Honduras - Third Industrial Credit Project

Documrent of The World Bank FOR OFFICIAL USE ONLY , AT,rZ)c3- /4Q Report No. P-4316-HO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$37.4 MILLION TO THE REPUBLIC OF HONDURAS FOR A THIRD INDUSTRIAL CREDIT PROJECT MAY 8, 1986 This document has a restricted distribution and may be used by recipients only in the performance or their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Lempira (L) US$1.0 L2.0 L1.0 = US$0.5 WEIGHTS AND MEASURES Metric System PRINCIPAL ABBREVIATIONS AND ACRONYMS USED BANADESA National Agricultural Development Bank BANMA Autonomous Municipal Bank BCH Central Bank of Honduras CAAFIID Central American Agreement on Fiscal Incentives to Industrial Development CACM Central American Common Market CDI Center for Industrial Development CEFEX Export Promotion Certificate CET Common External Tariff CONADI National Industrial Development Corporation CONSUPLANE National Planning Council FIA Agricultural and Industrial Finance Corporation FIDE Foundation for Entrepreneurial Research and Development FONDEI National Industrial Development Fund IDB Inter-American Development Bank PFIs Participating Financial Intermediaries SMEs Small and Medium Scale Enterprises SSIs Small Scale Industries UNDP United Nations Development Program UNIDO United Nations Industrial Development Organization USAID United States Agency for International Development FISCAL YEAR January 1 to December 31  FOR OMCAL USE ONLY HDNDURAS THIRD INDUSTRIAL CREDIT PROJECT LOAN AND PROJECT SUMMARY BORROWER: Republic of Honduras BENEFICIARIES Central Bank of Honduras (BCH), Borrower's Center for Industrial Development (CDI) and Secretariats of Finance and Public Credit, and Economy and Commerce. EXECUrTING AGENCY: The National Industrial Development Fund (FONDEI), a semi-autonomous department of BCH. AMOUNT: US$37.4 million equivalent. TERMS: 20 years with five years of grace, at the standard variable rate. RELENDING TERMS: The Borrower would relend US$37.1 million of the loan proceeds to BCH on the same terms as the Bank loan. BCH would transfer US$36.5 million to FONDEI for technical assistance and on-lending to industrial enterprises through participating financial intermediaries (PFIs) for investment in fixed assets, working capital, and consulting services for technology development. PFIs would bear the credit risk; FONDEI would bear the risk of interest rate variation between fixed rate sub-loans and the Bank's rate; BCH would bear the cross-currency risk; final beneficiaries would bear the foreign exchange risk under the dollar-denominated sub-loan option, and BCH would bear it for the rest of the loan. PROJECT The project would consist of credit for viable private DESCRIPTION: sector industrial enterprises and technical assistance. The credit component would finance: (i) fixed assets and associated permanent working capital; (ii) free-standing permanent working capital for FONDEI's previous sub-borrowers; and (iii) consulting services to identify technological improvements to iacrease the overall productivity of small- and medium-scale enterprises. Technical assistance would be provided to: (a) the Borrower for a study to streamline and expand the scope of the temporary admission regime; (b) BCH to strengthen its ability to monitor the performance of the commercial banking system, and for studies to improve understanding of the industrial sector; (c) FONDEI for improvement of its information management system, training to strengthen PFI's ability to appraise and supervise industrial investments, and studies to identify lending instruments to expand access to term credit; and (d) CDI for strengthening its capacity to provide technical and managerial extension services to small-scale enterprises. Ths document ha a restricted distribution and may be uwd by recipients only in the performance of their ofcial duties Its contents may not otherwe be disclked without World Bank authonrztion.  - ii - PROJECT RISKS: No special project implementation risks exist given the good performance of FONDEI under the two earlier projects. The unsettled situation in Central America may cause some investors, especially large-scale enterprises, to defer investments. However, since the majority (70 percent) of FONDEI beneficiaries are small- to medium-scale enterprises, the risk of delay is minimized. The pace of project implementation will also be sensitive to changes in the macro-economic environment. Based on the existing pipeline of viable sub-projects (about US$11.0 million) and the promotional efforts envisaged under the project's technical assistance component, however, the credit component is expected to be committed rapidly. ESTIKAIED COST: Local Foreign Total - (US$ million) - Fixed Asset/Working Capital Sub-loans 27.1 30.0 57.1 Working Capital Sub-loans 1.2 5.0 6.2 Technology Sub-loans 0.3 0.8 1.1 Technical Assistance 0.5 2.3 2.8 Total Project Cost 29.1 38.1 67.2 FINANCING PLAN: Local Foreign Total - === (US$ million) - Bank - 37.4 37.4 UNDP - 0.7 0.7 FONDEI 10.8 - 10.8 PFIs (minimum) 6.3 - 6.3 Beneficiaries 11.7 - 11.7 Government (for CDI) 0.3 - 0.3 Total 29.1 38.1 67.2 ESTIMATED BANK DISBURSEMIETS: (Based on Average Profile for IDF Bank Loans in Region) US$ million FY: 1987 1988 1989 1990 1991 1992 1993 Annual 5.0 10.1 10.1 5.1 3.1 3.0 1.0 Cumulative 5.0 15.1 25.2 30.3 33.4 36.4 37.4 RATE OF RETURN: Minimum FRR and ERR of sub-projects would be 12 percent. APPRAISAL REPORT: No. 6129b-HO, dated May 6, 1986.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF HONDURAS FOR A THIRD INDUSTRIAL CREDIT PROJECT 1. I submit the following report and recommendation on a proposed loan of US$37.4 million to the Republic of Honduras for a Third Industrial Credit Project. The loan would have a term of 20 years, including 5 years of grace, at the standard variable interest rate. The Government would retain US$0.3 million for studies and for technical assistance for the Center for Industrial Development (CDI) and would relend US$37.1 million of the proceeds on the same terms as the Bank loan, to the Central Bank of Honduras (BCH), which would transfer US$36.5 million to its National Industrial Development Fund (FONDEI). The remaining US$0.6 million of loan proceeds would be used for consulting services and studies to be carried out by BCH departments other than FONDEI. PART I - THE ECONOMY 2. A report entitled 'Current Economic Memorandum on Honduras" (3312-HO) was distributed to the Executive Directors on July 29, 1981. A Bank mission visited Honduras during September 1985 to review recent economic performance, and a draft Current Economic Memorandum is expected to be sent to the Government in June 1986. The main findings of the economic mission are summarized below. Country data sheets are attached as Annex I. Economic Structure 3. Honduras' per capita GNP was about US$670 in 1984, making it the second poorest country in the Western Hemisphere. Agriculture is the most important sector, employing over half the economically active population, accounting for slightly more than one fourth of GDP, and generating over three fourths of merchandise exports (agro-industrial exports generated another 10 percent of exports). The manufacturing sector employs about 8 percent of the economcially active population, accounts for about 13 percent of GDP, and generates less than 15 percent of exports. The service sectors employ about 30 percent of the economically active population, and account for about 42 percent of GDP. 4. Agricultural Sector. Only about 15 percent of Honduras' total land area of 112,000 kmz is suitable for cropping. An additional 50 percent has potential for extensive livestock production or forestry, both of which have begun to be exploited. Crops, of which the most important are bananas, coffee, corn, and sugarcane, account for two thirds of sectoral value added; livestock and forestry account for about 15 percent each, and other sub-sectors, including fisheries and beekeeping, account for about 3 percent. Sectoral output grew at an average rate of over 2 percent during 1970-1984, and the value of major agricultural exports grew at 3 percent a year. Output growth in 1985 is estimated at about  -. 2 - 4 percent; the sector's major exports grew by about 12 percent. The sector has good potential for diversification into exportable fruits, vegetables, and timber. 5. Industrial Sector. Still in an embryonic stage, development of the manufacturing sector holds promise as a source of growth of the economy in the medium term. Honduras is not formally a member of the Central America Common Market (CACM), but has participated in the CACH arrangement since the mid-1970s. Import-substitution policies have been pursued under the shelter of the common market, but not as aggressively as in other countries in the region. Therefore, most industries produce at or near international prices and are in sub-sectors in which Honduras is estimated to have a comparative advantage. The manufacturing sector is predominantly traditional, with many small artisans and fewer than 90 enterprises that can be characterized as large-scale (i.e. with more than 100 employees). 