Colombia - Economic position and prospects (Vol. 1 of 3) : Main report

Report No. 696-CO Economic Position and Prospects of Colombia (In Three Volumes) Volume 1: Main Report May 20, 1975 Latin America and Caribbean Regional Office Not for Public Use FILE COPY Document of the International Bank for Reconstruction and Development International Development Association 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 It may not be published, quoted or cited without Bank Group authorization.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. CURRENCY EQUIVALENTS Currency Unit: Peso Exchange Rate Effective April 17, 1975 Selling Rate - US$1.00 = Col$30.03 Col$1.00= US$0.333 Buying Rate - US$1.00 = Col$30.07 Average Exchange Rate (Selling) 1972 153 1974 US$1.00 ColT192 Col$23.l67 co26.14 col$l.00 US$.o56 US$.0h22 US$.0382 This report is based on the findings of an economic mission to Colombia during January-February 1975, composed of F.Z. Jaspersen (Chief), R. Bacarreza (General Economist), D. Babelon (Human Resources Expert), A. Goltz (IMF), N. Hughes (Investment Adviser), H. Levy (Transport Economist, Consultant), E. Meldau (Fiscal Economist), M. Trucco (External Debt Specialist), and R. Wheeler (Agricultural Economist, Consultant).  TABLE OF CONTENTS Page No. VOLUME I - Ti MAIN REIORT MAP COUNTEY DATA SUIMARY AND CONCLUSIONS i - xii I. GROWTH AND DEVELOPMENT OF THE COLOMBIAN ECONOMY...... 1 A. Background .............. ............. 1 B. Historical Growth Patterns.................... 2 C. Development of the Productive Sector............. D. Recent Growth and the Development Challenge...... 7 II. FINANCIAL REFORM AND RESOURCE rIOBILIZATION........... 10 A. Public Finances...... ..... .. .................. 10 Reform of the Tax System................... 11 Progressivity.. ...... ........ ..... #...... 13 Resource Allocation........#............... 14 Tax Administration...... ... ... .0. .......... 1 Stability and Revenue Yields........ o....... 15 B. Private Sector Financing..O..#..................... 17 Interest Rate Policy....................... 18 Legal Reserves, Portfolio, and Investmunt Requirements.............. 19 Rediscount Policy... ........ .... ......... 19 Other Measures.......... ........ . .. 20 II. BALANCE OF PAYMENTS AND GROWTH PROSPECTS............. 21 A. Recent Performance........................... 21 B. Medium-Term Prospects.................... 2........24 C. External Capital Requirements....... ............ 33 D. External Debt Management and Creditworthiness.... 36 ANNEX 1 - THE AGRICULTUTIL SECTOR............... 1 - 14 ANNEX 2 - THE INDUSTRIXL SECTOR............................ 1 - 16 ANNEX 3 - FINANCING DEVELOPM4ENT....... ............... 1 - 41 VOLUME II - STATISTICAL APPENDIX VOLUME III - THE COLOMBIAN TAX REFORM OF 197  o P ACI ~ic OCE A N -0 -4.. r--c- .J *- .". • - ro 0-j-. C r- > . -t- - - fl - * 1 ---o 0 0 - ---'Z 1 z - f- 1Z fr ,..-3' - - r-* --- ---'- z.. > -. r rr -  age 1 of 2 pages COUNTRY DATA - COLOMBIA AREA POPULATION DOCSITY 23.0 million (mid-1972) 20.2 per km2 1,139,000 km2 Rate of Growth 3.3 (from -- per km2 of arable land 1960 to 1972) FOPULATION CHARACTERISTICS, 1970 HEALTHt 170 Crude Birth Rate (per 1,000) 65 Population per physician 2,16 Crude Death Rate (per 1,000) 11 Population per hospital bed UD Infant Mortality (per 1,000 live births) 70 INCO1E D)ISTRIBUTION, 1970 DISTRIBUTION OF LAND OWNERSHIP, 19 0 of national income, highest quintile 59 % owned by top 10, of owners -- lowest quintile 6 owned by snallest 102 of owners -- ACCESS TO PIPED WATER, 1970 ACCESS TO !LECTRICITY, 1970 of -poulation - urban 70.1 of porulition - urb,n -- - rural 25.6 1/ - rural -- ,UTRITION,. 1968 EDUCATION, 1970 Clorie intake as % of requirements 88 Adult literacy rate % 76 Per capita protein intake 50 Primary school enrollment 5 95 GNP PER CAPITA in 1973 US 16. 3/ GROSS NATIONAL PRODUCT IN 1976 ANNUAL RATE CF GROWTH ($, constant prices) US $ M1n. 1?60-6 1965-7O 1973 1 GNP at Market Prices 12,083 100.0 . 5.5 7.0 Gross Domestic Ivestment 1,955 16.2 1.5 -1 7.L -1. Gross National Saving 1,977 16.4 2.1 10.8 22.7 -7.7 Current Account Balance - 156 (1.3) - - Exports of Goods, NFS 1,870 15.5 2.1 4.1 13.8 L-7 Imports of Goods, NFS 1,880 15.6 1.9 10,2 2.2 16.6 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1970 Value Added 6/ (Factor Cost) Labor Force V. A. Per viorker US $ Mln. Mln. US $ L Agriculture 1,05 29.1 2.3 37.0 019 Te Industry 1,606 26.8 1.1 17.7 1,660 132.9 Services 2,997 66.2 2.3 38.1 1,303 126.5 Unallocated - - 0. 7.5 - - Total 6,688 100.0 6.2 100.0 1,07 100 GOVERNMENT FINANCE General Government Central Government (Col.$ Million) d of GDP (Col1 Million) of GDP 1974, 1974 192 12L4 ] L 11972-7h Current Receipts 62,786 13.6 16.1 32,022 10.0 10.3 Current Expenditure 24,076 . 9.1 16 19 . . Current Surplus 18,710 5.9 14 0 Capital Expenditures 11,916 3.7 3.9 6,502 1.6 1.5 External Assistance (Gross) 6,011 1.9 2.8 -- -- -- 1/ Coverage of population living in villages. 2/ The Per Capital GNP estimate is at 1973 market prices, calculated by the sane conversion technique as the 1972 World Atlas. All other conversions to dollars in this table are at the average exchange rate prevailing during the period covered. Preliminary. "Unallocated" consists of unemployed workers. Central, Departmental and Municipal Government. -- not available - not applicable Page 2 of 2 pages COUNTRY DATA - 0OLOMBIA Dec. Dec. Dec. Dec. Dec. Dec. MONEY, CREDIT and PRICES 1971 11 172 193 19 (Million Col outstanding end period) Money and Quasi Money 12,683 30,761 35,151 4b,711 60,005 74,888 Bank Credit to Public Sector 5,22 5,617 7,171 6,893 6,211 9,816 Bank Credit to Private Sector 12,027 h0,025 47,132 56,579 71,913 91,650 (Percentages or Index Numbers) Money and Quasi Money as % of GDP 21.1 23.5 22.9 24.1 24.8 23.4 Consumer Price Index 1/ (July '54- June '55 = 100) 291.3 450.2 503.4 573.1 699.0 875.1 Annual percentage changes in: Consumer Price Index 7.1 6.7 11.8 13.8 22.0 25.2 Bank credit to Public Sector 18.5 -3.1 27.7 -3.9 -9.9 5B.0 Bank credit to Private Sector 12.8 30.3. 17.8 20.0 27.1 27.5 BALANCE OF PAYMENTS MERCHANDISE EXPORTS (AVERAGE 1972-74) 1972 1973 19274 us s lm L Exports of Goods, NFS 1,207 1,609 1,870 Coffee 589 45.2 Imports of Goods, NFS 1 6 1, 1,81 Other Agriculture 169 13.0 Resource Gap (deficit -) - 24 171 - 10 Minerals 39 3.0 Semi-processed and Manu- Interest Payments (net) - 124 - 1u, - 128 factured 263 20.7 Workers' Remittance All other commodities _ J6 18.1 Other Factor Payments (net) - 73 - 74 - 67 Total 1,302 100.0 Net Transfers 3 Balance on Current Account - 191 - 13, 164 YERATDFRT. ECEMBER 3, 197j[ Direct Foreign Investment 17 23 39 Net MLT Borrowing 2/ 260 274 239 u3 ,2 1n Disbursements 355 401 392 Total Outstanding Pnd Amortization -_J9_ - 130 1 Disbursed 2/ 2,177 Subtotal 277 297 278 Capital Grants DEBT SERVICE RATIO for 1974 1/ Other items n.e.i. 78 - 40 - 255 _. Increase in Reserves (+) 164 244 - 141 Amortization of Public Debt 8.2 Gross Reserves (end year) 404 580 460 Net Interest on Public Net Reserves (end year) - 12 232 91 Debt _.3 Total 13.5 RATE OF EXCHANGE IBRD/IDA LENDING, DECEMBER 31, 1974 (Million USJ) December 31, 1972 IBRD IDA US$1.00 = Col$ 22.83 Colc4l.00 = us$ 0.0438 Outstanding and Disbursed 555 23 Undisbursed 22 December 31, 1973 Outstanding including US$ 1.00 = Col$ 24.82 Undisbursed 847 23 Col$1.00 = US$ 0.0403 December 31, 1974 US$ 1,00 = Col$ 28.60 Col$1.00 = US$ 0.0350 1/ Annual average 2/ Public debt only I/ Ratio of Debt Service to Exports of Goods and Non-Factor Services / Certificate market selling rate Date: March 20, 1974 Department: Latin America and Caribbean J AND cNJLUC: Recent ?'rformance 1. The Colombian economy has, during the past year, registered its seventh consecutive year of strng oconomic growth, with GDP expanding by about 6 percent. Since 1967 Gross Domestic Product has increased by an average of 6.5 percent in reat terms, well above the historical average of less than 5 percent per annum (1950-67), and real per capita GDP has increased by an average 3.2 percent to US$500 in 197L. During this period, substantial structural transformation has taken place in the Colombian economy and the country is now well advanced in the transition from a predominantly rural, agricultural and largely self-contained economy to an urban, industrial economy, more interdependent with the world economy. Two mutually dependent phenomena, increased investment and relaxation of the foreign exchange constraint, have been major factors in bringing about the acceleration in growth which has occurred since 1967. In the earlier part of this period, gross fixed domestic investment rose steadily from an average 15 percent of GDP in the early 1950's to about 18 percent in the 1967-71 period. Adoption of a "crawling peg" exchange rate policy in 1967, together with fiscal and other incentives for minor exports, defined as non-coffee, non-p troleum exports, has resulted in a three-fold increase in exports since 1967, and most significantly, non-traditional or minor exports have become a more important source of foreign exchange earnings than coffee, increasing from 27 percent of merchandise exports to over 50 percent in 1971. Much of this increase was the result of both product and market diversifi- cation, esuecialli of man.:uactured exorts as the share of total exports shiTned to Latin American countries more than do'led. 2. Despite continued rapic economic growth in 1974, although at a slower pace than in the preceding three years, there were a number of develo'ments - weakening of balance of payments performance, loss of self-sufficiency in petroleum production, persistent and serious inflation, continued deterioration in public finances and reduction in public investment, which, if not dealt with satisfactorily, could prevent Colombia from reestablishing the accelerated rates of growth achieved during the past several years. In order to strengthen domestic resource mobilization, the new Colombian Government introduced far- reaching fiscal and monetary reforms shortly after taking office in August. These reforms will make a substantial contribution to improvement of this situation. While the need to cover the resource gap with drawdown of foreign exchange reserves in 19774 is a more recent development, it is of equal concern since its cnntinuation for any protracted period could result in a resurgence of the foreign exchange constraint which severely limited Colombian economic growth during the late 1950's and early 1960's. Colombia's recent loss of self-sufficiency in petroleum production will har an immediate adverse effect on the balan3u of payments. Declining domestic nroduction cou3d, if alloued to continue, houevcr, result in a serious burden on the country's balance of ayments by' 7 e end of this de.cade. 3. The Government has assigned a high priority to reducing inflation from the current level of 27 percent and it is likely that the increase in the price level will approach the targeted 20 percent by the end of 1975. Management of the Colombian economy in 1975-76 will, however, be a complex task since there is the danger that contractionary forces already set in motion by the Government's stabilization program could be amplified by recessionary pressures from abroad. It is already clear that GDP growth during this period will be below the average of 1970-74. 4. In 1975 the Colombian economy faces several forces which are bringing about a decline in growth. The new Government had inherited a difficult public finance situation with savings well below earlier levels and external borrowing of a much higher proportion of total investment. The Government's response was to reduce investment and mobilize new domestic resources by introducing several new tax measures. At the same time the economy was feeling the effects of recession in Colombia's external markets and a decline in coffee prices which was reflected in declining export earnings. The new economic team is aware that the economy is going through a period of transition in which the situation could change rapidly, and is attempting to follow policies aimed at reducing inflation, avoiding a sharp contraction in the rate of growth of output and employment, and protecting the level of foreign exchange reserves through a flexible exchange rate policy. In addition, the Government is anxious to step up its development effort. Simultaneous accom- plishment of these goals will not be easy given the difficult external situation lacing Colombia. 5. The development challenge facing Colombia is to return the economy to the higher rates of growth achieved in the recent past while preserving Colombia's favorable external liquidity position, and provide increased employ- ment opportunities and a broader distribution of the benefits of economic growth to all segments of the population. -The Government has already achieved considerable success in enacting fundamental monetary and fiscal reform which should provide the framework for increased saving and a more efficient allocation of that saving into investment opportunities. It is now turning its attention to achieving the goals of rapid growth and a more equitable distribution of its benefits through initiation of a development program aimed at accelerating agricultural and industrial growth, at increasing the partici- pation of the most deprived regions of the country in the development process, and at continuing the export diversification drive. Special emphasis is being placed on expansion of employment opportunities and increased investment in education, health and nutrition programs aimed at benefitting the poorest 50 percent of the population. Agriculture 6. Performance of the agricultural sector has in recent years improved considerably. Growth of output has accelerated to well above the 4 percent historical average. Exceptionally large crops of rice, cotton, and grain sorghum contributed to the large increase of output in 1974. Production of these crops has increased substantially over the past decade, and there have also been substantial gains for sugar, caraota beans, oil palm, potatoes, cassava, common dry beans, and cacao. Gains in crop output have for the most part been realized through expansion of planted acreage. Only in the case of rice has increased yield been a dominant factor and this is the result of replacement of irrigated rice grown under advanced technology for the tradi- tional cultivation of dry land rice. More double-cropping has accompanied the expansion in plantings of irrigated rice, cotton and plantains, with the result that the increase of nearly half a million hectares in total plantings of major crops over the last decade has been realized with only about half as large an increase in the area of cropland. Additions to cropland have mostly taken place in the coastal lowlands and eastern plains, rather than along the cordilleras. Much of the additional crop output is being produced under a new structuring of relationships between producers, land, and products. - iii - 7. Most of the expanded output of the livestock subsector has been associated with the 3 to 4 percent annual expansion of the national cattle herd, which in 1974 numbered an estimated 23.9 million head. Annual produc- tion of cattle (the number of animals slaughtered, exported, and retained for inventory expansion) has remained close to 16 percent of the national herd for a nunber of years, while the commercial extraction rate (slaughter plus live exports) has varied between 11 and 15 percent in a roughly cyclical pattern. Calving rates have been estimated at about 55 percent, with mor- tality at about 4 percent of total inventory. These performance rates reflect he relatively extensive type of livestock management which pre- dominates in Colombia and which is also to be found in such countries as BrAzil,and Paraguay. Animals of the dairy breeds and others classified as milking stock account for only about a seventh of all cattle and much of the milk output comes from cows kept primarily for beef production. 8. Colombia will need to continue to develop new lands and provide opportunities for the productive employment of farm workers. The new pre- sumptive income tax may contribute to this objective. Programs of land reclamation and allocation, colonization, and simple land redistribution under the existing land reform laws need to be strengthened. In the long run, Colombia will need to iicoarporate more of its undeveloped lands into such units. In localities where the problems of rural poverty are concentrated and where small farms, using both traditional and modern technology are numerous, programs specifically adapted to local resource and ;rket potential are needed to enhance productivity for ieeting nutritional needs and improving the welfare of the ruiral poor. The complexity of the production and marketing problems to be overcome on smal holdings suggests that appropriate supply responses will be attainable only if a package program approach, tailored to the needs of relatively homogeneous localities, including facilities for local assembly, storage, processing, and transportation is adopted. This will be possible, how- ever, only to the extent that technical and financial resources are expanded. 9. In the long run, Colombia has the potential to become a net exporter of food products while simultaneously improving local nutrition standards. Wilt traditional farmers' income could indeed be raised by promoting crops iuch as cassava, plantain, potatoes, and panela sugar, as recommended in the national nutrition plan, these products will do little to improve nutrition standards relative to the contribution which would bp made by the high protein protective foods. As specified in the nutrition plan, this will rfequire increased output of maize, wheat, soybeans, and boans, which can be obtained most rapidly through credit and appropriate price stimulants to those famers who have a greater capacity to respond to such stimulants. Improvement in nutrition will require interrelated measure' Ln several fields. Thus, an incroase in supply of high nutrient products would need to be accompanied by educational measures, improvement in distribution as well as an increase in purchasing power of the poor. - iv - Manufacturing 10. During 1967 through 1974 the manufacturing sector growth rate rose to between 9 to 10 percent annually, a level unmatched since the 1950's. During this period, the capital output ratio for industry declined and capacity utilization seems to have increased in several branches of industry. Desp'te rapid growth of industrial employment, labor costs did not increase as a proportion of value added and labor-intensive industries maintained their competitiveness. Tndustrial exports rose from an insignificant level to US$380 million ii 19ML. The post-1967 expansion of industrial exports has been characterized by a remarkabl diversification in the goods exported (especially notable in mechanical machinery, furniture and clothing categories) ana oy a continuation of diversification of geographica- trade partners. Despite acceleration of growth and employment since 1967, industry still faces serious and, in some respects, increasing problems. While the expansion in aggregate demand facilitated rates of industrial growth conside- rably higher than those recorded in the first of the 1960's, mounting inflation in recent years had had damaging effects on a number of industries. Increases in international prices, additional domestic costs, higher interest rates and longer delay in payments from customers have squeezed profits of a number of industrial enterprises. Shortage of raw materials and spares have caused additional difficulties. In 1974 the effects of inflation on real incomes reduced purchasing power, thus leading to underutilization of capacity in consumer goods industries such as textiles and clothing. 11. The five largest industrial branches are textiles, beverages, food products, chemical and non-metallic minerals, which contribute more than 60 percent of tltal value added in manufacturing. The share of the capital goods industry in total value added in manufacturing is somewhat lower in Colombia than in a number of other countries at similar stages of development. Electrical equipment is highly protected and with only a few exceptions, products of this group have high prices and are pro- duced rather inefficiently. This group of industries is not well suited to the scale of production which the Colombian market permits. The transport sector has also enjoyed high rates of protection and domestic prices are several times import prices. Domestic value added is low in this brancL of industry and its contribution to growth of value added in manufacturing has, as a consequence, been small. In contrast to the inefficiency of several capital goods branches, a number of industries producing consumer goods are quite efficient by international standards. This in part explains the large share of consumer goods in total industrial value added. The food processing and textile industries have not received heavy protection. They are long established and there is substantial domestic competition which has kept prices low. 12. Longer-term development of Colombian industry is constrained by the size of the internal market and the limited prospects for further import substitution. Export development is an essential ingredient of the Government'. industrial policy. The Government encourages greater efficiency in Colombia's economy and its export industries through a flexible exchange rate policy and other interrelated measures affecting import restrictions,tariffs, direct promotion incentives, accelerated trade with the Andean Market, expanded industrial finance and institutional support. The Government still has under consideration certain adaptations in its system of incentives and finance, -v - and the orientaticn and direction of its policies augur well for further export growth. The Colombian protective system, while not excessively restrictive, provides widely differentiated levels of protection. The degree of liberalization achieved in recent years has tended to follow improvements in industrial efficiency. Because of interdependence within the industrial sector, developing an internationally competitive export industry necessarily implies an overall improvement in the efficiency of the entire sector. The most effective way to achieve this is through maintaining a rational structure of industry, a flexible exchange rate policy and rationalization of the structure and level of industrial protection. 13. Colombian industry is well situated to benefit from creation of the Andean Common Market. Textiles, clothing, footwear and simple food products are produced in most Andean countries but the experience of other regional integration processes shows that even for such products the opening of borders allows for increased trade for specific products in these industrial branches. The textile industry, for example, includes an enormous variety of items which cannot possibly be produced by a single country. The development of mining and forestry-based industries, such as carbochemicals and paper pulp, and possibly of engineering industries which can use Colombia's well- trained labor force, should be studied in the framework of the Andean Group. Further work needs to be done to identify industrial branches where Colombia can most benefit from the Andean Common Market, and efforts need to be made to provide special technical assistance services to these industries. Monetary and Fiscal Reform 1b.. Although Colombia has a reasonably well developed financial system in comparison wit], most other countries in Latin America, the system has in the past operated under a high degree of Government control and regulation which has limited its effectiveness in intermediating private savings and in allocating these resources efficiently to alternative investment opportunities. Instruments of monetary policy havo been devised to channel credit to Government designated sectors and have tended to have an adverse effect on mobilization of private savings through the financial system. Most interest rates have been held at artificially low levels by the Government and wide differentials have existed between the interest rates available to different types of borrowers and savers. FInancial intermediaries have operated under cumbersome regulations that have forced them to direct a high proportion of their resources into specified investments at subsidized interest rates. Fragmented capital and money markets have contributed to misallocation of resources and have impeded entrepreneurial growth, perpetuating the use of inefficient production techniques. Resource mobilization by the private sectc has been hampered by competition from tax exempt public sector instruments with immediate liquidity which, in recent years, have been increasingly relied upon to shore up weak public sector finances. As a result of the severe constraints on the supervised financial sector, a large and active extra-bank market has developed wh,- has simultaneously prevented more rapid development of an efficient competitive system of financial intermediation. - vi - 15* Shortly after taking office,the new Colombian Government introduced important modifications of the financial system followed by comprehensive structural reform of the tax system. The financial reform package which was introduced by the new Administration shprtly after entering office in August 1974, was aimed at producing a more balanced flow of resources through Colombia's financial system and providing the authorities Wi.h greater monetary control. The reform included a restructuring of interest rates,including a maximum ceiling on the rate of monetary correction, a simplification of Colombia's complex reserve requirement system, the elimination of numerous portfolio requirements and preferential tax treatment given to public debt instruments, the elimination of several rediscount facilities and'the adoption of more stringent controls over existing facilities. 16. The reform narrowed the large interest rate differential between indexed savings and loan deposits and other financial instrumonts, by introducing a maximum annual ceiling of 20 percent on the calculation base for monetary correction, by lowering the basic interest rate of indexed certificates of deposit and on passbook accounts, and by removing the tax exempt status on part of the indexed portion of earnings. Simultaneously, interest yields on non-indexed passbook savings accounts were raised from 8 percent to 12 percent in 1974 and to 16 percent in early 1975. Further non- indexed negotiable three-month certificates of deposit,which were introduced in February 1974, can now yield a maximum nominal rate of 24 percent. Thus, the reforms will allow interest rates available to savers to more accurately reflect liquidity and risk of financial instruments and permit greater flexibility of rates to reflect changes in the domestic price level. 17. The Colombian monetary system provided a proliferation of rediscount facilities by the Banco de la Repfblica to assure, automatically and unconditionally, the credit needs of government-designated priority sectors and assure the liquidity of the banking system. This allowed virtually uncontrolled credit expansion and posed a serious challenge to effective monetary management. In recent years the growth of these rediscount facilities has reflected both the weak public sector savings performance as well as the shortage of financial savings to finance the Government's development priorities. The monetary reform established a new ordinary rediscount facility to meet the liquidity needs of the banking system, but unlike the previous facility it is neither a permanent nor automatic source of resources for the banking system, and it cannot be used to generate new credit. The reform also provided for the first timve for the use of fiscal instead of Central Bank credit resources in the financlng of the special development rediscount credft lines kiown as the Administered Funds. This was accomplished by raising the import surchargze from 1.5 percent to 5 percent, and earmarking the revenue captured for export promotion. In addition, the authorities have moved the Urban Develop- ment Fund from the Banco de la Republica to the Mortgage Bank with financing for this fund to accrue from Mortgage Bank profits. - vii - 18. The challenge posed to the authorities is how to continue financing Colombia's development priorities while reducing the reliance on central bank resources. Solution of this problem entails further increasing the volume of financial savings available in the system while improving the distribution of these savings through the financial system. With deceleration of inflation and the changes already made in interest rates, the prospects for the deve- lopment of a more effective capital market now appear brighter. Measures already undertaken, such as the increase and rationalization of the interest rate structure and of the system of forced investment requirements should result in a more active and more competitive short-term market. Furthermore, success of the Government's stabilization program will facilitate development of a long-term market. With a stronger and more active short-term market, a longer-term market could evolve as the rate of inflation decelerates and maturities are gradually lengthened. 19. Colombiats post-war experience suggests that strengthening of the country's fiscal system is a necessary first step to achieving an adequate level of self-sustained growth. Shortfallsin revenues resulted in chronic government deficits which were major sources of inflation and which impeded expansion of infrastructure investment and social programs vital to acceleration of development. While fiscal reforms in 1966 resulted in strengthened budgetary performance from 1967 to 1970, since 1971 there has been a steady deterioration of public finances characterized by a decline in the share of net current receipts of the National Government in GDP from 9.4 percent in 1971 to 8.3 percent in 197. Overall tax buoyancy declined sharply in the 1973-74 pe-iod as a result of the strong negative impact on Government cash revenue of the increased use of tax credit certificates (CATs) and as a result of administra- tive deficiencies. With the exception of 1972,when there was a sharp jump in National Government investment spending made possible by a three-fold. increase in external borrowing, deterioration of public finances has been reflected in a declining levelof investment by the National Government in real terms. Investment spending by the National Government declined from an average 4 percent of GDP in the 1967-72 period to 3.4 percent in 1973-74. 20. The deterioration of the National Government's financial performance since 1971 has been accompanied by weakening of the rest of the public sector's capacity (departmental and municipal government and public enterprises) to mobilize domestic resources and execute investment. Total net tax revenue of the general Government declined from a peak of 11.2 percent of GDP in 1971 to 9.4 percent in 1974. Operating revenues of the decentralized agencies also declined as a share of GDP during this period, from 5.1 percent in 1971 to 4.9 percent in 1973-74. As a consequence, total public sector savings fell from a high of 7.1 percent of GDP in 1970 to 5.5 percent in 1974. Despite the increase ir. net external borrowing of the public sector from 1.2 percent of GDP in the mid-1960's to 2.7 percent in the early 1970's, public invest- ment spending declined from 10.2 percent of GDP in 1970 to 8.6 percent in 197L. 21. In order to overcome these problems, the new Government implemented a tax reform of major proportions in the last four months of 1974, as part of a comprehensive set of stabilization measures under economic emergency authority provided in the Constitution. The reform covered almost every important component of the tax system and represents a clear and significant improvement over the prior system on nearly all counts. Major features of this reform include introduction of a new tax on capital gains, a presumptive income tax <on all sectors of the economy, and substantial increases in sales tax rates. These measu'res are expected to increase revenues, improve resource allocation and strengthen efforts to redistribute income. - Viii - 22. The principal objectives of the 1974 reform were a) increasing the progressivity of the tax system by reducing the tax burden on the lowest income groups, increasing taxes on the rich, and by closing numerous loopholes which have permitted high income groups to avoid paying taxes; b) improving horizontal equity; c) increasing the elasticity of the tax system; d) increasing tax revenues; and e) improving tax administration. The principal revisions in tax law designed to enhance progressivity were: a) adjustments in the rate structure of the personal income tax; b) elimination of a number of deductions and exempt income items which primarily served to benefit upper income taxpayers; c) conversion of most remaining exemptions and many former deductions into tax credits, the benefits of which do not depend on the marginal rate of tax faced by the taxpayer; d) increases in rates applicable under the net wealth tax, and rationalization of cxmptions under the tax; e) drastic restructuring of death and gift taxes, to enable more effective taxation of capital transfers of this type; f) measures to reduce the scope for tax evasion open to recipients of capital income, who are primarily found in upper income groups; g) heavier emphasis upon taxation of "luxury" consumption, through upward adjustments in sales tax rates on such itemsand h) inclusion, for the first time, of many services in the sales tax base, primarily those consumed by upper income families. 23. Various important elepents of the pre-existing tax system tended to produce significant anomalous and unintended effects on resource allocation and productive efficiency. The reform sought to eliminate many of these, or at least reduce the scope for adverse unintended effects, through the follow- ing adjustments: a) adoption of a flat-rate of income tax on business entities, in place of the previous complex of marginal rates for both the basic income tax and a host of complementary income taxes; b) enactment of more realistic tax treatment of operating losses and slightly more generous depreciation rules; c) abolition of several tax incentives and/or exemptions previously intended to direct business investment into favored activities, but which mainly served to reduce revenue, progressivity and often yielded undesired results; d) reduction in the scope of customs and income tax exemptions for state enterprises, decentralized agencies and government offices; e) inclusion of previously untaxed services of an income elastic nature in the tax base, thereby redressing the previous consumption incentives in favor of such services and against consumption of taxable goods; f) relaxation and/or removal of certain arbitrary limits on deductibility of expenses; and g) conversion of several business tax deductions into tax credits, thereby reducing some capricious features inherent in the previous system. - ix - 2. The reform did not serve to improve administrative feasibility in all respects. However justifiable the rate increases in the sales tax may have been on revenue and income distribution grounds, the present rate struc- ture still suffers from an excessive degree of "fine-tuning" that will render the tax more difficult to operate, and the height of some of the rates will increase incentives for evasion and for smuggling of high value, low bulk items. Only a truly determined and continuous campaign of enforcement will prevent sales tax evasion from rising above previous levels, as long as high luxury rates are included within the scope of the tax. Further, the inability of officials responsible for property tax administration to have access to net wealth tax declarations will permit continued high evasion for the former levy. Nevertheless, the reform should leave the tax system, on balance, more enforce- able than it was previously. 25. The reform served to appreciably enhance the ex-ante revenue elasti- city of the tax system with respect to nominal growth of GDP, and certainly will do so if administrative efficiency in tax collection does not decline over the next few years. Perhaps more importantly, the reform yielded a tax structure that, by virtue of its expanded base and rationalized structure, should be able to support revenue-increasing adjustments in rates consistent with equity and allocative tax policy goals in the future. While the measures will have a positive impact on reserves in 1975, the full effect will not be felt until 1976. The fiscal reform will not, by itself, generate savings sufficient to sustain levels of public investment consistent with the GD? growth rates which occurred in 1970-73. Until more experience with the new revenue measures has been gained, the mission's projections of additional resource requirements are necessarily tentative. 26. With the new revenue measures it should be possible to generate public savings sufficient to finance a larger share of an expanded level of public investment than in previous years. Public savings are projected to increase from 5.1 percent of GDP in 1975 to 5.5 percent in 1976, and 6.1 percent in 1980. Gross fixed investment of the public sector could increase from 7.1 percent in 1975 to 9.4 percent of GDP in 1980 as compared to 8.5 percent in the 1970-74 period. These levels of investment would be compatible with returning the economy to the higher levels of growth achieved in the early 1970's and include National Government investment of Col$15.2 billion and Col$21.2 billion in 1975 and 1976, respectively. While the 1975-76 investment figures are below what is regarded as compatible with a high rate of growth, an increasing share of the sales tax revenue is earmarked for the departments and municipalities to finance development expenditure in education and health. 27. In subsequent years National Government investment is projected to rise from 3.4 percent of GDP in 1974 to 5.1 percent in 1980. The current account surplus of the National Government is estimated at Col$10.6 billion in 1975 on the assumption that the new tax measures will begin to take hold and that additional measures are held in abeyance. In 1976 the surplus would increase to CoI$16 billion as additional measures which affect tax revenues are taken. In the financing of its investment expenditure the National Government will need to obtair financing of about Col$4.5 billion in 1975 and Col$5.2 billion in 1976. A substantial portion of these amounts are expected to be obtained from external commercial credits as described below. Over the long term, decentralized agencies will probably account for about half of public investment, only about one-fifth of which may be financed by savings of these agencies. The National Government is expected to remain the largest source of public sector savings and should continue to finance capital outlays of other agencies, departments, and municipalities, through capital transfers. - x - Total public sector savings should during 1975-80 be sufficient to finance about two-thirds of public investment on average, while net external borrowing, including disbursements and amortization of new and existing loans, is expected to finance one-third. Balance of Payments and Growth Prospects 28. Up -to now Colombia has avoided resurgence of the foreign exchange constraint which severely limited growth during most of the 1960's. Improving terms of trade and rapid growth in the volume of minor exports, combined with strong performance of domestic savings, permitted Colombia to accumulate substantial foreign exchange reserves over the 1971-73 period. Although Colombia has been able to increase the flow of imported goods and services, the country has had little difficulty in obtaining the foreign exchange necessary to finance these imports through its own exports and a large inflow of foreign capital. 29. During 1974 management of the balance of payments became more difficult due to a deterioration in the public savings performance, sharply increased imports, and reduced inflow of foreign capital. As a result, Colombia was forced to finance a portion of its external resource gap by drawing down its foreign exchange reserves. In 1975.the mission has assumed total export earnings of US$1,523,million on the basis of a coffee price of US$0.65 and a decline in the volume of manufactured exports of 12 percent. Effective import demand An the first half of 1975 is running well below the year earlier level. Given the current level of trade and capital flows, the external gap is likely to exceed last year's. In order to manage the situation the Government will have to increase external borrowing in 1975 and thereafter. The mission has projected external borrowing to include US$200 million and US$250 million of suppliers and financial credits in 1975 and 1976, respectively. This would not jeopardize the country's future creditworthiness and would be sufficient to assure that there will be no further decline in official reserves. 30. The adverse impact of loss of petroleum self-sufficiency on Colombia's balance of payments could be severe. If present production and consumption trends continue, imports of crude would, in the absence of appropriate remedial action, reach US$315 million in 1980 or about 10 percent of projected export earnings. Through its ownership of refining activities the Colombian Government has control over the prices of crude oil and gasoline. This power has in the past been used to hold the price of crude oil at a low level (an average of US$1.65 per barrel), and petroleum production has declined from a peak of 80.1 million barrels in 1970 to 61.0 million in 1974. While the internal reference price paid to producers for "new" crude was increased to US$4 per barrel in February 1974, prices to producers for existing flows of petroleum (including that from secondary recovery), as well as prices at refinery and consumer levels, have not been changed since June 1971, and are among the lowest in the world (US$0.11/gallon of gasoline retail). Creation of appropriate incentives for increased exploita- tion of oil from fields already in production, and a modest dampening of domes- tic demand would permit Colombia to hold down the level of its crude oil imports. -xi- If dedisive action is taken in 1975 to encourage exploration and drilling, moreover, it is entirely possible that new oil will become available in the next few years. 