Peru - Small-scale Enterprise Project

Document of p:; i n0PV The World Bank FOR OFFICIAL USE ONLY Report No. 3578-PE PERU STAFF APPRAISAL REPORT SMALL SCALE ENTERPRISE PROJECT November 16, 1981 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 offcial duties. Its contents may not otherwise be disclosed without World Bank autlhorizationm  CURRENCY EQUIVALENTS The exchange rate is being adjusted daily roughly in line with the difference between domestic and international inflation. The exchange rates and currency equivalents as of several dates were as follows: l Currency Unit = Sol (S/.) December 31, 1976 US$1 = S/. 69.37; S/. 1 = US$0.0144 December 31' 1977 US$1 = S/. 130.72; SI. 1 = US$0.0076 December 31, 1978 US$1 = S/. 196.68; S/. 1 = US$0.0051 December 31, 1979 US$1 = S/. 250.75; S/. 1 = US$0.0040 June 30, 1980 US$1 = S/. 286.07; S/. 1 = US$0.0035 December 31, 1980 US$1 = S/. 342.73; S/. 1 = US$0.0029 June 30, 1981 US$1 = S/. 418.92; S/. 1 = US$0.0024 LIST OF ACRONYMS ACAMPI - Asesoria y Capacitacion en el Campo de la Administracion para la Pequena Industria (Consulting and Training in Management of Small Industry) APEMIPE - Asociacion de Pequenas y Medianas Industrias del Peru (Peruvian Association of Small and Medium Industries) BCR - Banco Central de Reserva del Peru (Central Bank) BIP - Banco Industrial del Peru (Industrial Bank of Peru) CAPEI - Centro de Apoyo a la Pequena Empresa Industrial (Small Industry Technical Assistance Center) COFIDE - Corporacion Financiera de Desarrollo (Development Finance Corporation) ESAN - Escuela Superior de Administracion de Empresas (School of Business Administration) FIRE - Fondo de Inversiones Regionales (Regional Investments Fund) FONCAP - Fondo de Bienes de Capital (Capital Goods Fund) FRAI - Fondo de Redescuento Agroindustrial (Agroindustries Discount Fund) IDB - Inter-American Development Bank IDINPRO - Instituto para el Desarrollo Industrial y Profesional de la Pequena y Mediana Empresa (Institute for the Professional and Industrial Development of Small and Medium Enterprise) ITINTEC - Instituto de Investigacion Tecnologica Industrial y de Normas Tecnicas (Institute of Industrial Technology kesearch and of Technical Standards) MITI - Ministerio de Industria, Turismo e Integracion (Ministry of Industry, Tourism and Integration) SENATI - Servicio Nacional de Adiestramiento en Trabajo Industrial (National Industrial Labor Training Service). SSE - Small Scale Enterprise SSI - Small Scale Industry TRB - Tasa de Redescuento Bancario (Central Bank Rediscount Rate) UNDP - United Nations Development Programme USAID - United States Agency for International Development  PERU FOR OFFICIAL USE ONLY STAFF APPRAISAL REPORT SMALL SCALE ENTERPRISE PROJECT Table of Contents Page No. I. THE ECONOMIC SETTING ...................................... 1 Introduction ...........................................1 ] Major Economic Activitities ...... ......................1 l II. THE INDUSTRIAL SECTOR AND SMALL SCALE ENTERPRISE . .... .... 2 Background ........ ............................... 2 Industrial and Trade Policies ..... ..................... 2 Structure of Manufacturing ..... ........................ 4 Small Scale Enterprise ................................. 4 III. TERM LENDING TO SMALL SCALE ENTERPRISE .................... 10 Resource Mobilization and Interest Rates ............ .... 10 Banco Industrial del Peru . ...... ....................... 11 Central Bank ............................................ 14 Commercial and Regional Banks ..... ..................... 15 Other Intermediaries ....... ............................. 16 SSE Credit Guarantee Fund ...... ......................... 17 Prospects ............................................... 17 IV. TECHNICAL ASSISTANCE .18 Major Institutions Providing Technical Assistance .19 Prospects ..21 V. THE PROJECT AND PROPOSED BANK LOAN ........................ 23 Loan Amount and Objectives ...... ........................ 23 Borrower and Onlending Terms and Conditions .......... ... 24 Administration of the Project ........................... 26 Participation of Intermediaries ..... .................... 28 Eligible Beneficiaries and Lending Limits ........... .... 29 Operating Procedures and Free Limits ................ .... 30 Procurement, Disbursement and Audit ................. .... 31 Project Benefits and Risks ...... ........................ 31 This report is based on the findings of an appraisal mission which visited Peru in May 1981. The mission comprised Mr. X. Simon, Miss S. El Baroudy, and Mr. M. Penalver of the Latin America and the Caribbean Projects Department, and Messrs. N. Molenaar and G. Galan, consultants. Mr. P. Glaessner of the Latin America and the Caribbean Projects Department also participated in mission discussions. This document has a restricted distribution and may be used by recipients only in the performance of I their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Table of Contents (Continued) Page No. VI. AGREEMENTS AND RECOMMENDATION ......................... 32 Agreements ......................................... 32 Recommendation ...................................... ..... 33 ANNEXES 1. Estimated Schedule of Disbursements 2. Supporting Tables and Charts 3. Selected Documents and Data Available in Project File MAP  T. TILE ECONOMIC SETTING Introduction 1.01 Peru, the 5ourth largest country in Latin America, has a total area of 1,280,000 km , divided by the Andes Mountains into three regions with extreme topographic and climatic contrasts. Along the 3,000 km of the Pacific coastline, there is a narrow strip of flat and dry land (the Costa) covering only 11% of the country's total area but containing the major cities and nearly half of the total population. The Andean Highlands (the Sierra), above 2,000 meters, cover 26% of the country, are composed of steep mountain slopes and high valleys, and account for 44% of the country's population. East of the Sierra are vast tropical lowlands (the Selva), covering the remaining 63% of the country but containing only 10% of the population. The rugged topography limits trade and integration between the three regions of Peru, and modern economic activity has concentrated in the Costa. Thus, the main coastal cities account for well over 80% of industrial activity and commercial bank credit, with the bulk of it concentrated in Lima. 1.02 The natural resource base holds both major opportunities and constraints to Peru's future development. Vast mineral resources are the largest asset, and mining will remain the backbone of the economy as a source of savings and foreign exchange, although it provides little direct employment and may have, for a period of time, few linkages with the rest of the economy. A potential resource constraint is the scarcity and poor quality of agricul- tural lands. The population pressure on agricultural land is high, and the only new lands that could be brought into production are limited areas in the upper Selva and, with extensive irrigation and drainage, some valleys in the Costa. Energy is also a potential constraint. With the current proven oil reserves the country might become a net oil importer by 1985 if Peru's esti- mated high probable oil reserves are not explored rapidly and brought into production. A third potential natural resource problem is water, as the long term needs of the area west of the Andes will require water transfers from the eastern side of the mountains at a very high cost. 1.03 As a result of three decades of rapidly falling mortality rates, Peru's population growth accelerated during the 1930-1960 period. In the early 1960s, however, birth rates started a gradual fall, mainly caused by the urbanization process and by improved education. But with declining death rates, population has continued to grow at about 2.7% p. a., and is currently estimated at about 17 million. It is expected that population growth will fall only slightly to about 2.6% p. a., over the next 20 years, unless an effective demographic policy is adopted. The urban population is increasing rapidly at 4.5% p. a., and over 4 million people are concentrated in Lima. Given the structure of Peru's population, the labor force is expected to grow in excess of 3% per year during the next 20 years. Major Economic Activities 1.04 During the past 12 years, the Peruvian economy has gone through a period of rapid growth fueled by expansionary fiscal and credit policies (1968 to 1976), a serious financial and balance of payments crisis followedl  - 2 - by a recessionary period (1977 to 1979), and the incipient stages of an economic recovery (started in late 1979). The cyclical nature of the economic activity during the 1970s is reflected in the growth of GDP, which averaged 4.3% p. a. during the 1968-1976 period, dropping to minus 0.3% p. a. in 1977-78, and recovering to 3.4% p.a. in 1979-80. The sectoral distribution of economic activity changed substantially during the 1960s and early 1970s and stabilized after 1976 except for a continuing increase in the share of mining. At present, the largest contribution to GDP is that of manufacturing, accounting for about 27% of the total, followed by the commercial sector with 16%, mining (incl. petroleum) with 14%, and agriculture (incl. fishing) with 8%. With slow economic growth and a rapidly growing population (2.7% p. a.), the country's per capita income virtually stagnated during the late 1970s and was US$930 in 1980 as compared to US$910 in 1970 (at constant 1980 prices). The recent economic crisis and the high rate of growth of population have worsened a traditionally serious unemployment problem, and it is estimated that 11% of the non-agricultural labor force is currently unemployed and 44% under-employed. 1/ II. THE INDUSTRIAL SECTOR AND SMALL SCALE ENTERPRISE Background 2.01 After a decrease in industrial output and investment during 1977 and 1978, industrial production recovered slightly (4.1%) in 1979 and grew more strongly (5.9%) in 1980. Although the most recent sectoral data available does not lend itself easily to a separate analysis of small versus medium and large enterprises, it appears that the SSE sector is participating fully in the current upward trend in economic activity. The recent recovery of the industrial sector, however, has not yet changed a situation of very low levels of industrial employment. While manufacturing contributes an estimated 27% of the country's GDP, total employment in the formal manufacturing sector (firms with five or more employees registered with the Ministry of Industry) amounts to about 270,000 jobs, only 5-6% of total employment. Adding an estimated equal number of jobs in the informal sector, the total contribution to employ- ment remains in the 10-12% range. Industrial and Trade Policies 2.02 Prior to 1978 Peru followed the import substitution approach to industrial development providing high tariff protection -- supplemented by import prohibitions for a large number of products - generous fiscal incen- tives, and credit on relatively favorable conditions. Although export incentives in the form of negotiable export tax credit certificates (CERTEX) were introduced on a small scale in 1970, industrial development was inward- oriented and manufactured exports were relatively minor, amounting to some US$75 million in 1975 or roughly one percent of industrial output. Up to 1/ Earning less than the minimum wage or working less than 35 hours a week and wishing to work more.  - 3- 1973, tariffs increased steadily. During 1973-79, they remained essentially unchanged, but were gradually eroded through widespread exemptions and the overvaluation of the sol during 1968-75/76. Beginning in 1970, tariffs were gradually replaced by non-tariff barriers including import licensing, pro- hibitions, state monopolies, and, in particular, the National Register of Manufactures (RNM). The RNM consisted of a list of industries that was maintained by the Direction of Industry within the Ministry of Industry (MITI). Imports competing with goods produced by industries on the RNM were banned. Out of the 4,600 items in the customs classification, about 40 percent were subject to non-tariff barriers in 1973, and this share had grown to about 60 percent by early 1979 (inciuding about 1,400 items in the RNM). V 2.03 A major reorientation of industrial policies took place in connec- tion with the 1978 Economic Recovery Program, which was supported by a Bank Program Loan. The complex system of non-tariff protection was dismantled and replaced by a new tariff system. In addition, more vigorous export promotion efforts were undertaken along with a more flexible exchange rate policy, which complemented an increase--introduced in 1976--in CERTEX. The first important liberalization measures were introduced in March 1979, when the RNM was abolished and replaced by a greatly reduced temporary list of import prohibi- tions, which by now have virtually disappeared. The new tariff structure became effective in December 1979. These policy changes, together with fall- ing domestic demand in the late seventies, resulted in an important reorienta- tion of industrial development, with the value of manufactured exports increas- ing from about US$100 million in 1976 (equivalent to 1.6 percent of industrial output) to almost US$800 million in 1980 (equivalent to about 8 percent of output). Textiles and fish products accounted for most of this increase. 2.04 The new Government has accelerated the import liberalization process by further eliminating administrative barriers (including the whole system of import licensing) and by reducing tariffs. At present, the unweighted average of tariffs is close to 30 percent, with the maximum tariff at 60 percent. The Government is committed to reduce tariffs further over a period of three to five years through successive, pre-announced cuts and to make the tariff structure more uniform. The Government revised the CERTEX system in February 1981 to make it more responsive to the goal of industrial development and growth of manufactured exports and to correct abuses which have crept into its use. Moreover, the devaluation process is kept about in line with the differential between domestic and international inflation. The continuation of these policies, together with the general process of decontrol, should provide the appropriate framework for sustained growth of industrial invest- ment, production and exports. 