments TOTAL 1255 66400 8423.5 2504.0 1331 74894 10781.5 3154.2 Food, Beverages & Tobacco 372 22178 3725.1 1027.1 372 26679 4459.9 1142.8 Textiles & Clothing 232 14904 1263.9 343.9 255 16241 1900.0 705.4 Wood and Wood Products 87 4565 310.9 148.0 93 4965 492.1 139.5 Paper & Printing 134 5200 509.8 117.8 138 5727 588.4 107.9 Chemicals and Products 176 7518 1050.9 271.1 188 7585 1199.9 313.4 1 Non-Hetallic Minerals 54 3634 682.2 139.5 60 4004 865.1 252.6 O Basic Metals 7 421 197.8 117.2 15 695 288.7 97.6 4 Metal Products, Machinery and Equipment 158 7018 619.5 315.0 173 8022 895.3 359.1 Other 35 962 63.4 24.6 37 976 92.3 35.9 PERCENTAGES 1974 1975 TOTAI. 100.0 100.0 100.0 100.0 100.0 100.0 100:0 100.0 Food, Beverages and Tobacco 29.6 33.4 44.2 41.0 27.9 35.6 41.4 36.2 Textiles & Clothing 18.5 22.4 15.0 13.7 19.2 21.7 17.6 22.4 Wood and Wood Products 6.9 6.9 3.7 5.9 7:0 6.6 4.6 4.4 Paper and Printing 10.7 7.8 6.1 4.7 10.4 7.6 5.5 3.4 Chemicals and Products 14.0 11.3 12.5 10.8 14.1 10.1 11.1 9.9 Non-metallic minerals 4.3 5.5 8.1 5.6 4.5 5.3 8.0 8.0 Basic Metals 0.6 0.6 2.3 4.7 1.1 0.9 2.7 3.1 Metal Products, Machinery and Equipment 12.6 10.6 7.4 12.6 13.0 10.7 8.3 11.4 Other 2.8 1.4 0.8 1.0 2.8 1.3 0.9 1.1 Source: Encuesta de Manufactura y Minerfa, INEC.  - 65 - ANNEX 4 ECUADOR STAFF APPRAISAL REPORT FOURTE;DEVELOPMENT BANKING PROJECT Manufacturing Sector Classified by the Number of Employees 1974 1975 ---S/ million-- ---S/ million--- No. of Em- New Value No. of New Value Invest- 'Em- Invest- Firms ployees ments Added Firms ployees ments Added TOTAL 1255 66400 2504.0 9099.6 1331 74894 3154.2 10368.9 ' 7 173 770 9.2 42.7 16. 722 7.9 50.1 7 49 772 15913 386.3 1435.6 827 16421 555.4 1698.3 50 - 99 158 11136 431.5 1518.8 179 12579 536.9 1619.7 100 - 199 93 13133 818.2 2015.6 91 12556 530.6 2224.5 199 - 499 50 16183 533.0 2240.1 61 18572 1027.2 2848.9 > 500 9 9265 325.8 1846.8 11 14044 496.2 1927.4 Percentages 1974 1975 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 7 13.8 1.2 0.4 0.5 12.2 1.0 0.3 0.5 7 - 49 61.5 24.0 15.4 15.8 62.1 21.9 17.6 16.4 50 - 99 12.6 16.8 17.2 16.7 13.4 16.8 17.0 15.6 100 - 199 7.4 19.8 32.7 22.2 6.8 16.8 16.8 21.5 200 - 499 4.0 24.4 21.3 24.6 4.6 24.8 32.6 27.5 > 500 0.7 14.0 13.0 20.3 0.8 18.8 15.7 18.6 Source: Encuesta de Manufactura y Miner'a, INEC.  - 66 - 4 T-4 ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT CFN Balance Sheets (millions of S/., December 31, of indicated years). Assets 1974 1975 1976 1977 Cash and Banks 28.9 65.8 128.7 197.8 Other negotiable securities 160.1 155.4 85.7 65.2 Accounts Receivable and other current assets 71.8 66.9 85.6 123.1 Letters of Credit and Acceptances - - 99.3 373.9 Equity investments 443.3 585.4 862.3 996.7 Loans (net of provisions) 1472.3 1935.0 2780.7 3736.6 (of which maturing within one (322.8) (493.4) (582.8) (1220.4) year) Fixed assets 32.3 36.2 44.8 69.4 Other assets 93.0 71.4 84.8 106.1 Guarantees 155.9 267.9 385.1 586.1 Total assets and guarantees 2457.6 3184.2 4557.0 6254.9 Liabilities and Equity Banks 93.2 29.1 68.0 853.6 Current portion long-term debt 78.4 147.6 259.7 315.3 Other short-term liabilities 157.2 173.4 254.8 222.6 Bonds (non-current) 167.2 452.6 671.3 768.6 Letters of Credit and Acceptances - - 99.3 373.9 Long-term Debt (non-current) 915.7 1132.4 1765.8 1925.3 (Domestic) (232.0) (55.2) (Foreign) (900.4) (1870.1) ((of which Bank)) ((201.6)) ((228.8)) Equity 890.0 981.2 1053.0 1209.5 Guarantees 155.9 267.9 385.1 586.1 Current ratio: (excl. guarantees, 1.18 0.97 0.71 .78 Letters of Credit & Acceptances) D/E ratio- 1.76 2.24 3.32 4.17 FE exposure US$ equivalent 31.8 29.6 61.6 97.5 (excess of liabilities)  -67 - ANNEX 4 T-5 ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT C?N Income Statements CS/ milliona and % of average total assets including contingenciesl 1975 1976 1977 1978 S/ %ATA S_ ZATA S/ %ATA. S/ 7ATA Income Interest 181.4 6.4 284.4 7.3 399.1 7.4 485.2 7.4 Commssion and other 19.7 .7 22.8 0.6 30.2 0.6 19.7 0.3 Dividends 54.1 1.9 40.4 1.4 46.4 0.9 63.5 1.0 Total Income 255.3 9.0 347.6 9.0 475.7 8.9 561.0 8.6 Interest expense 99.3 3.5 175.5 4.5 264.9 4.9 350.3 5.4 Gross Spread 156.0 5.5 172.1 4.5 218.8 4.0 210.7 3.2 Administrative expense 71.6 2.5 85.2 2.2 116.2 2.1 133.0 2.0 Increasein provisions for losses 10.0 0.4 15.0 0.4 21.2 0.4 29.3 0.5 Net Income 74.3 2.6 71.8 1.9 73.4 1.4 48.4 0.7 Average total assets 2820.9 100.0 3870.6 100.0 5405.6 100.0 6523.8 100.0 Average equity 935.6 1017.1 1131.3 1244.2 Rate of return on equity 7.9 7.1 6.5 3,9 Inflation 11.1 13.0 12.3 10.8 Real rate of return on equity -2.9 -5.2 -5.2 -6.2  - 68- ANNEX 4 T-6 ECUADOR STAFF APPRAISAL BRPORT FOURTh DEVELOPMNYT BANK:ING PROJECT COFIEC Balance Sheets (millions of S/ December 31 of indicated years) 1974 1975 1976 1977 1978 Assets Cash and banks 58.2 68.6 82.4 93.2 141.7 Other negotiable securities 14.7 2.0 27.3 10.4 32.8 Accounts receivable and other 21.8 40.4 46.9 61.1 117.6 current assets Letters of Credit & Acceptances 168.0 3.51.7 387.9 502.0 540.7 Equity investments 24.8 28.9 51.9 '69.9 112.0 Loans (of which maturing 585.8 737.7 768.5 