Ecuador - Fourth Small Scale Enterprise Project

Docunrt ot The World Bank FOR OFFICIAL I SE 0)1.N Al. Re /port 1Re . 7691-EC STAFF APPRAISAL REPORT ECUADOR FOITRTH SMALL SCALE ENTZRPRISE PROJECT January 9, 1990 Country DepLrtment IV Lat.in America and the Caribbean Regional Office This document has a rv%tricted distribiution :nd ma% be used h% recipients on1 in the performane of their official dutie". Its certent% ma not othvrwisc he disCosed wNithout %Norld Bank authoritation CURRENCY AND EQUIVALENT UN1TS Country: Ecuador Currency Unit: Sucre (S/.) = 100 cents. US$1.00 (at appraisal - Jan. 1989) = S/. 461.29 (Official Rate) = S/. 520.00 (Free Market Rate) WEIGHTS AND MEASURES Metric ABBREVIATIONS BCE Banco Central del Ecuador (Central Bank of Ecuador) BEDE Banco Ecuatoriano de Desarrollc (Ecuadorian Development Bank) BEV Banco Ecuatoriano de la Vivienda (Ecuadorian Housing Bank) ENF Banco Narional de Fomento (National Development Bank) CD Certificate of Deposit CCT Comit6 de Cooperacion T6cnica (Technical Cooperation Committee) CEFE Centro de Formaci6n Empresarial (Center for Entrepreneurial Development) CENAPIA Centro Nacional para la Promoci6n de la Pequefta Industria y la Artesania Nacional (National Center for Promotion of SSEs and Artisans) CENDES Centro de Desarrollo Industrial (Industrial Development Center) CFN Corporaci6n Financiera Nacional (National Finance Corporation) CONADE Consejo Nacional de Desarrollo (National Development Council) FENAPI Federaci6n Nacional de CAmaras de Pequefios Industriales (National Chamber of Small Scale Industrialists) DFC Development Finance Company FOPINAR Fondo de Fomento para la Pequefta Industria y la Artesania (Development Fund for SSEs and Artisans) -NEC Instituto Nacional de Estadistica (National Institute of Statistics) IESS Instituto Ecuatoriano de Seguridad Social (Social Security Institute) INSOTEC Instituto de Investigaciones Socio-Econ6micas y Tecnol6gicas (Institute for Socio-Economic and Technological Research) MICIP Ministerio de Industrias, Comercio, Integraci6n y Pesca (Ministry of Incustry, Commerce, Integration and Fisheries) SECAP Servicio Ecuatoriano de Capacitaci6n Profesional (Ecuadorian Professional Training Service) SSEs Small Scale Enterprises TA Technical Assistance FISCAL YEAR January 1 to December 31 - i - FOR OFFICIAL USE ONLY ECUADOR FOURTH SMALL SCALE ENTERPRISE PROJECT Table of Contents Page No. LOAN AND PROJECT SUMMARY............................................... iii I. THE INDUSTRIAL SECTOR........................................... 1 A. The Economic Setting........................... ........... 1 - Macro Performance........................................ 1 - Issues and Reform........................................ 1 B. Manufacturing Industry.......................... ......... 2 - Nature of Manufacturing Growth........................... 2 - Exports of Manufactured Products.............. .......... 2 C. Small Scale Industrial Sector.............................. 3 - Role of SSEs .......................................... 3 - Policy Environment....................................... 4 - Effects of an Improved Policy Framework.................. 6 - Technical Assistance to SSEs................... .......... 6 II. THE FINANCIAL SECTOR............................................ 7 A. Institutional Structure and Development..................... 7 - Mdin Institutions........................................ 7 - Background............................................... 7 - Recent Developments...................................... 8 B. Interest Rate Policy. ......................................8 - Background.................................. ........7....8 - Recent Developments......................................... 9 TII. PRIOR BANK t~ECTOR INVOLVEMENT..................................... 10 A. Lending Strategy............................................. 10 B. Prior Bank Lending...........................................10u IV. THE PROJECT....................................................... 12 A. Project Preparation.......................................... 12 - Project Origin and Status of Preparation ....................12 B. Project Objectives and Descriptior........................... 12 - Project Objectives......................................... 12 - Project Descriptior........................................ 12 C. Project Execution............................................ 13 - Participating Institutions..................... ........... 13 - Executing Agency............................................. 15 This report was prepared by Ines Garcia-Thoumi, LA4TF, Mauricio Carrizosa, LA4TF, Ivan Rivera, LATTF, Fernan Ibanez (Consultant) and Jav:er Nogales (Consultant) based on the findings of an appraisal mission which visited Ecuador in January 1989. The mission comprised Mrs. Garcia-Thoumi, LA4TF, Messrs. Carrizosa, LA4TF, and Rivera, LATTF, and Messrs. J. Campos, L.A. Fuenzalida and F. Ibanez (Consultants). Ms. E. Cubillas assisted in the production of the report. 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. Table of Contents (Conc.) D. Project Cost and Financing Arrangements.................... 15 - Project Cost and Financing.............................. lb - Onlending Arrangements................................... 16 - Terms and Conditions of Financing........................ 17 - Procurement................... .......................... 18 - Disbursements............................................ 18 - Accounting, Auditing and Reporting....................... 18 E. Project Benefits and Risks................................ 19 V. AGREEMENTS AND RECOMENDATION................................... 19 ANNEXES I. Manufacturing Industry -Table 1: Decomposition of Industrial Growth Rates. 1965-82 -Table 2: Distribution of Firms, Employment and Value Added in Manufacturing, 1965-87 II. Small Scple Industry -Table la: Capital Intensity among Micro and Small-Scale Industries in 1984-CENAPIA (Size defined by Value of Output) -Table lb: Capital Intensity among Micro and Small-Scale Industries in 1984-CENAPIA (Size defined by Fixed Assets) III. SSE Survey Results -Table la: Type of Firms that Compete with Those Surveyed by Sector -Table lb: Source of Inputs by Sector -Table 1c: Main Problems in Input Purchases -Table id: Financial Sources for the Last Investment Made, by Size of Firm -Table le: Marketing Channels by Size of Firm -Table 1f: Form of Production by Sector of Surveyed Firms IV. Banking System Credit -Table 1: Banking System Credit to Small versus Medium and Large Enterprises. 1981-87 V. Fondo de Fomento para la Pequefla Industria y la Artesania (FOPINAR) -Chart 1: FOPINAR: Organizational Structure -Table 1: FOPINAR's Key Financial Indicators -Table 2: FOPINAR: Cash Flow Balance -Table 3: FOPINAR: Balance Sheets -Table 4: FOPINAR: Income Statements -Table 5: FOPINAR: Geographic Distribution of Subloans (1981-6/30/89) -Table 6: FOPINAR: Distrib. of Subloans by Fin. Intermediaries (1981-6/30/89) VI. Technical Assistance (TA) -Figure 1: FOPINAR's Future Activities -Table 1: Estimated Costs and Financing for Technical Assistance (TA) Program (1990-91) VII. Projected Investment in Manufacturing 1990-92 VIII. Interest Capitalization Scheme IX. Estimated Schedule of Disburserients Under the Proposed Loan X. Bank Monitoring of Project Implementation ECUADOR FOURTH SMALL SCALE ENTERPRISE PROJECT LOAN AND PROJECT SUMMARY Borrower: Republic of Ecuador. Beneficiaries: Private Small Scale Enterprises (SSEs) involved in manufacturing (including agro-industry), industry-related services, fisheries and tourism. Amount: US$50 million equivalent. Terms: Repayable over 17 years, including 5 years of grace, at the Bank's standard variable interest rate and charges. Relending Terms: The R?public of Ecuador, using the Central Bank (BCE) as its ager,t, would onlend the proposed loan resources in Sucres to the Nationai Finance Corporation (CFN) on the same maturity as the Bank's loan (17 year repayment period, including 5 years of grace). CFN, using the Development Fund for SSEs and Artisans (FOPINAR) as a second-tier mechanism, would rediscount all subloans made by financial intermediaries to eligible SSEs. The onlending rate has been set initially at the 90-day certificate of deposit rate. Beginning on July 1, 1990, it would be adjusted in uniform steps every six months to reach the market-determined commercial bank lending rate by June 30, 1992. The onlending rate would include a maximum spread of 6: p.a., for financial intermediaries, depending on the size of the subloans, and a spread of 2.5Z, p.a. for FOPINAR to cover its operating costs and part of the technical assistance activities. CFN would pay in turn a service fee of .125% p.a. to the Central Bank. Project Objectives: The proposed operation, would help enhance the contribution of SSEs to industrial development. Specifically, the loan would help midernize and expand production by: (a) facilitating the access of SSEs tc formal credit; (b) promoting lending to SSEs by participating financial intermediaries (PFIs); (c) providing more focused an. ntegrated technical and managerial assistance support to increase the productivity of eligible SSEs and reinforce coordination among organizations that provide technical and financial assistance to the small firms; and (d) further strengthening the management and technical skills of participating financial institutions that provide credit to SSEs. Project Description: To achieve these objectives, the proposed project would comprise: (a) a credit component of US$50 million to finance SSE fixed assets, permanent working capital (both associated and free-standing), and subproject related technical and managerial expenditures; and (b) a technical assistance progra7, of US$1.6 million equivalent, of which US$1 million would be financed by CFN and by a grant from the Inter-American Development Bank (IADB), and US$600,000 by local counterpart funds. - iv - Project Benefits: The proposed project would help integrate the SSEs more effectively into industrial development by increasing their productivity and competitiveness. The coordinated package of financing and technical assistance would stimulate production and provide the needed term financing. On the basis of experience under the previous three SSE loans, the proposed project is expected to finance some 4,500 investment subprojects. costing about US$83 million and generating about 14,500 new jobs. It is Llso expected that about 40Z of subprojects financed would be in the industrial centers of Pichincha and Guayas, which contain a high concentration of the urban poor in Ecuador. Better serviies to SSEs, as well as efficient subloan and subproject implementation, would result from the institutional support provided to FOPINAR. More than 1.000 enterprises would receive direct technical and managerial assistance. A further 1,500 firms would benefit from training and extension activities. Project Risks: One main risk can be identified: that high inflation and continued recession, coupled with the introduction of market- determined interest rates on subloans, could reduce loan demand and cause a slower pace of commitments and disbursements under the proposed operation than in the previous three SSE loans. The Government's commitment to stabilizing the economy and its success in reducing the fiscal deficit and inflation augurs favorably for a resumption of economic growth with relative price stability in the medium-term. The expected strengthening of the economy combined with the favorable outlook for SSE development should sustain strong demand for financing under the loan. Estimated Costs: Local Foreign Total --------US$ Million------- Investment Projects 33.0 50.0 83.0 Total Project Cost 33.0 50.0 83.0 Technical Assistance Prog. 0.6 1.0 1.6 Total Program Costs 6.0 1.0 1.6 Financing Plan: Bank - 50.0 50.0 CFN (through FOPINAR) 9.0 - 9.0 Financial Intermediaries 7.0 - 7.0 Subloan to Borrower 16.0 50.0 66.0 SSE Beneficiaries 17.0 - 17.0 Total 33.0 50.0 83.0 ECUADOR FOURTH SHALL SCALE ENTERPRISE PROJECT STAFF APPRAISAL REPORT I. THE INDUSTRIAL SECTOR A. The Economic Setting 1.01 Macro Performance. Ecuador has enjoyed average GDP growth of about 5% a year over the past twenty-five years, a record exceeded only by Brazil among the Latin American countries. This growth, more dynamic in the 1970s than in the 1980s, was mainly associated with the rapid development of the petroleum sector during 1973-82. The expansion, however, could not be sustained when oil revenues dwindled, external credit dried up and various other shocks (the 1983 floods, the 1987 earthquake, the collapse of the Andean Market) hit the economy. As a result, GDP grew by an average of only 0.6% p.a. from 1982-87. 1.02 Ecuador's economic performance has been hampered by the country's misguided development strategy during the 1973-82 oil boom phase. Oil export revenues and large scale external borrowing led to an appreciation of the real exchange rate, which undermined the development of agriculture and export-oriented manufacturing. The stock of external debt expanded without a commensurate strengthening of Ecuador's non-oil export capacity. Similarly, public sector finances were allowed to become excessively dependent on petroleum revenues whi'.e tax concessions and subsidies expanded. Under these conditions, i.djustment to reduced external credit and oil price shocks of the 1980s has bEen particularly difficult. 1.03 Issues and Reform. Facing in expected fiscal deficit of 102 of GDP in 1988 and inflation running at an annual rate of 80 to 90%, the Government (which took office in August 1988) acted quickly to introduce fiscal measures and restrict monetary growth. These policy measures, aided by a rise in international oil prices in late 1988, allowed the Government to cut the 1988 fiscal deficit to about 5.1% of GDP, about half of what had been projected at mid-year. Further measures on interest rates and exchange rates have been taken during 1989; gasoline prices have been raised monthly during the year. Indications are that the stabilization is succeeding. Preliminary figures for 1989 show that the consolidated non-financial public sector deficit was contained to about 32 of GDP in 1989. As a result of stabilization, GDP growth slowed down to between 0 and 1% and inflation was reduced to 54Z in 1989 from 89% in 1988. Other performance criteria under the IMF standby were also met in December. For 1990, the targets are a fiscal deficit equivalent to about 2% of GDP, growth of 3 to 3.5% of GDP p.a., and inflation at 40% p.a. or less. - 2 - 1.04 Ecuador's medium-term strategy calls for a more diversified structure of production and exports to protect the country against fluctuations in the international prices of oil and other traded commodities, and to establish a base for the post-oil era. At the core of Ecuador's structural problems is the need to shift resources from the production of non-tradeables, including public sector activities, into the efficient production of exports and competitive import substitutes. A step in this direction has already been taken with the substantial increase in the real exchange rate of the last two years. By late 1989, the gap between the official and free market rates had closed to within 5 percent. If Ecuador's potential in the medium-term is to be achieved, a strong and permanent trade reform, including basic industrial and labor policy changes, would be needed. To this end, the Government, after having addressed first fiscal and financial issues, is now implementing an income tax reform (which would align the cost of equity and the cost of debt capital) and preparing a trade and industrial policy strategy. The Bank is assisting the Government in the design of these reforms. The forthcoming Industrial Sector Study (ISS) currently under preparation by the Bank, will provide the basis for the policy dialogue. B. Manufacturing Industry 1.05 Nature of Manufacturing Growth. Value-added by Ecuador s manufacturing industries expanded faster than Gross Domestic P.oduct (GDP) until the early 1980s. Figh oil revenues and external credit financed both the expansion of domestic demand for manufactures and production capacity, while the expansion of the Andean market provided the basis for growth in industrial exports from less than US$50 million in 1975 to US$250 million in 1981. As a result, the manufacturing sector increased its share of GDP from about 16.2Z in 1972 to a peak of 19.42 in 1983. However, following the 1982-87 drop in GDP growth, the average growth rate of manufacturing output also dropped to 0.3Z p.a. compared to 8.4? p.a. over the preceding five years. Consequently, Ecuador's level of industrialization fell from a 19.3? share of GDP in 1983 to 16.82 in 1988. 1.06 Manufacturing growth haa been essentially inwerd-oriented and capital intensive. A decomposition analysis suggests that between 1975 and 1982, 53.1? of industrial growth resulted from import substitution, 36.7Z from domestic demand expansion, and only 10.2Z from export growth, which, in turn, was concentrated almost entirely in the initial processing of fish, shrimp, cocoa and wood (see Annex I, table 1). Manufacturing sector investment in machinery and equipment increased sharply during the 1970s, doubling its real value between 1973 and 1977, while labor absorption lagged behind. Whereas the share of industrial value added in GDP rose by 5 percentage points between 1973 and 1983, the share of the industrial labor force remained constant. 1.07 Exports of Manufactured Products. Rapidly expanding oil-exports, rising from virtually zero in 1970 to 70? of total exports in 1983, permitted the country to support an impozt-substituting industrial policy. The joint effect of oil export revenues, foreign debt sales and import protection on the real exchange rate discouraged the growth of manufactured goods exports. Though the real exchange rate has since depreciated in response to reduced oil revenues and external credit, a wavering exchange rate policy has created uncertainty among potential exporters. Three 3 subsectors (food, textiles and wood products) account for about 95? of manufactured goods exports. The remaining subsectors supply muz. than 992 of their production to the domestic market. With domestic demand slowing and possibilities for import substitution being nearly exhausted, renewed industrial growth will critically depend on export development. C. Small Scale Industrial Sector 1.08 Role of SSEs. The June 1989 SSE decree defines SSEs as firms with fixed assets (excluding land and buildings) of 50 million sucres (approximately US$100 thousand equivalent), valued at their acquisition value. Eligible enterprises for the proposed operation would comply with the legal definition for SSEs. SSEs, also defined as establishments with less than 50 employees, accounted for 74Z of manufacturing employment in 1987. Available statistics indicate that SSEs create employment at only a sixth to a quarter of the costs in large firms of similar industries. Thus, because the cost of SSE employment creation is relatively low, SSEs have generated virtually all of the additional manufacturing employment during the eighties. SSEs' production is largely concentrated in labor-intensive goods, which comprise much of the country's comparative advantage. SSEs account for an important share of production of goods for domestic consumpticn, particularly in the garments industry, wood processing, ard metalmechanics. During the 1980s, the share of SSEs in total indust7y value added increased, however, from about 362 in 1980 to 42Z in 1987. SSE's larger share in employment than in value added is due to the SSEs larger average labor intensity. 