Document of The WorldBank FOR OFFICIAL USEONLY ReportNo. 33538-CO INTERNATIONAL BANKFOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSEDFIRSTPROGRAMMATIC BUSINESS PRODUCTIVITY AND EFFICIENCY LOAN INTHEAMOUNT OFUS$250MILLION TO THE REPUBLIC OF COLOMBIA September 27,2005 Colombia-Mexico CountryManagementUnit Finance, Private Sector andInfrastructureDepartment Latin America and CaribbeanRegion This document has a restricteddistribution and maybe usedbyrecipients only inthe performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. COLOMBIA -GOVERNMENT FISCAL YEAR January 1-December 31 CURRENCY EOUIVALENTS (as of 20 September2005) Currency Unit = Peso 2,295 Pesos = US$1 WEIGHTS AND MEASURES Metric System SELECTED ABBREVIATIONS AND ACRONYMS AAA Analytical Advisory Activities IBRD lntemationalBank for Reconstructionand AI Agenda Intemaparala Productividady Development Competitividadde Colombia.(hemal IADB Inter-AmericanDevelopment Bank Agenda for the Productivity and IFC IntemationalFinanceCorporation Competitivenessof Colombia) I S 0 InternationalOrganizationfor Standardization AMUCFT Anti MoneyLaunderingiCombatingthe IMF IntemationalMonetaryFund Financingof Terrorism MCIT Ministerio de Comercio, Industriay Turismo BdR Bancode la Republica(Central Bank) (Ministry of Trade, IndustryandTourism) CAE Centro de Atencidn Empresarial(Centersfor MHCP Ministerio de Hacienday Credit0 Publico (Ministry EnterpriseAssistance) of Financeand Public Credit) CAF CorporacidnAndina de Foment0(Andean MSME Micro, Small and MediumEnterprise DevelopmentCorporation) MTEF MediumTerm ExpenditureFramework CAS Country AssistanceStrategy NGO Non-GovemmentalOrganization CFAA Country FinancialAccountability OECD Organizationfor Economic Co-operation and Assessment Development CHMC ColombiaHomeMortgageCorporation PLaRSSAL Programmatic Labor Reformand Social Sector Confecamams ConfederacidnColombiana de Camaras de Adjustment Loan Comercio (ColombianConfederationof PRAP Programade Renovacidnde la Administracidn Chambers of Commerce) Publica(Public Administration RenewalProgram) CONFIS Consejo Superior de Politica Fiscal(Senior RED1 Recent Economic Developmentsin Infrastructure Council onFiscalPolicy) REIF RealEstateInvestment Fund CONPES ConsejoNacionalde Politica Econbmicay SARC Sistemade Administracidn de RiesgosCrediticios Social(NationalCouncil on Economic and (Credit RiskManagement System) Social Policy) SB SuperintendenciaBancaria(Banking DIAN Direccionde Impuestosy Aduanas Superintendency) Nacionales(Tax and CustomsDirectorate) SENA ServicioNacional de Aprendizaje DNP DepartamentoNacionalde Planeacidn (National Training Service) (NationalPlanningDepartment) SIIF SistemaIntegradode Informacibn Financiera DPL DevelopmentPolicy LoadLending (Integrated FinancialInformation System) FDI ForeignDirect Investment ss Superintendenciade Sociedades(Companies FIAL ProgrammaticFiscaland Institutional Superintendency) Adjustment Loan sv Superintendenciade Valores (Securities FSAL FinancialSector Adjustment Loan Superintendency) FSAP FinancialSector Assessment Program TAL TechnicalAssistance Loan FRL FiscalResponsibilityLaw TES Titulos deTesoreria(Treasury Securities) FTA FreeTradeAgreement(US-Andean) UAIF Unidadde Infomacibn y Analisis Financier0 GDP Gross Domestic Product (FinancialInformation and Analysis Unit) GNI Gross National Income VIS Vivienda de Interts Social(low-income housing) GoC Government of Colombia WEF World Economic Forum Vice President: Pamela Cox Country Director: Isabel M.Guerrero Director, LCSFP: Makhtar Diop Sector Manager, LCSFF: Susan Goldmark Sector Leader, LCSFP: Anna Wellenstein Task Team Leader: Juan Carlos Mendozmartin Naranjo Landerer FOROFFICIAL USE ONLY COLOMBIA: FIRSTPROGRAMMATIC BUSINESSPRODUCTIVITY AND EFFICIENCY LOAN TABLE OF CONTENTS IINTRODUCTION 5 I1THE COUNTRYCONTEXT .. ..................................................................................................................................... ................................................................................................................. 6 RECENTECONOMICDEVELOPMENTS.............................................................................................. MACROECONOMICOUTLOOKAND CHALLENGES........................................................................ 6 8 I11THE OVERALLGOVERNMENTPROGRAM 9 I V KEY ISSUESAFFECTINGBUSINESSPRODUCTIVITY AND EFFICIENCY .. ................................................................................. ........................ -10 BUSINESSENVIRONMENT..................................................................................................... 12 FINANCIALSYSTEMAND CAPITAL MARKETS ............................................................................ FOREIGNTRADEAND COMPETITIVENESS.................................................................................... 16 QUALITY STANDARDSAND TECHNOLOGICALINNOVATION................................ 17 INFRASTRUCTUREAND LOGISTICS .............................................................................. V BANK SUPPORT TO THE GOVERNMENT'S STRATEGY . .......................................................... 34 LINKTOTHECAS COLLABORATIONWITHTHEIMFAND OTHERDONORSAND LENDERS................................ ................................................................................................................................. 34 RELATIONSHIPTO OTHERBANK OPERATIONS........................................................................... 34 LESSONS LEARNED......................................................................................... .35 37 ANALYTICAL UNDERPINNINGS....................................................................................................... 38 VI THE PROPOSEDPROGRAMMATIC DEVELOPMENTPOLICYLOAN . ................................. 39 OPERATIONDESCRIPTION................................................................................................................. 39 ............................ .................41 POLICYAREAS............................................................... LOANAMOUNT.............................................................. ........................................................ 41 VI1 OPERATIONIMPLEMENTATION . ................................................................................................ 43 SOCIALASPECTS AND POVERTYIMPACT ..................................................................................... 43 44 FIDUCIARY ASPECTS .................................................. SUPERVISION........................................................................................................................................ ............................................................ DISBURSEMENTAND AUDITING...................................................................................................... 44 ENVIRONMENT..................................................................................................................................... 46 47 R I S K S....................................................................................................................................................... 47 Annex 1:ColombiaAt A Glance ................................................................................................................ ANNEXES 49 Annex 2: Letter Of DevelopmentPolicy ...................................................................................................... .................................................................................................... 51 Annex 3: Debt SustainabilityAnalysis 63 Annex 4: Matrix Of Policy Actions And ExpectedOutcomes Annex 5: Fundrelationsnote .....................................................................................................................67 ................................................................. Annex 6:Financial Sector Overview .........................................................................................................69 73 Annex 7: QualityStandardsAnd TechnicalInnovation .......................................................................... 78 Annex 8: Colombia's OperationsPortfolio (IbrdAnd Grants) ............................................................... 84 Annex 9: StatementOf IFC's HeldAnd DisbursedPortfolio ................................................................. -85 ACKNOWLEDGEMENTS The World Bank Group greatly appreciates the close collaboration of the Government of Colombia in the preparation of this DevelopmentPolicyLoan. This loan has been prepared by a team composed of: Juan Carlos Mendoza and Martin Naranjo Landerer (Task Managers); Constantinos Stephanou (LCSFF); Pablo Fajnzylber. Leonid Kotyukin (LCSFR); Mary Morrison (LCSFP); Alessandra Campanaro (OPD); Bess Michael. Pierre-LaurentChatain. MarilynGoncalves(FSEFI); MariluzCortes (consultant). The team benefitedfrom the comments from other Bank staff including peer reviewers: August0 de la Tome (LCRCE). Patrick Honohan(OPD). and Simon Bell (SASFP)as well as Todd Crawford (LCOQE) and HaroldBedoya(OPCS). Additional assistance was providedby HelenaIssa. This document has a restricted distribution and may be usedby recipients only in the performance of their official duties Its contents may not be otherwise disclosed without World Bank authorization . . LOANAND PROGRAMSUMMARY COLOMBIA FIRST PROGRAMMATICBUSINESS PRODUCTIVITY AND EFFICIENCY LOAN Borrower Republic of Colombia Implementing Ministerio de Hacienda y Crkdito Phblico, Departamento Nacional de Planeaci6n Agencies Amount US$250 million Terms Commitment-linked Fixed-Spread Loan (FSL), U S dollar denominated, payable in 17.5 years, including a 5.5-year grace period. Levelrepayments o f principal at the standard variable interest rate for U S dollar FSLs Commitment 0.85 percent on undisbursedloanbalances for first four years and 0.75 percent on Fee undisbursedloanbalances thereafter Front-End Fee 1percent of the loan amount paidbythe Borrowerupfront Tranching Single tranche for the full amount o f the loan Objective This operation will support the Colombian Government's efforts to promote sustainable growth through the enhancement o f the business environment and the consolidation o f the financial sector and capital markets as pillars o f economic growth. Description The proposed loan is the first phase of a programmatic development policy operation in three phases, which would be executed over a period o f three years. The first proposed operation would support policy and institutional reforms inthree areas: 0 enhancement o f the business environment to promote investment and trade and improve competitiveness o f the productive sectors o f the economy increase the soundness and depth o f the financial system expansion o f access to capital markets bybusinessesand improvement o f efficiency o f financial secondary markets Benefits Theproposed loanwould support sustainable growth and alleviation ofpoverty by: facilitating the creation and operation o f businesses, leading to increased productivity and employment levels; and 0 fostering the sustainable growth o f a financial system and capital markets that address;he needs o f inditiduals and the produciive sector. Risks The proposed operation supports an institutional development effort widely perceived as n e c e k y by mostpoliticai gctors, and that the Goverkent is already actkely implementing. Therefore, there is little riskthat the actions already taken could be reversed and that the indicative triggers for the preparation o f the next operation are not reached within the twelve months following the effectiveness o f this first loan. However, there are some risks associated with the effective implementation o f the institutional and regulatory reforms supported by the proposedDevelopment Policy Loan (DPL). The most relevant risks are the following: 0 mechanisms for inter-institutional collaboration and coordination in support o f entrepreneurial activities may be hampered by inter-agency rivalries 0 measuresto increase access to financial services may take a long time to produce results 0 political uncertainty and any deterioration inthe internal security situation related to the 2006 elections may delay the implementation o f important institutional and regulatory reforms current levels o f public debt may pose a threat to overall macroeconomic stability Project IDNo. PO94301 INTERNATIONAL BANKFORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENTONA PROPOSEDFIRST PROGRAMMATIC BUSINESS PRODUCTIVITY AND EFFICIENCY LOAN TO THE REPUBLICOF COLOMBIA I.INTRODUCTION 1. The Government of Colombia (GoC) has taken great strides in consolidating the economic recovery since 2002 and has made improving the business environment and strengthening the financial sector central to the country's pursuit of faster economic growth. The 2005 "Doing Business'' report by the World Bank and the International Finance Corporation (IFC) ranked Colombia as the number two reformer in the area of business environment in a sample of 145 countries. Similarly, the Financial Sector Assessment Program (FSAP) Update, carried out inlate 2004, highlightedthe recovery of the financial sector since the crisis of the late 1990s due to a broad range of financial sector legal and regulatory reforms. The GoC has more recently embarked on a series of policy and institutional reforms to promote greater productivity and efficiency among enterprises. At the core of these reforms i s a concerted effort to further improve the business environment and continue strengthening the financial sector, to enable it to fundthe investment neededfor productivity and efficiency gains at the firmlevel. 2. The Bank's support for the GoC's program to promote greater business productivity and efficiency would consist of a three-phased programmatic development policy lending (DPL) operation. The entire program would be carried out over a period o f three years and would be complemented by recently completed, as well as concurrent, Analytical and Advisory Activities (AAA) carried out at the request of the GoC. The first operation-the US$250 million proposed here-would support greater business productivity and efficiency through reforms in three areas: (a) enhancing the businessenvironment through improvements inthe regulatory framework and a reduction in the administrative burden on enterprises; (b) increasing the soundness and depth of the financial system; and (c) promoting access to capital markets by firms and improving the efficiency of secondary markets. The second and third phases of the programmatic operation would continue to support the process of reforms initiated under this first operation and would consider its extension to other areas. Key triggers for the preparation o f the second operation include: (a) pursuit of greater international competitiveness for Colombian businessesthrough the establishment of institutional arrangements for implementing, monitoring and evaluating competitiveness plans, as well as the implementation of a new legal framework for quality standards and technology; (b) consolidation and extension of the financial sector reform process, to diversify the range of financial products and foster greater access to financial services; and (c) completion of the regulatory framework to improve access to the capital markets by the real sector. 