Colombia - Eighth Development Finance Companies Project

Document of The World Bank FILE COPY FOR OFFICIAL USE ONLY Report No. 2885a-CO STAFF APPRAISAL REPORT COLOMBIA EIGHTH DEVELOPMENT FINANCE COMPANIES PROJECT April 29, 1980 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 All currency amounts are expressed in Colombian Pesos (Col$) and US Dollars (US$). April 1, 1980 US$1.00 = Col$ 45.64 Col$1.00 = US$0.0219 Average exchange rate for calendar year 1979 was US$1:Col$ 42.59. GLOSSARY OF ABBREVIATIONS ANDI Asociacion Nacional de Industriales (National Association of Industries) BR Banco de la Republica (The Central Bank) CAT Certificado de Abono Tributario (Tax Rebate Certificate) CD Certificate of Deposit CF Corporacion Financiera (Investment Bank) CFP Corporacion Financiera Popular COFIAGRO Corporacion Financiera de Fomento Agropecuario y de Exportaciones COLCIENCIAS Fondo Colombiano de Investigaciones Cientificas y Proyectos Especiales (Colombian Fund for Scientific Research and Special Projects) DANE Departamento Administrativo Nacional de Estadistica (National Statistics Department) DDC Department of Development Credit of BR DFC Development Finance Company ERR Economic Rate of Return FEDESARROLLO Fundacion para la Educacion Superior y el Desarrollo (Institute for Economic Studies) FFI Fondo Financiero Industrial (Industrial Financing Fund) FIP Fondo de Inversiones Privadas (Private Investment Fund) IDB Inter-American Development Bank IFI Instituto de Fomento Industrial (Industrial Development Institute) IIT Instituto de Investigaciones Tecnologicas (Technological Research Institute) INCOMEX Instituto de Comercio Exterior (The Colombian Foreign Trade Agency) KfW Kreditanstalt fur Wiederaufbau PROEXPO Fondo de Promocion de Exportaciones (The Colombian Export Promotion and Financing Agency) UPAC Units of Constant Purchasing Power (Indexed Instruments Issued by the Savings and Loan Corporations)  FOR OFFICIAL USE ONLY COLOMBIA EIGHTH DEVELOPMENT FINANCE COMPANIES PROJECT TABLE OF CONTENTS Page No. I. THE MANUFACTURING SECTOR ... * ................... . . . . . . . . . . . 1 The Economic Setting ... ................... .. ....... . 1 Manufacturing Sector Evolution ................... 1 Sectoral Structure ......................... ....... 2 Export Policies and Performance .................. 3 Industrial Protection ............................ 6 Industrial Sector Planning ....................... 7 Geographic Distribution of Industry .............. 7 Employment .................................................... 8 Technology Policy . ............. . . . . .............. .. 9 Industrial Pollution Control ..................... 10 Outlook for Industrial Growth and Investment ..... 11 II. THE FINANCIAL SECTOR ................ .......... ....... . 12 Institutional Structure ........... .. ............. 12 Financial Sector Policies and Evolution ....... . .. 12 Recent Development and Prospects ................. 14 Industrial Financing ..... .................... . .. 15 Need for the Proposed Loan ....................... 19 III. INSTITUTIONAL ARRANGEMENTS AND PARTICIPATING INSTITUTIONS ...................... ... .. 19 A. Background ....................... ............. 19 B. Banco de la Republica ...... ...... o ........ o.. . 20 C. The Participating Financieras ... ....... ......... 22 Background and Ownership ...................... 22 Organization and Staff ....................... 23 Subproject Appraisal and Supervision ... oo ...... 23 Operations and Impact .......... o ............... 24 Financial Position and Results .... ............. 30 Resource Structure and Needs ................. 34 D. Participation of Additional Financieras .......... 37 This report is based on the findings of a mission to Colombia in November 1979 composed of Messrs. K. Challa, J.T. Bentley, G. Faillace and Ms. A. Velarde of the Bank, Mr. N. Bruck (UNIDO), and Mr. G. Castaneda and Ms. S. Atala (Consultants). Mr. P. Knotter participated in final mission discussions. 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.  TABLE OF CONTENTS (Continued) Page No. IV. THE PROJECT ........................................... 39 Project Objectives ....... ........................ 39 The Proposed Bank Loan and Components ......... ... 40 Eligible Enterprises and Lending Limits .......... 41 Onlending Terms and Interest Rates ............ ... 42 Margins to the Intermediaries ................... . 44 Participation in the Loan .................... .... 44 Approval Limits .................................. 45 Procurement and Disbursement ..................... 45 Cofinancing ...................................... 46 Review of the Loan Conditions ................ .... 46 Benefits and Risks .................... ........... 46 V. RECOMMENDATIONS ....................................... 47 ANNEXES Annex 1 Estimated Schedule of Disbursements Annex 2 Banco de la Republica - DDC's Statement of Operating Policies and Procedures Annex 3 Checklists for the Evaluation of Technology Development and Pollution Control Subprojects Annex 4 Supplementary Tables T-1 : Gross Domestic Product by Origin at Factor Cost, 1970-78 T-2 : Unemployment in Urban Centers T-3 : Wages and Salaries in the Manufacturing Sector T-4 : Effective Exchange Rate for Exports, 1970-79 T-5 : Exports of Manufactured and Other Products, 1967-78 T-6 : Manufacturing Sector Average Growth Rates in Real Terms T-7 : Capacity Utilization in the Manufacturing Sector, 1972-79 T-8 : Manufacturing Sector Structure by Product Category T-9 : Size Structure of Manufacturing Enterprises by Number of Employees T-10: Financial Structure of Manufacturing Enterprises by Asset Size and Activity, 1976-77 T-11: Protection in the Manufacturing Industry as of December 1976 T-12: Geographic Distribution of Industrial Activity T-13: Geographic Concentration of the 500 Largest Enterprises T-14: Imports According to Use, c.i.f., 1967-78 T-15: Exports Structure by Decree of Processing, 1970-78 T-16: Total Institutional Credit by Source, Term and Sector, 1974-78 T-17: Estimated Effective Yields on Financial Instruments, 1974-79 T-18: Industrial Credit Outstanding by Source, 1974-78 T-19: List and Characteristics of Financieras in Operation T-20: Distribution of the Sources of Funds for Industrial Development, 1974-78  TABLE OF CONTENTS (Continued) ANNEXES Annex 4 Supplementary Tables (Continued) T-21: Indices of Activity on Colombia's Stock Exchanges, 1972-78 T-22: Term Structure of Financiera Loans, 1974-78 T-23: Sources of Funds for Financieras, 1973-78 T-24: Net Financial Savings, 1971-79 T-25: Indicators of Banking System Activity, 1978/79 T-26: Analysis of Financiera Loan Portfolios as of September 30, 1979 T-27: Analysis of Total Subloan Approvals Under the Seven DFC Loans T-28: Analysis of Subloans Approved Under Loans 1223-CO and 1598-CO T-29: Evolution of Financiera Staff During 1979 T-30: Financial Statements of CF Caldas T-31: Financial Statements of CF Colombiana T-32: Financial Statements of CF Nacional T-33: Financial Statements of CF del Norte T-34: Financial Statements of CF del Valle T-35: Financial Statements of CF Santander T-36: Financial Statements of CF de Occidente T-37: Financial Statements of CF Aliadas T-38: Selected Financial Ratios of the Financieras T-39: Financial Ratio Projections, 1980-84 T-40: Financiera Arrears Position (as of September 30, 1979) T-41: Mobilization of Domestic Resources by the Financieras T-42: Cofinancing Results by Financieras (as of December 31, 1979) Annex 5 Documents Available in the Project File   I. THE MANUFACTURING SECTOR The Economic Setting 1.01 Over the past 15 years substantial structural transformation has taken place in the Colombian economy and the country is now well advanced in the transition from a predominantly rural, agricultural and largely self- contained economy to an urban industrial society, more interdependent with the world economy and with neighboring countries in the Andean region. Manu- facturing has made a major contribution to this transition, particularly since 1967. In the 1970s, the Colombian economy grew on average at about 6% p.a., manufacturing, utilities, finance, and transport and communications being the most dynamic sectors. The decade was marked by strong growth during the first half, averaging 6.8% per year during 1970-74 (continuing from the dynamism of the late 1960s), a significant slowdown during 1975-77, with GDP growth rates averaging 4.4% in real terms per annum, and a remarkable "bounce-back" in 1978, when GDP growth rate exceeded 8% in real terms (Annex 4, T-1). Inter- national reserves accumulated rapidly in the later part of the decade as a result of high coffee prices, and contributed to substantial growth in aggregate demand, as well as to unprecedented inflation levels. The growth rate in 1978 was the highest in the decade and reflected the significant recovery of the three largest sectors, namely, agriculture, industry, and commerce, and the high coffee export level. Urban unemployment in 1978 stood at its lowest level in many years (Annex 4, T-2). Real wages and salaries in manufacturing made significant progress in 1978 after several years of stagnation (Annex 4, T-3). While output was increasing rapidly in real terms, the average annual inflation rate was reduced from 34.8% in 1977 to 16.7% in 1978, through a variety of fiscal, monetary and trade measures oriented towards containing money supply growth. 1/ However, inflation accelerated again in 1979, reaching about 24.8% for the year on an average annual basis (Annex 4, T-4), and the near-term prospects are that it will average at about 18% over the next three years. Manufacturing Sector Evolution 1.02 After the second world war, industrialization became an important component of the country's development strategy. The principal instrument used to promote domestic industrial growth during these years was the creation of a barrier through high effective protection, which encouraged production for import substitution. Aided by these policies, industrial value added expanded rapidly at an annual rate of 6.7% from 1953 to 1968. By the mid-1960s, most of the easy import-substitution opportunities were exhausted. However, aided by periodic economic policy adjustments, manufacturing industry continued to be a leading growth sector during the decade of the 1970s, contributing between 17% and 19% of Colombia's GDP. 1.03 In an effort to cope with the recurrent foreign exchange problems, the authorities reconsidered the thrust of the country's economic policies in 1967. A new economic strategy was introduced which was intended to promote and diversify non-traditional exports. The most important elements in this 1/ Measured by the annual average of the blue collar consumer price index.  -2- strategy were the introduction of a crawling-peg exchange rate system, and an export incentives package that included a tax rebate certificate (CAT), credit on concessionary terms for export-related activities and an import duty draw-back system called "Plan Vallejo." In the ensuing years, manufacturing exports became an increasingly important source of both foreign exchange earnings and industry output growth. 1.04 Between 1968 and 1974, manufacturing GDP in real terms as well as employment in the sector grew at an impressive 8.3% per annum, consistently outpacing the growth of GDP as a whole during these years. Manufacturing exports rose from about US$62 million (12.1% of total exports) in 1967 to US$529 million (37.3% of total exports) by 1974 (Annex 4, T-5). To achieve the rapid growth, the average annual growth rate of gross manufacturing investment more than tripled from 4.1% in real terms for 1960-68 to 14.7% during 1968-74 (Annex 4, T-6). As a result of the recession in 1975 in many developed countries, domestic anti-inflation measures, and the consequent substantial slackening of manufactured exports, manufacturing sector growth rate dropped sharply during 1974-77 when the sector's GDP contribution grew only at an average annual rate of about 4% and its contribution to employment only at 2.3% (Annex 4, T-1 and T-6). Following near stagnation in 1975 (growth rate of 1.3% in real terms), the manufacturing sector recovered somewhat in 1976 and 1977, with growth rates of 6.7% and 4.2%, respectively, induced by an increase in domestic demand for consumer goods (generated by high coffee earnings and income from illegal exports) which compensated for the lagging demand for Colombia's manufacturing exports. Industrial investment grew rapidly in these two years to compensate for low investment levels in previous years. In 1978 the manufacturing sector's value added grew by 8.5%, investment by 6.0% and employment by 4.2%, reflecting further expansion in demand associated with higher coffee receipts and the recovery in investment. Manufacturing plant capacity utilization exceeded 85% during 1977-78, being substantially higher than the 75% average recorded in 1974-76. Capacity utilization was highest in the textiles, garments and clothing, chemicals, paper and printing, and food, beverages and tobacco industries (Annex 4, T-7), while wood, wood products, machinery and transport equipment subsectors had the lowest capacity utilization. 1.05 The growth rate of GDP as a whole as well as of industrial sector GDP is estimated to have slowed down to about 5.5% in 1979. Capacity utilization is still running high, and substantial investment is under consideration by the private sector. Since demand appears to be strong, while inventories at mid-year were at normal levels, 1/ the main constraining factors to achieve a high industrial growth are likely to be plant capacity and raw material supply. Sectoral Structure 1.06 Significant changes have taken place in the structure of manu- facturing production since the postwar years. In the early 1950s, consumer goods accounted for as much as 82% of gross output, intermediate goods for 16%, and capital goods for 2%. By the mid-1970s these shares were 55%, 36% and 1/ Based on ANDI and FEDESARROLLO surveys and field interviews by the appraisal mission.  -3- 9%, respectively. In value added terms, the food, beverages and tobacco industries lead all other sub-sectors with a 28.5% share, followed by the chemicals (including petroleum refining) with 22.3%, and textiles, garments and clothing with 18.7% (Annex 4, T-8). At present the largest number of manufacturing enterprises are found among the textiles, garments and clothing industries (22.9% of total number), followed by the food, beverages and tobacco (21%) and the metal products, machinery and equipment industries (20.7%). About 83% of the manufacturing enterprises have between 10 and 100 employees; however, about 52% of the employment in the sector, 64% of wages and salaries, and 62% of the gross product are accounted for by firms with 200 or more employees (Annex 4, T-9). 