Colombia - IFI Restructuring and Divestiture Project

' Z.AI 3/ /f 4FCO Document of The World Bank FOR OFFICIAL USE ONLY MICROFICICE C'OPY Report No. 10041-CO Report No. 10041'-CO Tyje: (SAR) JAIME, A / X39344 / I5141/ LA3TF STAFF APPRAISAL REPORT COLOMBIA IFI RE83TRUCTURING AND DIVESTITURE PROJECT FEBRUARY 12, 1992 Trade, Finance and Industry Division Department III Latin America and the Caribbean Region This document has a restricted distributionk and may be used by recipients only in the performance of their officfal duties. Its contents may not otherwise be disclosed withoxt World Bank authoriation. . . , ,, _ _ , _ , , , ,_~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~  CURRENCY EQUIVALENTS (December 31, 1990) Currency Unit - Colombian Peso (Col$) US$1.00 - Col$568.73 Col$1.O0 - US$0.00176 PISCAL YEAR OF THE GOVERNMENT OF COLMBIA ANDk IFI January 1 - December 31 LIST OF ABBREVIATIONS BCH Banco Central Hipotecario BFI Bono de Fomento Industrial BR Banco de la Republica BVC Bono de Valor Constante CAP Corporaci6n Andina de Fomento CAR Regional Environmental Agency CAV Corporaci6n de Ahorro y Vivienda CPP Corporacion Financiera Popular CF Corporacion Pinanciera CKD Completely Knocked-Down Kit CONPES Consejo Nacional de Politica Economica y Social CPI Consumer Price Index DEP Division for Environmental Policy DFC Development Finance Corporation DTF Deposito de Termino Fijo PEN Financiera El6ctrica Nacional FCE Fondo de Capitalizacion Empresarial FFI Fondo Financiero Industrial FIP Fondo para Inversiones Privadas FINDETER Financiera do Desarrollo Territorial FINAGRO Fondo para el Financiamiento del Sector Agropecuario GDP Gross Domestic Product ICB International Competitive Bidding ICT Instituto de Cr6dito Territorial IFI Instituto de Pomento Industrial LIBOR London Interbank Offered Rate MIS Management Information System NIC Newly Industrialized Country PFI Participating Financial Intermediary PRIME Interest rate charged by U.S. banks to pr.eferential customers PROEXPO Fondo de Promocion de Exportaciones PSRL Public Sector Reform Loan SAFICO Andean Trade Financing System SME Small and Medium Scale Enterprise SOE Statement of Expenditure TCC Tasa de Captaci6n Corporaciones TFP Total Factor Productivity  FOR OFFICIAL USE ONLY COLOMBIA IXF RESTRUCUNG, An DIVESTIUEPROJECT STAFF APPRAISAL REPORT TABLE OF CONTENTS Page. No. Loan and Project Summary . . . . . . . . . . . . . . . . . . . . . . . i I. THE SECTORAL CONTEXT . . . . . . . . . . . . . . . . . . . . . 1 A. Macroeconomic Performance and Policies . . . . . . . . . . . 1 B. The Industrial Sector o . . . ... . .......... 2 C. The Financial Sector . . . . . . . . ,. . . . . . . . . . . 4 IT. HISTORY OF THE INSTITUTO DE FOMENTO INDUSTRIAL . . . . . . . . . 10 A. Background . . . . . . . . . . . . . . . . . . . . . . . . 10 B. Organizational Structure . . . . . . . . . . . . . . . . 11 co Investments . . . . . . . . e X 12 C. Credit . . . . . . . . . . * . . . . . . . . 12 E. Sources of Funds . .. ... ....... ....... 15 F. IFI's Financial Condition . . e . . . . . . . . . . . . . . 16 Go Earnings . . . . . . a . . . . . . . . . . . . o a . . . . . 17 III. THE PROJECT . . . . . . . . . . . . . . . . . . . .o . . . . . 18 A. Project Objectives . . . . . . . . . . . . . . . . . . . . 18 B. IFI's New Strategy and Policies . . . . . . . . . . . . . . 18 C. Financial and Institutional Restructuring of IFI . . . . . 22 D. The Divestiture of IFI's Portfolio . . . . . . . . . . . . 24 E. Restructuring and r,vestiture of Special Companies . * * * 27 F. Projected Financial Results . . . . . . . . . . o . o . . o 34 IV. PAST BANK EXPERIENCE IN INDUSTRIAL SECTOR LENDING . . . . . . . . . 37 A. Past Bank Assistance to Colombian Industry . . . . . . . . . . 37 B. Lessor.s Learned from previous Bank Operations . * * * * * , , * 38 This report is based upon the findings of an appraisal mission which visited Colombia in May 1991. The mission was composed of Messrs. Andres Jaime (LA3TF) and Ira Lieberman (Consultant). Project preparation was also carried out in previous missions by Hu. Kris Hallberg and Messrs. Howard Jones and Roger Heath. Me. Antonieta Rodriguez assisted in the production of the report. Peer review was provided by Mmes. Rrls Hallberg and Herminia Martinez. 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 au(horization.  V. THE PROPOSED LOAN . . . . . . . . . . . . . . . . . . . . . . . . 40 A. Relation to the Country Lending Strategy . . . . . . . . . 40 B. Objectives, Strategies, and Beneficiaries . . . . . . . . . 40 C. Project Components . . . . . . . . . . . . . . . . . . . . 41 D. Project Cost and Financing . . . . . . . . . . . . . . . . 41 E. Relending Terms and Conditions . . . . . . . . . . . . . . 42 F. Project Implementation . . . . . . a . . . . . . . . . . . 43 G. Project Benefits and Risks . . . . . .. . . . . . . . . 46 VI. AGREEMENTS AND UNDERSTANDINGS REACHED . . . . . . . . . . . . . . 