3. Agreement on the reforms supported by the proposed operationhas beenreached through a broad process of consultation that the GoC has carried out, partly under the umbrella of negotiations for the Andean-U.S. Free Trade Agreement (FTA). The reforms thus have the backing of key stakeholders, which reduces the risks inherent in a program that will span two presidential administrations. 5 11. THE COUNTRY CONTEXT 4. With 45 million inhabitants, Colombia i s the third most populous country in Latin America, after Brazil and Mexico. The country's economy expanded steadily for decades until 1999, when a combination of domestic and international conditions triggered a severe financial and economic crisis. A difficult security situation over the last four decades has also held back economic growth and living standards. In2004, around 52 percent of the population was below the national poverty line. Annual Gross National Income (GNI) per capita, at US$1,920, was only 53 percent o f the average for Latin American and the Caribbean, classifying Colombia as a lower middle-income country. 5. Despiterecent diversification, Colombia's economy still depends onprimary exports, and i s vulnerable to swings in the prices of these. The country's traditional exports-crude oil, coal, coffee and ferronickel-generated 46 percent of total export revenues in 2004, while other agricultural produce and minerals (particularly cut flowers, bananas and gold) contributed a hrther 15 percent. Oil alone accounted for 25 percent of total export revenues, and a significant part of government revenues'. However, total crude output i s dropping as discovered reserves are depleted. Production i s now roughly 525,000 barrels a day, down from a peak of 830,000 in 1999. Security improvements and enhanced contractual terms for investors have attracted significant private sector exploration investment inthe last five years, but this has so far failed to produce the major discoveries needed to sustain oil exports. For industrial exports, key sectors include textiles, food production, chemicals, plastics andvehicle assembly. RECENT ECONOMIC DEVELOPMENTS 6. Colombia's economy has recoveredsince the start of the current CountryAssistance Strategy (CAS) period(2002-2006)*. The near stagnation of the economy duringthe four years prior to the CAS has since given way to a sustained economic recovery and a strengthening of consumer confidence. The turnaround is partly due to the much improved global economic environment: world growth has accelerated, the cost o f international credit has fallen, and the prices of Colombia's primary exports have risen. Domestic factors, particularly the improved security situation and stable macroeconomic polices, have also driven the country's recovery. Improving conditions are reflectedby an almost 1 percentage point increase inprivate investment as a share of Gross Domestic Product (GDP) since 2002, and real economic growth that accelerated from 1.6 percent in 2002 to nearly 4 percent in 2003 and 2004. Colombia's unemployment rate dropped from over 17 percent in 2002 to less than 12 percent in November 2004 (the lowest rate in the last four years), and has remained at roughly that level since. Inflationhas stayed under control, falling from 7.0 percent in 2002 to 5.5 percent in 2004. The annualized inflation rate during the first semester of 2005 was 4.0 percent. Table 1 compares Colombia's recent economic performance with that of the other five largest countries in the region and Table 2 summarizes key economic indicators for the country itself. Annex 1provides further economic and social data. State oil company Empresa Colombiana de Petroleos transferred 6.4 trillion pesos to the national overnment in2004. `The CAS Update, Report 32999-C0, scheduled for Board discussion on Sept. 29,2005, would extend this period through the end of2007. 6 Table 1: Comparative Macroeconomic Indicators Source: World Bank At a Glance indicators Table 2: Key Economic Indicators for Colombia 1 Private sector 7.0 I 8.1 I 9.3 9.6 Source: Ministerio de Hacienda, CONFIS, BdR. 7. The public sector deficit has improved, but fiscal concerns persist. The rapid expansion of public spending over the past decade, (from 25 percent of GDP in 1990 to over a third today), combined with growing pension and other liabilities, has led to significant and persistent structural deficits. The combination of domestic economic growth, improved international conditions, peso appreciation (which reduces the cost of servicing foreign currency- denominated debt), and revenue-enhancing policy reforms has improved the fiscal accounts. The deficit decreased from 3.7 percent of GDP in 2002 to 2.7 percent in 2003 and to 1.2 percent in 2004, well inside the 2.5 percent target of the country's current International Monetary Fund (IMF) stand-by agreement. Policy reforms have concentrated on the revenue side. In 2002, Congress approved Law 788, supported by the Bank's Fiscal and Institutional Adjustment Loan (FIAL) Program. This law sought to increase revenues and reduce tax distortions through the elimination of several targeted exemptions. Overall, the reform brought additional revenues of 0.7 percent of GDP in2003 and about 1.1 percent in2004. 8. Budget and legal rigidities that resist spending cuts have slowed the progress of policy reforms on the expenditure side. These rigidities affect two main areas, in which expenditures have continued to grow: transfers to sub-national govemments and the pensions system. In 2002, the enactment of Law 715 limited the growth rate o f transfers to sub-national govemments, mandated under the Constitution, but this measure i s set to expire in 20073, and further reform i s needed if the system i s to become sustainable. Transfers to the main state-run pension system will continue to expand over the next decade, as payouts greatly exceed new contributions. Fundamental reforms, including a rebalancing of contribution and payment levels, are needed to make the system viable, to reduce government support required and enable the GoC From 2008, the growth rate o f transfers will be calculated based on the weighted average o f the previous four years' GDP. 7 to fulfill its aim of providing a safety net to the poorest elderly citizens. A constitutional reform, enacted in June 2005, has made considerable progress in this area, by eliminating a series of special regimes for certain state employees and imposing ceilings on benefits inthe public-sector pension system. The reform reduced the net present value of pension liabilities by 19 percentage points of GDP (from 162 percent of GDP to about 143 percent). The original bill aimed for almost twice this, but the reform was watered down inCongress. MACROECONOMIC OUTLOOK AND CHALLENGES 9. In the absence of major external shocks, the economy is expected to continue growing at least at current rates in the medium term. Since prospects for significantly improving the factors supporting domestic demand (employment, internal peace, investment and credit) are modest, it i s likely that GDP growth will remain at around 4.0 percent through 2007. Imports are expected to grow by 5.4 percent in 2005, and, combined with lower exports, are expected to moderately increase the current account deficit to 2.7 percent of GDP in 2005. While the same trend is expected to continue in 2006, with a moderate appreciation of the currency contributingto a current account deficit of 2.9 percent of GDP, this figure i s expected to fall slightly, to 2.6 percent o f GDP by 2007. Foreign direct investment (FDI) flows are expected to increase with the likely signing of the FTA as well as with the enactment of some of the business environment reforms supported by this DPL series. 10. The level of public debt remains high but sustainable under most scenarios. Colombia's present level of public debt, at about 46.6 percent of GDP remains relatively high, But it appears manageable in the near term even when considering possible adverse economic shocks. The GoC's target is to reduce the level o f debt to 38 percent of GDP by 2015. Annex 3 analyzes the impact that several economic shocks could have on the overall debt level and the primary surplus (i-e., the fiscal surplus net of debt servicing) that would be necessary in each scenario to meet the 2015 target. This analysis concludes that even facing several combined shocks, if the primary surplus were to remain at the historical level of 2.1 percent o f GDP, total debt levels could be kept at manageable levels. 11. Elections and export markets will generate uncertainty in the coming months. Congressional elections inMarch 2006 and presidentialones inMay will likely slow the progress of some structural reforms and create uncertainty among investors and consumers, particularly if illegal groups attempt to undermine the process through violence. Congress in December approved a measure that would allow President Uribe to runfor a second consecutive term, but it i s not clear ifthe country's Constitutional Court will approve the measure. Abroad, oil prices will continue to have major effects on the economy, through their impact on export and fiscal revenues and as a key determinant of growth in Venezuela, the country's main market after the U S for non-traditional exports. And the implementation of the FTA, which could boost trade between the Andean countries and the US, still depends on both a successful outcome for negotiations and approval by the US Congress. 12. The Colombian peso has appreciated strongly in the last two years, and further strengthening could reduce the international competitiveness of local products. Driven partly by strong export revenues from higher prices for commodity exports, especially oil, Colombia's real exchange rate has strengthened by nearly 30 percent since early 2003. However, manufactured and other non-traditional exports have continued to perform strongly so far, with the value of 2005 first-quarter exports up 29 percent on year, and the current account deficit has remained stable. This suggests that a combination of productivity gains and sustained 8 international demand has allowed the export sector to cushion the negative impact of such appreciation. 111.THE OVERALLGOVERNMENTPROGRAM 13. The overall Government program i s based on the National Development Plan 2002- 2006 (Huciu un Bstudo Comuniturio). This plan was formally adopted through Law 812 of 2003. It has four overarching objectives: Address the security needs of thepopulation. The difficult domestic security situation exacerbated the deterioration of social indicators triggered by the economic recession of 1999,which reverseddecades of progress particularly inpovertyreduction. Actions to reduceviolence are essential for promoting economic growth and poverty alleviation. Support sustainable growth and employment-generating activities in a context of macroeconomic stability, debt sustainability and good access to international markets. Efforts here concentrate on improving overall competitiveness through reducing obstacles to entrepreneurial activity, promoting bilateral and regional free trade agreements, fostering technological innovation, and improving infrastructure. Alleviate income inequalities through the promotion of economic growth, efJicient social expenditures and better safety nets. This aspect o f the plan seeks to support improvements in human capital, increase the coverage of welfare mechanisms, upgrade urban areas and promote growth inproduction through an integrated strategy to support Micro, Small and Medium Enterprises (MSME)development. Increase the transparency and efJiciency of the state throughprofound cross- sectoral reforms and greater, more effective decentralization. This component will continue the process of modernization of the state, rationalizing its size and increasing the efficiency of processes and procedures including those associated with the public (i.e., bureaucratic procedures or "red tape"). 14. The GoC has requested the preparation of this operation, to support a program that will advance toward the second and third objectives of the National Development Plan. The proposed Business Productivity and Efficiency Programmatic DPL would support the GoC inthe implementation of elements of this Plan by fostering productivity, investment and growth inthe private sector, enabling it to maximize the benefits o f increased international integration. More specifically, the reforms supported by this DPL seek to improve the business environment, enhance international competitiveness and increase the soundness and depth of the financial sector. 15. This program is part of a broader set of policies seeking to enhance the country's competitiveness. As the recent Colombia Country Economic Memorandum4(CEM) highlights, competitiveness i s a broad term usedto refer to the overall economic performance of the country, Colombia Economic Memorandum: The Foundations for Competitiveness, Report 32035C0, June 17 2005 9 particularly its level of productivity, its ability to export its goods and services, and the extent to which it can provide a good standard of living for its citizens. Competitiveness therefore encompasses: a stable macroeconomic environment; the educational level and flexibility of the labor force; the ease of transport from ports and on roads; the efficiency of the legal andjudicial system in enforcing contracts and facilitating business activity; the quality and transparency of corporate governance; the stability ofpolitical institutions; the structure o f the tax system; and the conduciveness of the regulatory environment to market competition and management of systemic risks. 16. Strong and sustainable economic growth requires an enabling environment of stability as well as targeted microeconomic policy reforms to increase private investment, reducetransaction costs and enhance competitiveness. Since 2002, Colombia's strengthening macroeconomic and security situation has improved the business environment, with revived aggregate demand and greater confidence among consumers and producers. The GoC is also pursuinga broad program of microeconomic reforms to facilitate and promote business activity, in particular to hlly exploit the export opportunities offered by the prospective FTA. This programi s supportedby the policy actions to be coveredby this DPL series, as discussedbelow. IV. KEY ISSUES AFFECTING BUSINESSPRODUCTIVITY AND EFFICIENCY 17. Introduction. This section considers the main problems and challenges for doing businesses in Colombia, and government initiatives to address these. Within this policy context, the DPL program puts emphasis on actions and outcomes that are most important for the achievement o f the Government's objectives of stimulating broad-based economic growth and maximizing the benefits of increased international integration. The focus of this loan is also determined by the GoC's specific priorities and achievements within its reform agenda, as well as the coverage o f complementary programs from the Bank and other internationalinstitutions. 