Ecuador - Third Development Finance Companies Project

FILE rCopyDocument of The World Bank FOR OFFICIAL USE ONLY Report No. P-1935a-EC REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF ECUADOR FOR A THIRD DEVELOPMENT BANKING PROJECT December 14, 1976 T This doeument has a restricted distribution and may be med by recipients only In the performance of | their ofkcial duties. Its contents may not otherwise be disclosed without World Bank authoration.  JRUnicY KUIVAIXTS Curremy Unit - 911 (S/.) U$ - 5/. 25 S/A - U40.oh S/.1 ,000 - US$40.0 s/.1,O00,000 - US$40,00000 r,scai Year: January 1 to December 31  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 THE REPUBLIC OF ECUADOR FOR A THIRD DEVELOPMENT BANKING PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Ecuador for the equivalent of US$26 million to help finance a Third Development Banking Project. The loan would bear interest at 8.7% per annum and would be repaid in 15 years, including three years of grace, on a schedule reflecting the composite amortization terms of the sub-loans to be made by the participating DFCs. The proceeds of the loan would be channeled through the Central Bank of Ecuador to participating DFCs for the financing of foreign exchange costs of equipment and permanent working capital. Industrial enterprises would receive equity investments, and loans for a term not exceeding 15 years, including a maximumiin of three years' grace, at effective interest rates ranging from 13% to 16%. The Government would bear the foreign exchange risk. PART I - THE ECONOMY 2. A report entitled "'Ecuador: Economic Memorandum" (No. 1033-EC) was distributed to the Executive Directors on February 26, 1976. An economic mission visited Ecuador in August/September 1976 whose findings comprise the basis of the following analysis. Annex I summarizes the main economic and social indicators. 3. With the first shipments of crude oil from the Oriente Region in 1972, Ecuador became a net exporter of oil. This provided the country with additional resources which at least temporarily removed the savings and foreign exchange constraints that had severely impeded Ecuador's growth in the past. However, it has become clear that the country's oil wealth is smaller than previously estimnated. Crude reserves, in addition, are now being extracted faster than they are being replaced. The revised production esti- mates, reflecting a better knowledge of the difficulties involved in the exploitation of Ecuador's oil, indicate that Ecuador is not likely to accumu- late and retain substantial amounts oF foreign exchange reserves in the foreseeable future. 4. Furthermore, there has been a sharp decline in petroleum output since mid-1974 because of marketing difficulties for Ecuadorian crude in export markets and a protracted disagreement between the Government and the foreign concessionaires over the taxation of oil exports. The disappointing performance of the petroleum sector was not expected by the Government which had adopted policies designed to stimulate further growth. It had increased public expenditures, had offered more generous credit programs for agricul- tural and industrial investment and lifted most quantitative import restric- tions. I This document has a restricted distribution and may be used by recipients only in the performance 1 of their oMcil duties. Its contents may not otherwise be diclosed without World Dank authorization.  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 THE REPUBLIC OF ECUADOR FOR A THIRD DEVELOPMENT BANKING PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Ecuador for the equivalent of US$26 million to help finance a Third Development Banking Project. The loan would bear interest at 8.7% per annum and would be repaid in 15 years, including three years of grace, on a schedule reflecting the composite amortization terms of the sub-loans to be made by the participating DFCs. The proceeds of the loan would be channeled through the Central Bank of Ecuador to participating DFCs for the financing of foreign exchange costs of equipment and permanent working capital. Industrial enterprises would receive equity investments, and loans for a term not exceeding 15 years, including a maximumiin of three years' grace, at effective interest rates ranging from 13% to 16%. The Government would bear the foreign exchange risk. PART I - THE ECONOMY 2. A report entitled "'Ecuador: Economic Memorandum" (No. 1033-EC) was distributed to the Executive Directors on February 26, 1976. An economic mission visited Ecuador in August/September 1976 whose findings comprise the basis of the following analysis. Annex I summarizes the main economic and social indicators. 3. With the first shipments of crude oil from the Oriente Region in 1972, Ecuador became a net exporter of oil. This provided the country with additional resources which at least temporarily removed the savings and foreign exchange constraints that had severely impeded Ecuador's growth in the past. However, it has become clear that the country's oil wealth is smaller than previously estimnated. Crude reserves, in addition, are now being extracted faster than they are being replaced. The revised production esti- mates, reflecting a better knowledge of the difficulties involved in the exploitation of Ecuador's oil, indicate that Ecuador is not likely to accumu- late and retain substantial amounts oF foreign exchange reserves in the foreseeable future. 4. Furthermore, there has been a sharp decline in petroleum output since mid-1974 because of marketing difficulties for Ecuadorian crude in export markets and a protracted disagreement between the Government and the foreign concessionaires over the taxation of oil exports. The disappointing performance of the petroleum sector was not expected by the Government which had adopted policies designed to stimulate further growth. It had increased public expenditures, had offered more generous credit programs for agricul- tural and industrial investment and lifted most quantitative import restric- tions. I This document has a restricted distribution and may be used by recipients only in the performance 1 of their oMcil duties. Its contents may not otherwise be diclosed without World Dank authorization.  - 3 - process of negotiating its proposed withdrawal from the consortium. The State Petroleum Corporation cannot be expected to direct and finance the required further development driLling, the creation of production and secondary recovery facilities, the connection of different oiL fields to the trans-Andean pipeline, etc. The continued expansion of petroleum production and Ecuador's balance-of- payments prospects depend largely, therefore, on the decisions now confronting the Government on its policy towards foreign oil enterprises. 