47  COLOMBIA IF! RESTRUCTURING AND DIVESTITURE PROJECT STAFF APPRAISAL REPORT LIST OF ANNEXES Pase No. Annex I: IPI Policy Letter . . . . . . . . . . . . . . . . . . 50 Annex II: Organization Charts . . . . . . . . . . . 56 Annex III: IFI Credit Table 1: Credit Approvals, 1984-90 . . . . . . . . . 58 Table 2: Credit by Subsector, 1986-90 . . . . . . . 59 Table 3: Credit by Type of Credit and Firm, 1984-90 . 60 Table 4: Loans to Companies in Which IFI has Investments . . . . . . . . . . . . . . . . 61 Figure 1: Interest Rates on IFI Credit, 1987-90 . . . 62 Annex IV: IFI Investment Portfolio and Divestiture Plan Table 1: Companies Sold since 1988 . . . . . . . . . 63 Table 2: IFI Liquidations . . . . . . . .. . 64 Table 3: IFI Investments: Relevant Financial Data . 65 Table 4: Companies in the 1991-1994 Divestiture Plan 67 Annex V: Special Cases in the Investment Portfolio . . . . . . . 69 Annex VI: IFI Financial Statements Table 1: Balance Sheets . . . . .. . . . . . . . . . 79 Table 2: Income Statements . . . . . . . . . . . . . 80 Table 3: Bonos de Valor Constante . . . . . . . . . . 81 Annex VII: IFI Financial Projections Table 1: Projected Balance Sheets . . . . . . . . . . 82 Table 2: Projected Income Statements . . . . . . . . 83 Table 3: Projected Financial Indicators . . . . . . . 84 Annex VIII: Technical Assistance Component Management Information Systems Technical Assistance . 85 Training Program (1991-94) . . . . . . . . . . . . . . 86 Cost Breakdown of Technical Assistance Component . . 87 Annex IX: Terms of Reference for Studies under TA Component Terms of Reference for Cerro V'atoso Study . . . . . . 88 Terms of Reference for Monomeros Study . . . . . . . . 91 Terms of Reference for Concesion Salinas Study . . . . 94 Terms of Reference for IPI Privatization Study . . . . 97 Annex X: Disbursement Schedule . . . . . . . . .. . . . . 101 Annex XI: Items for Mid-term Review . . . . . . . . . . . . . . 102  COLOMBIA IFX RESTRUCTURING AND DIVESTITURE PROJECT Lon dProieSuar Borrower: Instituto de Fomento Industrial (IFI) Guarantor: Republic of Colombia Beneficiaries: (i) Instituto de Fomento Industrial; and (ii) Private industrial and service enterprises requiring long term credit, equity financing, and/or other financial services. Loan mount: US$100 million equivalent. Terms: To be repaid in 17 years including 5 years of grace, at the standard variable interest rate. Relending Terms: IFI would lend directly to productive enterprises as a first tier financial institution. Loans would be denominated in US dollars and would carry domestic market interest rates for foreign exchange loans, i.e. PRIME or LIBOR plus a margin sufficient to cover intermediation costs and lending risks. Project The objectives of the Project are: (i) to implement a Obiectives: divestiture and privatization program of IFI's existing equity holdings, including the development and implementation of individual restructuring and divestiture plans; (ii) to support the implementation of a new corporate strategy for IFI which will reorient its role in industrial and financial sector development by transforming it into a more efficient financial institution that can compete on an equal basis in the financial markets -- in the process enhancing compeLition in such markets and filling gaps in financial services needed to support investments consistent with the liberalization of the economy. Achievement of these two objectives would pave the way for the eventual privatization of IFI itself, for which a specific plan would be drawn up under the project. Moreover, the project would set strict financial performance criteria in order to guide IFI through the transition period in reaching this ultimate objective. Project The Project would include: (i) a restructuring and divestiture Descrrivtion: program of IPI's equity holdings which would help eliminate IFI's state holding company role and would allow it to become a genuinely market-oriented financial intermediary. The program encompasses the remaining 29 equity investments in IFI's portfolio, which would be privatized, liquidated or transfcrred; (ii) a credit program to be onlent by IFI to private productive enterprises to finance investment in fixed assets and working capital; and (iii) technical assistance, training and management information systems to support strategic and organizational changes in IFI, and investment banking and other services to assist IFI in implementing its divestiture program.  - li - Proiect Benefits: The Project would improve the financial situation and operational efficiency of IFI and support the withdrawal of the public sector from productive sector activities. By reorienting IFI's lending and investment strategy, the project would contribute to the development of long term credit, capital markets and other financial services, and would facilitate the supply response to the trade and financial aector reform. The Project would support Private Sector Development through: (i) privatization of public sector investments in the industrial sector; (ii) financial support for private enterprises' investment through the provicion of term credit; and (iii) transforming a large public development bank into an effic'.ent and competitive financial intermediary serving the private sector, and ultimately privatizing it. Project Risks: Project risks include the possibility that the Government and IFI would fail to complete the divestiture program and to eliminate the special regime and subsidies under which IFI has operated. Colombia's commitment to reform in the trade, financial and public enterprise sectors during recent years, as evidenced by the strong measures taken, suggest that these risks are not excessive. Estimated Costs: Local Foreign Total % Credit program 249.7 161.0 410.7 99X Technical assistance 1.7 2.9 4.6 12 TOTAL 251.4 163.9 415.3 100% Financing Plan: Local Foreign Total % World Bank Loan 1.1 98.9 100.0 24Z IPI Funds 127.1 127.1 31% BR Rediscount Lines 65.0 65.0 16% Firms' Internal Funds 123.2 123.2 30% TOTAL 251.4 163.9 415.3 100% Estimated Disbursements: FY92 FY93 FY94 FY95 FY96 FY97 FY98 Annual 3.0 10.8 27.2 27.7 20.3 7.7 3.3 Cumulative 3.0 13.8 41.0 68.7 89.0 96.7 100.0 Rate of Return: Subprojects under the credit component would require at least a 12 percent financial rate of return. Maps n/a  COLOMBIA IFI RESTRUCTURING AND DIVESTITURE PROJECT STAFF APPRAISAL REPORT I. THE SECTORAL CONTEXT A. Macroeconomic Performance and Policies 1. Colombia has been one of the most stable economies in the developing world, with growth averaging 4.5S over the past four decades. During the 1980s, however, external shocks and weaknesses in the economy resulted in deteriorated fiscal balances, inflationary pressures and sluggish growth. To remedy this, in late 1984 the Government introduced an economic adjustment program designed to achieve stabilization with growth. The authorities first stabilized the economy and then launched a medium-term program to address structural problems which, left untreated, would suppress long-term growth prospects. The administration that took office in August 1990 markedly increased the pace of the reform program, which is aimed essentially at more efficient use of resources through opening the economy to the competition and opportunities of international markets. To achieve this, the Government is strengthening macroeconomic management, reforming its trade regime, restructuring and downsizing the public sector, liberalizing the industrial and agricultural sectors and modernizing the financial sector. 2. One of the Government's main macroeconomic policy objectives since 1988 has been to moderate the rise in inflation. Nevertheless, the authorities failed in the last two years to meet the inflation target in the macroeconomic program, ending 1990 with one of the highest inflation rates in the last 20 years. In late 1990, the Government initiated an anti-inflation program with the objective of reducing inflation to 22% by the end of 1991. Fiscal policy was tightened in late 1990, and aided by high petroleum prices and the real devaluation of the peso, the fiscal deficit fell to 0.3% of GDP for 1990 as a whole. Though the fiscal element of the Government's stabilization strategy was significant, the main instrument of the anti- inflation program has been contractionary monetary policy -- limiting the growth in base money to an annual rate of 18-20%, increasing placements of open market instruments, and imposing a temporary 100% marginal reserve requirement. 3. As part of the medium term macroeconomic program, the Government has also launched a public sector reform program to improve the efficiency of public investment and public sector management. The main objectives of the program are (i) to strengthen the linkages between macroeconomic and sectoral programming, ensuring the application of adequate criteria in the evaluation and selection of public investment projects, improving the efficiency of operations and investment of public entities, and rationalizing the Central Government's role in the management of decentralized public entities; (ii) to promote private sector development, by opening to the private sector areas previously reserved for the public sector, reducing Government intervention and increasing competition via the privatization of publicly owned assets in  -2 the industrial and financial sectors; and (iii) to improve efficiency in the allocation of public resources, by rationalizing the programming and budgeting process and reducing earmarking. B. The Industrial Sector 4. A distinguishing feature of the 1984-87 economic recovery was the impressive growth of the industrial sector. Real industrial output grew 6.0% in 1985, 11.3% in 1986, and 6.3% in 1987; the manufacturing sector (excluding coffee) registered growth rates of 3.6%, 4.8%, and 6.62, respectively. Since 1987, however, the growth of industrial and manufacturing output has slowed considerably. Industrial output grew by 2.3% in both 1988 and 1989; real manufacturing GDP (excluding coffee) grew 4.1% in 1988 and only 1.62 in 1989. 