2.05 Small industry is expected to participate vigorously in Peru's economic and industrial growth. Preliminary indications are that small indus- try has benefited from the new import liberalization process. It is now able to purchase many imported raw materials and intermediate goods at lower prices than those that persisted when local manufacturing was practically the only source of supply. Also, because small industry is more labor intensive than larger firms, it has been more able to respond to changing market forces to remain competitive. The proposed project would provide term resources that would help small industry further adapt to the new industrial and trade policies.  -4- Structure of Manufacturing 1/ 2.06 Performance and Structural Features: By the end of the 1970s, the manufacturing sector accounted for roughly one-fourth of Peru's GDP. Growth of the sector during the past decade largely depended on the domestic market and was subject to large fluctuations, which mirrored those of the whole economy. During 1969-74, sectoral production grew at an average annual rate of 6.6% in real terms, well above GDP growth of 4.8%. During 1975-76, sectoral growth slowed down to about 4% per year and during 1977-78, because of the economic crisis referred to in Part I of this report, it dropped to a negative 4%. During 1979-80, as the economy rebounded, the sector resumed growth at annual rates of about 4% and 6%, respectively. Industrial investment fluc- tuated widely during the 1970s, doubling during 1971-75 and then dropping by 1978 to 25% below its 1975 peak. Investment in manufacturing came largely from public enterprises. 2.07 The manufacturing sector in Peru is diversified. Industrial policies pursued during the past decade led to a strong expansion of intermediate goods' industries such as textiles and chemicals. In 1978, traditional consumer goods' industries (food, beverages, and tobacco; clothing and footwear; furniture; and others) accounted for about 40% of manufacturing industry value added, the chemical and related industries (including petroleum refineries) accounted for another 30%, and metal processing industries for some 15%. Manufacturing is heavily concentrated in the Lima-Callao area, by far Peru's largest market. The Lima area accounts for about 70% of the number of firms, employment, and output. Other industrial centers of importance are Arequipa in the south as well as Trujillo, Chimbote, and Piura in the north. With the exception of Arequipa and Trujillo, industries outside the Lima-Callao area mainly process locally available raw materials such as sugarcane, bagasse, cotton, fish, and others. 2.08 While the private sector accounts for over 90% of the number of industrial firms and for about two thirds of output and employment, the state's role in manufacturing is substantial. State-owned enterprises accounted for one-third of output in 1978, mostly in tobacco, paper, petroleum refining, cement, iron and steel, and non-ferrous metals. The new Government is firmly committed to promoting the private sector, including foreign investment. It is also considering divesting itself of some Government owned industrial investments. Its general policy of decontrol is expected to result in the further revival of private investment, which started to pick up in 1979, and in a lessening of direct government involvement in the industrial sector. Small Scale Enterprise 2.09 Definition. Small scale enterprises are legally 2/ defined in Peru to include firms engaged in industrial, tourist services and commercial 1/ A more detailed review of the manufacturing sector, covering also indus- trial and trade policy is included in the SAR for the Second Industrial Credit Project for Peru (Report No. 3238-PE dated March 12, 1981). 2/ Law of Small Enterprises (D.C. 21435) of February 24, 1976. A new law approved by the previous Government in July 1980 has not been put into effect. The present Government has prepared a draft industrial law including a section dealing with small scale industry.  activities, as well as fishing, forestry, and mining operations. Small industrial firms (the most important type of SSE in terms of employment and contribution to GDP) are defined as private sector industrial enterprises with annual sales of up to 590 minimum legal wages (about S/. 191 million or US$500,000 equivalent in mid-1981). The legal definition is used by the Ministry of Industry (MITI) solely for purposes of application of the labor and incentive legislation, whereas most statistical data available classify industrial enterprises by size, according to the number of employees. Also, Banco Industrial del Peru (BIP), the main financial institution currently providing resources to SSE, uses a composite definition, including total assets (up to 295 minimum legal wages or about US$250,000), annual sales (up to 590 minimum legal wages or about US$500,000), and number of employees (up to 50). 2.10 A review of the most recent year for which reliable industrial census data is available (1975) shows that the legal definition above covers virtually all enterprises with less than 20 employees, plus a a large number of firms in the group with 20 to 49 employees. Also, the 1975 data (covering only firms with five employees or more) show that small industrial enterprises accounted for 87% of the total number of manufacturing establishments, 33.5% of total employment in the formal manufacturing sector, and 22% of value added. In addition to the industrial census data, the information used in this report has been complemented with data from the SSE Registry established after 1976, which contains a total of about 8,000 firms in the Lima-Callao area, and from a survey conducted in late 1980, of 248 small firms located also in the Lima area and selected randomly from the Registry (ESAN Survey). The Registry data show that about 74% of the enterprises had less than five employees, and an additional 20% had between five and ten employees. Firms with more than 30 employees were less than 1% of the total. Thus, the data from the Registry and the ESAN Survey cover the smaller end of the range and complement the 1975 census data. 2.11 Size and Number of Firms. In 1975, Peru had a total of 7,500 formal industrial enterprises with five or more employees and an estimated 25,000 unregistered "cottage industries," mostly with less than five employees but sometimes exceeding this figure. By 1980, the number of formal industrial enterprises had increased to 10,000, of which about 75% were estimated to meet the legal definition of SSE. In addition, registered and unregistered firms with less than five employees plus other informal sector firms, are likely to exceed 30,000. Thus, the total number of small industrial enterprises (including some services such as mechanical repairs) is estimated to be close to 40,000. In addition, there is a large number of purely commercial firms that also qualify as SSE. 2.12 Most Peruvian industrial enterprises are small. Two-thirds of the about 10,000 registered industrial establishments have less than 30 workers; and in 1975, there were less than 500 firms with more than 1,000 workers. Data for the nearly 8,000 firms in the SSE Registry indicate that average employment per firm was between four and five employees, and the ESAN Survey shows an average of about six full-time employees and an additional two to three part-time employees. The second set of data is likely to be more repre- sentative, as it reflects the actual situation as of late 1980, whereas the  - 6 - Registry data covers a period of four years and reflects only the expectations of enterprises at the time of registration. 2.13 Output and Employment. Assuming that non-registered SSE may be some- what smaller on average than registered ones, the average employment per firm, including full and part time employment, is estimated at about six jobs. Thus, small-scale industrial enterprises currently provide an estimated 240,000 jobs, about one-half of total industrial employment and one-third of value added. Small scale industry production is concentrated in consumer goods mainly in the lower price and quality ranges, with processed foods, textile, and clothing products accounting for more than 52% of the total number of firms, followed by metal products (19%). 2.14 Small-scale enterprises have generally a spatially limited market. The ESAN Survey shows that 75% of the enterprises in the Lima area sell most or all their output in the Lima market, with only less than 20% selling signi- ficant amounts in the rest of the country. A total of 10 firms in the sample (4%) entered the export markets, with 4 firms selling most of their output abroad. Most of the small firms in the sample sold directly to the public and/or to commercial enterprises, and only 11% sold to other industrial firms. 2.15 The firms included in the ESAN Survey reported average sales of about S/. 10.3 million in 1980 (about US$35,000). With a reported average investment of V/. 8.02 million (para. 2.19 below), the firms show a very low output/fixed assets ratio of 1.3. Even assuming a very high percentage of value added in the firms' output, the corresponding value added/fixed assets ratio would be well below the level shown by the 1975 data on the smallest group included in the census (para. 2.16 below). This probably reflects a lower value of the ratio for the smaller firms (in the ESAN Survey) but also the relatively depressed conditions prevailing in 1980 in contrast to the high level of economic activity prevailing in 1975. 2.16 Investment and Productivity. There is a strong positive relation- ship between labor productivity and size of firm for the Peruvian manufacturing sector as a whole (Table 2.1). Value added per employee in the largest size group of enterprises (1,000 or more employees) is nearly four times higher than in the smallest size group (five to nine employees). Also, fixed assets per employee (average investment cost per job) in the largest size group are more than three times higher than the smallest group, indicating that higher labor productivity is at least partly the result of higher capital/labor ratios.  Table 2.1 COST AND PRODUCTIVITY INDICATORS BY SIZE OF FIRM, 1975 (S/. thousand) Number Gross V.A. Fixed V.A. V.A.per of Average Output per per Assets per per Fixed Employees Salary Employee Employee Employee Wage Bill Assets 5-9 63.2 431.8 211.5 178.1 3.35 1.19 10-14 79.7 558.0 252.1 176.3 3.16 1.42 15-19 87.6 673.8 323.7 199.7 3.69 1.62 20-49 100.5 742.8 347.9 236.8 3.46 1.47 50-99 120.4 758.4 359.5 261.2 2.98 1.38 100-199 145.5 985.1 440.6 341.3 3.03 1.29 200-499 163.6 1000.5 528.1 387.6 3.23 1.36 500-999 160.1 1172.7 591.3 222.6 3.69 2.66 1000 and more 175.6 1534.5 804.9 561.1 4.58 1.43 Total Manu- facturing 129.6 940.7 443.6 302.4 3.42 1.47 Source: Annex 2, T-1 2.17 Labor productivity is only a partial measure of a firm's economic efficiency and market competitiveness. Capital/labor and capital/output ratios, as well as differences in factor prices among firms, also have a major impact on competitiveness. The three indicators together (labor pro- ductivity, capital/output ratio, and capital/labor ratio) suggest a modest increase in economic efficiency with an increase in the size of firm (see Table 2.1). However, a full measure of the degree of competitiveness has to include differences in factor costs (particularly labor) facing firms of different size. 1/ 2.18 A qualitative assessment of the overall efficiency and market com- petitiveness of industrial firms by size group can be obtained by looking at the last two columns of Table 2.1, which reflect the relationship between value added generated in the firms and the two main claimants to value added-- labor and capital. The higher the ratios, the higher the amount of value added which will go into profits; but the two ratios cannot be directly com- bined into a single measure because of their heterogeneity. While the wage bill is a flow concept, reflecting labor costs during the period, the value of fixed assets indicates a stock concept; and it is not possible to obtain direct data on the corresponding flow (capital use or depreciation during 1/ Differences in average salaries are the net result of several factors, including differences in labor skills and differences in institutional constraints, such as legal minimum wages. Similarly, the cost of capital for firms of different size may be quite different, reflecting easier access to the financial sector by large firms, different availability of subsidized financing and of import duty exemptions and others.  the period). A consideration of the two ratios plus a crude measure which combines labor and capital costs under two alternative assumptions 1/ (Table 2.2), indicates two local maxima, one for the largest firms with 500 or more employees and another covering two of the size groups of small-scale industries (those from 10 to 49 employees). The smallest firms (5 - 9 employees) also show reasonably good competitiveness: above that of medium- sized firms and very similar to the group with 200 - 499 employees. Table 2.2 PRODUCTIVITY AND COMPETITIVENESS INDICATORS, 1975 V.A. V.A. Employees Wage Bill Fixed Assets Competitiveness I Competitiveness II 5-9 3.35 1.19 2.61 2.14 10-14 3.16 1.42 2.59 2.19 15-19 3.69 1.62 3.01 2.54 20-49 3.46 1.47 2.80 2.35 50-99 2.98 1.38 2.45 2.08 100-199 3.03 1.29 2.45 2.06 200-400 3.23 1.36 2.61 2.19 500-999 3.69 2.66 3.24 2.89 1000 and more 4.58 1.43 3.47 2.80 Total 3.42 1.47 2.77 2.33 Note: Competitiveness I assumes a 10% depreciation rate and II a 20% rate, and are based on the calculations outlined in footnote 1 below. Source: Annex 2, T-1 and mission calculations 2.19 Recent measures of fixed assets in Peruvian small industries are of difficult interpretation because of very high rates of inflation and devalua- tion of the sol which are not adequately reflected in the standard accounting practices. The ESAN Survey included a question on the current value of the investment in machinery and equipment in the sample firms, in 1980 soles. The average investment is reported to be S/. 