Colombia - Sixth Development Finance Companies Project

Report No. 901a-CO FILE COPY ColombiaFIEOY Appraisal of the Sixth Development Finance Companies Project January 23, 1976 Project Department Latin America and the Caribbean FOR OFFICIAL USE ONLY International Bank for Reconstruction and Development International Development Association This document has a 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.  CURRENCY EQUIVALENTS 1/ Currency Unit - Colombian Peso (Col$) US$1.0 = Colt33.10 Col$1.0 ' US,$.302 Col$10 million = US$30,200 PRINCIPAL ABBREVIATIONS AND ACRONYMS USED BR Banco de la Republica (Colombia's Central Bank) CAT Certificado de Abono Tributario (Tax Credit Certificate) CDs Certificates of Deposit (Issued by commercial banks) CFP Corporacion Financiera Popular DDC Department of Development Credit of BR IFF Industrial Financing Fund (Fondo Financiero Industrial) IFI Instituto de Fomento Industrial (Industrial Development Institute) PIF Private Investment Fund (Fondo para Inversiones Privadas) PROEXPO The Colombian Export Promotion and Financing Agency Program Development Program and Export Expansion Loan to Colombia Loan (Loan 842-CO, 1972) Special Bank Study of the Development Impact of Past Financiera Study Lending in Colombia - carried out in 1974-1975 (copy distributed with this Report) UPACs Units of Constant Purchasing Power (Indexed Instruments Issued by the Savings and Loan Corporations) 1/ As of January 16, 1976  C 0 L 0 M B I A FOR OFFICIAL USE ONLY APPRAISAL OF SIXTH DEVELOPMENT FINANCE COMPANIES PROJECT TABLE OF CONTENTS Page No. BASIC DATA ON FINANCIERAS SUMMARY AND CONCLUSIONS ................................. i - iii I. INTRODUCTION ............................................ II. THE ECONOMIC SETTING AND INDUSTRIAL DEVELOPMENT. 2 Growth of the Economy .. 2 The Industrial Sector .. 3 Industrial Employment .. 3 Industrial Priorities and the Proposed Loan . . 3 Industrial Outlook ... 6 III. INDUSTRIAL FINANCING AND THE ROLE OF THE FINANCIERAS 6 The Financial System .. 6 Sources of Industrial Finance ................... 7 Need for the Proposed Loan ................. 10 Interest Rates and the Proposed Loan .......... .......... 10 IV. INSTITUTIONAL ARRANGEM1ENTS AND PARTICIPATING INSTITUTIONS 11 A. The Role of Banco de la Republica .11 Division of Responsibilities ,,,, ..... ., 11 BR's Capability for Increased Responsibilities 12 B. The Seven Participating Financieras .13 Ownership, Organization and Procedures .14 Operations and Impact .14 Financial Position and Results .17 Resource Mobilization and Future Requirements 19 C. Participation of Additional Financieras .21 This report is based on the findings of a mission to Colombia in May 1975 by Messrs. Cook, Reich, Santiago, Baranson, Doud and de La Fortelle, of the Bank Group. Messrs. Knotter and Berlin of the Bank Group participated in final mission discussions. This document has a 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.  Table of Contents (continued) Page No. V. THE PROJECT 22 The Lending Program Component ........................... 22 The Technology Component ................................ 23 The Equity Financing Component .......................... 24 Review of Loan Conditions .......................... 24 Participation in the Loan .......................... 25 Approval Limits ...............,. , ........ 25 Loan Repayment .......................................... 26 Disbursement and Procurement ............................ 26 VI. AGREEMENTS REACHED AND RECOMMENDATIONS 26 ANNEXES 1 The Industrial Sector in Colombia 2 Proposed Arrangements for Financing Technological Improvement at the Enterprise Level 3 Colombia's National Code for Renewable Natural Resources and Environmental Protection 4 Prevailing Interest Rates 5 Banco de la Republica - Statement of Operating Policies and Procedures 6 Financial Statements - CF Colombiana 7 Financial Statements - CF del Valle 8 Financial Statements - CF Nacional 9 Financial Statements - CF de Caldas 10 Financial Statements - CF del Norte 11 CF de Occidente and CF de Santander-Recent Performance and Future Prospects 12 Analysis of the Loan Portfolio of the Seven Financieras 13 Financial Ratio Projections of the Seven Financieras 14 Additional Private Financieras that may Qualify for Limited or Full Participation 15 Estimated Schedule of Disbursements 16 Financiera Operations in the Short-term Market 17 Development Strategies of Corporacion Financiera del Valle, S.A.  NE OhbI A APPRAISAL OF SIXTH DSVSLOFNSST FINANCE C(7HPAhlRS PROJ2LT. Sa.i Dsaa et. Pi-naierca COLSMSIANA FALIS NACI7NAL CAIDAS NORTtZ OCCIDENTE SANOTADER CONSOLIDAT8D 7 Aa of December 31. 