Ecuador - Industrial Finance Project

Dmnt Of The World Bank FOR OMCIuL USE ONLY Repat No. P-4175-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 USM115.0 MILLION TO THE REPUBLIC OF ECUADOR FOR AN INDUSTRIAL FINANCE 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.  Cszcr .unAL Currency Unit: Sucre (S/.) Calendar 1985 December 1985 February 1986 (Average Multiple Rates) (Unified Rate) (Unified Rate) US$1 - S/.82 - S/.97 - S/.110.O S/. I - US$.O1 - US$ .01 - Us$.009 S/. 1,000 - US$12.19 - US$10.30 - US$9.09 Fnca YmR January 1 to December 31 ABaxvnouNS 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) BNF - Banco Nacional de Fomento (National Development Bank) CFN - Corporacion Financiera Nacional (National Finance Corporation) COFIEC - Compania Ecuatoriana de Desarrollo, S.A. (Ecuadorian Development Company) DFC - Development Finance Company ECUFINSA - Financiera Ecuatoriana de Financiamiento. S.A. (Ecuadorian Financing Company) FINANQUIL - Financiera Guayaquil, S.A. (Guayaquil Finance Company) FINANSA - Compania Financiera Nacional, S.A. (National Finance Company) FINANSUR - Financiera del Sur, S.A. (Southern Finance Company) FINIBER - Financiera Ibero-Americana, S.A. (Ibero-American Finance Company) FOPINAR - Fondo de Fomento para la Pequena Empresa y la Artesania (Development Fund for Small Scale Enterprise and Artisans) GDP - Gross Domestic Product IESS - Instituto Ecuatoriano de Seguridad Social (Ecuadorian Institute of Social Security) IMF - International Monetary Fund MICEI - Ministerio de Industrias, Comercio e Integracion (Ministry of Industry, Commerce and Integration)  FOR OFCIL USE ONLY ECUADOR IDUSTIALnPmU PtoJEcr LOAN AND PROJW= StRAY Borrower: Republic of Ecuador Beneficiaries: Part A: The Government of Ecuador, which will receive foreign exchange to finan_.e essential imports. Part B: Private Ecuadorian manufacturing or agroindustrial enterprises; the Central Bank (BCE); the Superinten- dency of Banks; the Superintendency of Companies; and financial intermediaries. lsount: US$115 million equivalent. Terms: Repayable over 17 years on a fixed amortization schedule, including 4 years of grace, at the Bank's standard variable interest rate and charges. Relending Terms: The Borrower, through its agent, BCE, would onlend US$64.45 million equivalent in sucres from Part B of the loan to eligible financial intermediaries at variable positive real interest rates. Financial intermediaries would onlend these resources to project beneficiaries at the rates established from time to time by the Monetary Board. The intermediaries would receive a spread initially of 5 percent p.a. and BCE would retain a 0.25 percent fee. The revenues from the dif- ference between the Bank's lending rate plus BCE's fee, and the interest rates charged to financial intermediaries, would be used by BCE, as agent, to cover the foreign exchange risk on the Bank loan; however, any shortfall would be made up by the Government, which would assume the foreign exchange risk and pay the commitment fee on the Bank loan. US$0.2 million equivalent from the proposed loan would be made available to the Superintendency of Banks, and US$0.2 million to the Super- intendency of Companies on terms similar to those for sub- loans. US$.05 million would be lent to the Association of Development Banks on commercial terms acceptable to the Bank. US$0.1 million would be made available to BCE as a grant. Project The objectives of the project would be to encourage trade, Description: industrial, and financial policy reforms; promote efficient industrial development; and strengthen regulatory agencies and the analytical capabilities of financial intermediaries. To achieve these objectives, the loan would provide (i) US$50 million equivalent to finance essential imports in support of a series of measures to liberalize trade, industrial, and financial sector policies; (ii) US$64.45 million equivalent to I Thu 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.  - ii - financial intermediaries for onlending to industrial enter- prises to finance fixed assets and permanent working capital; and (iii) US$550,000 to finance programs of technical assist- ance to strengthen the analytical capabilities of the Central Bank and the financial intermediaries, and the regulatory capabilities of the Superintendencies of Banks and Companies. Jbnefits: The project would support recent far-reaching industrial, trade, and financial sector policy reforms which would begin to reorient fundamentally Ecuador's model of industrial development and strengthen the capacity of the financial system to mobilize and allocate domestic resources more effectively. It would also promote development of efficient industrial enterprises. About 90 investment projects creating about 3,400 new jobs would be financed. Further benefits would result from the associated dialogue with the Government on resource mobilization, interest rates, and industrial policies. RiAks: The major risks facing the macroeconomic reforms which the project would support relate to their political sustainability and the maintenance of an attractive exchange rate for export promotion. At the institutional level, some financial inter- mediaries are in a weakened financial condition resulting from the economic difficulties of recent years. In order for these institutions to be eligible to use loan resources, they would have to meet eligibility criteria designed to strengthen their financial structures and performance. To the extent that some of these institutions cannot participate, commitment of Bank funds could be delayed. Moreover, some participating finan- cial intermediaries may again experience financial difficul- ties which could delay subloan repayments. Technical assist- ance included in the project to strengthen regulatory agencies should limit this risk. Also, depending upon the rate of eco- nomic recovery in Ecuador and the potential short-term impact of import liberalization and interest rate reforms, demand for project resources for the credit component could slacken. However, even if loan disbursements slowed somewhat, project benefits arising from individual subprojects and the technical assistance programs should still be realized.  - iii - Estigated Costs Local Foreign Total I(US$ millon)- Estimated Costs: Part A Imports 1/ 50.00 50-00 Part B Investment Projects 33.00 69.34 102.34 Technical Assistance 0.11 0.55 0.66 Total Project Costs 2/ 33.11 119.89 153.00 Financing Plan: Bank - 115.00 115.00 Financial Interme- diaries - 4.89 4.89 Project Beneficiaries 33.00 - 33.00 BCE, Superintendency of Banks, Superintendency of Companies, financial intermediaries 0.11 - 0.11 33.11 119.89 153.00 Estimated Disbursements: 1987 1988 1989 1990 1991 1992 1993 'US$ millions by Bank Fiscal Year) Annual 51.3 10.4 16.3 16.9 11.0 6.5 2.6 Cumulative 51.3 61.7 78.0 94.9 105.9 112.4 115.0 Rate of Return: The minimum rate for subprojects would be 12 percent. Staff Appraisal Report: Report No. 5874-EC dated March 3, 1986. ! The US$50 million included in this project represents about 2.5 percent of Ecuador's projected 1986 imports. The Bank and the Government are beginning discussions which could lead to cofinancing being sought in the context of this project. 2/ The tax content of the project would be approximately US$9.2 million (9 percent of the cost of investments).  