Ecuador - Third and Fourth Development Banking Projects

Docuasut of The World Bank FOR oFFIcL USE ONLY Repat No. 5946 PROJECT COMPLETION REPORT ECUADOR - THIRD AND FOURTH DEVELOPMENT BANKING PROJECTS (LOANS 1359-EC AND 1731-EC) December 2, 1985 Industrial Development and Finance Division 1 Latin America and the Caribbean Regional Office nT. &wmmw ha a rerictid lrbum gd -y be wed by redplemls OmY In te Peuf,runtom Of thber .Xciu &2&e. 113 essts ay me othrwise be dbscmd without Word Dak mgborfbsBom  ABRREVIATIONS CRE a anco Central del Fcuador BNF Banco Nacional de Fomento COFIF.C Compania Financiera Fcuatoriana de Desarrollo, SA CFN Corporacion Financiera Nacional DFC Development Finance Company F.CUFINSA Ecuatoriana de Financiamiento, S.A. WINANSA Financiera Nacional, S.A. FINANSUR Financiera del Sur FINIBER Financiera Iberoamericana, S.A. FOPINAR CFN's Small Scale Enterprise and Artisan Lending Facility IDR Inter-American Development Bank SSE Small Scale Enterprise and Artisans IJSAID rTnited States Agency for International Development CURRENCY EOUIVALENTS Annual Averages of Official Rate 1971-1981 - 1 Sucre = 0.04 USS 1USS = 25.0 Sucres 1982 - 1 Sucre = 0.33 US9 I USS = 30.n Sucres 1983 - 1 Sucre = 0.23 USS 1 ITSS = 44.12 Sutcres June 1984 - 1 Sucre = 0.015 USS I USS = 66.0 Sucres  FOR OMCIAL USE ONLY PROJECT COMPLETION REPORT ECUADOR - THIRD AND FOURTH DEVELOPMENT BANKING PROJECTS (LOANS 1359-EC AND 1731-EC) TABLE OF CONTENTS Page No. PREFACF .................................................... BASIC DATA SHEETS ...ii HIGHLIGHTS ....... ..... v I. INTRODUCTION ........................................... 1 Industrial Sector Lending Activitv. Macroeconomic Setting and Sector Performance. 7 Monetary Policies and Capital Market Development .... 6 2. PREPARATION AND APPRAISAL OBJECTIVES OF THE LOANS ..... 7 Loan Preparation .. 7 Loan Objectives ..................................... 7 Development of Capital Market ............. 8 3. UTILIZATION OF LOAN PROCEEDS ........................... 9 Resource Transfer ................................... 9 Distribution of Loans .........................0...... l Economic Rate of Return ............................., 11 Procurement Procedures .............................. 12 Project Preparation and Evaluation .12 Current Status of Subproject .13 4. INSTITUTIONAL DEVELOPMENT .16 Capital Market Development .......................... 16 Institution Building ................................ 18 Financiera Systemn ................. 20 Financial Condition of DFCs ......................... 21 Auditing and Financial Reporting .................... 22 Supervision of Projects ......................... 22 5. SUMMARY AND CONCLUSIONS ................................ 24 This document has a restricted distribution and may be used by recipients only in the performance or their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  TABLE OF CONTENTS (Continued) Page No. TABLES (Main Text) Table 1 .............................o... 6 Table 2 ...... ...o............. *................ 13 Table 3 ..... ............. 15 LIST OF ANNEXES ANNEX 1 Industrial Development Policy 27 Table 1 GDP by Sector of Origin 1970-19820.... 28 Table 2 Principal Sources of Credit to the Private Sector 1970-1983 (Z of Total).ol.......o....... 29 Table 2A Principal Sources of Credit to the Private Sector 1970-1983 (Billion Sucres)o.o.....oo.. 30 Table 3 Direct and Indirect Sources of Credit 1973-19837 . .. 31 ANNEX 2 Table 1 Projected and Actual Loan Disbursements Loan 1359-EC.... 5...... .....o ... e.o.... .c..... 32 Table 2 Projected and Actual Loan Disbursements Loan 173 7E3.........E .. 33 ANNEX 3 Table 1-3 Comparison of Subprojects Financed under Loan 13 5 9 -E...... o.. ...... .... . ........... ... ... 34 Table 4-6 Comparison of Subprojects Financed under Loan 1731-EC.....,,......,, .....,,.,,,.... . 37 Attachment I Summary Analysis of Selected Subprojects...... 40 ANNEX 4 Table 1 Analysis of Supervision and Credit Management.. 65 Attachment 1 Financial Condition of Selected Development Finance Companiesmp....... . ... ............ o..o. 67 ANNEX 5 Letter from Corporacion Financiera Nacional dated September 24, 1985, with comments on the Project Completion Report (English translation) . ....... .. . . 77  PROJECT COMPLETION REPORT ECUADOR - THIRD AND FOURTH DEVELOPMENT RANKING PROJECTS (LOANS 1359-EC AND 1731-FC) PREFACE 1. This rePort reviews the performance of the Bank's Third and Fourth industrial credit vro1ects made through the covernment of Ecuador, wainly to the Corporacion Financiera Nacional (CFN), the National Industrial Development Bank, and to Ecuatoriana de Desarrollo S.A. (COFIEC), Ecuador's largest private development finance company (DFC). Included in these loans were several small, new DFCs which qualified to access small percentages of the loans that were set aside for their use. The report assesses the progress wade toward achievement of the main policy and institution-building ob.jectives which were integral to the design of the projects. Loan 1359-EC was approved on Februarv 18, 1977, and the final closing date was June 30, 1q82. Loan 1731-EC was approved on June 17, 1979, and the final closiag date was June 30, 1983. Small portions of Loans 1359-EC and 1731-EC (USS.2 and USS1.1 villion, respectively) remained undishursed and were cancelled at the loans' closing as suhprojects were reduced in scope. The existing pipeline of subprojects was handled under subsequent loans. 2. This project completion report was prepared`by the Bank's Latin America and the Carihbean Projects Department on the basis of data obtained during Bank missions to Ecuador in Auigust and October 1984. Comments received from the Borrower have been reflected in the report. 3. This project has not been audited by the Operations Evaluation Department.  - il - PROJECT COMPLETION REPORT ECUADOR - TRIRD AND FOURTE DEVKWOPMRNT BANKING PROJECTS LOAN 1359-EC BASIC DATA SiREET Key ProJect Data Appraisal Item Expectation Actual Loan Credit Original Amount USS26.OK USS 26.0 N Disbursed UTS$26.014 US$ 25.8 M Canceled US$ .2 r Repaid to 9/30184 USS 17.1 H Outstanding on 9/30/84 TJSS 8.7 M Financial Performance Satisfactory during life of loan. Re- cently financial system sharply deterio- rated because of re- cession and sharp devaluation. Institntional Performance DFCs matured and improved during life of loan. Currently, finan- cieras are beset by financial prohlems. Appraisal Other Project Data Expectations Actual. Negotiations 11/19/76 Board Approval 12/28/76 Loan Agreement Date 02/18/77 Effectiveness Date 08/09/77 Closing Date 06/30/81 06/30/82 Borrowers Republic of Ecuador Executing Agencies Proceeds of Loan made available to Corporacion Financiera Nacional, COFIEC, and several newly established DFCs. Follow-On Project: Fourth Industrial Credit Project LOAN 1731-EC Amount (US$ million) US$40 million Loan Agreement Date 12/17/79  - iii - PROJECT COMPLETION REPORT ECUADOR - THIRD AND FOURTH DEVELOPMENT BANKING PROJECTS LOAN 1731-EC BASIC DATA SHEET Key Project Data' Appraisal Item Expectation Actual Loan Credit Original Amount US$40.OM US$ 40.0 M Disbursed US$40.OM US$ 38.9 M Canceled US$ 1.1 M Repaid to 9/30/84 USS 12.4 N Outstanding on 9/30/84 US$ 26.5 M Financial Performance Satisfactory until mid-1982, when deterio- rated sharply because of continued recession, devaluation and credit restraints. Institutional Performance Performance improved through mid-1982 when the economy collapsed. DFC Loan portfolios were substantially affected and institu- tional performance declined as financial problems mounted. Appraisal Other Project Data Expectations Actual Negotiations 05/18179 Board Approval 06/17/79 Loan Agreement Date 12/17/79 Effectiveness Date 09/25/80 Closing Date 06/30/83 Borrower Republic of Ecuador Executing Agencies Mainly CFN and COFIEC. Eight new financieras were potentially eligi- ble to participate. Follow-on Project Fifth Industrial Credit Project Loan 2096-EC Amount US$60 million Board Approval 