FILE COPY. The World Bank. Document of. Public Disclosure Authorized FOR OFFICIAL USE ONLY. Report No Public Disclosure Authorized

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1 Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY FILE COPY Report No Public Disclosure Authorized ECUADOR - PROJECT PERFORMANCE AUDIT REPORT FIRST AND SECOND DEVELOPMENT FINANCE COMPANIES PROJECTS (LOANS 721-EC AND 930-EC) June 4, 1979 Public Disclosure Authorized Public Disclosure Authorized Operations Evaluation Department 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.

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3 FOR OFFICIAL USE ONLY PROJECT PERFORMANCE AUDIT REPORT ECUADOR - FIRST AND SECOND DEVELOPMENT FINANCE COMPANIES PROJECT (LOANS 721-EC AND 930-EC) TABLE OF CONTENTS Page No. Preface i Basic Data ii - in Highlights iv - v PROJECT PERFORMANCE AUDIT MEMORANDUM 1. Introduction 2. The Economic and Institutional Environment and the 1 Bank Objectives Commitment and Use of Bank Funds Overall Operation of the Financieras 5 CV-CFN 5-6 COFIEC Resource Mobilization Institution Building Conclusion Annex I. Comments received from the Central Bank of Ecuador (Translation) Annex II. Comments received from CV-CFN Attachment: Project Completion Report: I. Introduction 17 II. Objectives of Bank Lending III. Use of Loan Proceeds Subprojects Financed Under the Loans 19 Sectoral Distribution of Subproject 19 Types of Enterprises Financed Economic Returns IV. The Financieras 22 Growth Operations The Onlending Rate Quality of Portfolio Operating Results Financial Condition 28 Resource Mobilization Appraisal and Supervision IFC Investment in COFIEC Conclusion 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.

4 - 2 - TABLE OF CONTENTS Page No. Annexes: Annex 1 - Key Dates 34 Annex 2 - Estimated and Actual Disbursements 35 Annex 3 - Summary Breakdown of Subloan Approvals 36 Annex 4 - Economic and Financial Returns on Subprojects Financed under the Second Loan 37 Annex 5 - Industrial and Financial Indicators 38 Annex 6 - Industrial Finance (Disbursements) 39 Annex 7 - Money and Credit Indicators 40 Annex 8 - Savings and Investment 41 Annex 9 - CV-CFN and COFIEC: Comparison of Projected with Actual Assets and Equity 42 Annex 10 - CV-CFN: Summary Balance Sheets (Audited) 43 Annex 11 - CFN: Summary Income Statement 44 Annex 12 - COFIEC: Summary Balance Sheet 45 Annex 13 - COFIEC: Summary Income Statement 46 Annex 14 - Comparison of Structure of Portfolio 47 Annex 15 - Interest Rates 48

5 PROJECT PERFORMANCE AUDIT REPORT ECUADOR - FIRST AND SECOND DEVELOPMENT FINANCE COMPANIES PROJECTS (LOANS 721-EC AND 930-EC) PREFACE This report covers an audit of achievement under Loans 721-EC and 930-EC to the Republic of Ecuador for on-lending to the Comision de Valores-Corporacion Financiera Nacional (CV-CFN) and the Compania Financiera Ecuatoriana de Desarrollo (COFIEC). These two loans were approved in November 1970 and 1973, respectively. Loan 721-EC was closed, fully disbursed, in March As of September 1978, Loan 930-EC was 95% disbursed. An OED mission visited Ecuador in November 1978 and had discussions with both financial institutions (Financieras) as well as Central Bank officials. Assistance rendered to the mission during its visit is gratefully acknowledged. The audit memorandum is based on the attached Project Completion Report (PCR) prepared by the Bank's Latin American and Caribbean Regional Office, file review and discussions with Bank staff, as well as officials of the Financieras and the Central Bank during the OED mission. The memorandum discusses several aspects of project implementation. It also attempts to place into perspective the reform of the interest rate structure undertaken by the Government and its impact on the volume of the Financieras' long-term borrowings and lending operations. While the PCR deals with the period covered by the two Bank loans, the audit memorandum, in accordance with standard practice, brings some aspects of the institutional situation up to date. Comments were received from the Central Bank of Ecuador and from CV-CFN, and have been taken into account in finalizing the report. Comments related to the linkages made in the audit report between the Government's monetary policy and the Financieras' resource mobilization performance under the loans are appended as Annex I to the memorandum. Comments from CV-CFN are reproduced as Annex II to the memorandum.

6 - ii - PROJECT PERFORMANCE AUDIT REPORT ECUADOR - FIRST AND SECOND DEVELOPMENT FINANCE COMPANIES PROJECTS (LOAN 721-EC) BASIC DATA SHEET Amounts (in US$ m1n) As of 3/31/79 Original Disbursed Cancelled Repaid Outstanding Loan 721-EC Cumulative Loan Disbursement (i) Planned (ii) Actual % of (ii) to (i) Project Data Original Plan Actual or Est. Actual Conception in Bank 3/67 Board Approval 12/69 12/17/70 Loan Agreement 7/70 2/05/71 Effectiveness 10/70 10/15/71 Loan Closing 6/74 3/76 Total Costs (mln) 41.8 Mission Data Month, No.of No. of Year Weeks Persons Manweeks Date of Report Preappraisal 6/ Appraisal 9/ /70 Subtotal 7 14 Supervision I ] Supervision II Supervision III Supervision IV ] with Loan 930-EC w Follow-on Project Loan 930-EC of US$20.0 million, signed for Second 'DFC V-roject.

7 - iii - PROJECT PERFORMANCE AUDIT REPORT ECUADOR - FIRST AND SECOND DEVELOPMENT FINANCE COMPANIES PROJECTS (LOAN 930-EC) BASIC DATA SHEET Amounts (in US$ m1n) As of 3/31/79 Original Disbursed Cancelled Repaid Outstanding Loan 930-EC Cumulative Loan Disbursement (i) Planned (ii) Actual % of (ii) to (i) Project Data Original Plan Actual or Est. Actual Conception in Bank 10/71 Board Approval 12/72 6/26/73 Loan Agreement 3/73 8/17/73 Effectiveness - 11/15/73 Loan Closing 3/30/79 Total Costs (mln) Mission Data Month, No.of No. of Year Weeks Persons Manweeks Date of Report Preappraisal 7/ Appraisal 2/ /73 Subtotal 7 14 Supervision I 5/ /73 Supervision II 10/ /74 Supervision III 3/ /77 Supervision IV 3/ /78 Subtotal Follow-on Project Loan 1359-EC of US$26.0 million, signed 2/18/77 for Third DFC Project.

8 - iv - PROJECT PERFORMANCE AUDIT REPORT ECUADOR - FIRST AND SECOND DEVELOPNENT FINANCE COMPANIES PROJECTS (LOANS 721-EC AND 930-EC) HIGHLIGHTS This report covers an audit of achievement under Loans 721-EC and 930-EC to two financieras in Ecuador, the publicly-owned Comision de Valores - Corporacion Financiera Nacional (CV-CFN) and the privately-owned Compania Financiera Ecuatoriana de Desarrollo (COFIEC). These loans, in a total amount of US$28 million, were meant to support the lending operations of these institutions and help their financial and operational development. Through that, the loans had the long-term objective of encouraging the substitution of long-term funds for short-term credits. The end use of the loan proceeds was found to be satisfactory, although the average size of sub-projects financed under the loans was on the high side (US$2.2 million), reflecting the financieras' lack of promotion and their concentration on established entrepreneurs (para of the PPAM, paras. 7 and 8 of the PCR). Discussions between the Bank and the Government were at the origin of step increases in the financieras' maximum long-term lending rates (para of the PPAM; para.19 of the PCR). These led to a sharp improvement in the financieras' capability to raise resources on the domestic market; however, their performance in this respect has in recent years been subdued as a result of tight monetary conditions. The financieras' long-term operations have not experienced a growth commensurate with the improvement of their resource position (paras. 4.02, 4.04 and 4.05 of PPAM). For one thing, because of lack of active promotion, the financieras have been limited in their operations by the preference of established entrepreneurs which constitute the majority of their clientele for shorter-term credit on cheaper terms. In the case of COFIEC, this was compounded by the institution's own preference for short-term lending for profitability reasons (para of the PPAM), indicating that, particularly in this case, the Bank had achieved limited success in its objective to promote a change in the maturity structure of industrial finance.

9 Other points of interest are: - the problems experienced by COFIEC with its Quito regional office (para of the PPAM); and - CV-CFN's issues of 5-year bonds redeemable at par at sight to cover its long-term resource needs (paras and 5.04 of the PPAM).