INTRNAIO&LMMN POR RECOU1STZUCTIOE AND N LKVU.ONE REPORT AND RE0jIIENDATION OF TUE PRESIDENT OF THE IRaD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF ECWADO PFOR A INDUSTRIAL FINANCE PROJE 1. *I submit the following report and recommendation on a proposed loan to the Republic of Ecuador for US$115 million equivalent to help finance an Industrial Finance Project. The loan would be repayable over 17 years on a fixed amortization basis, including four years of grace, at the Bank's standard variable interest rate and charges. The Government, would provide its agent, the Central Bank (BCE), with US$50 million equivalent from the loan for the purchase of essential imports. Additionally, the Government, through BCE would onlend US$64.45 million equivalent in Sucres from the loan to eligible participating financial intermediaries to finance subloans bearing variable positive real interest rates to be determined periodically by the Monetary Board, consistent with criteria agreed with the Bank. BCE would retain a fee of 0.25 percent p.a. of subloan amounts. Financial inter- mediaries would onlend these resources to project beneficiaries at the rates established by the Monetary Board. The intermediaries would receive a spread initially of 5 percent p.a. Subloans would have a maximum maturity of.12 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. The remaining US$0.55 million of the loan would finance project-related technical assistance. 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 financial intermediaries, less BCE's fee and the Bank's interest rate. PART I - THE ECONOMY 1/ 2. The most recent economic report on Ecuador, Report No. 5676-EC entitled -Ecuador: Public Investment RevIev 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 Ecuado:: 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 1/ Part I is substantially the same as Part I in Report No. P-4110-EC of March 3, 1986.  -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 domestic 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 lend- ing, 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 equivalent 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 c: 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.  -4- Rei.t 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 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 complied 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 EIMF 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 officia'l 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 partially 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 Government's economic philosophy essentially supports the market as an efficient resource allocation mecharism, 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 invest- ment and subscribed to several investment guarantee schemes, including HIGA. 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. 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 sec- tor. Despite the recent sharp drop in oil prices, the oil sector will con- tinue 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 sdpport further reccvery 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 recom mended 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. 19. 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 (see Annex I) 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,  -6- the Bank, and the IMP 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. PART II - RAW( GROUP OPERATIONS IN EWCADOR 2/ 20. Bank Group operations in Ecuador date back to 1954 when a loan was made for a first highway project. Including the recently signed Agriculture Sector and Public Sector Management Loans, the Bank and IDA have extended 34 loans and 6 credits to Ecuador totalling US$733.6 million net of cancella- tions. As of September 30, 1985, US$455.3 million of this amount had been disbursed. The IFC has invested in five firms in Ecuador, including a large textile company, a sugar mill, a cement company, a mining enterprise and a development finance company. As of September 30, 1985, commitments for these operations amounted to US$28 million, of which IFC held US$6.7 million. Annex II contains a summary statement of Bank loans, IDA credits and IFC operations as of September 30, 1985. 21. Execution of Bank Group financed projects has often been hampered by weaknesses in Ecuador's implementation capacity, reflecting the insuffi- ciency of the country's public sector managerial and technical resources-a constraint that is still a serious obstacle to Ecuador's economic and social development. In recent years, the Government and Bank staff have worked together to step up disbursement of Bank loans. Among other initiatives, a Special Action Program for the country provided for revolving funds in five projects. As a result of these general efforts, disbursements rose from US$26 million in FY83 to US$42 million in FY85. The country has set up a monitoring committee for all externally financed projects which should rein- force efforts to accelerate disbursements. The Bank plans annual portfolio implementation reviews to detect and resolve specific obstacles to execution of Bank-financed projects; the first took place in November 1985. 22. Baik and IDA lending in Ecuador was originally concentrated in transport and power, where there were substantial bottlenecks to be over- come. To date, approximately 26 percent of Bank Group lending has been for infrastructure. Seven of the nine loans and credits extended for transport were to improve the country's road network and two were to help finance the expansion of the port of Guayaquil. Three power operations aimed at improving generation and distribution facilities in Quito. The first live- stock development loan, approved in FY67, marked the beginning of a diversi- fication in the Bank Group's lending program away from infrastructure. Since then, the Bank Group has made ten other loans and credits for agriculture and fisheries, seven loans to support industrial development, and two for pre- investment studies. These productive sector loans comprise 58 percent of 2/ Part II is substantially the same as Part II in Report No. P-4110-EC of March 3, 1986.  -7- total Bank lending to Ecuador. Bank Group support for social sectors-educa- tion, water supply and urban development--now accounts for about 16 percent of total Bank lending. 23. Turning to the future, the Bank strategy is to support, in close cooperation with the IMF, Government initiatives in macroeconomic and sector reforms over the medium term. This will be achieved through a series of sec- tor and project loans aimed principally at supporting policy improvements in energy, agriculture, and industry, and developing social and economic infras- tructure. In addition to the design and adoption of adequate sector poli- cies, Bank lending will emphasize the generation of exports and employment. Besides the Industrial Finance Project recommended in this report, for the near term the Bank is preparing small-scale industry, power engineering, agricultural credit, and water supply operations. In addition to Bank lend- ing, the IFC is analyzing several possible operations in agribusiness, fisheries, petroleum refining, hotels and merchant banking. 24. Substantial development financing has also been provided to Ecuador by the Inter-American Development Bank (IDB), the US Agency for International Development (USAID) and, to a lesser extent, by other bilateral sources. IDB nas been the single largest lender to Ecuador. Loans outstanding (including undisbursed) from IDB to the ccuntry as of December 31, 1985, totalled about US$1.2 billion equivalent. Past IDB lending has been concentrated in the power, agriculture, industry and transport fields. Most of IDB's loans to the country have come from the Fund for Special Onerations and normally carry concessional terms. It is likely that IDB will remain Ecuador's major devel- opment lender in the immediate future with power, agriculture and socially- oriented projects continuing to account for a large share of its lending pro- gram. By December 1985, USAID had about US$158 million in outstanding loans to Ecuador (including undisbursed). Its program concentrates on urban devel- opment, agriculture, health and the private sector. In addition to maintain- ing close contact with USAID, IDB and other aid agencies to assure compatibi- lity of programs, Bank staff have undertaken a full public sector investment review which could serve as the basis for a Consultative Group Meeting of Ecuador's creditors, possibly by end-1986. 