Chile - Industrial Finance Restructuring Project

Document of The World Bank FOR OmCIAL USE ONLY 0g/.~~ C. - <fw Repwt No. 5433-CH STAFF APPRAISAL REPORT CHILE INDUSTRIAL FINANCE RESTRUCTURING PROJECT May 20, 1985 Projects Department Latin America and the Caribbean Regional Office Thk daueut* bwaresatgdc dh~on* --rm be useod by redpkiets| only Ine pefrnossce of SbEr oShicd du&$.e lb eootsX M not o&uwise be d id sed wthmt World EBnk shdai  CURRENCY EQUIVALENTS All currency amounts are expressed in Chilean Pesos (Ch$) and US Dollars CUS$). Chile has a crawling peg that resulted in a nominal devaluation of 37Z in 1984. Exchange rate as of December 31, 1984 US$1.00- Ch$124 Ch$1.00- USSO.008 Average Exchange Rate B 1982 1983 1984 US$1.00 = Ch$50.91 US$1.00 - Ch$78.84 US$1.00 - Ch$96S.4/ Ch$ 1.00- US$0.0196 Ch$ 1.00- US$0.0127 Ch$ 1.00- US$0.0102 Weights and Measures Metric System Government of Chile Fiscal Year January 1 - December 31 GLOSSARY OF ABBREVIATIONS BHC Banco Ripotecario de Chile (now in liquidation) and, by extension, thle name of the business conglomerate that controlled it BHIF Banco Elipotecario de Fomento Nacional a private bank CB Central Bank of Chile Colocadora Nacional Colocadora Nacional de Valores. National Securities Underwriter, a private bank. ERR Economic Rate of Return FRR Financial Rate of Return GDP Gross Domestic Product IDB Inter-American Development Bank IFC International Finance Corporation (Member of the World Bank Group) LIBOR London Interbank Offered Rate PROGRESA One of the two largest business conglomerates in Chile SUPERINTENDENCIA Superintendencia de Bancos (Superintendency of Banks and Financial Institutions) UF Unidad de Fomento (Financial Unit of Account which reflects the movements in the Country's Consumer Price Index)  FOR OFFICIAL USE ONLY STAFF APPRAISAL REPORT CHILE INDUSTRIAL FINANCE RESTRUCTURING PROJECT TABLE OF CONTENTS Page No. LOAN AND PROJECT SUMMARY .......................................... i I. ECONOMIC AND FINANCIAL ENVIRONMENT . ....... . A. Background .....1 B. Recent Developments and Tren d* 1............. II. THE FINANCIAL AND INDUSTRIAL SECTORS ....... .................. 2 A. The Financial Sector e cr..... . .......... . ...... 2 B. The Industrial Sector. .............................. 5 Mi) Industrial Investment Requirements. 6 (ii) Industrial Restructuring 7 C_. Legal I s s u e s ....................B... D. Bank Strategy in the Industrial Sector. 9 Ill. THiE PROJECT .............................................................. 10 A. Project Objectives and Description ...................... . 10 B. Credit Component ....... .............. ..... 11 C. Onlending Terms and Conditions . . ......................... 12 D. Institutional Setting ... . ..................... 13 E. Subproject Appraisal and Supervision ..................... 14 F. Procurement and Disbursement ........................... . 15 G. Accounts and Auditing .................................... 16 H. Participating Intermediaries ............................. 16 I. Benefits and Risks . ................. .. 17 IV. AGREEMENTS REACHED AND RECOMMENDATIONS ................... ...... 17 This report is based on tHie findings of an appraisal mission which visited Chile on October - November 1984. The mission comprised Messrs. M. Hinds (LCPI2), M. Long (IND), N. De Souza (LEG), P. Jones (IFC), P. Glaessner, E. Saucedo and Ms. R. Halvorson (Consultants). This document has a restricted disibution and may be used by recipients only in the performnce of their official duties Its contens may not otherwise be disclosed without World Dank authoriation.  - i - REPUBLIC OF CHIlE INDUSTRIAL FINANCE RESTRUCTURING PROJECT LOAN AND PROJECT SUNKARI Borrower: Republic of Chile Ezeuting Agencty Central Bank of Chile (CB) kAount: US$100.0 million equivalent Terms: Repayment in 15 years, including three years of grace, at the standard variable interest rate. eBmdlng Terms: The Central Bank as fiscal agent for the Government would on- lend loan funds to commercial banks in US dollars or in Chilean pesos. US dollar-denominated loans to commercial banks would have rates equal to the Bank's interest rate plus a spread to compensate the Central Bank for the Bank's com- mitment fees and for the cost of operating the Technical Unit (TU). Commercial banks would onlend these funds charging a three percent spread. Interest rates on peso-denominated loans to commercial banks and subloans to beneficiary enter- prises would be equivalent to those of dollar-denominated subloans and would be expressed in real terms calculated upon a principal expressed in Unidad de Fomento (UF), by deflating the respective dollar rates by the United States Consumer Price Index (CPI). This would ensure that real interest rates would be the same for both dollar- and peso-denominated loans and subloans. The repayment terms for subloans would be up to 15 years, including a grace period of up to three years. Project Objectives: The proposed project would help the Government to undertake a financial restructuring program of industrial corporations on a selective basis. The project is conceived as a pilot ef- fort that would be replicative in restructuring efforts car- ried on outside of the project. Project Description: The project would include assistance for: (a) establishing and financing the institutional framework through which cor- porate restructurings would be devised, negotiated, and im- plemented; and (b) financing the purchase of capital goods and working capital necessary to maintain and increase pro- duction.  - ii - Project Beneflts: The proposed project would help to remove the financial dead- lock that is hindering the recovery of industrial production in Chile through the establishment of an institutional frame- work geared to promote the financial restructuring of selec- ted industrial companies and the provision of foreign ex- change financing needed by the restructured companies to carry out required investments. Project Risks: Credit demand could be curtailed if: (a) the economic situation deteriorates further; (b) the Technical Unit fails to promote restructurings or proves incapable of analyzing them properly; (c) individual restructurings prove too dif- ficult to be completed within the proposed loan's commitment period; or (d) after being restructured, the firms obtain credit from other sources. To mitigate these risks, the Technical Unit would: (i) have detailed Operating Pol4cies and Administrative Procedures in line with the project's ob- jectives; and (ii) be staffed by high-level professionals with experience in corporate restructurings. The benefits to Chile would be substantial, and the experience gained in this operation would be useful in the design of programs to sup- port firms in financial distress. Therefore, the overall benefits of the project are expected to outweigh the risks significantly. Estimated Costs: Local Foreign Total (USS Million Equivalent) Investment Sub-Projects 147.6 147.4 295.0 Technical Assistance to Technical Unit 2.4 2.6 5.0 Total Financing Required 150.0 150.0 300.0 Fimencing Plan: Government 100.0 0.0 100.0 Other Sources 50.0 50.0 100.0 Bank 0.0 100.0 100.0 Total 150.0 150.0 300.0 = = =~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~  - iii - Estlated Dlaburanemts: Bank FY: 196 1987 1988 1989 1990 1991 1992 Annual 1.7 10.2 19.4 30.4 18.0 15.7 4.6 Cumulative 1.7 11.9 31.3 61.7 79.7 95.4 100.0 Rate of Return: Not Applicable  I. ECONOMIC AND FINANCIAL ENVIRONMENT A. Background 1.01 Notwithstanding its strong recovery in 1984, the Chilean eronomy is still suftering from one of the worst crises in its modern histcry, following a fall of 14.9% in the country's GDP, in real terms, between 1981 and 1983. While this crisis shares, with past cyclical recessions, the prevalence of low copper prices, there is a key feature that sets it apart from previous recessions, i.e., the inability of the private sector to repay a substantial portion of its large debt to domestic and foreign creditors. Service of the external portion of this debt was identified by the most recent Economic Memorandum on Chile (Report No. 5099-CH) as a major obstacle to the country's future growth. At the end of 1984, the medium- and long-term Chilean external debt was estimated at US$17.0 billion (close to 85% of GDP), with interest payments representing over 40Z of exports in 1983. About 40% of this debt is public; the private sector owes US$4.5 billion directly to foreign banks and US$6.3 billion through the country's financial system. While the growth of the external debt was facilitated by the abundant liquidity of international banks during the late 1970s and early 1980s, the private sector's excessive indebtedness was, in part, caused by the incestuous relationships between firms and financial institutions that prevailed during 1975-1983 in some of the largest business conglomerates, by the 1979-1982 overvaluation of the currency, and, eventually, by distress borrowing at extremely high real interest rates. 1.02 The Government has made significant efforts, during the last two years, to service both public and private external obligations. To reduce domestic demand, it imposed austere monetary and fiscal policies and adopted a crawling peg that has kept the real exchange rate at its lowest value since 1978. As a result, the trade balance turned from a US$2.7 billion deficit in 1981 to a US$1 billion surplus in 1983, and the current deficit of the balance of payments was reduced from US$4.9 billion to US$1.5 billion during the same period. Most of this adjustment, however, was achieved through a drastic reduction in merchandise imports, which fell from US$6.6 billion to USS2.9 billion during the period; in spite of the favorable real exchange rate, the value of exports declined slightly from 1981 to 1983 as a result of falling commodity prices in the international markets, the depressed condition of Chile's neighboring markets and financial problems at the firms' level. B. Recent Developments and Trends 1.03 The depression bottomed out in late 1983. During 1984, GDP grey at a 6.3% annual rate, and 250,000 additional jobs were created, mainly as a result of expanding domestic demand, boosted by a large public investment program, and of the rescheduling of a substantial portion of the private sector's domestic debt (para. 2.07). Balance-of-payment problems, however, slowed growth in late 1984. Prices of non-copper exports declined 4.5%, while copper prices dropped 12% to their lowest level since the 1930s. As a result, despite an almost 10% volume increase in non-copper exports,  -2- Chile's total export earnings dropped 5%. Simultaneously, imports increased 18Z over their 1983 level as a consequence of the rising economic activity. In September 1984, in response to a growing external imbalance and to declining copper tax revenues, the Government increased the uniform import tariffs from 20% to 35% and devalued the currency 23%. These measures were followed by a sharp curtailment of monetary expansion, which succeeded in preventing a permanent surge of inflation after the measures were taken. Also, a new three-year Extended Facility Program was negotiated with the IMF. 1.04 In order to sustain the recovery, the Government is undertaking a three-year public investment program with emphasis upon export promotion and job generation. Corporate and individual tax reductions are now in place in order to stimulate investment and savings, and a general financial plan has been prepared to resolve the financial problems of the banking system (paras. 