Colombia - Second Small-scale Industry Project

FILE COPY Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-2033-CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO DE LA REPUBLICA WITH THE GUARANTEE OF THE REPUBLIC OF COLOMBIA FOR A SECOND SMALL-SCALE INDUSTRY PROJECT May 18, 1977 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 (At the time of appraisal and used in this report) Currency Unit - Colombian Peso (Col$) Col$l - US$0.0282 Col$1,000 - US$28.17 Col$1,000,000 - US$28,169 US$1 - Col$35.50 (As of March 4, 1977) Currency Unit,- Colombian Peso (Col$) Col$l - US$0.0275 Col$1,000 - US$27.49 Col$1,000,000 - US$27,495 US$1 - Col$36.37 WEIGHTS AND MEASURES Metric System GLOSSARY OF ABBREVIATIONS (see next page) BANCO DE LA REPUBLICA'S FISCAL YEAR January 1 to December 31  FOR OFFICIAL USE ONLY ACRONYMS ACOPI - Asociacion Colombiana Popular de Industriales (Colombian Association of Small Manufacturers) AID - Agency for International Development BR - Banco de la Republica (Colombia's Central Bank) CAJA - Caja de Credito Agrario Industrial y Minero (Agricultural, Industrial and Mining Bank) CFP - Corporacion Financiera Popular DANE - Departamento Nacional de Estadistica (National Department of Statistics) DFC - Development Finance Company FICITEC - Fundacion para el Fomento de la Investigacion Cientifica y Tecnologica (Foundation for the Development of Scientific and Technological Research) FFI - Fondo Financiero Industrial (Industrial Financing Fund) IFI - Instituto de Fomento Industrial (Industrial Development Institute) IIT - Instituto de Investigaciones Tecnologicas (Institute of Technological Research) KFW - German Kreditanstalt fur Wiederaufbau PROEXPO - Fondo de Promocion de Exportaciones (Export Promotion Fund) SENA - Servicio Nacional de Aprendizaje (National Vocational Training Organization) SMI - Small- and Medium-Scale Industry SSI - Small-Scale Industry UNIDO - United Nations Industrial Development Organization 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 discloed without World Bank authorization.   Page 1 of 2 COLOMBIA SECOND SMALL-SCALE INDUSTRY PROJECT LOAN AND PROJECT SUMMARY Borrower: Banco de la Republica (BR) Guarantor: The Republic of Colombia Beneficiary: Corporacion Financiera Popular (CFP) Amount: US$15 million equivalent Terms: 15 years, including 3-1/2 years of grace at interest of 8.2% per annum. Project Description: The project would provide term financing to 600-750 small-scale industrial enterprises to carry out neces- sary investments resulting from effective expansion, renovation, or relocation of their installed productive capacity. The project would also allow for the hiring of consultants needed by CFP and/or its clients. In view of the unsatisfied needs of smaller firms, at least 50% of the proceeds of the loan would be channeled to indus- trial enterprises with total assets below US$300,000 equivalent. Estimated Cost: Local Foreign Total (US$ Million Equivalent) Construction and Installation 6.0 1.0 7.0 Imported Machinery (CIF) - 1.0 1.0 Imported Machinery Acquired Locally 3.1 4.7 7.8 Locally Manufactured Machinery 3.1 2.6 5.7 Working Capital 14.0 6.0 20.0 Technical Assistance 0.5 - 0.5 Total 26.7 15.3 42.0  Page 2 of 2 Financing Plan: Local Foreign Total (US$ Million Equivalent) Bank - 15.0 15.0 CFP /1 9.7 0.3 10.0 Other Financial Intermediaries 7.0 - 7.0 Sub-borrower's own funds 10.0 - 10.0 Total 26.7 15.3 42.0 /1 Includes US$5 million in share capital contributions by the Government and US$5 million in new borrowings from domestic public sources. Estimated Disbursements: FY78 FY79 FY80 FY81 -----(US$ Million Equivalent)----- Incremental 2.7 4.9 5.5 1.9 Cumulative 2.7 7.6 13.1 15.0 Relending Terms: (a) US$14.9 million for fixed-asset financing: from BR to CFP (i) at 18.5% per annum on sub-projects located in Bogota, Medellin and Cali; and (ii) at 17% per annum on sub-projects located elsewhere. US$0.1 million for technical assistance: from BR to CFP at 12% per annum. (b) From CFP to its clients: (i) at 24% per annum for fixed-asset financing; and (ii) at 15% per annum for technical assistance financing. Procurement: As usual under DFC-type projects there would be no inter- national competitive bidding. Most capital goods would be purchased "off-the-shelf" from domestic distributors. Construction of industrial buildings would be by domestic firms. Consultants: Colombian consultants would principally be utilized for technical assistance to CFP and its clients. Rate of Return: Most sub-projects are expected to have a financial rate of return of over 20%. Appraisal Report: No. 1512a-CO, dated May 15, 1977.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO DE LA REPUBLICA WITH THE GUARANTEE OF THE REPUBLIC OF COLOMBIA FOR A SECOND SMALL-SCALE INDUSTRY PROJECT 1. I submit the following report and recommendation on a proposed loan to the Banco de la Republica with the guarantee of the Republic of Colombia for the equivalent of US$15 million to help finance a small-scale industry project. The loan would have a fixed term of 15 years, including 3-1/2 years of grace, with interest at 8.2% per annum. The proceeds of the loan would be relent by the Banco de la Republica to the Corporacion Financiera Popular (CFP) at 17% and 18.5% per annum, depending on the location of the ultimate beneficiary, on the equivalent of US$14.9 million to be made available for fixed-asset financing, and at 12% per annum on the equivalent of US$0.1 million to be made available for technical assistance financing. CFP's onlending rates to beneficiary firms would be 24% and 15% per annum, respec- tively. Banco de la Republica would assume the foreign exchange risk. PART I: THE ECONOMY 2. The latest economic report on Colombia (1548-CO) was distributed to the Executive Directors on May 13, 1977. It assesses current developments and provides a medium-term perspective of the Colombian economy. Country data sheets are provided in Annex 1. Background 3. During the past two decades substantial structural transformation has taken place in the Colombian economy. The country has made impressive progress in the transition from a predominantly rural and agricultural economy made up of largely self-contained regions to an urban industrial economy, more oriented toward international trade. Broadening of the country's productive base has been accompanied by rapid growth of nontraditional exports (those other than coffee) and development of a modern sector which relies to a considerable extent on imported inputs. From 1967 to 1975 GDP rose by an average 6.4% per annum in real terms, well above the historical average of less than 5% (1950-67), and real per capita income increased by an average annual 3.6%. Two mutually dependent phenomena, increased investment and relaxation of the foreign exchange constraint, have been the major factors in bringing about this acceleration. Merchandise exports have expanded more than three-fold since 