1/ 1.07 There are significant differences in the financial structure of manufacturing enterprises by size. In general, small enterprises rely more on equity and non-institutional sources of financing. An analysis of 1976-77 data shows that the smallest manufacturing enterprises (i.e., those with Col$ 20 million or less in total assets) financed 60% of their assets through credit or other liabilities, of which only 17% was from institutional sources of credit (Annex 4, T-10). In contrast, the medium-sized and larger enter- prises financed about one-third of their assets through institutional sources. The largest enterprises were able to finance more than one-quarter of their assets through retained earnings and reserves. Although the financial structure of the enterprises also varies throughout the different industrial groups among these subsectors, there are few substantial differences (Annex 4, T-10). Export Policies and Performance 1.08 Excessive reliance on growth of capital-intensive import substituting industries (which in turn depend heavily on imported inputs) became evident by the mid-1960s. The reforms implemented in 1967 maintained incentives for import substitution, but the relative attractiveness of exporting was substan- tially increased. Exporters were given a tax rebate certificate (Certificado de Abono Tributario--CAT) equivalent to 15% of the export value (f.o.b.), mainly to compensate for the overvalued currency. The exporters were also eligible to import duty-free intermediate products and raw materials needed for the production of goods for export. In addition, concessionary credit was made available through Fondo de Promocion de Exportaciones (PROEXPO). Finally, and perhaps most importantly, between 1967, when the crawling-peg exchange rate system was introduced, and 1975, the exchange rate of the peso for the US dollar rose by 67.6% in nominal terms and by 18.2% in real terms, 2/ making Colombia's manufactured goods more competitive in international markets. 1.09 In the years since 1975, faced with the task of managing balance of payments surpluses and the trade-off between the long-term development objectives and the short-term difficulties in controlling inflation, the government has maintained the crawling-peg exchange rate policy, but at a pace which resulted in an appreciation of the Colombian peso against the US dollar in real terms. 2/ Consequently, between 1975 and 1978 the US dollar exchange 1/ Percentages computed on the basis of sectoral statistics covering enterprises with 10 or more employees. 2/ Based on differences in the relative movements of the dollar and peso price indices.  - 4 - rate experienced about a 15% decline in real terms. 1/ Furthermore, in early 1975 the CAT rate was drastically reduced from 15% to 5% for most products and was virtually eliminated for others, in order to reduce its fiscal burden, 2/ to avoid providing subsidies to industries that did not need or deserve them (e.g., fictitious or low value-added exports which were becomiitg increasingly common), and to reduce potential for frictions with trading partners which were beginning to become noticeable. In 1977, new changes in CAT rates were introduced, increasing the rate for most industrial products to 8% and reducing it for most other products; the net effect of the 1977 changes was to slightly reduce the average CAT percentage. 1.10 In an attempt to compensate at least partially for the lagging exchange rate, CAT rates were raised again in 1978, establishing four different levels (12%, 9%, 5% and 0.1%), depending on the product category. Further adjustments were put in effect in 1979, reclassifying exports according to their value added, labor used and decentralization impact, but maintaining the the same four basic rates for CAT. The government's intention seems to be to maintain this level of rates and classification in the near term. Annex 4, T-4 (column F) presents estimates of the adjusted real exchange rate for exports over the last decade, taking into account the combined effect of movements in the nominal exchange rate, inflation and CAT levels. It shows that the adjusted real exchange rate in 1979 was 16.2% lower than in 1975. 3/ 1.11 Financing for non-traditional exports is provided by PROEXPO through rediscounting of credits (denominated in domestic or foreign currencies) provided by banks and other financial institutions to exporters. PROEXPO provides: pre-shipment working capital financing for up to 80% of the export value with terms of up to 8 months at a 17% interest rate; 4/ financing for capital goods and other production equipment in selected subsectors--up to 90% of the investment cost for agro-industrial projects, with terms of up to 8 years and a 14% interest rate, and up to 50% of the investment cost for tourism projects at annual interest rates of 18-20% depending on the term (maximum 8 years); and post-shipment financing denominated in US dollars of up to 100% of f.o.b. or c.i.f. value (depending on the carrier) for terms not exceeding 180 days in the case of exports of consumer and intermediate goods, and for longer terms of up to 7 years in the case of capital goods exports, at interest rates of 4-6%. PROEXPO also offers export insurance services. 1/ Excluding the impact of changes in credit subsidies through PROEXPO. See Annex 4, T-4, column D. 2/ By 1974 the payments for CAT absorbed about 8% of the country's current revenues. 3/ These estimates do not include the effect of credit subsidies provided through PROEXPO, since this effect varies considerably depending on the percentage of investment financed by PROEXPO, the term of such financing and the difference between the interest rates under PROEXPO's and alter- native sources of financing. Based on very approximate estimates, the average subsidy provided through PROEXPO's credits appears to have increased gradually from about 1% in 1974 to 2-3% in 1978/79. 4/ All interest charges are paid quarterly in advance.  1.12 PROEXPO's importance has grown since 1967 not only in terms of its largely expanded volume and proportion of non-traditional exports (i.e., other than coffee) financed, but also because of the increasingly favorable interest rates to the exporting enterprises in comparison with market interest rates. In order to increase PROEXPO's resources, the government raised the import tax destined to finance the institution, from 1.5% of the c.i.f. value, which had been in force since 1967, to 3.5% in September 1975 and to 5% in October 1975. Consequently, PROEXPO's resources and volume of operations expanded rapidly between 1974 and 1978. The volume of PROEXPO's short term credits, which account for the bulk (90%) of its operations, quadrupled from about US$151 million equivalent in 1974 to US$607 million in 1978. The corresponding total values of non-traditional exports supported through PROEXPO were US$680 million in 1974 (that is, a 22% coverage on the average by PROEXPO's financing) and US$1.0 billion in 1978 (62% coverage) respectively. Credits for industrial exports during the same period rose even more rapidly from US$101 million (26% coverage) to US$416 million (78% coverage). 1/ 1.13 The import duty drawback system (Plan Vallejo - para. 1.03) consti- tutes the other major instrument to promote manufacturing exports. It exempts raw materials, intermediate products and capital equipment used in the produc- tion of manufactured exports from all import duties and other charges. About 45% of all non-traditional exports in 1977-78 benefited from such duty-free imports, compared to about 35% in 1974-75. 1.14 Between 1967 and 1974, manufactured product exports grew at the average annual rate of about 35.9% in current US$ terms. The share of manufac- tured exports in total exports increased from 12.1% in 1967 to 37.3% in 1974 (Annex 4, T-5). 2/ The corresponding shares of exports in total industrial output rose from about 2% to 8%. The 1975 international recession resulted in a decline of 9.6% in nominal terms of manufactured exports, but the growth of total manufacturing output during 1976-77 (para. 1.04)--although offset in part by the appreciation of the real effective exchange rate (para. l.lO)--helped manufactured exports growth in dollar terms to keep pace with world inflation. 1/ In addition to the above major credit lines, PROEXPO administers several specialized credit lines including: those created by the Corporacion Andina de Fomento (CAF) to finance exports to the Andean Pact countries; credit support for the development of frontier areas; assistance to the Corporacion Financiera Popular for export financing of medium and small- scale enterprises; and financial assistance to the Instituto de Fomento Industrial (IFI). The total volume of these credit lines is US$20-25 million. 2/ There are three main sources of exports statistics in Colombia. DANE, which collects exports data on the basis of customs clearance documents ("manifiestos"); INCOMEX, which records data on export registrations for licensing purposes ("registros"); and Banco de la Republica which records the foreign exchange surrenders ("reintegros") from exports. Of these DANE's statistics seem to reflect actual exports most closely, and are the main data source used in this report. Also, the exports data need to be corrected for over invoicing, estimated by FEDESARROLLO at 6% of non-traditional exports for recent years, and for contraband shipments to neighboring countries.  - 6 - In 1978 manufactured exports registered a significant growth in real terms, having increased 29.5% in US$ compared to world inflation in equivalent dollar terms of about 16% (Annex 4, T-4 and T-5). 1/ 1.15 The single most important market for Colombia's manufactured export products is the Andean Group. More than 40% of Colombia's industrial exports are directed to the four other Andean Pact countries, and about 60% to the Latin American and Caribbean region as a whole. If illegal trade (mostly to neighboring Venezuela and Ecuador) is also taken into account, the Andean Pact countries probably receive as much as 50-60% of Colombia's total industrial exports. Colombia is relatively successful in exporting compara- tively sophisticated and capital intensive products to neighboring markets, while its exports to industrial countries are concentrated in labor-intensive products (wood products, garments and leather products). Industrial Protection 1.16 Although the general trend since 1967 has been towards lower and more uniform levels of protection, some industries established during the earlier import substitution stage of industrialization still receive high levels of pro- tection. The favorable balance of payments position which Colombia has enjoyed in recent years has been conducive to some progress in lowering import barriers. As of year-end 1976, the average nominal tariff ranged from 21.0% for basic metal industries to 59.6% for textiles, garments and leather products. 1.17 Imports in Colombia are classified into two types, free imports and those prohibited or requiring prior import license, the latest categorization of imported items having been performed in August-September 1979, when the government transferred 672 items from the prior license list to the free list. In 1974, 70.2% of the items in the tariff schedule were classified under prior license; this percentage, which had been reduced to 46.6% by August 1979 was further reduced through the latest measures to 33.4%. The latest changes, however, represent only about 4% of the total import value. The product categories that currently have the highest percentages of products under the prior license list are transport materials (81.5%), capital goods (42.9%), and agricultural products (41.8%). In addition to the above reclassifications, tariffs on an additional 8-9% of the total number of items on the tariff list were reduced substantially (by 10% or more) and another 25% of the items experienced minor tariff reductions; the resulting net average reduction of tariffs was about 2%. 2/ 1.18 An accurate computation of effective protection estimates within the Colombian industrial sector would have to take into account the composite effect of licensing, tariffs, prior deposits and available subsidized financing. 1/ Preliminary estimates indicate that manufactured exports grew by 38% in US dollar terms in 1979. 2/ Since August 1979, in an effort to absorb part of the excess liquidity in the financial system (and thus help control inflation), the Government has been requiring importers of capital goods to maintain a prior deposit equal to 35% of the value of the imports until the imports are cleared at customs. This measure more than nullified the effect of the 1% reduction affected in 1979 in the tariff for capital goods.  -7- The only reliable way of obtaining such estimates may be through direct price comparisons between domestic and equivalent imported products; such comparisons are difficult to make and have not been carried out for Colombia in recent years. The most recent study on effective protection was carried out by the National Planning Department of Colombia in 1977, based on tariffs in existence at the end of 1976. The results of this study indicate that average effective protection, without considering any lowering in the actual protection levels due to any redundancy ("water") in protection, varies between about 30% for the chemical industries to 116% for textiles, garments and clothing industries subsector (Annex 4, T-11). The study also indicates that Colombia's effective protection is close to the minimum external tariff (MET) specified under the Andean Pact for most product groups. With the exception of three product groups, namely, textiles, garments and leather products, metal products, machinery and equipment, and non-metallic minerals categories, the effective protection estimates were within 10% of the MET levels. The average effective protection level exceeded the MET level by the largest margin in the case of textiles, garments and leather products. 1/ Three manufactured products groups, basic metals, food and beverages and chemical products, had effective protection levels below those specified under MET. The average effective protection levels are likely to have decreased since the 1977 study, as a result of the recent import liberalization measures (para. 1.17). Industrial Sector Planning 1.19 While explicit industrial planning has been incipient, the Govern- ment's approach has generally been to adjust the framework of policies (e.g. those concerning industrial exports, protection and financial sector regula- tions) from time to time based on overall macroeconomic requirements (paras. 1.03 and 2.04), and to rely largely on the private sector to reflect the poli- cies in the form of detailed investment plans. The National Planning Department is currently preparing an indicative plan for the sector, which is expected to be published in the coming months. This plan is likely to be very general in nature, but the authorities have been developing indicative plans for the development of particular subsectors such as the glass, leather, pulp and paper, copper and plastics industries, which could serve as the basis for fixing priorities among subsectors in the global plan. Overall, the need for planning as a tool for rational industrial sector development policies is becoming increasingly recognized by the Colombian authorities. Geographic Distribution of Industry 1.20 Colombia's difficult topography has given the country a strong regional character. In spite of improvements in communications, it is still made up of several semi-independent regional markets. As a result, industrial activity is more decentralized in Colombia than in most other Latin American countries. Nevertheless, the three largest urban centers and their areas of influence, Bogota, Medellin and Cali, account for more than 60% of industrial value added and nearly 70% of industrial employment. By the mid-60s some concern began to develop over the excessive concentration of the economic 1/ Using data on actual price differentials for different clothing categories in 1978, realized effective protection for exporting firms using Plan Vallejo was estimated to be about 38%, compared to 30-100% (depending on the clothing category) for firms catering only to the domestic market; the effective protection for exporting firms not using Plan Vallejo was estimated to be negative. See Why the Emperor's New Clothes are Not Made in Colombia by David Morawetz, World Bank Staff Working Paper No. 368, January 1980.  