1974 No. of profeasienal personotl 29 28 16 16 21 8 10 No. of shareholders 207 189 211 238 560 219 104 Shalreholdigae as %. ef total share capital folcsshiao private sector 57.4 72.2 77.1 76.1 46.2 49.9 92.5 Colosbias public sector 0.3 0.4 0.2 6.5 9.9 8.3 7.5 Foreign cootr-lled 0.8 2.0 5.0 -- 1.8 1.8 -- Pbroign 35.3 23.0 14.5 9.9 32.2 40.0 -- IFC 6.2 2.4 3.2 7.5 9.8 -- (is Col$ =illion) l,aoo 1237.1 1169.9 983.2 486.1 513.4 54v,O 73.1 4716.8 67.6 ESpot-i-sp-rt fiosociog 520.3 298.4 95.5 34.6 113.8 25.0 22.2 1109.8 15.9 Equity iovrstseoor 166.4 58.3 164.4 131.0 74.1 38.2 12.4 644.8 9.2 Other oascts 151.6 121.8 69.6 66.6 60.9 25.9 12.7 509.1 7.3 Iotetaasers/Liabilitiie xnd Rosite 2075.4 1648.4 1312.7 718.3 752.2 343.1 120.4 6980.5 100.0 Liabilities sod Emitv SR and sties official sorcos 446.9 354.5 277.8 172.6 122.2 156.3 29.7 1560.0 22.3 IB8D 512.2 352.8 428.0 276.9 293.0 -- -- 1862.9 26.7 Foreigo bhnks 297.6 309.2 93.3 32.8 111.6 19.8 21.4 885.7 12.7 Rbods cod ,rie deposlit 250.2 169.9 126.6 71.0 29.1 73.7 5.4 725.9 10.4 Other 217.3 142.2 52.3 25.8 76.6 25.0 11.9 551.1 7.9 Efqity 351.2 319.8 334.7 139.2 129.7 68.3 52.0 1394.9 20.0 lrcoso irorevent (1974) Total income 324.3 260.9 216.8 108.3 131,1 48.1 19.5 Fine-ciul corst 174.8 152.3 121.1 70.8 75.2 26.8 4.8 Adoiist-atino cooto 29.4 21.6 14.9 13.1 17.2 6.3 4.7 Tases end portfolio peovisiooo 38.9 31.0 22.3 11.5 13.7 3.4 3.5 Tort vofit 81.2 36.0 _ 58.5 12.9 25.0 9.6 6.5 Total debt/equity (itol. guarantees) 5.3 4.2 3.1 4.3 5.3 4.4 1.9 fercntiage i-creas n coral assets 29.4 24.4 13.1 10.5 22.1 17.9 12.4 Net proEit at 7. of -eroge equity 25.6 19.2 18.0 9.7 20.8 15.1 14.1 Ad.imiscreti'e expenses as 7f c average coral coertc 1.6 1.5 1.2 1.9 2.5 2.0 4.1 Estimated Financial Atios As cf L-ec-bnr 31, 1975 2/ Totel debt/eqnity (inol. gueranteoe) 5.5 4.6 3.1 5.0 6.1 5.5 2.7 *len profit as 7. -eorage equity 24.0 19.0 21.3 11.5 18.0 16.6 14.6 ien profit growth 7. 17.0 31.4 25.1 54.0 (2.5) 22.1 27.0 Percentage inc-rass io tnots cete 22.6 27.1 10.5 32.8 32.1 35.5 29.0 V/ hasd on uoaodited interim fitagoi.1 stateenets -cei-ed dorlig 1975.   C O L O M B I A APPRAISAL OF SIXTH DEVELOPMENT FINANCE COMPANIES PROJECT SUMMARY AND CONCLUSIONS i. This report appraises a sixth project to assist private Colombian development finance companies (financieras) in their financing of the import components of investment projects of private productive enterprises - mainly in the industrial sector. The proposed US$80 million Bank loan would fill a major gap in the availability of long-term finance for industry and the project incorporates some novel features designed to support the Government's export expansion and industrial decentralization policies. ii. Since 1966, five Bank loans totalling US$162.5 million have been made to Banco de la Republica (BR), Colombia's central bank, for on-lending to the financieras. The five oldest and largest financieras (Colombiana, Nacional, Valle, Norte and Caldas) participated in all of these loans; two additional financieras, Occidente and Santander, participated in the Fifth Loan. These financieras are now the most important institutional sources of term credit for private industry. Their operations have made an important contribution to the rapid growth of industrial output and employment in recent years. In addition to financing directly about 12% of industrial investment, they have promoted and provided seed capital to new ventures, and fostered efficient resource allocation through their involvement in project preparation, evaluation and implementation. iii. Industry, which now accounts for one-fifth of Colombia's GDP, has been a leading growth sector. The growth of industrial output, averaging 9% to 10% annually since 1967, consistently exceeded GDP growth of 6% to 7% p.a. Employ- ment in manufacturing has increased by 6 to 7% per year. Manufactured goods exports rose from US$58 million in 1968 to US$380 million in 1974 and now provide 25% of foreign exchange earnings; with limited prospects for further efficient import substitution, exports represent an increasingly important factor in the future growth of industrial output and employment. iv. The industrial growth rate slowed to 7% in 1974 and further in 1975 as the Government introduced measures to combat accelerating inflation and weakening balance of payments, and export growth is being affected by the world trade recession. While prospects for Colombia to regain the higher growth rates achieved up till 1973 are reasonably good, an increased rate of industrial investment will be required since capacity utilization overall is already quite high. Due to the depressant effects of inflation on the domestic capital market and on corporate profits, firms may have to rely even more heavily than in the past on the financieras and on overseas sources for longer-term investment funds. The proposed loan will help meet part of this requirement. Preference would be given to efficient projects that would have difficulty in securing finance from alternative sources, and to projects that are in line with the Government's export expansion and industrial decentralization policies. v. The largest component (US$70 million) of