5. Since the beginning of the adjustment program, non-coffee exports have.increased, with particularly impressive growth rates in 1986 and 1987. In 1986, non-coffee exports grew 24% in U.S. dollar terms; in 1987, they grew another 57%, though coffee exports declined by 40Z due to the fall in coffee prices. The majurity of this increase was due to growth in exports of petroleum, coal, and nickel, though "minor exports" (including agroindustrial, industrial, and mineral products) increased by 21% in 1986, 142 in 1987, 19% in 1988, and 15% in 1989. The increase in minor exports during the recovery period was largely explained by the significant real devaluation of the peso that was a cornerstone of the adjustment program. 6. Despite the encouraging recovery of industrial output and exports during the adjustment period, this growth has not been the result of or accompanied by significant structural change. The importance of industry in Colombia has been and continues to be lower than in other Latin American countries and newly industrializing countries. The contribution of manufacturing to GDP has remained relatively constant since the mid-1970s, in contrast to the increased importance of this sector in other newly industrializing countries. Though the composition of manufacturing shifted toward intermediate and capital goods during the first stages of import substitution industrialization, growth in these sectors has slowed. Non- durable consumer goods now account for more than half of manufacturing output, in contrast to the greater importance of intermediate and capital goods in other NICs. 7. The inward orientation of industry also did not change significantly during the 1980s. The growth of minor exports has been concentrated in a few agroindustrial and industrial products, and the value of minor exports has just now recovered to its pre-recession level. The export orientation of most industries remains relatively low and, in many cases, below that of the 1970s; exporting continues to be a marginal activity for most industrial firms. Thus, a fundamental shift in the structure or market orientation of industry does not seem to have occurred. The exhaustion of import substitution activities and the inward orientation of the trade regime have limited industrial expansion to the growth of the domestic market. 8. In addition, an examination of total factor productivity (TFP) growth indicates that manufacturing output growth has been costly, in the  sense that it has been mainly due to expansion in the quantities of resources used (primarily capital) rather than increases in the efficiency of reoource use. The contribution of TFP growth to output growth has teen low, and frequently negative. In manufacturing, negative rates of productivity growth were evident not only during the recession of the early 1980s, when capacity was underutilized, but also during the economic expansion of the late 1970s. 9. Recent Bank sector work underscores the importance of the lack of both internal and external competition iU explaining the absence of structural change in the industrial sector.' The inward-oriented trade regime has affected industrial performance both directly via its impact on relative prices, and indirectly by limiting competitive pressure. The coverage of domestic manufacturing production by quantitative restrictions (import licenses), calculated in February 1990 at 84%, was high by international standards, and the dispersion across sectors and subsectors in the degree of coverage by import licenses creates non-neutral incentives across different import substitution activities as well as between import substitution activities and exports. The protective effect of the trade regime reinforces the lack of competitive pressure felt by industrial firms in domestic markets, which tend to be characterized by stable oligopolies. 10. The Government has recognized that to achieve more dynamic and less costly industrial growth, Colombia must change from an inward-oriented to an outward-oriented development strategy. In early 1990, the Government announced the adoption of a medium-term economic program (Programa de Modernizacion de la Economia Colombiana), Xocused on trade reform to gradually expose domestic producers to external competition and reduce administrative control over imports. Additional measures are included to increase the efficiency of transport services, simplify export requirements and incentives, reduce price controls, and control unfair trade practices. The first phase of the program, which began in February 1990 and t:as intended to last two years, replaced quantitative restrictions with tariffs and thb exchange rate as the main instruments of protection. The second phase, originally planned for the period 1991-94, was designed to incretse the degree of import competition by gradually reducing the level and dispersion of tariff protection, and by simplifying and making more t-ansparent the tariff regime. At the end of 1990, the Government announced the final targets for the 4-year program, which were an import-weighted average tariff of 152 and a maximum of 25%, to be reached by 1994. 