1.09 A comparison of the evolution of industrial structure by size duiing the years of high industrial growth (1965 to 1980) reveals the more dynamic growth of the large capital intensive enterprise vis-a-vis small and microenterprises. Large-industry share of value added increased from 53.32 to 63.62. See Arnex I, table 2. Available information also shows that labor productivity increases sharply with enterprise size. Productivity in the smallest firms (1-2 workers) is only 16% of productivity in firms with 200-500 workers. 1.10 The reason for the variance in labor productivity is explained by economies of scale and differences in capital intensity. The Industrial Sector Study has estimated a strong effect of scale on total factor productivity. On the other hand, a recent survey " shows a clear positive correlation between capital intensity, (assets per worker) and firm size, (fixed assets, excluding land and buildings) or value of production. The capital stock per job of the large enterprises varies between six and four times the cost of that of the small enterprises, depending on the measurements of size. These findings are confirmed by the annual industry survey, Encuesta Anual de Manufactura y Mineria, which includes manufacturing enterprises Employing ten or more workers. This survey shows, for manufacturing as a whole and at the subsector level. a decreasing ratio of the wage bill to value-added as the size of enterprise, measured by the value of output, increases. See Annex II, tables ia and lb. The largest increase in labor productivity occurs in moving trom microenterprises to SSE production. Since the investment cost per job in SSEs is only a sixth to a 1/ The most comprehensive survey of the SSE sector was done in 1985 by the National Center for the Promotion of SSEs and Artisans (CENAPIA). quarter of that in the large enterprises, while labor productivity is about 16Z-582, there appears to be ample room for a growth in the small enterprise sector in manufacturing. 1.11 A recent Bank sponsored survey of the microeconomic characteristics of the business environment of the SSEs, covering the four industrial subsectors (food, wood, textile and metalmechanic products) where SSEs are most important, shows that these firms compete mainly with other small enterprises. The labor market for SSEs shows high flexibility: annual reductions of 172 in temporary employment were reported as normal adjustments to cyclical fluctuations in demand. Production processes seem flexible; most SSEs produce more than five different products. Very few SSEs (three out of 194) export on a permanent basis, mainly because the production volumes are small, and the quality of inputs is not adequate for the requirements of foreign markets. (Details of the results of the survey are given in Annex III, tables la to lf.) .12 SSEs have an important role to play in Ecuador. Given Ecuador's factor endowments, and the flexibility and dynamism of the small scale sector, SSEs should continue to provide a pool of potential entrepreneurial talent. The Government attaches high priority to the development of the SSE sector because of its contribution to efficient industrial development and socio-economic objectives: entrepreneurial development, upgrading of labor skills, and employment creation. The proposed project would provide a specific line of long-term credit to SSEs, that coupled with a more focused and far-reaching program of technical assistance, would support the Government's SSE growth objectives. 1.13 Policy Environment. The industrial policy framework has been characterized by a high level of import protection and by policies that subsidize the cost of capital and raise the cost of labor. The tariff code and the industrial promotion law (which grants tariff exemptions from import duties for industrial inputs and capital goods, and gives income tax deductions for investment purposes), have resulted in major deviations in the rates of effective protection among sectors. Industrial protection has been widespread and pervasive, with the typical cascading pattern--higher for consumer goods and lower for intermediate and capital goods.2 Subsidized interest rates significantly lowered the cost of capital to business enterprises and, coupled with high taxation of dividends, encouraged these enterprises to become highly leveraged. Labor costs have been raised by legislation that sets minimum wages above market clearing levels and that increases the cost of labor mobility, thus exacerbating the factor price distor*ions implicit in financial and trade policies. 1.14 Ecuador's abundant labor factor endowment provides for a comparative advantage in labor intensive manufacturing. A large percentage of firms in labor intensive domestic resource based sectois are SSEs. 2/ Consumer goods are the most protected, with the highest average tariff (4C.7Z) and the high,.st Quantitative Restrictions (QRs) coverage (36Z of all consumer goods' tariff positions). Intermediate goods have an average tariff of 20.5Z; 27.6Z of all intermediate goods' tariff positions are covered by QRs. Capital goods have a higher average tariff than intermediates (33.72), but a lower QR protection (14.6Z). -5- Larger enterprises generate more value added per unit of labor because they use more physical capital or more skilled labor. Thus, lending to SSEs supports enterprises that absorb the less skilled segments of the manufacturing labor force, a key source of the country's comparative advantage. 1.15 Ecuador traditionally has pursued strong protectionist policies. Rates of effective tariff protection of manufacturing average about 63Z with a standard deviation of 90.6, using fairly aggregated sectors. However, key sectors with a high percentage of SSEs (food processing, textile and leather products. wood and furniture, metal products) have relatively low average rates of effective protection (between 20Z and 30Z). Quantitative restrictions (QRs) apply to about 25.0% of import items, principally consumer goods. Protection is less of a factor for SSEs than for large enterprises because: first, (a) a higher proportion of SSEs use little or no imported inputs; (b) SSE products are relatively poorer substitutes of imported goods; and (c) SSEs are less concentrated than LEs. Those enterprises that do not use imported inputs cannot benefit from the promotion laws that exempt imports from tariffs when these imports are not produced domestically. Therefore, enterprises that do not consume imported inputs will bear the cost of protection of domestically produced inputs, without benefitting from the tariff exemptions that are granted by industrial promotion laws which enhance the protection of enterprises that consume imported inputs by frequently exempting those inputs from tariffs that are not produced in the country. SSEs, typically import only a small fraction of their total inputs including capital goods, and therefore do not benefit from exemptions on input tariffs. 1.16 Second, protection has a greater effect on the prices of LE products because these products arc closer import substitutes. Most large firms produce goods that use similar technologies and inputs as those of imported manufactures. On the other hand, most SSEs produce goods geared exclusively for domestic markets, with no effective competition from imports. Third, protection provides many LEs with monopoly power. Value added in manufacturing is highly concentrated. For manufacturing as a whole, the largest 500 establishments, a large number of which are owned by a handtul of interlocked shareholders, account for about 74% of manufacturing value added. In contrast, the high degree of competition among SSEs is relatively impezvious to protection. 1.17 Factor market policies, in the aggregate, also would seem to have a less distortionary effect on SSEs. Subsidized credit and the tax incentives that encourage indebtedness and capital intensity have a significantly lower bearing on small enterprises, which have obtained less access to credit. On the other hand, enforcement of employment stability legislation, which requires employers to insure the employment at their enterprises, is applied more effectively to LEs. SSEs avoid stability regulations through temporary contracts or outright disregard that the Government is unable to control and the employee is often unwilling to denounce. Minimum wages are lower for SSEs than for LEs. In sum, interest rate and tax incentives to indebtedness and stiff restrictions on termination of employment, which encourage products and technologies with a higher capital intensity than is warranted by the country's factor endowment, are less important for SSEs than for LEs. Past subprojects by the Development Fund for SSEs and Artisans (FOPINAR) exhibit economic rates of return which average 40.1Z. These evaluations allow for the past overvaluation of the Sucre and overpricing of labor. 1.18 Limited funding, coupled with the high cost of credit delive:y, high perceived risk, inadequate collateral and accounting information are the main constraints in lend3ng to SSEs; this situation has been aggravated by the ownership structure of the financial sector in Ecuador which has shown a close relationship between banks, development finance companies (DFCs), and large industri-1/commercial groups. The SSE share of the banking credit system has been declining from 7.7Z in 1981 to 4.52 in 1987. See Annex IV, table 1. The other sources of financipg include the entrepreneurs' own resources plus loans from suppliers and street-lenders. In fact, a majority of the small companies visited by the appraisal mission, admitted periodic use of street-lenders at rates of interest around 10Z per month. The Bank survey confirmed that in the past five years, 44? of the firms were created and developed with financing limited to their own resources, and that bank credit made a significant contribution to their growth in only 242 of the SSEs compared to 67? in large firms. These constraints have resulted in a higher cost of credit for SSEs than for large industry. The lack of term credit for SSEs has been partially counterbalanced during the 1980s through formal SSE term lending, provided by FOPINAR. 1.19 Effects of an Improved Policy Framework. The Government is planning to reform the industrial incentive system with the support from the Bank. An improved policy framework would liberalize trade and reduce factor market distorsions. Under such a framework, the relative price of capital and the real exchange rate would be higher than they are today. These changes would encourage those sectors with low capital intensities. Many SSEs would be encouraged because a high percentage of firms in labor intensive sectors are SSEs. These firms would be in a better position to grow and thereby reap economies of scale in a more rational incentive environment that would support their edge in labor intensive production. Reduced protection would increase the prices of non-traded products relati-e to the prices of protected products, including tradeable inputs produced domestically. The removal of labor market constraints and of subsidies to capital would lower the relative price of labor, which would mostly benefit labor intensive LEs. Any transmission to the SSEs in the form of higher labor costs, however, will take time. On the other hand, removal of the present subsidies would allow SSEs to grow without having to face the high costs of labor laws that are mandatory for the larger enterprises. 1.20 Technical Assistance to SSEs. At present there is no active and coordinated TA program for small enterprises. Several private and public institutions have been established in the last two decades to provide such services (e.g., the National Center for Promotion of Small Scale Industry and Artisans - CENAPIA; the Socio-economic and Technological Research Institute - INSOTEC; private foundations; the Ecuadorian Professional Training Service - SECAP,etc.), but their coverage has been very limited both in quantity and quality. Moreover, their efforts have been scattered and uncoordinated and the results have been meager mainly because of insufficient financial resources and of the resulting lack of continuity in their TA programs. Similarly, FOPINAR's TA activities in the past have mostly concentrated on a small number of nonreimbursable contributions to other institutions, and particularly on promotional meetings and seminars dealing with preparation and appraisal of subloan applications. The proposed project would go beyond the previous three SSE loans in that the Bank would assist FOPINAR in the design and implementation of a TA program to finance the small entrepreneur's needs for technical assistance. While -7- the program would be financed entirely by the Corporacion Financiera Nacional (CFN), which houses FOPINAR, and by a grant from the Inter-American Development Bank, the Bank expects FOPINAR to play an important role in the coordination of the activities. 1.21 Recent studies, including a Bank study of the food-processing industry, as well as mission interviews and the Bank survey in October, have identified a strong demand for TA. Indications are that more focused assistance to SSEs would have allowed more effective use of equipment and more effective stock management. The majority of SSEs is far behind in product design, quality control, marketing techniques, and basic production management. The present SSE needs will require not only technological support but also a massive diffusion of information and training about basic techniques and procedures. Thus, an important SSE issue is the design of a TA strategy that focuses in improving the management, productivity and efficiency of existing small enterprises. II. THE FINANCIAL SECTOR A. Institutional Structure and Development 2.01 Main Institutions. The main institutions in Ecuador's financial system are the Central Bank (BCE), 31 private commercial banks with about 285 branches: three state banks--the National Development Bank (BNF), the Ecuadorian Housing Bank (BEV), and the Ecuadorian Development Bank (BEDE); and 12 development finance institutions (DFIs), including the publicly owned Corporacion Financiera Nacional (CFN). There are also 11 savings and loan associations (SLAs), more than 28 insurance companies, and various currency exchange offices and securities markets in Guayaquil and Quito. The Social Security Institute (IESS) is also a major depository for financial savings. As a group, commercial banks dominate Ecuador's financial system, and their outstanding loan portfolio represents 75Z of total lending to non-bank borrowers. Policy-making agencies include the Monetary Board, BCE, and the Superintendency of Banks (SB). The Monetary Board sets exchange rates, interest rates, and other financial policies implemented by BCE and the Superintendency of Banks. BCE also provides credit to financial intermediaries, including special discount credit lines. The SB supervises and audits financial intermediaries (FIs) and publishes statistical information on the banking system. 2.02 Background. The performance of the financial sector in Ecuador from the point of view of resource allocation, institutional strength, and mobilization of domestic resources for long-term lending reveals several weaknesses. These date back to the 1970s, when the financial system grew rapidly, mainly because of the availability of external financing which dimestic banks intermediated charging high margins for providing exchange rate guarantees for foreign loans to the private sector. Additionally, negative real interest rates charged to final borrowers and attractive margins and commissions provided to intermediaries stimulated lending growth. This environment provided little incentive for financial institutions to mobilize domestic resources on their own, who became increasingly dependenL on BCE credits and foreign borrowings for resources. The ensuing structural weaknesses of the financial system were compounded by easy granting of bank licenses, which in turn led to the establishment of many small, undercapitalized banks. Between 1973 and 1984, the number - 8 - of private banks increased from 21 to 32 and finance companies from 2 to 13. The system suffered grave liquidity problems beginning in 1983 as foreign resources dwindled and economic conditions deteriorated. Combined with the devaluation of the sucre, these factors combined to diminish 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. with the participating institutions obligated to repay BCE in sucres over a period of up to seven years. The program enabled the imediate liquidity crisis to be mana&ed and the financial system regained stability. 2.03 Recent Developments. Substantial improvements have occurred in Ecuador's financial sector regulatory system over the past two years. In particular, the office of the Superintendent of Banks has noticeably strengthened its supervisory capability. Through the Financial Sector Adjustment Loan (para. 2.06), the Bank has been providing technical and institutional support to the SB. Previously, the SB had concentrated its efforts on the formal aspects related to compliance with the Banking Law but had neglected the need to carry out a thorougi financial analysis of the financial institutions. It also did not undertake critical reviews of the existing regulations vis-&-vis the new neids of the community and the financial institutions. The deficiency had become a serious obstacle to the institutional development of the banking system, especially because many financial institutions began to show signs of serious financial stress. 