18. Multiple surveys and analytical works have identified key constraints to business productivityand efficiency inColombia, most of which the GoC is addressingwith direct or indirectBank support. Table 3 lists the main obstacles to doing business identified by survey respondents for the World Economic Forum (WEF). These results are consistent with those of other surveys and analytical studies conducted in Colombia, including the recently completed Colombia Country Economic Memorandum (CEM) and monthly surveys by Colombia's National Association of Entrepreneurs (AsociacibnNacional de Empresarios, ANDI). Table 3: Obstacles1 DoingBusinessin Colombia, in Order of PerceivedMagnitude 1. Corruption 2. Policy instability 3. High tax rates 4. Insufficient access to financing 5. Inadequate infrastructure 6. Inefficient bureaucracy 7. Tax regulation instability 8. Crime and theft 9. Restrictive labor regulations 10.Inadequately educated workforce so2 :e: WEF Global Competitiveness Report (2 104) 10 19. The presidential program to fight corruption is moving in the right direction: focusing on the local level. Corruption, identified as the greatest obstacle inTable 3, increases costs and reduces efficiency for individuals and firms. A presidential program aims to tackle corruption through increasing the transparency of government activities. The voluntary signing o f "transparency pacts" between municipal and regional authorities and citizens, has created a mechanism for local communities to gain information on the decisions and actions of government bodies, and to call them to account. Furthermore, the reduction of bureaucratic procedures (red tape) supported by this loan limits the scope for corruption by simplifyingand accelerating such processes, allowing more of them to be completed electronically and without personal contact with officials, andprohibiting some ofthe charges associatedwith suchprocedures. 20. Policy instability is particularly an issue with respect to the tax regime. In the last three decades, there have been 14 reforms to the tax regime in Colombia. Overall, the reforms have contributed to increasing tax revenues from 11 percent of GDP in 1970 to about 21 percent in 2003, and have improved fiscal accounts. But such frequent tax changes create instability, uncertainty and extra costs for businesses. Uncertainty over the outcome of other reforms, such as to pension systems and budget processes, may also cause businessesto delay investment plans. The current system disproportionately burdens businesses, with a basic corporate income tax rate of 35 percent. The Bank has supported, through the FIAL program, reforms that aim to broaden the tax base and reduce distortions inthe current tax code. 21, The persistence of labor market rigidities hinders business efficiency and productivity. The approval of Law 789 in December 2002 reduced payroll taxes, firing costs, overtime pay and the cost of hiring apprentice workers, as well as extending the working day. It also increased the flexibility o f the training system by allowing for greater use of private providers o f training services. However, inthe 2005 Doing Business report, Colombia's overall index o f labor market rigidity i s at 51, compared to 44 for the average Latin American country and 34 for the Organization for Economic Co-operation and Development (OECD). Indeed, while firing restrictions are now less stringent on average than inthe rest of the region, hiringnew workers remains more difficult and costly in Colombia, and continuing limits on overtime employment make it difficult to increaseoutput usingcurrent staff. Altogether, these factors raise labor costs for firms and hinder efficiency by curbing their ability to adjust production levels to changes in consumer demand. The Bank recently completed analytical work in this area' which provides the GoC with a basic framework upon which to build further labor reforms. 22. Given the time constraints and political economy challenges associated with fiscal and labor issues, additional reforms in fiscal and labor areas will probably have to be addressed by the next administration. The analytical work prepared by the Bank as part of the FIAL Program, the CEM and the labor study have contributed to create the consensus among most political stakeholders for the need for additional reforms in these areas. However, implementation of additional structural reforms i s more likely to be successful if carried out by the government starting in August 2006 during the period of increased political momentum that accompaniesa new administration. The Bank, inthe policy notes it will prepare for the incoming administration, will highlight the need for such reforms. 23. The GoC has designed a Program that addresses five key policy areas to stimulate business productivity and efficiency. The GoC has designed a Program to foster business productivity and efficiency based primarily on policy reforms in five areas: (a) overall business Labor Market Adjustment, Reform, and Productivityin Colombia: What are the Factors that Matter? Report32068-C0, June2005 11 environment6; (b) foreign trade and competitiveness; (c) financial system and capital markets; (d) quality standards and technological innovation; and (e) infrastructure and logistics. The Bank would support this reform programthrough a three-stage programmatic DPL operation. The first proposed DPL operation would support measures in the first three of these areas. The two subsequent operations would extend coverage to the other two, as presented in Figure 1. The remainder o f this section discusses key issues and policies affecting business productivity and efficiency in Colombia along all five dimensions, but with a particular focus on the three areas to be supportedbythe first proposed loan. Figure 1:PolicyAreas for EnhancingBusinessProductivity and Efficiency BUSINESSENVIRONMENT 24. Amid limitedgrowth in privateinvestment since the 1999 crisis, the GoC has made it a priorityto improvethe country's businessenvironment. Despitepositive macroeconomic developments, private investment has not yet recovered to pre-crisis levels. It fell from almost 12 percent of GDP in 1998 to less than 6 percent in 2000, rebounding to only 8.1 percent in 2004. Total gross fixed investment was also relatively stable in 2004, reaching 16 percent of GDP, compared with almost 20 percent in 1998 and 12.7 percent in 2000. Government efforts to facilitate a stronger private sector supply responsehave included the establishment of new fiscal incentives for certain types of private investments (Law 788 of 2002), increases in labor market flexibility (Law 789 of 2002), measures to facilitate foreign direct investment (Decree 1844 of 2003), and new incentives to promote credit to the private sector (Law 795 of 2003). 25. The enhancement of the business environment also seeks to address the problemof informalitybyloweringthe costs of beingpartofthe formaleconomy. Informalitycouldhave a significant impact on productivity and growth. Informal firms have limited access to credit from formal credit institutions and other sources of funding. They also lack the means to protect their property rights, business transactions, and contracts. Finally, informal firms have fewer incentives to invest intraining personnel and innovation through new machinery and equipment, and they have shortened investment horizons. All these factors also constrain the opportunities for technology adoption and growth. Informality in Colombia is as high as 40 percent for economic activity and around 60 percent for employment according to Confecamaras (National Federation of Chambers of Commerce, Confederacidn Colombiana de Camaras de Comercio) studies. Although tax evasion i s one of the main incentives for informality, hightransaction costs associatedwith, for example, licensinga business, also deter entrance into the formal economy. "Business environment" is defined here as the laws, regulations and administrative procedures that set the framework within which firms are created, operate, and invest. This category therefore incorporates actions to address obstacles 1,2, and 6 o f Table 3. 12 26. M a j o r improvements in Colombia's business environment have been highlighted in the Doing Business report. The 2005 edition rated Colombia the second-fastest reformer inthe world, after Slovakia. This highranking was due to the country's significant reforms inthe fields of administrative simplification, contract enforcement, and property registration. In addition, Colombia has taken important steps to increase labor market flexibility and stimulate foreign direct investment. 27. The National Development Plan establishes the reduction of bureaucratic administrative procedures or "red tape" as a central element of the GoC's drive to improve the business environment. Through the Directorate of Public Administration (Departamento Administrativo de la Funcidn Phblica, DAFP), the Government has compiled an inventory of bureaucratic procedures (trcimites), and identified those that have a direct effect on business activities: about 1,000 out of a total of 2,676 procedures. Inpolicy document No. 3292, of June 2004, the National Council for Economic and Social Policy (Consejo Nacional de Politica Econdmica y Social, CONPES) formulated a strategy to reduce red tape by means of inter- institutional coordination, an update of the legal framework, the rationalization of existing procedures, and the technological strengthening of government agencies. By December 2004, about 150 bureaucratic procedures hadbeen simplified and 18 eliminated. 28. The July 2005 approval of Law 962 is a significant achievement in this area. The law, drafted by the Ministry of Interior and Justice, created a new framework for the simplification of government procedures that extended beyond those that could be eliminated through administrative decrees. The so-called Ley Anti-Trcimites eliminated around 80 bureaucratic processes and prevented government agencies both from creating more of them and from raising funds through charges for such processes. It also permitted much more documentation to be submitted electronically or by mail, limiting the need for personal appearances, and rescinded the requirement for signatures to be notarized in most bureaucratic procedures. 29. Further progress came with the creation, in collaborationwith the private sector, of "one-stop shops" to streamline the process of starting a new business. The GoC's National Planning Department (Departamento Nacional de Planeacidn, DNP) has supported Confecamaras and local governments in establishing Centers for Enterprise Assistance (Centros deAtencidn Empresarial, CAEs) insix major cities. The design and initial implementation of the CAE program has been supported through a grant from the Inter-American Development Bank (IADB).7CAEs collect, process and transfer all the information to the 11 agencies, on average, that are involved in the registration and licensing process for new businesses. (These 11 include national, regional and municipal tax authorities as well as labor, health, and environmental agencies). The Government has enabled registration to be carried out on the presumption of compliance with these agencies' requirements, with ex post verification conducted by the respective organizations at their discretion. The CAE expansion program for 2004-2007 seeks to add 51 more cities to the six already covered, to further simplify the business registrationprocess, and to expand the array of entrepreneurial support services offered by CAEs. Table 4 summarizesthe program's results. 'IADBMultilateralInvestmentFundFacility ~ TC-99-05-04-7 13 Table 4: Achievements of the CAE Programby June 2005 Beforeprogram Resultsby June 15,2005 Target for 2007 Time to set up a 1I51 for individuals 1.8 business(days) 1 55 for legal entities 4 Number of times 31for individuals 3.3 entrepreneur must 1 meetwith officials 34 for legal entities 5 Organizations 10 for individuals I 1 entrepreneur must dealwith directly 11for legal entities 2 2 Administrative 17 separateprocesses; 3 16 of 17integratedinto All procedures processes previouscertification C a s ; 3 conceptos integrated into CAEs entrepreneur must processes(conceptos)for eliminatedinall cities andprevious follow whichcharges levied except Bucaramanga(1 certificationprocesses without legalbasis concipto left) eliminated Cost of creating a Direct cost around Total costs cut by 20% on Cut total cost by 30% company COP930,OOO plusaround average; and eliminate excess COP113,000 excess cost excess cost cut by around costs (mostlyfor conceptos) COP85,400 on average 30. Major administrative simplification efforts are also being made at the Ministry of Social Protection. These have concentrated in the unification of the forms used by the Government agencies and private companies that collect social security and other mandatory contributions. Decrees 3667 of 2004 and 187 of 2005 established July 2005 as the deadline for launching an integrated system with a single form Cformulario zinico) that will replace the 283 different social security forms previously used by different institutions. The new system is expected to allow for a significant rationalization of administrative procedures in the Ministry of Social Protection, with major benefits for individual and businessusers. 31, Reforms to contract enforcement and property registration have also had a positive impact on investor perceptions. The 2005 Doing Business report ranks Colombia as the top reformer during 2003 in the area of contract enforcement. Indeed, the average time needed to resolve a commercial dispute was cut by 30 percent, from 527 to 363 days. Changes were introduced in the stages of notification and enforcement, shortening these periods by 46 and 59 percent respectively. In the notification process, debtors are now informed of court filings by a private courier company, as opposed to a court clerk. Ifthe courier fails to reach the debtor, the notice i s published ina newspaper, and ifthe debtor does not show up incourt, the case continues without him. The judgment stage remained unchanged. For the enforcement of judgments, stricter time limits were introduced on the corresponding procedures and professionals other than court officials were allowed to perform them. For instance, notaries and the chambers of commerce- not only the judge-can organize auctions for the sale of assets. In the area of property registration, dramatic improvements have put Colombia well ahead of international averages: it now takes just 23 days to transfer a property title from the seller to the buyer, compared to 56 days on average inLatinAmerica, and 34 days inthe OECD countries. 32. The new "Legal Stability Law" seeks to address investor concerns about legal and tax instability. Law 963 of July 8, 2005, allows for limited guarantees of legal, regulatory and tax stability for major investors, both foreign and local, who enter into contracts with the 14 government for an annual fee of one percent of the value of the investment. In return, the government guarantees that the project covered will be exempt from any changes to applicable laws and regulations specified inthe contract. Exceptions include labor and social security laws, taxes and charges introduced in a state of emergency, indirect taxes and Central Bank (Banco de la Republica, BdR) rules. The contracts only cover new investments with a value greater than US$1 million, and can last for terms of 3 to 20 years. 