02/23/82 Loan Agreement Date 04/22/82 Effectiveness Date 10/05/82 Borrower Republic of Ecuador Executing Agencies CFN, COFIEC and new financieras (potentially 11)  - iv - PROJECT COmpLTION RE:PORr ECUADOR - THIRD AND FOURTH DEVELAPMENT BANKING PROJECTS (lOANS 1359-EC AND 1731-EC) Supervision Effort Related to DFC Operations and Policy Dialogue (FY1977 - FY1984) (In Nanweeks) Supervision Appraisal Loan Loan Loan Total Loan 2221-EC Total FY 1359-EC 1731-fC 2096-EC Suvervision Loan 2096-EC Effort 1984 - 1.3 30.6 31.7 - 31.9 1983 .9 1.0 34.1 36.0 - 36.0 1982 1.3 1.8 1.8 4.9 48.6 53.5 1981 1.4 15.2 - 16.6 41.2 57.8 1980 7.6 24.3 - 31.q - 31.9 1979 4.7 .1 - 4.8 - 4.8 1978 12.7 - - 12.7 - 12.7 1977 9.7 - 9.7 - Total 38.3 43.7 66.5 148.5 89.8 238.3  -v - PROJECT COMPLETION REPORT ECUADOR - THIRD AND FOURTH DEVELOPMENT BANKING PROJECTS (LOANS 1359-EC AND 1731-EC) HIGHLIGHTS 1. Bank funds were committed and disbursed under the Third and Fourth loans, after some initial delays, for the types of subprojects anticipated in the appraisal. The geographic locations and estimated economic impacts of projects were in line with expectations although subloans were, on average, larger than expected (paras 3.05-3.07). Beyond that, several unpredictable events affected the outcome of the loans and the achievement of its key institutional objectives. 2. In late 1981, while Bank funds under the Fourth loan were disbursing, Ecuador's economy began to falter as a result of foreign exchange constraints, high public sector expenditures, declining domestic demand, credit restraints to the private sector and interest rate policies which hampered resource mobilization and encouraged capital flight. By 1982-1983, Ecuador was in the midst of a deep recession made worse by catastrophic floods and droughts that destroyed major food and fiber export crops and fueled inflation. Major deva- luations in 1982-1983 resulted in a dramatic increase in DFCs' liabilities as their estimated US$300 million in guarantees for private sector borrowing from foreign banks became actual rather than contingent liabilities (para 1.07). Thus, the debt/equity ratios of the banking system and of all DFCs involved in the Bank's projects exploded. By mid-1983, all participating DFCs except CFN were found to be in substantial violation of the 10 to 1 debt/equity covenant of the Fifth DFC project (Loan 2096-EC), as the financial condition of the DFCs weakened because of lower earnings from deteriorating portfolios and the higher provisions taken to cover loan losses. The Bank and the Government agreed in May 1983 that Loan 2096-EC would be modified to help strengthen the DFCs' equity positions and, in early 1984, that the Bank would continue to disburse to DFCs exceeding agreed-upon debt/equity ratios, that the Government as Borrower had no objections to this plan, and that the Superintendent of Banks would advise the Government and the Bank should the financia. condition of any DFC deteriorate further (paras 4.10-4.11). 3. In that overall economic and financial context, a significant per- centage of Bank-financed subprojects have experienced difficulties. About 13% of the 82 projects financed under the Third and Fourth Loans are closed or in liquidation while an additional 21% have experienced difficulties and are not likely to achieve their projected financial and economic results. Ultimately, some of these projects may fail. Bank lending in Ecuador has in the past, however, encountered fair economic weather. Loans made under the Third and Fourth projects were faced with an economic storm that fully tested the DFC project preparation and appraisal process. The project appraisal and evalua-  - vi - tion process was found wanting, but the mechanics of preparation or presenta- tion of economic (ERR) or financial (FRR) rates of return were adequate. A high percentage of projects failed because market and distribution research and analysis were inadequate, and evaluations of executive and technical staff capability to run new or complex enterprise were often poor (paras 3.12-3.16). 4. The profitability, liquidity and financial structures of DFCs continued to decline in December 1983 and in 1984 as portfolio problems mounted. The debt/equity ratios rose from not more than 10 to 1 in 1982 to a range of from 15 to I to 25 to I for the five private DFCs which are participating in the program. In conjunction with Ecuador's regulatory and financial authorities, the Bank and the participating DFCs are seeking to reach agreement on the financial rehabilitation targets that would be conditions for their participation in future loans. A major institutional rebuilding job remains to be done, and some DFCs may fail to achieve rehabilitation targets. The DFC system is currently supported by the Central Bank's (CBE) special discount line and overdrafts. CBE is currently the source of 57Z of the system's resources. Because o' the financial crisis, private DFCs have begun to evolve into more complex financial organizations engaged in leasing, real estate and commercial paper operations. Recently, DFCs have had to be flexible in order to survive, and the standard DFC model is likely to disappear in many cases (para 1.11-1.12). 5. Overall, the Bank's Third and Fourth loans have provided DFCs with about 3 to 4 point financial spreads. At the debt/equity ratios provided for under the loans, financial spreads of 5 to 6 points were required by DFCs to earn modest real returns of 3% to 4% on equity. In the past, the Bank has not given ample weight to the risks inherent in term operations lending and the need for DFCs to make reasonable returns on investments to maintain their long term viability (para 4.09). 6. The Fourth project's major objective of completing formal capital market studies was not achieved (para 4.01). Retrospectively, the research project on capital markets was excessively ambitious for CBE's available professional staff to undertake at the same time that it was attempting to deal with inflation, devaluation, financial system crises, interest rate policy and declining resource mobilization. The study was probably also excessive in scope since half of it addressed complex long term institutional issues with low possible medium term benefits to the financial system. It was clear that, in the context of 1982-1983 events, the issues raised in the Fourth loan on capital markets were overtaken by the unpredicted deterioration of the economy. However, progress was made by the Government in 1982-1984 on the critical exchange rate and interest rate issues and on industrial policy issues (para 4.02). A good financial sector data base was prepared under the Fifth DFC loan, and a dialogue on financial sector issues was initiated with the Government. Key interest rate and industrial sector policy issues are under discussion in the context of preparation of a possible Sixth DFC Project.  