Colombia - Eighth Development Finance Companies Project

Document of FILE COPY The World Bank FOR OFFICIAL USE ONLY Report No. P-27 50a-CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON. A PROPOSED LOAN TO BANCO DE LA REPUBLICA WITH THE GUARANTEE OF THE REPUBLIC OF COLOMBIA FOR AN EIGHTH DEVELOPMENT FINANCE COMPANIES PROJECT May 5, 1980 'Tis document has a restrieted didributon and may be iwed by recipiets only In the performance of their offcial duties. Its contents may not ohenrwise be disclosd without World Bank authorization.  CURRENCY EQUIVALENTS Average Calendar Year 1979 April 1, 1980 Currency Unit = Peso - Col$ Col$ US$1 = Col$42.59 45.64 Col$1 = US$0.0235 0.0219 GLOSSARY OF ABBREVIATIONS AID - A?ency for International Development CF - Corporacion Financiera DDC - Department of Development Credit of Banco de la Republica DFC - Development Finance Company GDP - Gross Domestic Product IDB - Inter-American Development Bank IFC - International Finance Corporation OED - Operations Evaluation Department FISCAL YEAR January 1 to December 31  FOR OFFICIAL USE ONLY COLOMBIA EIGHTH DEVELOPMENT FINANCE COMPANIES PROJECT LOAN AND PROJECT SUMMARY Borrower: Banco de la Republica Guarantor: Republic of Colombia Beneficiaries: Private Development Finance Companies Amount: US$150 million equivalent Terms: Interest at &.25% per annum. Repayment in 17 years, including 4 years of grace. Onlending Terms: 1/ Maximum Te s --------- Interest (%)------------- (Years) - Dollar Funds Peso Funds Maturity Grace 3/ To Sub- To Sub- To DFC borrower To DFC borrower 4/ Sub-loans 12.25 15 24 27 15 3 Equity Investments - 24 not applic. 15 5 Technology Development - 21 24 5 2 Pollution Control - 21 24 10 2 Project Description: Development of private industry through contribution of foreign exchange for loan and equity financing by Development Finance Companies of investment projects, including technology development and pollution control, in manufacturing, mining and tourism. 1/ Banco de la Republica would assume the foreign exchange risk on peso funds; it would assume the cross-currency risk on dollar funds for a fee of 3.25% per annum payable by the subborrowers. 2/ Repayment terms are identical for the DFCs and the sub-borrowers, except in the case of equity investments. 3/ Included in maturity. 4/ Nominal rates; as interest is collected quarterly in advance, the effec- tive interest rate would be between 4 and 5 percentage points higher. This document has a restricted distribution and may be used by recipients only in the performance of their omcial duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - The entities involved in the project have been carrying out industrial credit programs, as the one proposed, for several years with very satisfactory results. Conse- quently, no unusual risks are anticipated in attaining the objectives of the project. Estimated Disbursements: FY81 FY82 FY83 FY84 FY85 ------US$ Millions--------- Annual 14 40 50 40 6 Cumulative 14 54 104 144 150 Staff Appraisal Report: No. 2885b-CO of April 29, 1980  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO DE LA REPUJBLICA WITH THE GUARANTEE OF THE REPUBLIC OF COLOMBIA FOR AN EIGHTH DEVELOPMENT FINANCE COMPANIES PROJECT 1. I submit the following report and recommendation on a proposed loan to Banco de la Republica for the equivalent of US$150 million, the proceeds of which would be onlent to private development finance companies (DFCs) for the development of private industry. The loan would have a term of 17 years, includ- ing 4 years of grace, with interest at 8.25% per annum. It would be repaid in equal installments of principal. PART I - THE ECONOMY 1/ 2. An economic report on Colombia (2535-CO) was distributed to the Executive Directors in June 1979. A small updating mission visited Colombia in mid-December and this section on the economy reflects its major findings. Country data sheets are provided in Annex I. Background 3. Colombia has made substantial progress over the past two decades in the transition from a predominantly rural and agricultural economy scattered among several isolated, but largely self-contained, regions to a more inte- grated, urban industrial economy. The productive base of the economy has been widened and diversified, and a modern sector relying heavily on imported inputs has developed. The country's external sector has been strengthened by the rapid growth of non-traditional exports. Fluctuations in domestic economic conditions resulting from unpredictable shifts in world coffee prices, while still considerable, have become more manageable. 4. Following several years of erratic economic growth and high unemploy- ment, the Colombian authorities introduced in 1967 a dramatic change in devel- opment policy, shifting emphasis from a protectionist policy of import substi- tution to measures designed to expand and diversify exports. With only minor modifications, this export promotion strategy remained in effect until the mid-1970s. These policies were successful in expanding non-coffee exports, thereby alleviating the foreign exhcange constraint to growth and making possible a higher level of investment. As a consequence, real GDP growth accelerated to an average 6.5% p.a. between 1968 and 1974, well above the historic average, and non-coffee merchandise exports rose nearly threefold. 5. Despite these advances, the economy showed signs of deteriorating by late 1974. This was largely the result of slower growth in the industrial economies, an inelastic tax system and imported inflation which led to a weakening of the public finances and balance of payments and an acceleration 1/ This section is unchanged from that included in the President's Report for Bogota Power Distribution Project (Report No. 2676-CO).  - 2 - in domestic inflation. In addition, the country was faced with a pending loss of self-sufficiency in petroleum, its primary energy source. These develop- ments prompted the authorities to introduce a stabilization program, accom- panied by basic reforms of the fiscal, monetary and trade systems aimed at restoring the basis for accelerated long-term growth. Concurrently, petroleum pricing policy was modified to improve incentives for oil exploration and development and policies were initiated to reduce the subsidy on local consump- tion of petroleum products. These reforms were successful in improving the public finances and reducing inflation in 1975, but initially caused economic growth to slow (from 6.0% in 1974 to 3.8% in 1975) as the economy adjusted to the changing domestic and international circumstances. Recent Economic Developments 6. During the three years 1976-78 the Colombian economy was subject to severe inflationary pressures which caused the Government to focus economic policy on short term stabilization rather than on long term development issues. The origin of these pressures was the exceptionally high world coffee price prevailing during this period which caused Colombia's export earnings from coffee to increase to US$1.8 billion and US$2.1 billion in 1977 and 1978, respectively (from an average US$725 million in 1974-75), producing an unpre- cedented rise in incomes and internal demand. The supply of consumer goods, particularly of basic foodstuffs which was adversely affected by drought conditions in most of the country, lagged behind the growth in demand and inflation accelerated to the unprecedented rate of 44% in the twelve months ending June 1977, from 26% the preceding year. The authorities responded rapidly by introducing a broad range of fiscal, monetary and trade policies designed to gain control over the explosive increase in prices. As a conse- quence of these measures and of a favorable second semester harvest, inflation declined sharply throughout most of the following 18 months, with the annual inflation rate leveling off at 29% in 1977 and falling to 18% in 1978. 7. Because of the lack of dynamism in world markets and modest increases in domestic investment, the Colombian economy expanded only moderately in 1976 and 1977, with real GDP growing by 4.6% and 4.8%, respectively, in those two years. In 1978, however, real GDP rose by an estimated 8.5% in response to continued strong growth in aggregate demand, supported by expanded private investment financed increasingly through a rapidly growing extra bank market and by favorable agricultural conditions. Since growth was concentrated in the relatively labor intensive sectors of the economy--personal services, trade, transport and communications, and small-scale manufacturing and agri- culture--unemployment declined sharply during this period. In 1978, unemploy- ment in the four major cities averaged about 8% of the labor force, compared with an average of about 12% a few years earlier. Both the balance of payments and the public finances generated large current surpluses in the 1976-78 period. Largely as a result of increased coffee export receipts, Colombia's net official international reserves had risen from US$573 million at the end of 1975 to US$2.5 billion by the end of 1978, equivalent to about nine months imports of goods and non-factor services. This increase in reserves occurred despite nearly 12% p.a. real growth in imports and slow growth in manufactured exports. Curbs on public investment and higher revenues from the coffee tax and from earnings on international reserves made possible unprecedented overall surpluses in the public finances.  