6. Financial Sector. The financial system is relatively simple in Honduras, in line with the level of economic development. The system, especially the commercial banling system, has grown rapidly in the past 15 years, and has played an increasingly important role in the development of private sector investment in both the industrial and agricultural sectors. The industrial and financial sectors are discussed in more detail in Part III of this report. 7. Social Conditions. The population of 4.3 million is growing rapidly, at 3.4 percent a year, straining available resources, and aggravating the unemployment problem (unemployment is estimated at about 25 percent of the work force). The Government is showing increased awareness of population problems. Family planning information and services are provided at Government health clinics and by the Honduran Family Planning Association to anyone requesting them. The United Nations, USAID and private organizations provide external assistance to the family planning programs. 8. Malnutrition is severe (it is estimated that in 1984, 30 percent of the population could not afford a diet satisfying minimum caloric requirements), and infant mortality is about 9 percent of live births. About half of the population is without safe water, one quarter has no access to health services, and three quarters of the households are without access to sanitary waste disposal. Significant improvements in public health have been achieved since 1982, with a substantial increase in the proportion of the population immunized against measles and polio, and sharp drops in malaria cases and infant mortality due to diarrhea. The Government continues to stress preventive care, public health education, basic sanitation, and healthy conditions in the workplace as the primary means to achieve its goals of reducing morbiditiy and mortality rates. It is also continuing its program to gradually extend health services to the urban and rural poor. 9. With an illiteracy rate of 42 percent, the Government has emphasized primary education and adult literacy campaigns. To achieve its target of eliminating illiteracy by thc. year 2000, the Government is facing the challenge of both expanding the primary education system and improving  -3- the efficiency of the system, while tapping private sector resources as much as possible for financing the secondary and higher education needs. In addition, the private sector plays an especially important role in vocational and technical training. 10. About two thirds of the population is inadequately housed, with an accumulated deficit of about 500,000 units, growing at 5 percent a year. The Government is in the process of formulating a coherent sectoral policy and examining measures to coordinate actions by the many institutions that participate in the sector. Recent Developments 11. In the 1970s, the Honduran economy grew rapidly, propelled by Government spending, growth of exports in the CACI, and private investment, assisted by the availability of external financing. In 1980-1983, economic conditions worsened due to the combination of a sharp reversal in the terms of trade, the drying up of external private bank lendings and the marked deterioration of the regional political climate. The slump in demand and political uncertainty undoubtedly affected private investment, which fell by half over the period. The country's external position also deteriorated and the current account deficit of the balance of payments amounted to US$300 million (12 percent of GDP) in 1980-1981. The financial position of the Central Government weakened because of rising current expenditures, an ambitious public investment program and the large additional burden created by assuming the National Investment Corporation's (CONADI) obligations with private foreign banks (para. 15). Consequently, the overall deficit of the Central Government remained high and reached 10.2 percent of GDP in 1983. 12. Real GDP recovered slightly in 1984 and grew by 3 percent in i985. Private investment remained depressed while public investment fell to 10 percent of GDP in 1985 following completion of the El Cajon hydroelectric project. Conseq-ently, fixed investment fell to 17.5 percent of GDP in 1985 (compared with its 1980 level of 25 percent). Export performance remained weak, though the balance of payments current account deficit dropped to 6.5 percent of GDP in 1985 as compared with 9.6 percent in 1984. This improvement largely reflects the higher levels of bilateral grants. In mid-1984 the Government undertook .o improve its financial position by raising taxes and by controlling expenditures more tightly. The overall deficit of the Central Government fell to 8.3 percent of GDP in 1985 as compared with 10.8 percent in 1984. The bulk of that deficit was finaaced with external resources, and net use of domestic financing by the public sector in 1985 declined to 11.2% of GDP compared with 12.4% in 1984. This alleviated the pressure on the strained balance of payments position and allowed a build up of gross reserves for the first time since 1980. Honduras has maintained a fixed parity of two lempiras to the dollar since 1918; since 1979 a parallel market for foreign exchange has developed. Inflation trends are moderate and in 1985 the CPI rose by an estimated 3%.  -4- Development Prospects 13. The modest recovery initiated in 1984 continued in 1985, and the prospects for 1986 are favorable because of the twin impact of the decline in petroleum prices and the increase in coffee prices. The following factors will also contribute to stabilize the balance of payments situation during 1986: (i) completion of the El Cajon hydroelectric project will reduce fuel imports (currently one fifth of total imports); (ii) the overall Central Government deficit is budgeteS. to decline to about 6 percent of GDP, and should be fully covered by external financing. In addition, the Government is expected to finalize a rescheduling agreement with the commercial banks on the CONADI debt (para. 15). 14. The medium-term prospects are manageable, assuming no serious deterioration in the regional political environment, and provided that the Government initiates an aggressive export-oriented strategy, which will require reform of the investment incentives and tariff protection systems and of the temporary admission regime. These measures should be accompanied by a strengthening of public finances, which in turn would further increase private sector confidence. The new Authorities have indicated their recognition of the importance of these issues, and have initiated the process of formulating an approach to addressing them (paras. 31-34). External Financing 15. In 1985, Honduras' disbursed public external debt repayable in foreign currency amounted to US$1.8 billion, or 187 percent of exports of goods and non-factor services; US$2.5 billion if undisbursed commitments are included. In the past, Honduras has managed to keep its external debt service ratio fairly low, because foreign loans to the non-financial public sector were almost all on concessionary terms. The debt service ratio in 1981 was 14 percent and is projected to increase to 22 percent in 1986. In December 1984, the Government reached an agreement with the foreign commercial banks to refinance the debts of CONADI and a few other public agencies. About 12 percent of the disbursed external public debt at the end of 1984 (about US$220 million) will be refinanced. Under the terms of the agreement, US$117 million of principal repayments due from 1981 to 1984 plus US$31 million due in 1985 are to be rolled over until June 1986. At that time, the situation will be reassessed in the light of the country's dialogue with the IMF, and a nine-year refinancing will be considered. 16. At the end of 1984, the Bank Group held about 21.5 percent of the disbursed public debt outstanding and repayable in foreign currency; excluding IDA, the Bank's share is about 17 percent. These shares are not expected to increase significantly in the next few years. One fifth of the Inter-American Development Bank (IDB) total loans disbursed and outstanding are repayable in local currency; IDB's share of the disbursed public debt repayable in foreign currency is 19.3 percent. The Central American Bank for Economic Integration (CABEI) accounts for 8.2 percent, privately held debt for 23.2 percent, and others for 8.5 percent. In addition, since 1983, the U.S. Government has provided substantial grant financing.  17. During 1970-83 external sources committed some US$2.9 billion of which the Bank Group provided 20 percent, IDB 16 percent, CABEI 10 percent, the US Agency for International Development (USAID) 11 percent, private banks 17 percent and others 26 percent. IDB has concentrated on industry, power, transport, water and sewerage; CABEI on transport and power and USAID on agriculture and education. 