25. As of December 31, 1984, the public and publicly-guaranteed medium- and long-term external debt of Ecuador (including undisbursed) totaled about US$7.7 billion, of which US$1.1 bilJ4on was undisbursed. Of the former sum, the Bank group was owed 4.2 percent; the IDB 12.2 percent and USAID 1.3 per- cent. Through 1988, the IBRD share of Ecuador's outstanding and disbursed public foreign debt is expected to remain below 7 percent, and the IBRD share of total public foreign debt service Is projected to remain about 5 percent. PART IIZ - THE MANUFACTURING AND FINANCIAL SECURS 26. In recent years the Bank has been associated with extensive indus- trial and financial sector work in Ecuador. This has included (i) a 1982 study of ways to reduce overall effective protection in the industrial sector; (ii) a study undertaken under the Fifth Development Banking Project (Loan No. 2096-EC) of the industrial incentives system; (iii) a recently con-  - 8 - cluded Bank review of the financial sector; and (iv) recent discussions with the Government on trade, Industrial, and financial policies. As a result of these efforts, an understanding of the major policy issues affecting the industrial and financial sectors has been obtained and discussed with the Government. This has formed the basis for measures which have or are to be taken on trade and financial sector reforms, some of the most important of which are being supported by the proposed loan. A. The Haufacturing Sector Structure and Growth of Manufacturing 27. Manufacturing remains at an early 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 accounted for about 18 percent of GDP in recent years, and in 1983 employed about 320,000 workers (11 percent of the work force). During the economic expansion from 1972 to 1982, manufacturing was Ecuador's leading growth sector, expanding at an average annual real rate of 9.5 percent. How- ever, the growth of manufacturing value added fell from 6.9 percent in 1982 to a negative 1.9 percent in 1983, reflecting the impact of economic reces- sion, severe shortages of raw materials resulting from import restrictions and poor weather conditions, and the lack of foreign as well as domestic cre- dit. As the economic recession continued, manufacturing value added con- tinued to decline by about 2 percent in 1984. Preliminary estimates for 1985, however, indicate that manufacturing activities grew at a rate of about 2.5 percent. As a result, it is expected that capacity utilization (which averaged about 65 percent in 1984) as well as investment in fixed assets will increase. The manufacturing sector's contribution to exports has been minimal during the past decade. Excluding processed foodstuffs, shrimp, and fuel oil, manufactured exports never amounted to even 5 percent of total exports (or 15 percent of non-petroleum exports). This situation, which is largely due to the anti-export bias of the import substituting policies adopted by the country, has worsened since 1983, owing to the closure of the Andean Market-Ecuador's major market for manufactured exports-and Ecuador's failure to penetrate new ones. 28. More than 80 percent of manufacturing employment and of manufac- turing value added is generated by firms located in Guayaquil and Quito. Firms in the Guayaquil area account for the major shares of food, paper, and chemical industries, while firms in the Quito area concentrate on textiles, wood products, metal products, machinery and equipment. Lack of appropriate infrastructure for industrial development in the rest of the country has apparently prevented a wider geographical location of industry, offsetting the impact of Government incentives aimed at encouraging industrial growth away from the country's traditional growth centers. 29. Manufacturing industry is also characterized by a small, modern oligopolistic segment of import substituting industries that has been super- imposed on a largely traditional sector where small firms prevail. In most  industries less than four firms control between 50 and 95 percent of the domestic market. This structure is largely the result of the administration and implementation of the Industrial Incentive Law, which induced investors to over-dimension their plants as a way to prevent the entry of competitors, since the existence of idle installed capacity could prevent the granting of incentives to new firms. To help remedy this and other problems, new regula- tions were issued by the current Administration in January 1985 (para. 35). 30. Prospects for sustained manufacturing output growth are dim if they continue to depend entirely upon the expansion of domestic demand. The current efforts of the Government to overcome the recent balance of payments crisis and inflation call for a restrictive domestic credit policy, which in turn will reduce the impact of domestic demand expansion as a source of growth in the short-term. Export expansion and more efficient import substi- tution would have to provide the basis for new sources of growth. Thus, industrial prospects will depend on the speed with which past policies can be reformulated to assure the increased efficiency of industry and competitive- ness of manufacturing exports. Industrial Policy Framework 31. Current industrial incentives were established by the 1957 Law of Industrial Incentives; they are also influenced by trade and foreign exchange policies. The core of the law emphasizes the development of import-substitu- tion industries. Trade policies have provided high tariffs for final con- sumer goods and low tariffs for raw materials, intermediate, and capital goods. Protection from imports has also been provided through numerous quan- titative restrictions, import prohibitions and prior authorizations for imports. This policy framework, and, until 1982, the fixed exchange rate for inputs and machinery imports, provided high effective protection to domestic industry, encouraged capital-intensive industries, and hindered the develop- ment of export-oriented activities. Thus, the high levels of protection granted to industry encouraged the establishment of enterprises that do not take advantage of the country's natural resource endowment and that are eco- nomically inefficient. Recent World Bank estimates indicate that the cost to the country of creating one job in the protected electric appliances and plumbing fixtures subsectors may be as high as five times the comparable cost to the country of creating one job in export activities, such as plywood pro- duction. These estimates--which indicate that for every job created making electrical appliances, four workers remained potentially unemployed--illus- trate the burden imposed upon Ecuador's work force by high protection. 32. The Administration, however, has begun formulating a new industrial development strategy aimed at fostering export expansion, more efficient import substitution, and more intensive use of domestic resources. Accord- ingly, important positive policy decisions have been taken in the areas of industrial and trade policies and some major measures already have been implemented. It is one of the objectives of the proposed project to provide resources to support the Government in dealing with the impact of these measures on the economy. The Government's program is described in the following paragraphs.  - 10 - Unification of the Foreign rExcbange Market 33. Between 1970 and early 1980, the official exchange rate appreciated by 40-48 percent. This, combined with the multiple exchange rate system which prevailed during that period, introduced major distortions in the allo- cation of industrial resources, systematically reducing the competitiveness of Ecuadorian exports and encouraging the development of inefficient import- substitution industries. Until September 1984, when all non-oil exports and most imports were transferred from the official foreign exchange market (where the rate of exchange was 67 sucres/US$) to the 'intervened foreign exchange market (where the rate was 97 sucres/US$), manufactured exports were discriminated against, as only limited access to the higher 'intervened- rate was permitted for export earnings. Import substituting industries however, not only benefitted from high protection granted through quantitative restrictions, but also from access to the official rate to pay for imports of inputs and machinery, and from the additional protection granted by the premium on foreign exchange in the 'intervened' market. 34. The unification of the official and -intervened- foreign exchange markets, formally completed in November 1985, represents a major step in eliminating these basic distortions hindering a healthier industrial sector. Regulations of the Industrial Incentive Law 35. In an effort to streamline industrial incentives and encourage manufacturing exports, more intensive use of domestic resources and better use of installed capacity, new regulations for the Industrial Incentive Law were issued in January 1985. Major reforms included: (i) granting of tax benefits based on export performance; (ii) reductions of income tax exonera- tions, especially for sectors with excess capacity, thereby eliminating a major inducement for the current oligopolistic structure of the manufacturing sector; (iii) introduction of progressive reduction and time limitations on tariff exonerations for raw materials and intermediate products; a maximum period of 4 years for existing enterprises, and of 10 years for new enter- prises, has been established. Under previous regulations, no reductions in tariff exonerations over time were required and, although the maximum period for obtaining benefits from the Industrial Incentive Law was 15 years, in practice, enterprises benefitted for indefinite periods, as these benefits were renewed automatically upon their expiration. Ellination of Quantitative Restrictions 36. In order to eliminate basic distortions in the allocation of resources caused by quantitative restrictions, the Government has begun sub- stituting tariffs for such restrictions. The first step was completed in March 1985, when import prohibitions that had been introduced in 1982, and which amounted to about 16 percent of 1981 imports, were eliminated. The Government is planning to remove the remaining import prohibitions and replace them with tariffs. The first step, which removed about 20 percent of the remaining import prohibitions, was implemented in January 1986. Further- more, the Government has begun to reduce the number of industrial inputs sub- ject to prior authorization for import, by lifting import licensing require- ments for about 50 items in February 1986.  - 11 - Revised Tariff Structure 37. Until recently, major characteristics of the import tariff struc- ture were: high dispersion, which discriminated against many types of manu- facturing activities, thereby hindering efficient resource allocation; and high tariff levels on manufactured products, which encouraged production for the domestic market and discouraged exports. It also attracted resources to manufacturing, thereby discriminating against agricultural production, and increasing the cost of some manufactured inputs used in the agricultural sec- tor. In a first major step to lessen these deficiencies, a revised tariff structure was adopted by the Government in January 1986. Import tariff peaks were reduced from a maximum (including all surcharges) of 220 percent to 100 percent, 3/ and tariff dispersion was reduced so that over 75 percent of commodities now have tariffs of 70 percent or less. Based on these data, average tariffs and tariff dispersion have been reduced for all tariff cate- gories by about 30 percent and 50 percent respectively. The reductions in nominal tariff levels on final products, together with the progressive reduc- tion of tariff exonerations on imported inputs and raw materials (para. 35), should reduce recent levels of effective protection significantly. Prelimi- nary estimates indicate, for example, that effective protection for some textile products should decline from 120 percent to about 70 percent, and for footwear products from over 200 percent to less than 100 percent. 38. The Government plans to continue revising tariff levels in order to lessen the anti-export bias introduced by tariffs for which exporters are not adequately compensated, and to improve the internal terms of trade, particu- larly between the industrial and agricultural sectors. A unit to be esta- blished in the Central Bank to estimate and monitor shadow prices under the proposed loan will also monitor, in coordination with the Agricultural Policy Analysis Group to be financed under the recently approved Agricultural Sector loan, changes in internal terms of trade and effective protection. The unit would also propose further imoort tariff reforms. B. The Financial Sector Institutional Structure and Development 39. 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 corpora- tions, 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 3/ Except for tariff levels of a few items, which were under import prohibitions between 1982 and March 1985. These import prohibitions were initiully replaced by tariff levels of up to 250 percent. The new tariff for these items ranges up to 125 percent, including surcharges.  - 12 - financial savings. As a group, commercial banks dominate Ecuador's financial system, and their outstanding loan portfolio represents 75 percent of total lending to non-bank borrowers. 40. Policy-making agencies are the Honetary Board, BCE, and the Super- intendency of Banks. The Monetary Board sets exchange rate, interest rate, and other financial policies which are implemented by the BCE and the Super- intendency of Banks. BCE also provides credit to financial intermediaries, including special discount credit lines. The Superintendency of Banks supervises financial intermediaries and is responsible for publishing statis- tical information on the Danking system. 41. The 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 wanted 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), includ- ing one that provides medium-term loans to Small-Scale Enterprises. The Funds financed by domestic resources grant mostly short-term credit with a maximum term of two years, and interest rates to final borrowers that are among the lowest available. 42. The financial system grew rapidly in the 1970s, mainly because bank ownership granted access to profitable BCE credit lines and because guaran- tees for foreign loans to the private sector grew rapidly and appeared pro- fitable. Additionally, negative real interest rates charged to final borrowers, and attractive margins and commissions provided to intermediaries, stimulated lending growth. However, such a 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 fragi'le because easy granting of bank licenses led to the establishment of many small, inefficient and undercapitalized 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 liqui- dity problems beginning in 1983 as foreign resources dwindled and economic conditions deteriorated. Combined with the devaluation of the sucre, these factors diminished the ability of borrowers to meet dollar-denominated obligations guaranteed by the banks. To help financial intermediaries, the Government carried out a 'sucretization- program under which BCE assumed foreign debts and the participating institutions became obligated to repay BCE in sucres over a period of up to seven years. While this program enabled the immediate liquidity crisis to be managed, one of its legacies was that BCE credit in 1983 financed about 35 percent of the commercial banks' and up to 60 percent of finance companies' portfolios. Interest Rate Policy and Resource Nobilization 43. Official interest rates are established periodically by the Mone- tary Board. Judged by international standards, Ecuador has in the past been quite unsuccessful in mobilizing domestic financial resources. A comparison for 1980 of a standard measure of financial deepening (the ratio of money supply (H3) to GDP) for six Latin American countries and Nigeria, an OPEC nation, revealed that only one country exhibited less financial deepening than Ecuador.  - 13 - 44. The poor past performance in resource mobilization is attributable mostly to the reluctance of prior Governments to adjust interest rates in response to changes in expected inflation. Until 1981, the authorities maintained interest rates at levels below inflation. Thus, Ecuadorians increasingly chose more attractive savings alternatives (foreign financial assets or unregulated inter-company financial market assets) over deposits within the Ecuadorian financial system. Since 1981, official interest rates on savings and time deposits were 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 finan- cial institutions to make long-term loans without assuming unreasonable risks. 45. 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 nominal official deposit rates to about 20-23 percent p.a. and effective lending rates to about 25-26 percent p.a. for loans up to two years, and 26 percent p.a. for loans over two years. CD rates are about 26 percent on twelve-month deposits; funds mobilized through such CDs are onlent for a similar term at about 30 percent p.a. These mea- sures brought official interest rates to positive levels in real terms (inflation was about 14 percent 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 as outlined in para. 47 below with the purpose of strengthening the financial condition of Ecuadorian financial institutions. 46. 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 percent 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 percent and 62 percent 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. During the dialogue on financial policies, the Bank explored the possibility of introducing financial instruments which would provide for partial capitaliza- tion 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. Recent Legal Reforms 47. With the purpose of strengthening the financial condition of Ecuadorian financial institutions, amendments were issued in August 1985 to the laws governing financieras and banks, and to the Monetary Law. In addi- tion to permitting variable interest rates on loans of more than two years  - 14 - term, these amendments included: (i) shortening of the minimum term of cer- tificates of deposit issued by financieras from 270 days to 90 days, which they may now repurchase prior to maturity, and permitting the Monetary Board to revise these terms from time to time; (ii) establishing that total liabi- lities of financial institutions cannot exceed 15 times paid-in capital and reserves; (iii) requiring that the loans of any financial institution to any one person cannot exceed 25 percent of the institution's paid-in capital and reserves (there are several important exceptions to this exposure limit, including credits resulting from the sucretization, and credits of less than 180 days covered by adequate guarantees used to finance exports); (iv) requiring financial institutions to establish a reserve for bad debts equal to 10 percent of all accounts receivable; and (v) expanding the powers of the oaperintendency of Banks as a supervisory agency. Past Bank Lending and Strategy in Industrial and Financial Sectors 48. The Bank has provided five loans for development finance companies in Ecuador. These loans total 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 percent disbursed. A Com- pletion Report has recently been issued for the third and fourth DFC pro- jects. Its main findings showed that by September 1983, devaluation, reces- sion, reduced consumer demand and public sector investment all reduced indus- try's ability to meet debt service payments on projects financed by DFCs. Inadequate financial sector policies and supervision by regulatory authori- ties, as well as weaknesses in DFCs' appraisal and supervision also contri- buted. The financial statements of DFCs therefore reflected sharply declin- ing revenues and income. The profitability, liquidity, and financial struc- tures of DFCs weakened as portfolio problems mounted. These problems are being addressed under the proposed project. 49. The Bank has also made two Small Scale Enterprise (SSE) loans and is processing a third. The first (Loan 1879-EC) for US$20 million was approved in June 1980 and disbursed one-and-a-half years earlier than expec- ted. A second SSE operation (Loan 2221-EC) for US$40 million was approved in December 1982. Execution of the project has proceeded smoothly and the loan was 95 percent committed at end-1985. Board consideration of a third SSE loan for US$30 million is scheduled for March 1986. 50. In line with Government objectives, Bank strategy for the indus- trial sector is to support employment-intensive and export-generating indus- tries, as well as those making efficient use of local resources. The pro- posed 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 resource allocation through financial sector reforms; and (ii) improving the industrial and trade policy framework to encourage more efficient industrial production.  - 15 - PART IV- TE POJ=C 51. The proJect was identified by the Bank in October 1984 and was pre- pared by the Government with the help of Bank staff. It was appraised in July 1985 and the appraisal mission's Report No.5874-EC, dated March 3, 1986, and entitled -Staff Appraisal Report - Industrial Finance Project' is being distributed separately. Negotiations for the proposed project took place in Washington from January 15-22, 1986. The Ecuadorian delegation was led by Mr. Alfredo Crespo, Subsecretary of Public Credit. Annex III contains a timetable of key events in processing the project. Project Objectives 52. The proposed project would (i) support changes in trade, industrial and financial policy; (ii) continue encouraging more efficient domestic resource mobilization and allocation throught an adequate interest rate structure; (iii) strengthen the financial condition of financial intermedia- ries; (iv) provide term credit for efficient industrial development; and (v) provide technical assistance to: the Government to derive shadow prices for more effective project evaluation; the Superintendency of Banks and the Superintendency of Companies to strengthen their supervisory capabilities; and financial intermediaries to strengthen their project evaluation capabili- ties. Project Description 53. The proposed loan would consist of two parts. Part A would finance essential imports in support of the series of measures which have been taken to liberalize trade, industrial, and financial sector policies, as outlined in paras. 33-38, 45 and 47, and summarized in Annex IV. These measures- which complement recent actions to improve resource allocation and the effi- ciency of the agricultural sector--would represent fundamental steps to reorient Ecuador's model of industrial development towards a more efficient one, and strengthen the capacity of the financial system to mobilize and allocate domestic resources more effectively. They are essential to promote Eucador's continued adjustment and growth, and are fully consistent with the Bank's policy dialogue. 