1967 and, most significantly, nontraditional exports have  become an increasingly important source of foreign exchange earnings, growing from 27% of merchandise exports to about 50% at present. Much of this increase was the result of both product and market diversification, especially of manu- factured exports, as the share of total exports shipped to Latin American countries more than doubled. Despite the substantial progress, Colombia still remains essentially an underdeveloped country with a limited modern sector superimposed on a large, traditional, and poor base. 4. When the present Government took office in August 1974, the country was faced with several adverse developments -- weakening balance of payments situation, impending loss of self-sufficiency in petroleum production, infla- tion, deterioration of public finances, and reduction in public investment -- which threatened to interrupt the high growth rate achieved by Colombia in recent years. The new administration embarked upon an economic stabilization program with the aim of restoring the basis for sustained economic growth. In line with this, it implemented basic reforms of the fiscal, monetary and price systems. 5. To help strengthen public finances, the new Government implemented a tax reform which covered almost every important component of the tax system and represented a significant improvement in terms of progressivity and elas- ticity. The Government also made certain changes in the financial system with the purpose of stimulating private savings and improving the allocational efficiency of the financial system. The action included a restructuring of interest rates, simplification of the complex reserve system, and elimination of many of the more rigid and cumbersome controls. 6. The Government also took steps to correct major distortions which existed in the price system. Price controls on a number of important agri- cultural products were removed. In May 1976, the Government introduced far-reaching modifications in its petroleum pricing policy which aim at regaining self-sufficiency in production of crude petroleum by improving incentives for exploration and exploitation. Under the new policy, foreign oil companies are now paid the international price of crude CIF Cartagena for new petroleum produced in association with the government petroleum cor- poration. (Previously the foreign oil companies received less than US$7 per barrel for new crude.) The Government is also encouraging incremental produc- tion from existing fields and, in this connection, eliminated the special petroleum exchange rate, effectively increasing the price of crude oil by about 20%. Furthermore, retail prices of gasoline have been raised in successive steps from US$0.11/gallon in August 1975 to US$0.27/gallon in January 1977, or by almost 150%. The Government proposes to continue this policy until the prices of gasoline and other petroleum derivatives approach international prices. 7. Economic growth slowed in 1975 (from 6% in 1974 to about 5%) and unemployment increased, reflecting both the impact of the stabilization measures adopted at the end of 1974 and the effects of the world recession.  - 3 - Towards the end of the year the etconomy began to recover, stimulated by increased exports, larger agricultural output and heightened industrial activity. The recovery continued in 1976 with real GDP growing by about 6%. During 1974-76 National Government savings increased substantially; due to the 1974 Tax Reform, tax revenues increased by over 40% a year while nominal GDP grew at an annual rate of about 30%. Private savings mobilized through the financial system also increased rapidly, growing by almost 50% a year during 1974-76. Moreover, the balance of payments turned favorable in 1975 as a result of the sharp increase in world coffee prices and expansion of non-coffee agricultural exports. The favorable balance of payments perfor- mance continued in 1976 with foreign exchange reserves reaching almost US$1,150 million, sufficient to cover over 5 months' imports. With increased export earnings, the public debt-service ratio declined from 17.0% in 1974 to 11.7% in 1975 and about 11.4% in 1976. However, despite strengthening of the Government's monetary and fiscal policies (which had reduced inflation from 27% in 1974 to 18% in 1975), the rate of inflation increased to 26% in 1976. Colombia, through a combination of domestic policies and fortuitous external developments, has come through the period of world recession and economic adjustment with a strong foreign exchange reserve position and a rapidly recovering domestic economy. Recent Economic Performance 8. The economic forces have continued to be favorable. Coffee prices are high and the balance of payments remains strong; foreign exchange reserves stood at more than US$1,400 million at the end of the first quarter of 1977, the highest level in Colombia's history. The increased demand generated by the higher incomes of the coffee producers has been a powerful stimulus to the economy. Real GDP growth in 1977 is projected at 7%. As a result, urban un- employment, down from about 13% in 1974 to about 9% by end-1976, is expected to decline further. 9. The inflow of foreign exchange from coffee sales has, however, led to a resurgence of inflation and this has prompted the Government to continue to give priority to short-term management of demand. Several measures have been taken. Legal reserve requirements have been increased and limitations on private external borrowing have been established. Import duties have been drastically reduced to shift part of the inflationary pressures to the exter- nal sector. Fiscal management was quite restrictive in 1976; the Treasury accounts had a surplus, which was used for repayment of the Government's short-term domestic debt. Almost two-thirds of coffee earnings are being kept from increasing the monetary base by measures adopted recently. /1 The Government's liberalized import policy will (although with a lag) increase the supply of goods, thus dampening pressure on domestic prices. Nevertheless, /1 The measures are: 15% of payments to coffee producers to be made in three-year compulsory savings certificates; an increase in the coffee retention tax from 23% to 46%, and investment of a substantial portion of this tax, including the four percentage points received by the Coffee Federation, in Government bonds.  