Peru - Small-scale Enterprise Project

ii flay Document of FILE COPY The World Bank FOR OFFICIAL USE ONLY Report No. P-3154-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE BANCO CENTRAL DE RESERVA DEL PERU WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR A SMALL SCALE ENTERPRISE PROJECT November 18, 1981 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 The exchange rate is being adjusted daily roughly in line with the differential between domestic and international inflation. The exchange rate and currency equivalents in 1980 and as of October 31, 1981 were as follows: Currency Unit = Sol (SI.) Calendar 1980 October 31, 1981 US$1 = SI. 288.65 SI. 470.12 S/.l US$ 0.0035 US$0.0021 S/. 1,000 = US$ 3.46 US$2.13 FISCAL YEAR January 1 to December 31 ABBREVIATIONS APEMIPE - Asociacion de Pequenas y Medianas Industrias del Peru (Peruvian Association of Small and Medium Industries) BCR - Banco Central de Reserva del Peru (Central Bank of Peru) BIP - Banco Industrial del Peru (Industrial Bank of Peru) CERTEX - Certificado de Reintegro Tributario a la Exportacion (Export Tax Credit Certificate) COFIDE - Corporacion Financiera de Desarrollo (State Development Finance Corporation) ERP - Economic Recovery Program FOGAPAI - Fondo de Garantias para Prestamos a la Pequena Industria (Guarantee Fund for Small Industry Loans) IDB - Inter-American Development Bank MITI - Ministerio de Industria, Turismo e Integracion (Ministry of Industry, Tourism and Integration) SSE - Small Scale Enterprise TRB - Tasa de Redescuento Bancario (Central Bank Rediscount Rate) UNDP - United Nations Development Programme USAID - United States Agency for International Development  FOR OFFICIAL USE ONLY REPUBLIC OF PERU SMALL SCALE ENTERPRISE PROJECT LOAN AND PROJECT SUMMARY Borrower: Banco Central de Reserva del Peru (BCR) Guarantor: Republic of Peru Beneficiaries: Corporacion Financiera de Desarrollo (COFIDE) and eligible financial intermediaries Amount: US$26.0 million equivalent Terms: Repayable in 15 years on a fixed amortization schedule, including 4 years of grace, at 11.6 percent interest per annum. Relending Terms: The BCR would assume the foreign exchange risk on the credit line portion of the Bank loan (US$25.25 million) and onlend the equivalent in soles as well as an additional US$10 million equivalent of its own resources to COFIDE. Onlending to COFIDE would also be for 15 years at the prevailing Central Bank discount rate (TRB) -- currently 42 percent per annum nominal. The proceeds of the technical assistance portion of the loan (US$750,000) would be onlent to COFIDE at the same terms as the Bank loan. Project Description: The proposed loan would provide term resources for small scale enterprise (SSE) investment projects, mainly in the manufacturing sector but also including all productive, commercial and service activities, except agriculture. It would help finance the foreign exchange cost of up to 1,500 subprojects with an estimated total cost of US$50 million and would help to create up to 10,000 new jobs. The project would also support Government efforts to eliminate subsidies and to standardize interest rates for term lending to SSEs. In addition, it would strengthen the term lending system for SSEs by involving a large number of financial inter- mediaries, thus promoting competition, better service and a broader regional distribution of resources. Finally, the proposed loan would help to finance a technical assistance program within COFIDE to train loan officers of the participating intermediaries to better meet the special needs of their SSE clients and to further develop COFIDE's own staff. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Special Risks: The proposed loan does not face unusual risks. Term lending to SSEs, however, would be a new activity for many intermediaries, which may delay their involvement. For this reason, their spreads have been structured to make such lending attractive and the loan officer training program would also stress appraisal techniques, the problems of SSEs and the lending and profit opportunities for financial intermediaries in the SSE sector. Estimated Costs: Local Foreign Total (US$ million) Investment sub-projects 25.00 25.25 50.25 Technical assistance 0.15 0.75 0.90 T 0 T A L 25.15 26.00 51.15 Financing Plan: Local Foreign Total (US$ million) Bank (incl. technical ast_ista -ice) - 2.OO 26.00 BCR 1.0.Ou - 10.00 COFIDE (technical assistance) G.15 - 0.15 Financial Intermediaries 5.0 J - 5.00 SSE Beneficiaries 10.0 - 10.00 T 0 T A L 25.15 26.00 51.15 Estimated Disbursements: 1982 1983 1984 1985 (US$ million by Bank FY) Annual 1.00 6.75 10.75 7.50 Cumulative 1.00 7.75 18.50 26.00 Appraisal Report: Staff Appraisal Report No. 3578-PE dated November 16, 1981.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE BANCO CENTRAL DE RESERVA DEL PERU (BCR) WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR A SMALL SCALE ENTERPRISE PROJECT 1. I submit the following report and recommendation on a proposed loan to the Banco Central de Reserva del Peru (BCR) with the guarantee of the Republic of Peru for the equivalent of US$26.0 million to help finance a small-scale enterprise project. The proposed loan would be repayable over 15 years, including 4 years of grace, on a fixed amortization schedule with interest at 11.6 percent per annum. The BCR would assume the foreign exchange risk for the credit line portion of the proposed loan (US$25.25 million). It would re- lend the equivalent of this portion in soles, together with an additional US$10 million equivalent of its own resources, to the Corporacion Financiera de Desarrollo (COFIDE) for 15 years, including 4 years of grace, at the prevailing Central Bank discount rate (TRB)--currently 42 percent in nominal terms. COFIDE would onlend these resources to eligible financial intermediaries at rates of 2 to 4 percent above the TRB, depending on the size of the subloan to the ultimate beneficiary, at a term equivalent to that of the subloan. The proceeds of the technical assistance portion of the loan (US$750,000) would be onlent to COFIDE at the same terms as the Bank loan. PART I - THE ECONOMY 2. An economic report entitled "Peru-Major Development Policy Issues and Recommendations" (Report No. 3438-PE) was distributed to the Executive Directors on May 4, 1981. This part is based on the report's findings and on those of economic missions to Peru in June and September 1981. Country data sheets are attached as Annex I. Natural and Human Resources 3. Peru, the fourth largest country in Latin America, is divided by the Andes mountains into three distinct regions: the coastal region (Costa), with 46 percent of the population and most of the country's modern economic activity; the mountain region (Sierra) with 44 percent of the country's population; and the sparsely populated tropical rain forests east of the Andes (Selva). The country's rugged topography limits trade between the three regions. 4. 6ru's natural resources include large deposits of minerals-- particularly copper, iron, silver, and zinc--located mainly in the Sierra and the southern Costa. There are also large phosphate deposits, located in the northern Costa. Petroleum resources found in the jungle areas and offshore are also substantial, but their full extent has not yet been ascer- tained. Another major natural resource is the large fishing potential in coastal waters, although the magnitude of the catch is subject to sharp fluctuations. Agricultural land is limited, and most of the soils suitable for intensive agriculture are already being farmed. 5. Crude oil is the dominant source of energy in Peru, supplying approximately 80 percent of Peru's commercial energy requirements. Although Peru's energy resource base is relatively diverse, with scope for expanding  - 2 - hydro and coal based power generation, petroleum is expected to remain the major energy source in Peru through the rest of this century. After having been dependent on imported crude oil for part of its energy requirements since the early 1960s, domestic oil production increased almost threefold between 1976 and 1979 to about 200,000 barrels per day, enabling Peru to export oil in substantial quantities (about 60,000 barrels per day). Despite this encour- aging production trend, domestic consumption is expected to rebound after several years of economic stagnation. To enable Peru to remain a net petroleum exporter, therefore, it is of crucial importance to accelerate secondary recovery and exploration efforts to increase production and to follow rational pricing policies to contain demand growth. The Government has begun to address the problem vigorously. Prices for domestically consumed petroleum products have been increased at regular intervals. In addition, new legislation was enacted offering special tax incentives to investors, both domestic and foreign (see para. 20). Response to the tax incentives has been positive. 6. As a result of three decades of rapidly falling mortality rates, Peru's population growth accelerated during the 1930-1960 period. In the early 1960s, however, birth rates started a gradual fall, mainly caused by the urbanization process and by improved education. But with declining death rates, population has continued to grow at about 2.7 percent p.a. and is currently estimated at about 17 million. It is expected that population growth will fall only slightly to about 2.4 percent p.a. over the next 20 years, unless an effective population control policy is adopted. The Govern- ment is conscious of the need to slow down Peru's demographic growth rate and is now developing a primary health care program which would contain a family planning component. The urban population is increasing at 4.3 percent p.a., and about a quarter of all Peruvians live in the Lima area. Given the structure of Peru's population, the labor force is expected to grow in excess of 3 percent per year during the next 20 years. Past Development Policies and Performance (1968-78) 7. Two successive military Governments, in office from October 1968 until July 1980, followed a development strategy aimed at promoting economic growth and improving distribution of income and wealth, not only on the individual level but also between regions. To achieve these goals, the first military Government expanded the role of the State in the economy, changed the pattern of asset ownership, reduced foreign ownership of national resources, oriented industry and agriculture toward production of essential goods for the domestic market, stimulated regional deconcentration, and reformed the educa- tional system. Through nationalization and creation of new enterprises, the State took direct control of key economic sectors. Moreover, the Government imposed complex legislation to control the operations of the private sector. 