8. Despite continuation of the stabilization policies in effect since early 1977, inflationary pressures increased somewhat in 1979. A mild frost in Brazil's coffee areas caused world coffee prices to rise early in the year, resulting in an acceleration in reserve accumulation and in aggregate demand growth. Widening interest rate differentials favoring Colombia and real appreciation of the peso, generated short-term capital inflows, which, together with delays in import payments, led to further reserve increases. Receipts from illegal exports provided an additional source of funds for the already overly liquid economy. In all, net official reserves rose by approxi- mately US$1.6 billion for the year, reaching the equivalent of 11 months imports at year end. About mid-year the authorities issued a new series of short term securities carrying highly competitive interest rates in an effort to absorb some of the excess liquidity existing in the formal and informal credit markets. This issue, which represents a significant break with past open market operations that were not interest-competitive and forced onto financial institution portfolios, was successful in attracting funds equivalent to 5.4% of the monetary base by year end, helping to reduce money supply growth (M2) in the formal market from 30% in 1978 to 24% in 1979. Nevertheless, large wage increases and higher energy costs, together with rapid growth in domestic demand, pushed inflation up to 30% for the year. Economic growth was strong again in 1979, with real GDP rising by an estimated 5.5%, and unemployment remained low. Inflation has slowed thus far in 1980 (on an annual basis the increase in the cost of living was 24.9% through March), and the Government is committed to reducing further the rate of inflation in coming months. Distribution and Welfare 9. The steady gains in per capita income, together with rapid rural/ urban migration and expanded employment opportunities for women over the past quarter century caused a dramatic drop in the crude birth rate. The achieve- ment of lower birth rates was facilitated by expanded family planning programs. Consequently, Colombia's population growth rate declined sharply, from over 3% in the late 1950s, to about 2.8% in the early 1970s and to an estimated 2.1% at present. Although 66% of the population lives in urban centers, there are now 22 cities with populations exceeding 100,000 persons. Some of the major cities have serious transportation, housing and urban congestion problems, however, and large numbers of persons live under poor conditions. 10. Available evidence suggests that the welfare of all income groups in Colombia has increased significantly since the 1950s and that the propor- tion of the population living in absolute poverty has declined. These gains were in part a consequence of reasonably good economic growth and of efforts to raise welfare through investment in health, education, low income housing, water and sewerage, and other social services. Existing data on income dis- tribution trends present a less clear picture. It is probable that some improvement occurred in income distribution between 1950 and the mid-1960s as a result of a strong shift of the labor force from rural areas to higher productivity jobs in urban industry and services and of relative wage gains for urban unskilled workers. Accelerated inflation through the early and mid- 1970s caused real wages to increase less rapidly than returns to non-labor factors of production. While the trends in income distribution during this period are unclear, it seems unlikely that any significant improvement occurred. Since 1977, however, rural wages have risen in real terms and  -4- unemployment has declined notably, supporting the presumption of some distributional improvement. Development Strategy of the Current Administration 11. The development strategy of the present Government is essentially unchanged from that of the previous administration, with the most significant variation being a greater emphasis on expanding economic and social infrastruc- ture. The key elements of this strategy are the promotion of non-coffee exports and investment, supported by measures to increase allocative and productive efficiency. Factor (particularly capital) and product markets are to be freed from unnecessary controls in order to increase efficiency and lower costs, and tariff and non-tariff barriers to imports are to be reduced to provide greater competition to domestic industry. These steps, along with periodic exchange rate adjustments as required by relative cost differences, tax rebates and favorable access to credit, are expected to provide the stimulus for rapid growth in non-coffee exports and in private investment. Public investment is to be accelerated, with particular stress on improving and extending the transportation network and on resolving the country's rapidly growing energy problem. Investments in transportation are expected to lower freight costs substantially and those in telecommunications to facilitate economic activity as well as to minimize the unnecessary use of transport; both are aimed at integrating regional growth centers into a natipnal market. Complementary measures to encourage industry to locate outside the four major metropolitan areas have been introduced. 12. Raising investment and productivity in agriculture and industry are important objectives of the Government's plans to expand growth and employment. Substantial increases in credit are being provided to agriculture. Extension programs are to be expanded to cover larger numbers of small and medium scale farms and widened to include farm management and broader dissemination of crop research. Innovative programs such as the integrated rural development (DRI) and nutrition (PAN) projects financed by the Bank are expected to receive continued high priority. Low income rural areas are to be helped through rural electrification, health and education programs and through an expanded feeder roads program. Industry, which is experiencing high capacity utiliza- tion ratios because of lagging investment in recent years, is expected to benefit from improved functioning of domestic capital markets, as controls are eliminated from these markets, and from increased incentives for exports as the real effective exchange rate recovers to pre-1976 levels. This, plus increased competition from imports as tariff and non-tariff barriers are lowered, should provide the stimulus for greater industrial investment and bring about more rapid technological change. 13. Projections of Colombia's energy balance indicate a rapidly growing deficit which is expected to reach significant proportions in the mid-1980s in the absence of an aggressive energy development program. High priority is being given to the development of additional energy resources in order to avoid the constraint on growth that large scale shortages of energy would entail. The strategy adopted is designed to reduce the country's dependence on petroleum as an energy source by developing substitutes. Major projects  - 5 - are being executed and others prepared to expand hydroelectric power genera- tion, and incentives are being given to private foreign companies for accel- erated exploration and development of the country's petroleum, coal and natural gas po'ential. Exports of coal and natural gas are expected to offset a large portion of the petroleum imports projected for the mid to late 1980s. Higher energy prices are expected to slow the growth in energy demand. W'hile the total investment cost of future energy development is still being deter- mined, preliminary estimates indicate that the required investment could run as high as US$8.0 billion in 1979 prices over the next decade. Even under the most optimistic assumptions regarding development of energy resources, however, Colombia will continue to rely heavily on energy imports until the mid-1980s when exports of coal and natural gas begin to reduce the nation's net energy deficit. 14. With Colombia's long term growth prospects enhanced by the increased availability of foreign exchange and with inflation expected to moderate, the authorities are beginning to focus policies on a number of issues that need to be addressed if the country is to achieve its full growth potential and poverty is to be alleviated at a more rapid pace. These issues include the reduced competitiveness of Colombian goods in external markets brought about in recent years by the relatively high domestic inflation uncompensated by foreign exchange adjustments, and the slow modernization and lowered efficiency of domestic industry resulting from low investment levels and limited foreign competition. Public investment has not increased significantly in the past few years and domestic resource mobilization is still insufficient, particu- larly in comparison to the expansion required in public investment. While income distribution and welfare trends appear favorable, substantial efforts will have to be made to reduce the widespread poverty still existing in the country. 15. Economic policy is presently in a period of transition as the authorities attempt to combine stabilization and growth measures so as to arrest inflation while still permitting the economy to expand. Some advances have already been made in dismantling the existing stabilization program and in bring- ing about conditions favorable to increased investment and growth. For example, the 100% marginal reserve requirement imposed on commercial banks has been rescinded and the Government has taken a more active role in the capital market through open market operations. The transition process, however, has been moving slowly in certain respects and the Government recognizes the importance of acting quickly in finding appropriate solutions to these potential constraints to growth. Exchange rate adjustments are expected once again to become a tool of development, rather than a component of stabilization policy, and further measures to stimulate private investment and encourage technological change are proposed. As inflationary pressures continue to recede, controls on interest rates and credit, which have already been relaxed somewhat, are expected to be further reduced as are tariff and non-tariff barriers to trade. Such measures, once fully effective, could be expected to produce a sizeable jump in private investment and in economic efficiency. Delays in carrying out economic and social infrastructure investments could adversely affect growth of the pro- ductive sectors and reduce economic welfare. Thus public investment is to be accelerated at the maximum consistent with continued progress toward economic stability. The Government is particularly concerned with the slow growth of energy sector investment (with the exception of investment in hydropower).  - 6 - Although some progress has been achieved as capital outlays by foreign oil companies have risen as a result of more profitable wellhead prices and the growth in demand for petroleum products has been slowed by higher retail prices, the Government intends to advance development of the country's other energy resources, i.e., coal and natural gas. 16. Since in the absence of corrective measures both the current account of the balance of payments and public sector savings are expected to weaken over the next few years, mobilization of domestic resources to support the strong expansion required in public investment is likely to be a critical issue in carrying out the Government's strategy. The authorities are already moving ahead on this issue, having taken measures to improve tax administration and enforcement and to generate resources through large real increases in charges for public services. Additional tax measures will probably be needed, however. Capital market improvements, including realistic interest rates on savings deposits, are expected to stimulate private savings. These efforts are being complemented by measures to encourage the production of basic foodstuffs-- which weigh heavily in the consumer market basket--as a means of reducing infla- tionary pressures and moderating inflationary expectations, which should have a further favorable effect on savings. 17. Given the country's strong resource base and with continued sound economic management, Colombia is expected to achieve annual real GDP growth averaging about 6% during the 1980-85 period. However, because of the expected decline in coffee prices and with accelerating oil imports and the high import content of future investment, the current account of the balance of payments is expected to be in deficit throughout the early to mid-1980s. Colombia is expected, therefore, to continue to be a large net importer of capital for some time to come. Even assuming that the Colombian authorities permit a drawdown of international reserves to the equivalent of three months' imports in the years immediately ahead, gross external capital requirements are projected at US$10 billion between 1980 and 1985, or an annual average of about US$1.7 billion. An increasing proportion of this capital inflow is expected to be provided by foreign commercial and financial sources. 18. Colombia's public external debt repayable in foreign currency amounted to an estimated US$4.4 billion at the end of 1978, equivalent to about 18% of GDP, of which US$2.8 billion was disbursed and outstanding. The Bank/IDA share of this external debt was 26.5% in 1978. Because of the expected decline in commitments from bilateral sources and corresponding recent acceleration in Bank lending, this share is expected to exceed 30% in the early 1980s, before falling to about 27% by 1985. Although the public debt service ratio fell in recent years as export growth accelerated, this ratio is expected to increase from 10% in 1978 to about 15% in 1985. The World Bank's share in public debt service is expected to rise to 26% in 1985 from 24% in 1978. Balance of payments prospects beyond the early 1980s will depend heavily on the timely development of domestic energy sources and on progress made in executing several natural resource-based export- oriented projects currently under preparation. Given the expected continuation of sound economic and financial management and timely execution of the country's energy program, Colombia is considered creditworthy for the required external borrowing on conventional terms.  - 7 - PART II - BANK GROUP OPERATIONS IN COLOMBIA 19. The proposed loan, the 87th to be made to Colombia, would bring the total amount of Bank loans to Colombia to US$2,582.6 million (net of cancellations). Of this amount, US$1,803.9 million was held by the Bank on December 31, 1979; IDA made one credit of US$19.5 million for highways in Colombia in 1961. Disbursements have been completed on 49 loans and the IDA credit. During 1972-77, disbursements averaged US$86 million equivalent per year, then declined slightly to US$74 million in 1978 and increased sharply to US$135 million equivalent in 1979. The improving performance of social sector institutions in the execution of Bank-financed programs, the gradual containment of inflationary pressures, which should allow for relaxa- tion of fiscal restraint, and the recent Bank lending for infrastructure projects, all point to higher levels of disbursements in the future. As of December 31, 1979, IFC had made investments and underwriting commitments of US$53.9 million in 24 enterprises and held US$16.7 million. Annex II contains a summary statement of Bank loans, the IDA credit and IFC investments as of December 31, 1979. The Annex also contains summaries on the execution of the 34 ongoing projects. 20. In response to the priority objectives established by successive Governments (self-sustained economic growth, increased employment and improved income distribution) since 1966, Bank lending to Colombia has become increas- ingly diversified and has been concentrated on production-oriented programs and activities which emphasized social as well as economic benefits. Twelve of the fourteen loans for industry have been made since then, eleven of the thirteen agricultural loans, all three loans for education, one loan for a a nautrition project, two loans for urban development projects and all nine loans for water supply and sewerage. During the same period only fourteen loans in the power and transport sectors were made, while before 1966 twenty- two out of a total of twenty-five loans were made to these sectors. 21. Bank lending to Colombia in FY79 consisted of two loans each for water supply/sewerage and power, and one each for urban development, aviation development and agricultural credit, totalling US$311.5 million equivalent. In addition to the loan proposed in this report, the FY80 program includes the recently approved loans for a nickel project, power distribution, telecommuni- cations and small-scale industry, as well as proposed loans for vocational training, power generation, and secondary oil recovery and exploration. Work is also under way on projects for land settlement, agro-industries, railways, ports, feeder and rural roads, further mining development, power (including village electrification), irrigation, agricultural credit, water supply and sewerage, urban development and environmental improvement, for possible consideration by the Executive Directors during the next two years. 22. The proposed Bank lending conforms closely with the Government's development strategy, which is attuned to the requirements of the era that began with the 1973 price rise of internationally traded petroleum. To help Colombia develop domestic sources of energy, a sizeable part of the proposed lending would be for hydropower. The Bank intends to assist the development of coal mines and petroleum, which hold potential in helping Colombia meet  - 8 - part of its energy requirements and in diversifying exports. Bank involvement in the energy sector would help mobilize additional external financing as some of the projects would require co-financing. Other future loans would finance agriculture and industry (including agro-industry) to assist the Government in its efforts to raise overall productivity, income and employment, and to strengthen and diversify exports. Closely related to these objectives would be the proposed Bank lending for transport infrastructure. In this context, the Bank is assisting the Government in preparing a rural and feeder roads project to integrate the more backward areas of the country into the modern economy. Other loans under preparation for ports and railroads are aimed at helping Colombia handle larger volumes of non-traditional exports and the imported inputs on which the modern sector of its economy relies for expansion. Lending for telecommunications would assist the Government in its efforts to integrate cities and towns into the national economy and reduce the large amount of congestion in existing networks. Finally, a relatively large number of loans are being prepared in support of the Government's efforts to help the iowest 50% of the Colombian population. Lending for urban development and slum improvement, rural electrification, land settlement, water supply and sewerage, irrigation and environmental improvement projects is principally designed to improve the standard of living of the poor. 23. The operations of external lenders in Colombia are shown in Annex I. While IBRD, IDB, and bilateral sources provided about 75% of gross disburse- ments to the public sector from external sources in the 1961-72 period, their share has decreased since then to approximately 50% for the 1975-77 period and it is expected that during the period 1979-83 this share will decline further to about 38% of external capital requirements. Like the Bank, IDB has given increased emphasis to social projects and has financed projects in low cost housing, urban and rural development, agrarian reform, university educa- tion, water supply, rural electrification, and land erosion control. In the future, it proposes to assist Colombia to develop sources of domestic energy and to expand the activity of the productive sectors to help generate increased employment. USAID has supported programs in education, urban development and small farm development, but is phasing out its aid program in Colombia over the the next few years with about US$10 million remaining to be disbursed on previous loans. The Governments of the Federal Republic of Germany and the Netherlands have also provided concessional financing for social and regional integration projects. PART III - THE INDUSTRIAL SECTOR IN COLOMBIA Industrial Growth, Structure and Exports 24. Manufacturing industry, which contributes about one-fifth to Colombia's GDP, is a leading growth sector. Between 1970 and 1978, manufac- turing output grew on average by 7.1% per annum, consistently outpacing the growth of overall GDP. During the same period, exports of manufactured goods increased seven-fold in current US dollars from US$96 million to US$699 million. 