11. In a remarkably bold action, the Government decided in August 1991 to advance the trade reform program by 3 years and move immediately to the final targets of protection. The new regime establishes a maximum tariff of 23% and a weighted average tariff of 12.6% (14.8% unweighted). Moreover, the trade reform is being complemented by an Industrial Restructuring and Development Program to speed the supply response of industry to the trade reform and reduce the costs of adjustment. The restructuring program includes industrial policy reforms as well as detailed restructuring programs for t"Colombia: Industrial Competition and Performance", Report No. 7921-CO, June 28, 1990 (gray cover).  -4- individual subaectors. Finally, in the program supported by the proposed project, the Government intends to reduce the role of the public sector in industrial production and strengthen the industrial development contribution of the Instituto de Fomento Industrial. C. The Financial Sector 12. Financial markets in Colombia are characterized by a continuing lack of long term credit and underdeveloped capital markets, imperfect competition in financial intermediation, credit allocation based overwheltingly on a collateral basis rather than on financial or economic project evaluation, and a disproportionately low share of credit allocated to medium-scale firma. At the samo time, the Government's trade reform program creates the need for financing new firms, products, and technologies with a wider range of financial instruments. Instituto de Pomento Industrial (IFI)'s new strategy (Section III. B) is designed to contribute to address these needs. 13. Market structure and deRree of compotition. Colombia's banking system includes 26 commercial banks (16 private and 10 public, including five that were nstionalized in 1982); 24 development finance corporations (corporaciones financieras, or CFs), of which 17 are private and 7 are public; 11 savings and loan institutions (corporaciones de ahorro y vivienla, or CAVs); and 32 trade finance companies. The Central Bank (Banco de la Republica, or BR), in addition to its role as the monetary authority, plays a significant role in credit markets. Institutional investors (insurance companies, investment, mutual, pension, and retirement funds, social security schemes, and trust companies) are very small relative to the banking system, accounting for about 4% of total financial system assets. 14. The oligopolistic structure of the financial system is evident. The four largest commercial banks account for more than 45% of the assets of the banking sector; the market for long term credit is dominated by six CFs that have traditionally intermediated BR development credit lines. The public sector is an important agent in financial markets, accounting for more than half of the total assets of the financial sector. Finally, there has been a trend toward the formation of financial groups, some of which started primarily as industrial groups and expanded into the financial area as a means of facilitating access to low cost deposits or subsidized credit. 15. In spite of the large number of financial institutions, the financing capacity of the sector is small relative to the financing needs of large projects. Financing of large projects by individual financial institutions is limited, due to their relatively small size. Although there is some syndication of loans among financial institutions, these practices are not standardized. In addition, the fact that few domestic banks have established relationships with correspondent banks abroad limits their ability to provide loans denominated in foreign currency. No significant new financial instruments have been introduced since the highly successful UPAC instrument was introduced in 1972. This is partly the result of imperfect competition in the financial sector and partly due to regulations that prevailed until recently on the instruments that could be offered by different types of financial institutions.  -5- l6. Credit markets. As in most countries in Latin America, the Colombian financial market has a heavy emphaois otI the short-term end of the -market. Commercial banks lend almost exclusively on a 90-day basis against heavy collateral requirements, and the long tern lending of CFs has declined. Only the CAVe and the Banco Central Hipotecario (BCH) are active in long term n'turities, specializing in financing housing and urban development through term transformation, while long term credit for industry and agriculture continues to be provided primarily through rediscounting credit lines. 