Ecuador - Third Power Project

CIRCULATING COPY RESTRICTED TO BE RETURNED TO REPORTS DESK Report No. P-1018 IFIELIEL COPY This report is for official use only by the Bank Group and specificaDy authorized organizations or persons. It mnay not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report. INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF ECUADOR FOR A THIRD POWER PROJECT January 20, 1972  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF ECUADOR FOR A THIRD POWER PROJECT 1. I submit the following report and recommendation on a proposed credit to the Republic of Ecuador for the equivalent of US$6.8 million for a third power project. PART I - INTRODUCTION 2. The Bank made two loans in 1956 and 1957 (137-EC and 177-EC, respectively), totalling $10 million, to assist Empresa Electrica "Quito" S.A. (EEQ) in financing the first stage of the Cumbaya hydroelectric project. These works were completed by the end of 1961 and have been operating satisfactorily. A deterioration of EEQ's finances in the early 1960's, mainly due to delays in increasing tarif's, made it necessary for the government to meet debt service payments for more than two years on the two Bank loans. EEQ's financial condition imp-oved after a tariff increase was finally allowed in January 1964, which permitted the company to resume service of its debt and to finance the second stage of the Cumbaya project mainly from its own resources. 3. In 1967, EEQ approached the Bank Group for assistance in financing further power development. The mission Twhich appraised the Nayon project for the first time in early 1969 found the company's financial position weak, and recommended a tariff increase. The company felt the government was not prepared then to follow this recommendation, ho-wever, and IDA decided not to consider financing the project at that time. EEQ's new management, appointed in August 1970, approached the Bank Group again later that year. Realizing the need to improve EEQ's finances, the new management pressed for an average 35 percent tariff increase, which was finally approved by the government in April 1971, and the Bank was then informed that the full 35 percent increase would go into effect beginning May 1971. The appraisal was completed and negotiations were conducted on this basis. In actual fact, however, although the new rates were charged in May, EEQ and the government subsequently reversed the increase and agreed instead on a phased implementation of the new rates, to be completed by December 1971. EEQ has confirmed that the billing in January 1972 includes the full 35 percent rate increase. Before the credit agreement is signed, however, EEQ will be required to submit its new schedule of rates. EEQ agreed during negotiations to apply for any  -2- necessary further adjustments in its tariffs (and the government agreed to grant such adjustments) to enable EEQ to earn a minimum return of 8 percent on its net fixed assets in operation. This should enable EEQ to make a reasonable contribution to its capital expansion program from its own funds. 4. The Third Power Project was reappraised in January/February 1971, and negotiations were held in Washington from June 30 to July 13, 1971. Ecuador was represented by Mr. Orlando Gabela, Minister-Counselor at the Embassy of Ecuador, Mr. Raul Sagasti, Deputy Director of Public Credit in the Ministry of Finance, and Mr. Jaime Durango, Commercial Attache at the Embassy of Ecuador. EEQ was represented by Mr. Sixto Duran-Ballen, President (also Mayor of Quito), Mr. Juan Sevilla, General Manager, Mr. Gustavo Castro, Technical Director, and Mr. Ivan Gallegos, Legal Counsel. It was agreed during negotiations that EEQ would complete credit arrangements with suppliers before submission of the proposed credit to IDA's Executive Directors. Two of these agreements (with Mitsubishi and Mitsui of Japan) have now been signed. The third, a supplier's credit for cement, had to be renegotiated when the original proposal was withdrawn. The signing of the third supplier's credit agreement will be a condition of credit effectiveness. 5. The proposed credit would bring the total of Bank/IDA lending to Ecuador to US$102.7 million (net of cancellations). A summary statement of nine Bank loans and four IDA credits made to Ecuador as of December 31, 1971, is attached as Annex I. About 50 percent of the lending ($51.6 million) has been in the transportation sector, a major part ($38.0 million) of it devoted to the improvement of Ecuador's roads network wqhere we have acted in concert with the Inter-American Development Bank and the United States Agency for International Development. As a consequence, the main roads network in the country has been substantially expanded. We have also been active in the development of agriculture (including livestock and fisheries), industry, power and education, and plan in the future (paragraphs 19 and 20 below) to substantially enlarge our involvement in agriculture and industry. In our continuing effort to assist the development of industrial and social infrastructure, the proposed credit would be the third Bank/IDA operation in Ecuador's powqer sector. 6. Of the thirteen previous operations, five made prior to 1964, comprising the two earlier loans to EEQ and three loans in the transportation sector, have been completely disbursed. Most funds under the first two livestock development operations (Loan 501-EC and Credit 173-EC) are committed and disbursements should be completed shortly. The Third Livestock Development Credit (222-EC), signed in December 1970, became effective on September 30, 1971; the number of participating banks (three thus far, and two more which have expressed interest), and the number of credit requests on hand (nearly 80 as of the end of November) point to a rapid disbursement of this credit. The Development Finance Companies Loan (721-EC), signed in February 1971, became effective on October 15, 1971. Sub-loan requests totalling about US$3.9 million have been received as of  - 3 - December 1971, and the two participating finance companies expect the loan to be fully committed before the end of 1972 and disbursed prior to the closing date of June 1974. 