31. The mission projects that total exports will grow at 7.6 percent annually in real terms during the 1975-80 period with coffee exports in- creasing only slightly, and minor exports growing by 15 percent annually. The favorable performance of minor exports is a key element in Colombia's forward momentum. Imports are projected to grow by 6 percent annually during the period, and under these circumstances, Colombia's resource gap would remain below 1.5% of GDP and the availability of foreign exchange would permit a resumption of the favorable growth rates achieved in the early 19701s. 32. As a result of the recent fiscal and monetary reforms and of additional measures to strengthen public finances and mobilize domestic savings which are currently being considered, the savings coefficient is projected to increase from about 19.5 percent in 1970-74 to about 22 percent in 1980, implying a marginal savings rate of .31. This would permit an increase in the share of gross fixed investment to GDP from 18.7 percent in 1970-74 to 21 percent in 1980 and would, in the absence of severe, pro- longed pressure in the balance of payments, be sufficient to reestablish the 7 percent growth path in the late 1970's. This growth path would reduce unemployment from the estimated current 12 percent to about 8.5 percent in 1980 and would require an estimated external net official capital inflow of US$3.0 billion during 1975-80 (US$4.5 billion gross). Official external commitments are expected to total about US$h50 million in 1975, about US$650 million in 1976, and about US$850 million in 1977, of which almost half is expected to be in the form of suppliers and financial credits. This level of commitments would provide sufficient capital inflow to return the economy to a 7 percent growth path assuming a recovery of export growth in 1976. 33. The Colombian Government plans to present a list of projects for external financing during 1975-77 at the next Consultative Group Meeting, many of which are already at an advanced stage of preparation. This list includes projects which require external financing of US$852 million in . 1975, US$1,061 million in 1976 and US$720 million in 1977. Assuming recovery of exports in 1976 and allowing for a reasonable amount of slippage, financ- ing for these projects, together with the expected contracting of a moderate amount of financial credits, should make possible achievement of the levels of commitment and capital inflow required to sustain a high rate of growth and external equilibrium. Although the level of non-commercial lending to Colombia is projected to increase substantially through 1980, it is unlikely that Colombia will be able to obtain sufficient external financing on long terms and a greater proportion of external capital is expected to be borrowed on commercial terms. Colombia's present external debt structure permits a moderate amount of increased commercial borrowing without jeopardizing external liquidity. The projected growth in external public debt and the hardening of its terms is thus likely to result in an increase in the share of external debt contracted on commercial terms from 23 percent in 1974 to a projected 31 percent in 1980, an increase in the debt service ratio from the current 13.5 percent to about 16 percent in 1978 and 19 percent in 1980. With strong balance of payments management and external debt policies these - xii - debt service ratios are manageable. Under such conditions there should be little difficulty in servicing the increased volume of borrowing provided export earnings expand adequately. The current Government is aware of the importance of controlling the increase in non-project commercial borrowing in such a way as to prevent an excessive increase in external debt burden. 34. There is little question that management of the Colombian economy will be more difficult in the immediate years ahead than it was in the early 1970's. Expansion of productive capacity will require substantially increased imports. Declining production of petroleum and the consequent need to import could, in the absence of appropriate remedial action, become a heavy burden on the balance of payments by the early 1980's. Uncertainties in world markets for coffee and many of Colombia's minor exports will require continued strong efforts at export diversification and expansion. The new Government has acted prudently to undertake badly needed fiscal and financial reform shortly after coming to office and with a continuation of sound fiscal, monetary, and, most importantly, balance of payments and external debt management, Colombia should be able to strike the proper balance between growth and external indebtedness, thereby remaining creditworthy for an increasing amount of external borrowing provided a significant proportion of such borrowing is obtained on favorable terms. CHAPTER I GROWTH AND DEVELOPMENT OF THE COLOMBIAN ECONOMY A. Background 1% The Colombian economy has, during the past year, registered its seventh consecutive year of strong economic growth, with GDP expanding by about 6 percent. Since 1967 Gross Domestic Product has increased by an average of 6.5 percent in real terms, well above the historical average of less than 5 percent per annum (1950-67), and real per capita GDP has inemased by an average 3.2 percent to US$500 in 1974. During this period, substantial structural transformation has taken place in the Colombian economy and the country is now well advanced in the transition from a predominantly rural, agricultural and largely self-contained economy to an urban, industrial economy, more interdependent with the world economy. Broadening of the country's productive base has been accompanied by develop- ment of a modern sector which relies to a considerable extent on imported inputs. Merchandise exports have increased three-fold since 1967 and most significantly non-traditional or minor exports have become a more important source of foreign exchange earnings than coffee, increasing from 27 percent of merchandise exports to over 50 percent in 1974. While employment opportunities have, as a consequence of the strong overall growth performance, grown more rapidly since 1967 than at any other time in the post-war period, rural-urban migration has accelerated, and unemployment continues to be a problem in most of Colombia's major urban centers. 2. Two mutually dependent phenomena, relaxation of the foreign exchange constraint and increased investment, have been major factors in bringing about the acceleration in growth which has occurred since 1967. Favorable world coffee prices, along with the dramatic increase in minor exports of almost 30 percent annual average during 1967-74 have increased the availability of foreign exchange, thereby making possible access of the modern sector of the economy to an adequate supply of intermediate and capital goods imports needed to expand output and employment. Adoption of a "1crawling peg" exchange rate policy in 1967,together with fiscal and other incentives for minor exports, defined as non-coffee, non-petroleum exports, have produced a substantially improved trade balance, which, together with considerable progress in the capacity to prepare and implement projects financed by international lending agencies and substantial inflow of private capital, resulted in a rapid accumulation of foreign exchange reserves during 1972, 1973 and first quarter of 1974. Minor exports increased from slightly over US$100 million in 1966 to over US$800 million at present. Improvements in the balance of payments were accompanied, at least in the 1967-71 period, by higher levels of domestic investment, spearheaded by an increase in public capital outlay following fiscal reforms in 1968. Since 1971, however, overall investment levels have sagged somewhat,largely reflecting a deterioration of central government finances and reduced availabilities of funds for public investment programs. - 2 - 3. Despite continued rapid economic growth in 1974, although at a slower pace than in the prcceding three years, there were a number of adverse develop- ments--weakening of balaice of payments performance, loss of self-sufficiency in petroleum production, persistent and serious inflation, continued deterioration in public finances and reduction in public investment, which, if not dealt with satisfactorily, could prevent Colombia from reestablishing the accelerated rates of growth achieved during the past several years. In order to strengthen domestic resource mobilization, the new Colombian Government introduced far-reaching fiscal and monetary reforms shortly after taking office in August. These reforms, described in detail in Annex 3, will make a substantial contribution to improvement of this situation. While the weakened balance of payments performance in 1974, characterized by reduced capital inflow and declining reserves, is a more recent develop- ment, it is of equal concern,since its continuation for any protracted period could result in a resurgence of the foreign exchange constraint which severely limited Colombian economic growth during the late 1950's and early 1960's. Colombia's recent loss of self-sufficiency in petroleum production will not have any significant immediate adverse effect on the balance of payments. Declining domestic production could, if allowed to continue, however, result in a serious burden on the country's balance of payments by the end of this decade. B. Historical Growth Patterns 4. Colombia's recent economic history falls into four stages: (a) the period of urbanization, import substitution and rapid industrial growth initiated as a result of disruption of international trade in the 1930's and continued at an accelerated pace during World War II when the country was deprived of a wide range of imported industrial products; (b) the post-war decade characterized by high world coffee prices, improving terms of trade, relative abundance of foreign exchange and rapid growth of GDP and income; (c) the decade from the mid-fifties to the mid-sixties marked by financial collapse and the overthrow of the Rojas Government in early 1957 and followed by low coffee prices, reduced rates of growth (about 4 percent annually), declining terms of trade and negligible increases in income per capita; and (d) the current period dating from 1967, during which time the economy has moved into a higher growth path as the result of introduction of a set of policies aimed at increasing domestic savings and investment, and at breaking the foreign exchange constraint through diversification and expansion of exports. 5. At the close of World War II Colombia was left with large holdings of foreign exchange reserves, the result of strong export performance and low import levels due to the inavailability of most industrial imports. This permitted the country to increase its imports of intermediate goods, and machinery and eauipment for investment. Thus, during the immediate post-war - 3 - period annual growth of GDP, led by the coffee and manufacturing sectors, averaged over 5 percent, while the increase in income was even greater due to improving terms of trade. While manufacturing investment, value added and employment grew at a rapid pace during this period, the increased production was, for the most part, substitution of imports and was itself heavily dependent upon imported inputs. The exchange rate, set by the high productivity coffee sector, was relatively stable throughout the period and trade policies resulted in a strong bias against production for export. 6. The unsatisfactory rate of growth of GDP during the 1957-65 period was the result of a binding foreign exchange constraint stemming from the collapse of coffee prices. The effects on growth were aggravated by an exchange rate policy which maintained the peso at an overvalued rate. Reduction of the employment problem during this period might have been achieved through progressive devaluation of the peso so as to increase foreign exchange earnings and reduce the import intensity of both consumption and investment expenditures. This did not take place and growth of GDP and employment seriously lagged begind what Colombia might otherwise have achieved. Stabilization efforts during this period which combined "once and for all" devaluations with import liberalization were largely unsuccessful since devaluations were generally insufficient and there was a lack of coordination between exchange rate and interest rate policies. Liberalization of import restrictions without appropriate upward adjustments in the effective real interest rate resulted in specula- tive substitution of real monetary balances for inventories of goods, prLiarily of imports, a phenomenon which placed additional pressure on the balance of payments and ultimately resulted in reimposition of import controls. 7. During the 1957-65 period, attempts to accelerate growth were undercut by lack of coordination between development strategy and macro- economic policy. The 1961 Five Year Development Plan, for example, called for an increase in the investment rate. It was not recognized, however, that this required an increase in the effective foreign exchange and real interest rates, and the economy operated under conditions of excess demand for foreign exchange and credit. Both foreign exchange and financial systems were managed through direct administrative controls. From 1960 to 1967 Investment declined and it was not until a wholly new set of policies which established the basis for the more recent acceleration in the rate of growth were introduced, that this trend was reversed. 8. The acceleration in growth of the Colombian economy over the 1967-74 period has, for the most part, been the result of trade and financial policies aimed at increasing the availability of foreign exchange, increasing savings and investment and improving resource allocation. While favorable world coffee prices played a positive role in this improved performance from 1970 on (coffee prices rose an average 12 percent per annum between 1969 and 1974 as compared to a decline of 3 percent per annum during 1956 to 1967), the most important cause was the dramatic shift in export structure stemming from fiscal, monetary and exchange rate incentives given to minor exports. With most of the easy import substitution completed -4- by the early 1960's, accelerated industrial growth could be achieved by expansion of the narrow domestic market through export. Failure of import substitution policies to further reduce the import coefficient and sustain the rate of growth was the result of capital-intensive import substitution investments where scale, skill and supply constraints are more binding and import dependency is high. To break out of the low-growth,foreign exchange constrained pattern of the early to mid-1960's,where expansion of industrial growth was limited by the need for increased imported inputs and investment goods, Colombia was forced to shift the relative emphasis of its develop- ment strategy away from import substitution toward export expansion. 9. Rapid expansion in the post-1967 period has been marked by a more balanced growth profile than during the earlier post-war period. The directly productive sectors have expanded more rapidly and there has been a shift in the production mix toward external markets. Growth of agricultural production has accelerated to 5.0 percent per annum in 1974, as compared to its low historical average of 3 percent. Export promotion policies appear to have played an important role in this improved performance by helping to sustain continued diversification away from coffee and impressive expansion of several export-oriented activities (cotton, sugar cane, oilseeds and cattle), growth of which might otherwise have decelerated as the scope for further import substitution was reduced. 10. Acceleration of growth of the manufacturing sector since 1967,as compared to the earlier post-war period appears for the most part to be the result of increased availabilities of foreign exchange for purchasing required intermediate imports 'and investment goods and to expansion of export sales. While it is still too soon to identify long-term trends which may have been triggered by the set of measures introduced in 1967-68, there does appear to have been a shift in resource allocation toward tradeable goods and a tendency for the economy to become more open as the ratio of total imports to GDP has increased from 14 percent in 1967 to about 17 percent in 1974. This in turn has permitted a more efficient allocation of resources and a higher rate of growth and has now allowed policy makers to shift their attention to resolution of the serious structural problems - such as rural and regional poverty, malnutrition, and existence of a low-productivity, traditional urban sector - which impede accelerated development. 11. Colombia has, during the high growth post-1967 period, achieved relatively more growth from a given level of investment than in the pastpas the implicit incremental capital output ratio declined from 3.93 during the 1960-67 period to 2.90 during the 1968-74 period. During the earlier period economic growth was repeatedly interrupted by erratic stop-go fiscal and monetary policies which generated excess capacity, especially in sectors which were either directly or indirectly dependent upon imported inputs. The result was a decline in the average level of capacity utilization and a corresponding increase in the incremental capital-output ratio. As the balance of payments situation improved during the post-1967 period and -5 growth accelerated, much of the increased output was generated by increased capacity utilization. Avoidance of stop-go cycles in the domestic economy, reinforced by strong demand in world markets,permitted more efficient invest- ment and production processes than those which took place under the erratic swings in aggregate demand of the 1960-67 period. Sustaining the higher levels of growth achieved since 1967 will, in the future, require additional increases in the investment coefficient, since there are indications that the economy is currently operating at close to full capacity and that an increasing share of incremental output will have to come from addition to installed capacity. Table I: COMPOSITION AND GROWTH OF GDP (1967-74) 1961 1970 1974 Growth 1967-70 Growth 1971-74 -- - --U ) - -- -) (%) GDP 100 100 100 6.4 6.5 Resource Gap -0.7 1.9 1.1 Available Resources 97.6 102.7 100.5 7.1 4.3 Consumption 80.6 82.7 81.6 7.4 6.1 Gross Domestic Investment 17.0 20.0 18.9 9.1 5.0 Gross Domestic Savings 19.4 17.3 18.8 3.5 8.7 Source: Banco de la Republica and IBRD. C. Development of the Productive Sectors &gricul ture 12. Performance of the agricultural sector has,in recent years,exceeded historical trends,as growth of output has accelerated to well above 4 percent. Exceptionally large crops of rice, cotton, and grain sorghum contributed to a large increase of output in 1974 and production of these crops has increased substantially over the past decade. There have also been substantial increases in production of export crops, such as sugar, cacao and caraota beans, and sub- sistence crops such as cassava, common dry beans and potatoes. Gains in crop output have for the most part been realized through expansion of planted acreage. Onl.y in the case of rice has increased yield been a dominant factor and this is the result of replacement of irrigated rice growr under advanced technology for the traditional cultivation of dry land rice Additions to cropland have mostly taken place in the coastal lowlands n-ud eastern plains, rather than along the cordilleras. Much of the additional crop output is being produced under a new structuring of relationships between producers, land, and products. -6- 13. The national cattle herd, which in 1974 numbered an estimated 23.9 million head has grown at a 3-4 percent annual rate. The production of meat is relatively low compared to the size of the herd, reflecting the relatively extensive type of livestock management which predominates in Colombia and which is also to be found in such countries as Brazil and Paraguay. Animals of the dairy breeds and others classified as milking stock account for only about a seventh of all cattle. The dairy industry continues to be rather unsophisticated as much of the milk output comes from cows kept primarily for beef production. Industry 14. During 1967 through 1974 the manufacturing sector growth rate rose to between 9 to 10 percent annually, a level unmatched since the 1950's. This was achieved with relatively modest investment levels,as capacity utilization seems to have increased in several branches of industry. Despite rapid growth of industrial employment, labor costs did not increase as a proportion of value added and labor intensive industries maintained their competitiveness. Industrial exports rose from an insignificant level to US$380 million in 1974. Despite acceleration of growth and employment since 1967, industry still faces serious near term problems. While the expansion in aggregate demand facilitated rates of industrial growth considerably higher than those recorded in the first of the 1960's, mounting inflation in recent years has had damaging effects on a number of industries. Increases in international prices, additional domestic costs, higher interest rates and longer delays in payments from customers have soneezed profits of a number of industrial enterprises. Shortages of raw materials and spares have caused additional difficulties. In 1974 the effects of inflation on real incomes reduced purchasing power, thus leading to underutilization of capacity in consumer goods industries such as textiles and clothing. 15. The five largest industrial branches in order of importance are textiles, beverages, food products, chemical and non-metallic minerals, which together contribute more than 60 percent of total value added in manufacturing. The share of the capital goods industry in total value added in manufacturing is somewhat lower in Colombia than in a number of other countries at similar stages of development. This group of industries is not well suited to the scale of production which the Colombian market permits. In contrast to the inefficiency of several capital goods branches, a number of industries producing consumer goods are quite efficient by international standards. The food processing and textile industries have not received heavy protection. They are long established, efficient and there is substantial domestic competition which has kept prices low. - 7 - D. Recent Growth and the Development Challenge 16. Despite the rapid growth and development of Colombia over the past six years, the broadening of its productive base and the strengthening of its infrastructure, the country remains a poor one, with a relatively small modern sector superimposed on a large traditional one. The benefits of economic growth have not been widely spread,as it seems clear that the exist- ing distribution of personal income is markedly unequal. The poorest fifth of the population appears to be receiving 4 percent of total income, while the richest fifth gets about 60 percent. Rural incomes appear to be more highly skewed than urban incomes, and the increasing concentration of the population in urban areas would seem to present a prima facie case for presuming a modest improvement in the overall national income distribution. This con- clusion is to some extent supported by national income accounts data which indicate that the share of wage and salary income of GDP increased from 36 per- cent in 1950 to 40 percent in 1970. Few Colombians would accept past rates of improvement as adequate, however, and a great deal remains to be done in order to spread the benefits of economic growth more widely. The new Government recognizes that rural development and a vigorous effort to boost overall production and employment growth are needed, and it has already initiated action in a number of important areas. 17. The Government is deeply conscious of the aspirations of the mass of the Colombian people for greater social equity. It is now turning its attention to the formulation of a long-term development strategy aimed at resuming the country's recent growth track and also at making major improve- ments in the structure of Colombian society, designed to improve the position of the poorest 50 percent of the population. To achieve this objective priority will be given to (1) apriculture, (2) nutrition, (3) the planned development of urban areas, (4) export expansion, and (5) industrial development. While there is little doubt that the potential exists in Colombia for the realization of such ambitious goals, success will depend upon continuing progress in the restraint of inflation and upon correction of the deterioration which occurred in the balance of payments in 1974. Equally important, the Government must reverse the decline in public savings and the associated reduction in the inflow of long-term official capital dating from 1971, which have caused a declining level of real public investment. 18. The accomplishment of the Government's ambitious development goals will depend heavily on its success in coping with weakening economic performance. While during 1973 and 1974 performance of the Colombian economy was outstanding in several important respects, there were clear indications, especially during late 1974, of economic difficulties ahead. Preliminary data for 1973 show GDP growth of 7.2 percent; however, estimates for 1974 indicate a slowdown to about 6 percent. - 8 - While industry continues to be the leading growth sector, expanding by 10 percent and 7.2 percent in real terms in 1973 and 1974, and accounting for about 30 percent and 25 percent of growth of GDP, a construction boom has taken place in Colcmbia and value added by that sector increased 12.6 percent and 11.6 percent respectively in 1973 and 1974. This rapid growth of the labor-intensive construction sector and of industry has resulted in a significant increase in urban employment, but despite this, rapid rural-urban migration and increased participation rates have resulted in higher rates of unemployment in most of Colombia's major urban centers. While the rates of growth of agriculture of 4.7 percent and 5.0 percent in 1973 and 1974 were well above the historical average of 3.3 percent, most of this growth in 1973 was concentrated in export agriculture. Reduced production for domestic consumption, insufficient to keep pace with domestic demand, contributed to accelerating inflation. Mining production fell by 4.2 percent and 5.4 percent in 1973 and 1974, respectively, due to declining petroleum production. 19. The most obvious symptom of economic distress was that during 1973 and 1974 inflation was a persistent and serious problem, reaching 25 percent by year-end 1973 and an annual rate of 30 percent during the first quarter of 1974. Acceleration in the rate of inflation was the result of a surge of aggregate demand stemming.from the large deficit in the cash opera- tions of the public sector, and a sharp increase of credit to the private sector. Tight controls on imports combined with rising costs of labor and credit, and a decline in the output of agricultural production for domestic consumption further aggravated inflationary pressures. 20. Measures adopted in late 1973 and early 1974 to limit the rate of expansion of aggregate demand and increase aggregate supply (including increased commercial bank reserve reauirements, quarterly ceilings on bank tPlacements, easing of import restrictions, and reductions in external tariffs) began to take hold during the second quarter of 1974, and the rate of inflation dropped to an annual rate of about 20 percent by July 1974. During the fourth quarter, however, the Government introduced an average 4O percent increase in sales tax rates and adjusted prices of several items which are important in the consumer price index. This corrective action, while necessary to prevent serious misallocation of resources, gave rise to a once and for all increase in the price level, and inflation reached 27 percent for the year, about the same rate as in 1973. 21. Since taking office in August 1974, the new Government has imple- mented strong fiscal, monetary and exchange rate measures aimed at reducing inflation, improving public finances and strengthening the balance of payments. The Government has assigned a high priority to reducing inflation from the current level of 27 nercent and it is likely that the increase in the price level will be down to the targeted 20 percent by the end of 1975. Management of the Colombian economy in 1975-76 will, however, be a complex task since there is the danger that contractionary forces already set in motion by the Government's stabilization program could be amplified by recessionary pressures from abroad. - 9 - 22. It is already clear that GDP growth during 1975-76 will be below the average of 1970-74. The new economic team is aware that the economy is going through a period of transition in which the situation could change rapidly, and is attempting to follow policies aimed at reducing inflation, while avoiding a sharp contraction in the rate of growth of output and employment, and protecting the current level of foreign exchange reserves which it considers to be at a desirable level. In addition, the Governmeni is anxious to step up its development effort. Simultaneous accomplishment of these goals would reouire increases in domestic savings and investment and substantial inflows of foreign capital. While stabilization will remain the Government's first priority during 1975, there is general recognition of the need to increase public investment spending in real terms so as to maintain the pace of development and offset recessionary pressures which seem to be gaining momentum. 23. In addition to persistent inflation, there were increasing symptoms of fiscal weakness, which required a scaling down of public investment efforts and which hampered the Government's attempts to arrest inflationary tendencies. Furthermore, there was evidence of deterioration in Colombia's terms of trade and a slackening in demand for manufactured exports, which could reinforce recessionary pressures. Finally, the loss of self-sufficiency in petroleum production which became increasingly apparent in 1973-74 and which was highlighted by the dramatic increase in world oil prices could have serious longer-term implications for Colombia's growth prospects. - 10 - CHAPTER II FINANCIAL REFORM AND RESOURCE MOBILIZATION A. Public Finances 24. Colombia's post-war experience suggests that strengthening of the country's fiscal system is necessary to achieve an adequate level of self- sustained growth. Fiscal weakness has in the past resulted in chronic govern- ment deficits which were major sources of inflation and has impeded expansion of infrastructure investment and vital social programs. Furthermore, a Govern- ment administration capable of appropriating and allocating a sufficient share of the productive resources of the economic system is a direct reflection of a country's commitment to developmeat and has an important bearing on income distribution, as well as the rate of growth of the economy. The post-war period in Colombia has witnessed numerous efforts at tax reform and a gradual increase in the importance of the National Budget relative to those of the Departments, but no sustained upward trend in the ratio of National Governmnent revenue to GDP, with the exception of the period from 1967 to 1971. 25. During this period there was a notable improvement in Colombia's fiscal performance due to strengthening of the sales tax, introduction of pay-as-you-go system for the income tax, reduction in the subsidy provided to consumers of gasoline through an increase in the "petroleum dollar", and implementation of a number of other revenue-producing tax measures of an administrative and legislative nature. Despite rapid growth of fiscal incentive payments for non-traditional exports during this period, net current receipts of the National Government increased from 8.0 percent of GDP in 1967 to 9.L percent in 1971. The rapid growth of current expenditures due to large increases in current transfers to departments and municipalities during this period would have resulted in a substantial decline in National Government savings had it now been strong revenue performance, and savings declined only slightly as a percentage of GDP from 3.1 percent in 1967 to 2.7 percent in 1971. 26. From 1971 to 197L, however, there was a steady deterioration in public finances characterized by a decline in the share of net current receipts of the National Government to GDP from 9.L percent in 1971 to 8.3 percent in 1974. Overall tax buoyancy declined sharply as a result of the strong negative impact on Government cash revenue of the increased use of export tax credit certificates (CAT's) and as a result of administrative deficiencies. With the exception of 1972 when there was a sharp jump in National Government investment spending made possible by a three-fold increase in external borrowing, deterioration of public finances has been reflected in a declining level of investment by the National Government in real terms. Investment spending by the National Government declined from 4.2 percent of GDP in 1970 to 3.4 percent in 1974 (see Table II). - 11 - TABLEII: COLOMBIA: 1ATIONAL GOVERMENT OPERATIONS (% of GDP) 1970 1971 1972 1973 1974 Net Current Revenue 9.2 9.4 8.6 8.4 8.3 Current Account Surplus 3.1 2.7 2.4 2.3 2.6 Investment Expenditures 4.2 3.9 4.5 3.5 3.4 Source: Banco de la Republica and IBMD. 27. The deterioration of the National Government's financial performance since 1971 has been accompanied by weakening of the rest of the public sector's capacity (departmental and municipal government and public enterprises) to mobilize domestic resources and execute investment. Declining tax revenue and operating revenues of the public decentralized agencies resulted in a drop in total public sector savings from a high of 7.1 percent of GDP in 1970 to 5.5 percent in 1974 (see TableIII). Despite the increase in net external borrowing public investment declined from 10.2 percent of GDP in 1970 to 8.6 percent in 1971. Reform of the Tax System 28. The Government of Colombia implemented a tax reform of major proportions in the last four months of 1974, as part of a comprehensive set of stabilization measures under economic emergency authority provided in the Constitution. The reform, described in its entirety in Volume III,covered almost every important component of the tax system and represents a clear and significant improvement over the prior system on nearly all counts. If the basic features of the reform remain intact over the coming months, it will stand as a landmark in the recent history of such undertakings, both among developing and developed nations. 29. The tax reform was the outgrowth of careful and intensive planning by a high-level team of Colombian experts appointed in May 1974 by the then President-elect to study alternatives for revamping the revenue system. In turn, many, but by no means all, of the tax measures were based upon six years of near-continuous discussion, under three administrations, of the proposals of the 1968-69 Colombian Commission on Tax Reform (known as the Musgrave Commission) which presented in early 1969 a comprehensive report setting forth options for fiscal reform in considerable detail. The reform,as adopted, incorporates many of the specific recommendations of the Commission report, but in a number of cases inproves upon these recommendations and embraces several issues not dealt with by the Commission. - 12 - TABLE III: COIMTA: UBLIC SECTOR RESOURCES FOR TVESTIENT 1970-7h (as per cent of GDP) ACTUAL ESTIMATED 1970 1971 - 1972 1973 1974 :1. SOURCE' A. Current Account Surplus 6.4 5.4 4.4 5.5 1. Central Government =59 47 National Government 4.6 4.7 4.2 4.0 4.2 National Highway Fund - - - - - Social Security 0.3 0.4 0.2 0.3 0.2 2. Decentralized Agencies 1.0 0.6 0.5 - 1.0 (a) National Decentralized Agencies 0.5 - - 0.1 - 0.6 0.5 ECOPETROL 0.4 0.6 0.7 0.6 1.6 IDEMA 0.1 - 0.2 - 0.3 - 0.6 - 0.7 TELECOM 0.2 0.2 0.2 0.2 0.2 Others -0.2 - 0.7 - 0.8 - 0.8 - 0.6 (b) Municipal Decentralized Agencies 0.6 0.6 0.6 0.6 0.5 EAAB 0.1 0.2 0.1 0.1 0.1 EEEB 0.2 0.2 0.2 0.2 0.1 EPM 0.2 0.2 0.2 0.2 0.2 Others 0.1 - 0.1 0.1 0.1 3. Departments 0.2 - 0.1 - 0.4 -0 4. Municipalities 1.0 0.8 0.5 0.5 0.4 B. Capital Account Revenues 0.6 0.4 0.4 0.5 0.3 C. Borrowing 5.7 5.9 7.2 6.4 5.3 1. External 2.7 2.7 3.7 3.3 1.9 2. Domestic 3.0 3.2 . 3.5 3.1 3.4 TOTAL 13.4 12.8 13.0 11.3 11.1 II. USES A. Investment Expenditures 10.2 9.8 9.4 8.6 8.6 1. Gross Fixed Investment 9.3 8.8 8.6 7.9 7.9 a. Central Government 1.8 2.0 1.8 1.4 1.4 National Government 0.6 0.6 0.6 0.4 0.5 National Highway Fund 1.2 1.3 1.2 0.9 0.9 Social Security - 0.1 - - - b. Decentr.lized Agencies 4.5 3.9 4.3 4.0 4.2 (1) National Decentralized Agencies 3.3 3.0 3.4 3.2 3.5 ECOPETROL 0.6. 0.6 0.8 0.7 1.0 INSCREDIAL 0.5 0.5 0.5 0.4 0.5 ICCE 0.2 0.2 0.2 0.3 0.3 CVC - 0.2 0.3 0.4 0.3 ISA 0.4 0.3 0.3 0.4 0.4 Otlers 1.6 1.3 1.3 1.0 1.0 (II) Municipal Decentralized Agencies 1.2 0.9 0.9 0. 0.7 EA/B 0.4 0.3 0.3 0.2 0.2 EPY 0.3 0.3 0.3 0.2 0.3 Others 0.5 0.3 0.3 0.4 0.2 c. Departments 0.9 1.0 0.8 0.7 0.6 d. Municipalities 2.1 2.0 1.7 1.9 1.7 2. Financial Investment 0.9 1.1 0.8 0.6 0.6 ICSS 0.5 0.6 0A4 0.4 0.4 Others 0.4 0.5 0.4 0.2 0.2 B. Amortization Payments 3.1 2.6 3.2 2.5 2.3 1. External 0.9 0.8 1.1 1.0 0.8 2. Domestic 2.2 1.8 2.1 1.4 1.4 C. Cash Balances - - 0.2 0.2 TOTAL Banc2.8 d l10 11. 3 1 Source: Banco de la Reputii~ ca ancL IBkUJ. - 13 - 30. The principal objectives of the 1974 reform were: a) greater progressivity in the distribution of the tax burden; b) removal of elements of the revenue system that had served to distort resource allocation; c) promotion of economic stability, through strengthening the revenue productivity of the tax system, particularly through measures to enhance the responsiveness of the tax system to growth in aggregate income; and d) reduction of tax evasion, both through enactment of new measures to combat evasion and through administrative simplification and rationalization of tax law. Progressivity 31. One of the principal features of the Government's announced program is that of improving the relative position of the lowest 50 percent of the income distribution, through use of budgetary and other policy instruments. While Colombian policy-makers recognizedthat the expenditure side of the budget is important in securing improvement in income distribution, they felt that tax policy should play a strong supportive role, and that fundamental tax reform in the direction of much greater progressivity was required for doing so. Many features of the reform may be expected to contribute to enhanced progressivity of the tax system. These include entirely new taxes as well as substantive revision in existing taxes. Prominent among the new measures for increasiAg progressivity were creation of a new tax on capital gains, and establishment of a new presumptive income tax on taxpayers in all sectors of the economy. 32. The principal revisions in tax law designed to enhance progressivity were: a) adjustments in the rate structure of the personal income tax; b) elimination of a number of deductions and exempt income items which primarily served to benefit upper income taxpayers; c) conversion of most remaining exemptions and many former deductions into tax credits, the benefits of which do not depend on the marginal rate of tax faced by the taxpayer; d) adjustments in rate structure of the net wealth tax and rationalization of exemptions under the tax; e) drastic restructuring of death and gift taxes, to enable more equitable taxation of capital transfers of this type; f) measures to reduce the scope for tax evasion opeli to recipients of capital income, who are primarily found in upper income groups; g) heavier emphasis upon taxation of "luxury" consumption, through upward adjustments in sales tax rates on such items; and h) inclusion, for the first time, of many services in the sales tax base, primarily those consumed by upper income families. - ilb - Resource Allocation 33. Various important elements of the existing tax system tended, to produce significant anomalous and unintended effects on resource allocation and productive efficiency. The reform sought to eliminate many of these, or at least reduce the scope for adverse unintended effects, through the following adjustments. a) adoption of a flat-rate income tax on business entities, in place of the previous complex of marginal rates for both the basic income tax and a host of complementary income taxes; b) enactment of more realistic tax treatment of operating losses and slightly more generous depreciation rules; c) abolition of several tax incentives and/or exemptions previously intended to direct business investment into favored activities, but which mainly served to reduce revenue, progressivity andfrequently yielded undesired results; d) reduction in the scope of customs and income tax exemptions for state enterprises, decentralized agencies and government offices; e) inclusion of previously untaxed services of an income elastic nature in the tax base, thereby redressing the previous consumption incentives in favor of such services and against consumption of taxable goods; f) relaxation and/or removal of certain arbitrary limits on deductibility of expenses; and g) conversion of several business tax deductions into tax credits, thereby reducing some capricious features inherent in the previous system- Tax Administration 34. The architects of the 1974 reform were cognizant of the problem of tax evasion. Many of the tax measures adopted as supportive of equity and revenue goals were also designed to reduce the scope for tax evasion and avoidance, while other measures were specifically directed toward enhancing the tax administration and toward curtailment of widesprcad evasion. These include: a) adoption of the presumptive income tax, applicable to all economic sectors; b) imposition of a heavier, but in most cases realistic, system of fines and penalties; c) closing off or limitinr7 avenues of avoidnce and evasion open to recipients of capitai income through a new tax on irregular income; d) simplification of the tax structure, particularly with regard to business taxes, and especially with regard to effects of the previous rate structure in complicating administration and compliance; e) adjustments in the exemption machinery for the sales tax - 15 - through installation of a rebate system to replace a complex mechanism for freeing exempt goods from tax; f) changes in the structure and orientation of taxes on payments to foreigners (dividends, interests, etc.), which served to limit the scope for evasion and avoidance on such transfers; g) changes in the tax treatment of intercorporate dividends, which served to place a mild tax on this item while also rendering avoidance through this device more difficult, and achieving notable simplification at the same time; h) abolition of a number of tax exemptions and adoption of limitations on others, both of which may serve to close off possibilities of evasion and avoidance arising from efforts to convert income into exempt or favored forms; i) adoption of higher income tax rates applicable at tne business entry level, for limited liability companies and partnerships. The earlier capture of a part of revenues at the entity level will, on the face of it, reduce scope for evasion at the individual level, after profits of such enterprises are distributed to the owners; and, j) tightening of the scope of, and eligibility requirements for, customs exemptions for state enterprises, decentralized agencies and government offices. 