Ecuador - Financial Sector Adjustment Operation Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-4692-EC REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$100 MILLION TO ECUADOR FOR A FINANCIAL SECTOR ADJUSTMENT OPERATION December 1, 1987 Country Department IV Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used bk recipients only in the performance of their official dutics. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit Sucre (SI.) S/.1.00 = 0.S047 US$ US$ 1.00 3 21 SI/. The US Dollar/Sucre exchange rate has been floatTng since August 1986. The official exchange rate reached the above level at the end of November 1987. FISCAL YEAR January 1 to December 31 WEIGHTS AN4D MEASURES 1 hectare (ha) = 10,000 m2 = 2.47 acres 1 kilometer (km) = 1,000 m = .62 miles 1 kilogram (kg) = 2.2 pounds 1 metric ton (mt) = 1,000 kg = 2,200 pounds 1 litre (1) = 0.26 gallons GLOSSARY OF ABBREVIATIONS BEV Banco Ecuatoriano de la Vivienda (Ecuadorian Housing Bank) BNF Banco Nacional de Fomento (National Development Bank) BCE Banco Central del Ecuador (Central Bank of Ecuador) CD Certificate of Deposit CFN Corporacion Financiera Nacional (National Development Finance Institution) DFI Development Finance Institution ENAC Empresa Nacional de (National Entity for Almacenamiento y Storage and Sale of Comercialization de Productos Agricultural Products) FOPINAR Fondo para la Pequena Industria (Small Scale Industry Fund) y la Antesania FSECAL Financial Sector Adjustment Loan GOE Government of Ecuador GDP Gross Domestic Product IESS Instituto Ecuatoriano de (Ecuadorian Social Security Seguridad Social Institute) ILO Int_.;national Labor Office IMF International Monetary Fund MLT Medium and Long Term Lending SR Superintendencia de Bancos (Superintendency of Banks) SL,. Savings and Loan Association TMC Tasa Maxima Conr'encional (Maximum Conventional Rate) M2 Money and Quasimoney  FOR OMCMiA USE ONLY ECUADOR FINANCIAL SECTOR ADJU'3TMENT LOAN PRESIDENT'S REPORT Table of Contents Page No Loan Summary ................................................ iii I. THE ECONOMY .................................... 1 Background ........ I, Recent Macroeconomic Developments .. 2 Adjustment Policy Issue . ......................... 3 Sources of External Financing . . 4 Ecuador's Relations with the IMF and Commercial Banks ................................. 4 Creditworthiness and Bank Exposure . . 5 II. FINANCIAL SECTOR ISSUES .......... 5 Dependence on Central Bank Rediscounts . . 6 Institutional and Financial Weaknesses . . 7 Inadequacy of Long Term Finance . . 10 III. THE GOVERNMENT'S FINANCIAL SECTOR ADJUSTMENT. PROGRAM ........................................... 12 Macroeconomic Framework .. 13 The Government's Financial Reform Program .......... 14 IV. THE PROPOSED OPERATION .. 20 History .......................................... 20 Description ......................................... 20 Financial Sector Scenario .. 21 Benefits ........................................... 21 Risks ............................................ 24 Loan Implementation .. 25 V. BANK GROUP OPERATIONS AND STRATEGY . . 26 VI. COLLOBARATION WITH THE IMF .. 28 VII. RECOMMENDATION ..................................... 28 This report is based on the findings of an appraisal mission which visited Ecuador in June/July 1987. The mission comprised Messrs. T. Hutcheson (INDFD); M. Carrizosa, J. Parker (LPCIl); M. Thobani (LC1PA); T. Hill (LEGLC), and J. M. Jimenez (Cons). This document has a restricted distribution and may be used by recipients only in the perforrni."- of their official duties. Its contents may not otherwise be disclosed without World Bank autt.snuno,.  - ii - Text Tables Table 1: Main Economic Indicators ................. 2 Table 2: Main Financial Sector Indicators. 7 Table 3: Indicators of Financial Sector Perfo.mance 22 List of Annexes Annex 1 Supplementary Tables ............................... 29 Key Macroeconomic Indicators .29 Balance of Payments .30 Status of Bank Group Operations .................... 31 Annex 2 Supplementary Project Data Sheet .33 Annex 3 Government's Statement of Financial Sector Policies 35 Annex 4 Macroeconomic Policy Matrix. 45 Annex 5 Financial Policy Matrix ............................ 46 Annex 6 Technical Assistance Program .52 MAP  ECUADOR FINANCIAL SECTOR ADJUSTMENT LOAN LOAN AND PROGRAM SUMMARY Borrower: Republic of Ecuador Amount: US$100 million equivalent Terms: Payable in 17 years, including a grace period of 4 years at the standard variable interest rate Description: The proposed loan would support an ongoing program of financial sector reform. The following objectives are being pursued by this program: (i) strengthened financial institutions (FIs) by improving the regulatory framework, upgrading the performance of the Superintendency of Banks and gradually restoring the capital adequacy of these institutions; (ii) more efficient intermediation by restraining the growth of Central Bank (BCE) rediscounts to FIs and by linking the interest rate on BCE funded credit to market determined rates; and (iii) development of the capital market by improving the conditions for adjustable rate lending, capitalization of interest and equity finance. Benefits: The benefits that are expected from the program include: (i) an increase in -le rate of economic grtwth, through an improvement in the allocation of investment and capital; (ii) a more resilient financial sector through an improved framework of regulation, supervision and enforcement and; (iii) a more efficient financial sector through improved conditions for competition and financial intermediation. Risks: The principal risk derives from the loan's timing since it would be implemented durixug the presidential electoral cycle and a period of political transition. This could diminish the Government's ability to maintain market determined rates, to carry out the measures agreed under the operation and to maintain an acceptable macro-economic framework. The  - iv - program could also face reversal by the next administration. These risks are minimized by the strong will demonstrated so far by the Government to continue its economic and financial sector reform programs, with the most sensitive reforms -- floating of interest and exchange rates -- having survived very strong challenges. The risk of abrupt policy reversal is not excessive given the fact that the reforms undertaken so far have had demonstrated beneficial effects in economic performance which have eased the adjustment to adverse external shocks. Finally, the IMF stand-by arrangement would be important in ensuring maintenance of an acceptable policy framework. Disbursement: The loan would be disbursed in two tranches of US$50 million each. It is anticipated that the first tranche would be disbursed upon loan effectiveness. The second tranciie would be released subject to satisfactory performance of the macroeconomic and financial adjustment program, as determined by a review to be held witilln six months of loan effectiveness. Disbursement of the entire loan is expected to be completed within nine months of loan effectiveness.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF iCUADOR FOR A FINANCIAL SECTOR ADJUSTMENT OPERATION 1. I submit the following report and recommendation on a proposed first Financial Sector Adjustment Loan (FSECAL) to the Republic of Ecuador for the equivalent of US$100 million. The loan would have a term of 17 years, including 4 years of grace at the standard variable interest rate. PART I - THE ECONOMY 2. An Economic Memorandum on Ecuador (Report No. 6592-EC) was circulated to the Executive Directors on April 14, 1987. A Country brief was distributed in September 14, 1987. A Bank mission visited Ecuador in June/July 1987 to appraise the proposed loan and review the economic situation. The Government's macroeconomic pelicy framework is summarized in Annex IV. The financial policy program and specific policy actions that are being suDported by this loan are surmiarized in Annexes V and VI. Background 3. Through the 1970's, the economic strategy in Ecuador relied on import substitution in the manufacturing sector financed by growing petroleum revenues. Although growth was initially high and substantial progress was made in social conditions, by the early 1980's it was becoming increasingly clear that the strategy was unsustainable. The exchange rate ha.4 become badly overvalued. Tariffs and quantitative restrictions on imports of finished goods and tariff exonerations on imported inputs gave high levels of effective protection to favored firms and subsectors. Petroleum eyploration slowed and production stagnated while highly subsidized prices of petroleum products internally encouraged rising consumption of petroleum products and declining exports of crude oil. Agricultural output sufiered from the policy-induced negative shift in the internal terms of trade. Imports rose and non-traditional exports made only limited prGgress. 4. This policy framework left the economy ill-prepared for a series of exogenous shocks, most ri:tably the stagnation of the value of exports and the severe external cred_it constraint that affected the country after 1981. The value of exports stagnated from US$2,913 million in 1981 to an average of US$2,821 million for the 1982-1986 period, after having grown vigorously until 1981. Net external disbursements fell from US$1,255 million in 1981 to an average of US$469 millicn for the 1982-1986 period, also after strong growth up to 1981. This decline in external funding forced the government to reduce the large public sector deficits of 1981 and 1982 that were financed by part of these resources. As a result of these shocks, aggregate economic performance faltered. The average rate of growth in 1982-1986 was only 2.02 compared to 6.12 p.a. in 1975-1981.  - 2 - Table 1: ECUADOR - MAIIt ECONOMIC INDICATORS. 1980-1986 Est. Year 1980 1984 1985 1986 1987 Total Exports (Million US$) 2866.5 2894.8 3295.0 2590.1 2491.3 Net Ext. Disbursements (Million USS) 1051.0 301.0 421.8 709.5 857.6 Growth of GDP (Z) 4.9 4.2 4.5 2.9 -3.2 Rate of Inflation (X) 12.8 29.7 28.7 27.4 33.3 Terms of Trade Index (1984=100) 109.1 100.0 96.1 61.7 70.3 Real Exchange Rate Index (1980=100) Excld. Oil (Trade Weighted) 100.0 127.1 121.6 171.8 173.4 Incld. Oil (Tradc Weighted) 100.0 132.8 127.0 173.7 n.a. Current Account Bal. (X of GDP) -6.4 -2.4 1.0 -5.3 -9.2 Public Sector Balance (t of GDP) -4.5 1.7 1.5 -4.1 -9.3 Public Sector Invest. (D of GDP) 10.0 6.4 7.1 8.6 9.3 Public Sector Saving (Z of GDP) 5.5 8.1 8.6 4.5 0.0 Source: BCE and staff estimates. n.a..: Not available Recent Economic Developments 5. In response to the external shocks of 1982, the Government initiated an economic adjustment program. It dramatically reduced its current expenditures and public investment, introduced import controls, devalued the sucre and rescheduled its external debt. The resulting contraction o aggregate demand contributed tc slow the rate of growth after 1981. The present government that took office in August 1984 continued and accelerated the adjustment program. The dual official exchange rates were unified at the higher of the two previous rates and theni devalued. This Dermitted the Government to ease import restrictions and to lift most domestic price controls. Oil export volume increased substantially and new exploration has begun, with foreign participation. A public sector surplus was achieved in 1984 and 1985, a unique achievement in Latin America. 