10. In view of these uncertainties, the Government has sought to make efficient use of its oil revenues. It has made substantial public invest- ments in highways. Investments in electric power and petroleum (mainly the Esmeraldas oil refinery) have been prominent as well, with smaller shares for agriculture and education. In total, the real annual growth of public invest- ment reached 33% between 1972 and 1975. Public investment further rose from 8.5% of GDP in 1975 to 9.4% in 1976. 11. Efforts have been made to improve the investment capacity of the public sector. Partly as a result of the work of the National Preinvest- ment Fund created in 1973, project preparation has been progressing reasonably well although somewhat unevenly. The number of prefeasibility and feasibility studies of development projects has increased sharply. In an attempt to further improve its public investment machinery, the Government recently announced the plan to establish a development bank--financed out: of petroleum revenues--for financing priority public investment projects. It has also declared its intention to step up public investment further over the next five years, partly through mobilizing greater flows of public and private external capital. In this connection, the Bank is now exploring the possibility of organizing a consultative group for Ecuador. 12. One of the major tests of the success of Ecuador's development effort will be in the agricultural sector. It is apparent that, only by ex- panding and raising the productivity of agriculture, can Ecuador create ade- quate employment for its rapidly growing labor force and raise living standards of most of its population. Unfortunately, over much of the past: decade, agri- cultural production has lagged behind the needs of the country, as reflected in the steady rise of food imports. 'Ecuador's biggest need now is to increase land and labor productivity. The Government has reacted positively to these problems. Since 1974, producer prices have been raised, the volume of credit increased, and import duties on agricultural inputs reduced, along with taxes on intermediate and capital goods used in farming. A good start has been made by public works agencies in expanding the system of all-weather feeder roads. Much remains to be done, however. Some of the most important deificiencies require the creation of more effective extension and marketing systems; and the improvement of producer prices. 13. Ecuador's development needs, as well as persistent structural and institutional weaknesses, call for continued external assistance to supplement the reasonably high level of domestic savings. Considerable assistance will  - 3 - process of negotiating its proposed withdrawal from the consortium. The State Petroleum Corporation cannot be expected to direct and finance the required further development driLling, the creation of production and secondary recovery facilities, the connection of different oiL fields to the trans-Andean pipeline, etc. The continued expansion of petroleum production and Ecuador's balance-of- payments prospects depend largely, therefore, on the decisions now confronting the Government on its policy towards foreign oil enterprises. 10. In view of these uncertainties, the Government has sought to make efficient use of its oil revenues. It has made substantial public invest- ments in highways. Investments in electric power and petroleum (mainly the Esmeraldas oil refinery) have been prominent as well, with smaller shares for agriculture and education. In total, the real annual growth of public invest- ment reached 33% between 1972 and 1975. Public investment further rose from 8.5% of GDP in 1975 to 9.4% in 1976. 11. Efforts have been made to improve the investment capacity of the public sector. Partly as a result of the work of the National Preinvest- ment Fund created in 1973, project preparation has been progressing reasonably well although somewhat unevenly. The number of prefeasibility and feasibility studies of development projects has increased sharply. In an attempt to further improve its public investment machinery, the Government recently announced the plan to establish a development bank--financed out: of petroleum revenues--for financing priority public investment projects. It has also declared its intention to step up public investment further over the next five years, partly through mobilizing greater flows of public and private external capital. In this connection, the Bank is now exploring the possibility of organizing a consultative group for Ecuador. 12. One of the major tests of the success of Ecuador's development effort will be in the agricultural sector. It is apparent that, only by ex- panding and raising the productivity of agriculture, can Ecuador create ade- quate employment for its rapidly growing labor force and raise living standards of most of its population. Unfortunately, over much of the past: decade, agri- cultural production has lagged behind the needs of the country, as reflected in the steady rise of food imports. 'Ecuador's biggest need now is to increase land and labor productivity. The Government has reacted positively to these problems. Since 1974, producer prices have been raised, the volume of credit increased, and import duties on agricultural inputs reduced, along with taxes on intermediate and capital goods used in farming. A good start has been made by public works agencies in expanding the system of all-weather feeder roads. Much remains to be done, however. Some of the most important deificiencies require the creation of more effective extension and marketing systems; and the improvement of producer prices. 13. Ecuador's development needs, as well as persistent structural and institutional weaknesses, call for continued external assistance to supplement the reasonably high level of domestic savings. Considerable assistance will  - 5 - production and.,one loan to assist Ecuador in the preparation of rural develop- ment projects. Bank/ID)A assistance for the productive and social sectors have grown to about '44.4% of total lending. 17. Externa-l development financing has also been provided by Il)B and USAII) and, to a lesser extent, by other bilateral sources. External finan- cing by sector and"by source through 1975 is summarized below: IBRD IDA IDB lJSAID (US$ millions, Figures Net of Cancellations) Lending 1954-64 54.0 8.0 35.3 64.2 Lending 1965-75 114.5 28.9 232.6 60.4 Transport 44.0 - 18.0 - Power - 6.8 67.7 3.5 Education 4.0 5.1 4.1 5.3 Health-&,Sanitation 23.2 - 49.3 9.5 Agriculture & Fisheries 15.3 17.0 53.6 12.0 Industry 28.0 - 21.2 8.1 Urban Development - - 14.4 - Other - - 4.2 22.0 168.5 36.9 267.9 124.6 IDB is the largest single lender, having extended most of its loans to Ecuador from the Fund for Special Operations, which has normally carried a 2% interest rate, a 10-year grace period, and repayment terms of up to 40 years. It is likely that IDB will, remain-lthe:major development lender in the immediate future, although.the'-terms-will be less-concessionary than in, the past. USAID loans generally have had=amortization;grace.periods similar to those of IDB, with interest at-.2-3%.. Education, health-and other socially oriented activ- ities, as well as agr.icultural.Tdevelopment,--have-been receiving increasing attention from the external lending agencies in recent years. IDB, USAID and the Bank Group--have: coordinated, their<.efforts in these fields.to assure the most effective use of all available.resofrces. 