PROJECT COMPLETION REPORT ECUADOR - THIRD AND FOURTE DEVELOPMENT BANKING PROJECTS (LnANS 1359-EC AND 1731-EC) I. INTRODUCTION 1.01 Industrial Sector Lending Activity. Between 1971 and 1983, the Bank made a total of seven loans to the Republic of Ecuador in support of the industrial sector - broadly defined to include manufacture, agro-industrv, fishery and small scale and artisan enterprises. These loans amounted to almost USS215 million (net of cancellations). Five development banking loans were channeled through an expanding system of development finance companies (DFCs) to help finance medium and larger size industrial enterprise. Two Rank loans (amounting to USS60 million) were channeled to artisans and small scale enterprises (SSEs) through an SSE proiect unit (FOPINAR), established as a second tier discount facility, in the Corporacion Financiera Nacional (CFN), a Government-owned DFC. In addition, IFC made a small investment (USS500,000) in Compania Financiera 'Fcuatortana de Desarrollo S.A. (COFIEC),Fcuador's largest private DVF. This Project Completion Report reviews Loans 1359-EC and 1731-EC, the Third and Fourth Development Banking Projects in Ecuador. These loans to the Republic of Ecuador were channeled mainly through CFN and COFIEC. Several newly established nFCs, which ultimately cualified to participate in the projects, used about 10% of the Third and almost 18% of the Fourth Loan. 1.02 The Rank's First and Second Development Ranking Projects (Loans 721-EC and 930-EC), totaling USS28 million, were approved in December 1970 and June 1973, respectively. By June 30, 1976, almost 100% of the loan resources had been approved for subloans for a wide variety of industrial projects. More than half of the projects were for natural resource-based industries in line with Ecuador's comparative advantages. A project performance audit report (PCR) was prepared for the first two projects (Report No. 2530 of June 1979). This report concluded that the projects were successful in achieving their objective of increasing long term financing to industry and in helping both CFN and COVIF.C, the main users of these resources, to develop into stronger and more mature institutions with improved subproject appraisal and supervision capabilities. The PCR recommended that, under futture DFC projects, more should he done to develop Ecuador's capital market as a means of aiding domestic resource mobilization  -2- rather than concentrating only on the relatively narrower issuies of interest rates that had been the focus of Bank attention.l/ 1.03 Macroeconomic Setting and Sector Performance. The Bank initiated its first industrial lending operation in Ecuador in 1971 when the orocess of transforming the economy from a predominantly agricultural to an increasingly urbanized one was accelerating, and the roles of manufacture, commerce and services were beginning to expand (Annex I, Table 1). During the decade of 1972-1982, as the Bank's first four industrial credit projects dishursed, Ecuador experienced an almost 8% p.a. real growth in GDP, which was fueled bv Government revenues from petroleum exports.I/ Real per capita GnP rose from UJSS840 in 1972 to US$1500 in 1982, and about half of Ecuador's population, mainly those living in urban centers, experienced real gains in their welfare. 1.04 Manufacturing led Ecuador's growth during 1972-1982, increasing at an average rate of 9.5%. Textiles and mineral products accounted for 22% and 13.52 of total growth while the food, beverage and tobacco sectors increased by 8.5% p.2. and, together, accounted for a total of 35% of the growth of manufacture. Ecuador's strategy for rapid growth through industrialization appeared to he working, but, verhaps, at the expense of domestic agriculture, which grew little (Annex 1, Table 2). Employment in manufacture grew at about 4% p.a., while overall sector productivity increased at a high 5% n.a. rate, as a result of increased capital intensification, better trained management and technical staff, and improvements in transport and communications infrastructure. All of these factors contributed to the high 63% growth in output per man hour during the decade and to the sector's ability to operate profitablv, to expand investment, and to increase wage rates. 1.05 GDP growth slowed to 4.5% p.a. in 1981 as petroleum prices and demand for Ecuador's key commodity exports weakened, foreign exchange constraints developed and the heretofore substantially stable parallel foreign exchange rate began to rise well above the official rate. For the first time since 1974, private sector Investment suffered a decline (26Z). In 1982, the current account deficit of the balance of payments again exceeded TJSS1 hillion, as it had in 1981. Between 30% and 402 of this deficit was financed by increased indebtedness of the private sector in the 1/ Under the Third Development Banking Project, the Rank had alreadv attempted initial steps in this direction. The Loan Agreement called for the Government to set up an office which would ultimately recommend ways of strengthening Ecuador's capital market. Disagreement within Ecuador, concerning under whose auspices the office would function, ultimately prevented its establishment. 2j Manufacture accounted for 20% of the real increase in (DP in the neriod from 1970 through 1982. Petroleum accounted for 23% of real growth while agriculture accounted for only 7.5X. Commerce and services (excluding public administration) added 16% and 14% respectively to real GDP growth.  -3- form of direct foreign debt or debt surported by guarantees from Ecuador's commercial banks and DFCs. These guarantees financed short, as well as medium and lon- term investments, including a portion of the boom in commercial and residential construction. 3/ Ay early 1q82, DFCs had accumulated an estimated TJS$100 million in direct foreign debt and ahout US$320 million equivalent in guarantees of their clients' foreign debt. 1.06 Bv 1982, real growth in GDP was a low 1.7% as natural disasters, low oil prices and closing international markets all combined to affect Ecuador's economy negatively.4/ To stem the drain on Central Bank foreign exchange reserves, the Sucre was devalued by about one-third (from S/25 - US$1 to S/33 = USS1) at the end of 1982, just as the last portion of Loan 1731-EC was being disbursed. At that time, the level of direct and contingent foreign exchange obligations held by the private sector increased from about S/15.6 billion to S/20.6 billion. With high inflation, continued shortages of domuestic credit, sharp declines in availability ot foreign credit and a reduction in the supply of basic commodities necessary to fuel Ecuador's agro-industries, the heretofore buoyant economy fell into a deeo recession. In 1983, Ecuador experienced a 3.3% decline in CDP, along with a 7% per capita decline in consumption as prices accelerated from the acceptable 10 to 15% experienced during the 197Os and early 1980s to about 50% p.a. 1.07 The subprojects financed by the Rank under the Third and Fourth loans from mid-1978 through the end of 19R2, experienced sharp changes in their uaderlying economic and business environments. Furthermore, Andean markets (mainly Colombia, Peru and Venezuela) closed their doors to a variety cf wood, leather, textile, metal and electrical/mechanical enterprises established to serve them. In that overall recessionary business cycle context, with foreign debt to the private sector through DFCs and commercial banks inflated to about S/45 billion by further devaluations, the 3/ The shortage of foreign exchange and Governmental expansionary fiscal policies crowded the private sector out of the tightened credit market. Tne prevailing view of enterprises was that the Covernment would not devalue; thus, enterprises reverted to dollar borrowing. 4/ In 1982, there was a sharp loss in fish vroduction and agriculture production because altered ocean temperatures and weather conditions created combinations of catastrophic floods and drought. These resulted in losses of 222 of banana exports, 50% of cocoa and 41% in fish products. Cotton, corn and other food grain and horticultural production were also sharply affected, and food and other prices rose sharply.  - 4 - nFCs, along with most commerci-qi hanks, suffered a series of sharp financial reversals as their loan portfolios deteriorated and thetr earnings hases eroded along with their capital structures (Annex 4). To prevent a possible failing of the financial svstem, the Government took steps to "sucretize" the registered private foreign debt, which was converted into Sucre loans from CRE to the banking system and matching Sucre obligation hy private industry and commerce to the banking system. 