6. The economy responded well to the government's policy program, growing by 4.5Z in 1985. Ecuador seemed poised for an accelerated recovery in 1986 when it was undermined by the sharp fall in petroleum prices. The terms of trade index fell from 96.1 in 1985 (1984=100) to 61.7 in 1986. Faced with this setback, in August of that year the exchange rate for private importers and exporters was allowed to float. The sucre depreciated in real terms by 372 during 1986 and by 70? over the average for the 19o0-1983 period. The depreciation permitted the elimination of many of the quantitative restrictions put in place in 1982-83, somewhat  reducing the distortions between agriculture and industry. Subsidies (via the preferential official exchange rate) on the imports of wheat and milk powder were eliminated even before the currency float, and procurement by ENAC (the producer and wholesale price controlling agency) was reduced to four commodities -- rice, hard corn, soya, and cotton. Similarly, official consumer price ceilings were eliminated for most products including fresh milk. Thus, in spite of the fall in petroleum prices, well-conceived measures allowed the economy to grow by 2.92 in 1986. This growth was led by agricultural production, petroleum output and a small but promising begiining of mining of gold and other minerals. 7. On March 5 and 6, 1967 the remote oil-producing northeastern region of Ecuador was hit by two major earthquakes accompanied by destructive landslides. The major economic cost to Ecuador was undoubtedly the interruption in oil production and exports which resulted from damage to major sections of the Trans-Ecuadorean Crude Oil and LPG (liquified petroleum las) Pipelines and the impact of these on the economy. The cost of restoring oil exports, through rebuilding the damaged pipeline system, construction of a connection to the Trans-Andean pipeline through Colombia, and re'.ated works is estimated at US$113 million. Damage to road and bridge infrastructure is estimated at US$20 million. Foregone oil revenues until the end of July 1987 are ?alued at about US$600 million, and the multiplier effect of reduced exports, decreased public expenditure, and restricted domestic oil consumption has been substantial. All in all, a conservative estimate of the damage is about US$1.0 billion, equivalent to over 8Z of GDP, but some of this loss is being recovered now through accelerated oil production. 8. Policies to mitigate the effects of the earthquake on the economy include a major increase in the domestic prices of petroleum products, building a new pipeline to Colombia, and arranging oil swaps with Venezuela, Kuwait and Nigeria. The repair of the ruptured pipeline system was completed in the middle of August as scheduled. In addition, by temporarily curtailing debt service payments to commercial banks, the government has momentarily staved off foreign exchange cash flow problems so that imports did not have to be cut. The net result of the contraction from the fiscal shortfall and reduced oil consumption, coupled with the expansionary impact of the reconstruction, is expected to increase non-oil GDP in 1987 slightly; however total real GDP is expected to fall by about 3-4Z. Adiustment Policy Issues 9. Continued action is necessary to complete the reforms adopted thus far, consolidate the gains, and meet new challenges. The most urgent problem in 1987 is the balance of payments and fiscal deficits retulting from the fall in petroleum prices and the recent earthquake. As a result of decreased export and tax revenues from oil, the current account deficit is expected to rise from 5.3Z of GDP in 1986 to 9.2Z in 1987, and the  - 4 - public sector deficit (on an accrual basis) will probably increase from 4.12 of GDP in 198 to 9.32 in 1987. The government will need to maintain a competitive exchange rate to permit continued growth in non-oil exports. It will also need to continue restraining public sector expenditu-es and monetary expansion. Of equal importance is the strengthening of a financial system that has been badly weakened by a decade of misguided financial policies and imprudence on the part of bankers and their clients. Finally, addition_., foreign resources will be necessary to support the reform process and smooth the adjustment to lower oil prices. Sourzes of External Financing 10. Since 1982, when limitations on the availability of external credit began to affect the Ecuadorian economy, the relative importance of the various sources of external finance has changed significantly. In 1982, multilateral official sources provided 28.22 of the increase in total net external debt. In 1986, these sources accounted for 61.92 of the total increase. Bilateral official lending supplied significant shares of total additional external funding between 1983 and 1985. Commercial banks reduced their net r.o'w lendings from 81.72 of the total in 1982 to 2.52 in 1984, and increased them to 33.22 ih. 1986. At this point the Government of Ecuzador is completing negotiations on a financing package for the next few years with the IMF, the World Bank, IDB, and commercial banks. Ecuador's Relations with the IMF and Commercial Banks 11. Ecuador has entered into ttree IMF Standby arrangements since 1983. In addition, it received Compensatory Financing Facilities in 1983 as a result of lowered export revenues due to floods and in 1986 as a result of lower oil prices. In December 1984, Ecuador agreed on a multiyear rescheduling with commercial banks for the period 1985-1989, and in April 1985 with the Paris Club for the period 1985-1987. Until 1986, all Stand-by targets were met, often with sizable margins. However, only one purchase was made under the Augutt 1986 Stand-by arrangement because of nonobservance of targets related to the public sector deficit. The targets were consistent with a public sector deficit of 3.22 cs GDP; due to higher than expected public expenditures, the deficit turned out to be 4.12 of GDP. By January 1987, the Government and the Fund were negotiating targets for 1987 with the view that the August 1986 Stand-by would be reactivated and fully disbursed in 1987. In January 1987, while seeking ways of filling the agreed financing gap with commercial banks as a consequence of lower oil prices, the Ecuadorien Government stopped its payments to commercial banks, citing shortage of foreign exchange. By February 1987 an agreement between the Fund and the Government had been reached on the main parameters of the 1987 program, with final agreement pending a rescheduling with commercial banks and some action on public revenues through domestic petroleum price increases. Immediately following the earthquake, the uncertainties were so great that the authorities felt that it would not be appropriate to negotiate a new Stand-by arrangement.  - 5- 12. Now that the situation is somewhat clearer, the authorities are seeking agreements -on a comprehensive rescheduling program for 1987-1988. An IMF mission visited Ecuador in October, and a Stand-by arrangement has already been recommended by the Fund's management to its Executive Board. A fresh aiproach was made to the commercial banks, which was well received. Negotiations with the commercial banks on a rescheduling of principal payments falling due between 1985 and 1995 and a fresh money facility of US$350 million are well advanced. Creditworthiness and Bank Exposure 13. Despite commendab'e policy improvements since 1983, Ecuador's creditworthiness has suffered from the sharp decline in oil prices which occurred in 1986 and the earthquake-induced interruption of oil exports in 1987. Improvement in Ecuador's ci-ditworthiness would depend substantially on sustained implementation of policies to improve economic efficiency and resource mobilization. The Government is putting together a program, embodying an IMF Stand-by, rescheduling and new money from the commercial banks, and adjustment loans from the World Bank, probably in conjunction with parallel cofinancing from commercial banks and official sources. While Ecuador can, under such arrangements, be currently considered creditworthy for World Bank lending, it will be necessary to monitor the situation carefully in the years ahead. A fall in the price of oil or a deterioration in policies could result in weaker economic and balance of payments performance. Even if Ecuador's performance continues on its present course, issues of Bank exposure and burden sharing among creditors must be revi-wed. As of September 30, 1987 Bank exposure in Ecuador (including exchange rate adjustments) totaled US$592 million or about 6.5Z of MLT outstanding and disbursed. This figure will rise in the years ahead, but should remain well within current Bank guidelines. The commercial banks are expected to lend a substantial part of the approximately US$1200 million of new MLT money needed for 1987-1988. In Jts future lending to Ecuador, the Bank will review carefully the contributions of the country's traditional creditors to ensure continued equitable burden sharing. PART II - FINANCIAL SECTOR ISSUES 14. The performance of the financial sector in Ecuador, from the point of view of resource allocation, institutional strength and mobilization of domestic resources for long term lending, has several weaknesses that can be summarized as follows: (i) The large volume of subsidized credit has hindered the efficiency in the allocation of financial resources, nonetary stability, resource mobilization from domestic sources and the development of long term business finance; (ii) Large portfolio losses, an inadequate supervisory and regulatory framework, and the creation of a large number of small banks and DFIs induced by the availability of subsidized credit have weakened the capital adequacy and operational efficiency of the financial sector; and  - 6 - (iii) Interest rate ceilings, tax discrimination, and the absence of an institutional framework to inform and protect investors have harnered the development of the capital market. Dependence on Central Bank Rediscounts 15. Increasing Supply of BCE Credit. The BCE has been the dominant lender in Ecuador, by granting low interest rate rediscounts to FIs. BCE's lending accelerated in the first half of the 1980s, especially after 1983, when the large foreign debts of the financial system were converted into sucre debts to the BCE at a favorable interest rate, with the BCE simultaneously assuming the foreign exchange obligations (commercial risk remained with the banks). During the period 1980-1984, BCE credit financed 62% of the increase in credit to the private sector (20% excluding the nationalized foreign debt). Another important component of preferential credit has been forced investments by commercial banks in the same sectors and on the same terms as credit with resources rediscounted from the Financial Funds.1 By 1984 credit from BCE accounted for 502 of total private credit and total preferential credit (i.e., BCE credit plus forced investments) reached abon;t 532 of the total. Not only are the amounts of these credits large, but by 1984 they were channeled through some 44 separate credit lines, thereby integrating a typical system of directed credit which has seriousl- diminished efficiency in the allocation of financial resources. In 1984 the interest rates charged by FIs on forced investments and BCE credits were within a range of 102-18? and provided a transfer (measured in terms of negative interest rates) to borrowers of around 3.8Z of GDP. The nominal interest rate on these credits, although adjustable by the BCE, is not explicitly linked to market interest rates. Therefore, the size of the subsidy could become large if market rates rise and the BCE does not adjust credit rates accordingly. 