Ecuador - Development Finance Companies Project

RESTRICTED FILE COPY Report No. P-88Z This report was prepared for use within the Bank and its affiliated orgonizations. They do not accept responsibility for its accuracy or completeness. The report may not be published nor may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF ECUADOR FOR A DEVELOPMENT FINANCE COMPANIES PROJECT December 3, 1970  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF ECUADOR FOR A DEVELOPMENT FINANCE COMPANIES PROJECT 1. I submit the following report and recommendation on a proposed loan in an amount in various currencies equivalent to US$8.0 million to the Republic of Ecuador. PART I - HISTORICAL 2. In March 1969, the Ecuadorian Government asked the Bank to con- sider a loan for two development finance companies, Comision de Valores- Corporacion Financiera Nacional (CFN) and Ecuatoriana de Desarrollo S. A. Compania Financiera (COFIEC). The Bank/IDA has made loans and credits in Ecuador for highways, electric power, livestock development, fisheries, and education. The proposed loan would be the first Bank or IDA lending in Ecuador for industry. 3. Negotiations were held in Washington from April 7-17, 1970. Ecuador was represented by Ivr. Carlos Mantilla Ortega, Ambassador of Ecua- dor in lWashington; Mr. Jose Correa and Mr. Raul Paez, President and Manager of the Technical Department of COFIEC, respectively; Mr. Cristobal Flores and Mr. Raul Padron, Assistant Manager and Financial Adviser of CFN, re- spectively; and Mr. Jaime Duirango, Commercial Attache, Embassy of Ecuador in Washington. Important issues remained unresolved at the end of these negotiations, however, and since there were several important developments and changes within the Government during the ensuing months, it was not un- til mid-November 1970 that agreemnent was reached on the outstanding issues. 4. The proposed loan would bring the total of Bank and IDA lending to US$95.9 million (net of cancellations). The following is a summary statement of Bank loans and IDA credits to Ecuador as of October 31, 1970:  -2- Loan/ Amount (US$ Million) Credit No. Year Borrower Purpose Bank IDA Undisbursed 5 loans 1954-58 45.0 - - 379 EC 1964 Republic of Ecuador) 9.0 - 1.1 51 EC 1964 Republic of Ecuador) Roads - 8.o 2.7 501 Ec 1967 Republic of Ecuador Agriculture 4.0 - o.6 124 EC 1968 Republic of Ecuador Education - 5.1 5.0 555 EC 1968 Republic of Ecuador Fisheries 5.3 - 5.2 173 EC 1969 Republic of Ecuador Agriculture - 1.5 1.5 1970 Republic of Ecuador Agriculture - l0.OM/ 10.0 Total (less cancellations) 63.3 24.6 of which has been repaid to Bank and others 22.9 Total now outstanding 40.4 Amount sold: 1.8 of which has been repaid 1.7 0.1 Total now held by Bank and IDA 40.3 24.6 Total undisbursed 6.9 19.2 26.1 1/ Not yet effective. 5. The status of disbursements of loans is still as described in para- graphs 5-8 of my Report and Recommendation on the credit for the Third Live- stock Development Project (P-875) dated November 12, 1970. 6. IFC has made two investments, one in 1965 of approximately US$2 million equivalent in equity and debt of La Internacional, a major Ecuadorian textile firm, and the other in early 1969 of about US$250,000 equivalent in equity of COFIEC, one of the beneficiaries of the loan now proposed. 7. Several projects are being prepared for consideration by the Bank and IDA. However, except for a possible operation of US$5 million for the Nayon Hydroelectric Project, it is not expected that any of these will be ready for presentation to the Executive Directors before the end of fiscal year 1972. IFC is reviewing a possible investment in a cement enterprise.  PART II - DESCRIPTION OF THE PROPOSED LOAN 8. Borrower: Republic of Ecuador. Beneficiaries: Comision de Valores-Corporacion Financiera Nacional (CFN) and Ecuatoriana de Desarrollo S. A. (Compania Financiera), called COFIEC. Amount: The equivalent in various curren- cies of us$8.0 million, to be divi- ded equally between the two com- panies. Purpose: To assist in financing industrial development in Ecuador by enabling CFN and COFIEC to cover the foreign exchange costs of specific invest- ment projects for productive pur- poses. Amortization: In 17-1/2 years, including a one-year period of grace, through semi-annual installments, beginning January 1, 1972, and ending January 1, 1988. Payments will be based on a composite amortization schedule substantially conforming to the schedules for the individual investment projects. Terms for the investment projects would be up to 15 years. Interest Rate: 7-1/4 percent per annum. Commitment Charge: 3/4 of one percent per annum. Relending Terms: 8-1/4 percent per annum to CFN and COFIEC (including one percent com- mission to the Central Bank for ad- ministrative costs). The development finance companies would have a minimum spread of 3 percent. PART III - THE PROJECT 9. An Appraisal report entitled "Appraisal of Comision de Valores- Corporacion Financiera lacional and Ecuatoriana de Desarrollo (Compania Financiera)" - DB-54a - is attached.  