33. The GoC has made considerable progress in combating money laundering but this illegal activity still creates difficulties for legitimate businesses. In recent years, authorities have tightened the regulatory framework to limit money laundering through the financial sector and capital markets, supported by the Bank's program of Financial Sector Adjustment Loans (FSALs), through Anti Money LaunderingKombating the Financing of Terrorism (AMLKFT) initiatives. These reforms are discussed in the financial sector section below. Inthe real sector, joint efforts by the National Tax and Customs Directorate (Direccidn de Impuestos y Aduanas Nacionales, DIAN), the Ministry o f Finance and Public Credit (Ministerio de Hacienda y Crddito Pliblico, MHCP) and the National Police have resulted in the capture and confiscation of large quantities of contraband imports, a principal form of asset-laundering through the non-financial sector. But the sale within Colombia of cheap, illegally imported goods, particularly domestic appliances, continues to represent unfair competition on a major scale for local producers, importers and retailers, as well as fuelling the drug trade. The operation of "front" companies and other illegal businesses in construction and other sectors also undercuts legal competitors. Furthermore, the entry of extra foreign currency through money laundering contributes to peso appreciation, which diminishes the competitiveness of exports priced in pesos (i.e. not commodities). 34. Despite importantrecent reforms, the Colombia business environment stillpresents major challenges, such as the need to facilitate bankruptcy procedures and strengthen investor rights. The country's collateral andbankruptcy laws are less conducive to lendingthan those inthe OECD. The average duration of bankruptcy procedures i s three years, which i s less than the Latin American country average of 3.7 years, but i s still highcompared with the OECD's 1.7 years. The Companies Superintendency (Superintendencia de Sociedades, SS) i s working on a draft bankruptcy law that, among other things, will reduce the time required for restructuring and liquidation procedures. However, due to the recent extension o f Law 550, which covers bankruptcy processes, consideration of the new proposed legislation in Congress i s likely to be delayed. The Bank has provided analytical support in the context of the Financial Sector Assessment Program (FSAP) update completed in 2005 regarding the required bankruptcy framework and given the importance that this has with respect to the supply of credit, this i s discussed further below in the Access to Finance section. With respect to investor rights, Colombia has a score of 2 on a scale of 0 to 7 in the Doing Business index that measures the degree of investor protection through the disclosure o f ownership and financial information. The regional average is 2.3 and the average for OECD i s 5.6. 35. In the area of business environment, the first DPL would support three of the measures describedhere. These would be: (a) the enactment of the Ley Anti-Trhmites; (b) the issuance of CONPES policy document 3292, establishing the strategy on inter-institutional collaborationto rationalizebureaucratic procedures particularly regardingbusiness activities; and (c) the enactment of the Legal Stability for Investors Law. 15 FOREIGN TRADE AND COMPETITIVENESS 36. The GoC i s using a broad consultative process to develop an inter-ministerial strategy for enhancing international competitiveness. The process aims to establish a "Internal Agenda for the Productivity and Competitiveness of Colombia" (Agenda Interna para la Productividad y Competitividad de Colombia, AI). The motivation for this initiative is the GoC's view that the potential benefits of the various trade agreements currently being negotiated by Co1ombia-e.g. with MERCOSUR and the U.S. and other Andean countries-depend on the adoption of a set of complementary domestic policies in the areas of innovation, human resources, infrastructure, environment, institutional development and MSME support. CONPES policy document No. 3297 established a methodology for drawing up the AI by defining, prioritizing and building consensus around the set of policies needed, through sectoral and regional. consultations coordinated by DNP. The strategy aims to enhance productivity and competitiveness in all regions and sectors, which should cushion those producers that could be negatively affected by these free trade agreements. The consultations took place in early 2005 and the final report i s scheduled for completion later inthe year. 37. The AI builds upon several ongoing initiatives to eliminate obstacles to competitiveness and coordinate policies for competitiveness enhancing purposes. One of the main initiatives is the "Colombia Competes Network" (Red Colombia Compite), coordinated by MCIT and with private sector participation. This initiative i s aimed at identifyingpolicies to deal with obstacles to competitiveness inten thematic areas. Another similar initiative i s the creation of "Competitiveness Agreements" (Acuerdos de Competitividad), also led by MCIT. These agreements have been established in 17 productive chains and clusters. In addition, there are various regional initiatives with a focus on coordinating support for SMEs, export promotion and science and technology policies at the regional level. 38. WEF data suggeststhat Colombia's competitiveness has improved considerably this decade. While Colombia's ranking inthe WEF competitiveness index i s still relatively low (64`h out o f 104 countries in 2004), this has improved dramatically in recent years. Indeed, after dropping from the 27th to the 10* percentile worldwide between 1995 and 1999, Colombia recovered to the 3gthpercentile in2003 and 2004 (Figure 2). In2004, Colombia was ahead o f 11 countries in Latin America and the Caribbean, including Peru, Argentina and Venezuela. It i s worth noting, however, that it trailed Chile, Mexico and Brazil-ranked respectively 22nd,48`h and 57`h-as well as five smaller countries. 39. The GoC has been working for more than two years with the 17 different government agencies involved to simplify import and export procedures. Through Decree 4149 of December 2004 the Government established a six-month timeframe for the implementation o f a single web-based system*-the Ventanilla Unica-through which businesses can obtain all authorizations necessary for importing or e~porting.~The MCIT aims for the system to reduce the administrative burden on exporters from around 35 forms to just one, with the average time needed for export-related bureaucratic procedures dropping from 20 to three days. The new service was launched on July 1,2005. * The web page i s www.vuce.gov.co The ventanilla unica is included within the GoC's broader strategy to reduce bureaucratic procedures, as set out inCONPESpolicy document 3292. 16 Figure 2: Colombia'sCompetitiveness 1 I Percentageof mntrieslessconpetitimthanColombia, 19952XM M . .., 36 30 25 20 15 10 5 0 1995 1996 1937 1998 1999 m 2001 2002 2003 2004 1 40. The implementation of an online Customs Management and Information System i s also expected to significantly reduce the time needed to clear customs. The new system was first operational inthe port of Buenaventura. The GoC now plans to extend it to other ports. In addition, the above-mentioned Decree 4149 also created the legal basis for a program aimed at reducing the number of physical inspections of export-bound containers, through coordinating the work o f the several Government agencies involved. 10 This program is being piloted at Buenaventura and Cartagena and so far has permitted the elimination of two out of the four physical inspections that were previously required, thus saving exporters more than US$lOO per container and allowing a reduction from 12 to 5 hours in the time needed for completing the inspectionprocess. 41. The first DPL would include a component to facilitate trade. This would be the issuance by the Ministerio de Comercio, Industria y Turismo (MCIT) of Decree 4149 dated 10 December 2004 establishing the Ventanilla Unica as a one-stop electronic platform to process all documentation to export and import goods and services, and simplifying container inspection procedures. FINANCIAL SYSTEM AND CAPITAL MARKETS 42. The banking crisis of the late 1990s surmounted, the Government i s seeking to expand sound and sustainable financial intermediation. The GoC, with Bank support, implementeda successful reformprogramthat has strengthened and stabilizedthe banking sector, Several policy initiatives are underway to deepen and develop the financial system, as discussed below. The areas focused on here are: housing finance; microfinance; integrated financial sector supervision and prevention of money laundering; capital markets; and money markets development. Further background onthe financial sector is presented inAnnex 6. Recent Developments 43. Credit to the private sector has fallen as a share of GDP, and there is little sign of a real recovery in lending to businesses. Claims on Colombia's private sector dropped steadily from 27 percent of GDP in 2000 to 23 percent in 2004. (Figure 3a). The recent level i s higher loThis measurewas also recommended inCONPES policy document 3342. 17 than several Latin American peers, even though these all have greater per capita incomes (shown in Table 1): Peru (with private sector credit at 19 percent of GDP), Mexico (17 percent) and Venezuela (11percent). However, Colombia still trails behind Chile (63 percent) and Brazil (35 percent). As a share of total domestic credit, claims on the private sector fell from 75 percent in 2000 to 67 percent in2004, reflectingthe credit expansion of the public sector. (See Annex 6 for a fiuther discussion o f this.) The total loan portfolio has started to expand recently in absolute terms, even adjusted for inflation. But the fastest growth has come from the consumer segment, not the productive sector (Figure3b). Figure3: Evolutionof Credit inColombia (a) Creditto the PrivateSector (% of GDP) Chile gbg 50% 6 $ 40% o I30% OH 0 20% 10% I 1997 1998 1999 2000 2001 2002 2003 2004 I I I Source: IMF Source: Asobancaria, World Bank analysis 44. Individuals' use of financial services has declined, and a tax on financial transactions may be one factor behind this. Disintermediation i s evident fiom a slight decline in the prevalence of bank accounts: in2003, there were 28.0 savings accounts and 4.4 current accounts per 100 people in Colombia, down from 30.5 and 4.7 respectively in 2000'1. In addition, cash incirculation (held by the public) has increased, from 48.5 percent o f the monetary base in 1998 to 70.8 percent in 2003. The tax (now at 0.4 percent) may have altered the composition of the monetary base and impeded the smooth functioning o f the payments system. The Carrasquilla and Zarate12Index and the Simplified Index proposed by Villar et al. (2005)13, both measures of the impact of regulatory cost on financial intermediation, show a constant decrease until the introduction of the financial transactions tax, which seems to have a non- negligible effect on the interest rate spread (Figure 4). The GoC has committed to further exploring alternatives to this distortionary tax and its impact will be reviewed and quantified with Bank analytical support as part of a financial sector AAA to be finished by March 2006. Asobancaria data. l2Regulaci6n Bancariay Tensi6n Financiera 1998-2001. Carrasquilla A and Zarate J. InANIF (eds.) El Sector Financier0 de Cara a1Siglo XI,Asociaci6n Nacional de Instituciones Financieras (2002) l3 Crtdito Represi6n Financieray Flujos de Capitales. Villar L, SalamancaD, Murcia A. Mimeo Banco de la Rephblica, www.banrep.gov.co (2005) 18 Figure4: The Impactof Regulatory Cost andBurdenonFinancialIntermediation Source; Villar, Salamanca and Murcia (2005)' "CrCdito, Represi6nFinanciera y Flujosde Capitales en Colombia: 1974-2003" 45. Intermediation margins have not narrowed in recent years, and are still wider than in 2000. Despite a gradual fall in the benchmark Fixed-Term Deposit interest rate (Depdsito a Tbrmino Fijo, DTF) and lower inflation, the banking sector's average lending rates and overall net interest margin have remained fairly stable for three years (Figure 5). This causes concem because higher lending rates deter borrowing and investment in the real sector, and may signal rising costs o f intermediation among banks. Possible explanations for higher costs include the overhang o f a large stock of bad loans (particularly for mortgage lenders), `financial repression' (Le. a term used to refer to the burden of financial taxes, reserve requirements and directed lending programs that affect a country's financial sector), and operational inefficiencies (overhead ratio of 5-6 percent of assets mostly due to banks' relatively small size). Alternative hypotheses for why lending rates have fallen less than deposit rates include: insufficient competition (despite relatively low sector concentration); and the `crowding out' of private sector borrowingby banks holdingmore government securities. Figure5: Evolutionof Colombia's Key Rates and Yields 0."O0* .p` 9cp`Jhe$` *.p% ,*$ ,."`,.p'*.p' ,*?' J',.p' *.* ,*e@ J,.s" *.p* +Average Yield on Net LoanPorHolio(annualized) -CNet InterestMargin +Interest on 8 M a y Deposit Csrtlflcates(DTF) +Inflation Rate (mlllng12-month average) Source; SB, DANE. Note: Net Interest Margin is net interest income of the bankingsector / average assets 19 Housing Finance 46. The mortgage sector i s recovering slowly from the crisis. The housing portfolio is relatively large by regional standards, accounting for 12 percent of GDP, against 4 percent in Brazil, 6 percent in Mexico, and 16 percent in Chile - all well below the US rate of 70 percent. Despite a recent boom inthe construction sector, Colombia still faces a large housing deficit. On the supply side, the establishment of the Colombian Home Mortgage Corporation (CHMC, Titulizadora Colombiana) has expanded market opportunities by creating a new source o f long term funds for mortgage banks, through the securitization of a large portion of banks' portfolios. Currently, 30 percent of the mortgage loan portfolio is securitized, while an additional 5 percent i s funded through bonds. On the demand side, Colombians are still reluctant to seek mortgages, after the experience of the 1998 system collapse, when soaring interest rates caused widespread foreclosures. Inthe high-income segment, now recovering strongly, the mortgage industry faces increased competition from savings and remittances. Obstacles to the recovery of the mortgage portfolio include: a) Cost of resources. Interest rates have fallen but remain high. Requirements for banks to make mandatory investments in certain instruments also exert pressure on interest rates; and b) Cap on interest rates. Colombia's Constitutional Court in2000 imposed a ceiling of inflation + 11 percentage points on loan rates for low-income housing (Vivienda de Inter& Social, VIS). As long as this cap applies, this segment of the market will not really recover without additional support, as banks are unable to adequately price their risks. The GoC has attempted to eliminate this ceiling, but its roomfor maneuver is limited giventhe court decisions. 47. The GoC is promoting the use of new investment vehicles for housing. To stimulate the use o f alternative sources of financing, particularly for VIS, the Government issued Decree 1877 of 2004. This provided the regulatory framework for real estate investment funds (REFS). REFSinvest primarily (at least 60 percent of assets) in real estate and the income stream is derived from the rental payments that this real estate generates. To promote investments in the construction of new VIS, the income stream from new VIS rental payments is tax free for 10 years. REIFs are also allowed, subject to caps, to invest in non-VIS housing, commercial real estate and mortgage-backed securities. 