FILE COPY Document of The World Bank FOR OFFICIAL USE ONLY Public Disclosure Authorized Report No.P-1789-EC REPORT AND RECOMMENDATION OF THE Public Disclosure Authorized PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE Public Disclosure Authorized REPUBLIC OF ECUADOR FOR A TECHNICAL ASSISTANCE PROJECT (AGRICULTURE AND RURAL DEVELOPMENT) March 18, 1976 Public Disclosure Authorized 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. CURRENCY EQUIVALENTS Currency Unit = Sucre (SI.) S/. 1.00 = usto.oA USt1.00 = SI. 25.00 S/. 1 million = US4hO,000 GOVERUMEN0T OF ECUADOR FISCAL YEAR January 1 to December 31 FOR OFFICAL USE ONLY 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 TECHNICAL ASSISTANCE PROJECT I. I submit the following report and recommendation on a proposed technical assistance loan to the Republic of Ecuador for the equivalent of MU$4.0 million toihe4p finance planning, pre-investment and project prepara- tion in agriculture and rural development. The loan would have a term of 15 years, including 4 years of grace, with interest at 8-1/2 percent per annum. PART I - THE ECONOMY 2. A report entitled "Ecuador: Economic Memorandum" (No. 1033-EC) was distributed to the Executive Directors on February 26, 1976. Annex I summarizes the main economic and social indicators. 3. With the firimt shipments of crude oil from the Oriente Region in 1972, Ecuador became a net exporter of oil. This provided the country with additional resources %lich at least temporarily removed the savings and foreign exchange constiraints that had severely impeded Ecuador's growth in the past. Oil income irose from $38 million in 1972 to over $420 million in 1974. However, during the last year it has become clear that the country's oil wealth is smaller ithan previously estimated. One year ago, it was esti- mated that the country had total -- proven and probable -- oil reserves equivalent to 5.7 billLon barrels. Current estimates are of only 2.5 billion barrels, owing to a substantial decline in the calculation of probable ex- ploitable reserves. Moreover, it is now expected that the production levels projected last year for 1976 will not be achieved until the early 1980s. These revised estimates, together with a better knowledge of the difficulties to be encountered in the expioitation of Ecuador's untapped oil fields, and with the transitory problems faced by the country's oil exports in 1974-75, in- dicate that Ecuador is not likely to accumulate substantial amounts of foreign exchange reserves in the foreseeable future. 4. There has been a sharp decline in petroleum output since mid-1974 because of marketing difficulties for Ecuadorian crude in export markets and a protracted disagreement between the Governmtent and the foreign concession- aires over the taxatiorn of oil exports. The total offtake of oil dropped from an average of 232,000 b/d during January-June 1974 to 123,000 b/d during the second half of 1974, and became irregular in 1975, owing to two breaks in the trans-Andean pipeline. For 1975, the average production is estimated at about 165,000 b/d. There has also been a virtual standstill in explora- tion during the past two years and the level of proven recoverable reserves, estimated at 1.5 billicn barrels, has remained unchanged. This document has a resuiived distribution and may be ud by rec4iplm o.nly in the performance of their ofllcial duties. Its contents may not otherwise be disclosed without World bank authorization. - 2 - 5. The disappointing performance of the petroleum sector had not been expected by the Government. Counting on rising petroleum income, the Govern- ment had adopted policies designed to stimulate further growth. It increased public expenditures -- including subsidies of essential consumption goods; offered more generous credit programs for agricultural and industrial invest- ment; and lifted most quantitative import restrictions. In 1974, import duties were cut by an average of 34 percent. Moreover, imports of agricul- tural inputs and of essential foodstuffs were fully exempted from duties. 6. The response of the economy to these policies, and to the prevail- ing very. optimistic economic climate was, in general, strong. Gross invest- ment grew by 22 percent in real terms in 1973 and growth of GDP at market prices reached a rate of about 15 percent, far above historical levels (5.5 percent from 1965 to 1970). Continuing rapid growth in industry, construction, trade and Government services made it possible to achieve an overall GDP growth rate of approximately 8 percent in 1974. This was obtained in spite of the significant decline in the oil sector product, and of the virtual stagnation of agricultural production -- which was hampered, until early that year, by the insufficiency of credit availabilities and by the inadequate price policies followed up to then by the Government. 