1/ The share of manufacturing industry in total exports rose steeply 1/ The figures differ from those in Annex I primarily because of the inclusion of goods produced by food processing industries.  from 13% to 37% in the early 70's, subsequently receding to 22% in 1977 and 1978 which were years of exceptionally high international coffee prices. In the ten years preceding 1978, employment in the manufacturing industry expanded from about 700,000 to about 1.2 million. This impressive growth of the industria' sector was made possible by adequate natural resources, human skills available at a reasonable cost, entrepreneurial initiative and appro- priate Government policies. 25. The five largest branches of Colombian industry are textiles, food products and beverages, chemicals, paper products, and non-metallic minerals, which together account for nearly 70% of value added in manufacturing. In the past ten years, the most rapid growth has taken place in metal products and machinery, oil products, and cement. In some of these branches of industry, Colombia has achieved a substantial degree of import independence. 26. Industrialization gained impetus after World War II, with the aim of import substitution. By 1967, local industry supplied the internal market with most consumer goods, about two-thirds of intermediate products and about one-half of capital goods. From then on, the Government adopted a policy of promoting industrial exports, with a view to reducing the country's dependence on coffee exports. A key element of this policy was the introduction of frequent exchange rate adjustments by virtue of which the pace of peso depreciation more than offset differences between internal and external price increases. 27. Spurred by this policy, investment in industry rose sharply. Between 1968 and 1974, value added in manufacturing rose in real terms at 8.3% per annum. Except for the products of some long established industries which remained highly protected, manufactured goods demonstrated their compe- titive advantage at home and abroad. In 1975, however, industry suffered from the international recession and the estimated capacity utilization dropped to 73% compared with 84% in 1973. Exports were further affected by a sharp reduction in fiscal incentives prompted by budgetary considerations. The Government tried to offset the latter measure by expanding credit to exporters on more favorable terms and by accelerating exchange rate adjust- ments. In late 1976, however, the Government had to reverse its policy to counteract growing inflationary pressures, arising from the accumulation of foreign exchange reserves because of the coffee boom. 28. The spillover effect of the high coffee prices brought about a sharp rise in aggregate demand, fostering a rapid recovery in industrial production. It is estimated that by 1977 industry operated at 86% of capacity. Manufactured exports, however, recovered more slowly because many products were diverted to the domestic market and lagging exchange rate adjustments did not compensate for the relatively rapid rise in domestic prices. In line with the improving fiscal situation, the Government raised tax rebates and made them commensurate to the value added, and again used credit as an export promotion tool, while continuing to depreciate the peso slowly for reasons of price stability. These measures encouraged export activity, with exports growing rapidly in 1978 and 1979. The Government continues to be committed to export expansion and diversification. Recently, the authorities have resumed adjustments of the foreign exchange rate and propose to continue doing so to encourage non-coffee exports.  - 10 - 29. With the forecast continued improvement in incomes, the resumption of rapid growth in manufactured exports, and the high degree of plant utiliza- tion in the industrial sector, sustained industrial growth can only be made possible through plant expansion and increased supply of raw materials. The Government recognizes this and plans to increase the availability of credit to industry. The proposed project would support the Government in this effort and would provide much needed long-term financing for industrial investment (see para 43). Decentralization Policy 30. Because of Colombia's difficult topography, several regional markets have evolved within the country. Consequently, industrial activity is more decentralized than elsewhere in Latin America. Nevertheless, about 80% of industrial establishments, output and employment are concentrated around the capital, Bogota, and in four departments: Antioquia, Valle, Atlantico and Santander. About 60% of manufactured goods is produced in 8% of the indus- trial establishments, which employ 200 or more workers each. The rapid growth of the largest cities has raised problems of congestion, and strained the capacity of urban infrastructure and public services. Moreover, serious water pollution problems now exist in the Bogota River and Medellin River basins. The Bank is supporting Government efforts to reduce pollution of the Bogota River. 31. The first Government policy measures to limit or reduce this concen- tration of industrial activity were implemented through special labor and wage legislation, enacted in 1967 to entice industrial enterprises to secondary centers. In 1975, the Government launched a more comprehensive decentraliza- tion policy. Direct foreign investment was prohibited in Bogota, Medellin (capital of Antioquia) and Cali (capital of the Valle Department); official development credits on favorable terms were offered to firms establishing themselves in the smaller agglomerations; steps were taken to improve the infrastructure in secondary centers and measures to set up industrial parks decided upon. Since the degree of industrial concentration has not changed significantly, the Government is intensifying its efforts to speed up decen- tralization by providing additional infrastructure in the less developed regions. It is also expanding incentives to stimulate supply of credit to industries outside the major centers. To support these efforts, the proposed loan includes special features to encourage industrial decentralization (see para 54). Employment in Industry 32. Industrial employment expanded rapidly at 8.3% per annum between 1968 and 1974; the expansion slowed down to an annual average of 2.3% in the mid-70's but rebound to 4.2% in 1978. By the middle of that year, 1.2 million people were employed in industry, representing 23.5% of total urban employment. By 1979, unemployment in the four major cities amounted to about 8% of the labor force compared to an average of 12% in the early 70's. This speaks well of the Government's efforts to increase employment, particularly in view of the rapid population growth, registered in the 60's, and the country's urbani- zation. In the industrial sector, most of the new employment opportuni- ties were in the labor intensive activities, such as textiles, apparel, metal working and mechanical engineering, which were in the forefront of the export drive.  - 11 - 33. Compared to many other Latin American countries, industrial wages in Colombia are fairly low. After stagnating, or even receding somewhat, for several years in the early and mid-70's, real wages rose in 1978 owing to lower inflation. While some comparative advantage in labor cost may have been lost thereby, Colombian industry has remained competitive in the Latin American sphere where it sells the bulk of its industrial exports. Colombia's Financial System 34. Colombia has a relatively well developed financial system consisting of a variety of specialized entities, including commercial banks, agricultural and mortgage banks, savings and loan corporations, public and private develop- ment finance companies (DFCs), commercial finance companies, and mutual funds. In 19/8, comnercial banks accounted for about 42% of total institutional credit, savings and loan corporations for about 21%, and public and private DFCs for over 16%. in lending to industry, the commercial banks and the DFCs supplement their resources by rediscounting loans with the Industrial Financing Fund and the Private Investment Fund operated by Banco de la Republica. 35. The allocation of financial resources within the Colombian economy has been strongly influenced by Government policies. For many years prior to 1974, the financial system was subject to complex reserve requirements and compulsory investment regulations. Different interest rate ceilings were imposed on different transactions, and the right to issue tax-exempt or indexed debt instruments was granted to one or another category of insti- tutions. This caused sharp swings in the amount of resources channelled through the various types of institutions. Agriculture, housing and the public sector were generally favored to the disadvantage of industry and commerce. 