Honduras - Industrial Credit Project

Document of The World Bank FILE C FOR OFFICIAL USE ONLY Report No. 2199 b-HO STAFF APPRAISAL REPORT HONDURAS INDUSTRIAL CREDIT PROJECT December 29, 1978 Projects Department Latin America and the Caribbean Regional Office | 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 EQUIVALENT Currency Unit = Lempira (L) US$1.00 = L 2.00 L 1.00 = US$0.50 GLOSSARY OF ACRONYMS ATLANTIDA - Banco de Atlantida BANAFOM - Banco Nacional de Fomento BANCAHSA - Banco Capitalizadora Hondurena BCH - Banco Central de Honduras BMA - Banco Municipal Autonomo CAAFIID - Central American Agreement on Fiscal Incentives to Industrial Development CABEI - Central American Bank for Economic Integration CACM - Central American Common Market CDI - Centro de Desarrollo Industrial CENAPEX - Centro Nacional de Promocion de Exportaciones CET - Common External Tariff CIDA - Canadian International Development Agency COHDEFOR - Corporacion Hondurena de Desarrollo Forestal CONADI - Corporacion Nacional de Inversiones CONSUPLANE - National Planning Council D/E Ratio - Debt to Equity Ratio ENF - National School of Forestry ERR - Economic Rate of Return FAO - Food and Agriculture Organization FONDEI - National Industrial Development Fund FUND - COHDEFOR's Forestry Industries Financing Fund INCAE - Instituto Centroamericano de Administracion de Empresas INFOP - National Institute for Vocational Training SB - Superintendency of Banks SMI - Small and Medium Industry SSI - Small Scale Industry UNDP - United Nations Development Program FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY HONDURAS: INDUSTRIAL CREDIT PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. I. THE INDUSTRIAL SECTOR A. The Economic Setting ................ 1 B. The Structure of Industry .......................... 2 Industrial Growth ....................*. ...... 2 Size and Distribution of Enterprises .......... 4 Employment and Wages . ............ .. ... ........ 5 Industrial Investment ....................... 6 Industrial Imports and Exports .............. 7 C. Industrial Policy . ................ . .............. 9 Industrial Incentives ............... .. ........ 9 Tariff Policy and Protection .............. ... 10 Export Promotion .... ........................ 11 Industrial Development Strategy and Outlook .. 11 II. THE FINANCIAL SYSTEM A. The Banking System .............................. 12 BCH ..... o ....... .................... o... 13 BANAFOM ..................................... *........... 13 Commercial Banks ................... ....... . 13 CONADI ... .. .. .............. ..... . .... . ... .... 15 COHDEFOR ......................................... 1 The Central American Bank for Economic Integration (CABEI) .... . ........... 16 B. Monetary Policy ..... .- . .............. . . . .. . . . 16 Objectives ...... o . ........................... 16 Interest Rates and Reserve Requirements .... .. 16 C. Mobilization of Resources .............. o...... 18 Deposits .......... .......................... 18 Rediscounts ....... o .................... ..... 19 D. The Financing of Industry ..... ................... 20 E. The Demand for Industrial Investment ............. 22 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. III. THE PROPOSED PROJECT A. Project Objectives and Institutional Structure ... 23 Background .................. ................. 23 Project Objectives ............ .. ............. 24 Institutional Structure ...................... 24 B. The National Industrial Development Fund (FONDEI). 25 Establishment, Management and Staffing ....... 25 Operating Policies and Procedures .... ........ 25 - Operating Regulations and Nature of Projects Financed ..... ................. 25 - Terms and Limits of Financing .... ........ 26 - Interest Rates ........... ... .27 Subproject Appraisal and Supervision . ........ 28 - Subproject Financing ..... ................ 28 Projected Financial Results .... .............. 30 C. Potential Intermediary Institutions .... .......... 31 Commercial Banks ............... 31 COHDEFOR ..................................... 32 CONADI ....................................... 33 CTI .......................................... 34 IV. THE PROPOSED LOAN A. General Description .............................. 35 Amounts and Terms ............................ 35 Maximum Size of Subloans and Free Limit ...... 36 Procurement .................................. 36 Commitment and Disbursement .... ......... 36 Accounts and Auditing ....................... 37 B. Project Benefits and Risks ....................... 37 V. RECOMMENDATIONS .................... ................... 39 This report is based on the findings of an appraisal mission which visited Honduras during May 1978. The mission comprised Messrs. D. Cook, T. Bentley, N. Hughes and M. Stoller (all of the Bank) and Messrs. J. Allchin and A. Cristi-Prado (consultants).  Table of Contents (Continued) LIST OF ANNEXES 1 FONDEI. Organization Chart and Staffing Plan 2 Policies and Operating Regulations of FONDEI 3 COHDEFOR. Organization Chart and Staffing Plan 4 Statement on Operational Policies and Procedures of the Forestry Industries Financing Fund 5 Supporting Tables: 1 Industrial Financing and Percentage of Total by the Commercial Banks (1975-77) 2 Analysis of Size of Industrial Enterprises Borrowing from Commercial Banks (July 1, 1976-June 30, 1977) 3 Analysis of the Size of Industrial Loans Granted by Commercial Banks (July 1, 1976-June 30, 1977) 4 FONDEI - Schedule of Maximum Annual Interest Rates for the Banking System 5 FONDEI's Total Commitments and Disbursements 6 FONDEI - Estimated Balance Sheet, 1979-83 7 FONDEI - Estimated Income Statement, 1979-83 8 FONDEI - Estimated Uses and Sources of Funds 9 FONDEI - Expected Size Distribution of Subloans 10 Estimated Schedule of Disbursements for the Proposed Loan 11 Estimated Sectoral Distribution and Employment Impact of Subprojects 6 MAP 7 Selected Documents and Data Available in the Project File   I. THE INDUSTRIAL SECTOR A. The Economic Setting 1.01 Honduras, with a population of 3 million and per capita income of $450 in 1977, is one of the poorest countries in the Western Hemisphere. The long-term rate of growth of the economy has been slower than that of the other Central American countries. During 1950-75 real GDP increased at an average annual rate of 3.7%, which was only slightly above the 2.7% rate of population growth. 1.02 The industrial sector is less well developed in Honduras than in the other Central American countries. In 1977 industry accounted for about 17% of GDP and provided employment for about 10% of the labor force. The development of industry was based initially on the processing of local raw materials, particularly agricultural and forestry inputs, and these activities still account for about 65% of manufacturing value added, with 6 firms contributing about 25% of the total. 1.03 The country's natural resource base is limited and the economy is still based predominantly on agriculture and forestry, which contribute about one-third of GDP and four-fifths of exports and provide two-thirds of employment. The country's extensive pine forests, which are the largest in Central America, are one of its most important resources but their exploita- tion has been limited and inefficient in the past, and they have been depleted by widespread burning of forests as part of the traditional system of shifting agriculture and because of poor conservation practices. 1.04 Forested lands account for 7.4 million ha. (about two-thirds of the total area of Honduras), of which 3.2 million ha. are broad-leaved, 2.0 million ha. are coniferous, and 2.2 million ha. are denuded. Broad-leaved forests (mostly mixed tropical hardwoods) are generally located in areas with difficult access, whose exploitation is often not commercially viable (i.e., low per ha. volume of commercially used species). Pine forests are better known, have better commercial possibilities, and the production of sawn pine wood is by far the most important forest industry activity. However, present production methods have been inefficient: only about 70% of usable harvested wood reaches the mills because of inefficient harvesting and difficulty in transport; and at the mills, wasteful production techniques result in an output of sawn wood amounting to only one-third of wood inputs. In order to protect forest lands, to control their exploitation, and to provide for a systematic and rational development of the forestry sector, in 1974 the government adopted a Forest Law which created the Corporacion Hondurena de Desarrollo Forestal (COHDEFOR) to carry out the government's new forestry policy. 1.05 Economic development has been hampered by the rugged terrain and by inadequacies in infrastructure, although significant progress has  been made in recent years towards creating a basic transportation network and expanding power generating capacity. Progress has also been made in diversifying exports, as coffee, lumber and beef have increased in impor- tance. However, with bananas still accounting for 40% of exports and heavy dependence on other agricultural exports, Honduras remains vulner- able to the vagaries of weather, as demonstrated by the dramatic economic impact of hurricane Fifi in 1974-75, which led to a 5% drop in per capita income and a major reduction in export revenues. 1.06 Since 1972 government development efforts have increased sub- stantially and several measures have been taken which are already showing positive results and are expected to lay the basis for an improved economic outlook. Public investment has increased, particularly in infrastructure, agrarian reform is being pursued actively, and increased investment is being directed towards the productive sectors, including agriculture, forestry, tourism and industry. Important institutional developments have also taken place with the establishment of COHDEFOR and the Corporacion Nacional de Inversiones (CONADI), the national industrial investment bank which is helping to promote, finance and implement large industrial investments. 1.07 While economic growth accelerated to 6.6% p.a. in 1976 and 7.9% in 1977, the balance of payments had a current account deficit of US$121 million in 1977, i.e., somewhat above the US$109 million recorded in 1976, mainly due to the suspension of coffee sales in the second quarter. The outlook for 1978 is for a higher deficit than in 1977, owing principally to a decline in coffee prices and increased imports as a result of a higher level of economic activity and of foreign equipment required by new public investment programs. Prospects are favorable for a continuation of economic expansion (real GDP growth rates averaging 6% p.a. are projected for 1978-83), provided adequate financing is available for the country's ambitious development program involving public and private investment. B. The Structure of Industry Industrial Growth 1.08 During the 1960s import-based industries including some new indus- tries producing detergents, cosmetics, metal products and plastics developed at a faster rate than the local input-based industries. However, this trend did not continue into the 1970s and traditional consumer goods industries, such as food products, beverages, tobacco, footwear and apparel, and inter- mediate goods such as lumber and cardboard boxes, are still predominant. The production of heavy intermediate and capital goods remains minimal given the size of the market (Table 1.1).  Table 1.1: STRUCTURE OF INDUSTRIAL VALUE ADDED (millions of lempira) 1960 1970 1975 Amt. % Amt. % Amt. % Food, beverages and tobacco 21.9 28.9 62.9 34.8 123.6 39.4 Textiles, clothing and leather 4.2 5.5 14.6 8.1 29.6 9.4 Wood and paper products 10.7 14.1 20.5 11.4 44.9 14.3 Chemicals, petroleum, rubber 3.3 4.3 17.6 9.8 34.3 10.9 Non-metallic minerals 1.7 2.2 9.1 5.0 14.2 4.5 Metallic products 2.0 2.7 6.5 3.6 13.0 4.1 Other factory products 0.4 0.4 1.5 0.8 4.4 1.4 Artisans 31.8 41.9 47.8 26.5 50.1 16.0 Total 76.0 100.0 180.5 100.0 314.1 100.0 Source: Central Bank of Honduras. 1.09 During the 1960s industrial value added grew by only 3.8% per year, at approximately the same rate as the economy was growing. Slow growth was due to the small size of the domestic market, infrastructure problems and the inability of domestic firms to take full advantage of the oppor- tunities offered by the creation of the Central American Common Market (CACM) in 1961. CACM intra-regional trade, the bulk of which was in manufactured products, increased rapidly from US$30 million in 1960 to US$252 million in 1968. While the volume of Honduran exports to the CACM grew from US$8 million to US$30 million over this period, its share of intra-regional trade dropped from 27% to 12%. The withdrawal of Honduras from the CACM, following hostilities with El Salvador in 1969, led to some disruption of trade within the region. Subsequently, Honduras signed bila- teral agreements with each of the CACM countries except El Salvador, providing for partial restoration of free trade along CACM lines but offering certain advantages to Honduras, which was permitted to charge tariffs on some manu- factured goods from CACM countries. 1.10 Industrial growth accelerated significantly during 1970-76, with industrial value added increasing at an average annual rate of 7%. Faster growth was facilitated initially by the reduction in competition from imports when Honduras left the CACM and was later aided by the renewed granting of industrial investment incentives, which triggered a process of modernization and expansion of industrial capacity. The industrial growth rate during this period would have been slightly higher but for the effects on the Atlantic coast region of the 1974 hurricane, which caused wind and water damage to  - 4 - industrial facilities, local raw material shortages, disruptions to trans- portation and lower demand for industrial goods from the affected population. Although industrial value added grew by only 2.6% in 1975, the sector re- covered rapidly thereafter, and industrial value added increased by 11.8% in 1976 and 11.5% in 1977. Size and Distribution of Enterprises 1.11 In Honduras most industrial enterprises are relatively small. The 1975 industrial census lists 847 firms with more than 5 employees (i.e. the factory sector), which together contributed US$150 million equivalent, or 83%, of total manufacturing value added and employed 36,733 workers. Artisan and very small enterprises (employing less than 5 workers) contributed a further US$25 million to manufacturing value added but gave employment to some 40,000 workers, a large proportion of whom work in family concerns. Of the 847 firms with 5 or more employees, 56% had less than 20 employees and more than 90% had less than 100; almost two-thirds were family owned and only 20% were in- corporated. Most of these firms were located in the country's two largest cities, Tegucigalpa (32%) and San Pedro Sula (39%), and the other enterprises (mostly smaller ones) in several medium-sized towns. 1.12 Much of the industrial investment in the 1960s and 1970s has led to a significant modernization of productive capacity and the establishment of larger and more efficient factories. As a result, the contribution to manufacturing value added by firms with less than five employees fell from 42% to 16% between 1960 and 1975, with a corresponding increase in the share of production by the country's larger enterprises. These trends have been accompanied by significant rises in labor productivity in sectors such as food, beverages and tobacco; and textiles and clothing, where a six-fold increase in value added has been achieved with only a doubling of the work force. The trend towards larger factories and higher productivity is partly a consequence of diversification into more capital-intensive products and processes and the growth of export-oriented industries such as meat packing, sugar, and textiles which have to be quite large in order to be competitive. However, the average capital intensity of the Honduran factory sector (capital per worker ratio of US$7,500 equivalent in 1975) is quite low by Latin American standards. 1.13 Out of the 847 firms in the factory sector, about 10% (those with more than 100 employees) accounted for 53% of factory output and 52% of factory employment. An additional 30% of firms provided 40% of output and 35% of employment. The remaining 60% accounted for just 7% of output but contributed 13% of employment. Most firms in this latter group have fixed assets of less than US$100,000 and a work force of less than 20. The pro- posed loan contains special features to ensure that these firms would derive substantial benefits under the project.  -5- Employment and Wages 1.14 Triggered by the rapid rise in investment, during 1960-70 employ- ment in firms with five or more employees increased at a relatively high average annual rate of 6.2% and total employment in such firms increased from 14,900 in 1960 to 36,733 in 1975. However, employment in firms with less than 5 workers grew much more slowly, at an average annual rate of 2.3% p.a. As a result, the overall rate of growth of employment in manufacturing averaged only 3.8% annually, i.e. barely above the 3% p.a. rate of growth of the country's population during that period. Within factory employment, the sub- sectors which contributed most to employment creation were food processing (24.6% of new jobs), wood industries (13.4%), metal products (10.0%), textiles (9.1%), tobacco (8.8%), non-metallic minerals (6.3%) and apparel (6.2%). These percentages generally reflect the relative importance of these subsectors in manufacturing value added. As indicated in Table 1.2, the subsectoral composition of employment in factories showed some shifts in the 1960s but did not change very substantially in the 1970s. Table 1.2: EMPLOYMENT IN FACTORIES (Thousands of employees) 1960 1971 1975 No. % No. % No. % Food, beverages and tobacco 6.4 42.8 10.1 35.2 12.9 35.0 Textiles, clothing and leather 2.2 14.9 4.9 17.1 6.1 16.7 Wood and paper products 4.0 26.5 7.9 27.8 9.9 27.0 Chemicals, petroleum, rubber 1.3 8.6 2.1 7.2 2.9 8.0 Non-metallic minerals 0.6 4.0 1.4 5.0 1.9 5.2 Metal products 0.4 3.2 1.5 5.2 2.0 5.3 Other - - 0.7 2.5 1.0 2.8 Total 14.9 100.0 28.6 100.0 36.7 100.0 Source: Ministry of Economy industrial surveys. 