the proposed loan would help finance the foreign exchange components of expansions in productive capacity. Financiera clients would, in general, borrow Bank funds at a minimum interest rate of 11-3/4% p.a. in US dollars, with BR covering the foreign exchange risk between the US dollars and the currencies actually disbursed. This interest rate level is designed to encourage the larger firms with good credit ratings  - ii - to look for, and to utilize, other external sources of finance (e.g. overseas commercial banks). However, smaller firms (with total assets less than Col$100 million), and firms undertaking export or industrial decentralization projects would have the option of borrowing in pesos at 25% - 26% p.a. interest, with BR covering the full foreign exchange risk. On current inflation projections, both the dollar and peso interest rates are about equivalent to a 5 to 7% real interest rate, but companies strongly prefer a peso obligation, when available, because it affords lower risk and some tax advantage. To ensure a wide distri- bution of loan proceeds, the aggregate use of Banks funds by any one firm or industrial group would generally be limited to US$4 million, as under the Fifth Loan. However, the circumstances in which exceptions to this limit might be granted would be clarified to reflect the sectoral focus of the proposed loan. vi. In further support of export expansion, a US$5 million component of the proposed loan would be pre-allocated to help finance technology improvement programs by firms wishing to make their products internationally more competitive. Such prograns would typically involve contracted technical assistance for research into new products or production techniques, and hiring of foreign technicians or training Colombian technicians abroad. Lump-sum payments to acquire unrestricted rights to a new production process, and the purchase of laboratory test equipment, could also be financed. Only costs external to the firm would be eligible for financing, and the firm itself would have to finance at least 25% of the total program. Technology subloans would be for a maximum of US$250,000 and borrowers would pay an annual interest rate of 18% p.a. in pesos. vii. The final US$5 million component of the proposed loan would be for use by the financieras to provide minority equity capital to new enterprises established outside the present major industrial centers. Subloans made by BR to a financiera would cover the foreign exchange component of the total investment, up to a maximum of US$500,000 for any one subloan. BR would charge the financieras 17-22% interest, in pesos, depending on the risks, economic merits and development period of the proposed investment. viii. BR would be the borrower, and would relend the loan proceeds primarily to the seven financieras that have participated in previous loans. Participation by additional financieras would be facilitated with the aim of reaching as wide a spectrum of subborrowers as possible and to help strengthen some of the smaller and newer financieras. As under the Fifth Loan, BR would be responsible for supervising Occidente and Santander and any new participants. In addition, BR would assume greater responsibility for reviewing and approving financiera investment proposals. In general, only the exceptionally large projects (those requiring more than US$1.5 million of Bank funds) would require prior approval by the Bank. With some further training,BR's staff in the Department of Development Credit (DDC) should be capable of discharging these increased responsibilities. ix. The five older financieras are now experienced and mature financial institutions with capable managements and competent appraisal staffs. They are in sound financial condition, although Caldas' financial position remains relatively weak due to the uncertain prospects of several companies in which it has made equity investments. These financieras now require comparatively little technical assistance from either the Bank or BR. The Bank will maintain  - iii - a direct relationship with these five financieras, in which IFC is a shareholder, but will concentrate attention on the broader aspects of their resource mobil- ization and overall development impact. x. Occidente and Santander are also financially sound and well managed. They have benefitted from BR supervision. Although adequate, the quality of their appraisal work and project supervision is relatively weak compared with the older financieras. BR will continue to assist them to strengthen their capabilities, particularly by reviewing in detail their investment proposals. On balance, they are both creditworthy and suitable participants in the new Bank loan. xi. Based on the financieras' extensive project pipelines and their financial projections, the proposed loan would be fully committed by mid-1978. To maintain comparable levels of fixed asset and working