18. With the favorable effects of coffee and petroleum prices, the coamitment of large official development assistance on concessionary terms, and the expected continuation of growth in output in 1986, the country's short-term difficulties are eased. Based on cautiously optiuistic assumptions with regard to the external environment and economic management, the medium-term outlook is also positive, and maintenance of a prudent borrowing policy will help keep the balance of payments situation manageable. On this basis, Honduras is creditworthy for Bank lending. PART II - BANK GROUP OPERATIONS 19. Since 1955, Honduras has received 31 Bank loans totalling US$501.6 million and 12 IDA credits totalling US$85.0 million, both net of cancellations. Of the Bank Group's total lending to Honduras, 20.0 percent has been for highways, 5.2 percent for ports, 40.8 percent for the energy sector, 17.6 percent for agricultural credit and regional development, 10 percent for industrial credit and tourism, 1.9 percent for education, 3.3 percent for water supply and drainage, and 1.2 percent for municipal development. Annex II contains a summary statement of Bank loans, IDA credits, and IFC investments as of March 31, 1986. As of that date, a total of US$69.4 million remained to be disbursed on 8 Bank Group-assisted operations. 20. overall, execution of projects has been satisfactory, with few overruns in either time or cost, and with principal project objectives achieved. Speed of disbursements in Honduras has varied considerably by sector, with power projects generally the quickest disbursing, as well as accounting for the largest share. In FY85, disbursements reached US$48.3 million, of which nearly half was accounted for by El Cajon, a major hydroelectric project. Agricultural and industrial credit projects have also been relatively fast disbursing, accounting for about 40 percent of all disbursements in FY85. 21. Bank Group lending initially concentrated on developing basic infrastructure in transport and power, where inadequate facilities hampered the development of the country. In the last decade, it has been increasingly diversified to provide support for the expansion of productive capacity in agriculture, industry, and tourism, while addressing major needs in education and water supply. Future lending to Honduras would be directed mainly at developing the productive and social sectors, in support of the Government's main objective of expanding employment and exports and improving living standards of the poor. In this context, a third education project is under preparation, and a second water supply project is planned. Further lending for agricultural credit is also envisioned. In addition, we will continue to support infrastructure development, albeit on  a much smaller scale than in the past. A power transmission/distribution project is currently under preparation, and a telecommunications project is being identified. One of the primary objectives of the latter project would be to improve efficiency in the sector, while permitting an increased transfer of revenues from the telecommunications company to the Central Government. The level and focus of our financing will continue to be partly determined by the activities of other major lenders such as USAID and the IDB, in view of the low level of absorptive capacity of the country relative to the availability of financial assistance. 22. As our dialogue with the new Government on economic policy objectives progresses, we plan to support Government's efforts to improve management and investment planning in the public sector, promote private sector management in several areas currently managed by the G vernment, and improve macro-economic and specific investment incentives to producers in both the agriculture and industrial sectors. 23. The proposed project would support both increased production and generation .1 employment by supplying a scarce resource-medium-term credit. By focussing on small- to medium-scale enterprises, the project would achieve a wide distribution of benefits, thus contributing to alleviation of poverty in the country. Technical assistance under the project would strengthen institutions in the financial sector and improve technical support for private sector industrial enterprises. 24. It is expected that the Bank's share of total external public debt disbursed and outstanding will remain close to its current level of 20 percent through the late 1980s. Annual interest and amortization on Bank loans currently represent about 15 percent of total public external debt service and is projected to increase to above 20 percent by the late 1980s. 25. IFC's activities in Honduras include a 1964 loan and equity investment, of US$295,000 and US$55,000, respectively, in a tannery, Empresa de Curtidos Centroamericana, S.A. In 1966 an additional equity investment of US$27,500 was made in this company. In 1968 and 1970 equity investments totalling US$75,000 were made in a pilot company, Compania Pino Celulosa de Centro America, S.A. In 1978 IFC approved a loan of US$9.0 million and an equity investment of US$1.0 million in Textiles Rio Lindo, S.A. de C.V., a locally owned textile company, to help finance an expansion and diversification project. In February 1986, IFC's Board approved a US$575,000 equity investment in Granjas Marinas, S.A. for Phase I of a shrimp farming project. IFC continues to look for investment opportunities in Honduras.  - 7 - PART III - THE INDUSTRIAL AND FINANCIAL SECTORS A. Industrial Sector Structure and Growth 26. Honduras' manufacturing sector is relatively undeveloped: it accounts for about 13 percent of GDP, produces less than 15 percent of total exports, and employs less than 8 percent of the economically active population. So-called "traditional" products, of which food and beverage products, refined sugar and sugar by-products, textiles and garments, and wood products are the most important, account for nearly 80 percent of sectoral value added. Manufactured exports include consumer goods (56 percent), of which the most important are processed foods (45 percent), intermediate goods (41 percent), half of which are wood products, and a small percentage of consumer durables (3 percent). Available data on the size distribution of the sector's establishments portray a clear picture of an atomized, traditional manufacturing sector. Reportedly, about 37,000 enterprises, including some 30,000 self employed artisans, employ fewer than five people; about 1,100 firms employ between 5 and 100 employees; and fewer than 90 firms could be classified as large-scale, employing mDre than 100 persons. 27. Import-substitution policies have been pursued in Honduras, though not as aggressively as in other countries in Central America. As a result, Honduran manufacturing is relatively efficient (i.e. most industries produce at or near international prices), though with considerable intrasectoral variability. A recent study shows that about 59 percent of Honduras' industrial output is concentrated in sub-sectors in which the country has a medium-term comparative advantage, about 28 percent in sub-sectors in which its comparative advantage is 'questionable", and only 13 percent of the output comes from sub-sectors in which the country has no comparative advantage. 28. The manufacturing sector grew at an average annual rate of nearly 9 percent in the second half of the 1970s, as a result of the belated but rapid expansion of Hondtran industries into the sheltered Central American Common Market (CACM) (para. 32). This buoyant trend was brought to an abrupt halt in the early 1980s, when the world recession triggered a sharp contraction in the domestic and regional markets for manufactured goods. The recession, with the associated drying up of external commercial bank financing and capital flight 'nduced by political uncertainties in the region, also caused a foreign exchange shortage, restricting access to imported inputs and curtailing production. Devaluation of other regional currencies led to loss of competitiveness of exportable manufactures in regional markets, and quantitative import restrictions by regional trading partners attempting to curb balance of payments disequilibria contributed to the collapse of established trading patterns within the CACH, leaving idle those plants established to cater to the regional market. Overall, manufactured exports dropped by nearly one third in current terms between 1980 and 1982.  - 8 - 29. Manufacturing output recovered slightly (2.2 percent) in 1984, but stagnated in 1985. At year-end 1985, sectoral output was still 9 percent below its peak level of 1981, with an 11 percent loss of employment. The mild recovery in 1984 can be attributed largely to the demand for manufactured goods generated by a high level of public investment and the modest price recovery of some exports, which led to increased domestic consumption. However, sustained growth of the sector must depend increasingly on expansion of exports to third countries. Existing Framework for Investment 30. Factors affecting investment derive both from elements of the macro-economic policy framework, such as the availability of foreign exchange and import rationing, export promotion policies, and from elements specific to the manufacturing sector, of which the most important are the links with the Central American Common Market (CACK). The major features of these elements are summarized below. 