48. Further regulation of other non-bank institutions will permit greater participation by them in the housing finance sector. In particular, Colombia's cajas de compensacidn familiar, non-profit associations for employee benefits and social services, are poised to expand mortgage lending, particularly to low-income members. The cajas have been allowed by law to fund the constructionand acquisitionofhousingsince 1973, and since 1990have beenrequiredto offer housing purchase subsides to workers earning less than four times the minimumwage. But grants of subsidies have consistently fallen short of projections (with 31,661 awarded in 2004 against a target of 36,000) as many potential recipients failed to qualify for mortgages from banks. The cajas themselves have only provided home loans on a limited scale to date, as they have not had capital backing for more. Law 789 o f 2002 remediedthis by permittingthe sector to start taking deposits from members. Enactment of Law 920/2004 allows for the provision of housing finance by cajas to its affiliates in a framework of adequate prudential regulation and MHCP has already regulated the financial activities to be carried out by the cajas. 49. The first DPL would promote the development of housing finance through support for such regulatory measures. Specifically, the program would include: the enactment of Law 920/2004 and the issuance by MHCP o f a decree regulating the financial activities to be carried out by the Cajas, as described inthe previous paragraph. 20 Microfinance 50. The GoC is seeking to promote an active microfinance sector in the country. While formal lenders have been reluctant to lend to the 60 percent of the households that earn informal incomes, unregulated micro-finance lenders are eager to do so. There are two types of micro- finance institutions in the country: Non-Governmental Organizations (NGOs), accounting for 40 percent o f the market and the regulated banking system, which accounts for 60 percent. The development of the microfinance sector i s hampered by NGOs' lack of capital and the cap on interest rates for microcredits for VIS, discussed above. Microfinance lenders, as in other countries, tailor loanproducts and collectionmethods to the earnings and living situations of low- income, informal households, and have managed to keep default rates low. The GoC i s seeking ways to ensure that microfinance lenders are run in a prudent financial way and gain access to long-term funds, to scale up their programs without losing the advantagesof their business model. 51. Through the National Guarantee Fund (Fondo Nacional de Garantias, FNG) the GoC is seeking to support the development of microcredit in Colombia. Established in 1982, the FNGis a government-owned company supervisedby the SB. One of FNG's objectives is to facilitate access to credit for MSMEs through the provision of partial risk guaranteed4. About 93 percent of the guarantees providedby FNGare automatic, meaning that they are granted by banks or other financial institutions without direct consultation with FNG by either the lender or borrower, under "global automatic guarantee agreements". These accords, which are a type o f proportional risk reinsurance agreement, are signed by institutions and the FNG after a risk study to establish the Fund's maximum exposure to a particular intermediary. To date, FNGhas signed such agreements with 15 banks and 26 non-bank financial intermediaries. Under a 2004 agreement, Bancoldex may now offer automatic guaranteeproducts to most of its MSMEclients. In 2005, FNG moved to create special guarantees for microfinance institutions (MFIs) to encourage private banks to extend credit lines to MFIs. The GoC i s aware that these guarantee facilities should be seen as temporary measures to foster the beginningo f relationships between banks and MFIs. The prudential regulation of FNG was strengthened by the issuance of decree 1324 o f 28 April 2005 by MHCP. 52. The first DPL would promote the development of microcredit through bolstering the FNG. Thus the program would include the issuance by MHCP of decree 1324 of 28 April 2005, to improve the FNG's prudential regulation. Prudential Regulation and Prevention of Money Laundering and Terrorism Financing 53. Prudential regulations continue to be strengthened in key areas. Significant revisions of the legal framework have been made since the crisis. Modifications to the Banking Law have raised minimum bank capital requirements for credit and market risk and provided the legal background for early warning systems, prompt corrective actions, and consolidated supervision. The Banking Law also sought to protect consumers and to diversify the range o f banking products. In addition, the SB issued regulations to define a new system of risk-based loan classification and provisions, encompassing specific and general provisioning requirements. Risk-based regulation and consolidated supervisionremain key issues going forward. The SBC, as recommended in the 2004 FSAP Update, issued norms concerning the role, duties, and responsibilities of external auditors and internal comptrollers (revisores Jiscales), setting audit 14Theguarantee applicable - o f at least ten different types-depends on the nature o f the borrower and the purpose for seeking funds (e.g. working capital, fixed investment, starting a business.) Depending on the type, the coverage o f FNG's guarantee i s capped at between 50 percent and 70 percent of the loan amount, for which commissions o f 1.50-3.05 percent are payable. 21 standards and greatly increasing its objectivity. The PensionsDepartment of the SB i s inthe final stages of the development o f an Early Warning System for the analysis, control and valuation of pension managers' portfolios. This new system will allow for daily monitoring o f the structure and regulatory compliance o f managers, rather than monthly and quarterly, as now. 54. With the stated objectives of consolidating supervision and avoiding regulatory arbitrage and overlapping of supervisory efforts, the authorities plan to merge the Banking and Securities Superintendencies. The Banking Superintendency (Superintendencia Bancaria, SB) and the Securities Superintendency (Superintendencia de Valores, SV) will be replaced by a new institution, provisionally named the Financial Superintendency (Superintendencia Financiera, SF). Most supervisory responsibilities over banks, insurance and pension funds are already concentrated in the SB. Consolidation of supervisory responsibilities is supported as a means to reduce interagency coordinationcosts. Giventhe dominance of financial conglomerates inthe banking system, the groundrules for cooperation shouldbe clearly definedwithin the new SF. These shouldinclude specific requirements for the exchange of information, consultationand assistance on policy, monitoring of markets and entities, and conflict resolution processes. The new agency should define a lead supervisor within its organization with clear consolidation scope, responsibility and accountability conceming market, credit and liquidity risks, and stress tests, at the consolidated financial conglomerate level. 55. It is desirable that the merger be conductedina way that not only limits disruption, but also promotes progress in governance and technical capabilities. The successful implementation of the merger will require that the new body receive additional resources to develop infrastructure, organizational arrangements, procedures and professional skills consistent with the new strategy. The current scheme guaranteesfundingfor the new entity to cover normal operating costs, through contributions from supervised entities. MHCP has prepared a Merger Plan that seeks to minimize any operational disruption during the process. The technical and organizational challenges for the final implementation o f the plan remain significant. Going forward, the Bank will be closely involved with issues associated with both the merger and strengthening governance and technical capabilities of the regulator, both for the banking sector and capital markets. Inparticular, the forthcoming AAA financial sector program includes work on consolidated supervision that will be used as input in defining the new superintendency's responsibilities. 56. Combating money laundering and the financing of terrorism is a key element in promoting a strong and sound financial system. Money laundering and terrorist financing can weaken individual financial institutions, as well as representing a threat to overall financial sector stability. The adverse consequences for institutions are generally described as: i)reputational; as high quality clients, that provide a stable deposit base and make reliable borrowers, lose confidence inan institution connected with money laundering and take their business elsewhere; ii)operational,where impairedintemalprocessesor relationswith other financial institutions impedethe institution's functions or raise its operating and fundingcosts; and iii)legal, due to the riskoflaw suits, adversejudgments, unenforceablecontracts, fines andpenalties. 57. Colombia's government attaches a high priority to AML/CFT actions, to combat drug trafficking and organized crime, and promote financial sector stability and a healthy climate for business. The govemment policy for preventing and combating the offense i s described in the President's Democratic Security and Defense Policy and the National Development Plan (Law No. 812 of 2003). This policy stresses the significance of the threat of money laundering and terrorist financing and enunciated GoC concems that the laundering of the proceeds of cocaine and heroin marketing contributes to terrorism. Moreover, the Colombian 22 government emphasizes that money laundering distorts the proper functioning of the economy as it disrupts the foreign exchange market and other financial markets, and promotes the under- invoicing of imports and exports and the making of fictitious or simulated exports as a suitable mechanism for bringingillicit money into the country with the appearance of legality. 58. Colombian authorities have moved to tighten the regulatory framework, to limit money laundering through the financial sector and capital markets. The SB has adopted several regulations (Circulares Externas, CEs) that have introduced new client due diligence mechanisms and reporting requirements for financial institutions and foreign exchange intermediaries, particularly concerning unusual transactions. These include: CE 25 of 2003 and CE 34 of 2004, on the contents and implementation of the Comprehensive Money Laundering Prevention System (SIPLA), and CE 40 of 2004 on the content of suspicious transactions reports. The SV, has also modified its "Know Your Client" (KYC) rules (obligation to identify clients and their economic activities).with CE 003 of 2005, regarding the application of simplifiedcustomer due diligence measures for non-resident clients. The BdR's resolution No. 6 of 2004 requires cross-border currency transactions above US$l0,000 to be performed only through authorized businesses. In addition, DIAN adopted in 2002 a regulation on the prevention of money laundering, requiring participants in international trade and currency exchanges to implement K Y C mechanisms. 59. The Financial Information and Analysis Unit (Unidad de Informacidn y Andisis Financiero, UIAF) plays an effective central role in the AML apparatus but needs improvements. The UIAF, established within MHCP in 1999, has broad authority to access information from the public and private sectors to combat money laundering. It analyzes suspicious transaction reports and other information filed by reporting entities, including banks, exchange houses, and wire remitters, and refers cases to law enforcement for investigation and prosecution. It also provides training on AML within Colombia and the region. The UIAF reports that Colombia has investigated more than 250 money laundering cases to date. However, independent analyses in 200415 identified key challenges for the UIAF. These include: (a) improving the volume, timeliness and quality o f cases that the UIAF refers to law enforcement; (b) adopting operational/organizational changes to enhance the flow of work within the unit and utilize more sophisticated IT tools, including data mining software; (c) increasing levels of financial expertise and analytical training among unit personnel; and (d) upgrading security, both for personnel and facilities, to better protect sensitive financial information. 60. The GoC i s working to improve inter-agency co-operation, the enforcement of AML regulations and the operational capacities of other supervising agencies. In2004 the GoC's issuedDecree 3420 to reorganize and streamline the Inter-institutional Coordination Commission for AML (CCICLA), the consultative body o f the national government and coordinator of the measurestaken by the Colombian stateto combat money laundering. The GoC i s also working to improve information-sharing, through the development of a secure centralized database system that will facilitate the flow of information related to AML among the UIAF, law enforcement, regulators and supervisors and other government agencies involved. Inaddition, the SB, the SV and the Superintendency of Cooperatives and Mutual Societies (Superintendencia de la Economi'a Solidaria, SES) have, with the assistance of the Bank, formulated strategies and action plans to address operational shortcomings inAML supervision. To strengthen its preventive and supervisory AML apparatus, the SB's priorities are to develop a risk-based approach to AML, including the establishment of an AML early warning system; and collect more AML data from financial institutions, using questionnaires. The SES aims to further train on-site and off-site ~~ ~ l5 Preparedby the Canadiangovernment, a Colombianfirm, GAFISUD,the IMF,andthe U.S 23 inspectors, raise awareness among supervised entities about AML/CFT and share experiences with foreign counterparts, to learnfrom internationalbest practices. 61. Further reforms are needed to Colombia's AML/CFT legal and operational framework. This has recently been assessed by the Regional AML Group for South America (GAFISUD) and the International Monetary Fund. The Colombian authorities have worked closely to address the identified weaknesses and shortcomings of the Colombian AML/CFT apparatus and have set the following priorities: (i)adopting appropriate legislation on the financing of terrorism, the freezing of assets and nonprofit organizations; (ii)extending to certain non-financial businesses and professions prudential rules; (iii)enhancing the operational capacities of supervisory agencies and the financial intelligence unit; and (iv) raising awareness of MLFT exposure. The Bank, through its Financial Market Integrity Unit, is assisting the GoC in addressing these issues through a technical assistance project being carried out during the Bank's FY06. 