10 PROJECT PERFORMANCE AUDIT MEMORANDUM ECUADOR - FIRST AND SECOND DEVELOPMENT FINANCE COMPANIES PROJECTS (LOANS 721-EC AND 930-EC) 1. Introduction 1.01 This report refers to the first two loans made by the Bank to the Republic of Ecuador for on-lending to Comision de Valores - Corporacion Financiera Nacional (CV-CFN) and the Compania Financiera Ecuatoriana de Desarrollo (COFIEC) of Ecuador. These two loans (Loans 721-EC and 930-EC) were approved in November 1970 and June 1973, respectively; they were followed in December 1976 by a third loan (Loan 1359-EC), the proceeds of which are to be shared by a larger group of development finance companies; a fourth loan intended to be channelled to a still larger group of DFCs, is currently under consideration The first of the two Bank loans, in an amount of US$8 million, was allocated equally between CV-CFN and COFIEC. Under the second loan, in an amount of US$20 million, US$8 million only were preallocated to each institution (financiera) to account for a possible uneven utilization of funds, US$4 million remaining.available to either of the two DFCs on a first-come-first-served basis, although COFIEC's access to this last tranche of US$4 million was conditional upon an increase in its share equity. Both loans were granted to the Republic of Ecuador and channelled through the Central Bank acting as agent for the Government CF-CFN is a publicly owned institution. It was originally established in 1948 as a securities commission (Comision de Valores) within the Central Bank, acting as fiduciary agent for the Government in the marketing of public bonds; it was later made an autonomous agency and authorized to trade in a number of private securities. In 1964, it was transformed into a development bank to provide term financing to industry; this last activity has progressively replaced CV-CFN's original fiduciary function in the sale of public securities OFIEC, on the other hand, is a privately-owned institution, enjoying since its incorporation in 1965 a widely distributed ownership pattern. In addition to receiving DFC-type loans from the Bank, COFIEC has acted as a channel to process the Bank/IDA's livestock loan/credits to Ecuador (Loan 501-EC of May 1967; Credits 173-EC and 222-EC of Sept and Nov. 1970, respectively). Following the decision in 1968 by COFIEC's board of directors to double the authorized share capital of the.company, IFC subscribed to a 9% share participation, thus becoming the financiera's second largest shareholder. IFC recently sold half of its holding in COFIEC's equity to DEG. 1/ 1/ Deutsche Entwirklungsgesellschaft (DEG).

11 The Economic and Institutional Environment and the Bank Objectives 2.01 While the first Bank loan was made in the context of a fairly modest industrial growth,l/ the sharp increase in the country's oil revenues since the loan appraisal has spurred domestic demand and led to a constant acceleration of industrial development, industrial growth averaging 10% between 1970 and 1977 compared to 4% during the previous four years Expansion has been further stimulated by an array of beneficial government policies toward private investment, which take the form of tax exemptions and reductions, investment incentives and a tariff protection against and quantitative restrictions on competing imports. At the time of appraisal of the second loan, the Bank, realizing the impact which such a protective environment could have on the soundness of the project selection process conducted exclusively on the basis of financial considerations as done up to then by the financieras, made the strengthening of the financieras' capabilities to appraise the economic merits of projects a specific objective of the loan, the computation of an economic rate of return being required for larger projects In spite of rapid growth, the structure of industry still testifies to the relatively early stage of its development with sub-sectors such as food processing, textiles and wood processing accounting for the largest share of value added as well as fixed investment. The Bank did not have any specific expectation as to the sectoral distribution of firms to which the loan proceeds were to be allocated, although mention was made under the third loan of the potential offered by export-oriented agro-industries as well as import-substitution industries related with construction Since the four-fold increase in oil prices a comparatively small proportion of additional public revenues has been channelled to the nonpetroleum industrial sector, as the Government gave priority to the development of the country's infrastructure. This, coupled with the limited availability of corporate earnings for reinvestment, had led, in the earlier part of the period under review, to a lag in overall industrial investment in relation to output whose rapid progress has been in part due to a more intense utilization of existing productive capacity. However, reflecting the two-pronged industrial strategy adopted by the Government, substantial public funds are proposed to be allocated to the promotion of export industries as well as to the creation of a number of large-scale import substitution industrial projects based on local resources. 2/3/ An export 1/ Manufacturing output was expected to increase at the rate of 4% per year during 1970 and / As part of the development plan the Government has established mandatory state participation in "basic industries" including steel, cement, basic chemicals, petrochemicals and mining. 3/ The Government also provided funds for the assistance of small-scale and artisan industries through the Fondo Financiero Industrial.

12 - 3 - promotion fund (FOPEX), administered by CV-CFN, was created in 1972 to provide concessionary short- and medium-term loans to "non-traditional" exporters. Later on, the Government set up the Industrial Directorate of the Armed Forces (Direccion de Industria del Ejercito - DINE) to promote, and take equity participation in, large projects usually predicated on continued progress in the integration of countries of the Andean Group (e.g. cement, petrochemicals). The Government has at the same time been using CV-CFN as an alternative instrument to promote industrial development along lines elaborated by the Planning Commission Given its stage of development, Ecuador has a relatively sophisticated financial system which has played a substantial role in recent industrial expansion. Aside from a fairly large number of domestic and foreign commercial banks, two institutions - CV-CFN and COFIEC - specialized in industrial financing; the Banco Nacional de Fomento (BNF), in addition to its main activities in the agricultural sector, is also engaged in industrial financing, dealing particularly with small industries. With the recent acceleration of industrial development, a number of new privatelyowned non-bank financial intermediaries have been (or are being) set up in Quito, Guayaquil and Cuenca, some of them with CV-CFN's financial and/or technical assistance. Still a major impediment to industrial growth has been the difficulty to mobilize long-term funds for fixed investment purposes, a substantial proportion of investment costs being traditionally financed through rolled-over short-term credits. In this context, a major objective of the Bank's lending to CV-CFN and COFIEC - besides the objectives of DFC operations to participate in the financing of the country's industrial development and foster the emergence of strong and efficient financial intermediaries - was to promote a change in the structure of industrial finance by substituting long-term funds for short-term credits Since the first Bank loan to CV-CFN and COFIEC, the Ecuadorian economy has been through three fairly distinct phases. The years preceding the increase in oil prices ( ) were marked by the Government's efforts at correcting the financial disequilibrium which had resulted from a deterioration in the fiscal situation and culminated in a balance of payments crisis in mid-1970; the tight credit policies undertaken by the Government following the devaluation of the Sucre in 1970 and the signing of a standby agreement with the IMF in 1971 placed a number of private companies in difficulty. The years which followed were on the contrary characterized by a sharp expansion in public expenditures and the creation of a number of special development funds within the Central Bank. Credit as well as personal incomes expanded rapidly as the Government was not able to offset the impact on the monetary base of the increase in international reserves; these developments were the cause of strong inflationary pressures which eventually led to an inflation rate in excess of 20% in Since 1975, the Government has called for the same monetary measures which it had followed during the early 70s; these have also included temporary ceilings on bank portfolios and the issue of stabilization bonds by the Central Bank (money and credit indicators are shown in Annex 7 of PCR).

13 A related factor was the increase in interest rates which took place towards the end of These measures have been successful in curbing excess liquidity within the economy and bringing down the inflation rate to the neighborhood of 10%. These strict monetary policies, however, coupled with the current political uncertainties and lower public revenues due to the difficulties experienced with oil production, have recently led to a certain slow-down in industrial investment in relation to the rapid growth experienced during the mid-70s. 3. Commitment and Use of Bank Funds 3.01 Whereas the proceeds of the first Bank loan went in equal proportions to CV-CFN and COFIEC, the latter eventually received a larger share of the second loan, having satisfied in a timely fashion the share equity increase requirement imposed by the Bank during negotiations (vide para. 1.02). The faster pace of commitment realized by COFIEC, especially when viewed in the context of the relative sizes of the two institutions (CV-CFN is about two-thirds larger than COFIEC) resulted from the limited availability to the latter of alternative long-term resources, its long-term lending operations being dependent to a very large, albeit somewhat decreasing extent, upon the availability of Bank funds (vide paras and 4.06) The conservative tailoring of the first loan, given the subsequent acceleration of industrial investment, led to some discrepancies between the commitment period of the first loan and that of the second loan, as funds under the first loan were committed much faster than had been originally expected (in one year instead of two, following loan effectiveness) and the Bank was not in a position to approve a second loan till nine months later. One contributing factor which led to quick commitment of funds under the first loan was the one-year delay which took place in having the loan declared effective after Bank approval, pending its approval by the country's legal authorities; this initial delay permitted the financieras to build up a list of loan proposals ready for approval as soon as the loan was declared effective. It is not clear, however, whether the Bank was unaware of this situation at the time or whether program constraints prevented an earlier approval of a follow-up loan. The same kind of delay took place between the second and third loans, although to a lesser degree. These lags were more detrimental to COFIEC than to CV-CFN because of its lack of complementary long-term resources, upon the availability of which the size of Bank loans was predicated (vide para. 5.01), causing interruptions in its long-term lending program The use of Bank funds is reviewed in the PCR (paras. 7 to 13). The total estimated investment cost of Bank-financed projects amounted approximately to US$150 million for an average cost of US$2.2 million; data on the actual cost of sub-projects are incomplete but indicate average cost-overruns of 10% on account of under-estimated inflation rates. Projects financed by CV-CFN were on average 80% larger than those financed by COFIEC (US$3.4 million vs US$1.9 million). The contribution of the financieras to