activities in a few urban centers, and the need to encourage further develop- ment in the nation's secondary cities. The first official attempt to halt or reverse the process of geographic concentration was introduced in 1967, through special labor and salary legislation, which was translated into minimum-salary and wage differentials among regions depending on the existing c:ncentration. However, the main industrial centers continued to grow, putting heavy pressure on infrastructure facilities, and causing increasingly serious problems of congestion and atmospheric and water systems pollution. 1.21 In 1975, the Government passed a new and more comprehensive set of policies for industrial decentralization. The major instruments for deflect- ing growth to secondary cities were: (a) restrictions on foreign investment in new enterprises to cities other than Bogota, Medellin and Cali and their areas of influence; (b) greater access to official development credit at slightly more favorable terms; and (c) infrastructure upgrading in secondary cities. In addition, development of industrial parks has been viewed by the Government as an important instrument for industrial decentralization, and a specific decree (Decree 2613) was passed in 1976 to stimulate their development. However, as the results of the industrial parks program to date have not been encouraging, the Colombian administration modified (through Decree 2143 of August 1979) the program, defining the specific areas where industrial parks development is permitted, and granting a series of incentives, including special credit facilities and tax benefits to industrial park developers as well as to enterprises wishing to locate their plants in the parks. 1.22 Overall, the progress achieved over the past decade towards reducing the concentration of industrial activity has been very limited. Indicators of concentration of the value added and employment in the three main urban centers appear to have remained about the same between 1967 and 1977 (Annex 4, T-12 and T-13). The Bank has supported the decentralization policies by helping to finance infrastructure projects and by allowing firms located outside the three main urban centers the option to have access to financing in pesos under previous DFC loans. Employment 1.23 Unemployment has generally decreased in Colombia since 1976. By early 1979, unemployment among the urban labor force was about 8%, lower than at any time during the past decade. This speaks well of the Government's efforts to increase employment, particularly in view of the rapid population growth in the 1960's, and the country's rapid urbanization. Manufacturing employment, which grew only at an annual rate of 1.6% during 1963-68, rose at a much more rapid rate of 8.3% per year during the 1968-74 period, reflecting the rapid industrial growth induced by the 1967 policy reforms. The employment growth was particularly notable in labor intensive subsectors, such as textiles, garments, footwear and mechanical engineering, which were export-oriented and responded well to the 1967 incentives. In the years since 1974, however, growth of manu- facturing employment has generally not kept pace with that of the sector's value added (Annex 4, T-6), reflecting at least in part the reduced export orientation of the manufacturing sector in the subsequent years (para. 1.14). In 1978, it was estimated that total industrial sector employment was about 1.25 million, or almost one quarter of the total urban employment. 1/ 1/ See also paras. 3.20 and 4.19 for a discussion of the employment impact of the previous and proposed Bank loans.  -9- 1.24 Despite periodic increases in wage rates, 1/ industrial wages are still fairly low in Colombia in comparison with other Latin American countries (para. 2.15). With the slower rate of peso devaluation over the past few years, Colombia has probably lost some of its comparative advantage in labor costs, but still remains quite competitive in the Latin American context. Technology Policy 1.25 Colombia has recently started to define an technology development policy. Until 1967, the acquisition of foreign technology or the related services was not subject to government regulations. Under Decree 444 of 1967, which regulates external trade and foreign exchange transactions, all technology transfer contracts are required to have specific authorization of the Royalties Committee and an authorization of the required foreign exchange from the Global Licenses Committee of INCOMEX. The Royalties Committee is to base its decisions on technology transfer on an analysis of Colombian and inter- national legal practices, balance of payments effects, and patents terms and other specific restrictions of the contracts. The Andean Group's Decision 24 of 1973 (elaborated further through Decisions 84 and 85) provided a more comprehensive framework for foreign technology acquisition and recommended a selective foreign technology import policy, based on the nature and impor- tance of the technology being considered, potential for its absorption and adaptation, possibilities for the domestic development of comparable technology, the expected impact on the Andean region and some specific contract features. In general, Colombian policies in the past have been "defensive" or protec- tionist, concerned mostly with control of royalty payments and the balance of payments impact, rather than a comprehensive approach towards local tech- nology development and adaptation. 1.26 There are two institutions in Colombia concerned specifically with technology development in the industrial sector--the Technological Research Institute (IIT) and the Colombian Fund for Scientific Research and Special Projects (COLCIENCIAS). IIT is a non-profit organization patronized by the Agricultural Fund, Banco de la Republica (BR), the National Coffee Federation, the Industrial Promotion Institute and the Colombian Petroleum Company. It has been operating since 1958 and offers technology research services, advice on production processes, and laboratory and other technical assistance. IIT currently employs 52 professional staff. Its physical facilities include two pilot plants, several laboratories, experimental kitchens and green houses and library facilities. A large proportion of IIT's contracts in recent years have been related to government projects (40%) and the patronizing institutions (13%), but private enterprises have also been getting significant amounts of assistance. Its efforts are currently concentrated in the processing of agricultural products, including product quality research of processed foods, and agro-chemicals, and in the research related to chemicals, ceramics and metal working industries. About 60% of IIT's costs are covered by income from ser- vices rendered; the cost of its services to small industrial firms is reduced by special subsidies. 2/ 1/ Minimum wages were increased by almost 40% in 1979, more than keeping up with inflation; increases in average wages are likely to be much lower than in minimum wages, however. 2/ The subsidies are provided through a special account in BR from out of the interest rate differential arising from channeling low cost KfW funds to the final beneficiaries.  - 10 - 1.27 COLCIENCIAS was created in 1968 to promote the country's technolo- gical development. It operates under the jurisdiction of the Ministry of Education and is responsible for providing financial support to technology development and for making recommendations on overall scientific and tech- nological policy. In addition to the government's budgetary allocations, COLCIENCIAS obtains financial and technical support from international orga- nizations. 1.28 COLCIENCIAS identifies the technological requirements of the devel- opment plan, sectoral programs, and of specific projects. It also helps strengthen and adapt the technological capacity of firms through provision of financial support to a variety of science, technology and related human resource development programs in priority areas such as nutrition, housing and construction materials, education and health, natural resources utiliza- tion and preservation, and physical environment improvements. Programs supported include those specifically related to productive activities in the industrial (especially mining and metallurgical) and agricultural sectors. Whenever applicable, it supports the development of engineering consulting services and of specific research programs undertaken. In order to facili- tate selection of the most suitable technologies by industrial firms, COLCIENCIAS has also been developing, in cooperation with other national and international institutions, an information system on the available technolo- gies in the various fields of industrial activity and their relative advan- tages and disadvantages. To strengthen the technological capacity of small industrial firms, COLCIENCIAS organizes visits for the managers of such firms to technologically advanced plants in the country and abroad. COLCIENCIAS identified the lack of adequate financial resources and shortage of technical experts as two of the major constraints limiting technology development in Colombia. Efforts made under past Bank DFC loans to promote technology development through provision of financing at preferential terms have had partial success and would be pursued more intensively under the proposed loan (paras. 3.21 and 4.10). Industrial Pollution Control 1.29 Colombia's industry is strongly concentrated in and around a few cities (para. 1.20), and pollution has become a serious problem in all of them. The first attempts to tackle pollution problems were made in 1963, when the Corporacion Autonoma Regional de la Sabana de Bogota y de los Valles de Ubate y Chiguinguira (CAR) passed regulations for water pollution in the areas under its jurisdiction. CAR was followed by another regional agency called Corporacion Autonoma del Valle del Cauca (CVC), with jurisdiction over the Cauca valley of which Cali is the center. Over the last three years, CAR and CVC passed more detailed regulations specifying maximum permissible levels of industrial effluents in their respective regions and deadlines for meeting such standards. Until recently, there has been little coordination among the various public agencies at the national level with respect to pollution standards and their administration. 1.30 The first comprehensive legislation at the national level was estab- lished in 1975 through the National Code for Renewable National Resources. This was followed by the promulgation of the National Health Code (Law 9 of January 1979) which gives the responsibility for formulating specific regulations re- garding the permitted levels of industrial emissions and effluents to the Ministry of Health. Among other things, the law prohibits the installation  - 11 - of industrial plants that do not comply with the new regulations, and contem- plates the establishment of deadlines for compliance by existing industrial plants and punitive measures for violators, ranging from admonitions and fines to mandatory closing of plants. The Ministry of Health is presently developing specific national regulations on emissions, which are expected to be passed by early 1980. In the interim, the Ministry of Health has delegated its authority to administer effluent standards to regional bodies such as CAR and CVC. 1.31 The most serious pollution problems in Colombia are found in some river basins. Since 1970, several studies had been made on ways to reduce the pollution level of the Bogota river, whose waters cannot at present be used for household or industrial purposes. The Bogota river pollution has become a national problem because of the large size of the area affected, which threatens the Magdalena river basin. However, no significant actions have yet been taken to improve the conditions of the Bogota river. Serious problems also exist in the basins of the Medellin river and, to a lesser degree, the Cauca river. 1.32 Private industry in general appears to have a positive attitude vis-a-vis the pollution problem. A few large industrial enterprises are now publishing advertisements alluding to the need to protect the ecology and the physical environment, and one of them introduced an annual prize in 1979 for the best work done in the field. Under the present circumstances, given the apparent readiness of the authorities to enforce the new regulations, the two main factors limiting pollution control efforts appear to be the lack of adequate financing, and, often, insufficient technical capacity to design the appropriate projects for meeting the minimum permissible standards. The proposed loan would help in overcoming the first obstacle by providing financ- ing for industrial pollution control investments at attractive terms and interest rates (paras. 4.10 and 4.12). As to the second, the authorities and the private sector industry associations are aware of the difficulties and are considering measures to develop an information system on specialized foreign consulting services to develop adequate local technical capacity. Outlook for Industrial Growth and Investment 1.33 Colombia's economic growth over the medium term will depend on the Government's success in its stabilization programs and in managing the external sector. Most estimates indicate that the economy should be able to grow at about 6% p.a. in real terms over the next few years. The industrial sector is expected to be one of the leading sectors, probably growing at a rate of 6-7% per year. To achieve the above rates, substantial increases in investment would be needed, particularly in the manufacturing sector, which is presently working at a high capacity utilization level (para. 1.04). Achieving the necessary investment levels in the manufacturing sector will depend on the success of the government's stabilization program and the availability of adequate term finance from domestic and external sources. The external market for Colombia's manufactured products is also likely to play an important role in the sector's growth, and would depend heavily on the government's future exchange rate adjustment policy and on the manufacturers' promotion efforts to find new markets. Based on historical experience, an average manufactured exports growth rate over the next few years of about 12% p.a. in real terms may not be unrealistic under a reasonable exchange rate regime.  - 12 - II. THE FINANCIAL SECTOR Institutional Structure 2.01 Colombia has a relatively well-developed and diversified financial sector comprised of the Central Bank (Banco de la Republica--BR), 29 each of commercial banks and investment/development banks (financieras), 1/ and several each of agricultural and mortgage banks and savings and loan corporations (10), commercial finance companies (39), insurance companies (77), and mutual funds (2), and two stock exchanges (Bogota and MIedellin). This structure of special- ization has evolved as a result of government financial policies favoring the institutional separation of financing functions. 