2.04 The primary new mechanisms in place are: (i) new rules relating to how financial institutions should classify their loan portfolio, reflecting degree of risk, that is normal, above normal, deficient, with doubtful recovery prospects, and declared loss; (ii) a new system to estimate provisions to cover possible losses based on the new portfolio classification; (iii) a new system that does not allow banks to accrue interest on problem loans or to roll over loans in arrears and capitalize on overdue interest; (iv) stricter rules requiring banks to maintain minimum equity levels in proportion to the risk assets they carry; (v) tight and continuous supervision of institutions with serious difficulties; and (vi) liquidation of institutions that pose a serious risk to the financial community. To implement the new system, the SB now relies me-e on independent external audits of the banks and financieras but carried out under new and more stringent regulations. As a result of the new system and procedures, the financial information available from the SB is now more accurate and reliable. B. Interest Rate Policy 2.05 Background. In the mid-1980s, the Government initiated a far- reaching program of financial reform to spur domestic resource mobilization and to strengthen financial institutions by allowing them to intermediate a larger volume of financial resources efficiently. Among the most important measures taken were: (i) creating a Certificate of Deposit with a freely determined interest rate; (ii) introducing adjustable rates on loans with resources from the BCE or international institutions; (iii) subsequent freeing of the interest rate on all deposit instruments, and freeing of interest rates on all lending instruments except BCE lines of credit and adjustable rate lending; and (iv) increasing the interest rates on BCE credit to align them more closely with market interest rates. I -9- 2.06 Recent Developments. During the past two years, the Bank has supported a strengthening of the banking system and a rationalization of the interest rate regime through the Financial Sector Adjustment Loan (2897-EC, FSAL). The Bank approved the US$100 million FSAL in December 1987, released the first tranche (US$50 million) in January 1988. and the second tranche in (US$50 million) in September 1989. The present Administration has demonstrated a strong commitment to the objectives of the FSAL program. which is focussing on: (i) strengthening financial institutions (FIs) through improvements in the regulatory framework. upgrading the performance of the Superintendency of Banks (SB) and gradually restoring tht capital adequacy of these institutions; (ii) more efficient intermediation by restraining the growth of BCE rediscounts to FIs and by linking the interest rate on BCE funded credit to market- determined rates; and (iii) development of the capital market by improving the conditions for variable interest rat- lending, for the establishment of short-term and long-term market-determined interest rates, and for promoting the issuing of equity finance by companies. 2.07 In August 1988, the new Government established a maximum spread of 19 percentage points on the passbook savings interest rate paid by each financial institution to determine the institution's maximum lending rate. This measure was the result of efforts to reconcile the Government's earlier political commitment to control interest rates with the objective of encouraging efficiency in financial intermediation. However, this system resulted in discrimination against foreign banks and development finance companies which by law are prevented from capturing savings deposits. 2.08 In April 1989, the Government introduced interest rate reform by modifying the maximum spread provision and by establishing a new interest rate regime, which allows the domestic commercial banks to set their lending rates at 15 percentage points above a reference base equal to the arithmetic average of the 90-day CD rate and their respective passbook savings rate. Other financial institutions, which do not issue savings deposits or certificates of deposit, would set their lending rates at up to 17 percentage points above the arithmetic average of the reference base of all domestic commercial banks. This provision met a key condition for the release of the second tranche of the FSAL, increased the flexibility of the system, and made it more responsive to market forces. 2.09 The changes in the interest rate regime, which the Government had introduced in the context of the second tranche release of the FSAL, have resulted in positive deposit and lending rates. The interest rates for certificates of deposit (CD) have been positive since April 1989, when interest rate reforms were introduced which increased the flexibility of the system and made it more responsive to market forces. Real interest rates for CDs are 4Z at present. Also, ceilings on internationally funded loans to large scale industry havo- been removed--a measure that goes beyond the requirements of the FSAL program. Furthermore, the Government has corm.,itted itsclf in a letter to the Bank to move the various sector specific interest rates, in uniform steps every six months, to the leval of the market based commercial bank lending rate within less than three years. These adjustments are the result of a dialogue on financial matters between the Government of Ecuador and the Bank which started in the early 1980s. The Government's commitment to raise the interest rates for small scale industrial and agricultural lending to levels determined by the market goes significantly beyond the understanding reached under the FSAL. - 10 - III. PRIOR BANK SECTOR INVOLVEMENT A. Lending Strategy 3.01 The Bank's strategy over the coming years is to support the Ecuadorian Government in the design and implementation of a medium-term program of adjustment and growth, including a viable external financing package. In doing so, the Ba.k has initiated a strong program of economic and sector work that shouia lead to a combination of policy-based sectoral adjustment and traditional operations, thereby allowing the Bank to respond with flexibility to policy initiatives. To realize Ecuador's medium-term potential, the policy agenda to be supported by the Bank encompasses the following main themes: (i) fundamental reform of public sector finances and institutions, including measures to raise non-oil income, stabilize oil revenues and improve resource allocation and effectiveness of public sector institutions; (ii) reorientation of petroleum development strategy; (iii) export development and economic diversification by improving international competitiveness through trade reform, structural change in the productive and financial sectors, and removal of bottlenecks; (iv) effective debt management; (v) poverty alleviation and human resource development, with special emphasis on protection of the poor from the cost of adjustment; and (vi) effective management of renewable and non renewable natural resources. These goals would be reinforced by future lending (para. 1.04) to reorient the industrial sector. The proposed operation is designed to tackle the third and fifth areas outlined above. B. Prior Bank Lending 3.02 To date, the Bank has approved three SSE loans to Ecuador, for US$90 million equivalent. The first Bank loan (Loan 1879-EC) for US$20 million was approved in June 1980; it helped establish FOPINAR. A second Bank SSE operation (Loan 2221-EC) for US$40 million was approved in December 1982; it helped FOPINAR consolidate and expand its operations. A Project Completion Report (PCR), dated June 29, 1988, prepared by LA4TF, shows that both loans were effective. More specifically, the loans generated significant employment and promoted regional development, in accordance with the project objectives of both loans. 3.03 The third SSE loan (Loan 2673-EC) for US$30 million was approved in April 1936. Subproject characteristics and geographical distribution have followed the same employment anc regional development tendencies shown in the first two Bank loans (para. 3.1:). About 20,000 new jobs have been created but only about 45Z of subprojects financed have been in the largest industrial centers of the country: Pichincha (Quito) and Guayas (Guayaquil), thus promoting regional development. Also, during joint loan negotiations of the SSE III loan and the Industrial Finance loan, agreement was reached with the Ecuadorian Government to establish a variable interest I rate regime for subloans, and to maintain interest rates on all loans to the industrial sector, with maturity exceeding two years, at positive levels in real terms, and which after July 1, 1987 were also adequate relative to a 90-day certificate of deposit (Polizas de Acumulacion and Certificados Financieros)), as measured by criteria agreed with the Bank. - 11 - However, the positive interest rate objectives were not fully accomplished because changes in the onlending interest rates were not automatically linked to the market reference rate. Instead, changes were discretionary, requiring issuance of regulations by the Monetary Board. 3.04 In addition, the Bank has provided six loans for development finance companies (DFC)in Ecuador. These loans total US$270 million, net of cancellations. The first five were DFC loans: Loan 721-EC, approved December 1970; Loan 930-EC, approved June 1973; Loan 1359-EC, approved December 1976; Loan 1731-EC, approved June 1979; and Loan 2096-EC, approved April 1982. A PCR, dated June 11, 1985, for the third and fourth DFC projects, shows that by September 1983, devaluation, recession, reduced consumer demand, and public sector investment had reduced industry's ability to meet debt-service payments on projects financed by DFCs. This was aggravated by inadequate financial sector policies and inadequate supervision by regulatory authorities along with weaknesses in DFCs' appraisal and supervision procedures. This caused the financial statements of DFCs to show a sharp decline in revenues and income. The profitability, liquidity, and financial structures of DFCs weakened as portfolio problems mounted. These problems were also found in the Fifth DFC project, as shown by the main findings of a recent PCR, dated June 30, 1989. On the positive side, a dialogue on financial matters between the Government of Ecuador and the Bank was o ened during the Fifth DFC loan. However, progress on the dialogue did not materialize until the sixth operation in the sector (Industrial Finance - Loan 2672-EC approved in July 1986), which was a hybrid operation consisting of a US$50 million policy component to finance essential imports in support of policy reforms. This loan was disbursed after the Government introduced a revised import tariff structure, removed about 201 of then-prevailing import prohibitions, and shifted from fixed rates to variable interest rates for industrial sector lending. There was also a US$65 million credit portion. The loan progressed well until March of 1988 when, due to noncompliance with interest rate covenants, a suspension of commitments went into effect. Upon establishment of the new interest rate regime (para. 2.08), the suspension was lifted in May 1989. 3.05 The agenda of the new Government in Ecuador heavily emphasizes the need to generate productive employment and to tackle socioeconomic imbalances, particularly in major and medium-size urban centers. Also, the Government appears willing to consider steps to reduce some of the distortions and inefficiencies in the industrial and financial sector and to increase the productivity and competitiveness of small industrial firms. Such firms are the foundation of the industrial sector in Ecuador. In this regard, the proposed SSE project is particularly timely in that it provides the needed resources for SSE financing. In addition, by launching a technicai assistance program and consolidating FOPINAR's role as the coordinating TA institution, the project would provide an integrated package of support to SSEs. Some of the non-credit obstacles to entrepreneurial development, among SSEs, will therefore be systematically addressed. - 12 - IV. THE PROJECT A. Project Preparation 4.01 Project Oriain and Status of Preparation. In November 1987, given the faster-than-expected pace of commitments and disbursements under the third SSE loan, and the lack of term financing, the Government requested the Bank to begin processing a fourth operation in time to be effective by mid-1989. The project was identified by the Bank in January 1988, pre- appraised in June 1988, appraised in January 1989, negotiated in September 1989, and prepared by FOPINAR with the help of Bank staff. B. Project Objectives and Description (i) Project Objectives 4.02 The proposed operation would help enhance the contribution of SSEs to industrial development. Specifically, the loan would help modernize and expand production by: (a) facilitating the access of SSEs to formal credit; (b) promoting lending to SSEs by participating financial intermediaries (PFIs); (c) providing more focused and integrated technical and managerial assistance support to increase the productivity of eligible SSEs and reinforce coordination among organizations that provide technical and financial assistance to the small firms; and (d) further strengthening the management and technical skills of participating financial institutions that provide credit to SSEs. Efforts will also be made to promote actions toward improving the environment and enhancing the role of women in business activities. Environmental safeguards will be built into FOPINAR's Statement of Policy and Operating Procedures. Specifically, approval of subprojects related to wood processing with potentidlly damaging effects from deforestation would require a satisfactory environmental assessment. With regard to the role of women, the Bank will, during execution of the project, pay particular attention to identifying barriers to women's opportunities to participate mcre fully in SSE activites, and to developing action plans to improve their access to credit and to technical assistance. (ii) Project Description 4.03 To achieve these objectives, the proposed US$50 million Bank loan would consist of: (i) a credit component of US$50 million to finance SSE fixed assets, permanent working capital (both associated and free- standing), and subproject relatel technical and managerial expenditures; and (ii) a technical assistance component of US$1.6 million, of which US$1 million would be financed by the Corporacion Financiera Nacional (CFN) and by a grant from the Inter-American Development Bank (IADB), and US$600,000 by local counterpart funds. The characteristics of these components are explained below. 4.04 Credit Component. The lending component (US$50 million) would finance: (i) subloans to cover fixed assets and related permanent working capital needs (both associated and free-standing) for the creation, - 13 - expansion or modernization of new or existing viable enterprises; and (ii) specific technical assistance expenditures related to preparation or operation of subprojects (e.g., product design, market studies, and managerial consulting). 4.05 Technical Assistance Component. This component (US$1.6 million) would complement the provision of credit by financing specific sub programs and proposals originating both in the private and public sectors. To ensure efficient execution and proper control in the use of the resources under the component, the institutional set-up within FOPINAR would include strengthening CFN's Technical Cooperation Committee. The TA component would include: (i) preparation and execution of programs to support development of a small entrepreneur's capabilities (e.g., training in financial and production management, booklets, and audio-visual aids for self-training of entrepreneurs, preparation of in-plant enterprise diagnosis and advisory services, inventory control, group ('clusters") actions for bulk purchases or joint sales, market studies by regions and subsectors to identify new sales and industrial opportunities, studies for the creation of trading companies, and/or other group marketing mechanisms; (ii) staff training programs and upgrading credit monitoring and internal information systems of FOPINAR and the PFIs to ensure a sustained quality of their credit delivery; and (iii) strengthening the TA delivery capabilities of participating institutions, including project-related training needed to provide a more focused assistance in the areas of enterprise management and production processes. C. Project Execution (i) Participating Institutions 4.06 Second-Tier Mechani m - FOPINAR. The Fondo de Fomento para la Pequena Industria y la Artesania (FOPINAR) would be the main responsible unit in CFN for the credit component. FOPINAR was es,ablished .-, May 1980, under the Bank's First Small Scale Enterprise Credit Project, as 1 permanent fund owned and operated by CFN, otherwise a first-tier l ,der for large industry only. Under the previous three Bank projects, it has rediscounted over 7,000 subloans made by financial intermediaries to small industry, reaching over 5,000 beneficiaries. These have shown a high repayment record, as only 3Z were i. arrears at the end of 1988, compared with 1OZ for the large-industry portfolio. In practice, as described in Annex V, FOPINAR has been working very effectively within CFN with its own staff and separate financial resources and accounts. Under the proposed project, CFN would continue to operate FOPINAR as a second-tier institution through the network of qualifying financidl intermediaries. However, while in the prior three projects a total of 36 financial intermediaries (24 commercial banks, 11 Development Finance Companies (DFCs), and the Banco Nacional de Fomento (BNF)) signed participation agreements with CFN, more stringent qualifying conditions may reduce the number of FIs to about 25. Agreement was obtained during negotiations on a new Statement of Policy and Operating Procedures for FOPINAR. 