14 - 5 - total project costs was not, on average, on the high side: 39% in the case of CV-CFN and 21% in that of COFIEC 1/; this last figure is particularly low, suggesting substantial contributions from project sponsors (59% of total cost-on average) and indicating a wider dispersion of Bank funds. The data also show that the two financieras financed a fairly large number of new projects (vide para. 10 of the PCR). However, the high figures of average investment cost show the emphasis of the financieras' activities on established entrepreneurs, some of whom could have obtained financing on commercial terms; to that extent, the promotional impact of the Bank loans was limited The financial performance of projects financed under the two Bank loans has been good. Profit margins were high but usually smaller than estimated; a number of companies registered losses in 1977 which, for some of them,was the first year of operation. Paras. 11 and 12 of the PCR deal with the economic performance of the projects. 4. Overall Operations of the Financieras 4.01 The growth of both financieras since the approval of the first Bank loan has been impressive in nominal terms as well as in real terms (vide paras. 14 and 15 of PCR). The overall expansion of domestic credit, by itself very large, barely kept pace with GDP. In this situation, CV-CFN and COFIEC have been able to increase their share of total industrial finance from 25% in to over 30% in , in part on account of the temporary ceilings imposed by the Central Bank on bank portfolios which did not apply to the financieras. 2/- However, given the Bank's objective to promote the institutionalization of long-term industrial financing, the growth in the financieras' long-term loan and equity portfolio is a more relevant indicator than that in their total assets which, in the case of both institutions, include a fairly large proportion of short- and mediumterm loans as well as substantial amounts of guarantee operations on foreign credits. This, in part,-has resulted from the ceilings imposed by the Banco Central on commercial banks' portfolios which have led industrial firms to look increasingly to DFCs and foreign sources of financing for their working capital needs. CV-CFN 4.02 Although its lending for working capital has been substantial, CV-CFN has demonstrated its commitment to long-term lending and has been in a position to mobilize domestic and foreign resources to supplement those provided under the Bank loans (vide paras and 5.03). Besides promoting long-term lending, CV-CFN has ventured in new activities and projects necessary for the industrial development of the country. As of 1/ These figures compare favorably with the average ratio of long-term debt to total assets for all industrial corporations. 2/ The Central Bank has indicated that no ceiling was placed on financiera lending, as such lending is confined to manufacturing activities.

15 end, its long-term loan and equity portfolio represented 70% of total assets and its short-term portfolio, constituted of loans, letters of credit and guarantees, formed only 20% of such assets. The growth in CV-CFN's equity portfolio has been particularly substantial, averaging 66% p.a. between 1970 and 1976; it represented in % of CV-CFN's share equity and 17% of its total assets; holdings are concentrated in a small number of firms, most of which have required CV-CFN's assistance in their promotion and in which CV-CFN holds sometimes a majority of share capital The role of CV-CFN as financier of Government projects has expanded considerably following the increase in the Government's oil revenues. The institution has been subject to some pressures from the Government to include in its portfolio some large public projects in steel, petrochemical, sugar and other sectors. In two cases the Board made exceptions to its policy of not lending more than 20% of its equity to a single company; out of these two cases, a sugar project (Aztra) appears to be of dubious economic and financial viability. CV-CFN's management is now trying to protect the company from such Government interference by drafting a specific Equity Investment Policy. COFIEC 4.04 The volume of COFIEC's long-term lending has not increased as was expected when the first and second Bank loans were appraised. As of 1976-end, COFIEC's medium- and long-term loan and equity portfolio represented only 20% of its total assets and its short-term portfolio 67%. Ceilings on long-term interest rates were for a long time responsible for COFIEC's difficulties in raising domestic long-term resources; this, coupled with the lack of a Government guarantee to obtain foreign resources, were in part responsible for its concentration on short-term operations which its Policy Statement does not preclude. A reform of the interest rate structure since 1976 has permitted COFIEC to engage profitably in the mobilization and lending of long-term resources and, as of 1977-end, COFIEC had been able to raise as much as US$7.4 million in 5-10 years bonds. However, COFIEC's long-term loan portfolio not covered by the Bank loans represented only 52% of this amount, indicating a term structure of lending shorter than that of borrowing Funds available under the Bank loans have accounted for most of the growth in COFIEC's term loan portfolio. Moreover, as suggested above, the largest part of COFIEC's term loans not originating in Bank funds consists in effect of medium-term operations (i.e. maturing in less than five years); indeed, as of December 1977, Bank resources available to COFIEC 1/ accounted for 76.4% of the latter's long-term loan portfolio and COFIEC had only been able to allocate US$3.7 million to long-term lending operations as a supplement to the US$12.5 million outstanding under the Bank loans. 1/ Including funds disbursed under the Bank livestock loans.

16 A number of factors, including Government policy, made shortterm operations more profitable than long-term operations; this was reflected in COFIEC's activities which gave greater emphasis to shortterm lending in its operations. Until the modification of the interest rate structure in 1976, prevailing interest rates and the possibility of raising short-term lending rates well above the legal ceiling of 12% 1/ made short-term credit operations significantly more profitable than long-term lending. In addition, since the restrictive credit measures imposed on commercial banks did not apply to.dfcs, this provided COFIEC with the opportunity of maintaining an attractive real return on its equity in the face of high inflation rates. Since 1976, additional commissions on long-term loans have made long-term lending a profitable undertaking, although clearly less so than short- and medium-term operations. COFIEC's current portfolio structure suggests the need for re-thinking on policies so as to give greater emphasis to developmental objectives by redirecting DFC operations towards long-term lending. In its absence, profitability considerations prevent a fuller commitment on the part of COFIEC to long-term lending. 2/ 4.07 COFIEC is organized in two separate regional offices in Quito and Guayaquil, each enjoying a fairly large degree of autonomy. During the first few years following approval of the first loan, COFIEC experienced some very severe difficulties with its Guayaquil branch. The liquidity squeeze which took place in following the Government's restrictive measures placed a number of industrial firms in difficulty; the effect on the portfolio of the Guayaquil office was particularly severe, indicating inadequate appraisal procedures. Moreover, the poor quality of the management. and staff of the Guayaquil office led to faulty control over operations. This was compounded by a lack of coordination and control between the Quito Headquarters and the Guayaquil office, making it impossible for COFIEC to handle the problems at hand. Since then, the situation has considerably improved; the management of the Guayaquil office has been reinforced and a reorganization of the company assuring control by the President over its two regional offices introduced. The Guayaquil branch, however, is still subject to deficiencies related to the looser business environment of the "Costa" region; appraisal procedures are less thorough than those conducted in Quito and the proportion of long-term loans in total operations is substantially smaller, indicating an even more commercially-oriented attitude than that of the Quito office. 1/ It is estimated that short-term credit carries an effective interest rate of 14% to 16%. 2/ Concerned about the volume of COFIEC's commercial operations, the Bank, on the occasion of the third loan, suggested that these be reduced to four times the size of the company's equity by the end of 1978; this requirement was included in COFIEC's Policy Statement. Preliminary indications suggest that COFIEC was not in a position to meet this target by 1978-end, although some measure of progress was achieved during the year.

17 -8-5. Resource Mobilization 5.01 The Bank did not set resource mobilization as a specific objective of the two loans under audit; however, the projections made, at the time of each loan appraisal, of the financieras' operations and financing requirements assumed the availability of a certain amount of domestic and foreign resources to bridge the resource gap which was expected. Moreover, the two financieras being the major long-term credit providers in the country, achievement under the Bank's objective to promote the institutionalization of long-term credit in Ecuador was to be the reflection of their resource mobilization performance. An important element seen to affect the financieras' performance in terms of domestic and foreign resource mobilization was the prevailing interest rate structure and, in particular, the ceiling imposed by the Government on long-term lending rates. Following discussions with the Bank the Government agreed to raise this ceiling from 10% to 12% in 1970 (vide para. 19 of PCR) and in 1976 allowed the financieras to charge additional commissions on top of their lending rates, bringing the maximum effective long-term rate to 16%. These reforms, however, have had for several reasons a subdued impact on the domestic resource mobilization performance of the financieras CV-CFN has traditionally raised its local resources in the form of 5-year bonds redeemable at par on sight. These bonds carry a tax-exempt 8% interest rate and benefit from a captive market in Ecuador owing to their two-pronged advantage of liquidity and security. After the first Bank loan was made and following oil discoveries and the subsequent hike in oil prices, CV-CFN's bond issues have increased significantly totalling US$30.7 million equivalent as of 1977-end, i.e. the equivalent of 64% of the institution's share equity. This is much higher than what was projected under the first loan when bond floatations amounting to S/30.0 million (US$1.2 million) annually were anticipated. During the last two or three years, this increase in domestic borrowing has been paralleled by a similar expansion in foreign borrowings, mostly in the form of US dollar denominated loans, to meet the priority requirements of the industrial sector, as CV-CFN took advantage of rates on medium-term financing which were lower on international markets than in Ecuador. Higher foreign borrowings, amounting to approximately US$97.5 million as of 1977-end, have meant an increasing foreign exchange exposure for CV-CFN, since it is prohibited by law to pass on the foreign exchange risk on its foreign borrowings, with the exception of Bank loans, to its sub-borrowers. This has been an increasing source of concern to the Bank although the relative stability of the US$/Sucre exchange rate has basically limited exchange rate losses so far to an older loan from KfW. Moreover, under covenant with the Bank, the Government has agreed to replace any of CV-CFN's capital lost due to exchange rate fluctuations. By 1976-end, accumulated unrealized exchange losses amounted to S/90 million (US$3.6 million) (vide para. 29 of PCR) Since 1976, the Central Bank, as part of its stabilization policy, has concentrated its actions on soaking up excess liquidity in the country by issuing large amounts of stabilization bonds. Moreover, commercial banks