35. The reform did not serve to enhance administrative feasibility in all respects. However justifiable the rate increases in the sales tax may have been on revenue income distribution grounds, the present rate structure still suffers from an excessive degree of "fine-tuning" that will render the tax more difficult to operate, and the height of some of the rates will increase incentives for evasion and for smuggling of high value low bulk items. Only a truly determined and continuous campaign of enforcement will prevent sales tax evasion from rising above previous levels, as long as high luxury rates are included within the scope of the tax. Further, the inability of officials responsible for property tax administration to have access to net wealth tax declarations will permit continued high evasion under the former levy. Nevertheless, the reform should leaiethe tax system, on balance, more enforceable than it was previously. Stability and Revenue Yields 36. The reform served to appreciably enhance the ex-ante revenue elasticity of the tax system with respect to nominal growth of GDP, and certainly will do so if administrative efficiency in tax collection does not decline over the next few years. Perhaps more importantly, the reform yielded a tax structure that, by virtue of its expanded base and rationalized structure, should be able to support revenue-increasing adjustments in rates consistent with equity and allocative tax policy goals in the future. While the measures will have a positive impact of revenues in 1975, the full effect will not be felt until 1976. The fiscal reform will not, by itself, generate savings sufficient to sustain levels of public investment consistent with the high GDP growth rates achieved in 1970-73. - 16 - TAELE IV: COLOMBIA: PROJECTED PATTERN OF FINANCING PUBLIC SECTOR INVESTMENT, 1975-1980 (In millions of Colombian pesos at current prices) P R 0 J E C T E D 1975 1976 1977 1978 1979 1980 Resource Re1quirmnts 33,063 43,945 58,977 78,027 98 540 120 A. Gioss Fixed InvLstrenat 28,599 39,150 52,194 68,046 84290 100,452 1. Central Goverint 5,720 7,556 10,073 13,133 16,268 19,387 National Govei Lent ( 1,985) ( 2,310) ( 3,079) ( 4,015) ( 4,973) ( 5,927) National. High . Fund ( 3,535) ( 4,972) ( 6,629) ( 8,642) (10,705) (12,757) Social Securi.y ( 200) ( . 274) ( 365) ( 476) ( 590) ( 703) 2. Dccentr;'itized <oncies 14,014 19,340 25,784 33,615 41,639 49,623 3. Departnents 2,574 3,602 4,802 6,260 7,755 t),242 4. Muuicipatita. 6,291 8,652 11,535 15,038 18,628 22,200 E. Amortization (E< £nal) 4,7644,795 6,78 9,981 14,250 19,633 Financing 33,063 43,945 58,977 78,027 9850120 085 A. Public Sectoi S . 20,621 27 859 35,470 44,911 55,205 65,529 1. Central ,ovLr ut 18,042 25,432 30,881 38,063 45,667 54,674 National Gove -at (17,158) (24,589) (30,133) (37,467) (45,287) (54,566) National i.h 3 Fund ( 118) ( 127) ( 136) ( 145) ( 154) ( 162) Social Seculit ( 766) ( 716) ( ) ( 451) ( 226) (- 54) 2. Decentralize] encies 2,696 2,848 5,371 8,038 11,191 12,998 3. Departments. -1,361 -1,682 -2,039 -2,430 -2,852 -3,287 4. Muicipalite 1,244 1,261 1,257 1,240 1,199 1,144 B. Capital Account i,- iues 1000 11000 11,000 1,000 1)000 C. Borrowing 11,442 15,086 22,507 32,116 42,335 53,556 1. External 12,786 15,392 23,067 30,008 36,638 42,452 2. Internal (ne tc) -1,344 - 306 - 560 2,108 5,697 11,104 Banking Sy;- ( 1,000) (- 834) ( 266) ( 4,008) ( 4,538) ( ) Other (-2,344) ( 528) (- 826) (-1,900) ( 1,159) ( 4,324) Source: IBRD estimates. - 17 - 37. As a result of the tax reform and measures under consideration public savings should in the future be sufficient to finance a larger share than in recent years of an expanded level of public investment. Gross fixed investment of the public sector could increase from 7.1 in 1975 to 9.L percent of GDP in 1980. These levels of investment should assure that infrastructure bottlenecks which might impede GDP growth do not arise while allowing higher levels of investment in social sectors consistent with the Government's distributional goals (see Annex 3). Decentralized agencies will probably account for about half of public investment, only about one-fifth of which would be financed by savings of these agencies. The National Government is expected to remain the largest source of public sector savings and should continue to partially finance capital outlays of other agencies, departments, and municipalities, through capital transfers. Total public investment on average, while net external borrowing, including disbursements and amortization of new and existing loans, is expected to finance one-third (see Table IV). B. Private Sector Financing 38. Although Colombia has a reasonably well developed financial system in comparison with most other countries in Latin America, the system has in the past operated under a high degree of Government control and regulation which limited its effectiveness in mobilizing private savings and in allocating these resources efficiently to alternative investment opportu- nities. Instruments of monetary policy which have been devised to channel credit to high priority sectors in terms of development strategy have tended to have an adverse effect on mobilization of private savings through the financial system. Most interest rates have been held at artificially low levels by the Governnent and wide differentials have existed between the interest rates available to different types of borrowers and savers. Financial intermediaries have operated under cumbersome regulations that have forced them to direct a high proportion of their resources into developmental activities at subsidized interest rates. Fragmented capital and money markets have contributed to misallocation of resources and have impeded entrepreneurial growth, perpetuating the use of inferior production techniques. Resource mobilization by the private sector has been hampered by competition from tax exempt public sector instruments with immediate Tiquidity which, in recent years, have been increasingly relied non to shore up weak public sector finances. As a result of the severe constraints on the supervised financial sector, a large and active extra-bank market has developed which has simultaneously prevented more rapid development of an efficient, competitive system of financial intermediation. - 18 - 39. The financial reform package which was introduced by the new Administration shortly after entering office in August 1974, was aimed at producing a more balanced flow of resources through Colombia's financial system and providing the authorities with greater monetary control. The reform included a restructuring of interest rates including a maximum ceiling on the rate of monetary correction, a simplification of Colombia's complex reserve requirement system, the elimination of numerous portfolio requirements, the elimination of several rediscount facilities and the adoption of more stringent controls over existing facilities. This section describes briefly the major features of the monetary reform and sets out recommendations for further policy action. A more detailed and comprehensive outline of the reform and its background is presented in Annex III. Interest Rate Pblicy o. Historically, interest rates have been kept low in Colombia, below those which would have prevailed in a free market. While banks have been able to circumvent fixed loan rates through the common practice of requiring compensating balances and pre-payment of interest, this has not been the case on the deposit side, and as a result it has been difficult to provide savers with adequate yields necessary to induce a larger flow of financial savings. The upsurge of inflationary pressures in recent years has accentuated these distorting elements by making financial yields sharply negative in real terms. The introduction in 1972 of indexation on the deposits (UPAC 's) of the savings and loan institutions resulted in positive yields, on one savings instrument, but at the same time the piece- meal introduction of indexation created new problems in the form of an imbalanced flow of resources through the financial system. Changes in Colombia's interest rate structure enacted in the 1974 reform represented an attempt to ameliorate distortions which had arisen through this policy. 4l. The reform narrowed the large interest rate differentials between indexed savings and loan deposits and other financial instruments by introducing a maximum annual ceiling of 20 per cent on the calculation base for monetary correction, by lowering the basic interest rate on indexed certificates of deposit on passbook accounts, and by removing the tax exempt status on the indexed portion of earnings. Simultaneously, interest yields on non-indexed passbook savings accounts were raised. Further, non-indexed negotiable three-month certificates of deposit which were intro- duced in February 1974, can now yield a maximum of 21 percent. 42. Higher interest rates were also introduced on the asset side. The loan rate for normal credit operations was raised and the rate for working capital loans made with resources accruing from certificates of deposit was increased. The interest rate on agricultural loans, and industrial loans were also boosted. - 19 - Legal Reserves, Portfolio, and Investment Requirements 43. Commercial and specialized banks in Colombia have been subject to legal reserve requirements on their deposit liabilities, to certain invest- ment requirements, and to portfolio distribution requirements. The reserve requirement mechanism in Colombia is more complex than in most other countries, as it is used not only to control the volume of bank lending, but also (although to a lesser extent) as a credit allocation device through the use of specified loans and securities which can be counted against the reserve requirement. Selective control over the destination of credit has also been achieved through a complex system of forced investment requirements which directs defined proportions of bankst'deposits and portfolios toward priority sectors such as housing and agriculture as well as the financing of the public sector deficit. The burden of the forced investment: regime has grown in recent years, and the low return on forced investments has acted as a stumbling block to the introduction of market related interest rates, preventing financial insti- tutions from competing with unregulated intermediaries for domestic savings. h4. Against this background, the 1974 monetary reform simplified the reserve requirement system and liberalized the forced investment requirement regime. The monetary reform eliminated the dual (reduced and regular) reserve requirement system under which banks adhering tospecified conditions were entitled to a reduced reserve requirement. In addition, the special reserve requirement on foreign indebtedness of commercial banks was eliminated. 45. The forced investment requirement which had channeled b4 percent of all savings deposits into housing and savings bonds issued by the Territorial Credit Institute was frozen at its June 1974 level. Similarly, the require- ment that 36 percent of resources captured through savings deposits be channeled into specified credits at concessionary rates was eliminated. The new negotiable certificates of deposit have not been subjected to any forced investment require- ment, and will have the effect of increasing freely disposable loanable funds available to the banks. Rediscount Policy 46. The Colombian monetary system provided a proliferation of re- discount facilities by the Banco de la Republica to meet automatically and unconditionally the credit needs of Government designated priority sectors and assure the liquidity of the banking system. This allowed virtually uncontrolled credit expansion and posed a serious challenge to effective monetary management. In recent years the growth of these rediscount facilities has reflected both the weak public sector savingo performance as well as the shorbage of financial savings to finance the Goverrment's development priorities. The mcnetary reform establiahed a new ordinary rediscount facility to meet the liquidity needs of the banking system, but unlike the previous facility, it is not a panent nor automatic mource of resources for the banking system, and it cannot - 20 - be used to generate new credit. The reform also provided for the first tne for the use of fiscal,as opposed to Central Bank rediscountedresources, 1 the financing of the special develorment rediscount lines known as the Administered Funds. This was accomplished by raising the import surcharge from 1.5 per cent to 5 per cent, and earmarking the revenue captured for the Export Promotion Fund. In addition, the authorities moved the Urban Development Fund from the Banco de la Republica to the Mortgage Bank with financing for this fund to accrue from Mortgage Bank profits. Other Measures 47. The reform eliminated all credit ceilings which had been in effect since 1972 on the portfolios of the commercial banks. Use of open market operations which the Central Bank had started in early 1974 has continued. Although these operations had not met with much success during 1974, the introduction of higher interest rates could render this a more effective instrument of monetary management, and thereby substantially reduce the need for frequent modifications of other instruments as well as the need to rely so heavily on administrative controls. 48. Investment bank bond issues an corporate bond issues have always been limited by the fact that BCH-and development bonds dominated the market owing to their tax-exempt status. However, the fiscal reform enacted in late 19714 has eliminated these tax exemptions on public sector debt instruments which were distorting competition between the public and private sectors as well as resulting in growing tax revenue losses. Thus, the ability of corporate and investment bank bonds to compete in the market has been enhanced. 49. A nroblem which has always confronted economic policymakers in Colomia has been the contrast between short-term, highly liquid nature of .nancial savnc-s and the need for longer-term resources to be channeled into 0,-(dj tf7. fr on ttemp-1t to sti-iult- a ln-emfuIIn( r"ut thu monetary reform introduced a measure 1-hich authorizes the insurance companies to issue a conmletelT ne, ti_e of life insurance policy under which the -nsured individual. i7 -uaranted to receive a part of the profits originatng from the investment of his premiums. Simultaneously, this measure frees all funds raised by the insurance companoes in this fashion from forced investment requirements. This new flow of funds into the insurance industry can be invested up to 30 percent in the stock market and the remainder in UPAC certificates and invest- .ent bank bon. In addition to the potential stimulus provided for the stock n_rket, it was hoped that this measure would offset the outflow of funds from the CAVs, thereb- preventing th( need for direct support from the Banco de la Repablica. However, in the first six months of operation this scheme has not been proven successful as the insurance companies consider their rate of return to be too low under the new scheme, and the high rates of inflation as well as the preference for liquidity demonstrated by the Colombian saver have discouraged demand. ./ Banco Central Hipotecario - 21 - CHAPTER III BALANCE OF PAYMENTS AND GROWTH PROSPECTS A. Recent Performance 5o. Colombia's external liquidity, as measured by its foreign exchange reserves and its debt service ratio, strengthened considerably during 1972-73. This was the result of strong export growth sparked by rapid expansion of coffee and most minor products. The surge in coffee expor+ V was particularly strong in 1973 largely as a result of spiralling world zoffee prices (from an average of US$0.57 per pound in 1972 to US$0.73 in 1973) which began in mid-1972 as Brazilian production declined. Of even greater significance was the remarkable growth of minor exports which increased 60% between 1971 and 1973, reaching US$671 million, or fully half of export earnings. While international inflation accounted for a significant proportion of the growth, rising volumes are estimated to have accounted for approximately half. While exports were surging, import growth was relatively modest 8 percent in 1972 and 13 in 1973. As a result, the current account deficit was virtually elimiated in 1972 and 1973. This, together with strong capital inflows during 1972 and 1973, resulted in total accumulation by the Central Bank of foreign exchange reserves of almost US$350 million in the two years and reserves reached US$515 million at the end of 1973. It should be pointed out, however, that the relatively small increase in import volumes and consequently large reserve accumulation were not an unmixed blessing, contributing to inflatiDnary pressures. Despite substantial capital inflows, the country's debt service ratio declined somewhat, from 14.8% in 1971 to 13.0% in 1973. 51. Balance of payments performance continued to be strong during the first half of 1974 as export performance was outstanding. Higher world coffee prices (US$.80/lb.) and a 34 per cent increase in volume of coffee shipped together with strong expansion of minor exports (58 percent) contributed to the continued rise in foreign exchange reserves. However, performance began to show signs of weakening in the second half of 1974 as government decisions to reduce reserve accumulation by advancing import payments, liberalizing imports and reducing external borrowing were accompanied by an unexpected spurt in import prices and a weakening of the coffee market. In early 1973 the monetary authorities, concerned with expausionary pressure steamnming from the large accumulation of foreigh exchange reserves moved to limit further increases in reserves by eliminating the system of advanced foreign exchange surrender for exports, and by increasing the reimbursable import budget from a montbly average US$86 milion in 1973 to US$125 million. As a consequence of this liberalization ., imports rose by 41 percent with more than half of this increase due to world inflation. Reduced external borrowing by the Rovernment, together with a decline in world coffee prices and reduced shipments of coffee during the second half of 1974, further lovered the inflow of foreign exchange and offi-e reserves declined by UO$7 joill7oi by year-,end, Leaving Colombia with ofial reserves of US$429 millior ,ufficient to cover about th-ree 'onrths f xIds and non-factor service imports !t +'e expected 19 7 rate. / e to the sharp increase in import reg-stratlions, sacrt-rm trade financing increased sharply in 19!l and net foreign exchange reserves of the banking system declined by US$339 million in 1974. -22 - TABLE V: FOREIGN EXCHANGE BALANCE 1972-74 (millions of U. S. dollars) 1972 1973 1974 1975 Current Inflows .1 1,230.4 1.418.9 1,523 Exports of goods 841.5 1,008.7 1,214.5 1,283 Coffee (433.6) (535.4) (543.4) (505) Other (407.9) (473.3) (671.1) (778) Petroleum capital 13.2 12.9 16.6 10.0 Export services 139.4 208.8 187.8 230.0 Current Outflows . 1,160.9 1,52.j 1,798 Imports of goods 9. 714.3 1,078. 1,301 Petroleum refining 47.3 51.4 67.5 70 Imports of services 288.8 365.2 416.5 427 Freight (41.8) (66.4) (112.4) (132) Travel (19.5) (38.1) (53.5) (30) Interest (net) (110.5) (138.8) (120.3) (125) Other (117.0) (121.9) (130.3) (140) Balance on Current Account -1.6 69.5 -113.6 -275 Capital Account 178.1 101.2 26.9 47.0 Private capital (net) 37.9 16.1 32.3 80.0 Loans (net) (25.1) (6.0) (17.5) (50.0) Direct investment (net) (12.8) (10.1) (14.8) (30.0) Official capital 154.7 144.4 .6 -8.0 SDR's (16.6) (---) (---) Official loans and grants (143.1) (138.8) (97.7) (101) General purpose financing (80.0) (98.5) (22.6) (20) Amortization (-85.0) (-92.9) (-119.7) (-129) Other -14.5 -59.3 -6.0 -25 Net Change in Reserves 176.5 170.7 -86.7 -228 1/ Projected Source: Banco de la Republica, Balance Cambiario. - 23 - 52. Given the.difficulties in Colombia's balance of payments in 1975, the authorities-are permitting some drawdown in reserves, while at the same time pursuing a flexible exchange rate policy. Prospects are that additional capital inflows are needed to forestall a further decline in reserves., De- clining demand for minor exports stemming from widespread recession in the developed countries, and the reduction of fiscal subsidies for such exports, together with a reduced volume of coffee shipments is expected to result in a slight fall in the volume of merchandise exports. Prices are expected to be above those of thd previous year for most Colombian export commodities, however, and as a consequence, merchandise export earnings are projected to grow by 4 percent during 1975. 53. The volume of coffee exports is expected to be 6.6 million 60-kg. bags, a decline of 4.4 percent with respect to the export volume achieved in 1974. Colombia's compliance with the coffee producers' agreement will require domestic retention equivalent to 20 percent of average production over the preceding three-year period. The average price of coffee is expected to be somewhat below the 197 level, and under these circumstances the value of coffee exports would fall by about 7 percent. Minor exports are expected to grow less rapidly in 1975 as a result of world recession but it is difficult to anticipate what effect reduced demand for such exports, combined with the various changes both in the export incentive and export restriction systems which became effective in early 1975, will have on their performance. Much will depend on the competitiveness of Colombian exports in world markets and on whether the depreciation of the exchange rate and the availability of subsidized credit to exporters are sufficient to compensate for the reduction of the fiscal incentives for minor exports. 54. Due to the expected strong performance of agricultural exports the value of minor exports is projected to grow about 10 percent in 1975. Non-coffee agricultural exports are expected to grow by over 20 percent in current prices as a result of good sugar and rice crops which will generate large exportable surpluses at a time when the international price for these products is very high. The volume of manufactured exports, on the other hand, is expected to decline by about 12.5 percent in 1975. Textiles and clothing, which represented almost 50 percent of manufactured exports in 1974, will suffer the sharpest decline (estimated at 35 percent) as a consequence of a weakened demand which is expected to recover only after 1975. Exports of chemicals, pharamaceuticals, metallic products, and mechanical and electric equipment are expected to maintain their 1974 levels, whereas other manufactured exports, especially paper and paper products, are expected to fall substantially due to reduced international demand. $5. The monthly import budget for reimbursable imports has been fixed by the Government at US$125 million for the first semester of 1975. Import prices for the year are expected to rise substantially over their 1974 level (about 13 percent). Under these circumstances merchandise import volume - 24 - is expected to decline but not sufficiently to offset price increases and the value of merchandise imports is expected to increase by about 12 per cent. The decline in the volume of raw material ana intermediate goods imports should be the most pronounced since requirements will not be as high as in recent years given the slower pace of GDP growth projected for 1975, and since part of these requirements may be provided from inventories accumulated in 197h. For the first time in the post-war period Colombia will in 1975 have to import petroleum. Assuming no modification in petroleum pric- ing policy, domestic production is expected to decline an additional 6.5 per- cent due to reductions in output of private firms. Domestic consumption of petroleum is expected to continue to grow by 8 percent and imports should reach over 5.1 million barrels of crude. 56. On the basis of the above, the current account deficit of the balance of payments could reach over US$320 million (see Table IX), more than double the 1974 level. Net inflow of long-term public and private capital is projected at about US$125 million, 40 percent lower than in 1974. The loss of foreign exchange reserves in 1975 is projected at over US$200 million. In order to prevent this foreign exchange reserve loss, Colombia is expected to contract an increased level of commercial finan- cial credits in addition to the roughly US$250 million projected loan commitments expected from international development agencies and bilateral sources. B. Medium-Term Prospects 57. In summary, rapidly improving terms of trade and rapid growth in the volume of minor exports, combined with strong performance of domestic savings, permitted Colombia to accumulate substantial foreign exchange reserves over the 1971-73 period. Although Colombia became increasingly dependent upon an increasing flow of imported goods and services, the country had little difficulty in obtaining the foreign exchange necessary to finance these imports through its oun exports and a large inflow of foreign capital. However, during 1971 there was a turn-around in this situation due to a deterioration in the terms of trade, increased imports and reduced inflow of foreign capital. As a result, Colombia was forced to finance a portion of its increased external resource gap by drawing down its foreign exchange reserves. The likelihood of adverse developments on the external side in 1975 as widespread recession in the developed countries results in reduced growth for Colombia's minor exports, combined with the need to prevent further declines in foreign exchange reserves, will reouire Colombia to encourage a substantial inflow of external capital and pursue a flexible exchange rate policy. Continued tightness in the world's capital markets could lead to a substantial shortening in external debt maturities in order to maintain capital inflow of the recuired magnitude. - 25 - 58. The Colombian Government has indicated that one of the principal objectives of economic policy will be to sustain the high rates of growth of output and employment achieved in recent years. Growth of GDP declined in 1974, however, and the outlook for 1975 is for continued deceleration as a result of reduced demand for Colombian exports, continued low levels of public investment and tightening of the foreign exchange constraint. However, if growth in the developed countries resumes in late 1975 and Colombia is able to improve its savings and investment performance, growth of GDP could begin to pick up in 1976 and reach 7.0 per cent by 1978 (see Table VI). It is unlikely, however, that Colombia's terms of trade during this period and beyond will be as favorable as in the high-growth 1970-73 period and the country will have to make a greater internal savings effort if it is to carry out the level of investment required to sustain a 7 per- cent rate of growth witbout recourse to excessive external borrowing. 59. The devl'opment challenge facing Colombia is to return the economy to the higher rates of growth achieved in the recent past and provide increased employment opportunities to all segments of the population and a broader distribution of the benefits of economic growth, in the face of a much less favorable world economic environment. The Government has already achieved considerable success in enacting fundamental monetary and fiscal reforms which should provide the framework for increased saving and a more efficient allocation of that saving into investment opportunities. It is now turning its attention to achieving the twin goals of rapid growth and a more quitable dis- tribution of its benefits t1rough a better use of the country's available resources. Based on the belief that past patterns of investment and growth would exacerbate growing unemployment, wide disparities in income and deep rooted rural and urban poverty, the Government has initiated a development program aimed at accelerating agricultural and industrial growth, at increasing the participation of the most deprived regions of the country in the development process, and at continuing the export diversification drive. Special emphasis is being placed on achieving more widespread distribution of the benefits of growth through expansion of employment opportunities and increased investment in education, health and nutrition programs aimed at benefitting the poorest 50 per cent of the population. 60. Given the likelihood that foreign exchange will be a greater constraint on Colombia's development in the medium-term future than over the past few years, the Colombian Government has designed its economic policy and development strategy so as to strengthen balance of payments performance, increase domestic savings, and improve public finances and has opted for a growth structure which optimizes use of scarce capital and foreign exchange. The policy reforms and development strategy pursued by the new Government, could enable Colombia to return to a rapid pace of development without encountering serious external impediments. - 26 - 61. Agricultural growth has, in recent years, accelerated to well above the historical average of about 4 percent, but there has been a noticeable slowdown in programs aimed at alleviating rural poverty with the result that broad segments of the population in the poorest regions of the country-- Nariio, Boyaca and Choco--have not noticeably benefitted from such accelerated growth. As discussed in Annex 1, additional resources will have to be made available to the sector, particularly through integrated programs aimed at increasing employment and incomes of the rural poor. Improvement of land use and distribution in areas where minifundia are interspersed with large tracts of underutilized land is an essential component of such an effort. Additionally, efficient commercial farms geared to production for foreign markets must be provided with the necessary incentives, infrastructure, credit, and technical support, since such units will continue to be the major vehicle by which Colombia develops its export agriculture. 62. Colombia will need to continue to develop new land and provide opportunities for farm workers to find productive employment. The new presumptive income tax should contribute to these objectives. Programs of land reclamation and allocation, colonization, and simple land re- distribution under the existing land reform laws need to be strengthened. In localities where the problems of rural poverty are concentrated and where small farms, using both traditional and modern technology are numerous, programs specifically adapted to local resource and market potential are needed to enhance productivity for meeting national needs and improving the welfare of the rural poor. The complexity of the production and marketing problems to be overcome on small holdings suggests that a package program approach, tailored to the needs of re relatively homogeneous localities, will be needed, including facilities for local assembly, storage, processing, and transportation. This will be possible, however, only to the extent that credit, extension and research are substantially expanded. 63. The Government realizes that more attention needs to be given to raising domestic nutritional levels which do not seem to have improved significantly despite substantial growth of per capita incomes. According to the Nutrition Plan, raising traditional farmers' income by promoting crops such as casava, plantain, potatoes and panela sugar, is to be comple- mented by increasing output of high protein foods, such as maize, wheat, soybeans, and beans, through credit and appropriate price stimulants to large farmers. - 27 - 64. One of the key priorities in the development strategy of the new Government is acceleration of the rate of growth of industry. Action has already been taken to achieve this objective through the recent tax reform which is expected to shift the structure of demand for industrial products. The skewed distribution of personal income in Colombia has created a pattern of demand biased in favor of luxury consumer goods and away from goods for mass consumption. Such luxury goods are either imported or produced locally with capital intensive processes and this has impeded development of a broad based productive structure capable of absorbing increases in the labor force and of realizing economies of scale and low unit costs of production. The major objective of the recent tax reform was to redistribute personal income so as to alter the structure of effective demand in favor of mass consumer goods. This could result in an improved combination of factors of production anu higher rates of growth of output of industry without aggravating Colombia's foreign exchange problem. 65. Colombian industry is well situated to benefit from creation of the Andean Common Market. Textiles, clothing, footwear and simple food products are produced in most Andean countries but the experience of other regional integration processes shows that even for such products the opening of borders allows for increased trade for specific products in these industrial branches. The textile industry, for example* includes an enormous variety of items which cannot possibly be produced by a single country. The development of mining and forestry-based industries, such as carbochemicals and paper pulp, and possible of engineering industries which can use Colombia's well-trained labor force, should be studied in the framework of the Andean Group. Further work needs to be done to identify industrial branches where Colombia can most benefit from the Andean Common Market, and efforts need to be made to provide special technical assistance services to these industries. Colombia would tend to benefit from a low and relatively uniform common external tariff and from freedom to increase the effective exchange rate so as to reduce the anti- export bias which may still exist. 66. Perhaps the most critical priority in the new Government's development strategy is strengthening of the external sector through accel- erated export expansion and diversification. Measures already taken reflect the belief that it is primarily through appropriate factor prices and by changing the pattern of growth that Colombia will succeed in strengthening its external sector and avoiding recurrence of the foreign exchange constraint. Since taking office, the rate of depreciation of the peso has accelerated from an annual rate of 6 percent in the first eight months of the year to over 20 percent during the last quarter of 1974. Continuation of this trend will compensate for reduction of the fiscal incentives provided to exporters. - 28 - 67. At about the sane time that the new Government accelerated the rate of depreciation of the peso it increased the average real rate of interest in the econony. In the absence of such action, depreciation of the peso could have resulted in an outflow of private capital and a shift away from real money balances in favor of speculative investment in inventories of goods, particularly of imported goods, with an adverse effect on the trade balance. By increasing the rate of interest, the Colombian authorities have further reduced the potential resource gap by lowering tne demand for imported capital goods and thereby encouraging utilization of more labor-intensive techniques of production. 68. The Colombian Government's emphasis on agriculture and industry is linked to the export expansion drive,since such a shift in the pattern of growth will increase supply in those directly productive sectors which will have to sustain the accelerated flow of goods to foreign markets. Accelerated industrial Cevelopnent, especially of resource-based export industries such as nickel, coal, gas and petroleum, can make an impressive contribution to export growth. The new emphasis on agriculture is especially important from the point of view of both balance of payments and income distribution since it is a sector which generates little demand for imported machinery, produces more growth per unit of investment than the rest of the economy and makes a major contribution to employment creation, thereby alleviating rural poverty. 69. Given the Colombian Government's development strategy, the actions it has already taken on monetary, fiscal and exchange rate policies,.and assuming a recovery in the world economy, sustaining a rate of growth of about 7 percent from 1978 on should be feasible. (See Table VI). This growth path woIud reduce unemployment from the current 12 percent to about 8.5 percent in 1980. Reestablishing 7 percent 7rowth would, however, require an increase in the shiare of gross fixed investment to GDP from 18.7 percent in 1970-74 to 21 percent in 1980. This implies an increase in the savings coefficient from about 19.5 oer cent in 1970-74 to about 22 per cent in 19=0 (marginal savings rate of .31 and would reqniire a net inflow of official capital of about US:4.5 billion during the 1975-80 period. Reform of the financial system, should permit private investment to increase from 10 percent of GDP in 1970-74 to 12 per cent in l9tU0. Improved public finances stemming from the recent tax reform and expected continued improvement in reducing subsidies and the financial performance of decentralized agencies, should make possible an increase of public investment from 8 per cent of GDP in 1970-714 to 9 per cent in 1980. This increase in public investment impliec investment spending by the National Government of 4.1 per cent of GDP in 1980 (as compared to 3.9 per cent in 1970-74) and an increase in National Govern- ment savings from 2.6 per cent of GDP in 1970-74 to 3.7 per cent in 1980. 70. Export prospects for 1976 suggest a significant recovery in the performance of minor exports as economic growth of the industrialized countries is resumed. Although manufactured export volume is expected to grow at a modest 7.5 per cent, minor agricultural export volume should expand by close to 30 per cent assuming that beef import restrictions by the EEC are lifted and that beef exports to Venezuela continue to increase. TAELE VI: COLOMBIA: AVAILABILITY AID USE OF RESOURCES 1970-80 (Millions of 1972 Colombian Pesos) Average Average Aver.g, Percentage Percentage Growth Growth of GDP of GDP Rate Rate 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1970-74 1980 1970-74 1974-80 GDP at Market Prices 164,315 173,334 185,535 198,896 211,039 221,960 234,799 249,543 266,437 285,036 304,955 100.00 100.00 6.46 6.33 Terms of Trade Adjustment - 1,203 - 2,396 - 1,435 563 - 828 - 2,088 - 3,431 - 4,251 - 4,998 - 5,572 (.17) (1.83) Cress Domestic Income 163,112 170,938 185,535 200,331 211,602 221,132 232.711 246,112- 262,186 280,038 299,383 99.83 98.17 6.72 5.95 Imports of Goode and MFS 25,431 28,465 26,356 26,926 30,795 30,495 31,463 34,150 37,113 40,288 43,717 14.79 14.34 4.90 6.01 Exports of Goods and NFS - 22,371 - 20,607 - 25,217 30,136 30,627 - 28,164 - 29,404 31,053 - 33,700 - 37,053 - 41,110 (13.82) (13.48) (8.17) (5,03) (including Terms of Adjustment) Resource Cap 3,060 7,858 1,139 - 3,210 168 2,331 2,059 3,097 3,413 3,235 2,607 .97 .86 Resource Availability 166,172 178,796 186,674 197,121 211,434 223,463 234,770 249,208 265,599 283,273 301,990 100.80 99.03 6.21 6.12 Consumption 130,798 139,982 149,351 157,043 172,265 185,423 190,589 19),433 207,523 219,063 232,489 80.32 76.24 7.13 5.12 Private 108,616 115,109 123,221 129,636 144,915 157,923 162,178 169,411 177,762 188,364 200,713 . - 66.60 65.82 7.47 5.58 Public 22,182 24,873 26,130 27,407 27,350 27,500 28,411 29,022 29,761 30,699 31,776. 13.72 10.42 5.38 2.53 Cross Pixed Investment 32,235 34,599 33.960 38,211 35,255 34,874 . 40,458 46,500 53,178 58.817 63.725 18,68 20.90 2.26 10.37 Private 16,931 19,377 17,993 22,491 18,543 19,248 22,308 25,663 29,332 32,451 35,151 10.22 11.55 2.30 12.66 Public 15,304 15,222 15,967 __ 15,720 16,712 15,626 18,150 20,837 23,846 26,366 28,574 8*46 9.35 2.22 7,94 Oanges in Stocks 3,139 4,215 3,363 1,867 4,250 3.167 3,723 4,276 4,899 5,394 5,777 1.80 1.89 Gross Domestic Investment 35,374 38,814 37,323 40,078 39,505 38,041 44,181 50,776 58,077 64,211 69,502 20.48 22.79 2.80 9.87 Cross Domestic Savings 32,314 30,956 36,184 43,288 39,337 35,709 42,122 47,679 54,663 60,975 66,894 19.51 21.93 5.04 9.25 Private 20,631 19,828 26,134 34,556 27,835 24,433 29,349 33,505 38,917 43,702 48,261 13,82 15.82 7.77 9.61 Public 11,683 11,128 10,050 8,732 11,502 11,276 12,773 14,174 15,746 17,273 18,633 5.69 6.11 - .39 8.37 Net factor Service Income . 4,469 - 4,254 -4,478 - 4,101 - 3,250 - 3,103 - 3,296 - 3,475 - 3,764 - 4,077 - 4,352 (2.20) (1.42) (- 7.65) ( 4.94) Net urrent Transfers 639 913 749 639 685 685 685 685 685 685 685 .39 .22 Cross National Savings 28,484 27,615 32,655 39,826 36,772 33,291 39,511 44,889 51,584 57,583 63,227 17.70 20.73 6.59 9.46 Cross National Product 159.846 169,080 181,057 194,795 207,789 218,857 231,503 246,068 262,673 280,959 300,603 97.80 98.58 6.78 6,15 Note: Percentages and growth rates in parentheses refer to negative figures. Public Sector figures include decentralized agencies, National, Municipal and Departmental goverrments. Source: Banco de la Republica; IBRD. 