841.4 1030.9 within one-year) V (318.2) (369.5) (331.2) (390.6) (289.8) Fixed.assets 21.7 61.8 133.6 141.6 164.4 Other assets 0.7 1.6 1.8 1.1 14.2 Guarantees 429.8 452.8 739.0 853.8 1462.3 Total Assets and Guarantees 1325.5 1745.5 2239.2 2574.5 3616.8 Liabilit7 and Equity Banks 63.4 76.6 83.5 113.1 54.0 Current portion of long-term debt and bonds 52.1 73.6 158.9 154.6 187.5 Other short-term liabilities 54.6 74.5 87.1 135.3 187.5 Letters of Credit + Acceptances 168.0 351.7 387.9 502.0 540.7 Bonds (non-current) 73.2 75.0 102.0 151.7 236.9 Long-term debt 336.5 457.2 420.4 360.9 608.6 (domestic) (108.0) ( 99.9) ( 50.1) (C) (foreign) (349.2) (320.4) (310.8) (608.6) (of which Bank) (304.3) (233.0) (239.0) (364.0} Equity 147.9 184.1 260.7 303.1 339.3 Guarantees 429.8 452.8 739.0 853.8 1462.3 Current ratio (excluding -guarantees, letters of credit and acceptances) 2.43 2.13 1.44 1.38 ,1.37- D/E Ratio 2/ 7.96 8.48 7.56 7.49 9.4 1/ Net of provisions for loss. 2/ Not including deferred changes and undrawn letters of credit.  - 69 - ANNEX 4 T-7 ECUADOR STAFF APPRAISAL REPORT FOURTH DEVELOPMENT BANKING PROJECT COFIEC Income Statements (SI millions as % of average total assets including contingencies) 1975 1976 1977 1978 S_ 7AATA S ATA S/ %ATA S ___ Income Interest & Commissions 124.2 8.1 139.3 7.0 162.5 6.8 198.4 6.4 Dividends 5.9 0.4 7.6 0.4 8.1 0.4 15.2 0.5 Other 1.1 0.1 2.0 0.1 3.0 0.1 13.7 0.4 Total 131.2 8.5 148.9 7.5 173.6 7.3 227.3 7.3 Interest expense 53.7 3.5 55.5 2.8 64.3 2.7 90.1 2.9 Gross spread 77.5 5.0 93.4 4.7 109.3 4.6 137.2 4.4 Administrative expense 32.8 2.0 39.9 2.0 48.0 2.0 68.7 2.2 Provisions for loss 3.9 0.3 4.7 0.2 7.1 0.3 7.2 0.2 Net income before taxes 40.8 2.7 48.8 2.4 54.2 2.3 61.3 2.0 Taxes 8.7 0.6 10.2 0.5 11.8 0.5 10.5 0.3 Net income 32.1 2.1 38.6 1.9 42.4 1.8 51.0 1.6 Average total assets 1535.5 100.0 1992.4 100.0 2392.3 100.0 309.6 Average equity 166.0 222.4 281.9 321.2 Rate of return on equity 19.3 17.4 15.0 15.7 Inflation (Z p.a.) 11.1 13.0 12.3 10.8 Real rate of return on equity 7.3 3.9 2.4 4.4  ECUADOR STAFF APPRAISAI. REPOHT FOURTHI DEVELOPMENT BANKING PROJECZ Eight Financleras: Comparative Structure of Balance Sheets December 1977 (illions of St and % ) 1/ ECUATO- IBERO- COFIEC ANDINA AUSTRO RIANA CUAYAQUII. AMERICANA!