1.15 Compared to the other CACM countries, the labor force in Honduras is less skilled, partly because the adult literacy rate is only 53% and vocational training systems are not highly developed. On the other hand, labor costs, including wages and social charges, are lower in Honduras than in Costa Rica, Guatemala and Nicaragua (Table 1.3). These relatively low labor costs, coupled with political stability and comparatively good management-labor relations, help to keep Honduras reasonably competitive in the CACM context.  - 6 - Table 1.3: INDUSTRIAL DAILY WAGES IN CENTRAL AMERICA, OCTOBER 1974 (in US$) % social charges Wages Social charges Total in wages Costa Rica 2.42 0.95 3.37 39.3 Nicaragua 2.16 0.58 2.74 26.9 Guatemala 1.99 0.64 2.63 32.2 Honduras 1.99 0.46 2.45 23.1 El Salvador 1.63 0.54 2.17 33.1 Source: IBRD, Agricultural Sector Survey of Costa Rica, July 1975. 1.16 With IDA assistance (Cr. 777-HO), the government is presently taking steps to upgrade workers' skills in the agriculture and forestry sectors. One of the beneficiaries of the IDA credit is the post-secondary National School of Forestry (ENF), whose facilities will be both improved and expanded. Many graduates of ENF are employed by COHDEFOR, and, as a result of the expansion of ENF's training activities, COHDEFOR would be provided with most of the technicians it needs to carry out its forestry development program. Formal technical training in the manufacturing sector is carried out by the post-secondary National Institute for Voca- tional Training (INFOP), while some informal training is provided by several secondary vocational schools. The Bank has been instrumental in assisting Honduras to develop its vocational training system through INFOP. Under the First Educational Project (Loan 954/Cr.452-HO), two vocational training centers were built and equipped in Tegucigalpa and San Pedro Sula. As a result, INFOP's annual output has increased from 333 graduates in 1973 to 7,075 in 1976. Of the total of 18,241 graduates, 5,946 (33%) have received industrial training, in such areas as electrical installations, welding, bricklaying, carpentry, graphic arts, printing, garment making, shoe making, tailoring, butchering, mechanics, machinery maintenance, and refrigeration. Industrial Investment 1.17 During 1965-70 investment in industrial fixed assets by firms employing five or more workers grew by about 7% per year in real terms, i.e. more than 50% faster than the real factory output growth of 4.3% p.a. During 1971, and particularly 1972, the rate of investment declined, partly as a result of the removal or reduction of investment incentives by Honduras following its withdrawal from the CACM. These incentives were partially restored after Honduras signed bilateral treaties with Guatemala, Nicaragua and Costa Rica in 1972-73, leading to an increase in investor confidence and the implementation of a number of projects which had been postponed. In 1973 new investment increased by 32% in real terms over the depressed level of 1972. This higher level of investment in fixed assets in factories,  - 7 - averaging about US$26 million 1/ annually (data for individual years can vary considerably due to the impact of individual large projects) was maintained during 1974 and 1975, despite the disruption in output and losses in plant and equipment of US$9.2 million caused by hurricane Fifi. During 1973-75 important new investments were made in four new sugar mills and in petroleum refining, and significant modernization and capacity expansion took place in meat pack- ing, beverages, textiles, sawmills, and plastics. 1.18 Preliminary estimates show that the pace of industrial investment increased further in 1976 and 1977 to reach about US$24 million 1/ in the latter year. Nevertheless, over the period 1970-77 the real industrial in- vestment growth rate averaged about 5% p.a. and did not fully keep pace with the real industrial output growth rate of almost 7% p.a. Since part of the investment was for modernization and replacement of existing plants, the growth rate of productive capacity lagged far behind increases in industrial production, with the result that capacity utilization is estimated to have increased from about 50% in 1968 to some 77% in 1977. 2/ 1.19 Direct foreign investment has not yet played a very important role in Honduras' industrial development, despite the availability of significant investment incentives and the virtual absence of restrictions on private for- eign investment in the sector before 1974. In general, foreign companies interested in establishing manufacturing facilities in Central America have tended to locate in the economically more developed countries of the region. Also, as part of the government's effort to begin a systematic development of the forestry sector (para. 1.04), tighter regulations have been imposed on foreign investments in the forestry and wood products sector. As a result, some foreign investors have been required to divest themselves of their owner- ship in enterprises involved in the export of lumber and resin production and to limit ownership to not more than 49% in enterprises involved in large-scale pulp, paper and wood products manufacturing. Industrial Imports and Exports 1.20 With its relatively small industrial base and small domestic market, Honduras has to import a wide range of manufactured products for which local production would not be economical. In 1960 approximately 41% of domestic demand for manufactures was met by imports, divided almost equally between consumer goods (33.6%), intermediate goods (32.6%) and capital goods (33.8%). While the overall proportion of manufactured goods imported did not change significantly between 1960 and 1970, Honduras was successful in substituting imports of some consumer goods by local production, with the result that con- sumer goods imports dropped to 27% of total manufactured imports by 1970. Table 1.4 shows that more rapid progress was made between 1970 and 1976. By 1/ In constant 1972 dollars. 2/ Based on a sample of 60 industrial companies which together account for almost half of total factory production.  - 8 - the latter year, manufactured imports had dropped to 36.5% of total domestic consumption of manufactures and the proportion of consumer goods imports in total manufactured imports had fallen to 20%. Table 1.4: MANUFACTURED IMPORTS AND EXPORTS (millions of current lempiras and percentages) 1960 1970 1974 1976 A. Industrial Production 235.2 628.9 1095.1 1321.9 B. Industrial Imports 145.6 384.6 530.9 654.8 C. Industrial Exports 23.8 91.0 182.8 222.6 D. Domestic Consumption 357.0 922.5 1443.2 1754.1 (A+B+C) E. Import Ratio (B/C) 40.8% 41.7 36.8 37.3 F. Export Ratio (C/A) 10.1% 14.5 16.7 16.8 G. Composition of Imports Consumer Goods 33.6% 26.9% 20.4% 20.3% Intermediates 32.6% 37.9% 43.1% 42.7% Capital Goods 33.8% 35.2% 36.5% 37.0% H. Composition of Exports Consumer Goods 27.5% 36.5% 44.3% 49.3% Intermediates 1/ 72.4% 63.3% 52.1% 44.8% Metal Products 0.1% 0.2% 4.2% 5.9% 1/ Including lumber. 1.21 Manufactured exports grew at 28% p.a. between 1960 and 1970, and at 24% p.a. during 1970 to 1976 to reach US$111.3 million equivalent in the latter year. In constant 1966 lempiras these rates of growth are equivalent to 13.6% and 2.3%, respectively. Primarily as a result of increased exports of pro- cessed foods and lumber to North American and European markets, exports grew somewhat faster than manufacturing output, and manufactured exports' share in total output increased from 10.1% in 1960 to 16.8% in 1976. Manufactured exports also increased as a proportion of total merchandise exports from 18% in 1960 to about 23% in 1976. 1.22 The composition of Honduran manufactured exports has changed markedly since 1960, when intermediate goods made up 72.4% of total manufactured exports, with lumber and lumber products representing 67.5% of the total. Despite considerable expansion of lumber exports in the late sixties and early seven- ties, by 1976 lumber exports represented only 28% of total manufactured exports, and intermediate goods only 44.8% of the total. The major increases in manu- factured exports occurred in consumer goods, of which food products (particu- larly meat and sugar) represented the most important category followed by textiles, apparel and furniture. Since 1970 Honduras has also been quite successful in increasing exports of light engineering goods produced by metal industries.  - 9 - 1.23 The proportion of Honduran manufactured exports going to other CACM countries remained approximately constant, at about 25%, during the 1960s. However, following its withdrawal from the CACM in 1969, the proportion of Honduran manufactured exports going to the CACM averaged less than 5% between 1970 and 1974. Honduras was successful in maintaining export momentum during this period by substantially increasing trade with Europe. Since 1974 exports to the CACM region have been increasing 28% annually on average and reached an estimated 33% of total manufactured exports in 1976. C. Industrial Policy Industrial Incentives 1.24 By far the most important policies affecting the manufacturing sector since 1960 have been those determined by the Honduran participation in the CACM. The main policy instruments have been the Central American Agreements on Fiscal Incentives to Industrial Development (CAAFIID) and the establishment of the Common External Tariff (CET). Both of these instruments were designed to support a strategy of regional import substitution within the CACM. Under the CAAFIID agreement, which superseded industrial incentive legislation enacted separately by the CACM countries shortly before 1960, qualifying industrial firms were granted exemptions for up to 10 years from income taxes and from tariffs on imported equipment and raw materials and other inputs. 1.25 Maximum benefits were provided to Group A companies that produce industrial inputs and capital goods as well as mainly consumer goods indus- tries that use raw materials and intermediate products, at least 50% of which are of Central American origin. Lesser benefits were provided to Group B companies producing high domestic value added products but depending to a significant extent on imported inputs. Group C industries, which receive the lowest benefits comprising a 3-year exemption from tariffs on imported equip- ment and raw materials, were those not qualifying as Group A or B but judged to be economically desirable in view of their domestic value added, balance of payments and employment impacts. Various modifications have been made to the incentive package during the 1960s and 1970s but the basic characteristics remain the same. After its withdrawal from the CACM in 1970 Honduras reduced or cancelled some of the investment incentives, but they were largely restored after Honduras signed bilateral agreements with all CACM countries except El Salvador. 1.26 The effect of the incentives program in encouraging industrial investment has been important overall, although it has been costly in terms of revenue foregone and it is likely that much investment would have taken place with lesser incentives. By 1975 some 261 of the 847 firms with more than five employees had benefited from the incentives program. These firms accounted for 62% of value added in factory production, 67% of book value  - 10 - of fixed assets, and 57% of factory employment. The cost of the incentives in lost fiscal revenues has been substantial, amounting to 15% of total 1975 tax revenues. While these problems are recognized in Honduras, pending a revision of the regional system the authorities have been reluctant to take action because of strong competition for investment by the other CACM member countries. 1.27 In the context of a more outward-looking industrial strategy, a revision of industrial investment incentives to reduce excessive protection in some branches has been under consideration for some time at the CACM level. While there appears to be support from most countries for making the incen- tives less generous and more selective and for placing increased emphasis on exports outside the region rather than concentrating solely on regional import substitution, to date specific details of the revision have not been agreed upon. The Bank has recently undertaken a study of industrial development policies in the CACM. The ongoing dialogue on the question of industrial incentives will be continued in the context of discussing the mission's report with the CACM member countries. Under the project, the subproject review process would pay particular attention to the economic justification of in- vestments contemplated, regardless of the incentives they might receive. Tariff Policy and Protection 1.28 Tariff policy in Honduras is closely related to liberalization of intra-regional trade and the establishment of the CET for imports from coun- tries outside the CACM. The CET followed the basic structure of national tariffs in the region, which provide high protection rates for consumer goods and their components and generally lower rates for inputs not available with- in the region and for intermediate and capital goods. While Honduras has generally followed the CACM model for the CET, as part of the bilateral agree- ments signed after 1973, it is permitted to charge moderate tariffs on some imports from other CACM countries. 1.29 Although nominal tariffs for industrial inputs vary substantially between products, with subsector averages ranging from 10% to 150%, most sub- sectors are below the 35% level. The average nominal protection rate of 22% (weighted by the gross value of domestic production with subsectors) in Honduras is quite low in comparison with Costa Rica (43%), and somewhat less than those of the other CACM countries. Effective protection rates are some- what higher, particularly for those subsectors with high nominal rates of protection (i.e. luxury items, processed agricultural products, seafood, wood products, clothing, textiles, soaps and detergents). However, most of these same subsectors are responsible for much of the increase in manufactured exports (para. 1.22), thus indicating that available effective protection has not been utilized in many instances. Consequently, with few exceptions Honduras' tariff structure has not encouraged production of goods on an uneconomic scale and at prices which are substantially above international levels. The bulk of industry is therefore still based on the processing of local inputs, some of which are exported in the world market, and competition within the region and the restricted purchasing power in the domestic market have largely prevented industry from taking undue advantage of protection levels.  - 11 - Export Promotion 1.30 Export incentives in Honduras are more limited and less generous than in some of the CACM countries: they comprise a drawback scheme and a guarantee bond scheme. Both of these mechanisms enable the exporter to obtain relief from paying taxes and duties on imported inputs used in the manufacture of products exported outside the CACM area. The drawback scheme provides a mechanism for obtaining a refund of taxes paid, while under the guarantee bond scheme the exporter does not pay the taxes on imported inputs but deposits securities with the government for the amount of such taxes until the finished products are exported. 1.31 All CACM countries have established export promotion agencies, but only Costa Rica offers tax credit certificates to exporters equivalent to 10-15% of the FOB value of the exports. The Honduran Government is presently attempting to establish a more systematic approach to export promotion; it is studying a draft law which would create the Centro Nacional de Promocion de Exportaciones (CENAPEX) as the government agency responsible for export pro- motion, particularly of non-traditional exports. CENAPEX would, among other things, be responsible for (i) reviewing the need for and proposing new export incentives; (ii) establishing qualitative and quantitative export targets; (iii) proposing mechanisms for export financing; (iv) creating a system of commercial attaches stationed in foreign countries; (v) promoting export projects; and (vi) carrying out studies of international markets. Industrial Development Strategy and Outlook 1.32 The National Planning Council (CONSUPLANE), in consultation with the Ministry of Economy and the Industrial Research Department of the Central Bank, has recently prepared an Economic Development Plan for 1979-83. This plan, which aims at maintaining a fairly high rate of economic expansion coupled with an improved balance of payments performance and a better distri- bution of economic benefits among the poorer sections of the population, envisages continuing heavy public investment in infrastructure and in the social sectors while giving more emphasis to rapid-yielding investment proj- ects in the productive sectors. Industry has been assigned a leading role in achieving rapid growth of value added, exports and employment. 1.33 The primary targets established in the 1979-83 Economic Development Plan for industry are: (i) achievement of an average real growth in indus- trial value added of 9% p.a. whereby industry would increase its contribution to GDP from 17% in 1977 to 19% in 1983; (ii) manufactured exports growing by 15% p.a. in current US dollars with the proportion of domestic value added in exports progressively increasing; and (iii) more rapid development of labor-intensive small- and medium-sized enterprises. To achieve these targets the plan envisages: (i) a more selective import-substitution strategy focusing on efficient industries in the intermediate goods and metal working fields; (ii) increased promotion of exports outside the CACM; (iii) promotion of industries in which Honduras has a comparative advantage, in particular those which use raw materials from forestry and agriculture; and (iv) provid- ing increased credit and technical assistance to small- and medium-sized in- dustry (SMI). The latter two objectives would receive special emphasis under the proposed loan.  - 12 - 1.34 Responsibility for the development of the forestry sector lies with COHDEFOR, which, in addition to protecting national forest lands from uncontrolled exploitation and restoring national forest resources, will also plan, stimulate and finance the growth of an efficient primary and secondary wood products industry, and help improve the living standards of the impoverished rural population, about one-third of which lives on the fringe of the forest lands. To accomplish this mandate COHDEFOR was given broad authority to manage the use of both public and private forest lands, to control timber sales and exports, and to engage in the financing of forest industry (para. 2.07). In support of the plan, CONADI is providing promotional, financial and managerial assistance to important projects with high domestic value added or involving industrialization of local resources, including projects in food processing, textiles and apparel, wood and paper products, and metal working and mineral products. 1.35 Given the disappointing results of past SMI lending through the Banco Nacional de Fomento--BANAFOM (para. 2.03), and in recognition of the importance of stimulating small- and medium-size industries' growth, the govern- ment has upgraded its Centro de Desarrollo Industrial (CDI), which has been providing technical assistance largely to artisans, in order to enable CDI to provide such services to small- and medium-scale enterprises (SMIs) in the future. A law to promote the development of small-scale and artisan industry was enacted in 1978, which has clarified the definition of the sector, extended to small enterprises the benefits of the industrial incentive legislation, and confirmed the government's intention to provide financial and technical assis- tance to the sector. 1.36 The Honduran industrial development targets, while ambitious, appear achievable. The strong performance of the economy and of the indus- trial sector in the past two years augur well for the future and have helped create a positive climate for investment. The project pipelines of COHDEFOR, CONADI and the commercial banks are already extensive and continue to grow. The more outward-looking philosophy developing within the CACM is also an encouraging sign. The proposed project is designed to help in the achievement of these industrial growth targets by assisting Honduras to strengthen its institutional capability to prepare, select and finance efficient industrial investment projects with particular emphasis on meeting the term financing needs and technical assistance requirements of SMI and of priority projects in the wood industry. II. THE FINANCIAL SYSTEM A. The Banking System 2.01 The banking system in Honduras is comprised of the central bank (Banco Central de Honduras--BCH), 13 commercial banks, 3 development banks (CONADI, BANAFOM, and Banco Municipal Autonomo--BMA), and 6 specialized credit  - 13 - institutions (mostly mortgage banks). Of these entities, all except BANAFOM, BMA and the specialized credit institutions are involved at present in channel- ling funds to industry. 2.02 BCH was established in 1950 as the government's central bank and fiscal agent, with responsibility for formulating and implementing monetary policy and for supervising the banking system. The BCH is generally regarded both within and outside Honduras as a professional, well-managed and adequately staffed organization. In recent years BCH has taken an active role in economic development, policy formulation, planning and financing. 1/ It is operating a guarantee fund for small-scale industrial lending and an export fund for finan- cing non-traditional exports and has assumed responsibility for administering IDA's First (Cr. 179-HO) and Second (Cr. 434-HO) Livestock and Agricultural Credit (Cr. 628-HO) Projects. Under the proposed project, BCH would expand its developmental role in the industrial sector (paras. 3.03-3.05). 2.03 BANAFOM, with assets of L 326 million as of December 31, 1977, is the largest bank in Honduras and until recently it was virtually the country's only source of industrial term credit to SMI. Founded in 1950 mainly as an agricultural bank, it became involved in industrial financing and in operating agricultural marketing and storage facilities as part of its agricultural price stabilization activity. By 1975 BANAFOM had acquired an industrial portfolio of L 12.6 million (out of a total portfolio of about L 131.9 million), mostly of medium- and small-size loans, of which about one-third were in arrears. Most of the small loans had been guaranteed by BCH's small industry guarantee fund (of which BANAFOM had received guarantees amounting to L 18 million or 89% of total guarantees granted). The rather small size of such loans, as well as the poor repayment record of loans guaranteed by the fund (42% of outstanding loans were in default) and the relatively high costs of administration associated with small loans, dis- couraged other banks from utilizing the fund. In early 1977 the BCH, on behalf of the government and along with BANAFOM's new management, undertook a review of the range of BANAFOM's activities and capabilities as a result of which it was decided that BANAFUM should focus its resources on its expanded agricultural development responsibilities and phase out of other activity. Thus, BNF's industrial lending activities ceased in July 1977 and a phase-out was begun of all agricultural marketing and storage functions. 2.04 Commercial banks. The 13 commercial banks (3 of which are foreign owned) form the core of Honduras' financial system. As of December 31, 1977, they held almost three-quarters of the financial system's assets (excluding the BCH) of L 1.5 billion and accounted for 80% (L 204 million) of total new industrial credits. In the past three years industrial credits, on average, accounted for 22% of the commercial banking system's outstanding total loan 1/ Along with the Ministers of Finance, Economy, and Natural Resources and Agriculture, the President of the Central Bank serves on the National Economic Council, which formulates economic policy, establishes programs and promulgates decrees affecting economic and social development.  - 14 - portfolio. Commercial banks are engaged mainly in short-term lending activities. In 1976-77 loans for less than one year accounted for 72% of resources loaned while longer term loans with maturities of three years and over accounted for only 8.7% of the total (Table 2.1). A major cause for emphasis upon short-term lending has been the structure of interest rates which, especially since late 1977, made it unattractive for commercial banks to seek long-term domestic funds (para. 2.10). Table 2.1: COMMERCIAL BANKING SYSTEM - TERMS OF NEW INDUSTRIAL CREDIT July 1976 - July 1977 Amount (thousands of Loan Terms Number of Loans % lempiras) % Less than 1 year 2,141 79.0 141,338 72.3 1 to 2 years 374 13.8 24,514 12.5 2 to 3 years 115 4.2 12,536 6.4 3 to 5 years 60 2.2 12,342 6.3 More than 5 years 21 0.7 4,708 2.4 2,711 100.0 195,464 100.0 Source: Banco Central de Honduras. 2.05 Several large banks, of which the largest and most important are the Banco de Atlantida (ATLANTIDA) and Banco Capitalizadora Hondurena (BANCAHSA), have traditionally dominated commercial banking activity. How- ever, in recent years, reflecting BCH's efforts to increase competition in commercial banking, important changes have occurred which helped restructure the banking system by giving it a broader base, an enlarged clientele, and an improved geographic spread. As a result, the number of commercial banks has increased by 40% (three specialized credit institutions became commercial banks in 1971 and 1976, and a new commercial bank was established in 1974), the system is channeling an ever-increasing amount of resources into produc- tive sectors (agriculture and industry), and the smaller banks have grown at a faster rate than the larger ones. These changes within the banking system, even in a short period, are quite significant. Thus, between 1975-77, while ATLANTIDA's industrial lending overall had increased substantially, its share of the market declined from 28.6% to 24.9% of total industrial lending. Two other large banks, BANCAHSA and Banco Financiera Hondurena, also experienced a share of market decline (from 19.6% to 15.9%) during the same period, as did the three banks with foreign ownership, whose industrial lending share fell  - 15 - from 17.2% to 12.0%. 1/ Seven smaller banks are rapidly growing in importance and have increased their share of new industrial lending from 13.5% in 1975 to 20.5% in 1977 (Annex 5, Table 1). With high competitive pressure and rela- tively low lending limits, 2/ the commercial banks have actively sought lend- ing opportunities to SMI. As a result, about one-third of the industrial firms receiving loans during July 1976-July 1977 had total assets below L 100,000, and one-third of the funds went for industrial loans of under L 100,000 (Annex 5, Tables 2, 3). 2.06 CONADI. In 1974 the government took a significant step forward in providing long-term resources for industrial investment through the creation of CONADI to fill a gap in industrial equity and term financing, promote and help develop a capital market, and expand public and mixed Honduran ownership of larger scale enterprises. To accomplish these objectives, CONADI was given a corporate charter with authority to engage in: (i) buying, negotiating and investing in stock and acting as a broker on account of others or on its own account; (ii) establishing investment funds for Honduran securities; (iii) pro- moting or participating in industrial underwritings; (iv) endorsing or guaran- teeing credits granted to industrial corporations; and (v) granting long- and short-term credits for fixed and working capital financing. In order to ensure that CONADI's operations are directed toward larger scale projects with substantial economic impact, CONADI's investments and credits in any enterprise must be for projects with a total cost in excess of US$375,000 equivalent. CONADI's portfolio of L 99 million as at December 31, 1977 included both loans of L 71 million and equity investments of L 28 million. The loan portfolio was made up of L 42 million, in long-term mortgage loans for tourism projects, and L 28 million in loans to industrial enterprises. CONADI's guarantee oper- ations have grown even more rapidly than its direct lending and amounted to L 82 million at year-end 1977. 2.07 COHJDEFOR. The forestry sector is also receiving significant finan- cial assistance from the banking system (L 12.9 million in new loans in 1977). Although it is not part of the banking system, an increasing share of finan- cing to the sector is being provided by CORDEFOR, which has been authorized to finance forest operations, primary and finished wood products industries and to provide working capital and medium-term credits to sawmills, resination plants, and importers and exporters of wood products. Its loans to the sector 1/ The importance of the larger banks, particularly of two of the three foreign owned banks, is underestimated since they also provide a sub- stantial amount of guarantees for dollar financing of industrial clients by foreign banks. 2/ Commercial banks are not permitted to have loans outstanding to a single enterprise greater than 20% of their equity. Thus the maximum size loan for the smaller 50% of the commercial banks is a relatively low US$500,000- US$750,000 equivalent.  - 16 - as of December 31, 1977, totalled L 22.8 million. COHDEFOR is presently lending mainly to finance inventories, other short-term needs, and exports. However, since 1975 it has expanded its financing activities to include term lending to finance fixed assets as well as equity participation in a variety of industrial ventures. Under the proposed loan it would substantially increase these activities (para. 3.28). 2.08 The Central American Bank for Economic Integration (CABEI) is another institution which, although not part of the Honduran banking system, has been active in financing Honduran industry. CABEI was founded in 1961 as the bank for economic integration of the Central American region, with headquarters in Tegucigalpa. Since its inception, it has made 67 loans totaling L 61.9 million to the manufacturing sector in Honduras, for projects with a total cost of L 166.6 million. Its most recent projects in Honduras have been relatively large in size (e.g., a L 6.8 million loan through CONADI to refinance and capitalize a food processing company) and closely linked to CACM export trade objectives. B. Monetary Policy 2.09 Objectives. Monetary policy in Honduras has traditionally focused on three principal objectives: (i) maintaining the stability of the lempira within a system of free-currency convertibility, (ii) seeking to achieve equi- librium in the balance of payments, and (iii) keeping the domestic inflation rate at about the same level as the USA, Honduras' principal trading partner. These objectives have been achieved in part by modifying legal reserve requirements on deposits, regulating the percentage of commercial bank lending for a particular purpose, limiting discount and rediscount facilities mainly to agricultural crop and export financing, and levying surcharges on imports of non-essential items. Interest rate adjustments have played only a small role in monetary policies. Partly as a result of these government policies, the historical rate of inflation in Honduras, as measured by the consumer price index, has been low compared to many other Latin American countries, and the US dollar-lempira exchange rate has remained at 2:1 for the past two decades. Inflation averaged 2.7% a year between 1966-73 and accelerated to 13% in 1974 before declining to 8% in 1975 and 5% in 1976. Inflation rose somewhat in 1977 to 8.6%, and the inflation rate is expected to remain at that level for the next three years. 2.10 Interest rates and reserve requirements. In the past decade interest rates have been modified infrequently. The maximum interest rates on produc- tive loans, 1/ which were constant between 1967 and 1971, were raised substan- tially from 8% to 11% in two adjustments (in 1972 and 1974) and have remained 1/ Loans to expand or improve output of agriculture and industry, which must constitute not less than 70% of commercial banks' lending, while lending for commerce and trade or consumption may not be more than 30%.  - 17 - at that level. Interest rates on loans for consumption or commerce, on the other hand, have been increasingly restricted since 1967 as the free market rate was replaced by the current 13% maximum interest rate (Table 2.2). In the face of a 66% increase in banking liquidity between 1975 and mid-1977, the BCH raised legal reserve requirements on all bank deposits, from 25% to 30%, thereby increasing the cost of resource mobilization by the banking system but also reducing incentives to raise longer term funds. 1/ 2.11 So as not to further restrict term lending, in early 1978 the monetary authorities implemented an experimental program under which interest rates for productive long-term loans (three years and over) would not be subject to restrictions except that the interest rates charged on such loans should bear a reasonable relationship to the cost of resource mobilization. This cost would likely be about 10.4% to 11.3% under the existing reserve requirements, and 9.8% to 10.8% should the BCH decide to return to the historic 25% reserve level. Given the uncertainty involved in predicting costs of resource mobilization and reserve requirements over the implementation period of the project, the range of interest rates for the minimum (10%) portion of the project to be financed by the financial intermediaries (para. 3.16) could vary from 12.5% to 14.5%. Under the most likely combination of interest charges (i.e., 12% for the Bank's portion and 14.5% for the intermediary's 10% portion) the interest cost to the final borrower would average 12.25% and would be significantly positive in real terms (para. 2.09). 1/ Thus, an 8% 12-month certificate of deposit now costs the banking system 10.2%, yielding a highly inadequate 0.8% spread given the maximum 11% interest rate on medium-term productive loans.  - 18 - Table 2.2: MAXIMUM ANNUAL INTEREST RATES 1967 1978 Loan rates for loans over L 2,500 Industrial and agricultural production, services, transportation, construction communications 9.0 11.0 Commerce and consumption Free 13.0 Agricultural exports (loans over L 100,000, with maturities exceeding six months) Free Productive purposes (loans over L 100,000 with maturities of 3 years or more) - Free Deposit rates Savings deposits 4.0 6.0 Time deposits: Up to 3 months 4.0 7.0 3 to 6 months 4.0 7.5 More than 6 months 7.0 8.0 More than 12 months 7.0 8.5 More than 18 months 7.0 9.0 More than 24 months 7.0 9.5 Minimum L 100,000 Free (more Free (more than 1 year) than 6 mos.) Source: Central Bank of Honduras C. Mobilization of Resources 2.12 Deposits. The government's policy of setting interest rates for time and savings deposits to yield savers positive returns on average, toge- ther with an effective resource mobilization effort by the commercial and housing banks, has succeeded in mobilizing subtantial, mainly short-term resources. Total deposits in the banking system increased from L 309 million to L 712 million in 1972-77 (almost a 20% nominal annual rate of growth). A substantial part of this high growth was due to the increased time deposits (mainly three months to one year) captured by the commercial banking system, which rose from L 183 million to L 404 million in 1972-77. 