Ecuador - Third Small Scale Enterprise Credit Project

Document of The World Bank FOR OMCIAL USE ONLY L&. SC6>3-J.C Reprt No. P-4110-EC 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$30 MILLION TO THE REPUBLIC OF ECUADOR FOR A THIRD SMALL SCALE ENTERPRISE CREDIT PROJECT March 3, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  --..ECT EQUInVALENS Currency Unit: Sucre (S/.) October 1985 December 1985 February 1986 (Average Multiple Rates) (Unified Rate) (Unified rate) US$1 = S/.82 = S/.97 = S/.110 S/.1 = Us$.01 = US$.O1 = US$.009 S/.100 = US$12.19 = US$10.30 = US$9.09 FISCAL YEAR January 1 to December 31 ABBREVIATIONS BCE - Banco Central del Ecuador (Central Bank of Ecuador) BNF - Banco Nacional de Fomento (National Development Bank) CENAPIA - Centro Nacional para la Promocion de la Pequena Indtistria y Artesania (National Center for Promotion of Small-Scale Industry and Artisans) CFN - Corporacion Financiera Iacional (National Finance Corporation, a State-owned development finance company) DFC - Development Finance Company FOPINAR - Fondo de Fomento para la Pequena Industria y la Artesania (Development Fund for SSEs and Artisans) MICEI - Ministerio de Industrias, Comercio e Integracion (Ministry of Industry, Commerce and Integration) SECAP - Servicio Ecuatoriano de Capacitacion Profesional (Professional Training Service) SSE - Small-Scale Enterprise IDB - Inter-American Development Bank USAID - United States Agency for International Development  FOR OMCAL USE ONLY ECUADOR T,D SMALL-SCALsE Q RDIT PROJECT LOAN AND PROJECT SUMMARY Borrower: Republic of Ecuador Dmenficiarieu: 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. Ternm: Repayable over 17 years on a fixed amortization schedule, including 4 years of grace, at the Bank's standard varia- ble interest rate and charges. Relending Term:. 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 1 percent p.a. and a variable foreign exchange risk fee. CFN would onlend about US$29.8 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 percent p.a., plus a 1 percent one-time commitment fee for its subloans. Financial intermediaries would receive a fee of 4-5 percent 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 employ- ment-intensive and efficient industrial development, and to encourage financial and industrial sector policy reforms. It would continue Bank support to the Govern- ment of Ecuador to develop further the SSE sector. To achieve these objectives, resources totaling US$58.6 mil- lion 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 US$0.2 million from the proposed loan to carry out studies related to the economics and technical assistance needs of the SSE sector. This document has a restricted distributon and may be wed by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorintion.  - II - Denefits: The project would promote SSE development at the regional level. It would help create about 18,000 new jobs, principally outside the major urban centers of Quito and Guayaquil. Further benefits would result from the asso- ciated dialogue with the Government on resource mobiliza- tion, interest rates, and industrial policy issues. Risks: Possible changes in FOPINAR's management could pose some future risks to efficient project execution. Assurances have, therefore, been obtained under the project that FOPINAR would continue to be managed soundly. Also, depending on the rate of economic recovery in Ecuador and the potential negative short-term impact of Import liberalization and interest rate reforms, demad for project resources could slacken. However, even if loan disbursements slowed somewhat, the project would remain viable. BEtimated Costs: Local oeign Total ~-( US$ million) - Investment Projects 51.6 42.2 93.8 Technical Assistance to FOPINAR 0.0 0.2 0.2 Total Project Costs Xl 51.6 42.4 94.0 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 f/ The tax content of the project would be approximately US$8.5 million (9 percent).  - iii - lEstiated Disburaemuts: 1986 1987 1988 1989 1990 1991 1992 US$ 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 Return: The minimum rate for subprojects would be 12 percent. Staff Appraisal Report: Report No. 5546-EC dated March 3, 1986.  INTERNATIONAL BANK FOR REWONSCIBIION AND DEVELPlENT REPORT ND CONDON OF TUE PRESIDNT OF TOE IBRD To TER ENCUIVE DiRECTORS O A PROPOSED LOAN TO THE REPUBLIC OF ECJANOR FOR A THERD SAL-SCALE ENTERPRISE CEIT PRJEVT 1. I submit the following report and recommendation on a proposed loan to the Republic of Ecuador for US$30 million equivalent to help finance a Third Small-Scale Enterprise Credit Project. The loan would be repayable over 17 years on a fixed amortization basis, including 4 years of grace, at the Bank's standard variable interest rate and charges. The Government, through the Central Bank (BCE) as its agent, would onlend the loan proceeds in sucres to the Corporacion Financiera Nacional (CFN) on the same terms as the proposed loan, plus BCE's agency fee of one-eighth of 1 percent p.a. and a variable foreign exchange risk fee. CFN, acting through FOPINAR, would blend the loan proceeds with its own resources, and for 2 fee of 2.5 percent p.a. plus a 1 percent one-time commitment fee, would rediscount these project funds to eligible banks and development finance companies (DFCs), which would onlend to final beneficiaries. Subloans would have a maximum maturity of 10 years and would be made on terms which would take into account the life of assets to be financed and the repayment capacity of sub-borrowers. Subloan interest rates would be variable as determined periodically by the monetary authorities in a manner consistent with criteria agreed with the Bank. Financial intermediaries would receive a fee of 4-5 percent per annum, depending on the term of subloans. The Government would assume the foreign exchange risk on the loan, but would cover such risk from the proceeds of the interest rate charged to final beneficiaries, less intermediation fees and the Bank's interest rate. PART I - THE ECONOMY 2. The most recent economic report on Ecuador, Report No. 5676-EC entitled -Ecuador: Public Investment RevieW was distributed to the Execu- tive Directors on December 16, 1985. The subsequent paragraphs reflect the findings of that report as well as those of an earlier general economic memo- randum, Report No. 5094-EC entitled -Ecuador: An Agenda for Recovery and Sustained Growth" distributed on October 5, 1984. Annex I provides the main social and economic indicators. 