2.02 Commercial banks dominate the institutional financial sector, accounting in 1978 for about 42% of total credit, followed by the mortgage banks and savings and loan corporations (27%), and the financieras (16%) (Annex 4, T-16). Direct lending by banks is supplemented by rediscounting facilities of BR funded in part out of the legal reserves of the banking system. For industry, the most important of these are the Industrial Financing Fund (FFI), which rediscounts loans made by commercial banks and financieras to small- and medium-size industrial firms (those with total assets of up to Col$ 60 million), the Private Investment Fund (FIP), which mainly finances firms larger than those covered by the FFI, and PROEXPO (para. 1.11). Financial Sector Policies and Evolution 2.03 Despite a relatively sophisticated institutional system in the financial sector, the high degree of government regulation and control and other past policies have retarded its full development and limited its alloca- tive efficiency. At least until recently (para. 2.08), the result has been the evolution of a relatively rigid and compartmentalized credit system with limited market determination of the terms and conditions of financial inter- mediation. The financial sector has been subject to a complex system of reserve requirements and forced investment regimes and low legal limits on nominal interest rates with wide differentials in rates for the different categories of borrowers and savers. The frequent changes in the regulations governing the financial sector, including tax treatment of earnings from savings instruments and interest rate policies, introduced substantial uncertainty in the mobilization of resources by the various financial instru- ments. This was exacerbated by unequal competition from public sector savings instruments and instruments issued for monetary management, which offered the advantages of tax exempt status and immediate liquidity (sometimes at guaranteed prices), and whose yields and other characteristics have varied substantially over time. The most notable among such instruments have been the indexed instruments to finance urban construction (UPACs) that were introduced in 1972 with the feature of full monetary correction, the coffee savings certificates (TACs) and bonds (since 1976), the tax certificates (CATs) and Certificates of Exchange (issued by BR), which became the most attractive short-term instru- nents towards the late 1970s, and most recently (since September 1979), BR's certificates of participation (para. 2.06). Annex 4, T-17 presents a summary 1/ The financieras include 6 public sector development banks, the largest of which is Instituto de Fomento Industrial (IFI) --- see para. 2.16.  - 13 - of the evolution of the estimated effective yields for the various competing instruments in the Colombian financial sector. The new instruments introduced from time to time and their varying yields caused sharp swings in the amount of resources captured through the various parts of the financial sector. 2.04 Financial policies for the development of the Colombian financial sector and capital market in particular have been influenced strongly by the recurrence of inflationary cycles, generated by, among other things, periodic rapid swings in the price of coffee, the country's main export product. The monetary authorities have used imaginative approaches to neutralize the infla- tionary impact of these developments, in part at the expense of introducing new elements of distortion into the financial market and credit system. In general, as inflation increased, traditional deposit and lending instruments of the banking sector were limited by low nominal interest rate ceilings, which did not permit the necessary adjutments in order to offer positive yields in real terms. Given the frequent changes in the available financial instru- ments and their yields, and the lack of a premium on medium- and long-term instruments, savings in recent years have been channeled almost exclusively to the highly liquid short-term instruments. The most important specific financial sector developments over the past six years are briefly discussed below. 2.05 Following tight government controls and regulation during the early 1970s, a major financial sector reform was carried out in 1974 to stimulate savings, integrate the fragmented market and promote more efficient alloca- tion of resources. A parallel fiscal reform was undertaken to make the tax system more progressive and to strengthen the fiscal base. Interest rates were permitted to rise in successive stages and differentials between rates were narrowed (Annex 4, T-17). The degree of monetary correction and tax exemption on value-indexed instruments was limited to bring yields in line with competing securities. Forced investment requirements of financial institutions were relaxed and new issues of public sector instruments no more had tax exempt status nor immediate liquidity. Through related measures, the financieras were authorized (under Decree 399 of 1975) for the first time to undertake short-term operations, permitting them to capture funds through the issue of 90-day fixed-term Certificates of Deposit (CDs) 1/ and time deposits and relending the proceeds over comparable periods for industrial production and sales financing. The financial reforms had a positive impact on savings mobilization by the financial system, especially by the financieras, and a better balance was achieved between savings captured through competing instru- ments. During 1975-76 savings channelled through the institutionalized financial system increased at an average annual rate of about 17% p.a. in real terms, as inflation rate dropped from 27% in 1974 to 18% in 1975 and 20% in 1976 (on a December-December basis) and permitted positive interest rates in real terms (Annex 4, T-24). 2.06 Financial policy measures taken to cope with the complex economic situation created by the world recession, illegal exports receipts, and the inflationary effects of the extraordinary rise in coffee prices and a major drought in Colombia in 1976, brought the progress achieved by the financial reform during 1974 and 1975 to a halt. To counter inflationary pressures resulting from the large inflow of export earnings from coffee and the shortage of basic food supplies, the monetary authorities imposed heavier reserve requirements and stricter credit controls. In 1977 a marginal reserve requirement of 100% was imposed on commercial bank demand deposits, which 1/ The financieras were also authorized later to issue longer term CDs.  - 14 - remained in effect until very recently (para. 2.08). 1/ Concurrently, in an attempt to avoid a slowdown of investment in key sectors, renewed emphasis was placed on the system of selective credit allocation through BR's industrial financing funds, the forced investment regime was partly restored through certain provisions for the acquisition of agroindustrial and IFI bonds, and interest rates were not permitted to rise with inflation. These measures initiated a counter-reform of financial policies which was continued and progressively widened during 1978 and 1979. Additional restrictive measures included the institution of reserve requirements (initially of 15% and later 25%) on CDs issued by the financieras, the issue by BR of 90-day "certificates of exchange" denominated in dollars for the purpose of "mopping up" the liquidity originating from the external sector, and, starting in September 1979, massive issues of certificates of participation (akin to treasury bills in the US) offering effective yields of up to 37% p.a., for maturities ranging from 15 to 90 days. A withholding tax of 5%, which was instituted through Law 20 of April 1979 for income on interest earnings, had a further dampening effect on resource mobilization by banks and financieras. Financial savings virtually stagnated in real terms in 1977 when the inflation rate reached 29% (on a December-December basis), but recovered to a 17% real growth rate in 1978 as the inflation moderated to 18% (Annex 4, T-24 and T-25). 2.07 Constraints on resource mobilization by the traditional domestic finan- cial system led to a reliance on external credit sources for a substantial portion (30-40%) of the industrial financing needs, and to the development of an increasingly large and flourishing extra-banking market, which is estimated to have provided more than 20% of the total industrial credit in 1978 (Annex 4, T-18). By some unofficial banking sector estimates, the extra-banking market may have grown to as much as one-quarter of the total financial system, accounting for a like proportion of total industrial credit. In an effort to improve the vigilance of the extra-banking operations, the Superintendency of Banks, through Decree 1970 of 1979, brought under its supervision the institu- tionalized segment of the extra-banking market which is comprised mainly of "commercial finance companies" (companias de financiamiento comercial). Under the new rules these institutions are subject to a minimum debt/equity ratio of 10:1 (compared to 20:1 for financieras), and all new commercial finance companies are required to have a share capital of at least Col$100 million. 2/ Recent Development and Prospects 2.08 At the end of January 1980, the Monetary Board put in effect a series of major reforms to remove or relax a wide range of regulations governing the operations of Colombian banks and financieras. Most importantly, it removed ceilings on interest rates on bank and financiera CDs and on loans made with funds raised through CDs. The Monetary Board also abolished the 100% marginal reserve requirements on current account deposits as of January 31, 1980 and substituted this by a gradual increase of the regular reserve requirements 1/ A marginal reserve requirement of 100% had been in effect earlier for brief periods during 1972 and 1975. 2/ By year-end 1979, as many as 29 commercial finance companies were operating in Colombia, the majority of which were established during or after 1977. Between year-end 1975 and mid-1979, the total assets of the commercial finance companies expanded from Col$4.1 billion to Col$11.9 billion, growing at an annual rate of about 35%. About one-third of their lending is to commerce, one-third to industry and construction and the remainder to other sectors.  - 15 - months from 45% to 50%. At the same time regular reserve requirements for the financieras' CDs were reduced from 25% to 15%. All the reserves kept with BR would in the future earn a return of 25%, up from 21% earlier. Finally, the Monetary Board lifted the 3-5 year mandatory ceilings on the terms for external financing contracted directly by the private sector for equipment purchases, and delegated to the External Trade Council (Consejo Directivo de Comercio Exterior) the authority to approve terms for each external financing operation compatible with the investment's gestation period and cash flow projections. Although it is still too early to analyze the full impact of the above series of measures liberalizing the financial sector, they are undoubtedly very encouraging, and can be expected to have a substantial positive impact on the mobilization and allocation of resources by the financial system and on the growth of the institutional financial sector. In particular, the flow of funds out of the banking to the extra-banking sector should be reversed, as the lower- ing of reserves requirement and freeing of interest rates will improve the terms that banks can offer to savers. Also, these measures may permit the financieras, over the medium-term, to gradually lengthen the maturities of savings instruments and loans. Achievement of the full positive impact of the liberalizing measures would depend in part on whether the Government can limit the possible short run inflationary effect of the reforms and is able to sustain them in the long run. 2.09 Through an earlier measure in mid-1979, the government created a National Securities Commission with the objective of stimulating and regulating the securities markets. Arrangements are currently under way to design the charter of the Commission and initiate its operations. A more effective operation of the security markets, if achieved by the Commission, could have an important positive influence on the capitalization of industry as well as resource mobilization in general in Colombia. 1/ Industrial Financing 2.10 Sources. In recent years, the industrial sector has obtained financing not only from the domestic commercial banks and financieras, but also from specialized institutions such as the Caja Agraria and the institu- tionalized and non-institutionalized extrabanking market. Between 30% and 40% of industrial financing has come from direct external borrowing, with external suppliers' credits accounting for 0.5% to 1.0% of industrial financing. During 1974-78, the volume of industrial credit expanded at an annual rate of about 30% compared to an average rate of inflation of about 25%. The real rate of growth was thus slightly below the 5.3% real growth rate of industrial production, confirming the belief of industrialists, 2/ that the availability of industrial credit has become progressively tighter. 37 2.11 During 1974-78 industrial investment as well as working capital in Colombia was financed increasingly with borrowed funds. Debt financing 1/ An IFC (CCM) mission is currently visiting Colombia to discuss possible Bank group assistance in the start-up phase of the Commission's operations. 2/ As reflected in the FEDESARROLLO quarterly opinion surveys, and field interviews carried out in connection with the appraisal. 3/ The thrust of anti-inflationary monetary policy during this period has been to reduce the overall rate of credit growth, particularly commer- cial bank credit. Substantial financial resources were withdrawn from the market through diverse types of forced savings (Agroindustrial and IFI bonds and Exchange Certificates).  - 16 - rose from about 37% of assets in 1965 to 58% in 1972 and ranged between 60% and 65% from 1974 to 1978. Of the total debt financing in 1978, total credit from banks and financieras using their own resources accounted for 27%, developmental credit supported through special rediscounting mechanisms for 28%, external loans for 29% and other sources (including extrabanking credit) for 15% (Annex 4, T-20). 1/ 2.12 Equity financing. Funds generated internally through retained earnings and depreciation allowances, which in the 1960s were the major source for financing manufacturing investment, have declined in importance, accounting for only 32% of investment funds in 1978. With new stock issues providing only about 10% of equity financing, retained earnings constituted the bulk (90%). In view of the relatively high levels of inflation experienced during the 1970s (averaging about 21% p.a. between 1971 and 1979), the tax system was modified in April 1979 by Law 20 (Ley del Alivio Tributario), which per- mits full annual inflation adjustments (equal to 100% of the cost of living index) to the value of assets and earnings, in effect fully neutralizing the impact of inflation on the taxable capital gains. This measure is expected to help in increasing the contribution of retained earnings to investment financing and strengthening the capital position of industrial firms. 2.13 Despite the operation of two stock exchanges in Colombia, new share issues by industrial companies have been infrequent and have provided only a small part (estimated at about 5% in 1978/79) of the financing for new industrial investment. Between 1972 and 1975, the index of industrial stock prices declined by about 2%, while consumer prices rose by 89%. However, from 1975 to 1978, prices of industrial shares rose more rapidly, at an average annual rate of 37%, compared to an average annual increase in consumer prices of 23% (Annex 4, T-21), thus reactivating investor interest in the stock markets. 2.14 Outside the stock market, the financieras have also made significant equity investments in industrial corporations, in response to Resolution 65 of 1977 of the Monetary Board, requiring financieras to hold at least 10% of their assets in the form of equity of productive enterprises (para. 3.23). The total value of equity investments made by the financieras participating in the Bank loan was about Col$1.9 billion at the end of 1979; the increments in the value of the equity holdings of these financieras in 1978 and 1979 are estimated to be equal to as much as one-quarter to one-third of the total value of shares of manufacturing enterprises transacted on the Bogota and Medellin stock exchanges. 