Peru - Industrial Credit Project

Document of L E C~ 0P'f The Woir1d Ban IFOIR OMFCEAL-US$E ONLY Report No. P-1962-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THIE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO CORPORACION FINANCIERA DE DESARROLLO (COFIDE) WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR AN INDUSTRIAL CREDIT PROJECT December 14, 1976 This dIcomnent has a restrficted taistuflion and mny be used by recipients only an the perfonnnace of their ofleilan dtg1tes. Its eontents many not otherise be disclosed withont Worid DnoS aucnthcrlmtain.  RATE OF EXCHANGE December 2, 1976 Currency Unit Sol (S/.) US $1 s/.68.oo s/. us$o .0147 S/.l,00O Us$14.71 S/.l,OOO,OOO us$14,705.88 FISCAL PERIOD January 1 to December 31 ABBREVIATIONS AND ACRONYMS BIP = Banco Industrial del Peru, Industrial Bank of Peru COFIDE = Corporaci6n Financiera de Desarrollo, Development Finance Corporation. 1/ On September 20, 1976, the Government instituted a policy of minidevaluations. Since then, the exchange rate has gradually changed from US$1.00 = S/.65.0o to its present level.  FOR OFFICIAL USE ONLY INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO CORPORACION FINANCIERA DE DESARROLLO (COFIDE) WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR AN INDUSTRIAL CREDIT PROJECT 1. I submit the following report and recomendation on a proposed loan to Corporacion Financiera de Desarrollo (COFIDE) with the guarantee of the Republic of Peru for the equivalent of US$35.0 million to help finance an industrial credit project. The interest rate on the proposed loan would be 8.7 percent per annum. COFIDE, in turn would relend the loan proceeds in foreign exchange at an interest rate of no less than 11 percent and with terms of up to 15 years including grace periods of up to 3 years. Amortization of the proposed loan would be based on the aggregate of the amortization schedules of COFIDE's subloans. PART I - THE ECONOMY 2. A report entitled "Economic Position and Prospects of Peru" (No. 655- PE) was distributed to the Executive Directors on March 3, 1975. Country data sheets are attached as Annex I. 3. Since 1968 the Government has followed a development strategy in which economic growth is linked to a transformation of the society to achieve broader popular participation in the country's economic, social and political life, thus addressing one of the most serious problems of Peru's economy and society -- the sharp differences in wealth and opportunities between income classes and geographical regions. A new government headed by General Morales Bermudez, which took office in August 1975, has been reassessing the progress made since 1968 and has publicly acknowledged the difficulties that have arisen during the past eight years in the onerous task of reconciling growth, financial stability and better income distribution. The main problems that arose were a contraction in domestic savings, particularly in the public sector, a fall in efficiency in the productive sectors and a retrenchment in the level of investment by the private sector. The President has stated the need for important modifications in policies that would leave the basic long term objectives unchanged, but would call for a more gradual approach to reforms of the economic and social system and would emphasize measures that increase domestic savings, encourage private sector investment and improve efficiency in production. 4. GDP grew at an annual rate above 7 percent during 1970/74 but fell to less than 3 percent in 1975. Gross domestic investment rose from 13 per- cent to almost 19 percent of GDP between 1970 and 1975, largely because of the increase of public and private investment in mining and petroleum. How- ever, as consumption also grew faster than GDP and heavy losses were incurred by public enterprises marketing imported petroelum and foodstuffs, gross This document hasa restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - 2 - national savings fell to less than 8 percent of GNP. The excessive growth of aggregate demand combined with the sharp rise in Peru's import prices since 1973 resulted in an acceleration of inflation -- from an average annual rate of 7.2 percent during 1969-73 to over 24 percent in 1975 -- and an increase in thie deficit of the balance of payments on current account from 0.5 to 11 percent of GDP between 1972 and 1975. Net long-term capital inflows rose from US$110 million in 1972 to US$840 million in 1974 and allowed a US$275 million increase in net international reserves in spite of the widened resource gap. In 1975, although net long-term capital inflows totalled an estimated US$1.1 billion, they were not sufficient to finance the current account deficit and net international reserves fell from US$680 million in December 1974 to around US$127 million in December 1975. Gross international reserves equalled $470 million at that time and were equivalent to less than three weeks of merchan- dise imports. 