8.02 million (about US$23,000 equiva- lent at the December 31, 1980, exchange rate). With an average employment of six employees, the average investment cost per job (excluding land and build- ings) is about US$4,000. About one-half of the firms in the ESAN Survey are considering making additional investments with an average of US$35,000 equiva- lent for machinery and equipment and US$56,000 in total investment per firm. 1/ Capital use or depreciation is approximated by using 10% and 20% of the value of fixed assets. Then we can obtain the ratio of value added to labor costs plus capital costs as V.A./(Wage Bill + d* Fixed Assets) where d is the depreciation rate. The results, included in Table 2.2 are consistent with the first two ratios considered separately.  - 9 - 2.20 A separate, smaller sample of enterprises interviewed during the preparation of the proposed project resulted in somewhat higher figures for fixed assets, employment, and investment cost per job. The sample, consisting of 45 firms selected from among BIP small-scale industry clients in the Lima, Piura, Ica and Cusco areas, indicates average fixed assets of about US$75,000 equivalent, average employment of 13, and an investment cost per job of US$5,800 equivalent. These figures seem to indicate that the BIP customers were selected from among a subgroup of relatively "large size" small firms and would be fully consistent with the figures in para. 2.19 above. 2.21 Wages and Salaries. A majority of small scale industry full-time employees receive the minimum legal wage, but it appears that most of the part-time employees may receive lower wages. The ESAN Survey indicates that the average monthly wage in late 1980 was S/. 26,000 (about US$80 equivalent), close to the minimum wage; and the average monthly salary for administrative employees was S/. 30,000. Also, the owner-managers of the firms in the ESAN Survey reported an average salary allocation of about S/. 50,000, less than twice the minimum wage. The average wages in small firms are well below those in medium and large firms (Table 2.1). 2.22 Financial Structure and Management. A large number of small-scale industrial enterprises operate outside of the formal financial sector. One- third of the 248 firms included in the ESAN Survey do not have any relations with a bank or other financial intermediary. Among the firms dealing with banks, the largest number (40 firms) deals with Banco de Credito (Peru's largest private commercial bank), whereas two other commercial banks (Banco Continental and Banco Comercial) follow. Banco Industrial del Peru appears only in the fourth position after the above. 2.23 The number of firms obtaining loans during the last few years is small. Of the firms in the Survey only 147 received loans during the last ten years, with an average loan size of S/. 3 million (about US$10,000 equivalent). Only slightly more than half of the total amount of the loans came from the banks, whereas 45% of the total came from friends and relatives. Significantly, however, 79% of the loans were received in the last three years, showing an increasing use of resources external to the firm. The low degree of participation in the formal financial system is typical of the lower end of the small industry range covered by the ESAN Survey. Also, the special attention given by BIP to SSE firms outside Lima-Callao may account for its limited importance as a source of finance among the firms in the ESAN Survey, which covered only the Lima-Callao area. 2.24 Industry and Trade Associations. There are two major associations of small-scale firms at the national level, the Small-Scale Industry Committee within the Sociedad de Industrias (Industrial Association) and the much larger APEMIPE (Asociacion de Pequenas y Medianas Industrias del Peru). In addition, a number of local associations of small-scale firms have been recently estab- lished in several departments outside Lima (mainly in Arequipa, Trujillo and Piura). These local associations are also members of APEMIPE and maintain a close relationship with the regional offices of the Ministry of Industry and other local authorities, as well as with the institutions providing technical  - 10 - assistance to SSE. Thus, the local associations may develop into a very impor- tant element to coordinate the provision of assistance to small enterprises in the different areas of the country. 2.25 Government Assistance to SSE. As indicated above (para. 2.09), the Law of Small Enterprises (LSE) was enacted in February 1976. The main feature and objective of the LSE was to relieve small enterprises of some of the obligations of profit and ownership sharing established by the Industrial Community Law. During its last days in office, the previous government approved another law for small enterprises in July 1980. The purpose of this new law was to encourage formal registration of small enterprises by simplify- ing administrative procedures and lowering the potential tax burden by estab- lishing a unified tax. However, the new Government, inaugurated in July 1980 indicated its intention to prepare a new industrial law covering also small industries and did not put into effect the Law approved by the outgoing government. Currently, there is a draft Industrial Law being discussed by Congress, including a small scale industry section. The draft law proposes to maintain and expand the benefits of small firms in terms of more liberal labor legislation, simplified registration procedures, and a single tax to be levied on small firms. The draft law would also expand the definition of small scale industry to cover a wider range of firms. III. TERM LENDING TO SMALL SCALE ENTERPRISE 3.01 The Peruvian financial system is dominated by the banking system which has historically held around 88% of the total assets of the financial system. Besides the Central Bank (Banco Central de Reserva del Peru - BCR), the banking system comprises Banco de la Nacion (the central Government's bank and tax collector), five specialized development banks, and 21 commercial banks including eleven non-specialized commercial banks, six regional commercial banks, and three construction and one savings commercial banks. The non-banking system includes the Government's development finance institution (Corporacion Financiera de Desarrollo-COFIDE), 10 financieras, 16 savings and loan associa- tions, 22 insurance companies, and over 500 small savings cooperatives and credit unions (Annex 2, T-4). Resource Mobilization and Interest Rates 1/ 3.02 Financial savings in Peru are mainly marshalled by the banking system, which at year-end 1980 held about 85 percent of all financial liabili- ties (including demand deposits) with the private sector. These financial instruments include savings and time deposits, various types of bonds, mort- gage certificates, and certificates of deposit. In past years, however, mobilization of medium- and long-term resources was severely constrained by 1/ A detailed review of the financial sector is included in the SAR for the Second Industrial Credit Project for Peru (Report No. 3238-PE, dated March 12, 1981). The relevant tables presented in Annex 2 of this report have been updated to include data for 1980.  - 11 - negative real rates of interest that prevailed during the seventies. During 1980 effective lending rates amounted to some 50%, compared to an inflation rate of 60%. Effective deposit rates were in the 35 to 40 percent range, with some instruments, like certificates of deposit and time deposits over two years with financieras, at higher rates. In early January 1981, the Central Bank made a full revision and simplification of the interest rate structure, including an upward adjustment of from 10 to 20 percentage points for most deposit and lending rates, which brought their effective rates to over 60 percent, above the current annualized rate of inflation of 50% (after briefly reaching 75% to 80% in early 1981) (Annex 2, T-12). 3.03 More recently, in July 1981, the Government and the Central Bank introduced indexation primarily for mortgage financing in the housing sector. Simultaneously, financial intermediaries are being allowed the option of using indexation in operations with maturities of more than one year. The index will be announced monthly, in advance, will be based on the prior month's non-indexed rates set by the BCR, and has been designed so that, at least initially, the combined indexation and interest on indexed obligations will result in the same effective "interest charges" as under the non-indexed system. As long as it remains optional, however, it is not clear whether financial institutions will adopt indexation. There are no apparent incentives for them to do so. With some exceptions the Central Bank will apparently continue its own lending operations without indexation. The financial system can only index their assets (loans) but not their liabilities (deposits they receive and obligations they issue). Cash flow volumes and thus available cash for new lending of financial institutions would be reduced. Without new additions of paid-in capital debt-to-equity ratios would increase substantially over time. The announced policy of the Central Bank is that under the existing or any new system, interest rates would remain positive in real terms. For borrowers, however, a reduction in their debt servicing burden would be expected. This would be particularly favorable to SSE. Finally, however, indexation was introduced by executive decree which must be confirmed by Congress through enactment of a bill presently before that legislative body. Whether Congress should enact the bill in its present form or limit indexation to the housing sector alone is currently being debated. Banco Industrial del Peru 3.04 In past years the main institution channelling term resources to the SSE sector has been BIP, one of the five specialized development banks. As of December 31, 1980, BIP had total assets of S/. 113 billion (US$328 million), net loans outstanding of S/. 92 billion (US$268 million), and equity of S/. 26 billion (US$76 million). (Annex 2, T-5, T-6 and T-7.) It has a network of 26 branches throughout the country of which only one is in the Lima area. BIP has in past years suffered from an inadequate organization (15 divisions report to the General Manager), over-staffing, and deficiencies in its resource mobilization side, owing mostly to the ready availability of low cost money from the Government. On the lending side, however, and particularly lending to SSE, BIP has developed a high degree of operational and institutional competence (para. 4.08). The only major weak- nesses on the lending side are cumbersome loan appraisals, where a much higher degree of thoroughness and quality is required by BIP than the smaller loans  - 12 - merit, and lenghty and time consuming processing procedures. The new General Manager who took office in February 1981 is addressing these issues. 3.05 BIP lends to SSE through its regular SSE lines of credit which have been funded mostly by IDB loans, and through the Regional Development Fund (RDF), a special program supported with USAID resources and targeted to SSE in rural areas. Of US$127 million equivalent in total loans approved by BIP in 1980, fully 35%, or US$44.5 million equivalent were for SSE (Table 3.1). In real terms, between 1978 and 1980 only RDF and normal SSE lending showed significant increases. An important reason for the high level of SSE lending prior to January 1981 was the large volume of low cost resources that were being made available by the Government exclusively to BIP for financing SSE at subsidized rates of interest. RDF and SSE lending in 1980 included some 12% to 14% of refinancing and were, in addition, inflated by the highly negative real interest rates that prevailed during that year. Discounting the effects of refinancig and negative rates, demand in 1980 would have more likely been in the range of S/. 9 billion (US$30 million) to SI. 10 billion ($33.3 million) instead of the SI. 13.4 billion (US$44.5 million) experienced. Branch managers of BIP with whom the mission met confirmed some slowdown in demand with the large increases in interest rates introduced after January 1981. Table 3.1. BIP LOAN COMMITMENTS (in billions of soles) Average % Real % Annual Increase in Share Growth 1980 Compared 1978 1979 1980 1980 Rate (%) to 1979 Industrial 4.2 7.0 12.1 31.8 29.5 8 SSE and Artisan 2.1 3.2 9.7 25.5 138.5 89 RDF 1/ .7 1.4 3.7 9.7 107.4 65 Fishery 1.1 1.6 2.8 7.4 93.4 9 Export 5.0 5.7 9.8 25.6 36.8 1.7 Total 12.9 18.8 38.1 100.0 48.7 26.7 1/ Regional Development Fund, also an SSE lending program. 3.06 Normal SSE lending operations were supported with three IDB loans made to the Government between 1977 and 1979 totalling US$54 million, most of which was passed to BIP as capital contributions, and of which one-third to one-half were used for SSE lending. Prior to January 1981, interest rates ranged from 32% to 48% p.a. nominal (37% to 60% effective) depending on the size of the firm and loan, with the smaller firms receiving the lower rates. In 1980, a total of 1,940 loans with an average loan size of about US$16,600 were made under the above lending program. The majority of BIP's SSE benefi- ciaries were in the center and north zones of the country. In terms of amounts  - 13 - approved, in 1978 Lima-Callao was the most favored area, but by 1979 and 1980 the north had become the major consumer of SSE resources (Annex 2, T-8). 