inflationary pressures are likely to persist. Even after the sterilization measures taken, the record coffee export receipts will add to the monetary expansion. Furthermore, current price and cost trends (the Government is attempting to hold wage increases in the public sector to 18%, but private sector wages will probably increase substantially more) as well as "corrective" adjustments in public-service prices make substantial deceleration of price increases unlikely during 1977. However, the rate of inflation is expected to decline over the medium term as the Government remains strongly committed to reducing inflation and its monetary, fiscal and trade measures begin to take effect. Although the reserves being built up during the "coffee boom" strengthen Colombia's longer-term prospects, the rapid increases in liquidity add to the difficulties of short-term economic management and illustrate the special problems facing economies with a heavy reliance on a single export commodity. Although inflation needs to be brought under control, the economy seems now poised for a period of rapid growth. Development Strategy and Prospects 10. The Government's development strategy is embodied in the 1975-78 development plan. The plan aims at creating the conditions necessary for sub- stantially reducing unemployment through increased capital accumulation in the private sector, improvement in the efficiency of the price system in order to encourage more labor-intensive production techniques and expansion of public investment. The plan places increased emphasis on the need to strengthen public sector institutions; particularly, public enterprises are in the future to earn a satisfactory rate of return on their revalued assets and financial intermediaries are to maintain the real value of their capital. In terms of public investment, the main thrust will be on providing adequate economic infrastructure to stimulate rapid growth and employment in industry and agri- culture, as well as on socially oriented projects to help eradicate rural and urban poverty. Within infrastructure, special priority has been assigned to the development of domestic energy sources to help reduce the country's impending dependence on imported energy. Also, the Government continues to stress agriculture because it is in the rural areas where the greatest con- centration of poverty exists and in agricultural activities where increases in employment can be most quickly achieved. Commercial agriculture is to receive support due to its strong contribution to export as well as employment growth. A substantial portion of public expenditures is being reoriented toward nutrition and primary education programs which affect the productivity of the poorest 50% of the population. Policies for promoting decentralization of industry away from the largest cities have been adopted to accelerate inte- gration of more backward areas into the modern sector of the economy. 11. Colombia's strong balance-of-payments prospects for the immediate future should make it possible in 1977 for the country to resume the high rate of growth of GDP (6-7%) achieved in the early 1970s. Export prospects for the next several years are excellent, as world coffee prices remain strong and economic growth is resuming in the industrialized countries. With the continuation of appropriate incentives, minor exports should grow very rapidly once again. Manufactured exports--textiles, chemicals, pharmaceuticals, mechanical and electrical equipment, and paper products--are over the long- term expected to lead this recuperation, along with non-coffee agricultural  exports. Given the improved outlook for coffee, Colombia is likely to maintain a favorable trade balance throughout the late 1970s. Under these circumstances an annual growth rate of GDP of about 7.4% is expected to be accompanied by 10% annual increase of imports in real terms. In light of favorable external economic conditions and domestic policies the marginal savings rate over this period is projected to be about 30% and public sector savings are projected to be about 8% of GDP. However, Colombia's public sector investment program calls for a high level of expenditures if both economic and social objectives are to be fulfilled. Capital expenditures are expected to be about 10% of GDP. Consequently, Colombia will continue to require substantial capital inflows to bridge the savings/investment gap of the public sector. 12. Colombia is expected to require gross capital inflows of US$4.2 billion during the five-year period 1977-82, of which almost US$350 million will be disbursed from commitments made through the end of 1976. To attain this level, annual gross capital inflow will have to increase from US$421 million in 1976 to US$990 million in 1982. Direct foreign investment is expected to provide only a small part (8%) of the required capital inflow, with approximately 50% being provided by official multilateral and bilateral sources and the remainder by suppliers', financial and other credits from private sources. 13. Colombia's public external debt repayable in foreign currency amounted to US$3.3 billion at the end of 1976, or about US$2.6 billion ex- cluding undisbursed commitments. The Bank Group's share of this external debt (disbursed only) as of the end of 1976 was about 28% and is expected to decline to about 25% by 1982. Service on this debt was about 11.4% of exports of goods and non-factor services in 1976, and is projected to remain at that level, assuming recovery of minor exports and the favorable outlook for coffee over the next few years. Balance-of-payments prospects beyond 1980 will depend to a significant extent on the results of petroleum exploration and on progress made in implementation of several resource-based export projects currently under preparation. The Bank's share of public debt service in 1976 was about 26% and is expected to decline marginally to 25% by 1982. With the maintenance of sound economic and financial policies, Colombia should have no difficulty securing or servicing the external capital it needs. PART II: BANK GROUP OPERATIONS IN COLOMBIA 14. The proposed loan, the 67th to be made to Colombia, would bring the total amount of Bank loans to Colombia to US$1,436.4 million (net of cancella- tions). Of this amount, US$1,040.4 million is now held by the Bank; IDA made one credit of US$19.5 million for highways in Colombia in 1961. Disbursements have been completed on 43 loans and the IDA credit. IFC has made effective investments and underwriting commitments of US$51.2 million in 23 enterprises and now holds US$28.5 million. Annex II contains a summary statement of Bank loans and the IDA credit as of March 31, 1977, and of IFC investments as of April 30, 1977. The Annex also contains summaries on the execution of the 22 on-going projects.  - 6 - 15. Since FY68, Bank lending in Colombia has become more diversified and has been concentrated on production-oriented programs and activities which carried social as well as economic benefits. Eight of the eleven agricultural loans have been made since then, six of the nine loans for industry, all three loans in the education sector and all six loans for water supply and sewerage. This compares with only seven loans since FY68 in the power and transport sectors. 