17. The main types of specialized credit for industry have been: (i) development credit lines offered by BR as rediscount lines to financial intermediaries (Fondo para Inversiones Privadas (PIP) for large scale enterprises; Fondo Financiero Industrial ("FI) for small and medium scale enterprises; and Fondo de Capitalizacion T . lresarial (FCE) for enterprise capitalization), totalling Col$S2.4 billiv outstanding as of August 1990; (ii) external credit lines supported principally by World Bank and IDB loans and channelled to financial intermediaries through BR (Col$63.3 billion); (iii) Fondo de Promoci6n de Exportaciones (PROEXPO) credit for export financing and export-related investment (Col$286.4 billion); and (iv) credit provided by the Instituto de Fomento Industrial, using both its own funds and BR rediscount lines (Col$73.4 billion). Directed credit has accounted for a substantial share of lending by formal financial institutions to che manufacturing sector, averaging 6&. over 1984-87. 18. Although interest rates on most directed credit lines were historically below market rates, the policy trend has clearly been to increase these interest rates, moving them closer to market rates, and to reduce the dispersion in rates across sectors and characteristics of borrowers. Interest rates on the three BR development credit lines to industry have been increased and homogenized, both with respect to the rates charged to final users and the rates charged by BR to participating financial intermediaries, and recently adopted regulations allow partial capitalization of interest and higher final intereElt rates according to loan maturity. Though PROEXPO interest rates were increased in November 1990, they are the lowest of all directed credit lines. Finally, interest rates on credit provided by IPI have recently been harmonized and moved toward market rates (para. 49). 19. Traditionally, the credit decisions of financial institutions in Colombia have been tied to the capacity of the borrower to supply collateral. There is less lending on the cash flow potential of individual projects, or on the expected return of the investmenc. This leads to a problem of economic efficiency -- since funds are not always allocated to the iighest return activities -- as well as a problem of political economy, since credit becomes an instrument of maintaining or increasing the concentration of wealth. 20. The failure of financial intermediaries to allocate credit based on project evaluation is attributable to a lack of reliable information on potential borrowers, the previous practice of the Superintendencia Bancaria of evaluating loan portfolios based on collateral sufficiency, imperfect competition in financial markets, and (in the case of directed credit) the desire to minimize risk on loans with fixed intermediation margi.s. A major  -6- concern related to the collateral-based allocation of credit is that the industrial restructuring ar.4 export supply response to the recently announced trade reform -- which would be expected to be characterized by new firms, new products and technologies, and new markets -- could be financially constrained. 21. Capital markets. Securities markets remain insignificant in size: few firms are listed on the excihanges, and the value of shares traded is small. Ownership of shares is highly concentrated, and minority shareholders have little impaot on the market. The reasons behind the lack of development of capital markets in Colombia are many and complex. From the point of view of firms, the main reasons for the lack of interest in securities markets have been the availability of directed credit at below-market interest rates and (until the 1986 tax reform) tax policies thaLt favored debt over equity financing; ard the concentration of ownersaip in the industrial sector and the reluctance of owners to share control (sometimes due to concerns over takeovers by illegal sources of income). The disclosure requirements of firms listed on the exchange, which art. not required of unlisted firms, discourage firms from using the securities market. From the point of view of investors, the lack of interest in securities markets can be explained by low after-tax returns and the reluctance to acquire minority ownership in a market characterized by concentrated ownership. 22. The 1986 tax reform began to remove the bias toward debt financing by eliminating the deductibility of the inflationary portion of interest payments (to be phased in over the next several years) and double taxation of dividends. Recently, there has been an increased volume of bonds issued by both public sector institutions and some large private corporations. 23. Financial policy reform. Following the 1982-85 financial crisis, the Government's financisl policy efforts correctly focused on strengthening weak financial institutions and improving prudential regulation in order to avoid such crisis in the future. Today, the financial system is subject to capital adequacy rules that follow the guidelines of the Basel accord; has portfolio classification and provisioning rules that are similar to those used in industrialized countries; has stringent regulations on exposure limits and portfolio diversification, as well as limits on transactions with related parties; and is subject to accounting and auditing standards that allow efficient Government supervision. The recovery of the sector is clearly reflacted in the profitability, solvency and risk of financial institutions, particularly during the past three years. 