'rO - 30 - Coffee export volume and price is expected to increase slightly in 1976, and total merchandise exports should rise by about 13 per cent in current dollars. Imports will also increase as the rate of Colombian economic growth starts to accelerate, although it is expected that efforts to liberalize import restrictions will not gain momentum until after 1976. Despite an expected trade surplus of about US$170 million the total re- source gap is projected at about the sane level as in 1975 due to the negative non-factor service balance. Assuming accumulation of foreign exchange reserves of about US$50 million, sufficient to maintain reserves at an equivalent of about 2.5-months imports, Colombia will require a net inflow of external capital of almost US$h00 million in 1976, of which close to 70 percent would come from foreign investment, medium- and long-term project loans from bilateral and international development agencies, and supplierst credits. Despite the higher debt service burden, the debt service ratio is likely to remain about constant as a result of the improved export performance. 71. After 1976, the performance of the external sector will largely depend upon: (i) the success of coffee-producing countries to regulate their exports in such a way as to prevent a decline in world coffee prices; (ii) the Government's effectiveness in pursuing appropriate price,exchange rate and promotion policies aimed at stimulating the growth of minor exports; (iii) import requirements resulting from the projected higher pace of GDP growth; (iv) petroleum policy; (v) the terms of trade; (vi) the ability to attract new private foreign investment, and (vii) the Government's success in contracting new development loans on favorable terms, essential for simultaneously maintaining adequate foreign exchange reserves and external debt structure. 72. The medium-term outlook for coffee will be strongly influenced bir current efforts to forge a new international coffee agreement. If it is possible to re-establish such an agreement, the price of coffee could grow by an average of 2 per cent per annum from 1976 on, compared to an average 7.5 per cent per annum projected rate of international inflation, reaching about US$.84 per pound by 1980. Coffee export volume, on the other hand, is expected to grow at an average of only 1.5 per cent per annum reaching 7.1 million bags by 1980. Over the long-term it would be to the advantage of coffee producers to bring consumer countries into the agreement along the lines of the old International Coffee Agreement, provided an appropriate negotiated price can be established. 73. Colombia has,in recent years,made considerable progress in establishing adequate incentives for exporters of non-traditional products. The Government is aware of the importance of maintaining such incentives and has recently offset the reduction in fiscal incentives by accelerated devaluation of the peso and an increased flow of resources to PROEXPO, the export promotion agency. PROEXPO is now preparing to assume a more active role, not only by making credit available to exporters, but by providing needed technical and marketing assistance. - 31 - 74. With appropriate incentives and promotion activities minor export growth should recuperate to rates achieved in pre-recession years. Volume of these exports is projected to grow at an average 16 per cent per annum, over the 1976-80 period. Manufactured exports are expected to lead this performance with those industrial products which have grown most rapidly in the-past--textiles, chemicals, pharmaceuticals, mechanical and electrical equipment, and paper products--continuing to make the greatest contribution. Minor agricultural exports should be able to expand by slightly below 14 per cent per annum due to strong medium- term prospects for food exports, especially sugar, bananas, and beef. 75. The projected acceleration of investment and output growth implies a sizeable increase in merchandise imports. Changes in the composition of imports experienced in recent years should continue as capital goods and intermediate raw material imports grow at an accelerated pace and imports of consumer goods decline relative to total imports. Expanded production in industry and agriculture will require increased imports of intermediate goods. Fuel imports, in particular, will grow rapidly in the absence of appropriate action to stimulate exploration and production of domestic crude petroleum. 76. The volume of imports is expected to expand at an average growth rate of over 8 percent per annum during the 1976-80 period. This implies an import elasticity roughly 20 percent higher than that historically observed elasti- city, the difference being accounted for by the unprecedented growth of petroleum imports. Colombia has been an exporter of crude petroleum and derivatives (mostly fuel oil) for several years. Since 1970, however, crude oil production has declined by 25 per cent and crude exports, which reached US$60 million (31 million barrels) in 1970 have now stopped altogether because of the need to ensure crude supplies for local refineries. Colombia will for the first time in the post-war perioa have to import crude this year. While Colombia was fortunate in having sufficient crude petroleum to escape any immediate adverse balance of payments effect of increases in world oil prices during the past 18 months, pricing policy has encouraged excessive consumption and contributed to the decline in output. 77. The adverse impact of loss of petroleum self-sufficiency on Colombia's balance of payments will in the immediate future be moderated somewhat by continued export of limited quantities of petroleum derivatives, by-products of domestic refining which exceed domestic needs. If present production and consumption trends continue, however, the burden on Colombia's balance of payments could become severe by the early 1980's. Irports of crude would in the absence of appropriate remedial action, reach over US$ 300 million in that year or, almost 10 per cent of projected merchandise export earnings (see Table VIII). Table VII: COLOMBIA: BALANCE OF PAYMENTS EXPORTS PROJECTION 1972 1973 1974 1975 1976 1977 1978 1979 1980 1985 II. Exports f.o.b. A. Constant (1972) US$ millions Gold, Emeralds3and Platinum 54.0 53.0 1.5 1.4 5.0 6.0 7.8 10.9 16.4 80.5 Crude Petroleum 31.0 19.5 1.1 - - - - - - . - Coffee 469.0 486.2 496.3 474.3 480.1 487.3 494.6 502.0 509.5 548.9 Cotton 56.0 24.5 38.7 42.0 40.0 42.8 45.8 . 49.0 52.4 73.5 Sugar 34.0 21.5 15.9 23.9 30.0 36.0 41,4 47.6 53.3 80.5 Bananas 24.0 21.6 25.4 34.7 45.0 54."0 63.2 72.7 81.4 121.8 Cattle and Beef 45.0 37.7 33.3 :4.5 45.0 54.0 63.2 72.7 81.4 122.9 Manufactured Goods 148.0 222.2 302.4 265.0 285.0 330.6 386.8 456.4 538.6 965.2 All Other Goods 118.0 171.8 249.2 263.6 290.0 330.6 380.2 441.0 511.6 869.4 o/w Refined Petroleum Products (20.5) (20.4) (19.2) (14.1) (12.1) (13.2) (14.2) (15.1) (16.0) (20.0) Total Goods 979.0 1,058.0 1,163.0 1,129.4 1,220.1. 1,341.3 1,483.0 1,652.3 1,844.6 2,862.7 Non-factor Services 228.0 245.3 201.4 187.5 210.0 224.7 . 240.4 257.3 275.3 386.1 Total Exports 1,207.0 1,303.3 1,365.2 1,316.9 1,430.1 1,566.0 1,723.4 1,909.6 2,119.9 3,248.8 B. Price Indices (1972 = 100) Gold, Emeralds, and Platinum 100,0 117.0 131.6 146.7 161.1 174.'8 188.8 203.0 217.2 304.6 Crude Petroleum 100.0 133.3 441.7 492.5 529.4 563.8 593.7 623.4 655.8 919.8 " Coffee 100.0 130.2 133.8 124.0 138.2 140.0 143.0 145.0 148.0 207.6 Cotton 100.0 167.6 183.7 167.5 181.1 186.5 202.7 216.2 232.4 326.0 Sugar 100.0 130.1 397.3 452.0 301.4 232.9 191.7 191.7 205.0 287.5 Bananas 100.0 106.6 110.2 118.3 136.2 136.0 144.1 152.9 163.2 228.9 Cattle and Beef 100.0 .127.2 138.0 147.2 159.2 175.2 195.2 2L6.0 248.8 349.0 Manufactured Goods 100.0 117.1 131.6 146.7 161.1 174.8 188.8 203.0 217.2 304.6 All Other Goods 100.0 117.0 131.6 146.7 161.1 174.8 188.8 203.0 217.2 304.6 Total Goods 100.0 125.0 137.9 148.1 155.2 162.5 172.4 183.8 197.2 284.7 Non-factor Services 100.0 117.1 131.6 146.7 161.1 174.8 188.8 203.0 217.2 304.9 Total Exports 100.0 123.5 137.0 148.0 156.1 164.3 174.4 186.4 199.8 287.1 C. Current U.S.$ millions Gold, Emeralds, and Platinum 54.0 62.0 2.0 2.0 8.1 10.5 14.7 22.2 35.6 245.2 Crude Petroleum 31.0 26.0 5.0 - - - - - - - Coffee 469.0 633.0 664.0 640.0 663.4 682.2 707.2 727.9 754.1 1,139.4 Cotton 56.0 41.0 71.0 70.0 72.4 79.8 92.8 105.9 121.9 239.7 Sugar 34.0 28.0 63.0 108.0 90.4 83.8 79.4 91.3 109.3 231.6 Bananas 24.0 23.0 28.0 41.0 61.3 73.4 91.0 111.1 .132.8 278.8 Cattle and Beef 45.0 48.0 46.0 36.0 71.6 94.6 123.3 156.9 202.5 428.9 Manufactured Goods 148.0 260.2 398.0 388.8 459.2 577.9 730.3 926.3 1,169.6 2,939.8 All Other Goods 118.0 201.0 328.0 386.8 467.2 577.9 717.8 895.1 1,111.0 2,648.0 o/w Refined Petroleum Products (20.5) (27.2) (85.0) (69.4) (64.1) (74.4) (84.3) (94.1) (104.9) (184.0) Total Goods 979.0 1,322.2 1,605.0 1,672.6 1,893.6 2,180.1 2,556.6 3,036.7 3,636.6 8,151.2 Non-factor Services 228.0 '87.2 265.3 275.4 338.7 393.2 454.4 522.7 598.4 1,177.1 Total Exports 1,207.0 1,609.4 1,870.3 1,948.0 2,232.3 2,573.3 3,011.0 3,559.4 4,235.0 9,328.3 Source: Banco de la Republica and IBRD - 33 - TABLE VIII: COLOMBIA: CRUDE PETROLEUM BALAN4CE 1972-80 Actual Estimated Ptojocted 1972 1973 197k 197 1976 197? 1978 1975 1980 Crude Petroleum Production 71,674 67,089 60,955 f6,9k0 55,805 54,750 56,253 57,683 58,877 (thousands of barrels) Domestia Demand 56,750 57,690 60,475 62,183 64,412 68,599 72,536 76,818 81,353 (thousands of barrels) Exports ' (Imports-) 14,924 9,399 480 -5,243 -8,612 -13,848 -16,283 -19,135 -22,k76 (thousantis,of barrels) Export/Import Price 2.06 2.73 9.10 10.15 10.91 11.62 12.23 12.84 13.51 (US$Aarrel) Exports (Imports-) 30.8 25.7 4.5 -53.2 -93.9 -160.9 -199.1 -245.7 -303.7 (Millions of US$) sotwes Banco d l Republisal IBW 78. Over the medium-term the current account deficit of the balance of payments is projected to increase gradually, reaching a maximum of US$ 630 million in 1980. This is the result of a growing resource gap, projected to peak in 1979, and higher factor service payments resulting from higher interest payments on external debt contracted from 1973 on. Overthe longer-term,strong export and domestic savings performances should enable Colombia to reduce the resource gap, the current account deficit and its dependence on external borrowing. C. External Capital Requirements 79. At this point in time it is not possible to predict the course of the world economy over the next few years with any degree of certainty. Given the considerable volatility of world coffee prices .and reduced demand for Colombia's exports, it is entirely possible that export earnings remain depressed for a prolonged period. If, however, exports recover in 1976, Colombia's external capital requirements would total about US$,.0 billion during 1975-80 (see Table IX). Such financing would average jS$590 million in 1975-77 (as compared to US$430 million in 1973-74), and increase to approximately US$1.1 billion annually in 1978-80. Foreign Investment is - 34 - expected to increase significantly over the period from an annual average of about US$30 million in 1973-74 to about US$65 million annually in 1975-77 and US$125 million annually in 1978-80 as a result of development of the abundant coal, nickel and natural gas resources which Colombia possesses. In order to maintain an adequate level of official foreign exchange reserves, gross disbursements on foreign public sector borrowing would have to total US$4.5 billion (of which about US$784 million will be disbursed on commitments made through the end of 1974), and average about US$525 million annually during 1975-77 as compared to US$405 million in 1973 and US$392 million in 197L. TABLIX: COLOMBIA: PWJECTED CAPITAL REQUIREIETS AND FINANCING 1975-80 (in US$ millions) 1975 1976 1977 1975 1979 1980 Total Exports 1967.9 2232.4 2573.4 3010.9 3559.3 L235.0 Coffee 640.0 663.4 682.2 707.2 727.9 754.1 Minor .cports 1032.6 1230.3 1498.0 1849.3 2308.8 2882.5 Hon-factor services 275.4 338.7 393.2 454.4 522.7 598.14 Total Imports 2109.2 2388.7 2830.0 3315.9 3870.1 h503.6 Resource Gap -161.3 -156.4 -256.6 -305.0 -310.6 -268.6 Current Account Balance -322.5 -347.6 -478.3 -569.1 -623.2 -629.4 Amortization 148.8 148.9 196.6 274.2 376.0 503.3 Reserve Accumulation 0.0 L6.6 73.7 81.2 92.5 105.8 Capital Requirements 471.3 543.1 748.6 924.5 1091.7 1238.5 Financing 471.3 543.1 748.6 924.5 1091.7 1238.5 Foreign Investment 45.0 65.0 80.0 100.0 125.0 150.0 Project loans 327.9 348.1 419.9 L96.0 579.0 65L.5 Financial Credits 98.4 130.0 249.0 330.0 388.0 434.0 Source: IBRD Note: Lower (15 percent) coffee prices and prolonged depressed demand for Colombia's minor exports would result in total gross capital require- ments of US$6.3 billion during 1975-80, or about ? percent higher than those shown above, ANNEX 1 Page 1 ANNEX 1 THE AGRICULTURAL SECTOR A. Recent Performance and Current Prospects 1. In 1974, growth of value added in Colombia's agricultural sector reached the relatively high rate of 5 percent. Agricultural Crops Sector (erent Livestock Other 1973 to 197. 3.3 n.a. 1963 to 1973 4.5) ) 3.1 4.6 4.0 1953 to 1963 3.0) Fishing, forestry, and miscellaneous components of agricultural output account for less than a tenth of the total, but their combined growth has been faster than that of the crop and livestock subsectors (Table 7.7, Statistical Appendix). Prospects now appear to be good that Colombia's agriculture has the potential to maintain an overall rate of growth of 5 to 5.5 percent over the medium term. Sources of Increased Production 2. Exceptionally large crops of rice, cotton, and grain sorghum con- tributed to the large increase of output in 1974. Production of these crops has increased substantially since 1963, and there have also been substantial gains for sugar, caraota beans (a dry bean not widely consumed in Colombia but favored in Venezuela), oil palm, potatoes, cassava, common dry beans, and cacao (Table 7.1, Statistical Appendix). Gains in crop output have for the most part been realized through expansion of planted acreage. Only in the case of rice has increased yield been a dominant factor (Tables 7.2 and 7.3, Statistical Appendix), and this is the result of replacement of irrigated rice grown under advanced technology for the traditional cultivation of dry land rice. More double-cropping has accompanied the expansion in plantings of irrigated rice, cotton and plantains, with the result that the increase of nearly half a million hectares in total plantings of major crops over the last decade has been realized with only about half as large an increase in the area of cropland. Additions to cropland have mostly taken place in the coastal lowlands and eastern plains, rather than along the cordilleras. 3. Much of the additional crop output is being produced under a new structuring of relationships between producers, land, and products. Irrigated rice, for example, is commonly being grown on different land and by different producers than the rain-fed crop which it replaced. I,INCORA's colonization activities have brought new entrepreneurs into agriculture, and ITCORA's existence has encouraged livestock producers in the Sinu Valley and elsewhere to plant higher value cash crops such as corn on same of their arable land. Available evidence indicates that small farms of the hillsides and highlands have added less to crop output than have new producers, both large and small, working with or without mechanization on the lowlands. ANNEX 1 Page 2 4. Most of the expanded output of the livestock subsector has been associated with the 3 to 4 percent annual expansion of the national cattle herd, which in 1974 numbered an estimated 23.9 million head. Annual produc- tion of cattle (the-number of animals slaughtered, exported, and retained for inventory expansion) has remained close to 16 percent of the national herd for a number of years, while the commercial extraction rate (slaughter plus live exports) has varied between 11 and 15 percent in a roughly cyclical pattern. Data for 1973 and 1974 show the extraction rate at only 11 percent when relatively large numbers of animals were presumably being held for herd expansion (Table 7.h, Statistical Appendix). Calving rates have been estimated at about 55 percent, with mortality at about 4 percent of total inventory./1 These performance rates reflect the relatively extensive type of livestock management which predominates in Colombia and which is also to be found in such countries as Brazil and Paraguay. In countries such as Argentina and Al'stralia, with more intensive technology, calving rates range from 70 percent to 80 percent, with sustained offtake at between 25 percent and 30 percent. Animals of the dairy breeds and others classified as milking stock account for only about a seventh of all cattle. Much of the milk output comes from cows milked only once a day in herds kept primarily for beef production. 5. Of the 114 million hectares comprising Colombia's surface area, no -ore than 20 mi"Llion hectares are grazed to an appreciable extent, but at least an equal additional area, mostly in the eastern plains, is considered to have some potential for livestock production. More irportantly, orly a -7nall portion of present grazing land is improved, so that stocking rates average only about one head (mature equivalent) per hectare. Improvement of tehnical performance rates will require substantial amounts of assistaice to small as well as large producers, since 20 percent of the cattle population 1.5 in herds of fewer than 50 head and about 30 percent is in herds of 50 to '20 head. With expanded assistance, cattle production could grow at 5 percent per year. 6. Total production and per-capita consumption of eggs, poultry, meet and pork are held in check by the high prices of feed grans and mixed feeds, Tbich account for 60 percent to 80 percent of the cost of producing these co-Lmodities under modern technology. Although corn is second only to coffee in planted area in Colombia, most of the output goes for direct human consump- tion or industrial processing at prices which make it a costly ingredient 7cr animal feeding. Combined production of corn and grain sorghum increased rapidly in 1974 and contributed to the limited but continuing otput expansion of poultry and eggs. Pork comes from swine usually kept under "backyard" conditions where there is considerable reliance on scavenged feedstuffs and availability of feed grains is a less important factor than for poultry. Domestic Food Supply 7. It is no small accomplishment that Colombia's agricultural sector now feeds 35 percent to 50 percent more people than it did a decade ago, and at the same time still supplies about 70 percent of the country's total exports. Visible shortages of individual foods have been rare, and the record 1974 production of rice, for example, was large enough to permit unprecedented exports in 1975. On occasion, food supplies for domestic consumers have been Z1 The indeterminate flow of contraband exports is sizable enough to affect the reliability of production and offtake estimates, as well as of total inventories. ANNEX 1 Page 3 protected by restrictions on such commodities as beef and sugar. With a similar objective, Instituto de Mercado Agropecuario (IDEMA) incurred large operating losses to maintain wheat imports during 1973 and early 1974 in the face of rapidly rising world prices. Such cases are, however, the exception, and production growth has enabled, for the most part, the rapidly growing population to maintain substantially the same level and pattern of food consumption as a decade or more ago. 8. Per capita food consumption, however, has not reflected such gains as have been made in per capita incomes. Although the average income elasticity for food may be as high as 0.5, gains in consumption of individual commodities with the highest income elasticities of demand have probably been constrained by both price and availability factors. The relative price of beef, for example, rose rapidly in Colombia in line with world market conditions, whereas relatively low fixed prices for fluid milk have curbed production and thereby reduced its availability. Moreover, given the increasingly urban composition of the population, a more than proportional share of the increased food supply has incurred the added costs of movement through commercial marketing channels. Individuals who have moved from rural to urban areas now find that part of their added income must go to pay additional costs of food marketing. Although food supplies have kept pace with population growth, the average diet has improved little if any over a decade or more. Recognizing this problem, the Government now identifies improved nutrition and rural development as inter-related priority objectives, and is examining ways of pursuing these objectives through integrated programs, along lines set forth as a Nutrition Plan. Export Products 9. Coffee retains first place among Colombia's exports, although its share of total exports hasdiminished with the process of export diversifi- cation which has occurred both within and outside the agricultural sector. Only about a decade ago, coffee accounted for about 75 percent of the value of total exports and it has now fallen to less than half. Production and exports have been held in check by quota provisions of the International Coffee Agreement, and recently by a stop-gap retention plan developed by the major exporting countries after they failed to agree with the consuming countries on renewal of the Agreement in 1973. Under the retention plan, participating countries agree to retain stocks of new-crop coffee equal to 20 percent of "normal" annual production. For the purpose of this plan, Colombia's "normal" production has been set at 8 million bags (of 60 kg), of which 6.L million can be exported during the 1974/75 agreement year. 10. Any breakdown of international arrangements for stabilizing coffee supplies and prices is of serious concern to Colombia, partly because of the magnitude of the country's coffee exports and partly because Colombian coffee is at the top of a price pyramid made somewhat unstable because of increasing competition from cheaper coffees marketed in processed forms. On the other hand, the country could continue as a tough competitor in an unprotected ANNEX 1 Page 4 market, at the cost of jower returns to producers and/or adverse fiscal effects for the Goernment. B1t p;resent policy is wisely based on efforts to maintain international stabiliz;.tion .arangements. 11. Estirates of coffee production show considerable year-to-year variation but only a very gradual upward tendency, primarily because of stabilization measures inplemented under the now expired International Agreement. In 1970, a census of about 303,000 coffee growers found 1.07 million hectares under coffee, with yields averaging 5h0 kg per hectare. Comparable acreage and yield data are not available on an annual basis, but it seems clear that neither area nor yield has moved upward rapidly. Between 1965 and 1974, only 100,000 hectares of the total coffee area had been replanted or renovated by producers assisted through the extension service of the Coffee Federation. Interest in renovation seemed to be increasing at the end of the decade, but progress appears to have been slow. The Federation's technical services urge growers to renovate old stands as one of several defensive measures against a possible outbreak of rust, which has already caused severe danage to coffee plantations in Brazil. As long as yields can be maintained, however, many growers will hesitate to incur the substantial costs, currently ranging up to Col$9,000 per hectare, for reno- vating with denser stands of newer varieties. Stocks of Colombian coffee are not considered excessive, and, while prices at the farm are not unfavorable, there is evidence that cacao and panela are strong competitors for land which might otherwise be used to expand coffee plantings. 12. Growth of non-coffee agricultural exports in recent years reflects gains in quantity and/or value of products of cattle enterprises (frozen beef, live animals, hides, and cheese), cotton, tobacco, sugar, and cut flowers, as well as limited shipments of dry beans and miscellaneous fruits and vegetables. But much of the increase between 1970 and 1974 in export earnings can be attributed to rising world prices rather than to larger physical quantities. In 1974, the combined surrender of exchange from exports of cotton, sugar, bananas, tobacco, flowers, beef, and live cattle was 59 percent higher than in 1970 (Table 7.15, Statistical Appendix), but sustained upward trends in exported quantities of these items can be found only for frozen beef (Table 7.16, Statistical Appendix) and flowers.L Virtual termination of beef shipments to Europe in early 1974 cut severely into total beef exports for the year as a whole. Exports of carnations, roses, and other flowers have risen in value from US$1.0 million in 1970 to US$15 million in 1974. Recession conditions in the United States, the principal export market, is expected to reduce flower imports by one third in 1975. 13. Cotton exports for 1975 may reach 80,000 tons, but proceeds from this large volume will be equivalent to those of 1974 becaus.e of lower world market prices. Continued moderate growth in cotton exports can be expected but there are obvious advantages in exporting as much as possible of the commodity in the form of clothing and textiles rather than as fiber. 14. Sugar exD,rts had been -estricted to conserve supplies for the domestic market. As a result, a sizeable contraband export flow has developed in respoise to the widening disparity between external and Government-controlled 1 Although quantity data are not available for exports of flowers, the rapid growth of value undoubtedly reflects sharply rising quantities. ANNEX 1 Page 5 internal prices. Colombia has both the production and milling capacity to become a competitive exporter of sugar. 15. While registered exports of cattle and beef have grown rapidly, so have contraband exports, particularly to Venezuela. Unregistered exports are curren ly estimated at 300,000 head. To bring at least half of this outflow within legal channels, a recent five-year border agreement with Venezuela was signed. If growth of cattle production can be sustained at a rate of 5 percent, the growth of registered exports should be at least as high, assuming earlier favorable world market conditions are restored. 16. Output growth of bananas has suffered some setback after local growers' organizations assumed some of the functions formerly exercised by the international marketing firms, which still purchase the crop and market it overseas. Further growth of banana exports can be expected, but only at a rate consistent with the limited growth of world demand. Growth of tobacco exports is restricted to the same constraint. In 1975, for the first time Colombia will have large supplies of rice to export (about 150,000 tons), which should be a start toward continued rice exports. Flowers and perishable fruits and vegetables, produced mainly around Bogota or along the coast, could have a larger share of exports because Colombia enjoys a substantial comparative cost advantage in such production. The development efforts which will be required, however, relative to the current effort, are considerable. ChaRgsin Labor Force and I'oductivity 17. Although agriculture is the major source of employment in rural areas, 15 percent of males and 71 percent of females in the rural labor force were identified with trade, services, and other non-agricultural sectors in June 1970; 15 percent of all males in the urban labor force were identified with the agricultural sector.Z1 Moreover, there is large seasonal variation in agri- cultural employment which generates seasonal labor movements from urban to rural areas, from one farming area to another, and from farm to farm. In view of the changes in rural employment, it is difficult to draw conclusions from available statistica3 data. A recent study of rural employmentZ2 concluded that farm families of the 1970 census could be classified according to principal source of income as follows: about half were operating their family size farms, while one-quarter were earning wages from agricultural work. The remaining were either operators of large farms or both small operators and wage earners at the same time. 18. Continuing rapid nigration from rural to urban areas has held the net increase in the agricultural labor force to an estimated 1 -ercent annually in recent years, notwithstanding high birth rates and population growth in the DANE. Analisis del Desenleo enColombia as cited in I7D Report 132-CO Z2 Leonard Kornfeld. Pew Denartures in Rural Development in Colombia. Prepared for AID under Contract1-o.0719-182-T7oTota:Dec. 97,. ANNEX 1 Page 6 country as a whole. In the hill areas, the agricultural labor force appears t have decreased slightly, with most of the increase taking place in the lowlands and eastern plains. Both areas have probably gained in productivity per worker; with agricultural output increasing at i.5 percent annually over the last decade, output per worker must have been increasing at about 3.5 per- cent annually. With continued migration of young people away from the hills toward the cities, however, opportunities for further productivity gains on the small farms of the hill areas will probably be limited. 19. Most attempts to analyze the rural supply and demand situations have shown considerable unemployment or underemployment. A recent study of the 1950-70 period concluded that average rural underemployment had fallen from 31 percent in 1950 to 25 percent in 1970, but that in the season of peak labor needs, the gap had narrowed from 20 percent in 1950 to 9 percent in 1970./1 Although there are still indications of unemployment in rural areas and of underemployment on farms, the employment situation seems to have improved in recent years. More detailed information about the size, origin, income sources, and seasonal availability of the actual and potential agricultural labor force is urgently needed. 20. It remains to be demonstrated that existing farm units, large or small, can absorb additional workers at a rate commensurate with the growth of the rural population. Pressure has been relieved in recent years by rapid migration to urban areas, and this has permitted some increase in productivity of the workers remaining in agriculture. To .the extent that small farms can increase output by yield-increasing practices such as the use of improved seeds and planting stock, and pesticides, additional labor inputs will be small in relation to increased production. To the extent that the available labor force performs many of the tasks required to cultivate a larger area, the new jobs will also be few. Larger farmers will almost inevitably rely heavily on additional inputs of machine services for accomplishing the tasks required for production increases, thus providing only a limited number of new jobs for farm workers. These circumstances lend emphasis to the importance of continuing or expanding RICORA's programs which create new farm units and new employment opportunities through land reclamation and improvement, land redistribution, and colonization. B. ISSUES AND POLICIES Improved Nutrition 21. Colombian diets have improved little,if any, compared to those of a decade or more ago. Calculations based on per-capita food supplies for various years since 1948 show a daily caloric supply of about 2,200 calories, and a daily protein supply of about 50 grams (Table 7.17, Statistical Appendix). Similar calculations for "enezuela, Brazil, and Chile made by FAO show average supplies during the mid-1960's for these countries of about 2,500 calories and /1 DANE. "La Agricultura en Colombia, 1950-72: La Demanda y la Oferta de Trabajadores en el Campo", Boletin Mensual de Estadistica -o. 277 (Bogota: Aug. 1974, 114-115). ANNEX 1 Page 7 65 grams of protein, including 22 to 26 grams of protein from animal sources (about the same as Colombia's 23 grams of animal protein in 1964-66). Although the calculations for different time periods are not wholly comparable,-they provide strong evidence that per-capita supplies of milk and other protective foods have not gained appreciably relative to the sugars and starchy roots. 22. With improved nutrition now designated as a priority objective, elements of a nutrition plan are taking shape. Considerable attention will focus on possibilities for manufacture and distribution of formulated and fortified foods, of which various formulas have now been developed and are available in Colombia. Expanded local production of these foods will facilitate gradual substitution of Colombian agencies for international food programs which currently carry out supplemental feeding programs for low income groups. 23. The Government seeks to satisfy nutrition objectives by measures which will also improve the welfare of the rural poor. Programis for integrated rural development are seen as means of promoting improved nutrition in rural areas while also augmenting supplies of nutritious foods for urban low-income families. Parallel measures would include adjustments in controls and supports for com- modity prices, with a view to redirecting consumption patterns toward improved n,itrition. In general, however, it will not be easy to use price policies for encouraging both increased production and increased consumption of commodities of high nutritive content without resort to substantial use of costly subsidies. Part of the solution may depend upon finding processes for lower cost and more effective delivery of commodities now handled as perishables. A project for developing a national agricultural marketing plan is now pending and results should help to pinpoint promising opportunities for more processing near the source. Price Policies 2A. Colombia's general price level has risen at an average rate of more than 10 percent annually for two decades or more and farm prices have moved upward at approximately the same pace as prices of non-agricultural products. In 1972, implicit GDP deflator indexes for the agricultural and non-agricultural sectors stood at 416.2 and 430.8, respectively (1958 = 100). In 1973 the relationship was reversed, with the agricultural index at 537.6 ana the non- agricultural index at 51L.3 (Table 7.8, Statistical Appendix). Taking the two years together, then, the two indexes have risen almost identically since 1958. Within the agricultural sector, prices for livestock and livestock products rose considerably more than for crops between 1958 and 1973. Within the crops subsector, prices for cassava, plantains, beans and panela rose more than for most of the crops now produced with improved and/or mechanized technolot.I Elasticity of demand with respect to price is probably not high for such crops as panela, beans, plantains, and cassava. Given the doubling of Coliombia's urban population in a decade or so, with no more than a very _smal increase /1 DANE. Boletin Mlensual de Estadistica. 'La Aericultura en Colombia." 1950-72: III. El Ciclo de Precios Agricolas, Jo-. 277 (Bogota: August 1974, 71-107). ANNEX 1 Page 8 in the labor force on small farns where most of the output of such crops takes place, it is not surprising that relative prices for these crops have risen. 2$. Support prices for corn, rice, wheat, barley, soybeans, sesame, common dry beans, and various other crops are set by IDEA on a semester- by-semester basis at levels intended to encourage the desired output without overtaxing the agency's limited capacity for intervention in marketing (Table 7.10, Statistical Appendix). IDEMA's purchases at the announced .upport prices serve mainly to forestall the extreme seasonal price drops which might otherwise take place during the harvest season, thus leaving the com- mercial sector to handle the bulk of most crops. In recent years, IDEM4A has commonly purchased one-third to one-half of the domestic wheat crop, up to a fifth of the rice crop, and less than a tenth of the corn crop. Purchases of both corn and beans in the first semester of 197h rose to a sixth of the respective crops. Some potatoes have been purchased for distribution through IDEMA's chain of stores and supermarkets, but the agency lacks storage suitable for holding potatoes long enough to effect an adjustment of seasonal flows. IDEA's ability to intervene in grain marketing is now strengthened by the availability of additional drying and storage facilities, including units constructed between 1970 and 1974 under financing from an IDB loan. Total storage capacity in silos and warehouses increased from about 260,000 tons in 1970 to 469,000 tons in 1974.and additional construction is expected to bring total capacity to $00,000 tons in 1975. But much remains to be done to assure that this capacity will be fully used to improve the marketing of storable com- modities and make the program of support prices more fully effective. A 1970 report called attention to the low utilization of the storage capacity avail- able at that time and the problema involved in achieving effective use of the total projected capacity./ There is little evidence that major problems recognized at that time have been resolved. 26. The weakness of the Government's policy to control retail prices of various food products such as sugar, has become painfully evident during the recent period of extremely high world sugar prices. The policy of maintaining the domestic retail sugar price at only a fraction of world price levels has required the prohibition of refined sugar exports, but this measure has not been fully effective in conserving supplies for domestic consumers. Results are two-fold: on the one hand, low consumer prices encourage an excessive rate of consumption of a commodity which does little for improved nutrition, while, on the other, contraband operations rob the country of possible foreign exchange earnings and leave consumers to face empty shelves from time to time. 27. Orientation of price policies toward improved nutrition could logically lead to somewhat higher consumer prices for sugar, incentives for '1 Richard Phillips and Harry B. Pfost. "Observations and Recommendations for Improving Grain Storage and Marketing in Colombia", Food and Feed Grain Inst., Kansas State University, Report No. 20, December 1970, as cited in the 1973 USAID Aricultural Sector Analysis Paper. ANNEX 1 Page 9 consumers to shift to more nutritious dietary components, and larger exports of a commodity for which the current world demand is strong. However, the short-run demand elasticity with respect to price is probably low, and a significant shift to more nutritious substitutes would not be easy to achieve without a long-term educational program. Infants now weaned on panela water would suffer even more than at present in the absence of special programs to provide nutritious substitutes and information about their use. Under the circumstances, it is not surprising that the Government is now assigning high priority to nutrition programs aimed at increasing the production of such substitutes and at strengthening long-term educational programs. 28. In September 1974, the Government moved to terminate the large ex- penditures incurred for subsidies to maintain a rate of wheat consumption that had been established when low-cost imports of U.S.P.L. 480 wheat were available. As the cost of wheat imports rose during 1972 and 1973, IDEMA incurred large, short-term obligations for the purchase of wheat which was sold internally at approximately the old price. IDEMA's total accumulated deficit approached Col$2,000 million before the subsidy effort was abandoned; a step which was feasible because bread had never attained as great importance in Colombian diets as in the diets of many other countries. In recent months, there has probably been some substitution of other cereal flours and products for wheat flour in consumption, and the-incentive for contraband outflows of wheat to: Ecuador and Venezuela has diminished. Higher prices for wheat at the farm can be expected to bring modest increases in domestic wheat production. Colombia, however, is not physically endowed with the resources for large and economical production of wheat, and there is strong competition between wheat and barley, potatoes, certain horticultural crops, and dairying in the areas of wheat production. 29. The pricing of milk has proven to be a difficult task in Colombia, as well as elsewhere. Whereas the product is highly perishable, the produc- tion process involves an extremely long biological cycle with seasonal complications. If seasonal surpluses are allowed to drive prices down to a point where cows in specialized dairy herds are liquidated, several years may be required to rebuild herds. During such periods, high prices or shorta-es of milk are to be expected. In Colombia, such extreme fluctuations are tempered by the availability of milk from beef herds, but it is difficult to establish and maintain even ninimum sanitary standards when supplies are obtained from such sources. 30. In general, retail milk prices in Colombia's major cities have been subject to controls on upward adjustnents, but these have been of limited real benefit to consumers, partly because handlers have a tendency to nake ends meet by diluting milk with water. 1oreover, compulsory pasteurization .as not yet been accepted in Dogota and elsewhere, partly on the grounds that it would add to costs and thus cause an increase in the existing controlled 'rice. Con- trolled prices have often been readjusted only after severe dislocations were noted, and production adjustments on specialized dairy units have been correspondingly erratic. At present, somewhat -ore freedom to initiate price chrnges has been allowed the i-dustry, subject to monitoring and approval by ANNEX 1 Page 10 Government authorities. Without vastly improved means of con-trolling product quality through measures including inspection and compuloory pasteurization, it will be difficult to make significant improvement in current policies for pricing fluid milk. Agrarian Structure 31. Since 1961, the Instituto Colombiano de la Reforma Agraria (INCORA) has been engaged in programs aimed at changing Colombia's rural land tenure with a view to achieving a more equitable and productive agrarian structure. These efforts and the underlying legislation reflect two widely held beliefs: (a) that ownership or similar control over land with agricultural potential should be shared more broadly among rural families interested in farming, so as to improve their opportunities for achieving a living above the poverty level; and (b) that such changes in rural land tenure can contribute to more effective land use and increased resource productivity. Since its creation in 1961, INCORA has redistributed 390,000 hectares to about 21,000 families and provided title to about 4.1 million hectares of public domain for 149,000 families. INCORA's land acquisitions have declined during the last four years from 322 properties totalling 98,000 hectares in 1971, to 85 properties totalling $,000 hectares. This reduction is the consequence of shortage of financial support to the institution, preventing it from developing the land already acquired, and of legal interferences by the expropriated landowners. Even in peak years, the number of new farming units created has not greatly exceeded the long-term average of fewer than 15,000 per year--a figure that many would consider far below a reasonable target, notwithstanding the difficulties which have hampered INCORA's persistent efforts. 