36. In 1974, a reform of the financial system was launched. The extent of controls was reduced and interest rates were permitted to rise gradually and becomle positive in real terms. Interest rate differentials were narrowed, and tax exemption and monetary correction features were restricted to bring yields of competing instruments into a better balance. In the following year, the :DFCs were authorized to engage in short-term operations, accept time deposits and issue 90-day certificates of deposit with relatively high interest rates, and relend the proceeds to meet working capital needs of industry. 37. Domestic inflationary pressures prompted the Government in early 1977 to raise reserve requirements and tighten credit controls. Interest rates were not permitted to rise with inflation and selective credit allocation was again used. To mop up excess liquidity originating in the external sector, Banco de la Republica intervened, requiring exporters to accept 90-day "exchange certificates" denominated in US dollars for their export earnings. In September 1979, it went further and issued 15-90 day "certificates of participation" with yields of up to 37% p.a., causing savers to withdraw funds from banks and DFCs, which paid much lower interest rates. 38. By the end of January 1980, the Government removed or relaxed a wide range of regulations affecting the operation of the financial system. The 100% marginal reserve requirements were removed, and interest rate ceilings  - 12 - were lifted for certificates of deposit and for onlending the proceeds. Moreover, mandatory limits on the final maturity of external loans financing industrial equipment purchases were abolished. As inflation continues to slow down, the Government expects to loosen monetary controls even further. Industrial Finance 39. In the past two decades, Colombian industry had to rely increasingly on borrowed resources to finance fixed assets and working capital. Equity financing declined steadily. The low real return on industrial shares traded on the Bogota and Medellin stock exchanges provided no incentive to float new share issues; only since 1976 have share quotations risen more rapidly than consumer prices. Funds generated internally through retained earnings and depreciation allowances, which in the 60's were the major source for finan- cing investment, declined steadily in importance, accounting in 1978 for roughly one-third of capital expenditure. Retained earnings have shrunk, owing to the tendency of many companies to pay out a high proportion of profits as dividends to attract shareholders and to qualify for tax exemption of dividend earnings. As to depreciation allowances, they were until recently based on historical costs and did not reflect rapidly rising replacement values. Only in April 1979 did a tax relief law provide for inflation adjust- ments by permitting annual revaluation of fixed assets; its enactment should strengthen the financial position of the industrial sector and raise the contribution of internally generated funds to industrial finance. 40. Debt financing of industrial investment and working capital increased from about 37% in 1965 to a range of 60% to 65% between 1974 and 1978. In the past few years, credit to the industrial sector was made available to the extent of 25-30% by the commercial banks, extending mainly short-term credit for working capital, to the extent of 17-19% by public and private DFCs, lending mainly at medium- and long-term for plant and equipment, and to the extent of 18-20% by the extra-bank market; the remaining 30-40% of credit requirements were met by direct borrowing abroad. Between 1974 and 1978, the volume of industrial credit expanded more slowly in real terms than industrial output; recently, the lack of adequate financing appears to have hampered the growth of manufacturing production. 41. The cost of industrial credit varies according to source. Most nominal interest rate ceilings are still determined by the monetary authorities but financial institutions raise the effective cost of borrowing by 2-6 percentage points through additional charges and collection of interest in advance. At present, effective interest rates on short-term commercial bank lending range from 35% to 40% per annum. On medium- and long-term loans, financial intermediaries charge effective interest rates of 25-29% annually. Term loans to small- and medium-scale industry, using rediscount facilities of Banco de la Republica, carry interest rates of 22-27%. The DFCs charge effective interest rates of 27-29% per annum for long-term loans in pesos and up to 40% for short-term working capital loans. At present and projected inflation, these interest rates are positive in real terms (see para 8).  - 13 - 42. While the continuing objective of the DFCs is to finance industrial fixed assets, the maturities of their loans have shortened considerably during the period 1974-78. Loans for more than five years dropped from 64% to 37% of the loan portfolio and short-term credit expanded at a very rapid rate. In the late 60's and the early 70's, the DFCs were able to mobilize substantial local resources by way of floating longer term bonds; but since 1975 the bulk of domestic savings attracted by them took the form of 90-day certificates of deposit. With access to official development credit becoming more difficult, the DFCs had to look abroad to an increasing extent for funds appropriate for long-term lending to, and equity investment in, manufacturing industry. Investment Outlook 43. After a decline in the mid-70's, investment in manufacturing picked up in 1978; capacity utilization is running high and inventories have receded to normal levels. The industrial sector is expected to grow at a rate of 6% to 7% per annum during the 1980-85 period, if no foreign exchange constraint arises, and if the Government continues the policy of peso depreciation to safeguard existing export markets and help find new ones. Thus, substantial investment in plant, equipment and permanent working capital will be required over the next few years. The achievement of the necessary investment levels will depend upon the availability of adequate long- and medium-term finance, domestic and external. Gross external capital requirements of the economy are put at about US$1.7 billion per annum in the years immediately ahead (see para 17) and a sizable proportion of this amount will be needed to meet the demands of the industrial sector. It is estimated that to provide their tradi- tional share of long-term financing needs of the industrial sector, the DFCs expected to participate in the proposed project would require external loans of the order of US$300 million over the next 2-1/2 to 3 years (this amount being net of the recently signed US$35 million IDB loan and the uncommitted balance of US$10.3 million on April 25, 1980 of the Bank's seventh DFC loan). Assuming direct borrowing in the international market by the largest companies, in accordance with the newly adopted policy of the Government (see para 52) and cofinancing of the order of US$60 million, the gap of about US$150 million would be filled by the proposed loan. Bank Role in the Sector 44. The Bank made its first loan for industrial development in Colombia in 1963 to help Acerias Paz del Rio to carry out a steel mill project. Between May 1966 and July 1978, the Bank made seven loans totalling US$342.5 million to Banco de la Republica to be onlent by the DFCs for industrial investment. These loans were characterized by rapid commitment and smooth disbursement, evidencing both strong demand and efficient utilization. Meanwhile, in 1972, the Bank granted to Colombia a US$60 million development program and export expansion loan, part of which was allocated for onlending to agricultural and industrial enterprises. In 1975, 1977, and again in the Spring of 1980, the Bank made available a total of US$52.5 million to Banco de la Republica for Corporacion Financiera Popular to finance small privately owned industries. In 1978, the Bank assisted with US$15 million the Cartagena Industrial Export Processing Project, which aimed at promoting manufactured exports and foster- ing employment in one of the very poor regions of the country. Finally, last  - 14 - year, a loan of US$80 million was made for the exploitation of the Cerro Matoso nickel laterite deposit, with the aim of increasing and diversifying Colombia's exports. 45. Through these operations, the Bank has contributed to the expansion of Colombia's industrial sector. However, industrial growth was not the only objective of Bank lending. The Bank has given support to the Government's efforts to promote and diversify exports, to strengthen the financial inter- mediaries specialized in long-term industrial lending, and to spread the benefits of industrialization throughout the country. In so doing, it has aimed increasingly at stimulating the establishment of medium-size and small industrial enterprises in the depressed regions of Colombia and at creating new employment opportunities for the poorer segments of the population. The OED's reports of October 1974 and October 1977 on the first four DFC loans concluded that the DFCs had been successful in allocating and channelling resources to medium-size and larger enterprises, but suggested that it could be more cost effective for the Bank in the long run to delegate more respon- sibility to Banco de la Republica and pay more attention to sector issues. Beginning with the fifth project, this comment has been taken into account. More recently, the Bank has been promoting mobilization of domestic and external resources to finance--pari passu with its loans--industrial plant, equipment and permanent working capital. PART IV - THE PROJECT Background 46. The proposed loan would be the eighth made for industrial development in Colombia, with private DFCs acting as intermediaries. It would raise the Bank's total lending of this type to Colombia to US$492.5 million equivalent. As in the case of the past seven loans, Banco de la Republica, the central bank, would be the Borrower and, similar to the last three operations, the proposed loan would enhance the responsibilities of Banco de la Republica and widen the distribution of loan proceeds among industrial enterprises and geo- graphic regions. 