capital lending, as in the past, the financieras will need to mobilize substantial amounts of local resources during the commitment period of the loan, particularly through recently authorized short- term operations. To encourage their efforts, a minimum resource mobilization target was agreed with the financieras during loan negotiations. xii. In view of the size, complexity and novel features of the proposed loan, and uncertainties in the economic outlook, a review of lending conditions and arrangements would be undertaken during the course of the loan. Twelve months after lean signing or when half of the loan proceeds have been committed, if earlier, the Bank would evaluate (1) the appropriateness of interest rates in the light of prevailing trends in domestic and world inflation, (2) the financieras' success in raising domestic resources, (3) BR's performance of its increased responsibilities, and (4) the utilization of the technology and equity financing components of the loan. In the light of this evaluation the Bank would review with the Guarantor and with BR the desirability of revising specific lending or investment policies and procedures under the project, or changing the conditions under which future commitments would be made. xiii. The project's direct and indirect benefits should be substantial. It would provide urgently needed investment financing for a broad cross section of Colombian industry, with preference for export-oriented and industrial decentral- ization projects. A recent special study of 29 subprojects that have received Bank financing in the past, indicated that financieras have assisted sound and worthwhile investments; financial and economic rates of return averaged 18% and 32%, respectively. In addition, the project would contribute to the further strengthening of BR's capability to allocate development funds provided by the Bank and from other domestic and overseas sources. The Executive Directors of the Inter-American Development Bank are actively considering a US$30 million parallel loan to BR, with virtually the same conditions as the Bank loan and based on the Bank's appraisal report. xiv. With the assurances listed in Chapter VI,obtained during negotiations, the project is suitable for a Bank loan of US$80 million for a fixed term of 17 years including a 3 year grace period.   C O L O M B I A APPRAISAL OF SIXTH DEVELOPMENT FINANCE COMPANIES PROJECT I. INTRODUCTION 1.01 Banco de la Republica (BR), Colombia's central bank, has applied for a Sixth Bank Loan to assist private development finance companies (financieras) in their financing of the foreign exchange components of the investment projects of private sector productive enterprises. The proposed US$80 million loan, to be guaranteed by the Republic of Colombia, would be made to BR for relending to (a) the seven financieras who have participated in previous Bank loans (Corpora- ciones Financieras Colombiana, Nacional, del Valle, del Norte, de Caldas, de Occidente and de Santander), and (b) additional financieras that can meet parti- cipation conditions during the loan commitment period. 1.02 Since 1966, five Bank loans totalling US$162.5 million have been made available through the financieras to over 200 enterprises, mostly in the manufacturing industry sector but including mining, agro-industry and tourism enterprises. The financieras also had access, together with other financial intermediaries, to a US$10 million portion of the Development Program and Export Expansion Loan (Loan 842-CO of 1972). By mid-1975, these loans were virtually committed. In January 1975, a US$5.5 million small-scale industry loan was made to Corporation Financiera Popular (CFP), a government-owned development bank, to reach companies with assets below Col$20 million -- a group that received less than 10% of Bank lending via the financieras. 1.03 In addition to filling a gap in the availability of long-term development credit, mainly for industry, the project is designed to achieve several important objectives: (a) to support,through financiera lending,the Government's export expansion and industrial decentralization policies, and improve access to Bank funds by medium-sized and smaller firms; (b) to intensify the financieras' efforts in mobilizing domestic resources, and strengthen the developmental impact of their operations; and (c) to further build up the capacity and increase the effectiveness of BR's Department of Development Credit (DDC) for supervising financieras, reviewing their appraisals of investment projects, and allocating scarce development funds efficiently. 1.04 In preparation for the loan, studies of the industrial sector and capital market were carried out in late 1974 and early 1975, and a special study of the development impact of past financiera lending (Special Study) was undertaken in 1974. 