32. Targets for the number of new farming units to be established through ICORA's programs for land reclamation, land redistribution, and colonization are difficult to establish. They cannot be derived by simply distributing present farmland more evenly, as this ignores the diversity of agricultural and livestock production conditions existing in Colombia. Clearly, Colombia's natural resources and geography provide appropriate conditions for a diverse agriculture comprising many different crop and livestock enterprises for which various levels of technology are suitable. Widely varying types and sizes of farm operating units are needed for effective use of such diverse resources in the production of commodities for domestic consumption and export. The number of new units needed to use Colombia's land resources effectively will depend in considerable measure on the number of qualified individuals seeking to establish themselves and make a successful living as fulltime farm operators. 33. Obviously, the number of potential farm operators with appropriate qualifications is large in relation to the 10,000 to 15,000 new units INCORA has been creating annually./l The number of landless workers and other candidates for becoming operators of new farm units has been variously estinated at up to a million or more individuals. INCORA's experience to date points to /1 Part of the evidence is to be found in the record of those who have engaged knowingly in illegal acts to establish themselves on new units acquired through the invasion process. See Roger E. Soles. Rural Land Invasions in Colombia, Research Paper No. $9, Land Tenure Center T.ladison, 197). ANNEX 1 Page 11 the conclusion that many of these individuals may not be qualified for operating units, but, even taking this into account, a greater effort appears to be warranted. The limited scale of INCORA's past accomplish- ments in land redistribution can be attributed partly to a conservative and prudent approach, but even more to the limited financial and political support which the agency has received. It seems likely that INCORA might have been able to adduce more support if stronger efforts had been made to develop convincing factual evidence for setting realistic targets concerning the number of'new farming opportunities to be created. In any event, such momentum and effectiveness as have been gained should not be lost, inasmuch as Colombia will surely need to continue to bring more lands into such units in the future. Drastic expansion of such programs, however, might produce fewer benefits per unit of input than other approaches to achieving intensified use of land now in farms. It is therefore suggested that a reasonable near- term g6al would be to increase the rate of creating new farm units through Tand reclamation, redistribution, and colonization two-fold as compared with the rate of recent years. The present state of project developnent, however, will probably not permit immediate realization of even this moderate increase in the rate of creating new small farm units. 34. Several recent measures can be expected to strengthen pressures for t,he kinds of adjustments in agrarian structure and/or intensification of land ose which have been sought through INCORA's programs. Under Law 4 of 1973, INCORA can now dissolve private title to land which remains unexploited for three years, instead of 10 years as before. Also, a complex schedule of ninimum levels of productivity for about 20 crops in 75 districts has been announced. Failure to meet such standards would provide a basis for action by INCORA to find the property inadequately exploited, ana hence subject to acquisition and redistribution. Beyond these measures, the dubious provisions of Law 1 of 1968 have been superseded by a new Law 36 of 1975 (Ley de Apace- Ila), which should encourage some landowners to reinstate sharecroppers under guidelines for long-term contractual arrangements which have something to offer to both parties. Taxation 35. Land taxes represent another possible instrument for encouraging more intensive land use. The presumptive income tax for agriculture enacted in 1973 has never been applied, but a general presumptive tax which imputes an 8 percent minimum return to many forms of assets patrimonio) was enacted in 1974. Thereafter, by Decree 2348 of 1974, the value of female breeding cattle, certain perennials, and half of the farm automotive equipment was exempted from the imputed income calculation. Although there have already been calls to set aside the presumptive income tax, on an emergency basis, there is every indication that it will be implemented in 1975, and it should provide additional stimulus for more intensive land use. 'Inbt, tutionaLa2pot 36. Recentl-', the Gcvernment as been considering the slty of Transferring inring responsibility for canstruction of i ;iiIon, drainage, and flood control works out of ItCO?A. It does not a,pnar that transfer of such functions to another public agency would seriG>J4 nnpair TICORA's ability to conduct 1ts remainin- pro5raris. More urgent, in terns ANNEX 1 Page 12 of program capability, is the matter of maintaining and strengthening INCORA's agricultural technical staff, which in 1974 included 191 agronomists, 76 veterinarians, and 578 technicians.Ll For the Instituto Colombiano Agropecuario (ICA) also, professional staffing may become a critical issue in the next year or two, particularly if large new responsibilities for integrated rural developnent are to be undertaken by the Caja Agraria with help from ICA. In May 1974, ICA had a total staff of nore than 6,000 includ- ing about 1,350 professionals, but fewer than 300 of the professionals, plus 900 others, were assigned to rural development, including extension. To date, ICA's accomplishments in research have been more outstanding than those in extension. This is partly because not much over 15 percent of the total budget has been devoted to extension activities and it is also a reflection of the fact that considerable research is needed before strong extension programs can be developed. On the other hand, expanded programs for integrated rural development cannot be expected to succeed without large inputs of pro- fessional and sub-professional workers skilled in the techniques of extension. ICA has few such workers to spare and the Caja Agraria has almost none so that it is unclear where they will be found without stripping needed expertise from ICA, ICORA, and other existing agencies. Financial Support 37. For 1975, Col$1,030 million (US$35.6 million) has been allocated to agriculture, or 3 percent of the total budget. Of this amount, Col$932 million or 91 percent, is for the autonomous agencies. By comparison, in 1973, Government contributions to the autonomous agencies were Col$1,167.6 million (US$40.3 million) and the budget for agriculture represented 5.4 percent of the total budget. The absolute decline in budgetary allocations to agri- culture should be measured against annual inflation rates of more than 20 percent since 1973. The relative decline of the budget for agriculture has been continuous for several years and has had a pronounced adverse effect on the operations of INCORA, which as the main land development institution, receives the major share, about 37 percent, of the total allocated to autonomous agencies. ICA received increased allocations over the five-year period ending 1973, but since 1974, its allocations have also declined. Support for the Instituto de Desarrollo de los Recursos Naturales Renovables (INDERENA) has always been far less than would be required to carry out the Ll Data supplied by INCORA Office of Planning ANNEX 1 Page 13 responsibilities it has been assigned for the vast water and forest re- sources of Colombia. As a result of the insufficiency of funds, agricul- tural institutions have accumulated large outstanding debts in order to maintain a reasonable level of activity which amounted to Col$2 billion for IDEMIA and about Col$l billion for ICORA by year-end 1974. Unless budgetary allocations for agriculture are increased at a rate of about 5 percent annually in real terms and funds are provided to progressively cancel outstanding debts, it will be difficult for agriculture to sustan its current rate of growth, provide additional rural employment opportunities, contribute to improved nutrition, and increase its non-traditional exports. Agricultural Credit 38. The Colombian banking system is characterized by a high degree of Government intervention as reflected by a complex set of regulations controlling interest rates and investment requirements. At the beginning of 1974, the agricultural credit portfolio totalled about US$400 million, which corresponds to about 26 percent of all outstanding loans, exclusive of those for housing, or an allocation approximately equivalent to the contribution of the agricultural sector to GDP. The increase during the last two years in nominal Colombian pesos was about 12 percent per year in 1972, 17 percent in 1973 and, according to preliminary data, an additional 17 percent in 1974. These increases are negative in real terms and more rapid increases in agricultural credit will be needed if a 5 percent growth rate in agriculture is to be sustained over the long run. 39. In March 1973, the Government introduced Law 5 to offset an expected decline in the availability of finds for agricultural lending due to the combined effect of low interest rates applied in the Government-controlled market and a rising inflation. Under this law, commercial banks are required to invest 15 percent of their placements in 8 percent agrarian bonds issued by the Central Bank. These funds are then relent through rediscount facilities arranged by the Fondo Financiero Agropecuario (FFA) to all credit institutions for agricultural lending. While Law 5 has undoubtedly channeled more funds to agriculture (not livestock), the increase has not matched inflation. 4O. In September 1974, the new Government replaced a complex set of interest rates for agriculture, ranging from 7 to 18 percent, with a system under which loans for most purposes are made at l percent, with an addi- tional 1 percent charged on large loans to provide funds to cover technical assistance to small borrowers. Loans for cattle fattening are made at 20 per- cent. The fact that credit institutions are paying higher interest rates on the financial market to mobilize funds under the high inflationary conditions and the rediscount margin on FFA's funds is narrow (3 percent), has serious implications for small farmer lending in Colombia. There are indic-tions that commercial credit institutions have increased the share of 1a'ger sized agricultural loans. USAIU has stopped contributing through -ITOPA to the Supervised Credit Scheme, which was more specifically aimed at the lower income farmers, and t'e total outstanding portfolio decli red from Col$1.3 bi11ion in 197? to Col'1.1 b-1lion in l173. While from 1969 through 1972, Caja Araria's lending to small farmers increased considerably, relative ANNEX 1 Page 14 growth in 1973 and 1974 was small. Caja Agraria has contributed substantially to development efforts in agriculture but many large loans have probably served partly to permit the transfer of ownership of cattle from one rancher to another, purchase of land, or transfer of the beneficiaries' capital to other more profitable sectors. hl. The new Government is aware of these problems and has taken steps to deal with the situation. The maximum size of FFA-discounted loans in 1975 has been set at Col$2 million (US$70,000) although a quarter of that limit would be more appropriate. In January 1975, Government increased FFA's allocations for short-term loans to CoL$3.8 billion (Col$2.5 billion in 1974). Without a commensurate budgetary allocation to strengthen the extension services, these amounts are likely to benefit primarily the larger farmers. To maintain a growth rate of.agricultural credit of 5 percent per year in real terms, credit allocations would need to increase by Col$2.5 bil- lion per year assuming an inflation rate of about 20 percent. By assigning the responsibility for implementing integrated rural development projects to Caja Agraria, Government hopes to direct Caja's main efforts to small farmers. In view of Caja Agraria's lack of credit supervisory staff, and lack of experience in this area, it is as yet not clear how this will be implemented. ANNEX 2 Page 1 ANNEX 2 THE INDUSTRIAL SECTOR A. Basic Characteristics Post-War Growth.and Import Substitution - 1945-68 1. During the two decades following World War II, Colombia's manufacturing sector grew rapidly and evolved into a complex and, in some ways, modern sector. Growth of manufacturing was more rapid during the period 1965-57 (8 percent annual average), when coffee prices were favorable, than during the period 1957-68. However, despite the continuously tight balance of payments situation from 1957 to 1967, manufacturing growth continued at a reduced but still reasonable pace averaging about 6 percent annually. 2. In the postwar period,industrialization became in Colombia, as in rost of Latin America, an important component of development policy. Import substituting industrialization was in part a reaction to the periodic balance of pay,ents crises, brought on both by fluctuations in the terms of trade and by the inflation-devaluation cycle. The relative importance of various components of the restrictive system (tariffs, import prohibitions, prior deposits and other controls) has varied over the period. Tariff levels and regular prohibitions were the most important elements of thr restrictive system during the period 1945-57, but in the period of balance of payments tightness which followed, quantitative restrictions became more and more important. 3. With the close of World War II, Colombia was still dependent on imports for the vast bulk of its capital goods. In 196, the domestic share of total supply (domestic absorption plus exports) was 36 percent for capital goods, 66 percent for intermediate goods, 69 percent for durable consumer goods, and 92 percent for non-durable consumer goods. By 1968, the domestic share had increased to51 percent for capital goods, 68 percent for intermediate goods and 98 percent for non-durable and durable consumer goods. Import substitution, one of the main sources of industrial growth throughout the 1950's and the early 1960's, became much less important as a driving force for industrialization after 1963. Imports declined as a percentage of available manufactures from 35 percent in 1953 to 21 percent in 1963 but were still more than 20 percent in 1968. With most of the easy import substitution opportunities exhausted by the mid-1960's, annual growth of industry slowed to about 5 percent in the period 1963-1968. ExLort Growth The late 1960ts saw the advent or manufacturing exports as an lncr2easingly important source of both foreign exchange and growth of anufactur- ing c-tput. During the period 1968-1974, there was an upward shift in the groDwth rate of the industrial factory sector and industrial growth exceeded 9 percent. An analysis of the sources of industrial growth during 1968-73 ANNEX 2 Page 2 indicates that export demand explained almost one-fifth of growth in that period. Industrial exports rose from US$5 million in 1968 to about US$330 million in 1973 or from 2 percent of manufacturing output in 1968 to almost 7 percent in 1973. 5. Excessive reliance on growth of capital intensive, import substitute industries dependent on imported input was by the mid-1960's increasingly apparent. To stimulate growth of manufactured and other non-traditional exports the Government introduced a crawling peg exchange rate in 1967. This policy was complemented by several other measures to promote exports involving fixed subsidies, improved credit availability for exporters and removal of some administrative obstacles to the use of import/export schemes. 6. The 1967 reforms, however, maintained incentives for import substitution. The key instrument for achieving this was the licensing system. Imports of goods whose domestic production was adequate were prohibited and, a "prior license" group was established consisting of goods whose domestic production was inadequate but where substantial foreign exchange saving could be achieved. Although incentives for import substitution remained, the relative attractiveness of exporting was substantially increased. 7. The acceleration of manufacturing growth since 1967/68 has not been accompanied by significant structural change as the relative share of consumer, intermediate, and capital goods in output and employment has remained. about constant. Within the consumer goods group, food, beverages and tobacco products continued their historic decline as a proportion of gross value added, while textiles and clothing rose significantly, largely as a result of expanded exports. Among intermediate products, paper, oil products, non-metallic minerals (primarily of cement of which substantial quantities are exported) and basic metals also increased their share of total value added but all other intermediate products showed a relative decline. Among capital goods, only mechanical machinery, which is exported in significant quantity, increased. Electrical and transport equipment declined due to difficulties encountered in moving beyond the mere assembly stage in these capital intensive import substitution industries given the relatively small size of the Colombian market. Degree of Import Dependence 8. Import substitution has led to some reduction in import dependence, especially for intermediate goods. The share of imports in total intermediate goods supply decreased by one-third from 1945 to 1972 to about 22 percent during the latter year. Import dependence for capital goods has been reduced somewhat but about half oi capital goods requirements are still imported. Throughout the post-war period consumer goods imports have represented a small proportion of total supply as the bulk of food and textile supply is produced in Colombia. Given the weight of consumer goods in total ANNEX 2 Page 3 manufactured supply, average import dependence has been reduced only slowly in the last quarter century and imports now stand at about 15-20 percent of total supply of manufactures. 9. Despite a long-term trend in reduction of import dependence, particularly for intermediate goods, the ratio of imported intermediate goods to total consumption of such goods has not fallen since 1968. The reason is that import coefficients of the small but rapidly developing industries, which have been providing inputs to the more traditional sectors, are much higher than the import coefficients of the older Colombian industries. To a considerable degree the import substitution process is now in the stage of"import bumping,"with the industries that were beginning to produce goods previously imported, themselves requiring substantial imported inputs. 10. As Colombia has expanded into import substituting producer goods industries where scale, skills and supply constraints are relatively more binding, the domestic resource cost of saving foreign exchange has tended to increase. Thus, although it is reasonable to presume further reductions in import dependency, the ratio of imports to gross value of output can be expected to fall only slowly unless there is an added incentive to import substitution. The share of locally produced capital goods in total manufactured value added has risen at a much slower rate since 1968 than in previous years. Such a slowdown in growth may partly reflect a failutre of statistical coverage, but it also may indicate a lessening of policy emphasis on import substitution in production of machinery and equipment. With import substitution becoming progres- sively more difficult and given the need to import machinery and essential raw materials for industry the rate of growth of non-traditional exports has become a critical factor in determining industrial output and employment. Recent Industrial Performance 1973-74 11. Despite acceleration of growth and employment since 1967, industry still faces serious and, in some respects, increasing problems. While the expansion in aggregate demand facilitated rates of industrial growth considerably higher than those recorded in the first half of the 1960's, mounting inflation in recent years has had damaging effects on a number of industries producing for the domestic market. Increases in international prices, additional domestic costs, higher interest rates and longer delays in payments from customers have squeezed profits of a number of industrial enterprises. Shortages of raw materials and spares have caused additional difficulties. Lack of sufficient internal resources have prevented industrialists from investing sufficiently to meet in- creasing demand. In 1974 the effects of inflation on real incomes reduced purchasing power, thus adding a new dimension to the problem of lagging invest- ment leading to underutilization of capacity in consumer goods indUstries such as textiles and clothing. As a result, manufacturing output may have grown at a somewhat slower rate in 197'4 -han in 1973. Uncertainty due to the change in government, the fiscal reform and the world economy have ompounded industry's problems. ANNEX 2 Page 4 12. On the basis of interviews with a number of industrialists at year-end 1974, market problems stemming from declining demand and narrowness of the market, and financial difficulties (delays in payments by customers, increased taxation, increases in cost of supplies, lack of credit) were quoted as the most serious short-term obstacles to accelerated indus- trial growth. Other problems were (i) the lack of availability of raw materials and parts, mainly due to shortages in domestic and international markets, and (ii) some delays in obtaining import licenses. In addition, important but less frequently cited problems included goverment price controls (essentially for food products such as sugar, vegetable oil and meal, animal ,eed), and price fixing on the part of some large companies enjoying a monopoly position in supplying inputs to other industries. Although many industrialists seem confident of being able to maintain exports in the future, some also feel that additional strong measures should be taken by the Government to further develop Colombian exports. Despite confidence expressed by many entrepreneurs regarding prospects for industry, the present situation is not conducive to expansion or creation of new industries, and promotional efforts will have to be made by the Government and financial institutions to identify and help to establish new lines of production in manufacturing. 13. Many industrialists support the view that better income distribution should raise demand for essential goods such as 'food products and clothing and thus give new impetus to the development of these industries. Improved income distribution and employment will contribute to enlarging the domestic market for manufactured products, thereby providing the base for sustained high rates of growth of manufacturing. Strong support is also expressed by manufacturers for integration within the Andean market and expanded trade with the Caribbean and Central American regions. The Andean market is considered important both as a short-term substitute for declining demand in OECD countries stemming from recession, and as a long-term solution to facilitate development of intermediate and capital goods in order to diversify and enlarge the existing industrial base. It is encouraging that Colombian industrialists do not generally view exports to the Andean and other Latin American markets as possible only behind a high protection wall but as natural and feasible, given Colombia's production capabilities and geographic position vis-a-vis its neighbors. Exports of manufactures to Latin fmerican countries and, in particular, to the Andean market have increased rapidly in recent years. Colombian entrepreneurs seem determined to strengthen already successful efforts to further develop such exports. Industrial Structure '1. The five largest industrial branches in order of importance are textiles, beverages, food products, chemical and non-metallic minerals. They 3ontribute more than 60 percent of total value added in manufacturing and have accounded for 60 percent of growth in value added since 1967. The most ANNEX 2 Page 5 rapid growth has taken place in textiles, which more than doubled production in five years. Among intermediate goods, paper products, oil products and basic metals showed high growth rates while leather products and metal products increased only slightly. Industries with particularly slow growth were electrical machinery and transport equipment. 15. The share of the capital goods industry in total value added in manufacturing is somewhat lower in Colombia than in a number of other countries at similar stages of development. Electrical equipment is highly protected and with only a few exceptions, products of this group have high prices and are produced rather inefficiently. Until recently,imports of electrical and electronic goods were prohibited. This group of industries is not well suited to the scale of production which the Colombian market permits. The transport sector (bicycles, automobile but excluding truck assembly), has also enjoyed high rates of protection and domestic prices are several times import prices. Domestic value added is elow in this branch of industry and its contribution to growth of value added in manufacturing has, as a consequence, been small. 16. In contrast to the inefficiency of several capital goods branches, a niumber of industries producing consumer goods are quite efficient by inter- national standards and enjoy a comparative advantage in Colombia. This in part explains the large share of consumer goods in total industrial value added. Food products have not received heavy protection. The industry is long established and there is substantial domestic competition which has kept prices low. Owing to its abundant meat and fish resources and potential for expanded fruit and vegetable production, Colombia is relatively efficient in food processing. The textile industry also possesses a strong comparative advantage in Colombia due to abundant supplies of local cotton at reasonably low prices and outstanding entrepreneurial talent. Geographic Distribution of Industry 17. In 1970, 82.5 percent of value added in manufacturing and 81.4 percent of employment originated in the departments where the four main industrial cities are located. The employment share of these departments in the total manufacturing labor force has not increased in the last ten years. With the exception of Boyaca, other less important centers have during the post-war period declined continuously as a proportion of total employment and value added. Medium-industrialized centers which have been established in this period are either highly specialized (petrochemicals in Cartagena, oil refining in Barrancabermeja, steel forging in Bucaramanga) or produce a wide range of traditional light consumer goods for local markets. Food, leather, clothing, building materials, and furniture industries can be found in most Colombian towns. Industries in smaller cities and towns have been hurt by falling transport costs as more efficient industries in mnajor centers could more easily supply rural and small urban areas from further away. ANNEX 2 Page 6 18. Colombia has made notable advances in improving its transportation network. Disruptions in inland transport no longer seem to be significant impediments to efficient large scale industrial production. Future industrial development will require, however, further expansion of specialized transportation facilities such as storage and port facilities for exports. Many of the geographical advantages which led to the original development of the four industrial centers still exist, and even with greatly improved means of transportation, transport costs are almost certain to remain so high as to justify the continued growth of the four main industrial centers. Colombian industry is already relatively decentralized as compared with that in other Latin American countries and there is every reason to expect that this pattern of development will continue in the future. 19. It has been argued for several years in Colombia that elimination of regional employment and income disparities requires decentralization of industry. While there is a strong case for encouraging decentralization of light non-durable consumer goods industries (such as footwear, clothing and agro-industries), for which external economies are relatively unimportant, the apparent decision of the government not to introduce costly subsidies to attract manufacturers to small centers is well conceived. Over- decentralization would have adverse effects on development since it would involve the loss of external economies and would require a shift of investment from high priority development programs to expansion of infrastructure in small towns. Employment 20. While employment in manufacturing grew at an annual rate of 3.5 percent during 1953-i963, and fell to 1.6 percent in 1963-68, it rose by about 8 percent annually from 1968 to the present, or more than proportionately to the increase in value added. Phis was due to a much increased growth rate of employment in non-durable consumer goods in the more recent period which in turn appears to be related to rapid growth of exports of these products since 1968. Exports appear to be much more labor intensive than the import substitution industries such as petrochemicals and chemicals, which played such a prominent role in growth during the 1950's and 1960's. This hypothesis is supported by calculations of employment-output ratios, and by declines in marginal capital-output ratios during the period of rapid export expansion. The higher ratio of manufacturing employment growth to increase in v,lue added since 1968 may thus reflect the shift from a capital intensive import substitution industrialization strategy to a more labor intensive export strategy. 21. Cost of labor is low in Colombia as compared to other Latin American countries./1 Increased social benefits have prevented labor costs from ZI Labor costs in free zone type industries are approximately US$1.50 a day, substantially lower than in Mexico and in the Dominican Republic, and comparable to Haiti. ANNEX 2 Page 7 declining as a proportion of value added as such benefits have increased from 24 percent of the total labor cost in 1958 to 47 percent in 1973. The increased importance of social charges in the wage bill could have adverse effect on future industrial employment. Despite this trend industry in Colombia continues to benefit from low labor costs. The stability of labor cost as a share of total value added in manufacturing has undoubtedly increased the employment growth potential of Colombia's limited investment capacity as well as Colombia's ability to invest and allocate investment efficiently by permitting Colombia to break into export markets. B. Issues and Policies Increasing Growth 22. During 1967 through 1974 the manufacturing sector growth rate rose to between 9 to 10 percent annually, a level unmatched since the 1950's. During this period, the capital output ratio for industry declined and capacity utilization seems to have increased in several branches of industry. Despite rapid growth of industrial employment, labor costs did not increase as a proportion of value added and labor intensive industries maintained their competitiveness. Industrial exports rose from an insignificant level to US$380 million in 1974. To maintain a high rate of industrial growth in the future, however, will require reform in fields of tariff policy, quotas, taxation, export promotion, economic integration within the Andean Group, assistance to small and medium scale industry, and provision of necessary credit to the manufacturing sector. On the basis of historical performance two main basic conditions must be met to sustain a relatively high industrial growth rate: (a) the domestic market must be enlarged through better income distribution and (b) industrial exports to regional markets and the outside world must be expanded. While the first condition would bring about significant results in a few years, additional export promotion measures would have an immediate impact. The System of Protection 23. Since 1967, Colombia has steadily shifted away from inward-oriented trade policies to a more outward-ooking orientation, although quantitative restrictions still remain a key feature of the restrictive system. The present system of non-tariff trade restrictions, foreign exchange regulations and export promotion policies were fully defined in Decree Law 444 of March 1967. With some modifications to this Law particularly in the second half of 1974, the system has remained basically unchanged since that time. The present system of protection for Colombian manufactures is composed of three elements: an ad valorem tariff enacted in 1964 but amended since, a system of prior deposits, and a system of quantitative restrictions embodied in an import licensing system. ANNEX 2 Page 8 Tariffs 24. The present tariff schedule of Colombia dates from 1964. However, since that date, the Government has introduced a number of changes in the tariff. The latest reform, in early 1974, involved a reduction of some tariff rates (particularly for capital goods and some intermediate goods). This development was primarily associated with a desire to reduce the cost of imported capital and intermediate goods and to bring Colombia's tariff structure in line with other Andean Common Market countries. 25. Tariff rates currently average 30 to 35 percent of the total value of imports. However, rates are widely differentiated between categories of goods and the tariff schedule by itself generates very high effective protection rates for some goods. Duties on industrial raw materials and capital goods are low. High tariffs exist on fairly simple goods which are produced in Colombia (e.g. synthetic fiber, textiles, food products). Consumer durables (including electrical products and transport equipment) tend likewise to have relatively high tariffs. On some high tariff items (such as textiles and food products) domestic competition has been sufficient to reduce domestic prices to close to the CIF import price. Low tariff items usually remain such until domestic production starts. Tariffs will then be increased or be replaced by quantitative restrictions. 26. Total or partial import duty exemptions are provided to imports from Andean and other LAFTA sources, for some basic industries (e.g. sulphur, pig iron and steel, coal, chemical pulp, fishing, etc.), purchases by some public sector entities, imports financed with aid credits, purchases by export manufacturers (Plan Vallejo), plus other ad hoc exemptions. Such exemptions are not always automatic and many are subject to review and approval. Only imports for "social purposes" such as hospital and medical equipment, electrical and water facilities equipment are still exempt. Duty free imports by the public sector have in recent years accounted for about 86 percent of total exempted imports. Principal beneficiaries in the private sector were the cement industry, automobile assembly, Acerfas Paz del Rio and Planta Colom- biana de Soda 7!Such tariff exemptions are generally not justified as they favored mostly capital goods imports and hence have resulted in reducing the cost of capital vis-a-vis labor costs. Clearly some industries like oil exploration and refining can do little to substitute labor for capital but in other activities like mining and many consumer goods industries such possibilities do exist. Prior Deposits 27. Until 1973 importers were required to deposit with the Central Bank an amount equivalent to a percentage of the value of the import. This amount was held on deposit by the Central Bank, earning no interest and eroded by inflation, 3 months after the merchandise cleared customs. During the second quarter of 1973, the advance import deposit system was abolished '1 Such exceptions expired in December 197h for the steel industry. ANNEX 2 Page 9 and replaced by a new system. The primary change was the elimination of numerous differential deposit rates and the provision that the new deposit could be used to make payment at any time following registration. Thus the system was changed from one of restriction to one of encouraging import payment. The opportunity cost of prior deposits expressed as an ad-valorem tariff equivalent (estimated at between 10 and 4 percent) is difficult to establish with precision, and given the nature of capital markets in Colombia it is likely to differ considerably among firms. Some companies may obtain foreign suppliers' credits for such purpose, others can obtain credit from the commercial banks, but, smaller firms may suffer severe hardships in raising the needed cash. Import Licensing 28. All imports into Colombia are now classified into one of two categories, imports which require a prior license and imports which can be imported freely. In August 1973, a third category which included a prohibited imports list was eliminated. Other substantial liberalization took place when at that date some 700 items were transferred from the prior license list to the free list. This last category includes a global free list applicable to all countries, a national free list applicable only to LAFTA countries and a free list applicable to only Andean Common Market countries. Items on the prohibited list were primarily non-durable consumer goods produced in Colombia such as food products, beverages, clothing, footwear and textiles and intermediate goods such as leather, wood products, paper products and fats and oils. For a number of formerly prohibited items, prohibition was redundant. A comparison of prohibited items with exported ones, shows that many items were found in both categories which implies that prohibited items were often internationally competitive. Taking into account that the average tariff on prohibited items was about 40 percent, there was little impact in moving these items from the prohibited to the prior license list. 29. Free list items can be brought into Colombia without a prior license; all that is required besides payment of duties and prior deposits is the registration of those imports with INCOMEX, the foreign trade authority. Typically the process is routine, but INCOMEX has the responsibility for verifying the price appearing in the registration so as to prevent overinvoicing. In 1971, the free list, excluding Plan Vallejo and LAFTA imports, included only about 150 items, or 3 percent of all categories in the tariff. In June 1974 the number of items on the free list rose to 1,442, or 33 percent of all tariff items. Free list items accounted for 29 percent of all registered imports in 1971, 27 percent in 1972 and 29 percent in 1973, but this ratio rose to 41 percent in January-May 1974. Goods on the free list include newsprint, a number of chemicals, some basic metals, including stainless steel products, mechanical machinery, electrical machinery and various scientific and medical items. ANNEX 2 Page 10 30. All other goods are subject to prior approval. The number of goods requiring prior approval has declined substantially in recent years and licenses have been issued more liberally. INCOMEX does not follow rigid rules when deciding on applications. If the application is satisfactory in form, INCOMEX examines whether products similar to those requested are produced locally. The presumption is that local goods are fully satisfactory for import replacement. Price differences, unless extreme, are not considered valid grounds for importing. If the import license is granted, import prices are checked closely so as to prevent inter-affiliate and other types of capital transfers which might be achieved through over-invoicing. Import Liberalization 31. The post-1967 trend seems to be a gradual expansion of the free list. While the prohibited list has been eliminated, there remains nevertheless, a fear that without import controls, and in spite of tariffs, there would be a strong upsurge of imports (as in 1966), loss of foreign exchange reserves and possible bankruptcies among local producers. The adverse effects of the import licensing system in Colombia do not appear to be severe. Capacity utilization,for example,seems to be related more to management and other factors than to import licensing. Most industries do not consider availability of import licenses a serious constraint. Further import liberalization, could, however, if properly managed, consolidate and slightly expand the post-1967 gains in industrial efficiency and growth. Effective Protection 32. It is clear from the foregoing discussion of the components of the Colombian import restriction system that the calculation of protection requires the undertaking of price comparisons between domestic production and import values in order to determine the composite effect of licensing, tariff redundancy and prior import deposits. Such price comparisons are difficult since allocation of import licenses directly to final users means that in many cases there is no domestic price for the imported commodity. The most conplete study on effective protection, carried out for 1969 and corro- borated by data obtained for 197, indicates that on average protection of aanufacturing was about 30 percent as compared to negligible protection for 'rimary production. While the average for industry as a whole is low as compared to other Latin American countries there are considerable differences between product groups. Transport equipment receives 319 percent effective protection, electrical apparatus 668 percent, but textiles and non-metalic mineral products receive only 8 percent and 1 percent respectively. Effective protection data indicate that Colombia has transferred income from primary sectors :o manufacturing through its incentive system. The domestic credit and tax system which favors primary production compensates for the transfer only in a very minor way. Changes introduced in the system since 1969 are unlikely to have affected effective protection significantly since protection was redundant for most items on which restrictions have been reduced. ANNEX 2 Page 11 33. The Colombian authorities are now doing further work on the level of effective protection in preparation for negotiations concerning the Andean Market's common external tariff. The Colombian position appears to be that effective protection should be moderate and more uniform (there is still a high degree of dispersion between effective protection rates). Once this analysis, including the effect of recent changes in export incentives, fiscal measures, and quantitative restrictions is completed,steps may be taken to reduce the dispersion of rates of protection of the overall system as well as within major product groups. In a second phase exceptions may be studied and more favorable treatment envisaged for particular industries on the basis of employment, export growth or income distribution. Export Promotion 34. The Colombian Government initiated its export promotion efforts in the early sixties when a highly repressive export tax was removed, tax incentives were granted to exporters and an import-export scheme was introduced. The export promotion program currently in operation, was introduced in 1967 under Decree 444. It consisted of(l) a fiscal subsidy on exports,(2) a drawback system, 0) subsidized financing, (4) free trade zones. Export Subsidy 35. Up to January 1, 1975 tax credit certificates (Certificados de Abono-Tributario, CAT) were issued to exporters when they surrendered the foreign exchange accruing from an export in an amount equivalent to l5 percent of the FOB value of the export. As of January 1975, the CAT rate was reduced to 5 percent or in some cases virtually eliminated. The CAT system, an important component of the export promotion program, had a strong negative impact, however, on government cash revenue with the proportion of taxes paid with these certificates rising to 6.7 percent in the first half of 1974, as compared to 3.5 percent in 1969-1971. Such a fiscal cost was reduced by difficult to quantify benefits such as increased collection of tariffs through higher imports, higher income taxes and higher indirect taxes. But there were, other problems: (1) it provided export subsidies to all industries even where they were redundant; (2) fictitious exports were becoming increasingly common in order to take advantage of the CAT; and (3) they created frictions with trade partners in the Andean region and elsewhere. ANNEX 2 Page 12 Import-Export Schemes 36. In 1959 Colombia established a drawback system known as the- Vallejo Plan. It provides that raw materials, intermediate products and capital equipment to be used for manufactured products destined for export may be imported exempt from prior license, advance import deposit and customs duties. Two alternative import-export schemes are the Vallejo Junior Plan and the "drawback". The Vallejo Junior Plan offers the same incentives as the Vallejo Plan, but on an ex post basis. After an exporter has completed an export, he can claim the benefits of the Vallejo Plan for his next import. The "drawback" is a system for the partial refunding of customs duties, with the amount refunded depending on the value added component of the product exported. Of the three import-export schemes, only the Vallejo Plan is used widely. The drawback has not yet become operational since the Government has not issued the required regulations for its implementation. Moreover, the Vallejo Junior Plan has not attracted many users, partly because of lack of knowledge and partly because it requires that more information be provided than some exporters are prepared to furnish. 