Ecuador - Third Small Scale Enterprise Credit Project

Docaomm Of The World Bank FOR OFFICULL USE ONLY AAf4p- ,;) Y-s Report No. 5546-EC ECUADOR STAFF APPRAISAL REPORT THIRD SMALL SCALE ENTERPRISE CREDIT PROJECT March 3, 1986 Projects Department Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authoriztion.  ECUADOR STAFF APPRAISAL REPORT THIRD SMALL SCALE ENTERPRISE CREDIT PROJECT CURRENCY EQUIVALENTS Currency Unit = Sucre (S/.) October 1985 December 1985 February 1986 (Average Multiple Rates) (Unified Rate) (Unified rate) USS1 = S/.82 S/.97 = S1.110 S/.1 = US$0.01 US$0.01 = US$.009 5/.100 = USS12.19 US$10.30 = US$9.09 Fiscal Year January 1 to December 31 Abbreviations BCE Banco Central del Ecuador (Central Bank of Ecuador) BEDE Banco Ecuatoriano de Desarrollo (Ecuadorian Development Bank) BEV Banco Ecuatoriano de la Vivienda (Ecuadorian Housing Bank) BN'F Banco Nacional de Fomento (National Development Bank) CD Certificate of Deposit CENAPIA Centro Nacional para la Promocion de la Pequena Industria y la Artesania (National Center for Promotion of SSEs and Artisans) CFN Corporacion Financiera Nacional (National Finance Corporation) DFC Development Finance Company ERR Economic Rate of Return FOPINAR Fondo de Fomento para la Pequena Industria y la Artesania (Development Fund for SSEs and Artisans) FOPEX Fondo de Promocion de Exportaciones (Export Development Fund) INSOTEC Instituto de Investigaciones Socio-Economicas y Tecnologicas (Institute for Social, Economic, and Technological Research) MFF Mecanismo de Fondos Financieros del BCE (BCE's Financial Fund) MICEI Ministerio de Industrias, Comercio e Integracion (Ministry of Industry, Commerce and Integration) SECAP Servicio Ecuatoriano de Capacitacion Profesional (Ecuadorian Professional Training Service) SSEs Small Scale Enterprises TA Technical Assistance  FOR OMCL USE ONLY ECUADOR STAFF APPRAISAL REPORT THIRD SMALL SCALE ENTERPRISE CREDIT PROJECT Table of Contents Page No. Loan and Project Summary ........................... lv I. THE DNDUSTRIAL SECTOR ...... .. 1 A. The Economic Setting .. * 1 Background ............................ ........... 1 Outlook .... ........................................ I B. Manufacturing and Small Scale Enterprise Sectors ............ 3 Structure and Growth of Manufacturing . . 3 Structure and Characteristics of SSEs . . 3 Performance of SSEs and Capacity Utilization . . 3 Financing and Financial Performance of SSEs . . 4 Technical Assistance to SSEs . . 4 SSEs Growth Prospects ....................... 5 C. Industrial Policies ......................................... 5 Features and Impact ...................................... 5 Government Action .. 5 II.THE FINANCIAL SECTOR ........................- 7 A. Institutional Structure and Development ..................... 7 Main Institutions ........................................ 7 Developments ............................................. 7 B. Interest Rate Policy and Resource Mobilization .............. 8 Performance .............................................. 8 Government Action ........................................ 9 Further Action Required .................................. 9 Agreements ............................................... 9 C. Past 3ank Lending and Strategy .............................. 10 III. THE PROJECT .................................................. 12 A. Project Objectives and Arrangements ......................... 12 This report was prepared by Javier Nogales and Ines Garcia-Thoumi, LCP II, based on the findings of an appraisal mission which visited Ecuador in December 1984. The mission comprised Messrs. J. Nogales, J. Culagovski (LCPI1) and L. Toledo and R. Halvorson (Consultants). This documnt hu a rnsticted distribution and may be u#d by recipients only in the performance of their officiad duties Its contents may not otherwise be disclosed witbout World Bank aulobriatiou  - ii - BaLckground .................................... 12 Project Objectives. ......... ......... ........ 12 Project Descriptiono........................................s..... 12 B. Participating Institutions....0.000000 .... ... ........ ..... * 13 Fondo de Fomento,para la Pequena Industria y Artesania (FOPINAR)o .... .o.o.0.0.0.0 ..00........... ........ 0- ......... 13 CFN and the Establishment of FOPINAR .........................-. 13 FOPINAR Plans for Strengthening Management and Administration... ...... . ....... .................... 14 Lending Volumes ....... .o *.*.o...e .... ...... ....-...... -. 15 FOPINAR Financial Conditiono.. o........................... 15 Collections and Portfolio Quality............................ 16 Subproject Appraisal and Supervision Activitiesoo ........- 17 FOPINAR's Technical Assistance to SSEs...................... 18 Participating Financial Intermediaries. ....o.................. .. 18 Financial Intermediaries ....o.-.o...... o....................... o-.-.. 18 C. Project Costs and Financing Arrangements ................o-... 19 Project Costs.oo- ... ...... oooo ...... 0.. ......... 19 Loan and Subsidiary Loan Terms .......... ............ .... 20 Subloans .................. oo......................... 21 Financial Agent .-.o-o.....o....o................... -.....-o... o. 22 Procurement ........................ . 22 Disbursements ....... o........o ............----...----.22 Bank Monitoring... .0................. .... 23 Accounting, Auditing and Reports ............................. 23 D. Project Benefits and Risks ........ o..o....o. -o *......... 24 Riskso............ ............... 24 IV. AGREEMENTS AND RECOMMENDATION...0..0..... .*000000.0. . 0000... ,- 25 Agreements ...... .... .. ......................... 25 Recommendation... ... ...... o......................... 26 List of Annexes Annex 1 - Geographic Distribution of FOPINAR Disbursements ....-..0. 27 Annex 2 - Average Balance Sheet of Survered SSEs........ ........ o..... 28 Annex 3 - The Sucretization Program .......... ..............._ 29 Annex 4 - Distortions on Debt Servicing of Long-Term Loan due to High Inflation ....000000 000 000000000 00 30  - iii - Annex 5 - FOPINAR's Use of Technical Assistance....................... * 33 Annex 6 Table 1- FOPINAR's Staff and Time Distribution................. 34 Table 2- FOPINAR's Staff Personnel Tasks Time Distribution.......... 35 Table 3- FOPINAR: Time Utilization per Task and Function - Second Semester of 1984 ........... .....0*..** .... 36 FOPINAR: Projected Time Utilization for Second Semester of lg86~~~~~~~~~..... 36 Table 4- FOPINAR's Operational Resources Requirements .37 Annex 7 - Chart 1 - FOPINAR: '84 Staff Time Distribution... 39 '86 Staff Time Distribution............. 