3.07 The Rural Development Fund. RDF was initiated with USAID's support in November 1975 to provide technical and financial assistance in order to create new iobs and support investments with better regional distribution. RDF's objectives were to be accomplished by making credit available to enter- prises in rural areas on highly preferential terms and conditions. RDF could make loans of up to US$60,000 equivalent to industry, commerce, services and artisanal activities. And, in order to encourage the creation of new jobs, the cost per job created was not to exceed the equivalent of US$4,000. RDF started its operations in 1975 in four areas: Cuzco, Junin, Puno and Ayacucho with a US$8.3 million component of a USAID loan to the Government that was passed on in soles to BIP as capital contribution. In addition, the Govern- ment made available counterpart funds of US$5.2 million equivalent. RDF, now operating through most of BIP's 26 branch offices, was replenished two years ago by a second USAID loan of US$8 million and counterpart funds of US$2.7 million equivalent. By 1980, RDF had made a total of 5,537 loans, of which 1,611 were approved in 1980, amounting to S/. 3.7 billion, for a monthly approval average of US$1.0 million and with an average loan size of US$8,000 equivalent (Table 3.2). Table 3.2. RDF COMMITMENTS AND LOAN SIZES 1977 1978 1979 1980 Cumulative a/ Number of loans 1,056 1,376 1,494 1,611 5,537 Amount in million S/. 342 66.9 1,353 3,736 6,100 Average loan size million S/. .32 .49 .91 2.32 1.10 Average loan size in US$'O00 3.2 3.0 4.1 7.7 4.6 b/ a/ Exchange rates used are the average rates provided by the Central Bank for each year as follows: 1977 = 100; 1978 = 163.7; 1979 = 223.7; 1980 = 300. b/ The weighted average exchange rate in relation to the amount of loans committed each year is 237.57. 3.08 Until January 1981, RDF lending operations carried highly negative interest rates ranging from 18% to 26% plus a 2% commission, as compared to an inflation rate of about 60% in 1980. Traditionally, cottage industries and smaller firms were charged the lower interest rates. In line with the new Government and BCR policy on interest rates (para. 3.02), BIP increased interest rates in January 1981, and RDF nominal lending rates, including commissions, moved up to a range of 32 to 49.5% including commissions (equivalent to effective rates of 37% to 62%) depending on the loan size and activity of the enterprise. The upper limit rate became the same as the prevailing commercial bank rate. More recently, all interest rates have been unified at the higher rate for long-term operations (currently 54% excluding commissions). RDF resources have been totally committed.  - 14 - 3.09 Prospects. BIP is going through a major reassessment of its role, policies and organizational structure. One major area that is receiving pri- ority is resource mobilization. Because of the large dependency on Government resources, in past years this area of BIP's operations failed to develop adequately. As a consequence, and because the new Government is no longer making available low cost money and is forcing all institutions to fend for themselves, BIP is in the process of strengthening its resource mobilization function and developing plans for raising new resources. The SSE programs are currently underfunded and some rationing began as early as March 1981, and BIP does not expect to begin capturing significant volumes of new resources before 1982. Consequently, the proposed loan is expected to help BIP through the early part of 1982. More importantly, because the resources of the project would be available to other financial intermediaries on equal terms and conditions, BIP will for the first time in many years face competition that should result in motivation to improve the efficiency of its lending operations where these are weak, particularly in the processing of loan applications (para. 3.04). Banco Central de Reserva del Peru 3.10 Special Funds. BIP term lending efforts to SSE have been comple- mented by a number of funds established by the Central Bank during the last three years, and which in November 1980 were transferred to COFIDE. The first to be introduced was the Fondo de Redescuento Agroindustrial (FRAI) estab- lished in 1978 to finance agroindustrial projects, and partially financed through a US$14.7 million loan from USAID (plus US$4.9 million equivalent in counterpart funds provided by the Central Bank). Subloans for a period of up to 10 years with up to 2 years of grace, for a maximum of US$750,000 equivalent are denominated in local currency and carry a nominal interest rate of 54%. A total of 25 financial intermediaries channelled FRAI resources, with 8 financieras accounting for 54% of the total, followed by 9 commercial banks (about 29%) and 4 regional banks (13%). 3.11 In November 1979, the Central Bank established the Fondo de Bienes de Capital (FONCAP) with a capital of S/. 5 billion (about US$17 million equivalent) to finance the sale of domestically produced capital goods and equipment. Subloans for a period of up to 10 years for a maximum of US$2 million equivalent are denominated in local currency and carry a nominal interest rate of 54%. Of the 20 intermediaries channelling FONCAP resources, eight financieras accounted for 63% of the total, three commercial banks used 30% and two regional banks 3%. A third Central Bank fund, the Fondo de Inversiones Regionales (FIRE), was established in February 1980 to finance a wide range of activities outside the Lima-Callao area. FIRE's capital was S/. 5 billion. Subloans of up to US$2 million equivalent can be denomi- nated in soles (for the local component of the projects) or in US dollars (for the imported component). Local currency subloans carry a nominal interest rate of 54%, and US dollar subloans carry a rate of 15%. Five financieras accounted for 73% of the total approved amount, two regional banks channelled 20% and two commercial banks the remaining 7%. Table 3.3 shows that FRAI and FONCAP have operated mainly as small and medium scale industry credit lines, while FIRE financed larger operations.  - 15 - Table 3.3. SPECIAL FUNDS OPERATED BY COFIDE, MLARCh 31, 1981 Total Approvals Average Loan Size in S/. billions No. of Loans US$'000 FIRE 6.88 40 446 FRAI 6.42 106 157 FONCAP 7.06 98 187 3.12 Regional Selective Credit. Because the majority of industries out- side Lima are small to medium scale, most commercial and regional bank loans outside Lima are directed to this sector. However, commercial bank loans are only on a short-term basis (up to 360 days); and regional banks, although authorized to make loans for up to five years, greatly depend on their ability to mobilize term resources for their term operations. Accordingly, commercial and regional banks have been using a special rediscount line of credit of the Central Bank, the Regional Selective Credit (RSC), for financing operations outside of Lima through their network of branches. 3.13 RSC rediscounts loans of up to S/. 50 million (about US$131,000 equivalent) for firms with total assets not exceeding S/. 300 million (US$750,000 equivalent). RSC total resources amount to S/. 5 billion of which 93% had already been used by June, 1981. Regional banks have used about 54% of the total amount, commercial banks 43%, and the rest have been used by other finance and savings institutions. Although RSC is formally a renewable short-term credit line, a pre-established amortization schedule of at least 20% (and in some cases 16.7%) every 180 days allows its conver- sion into medium-term loans with maximum maturity of 2-1/2 years (3 years). Many SSEs have benefitted from this facility, but at 2-1/2 to 3 years the terms are not fully adequated for financing most long-term investments. 3.14 Beyond the above programs, some of which have now been transferred to COFIDE, the Central Bank continues very interested in assuring the avail- ability of term resources for sectors currently underserved, and in creating competition among intermediaries in the whole financial system to assure the broadest possible distribution of term resources. The desire of the Central Bank to take the proposed loan and convert it into soles, and of passing it on to the entire financial system through COFIDE, with an additional counterpart of the Central Bank (para. 5.01), reflects the concern of the Central Bank in assuring the availability of term resources to SSE on a competitive basis through the largest number possible of intermediaries. Commercial and Regional Banks 3.15 There are eleven commercial and six regional commercial banks with a network of 770 branch offices, of which 688 are of the commercial and 82 of the regional banks. In 1980, these banks held 28.4% of the total assets of  - 16 - the financial system (Annex 2, T-4, T-9 and T-10). Except when specifically exempted by the Central Bank, commercial banks are not allowed to extend credits that exceed one year, and regional banks five years. To mobilize term resources only regional banks are allowed to issue certificates of deposit with maturities of up to three years. All commercial banks, except one, however, have created financieras (finance companies) as vehicles for mobiliz- ing and providing medium-term resources for their clients, although in the case of the financieras the lending orientation tends to be solely for medium and large industries (Annex 2, T-11). Despite these limitations commercial banks have been dealing extensively with SSE in working capital financing, and regional banks have been, in addition, providing medium-term financing to SSE, which is the predominant clientele in the regions outside of Lima. Commercial and regional banks, therefore, have a large potential for providing long-term credit to SSE, particularly in the regions outside of Lima. They have a large branch office network, they know the clients, and, perhaps most important, are more likely to make "character" loans to well known clients with insufficient physical guarantees, a problem that is particularly troublesome in lending to SSE. To-date the major limitation to extending long-term credit to SSE has been the lack of term resources. The proposed project would make available such resources; and would, in addition, contribute towards the upgrading of the term lending capabilities of the loan officers of commercial and regional banks through a training program that would be sponsored by COFIDE under the project (para. 5.15). Other Intermediaries 3.16 Cooperatives. There are about 530 savings and credit cooperatives that incorporate some 800,000 members. In 1979, credit cooperatives extended loans amounting to S/. 23.6 billion (US$94 million), which represented about 6% of the total credit commitments of the financial system in that year. Credit commitments of cooperatives increased by an annual average of 16.6% between 1976 and 1979. To-date the bulk of their operations have been for personal credits to members. However, their very structure, objectives, and distribution throughout the country give cooperatives the potential of becoming an important channel for mobilizing resources to the smaller size firms that normally would not have access to banking services. At the end of 1979, the capital of savings and credit cooperatives was estimated at S/. 16,000 million (US$64 million equivalent), which indicates an important mobilization of resources within the national financial system. There are two relatively large cooperatives in Lima that channel resources to other smaller cooperatives throughout the country: Banco Nacional de las Cooperativas del Peru (BANCOOP) and Central de Credito Cooperativo del Peru (CCC). The total assets of these two cooperatives in 1980 was S/. 6.4 billion (US$18.8 million equivalent) compared to 2.4 billion (US$9.6 million equivalent) in 1979 which indicates that their assets increased by 67% in real terms between 1979 and 1980. BANCOOP and CCC can act as intermediaries in this project by channel- ing part of COFIDE's SSE resources to the smaller cooperatives all over the country in an attempt to facilitate the access of smaller cooperatives to those funds. COFIDE is currently reviewing various alternatives and proce- dures for working with cooperatives under the proposed project. 3.17 Financiera de Desarrollo, S.A. FINDESA is a financiera currently being established in Lima to provide medium- and long-term financing for SSE.  - 17 - The main promoter of FINDESA is the Institute of Investigation and Development for Self-Management (INDA). INDA's resources originated from a donation of the Inter-American Foundation (USO3 million) and a credit from the IDB (US$500,000), in addition to some fixed-term deposits (US$450,000). INDA, which has been in existence for four years, has provided small short- and medium-term loans to some 70 small scale enterprises. INDA has also been providing technical assistance services to its clients, mainly in the field of project preparation and feasibility studies. INDA is now promoting FINDESA to allow expansion of term credit operations to SSE and will provide S/. 140 million as a contribu- tion to FINDESA capital, which represents 20% of the total capital and is the maximum allowed by law for a single shareholder. Negotiations are being con- ducted with German, Dutch, and Canadian groups to secure another 20% from a foreign source (an amount of US$350,000 equivalent). The remaining 60% of the minimum legal capital required (S/. 700 million) is still being sought in Peru. FINDESA is expected to come on stream before the end of 1981. Because it will be specializing in term credit to SSE, it has the potential of making a significant contribution to the development of the sector, and COFIDE has begun conversations with FINDESA about their participation under the proposed project. SSE Credit Guarantee Fund 3.18 One of the problems facing small scale enterprises in getting financing is the lack of sufficient collateral. To help ease this problem, a guarantee fund, Fondo de Garantia para Prestamos a la Pequena Industria (FOGAPI) was created in 1978. FOGAPI has a small capital (about US$85,000) that was provided by the West German aid agency (D.M. 100,000), COFIDE (S/. 6.5 million), BIP (S/. 