2.15 Banking system credit. Total domestic banking credit to the indus- trial sector grew at an average annual rate of 31% in nominal terms during 1974-78, or at about 6% annually in real terms (Annex 4, T-18), approximately equalling the growth of GDP over that period. The proportion of total domestic credit going to the industrial sector remained relatively constant in recent years, at about 25% (Annex 4, T-16). Commercial banks channelled about 40% of the credit outstanding to industry (including credit using their own resources as well as developmental credit supported through BR's special rediscounting mechanisms) and financieras, about 28%. However, 70% of the commercial bank lending is short-term, mainly for working capital financing, whereas more than two-thirds of financiera lending is in the form of medium- and long-term loans, for the purpose of making fixed industrial investments. Overall, the 1/ Based on quarterly industrial surveys carried out by FEDESARROLLO.  - 17 - financieras channel substantially greater amounts of medium- and long-term funds to industry (higher by 50% or more during 1974-79) than commercial banks. However, the average term of financiera lending outstanding to industry shortened considerably in recent years. Given the high liquidity preference of savers resulting from the prevailing conditions of high and varying inflation and other financial sector uncertainties, almost all the resources mobilized by the financieras in these years have been very short term (less than 180 days); in the absence of an adequate term transformation mechanism (para. 3.43) the financieras had to limit themselves to short term lending when using deposit resources. As a result, long-term lending to industry by the finan- cieras grew only at an average annual rate of 17% during 1974-78 (declining in real terms), and medium-term lending at 46% p.a., while short-term lending grew at more than 70% p.a. (Annex 4, T-22). 2.16 There are 29 financieras operating in Colombia, holding Col$ 65.6 billion in assets as of March 1979, including six public and 23 private insti- tutions. Annex 4, T-19 includes a listing and the main characteristics of the operating financieras as of year-end 1978. The principal public sector insti- tutions engaged in general industrial lending are the Industrial Development Institute (IFI), CF Popular and COFIAGRO. IFI is the largest financiera, holding along 25.5% of total financiera assets. It is primarily a holding company and financing agent for public sector industry, but also finances some large private sector projects. Of the other two public financieras, CFP, with about 3% of total financiera assets, concentrates on lending to small-scale enterprises with assets of up to Col$35 million, 1/ and COFIAGRO (Corporacion Financiera de Fomento Agropecuario y de Exportaciones), with about 1.3% total of financiera assets, deals primarily with agroindustry. The public sector financieras together have accounted for about 36% of total financiera assets and for about 23% of total financiera lending. 2/ The eight private financieras that have participated in the previous Bank loan accounted for about 59% of total credit of private financieras outstanding in mid-1979 and as much as 70% of their long-term credit; most of the remaining private financieras concentrate on short-term lending operations, and, except for Grancolombiana, are relatively small and of recent origin. 2.17 Other sources. Direct external borrowings (including suppliers' credits) has provided 30%-40% of the industrial credit outstanding in recent years. Between 1974 and 1977 direct foreign loans to the industrial sector registered with the Central Bank expanded at an annual rate of 22.6%, which was roughly equal to the rate of inflation during this period. External suppliers' credits, providing between 0.5% and 1% of industrial credits during these years, started from a small base and expanded more rapidly, growing at about 40% p.a. Industrial corporations lacking access to banking system credit have had to rely on the institutional or non-institutional extra-banking market to obtain short-term credits at high interest rates. The extrabanking market was dominated originally by the commercial finance companies, but commercial banks and financieras have also expanded into extrabanking activities over the last two years, through trust fund operations and sales of participation in their loan portfolios. 1/ The Bank has supported small scale industry through CFP by means of two loans in 1975 and 1977, and a third one was approved by the Board in April 1980 (para. 3.01). 2/ Based on mid-1979 data.  - 18 - 2.18 Interest rates. The cost of industrial credit varies according to the source and terms of funds used. Until recently (para. 2.08), maximum nominal interest rates had been established by the monetary authorities, but financial intermediaries, through additional charges and collection of interest in advance, were able to vary the cost of funds. 1/ As a result, effective interest rates from private intermediaries vary between 35-40% p.a. on short- term loans; for comparable loans the extrabanking market is charging about 40% p.a. and more. The interest rates on short-term loans have increased about 4-8 percentage points in the last year as the Monetary Board has steadily restricted lending growth. Intermediaries charge effective rates of 25-29% p.a. for medium- and long-term loans using BR rediscounting facilities. Term loans to small and medium scale industry using BR rediscounting facilities have interest rates between 22% and 27% p.a. The comparable annual effective interest rates on subloans under the regular lending component of the Bank's Seventh DFC Loan are in the range 27-29% p.a., that is, close to the high end of the rates under BR's rediscounting lines. Most rates on many of BR's rediscounting lines have generally been positive in real terms, when smoothed over a 1-2 year period. Onlending interest rates under the proposed loan would be periodically reviewed and adjusted, as necessary, to ensure positive real rates and general conformity with the rates in the financial markets (para. 4.08). 2.19 Access to industrial credit. Field interviews during appraisal confirmed that almost all categories of industries have experienced an increas- ingly serious problem in securing adequate financing. The problems are par- ticularly acute in relation to working capital financing, as this is normally financed from domestic sources. Within the financing regulations of the Monetary Board which had been in effect until recently (that is, maximum terms of 3-5 years and 6 months, respectively, for equipment and raw material imports), the largest industrial firms/groups have generally been able to obtain financing from foreign commercial banks in adequate amounts and attractive terms (usually at interest rates of up to 1% above LIBOR). Some of the medium-sized industrial firms had access to the external markets, although only to a much more limited degree and generally at interest rates of 2% or more above LIBOR. 2/ 2.20 Industrial firms which export part of their production have adequate access to the low cost credit of the export fund PROEXPO. Firms located out- side the largest urban centers, where no large financiera is headquartered, and the relatively small firms, appear to have considerably more difficulty in obtaining term credits and financial services, because of the higher adminis- trative costs and/or risks involved for the financieras. Given the very tight credit situation, industrial enterprises other than those belonging to the largest groups have often had to pay a variety of direct or indirect charges to the banks, so as to hike up the effective interest rate above the nominal rate ceilings fixed by the Monetary Board. In addition to the prepay- 1/ Effective interest rates can be 2-5 percentage points higher when prepayment of interest charges (usually quarterly) is taken into account. All interest rate estimates in this paragraph are effective rates, taking into account interest prepayments but not compensating balances or other loan charges. 2/ It is in this category of firms that the financieras can play an especially effective catalytic role by introducing such companies to the international financial markets.  - 19 - ment of interest charges and maintenance of compensatory balances, which are common practices with most Colombian banks and financieras, enterprises frequently have had to provide other benefits to the financial institutions, including through letter of credit operations, artificially designed "bridge loans" or arranged "arrearages" (all of which yield very high short-term returns). Firms crowded out from banking system credit have had to pay even higher effective interest rates, mostly upwards of 40% p.a., in the extrabank- ing market. Lack of adequate financing has thus been the main obstacle for the growth of many industrial firms.. Need for the Proposed Loan 2.21 Regaining a high rate of industrial growth will require the mainte- nance of a high rate of investment in the expansion of productive capacity. Based on recent investment levels, the present high plant capacity utilization levels (para. 1.05), and the public investment program, the industrial sector is estimated to require total financial resources exceeding Col$100 billion (US$1.9-2.1 billion) over the period 1980-83 for new fixed investments and associated working capital. The recent financial sector reforms, if sustained, should help a healthy growth of financial savings and of available working cap- ital financing, but longer-term credit from domestic sources is likely to remain in short supply at least for the next 1-2 years in view of the time needed for the impact of recent financial reforms to be fully reflected in the capital market and for the achievement of greater economic stability. As in the past, industry will have to rely partially on overseas sources, both official and commercial, to finance fixed asset expansions on adequate terms. The proposed Bank loan has been designed to meet the term financing needs of investment projects likely to be financed by the participating financieras after taking into account likely complementary resources (para. 4.02), and would enable the financieras to provide 10-15% of industry's term financing needs -- approximately the same proportion as they have financed in recent years. Assurances have been obtained in connection with the proposed loan that adequate amounts of domestic resources as well as financing from other external sources (through 'cofinancing') would be mobilized by the financieras to complement the Bank resources (paras. 3.41, 3.42 and 4.17). III. INSTITUTIONAL ARRANGEMENTS AND PARTICIPATING INSTITUTIONS A. Background 3.01 Bank DFC lending to Colombia started in 1966 with a first loan of US$25 million to BR for onlending through five private financieras--CF Colombiana in Bogota, CF Nacional in Medellin, CF del Valle in Cali, CF del Norte in Barranquilla and CF de Caldas in Manizales. 1/ To date seven DFC loans totalling US$342.5 million have been made to BR and the number of partici- pating financieras has increased to eight. Although all these loans were designed to assist efficient productive projects in general, the most recent loans contained special features designed to ensure a wide distribution of Bank funds, encourage lending to medium-size enterprises, and promote export genera- tion, technology development and industrial pollution control. However, it was also recognized that the nature of financiera operations--their lack of an extensive network of branch offices, the detailed project appraisals, and the relatively low margin on resources available to them--limited the assis- tance they could provide to smaller firms. Therefore, the DFC loans were 1/ All five are also recipients of IFC equity investments.  - 20 - complemented by two loans in 1975 and 1977, totalling US$20.5 million for Corporacion Financiera Popular (CFP), a government-owned DFC which specializes in financing small-scale enterprises. 1/ 3.02 Under the first four DFC loans the Bank focused its efforts on assisting the institutional development of the five participating financieras and closely monitored their operations. While this approach was successful in building these five older financieras into effective and mature term financing institutions, it placed heavy demands on Bank manpower and virtually precluded participation of the several other less experienced financieras. Institutional arrangements were progressively modified, starting under the Fifth Loan made in 1973, with the objective of developing within BR the capability to eventually take over most of the Bank's supervision functions. Since 1973 Bank supervi- sion efforts have been focused on strengthening the capability of BR's Depart- ment of Development Credit (DDC) (see para. 3.03) to discharge increased respon- sibilities in the areas of subproject review and supervision of financieras newly participating in Bank operations. Direct contact has been maintained with the five older financieras, but with attention centering on their overall developmental impact and less on operational details. The modified arrangements enabled two new financieras to participate starting under the Fifth Loan--CF Occidente in Pereira and CF de Santander in Bucaramanga--and an additional financiera-CF Aliadas of Medellin--under the Sixth and Seventh Loans on a lim- ited basis. The process of delegating increased responsibilities to BR and strengthening BR's capacity to discharge them would be continued under the proposed loan (para. 3.06). This is in line with past OED reports which concluded that the financieras had been an effective mechanism for allocating and channeling resources to medium-size and larger enterprises, but suggested that it might be more cost effective in the long run for the Bank to delegate greater responsibilities to BR and thus permit increased Bank attention to sectoral issues. The modified arrangements allow the Bank to concentrate more on the broader issues of industrial policy and capital market development in connection with the proposed loan. 3.03 As of February 29, 1980 approximately three-quarters of the US$100.0 million Seventh Loan (1598-CO) had been committed for subloans and equity investments, and the loan is expected to be fully committed by mid-1980, about six months ahead of appraisal estimates. Cumulative disbursements under the Seventh Loan by the end of February 1980 were about US$23.0 million, or about two months behind the disbursement schedule estimated at the time of appraisal of that loan. About US$5.6 million of the US$80.0 million Sixth Loan (1223-CO) was still uncommitted (and about US$10.0 million undisbursed) by that date, mainly as a result of cancellations or modifications of previously approved subprojects. B. Banco de la Republica 3.04 BR combines its central banking function with development banking activities involving the administration of various official lines of term credit, principally to industry and agriculture. All credit lines for productive sector lending (except for agriculture), including Bank DFC loans, are handled by DDC. Under the first four loans DDC's role was limited to screening subprojects submitted by the financieras to ensure that scarce funds were allocated to projects that were consistent with Colombia's overall 1/ A third loan of US$32.0 million to support small-scale industry was approved by the Board in April 1980.  - 21 - developmental priorities. The role has since been expanded to include respon- sibility for the review and approval of subprojects, and the full supervision of newly participating financieras. Over the past few years, BR's performance with respect to subproject review has continued to develop satisfactorily. There has been little turnover among project analysts, and the coverage of technical, financial and economic aspects has improved with the help of training programs carried out with Bank support. Most notably, BR analysts are going beyond routine reviews of compiled information to take a more critical look at project viability and discuss potential weaknesses with sponsors as part of the review process. However, in its review of the appro- priateness of onlending terms, DDC has increasingly tended to make excessive reductions in the subloan term and grace period requested by the financieras. Thus, under the Sixth Loan, 38% of subloans by amount had periods of 10 years or more, compared to only 17% under the the Seventh Loan. During negotiations, the Bank obtained understandings from BR that subloan terms and grace periods for future subprojects would be based on conservative estimates of the cash flow projections from the investments, taking into account probable impact of inflation and uncertainties inherent in cash flow forecasts. These understand- ings are incorporated into DDC's revised statement of policies and procedures agreed with BR in connection with the implementation of the Bank financed DFC projects (Annex 2). BR would also prepare and furnish to the Bank, by March 31, 1981, a program for further training of DDC staff as needed to strengthen and expand its operations. 3.05 Subloan processing from submission to BR to receipt of disbursement notification by the Bank has slowed, often taking six months or more, as a result of staff constraints, administrative procedures, and, frequently, excessive emphasis on details in reviewing subprojects. BR has acknowledged the problem, and has indicated that it will implement various measures to cut down project processing times, including increasing the number of analysts devoted to the Bank-supported projects by 3 to 5 professionals, providing training as needed to the junior analysts, and adopting a problem-oriented and pragmatic approach in subproject review, which takes account of the characteris- tics of the particular project. For example, projects involving new product lines may need a closer review of the technology and market analysis than those involving expansion of existing product lines by established firms. Similarly, DDC should delegate most of the responsibility for project evaluation and review to the financieras in the case of subprojects below their free limit vis-a-vis BR. These understandings were confirmed during loan negotiations, and reflected through appropriate revision in the operating policy statement of DDC (Annex 2). The Bank would also work closely with BR on possible measures to speed up disbursements to the final beneficiaries and to ensure early notification to the borrowers when disbursements are made to third parties on behalf of the borrowers. 3.06 BR's capability to supervise and provide assistance to the newly participating financieras, after a slow start, has improved significantly over the past year. In general, BR staff have performed adequate reviews of the technical capabilities and financial position of the financieras, and noted key changes required. On the other hand, the staff have not always been diligent in ensuring the financieras' compliance with all Bank loan covenants. At negotiations agreement was reached (this is reflected in the revised operating policy statement of DDC) on expanding BR's supervision role under the proposed loan to specifically include monitoring the compliance by the participating financieras with all the financial covenants contained in  - 22 - the Subsidiary Loan Agreements (including debt/equity, current assets and exp:sure limitations). During supervision missions Bank staff members would continue to accompany BR's staff on visits to new financieras in order to follow up on their performance. C. The Participating Financieras 3.07 The following sections review jointly the characteristics, operations, financial performance and economic impact, and resource needs of the group of seven financieras which participated fully under the Seventh Loan, and of CF Aliadas, which participated in the Sixth and Seventh Loans on a limited basis. In addition, one or two more financieras are likely to participate in the proposed loan on a limited basis, under conditions discussed in para. 3.46. Background and Ownership 3.08 The Colombian financieras were established to provide longer term debt and equity financing to private productive enterprises, principally in the industrial sector. Colombiana, Nacional, Valle, Norte and Caldas came into existence between 1959 and 1964. The former four are headquartered in the four largest urban centers of Colombia. Occidente and Santander were established in 1966 and 1967 respectively, and like Caldas, are located in predominantly agricultural regions which they are helping to diversify by developing industry. Aliadas, located in Medellin, was founded in 1975. 3.09 All eight financieras are predominantly Colombian owned. Despite a recent tendency towards concentration of ownership in some of the five older financieras, their shares are relatively widely held among banks, insurance companies, and industrial enterprises, except for Caldas, in which the National Coffee Federation and related entities hold about 70% of equity. IFC holds equity investments in each of the five older financieras, which were made from 1961 to 1967 and now range from 2% of equity in Valle to 5% in Norte. The shares of Occidente and Santander are more closely held. Occidente has two main shareholder groups: the National Coffee Federation with about 49% of share capital, and a local businessman (39%). About 75% of Santander's equity is owned by the Santo Domingo Group, a powerful industrial and financial services conglomerate. Also, the Santo Domingo Group has recently increased its holdings of Norte stock to 48% of Norte's paid-in capital, and is likely to assume a majority position in 1980. The Bank, through its normal supervi- sion, and IFC, which has a representative on Norte's board, are closely following the effects of the Group's increasing participation in Norte. Aliadas is owned by Inversiones Aliadas, a diversified holding company whose largest investment is in distribution and sale of pharmaceuticals. 3.10 A review of the portfolios of the closely held financieras during appraisal of the Sixth Loan showed a tendency for those financieras to give preference to lending to members of their controlling groups. To correct this undesirable trend, an exposure limitation was introduced with respect to each financiera's loans and investments in any single group of related companies so as to avoid excessive concentration of credit risks, limit "insider" transac- tions, and enhance the development impact of each financiera through an adequate dispersion of its lending and investment activities. This "exposure limit" was set at 25% of the financieras' net worth (defined as paid-in capital, retained earnings, reserves, and revaluation) for all outstanding loans, investments, and contingent liabilities to any single company, and 50% of net worth to any group of related companies. The impact of this limit had been  - 23 - positive, particularly in containing the financieras' provision of financing to their main owners and companies related to them. The treatment of revalua- tions for the purpose of computing total exposure in any group of related companies would be more clearly specified under the proposed loan and would be required to be fully consistent with that proposed in connection with debt/equity computations (para. 3.28). As part of its monitoring of the financiera operations (para. 3.06), BR would ensure the financieras' com- pliance with the exposure limits, through quarterly (or, if necessary, more frequent) reviews of their financial statements. Organization and Staff 3.11 The five older financieras and Santander have capable and experienced management. Occidente, on the other hand, has experienced substantial turnover at the senior management level and among its technical staff. Following a recent change in shareholders, its president resigned and has been replaced by the financiera's former financial vice president; other key staff have also been appointed recently (Annex 4, T-29). Aliadas has a capable president, but virtually no other managers with significant background and experience in development banking. Occidente and Aliadas would strengthen their profes- sional staff through recruitment and training as needed; these measures would be included in their respective plans of action which would be prepared in connection with the proposed loan to correct their institutional weaknesses (paras. 3.35 and 3.49). Substantial progress by Aliadas in implementing its plan of actions, including upgrading its middle-management and technical staff would be a special condition of effectiveness for its participation under the proposed loan (para. 5.02). 3.12 While the five older financieras and Santander have adequate staff at the senior levels, Norte and Valle have both suffered from a considerable turnover of the more junior analysts, due partly to their relatively low salary levels (Annex 4, T-29). This situation has been brought to the attention of these financieras, which have already initiated remedial steps. Subproject Appraisal and Supervision 3.13 A continuing objective of the Bank has been to encourage the finan- cieras make an important contribution to efficient resource allocation in the country through sound project appraisal. Most project appraisals prepared by the five older financieras and Santander are adequate, and their technical evaluations have gained in depth and coverage. Marketing analysis has improved but remains an area of relative weakness. Some deficiencies also remain in appraisals of technology development and pollution control projects; appro- priate understandings were reached at loan negotiations to correct them (see paras. 3.21 and 3.22). Economic evaluation of projects has been strength- ened substantially with the help of Bank-sponsored seminars to train BR and financiera staff in this important aspect of project work. However, in some cases, especially for related companies, the financieras have committed themselves to financing the subprojects prior to undertaking adequate feasi- bility studies. This aspect was discussed with the financieras during loan negotiations and understandings were obtained on appropriate corrective actions in subproject processing. As under the Sixth and Seventh Loans, economic rate of return (ERR) calculations would be required under the proposed loan for all projects seeking subloans in excess of US$250,000. Despite some improvements, appraisals submitted by Occidente have not yet reached the depth and quality of  - 24 - those prepared by the others; Aliadas has had little capability in the recent past to appraise subprojects, but has initiated steps to upgrade in this area prior to participating in the proposed loan (para. 3.49). It would be necessary for BR to continue to review closely all Bank subprojects submitted by Occidente and Aliadas under the proposed loan and to assist these financieras in upgrading their appraisal proficiency. 3.14 The five older financieras and Santander have adequate supervision and follow-up systems. Reliance on periodic reporting and informal supervision, occasionally through participation of financiera staff on the boards of some clients, is often justified as most clients are experienced, established firms. Norte, with a portfolio containing a relatively large number of new firms and firms located in a less developed region, faces more difficult supervision, but in recent years has become reasonably effective in monitoring clients' situations and reacting to possible problems. The majority of the financieras' clients are visited at least once per year, with the visits programmed on the basis of the risk exposure of the respective financieras--and the financial and operating situations of their clients. The financieras generally give priority to the supervision of Bank- and BR-financed projects, because of their larger size and the discipline imposed by Bank and BR reporting requirements. Improvement of supervision procedures of Occidente has been slower than expected, due to staff constraints and the lower priority assigned to this activity. In connection with the loan negotiations assurances were obtained from CF Occidente that it would improve its supervision, procurement and disbursement procedures; Occidente incorporated appropriate corrective measures in its plan of action (para. 3.35). Aliadas would develop its supervision capability and procedures as part of upgrading its appraisal capabilities (para. 3.49). Operations and Impact 3.15 Lending operations. The combined loan portfolio of the eight financieras amounted to about Col$ 18.9 billion (almost US$440 million equiva- lent) at the end of September 1979, having increased at a 29% compounded annual rate since year-end 1975, or about 6-8% p.a. in real terms. 1/ The short-term portfolio of the financieras (excluding the current portion of term loans) has increased rapidly since early 1975, when they were authorized by the Governemnt to offer higher interest rates than most other financial intermediaries on short-term borrowings and lending operations to help finance industrial working capital requirements. Thus, for the group of eight finan- cieras, the percentage share of short-term loans (loans made with a maturity not exceeding one year) rose from 9% of total loan portfolio at year-end 1975 to about 28% at September 1979. The shortening of the term structure of assets and liabilities of the financieras in recent years mirrors developments in the financial system as a whole, (para. 2.15) and also reflects the rela- tively low level of industrial investment during that period (para. 1.04). In connection with the proposed project, efforts would be made to enable the financieras to increase the relative volume of medium and long-term financing they can supply as investment activity recovers (paras. 3.41 to 3.43). 3.16 Sectoral and geographic distribution. About three-quarters of the outstanding loans of the participating financieras as of year-end 1979 were to manufacturing enterprises, and the rest to tourism, mining, and 1/ A continuing dynamic growth of their loan portfolios as well as their total assets is projected for most of the participating financieras over the next 3-4 years. See Annex 4, T-39.  - 25 - service industries (Annex 4, T-26). The combined industrial loan portfolio of the participating financieras accounts for about 15% of total industrial credit from the banking system. The most important sub-sectors financed were food and beverage industries (accounting for about 16% of the combined loan portfolio), chemicals (12%), textiles (11%), paper and printing (7%) and metal products (7%). 