39 Chart 2 - FOPINAR: Staff Distribution.................... 40 Annex 8 - FOPINAR: Real Disbursements Growth (Z)..................... 41 ECUADOR: Inflation Rate (% p.a.).......................... 41 Annex 9 - FOPINAR: Financial Projections............................. 42 Annex 10 - General Terms of Reference for Competitiveness Study....y.. 50 Annex 11 - Estimated Schedule of Disbursements Under the Proposed Loan 51 Annex 12 - Bank Monitoring of Project Implementation.................. 52 Annex 13 - Selected Documents and Data Available in Project File ..... 53 Map of Ecuador  - iv - EUA THImD SMALL-SCALE ETERPM SE CREDIT PROJECT WAN AND PROJECT SUDm Borrower: Republic of Ecuador Beneficiaries: Private Small-Scale Enterprises (SSEs) involved in manu- facturing, agro-industry, fisheries, tourism, and indus- try-related services and marketing activities. AMount: US$30 million equivalent. Terns: Repayable over 17 years on a fixed amortization scbedule, including 4 years of grace, at the Bank's standard varia- ble interest rate and charges. Relenting Terms: The Borrower, through the Central Bank (BCE) as its agent, would onlend the proposed loan in sucres to CFN, on the same terms as the Bank's loan, plus BCE's agency fee of one eighth of one percent p.a. and a variable foreign exchange risk fee. CFN would onlend about USS29.8 million equivalent of the loan proceeds to SSEs through qualified financial intermediaries at variable positive real interest rates, consistent with criteria agreed with the Bank. CFN would receive a fee of 2.5% p.a. plus a 12 one-time commitment fee for its subloans. Financial intermediaries would receive a fee of 4-5% p.a., depending on the term of the subloans. Variations in the interest rates charged to beneficiaries would result in variations in the foreign exchange risk fee paid to the Borrower through BCE. The Borrower would assume the foreign exchange risk on the Bank loan. Project Description: The objective of the project would be to support employment-intensive and efficient industrial deve- lopment, and to encourage financial and industrial sector policy reforms. It would continue Bank support to the Government of Ecuador to develop further the SSE sector. To achieve these objectives, resources totaling US$58.6 million from the Bank, CFN, and financial intermediaries would be made available to SSEs to finance fixed assets, permanent working capital, and technical assistance requirements. CFN would continue to manage a program of technical assistance, and would use up to USSO.2 million from the proposed loan to carry out studies related to the economics and technical assistance needs of the SSE sector.  -v - Benefita: The project would promote SSE development at the regional level. It would help create about 18,000 new jobs, principally outside the major urban centers of Quito and Guayaquil. Further benefits would result from the asso- ciated dialogue with the Government on resource mobiliza- tion, interest rates, and industrial policy issues. Risks: Possible changes in FOPINAR's management could pose some future risks to efficient project execution. Assurances have, therefore, been obtained under the project that FOPINAR would continue to be managed soundly. Also, depending on the rate of economic recovery in Ecuador and the potential negative short-term impact of import liberalization and interest rate reforms, demand for pro- ject resources could slacken. However, even if loan dis- bursements slowed somewhat, the project would remain viable. Estilmted Costs: Local. Foreig Total - (US$ million) Investment Projects 51.6 42.2 93.8 Technical Assistance to FOPINAR 0.0 0.2 0.2 Total Project Costs 1/ 51.6 42.4 94.0 Finncing Plan: Bank - 30.0 30.0 Financial Intermediaries 5.3 - 5.3 SSE Beneficiaries 28.0 7.2 35.2 CFN (through FOPINAR) 18.3 5.2 23.5 Total 51.6 42.4 94.0 I/ The tax content of the project would be approximately US$8.5 million (9%).  - 'VI - Estluated DIubaree eAts: 1986 1987 1988 1989 1990 1991 1992 US$ millions by Bank Fiscal Year Annual 0.6 4.8 7.5 7.8 5.1 3.0 1.2 Cumulative 0.6 5.4 12.9 20.7 25.8 28.8 30.0 Rate of Keturn: The minimum rate for subprojects would be 122.  I. THE INDUSTRIAL SECTOR A. The Economic Setting _/ Background 1.01 Since the 1960s, the Ecuadorian economy has changed from a predominantly agricultural to a predominantly urban society. From 1972 to 1980, the transformation of the economy occurred under the stimulus of growing petroleum exports and, to a lesser extent, the growth of the industrial sector. In that period, real GDP grew at an average rate of about 5% p.s. and per capita income in 1983 prices (Atlas Methodology) rose from US$1,190 to US$1,430. 1.02 In 1981, however, the Ecuadorian economy's fragility became evident when the terms of trade for Ecuador deteriorated for the first time since 1974. GDP growth slowed down considerably to 3.9%, private investments declined by 11.6% and signs of capital flight appeared. GDP growth slowed further to 1.8% in 1982 and turned negative to -3.3% in 1983. Investment continued to decline and unemployment to accelerate. By the end of 1983 Ecuador was facing, as most Latin American countries, one of the worst economic contractions since the Great Depression. Nevertheless, Ecuador complied with an IMF-supported adjustment program and avoided possibly an even worse income drop. 1.03 In 1984, Ecuador started to emerge from the recession mainly as a result of increased oil exports and the recovery of agricultural production, which had decreased by 14% the previous year as a result of severe floods. Other sectors, however, still faced constraints: a contracted international demand for non-oil exports; reduced availability of imported raw materials; low local demand for manufactured goods; minimal new foreign lending; and depressed prices for oil, Ecuador's main export. Nevertheless, in 1984, real GDP increased by 3.4%, reversing -the negative trend of the three preceding years. outlook 1.04 The present Administration which took office in August 1984, is the second one to be democratically elected after nearly a decade of military rule. The Government's economic philosophy essentially supports the market as an efficient resource allocation mechanism, with minimal Government inter- vention in economic affairs. It sees the longer-run development of Ecuador supported by vigorous, export-oriented agricultural and industrial growth, and recognizes the strategic importance of relative prices, including 1/ This section is based on the Report: Ecuador: An Agenda for Recovery and Sustained Growth - a World Bank Country Study, Report No. 5094-EC of October 5, 1984.  - 2 - exchange and interest rates and import tariffs. The Government is also com- mitted to strengthening private sector development, curtailing the role of public investment in activities which could be privatized, encouraging foreign investment, and improving the efficiency of public investment and operations. 1.05 Since coming to office, the Administration has taken a number of important and politically difficult corrective measures: it has devalued the sucre again and unified the multiple exchange rate markets; it raised domestic petroleum products prices; it improved the interest rate structure; it successfully obtained a multi-year rescheduling of its external debt; it took steps to liberalize trade; and it moved to free prices in the agricultural sector. It also mounted a campaign to attract foreign investment and subscribed to several investment guarantee schemes, including MIGA. These are important measures in the right direction; they should encourage more efficient utilization of resources and stimulate exports, agricultural production and domestic savings and encourage foreign investment. 1.06 Because of the devaluations of the sucre in the past two years, which have raised the price of oil in sucre terms, oil exports amounted to 18 percent of GDP in 1985. Virtually all oil income accrues to the public sector. DesPite the recent sharp drop in oil prices, the oil sector will continue to be essential to the economy. Adjustment to the loss of income (estimated to be close to half a billion dollars in 1986) will require faster shifts to non-oil sources of exports and fiscal revenues over the medium term. However, in the short run, oil still represents over half of current exports. Restricted fiscal revenues will require tightening of already frugal fiscal policies. An adequate flow of resources to the private sector from both domestic and foreign sources will be essential to support further recovery from the recent recession. Indeed, a public sector surplus may well be required to ensure that the private sector can expand its activities. This delicate balance between public and private sector needs underscores the importance of good public sector management. The Bank's recent public investment review found Ecuador's ongoing program generally a sound one, but recommended that petroleum exploration and production be accelerated, and that no sizable new projects be begun for a few years; an update of the program reflecting reduced foreign exchange earnings and fiscal revenues will be needed. 1.07 Ecuador will almost surely continue facing a shortage of foreign exchange in the next few years, given recent oil price declines. The Bank's most recent economic projections were made on a higher oil price expectation, and were consistent with both the Government's and the IMF's programs. The Government, along with both the Bank and the IMF, is now reviewing Ecuador's revised prospects. In view of the far-reaching economic effects of the most recent drop in oil prices, both the Bank and the IMF have scheduled economic missions to Ecuador for February-March 1986,to undertake further analysis. Nevertheless, it is already clear that Ecuador must likely quicken and deepen its adjustment program, while marshalling further external funds to assist its response to the oil price drops. Hence, the Government, the Bank, and the IMF are discussing with Ecuador's commercial creditors the possibility of further financing. Because of Ecuador's determined efforts to adjust its economy--and its creditors' positive responses so far --we believe Ecuador remains creditworthy for Bank lending.  - 3 - B. Manufacturing and Small Scale Enterprise Sectors 1.08 Structure and Growth of Manufacturing. Manufacturing remains at an earl, stage of development. Activities such as food processing, textiles and wood processing still account for about three-quarters of manufacturing value added. Most production is sold in the domestic market and is highly dependent upon imported inputs. The sector has contributed about 18% of GDP in recent years, and in 1983 employed about 320,000 workers (11% of the work force). In line with overall rapid economic expansion, manufacturing growth averaged 9.5% p.a. in real terms between 1972-1982. However, with the arrival of economic recession, real growth in manufacturing value added decreased by 1.9% in 1983 and by about 2% in 1984. Durlng 1985, economic growth resumed, led by increases in oil and agricultural output, and manufacturing grew by an estimated 2.5%. In the future, best prospects will likely be for those industries wiLh low indebtedness, that are based largely on local inputs, and that serve export markets, or local markets for basic consumer items. Small Scale Enterprises (SSEs) generally incorporate several of these characteristics. 1.09 Structure and Characteristics of SSEs. SSEs are defined as firms engaged in industry, agro-industry, fishing, tourism, and related Industrial services and marketing activities, with fixed assets of less than USS350,000 equivalent, excluding land and buildings. As official statistics on SSEs provide information only on the general structure and characteristics of the SSE sector, a survey of 101 SSEs was carried out by the Bank's appralsal mission. This survey provides further insight into the situation and performance of SSEs, although it could be expected that SSEs that have recently carried out investment projects, as is the case for the surveyed SSEs, would show a healthier growLh pattern than the average SSE. Overall, SSEs have shown great potential for job creation. In 1980, some 8,000 small firms and 200,000 artisans accounted for 12% of manufacturing output and employed about 40% cf total manufacturing labor. Moreover, the survey revealed that in 1982-84, SSEs created employment at an average cost per job of US$1,400--a fraction of the industrial sector average. SSEs are widely distributed geographically (Annex 1), but are concentrated in the food, wood processing, leather, garment, and light metalworking subsectors, where activities are mostly labor intensive and generally have not required large-scale production. They also utilize intermediate products that are less costly and have a higher local content than the rest of industry. The main markets of SSEs are local urban centers. Strong market segmentation prevails, owing to high transport costs, underdeveloped commercial infrastructure, and cultural differences among the country's various geographical areas. This market segmentation has prevented greater competition among SSEs. Better marketing infrastructure and information would thus promote efficiency among