16. The supply of credit from BCE to FIs is only one of the instruments of public sector intervention in the credit market. In addition, other public financial institutions (BNF, CNF, and BEV) allocate a good part (25.7% in 1986) of total credit to the private sector. These instruments have supported a strong tendency to subsidize and direct credit. The resulting misallocation of financial resources is one of the chief reasons for the increase in the incremental capital-output ratio from an average of 2.9 in 1971-1975 to an average of 5.2 in 1981-1985. Moreover, the supply of BCE credit to the private sector was the basic source accounting for monetary growth in Ecuador until about 1985, when it contributed almost 1302 of the yearly change in the monetary base. Since 1/ These funds were created in 1973, and there are funded by the BCE, the Government, and from foreign loans channeled through the BCE.  August 1986, Ecuador has been under a floating rate system, and barring extensive inte:vention in the foreign exchange market, domestic credit creation is the major policy variable determining monetary growth and the nominal exchange rate. Therefore, the Government's control of BCE credit to FIs is a key element in any policy to check monetary expansion. 17. Weak Domestic Resource Mobilization. The strong rate of capital accumulation that took place during the nineteen seventies raised significantly the demand for financial resources in Ecuador. As a result, the contribution of financial services to value added increased from 2.5% of GDP in 1970 to 3.9% in 1980. Yet domestic resource mobilization (money, quasimoney, and long term bonds) stagnated at around 24% of GDP until 1984, as a result of ceilings on interest rates. These ceilings became more restrictive as international interest rates and devaluation expectations increased during that period and therefore contributed to lower financial intermediation through those institutions subject to the ceilings, to investments in real assets and to capital flight. As inflation increased and the fixed exchange rate system was abandoned in the early 1980's, the Government adjusted interest rate ceilings moderately, but no increase in resource mobilization was achieved. 18. Other constraints have limited domestic resource mobilization. The lack of an adequate adjustable interest rate lending instrument that facilitates funding of long term loans with short term resources is one of the reasons why long term lending institutions (DFIs, SLAs and public sector FIs) rather rely on BCE or international funding for their long term lending. Also, the continued availability of cheap resources from BCE or BCE's subsidizing of foreign resources prevents those FIs from directly intermediating domestic private savings. A case in point is Banco Nacional de Fomento (BNF), a large public commercial and development bank with 11 regional offices, 57 branches and 9 agencies all over the country. Notwithstanding its extensive branch network, BNF has placed little emphasis on mobilizing resources from the public, so that these resources make up only about one quarter of its total funding. The potential for a larger funding of FI credit through domestic resource mobilization is indicated by the fact that, in 1984, 56% of credit to the private sector was financed by foreign liabilities. This percentage can be decreased by a market oriented pricing of both domestic and foreign resources. Institutional and Financial Weaknesses 19. Deteriorating Portfolio Quality. Available estimates indicate that portfolio losses not yet written off may equal the accounting equity of banks and may even exceed the accounting equity of DFIs. The reason for the extent of portfolio losses ia relation to FI capital can be attributed, in part, to the highly leveraged conditions of both FIs and business enterprises. High leverage at FIs, currently at more than 20:1 for banks  - 8 - Table 2: ECUADOR - MAIN FINANCIAL SECTOR INDICATORS Est. Year 1980 1984 1985 1986 1987 -------------------------------------------------------------------__--------__ BCE credit to FIs/FI credit to private Sector (2) 22.3 50.0 42.2 38.3 33.0 BCE credit and forced investments/FI credit to private sector (X) 25.8 53.3 44.9 40.9 35.9 Sources of Growth of the Monetary Base (X of Change in Monetary Base) Change in International Reserves 178.8 28.6 83.6 -37.7 n.a. Change in BCE Credit Public Sector -35.8 -92.7 -513.1 45.0 n.a. Private Sector 100.0 391.8 129.4 -10.7 n.a. Change ir Non-classified Assets -143.0 -227.7 400.1 103.4 n.a. Resource Mobilization by FIs (2 of GDP) 24.8 24.0 26.4 27.2 26.9 Of which: Money (MI) 15.3 13.7 12.4 12.1 12.2 Quasimoney 5.5 6.0 10.4 11.8 11.6 Long Term Bonds 4.0 4.2 3.6 3.3 3.1 Interest Rates (Annual 2) Passbook Savings 6-10 20-22 20-22 21-27 21-27 Certificates of Deposit 22-26 26-31 27-31 Preferential Lending 8-9 18 18 18 22 Non-preferential Lending 12 23 26-30 30-35 30-35 Total Liabilities/Capital Financial Institutions 7.38 13.91 17.45 16.33 16.63 Businesses 2.50 3.08 2.52 2.17 n.a. Commercial Banks (Z) Profitabiity as I of Capital 19.0 20.8 20.1 19.0 n.a. Oper. Cost/Total Liabilities 3.6 4.4 4.1 4.5 n.a. Forced Invs./Bank Crd. to Prv. Sect. 9.2 7.1 5.7 5.1 4.5 Required Reserves/Total Deposits 25.5 18.0 17.4 17.1 22.1 -------------------------------------------------------------------__--------__- Sourcess Central Bank of Ecuador, Superintendency of Banks and Superintendency of ^'npanies. n.a.: Not available.  - 9 - and at around 15:1 for DFIs, originated in imprudent behavior by Fl management, that was made possible by inadequacies of the supervisory and regulatory frameworks. For example, when access to external credit was easy, an important and profitable source of income for banks and DFIs was the guaranteeing of foreign direct loans. As businesses could not ;..evice their foreign debts, the guarantees were made effective and the leverage and exposure of FIs increased. On the other hand, high business leverage, measured by debt-equity ratios that peaked at 3.3 in 1983 from 2.3 in 1979, has responded to a number of incentives, including the availability of cheap credit from BCE and a favorable tax treatment to debt finance. With very high debt/equity ratios in business firms and FIs, the recession that began in 1981 and the subsequent devaluations that took place before the debt was nationalized in 1983 seriously limited the debt service ability of these firms and the capacity of FIs to make the appropriate write-offs. 20. Declining Operating Efficiency. The institutional strength of FIs is also limited by their small size and by their links to industrial financial groups. Some industrial groups established banks and DFIs because it was profitable for them to gain access to cheap BCE rediscounts. This was the case even though their small size prevented the institutions from taking full advantage of economies of scale and hence lower costs of intermediation. In addition, the links to industrial financial groups has made arms-length transactions less likely, thereby downgrading the quality of FI credit management and increasing the size of portfolio losses. 21. Reduced Profitability. Increasing portfolio problems and the reduction of income from the guaranteeing of foreign direct loans and from financial services related to international trade further reduced the profitability of banking. Reported ratios of profits to equity remained at around 202 from 1980 to 1986, even though banks were unable to collect an increasing share of accrued interest income and delayed the appropriate provisions and write-offs called for by the declining quality of outstanding loans. The large size of the estimated portfolio losses suggests that true profitability must have fallen much below 20X during those years, and probably turned negative for a number of institutions. 22. Profitability in banking has also been limited by the intermediation tax represented by reserve requirements and forced investments. Reserve requirements are 322 on demand deposits, 142 on savings and term deposits, 11X on certificates of deposit issued with more than 90 days to maturity, and 7Z on certificates of deposit issued with 90 or lesa days to maturity. All in all, reserve requirements were equivalent to 17.12 of deposits in 1986. Forced investments include 5 of savings deposits in bonds issued by Banco Ecuatoriano de Vivienda and 102 of total credit (excluding a number of important exemptions) to be lent in the same sectors and on the same terms as credits rediscounted from BCE's Financial Funds. Forced investments accounted for 5.12 of credit from commercial banks to the private sector (3.1? of total credit to the private sector) in 1986. Reserve requirements have been increased recently to control the growth of the money supply but forced investments were relaxed in 1986 to limit the extent of preferential credit.  - 10 - 23. Inadequate Supervision. In order to improve the financial soundness of FIs it is necessary to strengthen the Superintendency of Bank's (SB) capacity to regulate them. SB is an autonomous public body reporting to both the Congress and the President, and does not work as closely with the BCE as would be desirable. While its primary function should be to assess the riskiness of the operations of FIs and to ensure compliance with the legal requirements on their exposure and equity, it has not adequately supervised the FIs and unduly concentrated on ensuring that they meet the requirements on forced investments. Although the SB is to receive technical assistance under the Bank's Fifth Development Banking and Industrial Finance projects, the assistance has focused so far on analysis of the economic environment of FIs, bank operations under unstable conditions, credit analysis and strategic planning, and only minimally on assessing the financial soundness of FIs. 24. Weaknesses in the Regulatory Framework. The regulatory framework also has serious weaknesses. Maximum leverage ratios in banks are numerically reasonable but rendered useless by the liabilities that have been exempted from these ratios.2 Exposure ratios, also heavily exempted, are further weakened because the aggregation of mutually related debtors is n,t adequately regulated and has not been satisfactorily enforced. Until recently, regulatory and tax restrictions made it difficult for FIs to make provisions. Provisions for losses are only about 2? of portfolio among the DFIs and even more inadequate among banks. Writing off losses is still deficient, as write-offs are mandatory only after credits have been overdue for five years. Traditional accounting practices permit the accrual of interest on non-performing loans, thereby overstating profits and equity. Inadequacy of Long Term Finance 25. The development of long term finance with domestic resources from the private sector has been inhibited by a number of factors. The availability of subsidized credit from BCE is one of them. In addition, as there exists a legal ceiling on adjustable rate lending, private FIs are prevented from funding long term lending operations with short term resources and businesses from issuing free variable rate bonds. Finally, equity finance is discriminated against by a heavier tax burden for dividends than for interest and by the lack of an adequate institution that protects the interests of minority shareholders. 