1/ Almost three-quarters of the financieras' loans by amount were outstanding to enterprises located in the departments of Cundinamarca, Antioquia and Valle, which include respectively three principal cities--Bogota, Medellin and Cali--and their surrounding areas. This distribution, which is more concentrated than industrial value added originating from these regions (about 64%), is roughly the same as in 1974, indicating that there has been no significant overall change in the proportion of financiera lending to the less developed areas of the country. There has also been a steady decrease in the proportion of Bank financing channelled to subprojects outside the departments containing the three principal cities--from 34% under the Fifth Loan, to 31% under the Sixth, and and 24% under the Seventh 2/--indicating that the local currency denomination feature and differential margins to the financieras incorporated in the latter two loans partly to help industrial decentralization have had little success in encouraging lending in less developed areas; 3/ it also appears that the financieras did not make strong efforts during this period to promote projects in the decentralized areas. Under the proposed loan, use of preferential interest rates and higher spreads to the interme- diaries for decentralization projects would be discontinued. Nevertheless, the financieras reiterated at negotiations their commitment to intensify their efforts to promote industrial decentralization projects. In addition, the preferential treatment of medium-size enterprises (para. 4.08) and the intro- duction of a maximum size limit on eligible enterprise (para. 4.04) should ensure a wider spreading of funds among regions, because many of the largest enterprises are located around Colombia's three main urban centers and the other regions tend to have a comparatively higher proportion of medium sized and smaller enterprises. 3.17 Export generation. About 37% of the financieras' combined loan port- folio as of year-end 1979 went to exporting (at least 10% of output exported) and tourism projects. Bank lending for export projects decreased from 54% of 1/ The distribution of Bank funds committed to date under the Sixth and Seventh Loans has been similar, with the five largest recipient sub- sectors being food products and beverages (25%), chemicals (18%), paper and printing (10%), non-metallic minerals (9%) and textiles (9%). 2/ As Colombia's and the Bank's definition of industrial decentralization subprojects includes less-industrialized areas in the major depart- ments, these figures underestimate the actual decentralization impact of Bank lending. Data regarding Sixth and Seventh Loans are based on loan commitments as of February 29, 1980. 3/ Under the Sixth and Seventh Loans, the option to borrow in pesos was limited to enterprises undertaking export-oriented or industrial decen- tralization projects, and to medium-size and small enterprises.  - 26 - the Sixth Loan to 29% of the Seventh Loan. Import substitution projects accounted for 63% of portfolio, while projects involving non-tradables including services accounted for 11%. Nevertheless, the financieras' export promotion efforts under the Sixth and Seventh Loans appear to have had a significant export impact. On the basis of subloan commitments made as of December 31, 1979, the totai export contribution of subprojects financed under the two loans is projected to reach US$250 million per year when the subprojects are fully operational; the bulk of this is, however, accounted for by projects under the Sixth Loan. This volume of exports would be equivalent to more than one-third of manufacturing exports of Colombia in 1978 in nominal terms. Most of the projected exports are expected to be from chemicals (about US$100 million) and from processed food and beverages (US$110 million). Total export earnings over the first five years of operation of the Bank-financed projects (under the two loans) are expected to be, on the average, about twice the investment costs of the respective projects. 3.18 Size of client companies and lending limits. Features incorporated in three previous Bank loans have encouraged the financieras to widen their clientele and to devote more of their lending to medium size and smaller companies. A lending limit of US$4 million per subproject was introduced under the Fourth Loan in 1971, and under subsequent loans a cumulative lending limit of the same amount was established for the total funds committed and still oustanding from all Bank financiera loans per group of related companies. The US$4 million cumulative limit of amounts committed and outstanding under all Bank loans was later raised to US$8 million in the case of financing for export and decentralization projects. 1/ 3.19. In order to stimulate lending to medium-size and smaller enterprises under the Sixth and Seventh Loans companies with total assets below a specified limit (Col$100 million under the Sixth and Col$150 million under the Seventh) were offered the option to borrow in pesos. As a result, the percentage of total lending channelled to enterprises with up to Col$150 million in assets increased from 22% under the Fifth Loan to about 30% under the Sixth, but the proportion dropped to 25% under the Seventh Loan (partly because the size limit represented a lower value in real terms under the Seventh Loan). The corresponding percentages of lending to enterprises with less than Col$ 300 million in assets were 63% and 44%, respectively, under the Sixth and Seventh loans. In order to further encourage a wider distribution of lending, eligi- bility for financing under the proposed loan would for the most part be limited to industrial enterprises belonging to groups with total assets not exceeding a specified maximum size (para. 4.04), and the option to borrow Bank funds in pesos would mainly be available to enterprises with total assets of up to Col$150 million (the same nominal limit as the Seventh Loan). Also, the US$4 million limit on total commitments from the loan to any group of related companies, as well as the US$4 million and US$8 million cumulative limits (including prior loans) on total Bank funds outstanding per group (depending on whether the financing is for an export or decentralization project) would All be maintained under the proposed loan, implying a substantial reduction (25% to 30%) of the lending limits in real terms (para. 4.05). 1/ Under the Seventh Loan the US$4 million limit on total commitments from the loan per subproject was substituted by a more restrictive US$4 million limit on total commitments of funds under that loan to any single group of related companies. The loan agreement under the Seventh Loan was also modified during the commitment period to exclude and financing provided for industrial pollution control investments from all the above cumulative limits.  - 27 - 3.20 Economic and employment impact. The 1975 Special Study, 1/ which carried out an in-depth ex post analysis of a sample of 29 subprojects from the first four Bank DFC loans, found support for the economic merits of investment projects financed by the Bank through the financieras. The average economic rate of return for the sample of projects was 32%, which compares favorably with the economic opportunity cost of capital in Colombia, estimated at 11%. The average financial rate of return for the sample was 10%. The estimated ex-ante economic rates of return for the larger subprojects (i.e., those involving more than US$250,000 equivalent of Bank financing, for which a ERR calculation is required under past loans) financed to date under the Seventh Loan have all been above 15%, which is satisfactory. Preliminary estimates show the average cost per direct job created of about US$45,000 equivalent compared with US$28,000 (both in 1977 prices) under the Sixth Loan. The higher capital intensity under the Seventh Loan is partly explained by the drop in the share of export-oriented projects (para. 3.17), which generally tend to be comparatively more labor intensive. It may also reflect the pre- valence of modernization subprojects that often create few new jobs, and to the increasing capital intensity of Colombian industry as excessive unemploy- ment has decreased in recent years. Also, the above figures understate the net impact on employment because neither the number of jobs preserved (rather than generated) nor the expected indirect employment generation, are usually included in the estimates. 2/ Subprojects under the proposed loan are expected to be considerably less capital intensive in real terms than those under the Seventh Loan, as a result of the expected lower average size of the client enterprises (para. 3.19) and greater proportion of projects with substantial export orientation. 3.21 Technology improvement. With the encouragement of the Bank, the financieras have begun to assist enterprises to undertake technology improve- ment programs designed to raise production efficiency and to raise product quality to international levels. The Sixth and Seventh Loans each included US$5.0 million pilot component to finance technology improvement and pollution control subprojects; of these, US$2.0 million and US$3.1 million, respectively, had been approved as of March 31, 1980, including approximately US$0.5 million for technology improvement under each loan. Seventeen technology improvement projects were financed under the Sixth loan and five have been financed to date under the Seventh. The technology improvement projects financed to date included those in the basic metals, chemicals, cement and metallic products industries, principally for laboratory and quality control equipment, although recent sub- projects include technology transfer from foreign sources as well. The expe- rience to date shows that some worthwhile contributions to the operations of enterprises is likely be made by this component, but that stronger promotion of the component is probably required on the part of the financieras in view of the special nature of technology improvement investments. Funds would continue to be provided under the proposed loan for technology improvement programs at preferential terms, and an understanding was reached with BR and the financieras during loan negotiations to increase promotional efforts for this type of subproject (paras. 4.10 to 4.13). 1/ Colombia: Special Study -- Developmental Impact of Financiera-Assisted Projects, IBRD Report No. 1037-CO of January 1976. 2/ The 1975/76 Special Study on Financiera-Assisted Projects indicated that indirect employment at least equal to 50% of the employment generated directly can be expected.  - 28 - 3.22 Pollution control and environmental impact. The Bank and BR have asked the financieras to consider the environmental aspects of projects in their appraisals. Due to the lack of official Colombian guidelines and regulations regarding the permitted levels of industrial emissions and efflu- ents, the financieras had found it difficult in the past to cover these aspects adequately. Recently, however, on the basis of a code published in 1975 covering protection of the environment and renewable natural resources, the Government took specific steps to solve the most pressing problems by focusing on a limited number of polluted areas and polluting industries and coordinating efforts of the various ministries involved. In order to complement these measures, the technology financing component of the Sixth Loan was broadened at the time of the mid-term review to include financing of pollution control equipment. Due to the generally non-productive nature of pollution control investments and in order to induce enterprises to undertake such investments as soon as possible, at the request of the Government the Bank funds were provided at a preferential interest rate in pesos. Under the Seventh Loan, the Bank has approved 10 subloans for pollution control subproj- ects for a total of US$2.6 million. 1/ Use of the preferential rate funds for these purposes was initially restricted to a maximum subloan amount of US$500,000, which proved to be too low and was raised to US$1 million though an amendment to the Loan Agreement in February 1979. Only equipment to control pollution from machinery installed prior to December 31, 1977 was eligible for financing at preferential terms under the Seventh Loan, since an incentive was considered necessary for correcting pollution from equipment already in place. The Bank would continue providing funds at preferential terms under the proposed loan, which would be available for financing investments for the control of pollution caused by machinery and equipment installed at least one year prior to the submission of such financing requests to the Bank; financing for other pollution control investments would be provided only at the regular subloan terms and interest rates (para. 4.10). 3.23 Promotion of new enterprises and equity investments. The financieras have concentrated their lending in existing firms, reflecting in part a con- servative lending policy seeking to establish sound portfolios as well as the rapid growth and great demand for funds by existing firms. As of September 1979 a satisfactory 21% of the financieras' combined loan portfolio went to new enter- prises and to projects involving new product lines; 19% of the Sixth Loan and 15% of the Seventh Loan went to new enterprises (Annex 4, T-27 and T-28). 3.24 The financieras have also taken a cautious approach to equity invest- ments due to the risks involved, the long gestation period particularly for new enterprises, the relatively depressed yields on investments due to a tax system which until recently did not distinguish sufficiently between nominal and real profits, and the relative illiquidity of some such investments given Colombia's thin stock market. Traditionally, the return from the financieras' equity investments has been considerably lower than that on lending operations. Mainly as a result of the requirements of Resolution 65 (para. 3.25), but helped in part by the pilot components of the Sixth and Seventh Loans to finance at attractive terms and interest rates equity invest- ments by the financieras (in connection with priority industrial decentraliza- tion or export-generating projects), the financieras' combined equity portfolio 1/ Compared to 3 subloans for a total of about US$1.0 million under the Sixth Loan.  - 29 - (including revaluation) increased at a 41% p.a. nominal rate from year-end 1975 to September 1979. However, utilization of the equity investment compo- nent of Bank loans has been constrained by the fact that many firms prefer to use equity for working capital financing needs rather than in connection with a specific investment project. 1/ Also, the generally lengthy processing time for subprojects (para. 3.04), which can be covered by bridge loans in the case of subloans, discourages equity investments with Bank funds. To date US$2.3 million of the original US$5.0 million equity investment component of the Sixth Loan and US$2.6 million of the US$10.0 million component of the Seventh Loan have been utilized. In most cases the financieras played important promotional roles in projects involving their equity participations. 