SSEs, and would be supported under the proposed loan. 1.10 Performance of SSEs and Capacity Uitilization. Despite the recent economic recession, SSEs have enjoyed satisfactory growth, mainly because of their generally low foreign indebtedness and low reliance on imported inputs. The survey of SSEs reveals that in 1983 and 1984 annual real growth rates averaged 13% for sales revenues, 17% for profits, 15% for employment,  9.5% for total assets, and 17X for equity, all satisfactory. Despite this positive record, however, idle capacity has remained high, averaging about 42X in mid-1984. This excess capacity arose mainly from (i) scarcity of credit, especially for working capital; (ii) difficulty in obtaining imported inputs; and (iii) the high market segmentation. To encourage higher capacity utilization, greater support to SSEs is required through provision of ti) incentives (including long-terz1 financing at reasonable terms) to purchase existing idle capacity for more productive uses; (ii) more timely and adequate infomaztion to SSEs on capacity utilization to improve the basis for investment decisions; and (iii) sufficient working capital financing to allow more intensive use of fixed assets. Such support would be provided under the proposed prnject. 1.11 Financing and Financial Performance of SSEs. In the past, SSEs have faced considerable difficulties in gaining access to commercial financing. They have had to rely until recently almost entirely on the official credit lines offered by the National Development Bank (Banco Nacional de Fomento - BNF) and by commercial banks using a Central Bank rediscount facility (Fondos Financieros) (para. 2.03). These credits carry a maximum maturity of two years and require SSEs to run the risk that short-term debt used to finance fixed assets may not be rolled over. The only longer term credit available for SSEs is offered by the National Finance Corporation (Corporacion Financiera Nacional - CFN) through its Development Fund for Small Scale Enterprises and Artisans (Fondo de Fomento para la Pequena Industria y la Artesania - FOPINAR) established in 19BO with Bank support (para. 3.06). Owing to inflation, total official credit received by SSEs decreased by 29% in real terms between 1981-1983. This reduction has prevented more adequate replacement of obsolete equipment and more effective use of installed capacity. Indications are, however, that when adequate financial support is provided, SSEs can achieve satisfactory growth and maintain financial health. The survey showed an average debt-to-equity ratio of 1.1:1 and liquidity (current ratio) of 1.4:1, both satisfactory. Annex 2 summarizes Lhe average financial structure shown by the surveyed SSEs. 1.12 Technical Assistance to SSEs. The main organizations providing technical assistance (TA) to SSEs are the provincial Small Industrialists' Associations, coordinated by a Federation in Quito; the Ecuadorian Professional Training Service (Servicio Ecuatoriano de Capacitacion Profesional - SECAP) under the Ministry of Labor; and the National Center for Promotion of Small Scale Industry and Artisans (Centro Nacional para la Promocion de la Pequena Industria y la Artesania - CENAPIA) established by the Ministry of Industry Commerce and Integration (MICEI) to support firms registered under the SSE and Artisan Incentive Laws. Generally, efforts by these organizations to deliver technical assistance to SSEs have been scattered and uncoordinated. Hence, since 1981, FOPINAR has identified various prospective sources of professional assistance and sought their cooperation in sponsoring TA programs. As a result, commercial banks, technical sales representatives and materials suppliers have been mobilized to advise SSEs, and FOPINAR's offices have acquired increasing imporLance as points of design and coordination of TA activities from several sources. Two-thirds of FOPINAR clients have received TA over the past two years, mainly from SECAP and private consultants or suppliers, and mainly in the  fields of technology and know-how, and accounting and finance. Given the survey's indication of a continuing strong demand for TA, FOPINAR plans to provide further TA support to SSEs. 1.13 SSEs Growth Prospects. Prospec-ts for SSEs look promising over the medium term. First, overall prospects for the Ecuadorian economy are positive, mainly due to good prospects for increased oil production and better economic policies. Second, sales growth prospects for SSEs seem favorable owing to their emphasis on producing items unlikely to be subject to external competition, such as construction materials and furniture, processed foods, and printing industry items. Such goods are protected by high transport costs, low cost raw materials, or custom production. Finally, while continued adjustment of the Ecuadorian economy would put pressure on some SSEs in terms of stronger competition, both in price and quality, the solid capital structure and liquidity evident among SSEs should enable them to weather adverse conditions. C. Industrial Policies 1.14 Features and Impact. Industrial policies tariff protection for domestic production, liberal exoneration of taxes and import duties for use of imported capital and raw materials, and subsidized credit-have not significantly differentiated in intent between SSEs and larger firms. In practice, however, they might have discriminated against SSEs, which generally have (i) had more limited access to subsidized credit; (ii) demonstrated relatively low capital intensity; and Ciii) purchased their inputs mostly in the domestic market, unaffected by benefits from import duty exonerations. Only one-fourth of all SSEs have registered for benefits under the Industrial Incentive Law and only about IOZ of registered SSEs actually used available benefits in 1983. 1.15 Much of the current structure and vulnerability of the manufacturing sector is a consequence of past policies which: Ci) favored import substitution over exports, through high tariffs on final goods, low tariffs for capital goods and inputs, and widespread use of non-tariff import restrictions; (ii) provided tax and tariff exonerations for machinery imports and subsidized credit for investment in fixed capital; and (iii) permitted a concentration of production, both geographically and in terms of number of firms, through a discretionary project-by-project application of incentives. 