2.07-2.08). Major reforms in the structure of large business groups have been undertaken, and their ownership conflicts, caused by the financial collapse of their holding companies, are gradually being resolved. In spite of these actions, the Chilean recovery remains precarious, severely constrained by foreign exchange scarcity. Increased export earnings depend, in part, upon a rapid expansion of non-copper exports. The Government has established a competitive exchange rate policy and is planning a major enhancement of export incentives, including a program to reduce import tariffs to their previous levels. In order to maintain a moderate rate of growth of GDP, however, Chile also needs a substantial flow of external capital, which, in the immediate future, will be difficult to obtain from private sources. II. THE FINANCIAL AND INDUSTRIAL SECTORS A. The Financial Sector 2.01 As of November 1984, the Chilean financial system comprised the Central Bank of Chile (CB), 38 commercial banks (the largest of which, Banco del Estado, is Government-owned) and seven financial companies ("financieras'). Commercial banks are multi-banking institutions and operate at both the short- and long-term ends of the market, financing all kinds of activities and trading in mortgages and comercial paper. Many financieras, much smaller institutions, are associated with commercial banks. They do not receive demand deposits and account for less than 2% of the total system's outstanding credit. The banking market is highly concentrated: of the 38 commercial banks, the five largest account for 60% of the system's credit. Other financial institutions include seven mutual funds, 12 private pension funds, 51 insurance companies and the Santiago Stock Exchange. The Central Bank is the highest monetary authority in the country, sharing with the Superintendency of Banks (Superintendencia) the supervision of the financial system. It is managed by an Executive Committee of three members, appointed by the President of the Republic. The Chairman of the Committee is also the bank's president and has a rank equiitalent to that of a cabinet member. The Central Bank undertakes all of  - 3 - its credit activities through commercial banks and financieras. The Superintendencia is an autonomous body, and its authorities are appointed by the President of the Republic. Both institutions are well run and their staffs are highly qualified. 2.02 Several factors led to the creation of large industrial/financial conglomerates in Chile. At the end of the Allende regime, under the threat of widespread confiscations, the prices of all assets fell sharply, and many of them changed hands at extremely low prices. When the political regime was changed, the assets' prices increased again, creating a speculative mood in the business community. Speculation was further encouraged by the sale of most Government-owned firms that the new Government undertook shortly after its accession to power. Given the depressed state of the economy at the time, assets had not yet recovered their equilibrium prices, and those firms were sold in public auctions at very low prices, mostly to conglomerates formed to purclxse them. As the economic situation improved in subsequent years, asset prices increased, and the conglomerates obtained large capital gains. Later in the 19709, the Government denationalized the banks, and most of them were bought by the newly formed groups, which then used the banks' credit to finance further acquisitions and, in some cases, to pay for the shares of the banks themselves. Eventually, these conglomerates established networks of financial institutions (banks, mutual funds, insurance companies) that channeled the cash they needed to keep on growing through acquisitions. Two big groups predominated: the BHC group, controlling Banco de Chile and its subsidiaries (accounting for close to 302 of the financial system's credit) and the Progresa group, controlling Banco de Santiago. BHIF and Colocadora Nacional (accounting for about 20Z of the system's credit). 2.03 The trend toward incestuousness in the relationship between financial and nonfinancial companies worsened at the end of the decade, when a substantial overvaluation of the Chilean peso created incentives for cross currency speculation. From June 1979 to June 1982, the Government fixed the foreign exchange rate in dollar terms in order to reduce domestic inflation to international levels. During that period, prices of domestic nontradeable assets continued rising at the diminishing but still high local rate of inflation, while the price of the US dollar remained fixed in peso terms. This made it profitable to borrow in apparently low-interest dollar-denominated funds to speculate in real estate and in peso-denominated financial assets. Moreover, cheap imports discouraged tradeable activities, and nontraditional exports, one of the main sources of growth in the previous five years, lost international competitiveness and tended to stagnate. As a result, investment in industrial activities remained low, while the private sector's external debt was increasing rapidly, from US$2.7 billion at the end of 1978 to US$10.5 billion at the end of 1982. Eventually, close to 60Z of the private sector debt was denominated in US dollars, and about 60% of it was invested in activities that do not generate foreign exchange. This credit was highly concentrated; at the end of 1982, 19% of the financial system's credit was allocated to firms related to the creditor banks. One of them, the second largest bank in the country, had 42% of its total credit allocated to its related companies. When the devaluation finally took place in June 1982, the price of domestic assets fell drastically in dollar terms, large  capital losses occurred and, in mny cases, the value of the claims on those assets exceeded the valua of the assers themselves. 2.04 In market economies, louses incurred by defaulting firm are normally absorbed by their owners, the shareholders of creditor banks, or, if necessary, by the depositors and holders of other liabilities of failed banks The Government intended to take this approach when it became clear that several banks would fail as a result of the mounting financial crisis. In January 1983, however, as public confidence In the banking system eroded because of the mounting debt crisis, the Government provided ChS 100 billion in liquidity asistance to support domestic banks financially, intervenedl/ five of them, and guaranteed 100S of the value of deposits. Although, at the time of heavy external borrowing, the Chilean authorities had made it clear to all parties involved that no public guarantee would be provided for the private debt, in early 19F13, it explicitly guaranteed the external private debt maturing in 1983-1984 when it was rescheduled, and provided assurances to international creditors that the private financial debt would be serviced adequately during that period. These guarantees, however justified in the Government's view by the need to preserve the integrity of the financial system and to ensure the availability of external credit for Chile, effectively blocked the imin mechanism that the market has to allocate losses. As a result, only a small portion of the losses has been written off by both local and foreign banks, and there Is a discrepancy between the book value and the real value of the assets. 2.05 Banks are trying to avoid writeoffs by clinging to unrealistic repayment agreements they have reached with debtor firms and among themselves (para. 2.11). This attempt to forestall losses that have already been incurred has paralyzed the financial markets, at a very high cost to the Chilean economy. As a resulL. the losses that the banking system will eventually have to absorb in Its loans to these firms have increased considerably. Furthermore, productive activities are beinV hindered by the financial deadlock since resources are being kept away from efficient companies in order to sustain firms that, de facto, went bankrupt years ago. 2.06 Since 1982, the Chilean banking system has suffered losses equivalent to more than three times its equity capital and has been able to survive only because of the strong support it has received from the Central Bank. The losses, however, were concentrated In banks that had been controlled by large conglomerates, and, especially, in the five banks now intervened- by the Superintendencia, which account for 4t1 of the credit and bh% of the non-performing assets of the banking system. Some of the non-intervened banks, however, seem to be in conditions similar to those of the intervcned onen, and only one Chilean bank (BICE) has non-performing assets below 10X of its portfolio (Annex 3. Table 1). I/ -Intervention,' in the Chilean context, means the taking over, by the Superin- tendency, of the day-to-day management of financidl institutions, without af- fecting the institutions' ownership structure.  2.07 The Government implemented, in early 1984, a scheme to regularize the financial help provided to the non-intervened financial system. Under this scheme, participating banks and financieras sold their worst portfolio to the Central Bank, receiving, in payment, the funds that the Central Bank had already provided to then as liquidity assistance. Sixteen private banks chose not to participate in the program since, under the scheme, participating financial institutions would have to devote all their future profits to repurchasing this portfolio from the Central Bank, paying a 5X real interest rate on the outstanding amounts. In essence, this arrangement is a loan from the Central Bank to the banKs' shareholders, precluding them from recelving any dividends or capital gains until the whole loan Is repaid. The banks can, however, issUe new shares that woul. be exempt from this obligation and could receive dividends proportional to their participation In the institutions' equity. lmplementation of this solution has tailed, so far, to solve all of the portfolio problems of participating banks. Risk assets (i.e., loans in arrears for more than 90 days, accrued but uncollected interests, and goods received in payment as a result of toreclosures, and considered insufficient to cover their related debts) still represent 34% of the non-intervened banks' equity capital. Nevertheless, the financial situation of the non-intervened banks is improving since they are operating profitably and are building up reserves to cover potential losses that could arise from their risk assets. 