8. The pattern of asset ownership in the economy changed drastically. Through nationalization, the share of foreign-owned assets fell sharply. A sweeping land reform redistributed 49 percent of the country's best farmland to workers' cooperatives comprising some 30 percent of all rural families. Through other laws, industrial workers were given shares in their employers' firms and, in the mining sector, a share in profits. While these actions benefited large numbers of Peruvians, they barely reached the poorest groups, which continue to live in abject poverty. It is estimated, for example, that  - 3 - almost three quarters of rural families--mostly "minifundistas" (those farming less than 2 ha) and landless seasonal workers--were not reached by social programs. Moreover, subsidies were given to products that were more important in the consumption basket of high and middle-income groups than in that of the poorest groups. Artificially low prices for some products actually hurt the poor who produced these items, and affected production negatively. Although many of the policies and structural changes carried out after 1968 were meant to achieve rapid growth and more equality, their cost proved to be excessive and their implementation inefficient. 9. Between 1968 and 1977, the Government followed expansionary fiscal and credit policies. A rapid increase in expenditures was not matched by a parallel increase in revenues. Public sector savings dropped steadily in relation to GDP from 4.4 percent in 1970 to dissavings of 2.6 percent in 1977. As a result, aggregate demand considerably exceeded aggregate supply resulting in strong inflationary pressures and widening external gaps. 10. Inflation accelerated from 5 percent per year in 1970 to 38 percent in 1977. Interest rates, however, remained substantially negative in real terms, discouraging financial savings and stimulating capital flight. Moreover, the exchange rate remained practically constant between 1968 and 1975, thus contributing to the overall disequilibrium. National savings fell dramatic- ally from 16 percent of GNP in 1970 to 8 percent in 1977, when they financed only about one-half of investment. 11. The growing disequilibrium was reflected in the balance of payments. The current account deficit averaged US$1.1 billion per year in 1974-77, equivalent to nearly 9 percent of GNP. To finance this deficit, Peru accum- ulated a massive external debt. At year-end 1977, Peru's total private and public external debt--including short-term indebtedness--stood at almost US$8.3 billion, equivalent to two-thirds of GDP and almost four times annual exports of goods and non-factor services. Three-fourths of the US$6.4 billion long-term public sector debt (including undisbursed) was scheduled to be repaid over the 1978-82 period. 12. Following the 1968-74 period of rapid expansion during which GDP grew by more than 6 percent per year, the growth rate dropped progressively and became negative in 1977 and 1978. In this two-year period, GDP per capita dropped by over 6 percent and unemployment and underemployment rose to almost 60 percent of the labor force, up from less than 50 percent during the early 1970s. According to Government estimates, the purchasing power of the average salary had fallen 40 percent by 1978 compared to 1970 and that of the average wage by over 16 percent. Stabilization Policies and the Economic Recovery Program (1978-80) 13. From 1975 on, several unsuccessful attempts were made to cope with Peru's deteriorating economic situation. By mid-1978 the economic crisis had reached grave proportions, with a drop in real GDP and inflation approaching 100 percent on an annual basis. Moreover, the private sector was finding it increasingly difficult to open letters of credit for new imports and the banking system's net international reserves had dropped to a negative  - 4 - level of US$800 million. Financial instability had reached the point where practically all economic activities were adversely affected. The public sector was fast approaching the point where it would no longer be able to fully service its external debt. Peru was no longer creditworthy. 14. Beginning in May 1978, the Government adopted a number of important measures aimed at strengthening public finances, improving the balance of payments and curbing inflation. The Government also negotiated a stand-by arrangement with the IMF for SDR 184 million. In July 1979, this stand-by was replaced by a new one for SDR 285 million as continued support of the stabilization program. Peru's debt outstanding to the IMF as of September 30, 1981 amounted to SDR 589.8 million. 15. Major debt-relief operations carried out through the Paris Club and with the Soviet Union and commercial banks in 1978 enabled Peru to reduce the debt-service burden for 1979 and 1980 by postponing repayment of about US$1 bil- lion to the 1982-1986 period. In view of the strong balance of payments performance in 1979 and 1980 (see para. 18), the Government decided to forego parts of the rescheduling options in exchange for slightly better conditions for new loans from commercial sources. 16. To overcome the economic recession, in late 1978 the Government adopted a comprehensive Economic Recovery Program (ERP) which, in addition to the above-mentioned stabilization actions, included measures to open up the economy, promote non-traditional exports, strengthen the tax system by broad- ening its base, and generally improve the efficiency of resource allocation in the private and public sectors. Import liberalization was the most im- portant element of the ERP and is expected to have salutary long-term effects on resource allocation and on prices. The Government also drew up a public sector investment program that aimed at redirecting investment towards projects of clear economic priority and with positive effects on production and employ- ment. In support of the ERP, the Bank approved a US$115 million program loan in May 1979. The carrying out of the ERP was generally satisfactory. Perform- ance in some critical areas--e.g., export promotion and import liberalization-- actually exceeded expectations. In other areas--e.g., improvements in the quality of public investment and in raising interest rates--progress was more modest. 17. The Government's stabilization-cum-economic recovery program resulted in a strong improvement in public sector finances in 1979. Central Government revenues increased by 23 percent in real terms, while current outlays declined by 6 percent. Payments for wages and salaries alone fell by some 7 percent in real terms, partly as a result of a reduction in excessive civil service employment. Public sector current account savings rose from -0.5 percent of GDP in 1978 to about 3.7 percent of GDP in 1979, and the overall deficit was reduced from 5.7 percent of GDP in 1978 to 1.7 percent in 1979. In spite of the good fiscal performance, however, inflationary pressures remained strong, with consumer price increases of 67 percent in 1979 and of 59 percent in 1980. 18. The implementation of stabilization measures and of the ERP had a positive impact on the balance of payments. Moreover, an increase in petroleum exports, substantial price increases for silver, copper, petroleum, and other commodities, as well as the relatively low level of imports because  - 5 - of the recession contributed to high overall surpluses of the balance of payments in 1979 and 1980. At year-end 1980, the net reserve position was estimated at about US$1.3 billion, equivalent to about 4 months of imports. Peru also made greater use of assistance from official bilateral and inter- national sources thus improving the structure of its external debt. The short-term debt of less than one year was sharply reduced from US$1.8 billion at year-end 1978 to US$0.8 billion at year-end 1980. Real GDP growth rebounded to 3.7 percent in 1979; in 1980, growth dropped slightly to 3.1 percent owing, in part, to a drought which affected the agricultural sector. Recent Developments and Outlook 19. In July 1979, the military Government promulgated a new constitution, written by a popularly elected constituent assembly. Elections were held in May 1980, and following his electoral victory, President Fernando Belaunde was inaugurated on July 28, 1980. The new Government faced a challenging economic and social situation with a number of acute problems which had been somewhat disguised by the apparently solid financial situation: underlying inflation had been higher than reported because of price controls and deferred price adjustments for public goods and services; the public sector deficit had been reduced by freezing expenditures for economic and social services, and the rigid expenditure structure did not leave much margin for any significant reallocation of funds to high priority areas; the balance of payments showed a substantial surplus, but this was partly due to high commodity prices and to the fact that import levels were depressed; moreover, income distribution had deteriorated over the past several years resulting in increased social unrest. 