16. Bank lending to Colombia in FY76 consisted of one loan for develop- ment finance companies totalling US$80 million. The FY77 program includes the Integrated Rural Development Project and the Second Agricultural Credit Project approved last December, the Fourth Telecommunications Project, the proposed Second Small-Scale Industry Project and a proposed Seventh Highway Project. Work is also under way in nutrition, development finance companies, slum improvement (in which CFP may participate financing enterprises with assets below US$15,000 equivalent), power, water supply and sewerage, mining, small farm development and agricultural extension for possible consideration by the Executive Directors during the next two years. 17. In lending to Colombia, the Bank tries to assist the Government in achieving four major objectives. These objectives are interdependent and com- plementary. One objective is to spread the benefits of growth more widely than before and, more particularly, to attack directly the problem of rural poverty. A second objective is to help Colombia expand output, including exports, by supporting projects that directly or indirectly make large contri- butions to production and employment. A third objective is to support programs that will bring about improvements in the management of the economy and, par- ticularly, that will help to strengthen public institutions and financial intermediaries. A fourth objective is to transfer sufficient external resour- ces to complement Colombia's domestic savings and provide the necessary funds for maintaining an adequate level of economic and social investments in a framework of sound domestic finances and a viable balance of payments. 18. While the last objective primarily influences the magnitude of the Bank's program in Colombia, the other three jointly determine its composition. Naturally, many operations serve more than one of the ends listed and may, moreover, support more specific Government objectives. Thus, the Second Small-Scale Industry Project is not only designed to increase production and employment but also to foster more balanced regional growth in order to give more people an opportunity to participate in the production process. In addition, the project will support the Government's efforts to strengthen public financial intermediaries. 19. The operations of external lenders in Colombia are shown in Annex I. While IBRD, IDB and AID provided about 75% of total external financing to Colombia in the 1961-72 period, their share has decreased since then to approx- imately 40%. Like the Bank, IDB and AID have given increased emphasis to social projects. For instance, the IDB has assisted projects in low cost housing, rural development, agrarian reform, university education, water  - 7 - supply, and land erosion. AID has supported programs in education, urban development and small farm development, and recently it has moved to small project loans aimed chiefly at improving the distribution of income. AID is expected to phase out its aid program in Colombia in the current year. PART III: THE INDUSTRIAL SECTOR AND SMALL-SCALE INDUSTRY Growth, Structure and Employment 20. Manufacturing industry, which contributes slightly more than one- fifth of Colombia's GDP, is a leading growth sector. Between 1967 and 1976 manufacturing output grew by an average annual rate of almost 8%, a level un- matched since the 1950s. During the same period, exports of manufactured goods rose from US$25 million to US$392 million or from 6% to 25% of total exports. This export expansion has been characterized by a remarkable divers- ification in the range of goods exported and in the geographical location of trade partners. Exports to Latin America, and particularly to Andean Pact countries, have increased very rapidly. 21. 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 five years. Inter- mediate 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 account- ing for only about 20% of domestic consumption. Almost all consumer goods and 80% of intermediate goods are supplied domestically, although about half of capital goods requirements are still imported. 22. Rapid population growth and rural migration have resulted in conti- nuing high unemployment in urban areas (about 62% of Colombia's population is urban). The recent more rapid industrial growth has made an important contri- bution towards alleviating this problem. Employment in manufacturing has grown at 6% to 7% annually since 1968, considerably faster than the average annual rate of 3.5% characteristic of the 1953-63 period and 1.6% 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. The low cost and comparatively highly skilled labor force provides an important comparative advantage to Colombia that has contri- buted to recent export performance. Small- and Medium-Scale Industry 23. Small- and medium-scale industry, defined as manufacturing firms with 5 to 99 workers, represents about 93% of all manufacturing units, employs 38% of industrial labor, is responsible for 33% of manufacturing value-added,  - 8 - and accounts for an estimated one-third of net industrial investment. Although widely distributed among all industrial subsectors, small- and medium-scale industry is particularly important in the production of non-durable consumer goods and, to a lesser extent, in the manufacturing of intermediate goods for large-scale enterprises. Foodstuffs (20%), garments (10%), wood and wood furniture (9%), metal products (10%), printing (6%), non-electrical equipment (4%), textiles (6%), footwear (3%) and transportation materials (3%) accounted for almost three-fourths of small- and medium-scale industrial establishments in 1972. 24. Colombia's mountainous terrain and widely distributed population provide protection for decentralized small- and medium-scale enterprises 1/ in the form of high internal transport costs. Such firms enjoy a competitive position vis-a-vis the more centrally located large firms. Reflecting this, over three-fourths of small- and medium-scale manufacturing firms are located outside the Bogota area, serving local or regional markets. In many cases, however, uneven regional growth has slowed down the expansion of small- and medium-scale industry. 