10. Although Ecuador's industrial sector is still at an early stage of development it has grown rapidly over the past decade (about 6.5 per- cent per annumS and has increased its contribution to GDP from 15.4 per- cent in 1960-62 to 17.1 percent in 1966-68. There is room for considerable expansion, and opportunities exist for industrial investment in the pro- cessing of industrial raw materials and livestock products, and in textiles, fisheries, and tourism. Furthermore, Ecuador's participation in the Andean Group subregional arrangement opens up for its efficient producers a market nine times as large as that of Ecuador itself, while forcing its less effi- cient producers to rationalize to meet the competition of their neighbors. Both are likely to need long-term financing on an increased scale. In- creased capital for investment should provide more industrial employment, a factor important in view of Ecuador's fast-growing labor force. 11. About four-fifths of industrial financing in Ecuador is provided by the commercial banks in the form of short-term loans. Long-term financ- ing for industry has been achieved largely by renewing short-term loans. CFN and COFIEC are virtually the only institutions providing long-term financ- ing. Their importance is indicated by the fact that their share in industrial financing since the mid-1960's rose steadily and reached a peak of 21 percent of the total in 1968. 12. The Bank loan would be made to the Government and relent through the Central Bank of Ecuador to the two participating development finance companies, CFN and COFIEC. As COFIEC is privately owned, the Government prefers to be the borrower and relend to both companies. 13. CFN is publicly owned. It was organized originally in 1948 to establish a market for government bonds and only began incdustrial lending in 1964. Its management is competent. The general manager has held this position since 1957 and most of its directors are members of the business community. The quality of its appraisal work is generally satisfactory; its project supervision, however, needs some improvement. 14. CFN has been able to rely, to a great extent, on its large capi- tal and earnings as the main sources of funds. It has also had some suc- cess in obtaining long-term loans from foreign institutions. Total long- term resources utilized as of June 30, 1970, in an amount of US$40.7 mill- ionl/ equivalent were derived as follows: US$31.0 million equivalent from paid-in capital and retained earnings, US$4.8 million from an AID loan, US$4.5 million from an IDB loan, US$0.3 million equivalent from a loan from European banks, and US$0.1 million equivalent from a loan from the Kreditan- stalt fdr Wiederaufbau. 1/ CFN's figures have been converted at the official rate of S/18 per U.S. dollar ruling on June 30, 1970. They take no account of the subsequent devaluation of the sucre.  15. CFNt's portfolio on June 30, 1970, consisted of US$13.5 million equivalent in securities (mostly government and municipal bonds and loans to Government), US$27.1 million equivalent in loans to industry, US$1.8 million equivalent in equity investments, and US$4.0 million in loans to Government. The loans are well-secured by collateral, few clients are in difficulty, and arrears are low. Reflecting in part a low leverage, CFN earns only a modest return on net worth, but it is endeavoring to improve its earnings position. 16. COFIEC is privately-owned and started operations in 1966 as an industrial finance company. It has competent management and a nucleus of capable personnel, and has on its Board of Directors several prominent businessmen. It needs to strengthen its capability for appraisal and super- vision of long-term investments, although, in the past, when the volume of these investments was small, management's close contact with clients has compensated for this weakness. The company plans to improve these aspects of its operations. 