18. -Bank lending: is aimed at supporting the Government priorities out- lined in Part I above.- This objective will-be-met by emphasizing projects that will help,st.rengthen the institutional framework for development policy --particularly concerning. project,!planning, preparation..and implementation --in agriculture and rural-development, transportation and other high priority activities. The Bank can undertake a major institution-building effort in these fields, which should yield tangible benefits for Ecuador. For the  - 5 - production and.,one loan to assist Ecuador in the preparation of rural develop- ment projects. Bank/ID)A assistance for the productive and social sectors have grown to about '44.4% of total lending. 17. Externa-l development financing has also been provided by Il)B and USAII) and, to a lesser extent, by other bilateral sources. External finan- cing by sector and"by source through 1975 is summarized below: IBRD IDA IDB lJSAID (US$ millions, Figures Net of Cancellations) Lending 1954-64 54.0 8.0 35.3 64.2 Lending 1965-75 114.5 28.9 232.6 60.4 Transport 44.0 - 18.0 - Power - 6.8 67.7 3.5 Education 4.0 5.1 4.1 5.3 Health-&,Sanitation 23.2 - 49.3 9.5 Agriculture & Fisheries 15.3 17.0 53.6 12.0 Industry 28.0 - 21.2 8.1 Urban Development - - 14.4 - Other - - 4.2 22.0 168.5 36.9 267.9 124.6 IDB is the largest single lender, having extended most of its loans to Ecuador from the Fund for Special Operations, which has normally carried a 2% interest rate, a 10-year grace period, and repayment terms of up to 40 years. It is likely that IDB will, remain-lthe:major development lender in the immediate future, although.the'-terms-will be less-concessionary than in, the past. USAID loans generally have had=amortization;grace.periods similar to those of IDB, with interest at-.2-3%.. Education, health-and other socially oriented activ- ities, as well as agr.icultural.Tdevelopment,--have-been receiving increasing attention from the external lending agencies in recent years. IDB, USAID and the Bank Group--have: coordinated, their<.efforts in these fields.to assure the most effective use of all available.resofrces. 18. -Bank lending: is aimed at supporting the Government priorities out- lined in Part I above.- This objective will-be-met by emphasizing projects that will help,st.rengthen the institutional framework for development policy --particularly concerning. project,!planning, preparation..and implementation --in agriculture and rural-development, transportation and other high priority activities. The Bank can undertake a major institution-building effort in these fields, which should yield tangible benefits for Ecuador. For the  -7 - industry to total income, export diversification and employment has so far been limited. The industrial sector accounted for only 15.5% of GDP in 1975 at current prices, 11.5% of total employment and 10% of total exports. This comparatively small contribution is probably attributable to the domestic constraints impeding Ecuadorian industry. 22. Paramount among these constraints are the limited size of the domestic market and the shortage of qualified technical and managerial per- sonnel, as well as the limited competitiveness of Ecuador's non-traditional industriaL exports. The domestic market can be expected to expand along with the general rise of incomes and the improvement of transportation. Manpower limitations pose significant bottlenecks but the Government is making a con- siderable effort in this area, assisted by the US$4 million Bank loan approved in FY75 for vocational training. 23. Among the critical policy issues for future industrial development in Ecuador are the effects of the current tariff and price regulations. The present tariffs, price controls and incentive legislation may be stimulating investment in some inefficient industries. Besides the obvious costs in tax revenues, these policies tend to favor capital-intensive industries. On the other hand, the price ceilings for a number of goods--e.g., sugar, plywood, cement, vegetable oils--have induced or reinforced scarcities of those com- modities. In general, the recent experience in the administration of price policy suggests that a gradual reduction of price controls may be advisable to eliminate these distortions. There is some evidence as well that the system of protection is also fostering imbalances. These matters have been detailed in the aforementioned Sector Report. Based on this report, the Bank has started a dialogue with the Ecuadorian authorities with a view to- wards future improvement of industrial policies. Such improvements will depend in part on the negotiation within the Andean Pact regarding the common external tariff. 24. Yet another major constraint, which is the central factor in the background of the proposed loan, is the scarcity in Ecuador of risk capital and term financing. Commercial banks have traditionally met industry's short-term financing requirements and, to some extent, its medium-term needs, mostly on a roll-over basis. Oil revenues, which helped to increase the Government's financing of gross domestic investment from 1% in 1970 to 28% in 1974, have not made a sizable contribution to industrial finance, since most of these revenues have been channeled to public investment and the agricul- tural sector. Consequently, the long-term needs of Ecuadorian industry have been met primarily through direct external credit, accessible to prime borrowers only. Domestic long-term financing was practically unavailable to industry until two DFCs--Comision de Valores--Corporacion Financiera Nacional (CV-CFN) and Ecuatoriana de Desarrollo, S.A., Compania Financiera (COFIEC)-- started operations in the mid-1960s. At the end of 1975, the combined port- folio of CV-CFN and COFIEC stood at S/.4.2 billion, 7% of which was financed through two Bank loans (Nos. 721EC and 930EC) amounting in the aggregate to US$28 million equivalent. Those funds served to finance a wide variety of industrial projects. The average economic rate of return of the subprojects submitted for approval exceeded 30%. Almost half of the amounts approved  -7 - industry to total income, export diversification and employment has so far been limited. The industrial sector accounted for only 15.5% of GDP in 1975 at current prices, 11.5% of total employment and 10% of total exports. This comparatively small contribution is probably attributable to the domestic constraints impeding Ecuadorian industry. 