5. During 1975 the Government approved a series of tax and price measures to reduce the excessive growth of aggregate demand and to stimulate the growth of food output and exports but these were insufficent to reverse the deteriorating financial trends. Additional measures were taken in January 1976, including increases in taxes and official prices and cuts in public expenditures, but Peru's financial position continued to worsen during the first half of the year. Export earnings remained depressed mainly because of a decline in international prices for Peruvian goods; reportedly volume was also low because exporters were waiting for better world prices and were also expecting a further change in the dollar parity of the Sol, which had been devalued by about 14 percent in September 1975. On the other hand, imports continued to grow, although less rapidly than last year, and the current account deficit totalled over US$700 million during January-June 1976, equiv- alent to around 8 percent of GDP, somewhat less than the 11 percent reached in 1975. Long-term capital inflows were substantially lower than in previous years mainly because of a decline in private direct foreign investment and lower disbursements of foreign medium and long-term loans partly due to the reluctance of commercial banks to provide additional non-project credits. Moreover, short-term capital outflows increased substantially during the semester, caused mainly by the general uncertainty and the combination of increasingly negative interest rates in real terms and growing expectations of a substantial devaluation. Net international reserves fell during January-May by over US$525 million to a negative level of around US$400 million; the foreign currency holdings of the banking system were almost exhausted in spite of US$212 million of IMF assistance which included the first credit tranche and the use of the compensatory and oil facilities. 6. On the domestic side the public sector deficit also continued to widen rapidly. The Central Government deficit was caused by a combination of rapid growth of both current and capital expenditures resulting from inflation and very low growth of current revenues due mainly to the sharp fall in income tax payments by the mining sector and the declining imports subject to duty. The latter underlines two important weaknesses of the tax system: its dependence on foreign trade and its low elasticity to change in  nominal GDP. Although the income of many public enterprises rose substan- tially because of price measures taken in January, the combined deficit of all state enterprises remained large because of the operating losses of the steel and fishing companies, combined with low surpluses of the mining companies and large cost overruns on investment projects, mainly in the petroleum sector. 7. A series of drastic measures were taken in May and June of 1976 to cut down the growthl of aggregate demand, restore balance of payments equilibrium and reduce inflation. On May 19 additional tax measures were introduced that included mainly increases in sales, cigarette and automobile taxes, and a reduction of exemptions of import duties on capital goods as a first step in rationalizing and reducing the heavy fiscal cost of industrial incentives. At the end of May the statutory ceiling on interest rates was abolished and replaced by maximum rates that can be changed by administrative regulation. The maximum lending rates rose from 14 percent to 19 percent, while the maximum rates paid on deposits rose from 7 to 12 percent. Then on June 28, a further package of corrective measures was approved consisting mainly of: a devaluation of the Sol from S/.45 to S/.65 per U.S. dollar, a 15 percent tax on traditional exports and large increases in taxes on petro- leum products; a cut in public expenditures; substantial increases in the prices of petroleum products and foodstuffs; and the freezing of all wages till the end of 1976 after an adjustment of around 10-15 percent to ease the impact of the other measures on the cost of living. The May-June measures ar( (x)pected to increase public savings by 2.8 percent of GDP in one semester and reduce the overall public sector deficit from around 11 percent of GDP in 1975 to around 7 percent in 1976. This cut, combined with the devaluation, a fall in real wages, the increase in interest rates and tight credit policies, is expected to result in a sharp contraction of imports and a reduction in the current balance of payments deficit from 11 percent of GDP in 1975 to around 5.5 percent in the second semester of 1976 and less than 4.8 percent in 1977. As a direct result of the corrective measures taken, prices will rise 28 percent during the second semester of this year, but the Government expects inflation to fall to 10-15 percent during 1977 compared to an estimated 40 percent this year. As a complement of the stabilization package the Govern- ment obtained in early December US$330 million of balance of payments support loans from North American and European Commercial banks. 8. Besides moving forcefully towards financial stabilization, the Government has been approving a series of important measures with far reach- ing long-term development consequences. The drive towards eliminating the distortions in relative prices has made considerable progress. The Govern- ment publicly announced its determination to maintain the exchange rate at realistic levels. In September frequent mini-devaluations were started; by December 2 the dollar parity had reached S/.68. The Government also intends to follow a more flexible interest rate policy in the future and eventually bring the rates to positive levels in real terms. Although the maximum rates are still negative, the Government maintains that it would be inappropriate to increase the rates further since the inflation is expected to fall in 1977.  - 4 - However, should inflation remain over 15 percent in 1977, the Government intends to review the interest rate level to ensure that its goals of achiev- ing real levels is attained. Other price controls are gradually being relaxed. 9. Priority is now given to increasing efficiency in the productive system and real efforts to restore confidence and dynamism in the private sector are being made. President Morales has declared that the State should di'est itself of some of the nationalized enterprises. The first measure, taken in July, was to return the fishmeal fishing fleet to the private sector. Participation of the private sector in petroleum exploration and medium scale mining develpment is now being encouraged and the Industrial Community Legisla- tion is being modified (see para. 22 and 24 below). In the agricultural sector a new massive program to support the medium and small farmers (owning more than 3 hectares) is being launched and more attention is being given to the management and labor problems in the cooperatives. Moreover, further efforts to prepare rural development projects benefitting the poorer groups and to provide more infrastructure in rural areas are being made. Early in October the Government also acknowledged for the first time the need to reduce the population growtlh rate and is now developing a deliberate population policy. Finally, the pruning of the public investment program to a more manageable size is under way and a complete reorganization of public admin- istration has been announced. 10. Total public sector external debt (outstanding and disbursed) more than tripled between 1970 and 1975--from US$0.85 billion to US$2.67 billion-- and average terms deteriorated markedly. Average maturities of new commit- ments fell from 10.7 years in 1971 to 5.6 years in 1975 as a result both of heavy borrowinig for non-project purposes from commercial banks and the low level of lending from official sources. Between 1970-72 and 1975 the share of net disbursements coming from commercial banks rose from less than 30 to 50 percent whiile thie share from official sources fell from 70 percent to less than 36 percent. 11. The public debt service ratio rose from 23 percent in 1974 to an estimated 26 percent in 1975 reflecting both a sharp increase in interest payments and the decline in the value of merchandise exports. During 1976 the public debt service ratio is expected to fall to 22 percent because of the recovery in export earnings in the second semester of the year and a small decrease in debt service payments. However, given the very serious foreign liquidity squeeze the country is now going through, this level of debt service will place a heavy burden on the balance of payments. The Government has committed itself to give first priority in foreign exchange allocation to debt service payments. During 1977/80 the public debt service ratio may rise further to 27-28 percent, but would decline in the 1980s if the Government is successful in obtaining improved lending terms in future years.  12. Although Peru is a country with serious constraints to its develop- ment efforts it has a large untapped resource potential. The Government is trying to accelerate growth while broadening the participation of the population in the development process. It has been caught by some of the unavoidable effects of the structural transformation, by the negative effects of some errors and inadequacies in policies (generally now recognized and gradually being corrected), and by unfavorable external developments. Conse- quently, the present situation is difficult. The Government is aware of these difficulties and is taking action to resolve them. Improvements in the balance of payments position during 1977 and thereafter will depend on: (a) continued efforts to increase savings, contain import growth and reduce dependence on foreign commercial borrowing; (b) reducing dependence on imported petroleum with the completion of the oil pipeline and with additional petro- leum exploration; and (c) increasing export volume with the timely completion of mining projects now under way and the expansion of nontraditional exports. 13. In the longer run, besides restoring equilibrium to the country's finances and raising the level of savings, the development strategy will have to focus on increasing the efficiency of resource allocation -- parti- cularly in the industrial sector --, on diversifying exports to reduce vulnerability to sharp changes in world prices of primary commodities, and on developing more effective ways to attack the poverty problem. In the agricultural sector, the Government is taking action to improve management capacity and efficiency in the cooperative sector, stimulate investment in the private medium size farms, and accelerate the transfer of technology and inputs to the small farmers. However, since the potential of expansion in agriculture is limited, and mining expansion will not absorb much labor and since the future of fisheries is highly uncertain, the long-term growth of the economy will depend mainly on the industrial sector and (to a much lesser extent) on tourism. To promote industrial growth, the efficiency and international competitiveness of the sector will have to be increased primarily through changes in the incentive policy mix -- less protection, more selective and lower fiscal incentives, and a realistic exchange rate. The recent changes in policy discussed above represent significant progress on these issues. Concerning the poverty problem, important elements of the Government strategy include increasing labor absorption in the modern sectors of the economy, transferring technology and basic services to the tradi- tional sectors, and developing institutional mechanisms that promote self- help among the poorer groups. (The project in Lima and Arequipa slum areas which is supported by the recent Sites and Services Loan--PE 1283--is a good example of this strategy). 