7. Disbursements of the remaining loans and credits lag behind the rate forecast. The Second Highway Project (Loan 379-EC/Credit 51-EC), financed jointly by the Bank, IDA, the Inter-American Development Bank, and the United States Agency for International Development is approaching completion. While all road construction is nearly finished, the maintenance program has moved at a sloTwer pace; on account of this, the closing date had to be extended by four months to April 30, 1972. On the basis of revised cost figures, a saving of about $0.6 million in the credit is expected. The government wishes to utilize this balance for the purchase of additional maintenance equipment. This proposal, which entails a modification in the scope of the project, is currently under review. If approved, a further extension in the closing date will be necessary. 8. After some initial difficulties, the Education Project (Credit 124-EC) made progress in the latter part of 1970 and early 1971; lack of sucre funds, however, became a constraint to project implementation thereafter. Effective steps to correct the situation were recently taken by the government and school construction has now been resumed. As a result of past difficulties, the credit is not likely to be fully disbursed by the current closing date of December 1972, which date may consequently need to be postponed. 9. Disbursements on the Fisheries Loan (555-EC), also behind the rate forecast, are expected to pick up momentum following the award to a Mexican shipyard of a contract for the construction of the first four vessels under the project. The consultants for the fishing ports study, included in the project, have also been selected and contract negotiations are underway. The training component of the project has not made much headway yet, but details for its quick implementation were worked out with the local authorities by a supervision mission which visited Ecuador in early December 1971. The above delays may require postponement of the present closing date of October 1974. 10. Fiscal difficulties affecting the ready availability of comple- mentary local financing and weaknesses in the administrative machinery have been largely responsible for delays in the implementation of some of the above projects. However, improvements in the government's revenue prospects from petroleum exploitation (paragraphs 12 - 19 below), and in the instruments of fiscal management recently introduced, should help to overcome delays in future lending operations. The government has also taken steps to centralize control over public credit, the major economic ministries have been reorganized on more rational lines, and a special trust funds mechanism has been set up in the Central Bank for the separate administration of certain types of development funds, including external loans and credits.  - 4 - 11. IFC's total commitments through December 31, 1971, amounted to $2.2 million, consisting of a combined investment and loan of $2 million for a textile company and an investment of $0.2 million in a private development fLnance company. IFC's present holdings amount to $1.1 mil- lion. PART II - THE EC(NOMY 12. An economic report entitled "Current Economic Position and Prospects of Ecuador" (WH-208a) dated September 22, 1971, was distributed to the Executive Directors on October 15, 1971. The report observed that government revenues and the balance of payments will benefit greatly from the petroleum sector which will start operations in mid-1972. Based on these expectations, the report concluded that prospects for achieving a satisfactory growth rate over the medium term are favorable. 13. The opportunities that petroleum development offers for the country's growth are substantial. These opportunities would be further enlarged if the present intensified exploration for additional oil resources proves fruitful. However, the increased capacity to import resulting from petroleum exports poses new kinds of issues for Ecuador's development strategy. There is a danger that petroleum development might weaken fiscal discipline and encourage rising government expenditures. The income effect of oil exports is likely to put pressures on costs and prices within the country; while strengthening the balance of payments, oil exports may mask unfavorable developments in the price-cost relation- ship and competitive position of Ecuador's basic export crops. Also, as the demand for food grows in the face of increasing population and income, there may be a tendency for Ecuador to neglect agriculture and become a large-scale importer of foodstuffs. Finally, once the construction period is over,the petroleum industry would offer only limited direct employment. To increase employment and to overcome basic limitations of the economy it is necessary that activities other than oil development be improved and expanded and the economy diversified. 