22. Paramount among these constraints are the limited size of the domestic market and the shortage of qualified technical and managerial per- sonnel, as well as the limited competitiveness of Ecuador's non-traditional industriaL exports. The domestic market can be expected to expand along with the general rise of incomes and the improvement of transportation. Manpower limitations pose significant bottlenecks but the Government is making a con- siderable effort in this area, assisted by the US$4 million Bank loan approved in FY75 for vocational training. 23. Among the critical policy issues for future industrial development in Ecuador are the effects of the current tariff and price regulations. The present tariffs, price controls and incentive legislation may be stimulating investment in some inefficient industries. Besides the obvious costs in tax revenues, these policies tend to favor capital-intensive industries. On the other hand, the price ceilings for a number of goods--e.g., sugar, plywood, cement, vegetable oils--have induced or reinforced scarcities of those com- modities. In general, the recent experience in the administration of price policy suggests that a gradual reduction of price controls may be advisable to eliminate these distortions. There is some evidence as well that the system of protection is also fostering imbalances. These matters have been detailed in the aforementioned Sector Report. Based on this report, the Bank has started a dialogue with the Ecuadorian authorities with a view to- wards future improvement of industrial policies. Such improvements will depend in part on the negotiation within the Andean Pact regarding the common external tariff. 24. Yet another major constraint, which is the central factor in the background of the proposed loan, is the scarcity in Ecuador of risk capital and term financing. Commercial banks have traditionally met industry's short-term financing requirements and, to some extent, its medium-term needs, mostly on a roll-over basis. Oil revenues, which helped to increase the Government's financing of gross domestic investment from 1% in 1970 to 28% in 1974, have not made a sizable contribution to industrial finance, since most of these revenues have been channeled to public investment and the agricul- tural sector. Consequently, the long-term needs of Ecuadorian industry have been met primarily through direct external credit, accessible to prime borrowers only. Domestic long-term financing was practically unavailable to industry until two DFCs--Comision de Valores--Corporacion Financiera Nacional (CV-CFN) and Ecuatoriana de Desarrollo, S.A., Compania Financiera (COFIEC)-- started operations in the mid-1960s. At the end of 1975, the combined port- folio of CV-CFN and COFIEC stood at S/.4.2 billion, 7% of which was financed through two Bank loans (Nos. 721EC and 930EC) amounting in the aggregate to US$28 million equivalent. Those funds served to finance a wide variety of industrial projects. The average economic rate of return of the subprojects submitted for approval exceeded 30%. Almost half of the amounts approved  - 9 - PART IV - THE PROJECT 27. The proposed project would be the Bank's third operation in the industrial finance sub-sector of Ecuador. The appraisal was conducted in April-May 1976. Negotiations were held in Washington from November 19 to 24, 1976. At that time, the Republic of Ecuador was represented by Mr. Nieto of the Ministry of Finance; the Central Bank of Ecuador was represented by Mr. Fausto Munoz; Comision de Valores - Corporacion Financiera Nacional (CV-CFN) was represented by Messrs. Dongilio and Estupinan; ancd Ecuatoriana de Desarrollo, S.A. Compania Financiera (COFIEC) was represented by Mr. Correa. An Appraisal Report on the project (1298a-EC) is being circulated separately to the Executive Directors. A summary statement on the proposed project and loan is contained in Annex III to this Report. General Description 28. The proposed project would consist of the provision, through partici- pating DFCs, of equity capital and term financing to industrial companies for the development of productive facilities and resources in Ecuador. 29. In line with the strategy outlined in paragraph 18 above, the purpose of the proposed project and loan would be twofold. First, to support improvements in Ecuador's industrial sector, particularly regarding the financing of industrial growth. The measures recently enacted by the Govern- ment with regard to the interest rate structure (see paragraph 25 above) are a promising start and may be complemented with further measures which might be identified as appropriate through the capital market studies being planned (see paragraph 47 below). Second, to finance about 12.6% of the estimated foreign exchange requirements of the two major participating DFCs during the period 1976-80. Relending Terms 30. The institutional arrangements adopted for the previous two loans would be retained for the proposed project. The proceeds of the proposed loan would be entrusted to the Central Bank of Ecuador which, acting as the Government's fiscal agent, would relend those proceeds to the DFCs parti- cipating in the project. The Government would assume the foreign exchange risk. In addition to the interest on the proposed Bank loan, the Central Bank would charge participating DFCs a variable fee of 1.75-2% on their respective loans' outstanding balances. This fee would compensate the Central Bank for the foreign exchange risk coverage and the administrative costs it would incur (see Sections 4.01 and 4.02 of the draft Loan Agreement and Section 2.02 of the CV-CFN and COFIEC draft Project Agreements). The ultimate users would borrow from the participating DFCs at an annual interest rate of 12% on outstanding balances. In addition, they will pay a commission in accordance with the recently enacted regulations (see paragraph 25 above). Commissions charged would be at a rate ranging between the maxima allowed under the regulations and one percentage point below such maxima. (See Section 3.02(b)  - 9 - PART IV - THE PROJECT 27. The proposed project would be the Bank's third operation in the industrial finance sub-sector of Ecuador. The appraisal was conducted in April-May 1976. Negotiations were held in Washington from November 19 to 24, 1976. At that time, the Republic of Ecuador was represented by Mr. Nieto of the Ministry of Finance; the Central Bank of Ecuador was represented by Mr. Fausto Munoz; Comision de Valores - Corporacion Financiera Nacional (CV-CFN) was represented by Messrs. Dongilio and Estupinan; ancd Ecuatoriana de Desarrollo, S.A. Compania Financiera (COFIEC) was represented by Mr. Correa. An Appraisal Report on the project (1298a-EC) is being circulated separately to the Executive Directors. A summary statement on the proposed project and loan is contained in Annex III to this Report. General Description 28. The proposed project would consist of the provision, through partici- pating DFCs, of equity capital and term financing to industrial companies for the development of productive facilities and resources in Ecuador. 