3. Ecuador entered the 1970s as one of the least developed Latin American countries. In 1967, petroleum was discovered in Ecuador's Amazon region and in 1972 the country became a net oil exporter. In 1973 world oil  - 2 - prices quadrupled and Ecuador's export earnings doubled. During the 1970s, Ecuadorian income and output expanded rapidly, perhaps at a rate unprece- dented in its history. By 1983 per capita GNP had risen to US$1,430, placing Ecuador firmly among the Bank's middle-income borrowers. 4. Between 1960 and 1980, much social progress was made. Life expec- tancy increased by ten years; death and infant mortality rates dropped by more than 40 percent; and school enrollment expanded rapidly. By 1980 virtually all children were attending primary school, and a third of the relevant cohort attended schools of higher education. Today's citizens are better educated, in better health, and better fed than at any other time in Ecuador's history. Nevertheless, because of the low level from which Ecuador started, Ecuador's social indicators lag behind those of other countries with similar levels of per capita income. Moreover, the benefits of growth were not evenly distributed. While a sizeable middle class emerged, about 40 per- cent of the urban and 65 percent of the rural population live in absolute poverty. 5. Highly concentrated ownership of productive resources and unequal access to public services explain much of Ecuador's skewed income distribu- tion. For example, 60 percent of the country's farmers derive their liveli- hood from only 11 percent of the arable land. Their farms are small-less than 5 hectares-and tend to be of the poorest quality. Low levels of educa- tion, primitive cultivation techniques, scarce use of technical inputs, and limited access to credit and to commercial marketing channels contribute to low farm productivity and incomes. But uneven distribution of the oil income also accounts for the disparities in social conditions. Thus, during the 1970s only about a quarter of total public investment was channeled to the rural areas, where 56 percent of the population and most of the poor live. 6. For the years 1982-83, Ecuador not only suffered from declining international oil prices and suspension of commercial bank lending, but also from the ravages of the Nino current which practically wiped out cocoa exports (a major source of foreign exchange), severely damaged the country- side, and forced the country to import foodstuffs. Normally dGmestic produc- tion meets the country's food needs. Per capita income dropped in 1982, and in 1983 it dropped by more than 5 percent, resulting in increased unemploy- ment and severe liquidity problems for Ecuador's financial and industrial sectors. Ecuador has only begun to emerge from this severe recession; real GDP grew by about 3-3.5 percent yearly in 1984-85. The Impact of Petroleum 7. While the immediate causes for Ecuador's economic downturn in 1982 may be traced to falling oil prices and suspension of commercial bank lending, these factors only exacerbated pending problems, as the country had embarked on an unsustainable economic course. After the initial burst of oil exports in 1973, the country's volume of exports remained practically constant; export earnings increased mainly because the international price of oil went up, and the country's income increased because the terms of trade turned sharply in its favor. By 1980, the increased income made available since 1975 by relatively higher export prices was adding 8 percent to Ecuador's yearly income. The increased expenditures of the public sector-  - 3 - through which much of this income passed--were partially responsible for the improvement in the nation's living standards and physical infrastructure, as well as for accelerated industrial production. 8. Unfortunately, this income also had three adverse effects. First, it slackened efforts to collect taxes from the non-oil portion of the eco- nomy. Thus, while petroleum revenues doubled relative to GDP between 1973 and 1983. non-oil taxes, including social security contributions, fell from 17 percent of GDP in 1973 to 10 percent in 1982, and total revenues, relative to GDP, stagnated. 