/ NACIONAL 7 PRIVATE CFN TOTAL S/ X S/ Z S/ % S/ Z S/ 7. S/ 7. S/ Z S/ % S/ % S/ % Cash and Batiks 93.1 3.6 20.7 51.4 5.8 12.5 35.1 8.2 79.8 10.5 5.1 3.8 66.1 7.6 305.7 6.3 197.8 3.2 503.5 4.5 Othler negotiable securities 10.4 0.4 17.5 43.4 12.7 27.4 - - 6.2 0.8 - - - - 46.8 1.0 65.2 1.0 112.0 1.0 Other current assets 52.1 2.0 0.1 0.2 - - 2.4 0.6 16.2 2.1 - - 9.2 1.1 80.0 1.7 123.1 2.0 203.1 1.8 Loans 876.6 34.0 - - 17.9 38.7 71.6 16.7 137.4 18.1 49.6 36.7 183.7 21.2 1336.8 27.6 3771.1 60.3 5107.9 46.0 1 Provisions for losses (35.1) (1.4) - - (0.2) (0.4) (1.3) (0.3) - - - - (6.0) (0.7) (42.6) (0.9) (34.5) (0.6) (77.1) (0.7) _ Loans net of provisions 841.5 32.6 - - 17.2 38.2 70.3 16.4 137.4 18.1 49.6 36.7 177.7 20.6 1294.2 26.7 3736.6 59.7 5030.8 45.3 0 (of which current portion) (390.5)(15.2) - - (16.3)(35.6)(58.2) (13.6) (99.4)(13.1) (37.1)(27.4)(136.2)(15.8)(737.7)(15.2)O1220.4)(19.5)p958.1)(17.6) 1 Equilty Investmenits 69.9 2.7 - - - - 0.1 0.0 - - - - - - 70.0 1.4 996.7 15.9 1066.7 9.6 Acceptances 48.4 1.9 - - - - 7.0 1.6 20.0 2.6 6.0 4.4 16.0 1.9 97.4 2.0 - - 97.4 0.9 Letters of Credit 453.6 17.6 - - 1.2 2.4 54.2 12.6 215.2 28.4 20.0 14.8 171.2 19.8 915.4 18.9 373.9 6.0 1289.3 11.6 Fixed Assets 140.7 5.5 2.0 5.0 0.5 1.1 0.9 6.2 12.2 1.6 1.8 1.3 6.4 0.7 164.5 3.4 69.4 1.1 233.9 2.1 Other Assets 11.2 0.4 - - 1.8 3.9 0.6 0.1 2.4 0.3 6.1 4.5 2.2 0.3 24.3 0.5 106.1 1.7 130.4 1.2 Guarantees 853.8 33.2 - - 6.4 13.8 258.1 60.2 269.1 35.5 46.7 34.5 415.8 48.1 1849.9 38.1 586.1 9.4 2436.0 21.9 Total assets & guarantees 2574.7 100.0 40.3 100.0 46.3 100.0 428.7 100.0 758.3 100.0 135.3 100.0 864.6 100.0 4848.2 100.0 6254.9 100.0 11103.1 100.0 Accouints Payable 135.3 5.3 0.3 0.7 0.1 0.2 25.9 6.0 24.9 3.3 18.4 13.6 21.1 2.4 226.0 4.7 222.7 3.6 448.7 4.0 Short-tenu loans 161.5 6.3 - - 0.1 0.2 17.6 4.1 74.7 9.8 7.6 5.6 99.2 11.5 360.7 7.4 853.6 13.6 1214.3 10.9 Ietters of Credit 453.6 17.6 - - 1.2 2.6 54.2 12.6 215.2 28.4 20.0 14.8 171.2 19.8 915.4 18.9 373.9 6.0 1289.3 11.6 Bonds 185.7 7.1 - - - - - - - - - - - - 185.7 3.8 768.6 12.3 954.3 8.6 (of wtich current portion) (34.0) (1.3) - - - - - - - - - - - - (34.0) (0.7)(768.6)(12.3)(802.6) (7.2) Looig-teuii loans 481.5 18.5 - - - - - - 77.3 10.2 0.3 0.2 33.4 3.9 592.5 12.2 2240.5 35.8 2832.9 25.5 (of which currenit portion) (120.7) (4.6) - - - - - - - - - - - - (120.7) (2.5)(315.3) (5.0)(436.0) (3.9) Equity 303,1 11.6 40.3 99.3 38.5 83.2 72.9 17.0 97.3 17.8 42.3 31.2 123.9 14.3 718.0 14.8 1209.5 19.3 1927.5 17.4 Guarantees 853.8 33.2 - - 6.4 13.8 258.1 60.2 269.1 35.5 ,46.7 34.5 415.8 48.1 1849.9 38.1 586.1 9.4 2436.0 21.9 1/ Not orgainized until 1978 balanice sheets from Juine 30, 1978.  - 71 - ANNEX 4 T-9 ECUADOR STAFF APPRAISAL REPORT FOURTH DZVELOPMENT BANNlNG PROJECT SUary AnalysisJ o Subloans Aoorpved uneor Loan 721-EC and Loan 930-EC (US5 m