31. Availability of Foreign Exchange. In the early 1980s the Government was faced with an accelerating demand for foreign exchange, a drying-up of external commercial bank credit, and little interest on the part of foreign investors. Having decided not to resort to devaluation of the Lempira, the Government turned to non-market rationing of imports. Procedures followed under the rationing system in effect since 1981 lead to long delays between application for and receipt of foreign exchange for inputs and for machinery, equipment, and spare parts. Purchases financed from foreign sources, including FONDEI's line of credit, are exempt from import rationing. The proposed project would include technical assistance to help the Government evaluate the system for allocating foreign exchange and recommend measures for alleviating any constraints in the system (para. 53). A second factor limiting investment in the sector has been a dearth of term credit (para. 46 below), especially in foreign exchange. The line of credit financed by the Bank through FONDEI has helped to fill the need for both term credit and foreign exchange. In 1984-1985, a line of credit financed by the IDB provided short-term credit in foreign exchange for working capital needs, with preference given to export industries. 32. Industrial Incentives. Although 'onduras is not formally a member of the CACM, it has maintained close ties with it since 1975. This has resulted in Honduras' partial adoption of the CACM Common External Tariff (CET) and its full adherence to the Central American Agreement on Fiscal Incentives to Industrial Development (CAAFIID). Honduras' tariff schedule, originally fairly simple in design and intended as a revenue instrument, has evolved into a complex system including long lists of specific exemptions and surcharges, with both specific and ad valorem rates. The Government is preparing to convert all specific taxes to their ad valorem equivalents and to convert its current tariff classification system (unique to the CACM) to the adapted version of the Brussels Nomenclature recently adopted by CACM. A cariff reform and the abolition of CAAFIID were implemented by the CACH countries in January 1986, and the Government will need to consider proposed reforms to its own system in the light of those undertaken by its tr3ding partners if it decides to continue  -9- its informal links with the CACM. In evaluating reform proposals and in deciding on its future relationship with the CACM, the Government will also need to re-examine the levels and dispersion of effective protection rates and consider the extent to which the capital-intensive, anti-export bias created under the old CACM arrangements can be avoided. A study to help the Government analyze these issues is underway with UNDP assistance. Under the proposed project, the study would be discussed with the Bank, with a view to assisting the Government in formulating a plan of action. 33. Export Incentives. In 1984, an export-promotion law introducing new incentives for production of non-traditional exports was passed. The centerpiece of this law is a tax rebate on non-traditional exports (CEFEX). Although the law is a step in the right direction, the procedures followed under it are complex and cumbersome to administer, weakening the effectiveness of the new incentives. In an effort to overcome the anti-export bias created primarily by imnort-substitution incentives under the CACM, a temporary admission regime (TAR), under which export industries producing for third market countries are allowed access to imported inputs at international prices, was introduced in 1985. The TAR system is a marked improvement over the previous duty drawback system, but its effectiveness is hampered by the fact that exporters taking advantage of the TAR are denied access to CEFEX benefits, excessive paperwork and complicated authorization procedures, and the unwarranted rigid interpretation of eligibility criteria that results in the exclusion of raw materials. The Government has recognized the problems that weaken these incentive measures. Technical assistance provided under the project would help the Government to streamline and expand the scope of the system along the lines discussed above (para. 53). Government Objectives in the Sector 34. The Government's objectives for the industrial sector are to expand production, employment, and exports, particularly to third countries, since prospects for growth within the CACM are limited due to its small size and uncertain outlook. Production for third markets will require not only substantial investment in retooling and upgrading of existing plants and construction of new ones but also a considerable marketing effort. Its strategy to achieve these goals is to encourage private sector investment. The recent measures outlined above represent important steps to provide such encouragement. To assist private companies in identifying markets in third countries, the Government has recently established a private institution, the Foundation for Entrepreneurial Research and Development (FIDE), to provide technical assistance and market development services. In addition to the improvements in export-incentive measures (paras. 32-33), the Government intends to promote increased production and employment in the small- and medium-scale industries, which may be most responsive to incentives at this time, since they are less sensitive to perceived political and other non-market risk than are large industries. A number of programs have been initiated to provide both financial and technical assistance to this sub-sector, including a Small Business Development Project assisted by USAID and the technical and financial assistance components under the ongoing and proposed Bank-assisted projects.  - 10 - B. Financial Sector Institutional Setting 35. The Honduran financial sector comprises the Central Bank (BCH), 15 private commercial banks, two state-owned development banks (BANADESA and BANMA), the National Investment Corporation (CONADI), and 8 specialized credit and savings institutions, mainly housing-mortgage banks. Other institutions that play a visible, though less active role in providing financial services are the insurance companies, savings and loan cooperatives, and public social security institutes. In addition to the above institutional system, there are about 1,600 registered moneylenders and an unknown number of unregistered moneylenders, whose role is estimated to be extremely important as a primary source of credit for small borrowers. 36. Central Bank of Honduras (BCH). BCH has played a key role in guiding and stimulating the development of the financial sector, especially commercial banking. Of particular importance, has been its provision of lines of credit for specific on-lending purposes (its 'rediscount' lines), which have supported the emergence and rapid growth of new banks over the past 15 years. This is illustrated by the proportion of new loans rediscounted by such lines: of the L193 million net increase in credit to the private sector in 1984, 61 percent was financed through the rediscount lines. Of the 15 such lines currently offered by BCH, 3 are earmarked for industrial credit: (a) a fund in local currency for free-standing working capital loans with maturities less than one year; (b) an Industrial Reactivation Program (PRI) financed by IDB for working capital loans with maturities up to 24 months; and (c) the program administered by FONDEI for investment credit and associated working capital financed partly with Bank funds. 37. The rates charged by BCH to financial intermediaries for use of its various rediscount lines range from 6 percent (for basic grains production credit) to 14 percent (for the largest industrial borrowers under FONDEI). The longer maturity of most rediscount lines make them an attractive source of funds, particularly for the newer banks, whose deposit rates average over 10 percent (para. 41), and which have difficulty attracting sufficient funds even at the higher rates. In contrast, the larger and more established banks can attract deposits at lower rates, and they prefer to lend their own resources, since the rediscount lines entail higher administrative costs for appraisal and supervision and are subject to lower lending rate ceilings and close supervision by BCH, making it difficult for the banks to charge additional fees (which are prohibited for all loans but are common practice). 38. Through its Superintendency of Banks, BCH has also played a major role in maintaining the viability of the banking system. This role became increasingly important in the early 1980s when there wa& a sharp rise in arrears and bad loans, reflecting the difficulties encountered by businesses during the recent recession. Total overdue loans in the commercial banking system rose from 13 percent of total outstanding loans in 1981 to 22 percent in 1984; 1985 showed an improvement, with overdue  - 11 - loans falling to 16 percent of total portfolio. A time distribution of overdue loans is not available; the totals include loans with payments from one day overdue to uncollectible loans. Following the failure of one bank in 1980 the Superintendency of Banks tightened control to avert a crisis. Consultations are held with each bank every 18 months to reevaluate the classification of their loans by four categories: normal, qualified, doubtful, and uncollectible. BCH prescribes an overall provision to be written against income, based on the proportion of a bank's portfolio falling in each of the four categories. In addition to these measures to improve provision for arrears and bad debts, the Superintendency has increased reserve requirements for some weaker banks (the overall debt/equity ratio for the commercial benking sub-sector is currently 10:1). In spite of these improvements, however, further strengtheni.ng is needed, particularly with regard to banks' credit administration and portfolio analysis. Moreover, the effectiveness of the Superintendency's supervision is reduced by the fact that its recommendations are not always immediately enforced, nor does it impose a time limit for writing off bad loans. The proposed project would include technical assistance to strengthen the Superintendency's ability to regulate this aspect of the banking system (para. 53). 