29. In line with the strategy outlined in paragraph 18 above, the purpose of the proposed project and loan would be twofold. First, to support improvements in Ecuador's industrial sector, particularly regarding the financing of industrial growth. The measures recently enacted by the Govern- ment with regard to the interest rate structure (see paragraph 25 above) are a promising start and may be complemented with further measures which might be identified as appropriate through the capital market studies being planned (see paragraph 47 below). Second, to finance about 12.6% of the estimated foreign exchange requirements of the two major participating DFCs during the period 1976-80. Relending Terms 30. The institutional arrangements adopted for the previous two loans would be retained for the proposed project. The proceeds of the proposed loan would be entrusted to the Central Bank of Ecuador which, acting as the Government's fiscal agent, would relend those proceeds to the DFCs parti- cipating in the project. The Government would assume the foreign exchange risk. In addition to the interest on the proposed Bank loan, the Central Bank would charge participating DFCs a variable fee of 1.75-2% on their respective loans' outstanding balances. This fee would compensate the Central Bank for the foreign exchange risk coverage and the administrative costs it would incur (see Sections 4.01 and 4.02 of the draft Loan Agreement and Section 2.02 of the CV-CFN and COFIEC draft Project Agreements). The ultimate users would borrow from the participating DFCs at an annual interest rate of 12% on outstanding balances. In addition, they will pay a commission in accordance with the recently enacted regulations (see paragraph 25 above). Commissions charged would be at a rate ranging between the maxima allowed under the regulations and one percentage point below such maxima. (See Section 3.02(b)  - 1I - good in-house staff training and competitive pay scales account for this. Operations are conducted from the Quito headquarters and branches in Guayaquil, Cuenca and Manta. 34. CV-CFN is the senior institution of its kind in Ecuador and it has also been active in promoting the organization of COFIEC and other DFCs. So far, it has enjoyed a considerable degree of autonomy from the Government but, although primarily oriented towards the private sector, its operations broadly reflect the social and economic objectives of the Government. During negotia- tions it has been agreed that CV-CFN would furnish to the Bank the economic and financial rates of return (calculated in a manner satisfacEory to the Bank) of any investment project which entails an investment in excess of US$500,000 equivalent. In addition, CV-CFN has agreed to amend, before requesting any disbursements out of the proposed loan, its Statement of Operating Policies and Procedures in a way which would appropriately reflect CV-CFN's export promotion activities, primarily consisting of short-term export financing operations (see Sections 2.04(b) and 2.16 of the draft CV-CFN Plroject Agree- ment). 35. CV-CFN's appraisal and supervision procedures are very good. CV-CFN pays special attention to improvements of those procedures whenever they appear necessary, and it has agreed with the Bank to issue disbursements and supervision manuals satisfactory to the Bank within six months from the signing of the loan agreement (see Section 2.01(b) of the draft CV-CFN Project Agreement). Consequently, it has been agreed that Bank approval of CV-CFN's investment projects would be required only when the Bank funds to be committed would exceed US$1 million equivalent, provided that the total amount of Bank funds lent or invested without Bank approval would not exceed US$8 million equivalent (see Section 2.02(c) of the draft Loan Agreement). 36. On December 31, 1975, CV-CFN's paid-in capital and reserves had reached S/.981.2 million up 77% from its 1972 level. During the same period, CV-CFN's external borrowings outstanding grew by 120% (the Bank, IDB,' CAF, USAID and KfW have provided 30.4% of the increase in assets), while borrowings in the Ecuadorian market grew more than sixfold and financed 42.2% of assets growth, thus constituting its most important financial resource. However, CV-CFN has consistently shown a lQw debt/equity ratio which, at the end of 1975 stood at 2.2:1. CV-CFN plans a considerable expansion which would require a threefold increase in its equity during 1976-80. Since equity contributions depend on overall government investment policy, it would be prudent for CV-CFN to rely more on its unused leverage, should those contri- butions fail to materialize. Consequently, the Bank has agreed to an overall debt/equity ratio of 6:1 (see Section 2.11 of the draft CV-CFN Project Agree- ment). In addition to low leverage, two ,other factors have accounted for CV-CFN's low return on its equity (6.1% during 1968-75), i.e., the low yield of its assecs and inflation, which has been unusually high for Ecuador during 1973-74. The projected expansion of CV-CFN's business would increase its  - 12 - financial expenses and reduce its net income from its past average, 2.3% of assets to 1.5% during 1976-80. However, the larger spread on its operations (see paragraph 25 above) and a higher leverage should enable CV-CFN to increase its return on equity. 37. Although CV-CFN's liquidity has declined, it is still adequate. However, CV-CFN has agreed to establish and apply, within six months from loan signing, an improved budgeting system designed to prevent occasional liquidity constraints (see Section 2.01(b) of the draft CV-CFN Project Agreement). CV-CFN carries the foreign exchange risk on its operations, except when financed by Bank loans, and it has incurred exchange losses of S/.31.6 million in 1974 and S/.20.8 million in 1975. Exchange losses would be treated by CV-CFN as losses for the year within which they were incurred (see Section 2.06(b) of the draft CV-CFN Project Agreement). In accordance with prior agreements with the Bank, which would be retained for this project, the Government has agreed to reimburse CV-CFN the excess of any exchange loss incurred on external borrowings other than Bank loans over the total amount of CV-CFN's net profits and free reserves (see Section 4.07 of the draft Loan Agreement). Total arrears have increased to 4.3% of portfolio, but estimated losses would be covered by existing provisions. Although this change seems mostly due to restrictions on credit imposed during 1975, CV-CFN has agreed to increase its bad-debt provisions to 1.5% of portfolio by December 1978 and maintain that level at all times (see Section 2.01(b) (ii) of the draft CV-CFN Project Agreement). 