2.08 Intervened banks (which account for 41% of the credit market) show an asset account called deterred losses" in their books (losses that have already ti n recognized but have yet to be written off) equal to 932 of their nominal equitv. In addition, they have substantial arrears and have to repurchase the non-performing portfolio previously sold to the Central Bank. The Government is devising a plan to -recapitalize- these banks in two stages: (a) it would convert into equity a portion of the credit that the Central Bank has given them, in an amount sufficient to put these banks on financlal terms equlvalent to those of the rest of the banking system; and (b) It would then apply to them the scheme that was used with the non-intervened banks. To implement this plan, a law authorizing the Government to buy newly is3ued equity in these banks has been prepared; this law restricts Government holdings in any bank to a maximum of 49: of the shares outstanding at any given moment, and forces the Governmenit tc sell the shares to the public within five years after the purchase. The implemnntation of this plan started in the first half of 1985. Although it could take a long period for the Government to sell its participation in these institutions, the intervened banks would be recapitalized- as soon as the Government purchases these shares and the banks enter into the new portfolio repurchasing agreement with the Central Bank, in effect eniding the Government's intervention of the commercial banks. B. The lndustrial Sector 2.09 Since 1973, economic retorms have reduced the Government's intervention in the economv, allowing the market to allocate economic resources. Of these reforms, the liberalization of the external sector --  - 6 - tariff reductions from a 97Z average level in 1973 to a uniform 10% in 1979, ellminatic9 of quota restrictions - affected the structure of the industrial sector substantlally. The reduction cauced a shift in the allocatlon of resources, away from the production of import-mubstitution manufactures and into resource-based exports. A substantial portion of the import-substituting industry disappeared *nd resource-based exporters, such as pulp and paper, fishing, lumber and fresh fruits, grew at a very fast rate. Since the Chilean manufacturing sector had been largely oriented toward the domeatic m_rkat and had grown inefficient behind a ultitude of trade barrlers, the trade liberalizatLon resulted in a decline ln the share of the sector in the country's GDP from 25Z in 1970-1973 to 202 in 1981-1983. The share of manufacturing employment In the economy also fell from 172 In 1977 to 13% in 1983. 2.10 Since 1981, the drastic fall in domestic demand has depressed domestically oriented mnufacturers, especlally those producing consumer durables and intermediate construction goods. Given the nature of Chile's balance of payments problems , further measures to restrict domestic demand could be necessary. Thls Is likely to have a negative effect upon che future growth of manufacturing. The more competitive exchange rate, however, has increased deuand for locally produced goods with high domestic value-added (e.g., textiles, clothing, furniture and metal products) and has also lncreased the International competitiveness of Chilean lndustry. Several manufacturers who have so far produced only for the domestic market are now able to compete internationally and are currently exploring potential markets for their products. t 2.11 As a percent of value-added, credit to the manufacturlng sector decreased, during the years of overvaluation, from 45.1Z to 40.4Z, but, as a result of the 1982 devaluation, It went up to 65.7% (Annex 3, Table 2). Although this figure is lower than the average for the private sector as a whole (77% of GDP), the burden of this debt Is proving excessive for some manufacturing companies. As a result, principal and Interest on these loans have been repeatedly rolled over by commercial banks during the last two years. A large number of the country's productive companies are Involved in these agreements and are caught In a viclous circle since thelr repayment capacity depends upon thelr ability to grow, but they cannot expand because they are too heavIly in debt to undertake the necessary investments. The fallure to restructure these companies financlally when it first becamo clear that they would not be able to fully service thelr debts has significantly worsened their financial condition because accrued interests have compounded thelr financial distress to the extent that many of them, which were viable two years ago, now have lost their equity capital many times over. Although the most seriously affected companies tend to be those producing for the domestic market, several exporting companies are also weak financially, and some of them are troubled by the ownership problems resulting from the financial collapse of their holding companies. (i) Industrial Investment Requirements 2.12 The 1982-1985 devaluations have created opportunities for exporters and efficient import-substituting companies. which are currently  planning investments, to both increase their efficiency and expand their production capacity. In total, fixed investment demand from non-mining industrial companies can be estimated on the order of US$500 million for 1985-1987, of which US$300 million would represent foreign exchange expenditures. The weak financial situation of Chilean industrial firms, however, is making it difficult for them to proceed with their investment plans. Therefore, the materialization of industrial investment and growth crucially depends upon the realization of a case-by-case financial restructuring of industrial enterprises. (ii) Industrial Restructuring 2.13 Although the industrial sector is recovering from the 1982-1983 depression, its recovery remains precarious. The two major factors hindering recovery are: (a) the sector's debt burden; and (b) the legal uncertainties stemming from the financial collapse of lolding companies. The Central Bank has implemented two successive across-the-board reschedulings during the last two years, both aimed at firms owing less than US$3 million equivalent. Firms with larger debts were supposed to renegotiate their debts directly with their creditors on a case-by-case basis. The across-the-board programs for the smaller debtors, while extending loan maturities and reducing interest rates, addressed short-term constraints and, in effect, have probably delayed the long-run solution: the allocation of losses among creditors. The first round of renegotiations of the larger debtors is by now almost concluded. Many of these renegotiations, however, have resulted in unrealistic agreements that leave debtor firms unable to meet their new contractual obligations and also severely constrained in their growth potential. 2.14 Chilean banks could lower their long-run losses if they reduced the financial burden now imposed upon borrowers through immediate loan writeoffs (partial or total), conversions of debt into equity, or other relief schemes. Liberated from the excess burden, debtor firms could grow faster and repay a larger portion of their obligations than otherwise. Banks have not done this during the past two years, however, because of the following main reasons: (a) a thorough financial restructuring of the private sector would have caused the banks' own bankruptcy; and (b) creditors and debtors have been expecting a Government bailout that would allow banks to reduce the financial burden of their debtors without causing losses to the banks' shareholders. There is a growing perception, however, that the Government lacks the financial power required to bail out the entire private sector. These developments tend to favor the undertaking of a case-by-case restructuring that could effectively liberate efficient firms from their excessive debt burden and undo the financial deadlock that is hindering the country's economic recovery. 2.15 To undertake a once-and-for-all restructuring, the banks may have to: (a) reduce their claims on the firms' cash flows and (b) increase their exposure to finance normalized operations and, when appropriate, their expansion. For the reduction of their claims on the firms' cash flows, banks may prefer to substitute equity or quasi-equity for debt instead of writing off loans. This will allow banks to participate in the future profits or cash generation of the restructured firms. The Superintendencia  - 8 - is allowing banks to take newly issued shares as repayment, but the Banking Law requires them to dispose of shares within a maximum period of three years, even if they are non-voting stock. The Government is reluctant to change this provision of the law because the current banking problems were caused, to a large extent, by the interconnection between financial and nonfinancial firms; it therefore prefers the use of quasi-equity instruments such as subordinated convertible deaentures, i.e., loans at low (or zero) interest rates that can be converted into equity shares by the creditor, at a specified Price and within a given period, and whose payment is contingent upon the availability of resources to first service wore senior debt. 2.16 The use of convertibles would allow the banks to wait for a much longer period for the firms to generate profits, and then to participate in them through capital gains, if they can sell the debentures or shares at prices higher than those at which they acquired them. There are provisions in the law limiting the amount that banks can invest in bonds as well as the overall exposure that they can have in any single firm or conglomerate. The Superintendencia, however, is considering bonds received in payment and increases in exposure derived from restructurings as exceptions to these provisions. Furthermore, it has upgraded the classification of the remaining debt of properly restructured firms. 