37. Over the past decade, use of the Vallejo Plan has expanded rapidly with imports growing from US$2.2 million in 1963 to US$46.5 million in 1973. Exports under the Vallejo Plan represent at least half of total manufactured exports. Given the importance of Vallejo and Vallejo Junior plans, every effort should be made to streamline administrative procedure so as to make them more effective. In addition, the drawback system should now be implamented and a study should be made to determine whether additional rebate measures are needed to eliminate all domestic taxes from exports. Export Credit Facilities 38. The Export-Promotion Fund (Proexpo) was established in 1967 and is funded through an import surcharge of 1.5 percent (recently raised to 3 percent) to provide financing at subsidized interest rates for working capital, as well as for expenses related to promotion abroad, and cther export-related activities. Through the end of 1971 the use of these facilities was relatively unimportant . By the end of 1971, total Proexpo credit to the private sector amounted to only 13 percent of outstanding gross short- term liabilities of the commercial banks for export financing. Since 1972, however, Proexpo resources have been increased by significant amounts. In May 1972, Proexpo was provided with a special rediscount facility for the equivalent of Col$650 million at the Bank of the Republic and was authorized to reduce its interest rates in an effort to make them competitive with those available abroad. In August 1972 an additional Col $600 million was provided to be relent to financial intermediaries and in 1973 Proexpo rediscount facility was again increased by Col$l billion. Partly to compensate for the reduction in CAT rates, Proexpo has been provided with additional resources since January 1, 1975, of Col$300 million to finance industrial exports of which Col$140 million will be made available immediately at a rate of 18 percent to exporters for working capital purposes. ANNEX 2 Page 13 Other Export Promotion Measures 39. To provide additional resources for export promotion, the Government has raised the import surcharge earmarked for Proexpo from 1.5 percent to 3.0 percent. These resources will be for: (a) special credit facilities for financing sale of exports nnd for working and investment capital for export production and distribution; (b) incentives to new enterprises to cover part of production costs; (c) technical assistance to small and medium-sized export industries; (d) investment in and promotion of transport and storage systems needed for exporting to specific markets; and, (e) guaranteeing the acquisition of transport equipment used for export. IO. According to a Proexpo sample survey of 281 enterprises, the most critical problem in export production is the lack of finance. The subsidy element in export credits as compared to total value of industrial exports is relatively minor at present. Other export problems listed included in the following order: insufficient volume and quality of domestic raw materials (particularly in food products, leather for shoes and wooden furniture), lack of export information regarding opportunities abroad, insufficient promotion in foreign markets, and inadequate transport facilities. The transport problem is particularly serious for industries producing wood products, wooden furniture, food products and machinery. Such problems are not new but additional efforts should be made to handle them. Corrections of the peso exchange rate will compensate for the reduction in CATs, but what is needed is not only to maintain the present level of exports but to increase it substantially. The Andean Common Market 4l. By signing the Cartegena Agreement creating the Andean Common Market, Colombia committed itself to a gradual loss of purely national control over tariff policy. A common external Andean tariff is to be agreed upon during 1975 and should be fully implemented by 1980. The common minimum external tariff agreed upon in December 1970, and toward which Colombia is already moving, is close to the average level, but less varied than ANNEX 2 Page 14 Colombia's tariff structure. 1/ Technicians familiar with the minimum tariff have pointed to the desirability of making the eventual common external tariff no higher than the minimum tariff,which averages about 50 percent. The Common Market's Board has proposed that the common external tariff be based on effective rates of protection which are lower than those applied in any of the member countries but still high enough to involve a bias against primary production and export. Such proposals will be subject to detailed review and discussion by member countries in 1975. The extent to which Andean arrangements may prejudice Colombia s overall export growth will depend on the final degree of effective protection. A12. Colombia appears to be in a favorable position in the Andean Market with a lower cost, more developed industrial structure than any other member country. Economies of scale should be achievable through 7he larger Andean Market,although there is the danger that exceptions proliferate which prevent free trade in a number of important industries. Colombia had agreed to limit exceptions from the liberalization program of the Cartagena Agreement to less than 4 percent of the total of items. In contrast Peru has asked for almost 3 times more exceptions (in number of tariff nomenclature items). Colombia rightly feels it has an excellent opportunity to develop exports of producer goods to its less industrialized neighbors. The elimination of tariffs and quantitative controls over intra-Andean commodity flows should generate efficiency gains and exert salutary competitive pressure on industry as there seems to be much potential for trade creation within the Andean Group. The Andean Common Market may thus be viewed partly as insurance against declining exports to other markets. h3. Ad hoc industrial complementation agreements among Andean countries aimed at establishing trans-Andean import substitution schemes, can contribute to rationalization of existing inefficient industries such as steel, petrochemicals, vehicle assembly. In addition, specialization agreements in the metal manufacturing, automobile, petrochemical and fertilizer industries give exclusive rights to member countries for a period ranging from 5 to 15 years tomanufacture a particular product which would be traded duty-free within the Andean Market. Allocations of metal manufacturing products will have to be revised following Venezuela's entry into the Market and while this may have adverse consequences on the Paz del Rio company and other Colombian steel processing industries in the short-term,the long-term effects on industrial development should be positive. Agreement on automobile production aims at reducing the number of models, but eight firms will still share a relatively small market which is protected by tariffs ranging from 60 to 110 percent. 1/ About 700 of the 690 items in the tariff nomenclature had to receive higher tariffs (textiles, oil products, vegetable oil, metal products, machine tools, electric lamps, vehicles, etc.) ANNEX 2 Page 17 Taxation and Fiscal Incentives 44 - The 1974 tax reform has simplified the corporate income tax. For tax purposes, two types of enterprises are recognized: (i) corporations and foreign enterprises (the latter being previously taxed at a :ate of 20 percent only) and (ii) limited liability companies and partnerships. The first group is subject to a flat 40 percent rate and the second group to a 20 percont rate. The difference between the two rates is explained by the fact that only dividends distributed by corporations are taxable whereas for the second group of enterprises the entire after tax income is imputed to the owners for purposes of taxation under the individual income tax. According to tax authorities, the tax burden on these two types of enterprises has been equalized at a level which may be somewhat lower for corporations and higher for partnerships and limited liability companies. h5. Fiscal incentives have virtually been eliminated by the recent tax reform. The main purpose of most tax incentive legislation in Colombia traditionally was to encourage investment in specific "basic" industries considered to be necessary for the development of the country provided it purchased at least 60 percent of its raw materials domestically. Firms using products of the National Steel Mill, Acerias Paz del Rio, S.A. were permitted up to 100 percent exemption from the income tax. In addition, corporations were allowed to set aside free of income tax up to 10 percent of their profits for investing in producer goods or to compensate for liabilities accrued because of the purchase of such goods. This measure aimed at increasing industrial investment by improvi4g the beneficiaries' liquidity. But for the liquidity effect of tax incentives to be an important stimulus to investment, a strong desire to invest must be blocked solely by inadequate after tax profits. It seems most unlikely that this condition has often prevailed in Colombia, where market size and scarcity of imports and inputs have been much more imoortant factors in determining the pattern of investment. Recognizing this, the Government has now cancelled all the above incentives. Industrial Finance 46. During recent years commercial bank credit to industry has been severly curtailed relative to other sectors due to the Government's desire to stimulate urban construction. From 1968 to 1973, commercial bank credit to industry fell from 35 percent of total bank new lending to 23 percent. Newly established savings and loan institutions, offering monetary corrections on deposits, have at least until recently contributed to diverting funds for industrial lending from banks and the extra-bank market. Moreover, internal generation of funds, has been hampered since neither valuation of fixed assets for tax purposes nor the tax structure allowed for adjustments to compensate for inflation. In addition, industrial firms have been forced by the need to compete with comparatively high yielding debt-intstruments to maintain high dividend pay-out ratios, averaging about 6$ percent for leading individual stocks. ANNEX 2 Page 16 47. The equity market, in decline since 1970, has discouraged new share issues and comparatively few companies are listed. In September 1974 the price index of listed shares was below its 1968 level by about 60 percent in real terms. Trading volume in shares has represented a constantly decreasing proportion of total trading volume falling from 70 percent in 1968 to 26 percent in the first nine months of 197L. While the past poor performance of the equity market can be explained in part by the high yields available on competing debt instruments, particularly on the indexed-UPAC's, it can also be traced to the impact of high inflation rates and the taxation of purely inflation related profits, together with inadequate depreciation allowances. Introduction of a capital gains tax, accompanied by increases in the interest rate of some debt instruments seems likely to further depress the equity market. 48. While commercial bank credit has been relatively scarce, financiera lending has increased substantially by about 26 percent annually since 1969. This has more than compensated for the lack of commercial bank lending and has enabled medium and large industries to obtain sufficient funds for their investment requirements. Small and medium sized industry, however, has been most affected by reduced bank lending and it has had to resort to high-cost,short-term extra-bank market borrowing. Lack of working capital financing has become a more serious problem for large and small firms over the last few years due to the rapid rise in the costs of raw materials and accelerating inflation. Should a severe shortage of working capital persist, it would have an adverse effect on industrial expansion. h9. Raising equity finance for new enterprises, which has been inhibited by the depressed state of the equity market and unfavorable tax laws, has been made even more difficult by the recent fiscal reform. The introduction of a presumptive income tax, establishing a minimum tax base equal to 8 percent of net assets without a loss carry-forward provision will place an increased burden on new ventures,since operating losses incurred in the early years can only be carried forward to the extent that they do not reduce this presumptive income tax. Furthermore, the recent introduction of a capital gains tax reduces the incentive for investors to put this money into new ventures. Financieras also have little incentive to make equity investments in new enterprises since they incur several years with little or no return while the project develops and subsequently any gain from the sale of shares is treated as current income for tax purposes. ANNEX 3 Page 1 ANNEX 3 FINANCING DEVELOIENT A. Private Sector Financing 1* Although Colombia has a reasonably well developed financial system in comparison with most other countries in Latin America, the system has in the past operated under a high degree of Government control and regulation which has limited its effectiveness in mobilizing private savings and in allocating these resources efficiently. Instruments of monetary policy which have been devised to channel credit to high priority sectors in terms of development strategy have tended to simultaneously have an adverse effect on mobilization of private savings through the financial system. Most interest rates have been held at artificially low levels by the Government and wide differentials have existed between the interest rates available to different types of borrowers and savers. Financial intermediaries have operated under cumbersome regula- tions that have forced them to direct a high proportion of their resources into developmental activities at subsidized interest rates. Fragmented capital and money markets have contributed to misallocation of labor, land and capital and impede entrepreneurial growth, perpetuating the use of inferior production techniques. Resource mobilization by the private sector has been hampered by competition from tax-exempt public sector instruments with immediate liquidity which, in recent years, have been increasingly relied upon to shore up weak public sector finances. As a result. of the severe constraints on the supervised financial sector, a large and active extra- bank market has developed which has simultaneously prevented more rapid development of an efficient competitive system of financial intermediation. 2. Shortly after taking office the new Colombian Government introduced important modifications of the financial system followed by comprehensive structural reform of the tax system aimed at strengthening public finances and at improving resource mobilization by the financial system and at improv- ing its allocational efficiency through greater reliance on market forces. Recent changes in interest rates have increased before-tax yields on savings instruments and have narrowed interest rate differentials. Instruments offered by the savings and loan system have been modified to bring the net return on UPAC's more in line with competing instruments. Financial SavinEs 3. Monetary developments in 1974 were dominated by a sharp acceleration in the rate of credit expansion, a growth in private financial savings deposited with the banking system which was nevertheless unable to keep pace with the growth of nominal GDP, and a substantial decline in net foreign reserves. Financial savings defined as money and quasi-money (M3) increased by nearly 25 percent in 1974 compared with 31 percent in 1973, and an annual average of 20 percent in the previous three years (Table 6.1 Statis- tical Appendix). In relation to nominal GDP, financial savings which had demonstrated an upward trend in the period 1969-1973, reaching 24.2 percent in the latter year, declined to 23.4 percent at the end of 1974. This was in part the result of introduction of indexed UPAC deposits which in 1972 and 1973 yielded positive real rates of interest. In 197L monetai cor- rection was made subject to a ceiling of 20 percent and this, together with ANNEX 3 Page 2 an increase in. the rate of inflation, reduced real yields (see Appendix II). The major change in the composition of financial savings which had transpired during 1973 continued into 1974, with a strong reduction in the holdings of currency and demand deposits (Ml) in relation to nominal GDP, stagnation in The holdings of mortgage and investment bank bonds and a sharp growth in the holdings of indexed UPAC deposits and the new certificates of deposit. While The growth of the money supply decelerated sharply in 197L to only 20 percent on an end of year basis compared to 29 percent in the previous year, the income velocity of money continued to accelerate (reaching 6.4 percent in 1971; as compared with only 3.7 percent in 1973) as a result of the rising trend in domestic prices which together with the increase in interest rates paid on various financial assets induced a relative shift out of money into interest- bearing quasi-monetary holdings as well as physical assets (Table 6.2 Statistical Appendix). 4. Quasi-monetary liabilities continued to grow strongly in 1974 as in the previous year, the major source of which was the indexed UPAC deposits offered by the savings and loan system and the new negotiable certificates of deposit. The indexed UPAC deposits introduced in late 1972 rose to almost 30 percent of total quasi-money holdings by the end of 1974. With regard to the certificates of deposit introduced in early 1974, the banks were able, in only one year, to place Col$2. billion (9 percent of quasi-money). In addi- tion to compensating the commercial banks for the shift in funds from demand and savings deposits to the savings and loan UPAC deposits, the non-redeemability characteristic of the certificates of deposit represent an important step in strengthening the liquidity profile of the commercial banks. Savings deposits which had shown no growth during the first semester, reached Col$9.7 billion by the end of 1974 following a readjustment of the interest rate from 8 percent to 12 percent during the second semester. Nevertheless, their share of total quasi-money declined from 38 percent in 1973 to 34 per- cent in 1974. The decline of traditional savings deposits over the past two years in the face of a wide interest rate differential would have been far :reater ha d it not been for the rapid growth of rural income, particularly in the coffee sectors, areas in which the indexed institution have not as yet 'penetrated. Iortgage and investment bank bonds grew by only 3 percent in 1974 after having declined in absolute terms in the previous year, reflecting in both years the interest rate differential between these bonds and the UPAC instruments and certificates of deposit. In the inflationary environment of the past two years the Government as used interest rate policy as one of the instruments to mobilize financial resources. Quasi-noney holdings increased as a percentage of GDP in 1974 and there was an accompanying decline in money (1) as a result of tighter monetary policy aimed at reducing inflation. The increase in quasi-money holdings was insufficient to oflset the relative decline in Ml, and M3 as a percentage of GDP declined from 24.8 percent to 23.4 percent, suggest- ing sone spillover of financial savings into the extra-bank market or real assets. Thus, while the interest rate trend in 1974 was an upward one, ANEX 3 Page 3 prices increased more rapidly and all interest rates in the official barking system were negative Ln real terms. Moreover, the 197L tax reform which removed the tax exempt status from indexed deposits and mortgage bonds has had the impact of further reducinr the overall level of effective real interest rates in Colombia. The large recourse to Central Bank resources in the past two years by both the Government and the banking system has caused the Government to increase mobilization of financial resources to meet Colombia's development priorities through greater efforts at incre.as- ing the level of financial savings. Money Supply 6. Growth of the money supply decelerated to 20 percent in 1974 compared with 32 percent in 1973, and an average annual growth rate of 18 percent in the period 1969-72. In 1974, as in recent years, the financing of the Government's operations, the rediscount activities of the monetary authorities, the credit operations with the National Coffee Growers Federation, and foreign sector transactions have been the major factors explaining changes in base money (Table 6.3 Statistical Appendix). 7,. In 1974, the National Government increased its net indebtedness with the Central Bank by almost Col$2.3 billion. Of this amount, Col$700 million reflected purchases by the Central Bank of short-term emergency promissory notes issued by the Government and Col$1.6 billion for the purchase by the Central Bank on behalf of the Government of IDEMA notes. An additional Col$1.3 billion in short-term emergency promissory notes was forced-placed with the commercial banks and financed in their entirety by a reduction in the reserve requirement on sight deposits from 39 percent to 35 percent. The composition of the Government's debt was thus reversed from external Euro- dollar borrowings in 1972-1973 which partially explains the lar,e gains in net international reserves in these two years to domestic borrowing in 1974, which in turn partially accounts for the loss of foreign reserves in 1974. 8. Even more important than the operations of the Government in explaining the growth of base money in 1974, were the credit operations of the Central Bank with the commercial and specialized banks through rediscount facilities. After growing at an average annual rate of 11 percent in the period 1969-72, the growth of credit through the rediscount facilities accelerated to 24 percent in 1973 and 37 percent in 1974. In 1974, the commercial and specialized banks received an unprecedented Col 5 .2 billion through the rediscount facilities or three times the increase in commercial bank reserves deposited in the Central Bank. The specialized banks received Col$t3.3 billion from the rediscount facilities in 1974 or double the amount they had received in 1973. In both years, virtually all these fund wrere channeled toward the Administered Funds which in turn channel thes< resources into priority sectors. Almost half of these rcsources were loane_ to the Savings and Loan Imd (FAVI) to support operations of the CAVS in the face of a large withdrawal of denusits. The reorganized Agricultural Financing Fund (EAP) which had its first full year of opoeration in r7L received r0160 million and the Ihdustrial 7inarnciLn n an additional Col41400 mil- lion. In line with its expande1 actiltles, the Export 1Fromotion Fund ANNEX 3 Page 1 (FROEXPO) received Col$300 million, while the Urban Development Fund (FDU) received Col$200 million and the Private Investment Fund (FIP), Col$100 million. 9. The private sector relationship with the monetary authorities was on the other hand quite contractionary in 1974, largely a result of a substantial repayment by the National Coffee Federation in light of favorable price trends in the coffee market. The small growth of import deposits in 1974 resulted in a very slight contractionary impact relative to 1973. This reflected a change in the old advance import deposits system in mid-1973 under which the new prepayment deposit for import payments could be released at any time after registration. Open-market titles placed by the Central Bank with the banking system for the first time in 1974 had an insignificant contractionary impact as they,were placed at fixed interest rates well below those prevailing in the market, and met with little success. Banking System Developments 10. Net domestic credit of the banking system increased at a rapid pace in 1974, the equivalent of 29 percent measured in relation to liabilities to the private sector outstanding at the beginning of the year, which compared with an increase of 26 percent in 1973 and an average annual increase of 22 per- cent in the period 1969-72. The acceleration in domestic credit expansion in recent years has reflected the large increase in credit to the private sector owing to the strong credit flows to the construction sector through the savings and loan system and the substantial credit demand by the nonconstruction sectors, a portion of which has been made available by the ample rediscount facilities in the Central Bank. In addition, a weakened fiscal performance has necessitated substantial recourse by the public sector to the banking system, particularly in 1974, when the increase in deposits held by the social security system (ICSS) was, unlike previous years, insufficient to offset the expansion of credit to the rest of the public sector (Table 6.4 Statistical Appendix). Had it not been for the reduced level of Government invest-ment and substantial increase in external borrowing during 1970-73, credit required by the private sector to sustain an adequate rate of capital formation would have in the context of prudent supply and demand management been preempted by the public sector. 31. The major components of the banking system accounts are projected for the period 1975-80 in Table 6.4 Statistical Appendix, and provide a rough ind- ication of banking system financing which would be available for the public and private sectors, under a set of normative assumptions. Money in the hands of the public (currency plus sight deposits) is projected to increase gradually from 14.4 per cent of GDP in 1975 to 16 per cent by 1980, along the long- run historical trend, as the rate of inflation is assumed to decelerate over this period. Quasi-monetary holdings, including savings deposits, certi- ficates of deposit and bonds issued by the banking system, are projected to rise from slightly over 9 per cent of GDP in 1975 to 11 per cent in 1980. In addition to the normal upward trend of quasi-money resulting from the growth of financial intermediation, it is assumed that the 1974 interest rate reform described below and the introduction of yet greater interest rate flexibility in 1975, will have a positive impact in stimulating demand for quasi-money. Net foreign reserves of the Central Bank are projected to remain at a level equivalent to three months of projected imports. Under ANNEX 3 Page 5 the issumption that the growth of credit to the private sector would reflect a unitary elasticity with respect to the growth of nominal GDP, public sector credit was treated as a residua 'rom available financing. On the brsis of these assumptions, the public sector could receive Col.$l billion from the baring system in 1975, would have to be slightly contracti ary in 1)76-77, but could recei .e roughly Col.$4 billion a year in the period 1978-80. Capi 4a1 Market Developments 12. In relation to the banking system, the Bogota and Medellin stock exchanges account for only a small share of the private savings mobilized by 'he financial system. By the end of 1974, the overall value of trans- n0>i is in the Bogota and Medellin stock exchanges reached a level of Ccl 4.9 billion, which although representing a sharp recovery from the 1971 -72 depressed levels, was mainly accounted for by a large increase in bond transactions which rose from an average of 16 per cent of total stocR ekch:1nge transactions in 1971-73, to 29 per cent in 1974 (Table 6.5 Stti.,tical Appendix). This large increase in bond transactions whir-h occurred mainiy in the final quarter of 1974, reflected the remrval of 4+e ta.-exemIt bbatiis on UPAC accounts as well as any new bonds i6bued after January 1, 1975. However, since bonds still in circulation maintain their tax-exempt status, deiand for these increased substantially during 1974, with the heaviest trading occurring in the Government's development bonds. Despite a small decline in their overall share of total stock exchange transactions, trad- ing in Tax Credit Certificates (CATs) and Tourist Development Certificates (CDTs) continues to account for some 47 per cent of total transactions. Nbile CATs do not bear any int.est, they are traded at a discount in the itock exchange, and their tax-free yield has been one of the highest avail- ible in the financial system. H-wever, by the second semester of 1975, trading in CATs and CDTs will fall off quite sharply reflecting the re- duction in CAT rates enacted during the 1974 fiscal reform. The Government has converted the Col.$3.0 billion in short-term promi. sory notes ,- J :':rina the ,past six months into six-month Tax Credit Certificates for trading in the open market to replace the declining export CATs. 13. The equity market continues in a depressed stato, with the price ind x of shares below the 1968 level. After an upturn in 1973, orall i Ansactions in industrial and financial shares drolped :i'rply in 1974, reflecting lower corporate profits, higher yieldj oi. alternative assets, lower dividends, and the introduction of withholding and higher tax rates oxi dividend income. The index of banking and financial shares in the Bogota market declined by just under 14 per cent in 1974. Reflecting these devolopments, new stock issues were limited and at present only 7 per cent of all Colombian companies are listed on the exchange. In the absence of a decline in interest and inflation rates, as well as improved outlook for economic growth in general, the stock market cannot be considered a viable source of fresh capital for new or expanding firms. 14* The major setback to capital market development in 1974 was the decision by the Supreme Court rendering the five regional development funds unconstitutional. Under this proposal, all severance pay funds in ANNEX 3 Page 6 the private sector would have been transferred to five regional funds from which they would have been invested in the stock market, CAVs, and invest- ment bank bonds, thereby providing the capital market with an injection of long-term resources. It had been estimated that these regional funds would capture Col.02 billion in 1974 and grow by Col.$2 billion a year for the next five years. 13. The system of forced investment requirements and government control of interest rates has resulted in an active extra-bank market, which has been a major source of installment credit and short-term credit for industry. In the absence of declines in the rate of inflation and/or higher permissible nominal interest rates in the organized market and greater interest rate flexibility, the extra-bank market should continue to grow, a trend which is all the nore likely after the fiscal reform, because of the tax-evasion possibilities in the extra-bank market. Since the growth of the extra-bank market relative to the organized sector tends to impede development of an efticient system of 'inancial nterned;ation, a strong argument can be advanced for further I Uberation of the organized sector in order to limit tho ex-ansion of the extra-bank market. Reform of thi- Financial System 16. The monetary reform package which was introduced by the new Admi- nist:-ation shortl- after entering office in August 1974, was aimed at produc- ing a more balanced flow of resources through Colombia's financial system and providing the aithorities with greater monetary control. The reform included a rcstructuring of interest rates including a maximum ceiling on the rate of monetary correction, a simplification of Colombia's complex reserve requirement system, the elimination of numerous portfolio require- ments, the elimination of several rediscount facilities and preferential tax treatment given to public debt instruments, and the adoption of more stringent controls over existing facilities. Interest late Policy 17. Historically, interest rates have been kept low in Colombia, and below rates which would have prevailed in a free market. Wihile banks have been able to circumvent fixed loan rates through the common practice of requiring compensating balances and pre-payment of interest, this has not been the case on the depo'.t side, and as a result it has been difficult to provide savers with adequate yields necessary to induce a larger flow of financial savings. The upsurge of inflationary pressures in recent years has accentuated these distorting elements by making financial yields sharply negative in real terms. The introduction in 1972 of indexation on ANNEX 3 Page 7 the UPAC deposits of the CAVs resulted in positive yields, on one savings instrument, but at the same time the piecemeal introduction of indexation created new problems in the form of an '.mbalanced flow of resources through the financial system. Changes in Colombia's interest rate structure enacted in the 1974 reform represented an attempt to ameliorate distortions which had arisen through this system. 18. The reform narrowed the large interest spread which had prevailed by introducing a maximum annual ceiling of 20 per cent on the UPAC index, or the calculation base for monetary correction, by lowering the basic in- terest rate on indexed certificates of deposit from 6.5 per cent to 5 per cent and from 5 per cent to 4 per cent on passbook accounts, and by remov- ing the tax exempt status on the indexed portion of earnings over the first 8 per cent which are now taxed as capital gains. Interest yields on non- indexed passbook savings accounts were raised from 8 per cent to 12 per cent in 1974 and to 16 oer cent in early 1975. Nonindexed negotiable three-month certificates of deposit which were introduced in February 1974, can yield a maximum of 24 percent and are nonredeemable prior to the expiration period, a characteristic which should strengthen the liquidity profile of the banks. 19. Higher interest rates were also introduced on the asset side. The loan rate for normal credit operations was raised from 14 percent to 17 percent (24 percent effective), and the rate for working capital loans made with resources accruing from certificates of deposit was increased from 24 percent to 29 percent. The interest rate on agri- cultural loans rediscounted with the Administered Funds was raised to 15 percent, and industrial loans to a maximum of 26 percent. Legal Reserves, Portfolio, and Investment Requirements 20. Commercial and specialized banks in Colombia have been subject to legal reserve requirements on their deposit liabilities, to certain investment requirements, and to portfolio distribution requirements. The reserve requirement mechanism in Colombia is more complex than in most other countries, as it is used not only to control the volume of bank lending, but also as a credit allocation device through the use of speci- fied loans and securities which can be counted against the reserve require- ment. Selective control over the destination of credit has also been achieved through a complex system of forced investment requirements which directs ANNEX 3 Page 6 defined proportions of banks' deposits and portfolios toward priority sectors such as housing and agriculture as well as the financing of the public sector deficit. The burden of the forced investment regime has grown in recent years, and the low return on forced investments has acted as a stumbling block to the introduction of market related interest rates, preventing financial institutions from competing with unregulated inter- mediaries for domestic savings. 21. Against this background, the 1974 monetary reform simplified the reserve requirement system and liberalized the forced investment require- ment regime. The monetary reform eliminated the dual (reduced and regular) reserve requirement system under which banks adhering to specified condi- tions were entitled to a reduced reserve requirement. During this period the reserve requirement on sight deposits was lowered from 41 per cent to 35 per cent, although the banks were required to channel most reserves freed by this measure (Col.$1.3 billion) into noninterest-bearing emergency promissory notes issued by the Government. For the first time, a reserve requirement was imposed on the Savings and Loan Corporations equivalent to 10 per cent of certificates of deposit and,15 per cent of savings de- posits, a measure which in the light of the volatile shifts in indexed deposits experienced in the past should strengthen these institutions. 22. The forced investment requirement which had channeled 44 per dent of all savings deposits into housing and savings bonds issued by the Territorial Credit Institute was frozen at their June 1974 level. Similarly, the requirement that 36 per cent of resources captured through savings deposits be channeled into specified credits at concessionary rates was eliminated. The new negotiable certificates of deposit have not been subjected to any forced investment requirement, and will have the effect of increasing freely disposable loanable funds available to the banks. Rediscount Policy 23. The proliferation of rediscount facilities in the Banco de la Republica to meet automatically and unconditionally both the needs of the banking system and priority areas defined by the government, at relatively low, nonmarket-related interest rates has posed a serious challenge to effective monetary management in Colombia. In recent years the growth of these rediscount facilities has reflected both the weak public sector savings performance as well as the shortage of financial savings to finance the Government's development priorities. The monetary reform established a new ordinary rediscount facility to meet the liquidity needs of the banking system, but unlike the previous facility, it is not a permanent nor automatic source of resources for the banking system, and it cannot be used to generate new credit. The reform also provided for the first time for the use of fiscal as opposed to Central Bank rediscounted resources, in the financing of the special development rediscount lines known as the Administered Funds. This was accomplished by raising the import surcharge ANNEX 3 Page 9 from 1.5 percent to 5 percent, and earmarking the revenue captured for the Export Promotion Fund. In addition, the authorities have moved the Urban Development Fund from the Banco de la Republica to the Mortgage Bank with financing for this fund to accrue from Mortgage Bank profits. Other Measures 24. The reform eliminated all credit ceilings which had been in effect since 1972 on the portfolios of the commercial banks. Use of open market operations which the Central Bank had started in early 1974 has continued. Although these operations had not met with much success during 1974, the introduction of higher interest rates could render this a more effective instrument of monetary management, and thereby substantially reduce the need for frequent modifications of other instruments as well as the need to rely so heavily on administrative controls. 