38. The operations planned by CV-CFN for 1976-80 would involve about S/.13.6 billion (US$544 million equivalent) of industrial financing, 39% of which is expected to be covered by internally generated funds. CV-CFN enjoys a privileged position to place its bonds and plans to finance about 11% of its requirements from this source and 16% from other domestic sources. The balance would be covered by capital increases (9%) and external borrowings (25%). Foreign exchange requirements are estimated at US$137 million equiva- lent, about 43% of which is covered by undisbursed portions of loans already available. Of the resulting gap of US$78 million equivalent, 17% would be financed by the portion of the proposed loan to be allocated to CV-CFN and the balance through a possible loan from IDB and a Euro-dollar bond issue. 39. Most of CV-CFN's lending is concentrated on large projects (10% of its projects absorbed 63.7% of CV-CFN's lending during 1975). Loans maturing beyond 9 years (11 years has been the longest term) have declined from 57% of total lending in 1972 to 26% in 1975 reflecting the trend towards shorter maturities in Ecuador. The geographic distribution between Ecuador's two main economic regions (Sierra and Costa) has been about even, allowing for variations from year to year. About 38% of total lending has been channeled to food, textile and other agro-industries, with another 24% going to non- metallic mineral products. This distribution of funds seems satisfactory but CV-CFN should ensure that its lending is adequately spread among a larger number of borrowers compatible with CV-CFN's appraisal and supervision cap- abilities. Consequently, CV-CFN has agreed that, unless otherwise agreed by  - 12 - financial expenses and reduce its net income from its past average, 2.3% of assets to 1.5% during 1976-80. However, the larger spread on its operations (see paragraph 25 above) and a higher leverage should enable CV-CFN to increase its return on equity. 37. Although CV-CFN's liquidity has declined, it is still adequate. However, CV-CFN has agreed to establish and apply, within six months from loan signing, an improved budgeting system designed to prevent occasional liquidity constraints (see Section 2.01(b) of the draft CV-CFN Project Agreement). CV-CFN carries the foreign exchange risk on its operations, except when financed by Bank loans, and it has incurred exchange losses of S/.31.6 million in 1974 and S/.20.8 million in 1975. Exchange losses would be treated by CV-CFN as losses for the year within which they were incurred (see Section 2.06(b) of the draft CV-CFN Project Agreement). In accordance with prior agreements with the Bank, which would be retained for this project, the Government has agreed to reimburse CV-CFN the excess of any exchange loss incurred on external borrowings other than Bank loans over the total amount of CV-CFN's net profits and free reserves (see Section 4.07 of the draft Loan Agreement). Total arrears have increased to 4.3% of portfolio, but estimated losses would be covered by existing provisions. Although this change seems mostly due to restrictions on credit imposed during 1975, CV-CFN has agreed to increase its bad-debt provisions to 1.5% of portfolio by December 1978 and maintain that level at all times (see Section 2.01(b) (ii) of the draft CV-CFN Project Agreement). 38. The operations planned by CV-CFN for 1976-80 would involve about S/.13.6 billion (US$544 million equivalent) of industrial financing, 39% of which is expected to be covered by internally generated funds. CV-CFN enjoys a privileged position to place its bonds and plans to finance about 11% of its requirements from this source and 16% from other domestic sources. The balance would be covered by capital increases (9%) and external borrowings (25%). Foreign exchange requirements are estimated at US$137 million equiva- lent, about 43% of which is covered by undisbursed portions of loans already available. Of the resulting gap of US$78 million equivalent, 17% would be financed by the portion of the proposed loan to be allocated to CV-CFN and the balance through a possible loan from IDB and a Euro-dollar bond issue. 39. Most of CV-CFN's lending is concentrated on large projects (10% of its projects absorbed 63.7% of CV-CFN's lending during 1975). Loans maturing beyond 9 years (11 years has been the longest term) have declined from 57% of total lending in 1972 to 26% in 1975 reflecting the trend towards shorter maturities in Ecuador. The geographic distribution between Ecuador's two main economic regions (Sierra and Costa) has been about even, allowing for variations from year to year. About 38% of total lending has been channeled to food, textile and other agro-industries, with another 24% going to non- metallic mineral products. This distribution of funds seems satisfactory but CV-CFN should ensure that its lending is adequately spread among a larger number of borrowers compatible with CV-CFN's appraisal and supervision cap- abilities. Consequently, CV-CFN has agreed that, unless otherwise agreed by  - 14 - for 68% of COFIEiC's portfolio at the end of 1975. On the other hand, it has to be recognized that a private DFC must remain profitable if it is to grow to meet the increased demand for its services. During 1973-75 COFIEC's return on equity averaged 14.4% annually which, after making allowance for inflation, resulted in a negative return in real terms. Flexible and imaginative management permitted COFIEC to reduce administrative costs and turn to higher yield assets but required a disproportionate growth of short- term liabilities and, ultimately a reduction in its development financing role. The measures adopted recently by the Government (see paragraph 25 above) should contribute to arrest these trends and enable COFIEC to resume its function of primarily providing risk capital and term financing for industry. More specifically, the Bank would agree to COFTEC's increasing its debt/equity ratio (a) initially, from 7:1 to 8:1; and (b) in steps, from 8:1 to 10:1 in a manner and at times to be agreed with the Bank on the basis of the Bank's assessment of COFIEC's portfolio composition and quality, resource composition and appraisal and supervision capabilities and perfor- mance (see Sections 2.11 and 2.12 of the draft COFIEC Project Agreement). Moreover, new accounting procedures, satisfactory to the Bank, are to be established and maintained by COFIEC which will disclose at all times the amount of letters of credit which, upon liquidation, were converted into COFIEC's debt. In this regard, refinanced letters of credit would be subject to the debt/equity limitation. 43. COFIEC's arrears increased from 3.6% of portfolio in 1974 to 5.2% in 1975 reflecting primarily the tighter credit policy adopted by the Central Bank during the second half of 1975. Although COFIEC's auditors were of the opinion that bad debt provisions at end 1975 were adequate (1.8% of port- folio), COFIEC has agreed to increase such provisions net of estimated losses to not less than (.8% of portfolio by December 1978 and to 1% by 1979. For this purpose, COFIEC is expected to continue its program of writing off losses. Moreover, COFIEC has agreed to increase its monthly allocation for bad debt provisions from S/.350,000 to S/.600,000 beginning in January 1977 (see Sections 2.01(b) (ii) and (iii) of the draft COFIEC Project Agreement). COFIEC passes the foreign exchange risk of its borrowings to its clients except for foreign exchange obligations incurred up to February 5, 1971 for which a special reserve was created under the second DFC loan. The Bank agrees with COFIEC's auditors that the current level of such reserve is ade- quate and has received assurances from COFIEC that an adequate reserve will be maintained (see Section 2.06 of the draft COFIEC Project Agreement). 