2/ Maximum ratios of liabilities to capital in banks are as follows: 15:1 for commercial sections; 10:1 for savings sections; and 20:1 for mortgage bonds. Certificates of deposit issued by banks are not subject to a maximum leverage ratio. The maximum leverage ratio and the maximum ratio of credit assets (including investments) to capital of DFIs are both 15:1. Certificates of deposit issued by DFIs are included in the leverage ratio.  - 11 - 26. Development Finance Institutions. Thirteen development finance institutions (DFIs), including the publicly owned Corporacion Financiera Nacional (CFN), provide medium and long-term industrial finance mainly with funds from the international institutions and BCE. Since these sources of funds are cheaper, DFIs mobilize almost no resources from the domestic private sector. Until they are able to use adjustable rate lending to permit transformation of certificates of deposit into long term loans, their role as DFIs will continue to be limited to financial intermediation of BCE or multilateral development lending. Term transformation will require the removal of ceilings on variable rate lending and an appropriate link to market rates of lending and onlending rates on the resources provided by the BCE and international institutions. 27. Housing Finance. The housing finance system consists of Banco de Ecuatoriano de la Vivienda (BEV), the savings and loan associations (SLA), and the Social Security Institute (IESS). In addition, commercial banks finance a small amount of housing by rolling over short term loans. In the past, SLAs were able to mobilize resources from the public because they were allowed to pay a slightly higher interest rate on savings deposits than were other commercial banks and because to be eligible for a low cost loan, mortgage borrowers had to deposit a compensating balance to be maintained until sometime after the loan was granted. When interest rates began to rise in the early 1980's, SLAs experienced large losses because of the mismatch between their low-interest, long-term assets and their short- term, higher rate liabilities. When depositors became nervous and withdrew funds, the BCE had to step in and buy up much of the outstanding portfolio. This left SLAs quite liquid, but unable to continue lending for housing since the prevailing market determined interest rates on deposits (22z) and the remaining interest rate ceiling on long term lending made long term lending risky. 28. The publicly owned BEV was established in 1961 to provide housing finance and to regulate the SLA system created two years later. It provides about twice as much credit to the private sector as the SLAs. Although BEV mobilizes a significant amount of domestic voluntary resources from the public through passbook savings, its medium and long term foreign liabilities, including Bank loans, have been an increasingly important source of funds. The average interest on loans, 13?, is still moderately above the average cost of funds, 112, but its current loan rates, 19Z - 21?, are less than the rate it must pay on deposits, 22?. Thus, BEV still has to surmount a number of difficulties before it could become an autonomous and market oriented long-term credit institution. These include adjusting its interest rates towards market rates and introducing a flexible adjustable rate lending instrument. 29. The IESS mortgage lending is about equal to that of BEV and the SLAs combined. IESS has been making graduated payment loans, but it uses an initial low interest rate, rather than capitalization of interest. This procedure gives a large subsidy to the borrower (who, typically, is not poor) and, along with its holdings of low-interest government and  - 12 - mortgage bonds issued by commercial banks, is eroding the real value of IESS's assets quite rapidly. IESS has recently raised its interest rate on mortgages to 12%, which is still very low when compared to prevailing CD rates of 27Z to 302; unless IESS earns a higher rate on its portfolio soon, the government will have to step in, either to cover IESS's payments to retirees, raise the already high social security taxes, or cut benefits. The government has arranged for IESS to receive technical assistance from !LO in assessing the problem of its unfunded liabilities and dealing with its financial, operational, and information processing problems. 30. Mobilization of Long Term Resources by FIs. In sum, FIs have not developed adequate instruments of long term lending. As inflation became a more serious problem after 1981 and nominal interest rates had to be raised, the limited amounts of long term resources that FIs had been able to mobilize dried up. Banks were no longer able to sell 10 year fixed rate mortgage bonds and DFIs could not issue any more long-term obligations. SLAs attempted to lend long-term at fixed rates while mobilizing resources with short-term deposits with catastrophic results. Virtually all long term lending ceased except that funded by BCE (and IESS) and the remaining fixed-rate commitments implied a large subsidy in line with variations in the rate of inflation and in market interest rates. On the other hand, FIs have not developed principal indexing or interest capitalizing systems to ensure reasonable patterns of real amortization payments on long-term loans. The high nominal interest rates prevailing in the market include an important inflation component. Without capitalization of all or most of this component, borrowers' real amortization schedules are heavily front loaded. Such schedules bear little relation to the cash flow of the projects being financed and most likely there would be little demand for such lending at market determined interest rates. 31. Business Finance. Firms are highly indebted, largely to FIs and suppliers rather than to investors through market placement of firms' bonds or commercial paper. Each firm's equity, on the other hand, is concentrated in a small number of large shareholders and very few companies have significant numbers of small shareholders. The issue of commercial paper and long term bonds by businesses has been hindered by the absence of a regulation that authorizes variable interest rate bonds. Equity finance is hindered by income tax discrimination against dividends, the lack of appropriate auditing and accounting standards that provide reliable information to outside investors, and insufficient protection for minority shareholders. Moreover, the availability of subsidized loans from BCE has also inhibited direct mobilization efforts by businesses. Thus, security markets that exist in Quito and Guayaquil trade mostly interest-bearing securities issued by FIs rather than equities or bonds. PART III - THE GOVERNMENT'S FINANCIAL SECTOR ADJUSTMENT PROGRAM 32. The basic role of the financial system is to contribute to the efficient resource mobilization and allocation of investment and capital.  - 13 - To do this in an efficient way, the financial system must be enabled to mobilize an adequate mix of foreign and domestic resources, transforming their size, maturity, and risk characteristics, in order to satisfy the credit requirements of the domestic economy. The weaknesses in Ecuador's financial system, identified in Part II, provide the backdrop against which the financial sector policy program presented to the Bank by the Government of Ecuador can be appraised. The Macroeconomic Framework 33. Based on the expectation that the recent macroeconomic policy initiatives can be maintained. consolidated and extended, strong economic growth should be sustainable. The key elements of the government's medium term economic adjustment and reactivation strategy include: (a) the diversification of exports away from petroleum through the maintenance of a competitive exchange rate and the implementation of an effective import duty drawback mechanism; (b) a continuation of the gradual reduction in import protection for industry and the removal of tariff exemptions in all sectors; (c) improved putlic goods and services pricing, especially for electricity and petroleum, which is vital for strengthening government revenues, exports and economic efficiency; (d) a more rational public investment program; and (e) improved financial sector policies to permit greater mobilization and a more efficient allocation of resources. These measures are summarized in Annex IV. 34. It is also expected that the Government will follow prudent fiscal and monetary policies. Fiscal restraint and monetary stability are required to avoid excessive pressure on domestic financial markets and a resurgence of inflation, both of which would endanger the expected achievements of the financial policy program. Improvements in macroeconomic and financial policies are also necessary to ensure continued creditworthiness of the country. Thus, a conducive macroeconomic adjustment program must be in place for the financial sector program that would be supported by the proposed FSECAL operation. 35. Growth, Investment and Savings. Following the dip and surge in economic growth in 1986 and 1987, which is explained by the decline and recovery of petroleum production, the economy is expected to grow within the 3.5Z to 5.OX range that is consistent with historical performance. Growth is projected to accelerate within this range as oil exploration intensifies after 1988. Investment is expected to return to its historic level of about 18Z of GDP, following the recovery efforts of 1987. Increases in the efficiency of investment are expected as a result of the efforts to improve resource allocation through a better financial and trade policy framework. Finally, an increase in domestic savings is anticipated as a result of a better performance of public sector finances. 