25* Investment bank bond issues and corporate bond issues have always been limited by the fact that BCH and development bonds dominated the market owing to their tax-exempt status. However, the fiscal reform enacted in late 1974 has eliminated these tax exemptions on public sector debt instruments which were distorting competition between the public and private sectors as well as resulting in growing tax revenue losses. Thus, the ability of corporate and investment bank bonds to compete in the market has been enhanced. 26. A problem which has always confronted economic policy makers in Colombia has been the duality between short-term highly liquid financial savings and the need for longer-term resources to be channeled into "developmental" credits. In an attempt to stimulate a long-term funds market, the monetary reform introduced a measure which authorizes the in- surance companies to issue a completely new type of life insurance policy (Seguros de Ahorro con Participacion) under which the insured individual is guaranteed to receive, at a specified time, at least 70 per cent of the profits originating from the investment of his premiums. Simultaneously, this measure frees all funds raised by the insurance companies in this fashion from forced investment requirements, under which insurance companies were forced to channel a substantial portion of their funds into low-interest public sector paper. This new flow of funds into the insurance industry can be invested up to 30 per cent in the stock market and the remainder in UPAC certificates and investment bank bonds. In addition to the poten- tial stimulus provided for the stock market, it was hoped that this neasure would offset the outflow of funds from the CAVs, thereby prevent- ing the need for direct support from the Banco de la Republica. However, in the first six months of operation this scheme has not been proven successful as the insurance companies consider their rate of return to be too low under the new scheme, and the high rates of inflation as well as the preference for liquidity demonstrated by the Colombian saver have discouraged demand. ANNEX 3 Page 10 B. Public Sector Finances 27. Colombia's public sector consists of the National Government, decentralized agencies, the social security institutions, departments and municipalities. It accounts for about 46 percent of the country's annual gross investment, about half of which is carried out by decentralized agencies. The direct responsibility of the decentralized agencies for economic develop- ment is considerable. They not only provide the infrastructure and basic services essential to sustain economic expansion but also execute vital social expenditures in the fields of agriculture, health, and education that benefit the poorest segments of the population. The financing of these investments has relied chiefly upon the savings generated by the National Government (Table 5.1, Statistical Appendix). National Government Finances, 1970-1974 28. Poor revenue growth has been responsible for the deterioration in the current account performance of the National Government in recent years (Table 5.5 Statistical Appendix). During 1970-1973, the current account surplus decreased in real terms and dropped continuously as a share of GDP --from 3.0 percent in 1970 to 2.3 percent in 1973. This trend is attributable to the inelasticity of the tax system, while the share of current expenditures remained almost constant as a share of GDP. Although some improvement occurred in 197h, when the current account surplus reached Col$8,144 million as compared with Col$5,626 million ,in 1973, it nevertheless represented only 2.6 percent of GDP, or less than what had been achieved in 1970 and 1971. This recent improvement is a reflection of the combined effect of better revenue performance and a decline in the growth rate of current expenditures. ?9. Revenues. The structure of Colombia's revenues is characterized by a heavy reliance upon taxes on income and property. Thirty-nine percent of total National Government revenues originated from these taxes in 1974. This represented a substantial decrease since 1970, however, when they contributed forty-eight percent of total revenues. As a result of this reduction in the key role played by taxes on income and property, there has been greater reliance upon taxes on foreign trade and to a lesser extent upon taxes on domestic consumption and transactions. The trend observed in Colombia is primarily attributable to the poor performance of income taxes rather than to the rapid growth of other taxes. It reflects the tax base through tax incentives, higher personal exemptions, and legal restrictions on the tax administration, all of which tend to reduce the progressivity of the system as well as weaken revenue performance. 30. As a result of these factors, the growth of revenues has been in- elastic with respect to the growth of GDP. During the past four years real current revenues grew by only 3.7 percent annually on average despite an average increase in real GDP of 6.5 percent over the same period. ANNEX 3 Page 11 31. The buoyancy of Colombia's tax system plummeted after changes in the system of appeal against official assessments were introduced in 1970. The appeal system has since been used as a means of tax evasion, although the changes were intended to make the administration more efficient. It has been estimated that about Col$3 billion in claims have clogged the Tax Administra- tion over the past four to five years. The buoyancy of taxes on income and property consequently dropped to 0.87 in 1971, as compared with 1.41 in 1970 and 1.68 in 1969 and continued falling until 1973-1974 when it reached an average of 0.60. The weak performance of' this major source of revenue produced an overall revenue- income buoyancy of only 0.93 in 1973-1974. 32. Income taxes have drifted downwards as a proportion of total revenue from 45 to 37 percent over the last four years and as a proportion of UDP from 4.3 to 3.4 percent. The poor performance of these taxes in recent years has resulted not only from tax evasion by means of the legislation discussed above, but also from KYUnda- mental weaknesses in the tax structure. The system of business income taxation has been too complex and discriminatory among the various legal forms of business organization. It has consisted of numerous uncoordinated taxes, including the excess profits tax, special purpose or developmental taxes, and the income tax, frequently producing excessive marginal rates which may distort business practices. The tax base of the individual income tax has been eroded due to exempt income and special exemptions, and the tax has failed to effectively reach major groups of income recipients. The net wealth tax has also excluded many forms of wealth from the tax base. 33. The structure of business income taxation in Colombia has applied a different schedule of rates to corporations, limited liability companies, and partnerships. The rate schedule has been 12 percent, 24 percent, and 36 percent on corporations; 4 percent, 8 percent, and 12 percent on limited liability companies; and 3 percent and 6 percent on partnerships. The after-tax income of limited liability companies is imputed to their owners and subjected to the individual income tax, while corporate shareholders are only taxed on dividends. Despite this integration difference, however, the burden among entities has differed substantially. Inconsistent application of other taxes also affected the relative position of these different entities. For example, the excess profits tax has been levied on corporations but not on limited liability companies or partnerships, while the development tax has been levied on corporations and limited liability companies but not on partnerships. 34. This system has discriminated markedly against corporations, a differential tax treatment that could not be justified on the basis of size, as many limited liability companies and corporations are equal in terms of size and resources. Although most partnerships are small, they also include a substantial number of medium-sized companies. The excess profits tax has been inequitable and a disincentive to growth and efficiency. The Musgrave Commission, which visited Colombia in 1968, pointed out and recommended action on these structural problems as well as on the other forms of oarect and indirect taxation. The new Government instituted a comprehensive tax reform in late 1974 which completely overhauled the income and sales taxes along lines recommended by the Musgrave Commission, although it is a more far- reaching reform in several respects. The major changes introduced by he new laws are discussed in a subsequent section of this Annex and in more detail in Volume III. ANNEX 3 Page 12 35. The individual income tax base has been eroded through the exemption of various sources of income. Severance pay, service bonuses, vacation pay, social security benefit payments, and disability payments in lieu of salary have been excluded from taxable income. Limited exemptions have also existed for dividend income and interest on savings deposits. Interest income derived from UPAC deposits and various classes of bonds, i.e., mortgage bonds, and government development bonds has been exempt. There have been deductions relating to housing, i.e., interest payments on mortgages and the property tax and a limited special exemption for rent. The law also permitted specia exemptions for payments to professionals, medical expenses, educational expenses, and a limited deduction for charitable contributions. Some of these exemptions were not justified and a number have been discontinued. They distorted the distribution of the tax-burden and represented a substantial revenue loss. The value, or tax saving per peso, of an exemption, exclusion, or deduction increases with the taxpayer's income bracket. Tax Credits, however, are worth the same to all, regardless of the level of income, and the introduction of this concept under the Reform is a major improvement. 36. Capital gains also constituted an important form of exempt income, accruing largely to individuals in upper income brackets. Capital gains on real estate were taxed at ordinary rates, but for every year that the asset was held, the realized gain could be reduced by 10 percent. Gains from the sale of other assets were not taxable. The Tax Reform introduced a new, progressive, occasional gains tax and expanded the tax base. The concept of taxable income thus has been modified to more accurately reflect a taxpayer's ability to pay. 37. The net wealth tax improves the equity of the Colombian tax structure, encourages the efficient use of capital, and generates a significant proportion of the revenue from the individual income tax. It reaches wealthy individuals who declare little or no taxable income and permits better enforcement of the income tax through cross-checking. It also taxes increases in the value of property which have been escaping capital gains taxation. As the tax is independent of the income produced by an asset, there is an incentive to increase the return on assets. The tax, however, has excluded many important forms of wealth, including assets not capable of producing income and a wide variety of specific exemptions, e.g. property that produces tax exempt income (Government bonds, interest on savings accounts), and investments conducive to economic development. Net wealth is computed by deducting all fixed legal debts from the taxpayer's total assets. Exempting assets not capable of producin-, income undercuts the tax's incentive effect on the efficient use of capital and complicates administration. Finally, all debts may be deducted from total assets to calculate net wealth. Thus, taxpayers have been able to incur deduct- ible obligations to acquire nontaxable wealth, thereby avoiding the tax. ANNEX 3 Page 13 38. Foreign trade taxes are the second most important source of revenue for the National Government. In 1974, they produced Col$8,692 million or 30 percent of total revenue, as compared to Col$6,163 million or 28 percent in 1973. Most of this revenue has come from customs duties. These grew rapidly in 1974 as a result of a substantial increase in import registrations, higher import prices, and the 15 percent devaluation of the peso. Special foreign exchange account operations provided revenue of Col$3,041 million, 52 percent more than in 1973. The account is managed by the Banco de la Republica and its operations are comprised of revenues from a tax on coffee export earnings, net income from investment of international reserves, a loss from the sale and purchase of foreign exchange, and a loss from the petroleum subsidy. The petroleuim subsidy is paid to transportation and industry through the "petroleum dollar", fixed at Col$20 per U.S. dollar, exchange rate at which petroleum is purchased for domestic consumption. The favorable performance of the Special Exchange Account in 1974 is largely attributable to high international prices for coffee, although net revenues were diminished by the substantial increase in the petroleum subsidy, estimated at Col$328 million in 1974, resulting from increased internal consumption and the widening difference between the "crawling" certificate rate and the 20 peso fixed petroleum exchange rate. While the share of taxes on income and property declined from 48 to 39 percent during 1970-1974, the share of tames on foreign trade increased from 27 to 30 percent, and this is attributable in part to increased net revenues of the Special Exchange Account. 39. The sales tax is a major element in the tax structure and has accounted for a substantial part of National Government revenues. Collections have in- creased from 9 percent of total revenues in 1970 to 14 percent in 1974. It is the third most important source of tax revenue, after income taxes and customs duties. Colombia levies a single-stage value-added tax at the manufacturer's and importer's level. Until October 1974, rates were 25, 15, 10 and 4 percent, with 4 percent constituting the basic rate. Exports, popularly consumed food, school books, and certain agricultural inputs have been exempt. Tax credit has not been granted for sales tax paid on capital goods. ho. The buoyancy of sales tax revenues with respect to the growth of money GDP has declined in recent years from 1.03 in 1970 to 0.89 in 1273, despite higher tax rates introduced in 1971 (Table 5.8 Statistical Appendix). The ratio of the implied sales tax base to GDP declined continuously during this period. Inadequate tax administration and structural defects of the tax have contributed to this trend. Firms producing exempt commodities could make purchases from suppliers free of tax. This created opportunities for evasion and complicated tax administration. For example, exporters have been able to purchase from their intermediate suppliers free of sales tax and tax revenue is lost if an exporter overestimates the proportion of his inputs that are used for export production. The sales tax has also been used as a protective device by levying higher sales tax rates on a number of imported items. This compli- cates administration and is in violation of GATT rules. Furthermore, potential revenue has been lost by exc "ing many consumption-type services from the tax base. ANNEX 3 Page 14 4l. Good oales tax revenue performance in 974 reflected increased real GDP, i[flation, the introduction of the new sales tax law on October 1st which corrected many of the former defects in the law. The Reform increased rates on many items and led to accelerated purchases in September in anticipation of the higher rates. As a result, sales tax revenues increased with a buoyancy of 1.91 and yielded Col$3,94 million in 1974, an increase of 60 percent over the preceding year. The relative importance of the sales tax is expected to increase significantly as a result of the new law, discussed below, and de- crease the dependence upon other, less stable, sources of revenue. )-j2. The gasoline tax, discussed in greater detail in a subseonent section of this chapter, has been an inelastic source of revenue (buoyancy-of 0.23 in 1973-1974). The only increase in its base in recent years has been the increase in the "petroleum dollar" from Col$9 to Col$20 pesos in July 1971. The increased use of tax credit certificates (CATs) and tourism development certificates (CDTs) has also been an important contributor to the inelastic growth of cash receipts. Tax credit certificates are negotiable instruments, the purpose of which is to promote exports other than coffee and oil. Any taxpayer may redeem them in payment of income taxes, sales taxes, or customs duties, but only several nonths after they were issued. Tourism credit certificates are used to promote investment in the hotel industry and they are also negotiable and may be redeemed by any taxpayer at any time after issue in payment of any national tax. The proportion of taxes paid with these certificates rose from 6.5 percent in 1972-73 to 8.0 percent in 1974 as a result of the large increase in minor exports in 1974. Decree 2004 of September 24, 1974, however, reduced the CAT for most items from 15 to 5 percent of the value of exports and to one-tenth of one percent on several hundred other exports, effective January 10, 1975. 43. Expenditures The overall growth of current outlays, particularly consumption expenditures, has been restrained to protect the level of public sector savings in the face of lagging revenues. Total current expenditires increased by 4.4 percent annually in real terms over the past four years, while revenues were growing by 3.7 percent. However, in real terms, expenditures on wages and salaries increased by only 1.8 percent annually on average and expenditures on goods and savings declined by 30 percent. 44. The nost significant change in the composition of current expenditures has been the rapid increase in transfer payments to departments and municipalities. These increased by an average 28 percent annually in real terms during 1970-74 and as a proportion of total current expenditures from 15 percent in 1970 to 25 percent in 1974. These transfers are comprised of funds allocated according to revenue sharing schemes. The Government has shared its sales tax revenues with Departmentb since 1969, and began transferring a fixed percentage of ordinary revenues to Departments, Intendencias, Comisarias, and the Special ANNEX 3 Page 15 District of Bogota in 1973. Transfers of ordinary revenues are known as the "Situado Fiscal" and used to finance current expenditures on primary education and public health. Each recipient must spend 7h percent for primary education and 26 percent for public health. Each unit also is expected to appropriate a percentage of its own revenues, in addition to the transfers, for expenditures on education and public health equal to or greater than the percentage allocated for these purposes in 1972. The Government apportions thirty percent of the transfer payments equally among recipients and 70 percent on the basis of population. The Situado Fiscal may become a major drain on Government revenues in future years, as the share is to increase gradually from a minimum of 14 per- cent of current revenue in 1974 and 15 percent in 1975 by up to 2 percentage points per year until a maximum of 25 percent is reached, provided that ordinary income increases at a minimum average rate of 15 percent over the previous three years. 45. The second most rapidly growing current expenditure is interest payments, particularly on external debt. While interest payments only con- stitute about 9 percent of total current expenditures, they have been growing at an average annual rate of 8.6 percent in real terms since 1970. Payments on the external debt component of interest have risen by 20 percent in real terms. 46. Declining National Government savings has forced the Government to curb investment spending. Investment has fallen continuously as a proportion of GDP from 4.2 percent in 1970 to 3.4 percent in 1974, with the exception of 1972 when it reached a peak level of 4.5 percent. In real terms, it increased by 4.4 percent during 1974, as compared with a 17 percent decline in the previous year, but this was only 4. percent above what had been achieved in 1970. Investments executed by the National Government itself are minor compared with its total investment expenditures. Capital transfers constitute over 85 percent of the Government's investment expenditures, and over 80 percent of these are channelled to decentralized agencies. 47. A functional classification of total National Government expenditures indicates that marked changes have occurred in the composition of these expenditures in recent years. Expenditures on education, housing, and public health increased as a share of the total from 23 percent in 1969 to 33 percent in 1973, whereas outlays for economic services, particularly roads, fell from 25 to 18 percent. 48. Despite restrained growth of expenditures, inadequate revenues have required the use of substantial foreign borrowing in order to finance the expenditures that were incurred. During 1970-1973, net foreign borrowing financed about 32 percent of investment expenditures, current account surpluses about 65 percent, and net domestic borrowing the remainder. The relative importance of net foreign financing increased over the period and general purpose loans constituted a significant part of the external financing obtained in 1973. The new Government, however, markedly changed the pattern of financing in 19?h in the direction of greater reliance upon internally generated resources and domestic borrowing. As a result, three-fourths of investment expenditures were financed out of current account savings, 23 percent through domestic borrow- ANNEX 3 Page 17 ing, and less than 3 percent externally. The main source of this increased domestic borrowing was short-term bonds ("Bonos de Emergencia"). Since resources for purchasing these bonds were taken from Central Bank reserve deposits of commercial banks, this form of borrowing was equivalent to Central Bank'financing. Rest of Public Sector 49. Colombia's commitment to economic development is evidenced by the activities of its decentralized agencies. These encompass not only the infra- structure-related economic services typically provided by public entities in many countries, but also a host of purely development-oriented operations, i.e. activities that are specifically intended to benefit the less fortunate strata of the population both in urban and rural areas. The nature of many of these ag.ncy activities makes them financially unprofitable undertakings and frequently dependent upon the National Government for financial assistance. 50. The Central Government includes the Treasury (National Government), the Highway Fund, and the Social Security System. The National Highway Fund has no current expenditures, and its revenues are its savings. The rest of the public sector includes the decentralized agencies and departments and municipalities including their associated agencies. Of the more than one hundred decentralized agencies, twenty-nine account for an estimated 90 percent of the agency's total investments and revenues. The following analysis of consolidated public finances is based on detailed accounts of these twenty-nine most important decentralized agencies. Public savings by source has been determined by eliminating all transfers within the public sector and allocating revenues to the entities where they were generated. 51. Total public sector saving deteriorated sharply in recent years. During the first three years of the 1970-1974 period, public sector saving declined continuously from 7.1 to 4.h percent of GDP (Table 5.2 Statistical Appendix) and by 25 percent in real terms. Over the past year, saving increased to 5.5 percent of GDP, the result of the state oil company's large profits stemaing purchase of domestic crude at artificially low, controlled prices and export of some of its refined production at high international prices. 52. A parallel continuous decline also occurred in the level of public sector investment in relation to GDP from 10.2 percent in 1970 to 8.6 percent in 1974. Up to 1974 inadequate savings performance resulted in financing investment mainly through increased overall deficits of the National Government financed by foreign credits. The savin:s gap, gross fixed investment less gross savings, reached Col$8.5 billion in 1973 and about Col,11.0 billion in 1974 (adjusted to exclude refined petroleum exports), or 3.5 percent of GDP in 1973-1974. The percentage of public sector investment financed by savings fell from 76 percent in 1970 to 56 percent in 1973-1974 (Table 5.4 Statistical Appendix). ANNEX 3 Page 17 53.. The Central Government has in recent years generated, on average, 82 percent of public sector saving and the National Government by itself about 77 percent, while decentralized agencies and municipalities contributed minor proportions, and Departments have been net dissavers. A number of important decentralized agencies, particularly the Institute for Agricultural Harketing (IDEA), have constituted a major drag on public sector savings. Current transfers to finance operating deficits of decentralized agencies on average equalled 40 percent of the overall National Government deficit. Laring the period when the public sector savings gap increased from 2.2 to 3.5 percent of 0DP, decentralized agency savings gradually disappeared, becoming negative in 1973, and would have remained so in 1974 in the absence of petroleum product exports. 5h. The profitable enterprises, primarily ECOPETROL (petroleum), TELECOm (telecommunications), and EEEB an EF-1 (large municipal power companies in Bogota and edellin) have been able to offset the current deficits of the agencies. These funds, however, have been kept within these enterprises to help finance capital expenditures. Their financial situation is largely a consequence of official policies with regard to utility rates and petroleum prices. The revenues, savings, and investment expenditures of ECOPETROL are larger than those of any other public sector entity, with the exception of the National Government. The savings of this enterprise were achieved despite low domestic gasoline prices, because it could purchase crude petroleum from domestic producers at extremely low reference prices and in sufficient quantities to satisfy the internal market's demand for petroleum products. This favorable financial situation has now been reversed, however, and ECOPETROL has recently begun to import crude petroleum at the current high international prices. Because internal prices of refined products within Colombia have not been adjusted sihce 1971, ECOPETROL is currently sustaining a loss of close to $10/barrel of refined derivates sold domestically which flow from its imports. Increased gasoline prices would have a marked beneficial impact not only on the finances of ECOPETROL but also on those of the National Highway Fund and the National Government through gasoline consumption taxes and the new strengthened system for taxing ECOPETROL's profits. 55. While the major municipal decentralized agencies (public utilities) have been financing about 70 percent of investment expenditures out of internally generated resources, most national decentralized agencies have been incurring operating deficits and depending upon transfers from the National Government to finance investments. The single most important drain on public sector savings has been IDEMA. Inefficient management and huge losses on the buying and selling of imported wheat as a result of subsidized domestic prices, are estimated to have produced an operating deficit of over Col$2.0 billion in 17h. Substantial financing of IDEMA's deficit has been channelled through the Banco de la Republica. IDE1MA's finances should improve, however, as a result of the recent elimination of the subsidized domestic wheat price. ANNEX 3 Page 18 56. Colombia's development effort in the fields of agriculture, public health, and education is carried out by a large number of the decentralized agencies. The social expenditures of these agencies are central to the develop- ment process and will probably make the greatest contribution toward raising the welfare of the poorest segments of the population. Activities of these agencies in the agricultural sector include agricultural extension work, colonization projects, agrarian reform, and agricultural research (INCORA, ICA, TINDERENA). In the field of public health, the agencies carry out water supply and sewerage projects and nutrition programs (ICBF, INSFOPALj INFES). In education they are involved in school construction and vocational training (SENA, ICCE). Such activities need to be expanded further, but this will only be possible on a large scale to the extent that the finances of these agencies are strengthened. This will require periodic adjustments and rationalization of charges for the services they provide, in order to decrease their dependence upon National Government transfers. Reform of the Tax System 57. The Government of Colombia implemented a tax reform of major proportions in the last four months of 1974, as part of a comprehensive set of stabilization e,asures under economic emergency authority provided in the Constitution..- The reform covered almost every important component of the tax system and represents a clear and significant improvement over the prior system on nearly all counts. The reform did not serve, however, to purge the revenue system completely of pre-existing defects. If the basic features of the reform remain intact over the coming months, it will stand as a landmark in the recent history of such undertakings, both among developing and developed nations. 58. The tax reform was the outgrowth of careful and intensive planning by a high-level team of Colombian experts appointed in May by the then President-elect to study alternatives for revamping the revenue system. In turn, many, but by no means all, of the tax measures were based upon six years of near-continuous discussion, under three administrations, of the proposals of the 1968-69 Colombian Commission on Tax Reform (known as the Musgrave Commission) which presented in early 1969 a comprehens ve report setting forth options for fiscal reform in considerable detail.- The reform as adopted incorporates many of the specific recommendations of the Commission report, but in a number of cases improves upon these recommendations and embraces several issues not dealt with by the Commission. 1/ This reform is described in its entirety in Append x 1. 2/ See Richard A. Mus&rave and Malcolm Gillis, Fiscal Reform for Colombia: Final Report and Otaff Papers of the Colombian Commission on Tax Reform (Cambridge, Harvard Law School International Tax Program, 1971) (hereafter cited as Musgrave and Gillis, op.cit.). ANNEX 3 Page 19 59. The major strengths of the 1974 reform were clearly the adjustments made in the personal and business income taxes. The revisions in the sales tax and in import taxes were, on balance, somewhat less successful, either in terms of their consistency with the apparent overall objectives of the government or in terms of conventional wisdom on tax policy. Among measures not yet taken, the most important, in terms of consequences for resource allocation, revenues and quite possibly equity (income distribution) was adjustments of fuel tax/subsidy policy. 60. The principal objectives of the 1974 reform were: a) greater progressivity in the distribution of the tax burden; b) removal of elements of the revenue system that had served to distort resource allocation3 c) promotion of economic stability, through strengthening the revenue productivity of the tax system, particularly through measures to enhance the responsiveness of the tax system to growth in aggregate income; and d) reduction of tax evasion, both through enactment of new measures to combat evasion and through administrative simplification and rationalization of tax law. Progressivity 61. One of the principal features of the government's program is that of improving the relative position of the lowest 50 percent of the income distribution, through use of budgetary and other policy instruments. While Colombian policy-makers recognize that the expenditure side of the budget- is important in securing-improvement in income distribution, they feel that tax policy should play a strong supportive role, and that fundamental tax reform in the direction of much greater progressivity was required for doing so. Many features of the reform may be expected to contribute to enhanced progressivity of the tax system. These include entirely new tax9s_as well as substantive revision in existing taxes. Prominent among the new measures for increasing progressivity were a) creation of a new tax on irregular income, primarily capital gains, and b) establishment of a new presumptive income tax on taxpayers in all sectors of the economy. ANNEX 3 Page 20 62. The principal revisions in tax law designed to enhance progressivity were: a) adjustments in the rate structure of the personal income tax; b) elimination of a number of deductions and exempt income items which primarily served to benefit upper income taxpayers; c) conversion of most remaining exemptions and miany former deductions into tax credits, the benefits of which do not depend on the marginal rate of tax faced by the taxpayer; d) increases in rates applicable under the net wealth tax, and rationalization of exemptions under the tax; e) drastic restructuring of death and gift taxes, to enable more effective taxation of capital transfers of this type; f) measures to reduce the scope for tax evasion open to recipients of capital income, who are primarily found in upper income groups; g) heavier emphasis upon taxation of "luxury" consumption, through upward adjustments in sales tax rates on such items; h) inclusion, for the first time, of many services in the sales tax base, primarily those consumed by upper income families. Resource Allocation 63. Various important elements of the existing tax system tended to produce significant anamalous and unintended effects on resource allocation and productive efficiency. The reform sought to eliminate many of these, or at least reduce the scope for adverse unintended effects, through the following adjustments. a) adoption of a flat-rate of income tax on business entities, in place of the previous complex of marginal rates for both the basic income tax and a host of complementary income taxes; b) enactment of more realistic tax treatment of operating losses and slightly more generous depreciation rules; c) abolition of several tax incentives and/or exemptions previously intended to direct business investment into favored activities, but which mainly served to reduce revenue, progressivity and often yield undesired results; d) reduction in the scope of customs and income tax exemptions for state enterprises, decentralized agencies and government offices; e) inclusion of previously untaxed services of an income elastic nature in the tax base, thereby redressing the previous consunr,ion incentives in favor of such services and against consumtaion of t;a7le goods f) relaxation and/or removal of certain arbitrary limits on deductibility of expenses; and, g) conversion of several business tax deductions into tax credits, thereby reducing some capricious features inherent in the previous system. ANNEX 3 Page 21 66. The reform served to appreciably enhance the ex-ante revenue elasticity of the tax system with respect to growth of nominal GDP, and certainly will do so if administrative efficiency in tax collection does not decline over the next few years. Perhaps more importantly, the reform yielded a tax structure that, by virtue of its expanded base and rationalized structure, should be able to support revenue-increasing adjustments in rates consistent with equity and allocative tax policy goals in the future. However, most of the revenue-increasing impact of the reform will not show up until the beginning of 1976. Even inclusive of 1975, the in- herent buoyancy of the tax system over the coming five years should exceed unity if adjustments in fuel tax subsidy policy consistent with the allocative and distributional goals of the government are undertaken. Some of the reform measures will serve to increase revenues in the short-to- medium term, while other adjustments (made primarily for distributional reasons) will result in revenue loss. However, the net effect may be projected as significantly positive espcially after 1975. Page 22 Table V Schematio Illustration of Revenue-Decrea3iag or Fevenue-Neutral Tax Reform in 1974 (Short-to-IMediun-Tarn Effects Only) Nec;ative Impact on Revenues Impact Neutral Potentially Minor but or Sigi iiicant Significant Appreciable Marginal Uncertain Type of Tax Change (A) (B) (C) (D) (E) 1. Personal Income and Related Taxes X a. Rate chane. for taxpayers below ol.250,OO of net income x b. 10 percent credit on withholding on labor incori X 2. Business Income Taxes x a. Enactment of loss carry-forward for corporations x b. Depreciation reform x c. Abolition of complementary taxes (ex- cess profits, electricity, development, etc.) x d. Abolition of tax on fragmentation x a. Liberalization of salary deductiona . 3. Sales Tax I a. Widening of exemption structure x 4. Taxes and Subsidies on Foreign Trade I a. Reduction in coffee export taxes x b. Tariff changes for Andean Pact tariff harmonization ANNEX 3 Page 23 Table VI Schematic Illustration of Revenue-lnryaaing Tax Raform in 1974 (Short-to-Medium-Term Effects Only) Positive Impact on Reven.ues Potentially Minor but Significant Significant Appreciable Marginal Type of Tax Change (A) (B) (C( (D) 1. Personal Income and Related Taxes Z a. Rate changes for taxpayers above Col. $ $250,000 of net income b. Abolition of certain exemptions and deductions X c. Conversion of certain exemptions and deductions to tax credits (net effect) x d. Abolition or reduction in exempt income items and tax incentives x e Rate changes in net wealth tax X f. Presumptive income tax (natural persons) x g. Tax on occasional income (GON) x h. Gift and inheritance taxes X i. Procedural and administrative changes x J. Other adjustments 2. Business Income Taxes I a. Taxation of state enterprises X b. Conversion of certain exemptions and deductions to tax credits x a. Abolition or reduction of tax incentives and/or exempt income I .d. Depletion e. Tax on intercorporate dividends x f. Taxes on payments to foreigners (dividends, * interest, etc.) g. Presumptive income tax (corporations) h. Effects of higher rates at entity level (earlier capture) x i. Administrative and procedural changes J. Other adjustments 3. Sales Taxes and Other Internal Indirect Taxes X a. Changes in rate structure x b. Inclusion of additional services in base x c. Changes in exemption mechanism (not of rebates on exports and domestlc prqducticr) x d. Results of definitional and procedural changes and administrative improvements x 4. Taxes and Subsidies on Foreign Trade X a. Rate changes and import surcharges b. Reduction in customs exemptions for state X c. Changes in CAT rates x ANNEX 3 Page 2L Evasion Control and Administrative Rationalization 65. The other, prime objective of the reform can be only partially realized in the absence of major efforts to combat tax evasion and to limit the scope for large-scale tax avoidance activities. Tax evasion has historical- ly been significant in Colombia, and has been accomplished through a set of both elementary and highly sophisticated techniques that have resulted in sub- stantial losses of potential revenue. Even in very recent years, tax evasion under the sales tax has been estimated at as high as at 33 percent of potential revenues. The situation has been much worse in income taxation, where one study estimated that as much as two-thirds of actual taxable income escaped the tax net in 1971. 66. The architects of the 1974 reform appeared to be clearly cognizant of the stifling effects of defective tax administration and complexity of tax laws upon tax policy geared for developmental and distributional goals. Many of the tax measures adopted as supportive of equity and revenue goals were also designed to reduce the scope for tax evasion and avoidance, while other measures were specifically directed toward enhancing the tax administration and toward curtailment of widespread evasion. Not all the measures enacted for this latter purpose survived, as some were declared unconstitutional. 67. Nonetheless, certain measures adopted, some of which have been listed under other objectives of tax policy, did serve to enhance the prospects for more effective tax administration evasion control. These include: (a) adoption of the presumptive income tax, applicable to all economic sectors; (b) imposition of a heavier, but in most cases realistic, system of fines and penalties; (c) certain features of the new tax on irregular income, which will close off or limit avenues of avoidance and evasion open to recipients of capital income; (d) simplification of the tax structure, particularly with regard to business taxes, and especially with regard to effects of the previous rate structure in complicating administration and compliance) ANNEX 3 Page 2 (e) adjustments in the exemption machinery for the sales tax through installation of a rebate system to replace a complex mechanism for freeing exempt goods from tax; (f) changes in the structure and orientation of taxes on payments to foreigners (dividends, interest, etc.), which served to limit the scope for evasion and avoidance on such transfers; (g) changes in the tax treatment of intercorporate dividends, which served to place a mild tax on this item while also rendering avoidance through this device more difficult, and achieving notable simplification at the same time; (h) abolition of a number of tax exemptions and adoption of limitations on others, both of which may serve to close off possibilities of evasion and avoidance arising from efforts to convert income into exempt or favored forms; (i) adoption of higher income tax rates applicable at the business entry level, for limited liability companies and partnerships. The earlier capture of a part of revenues at the entity level will, on the face of it, reduce scope for evasion at the individual level, after profits of such enterprises are distributed to the owners; (j) tightening of the scope of, and eligibility requirements for, customs exemptions for state enterprises, decentralized agencies and government offices. 