4.07 FOPINAR's Management and Administration. CFN/FOPINAR have succeeded in organizing and maintaining a compact group of highly motivatea and well-trained professionals which have gained respectability vis-a-vis - 14 - the financial intermediaries and the entrepreneurial community. During appraisal, FOPINAR and the Bank agreed that, with respect to credit operations, FOPINAR has now reached an appropriate level of professional staffing. Any further efforts should concentrate on improving productivity by streamlining procedures and searching for a more satisfactory balance between its basic activities of appraisal and supervision. Other needs would be in the area of technical assistance, which is being strengthened under the proposed project (see Annex VI). Administrative costs as a percent of outstanding portfolio were expected to reach a low of 1.22 by year-end 1986 on the basis of indicators available at the time of appraisal of the Third Loan. However, the opposite occurred due to a very large increase in overhead charges by CFN, which caused FOPINAR's administrative costs to reach a high of 3.0 in 1985 and 1986. Following a Bank review, costs were reduced to 1.92 in 1987. CFN's management has agreed to reduce its charges flArther so as to reflect only the real cost of those support services required by FOPINAR for efficient operation. Under such conditions, administrative costs (including staff for financial management assistance) are expected to reach a level cf no more than 1.52-1.8Z of average portfolio by 1989. Agreement was reached during negotiations that the procedres to determine FOPINAR's operating L,dget and, in particular, the amounts charged by CFN for administrative support to FOPINAR would have to be reported to the Bank, in conjunction with FOPINAR's budget, by November 30 of each calendar year. 4.08 Participating Financial Institutions (PFIs). Commercial banks, DFCs, and BNF would continue intermediating FOPINhR subloans to SSEs. To qualify, they would be required to sign a Particilation Agreement in which they commit themselves to maintain an administratiie unit staffed with at least two qualified professionals to carry out subproject appraisals and supervision work along FOPINAR guidelines. CFN/FOPINAR would also enforce PFIs to comply with reporting requirements, especially on yearly supervisions, established in the Agreement. In the previous projects, PFIs were also required to meet criteria on portfolio quality and debt-to-equity ratios, and to contribute 102 of the lending resources from their own funds. It was agreed during negotiations that, in view of the recent bankruptcy of two DFC's and a commercial bank, the financial intermediaries would, in addition, be required to be in good standing with the SB which is better equipped than CFN/FOPINAR to judge the banks' and DFCs' financial situation. Financial institutions under the BCE's rehabilitation plan, would be excluded from participation. Twenty-two commercial banks, ten DFCs and BNF participated in the Third SSE Bank Loan. BNF was the most active intermediary, particularly with microenterprises, and financed nearly 5,000 operations (762 of the total) since inception of the program, using 452 of the resources. Agreement was obtained during negctiations that CFN will enter into Participation Agreements with BNF and with at least two other financial intermediaries by loan effectiveness. Among the other banks and DFCs, only four institutions have used more than 5Z of resources each: Banco del Pacifico (8.5?), Banco Pichincha (7.52), Banco La Previsora (6.72) and Filanbanco (5.1%). The remaining PFIs are all evenly distributed around 1-3Z of total FOPINAR credits. By comparison with BNF, which has concentrated its efforts on the microenterprises (average loan size of US$7,300), banks and DFCs have targeted small industries (average loan size around US$25,000). While for FOPINAR it has been important to stimulate the active participation of private banks and DFCs, it has also been beneficial to encourage the participation of BNF, which has the infrastructure to reach the microenterprises, especially those located in remote areas of the country. - 15 - 4.09 Technical Assistance Institutions. CFN/FOPINAR would be responsible for the administration of resourcesi and overall coordination of project execution. It would strengthen its Technical Cooperation Committee (Comite de Cooperacion Tecnica - CCT), to advise CFN/FOPINAR in the selection of activities in support of small enterprises to be executed through CFN/FOPINAR's sub-contracting of established private and public institutions (CENAPIA, INSOTEC, CEFE and others) as well as consultants. Through its present infrastructure and its TA Unit personnel, CFN/FOPINAR would operate in conjunction with local industrial associations in selecting beneficiaries and proposing specific TA activities to satisfy already identified needs. FOPINAR would supervise the execution of the resulting programs. The alternative of creating an extension service as a part of CFN/FOPINAR was considered during project preparation. However, it was discarded in favor of supporting existing institutions whose past operations can be enhanced through tighter coordination and providing closely managed additional resources through FOPINAR. CFN/FOPINAR is expected to run the TA program with the same efficiency displayed in the operation of the credit scheme. While the TA component would still be considered a pilot project experience, safeguards have been agreed with CFN to ensure that the new TA activities are complementary to the credit activities presently being carried out by FOPINAR. During negotiations, agreement was reached with CFN/FOPINAR on a detailed budget, describing the TA component's main activities and costs, and on the implementation program for the first year of operation of the TA component (Annex VI, paras. 8-10). During execution of the TA program, its activities and costs would be reviewed and agreed by the Bank and the Borrower on a semi-annual basis. It was also agreed during negotiations that the basic CFN/FOPINAR TA team responsible for implementation of the TA component would be employed or assigned by loan effectiveness and that the program would be carried out under terms of reference and according to a budget and timetables satisfactory to the Bank. (ii) Executing Agency 4.10 CFN/FOPINAR would be the executing agency for the project's credit and technical assistance components. D. Project Cost and Financing Arrangements (i) Project Cost and Financing 4.11 The appraisal mission esti-ated that total costs of new investments by SSEs in the next three years (1990-92) would be about US$180 million equivalent (Annex VII), of which about 461, or US$83 million, may be the total cost of projects rediscounted thrcugh FOPINAR. Of the US$83 million, it is likely that 60Z may represent foreign exchange costs. Thus, iitially a Bank loan for US$50 million, covering 1002 of foreign exchange costs, is proposed. Total project costs would be financed as follows: SS7s 20Z, the PFIs 8Z, Bank resources 602, and CFN--through FOPINAR--the remaining 12%. The subloans should finance a maximum of 80% of total project cost. The Bank and CFN resources (FOPINAR loan) should finance a maximum of 72% of total project cost. Of the FOPINAR loan, 85% would be financed by the Bank and 15? BY CFN. The TA component cost would be about US$1.6 million, of which US$1 million would be financed by CFN's - 16 - own resources and a grant from the Inter-American Development Bank, and US$600,000 by local counterpart funds. Of these, about 502 would be contributed by the beneficiaries. Since the Bank's Third SSE loan (Loan 2673-EC) was fully committed by mid-1988, and in view of the lack of alternative long-term resources in Ecuador. an amount not exceeding US$5 million (equal to 102 of the loan amount) would be available retroactively for financing expenditures made after December 13. 1989. (ii) Onlending Arrangements 4.12 The Republic of Ecuador, using the Central Bank (BCE) as its agent, would onlend the proposed loan resources in Sucres to CFN on the same maturity as the Bank's loan (17 year repayment period, including 5 years of grace). CFN, using FOPINAR as a second-tier mechanism, would rediscount all subloans made by fiinancial intermediaries to eligible SSEs. The onlending rate has been set initially at the 90-day certificate of deposit rate. Beginning on July 1, 1990. it would be adjusted in uniform steps every six months to reach the market-determined commercial bank lending rate by June 30, 1992. The onlending rate would include a maximum spread of 6Z p.a., for financial intermediaries, depending on the size of the subloans, and d spread of 2.5%, for FOPINAR to cover its operating costs and part of the teLhnical assistance activities. CFN would pay in turn a service fee of .125% p.a. to BCE. The spreads are to remain fixed during the life of the subloan. It was agreed during negotiations that an interest capitalization scheme, to be offered as an option to the final borrower to avoid the adverse effects on cash-flow management of high nominal interest rates, would be fully operational by July 1, 1990. (see Annex VIII). CFN will approve the design of the system by loan effectiveness. The Bank would work closely with the Superintendency of Banks and would proide technical guidance to CFN/FOPINAR during the implementation process. The signing of an agency contract between the Government and BCE and a subsidiary loan agreement satisfactory to the Bank between the Government, acting through BCE, and CFN, on behalf of FOPINAR, will be a condition of effectiveness. 4.13 While the onlending rate to final beneficiaries of the loan would be positive, there would initially be a difference of 11 percentage points compared to the commercial bank lending rate for large industries. This difference will be reduced in line with the schedule of adjustments towards the market-determined commercial bank lending rate; it will be eliminated at the latest by June 30, 1992 and considerably earlier if the present trend of declining inflation, and consequent decline in nominal interest rates, continue.3 The Central Bank would cover the exchange risk; this is justified because the small scale entrepreneurs do not have revenues in foreign exchange and because of the movement towards market oriented interest rates under the loan in the context of a freely floating exchange rate. 3/ Lending at the CD rate will, under current circumstances, imply a subsidy by the Central Bank if measured against its cost of funding and the intermediation spreads. This subsidy cannot be calculated with precision in v:ew of uncertainties about future exchange rate adjustments (inflationary expectations apparently are below present rates of inflation). The subsidy will eventually be eliminated in line with the adjustments towards a market-determined lending role. - 17 - (iii) Terms and Conditions of Financing 4.14 Nature of Enterprises and Eligible Expenditures. The proposed project would provide credit and TA for subprojects of enterprises involved in manufacturing (including agro-industry), industry-related services, fisheries and tourism. Eligible enterprises would be those with a maximum asset size (excluding land and buildings) of US$200,000 equivalent. The criteria of "number of employees" would not be applied in this Project since it would penalize SSEs capable of creating an even larger number of jobs within the fixed limits of investment. Under the present operation, industrial cooperatives and credit unions would also be eligible as credit beneficiaries through the PFIs. Financing to be provided for fixed assets would include new and used imported machinery and equipment; installation costs; building construction; handling and storage facilities; civil works; improvements of product; and quality and design. Free-standing working capital needs financed with loan proceeds would include raw materials, spare parts, other physical production inputs, work in process, and inventories of finished products. Under TA, SSEs might use credit to hire technical institutions or consulting firms to obtain advice and services in the fields of management, technology, finance, production, marketing, and subproject preparation. 4.15 Limits and Terms. Under the credit component, FOPINAR subloans would be made on terms which would take into account the economic life of assets to be financed and the repayment capacity of sub-borrowers. Subloans would have a maximum maturity of 10 years, including a grace period of up to 3 years, and would carry market determined rates, as agreed with the Bank. Collection of interest payments to the intermediaries and FOPINAR would be made semi annually. To foster an increased share of lending by PFIs, the onlending rate would include a spread of 52 and 6Z, which would depend on the size of the subloans, with the larger spreads applying to the smaller (less than US$10,000 equivalent) but more costly subloans. This spread would include all charges to the final beneficiaries, including a 2% commission p.a., established under the current interest rate regime, as an optional charge for the PFIs. In addition, the onlending rate would include a spread of 2.5%, which would be credited to FOPINAR to cover its operating costs and part of the TA activities. 4.16 Under the proposed loan, the maximum cumulative amount of subloans per sub-borrower would be US$85,000 equivalent. This maximum is based on the actual average size of subloans to SSEs under the three previous loans. All subprojects will be appraised by the financial intermediaries in accordance with FOPINAR's appraisal requirements established under the prior three SSE loans. FOPINAR will be required to furnish to the Bank for review all subprojects (ex-ante for subloans above US$50,00 equivalent and ex-post for those below such amount). The adequacy of this free limit would be reviewed from time to time and modified by agreement between CFN/FOPINAR and the Bank, as necessary. Furthermore, it was agreed during negotiations that FOPINAR would carry out an analysis of the soundness of the individual subprojects above the free limit. FOPINAR has performed, since the Third SSE loan, a screening of economically unviable subprojects which includes exclusion of subprojects in highly distorted sectors, as Provided for in FOPINAR's Statement of Policy and Operating Procedures. - 18 - (iv) Procurement 4.17 Procurement procedures for goods and services financed under the proposed project would be done through contracts requiring three price quotations from at least three suppliers. No international competitive bidding (ICB) is envisaged because of the low maximum limit of US$85,000 for subloans. Evidence of the three quotations requested would be required for the ex-post review, mentioned below, for procurement orders above US$60,000 equivalent. Imported used machinery could be financed by the Bank loan. provided that a satisfactory technical evaluation report has been provided by an expert, belonging to a roster selected by CFN/FOPINAR, which has been found acceptable to the Bank. The Bank's Procurement Guidelines would be applicable to contracting of consultants financed by subloans. All subproject appraisals would include a discussion of procurement procedures used and criteria for selection of suppliers of goods and services. As part of project supervision, ex-post review would be made of procurement procedures and documents. (v) Disbirsements 4.18 To facilitate project execution, a Special Account, to be opened and mainained in US dollars, will be established in the Central Bank with an initial deposit of US$2 million, based on four months' estimated average disbursements. The Government agreed during negotiations that CFN will be the Borrower's representative for managing withdrawals under the Loan, inclu,,ing the Special Account. CFN will: (i) maintain records and appropriate documentation of the subloan expenditures; and (ii) request to the Bank, under Statement of Expenditures (SOE) procedures, replenishment of the Special Account. Compliance with auditing requirements of the Special Account will be the Borrower's responsibility. Only expenditures made no more than 180 days prior to the day of receipt by the Bank of the corresponding financing request would be eligible for reimbursements under the proposed loan. This 180-day limit is justified in view of the arrangements involving participating financial institutions, CFN and FOPINAR. Although it is expected that the project will be completed by December 1994, if disbursements take place at the average rate for IDF loans in the region, it would take until June 30, 1995 to disburse fully the proposed loan (Annex IX). The final date for submission of subloans to the Bank for authotization or approval would be June 30. 1994, and the Closing Date June 30, 1995. (vi) Accounting, Auditing, and Reporting 4.19 CFN would maintain separate accounts for FOPINAR and adequate records to reflect FOPINAR's and the project's operations and financial situation in accordance with sound accounting principles consistently applied. CFN's accounts, FOPINAR and the Project's Account, and the Special Account would be audited annually, as in the three previous operations, by independent auditors acceptable to the Bank. The audit report, with scope and format satisfactory to the Bank, including opinion regarding the supporting documentation for disbursements based on SOEs, would be submitted to the Bank no later than four months after the end of each fiscal year. The Government shall cause BCE to submit to the Bank monthly statements of the transactions of the Special Account. CFN/FOPINAR would provide, at the Bank's request, reports on: the overall status of the project, including credit and TA matters; on the project financial situation and portfolio quality; and on the operations (statiltical information) and their expected impact. - 19 - E. Project Benefits and Risks 4.20 Benefits. The proposed project would help integrate the SSEs more effectively into industrial development by iacreasing their productivity and competitiveness. The coordinated package of financing and technical assistance would stimulate production and provide the needed term financing. On the basis of experience under the previous three SSE loans, the proposed project is expected to finance some 4,500 investment subprojects, costing about US$83 million and generating about 14.500 new jobs. It is also expected that about 402 of subprojects financed would be in tne industrial centers of Pichincha and Guayas, which contair a high concentration of the urban poor in Ecuador. Better services to SSEs. as well as efficient subloan and subproject implementation, would result from the institutional support provided to FOPINAR. More than 1.000 enterprises would receive direct technical/managerial assistance. A further 1,500 firms would benefit from training and extension activities. 4.21 Risks. One main risk can be identified: that high inflation and continued recession, coupled with the introduction of market-determined interest rates on subloans, could reduce loan demand and cause a slower pace of commitments and disbursements under the proposed operation than in the previous three SSE loans. The Government's commitment to stabilizing the economy and its success in reducing the fiscal deficit and inflation augurs favorably for a resumption of economic growth with relative price stabilily in the medium-term. The expected strengthening of the economy combined with the favorable outlook for SSE development should sustain strong demand for financing under the loan. V. AGREEMENTS AND RECOMMENDATION Agreements 5.01 During negotiations, agreement was obtained on the following: (1) With the Government on: (a) The proposed project's objectives and description (paras. 4.02 to 4.05); (b) The roles of the different participating institutions and the conditions and arrangements, including the support for the TA Cooperation Committee (para. 4.09); (c) The proposed project cost and financing, loan amount, onlending arrangements, and terms and conditions of financing (paras. 4.11 to 4.16); (d) The establishment of the initial onlending rate for SSE lEnding at the 90-day certificate of deposit rate to be adjusted in uniform steps every six months commencing on July 1, 1990 and reaching the market- determined commercial bank lending rate by June 30, 1992 (para. 4.12); (e) The subloans would contemplate an interest capitalization scheme, to be offered as an option to the final borrower to avoid the adverse effects on cash-flow management of high nominal interest rates. It was agreed that the scheme should be fully operational by July 1. 