1.08 Since the earlv 1960s, Ecuador's industrialization model and incentive structure have been based mainly upon fostering import-substitution industry. It is not surprising that industrial projects have proved to he relativelv highlv dependent upon imported inputs, capital intensive and with a low degree of export orientation (para 3.05). The use of an economic rate of return (EMR) calculation for most Rank-financed projects under the Third and Fourth loans was designed to filter ot1t Projects that could not produce reasonably efficiently in world terms and, thus, to neutralize the negative effects of industrfal policy. In that connection, since 1982 the Bank has engaged the Government in substantive dialogue regarding industrial policy under Loan 2096-EC (the Fifth Industrial Project). Policy improvements for the sector are critical to the prospects of the Rank advancing additional industrial projects. The new Government, which took office in August 1984, has begun to maKe efforts to foster more efficient industrial development. It has taken measures designed to ultimatelv unify the foreign exchange market. has adopted a managed flexible rate regime (currently S/96 = US$1) and has eliminated about one-third of the existing imDort restrictions. 1.09 Monetarv Policies and Capital Market Development. Fcuador's interest rate, exchange rate and fiscal policies of the past decade gave, and still give, its citizens little incentive to place their savings in either the commercial banking or the DFC svstem, or in Sucre-denominated financial instruments. Ecuador's under-developed capital market system results from a lack of firm policy regarding resource mobilization as well as: (a) the country's still under-developed system of commercial banking which limits commercial paper activity; (b) inadeanate regulatory, reporting and supervision activity; (c) lack of insurance programs to protect depositors; (d) insufficient corporate financial reporting and poor accounting and auditing;and (e) lack of effective administration capable of enforcing compliance with appropriate regulations. Inadequate disclosure rules further inhibit the development of a broader market for commercial paper, eouity or debt instruments. At the same time, the relatively low fixed interest structure has stimulated levels of borrowing far heyond possible financial savings, inducing Ecuadoran firms to seek credit abroad, thus increasing the country's foreign exchange obligations and inhibiting domestic savings and resource mobilization. These financial policies and institutional inadequacies were unsustainable in the long run: they succeeded in the decade from 1972 to 1982, while the p.,blic and private sectors could borrow abroad, and collapsed when the international commercial banks closed their doors to Ecuador.  - 5 - 1.10 The Fcuadoran banking svstem had only modest success in marshalling Private deposits during the decade from 1972 through 1983. The high real growth of the F.cuadorian economv during the 1970s was not accompanied by a corresponding use oF monev and savings deposits. Money supply relative to CMfP grew modestlv during the early 1970s, peaked during 1976-1978, and then fell. During 1q72-19R3, demand deposits grew at 7X per year in real terms, while time and savings deposits actuially fell. During this period, however, the private se.!tor increased investment by almost 10% per year in real terms. The fLancial svstem was, therefore, financing a rapidly growing economy while its ability to capture financial resources domestically was sharplY limited.5/ 1.11 nFCs became increasingly important as sources of credit to the private sector in the period from 1q72 through 1983 as they dramatically increased their share of credit to the private sector from 10.5% to 18.4% of the total (Annex 1, Table 3). DFCs sharply expanded their resources from S/620 million (ITSS24.R million equiivalent) to 8/37,000 million (rTSS422 million equivalent)61 from 1974 through 1983. Abouit two-thirds of this change in their resource base occurred in 1982 and 1983 when total liabilities of the system increased by S/21,60n million. Almost three-quarters of this increase is accounted for by a massive increase in DFCs' liabilities to CBE resulting from the program of -Sucretization' (para. 1.07) and the inabilitv of DFCs to mobilize resources under the existing interest rate policv. Thus, CBE currently provides almost 57% of the total resources of the DFC system and controls its future. 51 CRE hecame the major source of credit expansion (Annex 1, Table 2). During the 1970s, CBF was the major source of funds for state banks and DFCs. Thereafter, the dvnamic commercial hanking system also became highly dependent upon CBE, which, by 1983, accounted for more than one-third of commercial hanks' stock of credit. 6/ Using the free market exchange rate of USS1.00 = S/98. The official exchange rate In December, 1983 was S/54 = ITSS1.00.  -6- W{ME I DLO 1F LIAEMOrDIS Am CAPrL/ PRIVATE nVEsrW FDWE CANMS (Percmtaw of Total) Llablities 1974 1978 1983 -I- z _ Short Term Suce Debt 4.8 1.9 10.3 (xmmord.al lm*s - 4.9 Central Bami Credit 39.7 37.4 56.5 lltds Issued 14.3 9.3 7.6 Foreigi Debt Clid & 1xg Term) 17.5 9.3 11.4 Capital & Raserves 23.8 42.1 9.5 Total 100.0 100.0 10D.0 Total LiabilUties & Capita (Ibtflin mucres) 630 2.140 37,000 Sorce: Cmtral Rank of Fozdr, Misc. IMF Publications. 1/ E=3udirv Cotinget Liabl-ities 1.12 Consistent with the disappearance of term resources and industry's need for working capital rather than new plant and equipment, DFCs' short-term Sucre lending also expanded sharply (S/13,600 million). The net effect of these major changes in financial structure has varied among DFCs (Annex 4).The svstem as a whole is now highly leveraged (debt/equity ratios for DFCs range from 15 to 1 to 25 to 1) and volatile as reflected in the deteriorating loan portfolios. Thus, the major effects of devaluation and recession have been to alter the structure and soundness of the DFC system. The effects of Ecuador's restrictive credit and financial policy (including interest rates) have been to reduce the liquidity and profitability of the financial system and increasinglv to turn -he private DFCs and CFN into supplicants at CBE's discount windows.  -7-- II. PREPARATION AND APPRAISAL Loan Preparation 2.01 The Third project T(Loan 1359-EC) was intended to continue to build on the achievements of the first two projects by providing term resources to the industrial sector, expanding the size and scope of development finance company activity and improving nFC capabilitv to appraise and supervise projects. The Third project dealt witi the interest rate policV and its effect upon resource mobilization and, for the flrst time, shifted the Bank's focus to overall capital market objectives. These issues were identified and properly dealt with during appraisal. The Third project advanced smoothly, from the preparation and Loan Committee stages through negotiations. The terms approved by the Loan Committee prior to negotiations (November 1976) were accepted by the Ecuadorians with only two minor departures: (a) CFN's proposal that )VCs be allowed to charge commissions at one percentage point below the maximum allowed by the G,overnment regulations; and (b) the CRE's proposal that CBE foreign exchange risk coverage fee be increased from the Bank's proposed 1.5% to 2%. The acceptance of these points established a basis for an average minimum financial spread for DFCs of about 3%. The Fourth DFC project was intended to continue building upon the institutional gains achieved under the first three projects while focusing more fully on the achievement of capital market objectives. During preparation and loan negotiations, the Bank proposed that CBE establish a second tier facility which wouild inter alia: help determine eligibilitv under the loan of new DFCs, approve their participation in the program, and review and approve subprojects submitted hv eligible new DFCs for Bank approval. CUE did not accept this proposal indicating that its professional and management staff was more than fullv occupied with operational work (para 4.04). The Bank accepted CBE's position and agreed to shoulder responsibility for subloan review as well as for supervision of the eligibility of individual financieras. Loan Objectives A. The Third Loan Sought to: (i) Assist industrial sector growth bv providing long term financing on reasonable terms and conditions to cover foreign exchange costs of acceptable projects. (ii) Strengthen DFC's institutional capability to appraise the financial and economic merits of industrial projects and thelr supervision thereof. (iii) Enbance the ability of the financial system to mobilize and lend term resources by providing adequate interest and commission rates, and financial spreads, as well as limiting DFC short term operations. (iv) Contribute to the development of the capital market. B. The Fourth Loan Sought to: (i) Stimulate development of an economically efficient capital market so that financial institutions can  -8- mohilize effectively and channel increasing amounts of medium and long term resources. (ii) Encourage financieras to use additional resources to finance efficient term investment projects. (iii) Promote competition in resource mobilization and lending activity and achieve greater dispersion of Bank funds (presumablv geographic and sectoral) by making them available to qualified new financieras. 