18 -9- are no longer entitled to hold their legal reserves in the form of CV-CFN bonds as an alternative to Government bonds, further depressing the market for CV-CFN's debentures. In consonance with that, CV-CFN's bond issues have been below potential Whereas the increase in long-term interest rates was clearly instrumental in providing CV-CFN with sufficient financial revenues to engage profitably in foreign borrowings,l/ higher lending rates appear to have been little connected with its increase in domestic borrowings. Indeed, CV-CFN's bonds, being in effect short-term instruments and benefitting from tax exemption, have always sold at a rate sufficient to provide the institution with an adequate financial spread. The Bank has repeatedly encouraged CV-CFN to explore the possibility of floating true long-term bonds. Even during the high inflation years, CV-CFN was able to increase the volume *of its borrowings, as tax exemption, coupled with liquidity, gave its bonds a strong comparative advantage to a certain clientele over alternative financial instruments. The increase in long-term rates could have been instrumental in enabling CV-CFN to issue long-term bonds, subject, however, to the monetary authority's policies on allowing access to the capital market. In this context, it appears logical that CV-CFN continues to take advantage of the captive market it enjoys for its bond issues COFIEC's experience regarding resource mobilization has been somewhat similar to that of CV-CFN. Its issues of 5-10 year bonds carrying a,12% interest rate had been quite successful until the last two years when the volume of available resources started to diminish as a result of the massive issues of stabilization bonds by the Central Bank. COFIEC has also raised substantial resources of medium-term maturities (3-5 years) from the Social Security Institute (IESS). In both cases, higher lending rates have been critical factors in allowing COFIEC to engage profitably in such borrowings. On the other hand, because it lacked Government guarantees for its borrowings, COFIEC was not in a position to tap foreign sources of funds other than the Bank and AID. As an alternative, COFIEC has stepped up its guarantee operations of foreign loans made by Ecuadorian companies, most of them for short-term suppliers' credits Thus, the actual impact of the reform of the interest rate structure suggested by the Bank has been mixed, mainly because of the change in the economic situation since then. Higher long-term lending rates were clearly an essential step to enable the financieras to mobilize long-term resources efficiently and profitably. Still, the tight monetary policies followed currently by the Government have led to a slow-down in the flow of long-term resources into fixed productive investment, thus preventing this important reform from generating the impact which was expected. 2/ 1/ This trend has recently started to reverse with the emergence of higher rates on the American money market. 2/ The Bank has been trying to expand the scope of its discussions with the Government regarding the development of the local capital market (which is essentially a debenture market), but with little success. The creation of a Capital Market Office within the Central Bank as a tool to discuss capital market issues has been proposed on the occasion of the third Bank loan but has not materialized yet.

19 Paralleling the financieras' performance in mobilizing long-term resources, achievement under the Bank's objective to promote the institutionalization of long-term industrial financing has been only partially successful. As a direct result of Bank lending, the proportion of longterm loans within total credit has clearly increased as very little longterm credit was available to industry before the Bank's involvement. However, the multiplier effect of Bank loans has been limited as CV-CFN has not been able to mobilize long-term funds as a result of tight money market conditions, while COFIEC's efforts have to some extent been neutralized by the shorter average maturity of its lending operations. Moreover, the financieras do not appear to have been in a position to charge the maximum rate on long-term loans permissible under the 1976 reform (16%) because of the preference, by established entrepreneurs which constitute the majority of their clientele, for shorter-term credit on cheaper terms. This development further characterizes the limit of the Bank's success in promoting long-term industrial financing in Ecuador. 6. Institution Building 6.01 Appraisal procedures of both financieras have substantially improved under the two Bank loans. CV-CFN had adopted economic analysis as part of its appraisal procedures under an internal directive. In particular, CV-CFN and COFIEC have started since the second loan to compute FRRs and ERRs for sub-projects above the free limit, thus being the first DFCs assisted by the Bank to begin using the economic rate of return analysis as part of their evaluation procedures. However, whereas CV-CFN has sought to apply this new appraisal methodology also to projects not financed by Bank funds, COFIEC's appraisals of medium-term loans (which have accounted for the bulk of its term operations aside from Bank subloans) have been less thorough To date, the use of ERR, while providing a new dimension to the decision-making process, has not led to the rejection of a project on economic grounds while its being acceptable on a financial basis, as most projects benefitted from a rapidly expanding domestic demand generated by oil revenues; computation of an economic rate of return as part of the financieras' regular appraisal procedures should, however, become increasingly relevant in the future as the volume of lending to "marginal" projects increases Supervision. CV-CFN has substantially improved its supervision procedures since the second Bank loan. Firms are regularly visited and their financial situation closely monitored, and recommendations made to borrowers on actions needed to be taken. The institution is still, however, somewhat weak in its dealings with problem projects and suggestions made on management or technical matters have remained minimal. A contributing factor in the overall improvement appears to have been the separation of evaluation and supervision functions within the organization of the company which permitted a closer monitoring of manpower actually allocated

20 to project supervision. The particular structure adopted by CV-CFN might prove beneficial in the case of smaller institutions where the danger is particularly acute of having a rapid growth in operations prevent adequate supervision by putting too much emphasis on appraisal tasks when both functions are assigned to the same team of professionals COFIEC's supervision procedures have also improved, although less noticeably than those of CV-CFN. Staff allocated to appraisal/supervision functions is smaller and, for this particular reason, supervision has remained a second priority within the institution. The quality of COFIEC's portfolio suggests that supervision is adequate. 7. Conclusions 7.01 The performance under the two first loans to CV-CFN and COFIEC needs to be assessed in regards to their three objectives of (i) providing long-term financing to industry by financing the foreign exchange portion of the financieras' term lending program, (ii) improving the financieras' appraisal and supervision procedures as part of a general effort of institution building and (iii) promoting a change in the structure of industrial finance from short to long-term Achievement under objectives (i) and (ii) has been quite successful. Bank funds have been channelled to a number of projects which on the whole have proved valuable although financial results were clearly enhanced by the favorable climate generated by higher oil revenues. Project appraisals made by the two financieras are now much more comprehensive and include, for larger projects, the computation of economic rates of return following a satisfactory methodology. Project supervision has also substantially improved, particularly in the case of CV-CFN and it appears that the separation of the supervision function within the overall structure of the company has been instrumental in bringing about this improvement The success of the Bank in promoting the institutionalization of long-term industrial finance as an alternative to the roll-over of shortterm credit as previously used for the majority of investment projects is a more disputable question. The Bank's approach to the problem of longterm resource mobilization focused on the spread that the financieras would have on Bank funds. Discussions with the Government on the occasion of the three Bank loans led to successive reforms of the interest rate structure, leading eventually to the establishment of maximum long-term lending rates at levels permitting DFCs to carry out the intermediation of long-term funds profitably. It was seen, however, that for a number of reasons these reforms have not entirely succeeded in promoting the channelling of long-term funds to industry as it was expected. Indeed,

21 since the date of the main increase in long-term rates - CV-CFN's and COFIEC have not been able to increase their bond issues to any substantial extent because of tight money market conditions. This suggests that the Bank's focus on the issue of interest rates was not sufficient to promote the emergence of a financial environment conducive to proper resource mobilization by the financieras; intensive discussions with the Government on wider capital market issues are presently going on as part of negotiations for a fourth DFC loan to Ecuador In the case of COFIEC, difficulties in raising long-term funds have been compounded by the reluctance of the company to expand its longterm operations as rapidly as it could for profitability reasons. Longterm intermediation is now a profitable business but the channelling of short-term funds is - and is likely to remain - a better source of profit. In this context, a private DFC such as COFIEC cannot realistically be expected to fulfill its developmental purpose, except to the extent that it has access to long-term resources such as Bank loans for which it acts merely as a channel. It, thus, provides Bank funds with a very limited multiplier effect and runs the risk of remaining overly dependent upon the assistance of the Bank, making it difficult for the latter to phase out its lending program. The Bank has tried to deal with these difficulties by limiting the volume of COFIEC's short-term credit portfolio. This has proved difficult to enforce; a more direct way to assure a minimum multiplier effect to Bank funds would be to request, when necessary, borrowing institutions to invest local funds into long-term loans in a certain (possibly increasing) proportion of the Bank funds being disbursed. Operations Evaluation Department June 4, 1979