2.13 The rate of mobilization of medium- and long-term foreign resources by the banking system also increased, from L 49 million to L 189 million in  - 19 - 1972-77--an annual growth rate of 30%. About 40% of this amount represents obligations of the commercial banks, 10% CONADI and the balance (50%) BANAFOM debt. Short-term foreign borrowing is strictly limited to the short-term financing of exports of coffee, cotton, tobacco and other major agricultural or seafood products. With previous authorization of the BCH, banks may obtain long-term resources abroad, charging interest rates of at least 2% above the cost to the bank. The possibility of direct medium- and long-term foreign resource mobilization by industrialists also exists. However, this has been limited in practice because it has been difficult to contract loans of over 3 years for any but the largest Honduran industries. 2.14 Internally generated resources of the banking system have been declining in importance as a source of funds as deposits have expanded. Capital and reserves of the banking system amounted to L 141.8 million (32.8% of total resources) in 1972 and L 227.6 milion (15.1%) in 1976. However, commercial banks and other financial institutions are providing an important part of CONADI's capital, since, in addition to the government's capital con- tribution of L 10.2 million, CONADI receives contributions from each bank and insurance company in an amount equal to 10% of their capital and reserves, adjusted annually for changes in their capital position. These contributors receive preferred 6% shares in CONADI, amounting to L 8.6 million as of December 31, 1977. As quasi-equity, CONADI also has received L 9.2 million from industrial enterprises, which, under the industrial incentive programs, give an annual amount equal to 10% of total import duties or income taxes exempted by the government. Contributing industries receive non-negotiable 6% interest-bearing certificates repayable by CONADI in 20 years with 3 years of grace. 2.15 Rediscounts. The BCH's several rediscounting facilities are playing increasingly important roles in providing the seasonal liquidity needed to finance inventories of export commodities such as sugar, coffee and tobacco crops and seafood products as well as to meet some of the more urgent short- term needs for productive financing of agriculture and, to a lesser degree, industry. The BCH's general rediscount facility was established by law to rediscount short-term commercial bank loans for productive purposes and to meet short-term liquidity requirements, while the special rediscount facilities are linked to short-term financing of basic commodities. Rediscounts outstand- ing to the banking system rose from L 35.8 million in 1972 to L 117.2 million in 1976. BCH's rediscount rates range from 5-6% for short-term loans for productive purposes to 7-8% for short-term loans to commerce, 8-9% for longer term loans for housing, and 10% for liquidity purposes (i.e., to enable banks to meet current commitments). Rediscount rates have largely been stable, and few rediscounts have been granted in the past two years for other than agri- culture and export financing. In the past BCH has relied on the ad hoc estab- lishment of special rediscount facilities and on quantitative restrictions on these or on the general rediscount facility to channel credit in accordance with the overall objectives of development and monetary policy. A major objec- tive of the proposed industrial credit project is to create a facility within BCH that would provide long-term resources to finance economically sound industrial projects (para. 3.08).  - 20 - D. The Financing of Industry 2.16 About one-fifth of total credit from the banking system to the private sector is being channeled to manufacturing, whose share rose from L 82.7 million (18.4% of the total) to L 202.6 million (20.6% of total) during 1972-77. This was in line with the overall trend in which limited changes in the sectoral distribution favored industry while the volume of credit was undergoing a sizable expansion (26% per annum). Loans to agriculture and livestock, rising from L 107 million to L 251 million, remained at about 25% of the total during 1972-77. Lending for construction and real estate rose from L 87.2 million to L 170.5 million but decreased in relative importance from 19.4% to 17.3%, and lending for commerce and consumption rose from L 96.8 million to L 212.1 million and remained constant at 21.5%. 2.17 Internally generated resources have traditionally been the major source of funds for the financing of industry. Until 1971, equity, undis- tributed profits, and depreciation reserves provided over two-thirds of industrial resources while loans and credits accounted for less than one-third of financing requirements. This is reflected in the average total debt 1/ to equity (D/E) ratio for industry, which was a very low 0.48:1 in 1971 (Table 2.3). In recent years, however, principally because of the high 26% annual average growth in lending to the industrial sector through the banking system, the D/E ratio of industrial firms began to rise sharply and in 1975 the overall D/E ratio for industry was 0.75:1. 1/ Includes loans, accounts payable, suppliers credits, installment credits, liabilities for mortgages, etc.  - 21 - Table 2.3: INDUSTRIAL ASSETS AND LIABILITIES 1971 1975 1971 1975 (million lempiras) (Percentages) ASSETS Current Assets 163.6 446.4 35.3 39.9 Fixed Assets 240.5 565.2 52.0 50.5 Investments 21.0 51.7 4.5 4.6 Other Assets 37.9 56.3 8.2 5.0 Total 463.0 1,119.7 100.0 100.0 LIABILITIES Current Liabilities 94.3 303.3 20.4 27.1 Long-term Liabilities 54.9 167.2 11.8 14.9 Capital and Reserves 313.8 647.3 67.8 58.0 Total 463.0 1,119.7 100.0 100.0 SOURCE: Central Bank of Honduras, 1971 and 1975 sample surveys of 640 and 580 industrial firms. 2.18 The balance sheets for a large sample of the industrial sector in 1971 and in 1975 (Table 2.3) show that only one-third of industrial liabilities were for medium- and long-term obligations. There is also clear evidence (Table 2.4) that the larger Honduran industrial firms (assets over L 750,000) have had greater access to long-term credit than smaller firms, whose ratios of long-term to total obligations averaged only about 14%.  - 22 - Table 2.4: LIABILITIES -/ OF INDUSTRIAL FIRMS (in millions of lempiras) (1) (2) (3) (4) Medium- and Number of Short-term Long-term Total % Size of Firms Firms Liabilities Liabilities Liabilities 3 t 4 L 10,000 to 100,000 125 2.1 0.3 2.4 12.5 L 100,000 to 300,000 128 8.6 0.6 9.2 6.5 L 300,000 to 750,000 117 14.4 4.6 19.0 24.2 Over L 750,000 210 278.2 161.7 439.9 36.7 Total 580 303.3 167.2 470.5 Average 35.5 /1 Including bank loans, accounts payable, accrued liabilities and all other obligations. SOURCE: Central Bank of Honduras 2.19 With about 50% of the industrial borrowers from commercial banks in 1977 having total assets of less than L 500,000 (Annex 5, Table 2), the banking system appears to have been seeking SMI clients. This is not surprising given the overall small size of industrial enterprise and the competitive nature of commercial banking in Honduras. As indicated above, however, SMI is getting a smaller proportion of the highly rationed longer term resources, mainly because lending to small-scale enterprises is costly, since the loan amount is usually small and the cost of appraisal and supervision relatively high. Consequently, commercial banks have tended to consider the current spread on term loans to be insufficient for lending to small enterprises as increased costs are involved. The proposed project would involve an upward revision of interest rates and an increased spread, which would not only help mobilize private savings from the banking system, but encourage financial inter- mediaries to develop the capability to appraise and supervise projects and to lend to small enterprises. E. The Demand for Industrial Investment 2.20 Substantial indications exist that the demand for industrial invest- ment should grow at a high rate and that, providing the required financing is forthcoming, the 9% annual growth rate targeted in the 1979-83 Industrial Development Plan can be achieved. Banks are finding it increasingly difficult to meet even the demand for short- and medium-term financing. Also, in the  - 23 - absence of long-term resources, industrialists have been compelled to seek direct foreign loans to obtain longer terms, which, however, is only feasible for the largest firms. The existing project pipelines of major development institutions are an additional indication of demand. At present CONADI has a pipeline of 11 projects, and COHDEFOR of 17 projects, whose total investment requirements over the next three years are about US$80 million equivalent. Also, major commercial banks estimate that a number of important projects, which have been deferred because of the lack of long-term financing, would be put forward again once long-term funding becomes available. 2.21 To achieve the projected 9% annual growth rate over the 1979-83 period would require an estimated average industrial investment of about US$65 million per year, 1/ of which 70% would be allocated for fixed assets purchasing and 30% for working capital financing. Based upon recent trends in industrial financing (para. 2.17), on average about 50% of incremental industrial investment will be financed by lenders; thus, about US$33 million would be required each year. The proposed Bank loan of US$15 million would, over the 1979-83 disbursement period of the loan, finance about 8% of the funds required, i.e. most of the growth of investment during that period. The remainder of the investment requirements would be met largely as they have been in the past: through medium- and long-term direct foreign loans; by medium- and long-term loans from CONADI and COHDEFOR; and by renewal of short- and medium-term loans made by commercial banks. 2.22 Major constraints to achieving a high and sustained level of indus- trial investment are likely to be the lack of long-term funds, the need to replace BANAFOM as a source of financing to small-scale enterprises, and the lack of a capability among financial intermediaries to identify, prepare, and appraise industrial projects. The proposed project would place major emphasis on reducing all of these constraints. III. THE PROPOSED PROJECT A. Project Objectives and Institutional Structure Background 3.01 The proposed project would represent the Bank's first direct support for the development of the industrial sector in Honduras. For a number of years the Bank carried out preparatory work with a view to channeling resources for industrial financing in the Central American countries through CABEI; how- ever, mainly because of legal problems in connection with the provision of guarantees, the Bank has not been able to finalize a regional industrial lending 1/ Estimated by applying a 2.5 ICOR to the projected 9% incremental growth of the manufacturing sector.  - 24 - project involving CABEI. Moreover, during the 1970s Honduras and the other CACM countries became increasingly concerned with providing financial support to SMI, while CABEI concentrated primarily on large, regional projects, and most countries either established new or strengthened existing national insti- tutions capable of providing industrial finance. Accordingly, the Bank began working with the individual CACM countries to prepare projects designed to strengthen their developing national institutions and tackle the specific industrial sector problems and needs in each country. The proposed project was prepared by the BCH with the assistance of Bank preparation missions in October 1977 and February 1978. It was appraised in May 1978. Project Objectives 3.02 The project is designed to support the government industrial strategy outlined in paras. 1.32-1.33 and to assist the government in meeting its prin- cipal objectives for developing the industrial sector, which include promoting and helping to sustain rapid and efficient growth of industrial output, exports and employment. The project would assist the government to achieve these objectives by: -(i) establishing an effective system to provide term financing for financially sound and economically efficient investment projects of mainly small and medium-sized industrial firms; (ii) helping COHDEFOR to finance priority investments designed to upgrade efficiency and increase output in the primary and secondary wood industry sectors; (iii) assisting industrialists to improve the quality and thorough- ness of their investment planning; (iv) encouraging commercial banks to increase term lending to SMI, based on sound project appraisal techniques; and (v) building an effective service of technical assistance to the smaller industrial enterprises through CTI. Institutional Structure 3.03 A new government fund, the National Industrial Development Fund (FONDEI), has been established by BCH to carry out the project. A Comite Ejecutivo (Executive Committee) would be responsible for the fund's administra- tion and operation. FONDEI will operate as a second-tier financial institu- tion, providing part of the financing for term loans made by financial inter- mediaries to help finance investment projects of industrial firms. Although all commercial banks, together with CONADI and COHDEFOR, will be eligible to participate as FONDEI's financial intermediaries, no more than about two-thirds of the 13 potentially eligible commercial banks are expected to participate in the project. COHDEFOR will establish a separately staffed unit for long-term lending, and adopt lending and investment policies satisfactory to the Bank. All other intermediaries would be required to enter into less stringent  - 25 - participation agreements with FONDEI (para. 3.25). All intermediaries would assume the full credit risk on subloans and would service their debt to FONDEI in accordance with fixed amortization schedules. Technical assistance would be provided by CDI or by consultants, which would help small- and medium-sized enterprises with project preparation and technical assistance (para. 3.34). B. The National Industrial Development Fund (FONDEI) Establishment, Management and Staffing 3.04 FONDEI has been established by BCH resolution as a permanent insti- tution, with its own staffing, financial resources and separate accounting. FONDEI will be headed by a director responsible for managing its day-to-day operations who will report to a three-member Executive Committee established by BCH and which has overall responsibility for establishing FONDEI's operating policies, presenting budgets to BCH's Board, preparing staffing plans, approv- ing FONDEI loans and overseeing its activities. The resolution creating FONDEI spells out the broad objectives and scope of FONDEI's activities, specifies its initial resources and the sources from which it is authorized to secure additional resources in the future, and defines the composition of the Executive Committee. 3.05 BCH has prepared an organization chart and staffing plan for FONDEI (Annex 1). FONDEI will be headed by a director responsible for managing the operations of the fund. The BCH is responsible for appointing the director and providing FONDEI with supporting technical staff and logistics facilities adequate for carrying out the project, and expects to transfer most of the neces- sary professional staff from its Industrial Studies Department. FONDEI's director will be supported by three sections for: Analysis, comprising 4 economists/financial analysts; Engineering, comprising 3 experienced indus- trial engineers; and Administration, initially having one professional staff member. BCH has already selected a qualified director for FONDEI. Prior to effectiveness, BCH would appoint the full-time professional staff necessary to commence the project (including at least one industrial engineer). 3.06 Subloan administration, disbursement and repayment, record keeping and financial accounting would be handled for FONDEI by the BCH's Credit and Securities Department, which handles such work for other BCH funds (including IDA's agricultural and livestock development credits). The organization and staffing arrangements as presently proposed appear adequate to enable FONDEI to successfully carry out the project during the first two to three years. As the volume of operations grows, BCH would augment FONDEI's staff as required to implement the project. Operating Policies and Procedures 3.07 Operating reRulations and nature of projects financed. The policies and regulations that will govern FONDEI's financing operations are set forth in a statement of operating policies prepared by BCH (Annex 2). It specifies,  - 26 - among other things, (i) FONDEI's objectives in financing industrial investment projects; (ii) the types of projects that FONDEI would finance; (iii) the terms and limits of financing; (iv) criteria for project approval; and (v) the responsibilities of intermediaries receiving financing from FONDEI. The policy statement forms a satisfactory basis for FONDEI's channeling of Bank funds for productive sector lending 1/ under the proposed project. FONDEI's Executive Committee has adopted a policy statement satisfactory to the Bank. Any subsequent modification of the policy statement would require Bank approval. 3.08 FONDEI would finance the purchase of fixed assets and the corre- sponding permanent working capital, the installation of industrial equipment and services, the construction of industrial buildings, and the preparation of preinvestment studies and technical assistance services associated with such investment. Projects eligible for financing would have to entail the creation, expansion or modernization of the productive capacity of enterprises involved in manufacturing, agro-industry, forestry and wood processing, tourism, fishing and fish product industries, or in providing mechanical or specialized transport services closely related to industry. In its allocation of scarce resources, FONDEI would primarily finance projects which increase the utiliza- tion of local natural resources, generate export revenues or efficiently sub- stitute imports. 