36. The Balance of Payments and the Public Sector Deficit. Balance of payments and public sector balance projections (Annex I) show a significant decrease in the current account deficit of the balance of payments, from  - 14 - 9.22 of GDP in 1987 to 3.02 of GDP in 1988, as well as a sizable decline of the public sector deficit, from 9.32 to 3.4Z during the same time period. These improvements are due almost exclusively to the recuperation of petroleum production and exports as a result of the oil pipeline repair that has now been completed. Further reductions in the current account deficit to 0.32 in 1991 result from the assumed expansion of non-oil exports. Further declines in the public sector deficit to 0.1Z in 1991 would be the consequence of improved pricing of public goods and services and of a slight reduction in the ratio of public expenditure to GDP. The latter assumes a more rational public investment program. 37. Prospects and Needs for Financing. Projected medium and long term (MLT) external financing amounts to about US$1.2 billion during 1987 and 1988. The Government is negotiating the financing of this sum with the IMF, commercial banks, and the Paris Club, taking into ccnsideration expected disbursements from multilateral sources. The Government expects that World Bank disbursements less amortizations will provide from 252 to 302 of projected MLT lending in these two years; the IDB, bilateral sources, and commercial banks would provide the balance. A part of the total MLT lending could be conjunction with commercial bank parallel cofinancing of the proposed Financial Sector Adjustment Loan and an Export Development Loan under preparation. The Government's Financial Reform Program 38. The government's program for financial sector improvement objectives may be grouped into three categories: (i) Reducing the dependence of FIs on the Central Bank to promote a better resource allocation, greater monetary stability, and a more adequate volume of long term business finance. (ii) Improving the regulatory and supervisory framework to strengthen financial institutions. (iii) Improving conditions for adjustable rate lending, capitalization of interest and equity finance to promote capital market development. Reducing the Dependence of FIs on the Central Bank 39. Recent Policies. In 1985-86, the Government of Ecuador (GOE) reversed earlier trends and restricted the growth of preferential credit through private financial institutions, which had peaked in 1984 as a result of the foreign debt conversion program. Subsidized credit through private commercial banks has grown very little thereafter. As part of the policies introduced in August 1986, a large program of subsidized export credit was canceled, the interest rate on remaining credits for export promotion was raised from 10Z to 182, funds were shifted from lower to higher interest rate lines, and forced investments of banks were cut significantly. Between 1984 and 1986, as a result of these measures, the share of BCE credit to FIs in total credit from FIs to the private sector  - 15 - dropped from 50X to 38Z, while the share of preferential credit fell from 532 to 41% over the same period. Furthermore, with the decline in the rate of inflation the aggregate subsidy from BCE credit was reduced from 3.8% of GDP to 0.4Z of GDP. To prevent fluctuations in market interest rates from changing the size of the subsidy element in preferential credit, interest rates on BCE credits are now being linked to the market determined rates paid on Certificates of Deposit (CDs). The interest rate on preferential credit has thus been raised from 182 to 232, thereby reducing the gap with respect to the CD rate from 11 to 6 percentage points and further decreasing the subsidy on BCE credit. Finally, the reduction in the size of the credit subsidy has been complemented by a reduction in the number of different BCE credit lines. In 1986, 11 of the 44 existing lines were r.erged into one fund. During 1987, 7 of the remaining 33 credit lines were closed. 40. In 1985 a Certificate of Deposit was created with a market determined interest rate and in 1986 rates on passbook savings, time deposits, CDs and non-preferential lending were also allowed to float. The removal of interest rate ceilings has permitted FIs to mobilize more domestic resources, thereby reducing their dependence on BCE credit. The ratio of monetary and financial assets to GDP increased from 24.0% in 1984 to 27.2X in 1986, and free market lending, which was nonexistent in 1984, accounted for 34% of credit to the private sector in 1986. Also, under the Agricultural Credit Project (2752-EC) recently approved by the Bank, BNF is committed to mobilizing more resources from the public as it adjusts to the prospect of reduced availability of credit from BCE by using its wide branch network to attract low-cost deposits. 41. Action Program. To achieve a further reduction in the credit subsidy, the Central Bank will decrease the volume of lending through BCE credit lines and raise the minimum interest rates on these lines. Thus, the expansion in credit is being held to no more than S/12.0 billion, a nominal increase of less than 7% compared to expected inflation of about 33Z. Moreover, BCE intends to reduce its credit in real terms further during 1988, so as to bring it down to 65% of the outstanding level at the end of 1986. These actions should lead to t. fall in preferential credit from 41% of credit to the private sector in 1986 to 36X and 29% in 1987 and 1988 respectively. The reduction in the volame of BCE credit will be achieved in part by closing more preferential credit lines after January 1, 1988. This program for private sector credit is expected to be consistent with the control of net domestic assets of the BCE which is likely to figure prominently in the IMF program. 42. A further reduction in the subsidy element in preferential credit will be achieved through raising the minimum rates on BCE credit to within 5 percentage points or less of the 90-day CD rate before June of 1988, thereby continuing the adjustment towards market rates that was started in August of this year. The Government also intends to equate the minimum BCE rate to the market determined reference rate if and when the latter falls below 20%.  - 16 - 43. The largest single line of credit from BCE is the one extended for the nationalization of the foreign debt. Amortization of the credits under this line is scheduled to begin in 1988. There will be great pressure to roll-over the matulrities yet again. In that case, it would be important to eliminate, or at least greatly reduce, the subsidy element in these loans. According to the Government's program, any refinanced portion of the nationalized loans will be less than 50 of the outstanding amount at the time they are due and will bear an adjustaile interest rate no less than the free rate on certificates of deposit. The terms on which any portion of these loans are to be refinanced will be announced and in force before June of 1988. Strengthening Financial Institutions 44. Recent Policies. The Government has designed a program to deal with financial institutions with financial problems. Under that program, the government nationalized the foreign debt of the FIs, established "Rehabilitation programs," liquidated one commercial bank and took over another. At present three banks and two DPIs have entered Rehabilitation Programs that consist of a BCE advance (the least preferential of any BCE credit) combined with a workout over 5 years drawn up by SB and BCE. A workout is initiated when a FI is unable to repay its debt to the BCE. It typically entails non-payment of dividends, some contribution of fresh capital near the end of the work out period, and operational changes. The BCE also provides assistance by accepting the real assets that FIs have received from debtors as payment of the Ft debt to the BCE. Nevertheless, these programs are designed more to deal with liquidity than with solvency problems, and thus would require more emphasis on recapitalizing FIs. 45. To support its program of recapitalizing FIs and supervising capital adequacy, the Superintendency has started a thorough review of the portfolio quality of banks and DFIs. It has now completed the evaluation of sixteen banks and of all DFIs. The banks that have been reviewed include the larger as well as those that are perceived to have significant portfolio losses. SB has also begun to take steps to force FIs to increase capital and provisions for loss. The ratio of total credit assets to equity of private banks decreased from 18.2 in 1985 to 14.2 in 1986 and that of DFIs has fallen from 14.7 in 1985 to 13.6 in 1986. Overall, provisions for losses have risen from 0.2Z of credit and contingencies to the private sector in 1980 to 1.6Z in 1986. In 1986, SB disallowed distribution of profits in a number of institutions. A regulation was issued to prevent the accrual of interest on non-performing loans beginning in January 1988. 46. In February 1987, the Monetary Board authorized foreign debt creditors to "lend, transfer, or assign" their claims for equity investments. These debt-equity swaps can be made at a business firm or at an FI. In the first case, the capitalized firm would repay its nationalized debt to a financial institution, while the latter would cancel the corresponding debt to the BCE; in the second case, the capitalized Ft would pay its nationalized debt to the BCE. However, FIs and businesses have been unwilling to give up the highly subsidized debts for equity  - 17 - claims, and only very l.mited conversions have been taking place. As these credits are due to be paid starting in mid-1968, more debtors will find it convenient to finance these payments with debt-equity conversions. 47. Action Program. The Superintendency of BankF has a designed program of actions to tighten prudential regulation of FIs. To improve its monitoring and control of capital adequacy, SB will require !Is, beginning in 1988, to ask their auditors to provide audited supplementary information on portfolio quality, exposure to mutually related firms andjor individuals, the true value of equity, and the adequacy of pro-visions. SB will also begin to exchange views with auditors to harmonize criteria used for judging the financial soundness of FIs. Furthermore, before the end of the year the government will issue Monetary Board regulations, to the Bank's satisfaction, that would allow SB to control capital adequacy in relation to various categories of risk assets. In addition, SB will also issue regulations that are acceptable to the Bank to enforce more strictly exposure limits3 by aggregating lending or guarantee operations with mutually related firms andlor individuals and beginning a three year program to decrease excess expos-ures. 48. So far, the authorities have been reluctant to take the difficult decisions involved in closing or forcing the merger of weak banks and DFIs. Only one institution has been liquidated and another was taken over by the jovernment with the intention to resell it to the private sector. These actions are important but do not go far enough to restore the capital adequacy of FIs. Although the financial situation of the Ecuadorean banking system is relatively stronger th.an that of several other Latin American countries, it still requires substantial strengthening. Therefore, the Government has set the following principles to guide the process of consolidation: (i) Once the SB determines that an FI does not meet critical capital adequacy or liquidity limits, , review, including an extended audit, would be undertaken by SB and BCE to determine whether the FI should be liquidated or recapitalized. (ii) If it is determined that the FI can be recapitalized, the SB will negotiate a program for recapitalization with the directors of the Fl. Such a program will restore capital adequacy in no more than three years, with yearly intermediate targets. (iii) Deviation from the recapitalizatior. program, by more than 202 of the agreed capital adequacy target in any one year, will result in the immediate cessation of BCE lending or rediscounting operations with the delinquent Fl. 3/ 15% of paid in capital and reserves of the FI with exceptions mainly for certain export finance loans, loans under the Financial Funds mechanism and nationalized credits; an exposure over 15% and un to 252 is permitted when the excess over 152 is secured by real assets.  - 18 - To apply these principles, SB will use the capital adequacy critetia defined in relation to assets that the Monetary Board will issue before the end of 1987. At present, Rehabilitation Programs are limited to those FIs that fail to pay rediscounts granted by the BCE, thereby assisting an institution only at a stage when it is illiquid. Under the new principles, Rehabilitation Programs will be broadened to include FIs that do not meet critical capital adequacy or liquidity ratios but that are economically viable when refloated and strengthened. Although the aggregate recapitalization needed by banks and DFIs is sizable (estimated at about US$230 million), the financing would be spread over three year periods for each institution. To fund the required capitalizations, the Superintendency will continue to request that FIs do not distribute cash dividends and/or shareholders will be asked to bring in new resources when additional provisions are required, when portfolio losses have not been written off, or when capital adequacy is otherwise deficient. To the extent th'.t the existing shareholders are unable to provide or obtain from other investors the needed capitalizations, some non-subsidized funding would have to be accommodated within a total BCE credit program that preserves monetary stability. 49. The capitalizations would proceed in the context of the principles set forth in the previous paragraph. However, as even strengthened rehabilitation program- are not a fully satisfactory way of dealing with troubled financial institutions, the Government will study and discuss with the Bank the possible means to create and finance a Deposit Guarantee Fund to reorganize troubled financial institutions and guarantee the deposits at such institutions. Terms of reference for the study are now ready and the study and draft legislation, which should be satisfactory to the Bank, will be completed by June 1988. 50. As indicated before, the SB will have to focus more strongly on the assessment of the capital adequacv of FIs. This requires not only an examination of the portfolio, but also an understanding of credit management at FIs. At present, SB is not well equipped to perform these tasks. Therefore, to continue upgrading the supervision of FIs, SB will contract for technical assistance in training in four areas: (a) Portfolio inspection and classification and evaluation of provisions and capital adequacy; (b) Evaluation of FI's credit risk policy, organization, procedures and methods; (c) Use of information from FI's external auditors in supervision of FIs; and (d) Audit and supervision of FI's that operate in an electronic data environment. The detailed content of this program is described in Annex VI. It can be financed under World Bank loan 2672, depending on the availability of alternative sources. The Superintendency will have contracted the above technical assistance components by March of 1988. Improving Conditions for Long-Term Finance 51. Recent Policies. In 1985, in the context of discussions leading up to the Bank's Industrial Finance Loan (2672-EC), legal changes were made that permit FI lending at variable interest rates. Nevertheless, interest rates on adjustable rate loans were left subject to the 'Maximum  - 19 - Conventional Rate" (TMC), which is set by the Monetary Board. In November 1987 the TMC was about 2 percentage points below the average rate being paid on 90-day CDs. The existing ceiling still makes it impossible for FIs to transform short term deposits resources into long term lending instruments with adjustable interest rates. On the other hand, the Monetary Board changed the application of the law last November to permit as frequent interest rate changes as needed in adjustable lending; under previous regulations FIs could only adjust interest rates twice a year and only if the Monetary Board adjusted the TMC in the previous year. This change will improve the pricing of current adjustable loans funded by international institutions, which has now been linked to the CD rate. Irterest rates on all credit projects thus funded were set at two points below the interest rate on 90-day CDs in November of 1987. 52. Two recent policies are contributing to the development of bond markets. Last April, BCE began to collect and publish data on average interest rates paid on savings accounts and CDs of various maturities. The average 90-day CD rate is providing a reference for adjustable rate loans and for long term bonds. Secondly, in 1986, the Government, whose paper is not subject to the adjustable rate ceiling, successfully issued a long-term bond with a rate linked to the interest rate paid on CDs. This issue provided a novel source of public finance and stimulated the development of the long term bond market. 53. Action Program. Interest rates on adjustable rate lending are subject by law to the ceiling set by the Monetary Board. The Government will review the possibility of proposing a legislative change that permits adjustable rate lending without ceilings. Moreover, the ceiling will be raised to the level of the CD rate before June 1988 and adjusted accordingly thereafter. Eventually, FIs will be permitted to freely determine the margins above a reference rate of their choice. In the case of housing loans from BEV under the Low Income Housing Project, the onlending rate will be linked to the average market interest rate on savings accounts issued by financial institutions. 54. Even more than other FIs, BEV needs to develop a form of contract that combines market-linked interest rates with adjustable payment schedules. With the Bank's help BEV is perhaps the institution that is most advanced in designing such a contract. One of the principal features of BEV's Low Income Housing Project, wihich has been appraised, is the introduction of a housing finance contract whose interest rate is defined as the rate paid on savings deposits plus a margin but whose monthly payments are tied to the minimum wage. Market based interest rates will permit BEV to become progressively more self-supporting and able to mobilize funds from the market while interest rate capitalization will permit it to offer lower initial payments to its borrowers than it does now with subsidized rates of 19Z. Introduction of such capitalization by BEV should pave the way for wider acceptance of the concept by FIs in Ecuador. 55. So long as CD rates are market determined they are a workable indicator of credit market conditions, even though they are influenced by the perceived default risk of deposits in different FIs. A more precise  - 20 - indicator would be provided by the price of short term public bonds which have negligible risk of default. To create a market for this instrument and, at the same time, strengthen monetary control and/or short term public finance, the Government will introduce before May 1988 an auction market for treasury bills or Central Bank stabilization bonds. If this market is successfully established and acceptable to the Bank, the quoted yield will be used as the reference rate to price BCE credit and loans funded by international institutions. 56. Finally, the government plans to carry out a diagnosis of the fiscal and other factors that may discourage equity finance such as: (a) preferential tax treatment of interest as opposed to dividend income; (b) deductibility of the inflation component in nominal interest rates from company taxable income; (c} lack of protection of minority shareholders; and (d) legislation inhibiting underwriting. on the basis of this diagnosis, the government will draw up an action program and draft legislation that are acceptable to the Bank before June of 1988. It is expected that a program of financial reform in this area could form the kernel of a subsequent financial sector adjustment loan. PART IV - THE PROPOSED OPERATION History 57. An exploratory mission sent to Ecuador in 1983 identified the major weaknesses of the financial sector. In 1985, the Bank complet;d a document entitled "Brief Review of the Financial Sector," based on the work of the 1983 sector mission and on operational missions in 1983 and 1984. The policies that this operation would support are consistent with the recommendations of that report. A mission that visited the country in May 1986 found that the financial sector was seriously deteriorating as a result of the existing incentives for imprudent behavior in financial institutions. A pre-appraisal mission visited the country in February 1987 to develop a preliminary agreement on the specific policies that the project would comprise in support of these objectives. During the appraisal mission that visited Ecuador last June, the Bank and the Government refined the policy program to be supported, and obtained from the Government the "Statement of Financial Policies" that is included as Annex III. Description 58. The proposed Loan of US$100 million would support both the substantial progress already achieved as well as the program of further actions to be carried out in 1987-88 as described in Part III (See Declaration on Financial Policy, Annex III). The US$100 million loan would be disbursed in two equal tranches and would be used to finance general imports subject to a negative list. Financial sector policy conditions that have been completed for Board presentation as well as those that are required for Second Tranche release are summarized in Annex V. The proposed agreements under this Financial Sector Adjustment Loan have been discussed with the IMF and are being coordinated with the IMF's staff efforts in Ecuador to ensure a supportive macroeconomic framework.  - 21 - Financial Sector Scenario 59. Based on the Government's adjustment and reform program, a set of projections of selected indicators of financial sector performance during 1987-1991 have been prepared (see Table 3). The declining dependence of FIs on BCE credit is indicated by the falling ratio of preferential credit to credit to the private sector. As a result of the decline in the volume and the adjustment in the price of BCE credit, the subsidy on this credit will be significantly reduced. FIs will increasingly depend on their ovn resource mobilization and as the government will continue to permit market- determination of interest rates on deposits, an increase in the ratio of M2 to GDP would be observed. 