54. Part B would provide long-term loan funds to finance a project with two distinct components: (i) financing of privately controlled Ecuadorian manufacturing firms for fixed assets and permanent working capital to ini- tiate permanent programs to export, or expand or reorient production for export; to establish efficient new enterprises; or to expand or reorient the productive capacity of existing firms; and (ii) financing of technical assistance to: help establish within BCE a mechanism to calculate and update a set of shadow prices for the economy; strengthen the supervisory capabili- ties of the Superintendency of Banks and the Superintendency of Companies by developing and giving training programs for their staff, establishing new management information systems, etc.; and strengthen the project evaluation capabilities of the financial intermediaries which are or could become eligible to participate in the project.  - 16 - Partlcipating Institutions 55. Private Financieras. As discussed in para. 42, during the 1970s financial repression led to low domestic resource mobilization and heavy dependence on foreign borrowing. Much of this foreign borrowing was guaran- teed by local financial intermediaries. By the end of 1982, foreign borrow- ing had been largely curtailed and economic conditions had deteriorated. The recession, combined with the negative effects of devaluation, put a number of firms in financial distress. Their high levels of indebtedness and inability to repay outstanding loans further weakened business demand and caused a deterioration in the financial performance of the financieras. The sucreti- zation of the foreign private debt improved the debt structure of private borrowers and their liquidity positions; however, it caused a sharp deterio- ration of the debt/equity ratios of the financieras, from below 10 to 1 at end-1981 to between 15 to 1 and 25 to 1 at end-June 1984. Some of the finan- cieras have subsequently obtained fresh capital contributions and capitalized earnings, thereby improving debt/equity ratios to between 14 to 1 and 19 to 1 at end-1984. 56. During appraisal, the financial condition of the six largest private financieras which participated in the Fifth Development Banking Pro- ject (Loan 2096-EC) and Corporacion Financiera Nacional (CFN) was examined in detail, including their latest external audit reports and analyses of their loan portfolios. The external audits of these financieras have been carried out by Peat, Marwick and Mitchell or Price Waterhouse & Company. In the last year, the audit reports have been received by the Bank on a timely basis except for the 1984 audit report for COFIEC which was delayed. Clean audit opinions were issued during the period for all the financieras except for FINANSA (1983) and CFN for which qualifications were made concerning the recoverability of certain loans and the adequacy of the reserves for bad debts. In both cases appropriate corrective action has been taken. Also, the status of a number of subprojects financed under the loan was reviewed. The private financieras studied were ranked according to selected financial criteria, profitability, portfolio quality, etc. Based on these factors, three of the private financieras were considered to be in relatively good financial condition at end-1984; three others would need to take major steps to increase capital and loan loss provisions in order to qualify for partici- pation in the proposed loan. 57. Eligibility criteria have been established for participation in the proposed loan in order to assure that only financieras meeting certain finan- cial standards participate, and to encourage the financieras to take steps to improve their financial condition, including obtaining new capital contribu- tions from shareholders. Participating institutions would have to maintain a debt/equity ratio of not more than 15:1 as of the end of 1985; this would be reduced annually, declining to 12:1 at the end of 1988. Financieras would also have to meet annual targets '-'ith respect to interest coverage, liquidity ratios, and exposure limits which were agreed during negotiations. In order to obtain fresh capital resources for the financieras, improve their financial structure and mobilize domestic resources, each eligible financiera would be entitled to use US$9 equivalent from the proposed loan for each dollar increase in its equity after January 1, 1985, to finance subprojects. However, no single financial intermediary could commit more than 50 percent of the loan amount available for sublending under the project. In order to  - 17 - provide the financieras with an adequate return on equity in real terms, the initial financial spread on subloans would be 5 percent p.a., and interest would be required to be charged quarterly. The adequacy of financieras' spreads would be reviewed semi-annually by the Borrower and the Bank and adjusted, if warranted, to take into account changes in inflation levels and their cost and capital structures. 58. Corporacion Financiera Nacional (CFN). Established in 1960, CFN is the oldest and largest development finance company 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 conform with Government development objectives, CFN is relatively autonomous in its day-to-day operations. At end-1984, CFN's total assets were about US$200 million equivalent with equity of about US$35 million equivalent. CFN's financial position deteriorated in recent years as a result of: (i) an increase in non-earning assets due to the sucretization; (ii) liquidity pro- blems due to Government delays in reimbursing CFN for foreign exchange losses; (iii) low returns on equity investments; and (iv) deterioration of its loan portfolio. 59. During project preparation, a plan of action for strengthening CFN financially and institutionally, so that it could meet the same eligibility criteria for participating in the proposed loan as the private financieras, was discussed with CFN and the Government. As a result, the Government and CFN have recently taken a number of important steps. CFN reorganized its loan administration and established units responsible for collection and for restructuring problem companies. Loan recoveries have improved and a number of companies have been restructured. Moreover, in December 1985, the Govern- ment 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 will greatly improve the financial structure of CFN and greatly ameliorate its recent liquidity problems. The capital increase would reduce CNF's exposure in Aztra (a sugar company which has suffered con- tinuing financial losses) from 41 percent to about 19 percent, and greatly reduce its exposure in other companies. The standard loan provisions on exposure for all participating financial intermediaries would also apply to CFN. 60. A plan of further actions agreed for CFN requires (i) CFN to main- tain its efforts to improve credit collections and strengthen the financial condition of its clients; (ii) the Government and CFN to take, by June 30, 1986, all necessary measures spelled out in the decree authorizing the capi- tal increase required to legally effect the increase referred to in para. 59; (iii) CFN to avoid making loans or capital contributions to Aztra unless the funds for such purposes are provided by the Government as a capital contribu- tion or grant to CFN; and (iv) CFN to engage by June 30, 1986, consultants to strengthen its financial and accounting systems. In addition to the standard eligibility criteria for all financieras, CFN would need to fulfill all agreements under the plan of action to continue to be eligible to use the credit component of the loan.  - 18 - Nonitorlug 61. At present, the Financial Policy Unit of BCE establishes and moni- tors credit discount limits for commercial banks and financieras. Eligibi- lity and determination of the amount of participation of the financieras would be governed by criteria agreed with the Bank and applied by this Unit. The financieras would be required to have their accounts and financial state- ments audited, in accordance with appropriate auditing principles con- sistently applied, by independent auditors acceptable to the Bank; they would be required to furnish to the Bank and to the Financial Policy Unit of BCE, not later than four months after the end of each fiscal year, certified copies of their audited financial statements. Project Costs and Financing 62. Part A of the loan would provide US$50 million equivalent to finance the foreign costs of about 2.5 percent of Ecuador's projected 1986 imports. 4/ Since all policy actions which the loan would support have been takein, the full US$50 million under Part A would be available for dis- bursement upon loan effectiveness. Part B of the loan would finance subpro- jects and technical assistance. The total investment cost of subprojects is estimated at US$102.3 million. This includes an estimated US$69.3 million in foreign costs, and US$9.2 million of import duties and sales taxes. In addi- tion, technical assistance,would cost some US$660,000 (US$240,000 each for the Superintendencies of Banks and Companies, US$120,000 for BCE, and US$60,000 for financial intermediaries) making a total cost of US$103 million. Parr B of the proposed loan would provide US$65 million equivalent, or about 63 percent of the total cost of subprojects and technical assistance and 93 percent of foreign exchange costs. Beneficiaries would finance about 32 percent and financieras about 5 percent of such costs. Loan,* Subsidlary Loam and Subloam Terms 63. The proposed loan would be made to the Republic of Ecuador at the Bank's standard variable interest rate and charges. It would be repayable over 17 years, including 4 years of grace. The Government, through BCE as its agent, would onlend the proceeds from Part B of the loan to eligible financial intermediaries for subprojects, except for the portions for tech- nical assistance. For the latter: (i) US$100,000 from the loan would be made available to BCE as a grant to carry out a study on shadow pricing; (ii) US$200,000 from the loan would be made available by BCE to the Superinten- dency of Banks, and US$200,000 to the Superintendency of Companies to 4/ The Bank and the Government are beginning discussions which could lead to cofinancing being sought in the context of this project.  - 19 - carry out their respective technical assistance, and would be repaid on terms similar to those for subloans; and (iii) US$50,000 would be lent on commer- cial terms by BCE to the Association of Development Banks for the finan- cieras' technical assistance. Terms and arrangements for repaying the tech- nical assistance costs to BCE would have to be acceptable to the Bank. 64. The remaining US$64.45 million equivalent from Part 3 of the pro- posed loan would be onlent in sucres to financial intermediaries at variable positive real interest rates aa they are determined from time-to-time by the Monetary Board. Financial intermediaries would onlend these resources to project beneficiaries at the rates established from time-to-time by the Mone- tary Board. The intermediaries would receive a spread of initially 5 percent p.a. BCE would retain 0.25 percent p.a. fee to cover its costs of adminis- tration. The revenues from the difference between the Bank's lending rate plus BCE's fee, and the rates charged to the financial intermediaries would be used by BCE, as agent, to cover, in whole or in part, the foreign exchange risk on the Bank loan. However, any shortfall would be made up by the Government, which would take the foreign exchange risk and pay the commitment fee on the Bank loan. On the basis of current official rates (25 percent p.a.) which would be applicable to subloans, there is an ample spread over the current World Bank lending rate to cover the difference between domestic and world inflation (the expected foreign exchange risk). However, this relationship is likely to change if lending rates are lowered or inflation levels change significantly. To the extent that the Government continues the recent trend towards market-based interest rates, interest rate adjustments should be more responsible to such differentials. Signing of a fiscal agency agreement between the Government and BCE, satisfactory to the Bank, would be a condition of loan effectiveness. 65. Subloans for fixed assets (machinery, equipment and civil works) would be made for up to 12 years, including up to four years of grace, and, for permanent working capital for up to six years, including up to two years of grace. Lending terms and grace periods for individual subloans would take into account the economic life of assets to be financed and the repayment capacity of sub-borrowers. The maximum cumulative subloan amount from Bank- funded sources per sub-borrower or group of related firms would be US$5 mil- lion equivalent. It would be a condition of disbursement for any subloan that the participating financial intermediary had signed a Subsidiary Loan Agreement with BCE acceptable to the Bank. 66. 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, 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,  - 20 - 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. Subproject Review 67. A review of a number of subprojects financed under the Fifth Devel- opment Banking Project, indicated that, although subproject evaluation had impioved since previous DFC projects, areas for improvement still exist. For example, the analysis of management and markets should be strengthened, greater allowances should be made for contiugencies In financing plans, loan terms and grace periods should better reflect project life and implementa.ion schedules, and greater attention should be given to macroeconomic risk factors. A format listing all matters to be dealt with in subproject evalua- tion reports has been discussed and agreed with the financieras. All subpro- jects submitted to the Bank for financing would be required to follow the agreed format. In addition, a technical assistance component would be included in the project to offer training courses to staff of the financieras and CFN to upgrade their capabilities, especially in market, financial and economic analysis of projects. Based upon experience under the Fifth Devel- opment Banking Project, the following free limits for Bank review of subpro- jects have been agreed for the various financieras: CFN - US$2 million; FINANQUIL - US$1 million; COFIEC, FINANSUR and ECUFINSA - US$0.5 million; FINANSA and FINIBER - US$0.35 million. The free limits would be increased or decreased during project implementation once the Bank had reviewed the first four subprojects of any given financiera, and depending upon whether the Bank was satisfied that the project evaluations submitted had been performed ade- quately. Financieras other than the above would have no free limits until the Bank was satisfied with the project evaluations submitted. An economic evaluation would be required for each subproject with (i) a total investment cost exceeding US$1 million, or (ii) a subloan exceeding the free limit for the financiera involved. The minimum required ERR would be 12 percent. Procurenent 68. For Part A of the loan, procurement for any item over US$5 million would be by ICB following standard Bank procedures. Items costing less than US$5 million equivalent would be procured following normal procedures of the purchaser. For Part B, the financial intermediaries would satisfy themselves during subproject appraisal that procurement items were suitable for the res- pective investment project and reasonably priced, and that the beneficiaries had canvassed the main available sources of supply and were purchasing from advantageous sources. These procedures would conform to normal commercial practice for DFC-type projects. As under the Fifth Development Banking