1.16 Government Action. The Administration has begun formulating a new industrial development strategy aimed at fostering efficient import substitution, export expansion, and more intensive use of domestic resources. Accordlngly, important policy decisions have been taken in the areas of industrial and trade policies. First, unification of the exchange  -6- rate represents a major step in eliminating basic distortions hindering a healthier industrial sector. The adjustment and maintenance of the exchange rate at a realistic real level-as agreed by the Government with the IHF-provides the basis for a restructuring of the other instruments of protection for domestic production as well as for export promotion. Second, new regulations for the Industrial Incentive Law were issued in January 1985 to simplify and streamline industrial incentives, mainly through (i) reducing income tax exonerations, especially for sectors with widespread idle capacity, (ii) granting tax benefits based on export performance, and (iii) establishing time limitations on tariff exonerations for raw material imports. These reforms complement the measure adopted in March 1983, by which tariff exonerations on capital goods were reduced by 35%. Third, the Government has begun to replace quantitative restrictions by tariffs. The first step was completed in March 1985, by eliminating import prohibitions that had been introduced in 1982, which in value amounted to about 16% of 1981 total imports. Another step was taken in January 1986, when about 20Z of remaining import prohibitions were replaced by tariffs. Furthermore, the Government has begun to reduce the number of industrial inputs subject to prior authorization for import. Finally, in an initial attempt to lessen discrimination against exports within different manufacturing activities, a revised import tariff structure was introduced in January 1986. ImPort tariff peaks and tariff dispersion have been reduced so that over 75% of imported commodities now have tariffs of 70% or less.  -7- II. THE FINANCIAL SECTOR A. Institutional Structure and Development 2.01 Main Institutions. The main institutions in Ecuador's financial system are the Central Bank (BCE), 32 private commercial banks with about 285 branches; 3 state banks-the National Development Bank (BNF), the Ecuadorian Housing Bank (BEV), and the Ecuadorian Development Bank (BEDE)-and 13 finance corporations, including the public National Finance Corporation (CFN). There are also 11 savings and loans associations; more than 25 insurance companies; various currency exchange offices and securities markets in Guayaquil and Quito. The Social Security Institute (IESS) is also a major depository for financial savings. As a group, commercial banks domicate Ecuador's financial system, and their outstanding loan portfolio represents 75% of total lending to non-bank borrowers. 2.02 Policy-making agencies are the Monetary Board, BCE, and the Superintendency of Banks. The Monetary Board sets exchange rates, interest rates, and other financial policies which are implemented by BCE and the Superintendency of Banks. BCE also provides credit to financial intermediaries, including special discount credit lines (para. 2.03). The Superintendency of Banks supervises and audits financial intermediaries and publishes statistical information on the banking system. 2.03 Principal vehicles for BCE's indirect lending have been the Financing Funds (Fondos Financieros), which were established in 1973 to develop and strengthen specific activities that the Government wished to encourage. There are currently five Funds (three financed by BCE funds, one by Treasury budget funds, and one by foreign loans channeled by BCE), including one that provides medium-term loans to SSEs. The Funds finan.ed by domestic resources grant mostly short-term credit with a maximum term of two years, and interest rates to final borrowers that are about the lowest available. 2.04 Developments. The financial system grew rapidly in the 1970s, mainly because bank ownership granted access to profitable BCE credit lines and because guarantees for foreign loans to the private sector grew rapidly and appeared profitable. Additionally, negative real interest rates charged to final borrowers, and attractive margins and commissions provided to intermediaries stimulated lending growth. However, such situation provided little incentive for financial institutions to mobilize domestic resources on their own, and they became increasingly dependent on BCE credits and foreign borrowings for resources. The structurally flawed financial system which thus arose became all the more fragile because easy granting of bank licenses led to the establishment of many small, inefflcient and undercapitaliz,ed banks. Between 1973 and 1984 the number of private banks increased from 21 to 32 and finance companies from 2 to 13. The system suffered grave liquidity problems beginning in 1983 as foreign resources dwindled and economic conditions deteriorated. These factors, combined with devaluation of the sucre, d.minished the ability of borrowers to meet dollar-denominated  -8- obligations guaranteed by the banks. To help financial intermediaries, the Government carried out a Sucretization- program (Annex 3) under which BCE assumed foreign debts and participating institutions became obligated to repay BCE in sucres over a period of up to seven years. While this program solved the immediate liquidity crisis, one of its legacies was that BCE credit in 1983 represented about 35% of the commercial banks', and up to 60% of finance companies' portfolio. B. Interest Rate Policy and Resource Mobilization 2.05 Performance. Official interest rates are established periodically by the Monetary Board. Judged by international standards, Ecuador has been quite unsuccessful in mobilizing domestic financial resources. A comparison for 1980 of a standard measure of financial deepening (the ratio of money supply (M3) to GDP) for six Latin American countries and Nigeria, an OPEC nation, revealed that only one country exhibited less financial deepening than Ecuador (Table 1 below). TABLE 1 Indicators of Financial Development in Selected Latin American Countries December 1980 ECUADOR COLOMBIA MEXICO NIGERIA PARAGUAY PERU VENEZUELA M3/GDP (Z) -/ 19.3 30.9 28.2 33.8 21.1 18.4 c/ 44.6 d/ Avg.Inf.,CPI b/ 1975-80 (%) 12.6 24.3 21.2 16.9 14.7 50.5 11.1 Per Capita GNP (US$) 1,100 1,260 1,980 870 1,410 1,080 3,910 Sources: IMF, International Financial Statistics; IBRD, 1983 Atlas; for Ecuador, BCE; for Peru, Banco Central de Reserva, Cuentas Financieras del Peru: 1970-80. a/ GDP for 1980 and 1981 were averaged geometrically to obtain an end-of-year estimate; M3 = M2 + deposit type liabilities of other financial intermediaries. b/ Average annual consumer price index, average annual compound inflation rate 1975-80. c/ Includes foreign currency deposits equal to 5.7% of GDP. Tiy Excludes mortgage banks. 