25. Two additional factors have affected the development of small- and medium-scale industry, namely insufficient credit and inadequate technical assistance. Other problems have been the inherent difficulties which are common to small- and medium-scale industry in most developing countries, such as deficient management skills, inadequate technology, obsolete machinery, crowded workshops, shortage of qualified technicians, inadequate raw material supply and low capacity utilization in some branches. Also, Government poli- cies toward small- and medium-scale industry have not always been clearly defined and/or well coordinated. The Government readily recognizes this weak- ness and it proposes to take adequate measures in the near future to institu- tionalize responsibility for coordinating the activities of state and private entities related to the subsector. Industrial Credit 26. Colombia's credit system has traditionally favored agriculture, housing, and the public sector, with the result that industry and commerce have had to pay substantially higher interest rates than other sectors and have faced frequent shortages of capital for both short- and long-term pur- poses. Larger firms have been able to expand through internal cash generation and by making use of institutional sources of medium- and long-term credit, in which the Bank has played a major role since 1963. Such sources include (i) the Institute of Industrial Development (IFI); (ii) the Private Investment Fund, established within the Banco de la Republica, which has attracted exter- nal resources mainly from the United States, the Netherlands, and the Inter- American Development Bank; and (iii) seven investment companies (Financieras), which have served as the channel for six Bank loans totalling US$242.5 million. 1/ The average size of such firms is small, nine-tenths having total assets under Col$5 million (US$140,000 equivalent).  - 9 - On the other hand, except for the insufficient credit facilities being pro- vided by public sources (the Fondo Financiero Industrial (FFI), a rediscount fund operated by the Banco de la Republica; the Caja de Credito Agrario, Industrial y Minero (CAJA); and the Corporacion Financiera Popular (CFP)), smaller firms have relied mainly on the extra-bank market and thus have found it more difficult and expensive to undertake necessary borrowings. 27. In recent years, industrial credit has been expanding at about the same rate as total credit (between 1970-75 industrial credit increased at an annual rate of 25%, (i.e., one percentage point lower than the rate of nominal GDP). Large manufacturing enterprises were the main beneficiaries of this expansion. Industrial credit rose from 21.6% in 1973 to 22.5% in 1975 of total value-added by manufacturing. During the same period, however, credit to small- and medium-scale industry declined from 13.2% to 10.1% of value-added by small- and medium-scale industry. In large measure this decline is attri- butable to the depletion of FFI's resources and, to a lesser extent, to the anti-inflationary policies pursued by the Government. In recognition of this situation, the Government has agreed during negotiations, by December 31, 1977 to enlarge FFI's resource base and to take other measures to increase access of enterprises with assets of less than US$300,000 equivalent to FFI, and to increase the intermediaries' incentive to lend to such enterprises, especially those outside the main urban centers (Section 3.02 of the draft Guarantee Agreement and Section 4.02 of the draft Loan Agreement). 28. The cost of industrial credit varies greatly according to source. The effective interest rate of short-term commercial bank lending ranges from 24% to 32% per annum. On medium- to long-term loans CAJA is offering the low- est rates of 14-15% per annum but on a relatively small lending volume, fol- lowed by FFI's 18-24% per annum relending rates, CFP's lending with own resources at 18-24% per annum and IFI at 25% per annum. DFCs now charge up to 27% per annum for medium-term working capital loans and 25-26% per annum for long-term funds in local currency. Technical Assistance 29. There are several institutions rendering technical assistance to smaller industrial firms, but their programs focus on general managerial and vocational training and provide little specialized consulting. By far the most important and comprehensive programs are offered by the Servicio Nacional de Aprendizaje (SENA), a Government institution charged with improving skills of workers and managerial competence of entrepreneurs. The Fundacion para el Fomento de la Investigacion Cientifica y Tecnologica (FICITEC), a semi-private non-profit consulting institution, is providing commendable managerial, market- ing, planning, and production assistance to solve specific problems of indivi- dual firms, but the volume of its assistance (about 25 companies a year) is small. The trade association for small entrepreneurs, Asociacion Colombiana Popular de Industrias (ACOPI), organizes management seminars for its 2,200 members, and several universities have developed regional technical assistance programs in recent years. Corporacion Financiera Popular (CFP) also provides  - 10 - technical assistance to small- and medium-scale industry. Since mid-1975, CFP's technical assistance has improved significantly with the assistance of USAID and UNIDO. In general, however, technical assistance programs for small- and medium-scale industry are implemented randomly, uncoordinatedly and, therefore, have limited impact. To ensure more effective use of this technical assistance in the future, during negotiations CFP has agreed to enter into cooperative agreements with IIT and SENA (Section 6.01(d) of the draft Loan Agreement and Section 3.11 of the draft Project Agreement). Experience Under the First Bank Loan 30. To support the Government's objectives of fostering more balanced regional growth and increased employment, the Executive Directors approved in January 1975 a US$5.5 million equivalent loan (Loan 1071-CO) to Colombia's Banco de la Republica for onlending to Corporacion Financiera Popular (CFP) for medium- and long-term credits to small-scale industrial enterprises. The loan became effective in June 1975. 31. The project was implemented successfully and most of its objectives were achieved. Upon project completion (full commitment of this loan is scheduled for end-June 1977) about 300 small enterprises will have received financial assistance, 100 more than was anticipated during appraisal. The ultimate beneficiaries conformed closely with the intended target group; two-thirds of the assisted concerns were owned by less than five shareholders, had total assets below Col$3 million (US$85,000 equivalent) and employed less than 30 workers. Although the level of profitability varied widely, most of the enterprises were in sound financial condition at the time of subloan approval. Food (16%), apparel and footwear (7%), chemicals (13%), metal working (8%), textiles (6%), and non-metallic mineral industries (5%) accounted for more than one-half of the approved subloans. Despite the more rapid price increases, the onlending interest rate of 24% is estimated to have been slightly positive (about 0.6%) during the commitment period of the loan, i.e., June 1975-June 1977. 1/ 32. The employment impact of the project appears to have been substan- tial. Based on the results achieved through year-end 1976 and the experience gained under previous DFC operations in Colombia, 2,000 direct new jobs would be created as a result of the project at an average total subproject cost of about US$6,900 per direct job created or US$5,100 if only fixed asset cost is included, which is reasonable in the light of Colombia's urban conditions. 