14. On the assumption that the Government will continue its financial stabilization policies and make further progress in laying the basis for rapid and more balanced development, Peru remains creditworthy for Bank lending. The Bank, both as a lender and as a chairman of the Consultative Group, will continue to monitor developments closely.  - 6 - PART II - BANK OPERATIONS IN PERU l3ank Operations 15. The Bank has made 31 Loans in Peru for a total amount of US$492.2 million, net of cancellations; of these, 23 loans, totalling US$213.1 million, were fully disbursed as of October 31, 1976. About 45 percent of Bank lending to Peru has been for transportation (mainly highways and ports) 21 percent for electric power, 16 percent for agriculture, 9 percent for mining and industry, and also about 9 percent for an education project and a site and services project. Project execution has been generally satisfactory. Annex II contains a statement of Bank loans as of October 31, 1976, and notes on the execution of ongoing projects. IFC Operations 16. IFC commitments to date have been about US$24.0 million (US$15 mil- lion to Southern Peru Copper Corporation for the Cuajone Copper mining project and the remainder to industry) of which US$15.3 million is held by the Corporation. A summary statement of IFC investments as of November 30, 1976, is presented in Annex II. Bank Strategy 17. The main objectives of Bank lending to Peru have been to aid in (a) the creation of a physical and social infrastructure capable of sustain- ing and fostering the evolution of the nation's productive capacity; (b) the expansion of productive capacity in crucial sectors; and (c) the consolidation of structtural and institutional changes now under way, particularly land and educational reforms. In the past Bank lending has been concentrated on infra- structure in the transportation and power sectors; the most recent loans in these fields were made for the Transandean Corridor Project in May 1976 and for a power project in the l.ima area in September 1976. Our emphasis is now shifting to the more directly productive fields - mining, agriculture and industry - to aid Peru in reducing her current balance of payments problem and to strengthen institutions carrying out Peru's economic and social reforms. The recent: US$40 million mining loan, for instance, was designed mainly to expand production for export and strengthen the effectiveness of the public mining ent:erprise, CENTROMIN, particularly in project planning and execution. The indust:rial credit project now being recommended is designed to expand production for export and substitute economically for imports while improving the project evaluation capability of Peru's national development bank, COFIDE. Future Bank lending would give high priority to agriculture to help increase food production and raise the standard of living of the rural population and to strength:en the reLatively weak ministries and agencies operating in this field. An irrigation rehabilitation project to expand production of both export crops and agricultural products now being imported, as well as to aid in consolidating the land reform program and strengthening agricultural institutions in the coastal zone, will be negotiated shortly and a second agricultural credit project has been appraised.  Bank staff and the Bank/FAO Cooperative Program are assisting the Government in the preparation of projects for rural development in the mountain region. Preparatory work is proceeding on other projects in the water supply and transport sectors. The Bank also expects to continue to play a role in coor- dinating external assistance and being a catalyst for new sources of funds for major investment projects through the mechanism of the Consultative Group. PART III - THE INDUSTRIAL SECTOR Growth and Structure 18. Value added in manufacturing, which currently accounts for about 27 percent of GDP, has been growing faster than 7 percent per year since 1960. Manufacturing employment, on the other hand, has been growing about 4 percent per year, and the sector employs only slightly more than 5 percent of the labor force. Some 74 percent of value added and 76 percent of employment in manufacturing (excluding fish products) are concentrated in the Lima-Callao metropolitan area. 19. Peru's traditional import substitution policy has tended to favor consumer goods for the domestic market, often in the form of mere "finishing" of imported inputs. Despite increased emphasis since 1968 on production of basic and intermediate goods, consumer goods still account for more than half of manufacturing value added. Such traditional industries as food processing, beverages, tobacco and textiles are of particular importance. The limitations of the domestic market have constrained the possibilities