9. Second, because oil taxes were painless for the Ecuadorian con- sumer, there was an incentive to earmark them for various subsidies--imports, housing, roads, and education--and to keep domestic petroleum product prices frozen at the 1972 level. By 1980, the Ecuadorian consumer was paying only US$0.10 for a gallon of gasoline. The subsidy implicit in the difference between world prices and domestic prices was equivalenc to about 8 percent of 1980 GDP. 10. Third, the abundance of revenues and their ease of collection diminished incentives to control the growth of public expenditures. Current expenditures went up from 16 percent of GDP in 1973 to 24 percent in 1982. Public sector savings decreased to such an extent that the public sector sur- plus of 1973 (equivalent to 3 percent of GDP) became a deficit equivalent to 8 percent of GDP by 1982. Because of its status as an oil exporter, Ecuador was able to finance this deficit abroad with ease, but at a price. The public external debt more than doubled between end-1979 and end-1983; econo- mic adjustment was deferred until Ecuador found its access to foreign funds severely limited. The abundance of oil income also affected Ecuador's exchange rate, allowing it to appreciate in real terms without causing finan- cial problems. This made imports cheaper for Ecuadorian industrialists and consumers, but it also meant that non-oil exports suffered. With the important exception of shrimp, non-oil exports grew slowly in volume after 1974. Like the public sector, the external sector would also have encoun- tered problems after 1980 had it not been for recourse to large external borrowings. 11. Monetary policies complemented both exchange rate and fiscal poli- cies. Negative real interest rates led to a decline of financial savings relative to GDP. But Ecuador's financial system expanded credit rapidly in nominal and real terms, despite poor domestic resource mobilization, because foreign banks provided the Central Bank with increased resources. The external sector, with a fixed exchange rate, gave vent to what otherwise would have been inflationary pressures by increasing the supply of goods to the economy through imports. Heavy external borrowing provided the needed foreign exchange. Financial institutions, like the public and external sec- tors, became in effect dependent on petroleum (through the Central Bank) and ultimately on external borrowing, through guarantees they provided their clients on foreign loans. They too encountered severe problems when, in 1982, petroleum receipts stagnated and Ecuador's access to external funds became severely limited. Recent Events 12. During 1981/82, the terms of trade turned against Ecuador as oil prices began to decline. Export earnings fell by about 8 percent in 1982. Despite a reduced volume of imports, the current account deficit of the  - 4 - balance of payments exceeded US$1 billion, about 9 percent of GDP. To finance it, the authorities borrowed short-term and used up about US$460 mil- lion of the country's international reserves, almost depleting them in the process. When the economic downturn worsened in 1983, Ecuador had to manage with severely limited financial resources as foreign banks restricted their net, new lending to US$430 million. To make matters worse, the Nino current's climatic shifts, which had inflicted some damage in 1982, continued to ravage the countryside with floods. 13. The authorities' attempts to deal with the crisis were, for the most part, prompt and in the right direction. First, they dealt with the exchange rate. In 1982, the sucre was devalued for the first time since 1970 and thereafter was adjusted frequently. It now stands at a rate which is as attractive for exporters as it was in 1970, before the oil boom allowed it to appreciate. Second, they dealt with the liquidity crisis by temporarily pro- hibiting or limiting many imports and renegotiating principal on the external private and public debt. Negotiations with the commercial banks for a multi- year rescheduling covering maturities falling due in 1985-1989 were concluded in December 1985; a Paris Club agreement was reached in April 1985 to resche- dule official debt falling due between 1985-1987. Temporary import restric- tions were eliminated as the liquidity of the Central Bank improved. 14. A fiscal austerity program was put in place in 1983 in cooperation with the IMF. The public sector deficit was reduced from about 8 percent of GDP in 1982 to about 1.4 percent in 1983 and virtually eliminated in 1984. Ecuador also compliet with the rest of the IMF program. Partly as a result, inflation was more than halved in 1984, to about 23 percent; the balance of payments was practically brought into equilibrium, and growth resumed. An IMF program-a one year SDR 105.5 million stand-by-for 1985/1986 was just completed. Under this program, a public sector surplus equivalent to about 2 percent of GDP for 1985 was achieved by raising revenues and holding down expenditures. The exchange rates of the official and intervention markets were also unified, and inflation, which was about 23 percent for the year, fell to an annualized rate of about 14 percent during the last half of 1985. 15. Also, decisions taken prior to the crisis began to bear fruit. Owing to positive results of exploration efforts undertaken as far back as 1980, and the implementation of a secondary recovery program, oil production and oil exports rose over the past three years. Foreign contracts for conti- nued exploration have been signed. Thus, Ecuador appears to be in a reasonable position to offset pactially the more drastic declines in oil prices that ocurred in early 1986, through further increases in oil produc- tion. Outlook 16. 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 Governmernt'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 appropriate relative prices, including exchange and interest rates and import tariffs. The Government is  also committed 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. 17. 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 official 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 recources and stimulate exports, agricultural production and domestic savings and encourage foreign investment. 18. 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 sound but recommertded that petroleum exploration and production be accelerated, and that no sizeable new projects be begun for a few years. An update of the program, reflecting reduced foreign exchange earnings and fiscal revenues, will be needed.