6.5 million), and small amounts from the two national SSE associations, APEMIPE and the Small Industries Committee of the Sociedad de Industrias. While FOGAPI can have a guarantee portfolio up to 10 times its capital, so far it has only guaranteed the 21 loan applications it has received, amounting to 76% of its capital. Guarantee operations were all for BIP loans in the Lima area and started to be presented about two years after FOGAPI's creation. The main reason for the late start of FOGAPI activities has been lack of promotion, especially outside Lima. Recently steps have been taken to expand FOGAPI's operations in Trujillo and Arequipa. An increase in the operations of FOGAPI could be an additional factor facilitating the accessi- bility of credit to a larger segment of SSE, particularly at the smaller end. The availability of SSE funds to COFIDE under the proposed project would be expected to create a greater demand on guarantees and will be a good oppor- tunity to make increased use of FOGAPI. COFIDE, the administrator of the fund, is currently making arrangements to integrate FOGAPI's administration into the newly established SSE unit of COFIDE's Financial Intermediaries Division (para. 5.10). Prospects 3.19 Despite the existence of specialized funds and lending facilities and the use made of them for some lending to SSE by many financial intermedia- ries, the participation of financial intermediaries, other than BIP, in term lending to SSE has been quite limited. There are a number of reasons for this. Prior to January 1981 practically all term lending to SSE was at highly  - 18 - negative real rates of interest, mostly through BIP, with which private sector financial institutions were unable to compete with their own resources. When competitive resources were made available to a wide range of intermediaries, as was the case with the specialized Central Bank funds which until January 1981 also carried negative real rates of interest, financial intermediaries appeared ready and quite willing to lend to the smaller size spectrum of enterprises. The specialized funds, however, are specifically targeted and their resources limited so that the volume of resources available for SSE lend- ing is marginal to the subsector's needs. Finally, commercial and regional banks, which with their large network of branch offices can most effectively reach the large number of widely dispersed SSE, have not in the past been able to mobilize sufficient term resources with which to support the investment needs of small enterprises. The proposed project would make available term resources to the entire financial system for onlending to SSE. It is expected that this would increase the availability of term resources for SSE, and result in a larger number of small enterprises using the formal financial system for their investment needs. IV. TECHNICAL ASSISTANCE 4.01 SSE in Peru tend to suffer from a wide range of managerial and technical problems apart from limited access to finance. These problems tend to be associated with enterprise size and the background of the entrepreneur, and are not fundamentally different from those facing SSE in other developing countries. They include inadequate financial management and cost accounting, a weakness particularly troublesome in an inflationary economy; difficulty in keeping up with technological developments; limited knowledge of how to tackle new markets, particularly exports; inadequate quality control; and management weaknesses in purchasing, inventory control, production, labor management, and related areas of the business. 4.02 There are a large number of agencies, institutions, trade associa- tions, and public consultancies in Peru offering a wide range of technical assistance services that are relevant and useful to SSE, particularly small industry. No institution offers a comprehensive service, but at least five important institutions offer services that are specifically targeted to the needs of SSE. These are Servicio Nacional de Adiestramiento en Trabajo Industrial (SENATI); Instituto de Investigacion Tecnologica Industrial y de Normas Tecnicas (ITINTEC); Banco Industrial del Peru (BIP); Universidad del Pacifico; and Escuela Superior de Administracion de Negocios (ESAN). In addition, in three cities, Arequipa, Trujillo and Piura, executive committees have been established by the local authorities and trade associations and some of the above institutions in an effort to coordinate the activities of the participating institutions and thereby more effectively meet the needs of SSE in the region. Since last year the Ministry of Industry, Tourism and Intregration (MITI) also started to focus on the development problems of SSE, and there is currently under consideration the creation of a mechanism or agency to improve coordination and promote more effective and wider coverage throughout the country of the various technical assistance programs of the specialized institutions.  - 19 - Major Institutions Providing Technical Assistance 4.03 Servicio Nacional de Adiestramiento en Trabajo Industrial. SENATI is a semi-autonomous state institution established primarily to conduct professional and vocational training programs for the workers of Peruvian industry. Five years ago an attempt was first made to develop training and consultancy programs for SSE but these were designed and operated haphazardly. Almost simultaneously a technical assistance program sponsored by the Federal Republic of Germany was initiated. This program aimed at the creation of an institute for small industries development (Instituto para el Desarrollo Industrial y Profesional de la Pequena y Mediana Empresa - IDINPRO), and was co-executed by SENATI and the German Government. IDINPRO has focused on the metal working subsector in the Lima metropolitan area and provides SSE in that subsector with technical training, consultancy services, subcontracting arrangements and administrative assistance. Through this program a technical center was established which provides on-the-job training and testing facili- ties mainly in the design and manufacture of molds. The center also has a small unit for assistance and training in budgeting and costing, and a larger unit for conducting technical courses. 4.04 Another activity undertaken by SENATI to assist SSE is a management training and consultancy program for enterprises in all economic sectors (Asesoria y Capacitacion en el Campo de la Administration para la Pequena Industria - ACAMPI). ACAMPI was developed and executed with technical assis- tance sponsored by the Government of the Netherlands. Eleven courses were designed in the areas of general management, production, finance, and market- ing, and were made available to SSE on a national scale. A management advisory program was also introduced to give on the spot orientation and training to entrepreneurs. The ACAMPI program has been operated out of SENATI's Lima headquarters and its two regional centers in Trujillo (north) and Arequipa (south), with courses also having been conducted in five other cities. 4.05 Together with BIP, in 1979 SENATI established a technical assistance center in Trujillo (Centro de Apoyo a la Pequena Empresa Industrial - CAPEI) to make available technical training programs to SSE in the northern region of the country. CAPEI conducts courses on a selected number of topics and provides on-the-job training and technical assistance. It has its own physical infrastructure, including a machine shop for on-the-job training much like IDINPRO in Lima. Last year the management training and advisory activities of ACAMPI in Trujillo were physically integrated into CAPEI to allow for better coordination of the various technical assistance services provided by SENATI in the region. 4.06 SENATI has adopted a policy of decentralization of its activities. This policy has allowed for better response to the differing needs of SSE in different regions. In general, the SENATI programs are well designed and executed. However, in some cases they need to be better coordinated and integrated with the programs of other institutions. SENATI's ability and willingness to develop SSE oriented programs outside of Lima appears to be highly dependent on the availability of in-place infrastructure that can support the programs. For this reason the only programs that have achieved some degree of institutionalization are those located in Lima, Trujillo, and  - 20 - Arequipa, where SENATI operates large vocational training centers. Further- more, SENATI's existing SSE programs have been designed for the central person in small enterprise, usually the owner/manager, and are not compatible with SENATI's principal activity of providing vocational training for the workers of medium and large industry. This situation is currently being reviewed by SENATI's senior management, and by officials of MITI who are searching for a mechanism that would allow for better coordination and integration of the programs of all institutions (paras 4.14 and 4.15). 4.07 Instituto de Investigacion Tecnologica Industrial y de Normas Tecnicas. ITINTEC is a decentralized government agency concentrating on setting and overseeing standards of industrial products, granting and regis- tering patents and trade marks, and helping individual firms, until recently almost entirely large firms, in solving specific technological and quality control problems. During the last two years ITINTEC began showing interest in developing activities to support SSE, particularly in the dissemination of technical information of use mostly in the production and quality control functions. Together with other institutions in Lima, like SENATI and BIP, ITINTEC is currently developing a program for information retrieval by small industries, including the setting up of a small extension unit that will act as liaison between SSE and ITINTEC. At the regional level ITINTEC has offices in Trujillo and Arequipa where last year programs were developed to improve the use by SSE of ITINTEC'a technical information. As a result, in Arequipa the local ITINTEC office participates in the coordinating body of ACAMPI, and in Trujillo discussions are underway that would result in better coordination and integration of ITINTEC into the local programs of CAPEI and ACAMPI. 4.08 Banco Industrial del Peru. BIP's primary involvement in providing technical assistance to SSE is through its lending operations. Each of its branch offices is staffed with professionals, including at least one engineer, one lawyer, and one lending operations oriented accountant, that assist borrowers analyze their real financing requirements, fill in loan applications and obtain the documentation necessary in support of their application. While analyzing real financing requirements and later evalua- ting the loan applications, BIP's staff in effect have to do a diagnosis of each borrower's operations. This usually results in BIP staff delivering some assistance required by the borrower to solve some of his problems or more efficiently plan and implement his new investment program. Often BIP staff will also refer borrowers or potential borrowers to existing technical assistance programs of other institutions. This is particularly true in cities like Trujillo, Arequipa and Piura where technical assistance programs are well underway. The quality of BIP's technical assistance content and delivery capabilities vary considerably from one branch office to another, and are very highly dependent on the capabilities and initiative of indivi- dual branch managers. Although it is BIP's policy to assist its small clients, a unit does not yet exist in the organization that would assure a continuous upgrading of capabilities at the branch level and consistency in application of such capabilities throughout the country. BIP's new manage- ment is reviewing this situation and indicated to the appraisal mission that in coming months they would carefully reassess BIP's role in technical assistance.  - 21 - 4.09 Universidad del Pacifico. This institution is the most active of all Peruvian universities in the development of special programs of assistance to small enterprises. Like all other universities in Lima, however, its area of operation does not reach beyond the Lima metropolitan area except when invited to participate in specific programs. Presently the Universidad del Pacifico is undertaking an ambitious plan for setting up a management training and advisory program for SSE in Lima with financing from the Interamerican Foundation. There is little coordination with SENATI, and the program being developed appears to be duplicating many of the activities of SENATI's ACAMPI program. Universidad del Pacifico is also considering establishing a special unit for the training of industrial extension workers, investment and loan officers, project analysts and project engineers that would work with SSE. Universidad del Pacifico's current thinking is to orient this training program to the entire Andean Pact region. During appraisal the mission approached Universidad del Pacifico about the possibility of developing similar programs under the sponsorship of COFIDE. Such programs would be for the loan officers of Peruvian financial intermediaries under the proposed project and delivery of the courses would be at the regional level. Universidad del Pacifico was enthusiastic, and during appraisal a draft course outline, procedures for coordination and execution, including identification of possible professorial staff, and a tentative budget were prepared (para 5.15). 4.10 Escuela Superior de Administracion de Negocios. ESAN is a manage- ment training institute conducting training programs mainly for higher level executives of medium and large scale industry. During the past year and a half ESAN has been studying the possibility of developing programs for SSE, and plans are underway to develop special training programs and advisory services for the owner/manager of SSE. In the process ESAN carried out a com- prehensive survey on the problems and needs of SSE in the Lima area (para. 2.10). Although it is not yet clear how far ESAN will carry its current plans and how effective its coverage of SSE would be, its role could be major in future years if its activities can be properly coordinated and integrated with those of other institutions. Prospects 4.11 On the whole, in recent years reasonable progress has been made towards meeting the technical assistance needs of SSE in Peru. However, much remains to be done. The existing programs need to be further integrated and better coordinated to avoid duplication. Gaps in some of the existing pro-- grams need to be filled. The loan officers of financial intermediaries providing term credit to SSE need to be trained in the efficient and effective evaluation of SSE investment projects, in methods of providing SSE with assistance in at least financial management, and in guiding SSE to other specialized sources of technical assistance. Under the proposed project COFIDE would sponsor such training for loan officers of new financial intermediaries. 