22 -13- PROJECT PERFORMANCE AUDIT REPORT ANNEX I Page 1 of 2 ECUADOR - FIRST AND SECOND DEVELOPMENT FINANCE COMPANIES PROJECTS (LOANS 721-EC AND 930-EC) COMMENTS RECEIVED FROM THE CENTRAL BANK OF ECUADOR (TRANSLATION) OBSERVATIONS AND RECOMMENDATIONS ON THE PERFORMANCE AUDIT REPORTS FOR PROJECTS FINANCED UNDER IBRD LOANS 721-EC AND 930-EC Since 1974, the Government's anti-inflation monetary policy has tended to use open market operations and qualitative credit measures, while also managing to curb the restrictive effects of other measures (ceilings on bank portfolios and pre-import deposits, etc.). A significant development was the effective raising of interest rates in late These measures reduced the excess liquidity within the economy and brought the inflation rate down to about 10%. However, because of a somewhat slower rate of public expenditure, owing to difficulties in the marketing of petroleum--rather than the application of monetary measures--coupled with political uncertainties, there was apparently some sluggishness in industrial investment, particularly in relation to the rapid growth experienced during the mid-70s. (Section 2.06). The reference to portfolio ceilings for commercial banks as a cause for expansion in industrial financing by CV-CFN and COFIEC and the relatively high proportion of short- and medium-term loans should be eliminated. We feel that the impact of the portfolio ceilings was borne primarily by commercial and not industrial activity. Moreover, for structural reasons the banks and financieras both prefer short- and medium-term operations to long-term ones. (Section 4.01) The reference to the so-called depressed market for CV-CFN's debentures caused by the Central Bank's stabilization bonds contradicts the statement in Section 5.02, where it is stated that the actual figures were much higher than projected. In addition, the monetary authorities have preferred pure monetary instruments, which is why the bonds have been progressively eliminated as part of bank legal reserves. The anti-inflationary policy has attempted to absorb excess liquidity without damping the rapid economic growth, and taking into account the substantial inflow of foreign private capital which in the last two

23 ANNEX I Page 2 of 2 years has been earning lower than domestic interest rates. The reports challenge the policy of open market operations and use of certain monetary restrictions. CV-CFN marketed as many bonds as it wished without any difficulty, and it is felt that COFIEC could have acted in a similar fashion. It should not be forgotten that the competition from foreign credit impeded credit operations at the maximum rate of 16%. In addition, other measures such as portfolio ceilings are not considered to have had a significant impact on the granting of industrial loans since that measure mainly affects commercial bank credit, with the peculiarity that a request for this type of credit is not transferable in large part to the financieras, precisely because of its commercial nature. In addition, the document itself confirms our belief that "the financieras appear not to have been in a position to charge the maximum rate on long-term loans permissible under the 1976 reform [16.0 (sic) %] because of the preference, by established entrepreneurs which constitute the majority of their clientele, for short-term credit on cheaper terms." [ ---1I What was said above on the impact of stabilization bonds is also true with regard to COFIEC and the statement made therein on the restrictive monetary policy. Moreover, there has always been official interest in analyzing the development of the domestic capital market, particularly on the part of the Central Bank. This would explain its commitment to study that market as stipulated in the agreement for the third loan. (Sections 5.05 and 5.06) The constant observation in the document to the effect that "CV-CFN's efforts to mobilize long-term funds were somewhat frustrated by Government restrictions... " is not accurate and should be eliminated. (Section 5.07)

24 ANNEX II PROJECT PERFORMANCE AUDIT REPORT Page 1 ECUADOR - FIRST AND SECOND DEVELOPMENT FINANCE COMPANIES PROJECTS (LOANS 721-EC AND 930-EC) COMMENTS RECEIVED FROM CV-CFN (TRANSLATION) TELEX No DATED: MAY 19, 1979 RE PROJECT PERFORMANCE AUDIT MEMORANDUM ON ECUADOR. THIS CORPORATION HAS THE FOLLOWING COMMENTS: 2.02 AT THE TIME OF BANK APPRAISAL OF SECOND LOAN, ACCORDING TO [INTERNAL] DIRECTIVE NUMBER 15 OF JULY 29, 1971, CFN INTRODUCED APPRAISAL OF INDUSTRIAL PROJECTS, THEN CALLED MACROECONOMIC ANALYSIS, WITH OBJECTIVE TO MEASURE DIRECT OR INDIRECT IMPACT THAT PROJECTS FINANCED BY THIS ENTITY COULD CAUSE ON NATIONAL ECONOMY WE CONSIDER THAT [THE] REPORT SHOULD BE LIMITED TO THE RESULTS [OF THE] TWO FIRST LOANS, NOT MENTIONING EVENTS IN CONNECTION [WITH THE] THIRD LOAN RECTIFY STATENENT ON SHARE EQUITY OF CFN SHOULD READ 32% INSTEAD OF 82% TO COMPLY WITH PRIORITY FINANCIAL REQUIREMENTS OF INDUSTRIAL SECTOR, IT WAS NECESSARY FOR CFN TO MAKE FOREIGN LOANS. AT THE SAME TIME RATE OF INTERNAL INTEREST CHARGED ON ITS LOANS WAS MODIFIED.

25 ANNEX II Page BESIDES PROMOTING LONG-TERM FINANCING CFN HAS EXPANDED ITS OPERATIONS AND CREDIT MECHANISMS, HAS VENTURED IN NEW ACTIVITIES AND [IN SOME CASES] RISKY PROJECTS [BUT] NECESSARY FOR INDUSTRIAL DEVELOPMENT [OF] ECUADOR SUPERVISION REPORTS CONTEMPLATE, IN [THEIR] FINAL SECTION, RECOMMENDATIONS WHICH ARE SUGGESTED TO BORROWERS FOR THEM TO TAKE ADEQUATE AND OPPORTUNE ACTIONS FOR SUCCESS OF PROJECTS. WE HOPE OUR COMMENTS WILL BE CONSIDERED IN FINALIZING PROJECT PERFORMANCE AUDIT REPORT LOANS 721-EC AND 930-EC. WE APPRECIATE YOUR COLLABORATION, SINCERELY, ECON. MARCELO GARCIA B. ASSISTANT MANAGER OF RESOURCES CORFINAL/ECUADOR MAY 18, 1979

26 ECUADOR Project Completion Report First and Second Development Finance Companies Projects Loans 721-EC and 930-EC I. INTRODUCTION 1. Two financieras, Corporaci6n Financiera Nacional (CFN) and Compafla Financiera Ecuatoriana de Desarrollo, S.A. (COFIEC), were established in Ecuador during the mid 1960's to provide term lending to industry. CFN is a large, publicly owned institution that is strongly committed to term financing of medium and large firms, mainly in the private sector. COFIEC is a smaller, privately owned company that, because of its size, has tended to finance somewhat smaller firms than CFN. Following on an IFC investment in COFIEC in June 1969, in October 1970 the Bank appraised a first loan of US$8 million, divided equally between CFN and COFIEC, to be channeled to both financieras through the Central Bank. It was signed in February 1971 (Annex 1). A second loan of US$20 million was appraised in February 1973 and signed in August To allow for possible differences in the speed at which CFN and COFIEC might use the second loan, only US$8 million was preallocated to each; US$4 million was left on a first-come-first served basis.1/ 2. Bank involvement with the two financieras began at a time when growth expectatiomsfor Ecuador's industry were rather modest, the sector having grown at 7.1% during the 1960's, not much faster than the 5.4% rate of expansion of GDP over the same period. The economy had also been characterized by a low average rate of inflation, 4.7% p.a. in By the time the second loan was appraised, however, it had become clear that the emergence of petroleum as a major source of foreign exchange and public sector revenues was rapidly changing the economy, opening up new possibilities for industrial development. Industrial growth had accelerated to 8.2% p.a. in and rose still further to 10.3% p.a. in While the financieras made an important contribution to the rapid industrial growth in , an inflationary climate, which limited the resource mobilization and profitrbility of financial institutions, prevented them from contributing still more. II. OBJECTIVES OF BANK LENDING 3. At the time of the first loan appraisal in 1970 Bank procedures did not require explicit and detailed discussion of objectives of DFC-ty'pe loans. Nevertheless, the objective clearly sought was to support and stimulate industrial growth in Ecuador through expanding the access of the sector to lol,gterm financing, whose scarcity had been identified as an impediment. The loan amount, US$8 million, was estimated to cover the financieras' gap between 1/ is taken as the period during which the first two projects were executed and is therefore the focus of this completion report. A third loan of US$25 million was appraised in May 1976 and signed in February

27 potential lending and resource mobilization through 1972 by financing the foreign exchange portion of the financieras' term lending program. It was also recognized, however, that substantial institution-building efforts would be required, particularly in the case of COFIEC which had been involved mainly in short-term operations. Institution building had been one of IFC's objectives in investing in COFIEC in With these efforts, both institutionb were expected to develop into strong, term lending institutions which would channel investment funds from the Bank and other sources to sound projects. Although the first loan had no explicit capital market development objectives, the Bank did insist that maximum interest rates for long-term lending be raised from 10% to 12%, as a first step towards an appropriate interest rate structure. Bank efforts towards further interest rate reform continued (para. 19) and met success when rates for long-term lending were raised in 1976 as a result of discussion leading up to the third loan. 4. Based on experience under the first loan, the second loan was more explicit about objectives which were (i) to provide long-term financing to industry, (ii) to promote a change in the structure of industrial finance from short to long term, and (iii) to strengthen the ability of the financieras to appraise projects,particularly their ability to assess the economic merit of industrial projects they financed. Substantial institutional changes in COFIEC were also expected to correct the financial weakness and inadequate liquidity that developed in 1971 when many of its clients could not repay on time in the aftermath of the tight credit policies following the sucre devaluation in The US$20 million loan amount was approximately equal to the estimated foreign exchange gap for The Bank also recognized, however, that industrial firms needed additional local currency financing and agreed to send a mission to make recommendations on possible actions. III. USE OF LOAN PROCEEDS 5. The first loan became effective only in November 1971, a year after Board presentation, because of delays by the Ecuadorian authorities in taking the necessary legal steps. However, soon thereafter CFN and COFIEC bogan committing the loan at a fairly rapid pace and the loan was virtually fully con,- mitted by the end of Taking into account this initial delay, disbursements of most of he loan proceeds moved more rapidly than estimated at the time of appraisal I (Annex 2). It was not possible, however, to appraise a second loon until November 1972, when the first was almost fully committed. Notwithstanding a rapid appraisal (Board presentation in June 1973), delays in effectiveness until November 1973 caused a 13 month hiatus between the last subproject commitment under the first loan and effectiveness of the second. 6. COFIEC started committing the second loan in March and CFN in November / By November 1975 the loan was fully committed. Perhaps 1/ Most of the loan was disbursed in a two-year period instead of three but about 2% of the loan remained undisbursed for several years until it was cancelled in December / CFN took somewhat longer to begin using Bank funds because they had other long-term resources available.