20. The Government named a capable economic team which is committed to economic efficiency, decontrol of the economy (including divestiture of State-owned enterprises) , promotion of the private sector (including foreign investment), and policies aiming at a more equitable sharing of the benefits of development. Its reliance on, and promotion of, private initiative, in particular, distinguish the present Government's philosophy and economic program from that of its predecessors. During its first year in office, the Government took vigorous measures to address many pressing problems. It was successful in accelerating import liberalization by eliminating non-tariff barriers and lowering tariffs. At the same time, export incentives were streamlined and revised to eliminate abuse and make the system more responsive to exports of products with high manufactured content. The Government also enacted new legislation for the agricultural, mining and petroleum sectors offering greater financial incentives to investors. Finally, it made signif- icant institutional changes in the financial sector, revised the interest rate structure through substantial upward adjustments, and recently introduced a new banking law in parliament which would allow further rationalization and liberalization of the financial system. 21. In an effort to improve resource use, the Government made headway in correcting major price distortions. Food subsidies were greatly reduced and controlled agricultural prices adjusted to international levels. The marketing of agricultural products was liberalized, and public utility and petroleum prices were adjusted at regular intervals. Moreover, the Government endeavored to rationalize public investment and its financing -- an effort that was supported by a Bank sponsored Consultative Group meeting in May 1981.  - 6 - 22. The above efforts were complemented by measures to strengthen public sector institutions. The important public enterprise sector, for example, was granted greater autonomy by transforming these enterprises into State-owned limited liability corporations operating under private law. This measure permits these companies, inter alia, greater freedom in fixing staff compensation and, thus, helps them to recruit or to retain capable personnel. Many of the above measures have already had positive short-term effects, and they have laid the ground for medium-term structural adjustments of the Peruvian economy. 23. In spite of the above policy initiatives, economic performance in 1981 has been lagging behind expectations with growth of production and employ- ment still being sluggish. The balance of payments deteriorated substantially as a result of declining export prices, high interest rates on the country's debt with commercial banks, and a rapid expansion of imports. The loss in net reserves is expected to amount to about US$1 billion, equivalent to about 5 percent of GDP. A major factor in the deterioration of the balance of payments has also been the large public sector deficit which is expected to reach about 8 percent of GDP. On the positive side, however, inflation has decelerated during the past few months to an annual rate of about 50 percent, mostly because of the openness of the economy and the price dampening effects from an increase in imports. 24. Reducing the public sector deficit has, once again, become the major challenge facing Peru's economic managers. While the deteriorated export situation has had a negative impact on tax revenues, the deficit is mostly the result of steep increases in expenditures and somewhat lagging adjustments of petroleum and rice prices. Excess expenditures over initial budget allocations were incurred mostly for investment projects of lesser priority. To tackle the difficult public finance situation, the Government is drawing up a restric- tive financial program for 1982 with tight credit ceilings and limits to foreign indebtedness. It is also expected that the Government will trim the public investment program in line with its investment priorities. The Bank has an ongoing frank dialogue with the Peruvian Government on these issues. 25. Based on cautiously optimistic assumptions with regard to economic management and commodity prices, the country is expected to experience economic growth of about 5 percent per year and a manageable balance of payments situation during the next two years. The balance of payments situation could, however, become precarious, if the exportable surplus of oil declines. While measures are being undertaken to speed up petroleum exploration and to increase manufactured exports, these are endeavors with medium-term results which may not come in time to countervail the potential foreign exchange shortfalls. Against this background, there is a continuing need for official development assistance. Taking the above factors into account, considering an expected debt service ratio hovering around the 30 percent mark and assuming that the authorities continue the initiated course of economic policies, Peru is creditworthy for Bank lending. PART II - BANK GROUP OPERATIONS IN PERU 26. The Bank has approved 43 loans to Peru for a total amount of US$934.4 million, net of cancellations. About 30 percent of the Bank's lending to Peru has been for transportation (mainly highways and ports), 19 percent for  - 7 - agriculture, 17 percent for the energy sector, 16 percent for mining and industry, about 6 percent for education and urban development and 12 percent for a program loan in support of the ERP in 1979. 27. As of September 30, 1981, US$360.9 million was undisbursed on Bank loans currently in execution. (Annex II contains a summary statement of Bank loans as of September 30, 1981 and notes on the execution of on-going projects.) Disbursements on Bank financed projects moved slowly in the late 1970s, primarily because of weak project execution capacity and a shortage of counterpart funds that worsened as the economy deteriorated during this period. In an effort to improve disbursements: (i) the Bank opened a resident mission in Peru and restructured a number of slow moving projects; (ii) the Government took steps to provide adequate counterpart funds for Bank-financed projects; and (iii) the Government also set up a special commission to monitor loan execution and resolve administrative problems. These actions are bearing fruit. About US$44.0 million was disbursed on project loans in FY1980 and US$70.5 million during FY1981. This compares with average yearly disbursements of only US$27.5 million during FY1977-79. 28. The main objectives of Bank lending to Peru are to assist in (i) the creation of the physical infrastructure needed to sustain and foster economic development; (ii) the expansion of productive capacity in crucial sectors, i.e., petroleum, agriculture and mining; (iii) the strengthening, through technical assistance loans and regular operations, of local capacity to prepare, implement and operate projects effectively; and (iv) the improvement of living conditions for the urban and rural poor. In the past, Bank lending concentrated on infrastructure in the transportation and power sectors. More recently, the Bank's emphasis has shifted to more directly productive fields -- mining, petroleum, agriculture and industry -- to help Peru to strengthen its balance of payments. Lending for social projects has also grown. As part of its assistance strategy, the Bank convened a Consultative Group Meeting for Peru on May 25-26, 1981 to help the Government arrange financing for its public investment program. The next operations that would be ready for the Executive Directors consideration include projects in road improvement and rehabilitation, petroleum, power, agricultural research and extension, and water supply. The Bank is also considering a technical assistance loan to help strengthen public sector management. 29. Bank loans constituted an estimated 5.8 percent of Peru's total public external debt outstanding and disbursed at the end of 1980, and absorbed about 2.6 percent of the country's external debt service in 1980. Assuming increased recourse to long-term bilateral and multilateral aid by Peru, the Bank's share in the country's outstanding public foreign debt by 1985 could reach about 10 per- cent, and its share of debt-service would be around 4.5 percent. 30. IFC commitments as of September 30, 1981 were US$38.3 million (including US$15 million to the Southern Peru Copper Corporation for the Cuajone Copper Mining Project) of which US$15.9 million are held by the Corporation. A summary statement of IFC investments as of September 30, 1981 is presented in Annex II. The IFC is now considering assistance for a leasing project and a palm oil venture.  - 8 - 31. The other principal lending agencies active in Peru are the Inter- American Development Bank (IDB) and the United States Agency for International Development (USAID). Total loan commitments as of December 31, 1980 by IDB and USAID were US$652.4 million and US$348.6 million, respectively, and their shares of debt service as of end-1980 were estimated at 0.6 percent and 0.5 percent, respectively. In its future lending, IDB is expected to emphasize lending for agriculture, industry, mining, roads, and small scale irrigation. USAID is expected to stress rural development and health. PART III - THE MANUFACTURING, SMALL-SCALE ENTERPRISE, AND FINANCIAL SECTORS The Manufacturing Sector 32. Performance and Structural Features: From the mid-1950s to the end of the 1970s, the manufacturing sector's contribution to Peru's GDP grew from about 20 to 25 percent. Its share in employment currently amounts to 5-6 percent. Growth of the sector during the past decade largely depended on the domestic market and was subject to strong fluctuations, which mirrored those of the whole economy. During 1969-74, sectoral production grew at an average annual rate of 6.6 percent in real terms, well above GDP growth of 4.8 percent. During 1975-78, sectoral growth slowed down because of the economic crisis referred to in Part I of this report and, during 1977-78, it dropped to minus 4 percent. During 1979-80, as the economy rebounded, the sector resumed growth at annual rates of about 4 and 6 percent, respectively. Industrial investment, much of which was made by public enterprises (e.g., petroleum, basic metals, metal working), also fluctuated widely during the 1970s. 33. The manufacturing sector in Peru is diversified. Industrial poli- cies pursued during the past decade led to strong expansion of intermediate goods industries such as textiles and chemicals. In 1978, among the principal manufacturing categories, traditional consumer goods industries (e.g., food and beverage processing, tobacco, clothing, footwear, furniture) accounted for about 40 percent of manufacturing value added, the chemical and related industries (incl. petroleum refineries) accounted for another 30 percent and metal processing industries for some 15 percent. About 85 percent of the industrial firms in Peru are small with less than 50 employees, but over 80 percent of production is concentrated in larger firms employing over 50 persons. Manufacturing is heavily concentrated in the Lima-Callao area, by far Peru's largest market. The Lima area accounts for about 70 percent of the number of firms, employment and output. Other industrial centers of importance are Arequipa in the south and Trujillo, Chimbote and Piura in the north. With the exception of Arequipa and Trujillo, industries outside the Lima-Callao area mainly process locally available raw materials such as sugarcane, bagasse, cotton and fish. 34. While the private sector accounts for over 90 percent of the number of industrial firms and for about two thirds of output and employment, the State's role in manufacturing is substantial. State-owned enterprises accounted for one third of output in 1978, mostly in tobacco, paper, petroleum refining, cement, iron and steel, and non-ferrous metals. The current Government  - 9 - is firmly committed to promoting the private sector, including foreign invest- ment (see para 20). Its general policy of decontrol and divestiture of state-owned industries is expected to result in the further revival of private investment and in a lessening of direct Government involvement in the industrial sector. 