for product specialization in individual plants, as well as for the manufacturing of parts, components and accessories in separate establishments. The manu- facturing sector consequently is relatively unintegrated and shows a heavy degree of import dependence. Financing of Industry 2(. At present the Peruvian banking system includes the Central Bank, 6 state-owned development banks in the industrial, mining, agricultural and housing fields, 17 commercial banks, several private financieras and the state-owned Banco de la Nacion, which is the main depository of public funds and controls the reserve requirements of commercial banks. The most important sources of long-term industrial financing are two Government banks. One is the Development Finance Corporation (COFIDE), which is the Government's principal development finance institution, assisting not only state enter- prises but also private and other types of firms operating in Peru. The other is the Industrial Bank of Peru (BIP), which lends mainly to small and medium sized private firms, providing them with both short-term working capital loans and longer-term investment financing. The commercial banks are the main institutional source of short- and medium-term industrial finance in Peru, providing local currency loans and arranging foreign credit.  -8- Industrial Policies 21. Following the change of Government in 1968, Peru's industrial policies have been focused on linking production and economic growth with broader participation of the population in the country's economic, social and political life and on1 redressing what was considered to be excessive concen- tration on consumer goods production. In an effort to achieve these object- ives, the state assumed an active role in the economic management and a number of foreign-owned industries in strategic sectors were nationalized. 22. To refonr the dlistribution of wealth and income, the Government also embarked on a fundamental transformation of the economy's ownership and management structure by instituting employees' participation schemes in owner- ship, profits and management. These new arrangements have been of two types. One, called "reformed private" sector, involves the transfer of a specified portion of the annual profits of all private industrial enterprises above a prescribed minimum size (those with gross annual incomes of more than S/.25 million) to their workers in the form of shares until they acquire 50 percent of the firm's capital, and a corresponding number of seats on the Board. In addition, the workers receive 10 percent of profits in cash. The Indus- trial Community Law which established this sector is now being revised to limit distribution of profits to one-third of the share capital of the enter- prise in the form of special shares which would still allow for representation at the Board but would leave control of the enterprise to the common stock- holders. The other innovation was the Social Property sector, constituting the establishment of enterprises owned by workers as distinct from state or private ownership. Under this arrangement the workers control most of the operating, marketing and financial decisions through their elected repre- sentatives. In creating Social Property enterprises priority will be given to labor intensive industries, particularly in rural areas, in an effort to combat unemployment. Thus far only a few Social Property enterprises have begun operations but about 60 are being formed. 23. In order to foster inclustrial development within its overall reform objectives the Government has been giving high priority to selected categories of industries considered basic for the integrated development of the economy, mainly in the public sector, and to projects promoting geographical decen- tralization of development. The Government also established a complex indus- trial policy framework involving fiscal incentives, import restrictions, concessional financing terms and other subsidy measures. Spurred by these incentives and a growing domestic demand resulting from income redistribution policies, industrial outputt increased rapidly in recent years and the value added by the industrial sector grew at an annual real rate of 8.6 percent during 1968/74. 24. While total investment has been increasing in recent years, private investment has been largely confined to the reinvestment of profits because of uncertainty regarding the Government's posture toward the private sector. Recent policy statements by President Morales Bermudez have emphasized the role of the private sector in Peru's economic development. In addition, the  - 9 - President has announced that the Government will dispose of some of the enter- prises it now owns. The first such measure, decreed on July 20, 1976, provides for the return to the private sector of the anchovy fishing fleet which was nationalized three years ago. In addition offshore and eastern jungle areas, which had been reserved for development by the national petroleum company, PETROPERU, have again been opened up to private foreign companies to prospect for and exploit petroleum. The Government is also now stressing that social property enterprises are not to substitute for but to complement other forms of ownership. 