Colombia - Agricultural Sector Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 15884 PROJECT COMPLETION NOTE COLOMBIA AGRICULTURAL SECTOR CREDIT PROJECT (LOAN 3575-CO) June 28, 1996 Natural Resources Management and Rural Poverty Division Country Department III Latin America and the Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Currency Equivalent Currency Unit = Colombian peso (Col$) Exchange US$1.00 = Col$ 747 (1993) = Col$ 1070.25 (as of June 25, 1996) Weights and Measures Metric System Fiscal Year of the Government of Colombia January 1 - December 31 Glossary of Abbreviations BR Banco de la Republica CA Caja Agraria FINAGRO Fondo para el Financiamiento del Sector Agropecuario FOGAIN Fondo de Garantia de Instituciones Financieras FPF Financial Policy Framework GOC Government of Colombia ICR Implementation Completion Report LA Loan Agreement PCN Project Completion Note SAR Staff Appraisal Report  FOR OFFCIAL USE ONLY PROJECT COMPLETION NOTE (PCN) COLOMBIA AGRICULTURAL SECTOR CREDIT PROJECT (Ln. 3575-CO) This is the Project Completion Note (PCN) on Colombia-Agricultural Sector Credit Project (Ln. 3575-CO). It was prepared by Ms. Anne del Castillo, Consultant, and reviewed by Messrs. Jonathan Parker, Acting Chief, (LA3NR), and Robert Crown, Project Adviser, (LA3DR). This PCN has been prepared in lieu of a Implementation Completion Report (ICR) because no disbursements took place and the Loan, at the Borrower's request was cancelled effective January 1, 1995. It is based on internal Bank memoranda, supervision reports and interviews with Bank staff associated with the Project. A. Backzround 1. The project has its origin in the Financial Policy Framework (FPF) agreed to between the World Bank and the Government of Colombia (GOC) in 1991. The FPF was a set of guidelines and actions to be taken by the GOC to liberalize its financial sector, including market-determined interest rates, and encourage the participation of private institutions in the financial sector. Under the umbrella of the FPF, the Bank and the GOC had agreed in principle on a set of financial intermediation loans, including the Agricultural Sector Credit Project, which covered financial institutions in that sector. The project funds were intended "to help the GOC to adjust, during a transition period, the provision of agricultural credit towards a market based framework" and inter alia "to promote, encourage and facilitate the voluntary lending by commercial banks to the agricultural sector" . 2. The project was appraised in April, 1992. On August 13, 1993, the Loan Agreement (LA) for the US$250 million World Bank loan was signed. The project was declared effective on November 10, 1993. The original closing date was June 30, 1999. Upon the Borrower's request, the loan, having had no disbursements, was effectively canceled on January 1, 1995. The primary reason for the Loan's cancellation was the Government's lack of compliance with the dated covenants and conditions, contained in the LA, regarding the scheduled liberalization of the agricultural lending rates. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed wiLhout World Bank authorization.  2 B. Proiect Obiectives and Description 3. Project Objectives. The project's objective was to encourage the private financial sector to extend loans, especially longer-term loans, to agriculture. To achieve this, the project intended to introduce several financial reforms, related to the agricultural sector, which were consistent with those reforms agreed to between the World Bank and the GOC in the FPF. Specifically, the project proposed to support the Government's actions to: (i) implement the agreed program of financial and trade reforms; (ii) reduce and eventually phase-out forced investments', while promoting term-lending and voluntary lending by commercial banks to the agricultural sector without risking a significant decline in lending resources; (iii) monitor and analyze agricultural credit demand and supply, and recommend measures so as to ensure a smooth transition to a market-based credit system; and (iv) transform Caja Agraria (CA) into an efficient rural financial institution. 