2.02 with regard to the industrial credits granted und%r the Third and Fourth loans, it was expected that the proceeds of both loans would be used to finance mainly larger and medium size companies, with a maximum of US$3 million of Bank funds to anv individual project and with an aggregate of not more than US$5 million in Rank funds to any individual firm, and that a substantial portion of the funds disbtrsed would go to finance resource- oriented industries with backward linkages to agriculture or fisheries. The Fourth loan estimated that about 80 subprojects would be financed, with an average use of IUSS500,0M in Bank funds. The Third loan projected an average ERR of 30Z, while the Fourth loan estimated an average ERR of over 20% and that Rank funds would be used to finance about US$160 million (25%) in total Investment. 2.03 With regard to development of sound DFCs: (i) Both loans projected that the financial spreads available under the Bank loans would be adequate to provide profitable operations for the DFCs when considered in conjunction with the 8 to 1 debt/equity (D/E) ratio provided for under the Third loan and the 8 to 5 to 1 to 10 to 1 D/E ratios prescribed under the Fourth loan. (ii) TJnder the Fourth loan, special provisions were made to protect CFN from assuming excessive foreign exchange risk. Under the Third loan, special efforts would be made by CnFIEC to improve its financial forecasting and budgeting procedures. (iii) Both loans provided for continued assistance to DFCs to help them imDrove project appraisal and supervision processes. Development of Capital Market 2.04 Capital market develepment was an objective of both loans. The Fourth loan specified that the process would be advanced by the establishment of a svecial Capital Markets Study Unit (CMSTJ) within CRE which would carry out the five major policy, legal, and regulatory or technical studies within a 13-to-14 month period. The studies with first priority dealt with (a) interest rate policy (liberalization), (b) resource mobilization and (c) examination of methods to transfer foreign exchange risks to final borrowers through a possible dollarization of loans financed with foreign credit lines. The studies with second priority were scheduled to deal with the whole range of issues affecting operations of capital market institutions  -9- (security exchanges, etc.), giving greatest attention to defining more clearly the specialized roles of the various financial institutions. 2.05 High long range henefits to Ecuador's economv were anticipated from the successful completton of the proposed capital market studies and Lhe appropriate reform that would follow. The risk envisioned was the possibility that CNSIT would be slow to he formed and to get studies under way. To minimize that risk, the establishment of CMSU was a condition for Board presentation. Regarding institution-building objectives, no specific technical assistance program to DPCs was proposed. The major users of Bank funds ("FN and OWIEC) were iudged to be strong and mature institutions and that sYN would play a role in helping new financieras, and that additional required assistance to TFCs, if any, wotild be provided during Bank supervision and project preparation. 2.06 The extent to which these objectives were achieved is described in Chapters 3 and 4 following. III. UTILIZATION OF LOAN PROCEEDS 3.01 Resource Transfer. Ecuador's Third Development Banking Loan, 1359-EC (USS26.0 million), was signed on February 18, 1977 and became effective on August 9, 1977 after the Government, CBE and the DFCs had completed the lengthy process of internal contracting and the clearing of legal opinions. The US$26 million loan was initially allocated among CFN (ISS13 million), COFIEC (USSIO million) and five newly created financieras USS3 million). CFN and COFIEC committed their original project funds rapidly and, after a slow start, disbursed them within six months of the original disbursement schedule. The project closing date was extended twice, however, at successive six-month intervals until June 30, 19R2, in order to accommodate the delayed participation of the new financieras identified in the appraisal report as Potential participants.' To assure fulfillment of the project objective of Advancing the development of the new financial intermediaries, the project was modified to permit these fFCs to access Bank funds through CFN, which assisted them in meeting the conditions of participation that initially proved to he too strict. It took from mid-1978 to mid-1980 to finalize agreements affecting the participation of the new financieras, which ultimatelv disbursed their allocated portion of the loan in mid-1982. 3.n2 Thirty-three subloans were financed under Loan 1359-EC, of which CFN partially financed 9 investment projects totaling UJS$80 million, using almost tTSS12.8 million of its USS13 million. The average bank loan per project financed by CFN was a higher-than-anticipated USS1.42 million (See (Annex 3, Tahles 1-6, for distribution of loans by type and size). COFIEC's ITSS10.5 million disbursements under the loan were spread among 11 projects, of which six consumed more than 85% of Rank funds and the average loan size amounted to a high US$1.07 million. The new financieras used almost USS2.7 million of the loan to finance 13 medium size projects.  - 10 - 3.03 The Fourth Development Ranking Project (Loan 1731-EC), amounting to US$40 million, was signed on necember 17, 1979. Disbursement started later than anticipated during appraisal, again due to Ecuador's slow process of drafting and approving internal agreements. Once the project finally achieved effectiveness in September 1980, commitments and disbursements surged, and the Fourth loan was fully committed by the DFCs by December 1980 and disbursed by December 1982, essentially in line with appraisal expectation. The accelerated pace of commitment and disbursement under Loan 1731-EC is notable because the Bank raised its overall performance requirements on subproject evaluation. For the first time, participating DFCs began applying more complex economic analysis principles to their larger Bank-funded subprojects, thereby becoming the first financieras among Rank-assisted institutions to do so. ERR calculations initially Dosed some methodological difficulty for participating institutions, which often calculated border prices incorrectly and, less commonly, underestimated shadow wages, insurance and other economic costs. During subproiect review and supervision of the Fourth loan, Bank staff focused upon helping DFCs to improve their overall understanding of ERR analysis, and the technical quality of the financiera system's economic analvsis did improve (para 3.07). 