7. The rapid economic expansion was accompanied by inflationary pressures. The cost of living index for low and medium-income families in Quito, which had risen by about 8 percent per annum during 1971 and 1972, in- creased by 13 percent during 1973 and by over 23 percent during 1974. While the inflationary pressure was largely generated by the rapid rise of public expenditure, the strong expansion of credit to the private sector also con- tributed to the increasing money supply. Domestic supply could not respond in full to the growth in demand, which led to higher imports of wheat, oils and fats, and other products. In construction materials, domestic production did not keep pace with increases in demand. In manufacturing, the process of import substitution of finished goods accelerated, leading to rapidly rising imports of equipment, raw materials and semi-finished products. As a result, total imports of goods and non-factor services rose from about $440 million in 1972 to $515 million in 1973 and over $1.0 billion in 1974. This import growth in part also reflects a rise in import prices of 17 per- cent in 1973 and 28 percent in 1974. Exports -- also including non-factor services -- expanded from $365 million in 1972 to about $1.1 billion in 1974. Of the increase, about 75 percent was accounted for by petroleum. 8. Despite the growth of imports, Ecuador's balance of payments showed, until mid-1974, a marked improvement. In 1973, Ecuador achieved the first surplus in its resource balance since the early 1950s, and net foreign ex- change reserves rose from $128 million at the end of 1972 to $371 million by the end of June 1974. However, these favorable trends could not be main- tained after mid-1974. As oil exports declined and total imports continued to rise substantially, Ecuador's reserve position began to deteriorate rapid- ly. By August 15, 1975, the country's net foreign exchange reserves had fallen to $181 million, equivalent to less than two month's imports. 9. Until 1974, increasing oil revenues brought about a substantial improvement of the Government's financial position. For the Central Govern- ment 1/ -- which received about 54 percent and 57 percent of total oil revenues in 1973 and 1974 respectively -- these revenues led to a strong increase in current savings and to an expansion of capital expenditure substantially above the growth of current expenditure. With current savings rising to about $68 million in 1973 and $298 million in 1974, the overall cash position of the Central Government turned from a small deficit in 1973 to a $62 mil- lion surplus in 1974, despite a more than threefold increase in capital expenditure in 1974. FONADE, established in late 1973 in an effort to ear- mark part of the additional oil revenues for the financing of public invest- ment projects over and above budgetary allocations, disbursed about $93 mil- lion in 1974. Most of these disbursements helped finance the construction of the Esmeraldas refinery, and the credit programs of the National Development Bank and other financial institutions. As a result of the decline of oil revenues, current savings decreased by an estimated 20 percent in 1975 des- pite an improved performance of non-oil taxes. These developments led to a temporary financing gap in the Central Government operations and to the decision to contain the growth of Government expenditure in 1976. 10. A number of recent measures have contained the deterioration of the balance of payments, and foreign exchange reserves are estimated to have totalled about $245 million by the end of 1975. The measures included a reduction of the tax-paid cost of petroleum exports by the equivalent of about US$0.43 per barrel; the concession of higher allowances to oil companies for their production cost; and the introduction of import restrictions in August and September 1975. Oil production has recovered, mainly as a result of the cut-back in the income tax rate in oil exports; and is estimated to have reached over 210,000 b/d towards the end of 1975. 11. On October 2, the Government announced new financial objectives for 1976: to achieve additional increases in foreign exchange reserves and a more balanced budgetary position, which would make it unnecessary for the Government to borrow further from the domestic banking system or from foreign commercial banks durinUg 1976. The Government hopes to reduce the annual rate of inflation from some 15 percent in 1975 to about 10 percent in 1976. Fur- ther negotiations withi the oil companies are expected to open the way to increased exploration and development efforts.