35. Net direct foreign investment averaging US$110 million per year during 1975-80 has been mostly concentrated in petroleum and mining; about 18 percent went into other sectors, mainly industry and commerce. In 1980, direct foreign investment in the industrial sector amounted to some US$20 million -- a volume that slightly exceeded the average of the preceding five years. The resumption of economic growth and the change in the Government's attitude towards the private sector are expected to result in a revival of industrial sector investment, including direct foreign investment. Employment has closely followed the growth of production, with the exception of 1977-78 when overall industrial production declined and employment continued to grow slightly. It is estimated that during 1979-81 about 80,000 new industrial jobs were created -- an addition of about 13 percent or 4 percent per year. 36. Industrial and Trade Policies: Until the mid-1970s, Peru followed the import substitution approach to industrial development providing high tariff protection -- supplemented by import prohibitions for a large number of products -- generous fiscal incentives, and credit on relatively favorable conditions. Although export incentives in the form of negotiable export tax credit certificates (CERTEX) were introduced on a small scale in 1970, industrial development was inward-oriented and manufactured exports were insignificant. Beginning in 1970, tariffs were gradually replaced by non-tariff barriers including import licensing, prohibitions, state monopolies and, in particular, the National Register of Manufactures. Imports competing with goods produced by Peruvian industries on the Register were banned. By early 1979, the share of items subject to non-tariff barriers had grown to about 60 percent, with half these items on the Register. 37. A major reorientation of industrial policies took place in connection with the 1978 ERP mentioned in Part I (para 16). The complex system of non- tariff protection was dismantled and replaced by a new tariff system. In addition, more vigorous export promotion efforts were undertaken along with a more flexible exchange rate policy, which complemented an increase in CERTEX introduced in 1976. These policy changes -- together with a declining domestic market because of the recession -- resulted in an important reorientation of industrial development, with a large increase in the value of manufactured exports from US$200 million in 1977 to almost US$800 million in 1980 (equivalent to about 8 percent of output). Textiles and fish products accounted for most of this increase. 38. The present Government has accelerated the import liberalization process by further eliminating administrative barriers (including the whole system of import licensing) and by reducing tariffs. At present, the unweighted average of tariffs is close to 30 percent, with the maximum tariff at 60 percent. The Government is committed to reduce tariffs further over a period of three to five years through successive cuts and to make the tariff structure more uniform. It also revised the CERTEX system in February 1981 to correct abuses and make it more responsive to the goal of  - 10 - February 1981 to correct abuses and make it more responsive to the goal of industrial development and growth of manufactured exports. Moreover, the exchange rate is being adjusted about in line with the differential between domestic and international inflation. 39. The continuation of these policies, together with the general process of decontrol, should provide the appropriate framework for sustained growth of industrial investment, production and exports. Small-scale industry is expected to play an active role in this process; recent production trends indicate that small industries have benefited from the import liberalizatition process through access to lower-priced imports of raw materials and intermediate goods. 40. The Small-Scale Enterprise Sub-Sector: Small industrial firms, the most important type of small-scale enterprises (SSE) in terms of employment and value added, are legally defined for purposes of the application of labor and incentive legislation as private sector enterprises with sales up to the equivalent of 590 legal minimum wages, or about US$500,000. Production by such firms is concentrated in consumer goods, mainly processed foods, textiles and clothing in the lower price and quality ranges. The Government has given high priority to assisting small-scale industry. It has recently introduced a proposed new indusrial law in Congress which would improve the business climate for such firms by liberaliz- ing labor legislation, simplyfing registration procedures and unifying the taxes levied on small firms. 41. In 1975, small-scale industrial enterprises with 5 to 49 employees accounted for 87 percent of Peru's 7500 manufacturing firms in the formal sector (i.e., those with more than five employees), for 34 percent of total formal sector employment, and for 21 percent of the sector's value added. By 1980, the number of such enterprises had grown to about 10,000. In addition, there are currently over 30,000 firms with less than five employees. Thus, the total number of small industrial enterprises is estimated to be in excess of 40,000, about half of which are located outside of Lima. With the average employment per firm estimated at about six persons, small industrial enterprises currently provide an estimated 240,000 jobs, or about one-half of total industrial employment. The average investment cost per job (excluding land) is about US$5,000 equivalent. In addition to industrial SSEs, there are a large but undertermined number of SSEs in services, e.g., commerce and tourism. 42. Survey data comparing efficiency by firm size suggest that with lower wages and social benefits--because firms with undez five employees are not subject to minimum wage requirements and employ many family members -- small industrial enterprises seem to be reasonably competitive with larger ones. Rough estimates of the gross return to capital show little difference between SSEs and larger firms. These estimates suggest that small firms with 15-19 employees and large firms with 500-900 employees are the most efficient in capital utilization. 43. Institutional Framework: The most important institutions shaping industrial sector policy are the Ministry of Economy, Finance and Commerce -- which sets trade, tax and overall economic policies -- and the Ministry of Industry, Tourism, and Integration (MITI), which is responsible for administer- ing the system of incentives. Within the private sector, two trade associations stand out for their influence on public opinion and the design of sectoral policies: the Association of Industries and the Association of Exporters.  - 11 - There are two major associations of SSEs at the national level: the Small Scale Industry Committee within the Association of Industries and the much larger Peruvian Association of Small and Medium Industries (APEMIPE). In addition, a number of local associations have been recently established in several departments outside Lima. 44. Technical Assistance: SSEs suffer from a wide range of managerial and technical problems including inadequate financial management and cost accounting; limited market knowledge, particularly for exports; inadequate quality control; and weaknesses in purchasing, inventory control, production planning and labor management. To help deal with these problems a variety of institutions in Peru offer, or are developing, a wide range of technical assistance services to SSEs, with emphasis on small industry. The five principal institutions catering to the needs of SSEs are: (i) The Government's National Industrial Labor Training Service, which runs vocational and management training and advisory programs -- principally in Lima, Arequipa and Trujillo -- with assistance from the German and Dutch Governments; (ii) the Government's National Industrial Technological Research and Standards Institute, which provides technical information to SSEs, mostly on production and quality control problems; (iii) the Industrial Bank of Peru, which provides technical assistance, primarily on financial matters, in conjunction with its lending operations; (iv) the Pacific University, which is setting up a management training and advisory service for SSEs and is considering establishing a program for the training of industrial extension workers, project analysts and loan officers; and (v) the Superior School of Business Administration, a management training institute, which is planning to set up a training program and advisory services for SSE owners/ managers. In addition, executive committees have been established by local authorities and trade associations in Arequipa, Trujillo and Piura to promote and coor- dinate the extension of technical assistance activities to their area. 45. On the