60. Credit to the private sector would recover as a result of faster economic growth. Falling rates of inflation and declining BCE credit will promote a higher growth of equity finance. The strengthening of FIs will be reflected in an improved index of capital adequacy (total creditlcapital) and a better portfolio quality. Improved mobilization of resources for long term lending will result from the link of adjustable onlending rates to short term market determined rates. Table 3 also provides the expected monetary and economic growth frameworks. The projected growth rate, coupled with the decrease in monetary expansion that is enabled by declining BCE credit growth should permit a significant reduction in inflatioa. Benefits 61. The reform program of the Government is expected to improve significantly the performance of the financial sector in Ecuador. Freeing of interest rates on deposit and lending instruments not funded by BCE, control of BCE credit growth in real terms, the increase in interest rates on FI credit funded by BCE and the reduction in the number of separate credit lines are contributing towards the achievement of a number of objectives: increased resource mobilization from the private sector, more efficient pricing of financial assets and credit, reduced business leverage, and monetary stabilization. The increased flexibility of adjustable lending, market pricing of on-lending rates on loans funded by international institutions, the implementation of the low income housing finance project, and the improvement of short term reference interest rates are important initial steps to develop the long term capital market. Finally, the proposed study to identify the bias against equity finance should provide the basis for further important financial policy reforms aimed at reducing business leverage. 62. The proposed regulatory changes, the upgrading of supervision through technical assistance to the SB, and the Rehabilitation Programs are important tool3 to strengthen the capital base and improve the performance of financial institutions. In particular, higher standards for capitalization, increased provisions, faster write-offs, restrictions on loans to mutually related parties, and reductions in the volume and subsidy element in BCE credits make it less attractive for investor groups to control FIs. Thus it is expected that a number of FIs will be liquidated  - 22 - Selected Indicators of Financial Sector Performance (percent) Projections 1980 1984 1986 1987 1989 1991 Indicator Preferential Credit 25.8 53.3 40.9 35.9 23.3 16.6 /Credit to Pvt. Sect. Excess of CD Rate n.a n.a 9.0 7.0 0.0 0.0 over Minimum Lending BCE Rate (Z points) Total BCE Credit SubsidyJGDP 0.7 3.8 0.4 0.3 0.0 0.0 M2/GD 20.8 19.8 23.9 23.8 25.2 26.0 Credit to Pvt. Sect 42.5 50.4 45.9 43.3 43.1 44.8 /GDP Assets/FI Capital (Ratio) Commercial Banks 14.2 20.2 12.2 21.8 18.2 16.5 DFIs 7.5 18.1 15.3 15.9 14.9 15.6 Excess CD Rate n.a n.a 4.0 2.0 0.0 -2.0 over Maximum Adjustable Lending Rate Money growth 11.6 42.2 20.1 29.7 20.0 20.0 Inflation 12.8 29.7 27.4 33.4 14.4 14.5 GDP growth 4.9 4.2 2.9 -3.2 3.6 4.8 Source: Ministry of Finance, BCE, and staff estimates. n.a.: Not available  - 23 - or merged with other FIs whose owners pursue banking as a business rather than a source of cheap credit for their enterprises. 63. Other actions that the Government will attempt, subject to legislative approval, will further contribute to the objectives of the program. First, the creation of a Deposit Guarantee Fund will provide a better institutional framework than the current Rehabilitation Programs to refloat institutions and guarantee deposits. Once the fund is created, the current de facto insurance of deposits and refloating of FIs will be handled outside BCE, thereby strengthening BCE's control over money and credit. Second, legislative progress in freeing adjustable lending from interest rate ceilings will be an indispensable step to develop long term lending with domestic resource mobilization, thereby improving the performance of DFI.., SLAs, and other institutions that provide long term loans. Finally, to reduce the risk of business insolvency, the Government is very interested in pushing forward the solutions to the current legal and institutional difficulties that obstruct the development of equity finance and business bond issues. 64. Market determined real interest rates will be subject to offsetting pressures. As inflation falls in response to tight monetary and credit policies, the tax deductibility of the inflationary component in nominal interest rates will become less important, thereby reducing the demand for credit and stimulating the use of equity finance. The reduction of interest rate subsidies will also tend to reduce real interest rates in the non-preferential segment of the market, as lowered subsidies decrease the demand for investment. The process of consolidation that is likely to occur as weak financial intermediaries are weeded out should also reduce the costs of intermediation and thus the real cost of funds to borrowers. Competition from the development of a market in commercial paper and, eventually, of longer term obligations of firms may also be expected to force down the costs of intermediation. These tendencies toward lower real interest rates will be at work over the medium term. In the short run the resumption of movement in the nominal exchange rate will increase expected devaluation, and the acceleration of growth will speed up investment. These developments may place some upward pressure on real interest rates. 65. Generally, by reinforcing market signals, the financial an1 trade policy changes will contribute to improve the efficiency of capital and to strengthen the fragile capital base of business enterprises which ultimately will stimulate economic growth. By upgrading supervision, the Government will also enhance the ability of financial institutions to perform the transformation of risk, term and size of domestic resources. The program also will have positive social effects by improving distribution and employment. The elimination of interest rate subsidies that ber,efit primarily high income recipients, the decrease in the regressive inflation tax and a better protection to small depositors are efficient methods whereby the program will contribute to reduce the concentration of wealth and income. Moreover, the expected rise in the quality of investment and the financial stabilization of business ente;nrises should help improve the growth and stability of employment.  - 24 - Risks 66. The main project risk relates to the timing of this Loan, which would be implemented during the presidential electoral cycle, a period of political transition. Ecuador will elect a new President in 1988, with a first-round election in January, a likely run-off in May, and the inauguration in August. The uncertainties regarding the political transition, added to challenges which the current administration has faced in the implementation of its program since June 1986 when it lost congressional elections, could diminish the Government's ability to pmaintain the policies already in place and extend the financial sector reform program supported by the proposed loan. 67. Of particular concern would be the maintenance of market determined interest rates and of an acceptable fiscal deficit. The Government has already withstood a serious legal challenge to the floating of the interest rate, and in its letter of development policy undertakes to continue to support such reforms. Further interest rate measures to be supported by this loan have already beeni taken. The remaining measures supported by this loan are moderate, for they only require the Government to raise interest rates on BCE preferential credit two points closer to the certificate of deposit rate and to increase on-lending rates on loans funded by international institutions to the level of this CD rate. On the other hand, the risk of failure to maintain macroeconomic stability is minimized through continuing dialogue with the Bank and the IMF, including additional adjustment programs with both institutions. 68. Second, the Government elected in 1988 might reverse the reform program. Abrupt and wholesale reversal of the financial and economic program is not likely, given the fact that these measures have demonstrated beneficial effects on macroeconomic performance and eased the adjustment to a-verse economic shocks. In the event of some reversal of current financial policies, the most likely regime would be one of variable interest rates, perhaps subject to ceilings, that the Government would change as a function of the behavior of an indictor of market interest rates. 69. Third. many FIs are weak and undercapitalized. Even with vigorous efforts by SB and BCE to strengthen them, some insolvencies could result. In particular, although the faster growth that will result from the foreign trade policies embodied in the macroeconomic strategy will have a beneficial effect on portfolio quality, some firms will be hurt initially by continued import liberalization, thereby increasing the likelihood that they default on their debts to FIs. However, these effects on portfolio quality represent an improvement over those that would result from a strategy of continued protection and slower growth. Thus, since Ecuador's economy is already quite open, it is expected that the program of economic reforms will help restore growth to the 4Z-52 level from its recent near stagnation as well as irnprove portfolio quality.  - 25 - 70. Finally, although over the medium term the entire program with the supervisory authorities is designed to prevent the occurrence of system- wide insolvency, accounting and regulatory changes in the short run will uncover the existing weaknesses and may thus provoke the closure of some institutions. The government's fullest commitment to a set of principles for dealing with failing FIs through its strengthened Rehabilitation Programs and the eventual creation of a deposit guarantee fund or equivalent mechanism is the best way to deal with this contingency. An even greater danger could result, however, if the SB were unable to carry out the agreed program, thereby failing to uncover weaknesses and allowing the situation of a number of FI to deteriorate further. This highlights the importance of the technical assistance that SB will contract under the policy program. Loan Implementation Proposed Financing 71. The loan would apply to IOOZ of the c.i.f. costs of eligible private and public sector imports. Eligible imports would be all goods except those normally excluded under Bank policy-based loans, such as alcohol, tobacco, armaments, etc.; goods financed by other Bank loans; and expenditures under contracts costing less than US$5,000 equivalent. A maximum of 20% of the loan would be available to finance imports paid prior to loan signature but after July 10, 1987, when appraisal was completed. Disbursement, procurement, administration and auditing 72. The Republic of Ecuador would be the borrower of the loan. Bank disbursements would be made under the Statement of Expenditures procedure. As with previous loans to Ecuador, a Special Account (US$20 million) would be set up to acceletate disbursements. The first tranche is expected to be disbursed upon loan effectiveness and the second tranche after it has been determined that the Government has taken the required policy actions. Such determination is expected to occur within six months of loan signature. The time limit for the availability of the second tranche is September 1988, which provides an ample period for the borrower to comply with the agreed policies that ara required for tranche release. The BCE will be responsible for the coordination and collection of relevant documentation and preparing withdrawal applications under the loan 73. For all purchases under US$5 million, private firms would follow normal commercial practice and public sector importers would follow standard Government practices, which ensure reasonable prices. All purchases exceeding US$5 million would be through international competitive bidding, in accordance with Bank guidelines. 