25. The Government has also recognized the need to revise its basic strategy for the development of Peruvian industry, particularly since, in- stead of increasing its integration and independence as hoped for, the manu- facturing sector has been becoming excessively dependent on imports and thus on other sectors of the economy to finance its foreign exchange needs, there- by aggravating Peru's balance of payments situation. Governmental authorities concerned with industrial policy understand the need to replace gradually the present rigid priority and incentive system with a consistent and flexible industrial strategy to take full advantage of Peru's comparative advantages. Consequently, they also increasingly appreciate the importance of economic evaluation of projects to ensure efficient resource allocation. As explained below, the proposed loan would help in this regard through the application of economic efficiency tests designed to select projects for financing which utilize the country's resources effectively. PART IV - THE PROJECT Background 26. The proposed loan to COFIDE would be the Bank's first DFC-type operation in Peru and would help finance the foreign exchange component of a wide range of manufacturing projects, as well as others in the mineral, agricultural processing and tourism fields. The project was initially appraised in October 1974 and was reappraised in March and December 1975. Negotiations were held in Washington, D.C. on November 15-19, 1976, with the COFIDE delegation composed of Messrs. Seiner, Romero and Trovarelli and the Government represented by Mr. Montoya. The Appraisal Report (No. 1195-PE dated December 7, 1976) is being circulated separately to the Executive Directors. A loan and Project Summary is attached as Annex III. Project Objectives 27. The project's main objectives are to: (1) finance high-priority investment projects. In order to help over- come Peru's present balance of payments constraint financing would be provided for an expected 35-50 projects to expand exports and substitute efficiently for imports.  - 10 - (2) strengthen COFIDE's effectiveness. Through a direct lending relation with COFIDE, we expect to strengthen COFIDE's overall effectiveness as a development Bank. In this connection particular attention would be given to supplementing the tests presently utilized by COFIDE in evaluating projects by economic analysis in order to improve COFIDE's resource allocation ability. Although economic tests would be mandatory only for projects financed from the loan, it is expected that they will be used more widely within COFIDE and for reviewing the investment plans of other entities, once their usefulness has been demonstrated. Funds will be made available under the project for train- ing in techniques of project appraisal. The Borrower and Project Management 28. In addition to carrying out the usual lending functions of a DFC, COFIDE has a heavy but not yet fully defined responsibility for state enter- prises. By law it holds the shares of several major public enterprises, but a final decision is yet to be made whether this will continue to be done on behalf of Government or whether COFIDE will assume the character of a conglom- erate with both ownership and financial responsibility for them. In this situation of considerable uncertainty regarding both COFIDE's future role and the magnitude of its financial risks, an arrangement has been worked out to segregate the proceeds of the loan from COFIDE's other operations and to obtain from Government an explicit assurance of financial backing for COFIDE (Section 2.02 of the Guarantee Agreement). The loan proceeds, together with the local currency counterpart funds to be provided by COFIDE, would be channelled to sub-borrowers through a separate account (the Fund). The Fund would follow its own policy statement and, since it would be endowed with its own resources, it would operate with a certain degree of financial independence from COFIDE's other operations. A maximum debt:equity ratio of 5:1 would apply to COFIDE and its financial subsidiaries. 29. Loans financed with the Fund's resources would be appraised by COFIDE's regular staff. Personnel would not be assigned specifically to the Fund but COFIDE will be obligated to maintain qualified staff in sufficient numbers to assure adequate appraisal of subprojects. COFIDE has a competent management and an experienced technical staff whose evaluations need to be strengthened mainly by the systematic application of economic criteria. Therefore, COFIDE's normal procedures for processing projects would be ex- panded to include a calculation of the economic impact of each subproject. Subloans would be made on the basis of a detailed evaluation of the technical, management, market, financial and economic aspects of each project and of the creditworthiness of the recipient enterprise. 