1/ This report is based on the findings of these studies and of an appraisal / The findings of the industrial sector and capital market missions were incorporated in the Bank's latest Economic Report on Colombia (Report No. 696-CO of May 20, 1975).  - 2 - mission in May 1975 by Messrs. Cook, Santiago, Reich, Baranson, Doud and de La Fortelle of the Bank Group. Messrs. Knotter and Berlin of the Bank Group participated in final mission discussions. II. THE ECONOMIC SETTING AND INDUSTRIAL DEVELOPMENT Growth of the Economy 2.01 A detailed review of Colombia's economic situation is contained in the Bank's latest economic report "Economic Position and Prospects of Colombia" of May 20, 1975 (Report No. 696-CO). 2.02 During 1974, the Colombian economy registered its seventh successive year of strong economic growth; Gross Domestic Product (GDP) expanded by about 6% in real terms. Since 1967, GDP growth averaging 6.5% annually has been well above the historical average of less than 5% p.a. achieved from 1950-1967. Real per capita GDP has grown by 3.2% annually to reach US$500 in 1974 but remains lower than many other Latin American countries. Faster growth was achieved largely through trade and financial policies aimed at increasing (a) the availability of foreign exchange, through higher exports, and (b) domestic savings and investment, particularly in the urban construction sector. While favorable coffee prices after 1970 had a positive influence on growth, an important factor has been the dramatic rise in minor exports (non-coffee, non-petroleum) from US$97 million in 1966 to US$790 million in 1974 stimulated by fiscal and monetary incentives and the "crawling peg" exchange rate policy, introduced in 1967. Minor exports, almost half of which are manufactured goods, now contribute more than 50% of Colombia's export earnings, and their further rapid expansion is given high priority by the Government. 2.03 Colombia's 1971-1974 Development Plan aimed at accelerating economic growth by concentrating on four broad and inter-related strategies: housing and urban development, higher agricultural productivity, export promotion, and more equal income distribution. The plan placed emphasis on expanding urban employment quickly by increasing residential and commercial construction, thereby increasing demand for agricultural and industrial products of mass popular consumption. A savings and loan system was established, using monetary correction for deposits and loans, to stimulate the flow of funds into urban construction. Although the broad aims of the plan were met, rapid economic growth was accompanied by certain adverse trends during 1973 and 1974; high and accelerating inflation, deterioration in public finances and lower public investment, loss of self-sufficiency in petroleum production and weakening balance of payments performance. The compre- hensive package of fiscal and monetary reforms introduced by the new Government in August 1974 is now helping to stabilize the situation. By mid-1975, inflation was beginning to decline 1/ and fiscal revenues were substantially increased. However, economic growth in 1975 is unlikely to be more than marginally positive. The balance of payments outlook has improved somewhat with the recent increases in coffee prices, but the growth of minor exports is being affected by the world trade recession and petroleum imports are becoming a burden. The challenge facing Colombia is to return the economy to the higher growth rates achieved in recent years while controlling inflation and preserving a favorable external liquidity position. 1/ The consumer price index for blue collar workers, which increased by 22% in 1973 and 25% in 1974, is estimated to have increased by about 2O/Z during 1975.  -3- The Industrial Sector 2.04 Manufacturing industry, which contributes about one-fifth of Colombia's GDP, is a leading growth sector. 1/ Between 1967 and 1974, manufacturing output grew by 9 to 10 percent annually, a level unmatched since the 1950s. Industrial exports rose from an insignificant level in 1967 to US$380 million in 1974, representing over 7% of industrial output, and made an important contribution to industrial growth. This export expansion has been characterized by a remarkable diversification in the range of goods exported and continued geographical diversification of trade partners. Exports to Latin America, and particularly to Andean Pact countries, have increased very rapidly. 