39. Commercial Banking System. The 15 commercial banks form the most important part of the financial system in Honduras. They hold 60 percent of the system's assets, nearly 75 percent of its deposits, and more than 70 percent of the system's short-term external liabilities. The commercial banking network expanded from only two banks (Atlantida and Honduras) in 1950 to 15 banks by the early 1980s. After 1980, the banks rapidly expanded their branch networks, and by early 1985, the 15 banks operated 232 branch offices with nearly 4,000 employees. In spite of the rapid expansion, assets are still highly concentrated within four banks (Atlantida, BANCAHSA, Ahorro, and Occidente), which together account for 49 percent of total commercial bank assets and 47 percent of the sub-sector's total loans. Moreover, a few of the larger banks cooperate closely with each other and form economic groups with some large industrialists, reducing the scope for effective competition. Nevertheless, the competitive pressure within the system has been building in recent years, reflecting the rapid growth of some smaller banks. Between 1980 and 1984, the collective share of the five largest banks in total deposits in the sub-sector fell from 75 to 58 percent, and in value of loans granted from 63 to 55 percent. 40. According to aggregate data compiled by BCH, commercial banking is quite profitable in Honduras. After-tax profits totalled 17.7 percent of capital and reserves in 1930 and 1981 and 21.1 percent in 1984. Profits were more modest in 1982 and 1983. There is considerable variation among banks, with some of the established and more efficient banks earning profits up to 50 percent of their capital and reserves. These figures should be interpreted cautiously, however, in light of the arrearage situation discussed above (para. 38); because some banks made inadequate provision for bad loans in the past, their profits on paper may appear larger than they really were. BCH's stricter requirements for provision for bad debts should correct this anomaly in the future.  - 12 - Deposit Rates and Resource Mobilization 41. Commercial bank assets are composed of private sector deposits (73 percent), funds rediscounted by BCH (12 percent), and equity and other sources (15 percent). Deposit rates were freed from BCH control in mid-1981. The most established (and generally more conservative) banks offer 7 to 11 percent for savings deposits, while the newer, more aggressive banks pay 10 to 11 percent. The average rates for the sector are 7 to 8 percent. Time deposits with fixed maturities pay 11 to 13 percent. Government bonds pay 10 percent; though they have 10-year maturities, some are redeemable on demand with BCH. Although Government bonds are not strictly competitive with commercial bank time deposits, the bond rate does tend to set a guidepost, discouraging a downward adjustment in rates in response to lowered expectations of inflation. 42. With inflation dropping steadily in the early 1980s, (from 18 percent in 1980 to less than 4 percent in 1985), real deposit rates have become highly positive, and have been partly responsible for greater resource mobilization by the financial system, as reflected in an expansion of holdings of financial assets relative to the level of economic activity. Time deposits grew from less than 23 percent of GDP in 1970 to nearly 35 percent in 1984, in spite of the uncertain macro-economic environment of the 1980s. Lending Rates and Spreads 43. In view of the limited effective competition in the banking sector, BCH imposes ceilings on interest rates for commercial bank loans, according to the source of loaned funds and the type and maturity of loans. In practice, the banks treat the ceilings as fixed rates, except for loans to their preferred clients. For industrial loans rediscounted with FONDEI, the ceiling is 17 percent; for loans from banks' own funds, it is 19 percent. At current rates of inflation, the above ceilings result in real interest rates to the borrowers under FONDEI rediscount lines of 13 percent, and of 15 percent for the portion of loans financed from banks' own funds. FONDEI estimates that commissions, closing costs, special taxes, and other expenses associated with obtaining a loan add another 2.0 to 2.5 points to the real cost of the loan. 44. Taking into consideration the cost of different sources of funds discussed above, the above lending rates result in spreads of up to 5 percent for funds rediscounted with FONDEI and 6 to 12 percent for banks' own funds; administrative surcharges add 1.0 to 1.5 points. After rising sharply between 1979 and 1982, commercial banks' spreads have remained stable. However, the banks' administrative costs rose from 3.8 to 5.4 percent of total assets between 1979 and 1984, resulting in declining nominal profit margins. Administrative costs are defined to include, inter alia, personnel costs, non-personnel security costs, and provision for bad deibts. The last item has grown in response to the Superintendency of Banks' more stringent requirements in the last few years, and is expected to grow further as the regulatory body's recommendations are adhered to mwre closely (para. 38).  - 13 - 45. Prospects for Lower Interest Rates. BCH has recognized that the tendency of lending rates to remain high in spite of lower inflation may be discouraging both investment and more efficient utilization of installed capacity. In view of the objective to encourage increased competition from the faster-growing smaller banks, whose costs are higher (para. 41 above), BCH has taken a cautious approach to lowering the lending rate ceilings or takirg other measures to reduce spreads; until arrears can be brought down, such measures could endanger the smaller banks. In addition, BCH authorities feel that, given time, increased participation by newer banks will improve competition in the banking system and force rates down, making a ceiling unnecessary. At the same time, they recognize that the 10 percent rate on Government bonds pushes up both deposit and lending rates, and that a reduction in the bond rate may help allow a downward adjustment to occur. The proposed project would support the movement toward more flexible, market-determined rates by permitting flexibility in the on-lending rate (paras. 64-65, below). Structure of Lending 46. The fact that the bulk of loanable resources in the commercial banking system is derived from short-term deposits leads to a dearth of term credit in Honduras. Aggregate figures as of July 1985 show that 65 percent of outstanding loans (excluding rediscounted loans) had terms of less than 18 months; only 15 percent had maturities over 5 years. The bulk of longer-term loans were to banks' preferred clients--generally large-scale industries that they consider low-risk. In general, other industrial borrowers' only access to term credit is through the use of FONDEI's rediscount line, representing 20 percent of total commercial bank loans to the industrial sector, but over 80 percent of term credit for industrial investment. FONDEI's credit funds have been wholly responsible for giving small- and medium-scale industries access to institutional term credit. Private Investment and Demand for Credit 47. After a decline in the early 1980s that paralleled the stagnation in sectoral output (para. 28), industrial investment has begun to recover, particularly in the small- to medium-scale sub-sector, which represents the majority of FONDEI beneficiaries (para. 55). (FONDEI's existing pipeline of projects, totalling about 121 million, illustrates the recovery of this sub-sector). Assuming a continued modest growth rate for industrial investment of 1.5 percent a year, average annual investment in the sector would be L112 million from 1986-1989. Based on previous experience, about half of this amount can be assumed to represent investment in fixed assets, of which about 20 percent would be financed by large firms from their own resources and with commercial bank loans from banks' own funds. Of the remainder (L44.8 million), FONDEI would provide financing for about 80 percent (L36 million), using Bank loan funds for about 53 percent or L24 million (US$12 million) a year. This estimate is consistent with FONDEI's past commitment rate and its existing pipeline mentioned above.  - 14 - Bank Lending in the Sector 48. Past Bank lending for industrial development in Honduras has focussed on providing medium- and long-term resources through the commercial banking system to economically viable industrial enterprises, particularly small- and medium-scale firms. To this end, the Bank has approved two industrial credit projects: the Industrial Credit Project (Loan 1659-HO) of March 1979 for US$15.0 million, and the Second Industrial Credit Project (Loan 2075-HO) of May 1982 for US$30.0 million. Experience with execution of the two projects has been good; implementation proceeded in line with appraisal expectations, allocation of resources was economically efficient, and most institutional development objectives were achieved (paras. 54-55, 57). The principal lessons derived from the first two projects are: (a) financial intermediaries should assume greater responsibility for appraising and supervising sub-projects, and, in order to do so, require technical assistance to strengthen their capabilities in these areas; and (b) coordination of and improved definition of responsibility for technical assistance activities would help ensure the effectivenes of such assistance. 49. Bank Strategy. In line with Goverment objectives (para. 34), Bank strategy in the manufacturing sector has been to support private investment in export-producing industries and those producing efficiently for local markets. Particular emphasis has been placed on identifying industries in areas of comparative advantage for Honduras as well as supporting labor-intensive small-and medium-scale enterprises. The proposed project would continue to pursue this strategy, while taking a broader focus by: (a) strengthening institutions in the financial sector and exploring new lending instruments; and (b) contributing to the Bank's macro-economic and sectoral policy dialogue by improving the data base and analysis of key issues affecting sectoral development. PART IV - THE PROJECT 50. The proposed project was prepared between May and August 1985 by FONDEI with assistance from the Bank. Bank appraisal was completed in December 1985; a Staff Appraisal Report entitled -Honduras: Third Industrial Credit Project, (Report No.6129b-HO) is being distributed separately. Negotiations were held in Washington, D.C. from April 21 to 25, 1986. The Government delegation was led by Dr. Lizzeth de Paz, Legal Counsel, Secretariat of Finance and Public Credit, on behalf of the Borrower, and Mr. Arturo Corleto, Director of FONDEI, on behalf of the Central Bank. Supplementary data are contained in Annex III. Objectives and Description 51. The proposed project would: (a) support private investment in both export-oriented and efficient Import-competitive industries through the provision of term credit; (b) improve performance in the financial sector through technical assistance to strengthen the monitoring functions of the Superintendency of Banks and upgrade the capacity of participating financial intermediaries (PFIs) to undertake appraisal and supervision of  - 15 - investment projects; (c) provide financial and technical assistance to the small- and medium-scale industrial sub-sector, whose growth has been constrained in the past by inadequate support services, and which shows the greatest potential for expansion in the short-term; and (d) improve understanding of the potential of and constraints affecting growth of the industrial sector through specific studies as well as the initiation of the industrial census. The proposed loan of US$37.4 million would provide (a) credit for fixed assets and associated permanent working capital, free-standing permanent working capital, and consulting services for technology and product development, and (b) technical assistance to the Borrower, BCH, FONDEI, the Center for Industrial Development (CDI), and PFIs. 52. Credit Component. A total of US$52.7 million, including US$35.8 million of loan funds and US$16.9 million from FONDEI and PFIs, would be on-lent to final sub-borrowers. At least US$30.0 million of the proposed Bank loan would be used for sub-loans for fixed assets (purchase and installation or repair of machinery and equipment or replacement parts and construction of buildings and related infrastructure) and associated permanent working capital. Up to US$5.0 million of loan funds could be used for free-standing permanent working capital sub-loans to prior PONDEI sub-borrowers seeking to expand utilization of installed capacity. The remaining US$0.8 million in loan funds for the credit component would be used for sub-loans to finance technical assistance for technological improvements and product development and design. 53. Technical Assistance Component. The technical assistance component would consist of consulting services for: (a) continued strengthening of FONDEI's institutional capabilities, including improvements to its management information system. To support this work, financing would also be provided for the purchase of equipment, including several micro-computers and related software; (b) improvement of PFIs' appraisal and supervision capabilities, including assistance to selected PFIs for the establishment and initial operation of project units. Most training would be carried out through seminars conducted by FONDEI with consultants' assistance; PFIs with project units would be provided with several months of full-time consulting assistance; (c) training for staff of the Superintendency of Banks to improve its ability to monitor financial performance of commercial banks and to undertake diagnostic studies of banks in especially serious financial condition. Funds would also be provided for the purchase of micro-computers and related software to assist in database management and analytical work related to the Superintendency's monitoring functions; (d) strengthening of CDI through: (i) training its extension service staff in areas of enterprise management, production processes, including selection of appropriate technologies, and production  - 16 - control; (ii) carrying out pre-investment studies of industrial activities suitable for small-scale enterprises; (iii) training its credit administration staff in project evaluation and supervision. Funds would also be provided for the purchase of training aids, mobile training units, and micro-computers and related software for loan administration; (e) assistance to BCH in initiating an industrial census and conducting studies to (i) identify constraints to investment, and (ii) evaluate the system of allocating foreign exchange and recommend meacures for alleviating any constraints in the system (para. 31); (f) assistance to BCH/FONDEI in carrying out studies to determine the legal and institutional feasibility of introducing adjustable-rate lending instruments for industrial investment credit and identify mechanisms to encourage lending to small-scale enterprises by commercial banks; and (g) assistance to the Government in carrying out a study to develop mechanisms for expanding the scope of and streamlining its TAR system (para. 33). The results of the studies described under (e), (f) and (g) above would be reviewed with The Bank, and the Government would formulate a plan of action and an appropriate timetable for carrying out its plan. The total cost of technical assistance is estimated at US$2.8 million, of which US$1.6 million (US$0.1 million to the Government, US$0.7 million to FONDEI, US$0.6 million to BCH, and US$0.2 million to CDI) would be provided by the Bank Loan. Participating Institutions 54. FONDEI. FONDEI functions semi-autonomously under BCH as a second-tier rediscounting institution in accordance with its 'Statement of Operating Policies and Industrial Regulations' (FONDEI's Regulations), which have been revised to include the provisions of the proposed project. Ratification of FONDEI's revised Regulations by its Executive Committee would be a condition of loan effectiveness. FONDEI's director, who is responsible for managing day-to-day operations, reports to an Executive Committee chaired by the President of BCH and including representatives of the Minister of Economy and the commercial banking system. Since its establishment in 1978, FONDEI has developed into an efficient organization with an adequate number of well-qualified staff. 55. As of September 1985, FONDEI's portfolio consisted of some 400 sub-loans with a total investment cost of about US$92 million equivalent, of which FONDEI financed about US$51 million, including Bank resources of about US$42 million, averaging 46 percent of investment cost. About 68 percent of sub-loans, representing 21 percent of loan funds, were to small- to medium-scale industries, compared with the agreed target of 20 percent. FONDEI intends to maintain this emphasis under the proposed project. FONDEI has negligible arrears in PFI repayments, since BCH automatically  - 17 - debits PFIs' accounts for amounts due to FONDEI. With a debt/equity ratio of 2.1:1, FONDEI's capital structure is satisfactory. For 1984, its operating income permitted a 6.9 percent return to equity in real terms; at projected rates of inflation, this performance is expected to improve further. FONDEI enjoys a good liquidity position, which results from the shorter repayment period of sub-loans compared with repayments to the Bank; it has sufficient liquidity to provide all of its own counterpart requirements under the proposed project. 