62. There i s a risk that the adoption of prudential and AMLKFT regulations to strengthen the financial system might hinder access to finance in the near term, but a healthier system will better support financial intermediation over the medium to long term. Inparticular, there areconcernsthat proposedpolicyactions inthe areas ofbankingandcapital markets development (e.g. additional risk management regulations, AMLEFT legislation) might `raise the hurdle' for access to finance by SMEs inthe short term as a result of higher compliance costs and stricter client screening and risk assessment. These concerns are legitimate and additional analytical work needs to be undertaken to better understand the true costs and risk- return tradeoff. However, to the extent that such measures are tailored to local conditions and create the right incentives, they will result in a stronger financial system that can better weather cyclical downturns (and thereby avoid damaging boom-and-bust cycles), can more efficiently allocate existing resources (using sound riskmanagement methods) and can attract more domestic and foreign capital (because of greater integrity and financial strength). 63. The first DPL would therefore include four of the measures outlined in this section. These are: (a) the adoptionof a plan, approved by MHCP, to support the ongoing merger process o f the SB and the SV, to create the new SF; (b) implementation, by the SB, of an early warning system for pension funds; (c) issuance by the SB of circulars 052 and 047 separating the role of internal comptroller and external auditor and enhancing their role inriskmanagement; and (d) the issuance of decree 3420, reorganizing the Comisih de Coordinacih Interinstitucional Contra el Lavado de Activos. CapitalMarkets 64. Private capital markets have developed somewhat and stock market capitalization surged in 2004, but the public fixed-income market continues to dominate. Stock market capitalization jumped from 16 to 30 percent o f GDP between 1998 and December 2004, due largely to a 75 percent increase inmarket capitalization (to US$24.8 billion) over 2004. At this level, Colombia compares favorably with most Latin American peers (see Figure 10 of Annex 6). However, primary share issuesremain infrequent, withjust two in2004. Turnover inequities has increased, to roughly US$10 million a day in2004 from less than US$2 million in 1998. But this remains low by international standards, and fixed income transactions still generate over 90 percent of market activity. Overall, fixed-income securities represent 96 percent of outstanding securities, with the public sector providing 84 percent of the total. The remaining 4 percent is comprised of mutual funds, derivatives and stocks. (See Figure 11 of Annex 6). Institutional investors manage a total portfolio o f about U S 2 5 billion, more than two thirds of this inpension funds. 24 67. The SV is ais# taking steps to attract more issuers into the market and to i m ~ r ~ ~ ? e .tsl'hc sv fw the c tinns cos 1s to SCffRCof 25 initiative of creating an automatic prospectus-generating system i s also meant to improve competition by increasing transparency and cutting the costs of new issuances. Prospectuses will be accessible via internet, will be automated according to the different categories of instruments issued (common shares, preferred shares, preferred shares with voting rights, corporate bonds and commercial paper), and will facilitate the standardization of information available for each issuance. One prospectus module has now been fully implemented (for ordinary shares), and the others are under final development. The SV i s also promoting new issuances and new capital markets products through the issuance of a regulation establishing the framework to facilitate the creationof Private EquityFunds. 68. The SV has also embarked on an educational and promotional program (Colombia Capital). The program addresses firms that are potentially in a position to enter the financial markets, or that are already in them. It aims to raise the number and size o f issues and better understand the needs of companies, to possibly tailor new instruments accordingly. It will thus develop the SV's knowledge base of financial markets and create stronger links with the corporate sector. The programwill be launchednext year. 69. In the area of capital markets, the first DPL would support three actions. These would be: (a) the enactment of the Securities Law; that includes improved investor protection rules and upgraded supervisory powers for the SV; (b) the issuance of a resolution by the Sulu de Vulores establishing the framework to facilitate the creation o f Private Equity Funds; and (c) implementing an automatic prospectus generating system. Public Debt and Money Markets 70. The debt issuance strategy of the GoC may have a major effect on private sector issuances and the availability of longer term investment options. Duringthe past ten years, the GoC has implemented a sound strategy for developing the local debt market as a means to diversify the sources of public debt financing. As a result, the outstanding amount of treasury securities (Titulos de Tesoreriu, TES) grew from US$1.8 billion in 1993 to US$18.1 billion in December 2003, mostly in instruments denominated in Colombian pesos and issued at tenors greater than one year. At the same time, the financial and supervisory framework has been strengthened and structural reforms have been adopted, to promote long term investment (e.g. private pension funds). Additionally, the BdR has made, in coordination with the MHCP and market participants, significant contributions to improve market trading and depositary infrastructure. All this has considerably deepened the local capital market, especially in the longer half of the yield curve. Indeed, the most liquid public debt instruments (denominated in pesos) are inthis segment. The existence of this yield curve i s essential for the pricing of private sector instruments. 71. Efficient secondary markets in government debt are essential, to prevent risk concentration in the private sector. Episodes of market illiquidity and vulnerability such as the domestic public debt crisis of 2002 highlight the importance of implementing a mutually reinforcing set o f reforms to reduce the vulnerability of the system as money markets weakness can hinder not only the development of the public debt market but also the stability of the financial sector. The GoC i s aware of the risk inherent inthis situation, and the MHCP has been leading efforts to develop local debt markets, and capital markets overall. The document, `Reform Roadmap: Strategic Choices in the Development o f Colombia's Debt market^"^, l7World Bank, "Reform Roadmap: Strategic Choices inDeveloping Colombia's Debt Markets". February 2003. 26 developed by a multi-agency Colombian team assistedby the Bank, sets several key priorities for the improvement of market liquidity and the reductionof financial market risks. 72. The Government i s seeking to strengthen the local money markets and government debt secondary markets. Colombia currently lacks reliable, quotable money market rates, an illustration o f how underdeveloped these markets are. A study has been completed on the situation and limitations of the existing money markets, with emphasis on repos and other securities-based lending and including a diagnosis of current restrictions for the issuance and liquidity of TESs in primary and secondary markets. For the same purpose, SV and SB have issued norms to integrate legal, accounting and tax rules for securities borrowing and lending. 73. Money market development has been hindered, in part, by the debt issuance strategy's limited focus on the short term TES market. At another level, the historical presence o f two major liquidity providers (MHCP's Treasury and BdR), with different conventions in key areas such as "haircuts" for market risk, has also had an impact. MHCP- through both the General Directorate of Public Credit and Treasury-is currently running a TES issuance program focused on buildinga benchmark curve for the short end of the curve, in order to create a liquidindicator inshort term markets. Efforts are concentrated onproviding increased liquidityto the primary market and, intum,to the secondarymarket. Since July 2003, the MHCP has focused the short term TES auctions on the 90 day tenor, increasing the weekly auction amount from US$1.7 million in January 2003 to US$29.8 million in March 2004. As a consequence of this greater supply, the bid-to-cover ratio increased three-fold. Meanwhile, the short term secondary market has shown a significant improvement, with liquidity on the electronic trading systems rising from US$6.9 million per month in October 2003 to US$S9.5 millioninFebruary 2004. This appears also to be due to the existence of a primary dealer system, through which the MHCP to `grade' the market makers according to their active participation in the secondary market for short term TESs. 74. Strengthening the legal framework for short-term securities-based lending i s also essential to support additional money markets development and reduce the vulnerability of the financial system overall. Securities borrowing and lending mechanisms in Colombia are fragmented by the existence of a large number of contracts and market practices. The three main kinds of operations (repos, sell-buy backs or simultaneus, and securities lending) are characterized by uneven legal, regulatory, accounting and tax treatment. Among these financial transactions, the most common operations are repos18,widely used by the Treasury for its cash management operations as well as by the BdR as the main instrument of monetary policy. These two agents make up more than 90 percent of the rep0 market, which, during 2003, had a daily average turnover o f US$872 million. In contrast, sim~ltaneas'~have registered a daily average turnover o fjust US$63 million. They have been used by Colombian brokers partly as a means to finance short selling positions. Finally, although securities lending operations were approved in 1999, only a few operations have been carried out to date. Rep0 contracts themselves are not adequately harmonized, and the effects of inadequate infrastructure for them i s reflected in low levels of liquidity, increased risks of over-leveraging by market participants and in general of mismanaging their risk positions, undermining the overall soundness and stability of financial Repos are financial transactions o f cash for securities, where the collateral is kept frozen at the central securities depository (the Depdsito Central de Valores,DCV), and therefore cannot be sold or transferred further inother transactions. l9 Sell buy backs or simultaneasare a special kindo f financial transactions treated as a spot sale and a forward repurchase. As both legs are treated as distinct operations, a simultanea receives different legal, accounting and tax treatment from a repo, even though it can be used as a securities-driven instrument. 27 markets. Tax, accounting, and legal uncertainties also have hindered rep0 market development. A working group from the MHCP, BdR, SB and SV is working towards the development of the legal and regulatory framework related to this type of operations. It i s assisted by a team of international consultants financed through a FIRST initiative grant project2', and supervised by Bank staff. 75. A better framework for corporate insolvency is necessary to facilitate the restructuring and closure of firms, and ultimately increase the provision of credit. An effective insolvency framework stimulates the provision of credit as financial institutions expect lower net losses in case of default. The main weakness in insolvency and restructuring proceedings i s a lack of protection for secured creditors, who are not even considered as a separate class of creditors. Shareholders, who are entitled to vote on restructuringplans like any other creditor (secured or unsecured), often end up skewing the priority rules. As a result, legal rightsset out elsewhere inthe law may be modified inan insolvency context, greatly diluting the protection originally afforded by law. Furthermore, although the law gives liquidators in insolvency liquidation proceedings discretion on how assets are sold, it provides little other guidance. And Colombian law does not recognize prepackaged reorganization agreements and workouts. In sum, insolvency procedures introduce delay in realizing assets in liquidation and prevent companies from reorganizingrapidly. 76. A component of the first proposed DPL seeks to strengthen the domestic money markets and government debt secondary markets. This would be through: (a) the finalizing o f a study of the situation and limitations of the existing money markets with emphasis on repos and other securities-based lending and (b) the finalizing of a study that diagnoses current restrictions for the issuanceand liquidity of TESs inprimary and secondary markets. QUALITY STANDARDSAND TECHNOLOGICAL INNOVATION 77. The adoption of international standards by the service and industrial sectors promotes competitiveness among Colombian businesses. The wider application of international standards can raise the quality, safety, reliability, and efficiency of Colombian productive processes and outputs. These standards also set out the characteristics that products and services must meet in many international markets, so proving compliance i s essential for exporters. The International Organization for Standardization (ISO), a non-Governmental network of national standards institutes, i s the principal developer of international standards. I S 0 certifications are given to organizations based on their compliance (voluntary, not legally enforceable) with the standards applicable to their products and services. The most widely applied I S 0 standards are the I S 0 9000 series, on quality requirements for goods and services, and the I S 0 14000 series, which aims to minimize negative environmental impacts. 78. Colombia has the second highest number of ISO-certified companies in Latin America, due largely to government support for certification. At the end of 2003, almost 2,700 companies had obtained the I S 0 9000 certification, behind only Brazil (with 4,000 I S 0 9000 certificates). The government has subsidized most o f these quality certifications, particularly among MSMEs, through three main programs since 1999: (a) the MCIT's National Quality Assurance Program (Programa Nacional de Aseguramiento de la Calidad), which co- finances up to 50 percent of the cost o f training and technical assistance projects pursuing certifications. This is paid for by the National Training Service (Sewicio Nacional de *'The FIRST Colombia Money Market Project, which includes a component on the development o f a legal and regulatory framework for securities borrowing and lending, started inDecember 2004. 