28 because the first loan, after initial delays, was being disbursed rapidly, the Bank estimated only 2-1/2 years for disbursing the second loan, instead of 3 years as under the first loan. This proved to be too optimistic; in June 1978 US$1.9 million was still undisbursed and the closing date has been extended to March Nevertheless, all key lessons that can be learned from a loan completion report are now apparent. Subprojects Financed under the Loans 7. The two loans under review provided partial financing to 68 projects with total estimated investment costs of almost US$150 million equivalent (Annex 3). An average of US$409,800 per subproject of Bank funds was committed in loans whose average maturity was 8.4 years. The average subproject was financed as follows: US$ thousand equivalent % DFCs Own funds (164.6) (7.5) Bank funds (409.8) (18.6) Firm's own funds 1, Other sources Total 2, Although both financieras made equity investments during the period, neither used Bank funds for this activity,in part because they did not fully realize that this was permitted. 8. Projects receiving Bank funds made up almost 6Z of total private fixed investment and absorbed about 3% of total credit granted to the privt sector over the 7-year period. Although data on total industrial investment are deficient, Bank-financed subprojects may have accounted for as much as 35' of the private industrial sector investment. These indicators give a rough idea of the importance of Bank-financed subprojects. Sectoral Distribution of Subprojects 9. Eighty six percent of Bank funds went to manufacturing enterprises and most of the remainder to tourism. Almost two-thirds of the loans to manufacturing went to basic consumer goods and resource-based subsectors--food, textiles, leather, garments, wood products, and non-metallic minerals--with textiles being the single subsector receiving the greatest portion. The combined distribution of the two financieras, taken together, is broader and better balanced than either taken separately, showing a high degree of subsector complementarity between the institutions. The heavy concentration of subloans in the industry groups where Ecuador may be expected to produce rather efficiently helps to explain the high economic returns of the subprojecl. (para. 11). Types of Enterprises Financed 10. The DFCs have been quite promotional in their operations, with both having committed more than one-third of total Bank funds to new enterprises and

29 the average loan to new firms being larger than to established firms. CFN tended to use Bank funds for larger firms and projects; its average loan size was US$1,037,200 equivalent, compared to US$246,900 for COFIEC. Neither institution financed a significant number of truly small scale enterprises. Most firms receiving Bank financing were located in Quito and Guayaquil which benefit most from government infrastructure investments and where the preponderanc: of industrial activity takes place. Firms in the highland provinces (Sierra), where both financieras have their headquarters received about twothirds of Bank funds to one-third in the lowland provinces (Costa). COFIEC's Costa branch office, which was relatively stronger than CFN's Costa office, permitted COFIEC to achieve a somewhat better balance between the two regions which are of roughly equal economic importance. Import substituting and mixed import substituting-exporting firms absorbed the bulk of Bank funds (79%) in line with industrial sector developmental trends since the advent of petroleum exports. Economic Returns 11. Bank funds have generally been used to finance projects of high economic merit. Although the financieras were required to give attention to economic returns of subprojects financed under the first loan, this emphasis was strengthened under the second loan when the calculation of an economic rate of return (ERR) was required on projects using more than US$250,000 of Bank funds. The average ERR for the 19 subprojects on which it was calculated was almost 27% (Annex 4), considerably higher than the 11% opportunity cost Df capital in Ecuador, estimated by the Bank. A comparison of economic with financial rates of return (FRR) on the 17 subprojects for which both were calculated shows that most FRR's exceeded the ERR's, presumably because high protection inflated the FRR's. The differences between the rates of return of CFN subprojects and COFIEC subprojects do not appear to be significant. 12. These calculations in subloan evaluations were, of course, on an ex ante basis. The mission, therefore, interviewed a representative sample of firms, to form an impression of how Bank-financed subprojects were turning out ex post. While it is too early to make final judgements on the subprojec!; success, several conclusions emerged from these conversations: (a) investments were carried out about as planned in physical terms although there were moderate cost overruns due to insufficient allowance for inflation; (b) sales or production values were also generally underestimated in nominal terms, again reflecting the failure to incorporate inflation forecasts into the financial projections. They were overestimated in physical terms. (c) Profit margins were usually somewhat smaller than had been estimated. In several cases this appears to be the result of more competitive behavior in the industry as a consequence of these very subprojects;

30 (d) most firms receiving loans from the financieras had reasonable profits; only one firm, a new one just getting into operation, was suffering losses at the time of the visit; and (e) a few firms felt that they could have obtained financing elsewhere either from foreign banks or by rolling over short-term loans from local commercial banks for certain relatively small projects but preferred financiera loans because of their more attractive terms (para. 19). On the basis of these visits, it appears that ex post returns are not much below ex ante estimates. 13. Assets, sales and profits of the firms visited appear to have grown more rapidly than those of industrial firms in general. Likewise, they have somewhat higher ratios of long-term debt to total assets (see Table 1). It appears that support by the financieras helped client firms to grow more rapidly than firms that did not receive such loans. This conclusion was confirmed by several interviews, particularly in two new firms that stated they could not have carried out their projects, at least on the scale they did, without the assistance of the financieras. This was particularly true when a firm received a loan that was large in relation to its total assets. As these firms were also the ones which needed and received the longest term loans, this tends to confirm the Bank's expectation that long-term lending was the key contribution that the financieras could make to industrial development in Ecuador. Table 1: GROWTH INDICATORS OF FIRMS VISITED Firm No. Profits Sales Assets Long-term Liabilities/ (average annual nominal growth ratea Total Assets (%) b c/ c/ Average Comparison d/ 25.2e/ 15- a/ or longest subperiod for which data are available in the DFCs' files. b/ 1976 or latest year. c/ New firm starting from first year lose. d/ Value added in manufacturing. e/ Total fixed private investment. I/ All industrial corporation (ouperintendency of companies).

31 IV. THE FINANCIERAS Growth 14. Both financieras have grown rapidly during the period. On the average, CFN's total assets have grown by 27% p.a. in nominal terms 1/ and COFIEC's by 24% p.a. Even allowing for the inflation averaging 13.1% p.a.- over the period,these still represent appreciable real growth rates of 12.2% and 9.5%, respectively. Also,because of the severe effect of inflation on the real value of long-term loan portfolios, annual operations had to grow even faster to achieve these rates of growth in assets. The growth of the financieras' assets was in line with the growth in output of the industrial sector, their principal customer (but behind the growth of output of their own clients), and faster than the growth of the total financial sector which lagged behind both industry and GDP (Annex 5). This led to the gradual increase in importance of the financieras in total industrial finance (Annexes 6-8). 15. The growth of both financieras (see Table 2 ), as measured by nominal total assets, has exceeded that expected at the time of the two appraisals. CFN's assets in 1973 were about 5% greater than the amount projected for that year in the appraisal of the first loan; COFIEC's were 53% greater. Similarly, CFN's 1976 assets were 63% higher than projected in the second appraisal and COFIEC's were 68% greater. The projections of neither the first nor the second loan are based on an explicit inflation assumption and therefore it is impossible to determine exactly what was expected of the two DFCs in real terms. Assuming that these implicit assumptions were equal to the realized rates of inflation over the 5 years up to the year of appraisal, 4.7% p.a. and 8.1% p.a. for the first and second loan, respectively, the real growth of the two DFCs was still more rapid than expected. In view of the difficulties typically faced by financial institutions in high inflation environments as have prevailed in Ecuador in , the real growth of the financieras has been impressive (Annexes 9-14). 1/ GDP deflator for the non-petroleum sector.

32 Table 2:PROJECTED AND ACTUAL ANNUAL GROWTH RATES OF TOTAL ASSETS CFN COFIEC Total Actual nominal Projected nominal Actual real a/ Projected real b/ Actual nominal Projected nominal Actual real c/ Projected real d/ a/ 9.7 actual inflation (consumer prices). b/ 4.7 implicit inflation assumption. c/ 15.5 actual inflation (consumer prices). d/ 8.1 implicit inflation assumption. Operations 16. Since its conversion into a financiera in 1964, CFN was heavily involved in term lending to industry although it continued on a reduced scale to guarantee government, municipal, bank, and some industry bonds as'a holdover from its former role as securities commission. In the period about three fourths of CFN's portfolio was composed of medium-and long-term loans, long-term guarantees-or equity investments. Medium-end long-term loans outstanding have grown at 16.6% p.a. in real terms 1/ and equity investments at 47.6% p.a. The very rapid growth of equity investment,which reached 19.4% of its total portfolio in 1976,reflects the expansion of CFN's role as holding company for several government-owned firms and its practice of not selling its investments. A significant portion of its equity portfolio is in new firms and is not yet yielding a return although most of its older investments are in currently profitable firms. Guarantee operations, in contrast to other 1/ Excluding the current portion of medium- and long-term loans.