33. Perhaps the most important achievement of the project has been the strengthening of CFP. As agreed with the Bank, CFP restructured its organiza- tion and substantially upgraded its internal systems and procedures. These 1/ Based on actual price increases through March 1977 and projected thereafter.  - 11 - actions led to improvements in appraisal, supervision, technical assistance, auditing, portfolio control and financial management. 34. The project was less successful in other aspects. First, it did not achieve the regional distribution of credit envisaged during appraisal. For every two subloans in Bogota, CFP's regional offices made three operations outside the capital area, compared to an initial forecast of six. Second, little use was made of the US$0.5 million technical assistance financing com- ponent under the loan. As of December 31, 1976, only 11 technical assistance subloans had been made for an amount of Col$2.1 million (US$60,000 equivalent) as compared with 100 projected at the time of appraisal. Small entrepreneurs were unwilling to borrow for technical assistance as they considered it too costly, underestimating the benefits they could have derived from it. Thirdly, despite the timely capital contribution to CFP, the Government has not yet participated actively in the development of medium- and small-scale industry. Under the proposed project, therefore, corrective measures would be taken. To motivate CFP to decentralize its lending, it will receive a higher spread in the subloans made to less developed regions (see paragraph 53 below). More efficient technical assistance from IIT and SENA may decrease the need for technical assistance financing. Under the proposed loan the technical assist- ance financing component would initially be for US$100,000 equivalent. PART IV: THE PROJECT Background and Objectives 35. In the summer of 1976 Corporacion Financiera Popular (CFP) initiated discussions with the Bank concerning a possible second loan, and following receipt of a loan request endorsed by the Government, a Bank mission appraised the project in October/November 1976 and in February 1977. Negotiations were held in Bogota, Colombia, at the Bank's office, on the week of May 2, 1977, with a Colombian delegation led by Mr. Gabriel Turbay, Director of Public Credit, Ministry of Finance. 36. The proposed project aims at assisting CFP to expand its credit operations to small-scale enterprises. 1/ The project would provide financing to 600-750 small-scale enterprises to carry out necessary investments. To support the Government's economic decentralization policies, it is expected that about 40% of these subloans would be made outside the three large indus- trial centers (Bogota, Medellin and Cali). It is estimated that as a result of this part of the project 3,000-4,000 new direct jobs would be created with another 1,000-1,500 jobs created indirectly through forward and backward linkages. The project would also have an important role in institution building, as it would continue the work started under the first loan of strengthening CFP. 1/ In this section small-scale enterprises are defined to be firms with total assets of less than US$650,000 equivalent.  - 12 - 37. A project appraisal report entitled "Colombia: Second Small-Scale Industry Project" (No. 1512a-CO dated May 15, 1977) is being circulated separately to the Executive Directors. The main features of the loan and the project are summarized in the Loan and Project Summary and in Annex III hereto. Project Description, Cost and Financing 38. The proposed project would support a program costing approximately US$42 million equivalent of investments in small- and medium-scale enterprises over the next 2-1/2 to 3 years. Based on the results achieved under the first loan, the foreign exchange cost is estimated at US$15.3 million or 36.5% of total project costs. The proposed Bank loan of US$15 million would cover nearly all the foreign exchange cost. CFP would contribute US$5 million equivalent (11.9%) from new share capital increases and would channel an additional US$5 million equivalent from local borrowing sources. Of the remainder, other financial intermediaries would provide about US$7 million equivalent (16.6%) and ultimate beneficiaries US$10 million equivalent (23.8%). 39. The proposed Bank loan of US$15 million would be divided into two components: (i) a US$14.9 million lending component and (ii) a US$0.1 million technical assistance component designed to finance consulting services needed by CFP and/or its clients. This component could be increased by transferring funds out of the lending component, if demand would later on warrant it. In view of the large number of subloans envisaged (600-750), the Bank loan would not be repaid in conformity with the aggregate amortization of the individual subloans but in equal installments over a fixed 15-year term, including 3-1/2 years of grace. Since the average term of subloans (about 6.5 years) is expected to be lower than the proposed maturity, this would entail some roll-over of Bank funds. Such roll-over would assist CFP in improving its local currency resource base and in assuming the higher risk and default rate associated with lending to small-scale enterprises. 40. The lending component would finance the foreign exchange component of the project. The loan would be disbursed only against the cost of fixed assets(namely, capital goods and industrial construction) of subprojects resulting from an effective expansion, renovation, or relocation of the ultimate beneficiary's installed productive capacity. In view of the un- satisfied needs of smaller enterprises, at least 50% of the proceeds of the proposed loan would be channeled to enterprises with total assets below US$300,000 equivalent. The remaining 50% would be channeled to enterprises with total assets not exceeding US$650,000 equivalent (Section 3.02 of the draft Loan Agreement). Project Execution and Organization 41. As in the case of all DFC operations in Colombia, Banco de la Republica (BR) would be the borrower and would make the funds available to Corporacion Financiera Popular (CFP). CFP would be responsible for the appraisal and supervision of subloans, and for providing or making arrange- ments for technical assistance when required by its borrowers.  - 13 - 42. Banco Popular, a Government-owned commercial bank, founded CFP in 1967. As of December 31, 1976, CFP's subscribed share capital totalled Col$300 million (US$8.3 million equivalent), of which Col$234 million (US$6.4 million equivalent) had been paid in. Banco Popular and its sub- sidiary Corporacion de Ferias y Exposiciones, which is responsible for commercial exhibitions and conventions, held 52.6%; the Government (through the Ministry of Development and its agency, PROEXPO, which is responsible for export promotion and financing) 46.9%; the Institute of Industrial Devel- opment (IFI) 0.4%; and the private sector 0.1%. 