3.09 Terms and limits of financing. FONDEI's primary focus would be on financing investment projects of small- and medium-sized industrial firms and priority projects in the primary and secondary wood industry. Small indus- trial enterprises would be defined as existing firms having total assets, excluding land and buildings, of less than US$100,000 equivalent as of December 31, 1977, or new firms that will be established with total assets not exceeding that amount. This definition corresponds approximately to firms with up to 25 employees, and includes most firms which have had limited or no access to credit from the banking system. Although no upper size limit is proposed for total assets of eligible firms, FONDEI's maximum financing for any one investment subproject and enterprise would be limited to US$750,000 for general industry and US$1.5 million for wood industry subprojects financed by COHDEFOR, to avoid excessive concentration of FONDEI financing in a few firms. For the same reason, FONDEI would not approve financing for companies which it judges to have reasonable access to alternative local or foreign sources of financing on adequate terms. 1/ The Bank recently appraised a possible US$20 million tourism development loan to the Government of Honduras, of which US$16 million would be for a tourism credit program to help finance hotels and related tourism facilities. These tourism credits would be channeled through a separate FONDEI account to be used by participating commercial banks and CONADI. Appropriate additions for tourism lending will be incorporated into FONDEI's policy statement, once agreement is reached between the government and the Bank regarding the tourism project.  - 27 - 3.10 To ensure that a significant part of project resources benefit small industrial enterprises, FONDEI would: (i) allocate at least US$2.5 million of the proposed loan for small-scale enterprise lending; (ii) provide a differentiated spread to cover the higher costs of small-scale lending (para. 3.14); and (iii) coordinate with CDI, the government technical assis- tance agency, to ensure that small-scale projects are well prepared for submission to the participating financial intermediaries (para. 3.34); and BCH would make available for small-scale industry (SSI) financing a significant portion of its US$5 million contribution to FONDEI (para. 3.21). 3.11 FONDEI would establish appropriate maturities for each subloan on the basis of cash flow projections for subprojects. In the case of forestry subprojects, which may involve reforestation components, FONDEI's maximum subloan term would be 17 years, but for general industrial loans the limit would be 15 years. For all types of subloans the maximum grace period would be 3 years. Normally FONDEI would not approve subloans to firms able to repay their debt in less than 3 years, since banks would be expected to finance such subloans from their ordinary resources. 3.12 Within the above terms and limits of financing, FONDEI would parti- cipate jointly with the financial intermediary and the final borrower in financing a specific subproject. FONDEI would finance up to 65% of the cost of fixed assets and associated permanent working capital of new industrial subprojects, up to 75% for forestry subprojects, and up to 80% in the case of subprojects involving the expansion and modernization of industrial enterprises, provided that the financial position and prospects of the recipient company would permit a higher proportion of debt financing. Since the majority of SMI subprojects are likely to be expansions, and most small- and medium-sized firms have rather low D/E ratios because of their limited access to term credit in the past, FONDEI is likely to be asked to finance on average about 70% of total subproject costs. The financial intermediary would finance at least 10% of subproject costs and each subborrower the balance. 3.13 Interest rates. Subloans financed by FONDEI would be denominated in lempiras. Interest rates charged by commercial banks and other financial intermediaries on industrial loans made out of their own resources are subject to maximum limits established from time to time by the BCH. For subloans financed with FONDEI resources, the BCH is proposing to establish an interest rate of 12%, which is about in line with existing lending rates for medium- and long-term loans (although lending rates for over 3 years are freely nego- tiable, in practice medium- and long-term loans to industry are made at 12-13%). Since the average inflation rate was about 8% in 1977 and is not expected to exceed anticipated international levels of 7-8% in the next 3-4 years, the proposed interest rate is expected to be significantly positive in real terms, at least during the disbursement period of the project (para. 2.11). 3.14 The cost of FONDEI financing to the financial intermediary would vary depending on the asset size of the borrowing enterprise. For COEDEFOR projects and general industrial lending intermediaries would pay 9% for FONDEI resources, allowing a spread of 3 percentage points to the intermediary.  - 28 - However, on loans to small enterprises with fixed assets excluding land and buildings of less than US$40,000 equivalent or of between US$40,000 and US$100,000 equivalent, intermediaries would pay only 7% and 8%, respectively, allowing higher margins of 5 percentage points and 4 percentage points to the intermediaries. These higher margins are intended to encourage participating banks to assume the relatively higher costs and risks associated with lending to small industry (para. 4.02). 3.15 FONDEI expects to charge an average interest rate of about 8.75% on its resources, allowing an adequate margin over its borrowing to cover adminis- trative and other costs. The above interest rates and spreads would be reviewed not later than April 1, 1980 and from time to time thereafter, and could be modified, by agreement between the Bank and BCH, as necessary to reflect changing market conditions and inflationary trends. 3.16 While financial intermediaries would be required to lend their minimum 10% contribution for the same terms and with the same grace period as the financing extended by FONDEI, they would not be bound by the interest rate specified for FONDEI subloans. However, they would be subject to the regulations issued by the BCH governing interest rates on long-term industrial loans. Subproject Appraisal and Supervision 3.17 Financial intermediaries, in cooperation with subborrowers, would be responsible for preparing subproject appraisals. FONDEI would review these appraisals and approve financing for those subprojects it judges to be tech- nically sound, financially viable and economically efficient. To ensure uniform quality and content in subproject appraisals FONDEI plans to issue general appraisal guidelines specifying the key items to be covered in appraisals and offering standard definitions and methodologies for financial calculations. While more standardized appraisal reports would tend to evolve in the long term, initially each intermediary, working within the general guidelines, could develop an appropriate system taking into consideration its internal operational requirements and loan analysis procedures. The financial intermediaries participating in the IDA-financed agricultural credit programs (para. 2.02) have been successful in adopting their operations to the Bank's project appraisal and supervision requirements, and it 4S reasonable to anti- cipate that, given appropriate guidelines, they would also perform well under the proposed loan. 3.18 Subproject financing. Subprojects financed by FONDEI would vary considerably in complexity and size, ranging from wood industry subprojects requiring total investments of several million dollars, through medium-size industrial subprojects typically involving investments of several hundred thousand dollars to small industry subprojects in the up to US$50,000 equiv- alent range. Thus, in line with the general appraisal guidelines, the depth and sophistication of subproject appraisal and review would be varied to fit the size and nature of subprojects. For instance, intermediaries would only be required to submit simpler and less detailed appraisals of small industry subprojects focusing on the viability of the enterprise and its investment  - 29 - plan which CDI (para 3.35) or a consultant could help the small enterprise to prepare. For the same reason, FONDEI would use a rapid review procedure for small industry subprojects which would focus on checking that all necessary information for justifying the project has been provided, that the subproject is eligible for financing and that the proposed subloan terms are appropriate. All larger subprojects would be subject to a more detailed review of their technical, financial, marketing and economic aspects. Intermediaries would be expected to include in all appraisals calculations of certain key economic indicators (e.g., employment, domestic value added, net foreign exchange earnings and savings impacts). In the case of subloans above FONDEI's US$250,000 "free limit" (para. 4.03), the internal economic rate of return (ERR) would be calculated. 3.19 To prepare the technical staffs of FONDEI, COHDEFOR, the commercial banks and CDI for their future project preparation and/or appraisal respon- sibilities, a brief and well focused training in industrial project planning and evaluation and in economic analysis would be desirable. BCH is in the process of arranging a 2-3 week project evaluation course in Honduras in early 1979. Initiation of the program would be a condition for effectiveness of the proposed loan. 3.20 Financial intermediaries would be responsible for making periodic supervision vists to firms receiving FONDEI subloans and for maintaining records adequate to indicate the progress of subproject implementation and to compare operating results with appraisal forecasts. The intermediaries' supervision and reporting responsibilities would be clearly specified in the participation agreements which intermediaries would sign with FONDEI. The performance of intermediaries in subproject supervision would be monitored by FONDEI staff on the basis of periodic reports which the intermediaries would be required to submit and through spot visits to industrial beneficiaries. COHDEFOR and CONADI both have the capability to supervise the comparatively large subprojects they are likely to submit to FONDEI for financing. Commer- cial banks, however, which have done little long-term lending in the past, are less experienced in formal subproject supervision and will need assistance from FONDEI initially in organizing these activities. Draft appraisal guide- lines and supervision procedures for FONDEI and the participating financial intermediaries are satisfactory. Final approval of these guidelines by FONDEI's Executive Committee would be a condition of loan effectiveness. 3.21 FONDEI's resources would comprise the proposed loan of US$15 million, together with a contribution of US$5 million equivalent to FONDEI's capital to be made available by BCH. Approximately US$700,000 of this contribution would be used to cover initial financial and operating costs. The balance would be available for a revolving fund type arrangement to advance disbursements against Bank-approved subprojects while waiting to receive disbursements from the Bank and to finance part of the local currency component of approved subprojects. BCH has agreed that out of the US$5 million equivalent government contribution, sufficient funds would be made available for complementary financing of the small-scale industry subloans.  - 30 - 3.22 Based on analyses of the investment requirements of recently financed SMI projects in Honduras, the average foreign exchange content of the mix of subprojects that FONDEI would finance has been estimated at 53%, which would be financed entirely by the proposed loan. Overall, FONDEI expects to finance an average of about 70% of total investment cost. Since the financial inter- mediaries would have to finance at least 10% of investment costs, project sponsors would have to finance on average about 20% (at least 10% in the case of expansion or modernization of existing projects and at least 25% in the case of new projects). On this basis Table 3.1 shows the projected financing plan for the project. Table 3.1: PROJECT FINANCING PLAN (in US$ millions) Total Percentage Foreign Local Contribution of Total FONDEI BC Capital Contribution 1/ - 5.0 5.0 17.6 IBRD Loan 15.0 - 15.0 52.8 Intermediaries (minimum) - 2.8 2.8 9.9 Project Sponsors - 5.6 5.6 19.7 Total 15.0 13.4 28.4 100.0 1/ Net contribution after financing an estimated US$700,000 in start-up costs. 3.23 FONDEI is expected to commit its total resources in about three years, i.e. an average of US$6.4 million equivalent per year (Annex 5, Table 5). A best estimate of the types of subprojects that FONDEI would be likely to finance has been prepared based on the present project pipelines of the financial intermediaries and on the expected specific orientation of FONDEI's operations. About 40% each of FONDEI's financing is expected to support primary and secondary wood industry projects promoted by COHDEFOR and medium-sized industry subprojects. The remainder is expected to go to small industry subprojects. At the subsectoral level, the mix might be roughly as shown in Annex 5, Table 11. Projected Financial Results 3.24 FONDEI's projected financial results for 1979-83 are shown in Annex 5, Tables 5 to 7. During 1979 and 1980, its first two years of oper- ation, FONDEI's portfolio of disbursed loans would average only L 1.4 million  - 31 - and L 6.7 million, respectively, and it would incur operating losses of about L 315,000 in 1979 and L 220,000 in 1980. To the degree that it would not be able to cover its administrative costs and reimburse the government for costs (commitment fee) under the proposed loan out of the spread between its average borrowing and lending costs, payments would be made out of FONDEI's paid-in capital. Starting in 1981, with a loan portfolio averaging L 16.4 million, FONDEI would earn a small profit. By 1983, when the Bank loan is expected to be fully disbursed, FONDEI would have an outstanding loan portfolio averaging about L 37.2 million, yielding a net financial spread of L 934,000, or 2.8% on average loan amounts outstanding. With administrative costs rising gradually to about L 220,000 in 1983 (equivalent to about 0.6% of average total assets), FONDEI's net operating profit would be about L 700,000 in that year, equal to a return of about 7% on paid-in capital and accumulated retained earnings. Considering the expected rate of inflation (para. 2.09), FONDEI should be able to meet its policy objective of maintaining at least the real value of its capital, despite a comparatively low D/E ratio of about 2.9:1. C. Potential Intermediary Institutions 3.25 Although, in principle, COHDEFOR, CONADI and all commercial banks would be eligible for FONDEI financing, participation in the project would be limited to those institutions which could meet the requirements established under the participation agreements. These would provide that the participants would: (i) maintain or contract staff capable of performing satisfactory project appraisals; (ii) supervise projects to ensure that resources had been used for the purpose intended and that projects were progressing on schedule; (iii) adhere to terms of lending and repayment of loans; (iv) ensure that procurement and disbursement provisions were met; (v) maintain adequate records on Bank-financed projects; and (vi) provide FONDEI and the Bank with such information as they would reasonably request. As a condition for loan effectiveness, the Bank would need to receive satisfactory agreements between BCH and CORDEFOR and at least three other intermediaries. 3.26 Commercial banks. Based upon their sharply expanding industrial credit activity in the recent past (para. 2.16), commercial banks are expected to be active in seeking new lending opportunities and to account for about 88% of total projects financed through FONDEI. However, they would use only about 48% of total FONDEI resources, given their relatively greater emphasis upon smaller industrial credits (Annex 5, Table 9). Because of the small amount of term lending by commercial banks in the past, commercial banks participating in the project would need to take steps necessary to train existing, or to hire new professional staff, as needed, to carry out project evaluation and supervision tasks in conformity with FONDEI's requirements. Commercial banks, in general, tend to employ financial analysts and economists superior to the average available in Honduras (including many trained abroad or at INCAE's MBA program). Thus, with appropriate training (para. 3.19), commercial bank loan officers can be expected to adopt satisfactory project evaluation procedures and economic appraisal techniques.  - 32 - 3.27 COHDEFOR. With substantial assistance from FAO and CIDA, COHDEFOR's management has largely succeeded in establishing a sound organization, which includes an export marketing operation (modeled after the Canadian Government's pine export sales agency), which in 1977 sold about US$50 million in pine and strengthened its market position in the USA and Europe. COHDEFOR has also established a forest department of about 700 foresters engaged in reforestation, forest inventory and fire fighting activities covering about 1.5 million ha, and a protection division to monitor wood cutting activity and assist sawmills to upgrade the quality of their operations. 3.28 COHDEFOR's investment strategy for the wood sector involves substan- tial investments which could total US$75 million by 1983 and which would involve three main areas: (i) The Olancho project, a large-scale, multi-stage program which would put a major forest area under intensive production and reforestation, is currently being designed. The project would have a total investment cost of US$150-200 million in 1978-85; (ii) The Comayaqua forest area development program, which would involve the promotion of a wide variety of private and mixed public/private projects to: (a) increase regional lumber output 50% by 1981 through more efficient use of the degraded forest and better milling practices; (b) reduce costs of lumber production and transportation and improve quality of lumber products; and (c) introduce three resource centers into forest regions to upgrade existing logging operations and reduce trans- portation costs, while providing sharply expanded rural employ- ment opportunities in reforestation and forest fire protection and expanded resin production through rural cooperatives. Total investment in plant and facilities during 1979-82 is estimated at US$15-20 million; and (iii) Expansion of the secondary wood industry sector, utilizing mainly the increased output from the Comayaqua region. An effort would be made to attract local and foreign participation in the produc- tion of millwork, furniture, boxes, plywood, and other wood industry enterprises, which could involve a total investment of US$15-20 million during 1979-82. 