whole, existing programs and those now being developed would be adequate to meet the technical assistance needs of SSEs in Peru. These programs, however, need to be better coordinated to avoid duplication, some gaps in technical assistance need to be filled, and there is a need for better promotion to make SSEs aware of the programs available. A consensus has been reached -- among MITI, APEMIPE, and most institutions providing technical assistance -- on the need to create a small but effective semi- autonomous institute to coordinate the assistance programs of the various specialized institutions and to identify gaps that need to be filled. Plans are now being drawn up for this purpose by MITI. Such an institute or a similar coordinating mechanism, while being useful, is not critical to the provision of adequate technical assistance for SSEs under the proposed project. It is more  - 12 - important at this time to promote the utilization of existing technical assis- tance services. To this end, the technical assistance component of the SSE project recommended in this report would include a program for training loan officers of participating financial intermediaries in the evaluation of the technical assistance needs of SSEs and to guide their clients to the most appropriate source of services. The Financial Sector 46. Institutional Setting: The financial sector in Peru includes the Central Bank (BCR), the principal authority on monetary matters; the Banco de la Nacion, the Central Government's fiscal agent; 20 commercial banks including six regional banks; COFIDE, the Government's principal development finance institution; and five specialized development banks, including the Industrial Bank of Peru. In addition, there are 10 finance companies, 17 savings and loan associations, 20 insurance companies and a large number of small savings cooperatives and credit unions. Commercial banks account for about one-third of the total assets of the financial system. 47. Until 1978, the Government played an increasingly important role in the financial system. It owned three commercial banks, the development banks and COFIDE. In addition, it regulated commercial bank credit channelled to priority sectors and regions. Although it has not divested any of its bank holdings, Central Government involvement in banking has been gradually reduced since 1978, and the Central Bank has again become the governing authority on monetary matters. In recent years, the Central Bank also operated a number of special development funds, which were transfered to COFIDE in November 1980, in line with the Government's policy of making COFIDE the major wholesaler for term resources. 48. The commercial banks handle short-term banking operations. Currently, they operate about 690 offices, two-thirds of which are located in the Lima area. The industrial sector has traditionally received the major share of commercial bank credit. Confined by law to short-term lending, all but one of the domestic commercial banks have established finance company subsidiaries (financieras) to provide medium-term financing. While the six regional banks, which have 80 branch offices, operate as commercial banks focussing on the promotion of economic development in their respective regions, they are authorized, -- unlike commercial banks -- to make loans with maturities of up to five years. The five State-owned development banks provide specialized services, including term lending, for industry, agriculture, mining, and housing. Although these banks are authorized to accept deposits, they have mostly relied on funds from the Central Bank and foreign borrowings. 49. COFIDE, the agency which would oversee the proposed project's execution, was established in 1971 as a State-owned industrial development institution and has focused on financing medium- and large-scale industrial projects, particularly those of public enterprises. It serves as the channel for the Bank-financed first and second industrial credit projects (Loans 1358-PE of 1977 and 1968-PE of 1981). Although COFIDE has been successful in mobilizing domestic resources by issuing high yielding bonds with special tax benefits, it also relies on foreign currency borrowings and Central Bank credit. It has recently strengthened its wholesale credit function by setting up a specialized division for this purpose. This division will handle second-tier operations under the second industrial credit project. COFIDE has also set up an SSE unit within this division to manage the proposed project.  - 13 - 50. Resource Mobilization and Interest Rates: Financial savings in Peru are mainly marshalled by the banking system, which at year-end 1980 held about 85 percent of all financial liabilities (including demand deposits) with the private sector. These liabilities include savings and time deposits, various types of bonds, mortgage certificates, and certificates of deposit. The latter are both sol and dollar denominated. The non-banking system uses the same instruments (except for dollar denominated certificates of deposit). In addition, insurance policies constitute an important form of financial savings, and bonds and stocks are issued in limited numbers by non-financial institutions. 51. During most of the seventies, deposit and lending interest rates in local currency were negative in real terms. Despite major upward adjustments in 1978, effective lending rates amounted to some 50 percent in 1980, compared to an inflation rate of 60 percent. Effective deposit rates were in the 35 to 40 percent range, with some instruments, like certificates of deposit and time deposits over two years with financieras, offering rates which were about five points higher. In early January 1981, the Central Bank undertook a full revision and simplification of the interest rate structure--including an upward adjustment of deposit rates to close to 60 percent and lending rates to over 60 percent. This was about in line with the expected rate of inflation for CY 1981. During the first five months of 1981, however, inflation -- because of major corrective price adjustments -- exceeded this target running at an annual rate of about 80 percent. Since June it has moderated to an annual rate of some 50 percent. Currently, therefore, interest rates are positive in real terms, and it is BCR's stated policy to maintain positive rates. 52. In July 1981, indexation was introduced by Presidential Decree. Congressional ratification, which is required, is now being considered. Under this system, financial intermediaries could offer, on an optional basis, loans with maturities of more than one year whose principal is indexed. The objective of this system is to protect the value of the loan principal while offering term loans with reduced debt-service obligations during the early years. Indexation may only come into use slowly, as financial institutions would need indexed resources before contemplating important volumes of indexed lending. The only such resources currently available are limited BCR credit lines. 53. Term-Lending to SSEs: SSEs tend not to participate in the formal financial system, and their access to term financing has not been adequate. One-third of a recent sample of 248 small firms (with over five employees) surveyed did not have relations with any financial intermediary, and only 147 firms had received loans from any source during the last ten years, with an average loan size of about US$10,000 equivalent. About 55 percent of the total amount of these loans came from banks, while the remainder came from other sources. Significantly, however, about 80 percent of the loans dated from the last three years, showing an increasing use of resources external to the firm. It is estimated that SSE demand for term resources in the 1982-83 period would be about US$100 million, approximately 40 percent of which would be financed by the proposed project. The balance would come from new resources to be mobilized by the State-owned Industrial Bank of Peru (BIP), the principal lender to SSEs, and from repayments on BIP's current SSE portfolio. 54. In past years, the BIP has been the main institution channelling term resources to the SSE sector. Its 1980 loan approvals amounted to US$127 million equivalent, of which 35 percent was for SSEs. Over the years, BIP has  - 14 - developed a high degree of institutional expertise in SSE term lending, although its loan appraisals and processing tend to be time consuming. More- over, BIP suffers from organizational deficiencies, overstaffing and lack of experience in resource mobilization, since most of its funds come from Government transfers. In fact, the major reason for BIP's high level of SSE lending has been the availability of subsidized Government funds and low-cost resources from IDB and USAID. A new management, in office since February 1981, is addressing these problems. 55. In addition to BIP, SSEs have received financing from a number of specialized rediscount lines established within the BCR during the last three years and recently transferred to COFIDE. Since these resources were limited, the volume of financing available to SSEs through them was marginal. They did serve the purpose, however, of introducing financial intermediaries to SSE term lending, and the response was good. The main barrier to such lending has been the limited amount of resources at terms competitive with those offered under BIP's subsidized credit lines. 56. Since the upward adjustment and homogenization of the interest rate structure (including BIP's rates) in January 1981, financial inter- mediaries appear ready to lend to smaller size enterprises. With a network of 770 branch offices, commercial and regional banks have a high potential for providing investment credit to SSEs, and they already have some experience with SSEs through short-term operations. The proposed project would be the first major source of non-subsidized funds for SSE term lending available to the whole financial system and would thus help establish a broad-based credit system to serve SSEs. 57. Previous Bank Activities and Strategy: The Bank has made two industrial credit loans to COFIDE for US$35 million in 1977 (Loan 1358-PE) and for US$60 million in April 1981 (Loan 1968-PE). In addition, it made a US$2.5 million loan for a cement plant in 1955, which was successfully completed, and a US$5.0 million loan for technical assistance in 1980 to SIDERPERU, a public steel enterprise. Bank support of the ERP through the program loan of 1979 was instrumental in bringing about important changes in trade policies (see para. 16). Finally, the Bank has supported the development of the mining sector through two projects: the US$39.7 million CENTROMIN loan of 1976 for a mine water treatment plant and copper mine expansion and the US$7.5 million engineering loan of June 1980 for the Bayovar phosphate project. 