33 items, fell in real terms. Short-term operations maintained their share of the portfolio as letters of credit and short-term guarantees made up for the slow growth in short-term loans. CFN's short-term operations are usually the short-term complement to its project financing. 17. Although COFIEC was founded to engage in longer-term lending and equity investments,its available resource mix has never permitted it to limit its operations to these activities. In 1970 only about 15% of its portfolio was in medium.and long-term loans and equity investments'. Notwithstanding the growth of its medium-and long-term portfolio at 17% p.a. in real terms since 1970, this still made up only 23% of the total portfolio in Medium and long-term loans outstanding grew faster than total long-term portfolio (including equity) % p.a.-- and equity investments much slower. COFIEC's equity portfolio which makes up only 2.7% of total portfolio in 1976,has not been as profitable as expected and the company has been rather cautious about equity investments although there were indications that this might be changing. It tended to treat equity investments as an activity completely separate from term lending and thereby COFIEC may have overlooked some potentially profitable operations that might have combined the purchase of stock on favorable terms or perhaps a loan with convertible features as part of a package including long-term loans and short-term financing. 18. Growing at only 6.6% p.a. in real terms, the relative size of COFIEC's letters of credit and guarantee operations has decreased over time but in 1976 they still remained its most important line of operations. These operations give many medium-sized firms access to foreign bank financing they would not otherwise receive and are often made as the first step in a long-term loan. Nevertheless, some are unrelated to COFIEC's role as a term lending institution and have been taken on as a commercial bank-type operation to increase COFIEC's income. Loans maturing within one year have grown at 8.4% p.a. in real terms, somewhat faster than letters of credit and guarantees, because these contain the current portion of the more rapidly growing long-term portfolio. The Onlending Rate 19. One of the Bank's major accomplishments in connection with the first loan was to convince the government to abandon the 10% ceiling on interest rates that prevailed until 1970 as too low to permit a significant amount of long-term lending and to raise the maximum to 12% p.a. It was recognized at the time of the first appraisal that this rate, taking into account the risk of further devaluation and continuing inflation, was not ideal but that an increase of 200 basis points was a large and significant first step in interest rate reform. Subsequently, all lending by the financieras including relending of Bank funds was done at 12% p.a. Although falling in real terms, this rate remained positive through When the second loan was negotiated in 1973, it proved impossible to convince the government to further raise the interest rate ceiling, even for long-term lending, and permission for only an additional 1% commission charge on Bank funds alone could be obtained. Because of the

34 sudden increase in petroleum incomes beginning in 1972, inflation in (15.5% p.a.) was considerably higher than at any time in the preceding 20 years. As a result, the interest rates on DFC lending,including on Bank funds,became negative in real terms in , notwithstanding the additional commission (Annex 15). Financiera loans also bore a rate below interest rates commonly charged by commercial banks on short-term loans and were an attractive alternative to foreign credit because of the lack of exchange risk. 20. An important ingredient of the decisions made -concerning the cost of Bank funds to the DFCs and the subsequent onlending rate was the discussion concerning the appropriate fee to be charged by the government for bearing the foreign exchange risk. Under the first loan a fee of 1.25% p.a. for COFIEC and 1.0% p.a. plus O5% on each disbursement (equivalentto 0.06% p.a. on an average 9-year loan) for CFN was agreed to cover both the Central Bank's administrative cost and the foreign exchange risk. Under the second loan this fee was raised to 1.75% for both financieras. The discussions involving these fees revolved around the previous and expected changes in the sucre/us dollar rate; little consideration was given to changes between the US dollar and the currencies actually disbursed. In practice, however, the fee agreed under the second loan has been about adequate to cover this cross-currency exchange-risk. Through March 31, 1976, the basket of the currencies disbursed under the second loan had appreciated 1.5% p.a. against the dollar (and the sucre).. The appreciation of the currencies disbursed under the first loan, on the other hand, has been around 3.1% p.a., considerably more than the % p.a. fee charged by the government. 21. To some extent under the first loan but even more under the second, the Bank's approach to the interest rate question had to be mainly centered on the spread that the financieras would have on Bank funds. Because of the reluctance of the government to discuss general interest rate issues, relatively little attention could be given to attempting to find a level or structure of interest rates that would permit the financieras to mobilize domestic resources for long-term lending while maintaining adequate earnings. The IFC capital market mission that visited Ecuador in 1974,in part as an outgrowth of the second loan, concentrated mainly on the equity market because of the government's attitude on interest rates and financial intermediation and consequently could not help resolve the problem of the interest rate structure which had to await discussions surrounding the third loan. Quality of Portfolio 22. The quality of CFN's portfolio has not been a problem during its association with the Bank. The experience with COFIEC has been mixed but wits and improving trend (see Table 3). In the first few years of its association with the Bank, COFIEC had serious problems with the quality uf loans made by its Guayaquil branch office where proper procedures were sometimes lacking. COFIEC's portfolio was also affected by the sudden drop in foreign investment in the petroleum sector after 1971, which caused several of its clients to fall into difficulty, and by periodic economy-wide shortages of credit.

35 Table 3: PORTFOLIO QUALITY INDICATORS Year CFN COFIEC Arrears Estimated loss Arrears Estimated loss (% of port folio ) 1970 na na na na na na na na na na Bank supervision missions exerted considerable effort in helping COFIEC to identify problems with its portfolio and to sort out the underlying factors. The Bank also insisted on COFIEC's maintaining adequate provisions for loss and urged the company to recognize and write off bad debts as rapidly as the law allowed. These efforts have been generally successful and by 1976 portfolio quality was no longer a critical issue, although the Bank considered that COFIEC needed to further increase its provisions for losses from 0.4% to 1.0% of portfolio, a target which was included in the Project Agreement of the third lo an. Operating Results 24. Both financieras had relatively low levels of profits over the period. Income as a percent of average total assets (ATA) averaged 7.1% for COFIEC and 6.8% for CFN, and tended to rise over time. Financial expenses averaging 2.3% of ATA for COFIEC and 2.8% for CFN also tended to rise so that the gross spreads remained around 4.87 for COFIEC and 4.0% for CFN. Both financieras were able to reduce administrative expenses proportionally as they grew larger,so net income before tax as a percent of ATA (2.1% for COFIEC and 1.7% for CFN) rose over time. In addition, COFIEC hut not CFN paid income tax of 0.5% of ATA, giving it an after-tax return of 1.6% of ATA. Because of its much higher leverage of 7.7:1, COFIEC's nominal return on equity was around 13.4% while CFN with leverage of only 2.2:1, earned a mere 5.47 on equity. Taking inflation into accountcofiec's rate of return was barely positive in real terms although improving, while CFN's was uniformly negative 1/ (Annexes 11 and 13). 1/ This analysis does not take into account appreciation of fixed assets owned by the financieras but this was unimportant during the perior. COFIEC's income is 3omewhat overstted as it reported stock dividends is income whereas CFN, properly, did not. On the other hand, CFN's costs are understated ns it did not report exchange losses on foreign borrowing until realized.

36 As with the projections of growth in assets, the appraisal reports are not explicit about the real rate of return on equity expected of the financieras. The 1970 loan appraisal report projected a 15.2% return on equity for CO_fEC by 1975 and 10.3% for CFN. The 1972 appraisal report projected 1976 returns of 10.4% and 9.1% for COFIEC and CFN respectively. Using the same implicit inflation rate assumptions as in para. 15, it appears that the financieras have been significantly less profitable than expected. That profit projections should turn out to be overly optimistic is not surprising, however, since actual inflation was much higher than expected. Rather, it is a credit to both institutions that they have done no worse. 26. The major reason for the marginal profit performance was, of course, inflation averaging 13.1% between coupled with the interest rate ceiling on term loans. Inflation tended to reduce profitability in three ways but the financieras were able to offset the first two of these rather successfully. First, inflation tended to increase administrative costs relative to the rapidly declining real value of (and income from) existing long-term assets. Both financieras, however, were able to grow fast enough in nominal terms to offset the decline in the real value of their old portfolio. Second, in order to grow faster than inflation, the financieras had to turn to some more costly funds and their gross financial spread would have been squeezed had they not successfully raised their average lending rate by shifting to higher yielding operations, thereby preserving their financial spread. The third effect of inflation was on the real value of the financieras' equity. Although both were able to maintain and even increase the nominal return on equity, that increase was not enough to compensate for inflation. To have obtained an 11% real return on investment, the opportunity cost of capital in Ecuador estimated by the Bank, the financieras needed to obtain a nominal return of around 25% p.a. This return, given COFIEC's leverage, would have required a financial spread about one to one and one half percentage points higher than its actual level, or about 6% of ATA. CFN,with much lower leverage,would have required a spread two and one half percentage points higher, about 6.5% of ATA,just to break cr in real terms. 27. Because CFN had ample borrowing capacity enabling it to increase its assets without additional capital increase during and because it obt new subscriptions from the government in 1974 and 1976, low profit levels presented CFN with no operatioml problens during the period. The effects on COF1. were more severe. In its efforts to maintain nominal profitability, COFIEC h''. to concentrate on short-term operations which were its most profitable lines. For this reason, the highest proportion of long-term operations in COFIEC's portfolio was reached in 1972,just before the onset of the high inflation r,1tforced it to find ways to maintain its profitability. Thus, the flexibility cf COFIEC's management protected the company from a precipitous fall in real prc' t but at the expense of downplaying somewhat COFIEC's role as a term lending institution.