1990. The Bank would work closely with the Superintendency of Banks and would provide technical guidance to CFN/FOPINAR during the implementation process (para. 4.12); and - 20 - (f) The adequacy of spreads for the participating financial intermediaries and for FOPINAR (para. 4.15). (2) With CFN/FOPINAR on: (a) Revisions of FOPINAR's Statement of Policy and Operating Procedures (para. 4.06); (b) Revision of the procedures to determine FOPINAR's operating budget and, in particular, the charges by CFN for administrative support to FOPINAR. Such procedures and the resulting amounts would have to be reported to the Bank, in conjunction with FOPINAR's budget, by November 30 of each calendar year (para. 4.07); (c) Requirement that financial intermediaries be in good standing with the Superintendency of Banks (para. 4.08); (d) The procedures and structure of tne TA Cooperation Committee (TCC) (para. 4.09); (e) A detailed budget and implementation program for the first year of operation of the TA component, including the training activities for FOPINAR personnel. The program for subsequent years would be carried out under terms of refereace, budget and timetables satisfactory to the Bank (para. 4.09); (f) An analysis of the soundness of individual subprojects above the free limit, and exclusion of subprojects in sectors with very high rates of protection (para. 4.16); and (g) The project's procurement, disbursements and accounting, auditing, and reporting matters (paras. 4.17 to 4.19). 5.02 As Conditions of Loan Effectiveness, the following matters should be presented in form and substance satisfactory to the Bank: (a) The Government and BCE should enter into an agency contract, and the Government, acting through BCE, and CFN (on behalf of FOPINAR), should enter into a subsidiary loan agreement, for the operation of the project (para. 4.12); (b) That CFN has strengthened and expanded the Technical Cooperation Comnittee and employed or assigned, to the satisfaction of the Bank, a core team responsible for the implementation of the TA component (para. 4.09); 'c) That CFN has entered into Participation Agreements with the Banco Nacional de Fomento and with at least two other financial intermediaries (para. 4.08); and (d) That CFN approve the interest capitalization scheme (para. 4.12). Recommendation 5.03 With the above agreements, the proposed project would constitu:e a suitable basis for a Bank loan of US$50 million to the Republic of Ecuador on the terms and conditions shown in Chapter V. - 21 - ANNEX I Table 1 ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Decomposition of Industrial Growth Rates, 1965-82 Annuall Growth Rate Decomposition Growth 1976 - 82 1965 - 82 Rate I I _1985-821 0____ IS E D IS E Total Industry (09-20) 8.8 36.7 53.1 10.2 77.4 11.0 11.6 IIIII II I I I I I I I Food Products (09-14) 6.2 25.5 14.9 59.6 36.6 6.4 j 67.0 I I I I I I I (09) Fish Products 6.4 1(75.8)1 24.6 151.3 38.3 6.8 129.5 (10) Bakery and Cereals 8.7 96.0 15.9 (11.9) 89.9 7.5 2.7 II I I I I I (11) Sugar 1.2 1866.7 1 (149.3) (17.4) 1 255.1 1 -31.3 -123.8 I I I I I I I (12) Other Food Products 1 5.9 1-22.4 16.0 106.4 -29.3 -3.7 1 133.0 (13) Beverages 7.1 85.8 13.4 0.8 102.5 -3.0 0.5 II I I I I I 1(14) Tobacco 9.6 68.6 35.6 5.8 1 19.6 1 79.3 1.7 II I I IiI I 1(15) Textile Products 110.7 95.8 1 7.2 1 -3.0 75.9 22.7 1.4 I III II (16) Wood and Furniture 7.1 67.0 0.6 32.4 68.7 1.1 30.2 I 1 1 1 I 1(17) Paper Products 7.3 37.4 60.0 2.6 57.5 40.9 1.6 1 I 1 I (18) Chemicals A Plastics 111.3 1 52.2 47.4 1 0.4 65.9 44.4 -6.3 IIII I I I 1'19) Non-metallic Products 114.2 32.9 85.4 1.7 49.6 1 49.4 1 1.0 I I I I I I I 1(20) Metsl Products 118.4 16.4 1 97.8 1 1.8 1 39.1 1 60.2 1 0.7 I ___ I II _ _ I I Note: D = domestic demand; IS import substitution; E = exports. Source: Banco Central, Cuentan Nacionales - 22 - ANNEX I Table 2 ECUAOOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISES PROJECT Ditribution of F1rms. Employment and Value Added in Manufacturing Size 1965 1980 1987 (No. of Firms Employ- Value Fires Employ- Value Firms Employ- Value Workers) ment Added ment Added ment Added Self 81.0 51.7% 17.2X 74.3% 34.80 10.0 84.3W 47.7% 16.1W 1-9 18.7X 27.1% 18.3X 24.3X 26.9X 13.6 14.9X 19.3% 17.3X 10-49 0.2X 6.8% 13.2X 1.1% 9.8 12.7X 0.6W 7.3% 10.2X 50+ 0.1% 14.4X 53.3W 0.40 29.8X 63.eW 0.3X 25.7X 57.4% Total 100.0% lee.0% 160.0% 100.OW 100.eW 100.0W 100.eW 100.@W 100.0W Source: Estimates from Industrial, Population and Employment censuses. - 23 - ANNEX II Table la ECUADOR STAFF APPRAISAL REPORT FOURTH SHALL SCALE ENTERPRISE PROJECT Capitrl Intensity among Micro and Small-Scale Industries, in 3984 - CENAPIA (Size defined by Value of Output) Business size measured Frequency Average firm size Total assets per by value of output of Firms (total number of worker (inclusive (millions of S/.) workers including of occassional occassional ones) workers) in each stratum (Thousand of S/.) 0.0 - 0.49 1,130 5.1 240 0.5 - 0.99 417 5.3 244 1.0 - 4.99 1,304 9.8 373 5.0 - 9.99 487 16.6 434 10.0 - 19.9 308 21.7 578 20.0 - 29.9 107 31.1 640 30.0 - 39.9 62 36.0 608 40.0 - 49.9 33 36.0 801 50.0 or more 86 45.3 1,001 Source: Encuesta Nacional a la Pequefta Industria, CENAPIA, 1985, Quito, Ecuador. - 24 - ANNEX II Table lb ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Capital Intensity among Micro and Small-Scale Industries, in 1984 - CENAPIA (Size defined by Fixed Assets) Business size measured Frequency Average firm size Total assets per by fixed assets of Firms (total number of worker (inclusive (millions of S/.) workers including of occassional occassional ones) workers) in each stratum (Thousand of S/.) 0.00 - 0.49 1,622 7.3 255 0.50 - 0.64 174 7.9 182 0.65 - 1.19 412 9.2 232 1.20 - 3.59 778 12.1 336 3.60 - 4.99 258 14.9 494 5.00 - 9.99 392 18.9 614 10.00 - 18.99 198 24.9 862 19.00 - 49.99 91 34.3 1,165 50.00 or more 9 56.1 1,576 Source: Encuesta Nacional a la Pequefa Industria, CENAPIA, 1985, Quito, Ecuador. - 25 - ANNEX III Table la ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Type of Firms that Compete with Those Surveyed by Sector Food Textiles Wood Metal Mechanics Only firms with less than 35% 51% 50% 44% (86) 30 workers Only firms with more than 15% 10% 7% 16% (23) 30 workers oth types 50Z 39Z 43% 40% (82) 100% 100% 100% 100% (191) (52) (66) (30) (43) Source: World Bank SSE Survey, October 1988. - 26 - ANNEX III Table lb ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Source of Inputs by Sector Domestic Mostly Imported Mostly Only Domestic Only Imported Food 612 27Z 6Z 6Z 100Z (54) Textiles 65Z 22Z 12 12Z 100Z (68) Wood 67Z 332 - - 1007 (30) Metal Mechanics 172 332 26Z 24Z 100% (42) (104) (54) (15) (21) (194) Source: World Bank SSE Survey, October 1988. - 27 - ANNEX III Table ic ECUADOR STAFF APPRAISAL REPORT FOURTH SHALL SCALE ENTERPRISE PROJECT Main Problems in Input Purchases Food Textiles Wood Metal Mechanics High Price 482 55? 492 612 (143) Irregular Supply 382 312 30 252 (85) Low quality 12? 122 17? 7Z (32) Without major problems 2% 2Z 4Z 72 (10) al 100? 100? 100? 100? (270) (77) (90) (47) (56) a/ The surveyed firms provided more than one answer. Source: World Bank SSE Survey, October 1988. - 28 - ANNEX III Table id ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Financial Sources for the Last Investment Made. by Size of Firm Micro- Very Small Small Medium Enterprise Enterprise Enterprise Enterprise (1-4) (15-19) (20-49) (50-75) 100? Own Resources 64% 40% 392 8% (62) Fostly Own Resources 92 62 6% 25Z (12) Loans and Own Resources - 14% 9Z - (17) Mostly Loans 18% 26% 32Z 67Z (20) 1002 Loans 92 142 142 - (20) TOTAL 100? 1002 100z 1002 (159) (11) (92) (44) (12) Source: World Bank SSE Survey, October 1988. - 29 - ANNE III Table le ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Marketing Channels by Size of Firm Micro- Very Small Small Medium Enterprise Enterprise Enterprise Enterprise (1-4) (15-19) (20-49) (50-75) Direct Sales 672 34Z 302 182 (62) To Other Firms 276 162 82 92 (31) To Wholesalers 62 442 432 642 (75) To Supermarkets - 6% 192 9% (12) TOTAL 1002 1002 100% 100% (180) (15) (107) (47) (11) Source: World Bank SSE Survey, October 1988. - 30 - ANNEX III Table if ECUADOR STAFF APPRAISAL REPORT FOURTH SHALL SCALE ENTERPRISE PROJECT Form of Production by Sector of Surveyed Firms On Small Automatic Demand Lots Orders Combination Food 17? 302 36% 14Z 100? (54) Textiles 25% 172 29Z 29Z 100 (68) Wood 50? - 10% 40? 100% (30) Metal Mechanics 65Z 12? 7Z 16? 100? (43) TOTAL (69) (32) (47) (47) (195) Source: World Bank SSE Survey, October 1988. - 31 - ANNEX IV Table I ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Banking System Credit to Small versus Medium and Large Enterprises - 1981-87 o/ (Millions of Sucres) (1) (2) (3) (4) (5) (6) (7) Year Credit to X of Total Credit to Medium- X of Total CPI Credit to Credit to Medium- Small-Scale Credit to A Large-Scale Credit to Small-Scale A Large-Scale Enterprise Industry Enterprise Industry Enterprise Enterprise (Current Prices) (Current Prices) (1980 prices) io!l prices) 1980 121.3 1981 2,243.9 7.7 27,025.1 92.3 135.9 2,002.8 24,121.0 1982 2,875.7 7.4 36,185.3 92.6 158.1 2,206.4 27,762.6 1983 3,026.2 4.8 59,720.8 95.2 234.6 1,564.7 30,878.6 1984 5,051.9 6.2 76,247.1 93.8 307.8 1,990.9 30,048.0 1985 5,735.3 4.7 117,387.7 95.3 394.0 1,765.7 36,139.9 1986 6,006.6 3.9 149,554.4 96.1 484.7 1,503.2 37,427.2 1987 9,848.8 4.5 207,950.2 96.5 627.7 1,903.2 40,185.4 a/ Includes Central Bank (Direct Credit); Private Banks and Banco Nacional de Fomento. Source: Boletin Anuario No. 10 de 1987. Banco Central del Ecuador. Estadisticas de FOPINAR. - 32 - ANNEX V Page 1 of 7 ECUADOR FOURTH SMALL SCALE ENTERPRISE PROJECT STAFF APPRAISAL REPORT Fondo de Fomento para la Pequeta Industria y la Artesania (FOPINAR) 1. _ackyround. FOPINAR was established in May 1980, under the Bank's First Small Scale Enterprise Project, as a permanent fund owned and operated by the Corporacion Financiera Nacional (CFN), otherwise a first- tier lender for large industry only. CFN in turn, was established in 1963 as a wholly government-owned financial institution. It is the oldest and largest Financiera in Ecuador and the major provider of medium- and long- term credit to the industrial sector. CFN was authorized under its charter on 1962 to discount loans made by financial intermediaries to small-scale industries. Thus, the establishment of FOPINAR required no changes in CFN's charter and has been operating smoothly within CFN with its own staff and separate financial resources and accounts. FOPINAR is under the tutelage of the Development Department of CFN, which also supervises operations of a special exp t credit facility (FOPEX) and CFN's other first-tier industrial operations (FOGEN). Under the previous three Bank small scale projects, FOPINAR has rediscounted over 7,000 loans, reaching over 5,000 SSE beneficiaries, with a total of US$90 million in Bank loans. FOPINAR was recently identified by the Bank's Industry Development Division which conducted a world-wide study of 70 Bank-supported Small and Medium Industry (SMI) projects as a "model SMI refinancing program, one of the best of the SMI credit operations the Bank has supportcd." A more detailed review of FOPINAR by the proje.t preparation missions has identified a few areas were improvements can be made. However, FOPINAR is indeed an efficient organization (para. 2); CFN/FOPINAR would be the executing agency for the project's credit and technical assistance components. 2. FOPINAR's Management and Administration. CFN/FOPINAR have succeeded in organizing and maintaining a compact group of highly motivated and well-trained professionals which have gained respectability vis-a-vis the financial intermediaries and the entrepreneurial community. CFN/FOPINAR's management have been receptive to new ideas and strive to continue improving efficiency over the medium- and long-term. Under the Third SSE Loan, CFN/FOPINAR agreed to increase the FOPINAR staff from 22.3 person-year in 1984, to 32.3 by year-end 1986. By the proposed project's preappraisal, in mid-1988. CFN's personnel assigned to FOPINAR amounted to 32.6 staff-years, plus personnel support from CFN in areas such as Financial Management, Data Processing, Portfolio Management, Legal Counsel, etc., amounted to about 20.0 staff-years. CFN/FOPINAR and the Bank agreed that, with respect to credit operations, FOPINAR has now reached an appropriate level of professional staffing. Any further efforts should concentrate on improving productivity by streamlining procedures and searching for a more satisfactory balance between its basic activities of appraisal and supervision. Other needs would be in the area of technical  33 - ANNEX V Page 2 of 7 assistan:e, which is being strengthened under the proposed project (see Annex VI). To deal with these matters, CFN/FOPINAR would provide additional training to its professionals to develop the capability for interchangeability of role between appraisers and supervisors and to enhance feedback, which should facilitate technical assistance to SSEs (both technical and managerial) by drawing on the skills of itv own personnel as well as consultants when needed (para. 10). Administrative costs as percent of outstanding portfolio were expected to reach a low of 1.2% by year-end 1986 on the basis of indicators available at the time of appraisal of the Third SSE Loan. However, the opposite occurred due to a very high increase in overhead charges by CFN, which caused FOPINAR's administrative costs to reach a high of 3.02 in 1985 and 1986. Following a Bank review, costs were reduced to 1.9Z in 1987. CFN's management has agreed to reduce its charges further so as to reflect only the real cost of those support services required by FOPINAR for efficient operation. Under such conditions, admin-strative costs (including staff for financial management assistance) are expected to reach a level of no more than 1.5Z-1.3Z of average portfolio by 1989. 3. FOPINAR's Organizational Structure within CFN's headquarters in Quito comprises three sections: (i) evaluation; (ii) training and credit preparation (TA); and (iii) supervision. In addition, there is one regional group in Guayaquil (six staff) doing mostly appraisal and a small amount of supervision, and seven regional units, composed of CFN personnel, in each of the CFN regional branches, which contribute part of their time to FOPINAR's activities. While this structure (with a few variations) has served well during the initial stages of FOPINAR's development, some adjustments were recommended during appraisal to handle FOPINAR's present and expected levels of operations and to respond to the growing requirements of assistance to SSEs. The mission discussed with CFN/FOPINAR some alternative structures that would differentiate operational activities (e.g., appraisal and supervision of subprojects), which can be divided regionally, from support and policy-making activities (e.g., policy formulation, budgetary allocations, programming, promotion and technical assistance management, information processing), which should remain centralized. Under the proposed scheme there would be a central group in charge of the overall management of FOPINAR, physically located in Quito, while Quito would also have a regional office reporting to the central office, just as Guayaquil and other regional or subregional offices do. In particular, the new structure would ensure a unity of operational guidelines and procedures between the offices of Quito and Guayaquil, which now present coordination problems, as well as a more active monitoring of all FOPINAR activities in all regions of the country. Detailed functions for the central nucleus and for the regional offices appear in Chart I of this Annex. The relationship of FOPINAR to the supporting units of CFN was also discussed during appraisal. Supervision missions during the execution of the Third Bank SSE Loan detected an incursion on FOPINAR's autonomy which took the form of dispersing some of FOPINAR's responsibilities within the operational departments of CFN. The subject was discusced with CFN authorities and an agreement reached to ensure a proper relationship between FOPINAR and CFN, as well as to reinforce FOPINAR's capabilities to operate as the executing agency for the proposed Bank loan. - 34 - ANNIEX V Page 3 of 7 4. FOPINAR's Financial Condition. FOPINAR's financial performance has been satisfactory, allowing it to maintain a sound financial position. At the end of 1988. FOPINAR's equity was S/. 1.3 billion in real terms. While paid-in capital by law has been fixed at S/. 550 million, showing a decrease between 1984 and 1988. retained earnings have been increasing in real terms from S/. 526 million in 1984 to S:. 810 million by 1987, to a projected value of over S/. 6,600 million for 1992. Equity in US dollars shows a decrease from 1984 onwards mainly due to a drastic devaluation-- from S/. 68 - US$1 in 1984 to S/. 500 - U1S$ 1 at the end of 1988. However, comparisons in US dollars are not necessarily representative, since FOPINAR liabilities are in sucres. As of December 31, 1988, FOPINAR's capital structure was still adequate (Debt/Equity ratio of 7.8:1). This ratio had a rapid increase from its 1986 value (2.6:1) due to a grrwth of FOPINAR's portfolio and liabilities at a pace much faster than expected at appraisal. In fact, disbursements under the Third SSE Loan went so fast that, in spite of a slow start in 1986, by the end of 1987 they reached US$20.6 million, or the appraisal's estimate for June 1989. This rapid disbursement pace is expected to continue under the proposed project, but because of the anticipated increase in retained earnings, the ratio is projected to remain at a level of around 6.0:1. which is very conservative for a second-tier mechanism (Table 1). As for results, FOPINAR's income varied between 82 and 172 of average equity, reaching an amount of S/. 242 million (US$600,000) in 1988. Financial margins have remained around 4-52 of average loan portfolio in spite of a reduction of FOPINAR's spread under the Third Loan to 2.5 percentage points. FOPINAR's financial projections show that its financial condition and performance could be maintained at satisfactory levels over the next few years (Tables 2 to 4). 