47. The first of the DFC loans dates back to 1966. Its beneficiaries were the five DFCs established between 1959 and 1964: CF Colombiana in Bogota, CF Nacional in Medellin, CF de Caldas in Manizales, CF del Valle in Cali and CF del Norte in Barranquilla. The IFC holds equity in each of them. Under this and the three subsequent loans, the Bank monitored closely the operations of the participating DFCs, including their project appraisal and supervision. 48. Starting with the fifth loan of 1973, the functions of reviewing project appraisals, approving the subloans and supervising the operations of the newly participating DFCs have been increasingly delegated to Banco de la Republica, and the institution building effort shifted gradually from the DFCs to Banco de la Republica Department of Development Credit (DDC). Under  - 15 - the sixth and seventh loans, the number of beneficiaries increased to eight. Export 1/ and decentralization 2/ projects, and projects sponsored by small and medium-size enterprises, were designated for preferential treatment. Steps were taken to strengthen the capital structure of selective industrial firms by permitting DFCs to invest in equity part of the loan proceeds. Moreover, incentives were introduced to improve the technology of production processes and to control industrial pollution. 49. An analysis of subloans approved up to September 30, 1979 in the context of the seven DFC loans shows that about 20% each of the total amount benefitted the textile, and food and beverage industries; about 13% each was absorbed by chemicals and non-metallic minerals; and nearly 11% went-for paper and printing. According to the size of the enterprise, 31% of the total amount was lent to 400 firms with assets up to Col$ 100 million (about US$2.2 million equivalent); 44% to 216 firms with assets of Col$ 100-500 million (US$2.2 million to US$11 million); and 25% to 53 companies whose assets exceeded Col$ 500 million (US$11 million). Preliminary estimates of the employment effects of the sixth and seventh loans put the average cost per direct job created at, respectively, US$28,000 and US$45,000 at 1977 prices; however, these figures usually ignore the indirect job generation, often equal to 50% of the direct one. A study of the economic return of a sample of 29 Bank-assisted projects, made in 1975, showed an average rate of 32%, comparing favorably with the opportunity cost of capital in Colombia (see para 75). 50. Preliminary discussions on the proposed loan began in Colombia in December 1978 and continued in May 1979. In November 1979, the Bank dispatched an appraisal mission. Negotiations took place in Washington in April 1980, with a delegation, comprising representatives of the Government, Banco de la Republica and the participating DFCs. A Staff Appraisal Report is being circulated to the Executive Directors separately. Objectives and Special Features 51. The proposed loan of US$150 million is designed to: first, help finance industrial projects (including tourism and mining) consistent with the Government's aims of export promotion, industrial decentralization, support to medium-size enterprises, better capitalization of industry, improved technology and containment of industrial pollution; second, further strengthen the capacity of Banco de la Republica to review projects and exercise super- vision over the activities of the participating DFCs; and, third, shore up the DFCs as sound and effective long- and medium-term lending institutions, capable of securing additional share capital and mobilizing adequate domestic and external resources to finance industrial investment. 1/ Export projects are defined as having at least 25% exportable production and generating net foreign exchange earnings within five years of start- ing operations. 2/ Decentralization projects are those located outside of Bogota, Medellin and Cali, and their zones of influence.  - 16 - 52. Certain special features would be introduced for the first time under the proposed loan. First, large individual enterprises, or enterprises belonging to groups of related companies, whose assets exceed Col$ 1.5 billion (equivalent to about US$33 million), would have to turn to the international market and would no longer be eligible to borrow the loan proceeds, except for pollution control and research and development projects (Section 3.01(a) of the draft Loan Agreement). Second, to meet the desire of Banco de la Republica to reduce its substantial foreign exchange losses on the Bank's DFC loans, 1/ the aggregate amount of regular subloans denominated in pesos would be limited to 25% of the loan amount, mainly for small and medium-size enter- prises (Section 3.06(c)(1) and (f) of the draft Loan Agreement). Moreover, to restrict the cross-currency risk on dollar-denominated subloans, a risk premium of 3.25% would be incorporated into the interest rate charged by Banco de la Republica to the DFCs and passed on to the subborrowers (see para 58). Third, to further help satisfy the rapidly growing demand for medium-term capital by medium-size and small enterprises, Banco de la Republica would be permitted to use any subloan repayments, that might be in excess of the fixed amortization installments of the proposed loan, for lending to small scale industry (Section 2.09 of the draft Loan Agreement). Project Components and Onlending Terms 53. The proposed project would have three components: 85% of the loan amount would be used by the DFCs to make regular subloans, 10% to invest in equity, and 5% to finance subloans for technology development and pollution control. It is expected that about 300 subloans and equity investments would be made under the project. 54. In accordance with the objectives of the proposed loan, preferential treatment would be granted to medium-size and small industries, and--to some extent--to export and decentralization projects. These industries and projects tend to be relatively labor-intensive. Medium-size and small enterprises (defined as those belonging to groups with total assets not exceeding Col$ 150 million or about US$3.3 million equivalent) would qualify for peso-denominated subloans up to an aggregate amount equal to 20% of the loan. The larger enter- prises would have to assume an obligation in dollars; they would not only bear the peso/dollar exchange risk but would pay a premium to Banco de la Republica for assuming the cross-currency risk. An exception would be made for export and decentralization projects sponsored by the larger enterprises: for these projects, a limited amount of peso-denominated funds, blended with dollar funds, could be made available subject to a ceiling of 5% of the proposed loan. During the negotiations, the participating DFCs have undertaken to seek and promote export and decentralization projects. The progress of these promo- tional efforts would be reviewed after a year from the date of the Loan Agreement or after 40% of the loan has been committed, whichever occurs earlier (Section 3.04(b)(x) of the draft Loan Agreement). 1/ Banco de la Republica has prepared a report, demonstrating the high cost of the foreign exchange risk assumed by it.  - 17 - 55. In line with the approach adopted since the fourth DFC loan, the proposed project would encourage an ever wider distribution of loan proceeds. No single group of related enterprises would be permitted to borrow more than US$4 million of the proceeds of the proposed loan; there would further be a ceiling of US$4 million on the aggregate amount outstanding to any single group under the proposed loan and all the previous loans, with the exception of borrowing for export or decentralization projects, where the ceiling would be raised to US$8 million. 56. To promote technology development and pollution control, subloans for this purpose would be denominated in pesos and would--moreover--benefit frDm a preferential interest rate of 24%. Financing for technology upgrading would be limited to US$500,000 per enterprise. Subloans for pollution control would not exceed US$1 million per enterprise and would be restricted to checking pollution from equipment installed at least one year before the project has been presented to the Bank. The amounts available to individual enterprises for technology development and pollution control would not be included in the computation of the cumulative borrowing limits mentioned in the preceding paragraph. The DFCs have undertaken to deploy promotional efforts to familiarize their clients with the merits of these novel projects. 57. Funds for investment in equity would be made available to the participating DFCs by Banco de la Republica in pesos. In acquiring minority shareholdings, the DFCs would be limited to enterprises with total assets below Col$ 250 million (about US$5.5 million), and those larger enterprises which undertake export or decentralization projects. The DFCs would not utilize for equity investment more than US$2 million per group of related enterprises, taking into account outstanding loan proceeds invested in the past. 58. The onlending terms under the proposed loan would be as follows: Maximum Terms -----------Interest (%------------- (Years) 1/ Dollar Funds Peso Funds Maturity Grace 2/ To Sub- To Sub- To DFC borrower To DFC borrower 3/ Sub-loans 12.25 15 24 27 15 3 Equity Investments - 24 not applic. 15 5 Technology Development - 21 24 5 2 Pollution Control 21 24 10 2 1/ Repayment terms are identical for the DFCs and the sub-borrowers, except in the case of equity investments. 2/ Included in maturity. 3/ Nominal rates; as interest is collected quarterly in advance, the effec- tive interest rate would be between 4 and 5 percentage points higher.  - 18 - The 15% interest rate, payable by the sub-borrower for dollar-denominated loan proceeds, assumes a Bank lending rate of 8.25% and would allow for 0.75% to cover administrative costs of Banco de la Republica and for an interest spread of 2.75% to the DFCs; the balance of 3.25% would meet part of possible losses of Banco de la Republica arising from the appreciation, in terms of the US dollar, of the currencies disbursed by the Bank. This interest rate would be reviewed periodically by Banco de la Republica, on its initiative or that of the Bank, and might be adjusted, subject to agreement by the Bank (Section 3.08 of the draft Loan Agreement). 59. Peso subloans would bear a nominal interest rate initially set at 27%; the effective interest rate would be higher since interest is collected quarterly in advance. The proposed 27% nominal interest rate on peso denomi- nated subloans takes into account current projections of likely inflation rates and market interest rates, with a view to ensuring positive interest rates in real terms over the commitment period. This is also consistent with the objective of Banco de la Republica, as stated in the supplemental letter. Banco de la Republica has agreed to determine at six-monthly intervals, in consultation with the Government, the nominal interest rate applicable to subloans denominated in pesos and would inform the Bank promptly of the rate so determined. Should the Bank disagree with the new rate, the Government, the Bank and Banco de la Republica would review the matter within sixty days. In the event of the parties failing to agree, the Bank may refuse to authorize or approve subloans bearing the new rate and presented to it after the end of the sixty-day period (Section 3.07 of the draft Loan Agreement). 60. Under the proposed loan, the limit for subloans not requiring the Bank's prior approval (the "free limit") would be as follows: (i) US$2 million equivalent for projects presented by the original five DFCs and CF de Santander; (ii) US$650,000 for projects appraised by CF de Occidente; and (iii) US$250,000 for projects submitted by CF Aliadas and any new beneficiary; however, the Borrower would seek the Bank's prior approval for the first two projects submitted by CF Aliadas and any newly participating DFC. For all projects involving equity investment, the free limit for loans to the DFCs would be US$500,000. Procurement and Disbursement 61. Procurement would conform with standard practice for DFC loans. The DFCs would require their clients to obtain quotations from a reasonable sample of qualified suppliers for major items of equipment. Banco de la Republica monitors closely the purchases made under its loans, in order to ensure that the items are reasonably priced and appropriate for their intended purpose. 62. The loan proceeds would be disbursed for: (i) 100% of foreign expenditures for imported goods; (ii) the CIF cost of imported goods purchased off-the-shelf, or 60% of expenditures for such goods whenever the CIF cost cannot be ascertained; (iii) 35% of ex-factory price of locally produced equipment, and of construction and civil works expenditures; and (iv) 75% of expenditure on technical assistance, technology transfer and overseas training under technology development subloans. The above percentages reflect  - 19 - foreign exchange costs determined mainly by a review of past DFC loans to Colombia and are in line with comparable figures elsewhere. The proposed loan is expected to be disbursed by December 31, 1984. The 'Role of the Borrower 63. The proficiency of DDC in supervising and assisting the participating DFCs has improved significantly during the past 18 months, and its project review performance continues to be satisfactory. The Borrower is taking steps to monitor more diligently the compliance of the DFCs with the provisions of the Subsidiary Loan Agreements. Under the proposed loan, DDC procedures for project review and DFC supervision would be strengthened further, and training programs for DDC staff would be implemented, as needed. The Participating DFCs 64. Eight DFCs would participate in the proposed loan from the start: five are the original participants of 1966; the others are CF de Occidente of Pereira and CF de Santander of Bucaramanga, which were full participants in the sixth and seventh DFC loans, and CF Aliadas of Medellin, which partici- pated in these loans on a limited basis. At least one additional DFC, CF Union of Bogota, is likely to join on a limited basis for the first time in the course of the commitment period. 65. A distinction between full and limited participation was first adopted under the sixth DFC operation to allow the DFCs which may not be able to meet immediately the rigorous criteria of full participation, to utilize a limited amount of the Bank's loan proceeds. Under the proposed loan, this amount would be US$2 million per DFC and would be available to the DFCs which had been in operation for one year or more, have a capital of at least Col$ 100 million and a debt/equity ratio not exceeding 6:1, would agree with Banco de la Republica on a suitable plan of action to strengthen their staff, project appraisal and supervision capacity, and would retain qualified external auditors. As the technical and financial capacity of a DFC develops, the Bank may qualify it for full participation in the course of the commitment period (Section 3.12 of the draft Loan Agreement). 66. The nine prospective participants (including CF Union) are predomi- nantly Colombian owned. The shares of CF Colombiana, CF Nacional, and CF del Valle are relatively widely held. The National Coffee Federation holds about 70% of the share capital of CF de Caldas and about 49% of that of CF de Occidente. The industrial and financial Santo Domingo group owns 75% of the shares of CF de Santander and has recently increased its share holdings of CF del Norte to 48%. CF Aliadas is controlled by Inversiones Aliadas, a diversified holding company. To check the tendency of some of the DFCs to give preference to lending to member companies of their controlling group, the Bank limited under its seventh loan the financial exposure in any group of related enterprises to 50% of the equity of each DFC. This limitation would be continued under the proposed loan; it complements the 25% exposure limit in any single enterprise, contained in the policy statements of all participating DFCs.  - 20 - 67. The original five DFCs and CF de Santander have capable and expe- rienced management, and adequate senior staff. On the other hand, CF de Occidente has been affected by a substantial turnover at management and technical levels, and CF Aliadas lacks experience in development banking at the middle management level. To correct their weaknesses, these two DFCs would carry out "plans of action" agreed at the time of loan negotiations. Substantial progress in carrying out its "Plan of Action" would be required for CF Aliadas to participate, initially on a limited basis, in the proposed loan. 68. In order to contribute to the most efficient resource allocation, the Bank has consistently encouraged the DFCs to improve their project ap- praisal. Beginning with the sixth loan, economic rate of return calcula- tions have been required for all projects assisted with subloans exceeding US$250,000 equivalent. At present, most appraisals prepared by the original five DFCs and CF de Santander are thorough and soundly based; only marketing analysis, though improved, remains relatively weaker. Economic evaluation of projects has been substantially upgraded. Appraisals prepared by CF de Occidente are of lesser quality, and CF Aliadas' capacity to appraise projects is still inadequate; the Borrower continues to review in detail the projects presented by these two DFCs. The proficiency with which the individual DFCs carry out their supervision of projects corresponds closely to their capacity to appraise them. 69. As of September 30, 1979, the combined resources of the seven beneficiaries of the seventh DFC loan (excluding CF Aliadas) amounted to Col$ 25.6 billion (US$561 million equivalent). Contributing to this total were equity, official funds from Banco de la Republica and other sources, private funds mobilized in the domestic market, Bank loan proceeds and private foreign credits. At the same date, the eight DFCs participating in the Bank's seventh loan held loan portfolios totalling almost US$440 million equivalent. This amount represented about 15% of credit extended to industry by the financial system (excluding extra-bank lending). In real terms, the combined portfolio had increased at the rate of 3-4% per annum since the end of 1975. Short-term loans had grown fastest and accounted for 28% of the total. The equity portfolios of the participating DFCs expanded fairly rapidly in the past two years, as a result of compliance with a 1977 resolution of the Monetary Board, requiring the DFCs to hold at least 10% of their assets in shares of new or reorganized companies, the availability of funds for equity investment in the context of the sixth and seventh DFC loans, and a much improved performance of industrial shares. 70. The loan and equity portfolios of CF Colombiana, CF Nacional, CF del Norte, CF del Valle and CF de Santander are sound and adequately protected, with arrears remaining at acceptable levels. The other three DFCs are taking steps to reduce their exposure in some companies, which either does not conform to exposure limits or calls for excessive management attention. 