Pro- ject, informal international or local solicitation of offers would be fol- lowed for any purchase over US$250,000. Consulting services and goods for technical assistance would be procured in accordance with Bank Guidelines. Disbsirsments 69. Bank disbursements under Part A of the loan would be for 100 per- cent of the c.i.f. costs of eligible imports, but only for goods for which payment was made within 120 days from the date on which they were landed in Ecuador. Eligible imports would be all goods except those normally excluded  - 21 - under Bank policy-based loans, such as alcohol, tobacco, armaments, etc.; goods financed by other Bank loans; and expenditures under contracts costing less than US$50,000 equivalent. Disbursements under Part B of the loan would be for: 100 percent of the direct foreign expenditures for imported goods and services to finance fixed assets (machinery and equipment) and permanent working capital (inventories, raw materials); 70 percent of local expenditures for imported goods procured locally; and 35 percent of local expenditures for locally produced goods and services and for civil works. These percentages would reflect the direct and indirect foreign exchange cost. Disbursements under the technical assistance components would be for 100 percent of the costs of consulting services and equipment, excluding local taxes, local subsistence costs, and import duties. Disbursements under both Part A and Part B of the loan, except for technical assistance, would be made against Statements of Expenditures (SOEs). These would be certified for Part A disbursements by BCE, and for Part B disbursements by the financieras. The supporting documentation for SOEs would be retained by the financieras and BCE and made available to Bank missions for review. To facilitate disbursements, a Special Account of US$15 million equivalent would be established in BCE. The Special Account and SOEs would be subject to annual audits carried out by independent auditors acceptable to the Bank. The final date for submission of subloans would be December 31, 1988, and the Closing Date for the loan would be December 31, 1993. Project Benefits and Risks 70. Benefits. At the macroeconomic level, the industrial, trade, and financial sector policy reforms which the project would support represent fundamental steps to reorient the model of industrial development pursued in recent decades in Ecuador, and strengthen the capacity of the financial sys- tem to mobilize and allocate domestic resources more effectively. These policy changes are essential to promote Ecuador's continued economic adjust- ment and growth. In the medium-term, by promoting exports, improving the internal terms of trade between industry and agriculture, and promoting development of domestic resource-based industries which Ecuador's comparative advantage can support, the trade and industrial sector reforms should stimulate demand for agricultural products, promote urban and rural employ- ment and help improve the living conditions of the country's poor. The pro- posed project would also provide long-term resources for financing efficient industrial enterprises in Ecuador and help them adapt to the new policy framework. About 90 investment projects costing an estimated US$102.3 mil- lion and creating about 3,400 new jobs would be financed. Further important benefits would result from the continued dialogue with the Government on interest rates and industrial policies which affect the environment in which industrial enterprises operate. Financial policy reforms should in the longer-run reduce the reliance of financial intermediaries on the Government and the Bank for resources. 71. Risks. The major risks facing the macroeconomic reforms which the project would support relate to their political sustainability and the main- tenance of an attractive exchange rate for export promotion. Although the policy reforms supported by Part A of the proposed loan have already been taken, the Government will likely be under continuing pressure to modify or reverse them until they demonstrate widespread, tangible benefits. So far, the new Government has maintained its original policy objectives despite resistance to liberalization. Maintenance of an adequate exchange rate,  - 22 - vhich will be critical for the success of the trade liberalization measures and export expansion, is being closely monitored by the IMF. Both the Bank and the Fund have coordinated their analyses of export incentives so that the positions of the two institutions are consistent. 72. At the institutional level, some financial intermediaries are in poor financial condition and may be unable to meet the eligibility criteria in order to use loan resources to finance subprojects. As a result, comnit- ment of Bank funds could be delayed. In addition, participating financieras may again experience financial difficulties which could delay repayment of subloans to BCE. Technical assistance included in the project to strengthen regulatory agencies should limit this risk. Also, depending upon the rate of economic recovery in Ecuador and the potential short-term impact of import liberalization and interest race reforms, demand for resources from the credit component of the project could slacken. However, even if loan disbursements were somewhat slower than forecast, project benefits arising from individual subprojects and the technical assistance programs should still be realized. PART V - RKYO i oDATI0 73. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachments March 3, 1986 Washington, D. C.  -23- ANNEX I -^t SML Page 1If NM CHOI~sr uBcul IIUXUA t 190lk 1970t =un& LAT. iMICa * CAR guOn AA (cM. I. o- TOTAL - 283.0 203.0 253.0 AACOLIU3L 47.0 00.0 03.3 G IP CA (UM) .. * 1420.0 1873.9 2144.3 (KiLOGRAMS Or OIL UhA&UMT) 151.0 223.0 371.0 993.0 1119.6 POM1O _ WXM 3SUM POPULATIW.MID-TUA (TE _USD) 4422.0 534201.0 .260 DUA PWULAO CR Of TOTAL) 34.4 39.5 40.4 67.7 47.5 PoPULATIOU PrBmEC=0I POtIUlAON ri TM 2000 (HILL) 12.. W.tZ0U*a? PoILATZ CHILL) 23.0 POPULUXou 1_U 1.9 POPULATION DUIITY PU SQ. KM. 13.0 20.7 29.0 00.0 14.7 PU SQ. M. AM. LAWD 94. 120. 122.3 9*.1 U10.9 POOIATION AG! STRucIURI (C) 0-14 Yu 44.4 45.3 43.0 30.3 31.2 13-64 us 51.9 so0 32.7 57.1 0U.5 05 AND ANO 3.3 3.8 3.& 4.2 7.2 MPOPIATZOU GROMI RATE CZ) TOTAL 2.9 2.8 2.0 2.4 1.0 nRasl 4.9 4.2 3.0 3.0 3.7 Cluve lantl511 CP TIOUS) 46.0 43.2 37.0 30.9 23.4 CIDE OKATV RADl CPU T1355) 16.6 12.9 * .1 9 .0 0.9 GROSS hzPROmcTiou RAZ 3.4 3.2 2.0 2.0 1.3 FAMIILY FLAUSING ACC5T,. ANIIIL CTIEU) .. 9.0 32.3 1c USSJ CZ OFP tURU2D m .. .. *0.0 43.3 MURE OF 00 NW30. PU CAUITA (1963-71-100) 104.0 101.0 *2.0 109.b 109.1 PU CAPITA SUPU OF CALOKMS (Z of U IIUUNTS) 73.0 89.0 97.0 113.2 131.5 -,Drms5 (GUS Pn DAY) 40.0 52.0 30.0 69. 92.4 or MUCH AVIIL AND PULSE 25.0 27.0 26.0 id 34.2 34.3 CHILD C*S3 1-4) OWLIN U3t 26.2 17.J 7.0 4.8 4.7 1in Lit UPECr. AT BZRT CTEaaS) 30.7 53.9 62A 04.0 67.2 INfrNT 3MT. UTZ (CP T305) 140.0 107.5 76.0 39.7 53.3 ACCESS TO SAM MATESt (210) TOTAL 12.3 L. 34.0 45.0 /a 35.3 70.2 uu* 32.3 77.0 32.07; 76.3 n9.4 EMRAL 1.9 7U 7.0 16.07. 44.2 S7.0 ACCESS TO EXCRETA DISPOSAL (2 OF PoPULaTIo) TOaL .. 22.A 25.0 a 306.3 39.0 0UU .. .. 39.0 7; 73.6 03.9 RURAL .. .. &.o W 25.3 47.0 PO nLTIOU PEr PNsIc 2670.0 2320.0 760.0 1909.7 1070.0 PW. Pu NURSING Prr50 2300.0 Jf 1300.0 570.0 308.2 769.3 Pop. 7U WISPITAL MM TOTAL 530.0 420.0 X00.0 362.0 323.3 OREM 300.0 if 300.0 .. 422.0 201.9 UAL .. 440.0 .. 2716.7 4519.7 ASSIONS P OSPITAL .. 17.1 .. 27.5 20.0 MuIm AVERAGE SI Of HOUSELD TOTAL 5.1 If 3.2 Um .. .. W7AL .. .. AVU*AE NO. Of PUSStaM TOTAL 2.5 /f 2.3 UU1* 2.1 7 1.9 RJlAL 2.1 77 2.6 PKcZPrA= Of UIMLIISS WITH ELECT. TOTAL 32.3 /f .. 43.0 DUA3 7.s F .... 8.1133.. 3.3 7. ..  -24- ANNEX I Page 2 of 6 T A 6 L 3A ECUADOR - SOCIAL ZNDUZICTO DATA SHgm EcIDADOR umnhuuC caouPST CEIGHNTD AVERAES) tMOST 9CCOU(MT UT CSTMATc) lb - z,.