4. Project Description. The project would provide loan funds to Agricultural Financial Fund (Fondo para el Financiamiento del Sector Agropecuario, FINAGRO), the country's principal second-tier rediscount facility operating in the agricultural sector, to rediscount agricultural medium- and long-term loans made by commercial banks to finance investments by farmers and agro-industry. In addition, the project would encourage reforms to increase the efficiency and financial position of the CA, Colombia's largest bank and dominant agricultural lender. C. Maior Factors 5. Policy Conditionality. The project contained a number of policy conditions related to financial operations in the agricultural sector. The LA permitted FINAGRO to draw down the first tranche2 of US$100 million until June 24,1994, when there would be a mid-term review. As forced investments continued to provide FINAGRO with needed funds, FINAGRO never met criteria for the release of the funds from the first tranche. Access to the second tranche, US$150 million was to have been conditioned on: (i) full liberalization of final interest rates to medium and large farmers, no later than nine months after project effectiveness; (ii) the restructuring of the CA, as measured against key performance indicators; and (iii) the continuation of a satisfactory trade regime. 6. In September, 1993, the Central Bank (BR) issued regulations, fully satisfying the first condition. These were to have been implemented by April 1, 1994, five months prior to the date, August 10, 1994, required by the dated loan covenant. However, in Under the forced investments, each bank was obligated to buy from the Central Bank bonds at below market rates to the extent that the bank's agricultural portfolio was below a pre-determined target level. Forced investments represented the primary source of funds for agricultural lending. 2 As this was not an adjustment operation, the term "tranche" is used here to describe amounts available for rediscount financing when agreed ad hoc criteria, conditions or other covenants were met.  3 December 1993, Congress nullified this measure by passing Article 12 of Law 101, which rolled back lending rates to all farmers and postponed any interest rate liberalization at least until January 1996, with a caveat that future interest rates would remain below commercial rates. As a result, as of August 10, 1994, the Government had not satisfied the dated covenant related to interest rate liberalization. It should be noted that, by said date, FINAGRO had not yet taken the required administrative actions, on its part, so as to enable it to file withdrawal applications under the first tranche. 7. In addition, the CA failed to meet the performance indicators as agreed upon in its Corporate Plan. According to the LA, this would have been sufficient justification for loan cancellation. But, the Bank decided that cancellation at that time would foreclose the possibility of achieving the long-term goal of promoting financial reforms. Nevertheless, the Bank needed to send the GOC a clear signal indicating the seriousness of this default. On March 1, 1994, the Bank disqualified the CA as the primary financial intermediary for the project due to its failure to implement an acceptable Corporate Plan and meet key performance indicators. 8. In September 1994, while BR challenged the constitutionality of the congressional prerogative to preempt a BR regulation, the Ministers of Finance and Agriculture requested the Bank to grant a waiver and postpone the date for the liberalization of interest rates to January 1996. This would have permitted FINAGRO to use the first tranche before the Government had implemented its interest rate liberalization. In return, should Article 12 be declared unconstitutional, the Ministers committed themselves to begin the liberalization process sooner. 9. In October 1994, based on the GOC's commitment, the Bank agreed to give FINAGRO access to the loan's first tranche. A month later, Article 12 was declared unconstitutional. But, faced with rising market rates and mounting producer organization opposition, the government, unable to fulfill its commitment, maintained rate controls. GOC's actions, thus, invalidated the basis for the Bank's decision to make available the first tranche. 10. Request for Cancellation. In April 1994, the Borrower had informed the Bank of its intention to request cancellation. The Bank, desirous to have a serious dialogue on financial reforms with the incoming Administration, persuaded the Borrower to delay its request. However, once installed, the new Administration proved to be no more able to contend with the powerful agricultural lobby and implement the reforms than did its predecessor. On July 7, 1995, in response to the formal GOC request dated, May 12, 1995, the loan was retroactively canceled, effective January 1, 1995. By then FINAGRO still had not taken the actions referred to in para. 7. To compensate the Borrower for the costs incurred by delaying its cancellation request, the Bank, after deducting the costs associated with project appraisal and supervision, rebated to the Borrower the balance of the commitment fees paid.  4 11. Designation of FINAGRO as the Borrower and Implementing Agenc . As the project was originally designed, the GOC would have been the Borrower and would have on-lent project funds to FINAGRO, a financial institution under the Ministry of Agriculture. This approach appeared to be reasonable given that: (i) the GOC would be able to take full responsibility for the satisfaction of loan conditionality; (ii) the GOC could closely monitor the reform process of the CA through the on-going supervision of the Guarantee Fund for Financial Institutions (FOGAFIN); and (iii) FINAGRO was a new and relatively weak financial institution (established in 1991), having recently assumed the debt of other public agricultural credit institutions, including the CA. But as a result of a request made by the Colombian delegation at the negotiations and against the objections from the Bank's Legal Department, the Loan Borrower was switched from the GOC to FINAGRO. 