14. Largely due to an enterprising private sector, Ecuador has maintained a rate of growth averaging 6.7 percent over the period 1966-70. Manufacturing, at 8 percent per year, has contributed substantially to this growth, with agricultural production registering increases of less than 3 percent a year through 1969, although making a strong recovery in 1970. The aforementioned economic report observed that, taking into con- sideration the irapact of petroleum development, an 8 percent growth rate for GDP (excluding the petroleum sector) can be achieved over the period 1971-76. To achieve this rate of growth it would be necessary to increase investment, and to reverse the downward trend of domestic saving by limiting the growth of public sector current expenditures to no more than 8 percent per annum, and assuring conditions conducive to private saving. Over the period 1971-76, national saving could thus finance about 62 percent of domestic investment compared with 49 percent in 1968-70. Net capital inflow would finance around 38 percent of total investment over 1971-76. The GDP  growth projection would call for' the implementation of a sound public investment program aimed at economic diversification and building up of infrastructure in support of private sector development. Yearly increases of 15 percent in public sector investment are feasible; it is expected that public investment expenditures would rise from 4.0 percent of GDP at present to 5.4 percent in 1976. The two sectors where a major effort will need to be concentrated are agriculture for the domestic market, and resource-based industries producing for the domestic market as well as for export to the Andean Group countries. The prospects of growth of traditional exports - 85 percent of Ecuador's earnings are presently derived from bananas, coffee and cacao - are not favorable. At the same time, a rapid growth of population and higher income levels resulting from petroleum development will generate increases in the demand for food greater than those in the past. Unless production for the domestic market is therefore encouraged, the country will become increasingly dependent on food imports. Ecuador has the necessary resource-base; positive action is, however, needed to relieve constraints on domestic agricultural pro- duction. The manufacturing sector, despite its rap-d growth recently, is of limited scope at present. It is concentrated mostly in the production of consumer goods for the domestic market, mainly food products, beverages and textiles. Although steps have recently been taken to modernize and expand the factory sector, handicrafts still account for about 37 percent of manufacturing output and 70 percent of manufacturing employment. Any future development of this sector will have to take account of the oppor- tunities offered by the Andean Market, in addition to domestic requirements. The government has already set up an Institute of Fbreign Trade and Inte- gration to coordinate its integration activities under the Andean Pact, and to develop and execute export promotion policies. 15. It is clear from the foregoing that the Ecuadorian economy continues to suffer from substantial structural deficiencies. These deficiencies would have a greater effect after oil revenues stabilize in the mid-1970's, as is now expected. The urgent need, therefore, is to expand the economic and social infrastructure and diversity the economy, with emphasis on agriculLure and industry, and to develop non-traditional exports. This need will remain even if the oil boom continues beyond 1976 and must be met over the next five or six years. 16. Developments in the economy as a whole have been somewhat mixed since the last Bank economic mission visited the country in early 1971. Agricultural output has maintained its growth in 1971, exports have reached record levels, and investment expenditures by oil companies have made a significant impact on income and employment. Fiscal disequilibrium has, however, reasserted itself in the last 6-8 months, and has largely eroded the salutary effects of the devaluation of the sucre in mid-1970 and the accompanying fiscal measures. Despite a satisfactory growth of government revenues, a rapid increase in current expenditures mainly in the form of wages and salaries, resulted in a substantial fiscal deficit. Central Bank financing of the deficit-produced excess liquidity spilled over into the balance of payments and has led to a heavy loss of foreign exchange.  - 6 - 17. The government is now attempting to correct the fiscal imbalance and to rectify the reserve position through the adoption of several measures. It has recently instituted a budgetary reform aimed at simplifying the procedures for earmarking taxes, which had in the past made fiscal manage- ment exceedingly difficult and contributed to the endemic fiscal deficits of the central government. The new system provides the government with more effective control over the revenues it collects. While no additional tax measures have been taken, the temporary suspension of the issuance of Tax Credit Certificates, the inordinate growth of which in the last several months resulted in substantial revenue losses, should afford the central goverrment some relief. The government has been also negotiating a loan from U.S. commercial banks to cover part of the fiscal deficit. 