44. During 1972-75 the number of COFIEC's loan approvals has grown tenfold, and the amount lent increase!d almost 42% in real terms. Concentra- tion is not as marked as in CV-CFN (13% of COFIEC's projects absorbed 49% of its lending in 1975), but since COFIEC has maintained the average size of its loans lower than CV-CFN, it has been able to make almost three times more loans than CV-CFN with only 57% of the latter's volume. These figures do not represent,solely, a genuine increase in development financing. Rather they are in part a reflection of COFIEC's marked return to short-term lending. Industries processing agricultural raw materials received 46.8% of COFIEC's  - 14 - for 68% of COFIEiC's portfolio at the end of 1975. On the other hand, it has to be recognized that a private DFC must remain profitable if it is to grow to meet the increased demand for its services. During 1973-75 COFIEC's return on equity averaged 14.4% annually which, after making allowance for inflation, resulted in a negative return in real terms. Flexible and imaginative management permitted COFIEC to reduce administrative costs and turn to higher yield assets but required a disproportionate growth of short- term liabilities and, ultimately a reduction in its development financing role. The measures adopted recently by the Government (see paragraph 25 above) should contribute to arrest these trends and enable COFIEC to resume its function of primarily providing risk capital and term financing for industry. More specifically, the Bank would agree to COFTEC's increasing its debt/equity ratio (a) initially, from 7:1 to 8:1; and (b) in steps, from 8:1 to 10:1 in a manner and at times to be agreed with the Bank on the basis of the Bank's assessment of COFIEC's portfolio composition and quality, resource composition and appraisal and supervision capabilities and perfor- mance (see Sections 2.11 and 2.12 of the draft COFIEC Project Agreement). Moreover, new accounting procedures, satisfactory to the Bank, are to be established and maintained by COFIEC which will disclose at all times the amount of letters of credit which, upon liquidation, were converted into COFIEC's debt. In this regard, refinanced letters of credit would be subject to the debt/equity limitation. 43. COFIEC's arrears increased from 3.6% of portfolio in 1974 to 5.2% in 1975 reflecting primarily the tighter credit policy adopted by the Central Bank during the second half of 1975. Although COFIEC's auditors were of the opinion that bad debt provisions at end 1975 were adequate (1.8% of port- folio), COFIEC has agreed to increase such provisions net of estimated losses to not less than (.8% of portfolio by December 1978 and to 1% by 1979. For this purpose, COFIEC is expected to continue its program of writing off losses. Moreover, COFIEC has agreed to increase its monthly allocation for bad debt provisions from S/.350,000 to S/.600,000 beginning in January 1977 (see Sections 2.01(b) (ii) and (iii) of the draft COFIEC Project Agreement). COFIEC passes the foreign exchange risk of its borrowings to its clients except for foreign exchange obligations incurred up to February 5, 1971 for which a special reserve was created under the second DFC loan. The Bank agrees with COFIEC's auditors that the current level of such reserve is ade- quate and has received assurances from COFIEC that an adequate reserve will be maintained (see Section 2.06 of the draft COFIEC Project Agreement). 44. During 1972-75 the number of COFIEC's loan approvals has grown tenfold, and the amount lent increase!d almost 42% in real terms. Concentra- tion is not as marked as in CV-CFN (13% of COFIEC's projects absorbed 49% of its lending in 1975), but since COFIEC has maintained the average size of its loans lower than CV-CFN, it has been able to make almost three times more loans than CV-CFN with only 57% of the latter's volume. These figures do not represent,solely, a genuine increase in development financing. Rather they are in part a reflection of COFIEC's marked return to short-term lending. Industries processing agricultural raw materials received 46.8% of COFIEC's  - 14 - for 68% of COFIEiC's portfolio at the end of 1975. On the other hand, it has to be recognized that a private DFC must remain profitable if it is to grow to meet the increased demand for its services. During 1973-75 COFIEC's return on equity averaged 14.4% annually which, after making allowance for inflation, resulted in a negative return in real terms. Flexible and imaginative management permitted COFIEC to reduce administrative costs and turn to higher yield assets but required a disproportionate growth of short- term liabilities and, ultimately a reduction in its development financing role. The measures adopted recently by the Government (see paragraph 25 above) should contribute to arrest these trends and enable COFIEC to resume its function of primarily providing risk capital and term financing for industry. More specifically, the Bank would agree to COFTEC's increasing its debt/equity ratio (a) initially, from 7:1 to 8:1; and (b) in steps, from 8:1 to 10:1 in a manner and at times to be agreed with the Bank on the basis of the Bank's assessment of COFIEC's portfolio composition and quality, resource composition and appraisal and supervision capabilities and perfor- mance (see Sections 2.11 and 2.12 of the draft COFIEC Project Agreement). Moreover, new accounting procedures, satisfactory to the Bank, are to be established and maintained by COFIEC which will disclose at all times the amount of letters of credit which, upon liquidation, were converted into COFIEC's debt. In this regard, refinanced letters of credit would be subject to the debt/equity limitation. 43. COFIEC's arrears increased from 3.6% of portfolio in 1974 to 5.2% in 1975 reflecting primarily the tighter credit policy adopted by the Central Bank during the second half of 1975. Although COFIEC's auditors were of the opinion that bad debt provisions at end 1975 were adequate (1.8% of port- folio), COFIEC has agreed to increase such provisions net of estimated losses to not less than (.8% of portfolio by December 1978 and to 1% by 1979. For this purpose, COFIEC is expected to continue its program of writing off losses. Moreover, COFIEC has agreed to increase its monthly allocation for bad debt provisions from S/.350,000 to S/.600,000 beginning in January 1977 (see Sections 2.01(b) (ii) and (iii) of the draft COFIEC Project Agreement). COFIEC passes the foreign exchange risk of its borrowings to its clients except for foreign exchange obligations incurred up to February 5, 1971 for which a special reserve was created under the second DFC loan. The Bank agrees with COFIEC's auditors that the current level of such reserve is ade- quate and has received assurances from COFIEC that an adequate reserve will be maintained (see Section 2.06 of the draft COFIEC Project Agreement). 