Ecuador - Fourth Highway Project

FILE COPY Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-1792-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 FOURTH HIGHWAY PROJECT March 18, 1976 This document has a restrictedl distribution and may be used by recipients only In the performance of their official duties. Its conteints may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Sucre (S/.) US$1 = S/. 25 s/.I1 = Us$o.o4 s/.1,ooo = Us$40.o S/.l,OOO,OOO = US$40,OOO.00 Fiscal Year: January 1 to December 3.  INTERNATIONLL BANK FOR RECONSTRUCTION AND DEVEWLPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT !W THE EXECUTIVE DIRECTORS ON A PRDPOSED LOAN TO THE REPUBLIC OF ECUADOR -.OR A FOURTH HIGHWAY PROJECT 1. I submit the following report and recomxendation on a proposed loan to the Republic of Ecuador for the equivalent of US$10.5 million to help finance a fourth highway- project. The loan would have a term of 25 years, including five years of grace, with interest at 8-1/2 percent per annum. PART I - THE ECONOMY 2. A report entitled "Ecuador: Economic Memorandum" (No.1033-EC) was distributed to the Executive Directors on February 26, 1976. Annex I suumarizes 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. Oil income rose from $38 million in 1972 to over $420 million in 1974. However, during the last year it has become clear that the country's oil wealth is smaller than previously estimated. One year ago, it was estimated that the country had total -- proven and probable -- oil reserves equivalent to 5.7 billion barrels. Current estimates are of only 2.5 billion barrels, owing to a substantial decline in the calculation of probable exploitable reserves. Moreover, it is now expected that the production levels projected last year for 1976 will not be achieved until the early 1980s. Thec'e revised estimates, together with a better knowledge of the difficalties to be encountered in the exploitation of Ecuador's untapped oil fields, and with the transitory problems faced by the country's oil exports in 1974-75, indicate that Ecuador is not likely to accumulate substantial asounts of foreign exchange reserves in the foreseeable future. 4. 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 disagreemerLt between the Government and the foreign concessionaires over the taxation of oil exports. The total offtake of oil dropped from an average of 232,000 b/d during January-June 1974 to 123,000 b/d during the second half of 19741, and became irregular in 1975, owing to two breaks in the trans- Andean pipeline. For 1975, the average production is estimated at about 165,000 b/d. There has also been a virtual standstill in exploration during the past two years and the level of proven recoverable reserves, estimated at 1.5 billion barrels, has remained unchanged. 5. The disappointing performance of the petroleum sector had not been expected by the Government. Counting on rising petroleum income, the Government had adopted policies designed to stimulate further growth. It increased public expenditures -- including subsidies of essential consumption goods; offered more  - 2 - generous credit programs for agricultural and industrial investment; and lifted most quantitative import restrictions. In 1974, import duties were out by an average of 34 percent. Moreover, imports of agricultural inputs and of essential foodstuffs were fully exempted from duties. 6. The response of the economy to these policies, and to the prevailing very optimistic economic climate was, in general, strong. Gross investment grew by 22 percent in real terms in 1973 and growth of GDP at market prices reached a rate of about 15 percent, far above historical levels. Continuing rapid growth in industry, construction, trade and Government services, made it possible to achieve an overall GDP growth rate of approximately 8 percent in 1974. This was obtained in spite of the significant decline in the oil sector product, and of the virtual stagnation of agricultural production -- which was hampered, until early that year, by the insufficiency of credit availabilities and by the inadequate price policies followed up to then by the Government. 7. The rapid economic expansion was accompanied by inflationary pressures. The cost of living index for low and medium-income families in Quito, which had risen by about 8 percent per annum during 1971 and 1972, increased by 13 percent during 1973 and by over 23 percent during 1974. While the inflationary pressure was largely generated by the rapid rise of public expenditure, the strong expan- sion of credit to the private sector also contributed to the increasing money supply. Domestic supply could not respond in full to the growth in demand, which led to higher imports of wheat, oils and fats, and other products. In construction materials, domestic production did not keep pace with increases in demand. In manufacturing, the process of import substitution of finished goods accelerated, leading to rapidly rising imports of equipment, raw materials and semi-finished products. As a result, total imports of goods and non-factor services rose from about $440 million in 1972 to $515 million in 1973 and over $1.0 billion in 1974. This import growth in part also reflects a rise in import prices of 17 percent in 1973 and 28 percent in 1974. Exports -- also including non-factor services -- expanded from $365 million in 1972 to about $1.1 billion in 1974. Of the increase, about 75 percent was accounted for by petroleum. 8. Despite the growth of imports, Ecuador's balance of payments showed, until mid-1974, a marked improvement. In 1973, Ecuador achieved the first surplus in its resource balance since the early 1950s, and net foreign exchange reserves rose from $128 million at the end of 1972 to $371 million by the end of June 1974. However, these favorable trends could not be maintained after mid-1974. As oil exports declined and total imports continued to rise substantially, Ecuador's reserve position began to deteriorate rapidly. By August 15, 1975, the country's net foreign exchange reserves had fallen to $181 million, equivalent to less than two months' imports. 9. Until 1974, increasing oil revenues brought about a substantial improve- ment of the Government's financial position. For the Central Government /l -- which received about 54 percent and 57 percent of total oil revenues in 1973 and 1974 respectively -- these revenues led to a strong increase in current savings and to an expansion of capital expenditure substantially above the growth of current expenditure. With current savings rising to about $68 million in 1973 and $298 million in 1974, the overall cash position of the Central Government turned from L Including the National Development Fund (FONADE) and the National Partici- pation Fund.  - 3 - a small deficit in 197.3 to a $62 million surplus in 1974, despite a more than threefold increase in capital expenditure in 1974. FONADE, established in late 1973 in an effort to earmark part of the additional oil revenues for the financing of public investment p:rojects over and above budgetary allocations, disbursed about $93 million in 1974. Iost of these disbursements helped finance the construction of the Esmeraldas refinery, and the credit programs of the National Development Bank and other financial institutions. As a result of the decline of oil revenues, current savings decreased by an estimated 20 percent in 1975 despite an improved performance of non-oil taxes. These developments led to a temporary financing gap in the Central Government operations and to the decision to contain the growth of Government expenditure in 1976. 10. A number of recent measures have contained the deterioration of the balance of payments, and foreign exchange reserves are estimated to have totalled about $245 million by the end of 1975. The measures included a reduction of the tax-paid cost of petroleum exports by the equivalent of about US$0.43 per barrel; the concession of higher allowances to oil companies for their production cost; and the introduction of import restrictions in August and September 1975. Oil production has recovered, mainly as a result of the cut-back in the income tax rate on oil exports, and is estimated to have reached over 210,000 b/d towards the end of 1975. 11. On October 2, the Government announced new financial objectives for 1976: to achieve additional increases in foreign exchange reserves and a more balanced budgetary position, which would make it unnecessary for the Government to borrow further from the domestic banking system or from foreign ccommercial banks during 1976. The Government hopes to reduce the annual rate of inflation from some 15 percent in 1975 to about 10 percent in 1976. Further negotiations with the oil companies are expected to open the way to increased exploration and development efforts. 12. Ecuador's oil production is now expected to increase gradually and to reach about 270,000 b/d by 1979-80. An expansion beyond this level appears feasible, provided that a vigorous exploration and development program can be brought underway in the near future. Increasing export earnings from petroleum, coffee, sugar and manufactuired goods, combined with a net inflow of foreign capital in the order of $265 million a year during 1976-80 -- needed largely to finance new gas and oil-related ventures -- should make a substantial improvement of the overall balance of payments situation possible after 1976, and permit a moderate increase in foreign exchange reserves. The extent to which Ecuador's balance of payments situation will actually improve depends largely on the success of immediate stabilization policies, the development of oil production, the behavior of oil prices, and the mobilization of foreign capital. 13. Although the oil sector will continue to be the major source of foreign exchange in the medium term, there are oonsiderable uncertainties with respect to the possible production profile of this sector in the longer run. Most of the oil likely to be produced until the early 1980s has already been found. Unless exploration efforts are substantially stepped up nd new oil fields are discovered, production could decline soon afterwards. To make the most efficient use of oil  - 4 - revenues the Government therefore intends to begin to diversify the production base of the economy by developing agricultural and industrLal activities in which the country has a potential comparative advantage. Exports other than oil need to be developed -- for examples, natural gas, and agricultural and forest resources. An appropriate use of the financial resources provided by oil will also make it possible to alleviate the country's most pressing social needs. However, Ecuador continues to be one of the poorest countries in Latin Amerlca, with an estimated per capita income of $450 in 1974, and a large proportion of the population living at subsistence levels. Oil has only shifted Ecuador from the upper strata of the poorest countries to the lower brackets of the middle income developing countries. 14. Several years ago the Government designed an ambitious development strategy. It is reflected in the 1973-77 Plan Integral de Transformacion y Desarrollo and focuses on (a) promoting the diversification of the economy by fostering agricultural and industrial development; (b) alleviating poverty in the countryside through rural development programs; (c) upgrading social services; (d) expanding infrastructure; and (e) improving the absorptive capacity by over- coming major bottlenecks to development, notably the shortage of qualified manpower and the administrative weakness of the public sector. 15. To pursue these broad objectives, efforts have been made to improve the investment capacity of the public sector. In 1973, a preinvestment fund (FONAPRE) was set up to finance prefeasibility and feasibility studies. Inventories of projects and project ideas were compiled in the entire pub:Lic sector. Also the Government has been able to increase public investment rap:idly. However, progress has been slow in sectoral planning -- particularly in setting investment priorities in some major sectors -- and in the coordination of investments by region. The proposed project would help overcome these shortcomings in the transport sector. 16. Ecuador's development needs, as well as persistent structural and institutional weaknesses, call for continued external assistance. Although the country's creditworthiness has improved greatly, it would not be sound policy for Ecuador to rely on the capital market as the sole source of external finance. Neither the amounts nor the terms available to Ecuador in the market would make this advisable. Rather, a mixture of commercial and official financing will best suit Ecuador's needs during the next few years. 17. E3cuador is creditworthy for further lending on Bank terms. The external public debt outstanding on December 31, 197h was estimated at US$530 miliion, of which US$297 million was disbursed. Service on outstanding public debt is relatively moderate -- about $85 million in 1975, equivaleint to about 8.0 percent of the exports of goods and non-factor services. The debt service ratio is projected to fall to approximately 4 percent in 1979-80. The Bank /IDA share in outstanding and disbursed public debt as of December 31, 1974 was about 19.7 percent; it is expected to rise.  - 5 - PART II - BANK GROUP OPERATIONS IN ECUADOR 18. Starting with the first loan in 1954