3.29 The proposed project would assist CORDEFOR to meet part of the finan- cing needs to carry out (ii) and (iii) above. To this end, US$6 million equiv- alent of the proposed loan would be allocated for COHDEFOR's use for a period of 18 months. Because COHDEFOR would serve as a financial intermediary for a major component of FONDEI's resources, CORDEFOR would establish a Forestry Industries Financing Fund (Fund) within COHDEFOR and create a Wood Industry Project Unit within its Lending Division that would be staffed adequately to assume responsibility for industrial project promotion, evaluation, and super- vision in coordination with COHDEFOR's Production and Forestry Departments. The Project Unit would initially be staffed with a unit chief, two financial analysts, and an engineer who would assist in project analysis and coordinate and direct supervision activity. As far as necessary, COHDEFOR would provide  - 33 - training in project evaluation and appraisal techniques to Project Unit staff. The Project Unit would share credit analysis, accounting and portfolio control functions with another unit responsible for short-term credit operations (Annex 3, Organization Chart). 3.30 To ensure that (i) COHDEFOR subprojects submitted to FONDEI for financing would promote the long-term growth and modernization of the primary and secondary wood products and related service industries, 1/ and (ii) these objectives would be implemented in a financially, technically and economically sound way, COHDEFOR's Board would adopt a Statement of Operating Policy for the Fund (for a draft see Annex 4), defining standards for project lending, appraisal, loan approval and supervision activity as well as procurement, disbursement and accounting procedures of the Project Unit. To ensure that the government's policy of fostering mixed public/private enterprise in strategic wood industry projects is implemented, only private or mixed public/ private wood sector projects (not less than 30% private) could be financed by the Fund. As conditions for disbursement, (i) the Project Unit and the Fund would be established by COHDEFOR's Board, and (ii) COHDEFOR's Board would approve an Operating Policy Statement satisfactory to the Bank. 3.31 Although CORDEFOR is not a part of the banking system (para. 2.07), it was allowed to establish within the BCH an account mainly to finance the wood inventory and marketing requirements of sawmills, and exporters and importers of wood products. To facilitate COHDEFOR's lending operations through FONDEI, COHDEFOR will open another BCH account which will be utilized to channel FONDEI funds to COHDEFOR under the proposed project. 3.32 CONADI is expected to account for about 13% of total industrial financing under the FONDEI project, with an average project size of approxi- mately L 1 million (Annex 5, Table 9). CONADI's management is dynamic. Partly because it is comprised of former commercial bankers, financial analysts, and business consultants, CONADI's professional staff of about 25 persons engaged in banking and investment operations includes a well-qualified project analysis group that currently undertakes industrial project evaluation tasks. Thus it is anticipated that with some brief orientation in economic appraisal methodology (para. 3.18) CONADI could meet the Bank's project appraisal requirements for DFCs. With respect to project supervision, CONADI supervises its client companies in detail and often places its management representative on their boards. 3.33 CONADI has a backlog equal to about US$15-20 million in relatively large industrial projects; however, CONADI and other financial intermediaries (except COHDEFOR) would each be limited to US$2.5 million in Bank funds, in order to ensure that FONDEI resources are reasonably distributed and geographic- ally dispersed (para. 4.01). 1/ Including equipment for mechanical services to sawmills, pulp plants, and forest equipment repairs.  - 34 - 3.34 CDI. To ensure that resources made available to SSIs support well- prepared projects and that the errors of past SSI lending through BANAFOM are not repeated, the government in its 1979-83 development plan recognized the need to provide technical assistance as well as credit to SSIs. To achieve this objective, CDI, the government's existing technical assistance agency, which has been used mainly for artisan training and handicraft promotion and sales, has been transformed by law into an autonomous institution. Under this law, enacted in October 1978, CDI would furnish a comprehensive range of extension and promotional services including technical assistance to SSI. To provide CDI with the funds necessary to carry out its new mandate, the annual budget for CDI has been substantially increased, and the portion allocated for assistance to small and medium industry has been increased from L 469,000 in 1978 to L 873,000 in 1979, which is ample to accomplish the desired expansion into project promotion, preparation and technical assistance to SSI. 3.35 In fulfillment of its new and broader technical assistance mandate, CDI would establish mechanisms and procedures to assist small-scale enterprises, against a flat fee of not more than the equivalent of 2% of the subloan requested, to participate in the industrial credit project. CDI would help enterprises which were referred to it by participating financial intermediaries or attracted by CDI's own promotion activity to prepare projects for possible financing by providing technical assistance to the potential subborrower, which may often only consist of helping to obtain the data necessary for ade- quate review by financial intermediaries. Project implementation could involve technical assistance and continued CDI guidance and supervision (for a nominal fee--see above) needed to meet the overall needs of the project. To ensure coordination between CDI and financial intermediaries, FONDEI and a commercial bank representative would assist CDI in preparing project loan applications that would meet overall requirements set by the program. Participating financial intermediaries would not be bound to use CDI to advise potential subborrowers; they could, for example, recommend that potential subborrowers use private consulting firms or their own staff for limited assistance, It is anticipated that during the first year under its augmented budget CDI would, in addition to its existing functions, assist approximately 50 small-scale firms in pre- paration of their applications and project appraisals and provide follow-up technical assistance. As CDI gains experience it is expected to provide assistance to between 100-200 firms per year. 3.36 In the past, CDI's productivity, as measured in terms of number of artisans and SSI assisted and project evaluations completed, was rather low. Consequently, an important objective of the project would be to upgrade the capability of CDI's staff. CDI would therefore need to: (i) recruit, by early 1979, an experienced industrial economist and engineer; (ii) ensure participation of its staff in the project appraisal course to be arranged by the BCH; and (iii) obtain, during 1979-80, consultant expertise to assist CDI in preparing a long-range training program for its staff and to help the director and senior staff to improve procedures for preparing departmental budgets and programs, operating plans, manuals and guidelines. UNDP has tentatively agreed to provide approximately two man-years of assistance to CDI during 1979-80 to accomplish these tasks. UNIDO is expected to be the execu- ting agency. During loan negotiations the Bank reached an understanding on:  - 35 - (i) CDI's staffing plans and budget for 1979-80, (ii) the timing and nature of UNDP technical assistance, (iii) CDI's policy with regard to levying charges for its services, and (iv) CDI's assistance to SSI under the proposed project. The 1979 budget of CDI has already been approved. Prior to loan effectiveness CDI's arrangements for technical assistance would be finalized. IV. THE PROPOSED LOAN A. General Description 4.01 Amounts and terms. The proposed loan of US$15 million would be made to the Government of Honduras at the Bank's prevailing interest rate (presently 7.00%) and standard commitment fee of 3/4 of 1% p.a. The government would transfer the proceeds of the loan through BCH to FONDEI, to be channeled to industrial borrowers through financial intermediaries that meet FONDEI's conditions for participation (para. 3.25). The foreign exchange risk on the proposed Bank loan (primarily the cross currency exchange risk, since the lempira is expected to maintain its parity with the US dollar) would be borne by BCH. For this FONDEI would pay the BCH an annual fee of 0.5% on the balance of outstanding subloans. Subject to review no later than 18 months after loan signing: (i) US$6 million of the loan would be reserved for CORDEFOR's use, (ii) US$2.5 million would be reserved for lending to small-scale enterprises, and (iii) no single financial intermediary (except COHDEFOR) could commit more than US$2.5 million in Bank resources. Loans to small enterprises (with assets below US$100,000) would be exempt from the latter limitation. 4.02 To enable commitment of forest industry subloans which would require final maturities of up to 17 years, the loan would be repaid over 20 years including 5 years of grace (the Bank's maximum loan term for Honduras). Other industrial projects would carry final maturities of up to 15 years. Subloans would be denominated in lempiras. Loan repayments would be made in accordance with a fixed amortization schedule, enabling FONDEI to avoid the administrative complexity of dealing with component schedules for many small loans. Any surplus of repayments from subloans over repayments due to the Bank that would result from the use of the fixed amortization schedule would be used by FONDEI for further subproject lending in accordance with its Policy Statement. To capitalize FONDEI, BCH would make available: (i) US$2.5 million equivalent in capital prior to loan effectiveness and (ii) another US$2.5 million not later than one year after loan effectiveness; and the operating profits accruing to FONDEI would be integrated into its capital structure. Subloans made with FONDEI resources would carry maximum interest rates of 12%. 1/ At present and expected rates of inflation, this interest rate would be significantly positive in real terms. Participating financial intermediaries would be given financial spreads designed to encourage indus- trial credits to smaller enterprises with 5% for loans for firms with fixed 1/ Intermediaries would be allowed to charge somewhat less by reducing their spread on Bank funds.  - 36 - assets under US$40,000 equivalent, 4% for fixed assets between US$40,000 and US$100,000, and 3% for medium-size firms above that level. Interest rates and spreads (paras. 3.13 and 3.15) could be modified by agreement between the Bank and BCH. 4.03 Maximum size of subloan and free limit. FONDEI's maximum subloan for any one investment project or any one enterprise would be US$750,000, except in the case of COHDEFOR-financed projects for which the limit would be US$1.5 million. All subproject appraisals submitted by the financial inter- mediaries would be reviewed by FONDEI. The first ten subloans to small industry would be submitted to the Bank for review and comment 1/. All subloans above US$250,000 (the "free limit") would require Bank approval, and an ERR calculation would be prepared generally by FONDEI staff for all projects above the free limit using standard Bank guidelines for DFCs. This procedure is expected to result in review by the Bank of a representative sample of some 30-40 subloans covering about two-thirds of the loan amount. In addition, selected subloans below the free limit level would be reviewed on a post- approval basis by field supervision missions. 4.04 Procurement. The loan funds would finance the foreign exchange costs of imported and locally procured equipment, materials and services, including the foreign exchange component of construction contracts. Consult- ing services for preinvestment studies or technical assistance services used in conjunction with subprojects would be open to international recruitment. The financial intermediaries and FONDEI would satisfy themselves that procurement items were suitable for the respective investment projects and reasonably priced, and that the beneficiaries had canvassed the main sources of supply and were purchasing from the most advantageous source. Whenever justified, items would be procured on the basis of several quotations, in accordance with standard practice for IDF-type projects. Since it may be difficult or relatively costly to obtain quotations from several suppliers in the case of small orders, the solicitation of offers would be expected mostly for larger procurement contracts. 4.05 Commitment and disbursement. The final date for the submission of subloan proposals would be December 31, 1981, and the closing date for disbursements December 31, 1983 (Annex 5, Table 10). For subloans for small industry subprojects to borrowers with fixed assets of US$100,000 and under (excluding land and buildings) the Bank would reimburse FONDEI for 75% of FONDEI's total financing of individual subprojects representing their average foreign exchange content. 2/ Disbursement for small industry subprojects would be on the basis of a certificate of expenditure submitted by FONDEI, 1/ This would enable the Bank to check initially that appraisals of small industry subprojects are appropriate in depth and focus without delaying the approval process. 2/ The foreign exchange content of subprojects is expected to be 54% of total subproject cost, assuming that FONDEI finances an average 70% of subproject costs (see para. 3.22). The foreign exchange content would represent about 77% of FONDEI's financing.  - 37 - which would retain the supporting documentation in Honduras for inspection during Bank supervision missions. For medium-sized industry subprojects and COHDEFOR subprojects full documentation would be required, and the Bank would disburse for (i) 100% of documented foreign expenditures for directly imported machinery, equipment, raw material inventories and services; (ii) the CIF cost of foreign equipment purchased off-the-shelf or 70% of local expenditures for such goods where the CIF price cannot be ascertained; (iii) a standard percent- age of 35% representing the average foreign exchange content of investments in industrial buildings and related civil works; and (iv) in the case of forestry subprojects a standard percentage of 20% representing the foreign exchange content of wood and wood product inventories. Since the two-tier system, involving FONDEI, the financial intermediaries (including COHDEFOR), and CDI (for SSI lending), requires a longer time for processing of subprojects than is usual for IDF-type loans, disbursements would be made for expenditures incurred up to 180 days prior to the receipt of Bank subloan requests, in lieu of the normal 90 days limit. 4.06 Accounts and auditing. FONDEI would establish and maintain separate accounts for FONDEI as a whole, including the operations under the industrial credit project. Currently, the account of BCH and its special funds and trust accounts (including IDA's agricultural credits) are prepared by BCH's account- ing department and reviewed and audited by the BCH Internal Auditor and the External Auditor appointed by the President of the Republic. COHDEFOR would also establish and maintain separate accounts for its Forest Industries Financing Fund. FONDEI and COHDEFOR would maintain separate accounts which would be audited annually by the BCH External Auditor or independent auditors, respectively, satisfactory to the Bank, and the audited reports, of a content and in a format satisfactory to the Bank, would be submitted to the Bank not later than four months after the close of each fiscal year. B. Project Benefits and Risks 4.07 As indicated in Annex 5, Table 11, subprojects financed would have a significant economic impact. The bulk of financing is expected to go to those subsectors which depend mainly on domestic raw materials and which are the main exporting subsectors (e.g. lumber and wood products, food products, textiles and garments, and chemicals). Given the relatively high labor intensity of the wood, construction materials and metal products industries, which would receive an estimated 60% of sublending, the total investment assisted by the project is expected to result in the creation of about 4,000 new jobs at a relatively low investment cost of US$6,800 per job in 1978 prices. The wood industry component of the project would account for almost 2,450 of the expected 4,000 new jobs at a lower average cost of US$5,300 per job, due mainly to emphasis that would be placed upon financing of labor- intensive medium- and small-scale primary and secondary wood product projects which would also include several highly labor-intensive reforestation, forest management and resin production projects. Wood industry projects would largely benefit families living in the small rural towns and villages within the highly depressed Comayaqua forest region. Overall, about 25% of the jobs created  - 38 - would be at an average cost per job roughly equal to the UPP capital/labor threshold for Honduras. An additional 48% of jobs created would have costs ranging up to 60% over the UPP target. Only 18% of the new jobs would in- volve costs substantially over the threshold level. 