37 Financial Condition 28. The large equity base of CFN has permitted it to maintain a generally adequate financial position. As measured by the current ratio,cfn's liquidity would appear to have deteriorated since short-term liabilities have exceeded short-term assets in 1975 and CFN, however, considers that since its bonds have a nominal maturity of 5 years, although in practice they are redeemable at sight, these should be classified as long-term liabilities (para. 32). Under this interpretation its current ratio in 1976 would have been an adequate 1.4 instead of 0.7 (Annex 10). 29. Because CFN bears the foreign exchange risk on its foreign borrowings (except for Bank loans) the Bank has been concerned about the potential impact of exchange rate changes. Under the first loan the government was requiied to reimburse CFN within 90 days for any foreign exchange loss. In practice this did not occur and under the second loan the Bank partially accepted the government's argument that the size of CFN's equity base and its exemption from taxation permitted it to carry the foreign exchange risk on foreign borrowing except in extreme circumstances. Therefore the government's responsibility was limited to reimbursing CFN only for losses that exceeded its profits plus accumulated reserves. Under accounting practices accepted in Ecuador whereby an exchange loss was treated as an asset subject to gradual amortization, no losses requiring the government's reimbursement have occurred since the second loan went into effect. As part of negotiations of the third DFC loan, CFN agreed to the standard treatment of foreign exchange losses as charges against profits in the year they occur. In December 1976 CFN was exposed to a sizable foreign exchange risk, a considerable portion of which was in Deutschmarks and other hard currencies, and had accumulated unrealized exchange losses of S/90 millioi. 30. COFIEC's financial condition has also been of some concern but for other reasons. COFIEC's operating regulations do not permit it to be exposed to any significant foreign exchange risk on operations after 1970 but its liquidity was a cause of concern after it had to resort to unauthorized overdrafts of several of its foreign credit lines during the economy-wide liquidity squeeze in Improved budget procedures, several suggested by the Bank Group, and more conservative liquidity management have led to an improvement of COFIEC's financial position. COFIEC also had difficulty at times staying within the debt-to-equity limits agreed with the Bank. The definition of these limits was changed in both 1973 and 1976 but without allowing COFIEC to incr:iso significantly its total leverage,which varied between around 7:1-8:1 in the± period (Annex 12). Considerable effort was devoted to enforcing these agreed-upon limits. In retrospect, it seems that perhaps too much importance> was given to this problem and that a program of gradual increases in leverage tied to institutional improvements, as was agreed under the third loan, would have been a better solution.

38 Resource Mobilization 31. Increasing resource mobilization was not a major objective of the two financiera loans.- The topic was treated in the appraisal reports only from the standpoint of estimating the need for Bank resources. Nevertheless both institutions have mobilized a sizeable amount of foreign and local resources. CFN has mobilized foreign resources by borrowing abroad and relending. COFIEC has done so through guarantees of foreign loans to its clients. By 1976, the two financieras had mobilized the equivalent of US$31.9 million in the local capital market (Table 4), approximately 45% more than their use of Bank funds to that date. COFIEC had mobilized approximately US$5.1 million equivalent in 5-10 year bonds bearing a fully taxable 12% interest rate. CFN, because of its size and prestige in the local capital market, was able to issue over US$26.8 million equivalent in tax exempt 8% bonds redeemable at sight. These resources were used for its long-term lending. 1/ Although the Bank expressed uneasiness about this practice, CFN argued that it presented no real risk as any bonds redeemed could always be resold, as has been the case thus far. Moreover, in any true emergency the Central Bank would provide the institution with the liquidity to meet a massive redemption of bonds. During preparation of this report, CFN pointed out that it would have been helpful had the Bank encouraged the government to allow CFN greater freedom in issuing those bonds. It is doubtful, however, that the Bank would have wished to encourage CFN to engage still more heavily in term intermediation without adequate safeguards through mobilization of even larger amounts of short-term resources. The Bank should, however, have encouraged CFN to explore true long-term bonds and medium-ternl certificates as an alternative resource mobilization instrument. Table 4:DOMESTIC RESOURCE MOBILIZATION Year CFN COFIEC Total Total (S/. millions) (US$ millions equivalent) / Through term intermediation which occurs in case of borrowing short-term funds and lending them on longer termis.

39 The two financieras have grown in size and in the professional quality of their staffs since the beginning of their association with the Bank. In 1970 CFN had only 37 professional staff members but in 1976 this had increased to 146 including engineers, business management specialists, accountants and economists. CFN's organization has matured as it has grown and shows considerable strength even at third and fourth levels of responsibility. Functions are adequately delegated and responsibilities have become more clearly delineated. It should be recognized, however, that these positive developments are mainly the outcome of CFN management's comitment to organizational excellence; Bank advice and support are recognized as having been helpful but not critical. 33. Institutional improvements in COFIEC were more striking during the executi6n of the two loans and the Bank was crucial in helping COFIEC effect them. The number of professional staff has increased from 20 to 61 but organizational changes are more significant than the mere growth in numbers. During the execution of the first project severe organizational problems developed. In particular, COFIEC had several unfortunate experiences with its Vice Presidents for the Guayaquil region. Operating with considerable autonomy and in line with the more liberal banking traditions of the Costa region, those executives tended to commit COFIEC on the basis of inadequate appraisals and faulty procedures. The result of this was a disproportionate number of problem loans in the Guayaquil portfolio. Bank supervision missiort worked closely with COFIEC to define better the degree of autonomy and the type of manager needed for the Guayaquil office and to develop adequate appraisal and supervision procedures. In 1975 COFIEC was reorganized into two regional offices in Quito and Guayaquil with its central administration also in Quito. This reorganization and the appointment of a new Guayaquil manager was successful in starting to correct the problem but reinforced overcentralization of decision making in the President in the early stages. Gradually, however, delegation of authority has increased and the lower level staff have responded well to their growing responsibilities Improvements have also occurred in the financial management of the company in the areas of budgeting, cash control, and portfolio control. These changes are largely the result of the Bank Group's intensive institution-building efforts in COFIEC. Appraisal and Supervision 34. The institutional improvements achieved by the financieras in was reflected in the quality of their appraisals and supervision. CFN's appraisals, always thorough, became less mechanical and more judgmental with experience. As part of the second financiera project, CFN was required to calculate financial and economic rates of return on Bank subprojects over the free limit, US$250,000. At first CFN applied this methodology to projections of the sponsoring firms' cash flow but later began to apply a proper incremental analysis of the project. COFIEC's appraisals have also

40 improved as increasing weight has been given to the appraised merits of the subproject as opposed to relying exclusively on the collateral offered by the sponsoring firm. With Bank assistance COFIEC was the first DFC world-wide to calculate fiancial and economic rates of return applying the methodology presented in the Bank's guidelines. The process of improving appraisal methodology was continuous as the Bank, in connection with subprojects submitted for approval, has gradually raised the standards applied by the two financieras to their subprojects. The principal vehicle for dialogue with the financieras on project appraisal methodology was correspondence concerning approval of subloans, mainly involving those above the free limit, supplemented by detailed discussions during supervision missions. There may also have been scope for more exchange of information between the two financieras or even syndication in some of the larger projects. 35. Supervision procedures of both financieras were weak at first but improved after the second loan was made. By 1976 supervision was adequate and was usually quite good in the exceptional cases where the financiera's exposure was large, where there was an equity position, or the client was experiencing difficulty. The Bank's efforts consisted mainly of encouraging the financieras to be more systematic in their supervision rather than overconcentrating on problem loans. Both institutions now have staff that regularly supervise subprojects and the timeliness and quality of the information flow has improved. IFC Investment in COFIEC 36. IFC's investment of US$251,371 in 1969 to acquire about 10% of COFIEC's shares made t thesecond largest shareholder after ADELA and gave it representation on the Board of Directors. This investment and IFC's subsequent decisions to participate in a series of capital increases were crucial to COFIEC's growth in the early 1970's. The prestige of an IFC investment also helped COFIEC to mobilize lines of credit from foreign banks. 37. IFC participated rather actively in meetings of COFIEC's Board and its representatives were effective in raising issues which IFC and the Bank wished to have discussed. Coordination with the Bank was very close, with Bank staff preparing background material and briefing IFC's representatives extensively for their visits. While this arrangement worked well, the alternative of IFC using Bank Group staff rather than consultants to represent it might have been equally effective. 38. Through its participation IFC helped COFIEC to grapple with institutional problems of organization and staffing and to improve procedures relating to liquidity, provisions for bad debts and arrears. Despite IFC's contributions, however, COFIEC's basic problem--inadequate profits--could not be overcome completely. This problem,compounded by a devaluation of the sucre shortly following its initial investment, resulted in disappointing