2.06 The poor past performance in resource mobilization is attributable mostly to the reluctance of prior Governments to adjust interest rates in  -9- response to changes in expected inflation. Until 1981, the authorities main- tained interest rates at levels below inflation. Thus, Ecuadorians increas- ingly chose more attractive savings alternatives (foreign financial assets or unregulated extra-bank deposits) over deposits within the Ecuadorian finan- cial system. Since 1981, official interest rates on savings and time deposits have been raised periodically, but, until recently, remained below domestic inflation. As a result, there was little improvement in private domestic resource mobilization. Also, high and variable rates of inflation and fixed interest rates made it impossible for Ecuadorian financial institutirons to make long-term loans without assuming unreasonable risks. 2.07 Government Action. To spur domestic resource mobilization, at the end of 1984 the Government raised official interest rates and introduced large denomination (over one million sucres) Certificates of Deposit (CDs) bearing unregulated interest rates. This brought official deposit rates to about 20-23% p.a. and effective lending rates to about 25-26Z for loans up to 2 years and 26% p.a. for loans over 2 years. CD rates are about 26% p.a. on twelve-month deposits; funds mobilized through such CD's are onlent for a similar term at about 30% p.a. These measures brought official interest rates to positive levels in real terms (inflation was about 14% p.a. for the six months ending December 1985). Moreover, in late August 1985 the Government issued new legislation to allow long-term financial instruments to carry variable rates to be adjusted at frequencies determined by the Monetary Board, and amended the laws governing banks and financieras and the Monetary Law with the purpose of strengthening the financial condition of Ecuadorian financial institutions. 2.08 Future Action Required. The changes in interest rates have begun to have a salutary effect on domestic resource mobilization; during 1985 real deposits in commercial banks rose over 25%, and savings deposits and CDs more than doubled, in real terms. Furthermore, the introduction of variable Interest rates should greatly facilitate long-term lending. However, future action will be needed to allow more automatic adjustment of interest rate levels, especially to reflect changes in the rate of inflation, which oscillated in recent years between 14% and 62% p.a. Moreover, high nominal interest rates present a problem for long-term loans. Traditional repayment methods for such loans result in debt service payments which are concentrated In real terms in the earlier years, imposing liquidity strains on borrowers (Annex 4). During the dialogue on financial policies, the Bank explored the possibility of introducing financial instruments which would provide for partial capitalization of interest. However, the Government believes that such action would be difficult to administer and may be less urgent as its anti-inflation program takes effect. 2.09 Agreements. The Government has agreed to maintain interest rates on all loans to the industrial sector, with maturity exceeding two years, at levels which are positive in real terms, and which, after July 1, 1987, are also adequate relative to deposit rates, as measured by criteria agreed with the Bank. The Government would review with the Bank the adequacy of the level of lending interest rates at least semi-annually beginning October 1,  - 10 - 1986. It would also review semi-annually with the Bank the adequacy of domestic financial resource mobilization, based as well on criteria agreed with the Bank. The adequacy of spreads would also be reviewed on these occasions. If, during any of these reviews after July 1, 1987, the levels of lending interest rates, spreads, or domestic financial resource mobilization were inadequate and the Government and the Bank were unable to agree on remedies for this, then the Bank would have the right to withhold financing of fresh subloan commitments under the proposed loan. C. Past Bank Lending and Strategy 2.10 The proposed loan represents the third Bank operation for SSE development in Ecuador. The Bank has also extended five DFC loans to Ecuador totaling US$155 million, net of cancellations. The first four DFC loans (Loan 721-EC approved December 15, 1970; Loan 930-EC approved June 26, 1973; Loan 1359-EC approved December 28, 1976; and Loan 1731-EC approved June 19, 1979) are completed. The fifth loan (2096-EC), signed April 22, 1982, is fully committed and 92% disbursed. A Completion Report has recently been issued for the third and fourth DFC projects. Its main findings showed that by September 1983, devaluation, recession, reduced consumer demand and public sector investment, all reduced industry's ability to meet debt service payments on projects financed by DFCs. The financial statements of DFCs therefore reflected sharply declining revenues and income. The profitability, liquidity, and financial structures of DFCs weakened as portfolio problems mounted. Their debt/equity ratios rose from under 10 to 1 in 1982 to between 15 to 1 and 25 to 1 for the five major private DFCs by end 1983. The report, therefore, recommended a series of actions to strengthen DFCs, including increasing equity and improving portfolio collection. These are being dealt with under the proposed Industrial Finance Project. 2.11 Regarding SSE loans, the first Bank loan (No. 1879-EC) for USS20 million was approved in June 1980. This loan helped establish FOPINAR and was committed and disbursed one-and-a-half years earlier than expected. A second Bank SSE operation (Loan No. 2221-EC) for USS40 million was approved in December 1982. *The loan helped FOPINAR to consolidate institutionally and expand its operations. Execution of the project has proceeded smoothly and the loan was 95Z committed by end-1985. While a performance audit report has not yet been prepared, the results of the Bank's survey of SSEs discussed in para. 1.09 indicate that substantial benefits have been achieved under these two projects. The average scale of borrowers and FOPINAR subloans have progressively declined and an increasing share of lending has been directed to SSEs in secondary cities and rural areas, outside the main urban centers of Quito and Guayaquil. 