43. CFP's Board is headed ex officio by the Minister of Development and includes six other members from the Government, the industrial community, and national technical assistance and export-import institutions. The Board meets weekly and actively guides CFP's policies and operations. The Board is review- ing CFP's statement of operating policies and procedures, and the approval of a new statement satisfactory to the Bank would be an additional condition of effectiveness. The Board-appointed Loan Committee is empowered to: (i) approve operations between Col$600,000 and Col$2 million (US$16,900 and US$56,000 equivalent) and (ii) make recommendations to the Board on all larger requests. Also, in response to the Government's decentralization policies and to cope more efficiently with the increasing business volume, in mid-1976 CFP established Regional Advisory Boards in Bogota, Medellin, Cali, Bucaramanga and Pereira to: (i) review and approve credit applications between Col$350,000 and Col$1 million (US$9,900 and US$28,200 equivalent) in Bogota, Medellin and Cali and between Col$350,000 and Col$600,000 (US$9,900 and US$16,900 equiv- alent) elsewhere; and (ii) orient the activities of regional offices and provide operational assistance to them. The Loan Committee, however, is the key element in CFP's decision-making as it influences over 55% of the lending volume. 44. In line with CFP's operational growth and promotion policies during 1975 its branch network rose from 9 to 14 regional offices. Total staff also expanded from 177 at year-end 1974 to 354 as of December 31, 1976. Profes- sional staff, which accounted for about half of the increase, numbered 153 at the end of 1976, of which about 60% were in the regional offices. Although young and relatively inexperienced, CFP's professional staff has been perform- ing reasonably well. A problem has been the lack of competitiveness of CFP's salary scale, including fringe benefits, with the private sector, which has resulted in high staff turnover (about 20% per annum). CFP has introduced several revisions in its salary scale to remedy this situation. Financial Performance 45. Despite the lack of success in mobilizing sufficient local currency borrowings, CFP achieved the operational growth forecast under the first loan. Between year-end 1973-76 total assets rose from Col$411 million (US$16.6 million equivalent) to Col$1,010 million (US$28.4 million equivalent), or at a compounded annual growth rate of 36% in nominal terms. During the same period, CFP's total debt to equity ratio declined from 3.2:1 to 2.1:1 as com- pared to a 4:1 limit agreed with the Bank. The Government's timely contribu- tions to CFP's share capital and the limited internal borrowing accounted for this improvement.  - 14 - 46. Between December 31, 1973 and December 31, 1976, CFP made 5,203 loans for an aggregate amount of Col$1,591 million (about US$50 million equivalent), i.e., two-thirds of the total lending since its inception in 1967. About 83% of the loan recipients had total assets below Col$2 million (US$67,000 equivalent) and received on average financing of about Col$300,000 (US$10,000 equivalent) each. According to CFP, this assistance helped create about 16,400 new jobs. 47. One of the Bank's major concerns has been the quality of CFP's port- folio. As of mid-1976, total portfolio affected by arrears had reached a high of Col$145.4 million (US$4.2 million equivalent) equal to 24.1% of the loan portfolio as compared to Col$59.5 million (US$2.4 million equivalent) and 16.2%, respectively, at year-end 1973. During the second-half of 1976, however, CFP's improved portfolio control and collection procedures resulted in a steady reduction of arrears. As of December 31, 1976, principal in arrears for more than three months stood at Col$55 million (US$1.5 million equivalent), while total arrears stood at Col$121.7 million (US$3.4 million equivalent) or 14.4% of total portfolio. Provisions for bad debt (Col$30.8 million) corresponded to 25% of the portfolio in arrears, which is adequate. CFP's performance, which is expected to improve, is acceptable in comparison with similar institutions serving small- and medium-scale industry. 48. Consistent with the rapid growth of operations, revenues rose by 39% per annum between 1973 and 1976, reaching Col$147 million (US$4.1 million equivalent) by year-end 1976. To accommodate the increased lending and promo- tion activities, financial and administrative expenses also rose fast (38% per annum). Consequently, net profits before taxes were roughly the same in absolute terms but as a percentage of equity they declined from 5.4% in 1973 to 1.5% in 1976. The high cost involved in making numerous small loans and in providing technical assistance and other support activities to small- and medium-scale industry accounted for the low profits. CFP is concerned with the rapid growth of administrative expenditures and during negotiations it has agreed to reduce administrative expenses in relation to total assets by half a percentage point per year through 1981 (from 7.8% of total assets estimated for 1977 to 5.8% of total assets in 1981) (Section 3.11 of the draft Project Agreement). Furthermore, CFP has also agreed to improve its accounting system and operational procedures so as to keep adequate control of the admin- istrative costs and of the operational efficiency of its field offices and headquarters (Section 3.09 of the draft Project Agreement). Moreover, CFP has agreed to design and implement an automatized internal information system with the assistance of consultants (Section 3.10 of the draft Project Agree- ment), the employment of which would be an additional condition of effective- ness. Forecast of Operations and Additional Resources 49. On the basis of a sample survey of the subsector's financing needs and CFP's past performance, loan commitments are projected to rise rapidly from Col$1,055 million (US$26.6 million equivalent) in 1977 to Col$2,583 million (US$42.1 million equivalent) in 1981 or by 12% per annum in real terms. Approximately 60% of the demand would be for working capital and 40% for fixed investment. While CFP intends to increase its equity investments, they would remain small relative to its lending operations.  - 15 - 50. To achieve the foregoing level of operations, CFP must increase its resources, in terms of both equity and borrowings. Assurances were obtained that CFP's paid-in capital would be increased by not less than Col$75 million in 1977; Col$30 million in 1978; and Col$60 million in each of 1979 and 1980 (Section 2.02(a) of the draft Guarantee Agreement). 