4.08 The proposed loan would contribute to filling a major gap in term financing of industrial projects in Honduras and is expected to help finance, through FONDEI, about 165 subprojects with a total cost of US$28 million equivalent. Total financing under the industrial credit project, including the Bank loan, the contributions of BCH, and the mandatory financing by participating institutions, would provide about 8% of the new credits required by industry over the expected loan disbursement period (1979-83) and thus contribute significantly to the 9% p.a. expected industrial sector growth. 4.09 The project would have important institution building benefits. It would help strengthen BCH's developmental role in particular by estab- lishing a system for the analysis and evaluation of industrial projects and for providing term financing for the investment needs of such projects. In addition, it would strengthen COHDEFOR's capability to promote, appraise and finance projects in forest industries, and would provide CDI with the technical assistance it requires in order to meet the increasing demand of small enterprises for its services. 4.10 Indirect benefits resulting from the project are hard to measure. Primary wood industry projects, for example, would normally include in their investment plans such features as adequate basic housing for forest industry workers and their families, water, electricity, medical services and education facilities as part of the industrial infrastructure. Local small farmers would also benefit from new forest access roads and transportation to market centers. Also, it is anticipated that the impact of the program will be geographically dispersed, with agroindustrial subprojects focused mainly along the north coast, forestry subprojects in the mountainous central area, and other manufacturing subprojects located mainly in the cities of San Pedro Sula and Tegucigalpa. 4.11 The project would establish a system which would substantially improve the capacity of participating financial intermediaries to base their lending activities upon detailed project preparation and evaluation. Moreover, introducing economic appraisal into the project appraisal cycle through FONDEI would strengthen the monetary and economic development authorities' appre- ciation for the links between industrial policy formulation and industrial development. Based upon its expected main focus on wood industry and agroindustrial and export-oriented subprojects, the proposed project would assist the government in its efforts to increase non-traditional exports, the value added content in its traditional exportable raw materials, and selected substitution of imports. 4.12 By creating a specialized project unit within COHDEFOR, the proposed project would have the complementary effect of building institutional capability for sharply expanded wood industry project promotion, preparation, evaluation and financing. As a result of the project there would be increased prospects  - 39 - for identifying, promoting and financing mixed private/public sector forest industry projects combining industrial activity with ecologically sound and socially important programs of forest management. 4.13 The proposed project, as conceived, does not involve any unusual risks. However, because the institutional arrangements established under the project would be both new and untried, some initial delays in subloan processing among both the financial intermediaries (including COHDEFOR and CONADI) and FONDEI may occur. To minimize delays in project implementation, Bank supervision of and assistance to the project would be more intensive during the first year. V. RECOMMENDATIONS 5.01 During negotiations agreements were reached and assurances obtained from: I. The Government of Honduras on: CDI's staffing plan and budget for 1979-80, provision of UNDP technical assistance to CDI, CDI's policy regarding fees for technical assistance services, and CDI's assistance to SSI under the project (para. 3.36), II. The Government and BCH on: (i) the terms and conditions of the proposed loan (paras. 4.01-4.06); and (ii) BCH making available to FONDEI US$5 million equivalent as paid-in capital in two equal tranches (para. 4.02). III. The BCH on: (i) the content and status of the draft BCH resolution establishing FONDEI, and the proposed composition of the Executive Committee (para 3.04); (ii) FONDEI's policy statement including provision for subsequent necessary additions required for tourism lending (para. 3.07) and appraisal guidelines and supervision procedures for FONDEI and the participating intermediaries (para 3.20); (iii) FONDEI's initial organization and the qualifications of its staff (para. 3.05) and the policy for future staff increases (para. 3.06); (iv) a suitable training program on project evaluation and appraisal for selected staff from FONDEI, CDI and financial intermediaries (para. 3.19); and  - 40 - (v) the proposed participation agreements to be signed by participating financial intermediaries (para. 3.25). IV. The BCH and COHDEFOR on the legal and administrative mechanisms for resource channeling (para. 3.31); V. COHDEFOR on the organization and staffing of the Project Unit and the establishing of the Fund (para. 3.29), and the draft Operating Policy for the Fund (para. 3.30). 5.02 Conditions of loan effectiveness are that: (i) COHDEFOR and at least three financial intermediaries have signed satisfactory participation agreements with FONDEI (para. 3.25); (ii) the training program for the staff of FONDEI, CDI and participating intermediaries has been initiated (para. 3.19); (iii) satisfactory project appraisal and supervision guidelines for FONDEI and participating institutions have been approved by FONDEI's Executive Committee (para. 3.20). (iv) CDI has made arrangements for engaging consultants for improving its operations (para. 3.36); (v) FONDEI has received US$2.5 million equivalent in paid-in capital (para. 4.02); and (vi) FONDEI has appointed the full-time professional staff necessary to commence the project (para. 3.05). 5.03 Conditions of disbursement for COHDEFOR are that COHDEFOR's Project Unit and Fund would be established and COHDEFOR's Board of Directors would have approved a satisfactory Statement of Operating Policies for the Fund (para. 3.30).  HONDURAS - INDUSTRIAL CREDIT PROJECT ORGANIZATION CHART - NATIONAL INDUSTRIAL DEVELOPMENT FINANCE FUND (FONDEI) Executive Committee azr Director Unit Adminisiration & Unit (4) Supteruisiol (3) (3) World Bank - 9285  ANNEX 2 - 42 - POLICIES AND OPERATING REGULATIONS OF FONDEI 1. The objectives of FONDEI (a Fund of the Banco Central de Honduras) shall be: (a) To promote industrial development, including agro-industries, manufacturing industry, lumber and forest projects, the extraction and processing of marine products, tourist enter- prises 1/ and industry-related service undertakings, especially those that make greater use of natural resources, generate foreign exchange, or stimulate efficient import substitution; (b) To make loans through financial intermediaries to finance the creation, expansion and improvement of the productive capacity of small- and medium-sized businesses; (c) To ensure that smaller-scale businesses have access to long- term credit and to the technical assistance required for the efficient utilization of natural resources; (d) To stimulate the financial intermediaries to help borrowers improve the technical and financial quality of project pre- paration, and to improve their own methodology for project appraisal; (e) To use an appropriate system for the socio-economic appraisal of projects presented to FONDEI for financing; and (f) To devise appropriate systems for supervising the use of FONDEI resources. 2. FONDEI may use the Fund to carry out the following operations: (a) To discount medium- and long-term loans made by lending institu- tions for the purchase of fixed assets, the corresponding permanent working capital, the installation of industrial equip- ment and services, the construction of buildings, the prepara- tion of pre-investment and feasibility studies, and for tech- nical assistance related to the projects being financed; (b) Payment of all costs and charges relating to FONDEI's operations; and (c) Other financial transactions relating to the Fund's objectives. 1/ Subject to terms and conditions which will be established by agreement between the Bank and BCH.  ANNEX 2 - 43 - 3. The maximum amount of each loan authorized by FONDEI to expand or set up manufacturing, agro-industrial and fisheries undertakings shall be L 1.5 million. For forests and lumber projects, the limit shall be L 3 mil- lion. The financing of subprojects exceeding these limits may be approved by FONDEI only when these are top priority projects. 4. All subloans shall be expressed in Lempiras. To cover possible exchange risks, FONDEI shall pay BCH a fee of one-half percent per year on the outstanding balance of the loan granted by FONDEI. 5. The following criteria shall be borne in mind in the selection of projects to be financed: - The economic and financial rates of return; - The use of labor; - The increase or savings in foreign exchange; - The probability of increasing the percentage of value added; - The use of Honduran raw materials, goods and services; and - Other economic factors, according to the nature of the project. 6. FONDEI shall periodically examine the projects financed in order to ascertain that small-scale businesses are receiving a proper share of the Fund s resources and whether technical assistance, if required, is adequate; it shall likewise adjust the structure of the rediscounting rates and other conditions affecting the participation of the financial intermediaries, to ensure that the Fund's resources are being used for purposes referred to in Section 1, and that all interested intermediaries have access to the said resources. 7. The Fund shall operate indefinitely and shall be financed to carry out the purposes for which it has been created (paragraphs 1 and 2). It shall retain sufficient staff to carry out the regular activities of project design, promotion, appraisal and supervision, including the necessary administrative and accounting functions. Its principal resources for achieving its industrial objectives shall consist of an initial capital of L 10 million, contributed by BCH, and the funds allocated to it by the Government of Honduras from loans contracted with national and international organizations, its own earnings, and any other resources which it might obtain. 8. FONDEI shall provide financing up to a limit of L 5 million per institution through commercial banks and CONADI, on condition that such institutions develop proper facilities for appraising and supervising long-term loans, and that they also meet such other requirements as FONDEI may determine. Among the participants shall be the Honduran Corporation for Forestry Development (CORDEFOR), which will receive an allocation of L 12 million through a separate account at the Banco Central de Honduras. Eligible wood sector enterprises would need to have at least 30% private ownership.  ANNEX 2 - 44 -- 9. Within the limits laid down (paragraph 3) FONDEI may, in the case of (i) new projects, finance up to 65% of the value of the fixed assets and permanent working capital; the financial intermediaries shall provide not less than 10% of the project funds from their own resources, and the borrower shall contribute the balance of the total cost, as required to complete the financing of the sub-project; (ii) for the expansion and modernization of existing enterprises, finance up to 80%; and (iii) for forestry projects, up to 75%. FONDEI may authorize percentages different from those above in cases involving small-sized firms with a sound financial structure. 10. The terms and other conditions on which FONDEI provides financing shall depend on the characteristics of the investment. The intermediary institutions shall provide financing on the same conditions as FONDEI. Loans may be granted for a maximum period of 17 years for forestry loans, and 15 years for industrial loans, which may include a grace period of up to 3 years. 11. The interest payable by borrowers and financial intermediaries shall be established by FONDEI. The interest rates must cover FONDEI's financial and operating costs, and enable its capital to be preserved and increased. 12. The Fund may make loans for the execution of pre-investment and feasibility studies when these are related to projects eligible for assistance. These loans shall be granted on such conditions as the Trustee may in each case determine. If the pre-investment or feasibility study leads to the relevant project being carried out, the loan for the said study shall be consolidated with that granted for implementation of the project. 13. Financing provided by the Fund to lending institutions and other participants (financial intermediaries) are subject to the following basic requirements: (a) They may only be granted to financial intermediaries operating in accordance with the laws of Honduras. (b) The financial intermediary must ensure that the borrower will have access to sufficient funds to finance its working capital needs. (c) The financial intermediary shall help potential borrowers to prepare, in an acceptable form, a study of the market and of technical and financial factors, for its appraisal. (d) In the case of loans to small businesses requiring help with project preparation, the financial inter- mediaries shall request the Industrial Development Center (CDI) or other qualified advisors to provide the necessary technical assistance, against a fee of not more than 2% of the amount of the loan.  ANNEX 2 - 45 - (e) The financial intermediaries shall punctually repay their loans from FONDEI even though they may not have been reimbursed by their borrowers. They shall immediately pay to FONDEI any sums received in advance. 14. The Fund shall not finance projects which can call on alternative sources of financing on acceptable terms for the project. 15. FONDEI's accounts shall be audited by the External Auditor of BCH or by qualified independent auditors.  - 46 - ANNEX 3 HONDURAS - INDUSTRIAL CREDIT PROJECT ORGANIZATION CHART - FOREST INDUSTRY DEVELOPMENT FUND (FONDO) |Genera Manag COHDEFOR eProjecrt Loan ,eCommittee Director Department of F inance Short Terr Loan Cornmit-ee . Loan Planning and Division PrSject Promotion Wood Industry orest Industry~ ~~orstr Dearten | Short Term Proiad L FinancinL | (ChiefW | Credit Ceit AnI 1- --I- -- Computer Canter Portfolio Project iBMI Systems 3 r-antrol of Aait Billing and ___ Coilection n2iSS Reaortino Svstem 141 (2 \ ~~~~~~~Supervision \ & _ _ _~~Egieein Operating Oepartments > (11 ~~~~~~~~Forestry Department \ I ~~~~~~~~Production Oepartmem \ i ~~~~~~~Marketing Oepartment \ Potfolo Cnd rl_ and Supervision Collection (4) World Bank -19284  ANNEX 4 - 47 - HONDURAN FORESTRY DEVELOPMENT CORPORATION (COHDEFOR) TEGUCIGALPA, D.C., HONDURAS, C.A. ANNEX D FORESTRY INDUSTRIES FINANCING FUND STATEMENT ON OPERATIONAL POLICIES AND PROCEDURES I. PURPOSE The Forestry Industries Financing Fund (hereinafter called the Forestry Fund) is a financial development institution operating as an admin- istrative fund within the Honduran Forestry Development Corporation (COHDEFOR), whose principal objective is to accelerate the economic growth-rate of the forestry products industry, to which end it will promote and finance specific projects for the development of forestry products, industries processing wood and resins and related services. The Forestry Fund will therefore follow a judicious policy of promoting, financing and assistirg productive enterprises consistent with national development plans. The Forestry Fund will undertake its activities on the basis of sound criteria and practices in the investment field and within the framework of its charter, regulations and the present statement of policies and procedures. The administration of the Fund will be carried out by a Project Unit, adequately staffed for this purpose. II. FUNCTIONS The Forestry Fund shall perform the following functions and activities: (i) Promote the establishment of a primary forestry products induscry and of a secondary wood products industry, in order to enhance the value added and expand domestic pro- duction and exports of forestry products and of wood. (ii) Grant medium- and long-term loans to individuals and private and mixed companies for the expansion of produc- tion in the sectors to which paragraph (i) above refers. (iii) To these ends and with the agreement of the Board of Directors of COHDEFOR, it may obtain loans and, with the approval of the Central Bank of Honduras, issue bonds.  ANNEX 4 -48 - III. GENERAL FINANCING GUIDELINES 1. In the performance of its activities the Forestry Fund, on a basis of sound financing practices, shall display reasonable prudence in relation to the risks involved in financing operations and seek to diversify its financing activities in both geographical and subsectoral terms. 2. The Forestry Fund shall consider all proposals on their financial and economic merits and select those that promise an acceptable return and promote the economic development of the Republic of Honduras. 3. The Forestry Fund shall attach due weight to the economic aspects of the projects it finances. When the amount of a loan exceeds the equivalent of L 200,000, a detailed appraisal will be made of the economic aspects of the project. To this end, a system of analysis permitting the internal calculation of rates of economic return and other methods shall be adopted as a basis for decision-making. 