2.12 In line with Government objectives, Bank strategy for the industrial sector is to support employment-intensive and export-generating industries, as well as those making efficient use of local resources. The proposed project is designed to further the Government's objectives in the industrial sector, and to support progress on the broader aspects of Bank strategy, aimed at: (i) encouraging resource mobilization and more efficient  - 11 - resource allocation through financial sector reforms; and (ii) improving the industrial and trade policy framework to encourage more efficient industrial production.  - 12 - III. THE PROJECT A. Project Objectives and Arrangements Background 3.01 Given the positive results obtained under the prior two SSE projects -- confirmed by the overall positive results yielded by the survey car;lc4 out by the appraisal mission (para. 1.10) - the Government requested the Bank to process a third operation in time to be effective by early 1986. The projecL was identified by the Bank in October 1984 and was prepared by FOPINAR with the help of Bank staff. It was appraised in December 1984 and negotiated in August 1985 and January 1986. Project Objectives 3.02 The pcoposed Third Small SSE Credit Project would continue with the efforts started by the Bank and the Government under the prior two SSE projects. Its objectives would be to: (a) relieve the scarcity of term financing on reasonable terms to strengthen, expand, diversify, and modernize SSEs; (b) provide medium-term financing for permanent working capital to help reduce current idle capacity in the SSE sector; and (c) continue expanding the institutional capability of FOPINAR, which has satisfactorily carried out two-tier lending operations to SSEs under the prior two Bank SSE projects. Project Description 3.03 Under the proposed project, medium-and long-term Cup to 10 years) loans to SSEs would be provided for the financing of: (a) fixed assets (equipment, machinery,'! and civil works); (b) permanent working capital (the cost of inventories of raw materials, goods in process, and finished goods, as well as accounts receivable,2/ required to increase the level of SSEs output on a permanent basis); and (c) technical assistance required by SSEs to prepare or implement subprojects and to improve their overall productivity. I/ Financing of properly reconditioned equipment and used equipment, whose value, condition, efficiency and useful life would be certified by qualified independent experts, would be allowed under the loan (para. 1.10). 2/ However, for working capital subloans, Bank funds could only be used to finance inventories. FOPINAR would use its own funds to finance accounts receivable.  - 13 - Beneficiaries would be private SSEs involved in manufacturing, agro-industry, fishery, tourism, and related industrial services and marketing activities, with less than: (a) US$350,000 of fixed assets, excluding land, buildings, and the subprojects to be financed; and (b) US$750,000 of total assets, including land, buildings, and the subprojects to be financed. This would correspond normally to firms having less than 25-30 employees before implementing the subprojects3/. A total of 2,100 subprojects are expected to be financed under the project with an average investment of US$45,000. Also, technical assistance financing up to US$200,000 equivalent would be included in the Project, to support FOPINAR's ability to carry ouL sectoral studies (para. 3.14) and purchase of computing equipment to improve FOPINAR's data management handling capabilities (Annex 5). B. Participating Institutions 3.04 Under the proposed project, FOPINAR would continue to make loans as a second-tier institution through the network of qualifying financial intermediaries. Under the prior two projects, a total of 36 financial intermediaries (24 commercial banks, 11 DFCs, and BNF) have signed participation agreements with FOPINAR. Most of them are expected to continue operating under the proposed operation provided they comply with some additional requirements (para. 3.12) to further protect FOPINAR's financial condition. Fondo de Fomento Para la Pequena Industria y Artesania (FOPINAR) 3.05 CFN and the Establishment of FOPINAR. Under the First Small Scale Enterprise Credit Project, FOPINAR was established within the Corporacion Financiera Nacional (CFN) as a permanent second tier financial institution with its own staff, financial resources and separate accounts. Established in 1960, CFN is the oldest and largest Financiera in Ecuador and the major provider of medium- and long-term credit to the industrial sector. CFN is wholly Government-owned. Although its policies and operations must be in accordance with the development plans of the Government, CFN is relatively autonomous in its day-to-day operations. At the end of 1984 CFN's total assets amounted to SI. 20.0 billion, with equity of SI. 3.3 billion. The latest available audited financial statements (1983) show that CFN's financial condition had deteriorated mainly due to: (i) low profitability of its equity investments in state enterprises (e.g., sugar, cement); (ii) increased non-earning assets due to the effect of the sucretization program (Annex 3); (iii) delays in Government reimbursements to CFN on account of foreign exchange losses agreed to be assumed by the Government; and (iv) the 3/ Under the prior two projects, the definition under (a) above was utilized and will still be used for continuity purposes. However, as the objective of FOPINAR is not to finance very large projects, even for enterprises which were initially small, the second limit under (b) above will be added under the proposed operation.  - 14 - overall deterioration of its non-FOPINAR industrial loan portfolio principally due to the economic recession. CFN's profitability in 1984 amounted only to 0.52 on average earning assets, equivalent to 3Z on average equity which compares quite unfavorably with inflation (23% during the year). Recently, however, the Government and CFN took a number of steps to strengthen CFN financially and institutionally. CFN reorganized its loan administration efforts and established units responsible for collection and for restructuring problem companies. As a result, loan recoveries have improved and a number of companies have been restructured. Moreover, in December 1985, the Government took steps to increase effectively CFN's capital by some US$40 million equivalent. Finally, CFN has taken steps to sell a number of its equity holdings. These steps should greatly Improve the financial structure of CFN and substantially ameliorate its recent liquidity problems. Under the proposed Industrial Finance Project, the Government and CFN have agreed to implement a plan of action to improve further CFN's financial condition and efficiency. For the proposed SSE project, CFN's financial condition would not have a major impact on FOPINAR, given the latter's independent status. In practice, as described in the following paragraphs, FOPINAR has been working effectively as a separate institution, with separate accounts and staff, and has gained the confidence of the financial intermediaries and the SSE community. 