18. To protect the balance of payments, monetary authorities re- established in November 1971 a dual exchange rate system, which had been abolished as part of the stabilization program accompanying the devaluation of the sucre in 1970. The dual exchange rate system will comprise an official market based on the par value (US$1 = S/25) for purchases and sales of foreign exchange related to merchandise trade and government and other specified transactions, and a free market with fluctuating exchange rates (US$1, =3/27.50 at end-December, 1971) for all other transactions. The authorities have also reinstituted advance import deposits on essential commodities, which comprise about two-thirds of total imports, and raised existing import deposits on nonessential and luxury items. The imposition of advance import deposits has in the past succeeded in quickly arresting loss of reserves and may do so again. It is, however, too early to assess the impact of the new measures. Nevertheless, viewed in the context of the country's favorable medium term prospects, the present situation should not materially affect Ecuador's creditworthiness as evaluated in the Bank's latest economic report. Ecuador's low per capita income and relatively high fiscal burden which limited the scope for a rapid and substantial increase in public savings, have justified some lending from IDA. The prospective level of oil revenues changes this situation and after the credit now proposed, no further IDA lending is contemplated at this time. PART III - FUTURE DIRECTION OF BANK GROUP LENDING 19. In accordance with the requirements of the Fcuadorian economy discussed in paragraphs 14 and 15 above, future Bank Group lending will emphasize agriculture and industry. Our activities in the agricultural sector will aim at assisting the government to promote crop diversifica- tion, sustain agricultural employment, and increase production as well as productivity from agricultural land to avoid increasing dependency on food imports. An agricultural sector review has lately been completed by an IERD/FAO Cooperative Program mission, and another Cooperative Program mission has been assisting the government in preparing an agricultural credit operation for Bank financing. Further assistance in fisheries and forestry development to promote export diversification is also expected.  - 7 - The United Nations Development Programme will finance a feasibility study, with the Bank as executing agency, for a forestry development project in the Northwest. In order to improve Ecuador's absorptive capacity in the agricultural sector, the government has recently asked the Bank to participate with other international lending agencies in helping to formulate a four-year investment program for the sector. 20. On the industrial side, IFC has discussed the possibilities of investing in a cement plant, and may have further opportunities for financing some of the rapid industrial development expected in the coming years. A Bank mission has been reviewing the requirements for industrial financing in preparation for further loans to development finance companies. An economic mission, planned for February 1972, will include specialists in petrochemicals, electric power and industry to fur'ther help define the Bank's role in the future growth of these sectors in the light of petroleum development and its impact on the economy. The Bank would also expect to play a continuing role in the transportation and education fields, and support in some measure the necessary further expansion of the electric energy sector which is to be assisted by the credit now proposed. PART IV - THF POIWER SECTOR 21. The poTwer sector in the country is highly fragmented and facilities in general are overloaded and badly maintained. Statistics for some sixty companies with plants larger than 100 kw (there is also an undetermined number of companies owning smaller plants) show a total installed capacity at the end of 1969 of 170 NW. Based on these statistics, Ecuador's per capita generation at the end of 1969 was only 142 KWh, compared with Latin America's average of about 450 KWh. The two largest power companies, Empresa Electrica del Ecuador (EMELEC), a subsidiary of Boise-Cascade of the U.S.A., and EEQ, serve the areas of Guayaquil and Quito, respectively. 22. Electricity consumption throughout the country has been in- creasing at about 10 percent a year and installation of additional generating capacity has not been keeping pace. In the coming years, oil development is expected to stimulate a rapid growth of industry, causing the demand for power to increase at a faster rate. In recognition of this development and the crucial importance of power in industrial infrastructure, the government has earmarked 50 percent of royalties from oil production (royalties are expected to average $18 million per year) during 1972-75, and 35 percent thereafter, for a national electrification fund. The major part of this fund will be channelled through the Instituto Ecuatoriano de Electrificacion (INECEL), the state power company and regulatory agency. INECEL is expected to finance, construct and operate from 1975-76 onward practically all new generating and transmission facilities in the country, at the same time progressively integrating the many existing utilities. It will thus become in due course Ecuador's national power company. INECEL has preliminarily defined a development program for generation and transmission to meet main power requirements in the  _- a - country through 1975-89. Its first major project is the 65 MW Pucara hydro plant of the Pisayambo development. The Inter-American Development Bank approved in November 1971, a $27.7 million loan from its Fund for Special Operations to assist in financing this project, which is expected to be completed in 1975 and would interconnect and supply electric energy to the main towns in the central region of Ecuador, including Quito. PART V - THE FROJECT 23. A report entitled "Appraisal of the Third Power Project, Ebpresa Electrica Quito S.A. Ecuador" (PU-73a) dated January 20, 1972 is bieing circulated separately. The proposed credit would assist in financing part of the foreign currency costs of EEQ's 1971-75 expansion program intended to provide adequate generation and distribution capacity until 1975, when INECEL hopes to complete the first stage of its Pisayambo development (paragraph 22). The proposed credit would be made to the Republic of Ecuador on standard IDA terms. Ecuador would lend the proceeds to EEQ for twenty-four years including four years of grace, with interest at 7