5. Collections and Portfolio Quality. The financial intermediaries' (FIs) collection record for FOPINAR discounted subloans, under the first three loans has been quite satisfactory. As of June 30, 1989, arrears represented only 2.62 of the bank's portfolio with FOPINAR and 2.3Z of the DFC's portfolio. Both compare favorably with 10.62 and 10.72 for the arrears on the overall portfolio of the same institutions. The only bank which does not carry separate statistics for the FOPINAR financed portfolio, Banco de Fomento, has an overall arrearage of 10.32 on its overall portfolio but claims that only a minimal portion of its arrears can be attributed to its FOPINAR-financed clients. Under the Third Loan, some of the banks and financieras with higher cumulative arrears along the program (Banco Amazonas, Credito Hipotecario, FINANSA, and FIDASA) did not register any operations; this element alone should even further reduca the arrears under the program. The risk to CFN/FOPINAR is low with respect to beneficiaries because financial intermediaries are expected to repay CFN/FOPINAR regardless of repayments by SSE's. However, during 1988/89 FOPINAR was partially affected by the insolvency and intervention of one DFC (FINANSA) (in November 1988) and one Bank and two DFCs (BANINCO, FINANDES and FIMASA) (January 1989). Although total exposure in these cases is comparatively low (52 of total portfolio), and while CFN/FOPINAR stand a good chance of recovering most of the potential losses, the proposed project would have more stringent eligibility criteria for financial intermediaries. Collections would continue to be made through automatic debiting of tha financial intermediaries' accounts with BCE. It was agreed during negotiations that Participation Agreements as well as FOPINAR's Policy Statement reflect these arrangements, but eligible banks and DFCs would need to be approved by the Superintendency of Banks as well as comply with additional CFN/FOPINAR technical and financial requirements. - 35 - ANNEX V Page 4 of 7 6. Lending Volumes. As of December 31, 1988, and since inception of the program in 1981, FOPINAR had approved a total of 7,467 subprojects, representing a total investment of S/. 25,684 million and credit commitments for S/. 14,056 million (61.52 of total investment). The yearly evolution of operations is presented below; Number of Operations and Volume of Disbursements Years operations Disbursements (S/.) (in millions of sucres) 1981 180 332.5 1982 548 536.4 1983 781 611.4 1984 1,150 1,050.5 1985 1,425 1,986.0 1986 503 1,490.5 1987 1,859 4,565.3 1988 1,021 3,483.8 TOTAL 7,467 14,056.4 The only discontinuities in FOPINAR's growth occurred in 1986 and 1988. The first resulted from several difficulties (e.g., delay in effectiveness of the Third Loan and di.sagreements about the type of legal documents necessary to establish variable interest rates on the subloans and rediscounts), and affected the pace of approvals and operations. In 1987, after the legal obstacles had been settled, and in spite of the uncertain political climate preceding the early-1988 presidential elections, operatiois regained their original momentum. The second, in 1988, resulted from the delay in obtaining a new Bank loan and limited FOPINAR's capability to respond to a sustained credit demand. The Third Bank SSE Loan (2673-EC) was fully committed by May 1988. Thus, during most of 1988 and 1989, FOPINAR has been operating with recoveries from previous loans. During 1988 alone, subloans financed through recoveries amounted to S/. 2,306 million (US$5.5 million) but left a good number of subprojects unattended. In this context the proposed operation would be essential to maintaining the flow of resources to the small industry sector in Ecuador. 7. Subproject Characteristics. Subproject characteristics and their geographic distribution have followed the same tendencies along the three previous Bank loans, with the exception of the average size of subloans, where a steady increase has been observed over the years. Such increases are due in part to inflation but also to a growing sophistication in small enterprises, averaging about US$11,500 per subloan up to 1985, and increasing to US$20,500 for all subloans under the Third Loan, and to US$32,480 if microenterprises are not included in the average (financed - 36 - Page 5 of 7 mostly through Banco de Fomento). In spite of these increases, the average size of subloans and beneficiaries has been considerably below expectations at time of appraisal. The main reason for such size difference can be traced to the ceiling for eligibility of small enterprises established by the Ministry of Industry's legislation (Ley de Fomento de la Pequefla Industria). Up to June 1989, the ceiling to claim benefits as an SSE was S/.25.0 million in fixed assets. After successive devaluations of the sucre, the ceiling had been reduced to the equivalent of less than US$50,000 with a very stringent size limit imposed for SSEs. A decree issued in June 1989 raised the eligibility to S/.50.0 million or US$100,000 equivalent. As for their other characteristics, subprojects have been concentrated (although not very heavily) in five branches of industry: textiles and garments (15Z), food products (15Z), metallic products (9.1?), fishing (11.7Z), and wood products (6Z). CFN/FOPINAR subloans have contributed to decentralization b supporting no more than 52Z of subprojects in Quito (Pichincha) and Guayaquil (Guayas). See Table 5. Concerning the ase of financing, 1,565 subloans (21X) went to new enterprises, which required nearly 35Z of the subloan's amount. A high percentage of the credit funds (902) were used to finance fixed assets, showing a lack of medium-term resources earmarked for free-standing, working capital financing. 8. In terms of participation of FIs, the program (Third Loan included) has been quite successful, since nearly 40 banks ard DFCs have channeled the program's funds to SSEs. Although Banco de Fomento, the main state-owned development bank, has channeled nearly 42? of the funds to about 76Z of the subborrowers, such operations have been concentrated in the microenterprises with an average size of subloan during 1987-88 of about US$6,000 to US$7,000. The remaining banks and DFCs have been more active in the small enterprises, with an average subloan in 1987-88 of around US$30,000. Operational volumes by individual commercial banks and DFCs have been evenly distributed. The most active FIs have channeled from 5Z to 9Z of total credit resources, with the majority channeling between 1Z and 3? (Table 6). 9. Subproject Appraisal and Supervision Activities. CFN/FOPINAR's subproject appraisals have improved consistently along the period of execution of the three Bank loans. Moreover, through training seminars and practice, these capabilities have been partially transmitted to most participating FIs. Although frequent turnover of SSE officers in FIs requires constant retraining, most FIs have been actively responsible for preparing subproject appraisals which CFN/FOPINAR have regularly reviewed. For the proposed operation, CFN/FOPINAR would aim at strengthening processing procedures as follows: an element of price adjustability along the period of processing the subloan would be introduced so that in spite of inflation, disbursements would correspond with the initial needs of the subborrowers; market projections are generally too vague, particularly in export-oriented projeccs where country-wide statistics about foreign trade are being used as market studies; engineering/technical assessments are essentially based on machine supplier' information and not on practical data about productivity and adaptability of specific requirement to the Ecuadorian reality. The same is true regarding TA needs for specific subprojects, which are often based on the entrepreneur's judgement about his own weaknesses and not on a technical appraiser's opinion. Under the proposed project, improved appraisal procedures would include a diagnosis -37 - ANNEX V Page 6 of 7 of the enterprises. The entrepreneurial capabilities--which for FOPINAR's type of client could be more important than the project itself--should be sufficiently assessed by the FI and described in the FI's report to FOPINAR. Currently, FOPINAR reviews and approves every subloan application, including those under the FI's free-limit. Up to the third loan. FOPINAR had a system of preliminary approvals for subloans between S/. 10 million and S/. 21 million (US$20,000 and US$42,000, respectively), introducing an unnecessary delay in granting such subloans. Under the proposed operation, FIs would have an effective free limit equivalent to US$50,000. 10. Supervision activities use nearly 20Z of the staff-years in FOPINAR. In addition to the supervision forms received from some FIs, the supervision section carries out a vast program of direct supervisions, whereby in 1988 alone, 961 subborrowers were visited (529 in Quito and Guayaquil and 432 in the seven other regional offices). The sample of enterprises has been chosen, every year, to represent different sizes of subborrowers, different regions and several branches of iniustry. The results show a high degree of fulfillment, by subborrowers, of the expected subloan appraisal goals, particularly in terms of employment (98.42) and of sales (942). The visits have served, also, to identify new investment requirements, as well as needs for managerial and technological assistance (39Z of the borrowers in 1988). While supervision activities have achieved a significant advance, they would, under the proposed project benefit from scme strengthening and reorientation. At present, supervision is mainly oriented towards verification of expenditure and towards a control of the degree of fulfillment of some appraisal goals (e.g. employment, sales, use of raw materials). It also checks on dates and amounts of disbursements by FIs, as compared with initial estimates at appraisal. In addition, during supervision visits, the entrepreneurs are asked to identify their needs for TA. While the importance of the verifying function cannot be underestimated, it should not overshadow the need for a more active supervision intended to assess the evolution of each enterprise, to ascertain the enterprise's future repayment problems and/or capabilities, to review the owner's management abilities, and to identify, by the supervisor, any technical assistance needs. In the future, CFN/FOPINAR would rely more upon the FIs for verification of expenditures, requiring a more strict fulfillment by FIs of the Participaticn Agreement. Such agreement requires yearly submission, by FIs, of supervision reports covering all FOPINAR subborrowers (a clause which has not been fulfilled by most FIs). As a consequence, FOPINAR's own supervision would expand into the more technical/managerial matters. Finally, and in order to ensure better feedback between among subprojects, FOPINAR would reinforce the contact, between personnel in its supervision and appraisal sections, to an extent in which both activities could, in the end, be performed by the same personnel (which should be trained to operate in both capacities). 11. FOPINAR's Technical Assistance to SSEs. In the past, FOPINAR's TA activities have mostly concentrated on a small number of nonrefundable contributions to other institutions, and particularly on promotional meetings and seminars, dealing with preparation and appraisal of subloan applications. Within such self-imposed framework, FOPINAR attained, in 1989, very important results: (i) 49 promotional events, reaching an - 38 - ANNEX V Page 7 of 7 audience of over 1,900 people including entrepreneurs (over 90Z) and credit officials from financial intermediaries; (ii) 26 training seminars attended by 626 participants from financial intermediaries and from small enterprises and microenterprises, covering project appraisal concepts and preparation of subloan applications. FOPINAR is now ready to step up its technical assistance programs -nd move, either directly or through external consultants, into the areas of industrial extension and on in-plant managerial/technological assistance to small enterprises. Under the proposed project, FOPINAR would coordinate the Technical Assistance Program (see Annex VI). - 39 - ANNEX V Chart 1 ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT FOPINAR: Organizational Structure Existing: 1CFN Special Fund Dept. -CFN Regional FOPINARBranches FOP INARI Director 1 Support Services (relation not clearly defined) Project Training and Supervision Appraisals Promotion Proposed: r ---------- T -------- Special Fund Manager CFN CFN -- ------- FOPINAR Director TA Advisory Committee Support Credit Operations TA Operations Activitiesl & Supervisions a/ Budgeting - Quito - Quito - Guayaquil - Guayaquil Policies - Cuenca Other - Manta Statistics Regional - Ambato Branches Portfolio a/ Includes appraisals and supervision of subloans. ST_A1 AP .ASL_RLPO0R1 F rUR. '?Å!MAt -rA. E 1_1'ERPR E_RJ6CT (Values an Percentages) (<n M.ii on of Constant Sucros) Hator-, cel Projected ___________________________ Y..r Fd.ng D- 31 1984 1986 1987 1988 1989 1299 Lim Proft.tbl.lt/per Performance. Income. IC..s as 8 of Av_o aße . T!ota l _A8sets A.g. A t.s 7.977 5 9.213 2 10,346 6 12.501 6 12.977 8 13.168 6 17.976 3 25.629.2 35.814.7 Tot. 1a-n-om 898 7 11 3% 1.107 0 12 0% 1.278 2 12 4% 1,871 9 15 0% 2.265 9 17 5% 3,481 6 26 4, 5.093 3 28 35 7.492.3 29 2 10.S6.6 29 71 F.ac.i l.p.... 492 4 6 21 732 0 7 9% 851 0 8 3% 1.374 5 11 0% 1.690 4 13 01 2.6C9 7 19 8 3.539 7 19 7% 5.322.4 20 8 7.589.5 21 28 Ad... trt,- E Ep.. 43 2 0 5% 4 5 0 5% 59 % 0 61 76 8 c 6% 13 9 0 61 81 3 0 f1 69 4 0 58 98 4 0 48 108.2 0 3% CF1N/FOPINAR (Ind. r.at) 48 5 0 68 155 3 1 71 174 4 I 71 122 0 1 0% 20 0 1 5 216 0 1 65 233 3 1 35 252 0 1 0m 272.2 0.8% Pro ..on (24 8) -0 31 (25 8) -0 31 (21 0) 0 2% (16 2) -C 1% (55 2) -0 4% (70 1) -0 51 (76 2) -0 4% (82.4) -0.31 (8. 6) -O 28 F.n-~n ~al M-gin 406 27 5 1% 374 94 4 1% 421 17 4 1% 497 42 4 0 55 54 4 45 871 86 6 68 1.553 58 8 61 2.169.86 8 58 3.049.09 8 5% N.t P-of .t 314 52 3 91 172 09 1 91 187 21 1 81 298 62 1 4% 241 92 1 91 495 60 3 81 1.093 54 6 18 1,617.92 6.35 2.439 97 6 8 I.co- 1t... .. 1 of A-r. F,llty 1.877 5 2.178 3 1.910 3 1.758 I 1.508 7 1.549 2 2.277 6 3.570.6 552.5 N.t Prof. t 314 52 16 81 172 09 7 91 187 21 9 81 298 62 17 0 241 92 16 0% 495 60 32 0 1.093 54 48 0 1.617.92 45.3 2.439.97 44 28 F, .a..i Mrg,. 406 3 21 61 374 9 17 21 421 2 22 01 497 4 28 31 575 5 38 1 A71 9 56 3 1.553 6 68 28 2.169.9 6. 3.049.1 55.2% Income. Items. as L_9f Avera259 Por tfo .o Av-.. Portfoi,o 6.483 4 8.348 C 9.542 4 11.338 3 11.765 5 11,910 1 16.510 1 23.W2-6 33.734.7 I.- F- o. 715 5 11 0% 1.105 7 13 2% 1,275 9 13 1,655 7 14 68 2,252 2 19 18 3.463 2 29 11 5.073 9 30 71 7,476.1 31 48 10.Ø28.4 31 51 F..... l I 492 4 7 61 732 0 8 8% 857 0 9 08 1.374 5 1i 1% 1.690 4 14 41 2.609 7 21 9% 3,539 7 21 48 5.322.4 22 3Z 7.589.5 22 58 F,- al Mrg. 4,,6 3 6 38 374 9 4 58 421 2 4 41 49? 4 4 4% 575 5 4 91 871 9 7 39 1,553 d 9 49 2.189.9 9.11 3.049.1 9 0 Tot»- D.bt/t.-, ty 2 55 4 G3 4 85 7 46 7 79 7 29 6 64 5 89 5.22 A r I... 7 8 7 ' I 4 ' 5'. 45 2 4 2.5 2.1 q / A t. 28 29 1 91 17 1% 11 8% 1 41 12 1 13 15 14.5% 16.1% .8-r f ,,,,/./.a Ass , 3%1 3£ .8 38 4: 71 fly 48 91 3% 92 28 93 5% 94.7% - y% 1 6% 27 7 43 48 42 08 38 1% 1-1 ~ 1 -9 1 7 V~844 91 439 40 01 .1 1 .48 1'0 48 01s 581 - 41 - AISIE V Table 2 ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT FOPINAR: Cash Flow Balance (In million USS Dollar) Historical Projected 198 1967 1988 1989 1996 1991 1992 Deflator 435 435 436 436 436 435 435 Additions in period Income from operations 6.29 7.42 7.52 12.65 17.35 23.73 33.67 Current Liabilities BIRF 6.92 14.61 6.84 0.00 6.00 0.00 0.00 FMO 0.33 0.74 0.00 1.11 1.11 6.66 0.00 Other incomes 7.22 3.51 0.16 6.6 1.49 6.63 0.38 Subtotal 14.76 26.48 14.48 14.28 19.95 24.36 34.05 Substraction in Period Expenses from Operations 7.14 17.10 8.40 11.55 19.95 26.79 35.80 Cucrent Loans 5.:a 8.20 2.e0 1.m8 2.39 4.23 4.97 Long Term L.ans 0.00 0.6 2.75 4.24 4.67 4.94 5.19 Administrative Expenses 6.36 0.38 0.17 0.19 0.21 0.23 0.25 Other Expenses 1.27 0.47 0.32 1.06 1.31 1.40 1.14 Subtotal 14.13 26.66 14.34 19.61 28.63 37.59 47.35 Addition - Substraccion 0.64 (6.17) 0.12 (4.75) (8.58) (13.23) (13.29) Opening Cash Balance (from previous period) 6.69 0.68 6.24 6.38 6.44 0.41 0.36 Long Term Loan 6.66 6.66 6.6 4.83 9.20 15.76 19.31 Interest 6.66 0.66 . 6.00 9.86 2.68 6.68 Closing Cash Balance 0.72 0.39 .386 0.44 0.41 0.30 0.23 Source: CFN. ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT FOPINAR: Balance Sheets I/ (In million USS Dollar) ------------------------------------------------------------------------------------------------------------------ Historical Projected Year Ending December 31 1984 1985 1986 1967 1988 1989 1990 1991 1992 ------------------------------------------------------------------------------------------------------------------ orSeign Exchange 435 435 43 43 435 435 435 435 485 ------------------------------------------------------------------------------------------------------------------ Assets Current Assets Cash 0.81 6.11 0.72 1.39 0.36 0.44 0.41 0.3e 6.28 Current Loans 2.89 2.85 3.91 5.82 4.31 6.05 7.16 9.94 14.99 Interest receiv. 6.59 1.61 @.OR 1.34 1.84 1.46 1.82 2.86 816 Other current assets 1.62 0.23 1.04 1.66 6.75 1.21 1.78 2.06 1.96 Less Provisions W6W) ( 0 (0.84) (0.13) .16) w61) (6.19) (0.20) Total Current Assets 5.77 3.96 6.51 8.7 7.14 9.81 1998 14.46 2.68 Long Term Loans 13.42 19.22 17.82 24.51 19.45 24.95 37.83 54.88 75.49 Total Assets 19.19 23.17 24.491 33.68 26.59 33.96 47.69 69.14 96.52 Liabilities and Equity Current Liabilities 6.74 6.51 4.51 2.96 1.36 2.62 4.44 5.90 9.38 Long Term Loans 13.05 18.65 15.6? 26.21 22.26 27.84 37.88 53.20 70.79 Paid in Capital 4.19 3.27 2.615 2.05 1.26 1.26 1.26 1.26 1.26 Retained Earnings 1.21 1.34 1.52 1.86 1.76 2.83 6.11 8.78 14.08 TGtal Equity 5.46 4.61 4.17 3.91 3.03 4.10 6.37 10.04 15.35 TOTAL LIABILITIES AND EQUITY 19.19 23.17 24... 33.08 26.59 33.96 48.69 69.14 95.52 ---------------------------------------------------------------------------------------------------------- Source: CFN. ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT FOPINAR: Income Statements a/ (In milPion US$ Dollar) ------------------------------------------------------------------------------------------------------------------ Pistorical Projected Year Ending December 31 1984 1986 1988 1987 1988 1989 1996 1991 1992 ------------------------------------------------------------------------------------------------------------------ Foreign Exchange 435 435 436 436 435 436 436 436 436 Income From Loans 1.64 2.64 2.93 3.81 5.18 7.96 11.66 17.19 24.43 From Investments 0.42 6.66 6.01 6.56 0.03 0.04 0.04 0.84 0.03 Total Income 2.07 2.54 2.94 4.36 5.21 8.66 11.71 J7.22 24.46 Expenses Financial Expenses 1.13 1.68 1.97 3.18 3.89 6.00 8.14 12.24 17.46 Financial Margin 6.93 6.86 6.97 1.14 1.32 2.60 3.57 4.99 7.01 Administrative Expenses 6.10 0.11 0.14 0.18 0.17 0.19 0.21 0.23 0.25 Loan Loss Provisions 6.66 6.6g e.11 .00 0.16 0.03 1.01 0.01 0.01 Indirect Costs 0.11 0.36 0.401 0.28 0.46 0.59 0.54 6.58 0.68 Other Adm. Expenses 2/ 6.66 6.66 6.6N 6.00 6.63 0.15 6.30 0.46 0.61 Operating Expenses 6.21 6.47 6.54 6.46 0.77 0.86 1.66 1.27 1.40 Net Profit (Loss) 0.72 0.40 0.43 0.69 0.56 1.14 2.51 3.72 5.61 ------------------------------------------------------------------------------------------------------------------- a/ Source: CFN. - 44 - ANNEX V Table 5 ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT FOPINAR: Geographic Distribution of Subloans (1981-June 30, 1989) Province No. of Operations Credit Amounts Z (millions of sucres) Azuay 762 1,091.9 6.5 Bolivar 48 37.4 0.2 Caftar 91 100.0 0.6 Carchi 95 48.2 0.3 Chimborazo 221 317.4 1.9 Colon 10 71.8 0.4 Cotopaxi 186 381.2 2.3 El Oro 419 705.2 4.2 Esmeraldas 301 517.8 3.1 Guayas 1,187 4,559.7 27.0 Imbabura 487 673.9 4.0 Loja 704 546.5 3.2 Los Rios 456 1,242.7 7 4 Morona Santiago 88 72.7 0.4 Napo 67 122.4 0.7 Pastaza 51 65.1 0.4 Pichincha 1,545 4,086.3 24.2 Tungurahua 507 1,047.8 6.2 Zamora 38 34.2 0.2 TOTAL 71749 16j872.9 100.0 Total Quito-Guayaquil 1,889 24.4Z 40.0% Total Rest of Country 5,860 75.6Z 60.OZ - 45 - Table 6 ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT FOPINAR: Distribution of Subloano by Financial Intermediaries (1981-June 30, 1989) Financial No. of FOPINAR Disbursements Intermediaries Operations (millions of sucres) Z Banco de Fomento 5,843 6,284.6 42.0 Banco del Progreso 51 257.1 1.7 Banco Amazonas 23 76.8 0.5 Banco de los Andes 8 51.8 0.3 Banco del Austro 40 120.1 0.8 Banco del Azuay 67 325.9 2.2 Banco Bolivariano 5 20.1 0.1 Banco Continental 72 473.0 3.2 Bco. Credito Hipotecario 3 9.4 0.1 Banco de Descuento 5 19.9 0.1 Filanbanco 80 618.5 4.1 Banco de Guayaquil 113 435.3 2.9 Banco Ind. y Comei:ial 35 197.7 1.3 Banco Internacional 5 59.4 0.4 Banco de Loja 22 44.1 0.3 Banco de Machala 17 72.8 0.5 Banco del Pacifico 319 1,366.8 9.1 Banco del Pichincha 166 868.0 5.8 Banco Popular 49 207.7 1.4 Banco de Prestamos 71 335.4 2.2 Banco La Previsora 215 820.0 5.5 Banco del Tungurahua 12 64.9 0.4 Danco de la rroduccionr - 8 2.4 Bco. Caja de Credito Ag. 14 78.0 0.5 Banco de Cooperativas 47 119.9 0.8 Banco de America 1 8.3 0.1 Bco. Consolidado del Ecuador 12 89.1 0.6 COFIEC 14 79.8 0.5 FINANSA 33 115.2 0.8 ECUFINSA 13 121.6 0.8 Financiera de Guayaquil 27 153.4 1.0 Financiera del Austro 57 100.2 0.7 Financiera Iberoamericana 80 370.5 2.5 Financiera Andina 20 100.2 0.7 AMERAFIN 2 20.0 0.1 FINANSUR 55 270.7 1.8 FINANCIERA MANABI 83 173.7 1.2 FINANCERA DE LA REPUBLICA 3 33.2 0.2 FINEC CIA. FINANCIERA 6 41.6 0.3 FINANCIERA LATINA 1 4.5 0.0 TOTAL 7,749 14,965.2 100.2 Page 1 of 6 ECUADOR STAFF APPRAISAL REPORT FOURTH SHALL SCALE ENTERPRISE (SSE IV) PROJECT Technical Assistance (TA) A. Background 1. Mission interviews during project preparation as well as recent surveys revealed SSE needs for technological and managerial assistance. The most comprehensive of such surveys, one conducted by CENAPIA in 1985, covering nearly 4,000 small scale industries, as well as the most recent one, carried out in October 1988 by a Bank consultant, identified at least five areas of assistance perceived by entrepreneurs to be as important for them as financial assistance: market studies, production processes, marketing, management, and accounting. Mission meetings have shown that, even in cases where basic technical knowledge seemed sufficient for the entrepreneurs to produce reasonably good products, the managerial skills leave ample room for improvemant. Frequently the main and only advice about selecting the machinery cames from equipment salesmen. Similarly, the amount of raw material stock needed is often based on suggestions provided by local suppliers, which is frequently based on self-interest. Accounting is developed in response to the limited requirements of financial institutions and often is perceived more as a "necessary evil" and a fiscal obligation than as a managerial tool. Sales, in turn, depend more on the narrow possibilities of a network of personal acquaintences than on a marketing strategy. A few training initiatives undertaken in recent years by FOPINAR and some private SSE-oriented institutions (para. 4) have been welcomed by entreprenpurpaP. mentioned to the mission as an important contribution to improving their companies. Nevertheless, the past failure to provide more massive assistance to SSEs has allowed overequipment and overstocking in many small firms and left the majority far behind in product design, quality control, marketing techniques, and basic production management. The present SSE needs will require not only highly sophisticated technological support but also a massive diffusion of information and training about basic techniques and procedures. B. Present Institutional Setup for Assisting SSEs 2. There are several public and private institutions that have as an objective to provide (or claim to be providing) some degree of assistance to SSEs. The coverage and results so far appear meager and for the most part, have been limited to the areas of general training and preparing credit applications. Private and public programs tend to be uncoordinated and limited in resources. As a result, they encounter difficulties in reaching a critical mass and in producing any lasting impact. Even FOPINAR has undertaken several technical assistance activities in the past but these efforts have been restricted to assistance in preparing and processing credit applications. 47 -N-V Page 2 of 6 3. Public Institutions Assisting SSEs. The most visible public institution in the field is CENAPIA (Centro Nacional do Promocion do la Pequefta Industria y Artesania). CENAPIA is an autonomous institution, related to the central government through the Ministry of Industry. It was created to provide assistance to SSEs in matters related to feasibility studies, to marketing, and to financial and accounting management. At present, it has a staff of 47 professionals. Nevertheless, due to a very limited budget (US$300,000) in 1987, and to bureaucratic restrictions, its activities have been limited to surveys and economic studies for some branches of industry, and to preparation of free subproject studies for a limited number of small entrepreneurs. An indirect contributor to SSE assistance is SECAP (Servicio Ecuatoriano de Capacitacion Profesional). Its objective is to train workers for industry and services. It is well equipped with the necessary infrastructure, consisting of 14 training centers in different regions of the country, and a staff of 600 specialized technicians. Its financial resources come from a 0.52 tax on the worker's salaries, from government contributions from the national budget, and from bilateral donations by several foreign countries. While SECAP has made a substantial contribution in the field of training, most of its trainees are already, or end up being, workers of large industries. SECAP's technicians have reportedly very limited participation in activities outside their training centers. Other related public institutions include: FONAPRE (Fondo Nacional de Preinversion), responsible for promotion and preparation of large investment projects; CENDES (Centro de Desarrollo Industrial), which assists the private and public sector in preparing industrial investment projects, and in exploring new industrial opportunities. Also providing specialized technical assistance to large industries are DINATI (Direccion Nacional de Asescria Tecnica), responsible, within the Ministry of Industry, for coordination of foreign technical assistance programs directly benefitting public sector institu*ions; and TNEN (Instituto Ecuatoriano de Normalizacion), responsible for establishing and promoting technical production standards and quality control procedures. While all of the above institutions are, at present, only indirectly connected to the reality of small entrepreneurs, they are all potential participants and contributors in an SSE-tailored technical assis)ance program. 4. Private Organizations and Banks Assisting SSEs. Among private institutions, assistance to SSEs 1 has taken two different avenues: (a) the 1/ The May 1983 SSE decree (Ley de Fomento de la Peguefta Industria) defines SSEs as enterprises with a maximum asset size (excluding land and buildings) of 25 million sucres (about US$50,000 equivalent) and microenterprises as firms with a maximum asset size of 3 million sucres (about US$6,000 equivalent). However, for purposes of the economic analysis of the SSE sector, the mission has used a more widely used criteria based on number of employees, and has defined SSEs as those employing less than 50 employees and microenterprises as those employing less than five employees. ANNEX VI -48- Page 3 of 6 smaller enterprises (microenterprises), including formal and informal businesses, have been assisted through a host of private (in many cases foreign-supported) foundations and, to a limited extent, by some banks (e.g., Banco del Pacifico and Banco Nacional de Fomento); (b) the upper segment of small enterprises (between five to ten workers) have been assisted by the Chambers of Industry, and by INSOTEC (Instituto de Investigaciones Socio-Economicas y Tecnologicas). The foundations, of which over a dozen were visited by the mission, have no common pattern or common methodology of action. Many have chosen a case-by-case approach geared towards poverty alleviation projects. The Government established in 1986 a special unit. UNEPROM (Unidad Ejecutora del Programa de Microempresas) in the Ministry of Labor, whose purpose is to promote and coordinate the creation of private 4oundations and use them to channel donations of the informal sector microenterprises. The program has had little impact and few of the existing foundations were established as a result of the program. USAID is trying a new approach and has reached an agreement with FOPINAR and CARE/Fundacion Carvajal. from Colombia, to start a new project in four or five secondary cities in northern Ecuador, with a training/advisory/credit approach. The project started in early 1988 so it is still premature to assess the results. In the above context, the mission believes that, in spite of their present limitations, some of the foundations, if properly funded and guided, could become an appropriate vehicle to reach the micro-entrepreneurs with technical assistance programs. 5. A few larger size SSEs have been assisted in technological and managerial matters by INSOTEC. INSOTEC was established in the late 1970s and is the only private technical assistance institution which specificallv addresses the small scale firms. INSOTEC was established with the financial assistance of foreign private foundations and nominal contributions by FENAPI (Federacion Nacional de Camaras de Pequeftos Industriales del Ecuador). Although it constitutes a good embryo for a technical assistance institution, its present activities are limited by th- lack of financial and human resources (its present permanent staff is limited to sevcn people). It& maill aLeas of activity are in technology and training. In view of its relationships to FENAPI and of its nearly ten years of involvement in the sector, INSOTEC could play an important role among the private sector TA organizations. Among private training institutions, the best known is CEFE (Centro de Formacion Empresarial), established by ANDE, the National Association of Entrepreneurs for the training of middle and large size entrepreneurs and their employees. CEFE has recently started some training courses for small entrepreneurs and has expressed great interest in participating in the TA subprograms. C. The Proposed Project's TA Component 6. The main objectives of the TA component would be to: (i) support the growth and the increase in efficiency and productivity of SSEs; (ii) support the TA delivery capabilities of existing institutions and encourage the creation and strengthening of an integrated and coordinated system of support to SSEs; and (iii) increase the credit delivery effectiveness of financial institutions and expand the vclume and range of seriices they provide. A summary description of the TA component's main activities and costs is given in the following paragraphs and is schematically nresented in Table 1 (attached). ANNEX VI Page 4 of 6 7. Assistance to SSEs--Technical Assistance Coordination. The most important new development under the TA component would be the establishment of a coordinating mechanism for TA activities, and the reorientation of the present TA and supervision units in FOPINAR towards a role closer to that of industrial extension agents. Under the proposed project, FOPINAR would be required to strengthen the Technical Cooperation Committee for TA to small enterprises (Comite de Cooperacion Tecnica) The Committee would operate as a "second-tier window' for TA, using private and public institutions as well as consultants to execute TA activities in favor of SSEs. Through FOPINAR, funds (from CFN's own resources, a grant from the Inter-american Development Bank, and local counterpart funds) would be channeled to participating institutions (e.g., INSOTEC, CENAPIA, SECAP, CEFE, Foundations, Chambers of Industry) against presentation of bpecific programs, to be agreed with the Bank on a semi-annual basis. Activities identified so far, which are included in the cost estimate in Table 1 of this Annex, include the following: training of TA agents, preparation of extension brochures and booklets. enterprise diagnostics, surveys of regional investment oportunities, training seminars for entrepreneurs, in- plant assistance to eligible firms, studies on the establishment of joint marketing schemes. 8. Assistance to FOPINAR. To fulfill its new role, FOPINAR would require some institutional reinforcement including additional training to its senior staff as well as additional equipment (e.g.,computers, vehicles) for its regional offices and for headquarters. Such items are also included in Table 1 and have been agreed upon during appraisal. In addition FOPINAR would receive resources to reinforce the technical assistance procedures and activities of other institutions through the execution of TA programs, which would be assessed and coordinated under the Technical Cooperation Committee (TCC). 9. The TCC would include representatives from the Public Sector (e.g., Ministry of Industry and Trade, CONADE, and CFN) as well as from the private organizations (e.g. Associations of Banks and DFCs, FENAPI). The Committee would operate at the initiative and under the coordination of FOPINAR which would be the Committee's Sect?tariat. To fulfill its responsibilities FOPINAR would restructure the functions of its existing TA and Supervision units. At present, the TA unit is mainly concentrated in delivering seminars about the preparation of credit applications, and the Supervision Unit is geared towards expenditure verification tasks. In the future, they would take a more active role in: (i) proposing technical/managerial activities to satisfy the needs identified during their visits to enterprises or through contacts with entrepreneurs associations; and (ii) operating as a referral system for available services in other institutions. Initially, and in order to maximize the impact of financial and human resources available under the proposed project, the TA programs would concentrate in not more than four to five regions of the country. Those regions have been selected by FOPINAR in view of their level of SSE activity as well and of the interest expressed by the local Chambers of Industry (the proposed locations are Quito, Guayaquil, Manta, Ambato and Cuenca). 10. FOPINAR would operate with a basic team at Headquarters and one or twn staff in the selected regional offices, which would assist small ANNEX VI - 50 - Page 5 of 6 entrepreneurs, individually and in groups, to identify their TA needs and programs. While about half of the agents would come from the reassignment of existing FOPINAR staff, a few others would have to be specially recruited for the program. Typically they would have an engineering, accounting, or business administration background, with some previous experience with small firms. Due to the specialized kind of functions that they are expected to perform, the selection of candidates would require rigorous screening tests to assess their motivation and personal capabilities for establishing good relations with small entrepreneurs. After recruitment, both existing and new staff would go through a training program (six to eight weeks). The training would familiarize the agents with local institutions providing technical and financial assistance and with technical knowledge in areas such as: basic concepts of small enterprise management, elements of project preparation snd appraisal, industrial extension including techniques of grou) work, concepts of financial accounting management of small business, market studies and marketing techniques, etc. Previous to such training and in order to help in the final program design, it is expected that two or three senior staff members of the initial group would take two-week visits to some other countries operating a successful extension service (e.g., Mexico, Spain, Brazil). Initial training for the staff is expected to be completed by loan effectiveness. 11. In terms of delivery procedures, Lhe contact with entrepreneurs would combine, from the beginning, the individual approach with the group approach or "clusters" approach. Through the later procedure, developed and tried in Mexico during execution of three Bank-supportcl SSE projects, small firms in the same geographic area and in the same branOhes of industry (shoes, textiles, furniture, etc) are grouped together to receive technical assistance on their field of interest and to, eventually, organize joint activities, such as: raw material purchases, group exhibits, credit unions, and other forms of cooperation. In order to maximize the impact of the program, the direct contact with entrepreneurs would be complemented by the preparation/adaptation of self-learning guides and audio-visual training aids, covering the essentials of production and managerial techniques. The policies concerning payments for direct services would, initially, follow other countries' experience which show that while industrial extension services should, in the medium-term, be expected to be self-financed, they have to start charging only nominal fees and gradually increase the value of services as they became better known and appreciated. The program would also receive additional financing through the sale of brochures, seminars, and other standard products. As for diagnosis of enterprises and for in-plant assistance, each entrepreneur should be provided with a basic service (three to five days) free of charge and, subsequently, be referred to local consultants or institutions for the follow-up actions derived from the initial diagnosis. Such a procedure would allow for a clear identification and qualification of subsidies and for an identification of the sources to cover them. An essential element for the success of the system would be to allow an important degree of autonomy to the regional offices in proposing, and in executing, their working program according to the local needs and realiti.es and, most important, to the priorities perceived by the local groups of entrepreneurs. ANN=-VI -51 - Page 6 of 6 Flour* 1I- FOPINAR's Future Activities FOPNA's Actlytles r ITechnical Cooperation Credit Technical Assistance Committee 1/ o Banks o Financing Companies o BNF I Specialized Direct Duties 2/ Institutions 8/ o Identification of Needs o Chambers o Supervision of Enterprises o CENAPIA and Programs o INSOTEC o Referral Services o CENDES o Diagnosis of Enterprises o CEFE o Consultants o Etc. 1/ Suggested initial composition: MICIP, Banks' Association, CFN, FENAPI. 2/ Through own staff at regional units In Quito and pilot regions (Cuenca, Ouayaquil, Monts, Ambato). 