17. Unlike CFN, COFIEC has not had access to substantial long-term loan capital and has had to rely mainly on its paid-in capital and retained earnings of US$3.0 million equivalent (including an equity investment by IFC of about US$250,000) and the proceeds of loans from U.S. AID (US$2.9 million), the Bank/IDA (US$0.5 million equivalent for livestock lending), and Eximbank (about US$1.1 million) for a total at June 30, 1970, of US$7.5 million equiva- lent.l/ To maintain its growth, COFIEC recently has had to depend more heavily on short-term resources. 18. COFIEC had a portfolio on June 30, 1970, of US$7.8 million equiva- lent in loans, US$0.7 million equivalent investments, and US$13.0 million equivalent in guarantees and acceptances. Operating on the basis of high leverage, COFIEC has been able to attain a 16.1 percent return on net worth despite high administrative expenses. It needs to build up reserves to a more satisfactory level. 19. Taking into consideration the reasonably favorable climate for in- dustrial growth in Ecuador, and comparing the projected operations of CFN and COFIEC with the resources they expect to obtain from other sources, they will need an additional US$8.0 million equivalent over the next two years to help them finance the cost of imported goods and services for their clients' industrial projects. The proposed loan is intended to fill this gap and would be split evenly between the two companies. The Bank's prior approval would be required for projects utilizing US$100,000 or more of Bank funds, 1/ COFIEC's figures have been converted at the free market rate of S/22 per U.S. dollar ruling at the beginning of the company's 1970 account- ing year.  and the aggregate limit for each company on the amount of loan funds which could be utilized for projects not requiring the Bank's prior approval would be US$1.3 million. 20. The terms of sub-loans would be up to 15 years, including an ap- propriate period of grace not expected to exceed 3 years. Repayments from CFN and COFIEC would be based on repayments from their borrowers. The in- terest rate to the borrowers is expected to be 12 percent and that to CFN and COFIEC 8-1/4 percent, including a one percent commission to the Central Bank. The loan documents specify a minimum spread of 3 percent for each of the two companies. 21. The proposed Bank loan would complement the Inter-American Develop- ment Bank and U.S. AID loans, mentioned above, which have been directed, to a large extent, towards promoting the growth of small industrial firms. An earlier IDA credit (124-EC) for education will help to provide skilled workers for industry. PART IV - LEGAL INSTRUMENTS AND AUTHORITY 22. The draft Loan Agreement between the Republic of Ecuador and the Bank; the draft Project Agreements between the Bank and CFN and COFIEC, respectively; the Report of the Committee provided for in Article III, Sec- tion 4(iii) of the Articles of Agreement; and the text of a resolution ap- proving the proposed loan, are being distributed to the Executive Directors separately. 23. The draft Agreements contain covenants normally included in agree- ments for development finance company projects, including the full commit- ment charge. Particular attention is drawn to the following provisions: (i) CFN initially carries the exchange risk but an event of de- fault would occur if the company is not reimbursed by the Government or others for any loss derived as a result of carrying such risk (Section 6.02(ix) of the draft Loan Agree- ment); COFIEC agrees to take steps satisfactory to the Bank to protect itself against the exchange risk (Section 2.06 of the draft Project Agreement with COFIEC); (ii) At the Bank's option, the Loan Agreement may be declared ef- fective (Section 7.01), and an event of default established (Section 6.01), with regard to only one of the development finance companies. PART V - THE ECONOMY 2h. An economic report entitled "Current Economic Position and Pros- pects of Ecuador" (WH-201a) dated August 21, 1970, was distributed to the Executive Directors on September 4, 1970. The report indicated that the  - 7 - most urgent and immediate issue of development policy was the necessity to correct the severe fiscal disequilibrium which threatened the financial stability of the country. Until recently, the Government did not effective- ly limit the gioowth of its current expenditures, and the resulting deficit and expansion of cr3dit led to a devaluation of the sucre in August 1970 from S/18 to S/25 per U.S. dollar. 