3.04 The Fourth loan financed 49 suhprojects. The new financieras successfully disbursed about 90% of the USS7 million reserved for them in the Fourth loan for 9 subprojects . CFN used 522 of the loan proceeds and exceeded its originally allocated USS18 million nuota bv US$2.24 million, processing 24 projects averaging TTS$3.4 million in total project cost and USS843,700 in Bank financiig per snbproject. COFIEC received TJS$12.3 million of its appraised USS14 million share, which was applied to 16 subvrojects averaging US$3.9 million in total project cost and US$768,800 in Bank financing per subproject. Ninety-seven percent of the Fourth loan was disbursed by the June 30, 1983 original closing date. 3.05 Distribution of Loans. As with the first two DFC loans, subloan recipients tinder Loans 1359-EC and 1731-EC were mainly in resource-based sectors. Textiles and footwear, paper and wood products, foods and beverages, and mineral and chemical products accounted for 85% of all participating companies under the Third loan and 75% under the Fourth loan. Under these loans, however, activity shifted toward newer, higher technology import substitution projects and toward several major Andean Pact export- oriented operations. Almost USS25 million in total project financing was devoted to building new or incremental plant capacity to service the Andean Pact market (see Annex III for summary listing of projects). Winancing of metal trade and light machinery increased under the Fourth loan. Bv the conclusion of the Fourth loan, the portfolio composition of CFY and COFIEC had diversified substantially among eight sectors, in line with appraisal expectations. This tendency to broaden the hase of industrial coverage was mirrored in the aggregate data for the project, and no one sector received more than 20% of the total. Under the Third loan, 55% of CFN loans went to new firms, while COFIEC tended to maintain a somewhat more risk-average profile relending about 72% of Bank funds to established enterprises. lJnder the Fourth loan more than half of both institutions' lending went to existing firms.  - 11 - 3.06 Overall investment decisions in Ecuador's industrial sector reflected the relatively high incentives offered to import substitution industry as compared with export activity (Annex 1). lJnder the Third loan, about 27% of CFN and COFIEC lending went to finance export projects (mainly Andean Pact), while their financing for export industry was sharply reduced to only 5% under the Fourth loan. Given the over-valued exchange rate that prevailed since mid-1981 and the reduced level of incentives to export, this situation was not surprising. During loan supervisions, the anti-export policy bias, as reflected in the operations of the Fourth project, was identified, and policy discussions were held with the Government. The Bank addressed industrial and export policy within the framework of the Fifth DFC project (Loan 2064-EC), which established a minimum 20% quota for export projects and, more important, initiated substantive industrial sector policy discussions and prepared major sector studies. Discussions were initiated with the Government in 1982 which substantially improved the Government's understanding of the fiscal and economic costs of existing policy. Until the onset of serious foreign exchange problems in 1983, good progress had been made on tariff and export policy, especially with regard to exchange liberalization. The policy dialogue has continued in the framework of potential further Bank industrial sector lending. 3.07 Economic Rate of Return (ERR). For COFIEC subprojects in the Third loan, ERRs averaged about 35%. Estimated ERR's were somewhat lower for the Fourth loan (about 27%), reflecting Bank supervision of COFIEC's ERR estimation processes and improvements in their border and shadow pricing technique and application of proper methodology. CFN's projections were more consistent, more guarded (with a mid-range of about 25% for the Third and 26% for the Fourth loans) and more evenly distributed. Ex Post ERR calculations on a 20% sample of non-failed projects under the Fourth loan showed an average ERR of 15% compared with the 28% average projected for the sample. Overall, by the end of the Fourth loan, all participating financieras had developed adequate economic analytical skills. CFN had developed a computerized model (which was adopted subsequently by other DFCs). The technical quality of most economic analysis work for subprojects received under the Fifth loan was acceptable until mid-1983. Since then, a decline in the quality and organization of the subprojects submitted has been recorded. This decline appears to be due, first, to the high turnover rate among nFCs' professional staff and, second, to a DFC management's inabilitv to focus upon the quality of project appraisal work in the midst of their financial difficulties. 3.08 The US$59 million of the rUSS66 million loaned by the Rank through the Third and Fourth loans disbursed by CFN and COFIEC helped to mobilize US$220.0 million from other sources (equity US$100.2 million, other banks' and suppliers' credits US$72.2 million and CFN and COFIEC ITSS47.6 million) and resulted in USS279 million in total investment projects, more than had been anticipated during appraisal. The Bank financed 21% of total project costs rather than the 25% assessed during appraisal. Average subproject cost was slightly higher than anticiDated. Eighty-two subprojects were actually financed under the two loans averaging US$800,000, indicating that DFCs still continued to market their resources among the larger rather than small and  - 12 - medium scale enterprises. This tendencV was reversed substantially as a result of the Bank's small scale enterDrise (SSE) credit projects in which all major DFCs participated, with the exception of COFIEC. DFCs disbursed about US$15 million in SSE credits for an average loan amount of about USS125,000 in the period from mid-19R1 through 1983. 3.09 T-ith the exception of several major projects in Cuenca (resulting from a one-time policy thrust to sharply increase the pace of industrializa- tion of that area), almost all other Third and Fourth loan subprojects were located in Quito or Guayaquil. This was to he expected given the existing high focus of activity in those industrial centers, the location of major DFCs in those cities and the linkages between DFC management and the major industrial groups centered in the areas. CFN subsequently adopted a more aggressive regional posture through new branch operations in five secondary cities. As competition stiffened, DFC lending became more diversified, which Is reflected in the Fifth DFC project and DFC operations in the SSE Loans, under which more than half of the loans were made outside of the two major cities. 3.10 Procurement Procedures. Rarely questioned by the Bank during the first three loans, vrocurement procedures were lore commonly brought to the Financiera's attention during the course of the Fourth. The experience gained under the Fourth loan was reflected in Improved supervision under the Fifth DFC loan as DFCs were required to provide a more detailed and clear-cut procurement statement. During supervision of the subprojects submitted to the Bank for approval, the more exacting standards were more uniformly applied, especially when there was not an obvious arms length relationship between the borrower and the vendor. In such cases, even the small -B subprojects were carefully reviewed, and appropriate questions were raised. 