24. With these achievements, the Government has now been able to shift its attention to increasing competition in the financial sector, in order to improve allocative efficiency, reduce intermediation costs, and broaden the range of financial instruments. At the same time, efforts to gradually reduce and ultimately eliminate the distortions created by the system of forced investments and directed credit can be continued. 25. The need for this change in focus is greater than ever. The shift to an outward-oriented model of development requires a range of financial instruments and an allocation of financial resources different from those  -7- required under the import substitution strategy of development, and the ability of domestic producers to compete in international markets depends partly on their access to flexible, low cost financing. 26. The administration that took office in Akugust 1990, recognizing the importance of improving competition and efficiency in the financial sector in ite economic modernization program, announced its intention to pursue a structural reform program for the financial sector. In December 1990, Congress approved a financial sector reform law which authorized the Government to introduce the necessary institutional and regulatory changes that would encourage an increase in the depth and competitiveness of the financial system. In April 1991, the Government defined a financial sector policy framework establishing the structural reforms to be implemented during the remainder of the administration. 27. The Government's program of financial sector policy reforms is inten.ed to lead to a more efficient financial sector characterized by greater competition, a size capable of mobilizing domestic and external resources to finance investments in the productive sectors, and a wide range of financial instruments provided at market prices, including voluntary long-term credit and capital market instruments. The prograra includes reforms in three major areas: competition policies, reserve requirements and forced investments, and directed credit. During the current administration, the Government is committed to: increasing market contestaoility by facilitating the entry and exit of both domestic and foreign financial institutions, and by reducing regulatory and informational barriers to competition; * reducing, simplifying, and rationalizing the overall burden of reserve requirements and forced investments consistent with monetary and fiscal targets; * phasing out forced investments, except those financing credit programs for well-defined target groups to achieve equity objectives, and agricultural credit through the new second-tier sector intermediary FINAGRO; * reorienting the role of the pub ic sector in the mobilization and allocation of financial resources to the productive sectors by increasing the specialization of second-tier institutions in channelling external sources of credit to broadly defined productive sectors; * putting in place demand-responsive mechanisms which provide for flexible interest rate determination in order to reflect the scarcity value of funds lent from second-tier to first-tier financial instituti4ns; * liberalizing fully interest rates charged by first-tier institutions to final borrowers, and  defining a strictly limited number of specific target groups for which initerest subsidies through the financial system may be the most effective way to achieve equity objectives, and, to the maximtum extent possible given fiscal constraints, funding these subsidies from the fiscal budget. Specific steps taken and to be taken according to the 4-year reform program are detailed below: 29. Competition Dolicies. The Government intends to bring to the point of sale all five banks nationalized during the 1982-85 financial crisis, which represent about 25% of total banking assets. The first three banks have already been put on the market, and the first two have recently been sold. In addition, the Government intends to clarify the role and functions of remaining public financial institutions and move in the direction of making them profit oriented and/or privatizing them. The Government has recently announced its specific intention of privatizing, at least partially, Banco Cafetero and Banco Ganadero. 