4.12 Finally, programs for cities not yet covered need to be developed and implemented. The more meaningful regional programs now in existence in Peru have resulted from initiatives and continuous and effective lobbying by regional interest groups, mainly the local associations of small enterprises  - 22 - and in some cases the local offices of MITI and the regional development organizations. The most successful programs are those of Arequipa, Trujillo, and Piura. The success of the Trujillo and Arequipa programs, however, has been due in large part to the large presence of the national institutions in those two cities: SENATI with large regional centers, ITINTEC with regional offices, and BIP with larger offices and staff than in other cities outside of Lima. There is, therefore, an apparent need for a national body that would help promote the development of programs for other cities where the national institutions have not found it economically efficient to individually under- take their own programs on a permanent basis. 4.13 Supreme Decree No. 034-79 of November 6, 1979, created the National Committee for the Promotion and Development of Small Industry to form the base from which, among others, the previously mentioned problems could be solved. Its membership includes the chief officers of MITI, COFIDE, BIP, SENATI, the SSE committee of the national association of industries (Sociedad de Industrias), and the association of small and medium industrialists (APEMIPE). Among the basic objectives of the Committee are the development of policies that would regulate all activities in support of SSE, including lending policies, technical assistance and external financing of Peruvian programs; and the coordination of the efforts of the various institutions providing technical assistance. The Committee has not functioned mainly because the decree did not provide for funding nor for an executive committee or secre- tariat to carry out day-to-day activities. 4.14 One of the first measures of the new Government was to create a small working group within MITI that would focus on the development problems of SSE. Since then a consensus has formed within MITI, the Sociedad de Industrias, APEMIPE, and among most institutions providing technical assistance, about the need to create a small but effective semi-autonomous "institute" to coordinate and promote the efforts of the various specialized institutions now providing technical assistance. The institute would promote the creation of coordinating committees at the regional/city level which would contract the services of the specialized national institutions. Central to the development of the institute would be that it remain a small but effective institution. This would result from the institute not executing technical assistance pro- grams itself but instead promoting the development and execution of regional programs by the local coordinating committees and the specialized national institutions. The institute would also provide some funding, operational and administrative guidance, and technical assistance to the regional committees. Finally, at the national level it would lobby with the specialized institu- tions to assure their response to the requests for assistance from the regional committees. The small working group in MITI that has been developing the above scheme has made considerable progress towards outlining in more detail the scope, objectives, responsibilities, organization, funding, and early plans of action for the institute (documents B8(1) and B8(2) in the Project File--Annex 3--discuss in ronsiderable detail the institute and work done to-date). In addition to the above, MITI is undertaking a thorough review and evaluation of the existing programs and of the role of the national institutions executing the programs. 4.15 Given the wide variety of technical assistance services already avail- able to SSE, which although they may require strengthening are nevertheless  - 23 - generally adequate in quality, the mission concluded that the provision of additional programs was not necessary for the success of the proposed project and would, in fact, not be desirable until the thorough review and evaluation being made by MITI is completed. One of the major problems at this time is not the availability of technical assistance but rather the lack of a mechanism to put SSE in contact with the sources of assistance they require. Therefore, under the proposed project COFIDE would sponsor a training program for the loan officers of participating financial intermediaries so that they can evaluate the technical assistance needs of their clients and direct them to the most appropriate source of such services (para. 5.15). Also, during supervision of the proposed project, Bank staff would continue the dialogue that it initiated during appraisal with MITI officials about the further strengthening of technical assistance services, including the possible crea- tion of the institute or an alternative coordinating and promotion mechanism. Finally, the UNDP is planning a project to support MITI's effort to evaluate and coordinate existing services and to provide additional services in Arequipa and two other cites in the south. MITI has requested that the Bank be made executing agent for this project to insure coordination with the SSE project. V. THE PROJECT AND PROPOSED BANK LOAN Loan Amount and Objectives 5.01 A loan of US$26 million equivalent is proposed to finance the esti- mated foreign exchange content of up to 1,500 subprojects with an estimated overall investment cost of US$50 million, and a technical assistance program (US$750,000 of loan funds) to upgrade the capabilities of the staff of COFIDE and of financial intermediaries. Local counterpart term financing for onlend- ing to SSE would be provided by BCR (US$10 million), participating intermed- iaries (US$4 million), and project beneficiaries. Intermediaries are also expected to participate with additional short-term financing. In past years BIP has been virtually the only source of term financing for SSE. Based on BIP's 1980 lending levels (para 3.05), and considering inflation and some real economic growth, term credit demand of SSE is estimated at some US$100 million for 1982 and 1983 combined. Since it would be committed in about two years, the proposed loan would cover about one quarter of total SSE term financing demand. Including the local counterpart of BCR and participating financial intermediaries, the project would cover some 40% of the demand. BIP is expected to cover the remaining demand gap from resources it plans to mobilize in 1982 and recoveries of its current SSE portfolio. 5.02 The principal objectives to be achieved through this operation would be to: (a) Generate new employment opportunities. This loan would complement the Second Industrial Credit Project (Loan 1968-PE) by financing smaller scale projects which tend to have greater employment gene- ration potential. 10,000 new jobs would be expected to result;  - 24 - (b) increased participation by a larger number of financial inter- mediaries. Increased competition by financial intermediaries participating on equal terms and conditions would be expected to increase the availability of term resources for SSE, and result in a larger number of small enterprises using the formal financial system for their investment needs. Also, the participation of regional banks and of commercial banks with a large network of regional branch offices would provide more term credit to areas outside Lima and contribute to the further decentralization of economic activity; (c) policy improvements. The proposed project is designed to support the Government and Central Bank's efforts to eliminate subsidized interest rates and standardize financial terms and conditions for SSE lending. It would also establish uniform policy guide- lines for lending to small enterprise; and (d) support the overall institutional development of COFIDE and the SSE lending capabilities of intermediaries, and through the loan officers of intermediaries assure a more widespread and effective use by SSE of the technical assistance services available in Peru to small enterprises. Borrower and Onlending Terms and Conditions 5.03 The proposed US$26 million equivalent loan would be made to the BCR for 15 years, including four years of grace at the prevailing interest rate (currently 11.6% p.a.). Because of the large number of subprojects that would be financed under the project, the loan would have a fixed amortization schedule. The BCR would onlend in soles the US$25.25 million of the Bank loan intended for SSE financing and an additional US$10 million equivalent from its own resources for 15 years, including four years of grace, at the prevailing Central Bank discount rate (Tasa de Redescuento Bancario - TRB) to COFIDE (currently 42%). Interest payments to the BCR would be made monthly. In order to maintain the real value of the Bank funds to be onlent by BCR in soles, the BCR would semi- annually adjust the amount of its commitment to COFIDE, expressed in soles, to be financed out of such Bank funds. The adjustment would be equivalent to any difference that developed due to variations in the exchange rate during the previous six months in the amount of soles equivalent to the Bank loan not yet repaid. This, in effect, would be a form of indexing that would assure that the soles value of the disbursed and outstanding resources of the proposed Bank loan remain equivalent to the foreign currencies being held by the BCR throughout the life of the loan. The US$750,000 for technical assistance would be onlent to COFIDE in the same currencies and on the same terms and conditions as the Bank loan. Agreement on the above was reached during negotiations. Agreement was also reached on the BCR keeping separate accounts for the proposed loan and on a yearly audit of such accounts. 5.04 Recently, steps were taken that could result in indexation of loans with maturities of more than one year. The first steps, however, have been tentative -- indexation is currently only an option whose use is left at the discretion of financial institutions -- and it is not clear whether the new system will take hold, and whether Congress will ratify it in its present  - 25 - form (para 3.03). Until its outcome becomes clearer, onlending rates under the proposed project would be based on the existing non-indexed system. However, should indexation be ratified in its basic current form, indexing of loans would also be made available on an optional basis to beneficiaries under the proposed project. When the law regulating indexed loans is enacted, COFIDE would prepare policies and procedures satisfactory to the Bank for indexed onlending. The minimum requirements for indexed lending would be that the cost of money to beneficiaries and spreads to intermediaries be the same as under the current non-indexed lending system (paras. 5.05 and 5.06 below), and that the same amount of indexed funds onlent by intermediaries be indexed by the BCR in its loan to COFIDE. Confirmation of the BCR's agreement to these principles was obtained during negotiations. The Central Bank has indicated that its policy would be to maintain the cost of capital under the new system at the same acceptable levels of the present system. Reduced debt servicing burdens resulting from indexation would very likely be beneficial to most SSE, although additional training in financial management and budgeting may be required. 5.05 COFIDE would refinance or discount loans made by eligible inter- mediaries for the same periods as the loans received by SSEs, and at a rate equivalent to the TRB plus 2% for loans of up to US$10,000 equivalent, TRB plus 3% for loans between US$10,000 and US$40,000, and TRB plus 4% for loans above US$40,000, all payable monthly. This will provide COFIDE with a nominal spread of about 3% on average (an effective spread of about 4.4%). The differential rates to intermediaries would allow intermediaries a higher spread on the smaller loans which would be more costly to evaluate and process, and to COFIDE a higher spread on larger loans which would be above COFIDE's free limits to intermediaries and would thus require further appraisal by COFIDE. The higher spread on smaller loans would also be expected to provide intermediaries with an incentive for lending to the smaller enterprises among SSE. These terms and conditions were confirmed during negotiations, including agreement on the use of repayments from loans made under the project for further onlending for the purposes and under the same terms and conditions of the project. 5.06 Eligible intermediaries would onlend Bank and BCR resources to SSE for periods ranging between not less than two years and up to ten years, including a grace period of up to three years, when the investment is for fixed assets and related working capital; and for periods of not less than one and a half years and up to five years, including a grace period of up to two years, when the investment is for permanent working capital for utilization of installed idle production capacity. Interest rates would be at up to the pre- vailing maximum rate allowed for term lending (currently 54% nominal), would not include commissions, and would be payable quarterly (thus making the effective interest rate reach 65.95%). Intermediaries would be allowed to charge interest monthly but would be required to adjust the nominal rates so as not to exceed the effective rate with quarterly payments. These rates would be positive when compared to the current rate of inflation (about 50% over the past four months on an annual basis after having reached 75% to 80% in the early months of 1981), and would allow intermediaries a nominal spread of from 8% to 10% (on average about 10.4% effective). These spreads allow the intermediary a reason- able profit after covering estimated processing and risk costs of some 7% tco  - 26 - 8% depending on loan size. These terms and conditions were confirmed during negotiations. On their portion of their participation in short-term financing of subprojects, intermediaries would be free to charge any interest rates, commissions, and other charges allowed to them by prevailing BCR regulations. 