56. Center for Industrial Development (CDI). CDI is a public institution with responsibility for providing technical, managerial, and financial support to very small-scale enterprises. Though better equipped for its first two functions than as a financial intermediary, CDI is virtually the only source of institutional credit for small industrial borrowers; commercial banks are still reluctant to lend to the very small borrowers, even though they have access to FONDEI's rediscount line. Under the technical assistance component of the proposed project, a mechanism would be developed to promote commercial bank lending to small-scale enterprises. It is envisioned that the banks could rely on CDI to prepare, evaluate and supervise sub-projects and to continue providing technical assistance to the enterprises to assure their success and reduce the credit risk. Technical assistance would also be used to strengthen CDI's capacity to provide such services (para. 53). 57. Participating Financial Intermediaries (PFIs). According to the eligibility criteria specified in FONDEI's Regulations, a PFI may be CDI, the Industrial and Agricultural Finance Corporation (FIA), and any commercial bank that, inter alia, maintains a satisfactory financial condition, including control and provision for payment arrears, and employs adequate numbers of staff capable of undertaking sub-project appraisal and supervision. Overall, PFIs took less responsibility for appraisal and supervision of sub-projects than expected at appraisal of the last project; the proposed project would provide incentives for PFIs to accept more responsibility in these areas and technical support for those that do so (paras. 53, 61). All commercial banks participated under the previous project and are expected to continue under the proposed project. Sub-loan recovery by PFIs has been good: only 7 of some 390 sub-projects have failed, and another 11 have had sub-loans restructured by the concerned PFI with FONDEI assistance. These 18 -problem' projects represent total sub-loans of US$2.0 million equivalent, or 3.2 percent of PFIs' total portfolio rediscounted with FONDEI. Implementation Arrangements 58. FONDEI would have principal responsibility for implementation of both the credit and technical assistance components. To ensure adequate coordination of all technical assistance under the project, FONDEI would, as a condition of effectiveness, establish a Technical Assistance Unit and appoint a qualified Unit Chief. Technical assistance for CDI -would be provided by UNIDO, under the overall responsibility of FONDEI. In order to assure adequate coordination of CDI's technical assistance with the rest of the project, UNIDO's work program would be reviewed in annual meetings among representatives of the Bank, UNIDO, FONDEI, and CDI. Progress would  - 18 - be reviewed quarterly by UNIDO, FONDEI, and CDI. The study of the TAR (para. 53 (g)) would be carried out jointly by the Secretariats of Finance and Public Credit, and Economy and Commerce. 59. All PFIs would sign participation agreements with FONDEI that would specify, inter alia, the lending and repayment terms, procurement and disbursement procedures, the PFI's acceptance of responsibility for appraisal and supervision of sub-projects, and its agreement to provide at least 10 percent of the value of each sub-project from its own resources, report to FONDEI any sub-loan repayment that becomes 60 days overdue, and participate in any staff training programs provided by FONDEI for PFIs. Participation agreements would be renewable annually, subject to a review by FONDEI of the PFI's continued adherence to all eligibility criteria (para. 57) and compliance with the participation agreement. FONDEI would promptly advise the Bank of the renewal of agreements and any changes in the list of PFIs. Signature of participation agreements with at least three PFIs would be a condition of loan effectiveness. 60. Final Beneficiaries and Sub-Project Selection. Beneficiaries would be classified in three categories: very small-scale industries (SSIs), having total fixed assets, excluding land and buildings, but including the value of the proposed investment, worth less than US$50,000; small- and medium-scale industries (SMEs), with total assets between US$50,000 and US$200,000; and other firms, with assets worth more than US$200,000. The methodology for evaluation of investments would depend on the size of the sub-loan. For FONDEI financing over US$250,000, both economic and financial rates of return would be calculated; for financing between US$50,000 and US$ 250,000, a financial rate of return would be calculated. All approved sub-projects would have rates of return of at least 12 percent. In addition, an evaluation of market potential as well as the technical and managerial capacity of enterprises in these two categories would have to be carried out. For FONDEI financing of less than US$50,000, a streamlined cash-flow analysis of the enterprise would be undertaken, and the past performance of the entrepreneur would be considered, where applicable. 61. Appraisals would be carried out by PFIs and reviewed and approved by FONDEI. Selected PFIs that establish project units and demons;trate satisfactory application of guidelines would be authorized to approve sub-loans under US$50,000 equivalent. In view of FONDEI's demonstrated ability to select sound investments, it would have authority to approve sub-loans under US$800,000; sub-loans exceeding this amount would require Bank review arnd approval. Prior Bank review is expected to be required for some 20 sub-projects, accounting for about half of the loan amount. FONDEI's maximum financing for any one enterprise would be US$2.0 million equivalent, including any outstanding amounts from previous sub-loans, and US$500,000 for free-standing permanent working capital sub-loans. minimum FONDEI financing would be US$5,000 equivalent. Cost and Financing 62. Total project cost is estimated at US$67.2 million, of which about 56 percent represents foreign exchange. The proposed Bank loan of US$37.4 million would finance about 98 percent of foreign exchange requirements;  - 19 - the remainder would be financed by a UNDP grant of US$0.7 million. The total estimated cost of the credit component would be financed by US$35.8 million of Bank loan funds (56 percent), US$10.6 million of FONDEI funds (16 percent), at least US$6.3 million from PFIs' own resources (10 percent), and about US$11.7 of sub-borrowers' funds (18 percent). The total cost of technical assistance (US$2.8 million) would be financed by the Bank loan (US$1.6 million), UNDP (US$0.7 million), FONDEI (US$0.2 million), and the Government (US$0.3 million). Relending Terms and Conditions 63. The Government would relend US$37.1 million of the proposed loan to BCH on the same terms and conditions as the Bank loan, in accordance with a subsidiary loan agreement to be signed by the Government and BCH. Execution of the subsidiary loan agreement would be a condition of loan effectiveness. BCH would bear the foreign exchange risk except on the amount on-lent to sub-borrowers under the dollar-denominated sub-loan option (para. 65); it would bear the cross-currency risk on the entire loan amount. BCH would retain about US$600,000 for technical assistance and studies, and transfer US$36.5 million of loan proceeds to FONDEI, which would bear the risk of variation between the Bank's standard variable rate and the fixed on-lending rates to PFIs (para. 66). The Government would retain US$300,000 of loan funds for technical assistance, of which it would make available US$200,000 to CDI on a grant basis. 64. On-Lending Terms. FONDEI would use US$0.7 million for technical assistance and relend US$35.8 million of loan funds to PFIs for on-lending to sub-borrowers through sub-loans denominated in either Lempiras or dollars, at rates determined by the currency denomination of the sub-loans and the total assets of the beneficiary (para. 60). For Lempira-denominated sub-loans (which are expected to represent the bulk of sub-loans), FONDEI would lend to PFIs at: (a) 12 percent for sub-loans to SSIs; (b) 13 percent for sub-loans to SMEs; and (c) 14 percent for sub-loans to larger firms. Based on the current Bank rate (8.5 percent), these rates would allow FONDEI a spread of 2 percent per annum on all sub-loans to cover its risk and administrative cost and a residual of 1.5 to 3.5 percent, which FONDEI would pay to BCH for its foreign exchange and cross-currency risk fund. PFIs would be free to charge rates in line with their estimate of the creditworthiness of each sub-borrower and administrative cost of the corresponding sub-loan, subject to the ceiling imposed by BCE (currently 17 percent). Portions of sub-loans financed with PFIs' own funds are subject to BCH's ceiling of 19 percent (para. 43). 65. The dollar-denominated sub-loan option is expected to be exercised mainly by exporters and larger firms, which are accustomed to foreign currency movements. Under this option, and based on the current Bank rate, FONDEI's rates to PFIs would be:  - 20 - (a) for SSIs, 9.5 percent. FONDEI would retain a spread of 0.5 percent, and pay BCH 0.5 percent; (b) for SMEs, 10.0 percent. FONDEI would retain a spread of 1.0 percent, and pay BCH 0.5 percent; and (c) for larger firms, 10.5 percent. FONDEI would retain a spread of 1.0 percent and pay BCH 1.0 percent. Rates paid by sub-borrowers under this option would be subject to ceilings of 12.5 percent, allowing PFIs maximum spreads of 3.0, 2.5, and 2.0 percent, respectively, for sub-loans to SSIs, SMEs, and others. Dollar-denominated sub-loans would be disbursed in dollars and repayable in Lempiras, using the official exchange rate at the due date of each repayment, thus passing the exchange risk to the sub-borrower. 