12. The designation of FINAGRO as Borrower and project implementing agency proved ill-advised. As the very institution the project intended to phase-out, FINAGRO's interest in obstructing, rather than facilitating, the project should have been foreseeable. But, the project rationale was that FINAGRO's need for funds would force it to adopt project reforms. Unfortunately, with the passage of the legislation which continued forced investments, FINAGRO's financial autonomy was consolidated, thereby eliminating any immediate need FINAGRO might have had to draw down the Bank's credit line. 13. Further, FINAGRO had limited ability to effectively pressure CA to improve its performance targets, as CA did not fall under the authority of the Ministry of Agriculture, but rather under the FOGAFIN. Nevertheless, CA compliance with loan conditions was crucial to the project, as CA was to have been a primary conduit of project funds flowing from FINAGRO to the sector and was heavily indebted to FINAGRO. D. Lessons Learned 14. The SAR accurately identified possible backsliding on the agreed financial reforms as a major risk to successful project implementation. While the Bank had performance covenants in the LA to deal with this eventuality, the Bank could have assessed better the risk's probability and taken measures to reduce its occurrence (see para. 17). The Bank, aware of the political sensitivity of the reforms, was prudent to protect the project against a possible retreat by front-loading the project with conditionality and providing for recourse within the Mid-Term Review. 15. The project's chances for success appeared strong as the project had the full support of the BR, an independent agency with authority over national financial sector policies. While the Bank could not have been expected to have anticipated the passage of an unconstitutional legislation blocking the proposed reforms, the Bank could be faulted for having under-estimated the political clout of the medium to large farmers in Colombia and the importance they placed upon their access to subsidized credit. Having two World Bank credit projects recently accept interest rate caps for the industrial sector, made the call for their removal for the agricultural sector particularly difficult.  5 16. Certain actions could have been taken which might have helped to mitigate the risk of a Government retreat on reforms. During project preparation, maintaining open communication and collaborating with all agencies and political groups directly involved in or affected by the reforms could have improved the chance of a successful outcome. In this regard, as the agricultural sector, and not the financial sector, was the most seriously and immediately affected by the reforms, preparation efforts could have focused more on identification of sectoral needs and consensus-building within the farm sector. Given that the agricultural sector was experiencing a period of low market prices for its major export commodities, as well as adjusting to the shock of trade liberalization, packages to temporarily compensate the sector for the loss of subsidized credit could have made the reforms more palatable to some political groups in the sector. As mentioned above (see para. 12-14), project implementation might have been facilitated with a more appropriate Borrower and/or project implementing agency. 17. Bank management was steadfast in pursuing the project objective of financial reform for the agricultural sector, and, at the same time, maintaining credibility and an open dialogue with the Borrower. When presented with grounds for default, the Bank prudently delayed closing the loan, deciding instead to send a strong signal to the government concerning its failure to comply with loan covenants. 18. However, after thorough consultations with two Administrations, and once it became sufficiently evident that the GOC, despite their statements to the contrary, would not be able to muster sufficient political support to implement proposed reforms, the Bank canceled the loan.      IMAGING Report Nc. 15lB64 Type: PCN