58. The first industrial credit project got off to a slow start because of the 1977-78 recession in Peru and the requirement that the final borrower assume the full exchange risk. With improvement in economic conditions and COFIDE's agreement to finance projects identified by other financial institu- tions, however, performance improved. The loan is now almost fully committed and disbursements as of September 30, 1981 amounted to US$26.4 million. The subprojects financed have covered a wide range of subsectors including: chemicals, textiles, metals, fish products, metal products and others. The project has helped to support an estimated total investment volume of about US$100 million, which has helped to create about 4,000 jobs. The loan for the second project was signed in August 1981, and COFIDE is now beginning to evaluate loan applications. 59. The medium- and large-scale investment projects financed under the Bank's first credit operation have had a limited employment creation effect.  - 15 - This experience is expected to be repeated under the second credit project. In order to support Government efforts to deal with Peru's serious employment problem, therefore, Bank lending under the proposed project would focus on small-scale firms, whose average investment per job is expected to be about US$5,000 compared with US$25,000 for larger firms. The proposed project also help to strengthen the financial system catering to the SSE sector. PART IV - THE PROJECT 60. The project was identified in December 1980 and was mostly prepared by COFIDE, with assistance from Bank staff. Appraisal took place in May 1981 and a post-appraisal mission visited Peru in August 1981. The appraisal mission's report entitled "Staff Appraisal Report - Small Scale Enterprise Project (No. 3578-PE dated November 16, 1981), is being distributed separately. Annex III contains a Supplementary Project Data Sheet. Negotiations were held in Washington from October 21-26, 1981. The Peruvian Delegation was headed by Mr. Henry Barclay, Assistant Manager, Central Bank. Project Objectives and Description 61. The objectives of the proposed project are to: (a) create an institutional system, involving a large number of financial intermediaries, to provide term credit to SSEs in order to increase the flow of resources to this sector and improve service and, thus, complement the first and second industrial credit projects for medium and large industry; (b) increase the flow of term credit to SSEs outside of Lima in order to support regional development, through the involvement in the project of regional banks and commercial banks with extensive branch systems; (c) support the Government's policy towards financial intermediation based on non-subsidized interest rates and standardized financial terms and conditions and lending policies for SSEs; (d) improve the capability of financial intermediaries to service SSEs and to provide guidance to them on existing technical assistance services through a training program sponsored by COFIDE for loan officers of financial intermediaries; and (e) support the institutional development of COFIDE through a technical assistance program aimed at the training of COFIDE's staff. 62. The project would consist of a US$35.25 million credit line to financial intermediaries (US$25.25 million from the Bank loan and US$10 million from the BCR) to support up to 1,500 SSE investment projects in the areas of industry commerce and services. Such projects would an estimated total cost of US$50 million and would create up to 10,000 jobs. In addition, the project includes a US$900,000 technical assistance program, the foreign exchange component of which (estimated at US$750,000) would be financed by the Bank. The technical  - 16 - assistance component comprises three elements: (i) training of staff of financial intermediaries through courses and seminars organized by COFIDE to sensitize them to SSE needs; (ii) a young executive development program within COFIDE including inservice training and scholarships for post-graduate studies abroad; and (iii) training of COFIDE staff in mobilizing foreign resources and in project financing, including the design of cofinancing packages. Project Execution and Participating Institutions 63. The proposed loan would be made to the BCR with the guarantee of the Republic of Peru. The BCR would assume the exchange risk for the credit line portion of the Bank loan (US$25.25 million equivalent) and onlend in soles the proceeds of this portion of the loan plus US$10 million equivalent of its own resources to COFIDE, the agency that would manage the project. In its role as wholesaler for Government development credit programs, COFIDE would channel these funds through participating financial intermediaries to the final borrowers. COFIDE would also be in charge of carrying out the US$900,000 technical assistance program. a. COFIDE 64. COFIDE has competent and experienced management and staff and its project appraisal and supervision activities are satisfactory. The operation would be managed by the SSE unit of the Financial Intermediaries Division. COFIDE's comprehensive policy statement and operating procedures are satis- factory, but must be amended to cover SSE lending through financial inter- mediaries by spelling out, e.g., SSE and intermediary eligibility requirements, criteria for lending and procedures for subloan processing and approval. Drafts of these amendments were reviewed during project appraisal. The approval by COFIDE's Board of Directors of SSE policies, and by COFIDE's management of the procedures for SSE lending, both satisfactory to the Bank, would be a condition of loan effectiveness (Sections 6.01 (a) and (b) of the draft Loan Agreement). 65. COFIDE's financial structure and liquidity are good. In 1980, it had a debt/equity ratio of about 75/25 and a current ratio of 1.6 to 1. COFIDE's total loan and investment portfolio reached US$785 million equivalent at year-end 1980. Arrears and provisions for bad debts and losses in value of the investments portfolio were satisfactory. COFIDE's profitability, although improving during recent years, has remained low. In 1980, net profits after taxes were equivalent to only 4.5 percent of equity. In January 1981, however, COFIDE's management approved a new structure of interest rates and guarantee fees that will allow a more adequate return on equity. With this new structure and the divestiture of equity investments in nationalized basic industries that was agreed upon in conjuction with the second industrial credit project, the Bank estimates that COFIDE's financial position will remain good and that its return on equity will gradually increase to more satisfactory levels. b. Other Participating Intermediaries 66. All financial intermediaries legally established in Peru and in good standing with the BCR would be eligible to participate in the proposed project. Because if existing limitations (see para. 48), commercial and regional banks would require authorization from BCR to make loans with maturities exceeding one and five years respectively at the applicable term-lending rate. The issuance of this authorization for purposes of the project would be a condition of loan effectiveness (Section 6.01(c) of the draft Loan Agreement). COFIDE would  - 17 - sign contracts, satisfactory to the Bank, with intermediaries interested in participating in the project, and these agreements would provide the basis for their involvement (Section 3.04(a) of the draft Loan Agreement). The Financial Intermediaries Division of COFIDE would ensure that the inter- mediaries meet the conditions set forth in COFIDE's policies for financial intermediation, particularly those related to financial soundness and project appraisal capabilities. 67. In order to improve each participating intermediary's capability to service SSEs, COFIDE would, from time to time and as necessary, carry out a training program satisfactory to the Bank for their loan officers and this program would be initiated by June 30, 1982 (Section 3.08 of the draft Loan Agreement). The training program would upgrade the appraisal capabilities of loan officers and familiarize them with the problems and needs of SSE. With the greater knowledge of their clients and of the profit opportunities in a healthy and growing SSE subsector, which these courses are expected to provide, financial intermediaries can improve SSE support and provide guidamce to them on the effective use of existing technical assistance services. Cost and Financing 68. The total cost of the investments to be financed with the subloans expected to be made under the proposed project is estimated at about US$50 million equivalent, of which about US$25 million represents the foreign exchange cost that would be covered by the Bank loan. The local costs of the subprojects would be financed by BCR (US$10 million equivalent), financial intermediaries (US$5 million equivalent) and the ultimate beneficiaries (US$10 million equiva- lent). The technical assistance program is estimated to cost an additional US$900,000. The foreign exchange costs associated with the technical assistance component, amounting to US$750,000, would be financed out of the proceeds of the Bank loan; local costs would be financed by COFIDE. Eligible Beneficiaries and Lending Limits 69. Enterprises with annual sales of not more than US$750,000 equivalent and fixed assets, excluding land, of not more than US$300,000 equivalent and operating in any productive, commercial or service activity except agriculture and livestock would be eligible for financing under the project (Section 1.02 (d) of the draft Loan Agreement). For the average firm, the sales and