66. As in the past, rates on sub-loans would be fixed for the life of the sub-loan. The on-lending rates and spreads provided under the project would be adequate to cover all intermediation costs and would be positive in real terms, at projected rates of inflation. FONDEI and the Bank would review the rates twice a year to assure that they remain adequate by the above criteria. In addition, BCHIFONDEI would be assisted under the project in exploring the possibility of adjustable-rate instruments (para. 53). 67. Maturities and Repayments. The maturity of each sub-loan would be determined by PFIs and approved by FONDEI on the basis of cash-flow projec- tions for the corresponding sub-borrower. Sub-loans for fixed assets and associated working capital would have maximum maturities of 15 years, including up to three years grace; free-standing permanent working capital sub-loans would have maximum maturities of three years, including up to one year of grace. The portion of sub-loans financed from PFIs' own resources would have the same maturities as the portion rediscounted with FONDEI. Sub-loans for technology development would have maximum maturities of five years, including up to two years of grace. Repayment by each PFI to FONDEI would be based on a composite amortization schedule calculated as the sum of the repayment schedules of all the sub-loans in the PFI's portfolio. The roll-over of repayments to FONDEI over repayments due to the Bank would be used to provide FONDEI's counterpart funds and for continued on-lending for purposes similar to those of the project. The above regulations relating to terms and conditions of sub-loans, as well as the calculation of PFI repayment of rediscounted funds to FONDEI, would be contained in each PFI's participation agreement (para. 59). Procurement 68. Procedures for procurement of goods and services purchased with sub-loan funds under the project would be specified in each sub-loan proposal appraised by PFIs. For items over US$100,000, at least three quotations would be obtained. For items of lesser value, PFIs would assure that sub-borrowers had canvassed the main sources of supply and were purchasing from advantageous sources. PFI appraisals would discuss procurement procedures used, responses received and prices quoted, and  - 21 - criteria for selection of suppliers, and PFIs would maintain records of the procurement process during sub-project implementation. FONDEI would be responsible for ensuring that all PFIs comply with the above guidelines; it has had extensive experience in applying Bank procurement requirements satisfactorily. All consulting services, including services paid for under technology development sub-loans, would be open to international recruit- ment according to the Bank's Guidelines for the use of consultants. Disbursements 69. The final date for submission of sub-loan proposals for the Bank's approval would be December 31, 1989. The closing date for disbursements would be December 31, 1992, in accordance with the average profile for IDF loans in the region. However, faster disbursement is possible, if experience under the previous two loans is repeated. For sub-loans for fixed assets and permanent working capital, the Bank would disburse: (a) for SSIs, 75 percent of FONDEI's financing of the sub-loans; and (b) for SHEs and larger firms, 100 percent of direct foreign expenditures, 70 percent of expenditures for locally procured imported goods, 50 percent of ex-factory price for locally produced goods, and 35 percent of expenditures for buildings and related civil works. For sub-loans for technology and product development, the Bank would disburse 100 percent of total expenditures. For technical assistance, the Bank would disburse for 100 percent of total expenditures. Since the two-tier system involving FONDEI and PFIs requires a longer period between expenditure by the sub-borrower and disbursement by FONDEI than is normal for non-IDF projects, the Bank would disburse for expenditures incurred up to 180 days prior to the receipt of a disbursement request from FONDEI. Retroactive financing would be permitted for up to US$3.0 million for expenditures made after December 1, 1985 for sub-loans for fixed assets and associated permanent working capital. 70. To expedite disbursements under the proposed loan, a special account would be established by the Government and managed by FONDEI. The Bank would make an initial deposit of US$3.0 million, representing about four months of disbursement requirements. Accounts, Auditing, and Reporting 71. As with the previous projects, FONDEI would maintain separate accounts for all parts of the project except for technical assistance for CDI. FONDEI would retain independent auditors acceptab'e to the Bank to conduct annual audits of all project accounts, including the special account. Audit reports, to be submitted no later than four months following the end of each of FONDEI's fiscal years, would include an opinion regarding the adequacy of supporting documentation for disbursement of Bank loan funds based on statements of expenditures. Under the previous projects, the audits were carried out by a qualified external audit firm, which issued reports on a timely basis, with no reservations. The Govern- ment would ensure that CDI maintains separate project accounts on the same guidelines as FONDEI and that the accounts are audited and reports submitted according to the saie standards. FONDEI would submit to the Bank monthly reports of transactions relating to the special account; quarterly  - 22 - reports on the status of its portfolio and the collections of PFI sub-loans; and semi-annual reports on its overall financial situation and operations. Benefits and Risks 72. FONDEI is the single most Important source of term financing for industrial investment in Honduras. It is expected that the proposed project would provide financing for some 180 investment projects, costing a total of about US$65 million and generating about 2,500 new jobs. Both the expected employment generation and the emphasis on promoting investments by small-scale entrepreneurs would contribute to alleviation of poverty. The average cost per new job created would be about US$23,000, which is slightly below the average for similar projects in Latin America. At least US$16.9 million of the investment costs would be financed with funds mobilized from within the banking system (FONDEI and PFIs), and about US$11.7 million would be the beneficiaries' own funds. The project would also have a strong institution-building impact, not only on FONDEI, but also on CDI and PFIs. This would result in improved and more efficient provision of technical and financial services to the industrial sector, which would be of particular benefit to SSIs and SMEs, as well as continued development of financial discipline, through both strengthened monitoring of the commercial banks by BCH and improved credit administration by PFIs resulting from better appraisal and supervision of sub-projects. The project would also contribute to the development of increased flexibility in the lending rate structure by not fixing final on-lending rates, by permitting sub-borrowers to take lower interest rates if they assune the foreign exchange risk, and by studying the possibility of introducing adjustable-rate lending instruments for final borrowers. 73. The fact that FONDEI has developed into a mature and relatively efficient institution reduces both overall implementation risks and the risks related to financial and economic efficiency of resource allocation. The unsettled situation in Central America introduces an element of uncertainty, however, which may lead some potential investors to defer investments. Nevertheless, this concern is particularly applicable to larger-scale investors, which are expected to make up only 30 percent of FONDEI's beneficiaries. The majority of FONDEI's borrowers would be SSIs and SMEs, vhose investment decisions are generally less sensitive to political changes. Demand for investment would also be sensitive to changes in the macro-economic environment. At present, however, FONDEI's large pipeline of investment proposals (totalling about US$11 million) indicates that current investment demand is strong. Technical assistance under the project would include services to inform potential sub-borrowers of the technical and financial services provided under the project, increasing the likelihood that demand for credit will remain at least at its current level.  - 23 - PART V - RECOMMENDATION 74. I am satisfied that the proposed loan would comply with the Articles of Agreenent of the Bank and recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachments May 8, 1986 Washington, D.C.  -24 Annex! BOCIAL I ~~Paste I of 6 P4H5T (IB(S? BUCKET cSITUATE PLC1 T Y?IDDLK INCOME MIDLM A M MTIMIATELk LAT. AMEICPA & CAR