68. The reform did not serve to enhance administrative feasibility in all respects. However justifiable the rate increases in the sales tax may have been on income distribution grounds, the present rate structure still suffers from an excessive degree of "fine-tuning" that will render the tax more difficult to operate, and the height of some of the rates will increase incentives for evasion and for smuggling of high value-low bulk items. Only a determined and continuous campaign of enforcement will prevent sales tax evasion from rising above previous levels, as long as high luxury rates are included within the scope of the tax. Further, the inability of officials responsible for property tax administration to have access to net wealth tax declarations will permit continued high evasion for the former levy. Public Sector Savings Outlook, 1975-80 69. It is anticipated that revenues from income taxes should increase with a minimT= buoyancy of 1.0, substantially higher than the average buoyancy of recent years (0.73 in 1971-1974). This implies additional ANNEXK 3 Page 26 income tax revenue from new measures of about Col$800 million in 1975, and means that the continuous decline of income taxes as a share of GDP will have been arrested. The new sales tax law has already demonstrated a favorable impact upon revenues since October 1974, when the new rates went into effect. In 1975 the sales tax is expected to produce Col$7,000 million or about 20 percent of total revenue, as compared to 11 percent in 1973 and 9 percent in 1970. It appears reasonable to assume that the buoyancy of the sales tax will improve as a result of the elimination of ;a number of loopholes used to evade, better administration, and higher rates applied to income-elastic items. Revenues from sales taxes are expected to increase with a buoyancy of at least 1.0 during 1976-1978, somewhat higher than in recent years. 70. *As a result of higher sales tax revenues, the relative importance of taxes on domestic consumption and transactions is expected to increase from an average of 25 percent during 1971-1974 to 31 percent in 1975, despite a further decline in the share of gasoline taxes in total revenue. The projections for 1976-1980 shown in Table 5.12--Statistical Appendix illustrate expected revenue performance, if the Government were to increase gasoline and other petroleum products by 1976. Additional revenue of Col$ 3.0 billion from such action would be collected in 1976 and each year threafter. 71. Net Special Exchange Account revenue projections shown in Table $.32 Statistical Appendix illustrate the implications of eliminating the 20 peso fixed petroleum exchange rate by 1976. The subsidy on gasoline aid other petroleum products granted through the "petroleum dollar" is expected to increase significantly in 1975 to Col$730 million, as compared with Col$328 million in 1974. Due to increasing consumption and the widening difference between the depreciating certificate rate and the petroleum exchange rate this subsidy is projected to raise the subsidy to Col$1,170 million in 1976. Unless action is taken, therefore, the combined revenues projected for gasoline taxes and the Special Exchange Account in 1976 would probably be Col$4.0 billion less than the projected amount. 7?. Taxes on foreign trade, mainly customs duties and coffee export taxes, are expected to remain a major source of revenue for the National Government, contributing about one-fourth of total revenues during the next six years. Customs duties are to produce three-fourths of these revenues, growing at about 26 percent annually or from Col$4,845 million in 1974 to Col$19,203 million in 1980, assuming an average duty rate of 10.4 percent, thereby increasing their share of total revenues and taxes on foreign trade. This growth is expected to originate from rapid increases in the dollar value of imports and continued depreciation of the exchange rate. Pro- jections of revenues from coffee export taxes are based upon the exchange balance projection for 1975, and an assumed effective coffee price of 72 cents in 1976, gradually rising to 77 cents in 1980. After deducting trans- port costs and FEDECAFE overseas expenses, foreign exchange surrender i3 expected to amount to US$571 million in 1976, US$583 million in 1977, US$604 million in 1978, US$617 million in 1979, and US$629 million in 1980. The coffee export tax of 14 percent in 1976, 13 percent in 1977, and 12 percent in 1978-1980, converted at accounting exchange rates is expected to yield coffee tax receipts of Col$2,389 in 1976, increasing to Col$2,960 million in 1980 (See Table $:12, Statistical Ippendix). ANIEX 3 Page 27 73. With the improved buoyancy of the tax system expected to result from the Tax Reform and the raising of petroleum prices by 1976, at least 70 percent of total net revenues should be provided by the domestic tax base in future years (see Table VII). Taxes through redemption of CATs and CDTs have been projected to decrease by about 20 percent in 1975 and 48 percent in 1976 as a result of the legislation discussed earlier, and then increase by 22 percent in 1977, 24 percent in 1978 and 25 percent in 1979-1980. Revenue performance of income taxes and sales taxes should improve substantially as a result of the tax reform. Some improvement is also reflected in gasoline taxes and in the Special Exchange Account operations in 1976 as a result of the assumed increase in gasoline prices and elimination of the fixed petroleum exchange rate. Thereafter the performance of these revenues will probably depend upon the growth of gasoline consumption, coffee export earnings, and the other factors discussed earlier. Total current or cash revenues of the National Government should increase as a share of GDP to the extent that the behavioral assumptions with regard to major sources of revenue are realized and as a result of the projected decrease in the ratio of tax credit certificates to GDP. 7h. Current expenditures need to be restrained, as in the past, in order for the additional revenue produced by the Tax heform to be channelled into new investment. Expenditures on wages and salaries are estimated to increase by about 2.9 percent in real terms in 1975, reflecting the recent 20 percent wage increase granted to public sector employees, and have been projected at the rate of 2 percent annually in real terms during 1976-1980 in order to maintain the real level of wages and salaries and permit a small increase in the public labor force. Purchases of goods and services comprise many expenditures that are critical for the development effort, and these have deteriorated sharply in real terms during the recent past. It is assumed that the Government will, as part of its development effort, appropriate additional resources for these expenditures in future years in order that they may grow as rapidly as GDP. 75. Transfer payments to departments and municipalities, the fastest growing item in the Budget over the past five years are projected at 17 percent of total cash revenues in 1975-80, as compared with about 15.5 percent in 1972-73 and 17.0 percent in 1974, in order to support the expansion of educational and health services. Current transfers to decentralized agencies have been estimated to remain constant in real terms; however, o-pportunities need to be explored to reduce the financial dependence of recipients on the National Government. The Planning Department's projections of transfers to the private sector have been increased in the analysis by C:l$500 million in 1976 and an equal amount in real terms in subsequent years in anticipation of the need to subsidize public transportation if gasoline prices are increased. Estimated interest payments on external debt are based upon projected external borrowing, while domestic interest payments are expected to increase with the rate of inflation. Total current expenditures have been estimated, therefore, to increase with an average buoyancy of 0.86 over the next six years which is somewhat below expenditure growth with respect to GDP in recent years. If National Government revenues and expenditures develop as projected, current account surpluses will increase from 2.6 to 3.6 percent of GDP (Table 5.13 Statistical Appendix). ANNEX 3 Page 28 76. The summary of projected public sector finances shown in Table VIII indicates the expected saving in each subsector of the public sector. Savings of the National Government, estimated to increase from 4.3 percent of GDP in 1975 to about 5.1 percent by 1980, were derived as follows: 1975 1980 (Col$ millions) A. Own Current Revenues 33,108 89,467 Total Current Revenues 33,513 90,955 - transfers received from rest of public sector - 05 -1,088 B. Direct Current Expenditures 15,950 34 900 Total Current Expenditures 22,900 - transfers paid to rest of public sector -6,950 -17,758 Gross Savings 17,158 Sh,566 (=current account surplus before transfers) 77. Opportunities for increasing savings of decentralized agencies should be utilized to increase the proportion of investment financed with internally Renerated funds. Tariffs for electricity, water, and sewerage would be periodically adjusted to generate larger savings for the major national and municipal public utility companies, e.g., Empresas Publicas de Medellin (EPM), and Empresa de Acueducto y Alcantarillado de Bogota D.E. (EAAB). Domestic prices for petroleum products could be increased in order to eliminate ECOPETROL's financial loss on imports, encourage greater production (perhaps through secondary recovery methods) and exploration, and rationalize the consumption of petroleum products in the domestic market. INCORA's finances could be improved by raising charges for land titling, and for irrigation. INCORA will, nevertheless, continue to need Government budgetary allocations, since nIUch of its work consists of providing infrastructure, and access roads in rural areas, for which no charges can be levied. INDERENA should increase charges on removal of timber from forest land and establish stricter application of these rates on the large Pacific Coast concessions which it has granted to private lumber companies. Finally, the internal efficiency of IDEMA needs to be inproved to minimize losses due to poor management. Table VIII. COLOMBIA: PROJECTED PUBLIC SECTOR Fi.ANCES, 1975-1980 (In millions of Colombian pesos at current prices) 1975 1976 1977 1978 1979 1980 Central Government Current Revenues 38,748 51,116 61,700 73,720 87,101 101,705 Current Expenditures 20,706 25,684 30,819 35,657 41,434 47,031 Current Account Surplus 18,042 25,432 30,881 38,063 45,667 54,674 Decentralized Agencies Current Revenues 20,256 24,376 31,463 39,296 48,075 55,783 Current Expenditures 17,560 21,528 26,092 31,258 36,884 42,785 Current Account Surplus 1/ 2,696 2,848 5,371 8,038 11,191 12,998 Departments Current Revenues 4,819 5,450 6,20 6,830 7,547 8,256 Current Expenditures 6,180 7,132 8,159 9,260 10,399 11,543 Current Account Surplus 1/ -1,361 -1,682 -2,039 -2,430 -2,852 - 3,287 Municipalities Current Revenues 7,373 8,273 9,216 10,202 11,192 12,166 Current Expenditures 6,129 7,012 7,959 8,962 9,993 11,022 Current Account Surplus 1,244 1,261 1,257 1,240 1,199 1,144 Public Sector Current Revenues 71,196 89,215 108,499 130,048 153,915 177,910 Current Expenditures 1/ 50,575 61,356 73,029 85,137 98,710 112,381 Current Account Surplus 20,621 27,859 35,470 44,911 55,205 65,529 1/ Before transfers. Source: Mission estimates. CD ANNEX 3 Page 30 78. These measures could well raise the buoyancy of decentralized agencies' revenues with respect to GDP from an average 0.97 during 1970-1974 to an average of about 1.0 during 1975-1980. If, in addition, growth of current expenditures of these agencies is restrained as in 1972-1973, they could provide about 17 percent of public sector savings over the next six years, as compared with only 11 percent during 1970-1974. Under these circumstances, their combined savings may increase from 0.7 percent of GDP in 1975 to 1.2 percent by 1980. 79. If public sector finances develop as projected, total public sector savings could increase from Col$20,621 million in 1975 to Col$65,529 million in 1980 or from 5.1 percent to 6.2 percent of GDP. The extent to which these estimates are realized -:ill largely depend upon the effectiveness with which the Tax Reform is implemented and on improvement in the revenue performance of decentralized agencies. Financing Public Investment, 197'-1980 80. If the trends outlined above are realized, savings generated by the public sector should be sufficient to finance a larger share of an expanded level of public investment than in previous years. Gross fixed investment of the public sector has been projected to grow from 7.1 to 9.4 percent of GDP, an amount sufficient to carry out the sectoral investments re;uired to fulfill developmental aspirations and growth objectives over the medium term. Decentralized agencies are estimated to account for about half of public investment, only about one-fifth of which may be financed by savings of these agencies. The National Government is expected to remain the largest source of public sector savings and should continue to partially finance capital outlays of other agencies, departments, and municipalities, as its gross fi-e ievestment represents a minor proportion of public inve7tment. Total public sector savings should be sufficient to finance aboYt two-thrds o public investment on average, while net external borrowing, including disbursements and cmortization of new and existing loans, is exnected to finance one-third (see Table IX). Table IX: COLOMBIA: PROJECTED PATTERN OF FINANCING PUBLIC SECTOR INVESTMENT, 1975-1980 (In millions of Colombian pesos at current prices) -- - - - - - - - - - - - - Projected - - - - - - - - - - - - - 1975 1976 1977 1976 1979 1980 Resource Re uirements 40633 77 78 027 40 120,085 A. Gross Fixed Investment a2 _21 i7 6 290 100 ' 452 1. Central Government 5,720 7> 10,073 13,133 1 19,387 National Government ( 1,985) 2,310) ( 3,079) ( 4,015) ( 4,973) ( 5,927) National Highway Fund ( 3,535) 4,972) ( 6,629) ( 8,642) (10,70 ) (12,757) Social Security ( 200) 274) ( 365) ( 476) ( 590) ( 703) 2. Decentralized Agencies 14,014 19,340 25,784 33,615 41,639 49,623 3. Departments 2,47 3,602 2,802 6,260 7,755 9,22 4. Municipalities 6,291 8,652 11,535 15,038 18,628 22,200 B. Amortization (External) 464 k 9 6,7 83 9,981 l4,25o 19,633 Financing 33,063 43,9U 58,977 78,027 98,5240 120,085 A. Public Sector Savings 20 621 535 470 244 911 65 529 1. Central Government 18'4 - 3 0,8 567 5, National Government 17,158) (24,589) (30,133) (37,467) (45,287) (54,566) National Highway Fund 118) ( 127) ( 136) ( 145) ( 154) ( 162) Social Security 766) ( 716) ( ) ( 451) ( 226) ( - 54) 2. Decentralized Agencies 2,696 2,848 5,371 8,038 11,191 12,998 3. Departments -1,361 1,682 -2,039 -2,430 -2,852 -3,287 4. Municipalities 1,244 1,261 1,257 1,240 1,199 1,144 B. Capital Account Revenues 1,000 1 000 0000 , 000 11000 C. Borrowin 15086 22507 32 116 42.33 1. External 1278T6 15,392 36,68 4,45 2. Internal (net) -1,344 - 306 - 560 2,108 5,697 11,104 Banking System ( 1,000) (- 834) ( 266) ( 4,008) ( 4,538) ( ) Other (-2,344) ( 528) (- 826) (-1,900) ( 1,159) ( 4,324) Source: Mission estimates. ANNEX 3 Page 32 C. Public Sector Investment Public Investment 197-1980 81. The Government has developed a broad strategy aimed at what it views as the most urgent development priority facing Colombia today, which is to improve the quality of life for the pborest 50 percent of the pop- ulation. The approach is an integrated one, with emphasis on linking improved production and productivity in basic foods with high nutritional value at the small farmer level, to a national nutrition program whose goal is to provide low-cost, high nutritive foods to the rural and urban poor. The second sector of priority is regional and urban development. The guiding concept is community development through creation of "cities within cities", with the aim of integrating the urban dweller at even the lowest economic level into society by providing essential infrastructure, as well as jobs. This entails a shift of focus from the previous soernnent, which viewed the urban problem mainly as one of stimulating construction and increasing employment. Thirdly, export expansion and diversification is viewed as a major component of the new strategy, with an emphasis on stimulating increased output of both industrial and agricultural products. The fourth priority, industrial development, is'viewed as a necessary preiequisite for export promotion, and acceleration of regional Antegration. 82. A comparison of the Government's projected investment targets for 1975-80 with actual investment over the period 1970-71 (see Table X), indicates a relative increase in investment for industry, nutrition and health, agriculture, power, water and sewerage, and telecommunications. Investment in education (with emphasis on investment in lower cost rural facilities) would also maintain the relative share of the total which prevailed during 1970-7h but current transfers from the National Government to the Departments and Municipalities to finance expenditures in education are expected to increase substantially over the period. There would be a substantial reduc- tion in investment for transportation, and a cutback on increases would also be made in investments in tourism and urban development. In absolute terms, the most important sectors would be industry and power, which together would account for 40 percent of new investment. Agriculture, nutrition and health, water and sewerage, communications and education, would make up the bulk of the difference (51 percent), with transportation, tourism and urban develop- nent accounting for 9 percent. Table X. . COLOMBIA: SECTORAL DISTRIBTIlON OF PUBLIC GROSS FIXED INVESTMENT, 1970-80" (Mill ion oi Col ) 1970 1971 197- 1973 1974 1975 1976 1977 1978 1979 1980 Amont 7. Amount Amount I Amount 7, Amount % Amount Amont 7. Amount 3 Amount % Amount 7 Amount 7 1. Agri- Itur, 1,801 14.8 1,796 13.3 2,491 15.6 2,339 12.2 3,133 12.4 2,888 10.1 4,385 11.2 5,898 11.3 7,757 11.4 9,862 11.7 11,954 11.9 2 2. Todusty 718 5.9 905 6.7 814 5.1 1,515 7.9 1,870 7.4 2,145 7.5 2,936 7.5 3,967 7.6 5,648 8.3 7,502 8.9 9,141- 9.1 3. Nutrition & Health 1,144 9.4 837 6.2 1,182 7.4 1,035 5.4 1,945 7.7 2,717 9.5 3,563 9.1 4,854 9.3 6,532 9.6 8.429 10.0 10,447 10.4 4.I water Supply & Sewerage 438 3.6 405 3.0 463 2.9 613 3.2 808 3.2 1,287 4.5 1,879 4.8 2,505 4.8 3,743 5.5 5,142 6.1 6,730 6.7 5. Pover 450 3.7 675 5.0 656 4.1 1,419 7.4 2,148 8.5 2,688 9.4 3,367 8.6 4,489 8.6 5,988 8.8 7,586 9.0 9,141 9.1 . TeIlomniations 182 1.5 148 1.1 144 0.9 441 2.3 632 2.5 715 2.5 940 2.4 1,253 2.4 1,701 2.5 2,023 2.4 2,310 2.3 7. Traportation 3,626 29.8 3,618 26.8 3,848 24.1 4,313 22.5 5,104 20.2 5,491 19.2 6,773 17.3 10,282 19.7 12,997 19.1 15,762 18.7 17,881 17.8 8. 1Auca t.on 900 7.4 1,121 8.3 1,996 12.5 2,396 12.5 4,194 16.6 4,519 15.8 6,342 16.2 8,038 15.4 10,275 15.1 12,222 14.5 13,963 13.9 9. Torism 110 0.9 81 0.6 64 0.4 134 0.7 202 0.8 286 1.0 391 1.0 574 1.1 680 1.0 843 1.0 904 0.9 10. Urban evelopment 743 6.1 756 5.6 1,229 7.7 1,879 9.8 2,299 9.1 2,545 8.9 3,719 9.5 4,906 9.4 6,601 9.7 8,766 10.4 11,050 11.0 11. Centrtl Service 511 4.2 378 2.8 367 2.3 364 1.9 531 2.1 801 2.8 11214 3.1 939 1.8 1,089 1.6 1,264 1.5 1,406 1.4 1 . Oter- 12.7 2 20.6 2 17.0 272 14.2 2,4 9.5 2.517 8.8 3.641 9.3 4.49 8.6 4,889 5.8 5,525 5.5 12,168 100.0 13,501 100.0 15,967 100.0 19,170 100.0 25,266 100.0 28,599 100.0 39,150 100.0 52,194 100.0 68,046 100.0 84,290 100.0 100,452 100.0 1, fata Co, 1970-7, 1 cu ia; for 1975-00 is projected. 7/ ncud- nnuacturi, miring and petrolemc I / Tocldlo4 p,bllc build- u, rhan works and roads, development studies, purchase of food by IDEKA. ANNEX 3 Page 34 Agriculture 83. Colombia has potential for producing a variety of crops, but at the same time, the area suitable for crop and livestock development is limited in relation to Colombia's size. In addition, much land potential is still under- developed with only about one-third of the potentially arable land under cul- tivation, and one-half of potential pasture land being used for livestock development. Much of the potential arable land is in large holdings, and mainly used for livestock development. Efforts at land reform have been modest, and tenure of land remains highly skewed, with 10 percent of farm units accounting for 80 percent of total farm land, and 50 percent of farm units comprising less than 3 percent of farm land. Most of Colombia's rural population still live at close to a subsistence level. 84. The main investment effort of the new Government will, therefore, be directed to improve the quality of life of the rural poor. The Government intends to do this by improving the productivity and well-being of low-income rural families through integrated rural development programs. Such an em- phasis would be consistent with Government's overall goal of benefiting the poorest 50 percent of the population. It would also be in line with Govern- ment initiatives in the field of nutrition and health, since emphasis would be given to producing low-cost foods with high nutritional content which would provide increased rural employment and a transfer of real income to the rural population. The Government is also seeking to stimulate production in areas which up to now have received little attention, such as agro- industry, fishing and forestry. Industry 85. Manufacturing. The structure of manufacturing is heavily oriented toward privately-owned firms producing consumer goods, notably non-durable consumer goods such as processed food, textiles, clothing and footwear, which account for almost one-half of manufacturing output and employment. Public investment has concentrated in heavy industry and investment goods production, areas in which the Government felt that private initiative and capital were insufficient to develop projects. It was on this basis that the Instituto de Fomento Industrial (IFI) was established as a holding company to promote and own such enterprises on behalf of the Government. IFI helped to promote Paz del Rio, Colombia's first steel mill, but not until recent years did it begin to operate on an important scale in such areas as automobile assembly, construction of light aircraft, fishing vessels and railroad cars, manu- facture of chemicals, petrochemicals and mining. 86. Petroleum and Mining. Colombia has, until 1974, been self-sufficient in petroleum production. It is the world's only major producer of emeralds and has one of the richest deposits of nickel in the world. Additionally, ANNEX 3 Page 35 it is the only producer in Latin America of platinum, is a leading gold producer, and has the region's largest known coal reserves. Investment and exploitation of sub-surface resources are carried out by two state-owned corporations, ECOPETROL and ECOMINAS (mining). 87. Colncbi, a's most urgent problem is to regain self-sufficiency in Detroleun production, and to this end, ECOPETROL has projected an extensive program of exploration and perforation for 1975-79. At the same time, ECOPETIROL is acting to expand its refining capacity in Barranca-Bermaja and Cartagena. The government is also moving ahead to develop its coal and natural gas resources in the Guajira area, and the large Cerro Matoso nickel deposit. The latter three projects will be carried out in partner- ship with foreign firms. Education and Health 88. In Colombia, as in most developing countries, nutrition and health care have not in the past held a high priority as development goals'. The ratio of physicians to total population is low (h:10,000) and only 10 percent of physicians serve the two-thirds of the population which live in the rural areas. Health services at the national level are under the direction of the Ministry of Heal-h. Specific groups in the population are also provided health services by other organizations to which they belong, such as the military, the police, Social Security Institute, National Railways, Ministries of Education, Labor and Public Works. Yet, covera-e of the population is spotty, and consultation rates reveal that only a relatively small proportion of the population has access to medical aid while they are ill (there is one chance in seven that an individual living in rural areas will obtain any kind of assistance and one in thirteen that he will be seen by a physician). A decree promulgated in January ]975 hqs established the basis for coordination of sector planning and integration of other activities under the Ministry of Health, but its .mplementation will rejuire a good deal of time and effort. 89. The close association of disease, malnutrition, lack of sanitation, poverty and illiteracy on the learning curves of school children and on the efficiency and productivity of the working population. The new Government is especially concerned that the most vulnerable groups, pregnant and nursing mothers and young children, receive improved nuirition. 90. The Government's investment policy in this field is an integrated one, aimed aL (i) inceasing the nutritional content of the diet of the pcorest 50 percent oC the population by increasing production of relatively low-cost and high nutritional value food crops; (ii) increasing food processing facilities for fortified and enriched foods; (iii) upgrading the exisin 7 food storage and marketing systems; (iv) establishinT a supplemental feeding program for the poorest 10 perccent of the population; (v) creains rural health posts ofering medical, n-Iernal nd ily planning care (vi) training para- medical workers to staff rurl health posts; and (vii) establishing a program of mass media nutrition education. ANNEX 3 Page 36 Water Supply and Sewerage 91. Water and sewerage services to about two-thirds of the population in Colombia are provided by three main groups of entities. Twenty one cities with populations ranging from 25,000 to 3,000,000 have municipal public utilities. These cities have a combined population of about 8,000,000 or over one-third of Colombia's total. All other towns with more than 2,500 inhabitants (totaling about 6 million people) are served by Instituto de Fomento Municipal (INSFOPAL), the national water supply and sewage agency-and its subsidiary system of "Acuas". Rural communities with a population of less than 2,500 depend upon the Instituto Nacional para Programas de Salud (INPES), which has managed to provide water and sewerage services to an estimated 30 percent of the ten million people under its jurisdiction. 92. Major problems in this sector are (i) insufficient funds for investment due to inadequate water rates and poor collection performance; (ii) insufficient coverage of water and sewerage services, particularly in the maller cities and towns; (iii) lack of metering and resulting incidence of water waste; (iv) lack of adequate sewage treatment in urban areas. 93. Although no formal planning for this sector exists, the Government has established as its chief objective the extension of water and sewage facilities to 80 percent of the population by 1980, and a major effort is being made to extend such services to medium and smaller-sized cities. However, due to lack of funds and public hostility to the sizeable tariff increases required, it is doubtful that the goal of 80 percent coverage will be reached within the time indicated. Sewage and industrial waste are generally untreated in Colombia, and another major objective is the building of sewage treatment and disposal plants where pollutant loads are reaching dangerous levels such as in Cali. In addition, the Government hopes to centralize advisory and financial functions for the entire sector within INSFOPAL, and to build up INSF0PAL as a national institution. A presidential decree of April 1974 has laid the basis for a reorganization of INSFOPAL so that it would be divested of its operating functions ("Acuas" would be independent operating entities), while its financial and advisory functions would be strengthened to include channelling of all internal and external credit to the sector. 94. The goal of increasing coverage is reflected in the projected investment program and both INSFOPAL and INPES expect to carry out sizeable expansion of water and sewerage resources to medium and small cities. Other sizeable investments include a project to improve the flow of the Bogota River, and the construction of a sewage treatment plant in Cali. Power 95. Approximately 90 percent of the electricity generated in Colombia is supplied by public corporations owned by the central, departmental and mai- cipal governments. Industrial electrical plants account for the balance. One public entity at the national level, Instituto Colombiano de Energia ANNEX 3 Page 37 Electroca (OCEL), and three at the regional level, Empresas Publicas 'de Medellin (EPM), Empresa de Energia Electrica de Bogota (EEEB) and Corpo- racion Autonoma Regional del Cauca (GVC), supply 95 percent of the publicly generated electricity. Since 1967, Colombia has moved toward national integration of its power output, and two institutions, Interconexion Electrica, S.A. (ISA) and Corporacion Electrica de la Costa Atlantica (CORELCA), were created in that year, with responsibility for interconnecting major markets in the central and northern regions, respectively, EPM, EEEB, ICEL and CVC are the major shareholders in ISA. Through ISA, coordination and integration of sectoral planning on a national level has begun, but there is as yet no national energy policy. In addition, regional interests still predominate and the local orientation of ISA shareholders has not enabled the latter to emerge as a strong national institution. The principal natter at issue is whether or not ISA should be responsible for building, owning and operating the major new generating plants. The implications of the latter course of action are greater centralized control at the operating level over the sector as a whole, but this poses a threat to the: independent operations of the Vegional companies. This matter is presently under review by the Government. 96. Major problems facing the sector are: (i) the need for further consolidation of national lines (six regions have presently been identifiedl through interconnection programs; (ii) low nationwide tariff levels in relation to financial needs of operating companies; (iii) poor quality of service in small towns; (iv) failure to implement rural electrification programs to serve the approximately 6 million people living in the rural areas. 97. The Government intends to pursue its goal of greater rationali- zation through centralization of financial controls and planning. At the same time, it will carefully scrutinize proposed investment programs to determine if they are of real national priority. Major investments are expected to take place in generating capacity (90 percent hydroelectric) and its distribution, with the greater portion for interconnection with the Atlantic Coast. This is in line with the Government's objective of increasing power availability by one-third (from about 12 million NH to 18 million KWH) over the period 1975-78 in order to meet theincrease in expected demand. Planned interconnection projects would link the central to the Atlantic region and would extend the Atlantic system into the departments of Cesar and Magdalena. Telecommunications 98. Local telephone services in Colombia are provided by '54 entities. The sole government-owned entity, Empresa Nacional de Telecomunicaciones (TELECOM), has exclusive license to provide national tele.-raph, telex, long-distance and international services, in addition to thelocal telephone services it provides. However, TELECOM only owns and operates S percent of the local subscriber lines (35,000 out of 677,000). Empresa de Telefonos de Bogota owns 46 percent of local lines, Empresas Publicas de Medellin owns 2C percent and the other 50 companies own the balance (24 percent). ANNEX 3 Page 38 99. The main problem of the telecommunication sector is the fragmented operation of local telephone service. The large number of entities hinders efficient functioning of telecommunications due to differing operating standards and lack of coordinated planning of facilities. Some large municipalities provide reasonably good service. In smaller cities and towns, however, the quality of the telephone service is unsatisfactory due to the small scale of operations, and the lack of attention paid to the extension and improvement of service. 100. A sector review has recently been undertaken to assess the investment requirements of the sector, establish priorities for investment, and consider possible sources of funds. The main conclusions of the study are that the present fragmentation of the sector has resulted in increased costs and lowered efficiency, as well as lack of coordination and rationalization in policy planning, investment programming and budgeting, procurement and regulatory control. Its most important recommendation is that the most appropriate solution to this problem lies in consolidation of the ma-y separate entities into o)ne; namely, TELECOM. 101. AnticipaLed annual demand for local telephone'service is expected to grow by 9.5 percent during the period 1975-77, and a major emphasis has been placed by the Government on expanding service in this area. Consequently, orders for a total of 300,740.1ines of automatic exchange equipment have alreadv been placed for commissioning during 1975-77, and an additional 120,000 lines are expected to be ordered and placed in commission by the end of 1977. Transnortation 102. Upon reaching Colombia, the Andes Mountains divide to form three major mount ain chains, thus separating the country into two major river systems (the Cauca and Magdalena) and numerous intermontane valleys. The mountains also form a barrier between the eastern savannah, the amazon basin to the souAhest, and the dense swamps and jungle of the pacific plain. Due principally to these geographic constraints, the transportation netwcrk developed historically in an unintegrated manner. Attempts were made to connect the major andean cities (Bogota, Medellin, Cali) to ports: Cali to the Pacific port of Buenaventura; Bogota and Medellin to the Atlantic by way of the Magdalena River, which is navigable for almost 1,000 Km. Neverthelcss, well into the twentieth century, population centers in Colombia were largely isolated. Although this provided a stimulus for the early development of avialion (AIALNCA was founded in 1919), road transport, and to a lesser de(iree, rai-I transport, have lagged behind. Understandably, transportation policy over the past twenty years has focused on overcoming the problems imposed by geogra,phy, and emphasis has been placed on building direct railway and highway links to the Atlantic coast and on establishing ade-uate road connections beLween the principal Andean cities. ANNEX 3 Page 39 103. The main trunk system of highway-railway lines is almost complete and the ports facilities have sufficient capacity to handle foreseable ship traffic through 1980. However, the transportation network has never operated with real efficiency because certain fundamental problems have not been dealt with. These are: (i) lack of planning, coordination and integration of facilities (particularly) in the Atlantic corridor along the Mriagdalena Valley; (ii) inadequate road and track maintenance (particularly important due to the severe climate and difficult topography); (iii) problems of organization and administration at the institutional level; (iv) distortion of the real costs and comparative advantages of different forms of transportation by means of a gasoline subsidy (11 per gallon); (v) inadequate secondary road and feeder systems; and (vi) use of narrow gauge railway line has resulted in -avere technical and procurement problems. 104. As a consequence, the Government's investment strategy is oriented toward maintenance and upgrading of the existing system. Major investments are expected to be made in construction of secondary rcads ("caminos vecinales"), a second stage of the road paving program, and the recuperation of the existing trunk system, both road and rail. Education 105. During the 1960's enrollment increased greatly, and great stress was placed on the existing education system. The Government reacted by moving to increase enrollment capacity and to link education more closely to the skills required in a developing economy. Extra shifts were intro- duced into existing schools, and the IEM's were initiated as a comprehensive secondary school which would integrate academic and vocational training. However, the new Government feels that this program has been too costly, and has not adequately dealt with basic structural problems in rural areas. Rural education is inadequate and rural schools have high studnt drop out rates and irregular attendance, and lack both teachers and facilities. Although schools in urban areas are generally of a much higher standard, they also show low retention rates. This problem is compounded by the fact that most students who complete secondary school follow an academic program, and there is a lack of job opportunities for such graduates. Conversely, the economy suffers from a shortage of specialized technicians. 106. The Government has recently focussed more closely on the rural problem with emphasis on providing more primary schools and teachers, and introducing an extra shift into rural schools. The Government is also lov3ring the level of b; sic educational requirements by reducing basic education to 4 years (previously 5 years) of primary and 4 years of secondary. Government policy for secondary education has not been defined, and the status of the INEM program is unclear. Prcjected investment in education is expected to continue to be substantial (about 15 percent of total public investment), and the investment. 'hudget continues to show a major emphasis, as in the past, on university educz.ation. ANNEX 3 Page h Tourism 107. Colombia's most valuable assets from the point of view of international tourism, lie on its northern Caribbean coast, where clear waters, agreeable climate, good quality beaches, historical sites and relatively low costs offer an attraction to foreign tourists. At present, tourists visit Bogota (its main attraction is a pre-colombian gold museum) almost exclusively, and generally as part of a group tour. Colombia is readily accessible to the U.S. (via Miami) and Venezuelan markets, both important sources of tourism. 108. Government strategy had originally focussed on developing three "poles" simultaneously, in Cartagena, Santa Marta and San Andres. A Baru-Cartegena project would be oriented to developing the tourist potential of the excellent beaches of Baru Island (30 km from Cartagena) and the colonial section of Cartagena. In the colonial period Cartagena was the main port of trans-shipment of New World wealth to Spain, was the prime target of bucaneers, and is therefore a city dominated by fortifications and historical landmarks. Cartagena has therefore considerable potential historical and cultural interest, but the old city has been poorly preserved. Its beaches are of secondary importance and thus the Baru component would complement it well, Santa Marta was the first city settled in Spanish America (1525), and its most important tourist attractions are fine beaches backed by the snow-capped peaks of the Sierra Nevada mountains. As originally conceived, this project was to be located in the Parque Tairona, a national park about 15 km east of Santa Marta; however, for ecological considerations this concept has been dropped, and the present concept is to develop the project to the west of the city, on other land already owned by the Government. Tourism is essential to the development of San Andres Island, and although the beach area is not extensive, the island's free port status would provide an added incentive for tourism. A basic problem is lack of infrastructure and fresh water. Major efforts in those areas would need to be undertaken prior to tourism development. 109. The basic problems which hold back tourism development on the Caribbean coast are the following: (i) poor quality of accommodation and related services in most areas; (ii) the lack of a flexible "open skies" policy which would give foreign airlines access to Colombia; (iii) inefficient port facilities for the handling of cruise ship traffic; (iv) the poor state of preservation of the old city of Uartagena; and (v) lack of infrastructure (drinking water, telephone, electricity), on San Andres. Urban Development 110. Almost half of Colombia's population of 22,000,000 lives in suburban centers of more than 10,000 and about 6,000,000 people live in urban centers of 30,000 or more. The latest census (1964) has shown that whereas in 1938 ANNEX 3 Page 41 half the urban population lived in centers of 10,000 or less, by 1964 half of the urban population lived in centers of 100,000 or more. During this period, therefore, not only did the urban population more than treble in size, but most of the increase occurred in the larger centers. In addition, the isolation imposed by geography and climate has fostered regional concentrations of population centered around the largest population centers. Consequently, the Government must give considerable emphasis to maintaining a regional "balance," in which all regions can share in the benefits of economic growth, and it is in this context that urban development must be viewed. 111. The need to establish planning and urban development guidelines in the rapidly expanding centers, is particularly crucial in Bogota and the other large cities such as Medellin, Cali, Barranquilla, Cartagena and Bucaramanga. Feasibility studies are being carried out for a number of cities and studies of two areas in Bogota, "El Salitre" and "Modelia," have recently been completed. The concept guiding these studies is that of developing "cities within cities," with the object of establishing and integrating a stable population within a specific area by providing low- cost housing, the necessary infrastructure and easy access to jobs. The Government intends to initiate "cities within a city" projects in Bogota, Cartagena, and Barranquilla during 1975-79.