4. The Forestry Fund shall base its operations on sound develop- ment financing policies consistent with COHDEFOR's charter. The Fund shall utilize its long-term resources for the follow- ing financial operations: (i) Purchase of operational equipment and plant for primary and secondary wood products; (ii) Purchase of equipment for the expansion and moderniza- tion of existing operations for primary and secondary wood products; (iii) Purchase of plant and equipment for the service organi- zations that are essential to the industry producing primary and secondary wood products; (iv) Purchase of equipment and tools for cutting timber and forest conservation and for groups and cooperatives in the resin industry; (v) Purchase of fixed assets including equipment for the timber industry; and (vi) Permanent operating capital. 5. Loans shall be sufficient to cover the costs involved, which are shown in the subproject investment program. Terms and periods of grace in financing provided by the Forestry Fund shall duly reflect the useful life of the goods financed and the projected flow of funds in the case of each project.  ANNEX 4 - 49 - 6. The Forestry Fund shall not finance more than 75% of the total cost of a project, excluding land costs. Exceptions may be made to this general rule when there are special grounds for these, such as in the case of financial assistance for small and medium scale enterprises or the expansion of a pro- ject in which the borrower's financial structure is adequate. 7. Loans guaranteed by mortgages shall not exceed 60% of the value of the mortgaged real property. Loans guaranteed by pledges or other similar liens shall not exceed 50% of the value of the item pledged. 8. The Forestry Fund shall require borrowers to undertake their activities with reasonable diligence and efficiency and on the basis of sound financial, administrative and technical practices, keep adequate documenta- tion and records, and provide financial statements at least once a year but more frequently in the case of enterprises facing difficulties. The Forestry Fund shall also require an enterprise to pay on time its tax, social security and other legal obligations. 9. The Forestry Fund shall ensure that goods and services intended for the projects it finances are only purchased after a comparison between the prices and technical specifications submitted by various suppliers, whenever this is possible, so that each project is undertaken at the lowest possible price with the best possible goods and services. 10. The Forestry Fund shall require borrowers to obtain and keep up adequate insurance against various risks. Borrowers will also cover other risk factors associated with the purchase of the goods financed and their transportation and delivery to the place of their use or installation. 11. The Forestry Fund will not grant loans or guarantees to government agencies or autonomous institutions. 12. The Forestry Fund shall make loans only to private or mixed enterprises in which CORDEFOR participates in cases in which: (a) COHDEFOR's participa- tion in the enterprise does not amount to more than 70% of the total; (b) the outstanding balance of financing granted to any single individual or enterprise shall not exceed 20% of the capital and reserves of the Forestry Fund; (c) the corporate objective of the enterprise is to produce a reasonable return on the assets invested; and (d) an assurance has been given that partners with the necessary technical expertise will participate in its management. IV. PROJECT SUPERVISION GUIDELINES 1. The Forestry Fund shall itself assume responsibility for inspecting properties, equipment, activities, plant and works included in the projects it finances and in their operations, together with all pertinent documenta- tion and records.  ANNEX 4 -50 - 2. The Forestry Fund shall seek at all times to improve and strengthen the technical, commercial and financial management of the enterprises it finances, distributing appropriate guidelines either through its own personnel or through consultants or experts appointed for this purpose, as necessary. The Forestry Fund shall assume no responsibility for the management of the enterprises that it assists. 3. The Forestry Fund shall disburse its loans according to progress made with the implementation of the project and shall satisfy itself that the funds disbursed have been properly used. 4. The Forestry Fund shall introduce a permanent system for monitoring, supervising and collection on its loan portfolio, with a view to maintaining a high quality portfolio with a minimum of delinquent accounts. 5. In the case of borrowers with outstanding loan balances exceeding L 50,000, irrespective of the periodic examination of the financial statements of each borrower, the Forestry Fund shall inspect the installations and opera- tions of each borrower at least once each year and, in the case of enterprises experiencing difficulties, as frequently as necessary. Such inspections shall comprise an evaluation of the guarantees furnished by each borrower, in order to ensure that they maintain adequate insurance with responsible insurance companies based on sound commercial practices. 6. If necessary, according to the status of each enterprise, the Forestry Fund may impose the following requirements: (a) The enterprise shall not enter into further obligations without the prior authorization of the Forestry Fund, except for normal credit facilities for operating capital; (b) A firm of independent auditors shall be engaged acceptable to the Forestry Fund; and (c) The enterprise undertakes to pay no dividends if its financial situation should so require. V. FINANCIAL GUIDELINES 1. The Forestry Fund shall carry out its operations in such a manner as to ensure at least a reasonable return sufficient to maintain the real value of its capital. Interest rates, commitment charges and other charges shall be established by the management of the Fund in order to ensure proper observance of these guidelines. 2. In the course of its operations the Forestry Fund shall not assume foreign exchange risks: it shall pass these on to its clients.  ANNEX 4 - 51- 3. Schedules for the maturity of the assets of tlw Forestry Fund shall be equal to, or of shorter term than, the corresponding schedules for the discharge of its obligations. 4. The Forestry Fund shall not enter into obligations, including con- ditional obligations, that exceed eight times its paid up capital and reserves, less losses. 5. The Forestry Fund shall introduce a system of periodic evaluation of its loan portfolio and other accounts and, on this basis, set aside adequate reserves to cover bad debts and other losses in conformity with sound finan- cial practice. In the case of delinquent amounts the Fund shall review the financial status of the borrower every three months. 6. The Forestry Fund shall arrange for its accounts, financial state- ments, balance sheets and profit and loss statements for each fiscal year to be audited in conformity with the General Law on Commerce. 7. The operations and financial statements of the Forestry Fund shall be audited each year by independent external firms of auditors satisfactory to BCH. 8. The Forestry Fund shall not finance any project that already has alternative sources of financing on terms acceptable to the project. VI. MANAGEMENT GUIDELINES 1. The operating costs of the Forestry Fund shall be maintained at the minimum level compatible with its objectives and the scope of its operations. 2. The Forestry Fund shall provide additional training for its man- agerial and technical personnel in order to build an effective organization that can undertake project evaluation and subsequent supervision of borrowers. 3. The Forestry Fund shall introduce an effective system of remunera- tion and incentives for its staff and set aside sufficient funds for their education and training. 4. The staff of the Project Unit, which shall initially include a chief, two financial analysts and one engineer, shall be recruited and promoted in accordance with their competence and professional experience. Additional staff shall be recruited as required to ensure satisfactory operation of the Fund. 5. The Forestry Fund shall submit reports each year or more frequently comprising: (a) Evaluation of new projects; (b) Progress on projects already financed;  ANNEX 4 - 52 - (c) Financial statements; (d) Delinquent borrowers; (e) Other matters of importance relating to the financial condition and operational status of the Forestry Fund. 6. The management of the Forestry Fund shall ensure that the guide- lines and procedures defined above are uniformly applied.  -53- ANNEX 5 Table 1: HONDURAS - INDUSTRIAL CREDIT PROJECT Industrial Financing and Percentage of Total by Commercial Bank (1975-77) (new loans in millions of U.S. dollars) 1975 1977 Amt. % Amt. Commercial Banks Atlantida 17.4 28.6 24.1 24.9 Honduras 4.3 6.9 3.6 3.7 Occidente 1.1 1.8 3.2 3.3 Londres y Montreal 3.1 5.0 3.5 3.6 El Ahorro Hondureno 2.7 4.3 6.1 6.2 Bank of America 3.3 5.3 4.5 4.7 Los Trabajadores 0.3 0.5 1.3 1.3 BANCAHSA 5.4 8.7 7.4 7.7 Del Comercio 3.1 5.0 3.1 3.2 Financiera Hondurena 6.8 10.9 7.9 8.2 Continental 0.7 1.1 2.8 2.9 Financiera Centroamericana 0.2 0.3 1.9 2.0 Hipotecario 0.3 0.5 . 1.5 1.6 Commercial Bank Total 48.7 78.3 70.9 73.3 Percentage of Banking System Total 78.3 73.3 SOURCE: Central Bank of Honduras and mission estimates.  - 54 ANNEX 5 Table 2: HONDURAS - INDUSTRIAL CREDIT PROJECT Analysis of Size of Industrial Enterprises Borrowing from Commercial Banksl/ (July 1, 1976 - June 30, 1977) Number of Total Assets Asset Size Borrowing (Thousands of Firms Z Lempiras) Under L. 30,000 159 14.0 3,014 30,000 to " 50,000 76 7.0 3,004 50,000 " " 100,000 89 8.0 6,885 100,000 " " 300,000 159 14.0 31,587 300,000 " " 500,000 65 6.0 22,436 500,000 " " 750,000 61 5.0 36,880 Over " 750,000 510 46.0 2,555,477 Total 1,119 100.0 2,659,281 1/ Based upon reports by each of the 13 commercial banks in the banking system to the Central Bank for the 12 months ending June 30, 1977. Commercial banks reported on the terms, interest rates, purpose and size of 2,711 industrial loans granted. Banks also reported on the asset size of the 1,119 companies to whom industrial credits had been granted based upon the balance sheet and other financial information provided by borrowing enterprises and credit information obtained by the commercial banks. The carrying value of land and buildings owned by the borrower is included in asset valuation. SOURCE: Central Bank Survey of Commercial Banking System, January 1978.  - 55- ANNEX 5 Table 3: HONDUSRAS - INDUSTRIAL CREDIT PROJECT Analysis of the Size of Industrial Loans Granted by Commercial Banks (July 1, 197.6 - June 30, 1977) Amount Loan Size Number Z (Thousands of Lempiras) 7 * Less than L. 10,000 890 32.8 2,197 2.2 10,000 to " 30,000 628 33.2 6,083 6.2 30,000 " " 50,000 363 13.4 7,794 8.0 50,000 " " 100,000 370 13.7 14,074 16.6 100,000 " " 300,000 321 11.8 28,134 28.8 300,000 500,000 93 3.4 18,507 18.9 500,000 ' " 700,000 23 1.0 7,198 7.4 Over " 700,000 23 1.0 12,749 13.0 Total Borrowing 2,711 100.0 97,732 100.0 SOURCE: Central Bank Survey of Commercial Banking System, January 1978.  -56 -M 5 Table 4: HONDULRAS - INDUSTRIAL CREDIT PROJECT FONDEI - Schedule of Maximum Annual Interest Rates for Banking System (Loans Over L2,500) 1967 1978 Loan rates: Productive Purposes: (Industrial and agricultural production, services, transportation, construction and communications) 9.0 11.0 Commerce and consumption Free 13.0 Housing loans 10-15 years 10.0 11.0 Housing loans over 15 years 11.0 12.0 Agricultural exports (loans over L100,000 with maturities exceeding 6.months) -- Free Productive Purposes (loans over LlO0,000 with maturities of 3 years and greater) -- Free Deposit rates: Savings deposits 4.0 6.0 Time deposits Up to 3 months 4.0 7.0 3 to 6 months 4.0 7.5 More than 6 months 7.0 8.0 More than 12 months 7.0 8.5 More than 18 months 7.0 9.0 More than 24 months 7.0 9.5 Minimum LlO0,000 Free (more Free (more than 1 year) than 6 mos.) SOURCE: Central Bank of Honduras  Table 5: HONDURAS - INDUSTRIAL CREDIT PROJECT FONDEI's Total Commitments and Disbursements (Lempiras 000 Omitted) 1979 1980 1981 1982 1983 Approval 14,000 17,000 9,000 Commitments 14,000 17,000 9,000 Disbursements 2,800 7,800 12,000 11,400 6,000 Ln Of which IBRD 2,160 5,840 8,680 8,680 4,640 Cumulative IBRD 2,160 8,000 16,680 25,360 30,000 SOURCE; Central Bank of Honduras and mission estimates. 3>  - 58 - ANNEX 5 Table 6: HONDURAS - INDUSTRIAL CREDIT PROJECT FONDEI - Estimated Balance Sheet (Thousands of Lempiras) 1979 1980 1981 1982 1983 A. ASSETS 1. Cash 45 105 116 138 157 2. Loan Portfolio 2,800 10,600 22,660 34,005 40,425 3. Provisions - - - - - 4. Fixed Assets - 10 25 40 60 5. Depreciation - - 2 4 7 6. Net Fixed Assets - 10 23 36 53 6. Total Assets 2,845 10,715 22,749 34,179 40,635 B. LIABILITIES 1. Foreign Long Term Debt 2,160 8,000 16,680 ,25,360 30,000 2. Other Liabilities - - - - 3. Paid in Capital 1,000 3,250 6,550 8,895 10,000 4. Retained Earnings (315) (535) (491) (76) 635 5. Total Capital 685 2,715 6,069 8,814 10,635 6. Total Liabilities and Capital 2,845 10,715 22,749 .34,179 40,635 e===== ===== ~===S== ==~==== ====== Average Loan Portfolio 1,400 6,700 16,630 28,332 37,215 SOURCE: Central Bank of Honduras and mission estimates.  -59- ANNEX 5 Table 7: HONDURAS - INDUSTRIAL CREDIT PROJECT FONDEI - Estimated Income Statement (Thousands of Lempiras) 1979 1980 1981 1982 1983 1. Income / 140 543 1,359 2,370 3,164 2. Financial Costs 303 593 1,119 1,748 2,230 3. Financial Spread (163) (50) 240 622 934 4. Direct Costs 150 160 180 190 200 5. Other Costs - 10 15 15 20 6. Operating Profit (Loss) (315) (220) 45 402 714 7. Provisions 0 0 0 0 0 8. Depreciation 2 2 3 9. Net Profit (Loss) (315) (220) 44 415 711 Average Portfolio 1,400 6,700 16,630 28,332 37,215 1/ 1979 1980 1981 1982 1983 Key Operating Ratios Net Profits/ATP - - - 1.5% 1.9% Net Profits/Capital - .7% 4.7% 7.0% Financial Spread/ATP - - 1.4% 2.2% 2.5% Operating Expenses/ATP 10.7% 2.2% 1.0% .7% .6% SOURCE: Central Bank of Honduras and mission estimates.  - 60 - ANNEX 5 Table 8: HONDURAS - INDUSTRIAL CREDIT PROJECT FONDEI - Estimated Uses and Source of Funds (Thousands of Lempiras) 1979 1980 1981 1982 1983 A. Source Net Profit (Loss) (315) (220) 44 415 711 Depreciation - - 2 2 3 Foreign Loans 2,160 5,840 8,680 8,680 4,640 Portfolio Recovery - - 350 1,340 2,910 Paid in Capital 1,000 2,250 3,300 2,340 1,110 B. Uses Disbursement (Initial) 2,800 7,800 12,000 11,400 6,000 Disbursement (Reinvestment) - - 350 1,340 3,304 Increases in Fixed Assets - 10 15 15 20 Repayment of Foreign Loans - - - - - Increases (Decrease) in Cash 45 60 11 17 19 C. Net Cash Level 45 105 116 138 157 SOURCE es=== C=== o===sai i===mts SOURCE: Central Bank of Honduras and mission estimates.  - 61 - ANNEX 5 Table 9: HONDURAS - INDUSTRIAL CREDIT PROJECT FONDEI - Expected Size Distribution of Subloans (Amounts in Lempiras) Number of % of Total % of Projects Total Amount Total (000 omitted) Commercial Banks Up to 30,000 45 27 674 1.5 30,000 to 100,000 49 30 2,004 4.6 100,000 to 200,000 15 9 2,250 5.2 200,000 to 500,000 25 15 7,748 17.9 500,000 to 700,000 5 3 3,000 6.9 700,000 to 1,500,000 5 3 5,000 11.5 Total 144 88 20,676 47.8 CONADI Up to 500,000 3 2 1,000 2.3 500,000 to 1,500,000 6 4 4,500 10.4 Total 9 6 5,500 12.7 COHDEFOR Up to 500,000 3 2 1,118 2.6 500,000 to 3,000,000 8 5 16,000 36.9 Total 11 7 17,118 39.5 Total Project 164 100 43,294 100 SOURC: C== ==== ==== SOURCE: Central Bank of Honduras and mission estimates.'  - 62 - ANNEX 5 Table 10: HONDURAS - INDUSTRIAL CREDIT PROJECT Estimated Schedule of Disbursements for the Proposed Loan Disbursement IBRD Fiscal Year and Quarter By Quarter Cumulative (US$000) FY 1979 To March 31 June 30 50 September 30 250 December 31 580 880 FY 1980 To March 31 750 June 30 750 September 30 800 December 31 820 4,200 FY 1981 To March 31 900 June 30 1,000 September 30 1,100 December 31 1,340 8,340 FY 1982 To March 31 1,500 June 30 1,100 September 30 900 December 31 840 12,680 FY 1983 To March 31 800 June 30 700 September 30 600 December 31 220 15,000 SOURCE: Central Bank of Honduras and mission estimates.  - 63 - ANNEX 5 Table 11: HONDURAS-INDUSTRIAL CREDIT PROJECT Estimated Sectoral Distribution and Employment Impact of Subprojects (In US$ Adjusted to 1978 Prices) Subprojects Total Assets Employment Subprojects Total Costs Per Job Generation (000 omitted) % x a/ Primary Wood Projects 9,000 32 6,300 1,430 34.3 Secondary Wood Projects 4,000 14 4,000 1,010 24.3 Food, Beverages 6,000 21 14,600 410 9.9 Textile, Leather 3,000 11 9,100 329 7.9 Paper, Printing 1,000 3 11,300 88 2.1 Chemicals 2,000 6 10,200 195 4.7 Construction, Materials (clay) 1,000 3 4,900 205 4.9 Metal Products, Machinery 1,000 3 7,800 129 3.1 Other 2,000 7 5.600 358 8.6 TOTAL 28,000 100 4,154 100.0 Average 6,800 Source: Appraisal estimates, based upon COHDEFOR and CONADI project lists and commercial bank survey. Assets per job based upon 1975 Census of manufactures adjusted to 1978 price levels. a/ Figures do not total 100% due to rounding.   -64 - ANNEX 7 HONDURAS INDUSTRIAL CREDIT PROJECT Selected Documents and Data Available in the Project File 1. Investigacion Industrial, 1975. Presents data on the industrial sector. 2. Industria Artesenal, 1974. Presents data on the artisan sector. 3. Boletin Estadistico, monthly. Publications by Central Bank of data mainly regarding the banking sector. 4. Honduras en Cifras, 1974-76. Publication by the Central Bank of general economic data. 5. Desarrollo y Perspectivas de la Pequenia Industria y Artesania, 1975. Final report of the UNDP advisor to CDI. 6. Caracterizacion y Bases de un Programa para el Desarrollo de las Peguefias, Medianas Industrias y Artesanias en Honduras and Sistema de Asistencia Tecnica y Creditos Supervisados para las Pecuefias, Medianas Industrias y Artesanias, October, 1977. The preliminary proposal of the National Economic Planning Council for the project appraised in this report. 7. Ley del Centro de Desarrolla para la Peguefia y Mediana Empresa Industrial y la Artesania. New law regarding the legal status and activities of CDI. 8. Memoria COHDEFOR, 1975-77. Annual reports of COHDEFOR. 9. Ley de la Corporacion Hondurefia de Desarrollo Forestal, 1976. Law establishing COHDEFOR.   1 0 : . : /' ~~~~~~~M ft:gX~~~~~~~~~~~~~~~~~~~~~~~ ty S:X:~~~~~~ - ------ : o \ i: 3 < o o ) : v f n~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~W