5.07 The above procedure for establishing interest rates is based on the Central Bank's TRB and maximum allowed commercial rates, both of which are changed from time to time. This procedure has the advantage of following standard practice in the Peruvian financial system (most rates are set in points above the TRB) and of providing an automatic mechanism for adjusting lending rates upon changes in the TRB and the rate of devaluation which, under current policies would reflect the rate of differential inflation between Peru and the rest of the world. This system has the further advantage that when the country's structure of interest rates is modified, all interest rates on out- standing loans are also adjusted. During negotiations it was agreed that should such policy be abandoned a revision to the procedure for establishing lending rates for project resources would have to be agreed upon to assure that these remain competitive and adequately reflect expected levels of inflation, and that the spreads to intermediaries remain reasonable and competitive with other lending programs. Administration of the Project 5.08 For many years BIP was practically the only financial institution channeling term resources to SSE (paras 3.04 and 3.05). Since July 1980, the new Government has been reviewing the role of public sector financial insti- tutions, particularly those channelling term resources. As part of the result- ing reallocation of functions, foreign term resource mobilization is being conducted predominantly by COFIDE in its capacity as financial agent for medium- and long-term foreign borrowings of public enterprises, and by Banco de la Nacion in a similar role for the Central Government. COFIDE was also assigned the role of major wholesaler of term resources, both local and foreign. In this capacity, COFIDE would be the executing agency for the proposed project. Project resources would in turn be retailed by eligible financial intermediaries. 5.09 COFIDE was established in 1971 as an autonomous state enterprise. As part of the ongoing realignment of public sector financial institutions channeling term resources, COFIDE recently went through a fundamental reassess- ment of its role. The outcome has been a reorientation of COFIDE's objectives and priorities. COFIDE is divesting itself of its frozen investments in industries nationalized through 1979 and will now concentrate on development banking functions. A major objective of COFIDE will be to expand its lending operations to the private sector, and to increase the coverage of that sector by channeling increasing amounts of term capital, particularly foreign resources, through financial intermediaries. Although COFIDE began lending through intermediaries in 1978, it did not initially actively promote this method of lending because it lacked the organizational capability to do so. COFIDE's Board of Directors remedied this situation with the organizational changes it approved on September 23, 1980, and which included the creation of a new Financial Intermediaries Division along with COFIDE's other two operat- ing divisions. The new division has been partly staffed with personnel  - 27 - experienced in dealing with intermediaries as a result of the transfer to COFIDE on November 13, 1980, of four specialized funds operated by the Central Bank. 1/ 5.10 The Government exercises its authority over COFIDE through the Ministry of Economy and Finance (MEF), and COFIDE's Board of Directors. COFIDE's organization includes a seven-member Board of Directors and a Credit Commmittee. The Board, which is COFIDE's highest authority, is appointed by the MEF (Annex 2, T-13). The members of the Board and the senior management have the experience, skills and capacity to carry out this role successfully. Under the General Manager, who is mainly responsible for day-to-day operations, operational responsibilities have functionally been assigned to the new Resources, Operations, and Financial Intermediaries divisions (Annex 2, C-1). COFIDE's second-level management and professional staff are competent and experienced. For the management of the proposed project, a special unit was created in the Financial Intermediaries Division. This new unit is now staffed by two professionals and a third would be added upon project approval, which would be adequate for the management of the proposed project. 5.11 The recent expansion of COFIDE's lending operations through finan- cial intermediaries made necessary the preparation of a comprehensive set of policies to govern these activities, and which were approved by COFIDE's Board in June, 1981. Except for the need to expand on policies applicable to lending for SSE to or through financial intermediaries, the existing overall policies and procedures are adequate. During project preparation a draft set of policies and a comprehensive operations manual (document B7 in the Project File--Annex 3) to govern onlending to SSE were prepared. During negotiations agreement was reached on approval of policies by COFIDE's Board and operat- ing procedures by COFIDE's and BCR's senior management, both satisfactory to the Bank, as a condition of effectiveness of the proposed loan. Agreement was recently reached with COFIDE on the appointment of independent auditors, acceptable to the Bank, to prepare annually full audit reports following the long form format for DFCs associated with the Bank. 5.12 At year-end 1980, COFIDE had total assets of SI. 272.7 billion ($796 million). Long-term borrowings amounted to SI. 83.1 billion ($254 mil- lion) and total equity stood at SI. 67.8 billion ($198 million). The S/. 31.8 billion ($93 million) in paid-in capital is fully owned by the Government. (Annex 2, T-14.) Since mid-1978, COFIDE's operations have grown substantially in line with Peru's overall economic recovery. Geographically, operations have been reasonably well distributed. By maturity, 75% of COFIDE's loans and guarantees during the same period were for more than 5 years and 18% were for 2 to 5 years. (Annex 2, T-16 and T-17.) COFIDE's exposure reached S/. 269 billion ($785 million) at year-end 1980. On the whole, the quality and management of COFIDE's portfolio are adequate. Arrears over 90 days affected only 6.2% of the loan portfolio, and exposure to companies in arrears consti- tuted only 5% of COFIDE's overall exposure (Annex 2, T-18 to T-20). Provisions 1/ A more detailed description and appraisal of COFIDE is included in the SAR for the Second Industrial Credit Project for Peru (Report No. 3238-PE dated March 12, 1981).  - 28 - for bad debts and losses in value of the investments portfolio are also adequate. COFIDE has an adequate financial structure (with a long-term debt to equity ratio of 2.9 to 1 in 1980) as well as a satisfactory liquidity situation (with a current ratio of 1.6 to 1 in 1980). However, COFIDE's profitability, although improving during recent years, has remained low. In 1980 net profits after taxes were equivalent to 4.5% of equity--well below the opportunity cost of capital in Peru. In line with Government policy to raise interest rates to positive levels in real terms, COFIDE's management approved in January 1981 a new structure of interest rates and guarantee fees that will allow a more adequate return on equity. With the new structure of interest rates and the divestiture of equity investments in nationalized basic indus- tries, the Bank estimates that COFIDE's financial position will remain adequate and that its return on equity will gradually increase to satisfactory levels. 5.13 Technical Assistance to COFIDE. COFIDE has given particular impor- tance to upgrading the technical and managerial competence of its staff, and the project appraisal capabilities of both its staff and of the staff of the financial intermediaries it deals with. Accordingly, COFIDE requested that a US$750,000 technical assistance component be added to the proposed project to finance the foreign exchange costs of a US$900,000 program to upgrade the capabilities of its staff and that of financial intermediaries. The program would essentially consist of three subprograms: (i) training of the staff of COFIDE and financial intermediaries on project appraisal and lending techniques, including the comprehensive training programs for loan officers of financial intermediaries dealing with SSE (para. 5.15). Under this sub- program COFIDE would sponsor, and in some cases carry out itself, comprehensive courses and seminars; (ii) a young executive development program within COFIDE, including inservice training with international banks, both in Peru and over- seas, and scholarships for post-graduate studies abroad. At least eight young executives would receive training abroad over the next two years; and (iii) training of middle level executives of the Financial Resources Division, particularly the International Department, in foreign resource mobilization and cofinancing. This would allow COFIDE to play a more important and effec- tive role in its capacity as financial agent for term foreign borrowings of public enterprises (para. 5.08). Outside consultants would be contracted to provide guidance in organizing a unit which would specialize in mobilizing foreign resources both for COFIDE and, through cofinancing, for its public and private sector clients. COFIDE's staff would be trained overseas through inservice programs with international banks and export financing institutions. In addition Bank staff and consultants would assist COFIDE's staff to estab- lish close working relationships with exterior official and private financing institutions. Participation of Intermediaries 5.14 All financial intermediaries legally established in Peru and in good standing with the BCR would be eligible in principle for participation under the proposed project. Institutions currently meeting the eligibility criteria include state development banks, financieras, commercial and regional banks. Commercial and regional banks would require a special permission from BCR to undertake long-term lending operations (para. 3.15), and to charge up to the maximum rate allowed for term lending in Peru. Such exemptions from  - 29 - current banking regulations are commonly extended by the BCR for special lend- ing programs, and their extension to the proposed project was confirmed during negotiations as a condition of loan effectiveness. Before signing participa- tion contracts, the Financial Intermediaries Division of COFIDE would ensure that the specific intermediaries meet the above criteria, as well as the conditions set forth in COFIDE's policies for financial intermediation, particularly regarding sound financial practices and project appraisal capa- bilities. New types of financial intermediaries or existing institutions 2 subject to a revised legal framework may be considered for participation in the project if they comply with the general requirements of the BCR, and are willing to participate under the policies and operating procedures of the proposed project. 5.15 During negotiations agreement was reached with COFIDE, whereby COFIDE would sponsor a training program for loan officers of financial inter- mediaries. The training program would go well beyond upgrading the appraisal capabilities of loan officers. Over the course of 16 weeks (tentatively 6 weeks full-time after banking hours to the public, 8 weeks part-time, and 2 weeks evening courses) loan officers would be exposed and sensitized to the problems and needs of SSE, and to the lending and profit opportunities available to financial institutions operating in the SSE sector. Since most operations of the financial sector outside of Lima are with SSE, the first two courses would be in Arequipa and, tentatively, Trujillo. It is expected that a greater knowledge of their clients and of the profit opportunities that can can open up to their institutions from healthy and growing SSE would result in loan officers making an important contribution toward supporting and providing some important technical assistance to the sector. A draft course outline, procedures for coordination and execution, including identification of possi- ble professorial staff, and a tentative budget (about US$18,000 per course) have been prepared. Eligible Beneficiaries and Lending Limits 5.16 Enterprises with annual sales of up to US$750,000 equivalent and fixed assets, excluding land, of up to US$300,000 equivalent before the new investment in all productive, distributive or service activities, except agriculture, but including construction and agroindustry, would be eligible for financing under the project. According to available statistics these limits are essentially equivalent for the average firm. Furthermore, the sales limit is in line with the new definition included in the draft industrial law presently before Congress, and not much higher than existing definitions (para. 2.09). Based on mission findings, the definition adopted here would allow the lending pro- gram under the project to overlap with other lending programs for medium and large industry only sufficiently to assure that term credit is available to the whole size-spectrum of enterprises. Nevertheless, to avoid excessive use of resources by enterprises in the borderline between small and medium, and by those which are sufficiently large to have access to other credit programs, the maximum investment eligible for financing under the project would be US$200,000. This limit should also help assure use of project resources by a larger number of small enterprises. Based on the experience gained from existing SSE lending programs, it is expected that the average subloan size would be about US$25,000.  - 30 - 5.17 COFIDE would refinance or discount 90% of the loans made by inter- mediaries for fixed assets and permanent working capital. In the case of new enterprises such loans would not exceed 80% of the investment required to establish the new enterprise. For expansion of existing capacity or for permanent working capital with which to use idle capacity, whether, and in what proportion the beneficiary should participate with risk capital of his own would be left at the discretion of the financial intermediary. In such cases the intermediary would base his decision on the adequacy of the capital- ization of enterprises that are already established. Bank participation would be limited to a maximum of 50% of the investments in fixed assets or permanent working capital, which is the estimated direct and indirect foreign exchange content for the expected typical subproject. Operating Procedures and Free Limits 5.18 The proposed project would be handled by COFIDE only at the whole- sale level by discounting or refinancing loans by participating intermediaries. The unit that would manage the project (para 5.10) has already prepared draft operating procedures for the purpose (para 5.11). Given the small size and large number of subloans expected under the project, an automatic discount mechanism would be used for most subloans. This would be equivalent to a free limit given by COFIDE to the intermediaries below which the only information required would consist of a list of the basic features of the firm and the investment being financed, and the terms and conditions of the subloan to prove eligibility. Upon presentation of such information COFIDE would auto- matically discount the corresponding percentage of the subloan. Documentation evidencing the final expenditure would be forwarded to COFIDE ex-post. Other detailed documentation for the subloan, including the list of goods financed, would remain with the intermediary, available for ex-post sample review by COFIDE and the Bank. For subloans above COFIDE's free limit to intermediaries, evaluation and approval of subprojects would be done by COFIDE's Financial Intermediaries Division. Free limits for each intermediary would be estab- lished by COFIDE in its intermediation contracts, and would be arrived at after careful appraisal of each intermediary, including its SSE lending evaluation capabilities, by COFIDE's Financial Intermediaries Division. Based on the appraisal mission's findings tentative free limits were developed by type of intermediary: for BIP at least US$100,000 based on its extensive experience and capabilities in SSE lending; for other development, commercial and regional banks, and financieras about US$70,000; and for credit cooperatives and other intermediaries about US$40,000. These, however, are only guidelines for COFIDE to use in arriving at a final figure on a case by case basis for each intermediary. It is expected that COFIDE would review from 5% to 10% of the subprojects. 5.19 Given the small size of the maximum subloan under the project (US$180,000 including only US$100,000 of Bank funds), detailed Bank review of subprojects would take place ex-post on a sample basis during supervision missions. Because of the expected large number of subloans under the project, an ex-post random sample of subprojects regardless of size would be more indicative of the quality of appraisals being made by intermediaries than the selected sample that would result from the Bank reviewing ex-ante only the largest projects sent by COFIDE to the Bank. Choosing for ex-ante review by the Bank the first two or three subprojects, regardless of size, of each  - 31 - intermediary would also not result in a meaningful sample because of the large number of branch offices of many banks and the likely difference in appraisal quality from one branch to another. Procurement, Disbursement and Audit 5.20 Because of the large number of small subprojects expected under the project, procurement would be made by SSE following standard commercial practice. It is expected that most goods will be purchased locally and since it would not be practicable to determine the foreign exchange content of each individual subproject, Bank disbursement would be based on the 50% estimated foreign exchange content of the average investment made by SSE. Accordingly, for each subproject financed under the proposed project, the Bank would reimburse COFIDE for up to 100% of its participation in the financ- ing provided that the Bank's participation does not exceed 50% of the cost of the machinery, equipment, installation, civil works, or permanent working capital, that make up the investment for the subproject. 5.21 Bank disbursements for subloans to SSEs would be made against state- ments of expenditure issued and certified by COFIDE for specific subprojects. The detailed documentation evidencing the final expenditures would be retained by COFIDE for inspection by the Bank in the course of project supervision. Applications requesting Bank authorization to withdraw for subprojects would include information required under the Bank's Subproject Data System for DFCs. Because all subloans under the proposed project will be made by second-tier financial intermediaries, expenditures made not more than 180 days prior to Bank receipt of the corresponding withdrawal requests would be eligible for Bank reimbursement. All technical assistance expenditures would require prior Bank approval, for which purpose COFIDE would from time to time present discrete programs for approval by the Bank. Consultants would be hired in accordance with Bank guidelines. Disbursement would be made against the documentation normally required for technical assistance financing. During negotiations confirmation was obtained that COFIDE keep separate accounts for the project and that a special audit of such accounts and of the state- ments of expenditure and supporting documentation be made as part of the annual independent external audit of COFIDE. The final date for submission of approval requests would be December 31, 1984, and the closing date December 31, 1985. Project Benefits and Risks 5.22 The proposed project would enhance the development of the SSE sector and the generation of new job opportunities at a relatively low capital cost. Investment cost per job is expected to range between US$4,000 and US$6,000 (paras. 2.19 and 2.20). Thus, the proposed project would generate about 10,000 new jobs. The project would also result in increased competition between financial institutions and better service for SSE. The technical assistance component would strengthen the institutional development of COFIDE (para. 5.13); and the program to upgrade the capabilities of the loan officers of intermediaries (paras 4.09, 4.15 and 5.15) would help improve the delivery of existing technical assistance programs. The proposed project would also further strengthen COFIDE's role as a whole- saler of term resources through a wide range of financial intermediaries. With this project COFIDE would be reaching and helping develop new financial intermediaries with which it had not previously worked, particularly  - 32 - credit cooperatives. Finally, regional banks and the large network of regional branch offices of commercial banks would allow increased channelling of term resources to areas outside of Lima, thus contributing to further decentralization of economic activity. 5.23 While the project does not involve unusual risks regarding attainment of its major objectives, the term credit processing capacity of intermediaries, other than BIP, may somewhat delay the speed with which the entire financial system becomes involved in term lending to SSE. The incen- tives to handle term credit are nonetheless high since intermediaries would be in a better position to offer a wider range of services to what is by far their largest potential market in terms of the number of industrial borrowers. This is particularly true outside of Lima where the number of medium and large enterprises is very small relative to SSE. Another risk is the interfacing between COFIDE and BIP, the only institution that has to-date specialized in term lending to SSE, since this is a completely new arrangement for BIP in its mobilization of resources for financing SSE. Misunderstandings between the two institutions could delay project implementation. This risk, however, is mitigated by the simplified appraisal criteria and processing procedures that have been developed for the project based in great measure on BIP's own procedures. Also, the free limits that would be allowed BIP are relatively high and in line with the free limits that BIP itself allows its branch offices. Finally, regardless of the level of BIP participation, the SSE sector would be benefiting substantially from the increased competition among intermediaries and the larger financing options that would become available to the sector. VI. AGREEMENTS AND RECOMMENDATION Agreements 6.01 During loan negotiations agreements were reached on the following: (a) With the Government on provision of the loan guarantee; (b) With the Central Bank on (i) loan amount, local counterpart, and terms and conditions for onlending to COFIDE, including the maintenance of value of the Bank resources onlent to COFIDE, the keeping of separate accounts, and audit of such accounts (para. 5.03); (ii) exemptions from current regulations to allow commercial and regional banks to make loans of more than one and five years, respectively, and to allow such banks to lend at rates up to the maximum allowed for term lending operations (para. 5.14);  - 33 - (c) With COFIDE on (i) a draft policy statement for SSE lending operations (para. 5.11); (ii) terms and conditions for onlending to intermediaries, including onlending of repayments (para. 5.05) and to SSE (para. 5.06); a periodic review of these, including immediate review of the method for establishing interest rates and spreads should the current policies for establishing the TRB change (para. 5.07); and the terms and the development of policies and procedures for possible future indexed onlending (para. 5.04); (iii) sponsoring a training program for the loan officers of financial intermediaries (para. 5.15); (iv) lending limits to each beneficiary (paras. 5.16 and 5.17); (v) procedures for Bank disbursement, keeping of separate accounts for the project, and audit requirements (paras. 5.20 and 5.21). 6.02 The following would be conditions of loan effectiveness: (i) approval by COFIDE's Board of the policies and COFIDE's and BCR's management of the operating procedures for lending to SSE (para. 5.11); and (ii) extension by the BCR of the necessary exemptions to allow commercial and regional banks to engage in term operations under the project (para. 5.14). Recommendation 6.03 The proposed project would constitute a suitable basis for a Bank loan to the Central Bank of Peru, guaranteed by the Republic of Peru, of US$26 million equivalent with a term of 15 years, including four years of grace, at the prevailing interest rate (currently 11.6% per annum).  - 34 - ANNEX 1 PERU STAFF APPRAISAL REPORT SMALL SCALE ENTERPRISE PROJECT Estimated Schedule of Disbursements Cumulative Disbursements IBRD at End of Quarter Fiscal Year and Quarter (US$ thousands) FY1982 March 31, 1982 250 June 30, 1982 1,000 FY1983 September 30, 1982 2,250 December 31, 1982 3,850 March 31, 1983 5,600 June 30, 1983 7,750 FY1984 September 30, 1983 10,000 December 31, 1983 12,600 March 31, 1984 15,400 June 30, 1984 18,500 FY1985 September 30, 1984 21,250 December 31, 1984 23,850 March 31, 1985 25,000 June 30, 1985 26,000  -35- PERU ANNEX 2 STAFF APPRAISAL REPORT SMALL SCALE ENTERPRISE PROJECT Supporting Tables Tables T-1 Structure of Manufacturing by Firm Size, 1975 T-2 Structure of Manufacturing by Subsector and Firm Size, 1975 T-3 Structure of M4anufacturing Output and Share of SSI T-4 Structure of the Financial System T-5 Small Scale Enterprise Project T-6 Specialized Development Banks: Summary Balance Sheet as of December 31, 1980 T-7 BIP: Balance Sheets as of December 31, 1979-1981 T-8 BIP - Loans Approved for SSE by Geographic Location T-9 Non-Specialized Commercial Banks T-10 Regional Banks T-ll Financieras T-12 Maximum Lending Rates of Peruvian Financial Institutions T-13 COFIDE: Board Members as of July 31, 1981 T-14 COFIDE: Audited Balance Sheets as of December 31, 1975-1980 T-15 COFIDE: Audited Income Statements, 1975-1979 T-16 COFIDE: Breakdown of Operations, 1976-1980 (first half) T-17 COFIDE: Sectoral Distribution of Approvals, 1976-1980 (first half) T-18 COFIDE: Analysis of Outstanding Loan and Equity Portfolios and Guarantees as of June 30, 1980 T-19 COFIDE: Statement of Arrears and Affected Loan Portfolio as of June 30, 1980 T-20 COFIDE: Total Exposure to Companies in Arrears Over Three Months as of June 30, 1980 C-1 COFIDE: Organization Chart as of July 31, 1981  P ERU STAFF APPRAISAL REPORT SMALL SCALE ENTERPRISE PROJECT Structure of Manufacturing by Firm Size, 1975 S/. million No. of Total Gross Value Fixed- Fixed Size _ No. of Est. Employees Wage Bill out At Assets Annual Invest. 5 to 9 emp. 3,513 23,440 1,480.5 10,120.5 4,957.7 4,173.7 744.9 10 to 14 1,157 13,740 1,095.3 7,667.0 3,464.0 2,422.6 435.1 15 to 19 634 10,701 937.9 7,210.1 3,463.8 2,137.4 402.4 20 to 49 1,228 37,768 3,797.1 28,055.7 13,138.5 8,942.6 2,067.8 50 to 99 485 33,951 4,089.0 25,747.5 12,205.3 8,867.0 2,309.3 0 100 to 199 275 39,232 5,707.2 38,648.3 17,284.5 13,391.8 3,617.1 200 to 499 165 50,384 8,245.G 60,411.8 26,607.1 19,530.1 4,734.5 500 to 999 39 24,542 3,928.4 28,779.8 14,511.6 5,461.9 1,489.1 1000 or more 12 22,305 3,916.9 34,226.2 17,952.9 12,515.8 3,088.4 Total 7,508 256,063 33,197.4 240,867.0 113,585.4 \ 77,442.9 18,888.7 Souicz: Ministry cf Industry and Tourism H . Pt  -37 - ANNEX 2 T-2 PERU STAFF APPRAISAL REPORT SMALL SCALE ENTERPRISE PROJECT Structure of Manufacturing by Subsector and Firm Size, 1975 1/ ~~~~11 Manufacturing Sector