3/ Provide services through own resources or through contracts with CFN/FOPINAR. Bet=t~ o~ ad n i t fr e~ica fsix ('ia) Prr (1990-91) (bject ive IE [tom to be f^iu I incal 'tmal Inst itut innm[ !pcted infits (lae of Cai~nm Ri of RWIIu (a) Prwide trainie for In>4ek stidy trips to Internatinnal trovelirw ani 15,X) 3,mM V I8,jm0 RWIA Ttmin 4 staff ist 9)-ter 1990. taff of RWMff mmtrien with &ucce~ful expenIe. m . d RWIIR's inistrtal extensio gemues 0~1nmntlrw (e.g. mekn, frazIl, $San). Oittee. Rgrm~ to te npene tn perticipptin Six-week trai~nr prngrot Internml travel. nrgitrAt Imal b~k (PR). including therettca] and expPns. Instrxtor- mni 40,TYI 10.000 sn.M i fl A ain 10 RIWå 1rEI 9mrtPr 3990. praVtical exPerfen (e.g. Mterialq. staff w~"ers and ar~mti,. prnduttm. in others frm mw~mEt, merEtiw, legal participatifR prn ~trs tax, etc.) inrt ituetinn. b) Mst RiufR In Priide reur"e to RWiJI 10 TA staff muri sup"nrWIt - Inffl) 1PA).(WY) 9r'l*A/YN Fatablish a TA 1990-91. peatirk the prr~ to bWInt TA pgram. verunuPl. del tvery syntmB dairg firet three åmi c~rdinttiW years. mPelo s. (c) Aist pWl~RB 4e aminerq and 4 foImer 0wis"lrti, ranlI, il,w . 4tr) ,(r1,1 l-.i.tNk ...t Iraln n profe - 1990:4 *emin:nr, in strertv~nirw ce sturly uwrksl~In for nruanl%t fr.i.al .in.. I Pi..• . fnrifal Irfim ' éi fi• Cmities In staff frne RWIINA mni brs. FWIMR :mei Ny*n. Gipraial and muerwry: appraMsaI ,l MMrvisim of uprvqfn of quhaets. ipnjects. (d) Fepr extenem nt develnped extenmim tM1 preparatin. 14.I 6,6M RWINAR 0lete åo n990: 5 booklets =teriala fr Infi- =teriala (bmnMets. audio- awin-vimul equipmnt. 24.,CI) i j,( (throtOi >ther bnnklets ami 1991: 5 bIoklets Ellnn aI elt- vinual trainis~ aids) in foreign literature. 9,600 4.400 70.X) insti is) bic G O / trainilU of entr- m nt/arait irg/ aouthir tapic. or nr. P~ndutitm tnpicR. (e) PtUide RWIIlt with Equipmnt. 6 yehicleff, 132.fIf) RNAR/CFN Fqup L.Q. and 1990. -eesary equ at typirm ad oapying equiPent. 0,M regimal nffices. for its initil IR 13 ~r)pters w/softuare, gertinnm. nthe»r. 20,(X1 172.11 - AR . 2 n . -53 ANNEX vi Ta-ble 1 Page 2 of 2 -41 e@ i il i li1gg i i mil 1 f l ita i - 54 - ANNEX VII ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Projected Investment in Manufacturing, 1990-92 (Millions of US$) Number of Workers 1990 1991 1992 1-9 13 13 14 10-19 12 13 13 20-49 32 34 35 50-99 46 48 50 100-199 56 59 61 200-499 86 90 93 500 and More 64 67 69 Projections are made undcr the assumption that valued added in manufacturing will show an average growth rite of 4Z per year. To translate value-added figures to investment, the ratio of investment to value added in 1985 was used. - 55 - ANNEX VIII Page 1 of 4 ECUADOR STAFF APPRAISAL REPORT FOURTH SMALL SCALE ENTERPRISE PROJECT Interest Capitalization Scheme Proposal to Minimize the Current Accelerated-in-Real-Terms Debt-Servicing Requirements due to High Nominal Interest Rates A. Introduction 1. When traditional loan repayment methods are used by the banking sector and, at the same time, nominal interest rates are high, a distortion is generated by which the actual debt-servicing of the loans ends up being accelerated, when measured in real terms. Traditional debt-servicing methods were originally designed for non-inflationary situations and have proven to be inadequate for high inflationary environments, such as the one prevailing in Ecuador. This distortion generates a negative impact on the cash-flow of the borrowing enterprises, especially in the case of medium- and long-term development loans. 2. The resulting cash-flow problems not only tend to exaggerate the deteriorating quality of the banking sector's portfolio, but also tend to create the following additional problems to the private productive borrowing enterprises: (i) higher collateral requirements; (ii) shorter nominal maturities for new lending; and (iii) a damaging perception of an exaggerated financial deterioration, usually misdiagnosed by most bankers as a problem of profitability or insolvency of the productive enterprises, that further erodes their creditworthiness. This, in turn, usually becomes a self-fulfilling prophecy that can negatively affect the private sector and seriously undermine the Bank's support to strengthen industrial development through development finance projects. 3. There is the need, therefore: (i) to fully understand the reasons why high nominal rates together with traditional debt-servicing schemes generate an accelerated-in-real-terms debt servicing problem; and (ii) to design a new debt servicing scheme that can result in an evenly distributed debt servicing burden to borrowing enterprises and eliminate, or at least minimize, political problems to the government due to side-effects due to "loan indexing" or complaints due to "ever inflating debts". 4. During negotiaticns, it was agreed that the Corporacion Financiera Nacional (CFN) will offer--as an option--a system acceptable to the Bank, that will allow final beneficiaries to have a level servicing of subloans in real terms (constant prices). The scheme will have to be approved by loan effectiveness, and become operational by July 1, 1990, to permit authorizations for new commitments under the Loan. - 56 - ANNEX VIII Page 2 of 4 B. Acceleration in Real Terms of Debt Servicing Requirements 5. Table 1 below shows as Case I an example of a local currency, 10 year long-term loan (plus one year of grace), under a traditional debt- servicing schedule. Inflation is assumed to be 802 while the lending interest rate is assumed to be 70Z (negative in real terms!). It is compared with Case II, that assumes that the proposed new debt-servicing scheme will be in place. TebIe 1 Acceleraed in ReI Terms Debt Servicing (in Sucres) CASE I: Assumptions: Loan size: S/.1 million; Lending Rate: 70p.a.; Inflation x 80%p.a.; Terms = 10 years plus one year of grace; Traditional Debt-Servicing Scheme. Y.End Beginning Total D.Serv. Cum.D,S. Price Principal Amort in Interest Debt in Real in Real Year Index Balance Period Accrued Service Terms Terms 1 1.80 1,000,00W 766,666 700,600 388,889 388,889 2 3.24 1,660,606 166,00 700,600 6-e,006 246,914 635,803 3 5.83 -00,000 100,606 630,000 730,000 125,171 760,974 4 10.560 800,00 100,000 5680,00 680,000 62,857 823,831 5 18.90 700,000 100,000 496,000 596,000 31,217 855,048 8 34.01 600,000 100,666 420,000 620,666 16,289 880,337 7 61.22 600,000 10,666 3560,000 460,000 7,350 887,687 8 110.26 400,000 166,066 280,66 380,000 3,448 891,136 9 198.36 300,000 100,000 216,600 310,000 1,663 892,698 10 367.65 200,000 100,000 140,000 240,000 672 893,370 11 642.68 100,666 100,666 70,000 176,006 266 893,635 CASE II Assumptions: Loan Size: S/.1 million; Lending Rate 80O p.a.; Inflation = 80% p.s.; Terms = 10 years plus one year of grace; New Feature: includes voluntary capitalization of interest (up to 100% of interest) and annual amortization equal to new balance divided by nut,bers of years left). Accrued # Nominal D.Service Beginn. Interest New Yrs. Debt in Real Year Balance Period Balance Left Service Terms 1 1,666,006 366,666 1,666,666 11 2 1,866,666 1,440,666 3,246,600 16 324,000 100,666 3 2,916,006 2,332,800 6,248,800 9 583,206 166,00 4 4,6866,00 3,732,480 8,398,080 8 1,649,760 100,00 5 7,348,320 5,878,8560 13,226,976 7 1,889,568 100,666 6 11,337,408 9,069,926 20,407,334 6 3,401,222 100,0 7 17,06,112 13,604,890 3:,611,002 6 6,122,200 10,660 8 24,488,801 19,691,041 44,079,842 4 11,019,961 100,000 9 33,059,882 26,447,9065 59,607,787 3 19,836,929 100,0 16 39,671,868 31,737,488 71,409,346 2 35,704,672 100.0 11 35,704,672 28,683,738 84,268,416 1 64,288,416 100,6 - 57 - ANNEX VIII Page 3 of 4 Table 2: Comarison between Cases I and II (in constant thousand S/. of year 0) Year CASE I CASE II Difference 1 388.9 0.0 388.9 2 246.9 100.0 146.9 3 125.2 100.0 25.2 4 62.9 100.0 -37.1 5 31.2 100.0 -68.8 6 15.3 100.0 -84.7 7 7.4 100.0 -92.6 8 3.4 100.0 -96.6 9 1.6 100.0 -98.4 10 0.7 100.0 -99.3 11 0.3 100.0 -99.7 TOTAL 898.2 1,000.0 101.8 6. Table 2 compares Case I with Case II of the above example. Under Case I, it is striking to see that its terms reflect the worst of all possible situations, because : (i) in the first year --when it was expected that the grace period would give some relief to the borrower-- over 402 of the total repayments in real terms would need to be made, which would not seem viable for the majority of subloans; and (ii) total payments in real terms would not suffice to cover the loan's initial value, because of the negative real interest rate level. In other words, not only the Government would lose by passing on the funds at nigative real levels, but the borrowers would get into difficulties by repaying about 40Z of a 10-year subloan's real value, during the first year alone. Case II shows that under the proposed scheme, not only the subsidy would be eliminated but also the debt-servicing pressure on the cashflow would be made even during the subloan's lifetime. C. Description of the Proposed New Scheme. 7. The "Original Subloan' would first be made in the traditional way (i.e. as in Table 1 above, the subloan would have a grace period, level amortizations and a nominal interest rate that would be applied to the outstanding balance of the subloan). As a second step, at the end of the first year, CFN would compute --in constant prices of the beginning of the year-- the value of such a traditional debt-servicing.1 At the end of every year, the difference between the debt-servicing under the traditional method and the target amortization in real terms, would be equal to the maximum eligible amount of "new money" loans that could automatically be used by the sub-borrower, at his option.2 As Table 4 (attached) shows, 1/ In our example, the first year was to be a grace period, and therefore the target debt servicing for the first year would be equal to zero. 2/ The amount of the target amortization in real terms would simply be equal to the original loan amount divided by the number of amortization years. ANNEX VIII - 58 - Page 4 of 4 total debt- servicing of the original loan will amount to S/. 388.889 in constant prices at the end of the first year, while the target amortization for that year is zero. Therefore, at the end of the first year, "new money" loan No. 1 could be as high as S/. 388.889 in constant prices, equivalent to S/. 700,000 in nominal terms. 8. The 'new money" loan terms would be: (i) the interest rate equal to the rate for the new subloans to SSEs, in line with the interest rate agreement as defined in Schedule 2 to the Project Agreement: and (ii) the maturity equal to the number of years left under the original loan. Thus, the maturity of "new money' loan No. 1 would be equal to 10 years (11 years minus one, at the end of the first year). 9. Applying the criteria to our example, we find that the amount and terms of the "new money" loans would be as follows: Table 3 ONew Money' Loans (In Sucres) (In Years) End of Amount of Maturity Year 'New Money" Loans of Loans 1 700,000 10 2 1,036,000 9 3 1,498,111 8 4 2,067,915 7 5 2,640,401 6 6 2,879,641 5 7 1,904,839 4 8 0 3 9 0 2 10 0 1 Source: Table 4 10. Table 4 shows in its "summary of net total impact" that the resulting servicing of the subloans would be level in constant prices until the seventh year. From then on, it would start to diminish as a result cf the subsidized interest rate in the example (inflation of 80Z p.a. and an interest rate of 70Z p.a.). In case of positive real lending rates, however, this would not be the case. Conclusions and Recommendations 11. In case a sub-borrower decides to use the full amount of the ceilings for the "new money" loans, the servicing of his/her subloans would be level in constant prices. 12. On the other hand, if the sub-borrower decides to borrow in "new money" loans less than the ceilings permit, the results would still be attractive, because the system would allow to shorten up the maturities of the iubloans in constant prices, for sub-borrowers that can afford to pay faster than originally foreseen. ANNEX VIII - - Table 4 ECUADOR: Interest. Capitalization Scheme Page 1 of 2 ----e-m----e--ewome-ome-eee*-*-*------* Year-End Beginning Original Total D.Serv. D.Serv. Loans in Price Principal Amort. Interest Debt in Real in Real Nominal Year Index Balance in Period Accrued Service Terms Terms Terms Original Subloan: S/1,000,000 1 1.8 1.000.000 a 700,000 700,000 388,889 0 700,000 2 3.2 1,000,000 100,000 700,000 800,000 246.914 3 5.8 900.000 100,000 630,000 730,000 125.171 4 10.5 800,000 100,000 560,000 660.000 62.872 5 18.9 700.000 100,001 490,000 590.000 31,224 6 34.0 600,000 100,000 420.000 520.000 15,289 7 61.2 500,000 100,000 350,000 450,000 7,350 8 110.2 400.000 100.000 280,000 380.000 3.448 9 198.4 300.000 100,000 210.000 310.000 1,563 10 357.0 200.000 100,000 140,000 240,000 672 11 642.7 100.000 100.000 70,000 170.000 265 "New Money" Loan 1 1: S/700,000 2 3.2 700,000 70,000 490,000 560,000 172.840 100,000 1.036,000 3 5.8 630,000 70,000 441.000 511,000 87,620 4 10.5 560,000 70,000 392,000 462,000 44,010 5 18.9 490,000 70,000 343,000 413,000 21.857 6 34.0 -20,000 70,000 294,000 364,000 10,702 7 61.2 351,000 70,000 245,000 315,000 5.145 8 110.2 28L,000 70,000 196,000 266,000 2,414 9 198.4 210,000 70,000 147,000 217,000 1.094 10 357.0 140,000 70,000 98,000 168,000 471 11 642.7 70,000 70,000 49,000 119,000 185 "New Money" Loan # 2: 5/1,036,000 3 5.8 1,036.000 115,111 725,200 840.311 144,086 100,000 1,498,111 4 10.5 920,889 115,111 644,622 759,733 72,372 5 18.9 805,778 115,111 564,044 679,156 35.942 6 34.0 690,667 115,111 483,467 598,578 17,599 7 61.2 575,556 115,111 402,889 518,000 8,461 8 110.2 460,444 115,111 322,311 437,422 3.969 9 198.4 345,333 1.5.111 241,733 356,844 1.799 10 357.0 230,222 115,111 161.156 276,267 774 11 642.7 115,111 115.111 80.578 195,689 304 "New Money' Loan # 3: S/1,498,111 4 10.5 1,498,111 187.264 1,048.678 1,235,942 117,736 100,000 2,067,915 5 18.9 1,310,847 187,264 917.593 1,104,857 58,471 6 34.0 1,123.583 187.264 786.508 973,772 28,630 7 61.2 936,319 187.264 655,424 842,688 13,764 8 110.2 749,056 187,264 524,339 711,603 6,457 9 198.4 561,792 187.264 393,254 580,518 2.927 10 357.0 374,528 187,264 262,169 449,433 1,259 11 642.7 187,264 187,264 131,085 318,349 495 'New Money" Loan # 4: S/2.067,915 5 18.9 2,067,915 295,416 1,447.541 1,742,957 92,241 100,000 2.640,401 6 34.0 1,772,499 295,416 1,240.749 1,536,165 45,165 7 61.2 1,477.082 295,416 1,033,958 1,329,374 21,714 8 110.2 1,181,666 295,416 827.166 1,122,582 10,187 9 198.4 886,249 295,416 620,375 915,791 4,617 10 357.0 590,833 295,416 413,583 708,999 1.986 11 642.7 295,416 295,416 206,792 502,208 781 - 60 - ANNEX VIII Table 4 ECUADOR: Interett Capitalisation Sch=@ (Cont.) Page 2 of 2 Target New Koney Yeat-End egknning Original Total D.Serv. D.Serv. Loans In Price Principal Art. Intert Debt in Real in Real Nominal YeaC Index Satance A Period Accrued Service Teram Terms Terma .. . . . . . . . . . .4 -- -« " . . . . ..... --- - - - - "New mney" Lom 0 5: sk2.640,401 6 34.0 2,640,401 440,067 1,848.281 2,288.348 67,280 100.000 2,879,641 7 61.2 2.200.335 440,067 1.540,234 1,980.301 32.346 * 110.2 1,710,268 440,047 1,232,187 1,672.254 15.175 * 198.4 1.320,201 440,067 924,140 1.364,207 6,877 10 357.0 80,1.34 440,067 616.094 1.056,161 2.958 11 042.7 440,067 440,047 308.047 748,114 1.164 *New onoey6 Loan # 6 S12,879.641 7 81.2 2,879.641 575.928 2.015.749 2.591,677 42.332 100.000 1,904,839 8 110.2 2.303,713 575,928 1,612.599 2,188,527 19.860 9 198.4 1.727,785 575,928 1.209.449 1,785.377 9.001 10 357.0 1.151.856 575.928 800,299 1.382,228 3.871 11 642.7 575.928 575,928 403,150 979.078 1.523 'New Money' Loan # 73 5/1,904,839 8 110.2 1.904,839 476.210 1.333.387 1.809,597 16.421 100.000 0 9 198.4 1,428,629 357,157 1.000.040 1.357,198 6,842 10 357.0 1.071,472 267.868 150,030 1.017,898 2,851 11 642.7 803,604 200,901 562.523 763,424 1.188 *New Money' Loan # 8: SI.00 9 198.4 0 0 0 0 0 100,000 0 10 357.0 0 0 0 0 0 11 642.7 0 0 0 0 0 'New Money' Loan 1 9: S/0.00 10 357.0 0 0 0 0 0 100,000 0 11 642.7 0 0 0 0 0 'New Monty' Loin f 10: 5/0.00 11 642.7 0 0 0 0 0 100.000 0 ...............................SUMMARY OF NET TOTAL IMPACT Year-tad Begifg Total Total D.Serv. D.Serv. Price Pricipul Awrtia. Interest Debt New Mosey in Nominal in Real Y*ar Index galmce a Period Accrued Service Loana Terms Termg -0e. .... .... ................. .................... .......... 1 1.8 1,000,000 0 700,000 700,000 700,000 0 0 2 3.2 1,700,000 170,000 1,190,000 1.360.000 1,036.000 324.000 100,000 3 5.8 2.56,000 285,111 1,796,200 2,081,311 1.498.111 583,200 110.000 4 10.5 3.779,000 472,375 2,645,300 3,117,675 2,067.915 1,049,760 100,000 5 18.9 5,374.540 767,791 3,762,178 4,529,969 2,640.401 1,889,568 100,000 6 34.0 7,247.150 1.207,858 5,073,005 6,280,863 2,879,641 3,401.222 100,000 7 61.2 8,918.933 1,783,787 6,243.253 8,027,039 1.904.839 6,122,200 100.000 8 110.2 9,039,985 2.259.996 6.327,990 8,587,986 0 8,587,986 77,931 9 198.4 6,779,989 2.140.944 4,745,9k2 6,888,936 0 6,886.936 34,720 10 357.0 4,639,045 2,051,655 3,247,331 5,298,986 0 5e298,986 14,841 11 642.7 2,587,390 1,984,688 1.811,173 3,793,861 0 3,795,861 5,906 - 61 - ECUADOR STAFF APPRAISAL REPORT FOURTH SHALL SCALE ENTERPRISES PROJECT Estimated Schedule of Disbursements Under the Proposed Loan IBRD FY and US$'000 Quarter Ending On By Quarter Cumulative FY90 March 31, 1990 250 250 June 30, 1990 250 500 FY91 September 30, 1990 1,000 1,500 December 31, 1990 1,000 2,500 March 31, 1991 2,000 4,500 June 30, 1991 2,000 6,500 FY92 September 30, 1991 3,750 10,250 December 31, 1991 3,750 14,000 March 31, 1992 3,000 17,000 June 30, 1992 3,000 20,000 FY93 September 30, 1992 3,000 23,000 December 31, 1992 3,000 26,000 March 31, 1993 3,250 29,250 June 30, 1993 3,250 32,500 FY94 September 30, 1993 3,250 35,750 December 31, 1993 3,250 39,000 March 31, 1994 2,500 41,500 June 30, 1994 2,500 44,000 FY95 September 30, 1994 2,500 46,500 December 31, 1994 2,500 49,000 March 31, 1995 500 49,500 June 30, 1995 500 50,000 - 62 - ANNEX X ECUADOR STAFF APPRAISAL REPORT FOURTH SHALL SCALE ENTERPRISE PROJECT Bank Monitoring of Project Implementation A. Key Operational Indicators 1990 1991 1992 1993 (i) Loan Commitments 302 302 302 10? (ii) SSEs fir-.,ced (iii) SSEs assisted (iv) Jobs created B. Key FOPINAR Indicators (i) FOPINAR Staff (person-years) Admin. Costs/Avg. Portfolio Indirect CFN Costs/FOPINAR costs (ii) Total Debt-Equity Ratio Profitability/Equity FOPINAR's Equity (iii) FOPINAR Commitments (US$ mil.) FOPINAR's Portfolio Arrears Banking System Arrears C. Reporting Requirements (i) FOPINAR Operation (semiannually). Number of subprojects financed: total cost, FOPINAR/IBRD participation (breakdown by participating FIs, by regions, and by type of industry. (ii) FOPINAR's Outstanding Portfolio Arrears (semiannually). Arrears by FIs and breakdown by micro and small enterprises. Subprojects financed with loan proceeds and by rollover funds from previous loans or FOPINAR's own resources. (iii) Advance reports on TA activities (semiannually). Number of enterprises assisted, type of service rendered, preliminary results obtained, and number of entrepreneurs trained. (iv) FOPINAR's Audited Financial Statements (annually). (v) Socio-economic aspects and Project Completion Report (PCR) type information. FOPINAR will prepare annually a set of tables summarizing overall project results.