2.17 Given the significant participation of foreign banks in the financing of Chile's private sector, the participation of these banks in the restructuring process is essential. A case-by-case approach, linking repayments to the cash-generating capacity of each individual firm, would encourage such participation. Moreover, a precedent was established in September 1984, when several foreign banks wrote off 80% (US$44 million) of their claims on an industrial company declared bankrupt, in exchange for repayment, in cash, of the remaining 20%. After l-'Iis action was taken, the bankruptcy was lifted and the company is now operating normally. It is likely that international banks will have to go th-:ough similar operations in the immediate future because no alternative solution appears to exist for a substantial portion of the country's industrial firms. 2.18 If it is restructured well, lending to a company previously in financial distress could be an attractive business proposition because the company would represent a better risk. While international banks are reluctant to increase their exposure in Chile, Chilean banks have to increase their operations in order to recover from their losses, and there are not many good credit risks in Chile nowadays. A more serious problem is posed by the availability of resources to pass on to the restructured firms, which, at least initially, will have to be provided in part by equipment suppliers and by multilateral lending institutions, such as the Bank and the Inter-American Development Bank (IDB). C. Legal Issues 2.19 Chilean legislation provides an adequate framework for restructurings to take place. The main instruments used in financial restructurings (writeoffs, conversion of debt into equity or quasi-equity,  -9 - subordinated loans, warrants and options, preferred shares of various kinds) can be utilized legally in Chile. The absence, in Chilean law, of provisions similar to those in "Chapter 11" of the U.S. Bankruptcy Code (temporary protection from bankruptcy) has frequently been mentioned as a hindrance to potential workouts. It has also been suggested that its inclusion would be the main improvement that can be introduced to facilitate .ebt renegotiations. However, this is not a key issue because, under existing Chilean legislation, creditors and debtors can reach judicial or extra-judicial agreements that substitute for temporary protection from bankruptcy. Moreover, even if companies are declared bankrupt, they can continue their operations for up to 18 months ("continuidad de giro") if certain conditions are met, and bankruptcy can subsequently be lifted if creditors accept the conditions set by the receiver to restructure the company (if not, the company is liquidated immediately). This mechanism can actually prove more effective than protection from bankruptcy to force realistic agreements because it presents the choices quite clearly and demands more rapid decisions. D. Bank Strategy in the Industrial Sector 2.20 The financial crisis of the industrial sector is one of the main obstacles to Chile's future economic growth. The Government, aware that previous measures have been insufficient to remove it, has decided to take a case-by-case approach in assisting industrial firms to design and execute financial restructurings conducive to investment and growth. Financial restructuring of the private sector involves two tasks: (a) the reduction of the financial burden of productive companies to levels that could allow them to invest and grow; and (b) the strengthening of the banking system to withstand the losses resulting from this reduction. The Government is currently implementing a program to -recapitalize the banking system and has asked the Bank to concentrate its help in this project upon corporate restructurings. 2.21 In designing the proposed project, the Bank agreed with the Government on the following strategy: (a) case-by-case restructurings would ensure that scarce financial resources would be allocated to efficient firms only; (b) all decisions concerning individual workouts would be taken by the parties directly involved (debtors, creditors, shareholders and, whea appropriate, receivers and baakruptcy judges); (c) the Government would be a catalyst, facilitating and promoting individual workouts; and (d) the proposed project would set up a mechanism to facilitate restructurings and then provide fresh resources to finance the normal operation and expansion of restructured firms. No funds of the proposed loan would be used for refinancing of existing obligations. 2.22 Given the magnitude of the private sector debt, it is proposed to use the proceeds of the proposed loan for financial restructurings of industrial corporations (including mining aad agroindustry), although the proposed project's institutional framework could also be used to help in workouts of firms in other sectors of the economy. To make restructurings  - 10 - possible, the Government would agree to abstain from granting subsidized credit lines that could compete with the proceeds oa the proposed loan with easier borrowing conditions. Since the costs Involved in the establishment of this institutional framework make it suitable primarily for channeling relatively large subloans, the proposed loan is expected to assist mainly medium- and large-scale firms. Help to small-scale firms would be channeled through a proposed Small Scale Industry Project, now under preparation. III. THE PROJECT A. Project Objectives and Description 3.01 The proposed project would help the Government in the undertaking of financial restructurings of industrial corporations through: (a) assistance in establishing and financing an institutional framework through which corporate workouts could be devised, negotiated and implemented, and (b) assistance in financing the purchase of the intermediate and capital goods necessary to maintain and increase production of restructured firms. 3.02 The benefits of the loan would be open to any efficient industrial company, including agroindustrial firms, which could earn or save foreign exchange. The proposed project would be considered a pilot project geared to setting replicative examples of restructuring processes for economically viable, but financially troubled, firms, within a case-by-case approach, which could later be extended to other firms under similar conditions. 3.03 The Government of the Republic of Chile would be the borrower and CB the executing agency. CB would onlend the loan proceeds to participating commercial banks in accordance with Subsidiary Loan Agreements, satisfactory to the Bank (para. 3.20), entered into as a condition precedent to disbursements with respect to each commercial bank. At least two Commercial banks would participate in the financing of each subloan, and would assume the responsibility for carrying out the respective subproject to completion jointly and severally. No intervened banks would be eligible to participate in the loan. Subprojects to be financed out of the proceeds of the proposed loan would be selected on the basis of subloan requests, which, for companies in need of restructuring, would include a workout proposal (para. 3.13). 3.04 Excluding large copper mining projects, the aggregate investment cost of industrial projects over the next 36 months (the proposed loan commitment period) is estimated to be on the order of US$500 million (para. 2.12), of which US$300 million would represent foreign exchange expenditures. Imports of current inputs for industry are estimated at US$1.2 billion per year. Adding this figure to the foreign exchange needed to finance imports of capital goods for the industrial sector, total  - 11 - foreign exchange needed amounts to US$4.2 billion for 1985-1987. Of this amDunt, approximately US$800 million would be demanded by firms eligible for Bank financing, divided equally between fixed investment and permanent increases of working capital (the rest corresponds to normal working capital imports, and to foreign exchange needs of large firms and projects tha-. exceed the scope of the proposed project). Given the pilot nature of this project, it is expected that investments amounting to US$300 million would be financed out of the proceeds of the loan. After taking into account other probable sources (i.e., a proposed US$128 million IDB loan for free-standing working capital and suppliers' credit), a Bank loan of US$100 million equivalent is proposed to help fill part of the sector's estimated foreign exchange gap. It has been estimated that this amount is needed to make a meaningful impact upon the industrial sector, as well as to justify the creation of a Technical Unit (TU, para. 3.12) to manage financial restructuring loans, which could later be the key agent in the replication and expansion of the restructuring process by the Government. 3.05 The proposed US$100 million loan would be allocated as follows: (a) US$97.4 million for the credit component, which would cover the foreign exchange costs of subloans made by commercial banks for working capital or fixed investment purposes, including increases in, or rationalization of, productive capacity of enterprises, and for technical assistance required to undertake those projects; and (b) US$2.6 million to help finance the costs of the special unit created by CB to appraise workout proposals. 3.06 The proposed loan would have a 15-year maturity, including three years of grace. The Government would assume the foreign exchange risk between the currency pool obligations incurred under the Bank loan and the currency of CB's onlending to commercial banks (i.e., US dollars or Chilean pesos, para. 3.10). The loan would be repaid according to a standard fixed amortization schedule. CB would utilize the proceeds accrued from the repayment of principal and interests of subloans, which are not required for the repayment of the loan, for paying the administrative expenses of TU and for making loans for the same purposes, and under similar terms and conditions, as the loan. B. Credit Component 3.07 Subloans wor'd cover estimated foreign exchange costs of: (a) fixed assets (machinery, equipment, factory buildings and related civil works and services); (b) permanent working capital (initial stocks or increases in stocks of imported raw materials, spare parts and components required for increases in productive capacity or in the rate of utilization of the existing capacity); and (c) technical assistance services required by industries. Not more than 50% of the loan would be used to finance subprojects requiring working capital financing in excess of 70% of the subloan.  - 12 - 3.08 Eligible firms should not have gover.mental participation (directly or indirectly) in excess of 50% of their equity capital, unless specific plans are submitted to decrease such participation to less than 50% within a five-year period. Similarly, firms controlled by commercial banks would not be eligible unless specific plans are submitted to reduce the banks' controlling ownership through sales to private enterpreneurs within a three-year period. A firm would be eligible as beneficiary of the proposed loan only if the ownership of shares adding up to a controlling interest in its capital is clearly and unquestionably defined. Also, firms would be eligible only if it h-As been clearly established that they are not responsible for obligations of third parties, including those of their former holding companies. No enterprise, including its subsidiaries, would be eligible to obtain financing from the proposed loan in excess of US$15 million equivalent, and not more than US$10 million equivalent would be allocated for working capital in any given subloan. Any subloan exceeding US$10 million equivalent could be processed only after confirmation that best efforts have been made to arrange a cofinancing program undertaken with IFC, other multilateral agencies and/or foreign commercial banks. In these cases, the subprojects would be reviewed with help from the Bank's Industry Department and/or IFC. These limits are intended to: (a) ensure a reasonable degree of dispersion of loan funds while giving access to these funds to exporting firms with relatively large investment projects and (b) reduce concentration of credit in the largest enterprises. C. Onlending Terms and Conditions 3.09 Within these limits, enterprises would have an option to borrow in either US dollars or Chilean pesos. Interest rates in both currencies, for both new and outstanding subsidiary loans and subloans, would be based on the Bank's standard variable rate of interest. These rates would be adjusted semiannually in order to reflect the changes occurred in the Bank's interest rate. No adjustment, however, would be made to the subloans' outstanding amounts on account of the revaluations effected in the dollar value of the Bank's currency pool (the exchange risk between the Bank's pool and the US dollar would be assumed by the Government, para. 3.06). Interest rates on dollar-denominated subsidiary loans would be equal to the Bank's interest rate plus a spread that would compensate CB for the cost of the Bank's commitment fees (1/10%) and for the cost of operating a Technical Unit (TU) in charge of appraising subproject proposals and their associated workout programs (1/2%, para. 3.11). Interest rates on dollar-denominated subloans would be calculated adding a 3% spread (compounded) to the interest rates on subsidiary loans. Under present conditions, this would result in interest rates for dollar-denominated subsidiary loans and subloans of 9.95% and 13.2%, respectively. Interest rates on peso-denominated subsidiary loans and subloans would be expressed in real terms, calculated upon a principal adjusted for local inflation in accordance with the Unidad de Fomento (UF), which reflects the daily changes in the country's Consumer Price Index (CPI). Real interest rates on peso-denominated subsidiary loans and subloans would be calculated by deflating the respective dollar interest rates by the CPI in the United States. This would ensure that real interest rates would be the same for dollar-denominated and  - 13 - peso-denominated subsidiary loans and subloans; presently, rates for peso loans would be about UF+4.7% ar,d UF+7.8Z, respectively, which are in line with prevailing rates in Chile. The formulae to calculate interest rates are contained in Annex 2 and in the Schedule of the Project Agreement. CB would review the formulae semiannually for the determination and adjustment of interest rates on subsidiary loans and subloans, exchange views with the Bank on the results of such review and, if necessary, revise such formulae in a manner satisfactory to the Bank so as to ensure that the interest rates on subloans determined thereby are positive in real terms. The Government would provide assurances that the basis for establishing the interest rate charged on peso-denominated subloans reflects Chile's rate of inflation. 3.10 Subloans for fixed investment and associated permanent working capital would have maximum maturities of 15 years, including grace periods of up to three years. Subloans granted exclusively for permanent working capital financing would have maturities of 18 months to five years, including a grace period of up to one year. No subloan would mature after the loan's maturity date. Subloans financed out of the proceeds of the loan would rank pari passu with all other senior obligations of the restructured firms in terms of both debt service and repayment in case of bankruptcy. D. Institutional Setting 3.11 CB would, as executing agency, manage the funds of the proposed loan and would be responsible for all the associated administrative tasks. To appraise subloan requests, CB would create an entity (Technical Unit, TU) with a Board of Directors comprising representatives of CB, the Ministries of Finance and of the Economy, and of the Superintendencies of Banks and of Corporations. The representative of CB would be the President of TU to ensure a close coordination between it and CB. TU would be staffed with high-level professionals and consultants as required (hired in accordance with the Bank's guidelines for hiring consultants), under the direction of a manager who would report to the President, who, in turn, would report to the Board. Subprojects approved by the Board would be submitted to CB's management for final approval at the Government level. TU would not be tied exclusively to the proposed Bank loan, but would also help to arrange other large workouts. CB would pay for the expenditures of TU On behalf of the Government. A US$2,600,000 component has been included to help finance TU's staffing expenditures. TU would initially be staffed with four professionals, including the manager. One would be a lawyer specializing in corporate law, and the rest would be economists or business management specialists with strong financial and corporate backgrounds. In addition to the permanent staff, TU would also hire temporary consultants as needed in order to appraise proposed subprojects and their associated workouts. TU would be managed in accordance with a Statement of Operating Policies and Procedures satisfactory to the Bank. A draft of this Statement appears as Annex 2 to this report. The full staffing of TU would be a condition for effectiveness of the loan.  - 14 - E. Subproject Appraisal and Supervision 3.12 Workout proposals for companies seeking Bank financing would be arranged by the companies themselves (or by consultants hired by them). Participating commercial banks would assume the commercial risk of subloans financed out of the proceeds of the proposed loan, and, therefore, would have to undertake a thorough appraisal of the proposed subprojects and any restructuring arrangements involved. TU would also carry out a detailed analysis of each workout proposal to ensure that: (a) the firm would become economically and financially viable as a result of the proposed workout on the basis of reasonable assumptions regarding its future performance; (b) the proposed restructuring, if carried out, would be legally binding and no further claims could be leveled .against the firm in connection with its liabilities at the time of the restricturing (para. 3.15); (c) the ownership of the beneficiary firm's controlling interest is incontestably defined; (d) the proceeds of the subloan would not be used to repay other obligations existing at the time of the restructuring; and (e) the proposed operation is in accordance with the Loan Agreement and TU's Statement of Operating Policies and Procedures. Upon CB's approval, the first two subloans requiring Bank financing and, subsequently, all those requiring Bank funds in excess of USS5.0 million equivalent (free-limit), would be submitted to the Bank for final approval. Subprojects requiring subloans in excess of US$10.0 million would be reviewed with help from the Bank's Industry Department and/or IFC (para. 3.08). 3.13 The workout proposals would be based upon a 'workout strategy" that would include: (a) a marketing plan, aimed at increasing the firm's revenues, through emphasis upon the more profitable products and customers, product redesign, quality and packaging improvements, geographic coverage, etc; (b) a production plan, devised to fill the needs resulting from the marketing plan, and which could include measures ranging from curtailment of productive capacity to a fuller utilization or expansion of existing capacity; and (c) a financial workout plan, devised to implement the preceding marketing and production plans. The financial plan would typically include: (a) streamlining of management and administration; (b) the sale of unnecessary assets; (c) a reduction in the firm's financial burden, accomplished through the use of any of the instruments suitable for restructuring, or a combination of several of them; (d) other measures to improve the firm's financial situation (extended maturities, for instance); (e) an issue of new shares to mobilize fresh capital, whenever possible; (f) a request for a subloan that could include financing for free-standing permanent working capital, fixed investment, or a combination of both; and (g) financial projections showing the expected results of all these planned measures. 3.14 Appraisals of all subprojects and their related workout strategies" would include a calculation of the subprojects' Financial Rate of Return (FRR) and Economic Rate of Return (ERR), and the subprojects would be financed only if such rates exceed 11% in real terms. The ERR would be estimated using border prices. To determine if a restructuring package is viable, TU would ensure that, on the basis of reasonable  - 15 - assumptions, the proposed "workout strategy" would enable the company to adequately service Its debt while mantaining a sufficient level of liquidity. Criteria to carry out this evaluation have been Included in TU's draft Statement of Operating Policies and Procedures (Annex 2). Particular attention would also be given to the following additional items: (a) if the company is planning to borrow in foreign currency, it should have a corresponding source of hard-currency-denominated revenues which should be enough to repay the obligation (even if, in the long run, the cost of indexed peso-denominated loans would tend to be equivalent to the cost of dollar-denominated loans, short-term fluctuations could be severe enough to cause the demise of a borrower); and (b) when required, a sinking fund of appropriate size should be gradually built up to anticipate the contingency of holders of convertible debentures choosing not to convert at maturity. 3.15 To confirm that the beneficiary firms' controlling interest was clearly established, and that the proposed refinancing scheme was legally binding and enforceable, TU would request, as part of a subloan approval process, an independent legal opinion confirming the legality of the proposed arrangements. Covenants limiting the incurrence of future loans would be included in subloan agreements. 