30. Subprojects would be selected on the basis of their economic effi- ciency and loans would be available to all types of enterprises operating in Peru. However, no more than US$10.5 million (30 percent of the proposed loan amount) could be relent to enterprises in the Social Property sector. This limitation has been established because the Social Property type of enterprise is still in an experimental stage and COFIDE has had little experience with it. For the same reason all subloans to Social Property enterprises would  - 11 - require Bank approval. A "free-limit" of US$500,000 would apply to other subprojects which would ensure Bank review of a sufficient number of subloans. Finally, to avoid excessive concentration in relending Bank funds, a maximum limit of US$4.0 million per subloan and sub-borrower would apply (Section 2.02 of the Loan Agreement). Lending Terms 31. The loan proceeds would be relent from the fund at a fixed rate of interest of no less than 11 percent with the sub-borrowers bearing the foreign exchange risk. COFIDE would receive up to 1.5 percent as an administration fee. The remainder of the spread between the cost of Bank funds and the ultimate relending rate would accrue to the Fund and would be available to finance training programs for project analysts and for techni- cal assistance in promoting and implementing small-scale industries, mainly in the Social Property sector (Sections 3.02 and 3.03 of the Loan Agreement). This component of the project would complement the assistance given to such industries under the recent Sites and Services loan (Loan PE-1283). It would also provide us with valuable experience for a planned loan for small scale industries. 32. Subloan terms are expected to range between 5 and 15 years, includ- ing grace periods ranging from 1 to 3 years. The usual composite amortiza- tion schedule for Bank loans for DFCs would apply. The terminal date for submission of subproject proposals under the loan would be June 30, 1979; the closing date for disbursements June 30, 1981. 33. The interest rate and other terms on the lending of local currency through the Fund would follow COFIDE's general pattern. In line with the recent upward revision of the structure of interest rates in Peru, summarized in paragraphs 6 and 7 above, all of COFIDE's local currency relending rates have recently been raised by 3.5 percent. As a result the bulk of COFIDE's local currency lending is now being made within the range of 11.5-15.5 percent, with the precise rate dependent on the priority of the enterprise involved. The Government intends to keep the general interest rate structure under review, as indicated in paragraph 7 above, and COFIDE is expected to adjust its interest rates whenever necessary to meet conditions in the capital market and to give it a reasonable profit. Specifically, the Government and COFIDE undertake to review periodically with the Bank the adequacy of interest raL:es and progress towards positive real levels of interest. The first such consul- tation will take place no later than one year after signing of the loan (Section 4.07 of the Loan Agreement and Section 3.02 of the Guarantee Agree- ment). Procurement and Disbursement 34. Subloans would cover up to 100 percent of the import component of subprojects. In most cases, they would finance the direct foreign exchange cost of equipment imports -- including goods purchased "off-the-shelf" from  - 12 - domestic distributors, provided c.i.f. prices can be established. Other- wise, 50 percent of the local invoice price would be reimbursed. In the case of projects for industrial construction or tourism, disbursements of Bank funds would be made for 35 percent of documented expenditures (unless a higher foreign exchange component of a specific project can be established). These percentages would be equivalent to the estimated foreign exchange component of eligible projects. COFIDE would satisfy itself that the goods and ser- vices financed are adequate in quality and competitive in price. Project Justification and Risks 35. The project would aid Peru in reducing its balance of payments constraint and generate additional production and employment by financing some 35 to 50 development projects in a wide range of productive subsectors. The guidelines according to which the economic rate of return will be calcu- lated require a special justification for subprojects with a return below 10 percent. Most significantly, it is hoped that the use of systematic economic tests in project decision-making will spread more widely in COFIDE and other government agencies. In summary, the proposed loan would open a direct relationship between the Bank and COFIDE and contribute to strengthening COFIDE's effectiveness as Peru's major development bank, mainly by improving its resource allocation and mobilization capacity, which, in turn should indirectly help to improve Peru's productive sector development planning and investment decision-making process. 36. Great uncertainties currently exist in the industrial sector in Peru because of changing and evolving institutions and policies. However, two special provisions of the loan are designed to insulate the project from the financial risks involved. One is the Fund arrangement, summarized in paragraph 28, containing operational and financial provisions which would protect the project to a certain degree from the effects of a significant change in COFIDE's role. The other is the Government's explicit financial backing which assures that COFIDE will continue to be a financially viable institution even if it is transformed into a holding company for large governmental enterprises. The limited experience with the Social Property concept is taken into account through the requirement that the Bank review all subprojects to Social Property enterprises and through the limit on total lending to them. PART V - LEGAL INSTRUMENTS AND AUTHORITY 37. The draft Loan Agreement between the Bank and COFIDE, the draft Guarantee Agreement between the Republic of Peru and the Bank, the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement and the text of the draft resolution approving the proposed loan are being distributed to the Executive Directors separately.  - 13 - 38. The draft Loan and Guarantee Agreements conform to the normal pattern for loans to development finance companies except for (a) the requirement to establish the Fund through which the proceeds of the loan will be channelled; (b) an undertaking by the Guarantor to provide COFIDE with the flnds necessary for carrying on its operations; and (c) the limitation of the Bank's negative pledge clause--which is required if the Borrower is not the Government--to COFIDE and its financial subsidiaries. Normally, this clause applies to all the subsidiaries of the Borrower and, according to it, the Borrower undertakes not to create a lien on its assets or the assets of its subsidiaries as security for any debt unless it grants an equivalent lien to the Bank. This latter change was introduced in recognition of COFIDE's special role as a holding company for state enterprises. An additional condition of effective- ness would be the establishment of the Fund (Section 6.01 of the Loan Agree- ment). As in previous loans to or to be guaranteed by the Republic of Peru, the Republic of Peru must formally approve the legal instruments therefore by means of a Supreme Decree to be issued after Board approval and before loan signature. 39. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATIONS 40. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments Washington, D.C. December 14, 1976   * I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~W ~~~~~~~~~ ::~~~~~~~~~~~~~~~~~~~~~~I * 2* ii .03~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~t -z CZ i 1 5 0 ~ 0n . -o . ' o a 0 *4 - I S I . I I S S S S ** . S * S S S * .53~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~0. %D o 0 - -- ...020 ...tg CI A.NGI 0- 04/V 000 ......0 0 - . Os~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~W 0 ~~~~~~~~~~~~ a2 Na ' U 5 * 4 0 4 I I N 0 . - N UaN S OhM I S~~~~~~~~~~~~~~~~~~~~~~V 4 .I n ~ - S S~~~~~~~~~~~~~~b AC S iOll053 * 4 4 ONN - -~~~~~~~~~ . a I ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~~~~~~~~0D CMI - 5 .~~~~~~~~~~~~~~~~~~~~az - - C0 'W 01 .....Il 1.3410 .0 00 00/sr-a 0/WI .5/ 0/Os . * .00~~~~~~~~~~~~a a n V ZN o I . N I 0c 0 0a 5 0/3/ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~I0 2I0a0 1 0/C,IA t .45 A..3 N~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~1C S -SO -. Ql'- WI~~~~~~~~~~~~~~~~~~"C -jW 6 C Z0 0 0a SO S0 - o6 S'~~~~~~~~~*~~''I~~~ 1/3. N 0 0j W I 0/NU 05,IL0 W a*1.i NO Os ox SC SN -~~~IJ f JL W ..SU ZN a N0*N n.A 0 -51.. * .3 S/il UN 0.N4 - 4 S~~~~~~~~~~~- -a 3 - = 1 aSt S3 4 5I5L L 1 Z S S a . 4. 1 L IL 16 06 IL.. IL .I dli U M 'A I 0kL "W4 AC' -~ S a05 I 5 U NV0- . 500 ~ 5 00 -s/- 000 000IL00I 00. 0 or 0 0I C ZS 26 I5 SIaMC Z a~ ~ ~ ~ ~~~~~~SA  MOMl ag2of4 pages U.la.. otheroiee noted, data for 1960 refer to acy yea beteen 1959 and 1961. for 1970 betwee 1968 and 1970, and for Most8eat Recet tEoat. beteeen 1971 and 1975. no Spain h-y bon selcted as n objective country b.c.use it. ec-tfi eahi-.ets could nerVe 00 -1oa for Peru PERl .960 L. lEtl.ding Indian jungle pop.lattoc; .b 1960-65 avera.ge; /t 1956-61; /d 3964; /. 1962; If 1960.62; LA 6-1U and 12-16 yeace of age -eepetiv-ly; .Lh Including evening ..hooI.; Li 17 year. and -vr, L 1 Iade only; /k Pereonl Incoe within labor force. 1970 1. 1966; lb Eacluding Indian Jungle popualation; J. 1961-70; Ld Ratio of population uader 15 and 65 and ove to total labor force; /.L Urban only; /f Incladlng eveing scbools; LI 6-11 and 12-17 peac of age re-p-tlely. 791ST RECENT iSTINfTE. /. 1971; lb FgliadinA Indian Jungle population; /L. 1972; I.d 15 yearn and over; L.a irban only; /f 1971-72, /A 1969-71 averag; /h 7-11 and 12-16 yeae- f age -enpetivey. CcI. I /7) 7., Gr.. S-ntiago; lb~ Parrso-l In go-ooent ecocnonly; Li 6-13 and 14-17 yeare of age reupecti-rly. "i.i..c 7; 1., bi4-66; lb b-1l and 12-17 yeses of age respoctively; / insilde only. SPAIN i~79 I. bgiat-rd oeanployoi; lb fegleteed, not all practicing in the -ovtry; Ic 6-10 and 11-16 yearn of age r.epecti-vly. R5, No-nber, 2, 1976 llMF5INTI0NS OF SOCIAL. INDICATORS Lard Area tIhOo lou2) ~~~~~~Ponulatlo ear nuarsing peree - PpoplatIon dvi"ded by .-aber of practIcing Total - Tocal -orfvc~ area conprielog land area and inland vatere. male and fmalne graduate ouree, "trained'1 me certified- noraee, and Agrlc. - M- c recent eetbnace of agricultural ama uaed teomparily orauiliary per.,sal vitb training or es,periemee. p-ve-ociy for crope, p..aruree -Iarat & kitchen gardens or to ILe Pm.alatle enar haeeitl bed - Popaltoaio dirided by monhe of hoapital beda foIl ou. ava~~~~~~~~~~~~~~~ilable in public and private general and apeoLaed hospital and rebabilitation ceotcern ; ...nludee morning hose end eotnblihalote for GCUP pccr pi-a (USO) - GNiP Per c-pit. etloatee at carreet earkte pricea, tue tdie1 and preventive .car. ac.l.ocotd by be. oaam cs-verioe method an World gaol Atlas (1973-75 Per ..pIt. supply of caloriem CX of renuiesects) - Computed from energy boom)., 197.0 1970 and 1975 data, equivalent of met food aupplies available in country per capita per day; available supplies compri.e dow.ti. produetiom, Imports lena eaprte, P.pulation and vital statintics end changes in etank; net nnppliea enclde aniwal feed, sueda, q-ati- Ppoplation