2.05 The five largest industrial branches-are textiles, beverages, food products, chemicals and non-metallic minerals, which together account for more than 60% of value added in manufacturing. The most rapid growth has taken place in textiles with production doubling within 5 years. Intermediate goods such as paper, oil products, non-metallic minerals (particularly cement) and basic metals have also grown rapidly. Colombia has now achieved a substantial degree of import independence, with manufactured imports accounting for about 20% of domestic consumption. Almost all consumer goods and 80% of intermediate goods are supplied domestically, but about half of capital goods requirements are still imported. With further efficient import substitution opportunities becoming progressively more difficult to find, exports will be increasingly important in the future expansion of industrial output and employment. Industrial Employment 2.06 Rapid population growth (3% annually) and rural migration have resulted in continuing high unemployment in urban areas. The recent more rapid industrial growth has made an important contribution towards alleviating this problem. Employment in manufacturing has grown at 6 to 7 percent annually since 1968, considerably faster than the rates of 3.5% p.a. characteristic of the 1953-63 period, and of 1.6% p.a. for the period 1963-68. Faster growth was largely the result of rapidly growing employment in non-durable consumer goods industries, particularly in the export sector. Cost of labor is low in Colombia in comparison with other Latin American countries. 2/ Minimum wages have not increased significantly in real terms since 1967, although social benefits have been progressively increased and now amount to over 40% of total labor costs. Overall wages and salaries in the manufacturing sector have remained approximately constant as a percentage of value added, but real remuneration per employee has declined slightly. The low cost and comparatively highly skilled labor force provides an important comparative advantage to Colombia that has contributed to recent export performance. Industrial Priorities and the Proposed Loan 2.07 Maintaining a high rate of industrial growth has high priority in the development strategy of the new Government, although attention is currently focused on controlling inflation. While the Government is still in the process 1/ A Bank survey of the manufacturing sector in Colombia was undertaken in late 1974, the findings of which are summarized in Annex 1.1 2/ Wages in many export industries are about US$1.50 per day which is substan- tially lower than in Mexico and the Dominican Republic and comparable to Haiti.  - 4 - of elaborating its medium-term industrial development policies, it has indicated that primary emphasis is to be placed on expanding and diversifying exports, and on promoting the development of industry outside the present major industrial concentrations. Several features have been incorporated in the proposed project that are designed to help the financieras support these objectives through their financing activities. 2.08 Export expansion. With a well-developed industrial sector, a dynamic and experienced enterpreneurial base, and low labor costs, Colombia is well placed to benefit from the development of the Andean Common Market and to expand exports to the rest of the world. However, future success will depend on the stimulation of greater industrial efficiency and on the provision of effective incentives to encourage import substituting firms to tackle export markets. Colombian industry developed on the basis of import substitution and, despite recent export growth, 93% of production is consumed in the domestic market. Overall, the protection system, based on tariffs and import licensing,l/ has not been excessively restrictive, and several industrial branches are competitive in international terms. However, nominal protection, averaging 30-35%, is highly differentiated between categories of goods, and some enjoy very high effective protection (e.g. automotive goods and electrical machinery). Some gradual reduction of protection has been achieved in recent years but the Govern- mentrecognizes that some further reduction and rationalization could be a useful stimulus to industrial efficiency. However, future changes are complicated by the on-going tariff negotiations among the Andean Pact countries. In these negotiations, Colombia has been arguing for moderate levels of effective protect- ion and reasonable uniformity between categories of goods. 2.09 To compete successfully in export markets, many import substituting firms may have to progressively upgrade their products and production technology. Firms enjoying relatively high protection in the domestic market often lag behind in production techniques and product quality, rely heavily on imported inputs, or depend on expensive and often restrictive agreements with foreign licensors or suppliers for technological support. To complement reductions in protection, specific programs and measures are needed to encourage and assist firms to raise their level of technical proficiency. To assist in this process, a small proportion of the proposed loan would be reserved to help finance specific technology improvement programs by Colombian firms. (Annex 2 and para. 5.05). 