71. Between December 1977 and December 1979, the composite debt/equity ratio of the seven participating DFCs (excluding CF Aliadas) declined from 5.8:1 to 4:1. All DFCs stayed within their debt/equity limits, set under the Bank's seventh loan at 9:1 for the original five DFCs, at 7:1 for CF de Occidente and CF de Santander, and at 6:1 for CF Aliadas. The same ratios  - 21 - would be maintained under the proposed loan, with the exception of CF ue Santander for which the debt/equity ratio would be raised to 9:1, in recogni- tion of financial soundness and institutional maturity. These ratios would provide adequate margins for growth without the immediate need for share capital increases, except in the case of CF del Norte. A uniform current assets/equity ratio of 4.5:1 was introduced under the seventh loan, to pro- vide a reasonable scope for short-term operations while ensuring that the DFCs remain principally long- and medium-term lending institutions. This ratio would be continued under the proposed loan; among the participating DFCs, only CF del Norte has drawn close to it. 72. While in the early 70's the DFCs were making reasonable profits, they lost ground to inflation in the subsequent period. Under the sixth and seventh DFC loans, the Bank tried to bolster their profitability by raising debt/equity limits and permitting a higher interest rate spread on subloans denominated in pesos. Over the last 18-24 months, the financial results of the DFCs have been helped by the relatively favorable performance of their equity investments. The overall profitability of the DFCs is expected to evolve satisfactorily over the commitment period of the proposed loan. Mobilization of Local and External Resources 73. In line with the conditions of the Bank's sixth and seventh loans, each DFC participating in the proposed loan would commit itself in a Subsid- iary Loan Agreement with Banco de la Republica to make all reasonable efforts to raise locally through debt instruments, share capital and retained earn- ings, on an annual basis, resources equivalent to the net Bank loan proceeds (including proceeds of prior loans) disbursed by it (Section 3.04(b)(ix)A of the draft Loan Agreement). An interim target for the mobilization of local funds by all participating DFCs during the eighteen months following the date of the Loan Agreement would be set at Col$ 3 billion (Section 3.04(b)(ix)B of the draft Loan Agreement). In nominal terms, this amount would be double the Col$ 1.5 million target for a comparable period under the seventh DFC loan of 1978 and would represent an increase of 58% over a much larger amount of Col$ 1.9 billion actually raised by the DFCs. The Government has agreed to make all reasonable efforts to enable the DFCs to comply with these contractual provisions (Section 3.03 of the draft Guarantee Agreement). The progress made by the DFCs in raising domestic resources, and the manner in which they are used for medium- and long-term lending to industry, would be reviewed and analyzed by the Government, the Bank and Banco de la Republica after a year from the date of the Loan Agreement, or after 40% of the loan has been committed, whichever occurs earlier. 74. In connection with the Bank's seventh loan, the original five DFCs agreed to make best efforts to raise in the international market US$20-30 million. To date, the five DFCs have signed contracts with foreign commercial banks for an aggregate amount of over US$30 million, with maturi- ties of up to seven years. Additional lines of credit are currently being discussed. Thus, the objective of introducing the Colombian DFCs to the international capital market has been achieved, notwithstanding the fact that some of the lenders were shareholders and/or correspondent banks of one or more of the DFCs. In the context of the proposed loan, the DFCs  - 22 - would aim at borrowing privately overseas not less than US$60 million equiv- alent (Section 3.04(b)(ix)(C) of the draft Loan Agreement) from a larger number of banking institutions and, possibly, with longer maturities as recently authorized by the Monetary Board (see para 38). 1/ The progress made in raising external resources, and their terms, would be reviewed by the participating DFCs with the Government, the Bank and Banco de la Republica at the time of the review of the results of the domestic resource mobilization (see para 73). Benefits and Risks of the Project 75. The proposed loan is expected to help finance nearly 300 projects, involving a capital investment of about US$485 million in a wide range of industries. It would expand industrial production capacity, which has lately become a salient factor holding back the sector's growth. Based on past experience, these projects would generate between 11,000 and 12,000 direct jobs at an investment cost per job of US$39,000 to US$45,000; in addition, there might be an indirect employment impact of about 50%. It is expected that most of the projects would have an economic rate of return in the range of 15% - 40%. During the first five years of their operation, the projects assisted by the proposed loan are expected to generate export earnings of about US$900 million. Moreover, the proposed loan should bring about institutional improvements in the work of the DDC and help the DFCs to increase their resources and expand their operations. 76. The proposed project, as designed, does not involve unusual risks in attaining its major objectives. If the rate of inflation were to accel- erate, the arrangements for a review and adjustment of interest rates on peso subloans should act as a safeguard for maintaining a positive interest rate in real terms and ensuring efficient resource allocation. The expe- rience of the participating DFCs in meeting resource mobilization targets under the Bank's sixth and seventh loans has been encouraging and--given appropriate Government policies--should be repeated during the commitment period of the proposed loan. PART V - LEGAL INSTRUMENTS AND AUTHORITY 77. The draft Loan Agreement between the Bank and Banco de la Republica, the draft Guarantee Agreement between the Republic of Colombia and the Bank, a letter from the Borrower concerning its interest rate policy, and the report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement are being distributed to the Executive Directors separately. 1/ Banco de la Republica borrowed US$35 million from the IDB on February 1, 1980. The objectives of this loan are similar to those of the Bank's DFC loans; its proceeds will be channelled through the private DFCs and the Government-owned Industrial Development Institute.  - 23 - 78. Special conditions of the loan are listed in Section III of Annex III. An additional condition of effectiveness of the proposed loan would be that the participating DFCs prepare and present to the Bank a satisfactory plan to achieve the domestic resource mobilization targets (see para 73). 79. After the conditions of effectiveness regarding the Borrower and the Guarantor are fulfilled, the Loan Agreement would become effective with respect to each DFC upon fulfillment of the conditions affecting such DFC, independently of the status of the conditions affecting the participation of the remaining DFCs. The Loan Agreement would, however, become effective in respect of CF Aliadas only after it has demonstrated that it has made substan- tial progress in the execution of its "plan of action" (see para 67). 80. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 81. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President by Ernest Stern Attachments Washington, D.C. May 5 , 1980  -24- ANEX_I Page 1 of 5 COLOMBIA - SUCIAL INDICATORS DATA SREET LAND AREA (THOUSAND Sq. 101.) COLOMBIA REFERENCE GROUPS (ADJUSTED AyjEAGES LANFD AREA (SHOUSAND SQ. KH.)- LT RECENT ESTIMATE) - TOTAL 1138.9 SAME SAME NEXT HIGCUR AGRICULTURAL 225.6 MOST RECENT SZOGRAPHIC INCOME INCME 1960 /b 1970 /b ESTIMATE /b REGION /c GROUP /d GROUP /a GNP PER CAPITA (US5) 240.0 38C.0 870.0 1124.4 1097.7 1942.6 ENERGY CONSUMPTION PER CAPITA (URLOGRAMS or COAL EQUIVALENT) 491.0 606.0 685.0 943.1 730.7 1646.7 POPULATION AND VITAL STATISTICS POPULATION, MID-YEAR (MILLIONS) 15.8 21.3 24.6 URBAN POPULATION (PERCENT OF TOTAL) 48.2 59.8 65.5 59.3 49.0 51.2 POPULATION PROJECTIONS POPULATION IN YEAR 2000 (MILLIONS) 38.0 STATIONARY POPULATtON (MILLIONS) 55.0 YEAR STATIONARY POPULATION IS REACHED 2065 POPULATION DENSITY PER SQ. KM. 14.0 19.0 22.0 23.5 44.6 28.2 PER SQ. KM. AGRICULTURAL LAND 71.0 93.0 109.0 80.5 140.7 100.5 POPULATION AGE STRUCTURE (PERCENT) 0-14 YRS. 46.0 46.8 38.0 40.9 41.3 35.4 15-64 YRS. _ 51.0 50.5 59.0 54.4 55.3 56.3 65 YRS. AND ABOVE 3.0 2.7 3.0 3.9 3.5 5.1 POPULATION GROWTH RATE (PERCENT) TMTAL 3.1 3.0 2.1 2.4 2.4 1.7 URBAN 6.OLj 5.2 3.9 3.7 4.5 3.0 CRUDE BIRTH RATE (PER THOUSAND) 46.0 36.0 30.0 32.8 31.1 27.5 CRUDE DEATH RATE (PER THOUSAND) 14.0 11.0 8.0 8.5 9.2 9.1 GROSS REPRODUCTION RATE 3.2 3.2 1.8 2.4 2.2 1.8 FAMILY PLANNING ACCEPTORS, ANNUAL (THOUSANDS) .. 115.4 263.8 USERS (PERCENT OF HARRIED WOMEN) .. .. 48.6 17.7 34.7 FOOD AND NUTRITION INDEX OF FOOD PRODUCTION PER CAPITA (1969-71-100) 97.0 99.0 107.0 99.4 104.4 102.0 PER CAPITA SUPPLY OF CALORIES (PERCENT OF REQUIREMENTS) 94.0 92.0 94.0 /k 107.0 105.3 120.8 PROTEINS (GRAMS PER DAY) 50.0 51.0 45.5 E 60.4 64.4 80.9 OF WHICH ANIMAL AND PULSE 28.0 29.0 36.8 /k 28.3 23.5 31.3 CHILD (AGES 1-4) MORTALITY RATE 17.0 13.0 9.0 6.7 8.6 5.1 HEALTH LIFE EXPECTANCY AT BIRTH (YEARS) 53.0 58.5 62.0 63.6 60.2 65.6 INFANT MORTALITY RATE (PER THOUSAND) .. .. 98.0/j 76.1 46.7 45.5 ACCESS TO SAFE WATER (PERCENT OP POPULATION) TOTAL .. 63.0 64.0 63.4 60.8 69.4 URBAN .. .. 73.0 79.5 75.7 85.1 RtRAL .. .. 46.0 38.6 40.0 43.0 ACCESS TO EXCRETA DISPOSAL (PERCENT OF POPULATION) TOTAL .. 47.0 48.0 58.8 46.0 70.1 URBAN .. 75.0 73.0 77.8 46.0 88.3 RURAL .. 8.0 13.0 24.5 22.5 33.2 POPULATION PER PHYSICIAN 2400.0 2170.0 1820.0 1841.9 2262.4 1343.2 POPULATION PER NURSING PERSON 3740.0 2040.0 .. 933.7 1195.4 765.0 POPULATION PER HOSPITAL BED TOTAL 580.0 510.0 530.0 563.4 453.4 197.6 URBAN .. .. 320.0 279.4 253.1 260.2 RURAL .. .. 9670.0 1140.9 2732.4 1055.0 ADMISSIONS PER HOSPITAL BED .. 23.0 25.0 25.7 22.1 17.3 HOUSING AVERAGE SIZE OF HOUSEHOLD TOTAL .. 6.0 5 .0 5.3 4.7 URBAN .. .. 5J