74. The BCE would maintain separate records and accounts of all transactions under the loan. All such accounts would be audited annually by independent auditors acceptable to the Bank, and the auditor's report would be submitted to the Bank not later than four months after the end of  - 26 - each Ecuadorian fiscal year. Audit reports would include a separate opinion with respect to the disbursement requests submitted to the Bank on the basis of Statements of Expenditures and state whether such requests have been affected in accordance with the terms of the Loan agreement. Monitoring and Tranche Release 75. The progress of the financial sector reforms supported by the proposed operation would be monitored through regular supervision, including a continued close cooperation with the IMF. Release of the second tranche would be contingent on specific financial sector reform actions to be taken (see Annex V). Furthermore, release of the second tranche would require the maintenance of satisfactory macroeconomic performance, including a reduction in the public sector and balance of payments current account deficits and in the growth of BCE credit. Compliance with these conditions would be reviewed by a Bank Mission before release of the second tranche. PART V - BANK GROUP OPERATIONS AND STRATEGY 76. Bank Group operations in Ecuador date back to 1954 when a loan was made for a First Highway Project. The Bank and IDA have extended 40 loans and 6 credits to Ecuador totalling US$1,036.5 million net of cancellations. As of June 30, 1987, US$760.5 million of this amount had been disbursed. The IFC has invested in seven firms in Ecuador, including enterprises in textiles, sugar, food processing. financial services, mining and cement. As of June 30, 1987, commitments for these operations amounted to US$45.7 million, of which US$17.7 million was undisbursed. 77. Execution of Bank Group financed projects has often been hampered by weaknesses in Ecuador's implementation capacity, reflecting the insufficiency of the country's public sector managerial and technical resources--a constraint that is still a serious obstacle to Ecuador's economic and social development. One effort directed at overcoming these weaknesses is the Public Sector Management Project (Loan 2516-EC) which focuses on fiscal management. Furthermore, in recent years, the Government and Bank staff have worked together to step up disbursement of Bank loans. Among other initiatives, a Special Action Program established revolving funds in five projects. As a result of these general efforts, disbursements rose from US$26 million in FY83 to US$176 million in FY87. The Government has set up a monitoring committee for all externally financed projects which should reinforce efforts to accelerate disbursements. The Bank is undertaking annual portfolio implementation reviews to detect and resolve specific obstacles to execut;nn of Bank- financed projects. The latest took place in February 1987 and its conclusions highlighted the need to provide adequate counterpart funding and to improve project management. 78. Bank and IDA lending in Ecuador was c.iginally concentrated in transport and power, where there were substantial bottlenecks to be overcome. To date, approximately 25 percent of Bank Group lending has been for infrastructure. Seven of the nine loans and credits extended for  - 27 - transport were to improve the country's road network, and two were to help finance an expansion of the port of Guayaquil. Three power operations aimed at improving generation and distribution facilities in Quito; the fourth power operation aimed at improving efficiency of sector institutions. The first Livestock Development Loan, apiroved in FY67, marked the beginning of a diversification in the Bank Group's lending program away from infrastructure. Since then, the Bank Group has made 10 other loans and credits for agriculture and fisheries, 9 loans to support industrial development, 2 for pre-investment studies, and one each for reconstruction of earthquake-damaged petroleum infrastructure and public sector management. These productive sector loans comprise about 60 percent of total Bank lending to Ecuador. Bank Group support for social sectors-- education, water supply and urban development--now accounts for about 15 percent of total Bank lending. 79. Turning to the future, the Bank strategy is to-support Government initiatives in macroeconomic and sector reforms over the medium term. This would be achieved through a series of sector and project loans aimed principally at supporting policy improvements in energy, agriculture, the financial sector, industry, and developing social and economic infrastructure, as well as addressing weaknesses in public sector management. In addition to the design and adoption of adequate sector policies, Bank lending will emphasize the &.aneration of exports and employment. Projects in the housing, education, health and water supply sectors will specifically target low-income groups. For the near term. besides the proposed financial sector loan, the Bank is preparing a low income housing operation, the present financial sector adjustment loan, and an export development operation. The objective of the latter is to accelerate the growth of exports, thus strengthening Ecuador's creditworthiness and helping it return to an acceptable medium term growth path in the aftermath of the March 1987 earthquake. In addition to Bank lending, the IFC has approved recently investment operations in development finance, gold mining and capital markets, and is considering a further operation in development finance and an agribusiness line through a local commercial bank. 80. Substantial development financing has also been provided to Ecuador by the Inter-American Development bank (IDB). the US Agency for International Development (USAID) and, to a lesser extent, by other bi- lateral sources. IDB has been the largest lender to Ecuador. Loans outstanding (including undisbursed) from IDB as of december 31, 1986, totalled about US$1.4 billion equivalent. Past IDB lending has been concentrated in the power, agriculture, industry and transport fields. Most of IDB's loans have come from the Fund for Special Operations and carry concessional terms. It is likely that IDB will remain Ecuador's major development lender in the immediate future with power, agriculture, and socially oriented-projects continuing to account for a large share of its lending program. By September 1986, USAID had about US$159 million in outstanding loans to Ecuador (including undisbursed). In addition, USAID has, since 1979, provided US$64 million in project grants and US$24 million in balance-of-payments grants. Its program concentrates on urban development, agriculture, health and the private sector. In addition to  - 28 - maintaining close contact with USAID, IDB and other aid agencies to ensure compatibility of programs, Bank staff have undertaken a public sector investment review which could serve as the basis for a meeting of Ecuador's creditors in 1988. PART VI - COLLABORATION WITH THE IMF 81. The Bank and the IMF will continue collaborating in the review and discussion of macroeconomic developments in Ecuador. This collaboration will be particularly important during the first semester of 1988, when significant adjustment policies are due to take place and when the Bank will supervise the compliance with the policy program for the release of the second tranche. The Fund's evaluation and recommendations of short term macroeconomic policy actions and results is an important input in the Bank's own evaluation of the adequacy of the macro framework for the success of the financial policy program. Thus, the Bank will take into account the Fund's iudgement in assessing whether macroeconomic conditions warrant the release of the second tranche. PART VII RECOMMENDATION 82. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Attachments Washington, D.C. December 1, 1987  AWV7C T -29- Page 1 of 4 ECUADOR - Key Nacroeconogic Indicators trercent) -. -. ---- -... -.. --- -. ------ . ..................................... _. ._ ........... . _...... .. .--Actual--- Estimate i----------Projected----------' 1984 1985 198 1987 1988 1989 1990 1Q; SOP Growth Rate 4.2 4.5 2.- -3.2 9.2 3.6 4.4 t,- 8SN 6rowth Rate 5.9 5.1 -3.1 9.9 4.2 4.8 S.5 GNt Growth Rate 4.7 -6.1 1.6 3.8 3.4 5.3 6.4 GNP/Capita Growth Rate 2.9 2.2 -5.8 6.9 1.3 1.9 2.6 Dett Servite (Gillian US S1 1144 1060 1Q69 1080 1154 11a2 1141 1!' Debt Serviceflls 38.5 31.9 40,8 42.8 34.0 32.9 30.3 2!. Dent Service/SDP 10.9 8.5 8.9 10.a 9.9 9.2 8.- 8. 6ross Investaent/WDP 18.3 18.6 18.3 19.6 18.0 17.9 17.9 17.9 Dosestic SavingsG6OF 26.4 28.5 21.0 19.9 22.7 21.8 22.3 23.1 National Savings/GDP 15.9 19.8 13.8 13.0 16.1 15.7 16.4 V7.7 -arginal National Saving% Rate 1.1 1.0 -1.0 1.4 0.1 6.3 0.4 Public Investeentt4DP 7.1 8.6 9.3 7.9 7.7 7.6 7.6 Public Savingsl6DP 8.6 4.5 0.0 4.5 5.5 6.5 9 ' Private tnvesteent/GDP 9.6 8.2 8.8 8.6 8.7 8.8 a.9 Private Savings/SDF 11.2 11.5 13.0 11.6 10.2 9.9 10. Ratio of Public/Private Investernt 38.3 47.0 47.6 43.7 43.1 42.6 42.2 Government Revenueu/GDP 29.2 29.2 24.5 22.0 25.0 26.3 27.0 -27.0 Government Expenditures/G0P 26.5 2b.7 28.6 31.3 28.4 28.5 28.1 27.1 Delicitc-i or Surplust+)/GDP 1.7 1.5 -4.1 -9.3 -3.4 -2.2 -1.1 -(.1 Export Srowth Rate 13.3 17.7 4.1 -18.4 39.9 -0.: 5.0 4.7 Non-traditional Export 6rowth Rate 38.8 . 6.9 23.8 34.4 13.3 11.0 9.6 1 . Eqorts/SDP 27.5 31.0 31.3 26.4 33.8 -32.5 32.7 I.LI I:port Growth Rate 1.1 7.8 -8.5 4.5 -1.3 2.6 4.7 4.6 I vortsMPDP 19.4 20.0 17.8 19.2 17.3 16.3 16.3 l." Current Account (million US S) -248 126 -64' -938 -3'v -397 -271 -47 Current Account/GOP -2.4 1.0 -5.3 -9.2 -3.0 -3.1 -2.1 -0.3 Source: Central Bank of Ecuador for historic data; Norld Bank estiates for projected data. i5-Oct-87  ANNEX I - 3n - Page 2 of 4 ECUAD3; -- BA4AhuE OF PAMEIMETS (US$ sallions at Current Pricesl ----------------Actual --------------- Est.