3.11 Project Preparation and Evaluation. By the end of the Fourth DFC Project, the financieras collectively suct:eeded in establishing and/or strengthening their subnroject preparation capabilities and, on the whole, improved the organization and the financial and economic content of their evaluation procedures. Information forwarded to the Rank on each prospective client for Fourth loan proceeds was more comprehensive, more detailed and better organized than that which had been generated as a consequence of the Third loan, reflecting the efforts made during supervision to upgrade the overall quality, content and presentation of aporaisal documents. At the same time, subloan evaluation by the intermediaries still tended to he economics, engineering and production-cost-oriented. Reports tended to approach the more subjective, hut critical, issues of markets, risks and executive capability in a mechanical, and often naive way. Reports were often thin, or poorly done, regarding (a) market prospects and risks, (b) distribution issues, (c) competitive challenges and (d) quality of management. These shortcomings in pro7ect analysis proved to be critical to the outcome of a substantial number of these projects subject to ex Post reviews.  - 13 - 3.12 Current Status of Subproiects. E.cuador's economv plunged into a broad recessionarv trough at the end of 1Q82 (paras 1.06 and 1.n7) just as manv of the major projects financed under Loans 1359-EC and 1731-EC sought to produce and reach markets. As indicated on Table 2 below, five of the 33 Proiects financed under Loan 1359-F.C and one of the 49 projects financed under Loan 1731-EC totally failed to achieve profitablA --erations and have heen closed or are in the process of liquidation, major reorganization or sale. Failed subloans financed from the proceeds of the Third and Fourth loans represent about 13% (ITSSR.3 million) of the almost fTSS65 million disbursed under these two loans.7/ Tn addition, 16 subloans involving 13 firms are classified as in difficulty, and it Is highly unlikelv that any of these proiects will achieve Positive financial or economic rates of return; some of them mnav have to liquidate. This group accounts for UJSS13.4 million (21X) of the almost UTSS65 million dishursed. Thus, fully 34X of the resources disbursed under the Third and Fourth loans are, in economic terms, lost or at risk. It is noteworthy that all hut one of the subprojects classified as failed or in substantial difficulty were financed by COFIEC or CFN. To date, only one of the projects presented to the Rank by the new financieras is reported to be in difficultv. TABLE 2 STA1I1S OF SUBUOAS (As of Jure 30, 1984) No. Failed In Difficulty In. 1359-FC 33 5 - in. 1731-FC 49 1 16 Total 82 6 lfi Tbtal fls1ursenents 64.7 8.3(13%) 13.4(212) (in iES =11ions) 3.13 A number of the main reasons for project failure under the Third and Fourth loans were identified by the PCR mission, which conducted detailed reviews of the documents of 23 companies (Annex 3, Attachment 1) ineluding 16 firms which either failed or were in difficulty and 7 enterprises (control group) whose proiects were advancing satisfactorily. These reviews were supported bv field visits to 14 of the project sites where management was 7/ CFN reports that as of September 24, 1q85, two projects classified as "Fai]ed are now in the process of rehabilitation and should be moved to "In Difficultv classification. No further information on the nature of the process was given.  - 14 - interviewed and the condition of operations observed. This research effort revealed that while the recession played a large role in reducing Project Profitability, it turned out not to he the major canse of project failure.8/ The major controllable, internal reasons were few in number: (a) Marketing and/or distribution issues were often inadequately or incorrectly addressed, which accounted for about 4nz of problem projects. These inadequacies were not given sufficient attention in Bank reviews. (b) Management proved to be inadequate, and unable to plan for and to execute, project startup or to run the enterprise once it was under way, which accounted for about one-third of project difficulties.9/ 3.14 The main reasons for problem projects that were external to the project but subject to risk analysis included: (a) shifts in Government industrial or export incentive policy; (b) reduced public sector program expenditures; tc) devaluation and sustained financial distress; and (d) export market (Andean Pact) closings. (See Table I for summary of reasons for project failure.) TFCs did not attempt to address or deal with these risk features systematically in their subproject reviews. nften the contrary was true. Project appraisals proved that project viability was assured because of the existence of Government programs that offered a secure market. A high percentage of the problem projects reviewed in detail for the PCR depended, in some measure, upon Government programs for their profitability (export incentive subsidies, public construction programs or Andean Pact arrangements). The fact that a major risk is often associated with these special arrangements was not discussed or evaluated.ln/ In one subproject appraisal reviewed, the data indicated that almost 1ii07 of annual profits would he accounted for in the early years by the 15X incentive rebate on export (CAT). The repeal of this CAT and its subsequent reinstatement at a lower level was one reason for the difficulty experienced hy this subproiect. 8/ CFN emphasizes the importance of the economic crisis and other factors external to the project evaluation for the ultimate failure of many projects to achieve their projected results (Borrower's Comments, Annex 5, Paras. 2.1 - 2.2 and 3.1). 9/ CFN commented that management appraisal for new projects was often incomplete because the managerial and senior technical staffs had not yet heen engaged (or chosen) at the time of appraisal, and would not he chosen until project start-up. 10/ These failings in Project appraisal methodology continued to applv in the Fifth project.  iffjrr axPEaN REIr1 1 IIZ - 11I) AMI MMEfIN MW &WMM I1MM (UWS 13594E AM 1I-3W) MA1Xym1s of Bart-Firwicd Sublowe Wiich H Me Falled or Are In Diffl wity Cmemm for Failure mid Staiti of &abmoJects CAUSES OF DIFFICULTY Potentlal Ion Fairuy Recessla/ 3;t ODerdrMirns,uii= D"alAtMiM ' Subicin TotAl i*et Aidniatrati%e Flnancial DnmlbsJ terIun, TadlUcal PoUcy md High Forea Msltt Oibloan IJC Sector Statu Sine ,ject Plemng Prohlem ProblA lam a1 lA Proble O F Fobeml Debt GCwtitai Claed FAIUD SWL9IJECIS 1 1359 Admss An11iir OWC Phar Praurts Uqudction LSSI,750 US$17,003 x x ' A x x ECAM a)FIE White Cbrd gotlatbon 365 4,-)) x x x Ahff1VzlRCS awIYL Whasms r,tittlon 480 I.03 T1U24 CiN Plutic CaIble liqgddetlon 350 753 x x SUILA GIN PLattc TUles Uqlddatlon 2,475 5,710 a x x x Latn 1731-EC Arteiractico CFN Furntture *90tiation 2,999 26,00D x x x x x x TrAL USS8,345 18555,463 t SuLWCC1 DI DZFLCJLTY lo J731-SC wllAS oTaF Dry il hlttmry OpeCrtir Haiginwlly US51,28S USS2,960 x a a a hit Refinarcd ECJIUN OWDVIC Ttarforutu MInad Product on 1, 5W 4, I x x x x x PR0U(0 CDFIC Ociante Clred 939 1,970 x a GanaT 1o qpDrahm IWFI Soft drinlix Fmllear Sales bit to) 5,1X17 x x x Highly Laveral mad tl Uq dd PolUmiJa (DFIEC PVC Lamtnaes xe of capaclty 499 1,429 x x 0W OCN Tires labor Problew/now l.,W 12,400 x at 8Mt of CQqucty rW PFtoL: 8D2 of Cquclty 2,1171 alcareus Hy jyco 1/ CON Ura ectraction IliquLd; at low 918 3,241 x x x x Caicare. HLayco FIIY8A Level tpratlo,u 279 Celizrema Hl.yw CO4 (See Abo) 503 .Mcoitns AtLwa CiN Carade tUet Ibbt consolidation 441 2,044 x a a ISIAEc OC H4dhln-tools ?Hrginal proiuctk.n 152 2,250 x a x V1TPlA CFN Claims aplee oft - lidatcin 144 515 x x x x x OAISA C1 Carmiptel etal Oaratfi at Iow lawla 1,074 1,870 x laM C74 White Codos cqmtirU at low teIla 834 917 x x a Crea 0aN Sraipa Qprattli at low lawla 684 1,654 ax x x Tlrm. USS13,160 USS55,989 Scurci: Bx '1jstan Reiecw of Individwal Sebprojects, Financial an) Portfolio Coidittmn Plints of ON and 011H 1/ PartilIly trtn Iti 13594Er  - 16 - 3.15 There is no evidence that the Rank's subproject review, as practiced in the Past, contrihuted toward preventing subproject failures. The B"M subproiects, which are the smaller projects not generally reviewed in substance by the Bank, have suffered fewer failures or difficulties than have the large "A" subpro,iects, which receive substantive review by the Bank. Part of the reason why past subproject reviews may not have made an effective contribution toward identif-ing gaps in the vroject analysis process is that at that time the Bank focused mainly on the quality of the economic analysis. Bank reviews did not contribute much to identifying shortcomings in the critical portions of project appraisal affectina markets, distribution, management, and risks which proved to be critical to project success or failure. 