30. Reforms in the regulatory framework are intended to encourage more competitive behavior among financial institutions and to reduce regulatory barriers that artificially segment markets. Legislation passed in December 1990 allows up to 100% ownership and control of financial institutions by foreign investors. The December 1990 law allowsf free entry of new financial institutions, subject to minimum capital requirements and the suitability of ownership and management; allows free entry into all segments of the market so that no special competitive advantage is granted to certain financial agents; facilitates conversion from one type of financial institution to another when minimum capital requirements are fulfilled; simplifies the regulations governing liquidations, mergers, and foreign investment in the financial system; and improves regulations regarding the flow of information to market participants. 31. Reserve requirements and forced investments. Forced investments (portfolio requirements as a share of deposits or assets of financial institutions, at below-market returns) have been used as a source of funds for directing credit to the private sector and a number of public agencies. These forced investments created a significant quasi-fiscal burden on financial institutions: in the mid-1980s, the tax on financial institutions implied by reserve requirements and forced investments explained about half of the ten- point average intermediation margin. Previous administrations have moved to reduce the quasi-fiscal burden of forced investments on financial institutions by reducing the volume of forced investments and increasing their return in real terms. In May 1990, new forced investments from commercial banks for the direct financing of the Central Government were eliminated, as were forced investments used to finance the Financial Institutions Guarantee Fund. New forced investments required of insurance companies to fund the Instituto de Credito Territorial (ICT) were also eliminated in 1990, and bonds used to fund FINDETER were phased out.  -9- 32. As part of its financial sector reform program, the current administration intends to further reduce forced investments, limiting them to those which finance targeted credit programs and those which substitute for direct lending requirements to the agricultural sector. All others will be phased out by freezing the existing stock at the end-1990 level, and restructuring the terms and conditions to make them consistent with how the resources are being used. At the same time, the Government intends to increase the average return on those forced investments that remain. The quasi-fiscal burden on the financial system will fall as these measures are taken and as existing forced investments are amortized (over an estimated six to seven years). 33. The Government has reduced reserve requirements and substituting investments, and intends to continue to reduce the overall burden of forced investments and reserve requirements in the future. As part of its anti- inflation program, however, the Government imposed a 100% marginal reserve requirement from January to September 1991. 34. Directed credit and administered interest ratee. Since the mid- 1980s, the Government has attempted gradually to reduce market segmentation and interest rate distortions in the directed credit system. Most directed credit interest rates -- both the rates between second- and first-tier financial institutions, as well as lending rates to final borrowers -- have been made variable by linking them to DTF (index of deposit interest rates). Implicit subsidies to final borrowers of directed credit have been reduced by raising administered lending rates toward levels similar to short term lending rates in the uncontrolled market, and terms have been harmonized across sectors and categories of borrowers. Recent reforms made interest rates variable on the few agricultural credit lines with fixed nominal rates that still remained, and interest rates on PROEXPO credit were raised and made variable. 35. The Gover.=ent intends to continue its reform of the directed credit system by focusing on the coverage and role of second-tier financing facilities, the pricing of resources between second-tier and first-tier institutions, and the pricing of credit to final borrowers, as follows: * Second-tier financing facilities will be consolidated into at most three financing institutions (currently expected to be the Central Bank (BR), FINAGRO, and PROEXPO, recently converted into Banco de Comercio Exterior), providing financing for the productive sectors with the broadest possible eligibility requirements. * Second-tier financing facilities will become increasingly specialized in the intermediation of external resources, such as loans from multilateral, bilateral, and external commercial sources. Along with the reduction in forced investments, the Government will elaborate a program for a phased reduction in access to other domestic sources of funds for BR and other second-tier institutions. Excluded from this specialization are second-tier institutions established to channel funds to decentralized public sector agencies  - 10 - for infrastructure development (currently FINDETER for mun4.cipal development and PEN for energy sector infrastructure). * Rediscount funds will be allocated from second-tier to