44. During 1972-75 the number of COFIEC's loan approvals has grown tenfold, and the amount lent increase!d almost 42% in real terms. Concentra- tion is not as marked as in CV-CFN (13% of COFIEC's projects absorbed 49% of its lending in 1975), but since COFIEC has maintained the average size of its loans lower than CV-CFN, it has been able to make almost three times more loans than CV-CFN with only 57% of the latter's volume. These figures do not represent,solely, a genuine increase in development financing. Rather they are in part a reflection of COFIEC's marked return to short-term lending. Industries processing agricultural raw materials received 46.8% of COFIEC's  - 17 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 49. The draft Loan Agreement between the Republic of Ecuador and the Bank, the draft Project Agreements between the Bank and, respectively, CV-CFN and COFIEC, the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement, and the text of a draft resolution approving the proposed loan are being distributed to the Executive Directors separateLy. 50. Features of the draft Loan and Project Agreements which are of special interest are referred to in paragraphs 25, 30, 32, 34, 35, 36, 37, 39, 40, 41, 42, 43 and 46 of this Report. They are listed as well in Section III of Annex IV along with the timetable of key events. In addition, the following have been agreed as: (a) conditions of effectiveness (see Sections 7.01 of the draft Loan Agreement): (i) that the Republic of Ecuador shall have entrusted the proceeds of the proposed loan to the Central Bank; and (ii) that the Project and Subsidiary Loan Agreements with either CV-CFN or COFIEC shall have been duly authorized and signed and become effective. (b) conditions of disbursement for CV-CFN and COFIEC (see Section 2.02(b) (iv), (vi) and (vii) of the draft Loan Agreement): (i) that their respective Project and Subsidiary Loan Agree- ments shall have been signed and become effective; and (ii) that their respective Statements of Policies and Proce- dures shall have been amended to reflect, to the extent needed, the agreements reached with the Bank. otherwise, the draft agreements conform to the normal pattern for loans for D)FC projects. 51. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank.  - 17 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 49. The draft Loan Agreement between the Republic of Ecuador and the Bank, the draft Project Agreements between the Bank and, respectively, CV-CFN and COFIEC, the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement, and the text of a draft resolution approving the proposed loan are being distributed to the Executive Directors separateLy. 50. Features of the draft Loan and Project Agreements which are of special interest are referred to in paragraphs 25, 30, 32, 34, 35, 36, 37, 39, 40, 41, 42, 43 and 46 of this Report. They are listed as well in Section III of Annex IV along with the timetable of key events. In addition, the following have been agreed as: (a) conditions of effectiveness (see Sections 7.01 of the draft Loan Agreement): (i) that the Republic of Ecuador shall have entrusted the proceeds of the proposed loan to the Central Bank; and (ii) that the Project and Subsidiary Loan Agreements with either CV-CFN or COFIEC shall have been duly authorized and signed and become effective. (b) conditions of disbursement for CV-CFN and COFIEC (see Section 2.02(b) (iv), (vi) and (vii) of the draft Loan Agreement): (i) that their respective Project and Subsidiary Loan Agree- ments shall have been signed and become effective; and (ii) that their respective Statements of Policies and Proce- dures shall have been amended to reflect, to the extent needed, the agreements reached with the Bank. otherwise, the draft agreements conform to the normal pattern for loans for D)FC projects. 51. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank.  - 17 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 49. The draft Loan Agreement between the Republic of Ecuador and the Bank, the draft Project Agreements between the Bank and, respectively, CV-CFN and COFIEC, the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement, and the text of a draft resolution approving the proposed loan are being distributed to the Executive Directors separateLy. 50. Features of the draft Loan and Project Agreements which are of special interest are referred to in paragraphs 25, 30, 32, 34, 35, 36, 37, 39, 40, 41, 42, 43 and 46 of this Report. They are listed as well in Section III of Annex IV along with the timetable of key events. In addition, the following have been agreed as: (a) conditions of effectiveness (see Sections 7.01 of the draft Loan Agreement): (i) that the Republic of Ecuador shall have entrusted the proceeds of the proposed loan to the Central Bank; and (ii) that the Project and Subsidiary Loan Agreements with either CV-CFN or COFIEC shall have been duly authorized and signed and become effective. (b) conditions of disbursement for CV-CFN and COFIEC (see Section 2.02(b) (iv), (vi) and (vii) of the draft Loan Agreement): (i) that their respective Project and Subsidiary Loan Agree- ments shall have been signed and become effective; and (ii) that their respective Statements of Policies and Proce- dures shall have been amended to reflect, to the extent needed, the agreements reached with the Bank. otherwise, the draft agreements conform to the normal pattern for loans for D)FC projects. 51. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank.  t 1
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t T 2 > 9 2 4 9 t t Z 4 Z '9 4 g z . . . . . . . . . . 4 E 41 9 EL . A Z t 4 A 8 2 t B E 4- 9 t L  ANNEX IV Page 2 of 2 increase its debt/equity limit (paragraph 36); establish an im- proved budgeting system (paragraph 37); increase its bad-debt pro- visions (paragraph 37); and not commit more than US$3 million of the proposed loan to projects proposed by the same enterprise (paragraph 39); 7. COFIEC will implement a reorganization plan (paragraph 40); streng- then its appraisal and supervision staff (paragraph 41); calculate financial and economic rates of return on all subprojects in excess of US$250,000 to be financed under the loan or US$500,000 in other instances (paragraph 41); increase its debt/equity ratio under certain conditions (paragraph 42); and increase its bad-debt provisions (paragraph 43); and 8. Thie Government will carry out capital market studies (paragraph 47).