Ecuador - Second Development Finance Companies Project

CIRCULATING COPY 10T BE. RETURNED TO REPORTS DESK DOCUMENT OF INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT Not For Public Use Report No. P-1231a-EC REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF ECUADOR FOR A SECOND DEVELOPMENT FINANCE COMPANIES PROJECT June 14, 1973 This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization.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.  RATE OF EXCHANGE Currency Unit Sucre (S/) Us$1 = S/25 S/I = uS$o.o4 sA,ooo = us$40 S/l,OOO,OOO = us$40,ooo Ecuador Fiscal Year - January 1 to Decemnber 31  REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF ECUADOR FOR A SECOND DEVELOPMT FINANCE COMPANIES PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Ecuador for the equivalent of $20 million to help finance productive investment projects in Ecuador. The proceeds of the loan will be relent through Banco Central to Comision de Valores-Corporacion Financiera Nacional (CV-CFN) and Ecuatoriana de Desarrollo S.A. - Compania Financiera (COFIEC), to be used for sub-loans to enterprises with terms up to 15 years, including a grace period not exceeding three years. Sub-loans would carry an interest rate of 12 percent per annum plus a supervision fee of not less than one percent per annum. Repayment to the Bank will be based on a composite amortization schedule substantially conforming to the aggregate of amortization schedules corresponding to the individual invest- ment projects; interest would be at 7 1/h percent per annum. PART I - THE ECONOMY 2. A report entitled "Current Economic Position and Prospects of Ecuador" (No. l1a-EC), dated June 1, 1973, is being distributed to the Executive Directors separately. The report observes that government revenues and the balance of payments will benefit to a great extent from petroleum exports which started in mid-1972. It concludes that prospects for achiev- ing a satisfactory growth rate over the medium-term are very good provided the Government follows appropriate policies. Resolute action is required to increase the absorptive capacity of the public sector and enable it to mobi- lize available resources to come to grips with the country's development needs. Annex I shows the main economic and social indicators. 3. Although a precise estimate of the country's petroleum resources does not yet exist, it is clear tnat they would provide an opportunity to achieve both a faster rate and a more balanced pattern of economic growth. The anticipated high level of foreign exchange earnings from petroleum exports strengthens Ecuador's creditworthiness for external borrowing as well as its capacity for direct financing of the imports required to support the development efforts. Substantial tax revenues from petroleum should strengthen public finances, thereby enabling the Government to support a high level of develonment exDenditures. 4. However, there is also the danger that the petroleum boom will weaken fiscal discipline, encourage unnecessary imports and at the same time put pressures on costs and prices within the country, which could undermine Ecuador's competitive position in both agriculture and industry. As the demand for food grows due to increasing population and income, a  - 2 - tendency may develop for Ecuador to become a large-scale importer of foodstuffs, rather than develop its agricultural potential. Moreover, the petroleum industry as such contributes relatively little to the expansion of employment opportunities -- a priority objective in view of the 3.4 percent per annum population growth rate and the existing widespread underemployment. Therefore, to increase employment and to overcome the basic 'imitations of the economy, it is urgent to diversify the economy. Expanding and improving activities other than oil production will permit the country to continue self-sustained development when the expansion of the petroleum sector eventually levels off. 5. Furthermore, although petroleum will play a leading role during the next several years in terms of its contribution to aggregate growth, its direct effect on the standard of living of the population will be small in the absence of well-designed government programs. Thus, spreading the opportunities made possible by the petroleum-generated wealth over large segments of the population will be one of the major challenges facing the Ecuadorian authorities in the 1970's and appropriate development strategy for the 1970's will have to focus on removing severe constraints to output expansion and income redistribution. 6. Balance of payments equilibrium at the prospective economic growth rate of 10 percent estimated in the above-referred economic report, will re- quiire gross capital inflows totalling over $1 billion in the period 1973-77, compared with a total of $675 million in 1967-71. Direct foreign investment, 75 percent of which is likely to be in the petroleum sector, is expected to cover almost 60 percent of these requirements; gross public sector inflows would provide the balance, averaging around $90 mil'Lion annually. Of this, suppliers credits are estimated to amount to some $24 million annually (only slightly higher than the levels of the past several years), and the remainder would come from external development financing agencies. Because of- large amortization and interest payments, the net transfer of public external re- sources over the period would be of the order of $1:10 million or some $22 million annually. These levels of external financing would permit foreign exchange reserves to rise to a more secure level equivalent to almost four months of imports by 1977. The projected pattern of financing would also lead to an improvement in the structure of the public external debt; on the basis of reasonable assumptions about terms of new 'Lending and the foreseen large expansion in exports, the debt service ratio is expected to fall from 15 percent of exports of goods and services in 1972 to a little over 10 per- cent in 1977. The Bank/IDA share in total debt service payments would at the same time increase from 10 to slightly over 14 percent. 