3.16 Each commercial bank would regularly supervise the subprojects financed by it to see that subloans are utilized for the purposes intended and that the financial and other conditions affecting subproject performance are progressing satisfactorily. Each bank would send a copy of its periodic supervision report to TU, which would review it and would have the right to obtain clarifications from either the beneficiary firm or the corresponding commercial bank. Additionally, TU and commercial banks would have the right to visit the beneficiary enterprises as necessary and to receive from them the relevant information on the firm and the subproject. TU would be responsible for supervising the performance of participating commercial banks and their compliance with the conditions agreed in the proposed loan. To this end, TU would make periodic visits to commercial banks and would receive quarterly reports from them on the performance of the portfolio financed out of the loan proceeds. These understandings would not be modified without the Bank's consent. F. Procurement and Disbursement 3.17 Procurement procedures would conform with standard practice for IDF loans; TU would monitor procurement to be financed out of the proposed loan in order to ensure that the items are reasonably priced and appropriate for their intended purpose. Subloans would finance up to 60% of the total cost of approved subprojects, and the loan proceeds would be disbursed against 100% of the amount of the subloans. This percentage reflects estimated average foreign exchange costs of the respective expenditure categories. Also, the loan proceeds would be disbursed against 100% of the costs involved in hiring consultants for TU, up to the amount allocated for this purpose (para. 3.05). Terms of reference for consultants hired to provide technical assistance in the implementation of subprojects/workouts would have to be acceptable to TU, and the procedures  - 16 - used for hiring such consultants would be consistent with the Bank's standard guidelines. Only expenditures made within not more than 180 days prior to the date of the receipt, by the Bank, of the corresponding financing requests would be eligible for disbursement out of the proposed loan--rather than the 90 days customary under the Bank's IDP loans--in view of the administrative complexities and the time lags involved in a two- tier operation with many participating financial intermediaries. Annex 1 provides an estimated disbursement schedule, which is based on the average disbursement profile for DFC operations in the LAC region and adjusted for slower disbursement rates in order to allow for delays in restructuring arrangements. The closing date would be December 31, 1991. To cover the foreign exchange requirements of participating commercial banks for investments that they would be financing after the proposed loan had been approved by the Executive Directors, but before it became effective, retroactive financing of up to US$10 million, 10% of the loan amount, has been provided. 3.18 In order to ensure timely payment of reimbursement claims, as a condition of loan effectiveness, a Special Account in US dollars would be established in CB to cover estimated expenditures for four months. The Bank would make an initial deposit of US$10.0 million into the Special Account. CB would claim reimbursement of the Bank's share of expenditures from the Special Account upon presentation of fully documented withdrawal applications forwarded to the Bank for replenishment of the Special Account. The Bank would receive from CB a monthly statement of the Special Account which would reflect transactions during the previous month. The Special Account would be subject to the same audit procedures as the other project accounts. G. Accounts and Auditing 3.19 Beneficiary firms would be required to appoint exteroal auditors acceptable to TU. Commercial banks participating in the proposed project would be required to maintain adequate records, reflecting their operations financed out of the proposed loan, and to submit annual statements of account, audited by independent auditors following principles satisfactory to TU. CB would maintain adequate records concerning the progress of the project and reflecting, separately from its other operations, the operations and financial transactions related to the proposed loan. These accounts would be audited by independent auditors following principles satisfactory to the Bank. H. Participating Intermediaries 3.20 No intervened banks would be allowed to participate in the proposed project as long as they remain intervened. AU other comercial banks would be eligible to participate, provided they sign a Subsidiary Loan Agreement in terms satisfactory to the Bank. The signature of Subsidiary Loan Agreements with at least two participating banks would be condition of effectiveness of the loan (para. 3.03).  - 17 - I. Benefits and Risks 3.21 The proposed project would help to remove the financial deadlock that is hindering the recovery of industrial production in Chile through: (a) establishing an institutional framework geared to promote financial restructurings in all sectors in the economy and (b) providing foreign exchange financing needed for the restructuring of a number of industrial companies. In this process, the project would contribute to establishing replicative examples that could be extended to other economically viable, but financially troubled, firms in other sectors of the economy. The project would also help in closing the foreign exchange gap that could prevent the country's economic growth. A total of 20-30 industrial firms are expected to benefit directly from the project. On the risk side, commitments could fall short of expectations if: (a) as a result of copper prices remaining low, or international interest rates high, for a long time to come, the country's economic situation deteriorates significantly, causing a contraction in investment credit demand; (b) TU fails in promoting restructurings or proves incapable of analyzing them properly; (c) individual restructurings prove too difficult to be completed within the proposed loan's commitment period; and (d) once restructured, currently troubled companies obtain credit from other Ieders (inbthi cas project would be successful, but the loan would not disbutse). aivelvWthe precarious condition of the Chilean economy, and the oncertainties associated with restructuring, the risks of the project are significant. However, the benefits to Chile could be substantial, and the experience gained in this operation would be useful in the design of programs to support firms in financial distress. Therefore, the overall benefits of the project are expected to outweigh the risks significantly. IV. AGREEMENTS REACHED AND RECOMMENDATION 4.01 During loan negotiations, final agreement was reached with the Chilean Government and CB on: (a) the loan amount and components (paras. 3.04 and 3.05); and (b) arrangements for channeling the resources (paras. 3 03 and 3.11), repayment of the Bank loan, (pars. 3.06); (c) project's objectives (para. 3.01), terms and limits of financing, (paras. 3.09 and 3.10), eligible enterprises and draft operating policies and regulations (operating guidelines) (paras. 3.02 and 3.11), eligible expenditures for financing and procurement and disbursement procedures (paras 3.17 and 3.18); (d) onlending interest rates and spreads (para. 3.09); and (e) institutional arrangement for implementing the project (para. 3.11); and (f) accounting and auditing arrangements (para. 3.19)  - 18 - 4.02 Special Conditions The Government would provide assurances that: (a) Firm agreement has been reached between the Government and its international creditors on a financial package consistent with closing the country's estimated balance of payments gap in 1985; (b) the Government would not make available subsidized lines of credit for financial restructuring with terms and conditions that could undermine the proposed loan (para. 2.22); (c) the Technical Unit would be nmnaged in accordance with a Statement of Operating Policies and Procedures satisfactory to the Bank (para. 3.11) (d) not more than $50 million of the loan would be used to finance sub-projects with a working capital requirement exceeding 70 percent of total estimated cost (para. 3.07); (e) eligible firms will not have governmental participation in excess of 50 percent (para. 3.08); (f) on-lending arrangements between the Central Bank and each participating institution would be covered by subsidiary loan agreements containing terms and conditions satisfactory to the Bank (para. 3.03);and the Government would assume the cross-currency risk (para. 3.06); Cg) interest rates would be reviewed by the Borrower and the Bank every six mDnths for purposes of maintaining interest rates positive in real term, and responding to market conditions (para. 3.09); (h) the basis for establishing the interest rate charged on peso-denominated subloans reflects Chile's rate of inflation (para. 3.09); and (i) a Special Account of US$10 million would be established to insure timely payment of reimbursement claims (para. 3.18). 4.03 If approved, the Loan would become effective after: (a) the Government has designated CB as its fiscal agent; (b) the Government shall have secured external financing sufficient to cover the foreign exchange required to close the borrower's balance-of-payments accounts for its fiscal year 1985; (c) TU's staffing has been completed (para. 3.11);  - 19 - (d) it least two subsidiary Loan Agreements have been signed with two participating banks (pars. 3.20). 4.04 Subject to tha above, the proposed project would be eligible for a Bank loan of USS100 million equivalent, with a term of 15 years, including a grace period of three years. May 20, 1985  - 20- AME= 1 Page 1 of 1 DLAL FDWAN WIUEDG FW EsI=ted Sdu&ule of Isb t */ IED Flgcial Year and letimted Di _buzunts Quuatla1 qarter ending 1Dur the Qtnrter Fad of Qupr FY 1986 Septeber 30, 1985 Irornder 31, 1985 299.2 299.2 March 31, 1986 720.0 1,019.2 June 30, 1986 720.0 1,739.2 FY 1987 Sepcer1er 30, 1986 2,118L3 3,857.5 DeImber 31, 1986 2,118.3 5,975.8 Mbrch 31, 1987 2,966.5 8,942.3 Jume 30, 1987 2,966.5 11,908L8 FY 1988 September 30, 1987 5,158.8 17,067.6 I^^-her 31, 1987 5,158.8 22,226.4 Mardh 31, 1988 4,563.6 26,790.0 June 30, 198B b/ 4,563.6 31,353.6 FY 1989 Sepoeibcr 30, 1988 7,499.5 38,853.1 DeceIber 31, 1988 7,499.5 46,352.6 March 31, 1989 7,654.5 54,007.1 June 30, 1999 7,6C..5 61,661.6 FY 1990 September 30, 1989 6,874.6 68,536.2 3ecembrr 31, 1989 6,F,74.6 75,410.8 March 31, 1990 2,142.7 77,553.5 June 30, 199D 2,142.7 79,696.2 Fl 1991 Se tr 30, 1990 5,234.7 84,9W09 Doember 31, 1990 5,234.7 90,165.6 Murch 31, 1991 2,635.7 92,801.3 Junm 30, 1991 2,635.7 95,437.0 FY 1992 Stecr ber 30, 1991 2,281.5 97,718.5 Iaombeur 31, 1991 cl 2,281.5 100,000.0 a/ Based co the auzer dLsbu4reet profiles cf IGF projects In the AC reginm, adjuitsl for slower disbxu --t race, gimn the Unaou d the poject. b/ FEtidtedend date for subaiasion of subloms. cl tod date.  - 21 - ANNEX 2 Page 1 of 8 STAFF APPRAISAL REPORT CHILE INDUSTRIAL FINANCE RESTRUCTURING PROJECT Central Bank of Chile. - Technical Unit of Financial Restructuring Statement of Operating Policies and Procedures This Statement lays down the policies and procedures that the Central Bank of Chile (CB), as executing agency, will carry out through the Technical Unit of Financial Restructuring tAU) in discharging its responsibilities under the proposed Financial Restructuring Project (the Project) and its associated Loan (the Loan) of the World Bank (the Bank). I. Organization (a) TU will consist of two main bodies: the Board of Directors and the Secretariat. The Secretariat will review proposed investment projects in order to ensure that they are eligible for financing out of the proceeds of the Loan. Based upon this review, the Secretariat will recommend to the Board of Directors their approval or rejection. Subprojects approved by the Board will be submitted to CB's management for final approval at the Government's level. CB will decide on approving or rejecting investment proposals using the Project's criteria exclusively. Upon CB's approval, the first two subloans requiring Bank financing, and, subsequently, all those requiring Bank funds in excess of US$5.0 million equivalent (free limit), will be submitted to the Bank for final approval. (b) The Board of Directors will consist of five uembers, one representative each of CB, the Ministries of Finance and of the Economy, and the Superintendencies of Banks and Corporations. CB's representative will be the Chairman of the Board and will be responsible for the coordination between TU and CB's units in charge of managing the proceeds of the Loan and of keeping the records of transactions carried out under the Project. (c) The Secretariat will consist of a Secretary General and a number of professionals, some of whom will be working full time on the Project while others will be hired temporarily for specific tasks. The Secretary General will manage TU and will report to the Chairman of TU's Board of Directors. In addition to the Secretary General, at least three professionals will work full time in TU: one lawyer and two financial experts. Instead of hiring a full-time lawyer, however, TU could hire a legal firm that would assign to TU man-hours equivalent to a full-time lawyer. This arrangement would provide the flexibility required to handle all the different legal aspects of restructurings, which could exceed the expertise of any individual lawyer. (d) TU will take all the steps necessary to ensure that its staffing remains both capable and sufficient in numbers to discharge the responsibilities associated with the Loan. Both its managerial and technical staff, including consultants, will be hired in accordance with the Bank's guidelines for hiring consultants.  - 22 - ANNEX 2 Page 2 of 8 II. Utilization of Funds (a) The Loan's funds will be managed by CB, which will disburse them at the request of TU. (b) The proceeds of the Loan shall be used, in accordance with the terms of the Project and Loan Agreements, to finance the procurement of capital and intermediate goods, raw materials and services needed for the normal operation, or expansion, of privately controlled industrial firms that are currently in financial distress and which undergo a financial restructuring that transforms them into fully viable enterprises. (c) The economic activities that may receive financing shall include manufacturing industry, mining and agroindustry. (d) The proceeds of the Loan will be used to finance only specific projects that are technically, legally, financially and economically sound. Financing out of the proceeds of the Loan will be provided only for the purposes, and to cover the types of expenditures, stated in the Loan Agreement. III. Subloans Terms and Conditions (a) Subloans will finance fixed investments (including investments carried out in order to imprcve the beneficiaries' technical capabilities) and permanent working capital. Subloan components financing permanent working capital not directly associated with fixed investments will have maturities ranging between Id months and five years, including grace periods of up to one year. Subloan components financing fixed Investment, and the permanent working capital directly associated with these investments, will have maturities not exceeding 15 years, including up to three years of grace. No subloan, however, will mature after the Loan's maturity date. (b) Subloans will be denominated in either US dollars or Chilean pesos, depending upon the preferences of beneficiaries. Each subloan will be intermediated by at least two commercia'l banks, which will make a commitment to carry out the investment project to its completion jointly and severally. (c) Interest rates in both currencies, for both new and outstanding subloans, will be adjusted every six months (on January 1st and July lst) in order to reflect the changes occurred in the World Bank's interest rate expressed in dollar terms. No adjustment, however, will be made to the subloans' outstanding balances on account of the revaluations eff cted in the dollar value of the World Bank's currency pool. The new interest rates will be applied for the next six months. (d) Interest on the principal amount of dollar-denominated Subsidiary loans and subloans will be payable at a rate adjusted semiannually, on each January 1 and July 1, according to the following formula: r$ = [(1+B)(1.001)(1.005)] - 13 x 100 i$= {t(l (1.03)1 - 1 x 100,} 100  - 23 - ANNEX 2 Page of 8 where: r$ - the rate at which CB will onlend the proceeds of the loan to participating commercial banks in dollar terms. B - the Bank's interest rate prevailing on the date the subsidiary loan was made or, for the purpose of the semiannual adjustments, on the date of such adjustment. i$ - the rate at which commercial banks will onlend to beneficiary firms in dollar terms. (1.001) = the estimated cost of the Bank's commitment fees. (1.005) = the estimated cost of operating TU. (1.03) = the spread to commercial banks. (e) Interest rates on peso-denominated subsidiary loans and subloans will be expressed in real terms, calculated upon a principal adjusted for local inflation in accordance with the Unidad de Fomento (UF), which reflects the daily changes in the country's Consumer Price Index. Real interest on peso-denominated subsidiary loans and subloans will be payable at a rate adjusted semiannually, on each January 1 and July 1, according to the following formula: rch = { [(1+s /(1+ CPI)] - 1 1 x 100 ich = t - 1 x 100 100 where: rch = the real rate at which CB will onlend the proceeds of the loan to participating commercial banks in peso terms. r$ - the rate at which CB will onlend to participating commercial banks in dollar terms. i CPI - the annual rate of change in the US's Consumer Price Index, calculated between April and September for the January 1 adjustment, and between October and March for the July 1 adjustment. ich = the real rate at which commercial banks will onlend to beneficiary firms in peso terms. iS - the rate at which commercial banks will onlend to beneficiary firms in dollar terms. (f) -CB shall review semiannually the formulae for the determination and adjustment of interest rates on subsidiary loans and subloans, exchange views with the Bank on the results of such review and, if necessary, revise such formulae in a manner satisfactory to the Bank so  - 24 - ANNEX 2 Page 4 of 8 as to ensure that the interest rates on subloans determined thereby are positive in real terms. IV. Subproject Appraisal and Supervision (a) TU will specialize in corporate workouts. For the purposes of the Loan, it will review the proposals of restructuring presented by potential beneficiaries in order to approve or disapprove requests of financing. Subloan requests should include a "workout proposal' and its associated investment project. The workout proposals would be based upcm a "workout strategy" that would include: (a) a marketing plan, aimed at increasing the firm's revenues, through emphasis upon the more profitable products and customers, product redesign, quality and packaging improvements, geographic coverage, etc; (b) a production plan, devised to fill the needs resulting from the marketing plan, and which could include measures ranging from curtailment of productive capacity ti a fuller utilization or expansion of existing capacity; and (c) a finanLial workout plan, devised to implement the preceding marketing and producticn plans. The financial plan would typically include: (a) streamlining of management and administration; (b) the sale of unnecessary assets; (c) a reduction in the firm's financial burden, accomplished through the use of any of the instruments suitable for restructuring, or a combination of several of them; (d) other measures to improve the firm's financial situation (extended maturities, for instance); (e) an issue of new shares to mobilize fresh capital, whenever possible; (f) a request for a subloan that could include financing for free-standing permanent working capital, fixed investment, or a combination of both; and (g) financial projections showing the expected results of all these planned measures. Subloan requests should also include an independent legal opinion, on terms satisfactory to TU, stating that the proposed workout is legally viable, that no further claims can be leveled against the firm in connection with its liabilities at the moment of restructuring, and that the ownership of the company's controlling interest is clearly defined (or that it will be so as a result of the workout). (b) In reviewing subloan requests, Tm will obtain from the applicant firms a complete disclosure of all the information relevant for the appraisal of the subproject, including information about the identity and history of the company's owners. To proceed with the appraisal of an application, audited financial statements, certified by external auditors satisfactory to TU, will be requested, and beneficiary firms will be contractually obliged to appoint external auditors satisfactory to TU. (c) In appraising a subproject, TU will pay special attention to ensure that: Ci) The owners are bona-fide enterpreneurs, committed to the success of the enterprise. If the firm's ownership is controlled by commercial banks, the workout proposal must provide for the transfer of such controlling ownership to private enterpreneurs within a three-year period. Eligible firms should not have Governmental ownership (directly or indirectly) in excess of 50Z of their equity capital, unless specific plans are submitted to decrease such participation to less than 50X within a five-year period.  - 25 - ANNEX 2 Page 5 of 8 (ii) The managerial abilities of the firm's executives are sufficient to undertake the tasks required by the plans included in the "workout strategy." (iii) The administration and organizational setup of the firm are adequate to carry out the proposed 'workout strategy," and salaries and wages are reasonable. (iv) The company has either already sold, or is planning to divest itself of, all assets not necessary for its industrial activities as spelled out in the corresponding "workout strategy. (v) The company does not have obligations, binding or contingent, derived from debts of another enterprise, unless this other company is a subsidiary and is included in the workout. (vi) No funds financed with the Loan will be used for repayment of existing obligations of the firm. (vii) All expenditures financed with the proceeds of the Loan are eligible in accordance with the Loan Agreement. (viii) The subloan financed out of the Loan will rank pari passu with other senior debts of the beneficiaries. (ix) The firm's Financial Rate of Return (FRR) and Economic Rate of Return (ERR) both are equal to, or exceed, 11% in real terms, after taking into account the proposed investment subproject. The ERR will be estimated =sing bordc= prices. Cx) The projected debt-service-ratio (cash generation divided by financial charges plus principal repayments) is no less than 1.0 in each and every year of the life of the project, and averages not less than 1.2 during that period. (xi) The projected current ratio (current assets divided by short-term liabilities) is not lower, at any time, than 1.2, unless the Bank agrees otherwise. (xii) The initial long-term-debt-to-equity ratio does not exceed 1.2. (xiii) If the company is planning to borrow in foreign exchange, it has a source of hard currency that allows it to service and repay the debt. (xiv) Cash-flow and other financial projections have been elaborated taking into account the mandatory dividends established by Article 79 of Law 18046 (Ley Sobre Sociedades Anonimas). (xv) The company has considered in its financial plans the contingent liabilities that could arise from the restructuring process. In particular, if subordinated convertible instruments were used to  - 26 - ANNEX 2 Page 6 of 8 restructure the firm's debt, a sinking fund should be established in order to cover the cash outlays that would take place if the holders of these instruments decided not to convert at maturity. (xvi) For the purposes of estimating the current and long-term-debt-to-equity ratios, the term 'debt' will include all outstanding and contingent liabilities of the company with respect to persons or entities other than its shareholders, excepting only those that are subordinated in both service and repayment of principal. The term "subordinated- will be used to identify those debts that are senior only with respect to the claims of the shareholders. A debt will be "subordinated in the service of debts- when it is serviced only after all normal debts have been serviced, and then, only if the liquidity of the firm is enough to service it while keeping it within the limits agreed on in the Subloan Agreement (item xi). A debt will be "subordinited in repayment of principal" when, in case of failure of the company, repayment of its principal is effected only after all normal debts have been fully repaid. The term -capital' will include all net claims of th3 firm's shareholders, plus those of the holders of subordinated debts. (d) TU will also make sure that the Subloan Agreements are in accordance with the provisions of the Loan and Project Agreements. V. Conditions of Disbursement (a) All relevant agreements should have been entered into and be binding, including, inter alia, existing debt restructuring agreements, loan agreements for new debt included in the "workout strategy,- shareholders agreements whereby shareholders agree to offer the necessary pre-emptive rights needed to implement possible conversions, warrants, new equity issuance, etc., as well as possible security agreements, shareholders undertakings regarding actual or contingent comnitments to provide financial support. (b) Disbursements of the subloans should be made pari passu with other disbursements forthcoming under the workout implementation. (c) For each disbursement to take place, but after taking into account such disbursement, the current ratio should be equal to or higher than L.2, and the long-ter-to-equity ratio should be equal to or lower than 1.2. (d) All other disbursement conditions established in the Subloan Agreement should have been complied with. VI. General Subloan Conditions (a) Beneficiaries will present to TU quarterly financial statements and annual audited financial statements. (b) All transactions effected by the beneficiary with any individual or company related to it through ownership should be at arm's length.  - 27 - ANNEX 2 Page 7 of 8 (c) All or any revenue-sharing arrangements entered into by the beneficiary should be subordinated to payments to senior creditors. (d) Liens and mortgages will be shared proportionately with the subloan to ensure that it ranks pari passu with other senior debt. (e) The beneficiary will not declare nor pay dividends in excess of the minimum established by Article 79 of Law 18046 until the investment/divestiture programs contained in the 'workout strategy" have been carried out, and then only if, after taking into account such dividends, the current ratio is equal to or higher than 1.2, the long-term- debt-to-equity ratio is equal to or lower than 1.2 and reserves have been set aside to cover the full redemption of outstanding convertible instruments. Such dividends should be paid only out of current profits. (f) Limits will be imposed upon investments and indebtedness not included in the "workout strategy," and upon the incurrence of short-term debt in absolute amounts and to maintain a current ratio not lower than 1.2. (g) No prepayments of long-term debt will be effected unless proportionate payment is also made to the subloan. (h) Except in the ordinary course of business, the beneficiary will not provide loans, advances or deposits to subsidiaries or other entities whose ownership is in any way connected to it. (i) No change in the beneficiary's by-laws ("Estatutos") will be effected except with TU's approval. ij) If the beneficiary controls other enterprises, all these provisions are to be applied mutatis-mutandis to the consolidated financial statements. (k) All other conditions contained in the Loan and Project Agreements. VII. Supervision TU will be responsible for supervising the disbursements of subloans, ensuring that transactions between banks and beneficiaries with respect to the Loan are conducted in an arm's-length fashion. To tbis end, TU will review the documentation submitted for disbursement and will pay periodic visits to the beneficiary's facilities to confirm that the -workout strategy" is being implemented in accordance with the Subloan Agreement. During the period of disbursement, these visits will be realized quarterly, and, after disbursement, once every year. TU will carry out at least one major formal review of each subproject per year, and will send a copy of its results to the Bank. Participating commercial banks will be required to maintain adequate records reflecting their operations financed out of the proceeds of the Loan, and to submit quarterly reports on the performance of the portfolio financed out of the Loan. Banks will also present annual audited statements of account with respect to the Loan's funds.  - 28 - ANNEX 2 Page 8 of 8 VIII. Procurement TU will monitor closely the procurement of items to be financed under the Loan, in order to make sure that the items are reasonably priced and appropriate for their intended use. Particularly, TU will ensure that commercial banks require quotations from at least three qualified suppliers for pieces of equipment or single procurement packages worth US$250,000 equivalent or more. Expenditures carried out to improve the beneficiary firm technologically will be eligible for financing out of the proceeds of the Loan. Only the following types of expenditures, or such other expenditures as may be agreed by the Bank, would be eligible for financing as technology improvement expenditures: (i) Research and development programs, carried out to initiate or increase exports, or to improve production techniques, sub- contracted to national or foreign technical research institutes or equivalent agencies, or carried out in cooperation with overseas agencies. (ii) Training of Chilean technicians abroad in international marketing or production techniques, for periods of up to one year, when not included as part of a normal licensing arrangement. (iii) Hiring of foreign technicians or consultants to work with a company for up to one year. (iv) Establishment of a laboratory and/or purchase of ecuipment, laboratory supplies and instruments for quality control, r-terials te.ting or product research. Cv) Lump sum payments to purchase outright, and without restrictions, the rights to utilize a new or modified production process or to produce some new product patented by a foreign concern. IX. Amendments and Clarifications Amendments to this policy statement may be made upon agreement between CB and the Bank. In addition, the procedures to be used by CB or TU in dealing with any subloans or investments of a type not previously subject to agreements between the Bank and CB would be clarified through an exchange of letters. In case of conflict between this Statement and the Loan or the Project Agreements, the provisions of the Loan Agreement and the Project Agreement should prevail.  - 29 - STAFF APPRAISAL REPORT T-1 Table 1: Finaicl Indicators of the Cbim Baldxg Systn C:.Kdit AdjustI Risk Risk Portf. Rlsk Market Equity/ Assets/ Aesets/ Sold/ Assets + Share IbN1mU Port- Adjusted Adjusted Sold Prt/ Equity Folio EquLty Equity Adjusted Equity Intervened Barks 40.8 0.07 0.18 30.03 21.89 51.92 De Chile 22.1 0.04 0.12 54.76 39.06 93.83 Sant 10.8 0.07 0.32 40.53 29.63 70.16 Cwx~epcLoci 4.7 -0.09 0.21 -28.53 -17.75 -46.24 Colocadora 2.0 0.65 0.14 2.65 2.57 5.22 Intternmcional 1.2 0.39 0.05 1.15 2.39 3.54 Category B Private 35.1 0.91 0.06 0.77 2.36 3.13 Credito 6.1 0.80 0.05 0b2 3.18 4.00 SudAmhericLa 4.9 1.00 0.09 1.22 2.52 3.74 Trabajo 3.8 1.00 0.07 0.97 1.89 2.87 -51F 3.5 1.00 0.05 0.89 2.49 3.38 A. Edards 3.2 1.00 0.07 1.01 2.46 3A8 D. H