2.10 The system of export incentives established in 1967, which had a major impact on the growth of Colombian exports, 2/ has been modified recently. Direct fiscal subsidies 3/ have been substantially reduced, because of their high budgetary costs, policing difficulties, and some frictions with trading partners. Instead, greater reliance is to be placed on maintaining an appropriate exchange rate and on increasing the volume, of credit, at advantageous terms, that is made 1/ A fuller description of the Colombian system of protection is given in Annex 1, pages 6-9. 2/ A fuller description of the Colombian system of export incentives and of the recent changes is given in Annex 1, pages 10-12. 3/ Since 1967, Tax Credit Certificates (CA]3) have been issued for minor exports. The value of the CAT was equivalent to 15% of the f.o.b. value of exports but since January 1, 1975, the CAT rate has been reduced to 5% for most products and virtually eliminated for the others.  - 5 - available to finance export sales.l/ In addition, exporters are given prefer- ential access to BR's industrial development funds and to foreign borrowings, and they are allowed, as in the past, to import raw materials, intermediate products and capital goods free of duties. However, many industrialists argue that the recent changes have tended to weaken export incentives at a time when world trade conditions are becoming much more difficult. The Government is monitoring the effects of the changes and has expressed its readiness to consider further adjustments if warranted. In recognition of the higher risks associated with competing in export markets, the Government has agreed that BR would assume the foreign exchange risk on Bank financed subprojects that are designed to generate substantial increases in exports, whereas import-substitution projects would, generally, not be granted this concession (para. 3.14). In the light of their experiences following the erratic devaluations of the peso in the 1950s and 1960s and the progressive acceleration of domestic inflation in recent years, industrialists strongly prefer to borrow in local currency whenever possible. Thus, the proposed arrangements would provide an important incentive for firms to develop export projects. 2.11 Industrial decentralization. Colombia is already well urbanized compared with other Latin American countries (70% of the population live in urban areas). However, industry is strongly concentrated in and around the four largest cities, Bogota, Medellin, Cali and Barranquilla, which account for over 80% of industrial employment and output. Rapid population growth and continued migration to these cities creates intractable problems of unemployment and urban poverty and is putting severe pressures on inFrastructure resources. 2/ Industrial pollution is also becoming a more serious problem in the big cities. There are another 15-20 medium-sized cities that hne baoic electricity supply, water and waste disposal facilities'and that are relatively well placed to serve certain internal or external markets. Initial government calculations suggest that the cost of developing these cities as alternative growth poles may be lower than the cost of unrestricted expansion of the large cities. In May 1975, the National Planning Department published a report outlining the government policy of industrial decentralization. Direct or fiscal subsidies to attract industry to the smaller towns are not contemplated. However, the report describes a range of other instruments and incentives the Government is planning to use including:(i) controls over the localization of new direct foreign investment; (ii) increased allocation of public investment in upgrading infra- structure facilities in the smaller cities; (iii) preferential access to official development credit sources for decentralization projects; and (iv) greater emphasis on manpower training and technical assistance for firms located in the smaller cities. Barranquilla, the fourth largest city, is included as a priority industrial developrletit arua because of che high rate of unemployment (about 20%) in the city, but industrial development in the 3 larger cities is to be de-emphasized. To support this policy, two features are incorporated in the proposed project. A US$5 million component would be reserved for on-lending to the financieras, under favorable conditions, to help them make equity invest- ments in new enterprises outside the main industrial centers. In addition, and as in the case of export projects, firms sponsoring decentralization projects would be given the option of borrowing the Bank funds in pesos (paras. 5.02 and 5.04). 1/ The government export promotion and financing agency, PROEXPO, provides working capital and sales financing credits (mostly 180-day loans) to exporters at 18% annual interest using resources derived primarily from a surcharge on imports; recently, this has been raised from 1.5% to 3%. 2/ The population of Bogota is projected to increase from 3