7. Despite these favorable prospects, Ecuador will for some time remain one of the less developed countries in Latin America. While the Government has decided to tackle some of the obstacles which have tradition- ally hampered the developmnit of the country - low savings capacity of the public sector, limited government power to direct the economy, insufficient growth in the rural sector, and slow development of non-traditional exports - the solution of these problems will require substantial changes in the economic and administrative structure which can only be achieved gradually.  - 3 - During the transition period, and pending a more precise determination of the country's petroleum production prospects, Ecuador may still need to receive part of her foreign assistance under concessional terms. 8. In the longer ternconditions for lending to Ecuador will depend on actual developments and perspectives in petroleum and on the ability of the Government to meet the challenges created by them. The degree of execution of -&he Five-Year Development Plan, recently approved by the Govern- ment, will be a good indication of the Government's success in fostering Ecuador's economic and social development. Explicit aims of the Development Plan are the improvement in the situation of the poorest sectors of the popu- lation; the strengthening and expansion of the country's productive capacity; and the creation of exployment opportunities. PART II - BANK GROUP OPERATIONS IN ECUADOR 9. Since 1954 the Bank and IDA have made nine loans and five credits to Ecuador for a total of $102.7 million, net of cancellations. Of this amount, about 50 percent has been for transportation, to finance the expan- sion of Ecuador's road network and a new port at Guayaquil; 20 percent for agriculture, to develop the country's livestock and fisheries sectors; 16 percent for power generation and transmission for the City of Quito; 8 percent to support the industrial development activities of two development finance companies, and the remainder for education. As of April 30, 1973, a total of $25.9 million remained to be disbursed on nine loans and credits. In addition to the proposed loan for a second development finance companies project, a $5.5 millhon credit for irrigation is to be presented shortly for your approval. IFC's total commitments to date amount to about $4.0 million - all in industry - of which $2.4 million is still held by the Corporation. A summary statement of Bank loans, IDA credits and IFC in- vestments as of April 30, 1973, and notes on ongoing projects are attached as Annex II. 10. Apart from the Bank Group, external development financing is pro- vided principally by USAID and IDB. External financing by sector and source as of the end of 1972 is summarized below: (In millions of US dollars) IBRD IDA IDB AID Lending 1954-1964 54.0 8.0 35.3 67.7 Lending 1965-1972: T777 2T7. Transport - .0 Power 6.8 16.2 3.6 Education 5.1 4.1 5.3 Health and Sanitation 19.6 / 2.8 Agriculture & Fisheries 9.3 11.5 12.3 10.8 Industry 8.0 21.2 8.0 Other 4.2 11.5 Total 71.3 31.4 130.9 109.7 I/ Another $29.7 million were approved but not signed in 1972.  -4 - AID loans are normally for a term of 4O years with interest at 2 to 3 percent. IDB extends most of its loans to Ecuador from the Fund for Special Operations; they carry 2 percent interest and terms of up to 40 years with ten years of grace. 11. In line with the external financing requirements discussed in paragraph 6 and assuming a continued government effort to adopt appropriate sector policies and achieve adequate levels of public savings, we would ex- pect Bank Group financing to increase substantially in the period 1973-75. Since the Government is now likely to have less severe budgetary constraints for local financing owing to petroleum development, the main limitation to Bank lending to Ecuador in the future may very well be the Government's capacity to identify and prepare high priority development projects. To help overcome this constraint, we plan to include an adequate component of technical assistance in our loans. 12. In spite of the expected expansion of petroleum output in the next few years, Ecuador is likely to remain a primariLy agrarian economy for some time, and the performance of the agricultural sector will be a decisive element in the country's economic and social development. We intend, there- fore, to expand our lending activities in agriculture. Our operations in the sector will aim at assisting the Government to promote crop diversifica- tion, sustain agricultural employment, and expand production to avoid in- creasing dependency on food imports. Recognizing the high level of rural poverty in Bcuador, we will give priority to projects which directly benefit the poorer farmers; the first example of this type of undertaklng is the Milagro Irrigation Project, to be presented for your approval shortly. We will also be reviewing with the Government, on completion of a German-financed feasibility report in the summer, possible assistance to the Chone-Carrizal project in the highly populated and depressed area of Manabi Province, which is likely to entail a broad-based program of agricultural development with irrigation. Further support to the development of livestock production is envisaged through a fourth operation, currently being prepared. An agricul- tural credit program is also under consideration; however, its timing de- pends on progress in similar credit operations being financed by AID. The Bank will also act as Executing Agency for the UTNDP in a feasibility study to develop 3cuadorls rich forestry resources in the north-western coastal plain. 