25. These developments induced the Ecuadorian authorities to adopt a financial program which was worked out with the II-IF. A stand-by agreement based on this program was made on September 11, 1970. The implication of this program, combined with tax measures taken earlier in the year and the favorable fiscal impact of the devaluation, is expected to reduce the 1971 budget deficit to a level consistent with a moderate expansion of credit to the private sector and the maintenance of the new exchange rate. The Ecuadorian authorities took the opportunity of the devaluation to simplify the exchange system, eliminating the dual rate system and other multiple exchange rate features; they also eliminated all restrictions on current transactions, thus making the sucre a convertible currency under Article VIII of the IMF Articles of Agreement. Already the devaluation has begun to have a beneficial impact on the balance of payments as it has provided increased returns to exporters and, especially significant at this time, has improved the position of Ecuadorian producers vis-a-vis their Andean market competi- tors. 26. Ecuador's external debt management has been generally sound; the debt service ratio on the public external debt is estimated at about 13 per- cent of foreign exchange earnings in 1970. Provided relatively prudent monetary and fiscal policies are maintained, Ecuador should continue to be creditworthy for moderate amounts of additional external lending on conven- tional terms. Nevertheless, even under conditions of sound economic manage- ment, Ecuador's low per capita income and relatively high fiscal burden place a limit on public sector savings that can be generated, and at least part of the capital required frQm abroad siould be provided on concessional terms. 27. A basic data sheet is annexed hereto. PART VI - COMPLIANCE WITH ARTICLES OF AGREEMNT 28. I am satisfied that the proposed loan would comply with the Arti- cles of Agreement of the Bank.  - 8 - PART VII - RECONIIENDATION 29. I recommend that the Executive Directors approve the proposed loan. Robert S. MicNamara President Attachments Washington, D.C. December 3, 1970  Annex ECUADOR BASIC DATA Population: 6.1 million (mid-1970) Rate of growth per year 1960-69 3.4 percent Density per sq. km. 22 Area: 271,000 sq. kilometers Income: Gross Domestic Product, 1969 30,317 million sucres, current prices National Income, 1969 25,279 million sucres, current prices Rate of Growth, real GDP 1950/52 - 1959/61 4.9 percent per annum 1960/62 - 1967/69 4.9 percent per annum GDP by Industrial Origin (1967-69 average): Percent of GDP Agriculture and fishing 31.9 Manufacturing and mining 19.1 Construction 4.6 Utilities and transport 5.2 Banking and trade 13.5 Government and other services 25.7 Financing of Investment (1967-69 average): Percent of GDP Investment 13.6 Domestic Savings 10.8 Less: Factor Income Payments -2.6 National Savings 8.2 Net Capital Inflow 5.4 13.6 Per Capita GDP, Current Market Prices, 1969: US$254 Balance of Payments: 1968 1969 (million US$) Balance on current account -67.5 -87.3 Exports f.o.b. 210.7 186.0 Imports f.o.b. -214.7 -215.0 Investment Income (net) -27.2 -27.4 Other invisibles -49.5 -44.4 Transfers (net) 13.2 13.5  Balance of Pa ment,s (Cont'd.): 1968 1969 7 million USW Balance on capital account 67.5 87.3 Direct investment 32.0 34.9 Medium and long-term loans (net) 27.8 25.8 Decline in short-term assets (net) 7.7 36.6 (including errors and omissions) Money and Banking (year end): 1967 1968 1969 (mllion sucresJ Currency and demand deposits 3,281 3,815 4,361 Quasi-money 3,634 4,413 4,871 Total money and quasi-money 6,915 8,258 9,232 Increase from end of previous year 13.4% 19.4% 11.8% Increase in cost of living 4.9% 2.9% 4.0% Central Government Finances (fiscal years): 1967 1968 1969 y ) llion sucres Total revenues 2,338 2,554 2,930 Current expenditures 1, 863 2,787 2,899 Savings before transfers 475 -233 33 Transfers 520 -558 -610 Savings after transfers -45 -791 -576 Capital expenditures 396 441 501 Deficit 441 1,232 1,077 Relationship to Monetary and Custorm Area: Member, LAFTA and Andean subgroup Official Foreign Reserves (October 1, 1970): US$54.7 million Debt Service Ratio, 1969: 13.2 percent (export of goods) IMF Position (November 1, 1970): Quota US$33 million Cumulative drawings (incl. Compensatory Fin.) US$68.25 million Cumulative repurchases US$46.25 million Exchange Rate: 1970 Par Value US$1 = S/25 (sucres) December 3, 1970