assets limits are basically equivalent. Moreover, the sales limit is in line with the definition used in the draft industrial law now before Congress, and the assets limit is equivalent to the statistical definition of small firms with employment of up to 49 persons. The maximum investment eligible for financing under the project would be US$200,000 (Section 1.02 (e) of the draft Loan Agree- ment). Based on experience with existing SSE lending, it is expected that the average subloan size would be about US$25,000. Terms and Conditions 70. The proposed Bank loan would be repayable on a fixed amortization schedule because the large number of small subloans would make repayment on a composite amortization basis impracticable. Since the subloans financed under the project would have shorter maturities than the Bank loan and COFIDE would, therefore, receive repayments not required to service the Bank or BCR loans, COFIDE would use such repayments to finance additional SSE projects under the  - 18 - same terms and conditions as the project (Section 3.09 of the draft Loan Agreement). In order to maintain the value in soles of the foreign exchange resources available from the credit line portion of the Bank loan, throughout the term of the proposed loan, the BCR would make semi-annual adjustments to these soles amounts in accordance with movements of the exchange rate during the previous six month period (Section 3.03(c) of the draft Loan Agreement). The amounts in soles resulting from the adjustment, less commitment fees on the proposed loan paid by BCR to the Bank, would be made available to COFIDE at the rate set forth in para. 71. 71. The BCR would onlend the credit line portion of the proposed loan (US$25.25 million) to COFIDE in soles at the prevailing Central Bank discount rate (TRB), currently 42 percent (Section 3.02(a) of the draft Loan Agreement). COFIDE, acting as a wholesaler, would onlend these funds, complemented by US$10 million equivalent of BCR's resources, to the participating financial intermediaries at rates equivalent to the TRB, plus a spread of 2 percentage points for loans up to US$10,000 equivalent, 3 points for loans of between US$10,000 and US$40,000 and 4 points for loans above US$40,000 (Part A.2 of Schedule 3 to the draft Loan Agreement). COFIDE's differential onlending rates would allow intermediaries a higher spread on smaller loans with higher processing cost, while allowing COFIDE a higher spread on larger loans, which would require additional appraisal work since they would be above COFIDE's free limits for intermediaries. The nominal average spread is expected to be about 3 percentage points. The effective average spread, however, would be about 4.5 percentage points, because interest would be charged monthly. 72. The participating financial intermediaries would onlend the loan proceeds, complemented by BCR's and their own resources, to the ultimate benefi- ciaries at a uniform interest rate not exceeding the equivalent of the prevail- ing maximum term lending rate (Part B.3 of Schedule 3 to the draft Loan Agreement). Currently, the rate, authorized by the BCR, is 54 percent per annum nominal or -- based on quarterly payments -- about 66 percent effective. If interest were charged monthly, as is to be expected, the nominal rate would be adjusted downwards so that the effective rate would not exceed 66 percent. With inflation moderating to some 50 percent in recent months and expected to decelerate further in 1982, the interest rate charged to the ultimate beneficiaries is highly positive in real terms. 73. With a TRB of 42 percent and a spread for COFIDE of 2-4 points, intermediaries would have a nominal spread of between 8 and 10 points and an effective spread of between 8.9 and 11.9 points. This would be sufficient to cover processing costs and provisions for bad debts and provide a strong incentive to the intermediaries to expand SSE term lending. The interest rate structure applicable under the project would be reviewed periodically by BCR, COFIDE and the Bank (at the request of any of these three parties) to ensure its adequacy (Section 3.07 of the draft Loan Agreement). The adequacy of interest rates and spreads would be judged on the basis of inflation and conditions on domestic and international capital markets. If, within 60 days of a request to meet to review the interest rate structure, there has been no agreement on interest rates and/or margins to be charged under the project, the Bank would have the right to deny authorization for further loan withdrawals (Section 2.03(e) of the draft Loan Agreement).  - 19 - 74. As mentioned in para 52, indexation was recently introduced for term financing on an optional basis but Congressional ratification is necessary. Indexation would not apply under this project unless the Bank, BCR and COFIDE agree on the procedures and policies for indexing and the applicable interest rate (Parts A.3 and B.4 of Schedule 3 to the draft Loan Agreement). 75. COFIDE would refinance up to 90 percent of all subloans made by financial intermediaries. In the case of new enterprises involving higher risks, however, beneficiaries would be required to provide at least 20 percent of the investment cost (Part A.5 of Schedule 3 to the Loan Agreement). In the case of established firms, the contribution of the ultimate beneficiary would be determined by the intermediary in accordance with normal banking practice. 76. Subloan maturities would be determined based on the characteristics of the investment project. In the case of financing for fixed investment and related working capital, subloans would be made for two to ten years, including a grace period of up to three years. In the case of permanent working capital, subloans would have maturities of from one and a half to five years, including up to two years of grace (Part B.2 of Schedule 3 to the Loan Agreement). 77. With respect to the technical assistance component, BCR would pass on the loan's proceeds to COFIDE at the same terms as the proposed loan would bear (including commitment fee), and COFIDE would assume the foreign exchange risk for this portion of the loan. Each element of the technical assistance program would be submitted to the Bank for prior approval (Section 2.03(a)(ii) of the draft Loan Agreement). Disbursement and Procurement 78. The terminal date for submission of subprojects to the Bank for approval would be December 31, 1984, and the closing date would be December 31, 1985. In accordance with standard practice for SSE operations, procurement for subprojects would follow normal commercial practice. It is expected that most goods would be purchased locally. Bank disbursement would be based on the assump- tion that the average SSE investment would have an estimated foreign exchange component of 50 percent since it would not be practical to determine the foreign excahnge content of each subproject. Accordingly, for each subproject financed under the proposed operation, the Bank would reimburse COFIDE for up to 100 percent of its participation in the financing, provided that the Bank's participation does not exceed 50 percent of the cost of the machinery, equipment, installation, civil works, or permanent working capital that make up the investment for the subproject (Section 2.02 (b) (i) of the draft Loan Agreement). 79. Bank disbursements would be made against statements of expenditure and disbursement issued by COFIDE and the BCR, respectively. The detailed documentation evidencing the final expenditures would be retained by COFIDE and would be subject to inspection by the Bank in the course of project supervision (Section 4.03 and of the draft Loan Agreement). Because of the processing time involved in operating through a two tier system, expenditures made up to 180 days prior to Bank receipt of the corresponding withdrawal re- quests would be eligible for Bank reimbursement (Section 2.02(b) (iii) of the draft Loan Agreement). 80. Given the small size and large number of subloans expected under the project, COFIDE would give a free limit to the intermediaries, below  - 20 - which the only information required would consist of a list of the basic features of the firm (including its creditworthiness), the financial appraisal of the investment and the terms and conditions of the subloan to prove eligi- bility. Upon presentation of such information, COFIDE would finance the corresponding percentage of the subloan. Free limits for each intermediary would be established by COFIDE in its intermediation contracts after careful appraisal of each intermediary, including its SSE lending evaluation capabilities. Such limits would be expected to range between US$40,000-US$100,000 and criteria for establishing limits would be spelled out in COFIDE's policies and procedures to be approved by the Bank (see para 64). On this basis, it is expected that COFIDE would review about five to ten percent of the subprojects. 81. Given the small size of the maximum investment to be financed under the project (up to US$200,000), the Bank would only review subprojects on an ex-post sample basis during supervision missions. Because of the expected large number of subloans under the project, an _x-poEst random sample of subprojects, regardless of size, would be more indicative of the quality of appraisals being made by each intermediary than the selected sample that would result from the Bank reviewing ex-ante only the largest projects sent by GOFIDE to the Bank. 82. All technical assistance subprojects would be subject to prior approval by the Bank (Section 2.02(b)(iv) of the draft Loan Agreement). Consultants' services, estimated to amount to about six man-months, would be contracted in line with the Bank's guidelines (Section 3.10(a) of the draft Loan Agreement). Disbursements under the technical assistance component would only cover expendi- tures incurred in foreign exchange (Section 2.02(b)(v) of the draft Loan Agree- ment). Project Benefits and Risks 83. The project would significantly increase the term financing resources available to the SSE sector. It would provide financing for an estimated 1,500 subprojects with estimated total investment cost of about US$50 million. With investment per job expected to range between US$4,000 and US$6,000, the proposed project would generate about 10,000 new jobs. 84. The project would enhance SSE financing and, by involving a large number of financial intermediaries, most of which are private, it would stimu- late competition and improve service to SSEs. Also, the participation of regional banks and commercial banks with large branch networks would increase the availability of term resources outside Lima, thus facilitating the decen- tralization of economic activity. Finally, the proposed project would further strengthen COFIDE's role as a wholesaler of term resources and enable it to reach new financial intermediaries with which it had not previously worked, such as credit cooperatives. 