13. With respect to industry, besides the proposed development finance companies loan, the Bank is planning to participate in the financing of small- scale industries to support the Government's efforts to broaden the industrial base and create additional employment opportunities. In the energy sector, we are considering a fourth power project to help expand Quito's generation and transmission system, and we have had discussions with the Instituto Ecuatoriano de Electrificacion (INECEL) regarding possible assistance in carrying out some projects included in INEEL's 1973-78 development program. In the area of transportation, further Bank participation in the development of the country's road network is expected to result from a highway master plan being drawn up with Bank/IDA financing (Loan 379-EC/Credit 51-EC). Finally,  in the social sector, the Government is currently preparing for possible Bank financing a second education project identified with assistance from UNESCO in the fall of 1972, and we have had preliminary discussions with the Ecuadorian authorities on possible sites and services and water supply projects. In proceeding with further lending, the Bank will continue to stress the importance of strengthening the fiscal system and the institu- tional set-up, as well as the need for undertaking an effective program to improve standards of living and development opportunities for the poorest segments of the population. PART III - INDUSTRY IN ECUADOR 14. The contribution of Ecuador's manufacturing sector to output, export diversification, employment and income distribution has so far been limited. The main constraints to a more vigorous expansion of the sector have been the limited size of the domestic market, insufficiency of trained human resources, inadequate physical infrastructure, and the absence of coordinated government action to stimulate and regulatemanufacturing expansion. 15. In the 1950's, total manufacturing value added increased at an annual rate of 4.5 percent, slightly below the GDP growth rate of 4.8 per- cent. A number of incentives (mainly exoneration from import duties on capital equipment) pro,&ed by Ecuador's Industrial Development Law in 1957, and the commencement of industrial credit operations by CV-CFN and COFIEC in the mid-1960's made possible a more rapid expansion of the sector, leading to the development of new industries in metal products, machinery, chemicals and pharmaceuticals, paper, and synthetic fibers. As a result, the growth of value added in manufacturing accelerated in the 1960's to an average of 6.3 percent against a GDP increase of about 4.5 percent, and manufacturing's share of GDP increased from about 15 percent in the 1950's to around 17 per- cent in the 1960's. This growth in manufacturing was also accompanied by increased emphasis on intermediate and capital goods: whereas consumer goods accounted for two-thirds of factory output in 1964, they represented less than 55 percent of the 1971 output. 16. Until the mid-1960's no long-term credit was provided by financial 4rstitutions in Ecuador, except for some very limited amounts granted by the Nlational Development Bank (ENF) to small industries. Extensions of short- term credit on a rollover basis by commercial banks met some of the medium- term needs, but only financially strong enterprises benefitted from such extensions. However, since the mid-1960's, when CV-CFN and COFIEC started to operate, the availability of long-term credit to industry has improved markedly, but it is still not sufficient to meet all needs. In 1971 long- term financing represented less than 15 percent of the total credit advanced to manufacturing industries by the financial system.  17. Under the impetus of the rapid development of the petroleum sector, the investment climate is becoming increasingly favorable and the demand for industrial finance is accelerating. Moreover, together with Bolivia, Ecuador enjoys preferential treatment in various ways under the Andean Pact regime: ic offers more liberal terms for foreign investment and is better placed within the group in terms of progressive elimination of tariff barriers. To e-ploit these opportunities, the Government plans a more aggressive role in n,irecting industrial growth toward priority areas such as agroindustries a; metal and chemical industries. The Government has also reserved certain _ ic industries for State ownership, and intends to broaden the industrial base by expanding long-term credit programs so as to reach not only the large and medium-size enterprises, but also the small entrepreneurs. PART IV - THE PROJECT 18. A report entitled "Appraisal of the Second Financieras Project" (No. 122a-EC,, dated June 6, 1973) is being distributed seDaratelv. The main features of the project and the proposed loan are summarized in Annex III. 19. The first Bank loan (721-EC) for the two finance companies, amount- ing to $8 million ($4 million to each company) was approved by the Board in December 1970 and the loan agreement was signed in February 1971. Because of delays in the fulfillment of the conditions of effectiveness, the loan became effective only in October 1971, The high demand for long-term industrial credit resulted