3.16 The mission found that only ln% of subprojects reviewed contained an adequate examination and evaluation of the project's management team. Most appraisals reviewed and commented on the project's financial sponsors or directors, hut not the actual operating management team. This was not surprising, because It would have involved the DFCs' professional staff in making judgment on executives selected by the major financial and industrial personages who sponsored the project. This is a difficult problem, and it is not likely that such an analysis would he undertaken without (a) more direct involvement of financial intermediaries in the projects that they finance and (b) increased training of DFC loan officer staff and awareness of how to judge management capability. 'A.17 It is not possible at this stage to forecast with precision the losses that COFIEC and CFN may ultimately sustain as a result of the performance of proiects they financed under the Third and Fourth loans since many of the owners of the affected enterprises have continued to repay their loans from other resources.11/ It is likely that a sizeable percentage of the potential losses of principal and interest that the DFCs may ultimately suffer could be offset by the proceeds from the sales of land, and plant and equipment, which are the underlving guarantees for each project. Nevertheless, economic losses of failed projects could be substantial. TV. INSTITUTIONAL DEVELOPMENT 4.fll Capital Market Development. A primary objective of the Third and Fourth loans was to advance the development of a more effective capital market to enable financial institutions and enterprises to mobilize and 11/ Only three of COFIEC's failed or difficult subproiects from Loans 1359-EC and 1731-EC were reported to he in arrears. However, a number of such proiects have been rescheduled and are still in doubt.  - 17 - channel increased resources efficiently.12/ To help fulfill this very broad objective, CRE established a capital markets study unit (CMST7) as a condition for presentation of the Fourth loan to the Board. A comprehensive multi-stage work program was agreed upon, and rMSTJ was staffed with two qualified young professionals. It was hoped that the creation of CMSU would ultimately have far-reaching effects upon research, policy formulation and institution creation. Three events intervened: (a) Despite the creation of CMSIT, the project was not firmly institutionalized at the key senior professional levels. Agreements regarding the program of study between the Rank and the reneral Manager of CBE and his staff were not transmitted to the line managers responsible for CMSIJ activity. Subsequently, CRE's General Manager resigned, CRE was reorganized and the line managers were replaced. This process of change occurred at the general manager and department director levels three more times from 1980 through 1983. Since the need for the capital market studies and their terms of reference proved to he somewhat ambiguous, the impetus to get them done in the narrow 13-month allotted timeframe was diminished, especially since accomplishing the multi-disciplinary studv originally envisaged could have required much more legal, accounting, financial and economic skills than were provided for. At the time, CBE was neither staffed nor hudgeted to accomplish the complex study pronosed. (b) With sharp]y rising inflation, increased credit restraints and emerging foreign exchange problems, the attention of CRE's senior monetary policy staff focused full time upon the serious immediate problems arising from the existing structure of inflexible and negative interest rates, multiple exchange rates and the like. CRE's most senior economists were requested to prepare a paper directed toward resolution of these problems. This paper was prepared outside of the formal structure of CMSU and CRE's agreement with the Rank concerning prior review of terms of reference. The interest rate paper was subsequently reviewed hy Rank staff during supervision; it was considered to he incomplete in scope, narrow in content and not complying with the terms of reference for the study. Retrospectivelv, although incomplete hy formal research standards, this policy Paner on interest rates (directed to the Monetarv Board) represented a breakthrough in financial policy formulation. The paper proposed that Ecuador adopt, for the first time, a policy of gearing its lending rate structure to a base rate which would approximate the market rate for savings deposits. (c) In spite of the difficulties in the way in which the capital market study was being handled by CBE, progress was made for the first time on some of the fundamental policy issues the study was designed to address. During 1982-1983, the frequency and quality of the Rank's policy dialogue with the Government improved because of (a) the increased frequency of Rank/Government 12/ IJnder the First, Second and Third loans, financial sector policy dialogue focused on the issue of expanded resource mobilization via-a-vis interest rate reform. The Bank's Project Performance Audit Report--prepared in connection with the first two proiects-concluded that the Rank should focus increasingly on broader issues of developing Ecuador's capital market. This broad, somewhat undefined, ohiective was picked up and advanced during appraisal of the Fourth loan.  - 18 - contact during the supervision of Loans 187Q-EC (SSE I) and Loan 2096-EC (Fifth DFC prolect) and the preparation of Loan 2221-EC (SSE II) and (b) the availability of financial and economic studies around which policv dialogue could focus. Bank project and program staff were deeplv engaged in a Joint effort with the Ministry of Finance to establish estimates of the fiscal cost of Ecuador's industrial policy and the fiscal costs (or savings) of policy reforms. At the same time, discussions were being held with CRE on financial policy issues. A report]3/ was prepared by Bank staff which resulted in a focusing of attention on the major issues of resource mobilization and interest rate policy. In that context, the more remote, broad-ranging capital market development issues proposed for study under the Fourth loan hecame relatively less important and were, in effect, abandoned. 4.02 Discussions on interest rate issues during the course of the Fourth and Fifth DFC projects and the First SSE project resulted in agreements to maintain interest rates on loans in real terms. Negotiations on broader financial sector issues affecting resources mobilization were opened in August 1983, based upon the newly completed financia] sector review which had adopted, in some measure, CBF's earlier staff proposal to move toward a more flexible indexed interest rate regime pegged to a reference savings rate. Agreement on reasonable progress on Ecuador's economic and financial policy was made a condition for committing the final 3nx of the Fifth loan and the balance of the Second SSE project. Government assurances on economic and financial policy satisfactory to the Rank Managei'ent were given in September 1983 and these were followed by a series of agreed upon interim actions in trade policy, exchange and interest rate levels. In late 1984, under Ecuador's new administration, CBE started working with USAID on the preparation of a study and program for capital market improvement in Ecuador for the next decade. 4.03 Institution Building. Since the Rank viewed, during loan preparation, that it was dealing primarilY with two mature DFCs, neither the Third nor the Fourth loans explicitly detailed prograws of technical assistance to the DFCs. CFN and COFIEC had adopted sat