85. The project's technical assistance component would strengthen the institutional development of COFIDE by financing a young executive program and training staff in project financing. In addition, this component would help to finance a training program that COFIDE would organize for staff of financial intermediaries participating in the project to upgrade their term- lending capabilities and ability to service SSEs, particularly in regard to providing guidance on the availability of technical assistance resources.  - 21 - 86. While the project does not involve unusual risks, term lending to SSEs would be a new activity for many intermediaries, which may delay their involvement. For this reason, their spreads have been structured to make such lending attractive. Moreover, the loan officer training program mentioned in the preceding paragraph would familiarize intermediaries with the opportunities of SSE lending. Another possible risk is delay to the project because BIP, the principal SSE lender, is not accustomed to operating under a two tier system. To reduce this risk the simplified appraisal criteria and processing procedures for the project have been based, to a large extent, on BIP's own procedures. The free limit to BIP would also be relatively high (tentatively US$100,000) in recog- nition of their experience in this field. This should help to minimize problems. PART V - LEGAL INSTRUMENTS AND AUTHORITY 87. The draft Loan Agreement between BCR, COFIDE and the Bank as well as the draft Guarantee Agreement between the Republic of Peru and the Bank and the Report of the Committee provided for in Article III, Section 4(iii) of the Bank's Articles of Agreement are being distributed to the Executive Directors separately. 88. These draft agreements conform to the normal pattern for small-scale enterprise credit operations, adjusted to take into account the special features of this project. The main features of the Loan and Guarantee Agreements are referred to in the text of this report and are listed in Section III of Annex III. Special conditions of effectiveness would be: (i) approval by COFIDE's Board of the policies and by COFIDE's Management of the operating procedures for SSE lending (para 64); and (ii) authorization, by the BCR, that commercial and regional banks would be able to make loans maturing in more than one and five years, respectively at the applicable term-lending rate (para 66). 89. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 90. I recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachments by Ernest Stern November 18, 1981 Washington, D. C.   ANNEX I - 22 - Page 1 of 5 Page 1 TABLE 3A PERU - r AL INDICATORS DATA SHEET PERU REFERENCE GROUPS (WEIGHTED AVE.AGES LANU AREA (THOUSAND Sq. KH.) - MOST RECENT ESTIMATE)-a TOTAL 1285.2 MOST RECENT MIDDLE INCOME MIDDLE INCOME AGRICULTURAL 305.5 1960 /b 1970 /b ESTIMATE /b LATIN AMERICA & CARIBBEAN EUROPE GNP PER CAPITA (US$) 230.0 410.0 730.0 1616.2 2609.1 ENERGY CONSUMPTION PER CAPITA (KILOGRAMS OF COAL EQUIVALENT) 436.3 691.8 736.9 1324.1 2368.4 POPULATION AND VITAL STATISTICS TOPULATION, MID-YEAR (THOUSANDS) 10181.0 13461.0 17149.0 URBAN POPULATION (PERCENT OF TOTAL) 46.3 57.4 66.5 64.2 53.2 POPULATION PROJECTIONS POPULATION IN YEAR 2000 (MILLIONS) 28.5 STATIONARY POPULATION (MILLIONS) 55.0 YEAR STATIONARY POPULATION IS REACHED 2085 POPULATION DENSITY PER SQ. KM. 7.9 10.5 13.3 34.3 80.6 PER SQ. KR. AGRICULTURAL LAND 33.0 44.0 54.6 94.5 133.9 POPULATION AGE STRUCTURE (PERCENT) 0-14 YKS. 43.6 44.3 42.8 40.7 30.1 15-64 YRS. 52.0 51.8 53.6 55.3 61.5 65 YRS. AND ABOVE 4.4 3.9 3.6 4.0 8.3 POPULATION GROWTH RATE (PERCENT) TOTAL 2.4 2.8 2.7 2.4 1.5 URBAN 5.1 5.0 4.3 3.7 3.1 CRUDE BIRTH RATE (PER THOUSAND) 46.4 41.8 37.8 31.4 22.9 CRUDE DEATH RATE (PER THOUSAND) 19.7 14.5 11.1 8.4 9.1 GROSS REPRODUCTION RATE 3.4 3.0 2.6 2.3 1.6 FAMILY PLANNING ACCEPTOKS, ANNUAL (THOUSANDS) USERS (PERCENT OF MARRIED WOMEN) .. .. FOOD AND NUTRITION INDEX OF FOOD PRODUCTION PER CAPITA (1969-71-100) 96.0 102.0 86.0 108.3 119.8 PER CAPITA SUPPLY OP CALURIES (PERCENT OF REQUIREMENTS) 95.0 99.0 97.0 107.6 125.7 PROTEINS (GRAMS PER DAY) 62.0 61.0 59.0 65.8 92.5 OF WHICH ANIMAL AND PULSE 27.0 25.0 24.0 34.0 39.7 CHILD (AGES 1-4) MORTALITY RATE 28.5 19.6 13.7 7.6 3.4 HEALTH LIFE EXPECTANCY AT BIRTH (YEARS) 47.7 53.5 58.0 64.1 68.9 INFANT MORTALITY RATE (PER THOUSAND) .. 122.0/c 86.0 70.9 25.2 ACCESS TO SAFE WATER (PERCENT OF POPULATION) TOTAL 14.6 35.0 48.3 65.7 UKBAN 30.2 58.0 60.0 79.7 RURAL 0.8 8.0 25.0 43.9 ACCESS TU EXCKETA DISPOSAL (PERCENT OF POPULATION) TOTAL .. 36.0 34.0 59.9 URBAN .. 52.0 51.0 75.7 RURAL .. 16.0 .. 30.4 POPULATION PER PHYSICIAN 2011.7 1904.9 1545.1 1728.2 973.3 POPULATION PER NURSING PERSON 2205.0/d 738.0 745.0 1288.2 896.6 POPULATION PER HOSPITAL BED TOTAL 425.1/e 469.6 542.7 471.2 262.3 URBAN .. 524.8 430.1 558.0 191.8 RURAL .. 3055.3 5747.6 ADMISSIONS PER HOSPITAL BED .. 19.0 23.0 .. 18.2 HOUSlNG AVERAGE SIZE OF HOUSEHOLD TOTAL 4.9 4.8/f URBAN 4.8 4.9/f RURAL 4.9 4.6/f . AVERAGE NUMBER OF PERSONS PER ROOM TOTAL 2.3 1.9/f URBAN 2.0 1.7/f . RURAL 2.7 2.47 .. ACCESS TU ELECTRICITY (PERCENT OF UWELLINGS) TOTAL 26.0 32.1/f .. URBAN 50.7 54.3/f .. RURAL 4.2 2.7/f ..  ANNEX I - 23 - Page 2 of 5 TABLE 3A PERU - SOCIAL INDICATORS DATA SHEET PERU REFERENCE GROUPS (WEIGHTED AVERA5ES - MOST RECENT ESTIMATE) MOST RECENT MIDDLE INCOME MIDDLE INCOME 1960 /b 1970 /b ESTIMATE /b LATIN AMERICA & CARIBBEAN EUROPE EDUCATION ADJUSTED ENROLLMENT RATIOS PRIMARY: TOTAL 83.0 103.0 112.0 101.7 105.9 MALE 95.0 111.0 116.0 103.0 109.6 FEMALE 71.0 96.0 106.0 101.5 102.2 SECONDARY: TOTAL 15.0 30.0 50.0 35.3 66.3 MALE 18.0 34.0 53.0 34.9 73.2 FEMALE 13.0 26.0 46.0 35.6 59.5 VOCATIONAL ENROL. (2 OF SECONDARY) 20.0 17.0 16.0 30.1 28.4 PUPIL-TEACHER RATIO PRIMARY 34.0 35.0 40.0 29.6 26.8 SECONDARY 12.0 17.0 29.0 15.7 23.6 ADULT LITERACY RATE (PERCENT) 61.0 72.5/f 79.7 80.0 75.4 CONSUMPTION PASSENGER CARS PER THOUSAND POPULATION 8.0 17.1 18.5 42.6 83.9 RADIO RECEIVERS PER THOUSAND POPULATION 108.0 135.1 135.4 215.0 181.6 TV RECEIVERS PER THOUSAND POPULATION 3.2 29.3 50.8 89.0 131.1 NEWSPAPER ("DAILY GENERAL INTEREST") CIRCULATION PER THOUSAND POPULATION .. 123.3 51.0 62.8 123.8 CINEMA ANNUAL ATTENDANCE PER CAPITA .. .. .. 3.2 5.7 LABOR FORCE TOTAL LABOR FORCE (THOUSANDS) 3193.9 3896.8 5079.7 FEMALE (PERCENT) 21.1 20.7 22.8 22.6 32.9 AGRICULTURE (PERCENT) 53.0 44.8 37.8 35.0 34.0 INDUSTRY (PERCENT) 19.0 20.1 20.0 23.2 28.7 PARTICIPATION RATE (PERCENT) TOTAL 31.4 28.9 29.6 31.8 42.3 MALE 49.6 45.8 45.6 49.0 56.5 FEMALE 13.2 12.0 13.6 14.6 28.5 ECONOMIC DEPENDENCY RATIO 1.5 1.7 1.6 1.4 0.9 INCOME DISTRIBUTION PERCENT OF PRIVATE INCOME RECEIVED BY HIGHEST 5 PERCENT OF HOUSEHOLDS 39 ./ HIGHEST 20 PERCENT OF HOUSEHOLDS 64.4Th 61.0/f LOWEST 20 PERCENT OF HOUSEHOLDS 2.5/ 1.9/f LOWEST 40 PERCENT OF HOUSEHOLDS 8.0/S 7.-7 . POVERTY TARGET GROUPS ESTIMATED ABSOLUTE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN .. .. 235.0 RURAL .. .. 180.0 187.6 ESTIMATED RELATIVE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN .. .. 293.0 513.9 RURAL .. .. 200.0 362.2 385.1 ESTIMATED POPULATION BELOW POVERTY INCOME LEVEL (PERCENT) URBAN .. .. 49.0 RURAL .. .. Not available Not applicable. NOTES /a The group averages for each indicator are population-weighted arithmetic means. Coverage of countries among the indicators depends on availability of data and is not uniform. /b Unless otherwise noted, data for 1960 refer to any year between 1959 and 1961; for 1970, between 1969 and 1971; and for Most Recent Estimate, between 1976 and 1979. /c 1970-75; /d 1964; /e 1962; /f 1972; /a Personal income within labor force. May, 1981  ANNEX I - 24 - Page 3of 5 P DEFINITIONS OF SOCIAL INDIICATORS 9o-.e Altbough the date -r draw f-n sore sely judged h m-s utho-it-i-e end reliable, it shoudae. eatdna hymynth na- ntionally. fi . c .marbl rbecueo itako ettdriad einitions ad concpts usd by differet cuneeicoerigthedat.Tedteae oe theim., sefu to escrbe oders of eagoituda, indicate trend., and -Ototeis eran ajr.ifeene btwenouerie Camsth snen.. group ore (l rtheseeooutry group Of tie eubjent conty sed (2)' a oocnrY Stuup norb .omewhan high.t ereeg irtom theteonr ary of theeuh .so outrp (seo.sPt for "Cepitri turylue oil tePorters" grru where 'ttddls InuaNridro.n tdl at eoaa ess fsoae eucir-Oultural...ffinines j. I h deaeegru dtath awaregee er PoPulation oighoad erirbeenic eeen for eahfdcto e bre eywe majority of the orunariesin a group has dens for ier inoicaror. Since nbeoreregecf rcurdr leeTu.o. -he indirerorsydrpaeds o hthe ensllbbiiiryOofddtr on bdica'rm en a tiae osoag the r-utry end -sferenc grou.. SAtSS -al t1 tlaa f_iousiu&eq.he.)Prolt prueuts!l rd-tt re,aditl-Ppbar eei foa.-Snl ufosaeacmriigladarsed yln ratr.ohe n rurl inis bythier r_aeoivoehsf herPitel beds fo p,Pesturee, market end btnhe gade r nr lie fai1or; 1978 data. ahbllitution _etere -Ors.pinseseerbikae haseestlyasfn 09(PR UAIT iS$) GNlP peso .pita estintee en -ar-t. markan yTi-e, osJ- dIl ae r rtinlde. ualbeptla owvr, tanlyd health cuama by" sesonvret m o usIldS 1 Alsf977-79 beebe) 1960. an md rl eree otp Rmret.. na e byh atl. physriete 4 (hoeby 197,ied199doa md.trc Psirane, ras. edldwf, etc.) whioh Offer Je-pstl_t _00_ --ra.1 y ~ ~ ~ ~ at-n rd roide aliteited rugs o.f eedtasl ftli Oe. r steet ed lgie ptnee ntrlgs n yro,roerde atera c and Irure is,:pital local.. IOr -nra hoepitla end msdtosl ed m_t_riey oriolcyf ir holocrame of coal eqoivaleno per cepars; 1901, 1971, and 2079 ocececs. Speoieliaed boepindels eoe. bhacluded or. eld ly uy der tatat. fro ,oPir d aidd by tbs nuebse of beds. 'PUPSOATION AND VITAL, STATISTICS 1 i d " a ft rd--. t.