28 Aprendizaje, SENA); (b) the Program for Environmental Management and Quality in MSMEs (Programa de Calidad y Gestidn Ambiental en la PYME) developed by ICONTEC2`, the local non-profit internationally recognized certification body, with support from the IADB; (c) funding through FOMIPYME, for up to 65 percent of certification projects. (Further details of these programs and other aspects of quality certification inColombia inAnnex 7 ) 79. The weak link in Colombia's quality certification system i s accreditation, for which functions are dispersed and objectivity compromised. The Divisionof Technical Standards of the Superintendency o f Industryand Trade (SIC) of the MCIT now accredits and supervises most certification bodies (independent organizations that assess and certify conformity with international standards), as well as testing and calibration laboratories. This arrangement has several shortcomings: (a) the other functions of the Division of Technical Standards raise conflicts of interest: it also accredits certification bodies for mandatory technical regulations22,as well as enforcing compliance with those regulations. In addition, it offers calibration services. (b) the current organization of SIC does not guarantee that the activities of the departments related to those other hnctions do not compromise the confidentiality, objectivity and impartiality o f its accreditation services. (c) Other government agencies also have accreditation functions insome areas, such as INVIMA,the National Institute for the Supervision of Medicines and Food (Instituto Nacional de Vigilancia de Medicamentos y Alimentos). That the different accreditation functions are not clearly defined or delineated creates uncertainty for potential "clients" and generates conflicts between the various agencies involved. 80. Colombia's accreditation body i s weak and lacks independence, so the Government i s studying options to address this. In the current system, accreditation by SIC has little international recognition, which has prompted ICONTEC to seek additional accreditation from bodies in other countries, for its quality certifications to be recognized abroad. SIC i s not a member of the main regional or international accreditation bodies23and has entered only one internationalmutual recognition agreement, with the Andean Community. The other problems of the current arrangement outlined above could be addressed through internal changes in SIC to separate accreditation hctions more clearly from other activities. But pursuing greater international recognition may require the establishment of a legally separate, more autonomous accreditation body, with greater flexibility to enter international groups and agreements. (Government departments must pursue these-as with treaties-through the Ministry of Foreign Relations.) Whether or not a new entity i s created, accreditation needs more resources, particularly to improve technical evaluation and pay the fees and expenses associated with membership of international bodies. The GoC has allocated no new funding for accreditation since 1997. 81. Besides continuing the efforts to upgrade the quality of products and services, Colombia needs further actions to improve the private sector's ability to adopt and develop new technologies. International quality standards are typically based on state-of-the-art technological processes, so complying with such standards can be a beneficial way to transfer technology to developing countries such as Colombia. The GoC also pursues a range of policies to promote technology and innovation, as discussed below. But more needs to be done. 2' ICONTEC i s the Colombian Institute for Technical Rules and Certification (Instituto Colombiano de Normas Ticnicasy CertiJicacidn) 22Technicalregulations are imposed by the Government, typically to protect health, safety or the environment. 23 These include the Inter American Accreditation Cooperation (IAAC), the International Accreditation Forum(IAF)andthe InternationalLaboratory Accreditation Cooperation (ILAC). 29 Colombia still compares poorly for indicators on productivity, skills and technology, even within the context of Latin America, which compares poorly with other regions. While countries inthe region spend an average of 0.5 percent of GDP on research and development (R&D), Colombia spends only 0.2 per~ent.'~Similarly, Colombian R&D expenditures per worker (IJS$lO) are less than a third of the regional average. The country i s also below regional norms for years of schooling o f its population, the share of capital good imports to GDP, and the number o f domestic and U.S.patents granted to local inventors. Within Colombia, there i s a considerable regional concentrationo f resources for science and technology, with 80 percent going to Bogotti.25 82. Colombia's government offers funding, financing and tax exemptions for research and development (R&D) activities, but these have mostly benefitedthe public sector. The Colombian Institute for the Development o f Science and Technology (Instituto Colombiano para el Desarrollo de la Ciencia y la Tecnologia, Colciencias) i s the agency responsible for implementing the country's Innovation Policy, which includes measures to support R&D, including financing mechanisms for universities and other research centers and funding for R&D activities in private firms (Annex 7 includes further details of these programs). Colciencias also coordinates the National Science and Technology (S&T) Council, which includes representatives from the private and public sectors as well as the academic community. This body establishes general guidelines for S&T policy. Colciencias has been the top recipient of government funds for S&T, followed by the Ministry of Agriculture, the National University and a large number of educational institutions, technology development centers and other research institutes. Tax incentives created in the early 1990s to stimulate R&D activities also mostly benefit the public sector. Although the law provides for such deductions for all organization, the public sector- primarily publicly supported Technology Centers, Government agencies and state universities- received74 percent of them in 1995-1999? 83. SENA plays an important role in supporting innovation and competitiveness among MSMEs. A 1996 Law mandates that SENA devote 20 percent of its parafiscal revenues to programs aimed at promoting technological development or increasing the competitiveness of the Colombian productive sector (Law 344). The current Government mandated that 25 percent of the resources for SENA should go to innovation and competitiveness promotion - almost US$14 million in 2003 should be allocated directly to Colciencias. In 2003, the resources obtained through SENA represented 32 percent of Colciencias' budget, thus compensating for a reduction in its allocation from the national budget. SENA also plays a crucial role in promoting the competitiveness of the private sector through its traditional training programs. Recently, the government announced its intention to increase competition in the National Skills Formation System by mandating that SENA earmark an increasing share o f its budget to fund privately provided training services (70 percent by 2006), and by reallocating SENA's accreditation and regulatory functions to other government agencies. 84. Other government programs that support technology adoption and innovation are targeted at MSMEs. The MCIT manages FOMIPYME, the Colombian fund for the modernization and technological development o f MSMEs, created in 1990. In 2003, FOMPYME co-financed projects for about US$9 million (US$4 million in2002). About two 24 Closing the Gap in Education and Technology. De Ferranti D, Perry G, Gill I, J, MaloneyW, Guasch Sanchez C, Schady N. The WorldBank (2003). 25 Scienceand TechnoZogyin Colombia. AgapitovaN,Holm-NielsenL,Vukmirovic G. The WorldBank LCSHD Series (2002). 26 Agapitova et al. (2002). 30 85. thirds of the projects financed by FOMIPYME are for micro enterprises, with the remaining allocated to SMEs. Colciencias has also directed an increasing share of its budget (46 percent in 2004 compared with 32 percent in 2003) to financing private sector technological development and innovation, with a large share of the corresponding funds directed to MSMEs. In2004, Colciencias spent more than US$11 million (US$7.5 million in2003) financing those activities, either through direct support to private companies or through Centers o f Technology Development, company incubators or other entities of the National Innovation System. 86. Measures to strengthen quality certification and technical innovation programs are expected to be included in the program for the second programmatic DPL. Ongoing analytical work inthe Bank, particularly through the logistics, quality and competitiveness AAA, will help to clarify needs and priorities in these areas, informing government policy design and providing a basis for future Bank support, possibly through the secondloan of this series. INFRASTRUCTURE AND LOGISTICS 87. More reliable and affordable infrastructure, particularly as it affects logistics, is critical for Colombia's competitiveness and therefore to boost economic growth. The Recent Economic Developments inInfrastructure (RED127)study indicates that Colombia would need to invest around US$2.6 billion per year (or 3.2 percent o f GDP) on infrastructure, to improve the productivity and competitiveness of the country. Inparticular, transport sub-sectors-roads, ports, airports and inter-modal facilities-present pressing investment needs. Overall, the RED1 estimates the share of the total infrastructure investment that could be financed directly by the private sector at around a third (or 1 percent of GDP). However, private sector participation is still hampered by constraints including: unclear prioritization among infrastructureprojects by the govenunent; the instability of the legal framework for public-private partnerships; inadequate access to finance; and security concems. 88. Logistics costs are too high in Colombia. The costs, times, and difficulties involved in moving materials along the production chain and in getting products to markets are excessive in Colombia, which impedes competitiveness. Much of the problem i s geographical: production i s concentrated in the mountainous interior, while around 85 percent of exports leave by sea. The security situation also increasesthe cost and risks of transportation. But there i s still considerable scope to reduce costs and delays by improving the quality, efficiency, organization and governance of logistics. Logistics costs in Colombia represented 18.6 percent o f sales in 2003- 2004, which is higher than key competitors: the average for the Andean Community (minus Bolivia) i s 13.9 percent, while for Central America it i s 14.3 percent (Figure 7). However, such costs are muchhigher inMercosur and Chile, at 31.6 percent. 27Report 30379-CO 31 Figure 7: Logistics Costs as a Percentage of Sales M e l C Q S U r t C h i l e M e x i c o C Q l Q m b i a L a t i n A m e r i c a a v . C e n t r a i A m e r i c a A n d e a n C o m m u n i t y u s 0 5 1 0 1 5 2 0 2 5 3 0 3 5 K Source: Quality, Logistics and Infrastructure, World BankReport2005 89. Colombia's government has made roads the main priority for 2006 infrastructure investment, but longer term funding still needs to be secured. The RED1 identified Colombia's roads as the country's greatest area of competitive disadvantage, in terms of infrastructure. The proportion of the paved road network considered by the government to be in fair or bad condition rose from 22 percent in 1998 to 29 percent in2003. (Around 70 percent of the primary network and 15 percent of the total network is paved.) The Government's 2006 budget proposal allocates 880 billion pesos for road construction and paving, making this the largest programof public works inrecent years. A further 144billionpesos i s earmarked for road maintenance. However, for the longer term, roads expenditure remains too dependent on budget allocations, which have tended to be bothunstable and insufficient. The creation of a roads hnd could remedy this. 90. The trucking sector i s inefficiently organized and coordination between different transportation modes and services i s poor. Only about 25 percent of truck freight i s carried on shippers' own fleets and long-term contracts are unusual. Most trucking is outsourced to formal transport firms, which usually sub-contract to informal owner-operators (82 percent of whom own only one vehicle.) Tensions between transport f m s and operators have prompted govemment regulations to set mandatory rates for different types of vehicles indifferent regions, rates which bear little relation to market levels. The recent Bank analytical work on logistics and competitiveness" included a study of the trucking sector, to support future reforms to it. The atomized structure of the trucking sector, as well as regulatory, insurance and other issues complicate the provision of coordinated transport services. Colombia lacks multimodal transport systems and providers and intermodal facilities are inadequate. There i s also a real need for firms to modernize their own transport and logistics systems. Some public investment in multi-modal terminals and logistics complexes will be neededto complement changes inmanagerial practices intheprivatesector. 91. Projected increases in import and export volumes will put particular stress on gateways. The volume o f foreign trade is expected to increase significantly with trade agreements and international trends towards greater economic openness and the globalization of supply chains. World Bank projections based on DNP data suggest that import volumes will grow by 9.5 percent per year until 2010, while export volumes expand at the slower rate of 6.1 28Qualityand LogisticsInfrastructurefor Competitiveness,reportnumber forthcoming. 32 percent. Improvements to ports and airports, the main gateways for international trade, are therefore a priority, to handle the extra traffic projected and facilitate export growth. 92. The government has developed a strategy to modernize and improve the ports sector, based around a revision of the concession framework. This strategy i s expressed in CONPES policy document 3342 of March 2005, which was prepared with Bank assistance. The central pillar of this strategy i s the revised, more rigorous contractual arrangement that the Ministry of Transport is developing for the private operators of the five public maritime ports (Barranquilla, Santa Marta, Cartagena, Buenaventura, and Tumaco.) The original 20-year concessions awarded in 1993 did not specify clear quality or investment requirements and allowed a range of management and operation structures, all of which has contributed to the varying (and sometimes poor) standardsof port operations now evident. CONPES 3342 also sets out other key improvements to be sought: the deepeningof port access channels (Barranquilla and Buenaventura) and the improvement of land access (Buenaventura, inparticular); the institutional reorganizationof the sector; facilitating the development of private ports; and the improvement of information systems. An earlier CONPES document (no. 3315 of November 2004) puts port investment needs are put at US$50 million a year for the period 2005-10. The bulk of this (US$40 million a year or US$240 million in total) will be sought from private operators, to increase capacity and improve performance through investments in equipment, facilities and systems. Complementary public investments are neededto improve land and sea access. 