51. CFP proposes to borrow, through 1980, Col$2,700 million (US$53.4 million equivalent) in local currency and Col$1,100 million (US$23.3 million equivalent) in foreign currency. For local currency borrowings, CFP would rely heavily on its traditional creditors, namely, Fondo Financiero Industrial (FFI), Banco Popular and PROEXPO. Assurances were obtained that CFP would borrow not less than Col$50 million annually, from 1977 through 1980, from new sources in Colombia, over and above the level of its domestic borrowing in 1976 (Section 2.02(b) of the draft Guarantee Agreement). There will be annual reviews by the Government, the Bank and CFP of the amount of additional resources obtained by CFP, and of the terms on which CFP has been able to borrow funds, in the light of CFP's objectives. With respect to foreign currency borrowings, the existing US$5 million USAID loan, a proposed DM 8 million loan from the German Kreditanstalt fur Wiederaufbau (KfW) and the proposed Bank loan would provide most of the requirement. 52. CFP has agreed not to exceed an overall debt:equity ratio of 5.5:1; debt related to all short-term plus export financing operations will not exceed a ratio to total equity of 2:1; and debt related to export financing of large enterprises (total assets exceeding Col$35 million) will not exceed a ratio of 1.5:1 (Sections 3.04 and 3.05 of the draft Project Agreement). Relending Terms and Conditions 53. As in the case of all DFC operations in Colombia, Banco de la Republica (BR) would assume the foreign exchange risk and would make the peso equivalent available to CFP as follows: (i) the lending component at 17% and 18.5% per annum, depending on the location of the ultimate beneficiary and (ii) the technical assistance component at 12% per annum. CFP would charge ultimate beneficiaries an interest rate of 24% per annum, the same as in the previous loan. To encourage CFP to expand its lending outside the major industrial centers, it would receive a spread of 5.5% in the subloans made to small- and medium-scale enterprises located in Bogota, Medellin and Cali, and 7% elsewhere. CFP would make available technical assistance funds to small- and medium-scale enterprises at 15% per annum. This lower rate, although implying a subsidy, appears justified as fairly large incentives for the small entrepreneurs will be needed in order to broaden the application of more sophisticated techniques to the production process in small-scale enterprises. 54. In view of the recent rate of inflation in Colombia (about 30% per annum), in the short run it is unlikely that CFP's onlending rate for fixed assets will be positive in real terms. As the Government's economic stabil- ization program continues to be implemented, the rate of inflation should decline and, as a result, CFP's onlending rate would gradually turn positive.  - 16 - We, therefore, consider it likely that during the 1977-80 commitment period of the loan CFP's onlending rate will be at least 2% positive in real terms. Procurement and Disbursement 55. As usual under this type of project, there would be no international competitive bidding. Most capital goods would be purchased "off-the-shelf" from domestic distributors. Construction of industrial buildings would be by domestic firms. 56. Disbursement of Bank funds would be made in respect of disbursements by CFP covering 100% of foreign expenditures for goods directly imported, up to 90% of expenditures for goods procured locally, and in respect of 100% of the cost of consultants' technical assistance services. Based on the exper- ience gained under the first Bank loan, on average, disbursements under this formula are expected to be equivalent to no more than the estimated 36% foreign exchange component of the project. 57. CFP would apply for disbursements on behalf of Banco de la Republica. Detailed documentation for expenditures would normally not be submitted to the Bank but retained in Colombia for inspection by Bank supervision missions. 58. The limit for sub-projects not requiring the Bank's prior approval (the "free limit") would be US$100,000 equivalent (it was US$50,000 in the first project). Under the first project the Bank does not finance investment expenditures made more than 180 days prior to the receipt by the Bank of the sub-loan request. This period has been shortened for the proposed project to 135 days counted from CFP's sub-loan approval. Justification and Risk 59. The economic and social benefits resulting from the project would be substantial. Most significantly, the project would provide credit to a group that has been generally denied access to term financing, help develop local management capacity and contribute to the broadening of business owner- ship in Colombia, while creating new employment opportunities. Given the expected wide geographical distribution of subloan recipients, the project would also support the Government's policies to achieve a more balanced regional development and decentralize economic growth. As borne out by the results achieved under the first loan, the project's financial rate of return would be satisfactory, likely in excess of 20%. In view of Colombia's high unemployment, the heavy reliance on locally manufactured inputs of small- and medium-scale industry and the low level of protection enjoyed by the industrial sector, it can be asserted with confidence that the projected economic rate of return would be high. 60. The project is technically feasible and offers limited risk. The only possible risk is that the project may not be implemented in the time proposed if CFP would be unable to mobilize the required local currency  - 17 - resources as anticipated. Given the assurances obtained from the Government that adequate additional funds will be obtained in a timely fashion (para- graphs 50 and 51), it is expected that the project will be carried out in the intended period. PART V: LEGAL INSTRUMENTS AND AUTHORITY 61. The draft Loan Agreement between the Bank and the Banco de la Republica, the draft Guarantee Agreement between the Republic of Colombia and the Bank, the draft Project Agreement between the Bank and the Corporacion Financiera Popular, the Report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement, and the text of a draft resolu- tion approving the proposed loan are being distributed to the Executive Directors separately. 62. Special conditions of the loan are listed in Section III of Annex III. Special conditions of effectiveness are that BR and CFP have entered into a Subsidiary Loan Agreement, that CFP has completed cooperative technical assis- tance agreements with IIT and SENA, that CFP has employed the consultants referred to in paragraph 48, and that CFP's Board has approved a new statement of operating policies and procedures satisfactory to the Bank (Section 6.01 of the draft Loan Agreement) (paragraph 43). 63. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI: RECOMMENDATION 64. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments May 18, 1977   p of 4 Rue. COLONIIA - SOIAL tISmTIca S DATA SlEET L^8"0A8oO1 OBI A REFEtENCE CEUNTRIES (191701 ToTAL 1138s.9 K1OT RECCNY ME AGttC. t7.B8 1960 1970 ESTIMATE TURKEY -RAZIL MEXICO