3.06 CFN had been authorized under its Organic Law of 1962 to discount loans made by financial intermediaries to small industry. The establishment of FOPINAR required no changes in CFN's Charter and was accomplished in May 1980 by CFN'S Board of Directors approving a Statement of Policies and a Statement of Operating Procedures for FOPINAR. FOPINAR was established in CFN's Quito headquarters within the Development Department.4/ Subsequently, FOPINAR offices have been opened in 5 other cities (Guayaquil, Cuenca, Machala, Manta, and Ambato) and have worked under the supervision of CFN managers in those cities. 3.07 FOPINAR Plans for Strengthening Management and Administration. FOPINAR's management has been quite capable and strives to continue improving efficiency over the medium-term. One area requiring strengthening is the interaction between staff of headquarters and other offices. Also, project supervision and other activities need to be brought up to the level of efficiency that has been achieved in project evaluation. To deal with these matters, FOPINAR has modified its Policy Statement to: (i) include guidelines describing responsibilities and procedures to be followed outside headquarters both by FOPINAR and other CFN staff; and (ii) provide for broadening the focus of its activities so that an increased share of staff time would be devoted to project follow-up and technical assistance. In its program, FOPINAR's management has also agreed with the Bank to gradually increase its staff in view of the increased number of envisaged operations. 4/ The Departamento de Desarrollo (CFN's lending department) also operates special export credit facilities (FOPEX) and the Industrial Loan Division.  - 15 - As a result of such a plan, FOPINAR would increase its staff from 22.3 person-years in 1984 to 32.3 by year-end 1986 (Annex 6, Tables 1-4) and staff distribution by activity and region are expected to end up significantly more balanced (Annex 7, Charts 1 and 2). Furthermore, FOPINAR would acquire low-cost micro-computing equipment to be financed under the Technical Assistance allocation of the proposed project, to upgrade its data handling capabilities. Based on steady gains over the past four years, current productivity levels are expected to be maintained and possibly further improved in spite of staff increases. FOPINAR's average administrative costs on outstanding portfolio are expected to reach a low of 1.2% by year-end 1986, which compares favorably with 4.6Z in 1981 (its first year of operation), 2.3% in 1982, 1.6% in 1983, and 1.3% in 1984. 3.08 Lending Volumes. FOPINAR has shown an impressive disbursements growth record (Annex 8). In spite of the recession in the 1981-84 period, FOPINAR disbursements have increased in real terms at 18% p.a. (50% p.a. in nominal terms compared to average inflation of 27Z p.a. in the period) well above the average growth of lending of other credit programs in Ecuador. While FOPINAR's rate has been quite attractive (it has been negative in real terms) it has been in line with other rates in the system. The strength of the demand for FOPINAR funds is explained mostly by the above-average financial condition of SSEs mainly due to their low overall indebtedness, which has made it attractive for financial intermediaries to lend to them. The strength of the demand is also due to the fact that only a small proportion of all SSEs have accessed FOPINAR and that FOPINAR's market is still far from saturation. Increased resources would continue to be required to satisfy SSE needs over the next few years. FOPINAR disbursements are expected to increase in real terms at 15% in 1985, 12% in 1986, and 10% in 1987 and 1988, ranging from US$15.2 million in 1985, to US$24 million in 1988 (Annex 9, pages 1 and 2). 3.09 FOPINAR Financial Condition. FOPINAR's financial performance has been quite satisfactory and has allowed it to maintain a sound financial position since its inception in 1981. As of December 31, 1984, FOPINAR's capital structure was adequate (Debt/Equity ratio of 4.2:1) and its liquidity satisfactory (with a very high current ratio of 5:1 due to almost non-existing short-term liabilities). However, on account of unexpectedly strong demand for FOPINAR funds in 1985, FOPINAR's liquidity stood only at about US$2 million equivalent at the end of the year instead of about US$5 million equivalent which had been forecast during appraisal. As a result, FOPINAR was contemplating resorting to Central Bank credit lines as bridge financing to continue financing its operations before effectiveness of the proposed Bank loan. FOPINAR has also had a satisfactory cost structure. In 1984, for example, its total revenue amounted to 15.9% of the average outstanding portfolio (compared to financial costs of 9.1Z), which left an adequate financial spread of 6.8%. Since FOPINAR's administrative costs amounted to only 1.3% of outstanding portfolio, its profit amounted to 5.5Z, equivalent to 24% on FOPINAR's equity, well above the average for Ecuadorian financial institutions.  - 16 - 3.10 FOPINAR's financial projections show that its financial condition and performance would be maintained at satisfactory levels over the next few years (Annex 9). For year-end 1988, when most of the proposed loan should be disbursed, FOPINAR would continue to have an adequate capital structure (Debt-to-Equity ratio of 6.5:1) and liquidity. The probability of realizing these projections would be enhanced with an early implementation of the Government's new interest rate policy (paras. 2.07 and 2.09), especially because of the variable and positive-in-real-terms interest features. 3.11 Collections and Portfolio Quality. FOPINAR's collection record has been impressive since the beginning of its operations. As of December 31, 1984, only 2% of the FOPINAR -financed portion of the portfolios of participating financial institutions was in arrears, which compares quite favorably with an average 202 for the overall portfolio of Ecuadorian financial institutions. While no statistics on affected portfolio are available in Ecuador, the surveyed SSEs showed that as of December 1984, about 7.3Z of FOPINAR's portfolio was affected by arrears over 60 days, which seems tolerable.5/ Moreover, the risk to FOPINAR would be smaller than suggested by suc