3.25 In order to address the problem of low capitalization levels of industrial firms, the Monetary Board passed Resolution 65 in 1977, requiring the financieras to hold at least 10% of their assets in shares of productive enterprises; any shortfall from this percentage would have to be offset by the purchase of FFI bonds, which until recently were bearing an interest rate of 21% (increased in February 1980 to 25%). While the financieras and the Bank were initially concerned about the impact of the resolution on financiera earnings and liquidity, the phased implementation of the resolution by BR and the generally good performance of equities over the past few years (especially during 1979) have had a positive impact on the financieras' earnings (para. 3.30). After some initial shortfalls in the amount of equity investments, all the financieras participating in the Bank loans have achieved, and are expected to be able to maintain compliance with the resolution without undue difficulties. The Bank would closely follow the experience on this and discuss with the Govern- ment any emerging issues in this connection. Through Law 20 of 1979 (para. 2.12), the Government also took steps to reduce capital gain tax liabilities on the sale of fixed assets and equity investments (to compensate for inflation-related gains), and to reduce the incidence of 'double-taxation' of dividends to share- holders, thus making equity investments more attractive to investors. These measures, together with the recent steps to liberalize financial markets (para. 2.08) and the operation of the new Securities Commission (para. 2.09), are expected to help improve substantially the performance of the financieras under the equity investment component of the proposed loan. 3.26 Strategy papers. The financieras were asked to prepare brief state- ments outlining the strategies that they intended to adopt over the commitment period of the Sixth and Seventh Loans to enhance the developmental impact of their operations. In line with the objectives of those loans, the financieras' statements focused mainly on steps to promote export and industrial decentrali- zation projects, and to increase their support for medium-sized firms. The financieras updated their respective strategy papers to incorporate under- standings reached on their latest strategies regarding institutional improve- ments, promotional activities, and investment goals and limitations, and would gather data to monitor achievement of specific goals contained in the 1/ As under the Seventh Loan, the financieras would be able to obtain financing corresponding to the foreign exchange component of the total cost of the investment project being supported through an equity investment. This should help overcome part of the above problem; the appropriate disburse- ment procedures in this connection were clarified during loan negotiations, in view of past ambiguities in the financieras' understanding of such procedures.  - 30 - statements. 1/ The strategy papers were discussed at loan negotiations and their compliance will be followed up as part of Bank supervision. Financial Position and Results 3.27 Financial structure. Annex 4, T-30 through T-39 present the past and projected financial statements and summary financial ratios of the eight financieras which participated in the Seventh Loan. The composite debt/equity ratio of these financieras (excluding Aliadas) fell from 5.8:1 at year-end 1977 to about 4:1 by year-end 1979, i.e., substantially below the limits established by the Bank. In view of their generally low debt/equity ratios, sound and adequately protected portfolios, projected increased earnings capacity, and experienced management and staff, the financieras (except for Norte) still have the capacity to assume an increased debt burden while maintaining adequate debt-service ratios. All financieras have stayed within their debt/equity limits, set under the Seventh Loan at 9:1 for Colombiana, Valle, Nacional, Norte and Caldas, 7:1 for Occidente and Santander, and 6:1 for Aliadas. Also under the Seventh Loan, a current assets-to-equity limit (of 4.5:1) was set for all the financieras to provide reasonable scope for short-term operations while ensuring that their traditional long-term operations did not suffer as a result. This limit was set at a relatively high level since, for operational simplicity, the current portion of medium and long-term loans and utilized letters of credit 2/ were included in the definition of current assets. The limits would be maintained under the proposed loan, with the exception that legal deposits and forced investment requirements in BR instruments would be excluded from the current assets computation under the proposed loan. In the case of CF Santander the debt/equity limit would be raised to 9:1 (equalling that for the five older financieras), in recognition of its financial soundness and the institutional maturity it has achieved. The current assets-to-equity and overall debt/equity ratios of individual financieras are shown below: As of December 31, 1979 - Financieras Current Assets/Equity Total Debt/Equity Colombiana 1.8 3.4 Valle 3.5 5.7 Nacional 1.7 2.8 Caldas 1.6 3.7 Norte 4.4 8.2 Occidente 4/ 2.6 4.3 Santander 4/ 3.1 6.4 Aliadas 4/ 2.0 2.4 1/ In connection with the latter, as well as to determine the performance under Bank-financed subprojects, the Subproject Data System (SDS) being implemented by the Bank for its DFC projects could be a useful monitor- ing tool. 2/ Excluding letters of credit issued for equipment to be utilized for Bank-financed subprojects. 3/ Includes revaluation of assets. 4/ Data as of September 30, 1979.  - 31 - 3.28 Thus, the existing debt/equity limitations offer the financieras, with the exception of Norte, ample room for growth without the immediate need for share capital increases. In the past the Bank had required the financieras to value equity investments and fixed assets on the basis of their historical cost or market value, whichever is lower; this tended to substan- tially understate the value of some of the financieras' assets which had been held for a considerable period of time (e.g., equity investments and office buildings). Under the Seventh Loan the financieras were allowed to revalue their fixed assets and equity investments for the purpose of determining their debt/equity ratio. This practice would be continued under the proposed loan. However, in consideration of the uncertainties associated with the substantial revaluations of the equity portfolios held by the financieras, which in turn cause revaluation of the financieras' own equity, the treatment of revaluation under the proposed loan would be more closely specified in two ways. First, all revaluations of shares traded in the stock exchanges would be based on a conservative estimate of the average share price over the preceding year, and revaluation of non-traded stock would be based on the certifications of the Ministry of Finance (Administracion de Impuestos) issued at the end of the preceding fiscal year. Second, the total amount of revaluation included in an individual financiera's net worth calculation would be limited to 50% of its paid-in capital, retained earnings and reserves, for the purpose of all financial covenants under the proposed loan including debt/equity, current assets and exposure limitations. BR would be expected to monitor the accuracy of these revaluations as part of its increased supervisory functions (para. 3.06). These procedures have been reflected through appropriate revisions in DDC's operating policy statement (Annex 2). 3.29 The liquidity position of the financieras tightened further as a consequence of their expanding short-term operations and the scarcity of long-term funds to finance their loans and equity investments. Nevertheless, their current ratios are still acceptable, ranging from 1.0:1 to 1.2:1. Over- all, the financial structure and liquidity of the participating financieras are expected to develop satisfactorily over the commitment period of the proposed loan (Annex 4, T-39). 3.30 Profitability. The nominal after tax rates of return on equity of the eight financieras over the past ten years are shown below:  - 32 - AFTER-TAX RETURN ON EQUITY a/ (percentage) Inflation Colombiana Valle Nacional Caldas Norte Occidente Santander Aliadas Rate c/ 1970 11.3 17.0 17.4 3.8 13.4 9.4 13.2 - 6.3 1971 9.1 14.9 17.5 0.2 14.7 10.1 14.6 - 14.7 1972 10.4 15.2 18.1 5.2 b/ 12.7 16.6 b/ 13.0 - 14.0 1973 13.6 17.6 19.4 3.4 b/ 21.2 16.6 9.8 - 25.0 1974 25.9 19.2 17.9 9.7 b/ 20.8 15.2 14.1 - 26.9 1975 25.6 23.6 23.6 4.8 b/ 17.4 17.2 15.6 24.0 17.9 1976 26.9 22.5 24.8 10.3 16.9 20.6 13.6 16.0 25.9 1977 29.4 24.4 26.4 18.1 18.2 19.5 16.4 16.5 29.3 1978 26.7 24.6 29.3 19.8 17.0 19.3 16.6 21.3 17.8 1979 d/ 28.0 25.2 62.4 e/ 30.4 f/ 21.6 20.1 14.2 21.0 29.8 a/ Excluding revaluations and unrealized capital gains. b/ In the opinion of the external auditor, over-stated because of inadequate provisions for portfolio losses. c/ As reflected in the blue collar price index; calendar year basis. d/ Unaudited figures. In the case of Santander, Occidente, Aliadas, figures are annualized on the basis of the data from the first three quarters of 1979. e/ Includes an extraordinary capital gain of Col$ 247 million from the sale of one large equity investment and Col$63.9 million dividends received from another equity investments. If these items are excluded, the return on equity would still be a reasonable 24%. f/ Includes about Col$33.5 million received in dividends from an equity investment. 3.31 As shown in the above table, most of the financieras were earning positive real rates of return on equity during periods of moderate inflation, but lost much ground during years of high inflation, due to fixed loan margins which became progressively lower in real terms, and a system of taxation which did not distinguish adequately between real and nominal profits of financial intermediaries which had few non-monetary assets. Changes were introduced in 1976 under the Sixth Loan to help increase the level of the financieras' profitability by raising their debt/equity limits and permitting higher lending margins of up to 4% in peso subloans. These measures appear to have contributed at least partly to the improvements in profitability achieved in 1977 and, especially, in 1978, when the after-tax returns on equity of several of the financieras substantially exceeded the inflation rate. 3.32 The financieras were able to maintain their profitability in several instances only by significantly expanding the higher margin short-term lending operations. During the preparation of the Seventh Loan, it became evident that a continuation of these trends could seriously hamper the financieras' ability and willingness to focus their efforts on longer term project financing. Under the Seventh Loan, lending margins for subloans in pesos were therefore set at 4% for decentralization projects and at 3% for all other projects. The margins for dollar-denominated subloans were maintained at 2.75%. While it was assumed that these measures would not have a significant impact on the profitability of the larger financieras, the impact on the smaller and less  - 33 - profitable ones, located outside the three principal cities, was expected to be significant. In addition, as a result of government measures and support through Bank loans to improve the capitalization of industry (para. 3.25), the financieras increased their equity portfolio appreciably and, reflecting the recent dynamism of Colombia's industrial sector, have recorded substantial capital appreciations from these equity investments. 1/ Overall, these measures helped the financieras maintain or increase their profitability in 1978-79, which should improve their ability to attract additional share capital and accelerate growth. 3.33 Under the proposed loan, the margins for the financieras would be 2.75% for dollar-denominated subloans, and 3% for peso-denominated loans available principally for medium-size and smaller enterprises (para. 4.13). Thus, the margins to the financieras under the proposed loan on peso denominated subloans will be lower than those under the Seventh Loan. However, over the coming years, the financieras are expected to be able to slightly increase the overall profitability of their lending operations, as a result of expected increases in their gross margins (stemming from the favorable effects of the recent financial sector reforms-see para. 2.08) and slight reductions, on the average, in their administrative costs as their operations grow (Annex 4, T-39). The profitability of the financieras' equity portfolio, which was good in 1979, is subject to more variation, however, depending to a large extent on the overall economic conditions. 3.34 Portfolio quality and reserves. The five older financieras have sound loan and equity portfolios overall (Annex 4, T-40). In the past Caldas has faced difficulties related to poor portfolio quality and tight liquidity, but substantial efforts by its management have resulted in significant improvements in its operations. Nevertheless, Caldas still needs to reduce its equity investments in some of the companies promoted by it, which tend to require excessive management attention. During negotiations, Caldas confirmed, through a letter, that it would continue to reduce its equity investments in these companies. 3.35 As a result of a substantial turnover at the senior management level and among Occidente's technical staff, liquidity problems and excessive uncov- ered exposure in enterprises facing difficulties, the institution was required, in connection with its participation under the Seventh Loan, to prepare and implement a plan of action to resolve these problems. By mid-1979 Occidente had satisfactorily carried out its plan of action. Nevertheless, some weak areas still remain, including, in particular, large exposure in a single problem enterprise (Ingenio Risaralda, a sugar refinery, 2/ in which Occidente's total exposure represents about 20% of Occidente's equity), insufficient reserves for possible losses (amounting to Col$8.0 million, or 14% of Occidente's 1/ Including revaluation of equity investments, the financieras' return on equity would be as follows: Caldas (48.1%); Colombiana (74.2%), Valle (62.0%); Nacional (85.8%); Norte (40.5%); Occidente (24.7%): Santander (21.7%); and Aliadas (43.8%). However, with the exception of Nacional, most of the capital gains have not yet been realized by the financieras, and therefore have considerable uncertainties associated with them. 2/ As the sugar mill is considered of "regional interest," the chances of its liquidation appear low, particularly since the powerful Federacion Nacional de Cafeteros (Coffee Growers Federation) is involved, with 20% of the equity.  - 34 - uncovered exposure) and weak appraisal and supervision capabilities. In connection with the proposed loan, Occidente updated its plan of action (para 3.14) to include measures to correct the remaining weaknesses in its portfolio. BR would be expected to closely supervise the progress in imple- menting the plan of action. 3.36 Valle's loan and equity portfolio, which was very sound until 1977, when only 2.7% of its portfolio was in arrears, deteriorated in 1978, when 6.3% of its portfolio was affected by arrears. Exposure in enterprises with significant arrears or facing other difficulties amounted to 76% of Valle's equity, of which about 29% was not covered by adequate loan securities. The largest single exposure was in Siderurgica del Pacifico, which fell into finan- cial difficulties, and in which Valle held an equity investment of Col$175 million (about 28% of Valley's own equity), i.e., slightly above the 25% limita- tion under its policy statement. Valle's portfolio has since been improved; in connection with the loan negotiations, Valle confirmed that it has reduced its participation in the equity of Siderurgica del Pacifico in line with the provisions of its policy statement. At the same time, Siderurgica's financial position has improved significantly, particularly following a recent large issue of new shares, which were quickly subscribed. 3.37 Colombiana, Nacional, Norte and Santander all have sound portfolios and adequate reserves, with arrears and reschedulings remaining at low levels. Aliadas has also maintained a sound loan and equity portfolio, but has exceeded its exposure limitations. Aliadas's plan of action, which has been prepared and submitted to the Bank in connection with the proposed loan (para. 3.49), rcludes measures to achieve full compliance with the exposure limitations. Resource Structure and Needs 3.38 Resource structure and domestic resource mobilization. The combined resource structure of the seven financieras participating fully under the Seventh Loan is shown below: ---------