93. Bogota's El Dorado airport needs to handle cargo better. El Dorado is South America's busiest airport for cargo, handling 404,000 tons in2002. It processes 80 percent of the country's internationalair cargo. But cargo administration i s uncoordinated, cargo terminals have insufficient capacity and other facilities need modernizing. Cut flowers, the main product flown out of the capital, are generally transshipped directly from trucks to aircraft due to a lack of appropriate warehouse facilities. Colombia's Civil Aviation Administration Unit (UAEAC) is aware of the need to address the situation, and is developing a Cargo Master Plan for El Dorado. Such a cargo strategy-with the investments it would entail-could be incorporated into or at least accommodated inthe concession process that the govemment i s preparing, with Bank advice, for the operation of the airport's mainpassengerterminal. 94. The electricity supply has become more reliable but remains a concern for businesses, leading many to incur the cost of owning generation capacity. Colombia's dependence on hydropower prompted drastic, economically damaging rationing of electricity duringthe serious drought in 1992/1993. Since then, the country has reduced the dominance of hydropower from 80 percent to 66 percent of total capacity, primarily through promoting generation fueled by natural gas. The droughts of 199711998 and 2002/2003 passed without major economic loss. However, around 40 percent of firms surveyed for the REDI in 2004 maintained their own generation capacity, almost two thirds of these motivated primarily by the need to ensure energy supply. Additional measures to improve supply would reassure firms, and reduce precautionary outlays on generators. The REDI concluded that the key measures in this regard would be cross-linking the radial structure o f the transmission network and investments to rehabilitate the sub-standarddistribution networks of local utilities. 95. The reform process in infrastructure is moving ahead, with broad Bank involvement, and is expected to be supported by the third operation of this DPL series. The GoC is developing an integrated policy approach to infrastructure and logistics, moving away from separate structures for each transport modality. Taking the REDI's diagnosis as the basis for its dialogue with the Government, the Bank is actively supporting this process. The recent logistics and competitiveness AAA has built on the RED1to identify bottlenecks that hinder 33 Colombia's competitiveness. All of this analysis may form the basis for future Bank support for measures to improve infrastructure and logistics, and hence competitiveness, possibly in a third Programmatic Business Productivity and Efficiency DPL. And while the current program does not directly support infrastructure actions, the strengthening of capital markets backed by this operation should contribute to the provision of long term financing, which i s key to the implementationof infrastructure projects. V. BANK SUPPORT TO THE GOVERNMENT'S STRATEGY LINKTO THE CAS 96. Inpromoting business productivity and efficiency, the proposedloan aims to foster fast and sustainable growth, the pursuit of which is the first thematic pillar of the Bank's Country Assistance Strategy (CAS) for Colombia. The Bank Group strategy, as expressed in the CAS report 25129-CO dated December 24, 2002, which was discussed and endorsed by the Executive Board on January 16, 2003, has two other mainpillars: sharing the fruits of growth; and building efficient, accountable and transparent governance. The proposed loan would, less directly, advance toward these two other goals: the first by improving the business environment, and reducing the costs ofjoining the formal sector, which should help reduce informality. Joining the formal sector can bringfinancial and other benefits to MSMEs,employees and the self-employed. Inaddition, the simplificationofbureaucratic procedurescontributes to better governance. 97. The design of the proposed loan i s informed by the Private Sector Strategy, which cuts across the World Bank Group activities envisaged inthe CAS. The Strategy aims overall to help foster a business environment with fewer impediments to the achievement of the potential of the private sector, especially in accelerating growth. It has four priority elements, of which this operation focuses on the first and third: (a) bringing about a strengthening of the business environment through improvements in the regulatory framework and reductions in the administrative burden on enterprises; (b) improving the efficiency of infrastructure and natural resources sectors; (c) restoring to health and developing the financial sector, including the pension system and capital markets; and (d) assisting in the restructuring and recovery of otherwise strong private firms hit by the economic downturn and erosion in their access to finance. 98. The CAS Progress Report scheduled for Board discussion on September 29, 2005 extends the current Bank's partnership with the GoC over the coming two years (FY06-FY07). The proposed loan is part of the CAS high lending scenario that was presented to the Executive Board in the Progress Report. The Bank team agrees that the triggers for the high case- macroeconomic sustainability, advancement in structural reforms-are being met. Execution of the subsequent two operations i s conditional upon Colombia continuing to meet these macroeconomic conditions for remaining inthe highcase. COLLABORATIONWITH THE IMFAND OTHER DONORS AND LENDERS 99. A new US$613 million Stand-By Agreement betweenColombia and the IMF was signed at the end of April. This Agreement covers the next 18 months (until October 2006) so as to include the transition to a new government. The agreement will be treated as precautionary, as a transition to the end of further IMF support.29 The IMF Colombia team has been consulted 29 In January 2003, the IMF approved a two year Stand-By Agreement (SBA) of US$2.3 billion. The govemment treated the arrangement as precautionary and did not draw on it. Colombia metlexceededthe program's targets 34 during the preparation of this operation to ensure consistency with the benchmarks specified in the current IMFagreement with Colombia. 100. The IADB has been supporting improvements to the business environment and the development o f new businesses primarily through targeted grants. The IADB's Multilateral Investment Fund has provided grants to the Association of Chambers of Commerce, Confecamaras, to facilitate the streamlining of new business registrationprocedures. It has also supported the development of new businesses by providing a grant to the University of Los Andes to provide technical and financial support to clusters of fledgling MSMEs. The IADB i s preparing a policy-based loan in 2006 in support of some of the measures that the GoC will take as part of the implementation of some of the recommendations of the AI (Agenda Interna) process. The Bank team preparing this operation has coordinated with the IADB carrying out the competitiveness dialogue to ensure complementarity of the areas supported by each institution particularly with respect to the secondand third operations of this DPL. 101. The Andean Development Corporation (CAF) has concentrated its support to the GoC primarily in the area of infrastructure financing for a transportation network upgrading plan which seeks to enhance overall competitiveness by addressing some o f the transportation bottlenecks inthe country. The GoC andthe CAF are finalizing the negotiation of a policy-based loan that supports regulatory changes in the infrastructure sector that would directly affect competitiveness, particularly to enhance competition inthe telecommunications and ports sectors. The LatinAmerica andthe CaribbeanFinance, Private Sector and InfrastructureUnit of the Bank, has reviewed these operations with CAF staff to ensure alignment o f strategies. More recently, CAF has also supported the strengthening of the financial supervisory regime by providing technical assistance to MHCP in the process of merger of the banking and capital markets superintendencies. RELATIONSHIP TO OTHER BANKOPERATIONS 102. The proposed program would build on the achievements o f two recent Bank programmatic financial sector adjustment loans (FSALs), approved inApril 2003 and September 2004. The first of these followed on from an earlier FSAL (approved in October 1999) and supported advances in the process of restoring soundness to the banking system after the crisis that started in 1998. It also aimed at strengthening the government's capacity to manage and mitigate weakness in the financial system, as well as fortifying and diversifying the mortgage market, improving access to finance for the micro sector and strengthening non-bank financial services and securities institutions. The second programmatic FSAL sought to consolidate earlier reforms in the banking sector and ensure future stability, capitalization and capacity for savings and credit intermediation, through the implementation of a new legal framework for managing bankingrisks. 103. The Bank is also engaged in a Programmatic Labor Reform and Social Structural Adjustment Operation (PLaRSSAL) to Colombia. The Executive Board approved the first of these loans in September 2003, the second in November 2004, and a third i s slated for consideration in FY06. The PLaRSSAL loans include support for a number of reforms that will ameliorate two key aspects o f the business environment that are not a direct focus o f the program proposed here: the labor market and human capital. Such measures aim to stimulate employment and expand training by reducing the wedge between employers' hiring and training costs and acceptablewages, while improving the social protection o f vulnerable workers. Inparticular, the approval of the Labor Reform Law (Law 789) in 2002, decreased labor market rigidities by reducing payroll taxes and overtime pay and extending the working day. In addition, the 35 modernization of the National Training Service (SENA) has increased its efficiency and effectiveness. 104. By promoting the simplification of bureaucratic procedures that involve businesses, the proposed operation also relates to broader efforts to streamline and bring greater transparency to the public sector, as supported by the Bank's program of three fiscal and institutional structural adjustment loans (FIALs.) The FIALs' support for stronger more transparent state functioning, particularly inthe areas of procurement, financial information and budgeting,counters corruption in the public sector. This complements the current program's efforts to improve the business environment, given that businesses consider corruption the most significant obstacle to doing business inthe country, as discussed above. The first of the loans of this program was approved inMarch2003, the secondinNovember 2003, andthe thirdinMarch2005. 105. A number of bank projects have supported improvements to infrastructure, a key determinant for businessproductivity that is not included inthe current program. Inthe transport sector, the Bogota Urban Transport Project has led to the IntegratedMass Transit project, which extends bus rapid transit systems to other medium-sized cities. Ongoing water projects and the new Water and Sanitation Sector Support Project are bringing efficiency improvements through public sector capacity building combined with private sector participation. The Bank i s also supporting regional water projects, particularly in La Guajira, while the Bogota Urban Services Project provides social infrastructure to 600,000 of the poorest residents of the city. This operation i s also related to several M activities discussed below under Analytical Underpinnings. 106. IFC's work in Colombia is directly related to the development objectives of this loan. The IFC has focused on: (i) improving access to finance; (ii)investing incompanies that promote growth and employment; (iii) infrastructure investment; and (iv) supporting environmentally and socially sustainable business practices and corporate governance. Highlights of IFC's recent activities include development of the mortgage market, launching o f a number of innovative financial products (e.g. the first Peso-denominated bond and the increased use of partial guarantees), and support to companies in the manufacturing and financial sectors. The increased use of guarantees and the issuanceof domestic bonds have been instrumental for the development of local capital markets. They have also helped to improve the debt profile of many Colombian companies. 107. Inthe mortgage sector, IFCprovidedapartial credit guaranteeto the ColombianHousing Mortgage Corporation, a secondary mortgage company, for the issuance of Latin America's first non-performing mortgage loans securities. This investment has been instrumental inestablishing a bridge among capital markets and the mortgage banking industry. IFC also provided support to Davivienda, a leading mortgage originator for local bond issues. For FY03-05, IFC committed US$l58 million. As of endJune 2005, IFC's exposure (outstanding balances) stood at US$290 million. The quality of the portfolio also improved markedly, with the elimination of non- performing loans. 108. Duringthe remainder of the extended CAS period, the IFC will concentrate its work in four areas: (i) strengthening and deepening of financial sector institutions and local financial the markets to better serve the needs of local companies, including SMEs and micro enterprises (ii) the development o f infrastructure, including potential public-private partnerships and support to sub-national entities in the provision of infrastructure, in coordination with the Bank as warranted; (iii)the modernization of Colombian businessesto help improve their competitiveness 36 and support their expansion both domestically and abroad; and (iv) investment in extractive industries. The first three ofthese areas are directly relatedto the objectives ofthis DPL series. LESSONSLEARNED 109. The design of the proposed programmatic DPL takes into account the lessons learned from the overall program with Colombia as presented in the recently completed CAS Progress Report as well as specific operations such as the programmatic financial sector adjustment loan program in Colombia (FY04 and 05) and other recent policy-based lending operations in Latin America covering private sector development and financial sector strengthening. Inparticular, lessons learned were incorporated from the Brazil First Programmatic Loan for Sustainable and Equitable Growth (Ln. 7218-BR), which highlighted the benefits that arise from addressing business environment and financial sector issues jointly. Other operations considered included the Honduras First Programmatic Financial Sector Development Policy Credit (Cr. 4036-H0), approved in February 2005, the Guatemala Financial Sector Adjustment Loan (Ln. 7130-GU), approved in June 2002, and the Uruguay Financial Sector Adjustment Loan (Ln. 4540-UY), approved inFebruary2000 (ImplementationCompletionReport (ICR) issued inDecember 2000). The most important lessonsfrom these operations arethe following: 110. The importance of flexibility to respond to changing circumstances. In order to implement a lending program that best addresses Colombia's needs as a creditworthy middle income country, the Bank needs the flexibility to be able to respond quickly to changing circumstances. This i s particularly important when supporting a Program, such as is the case in this DPL series that spans across two presidentialadministrations. The programmatic approach, as opposed to a multi-tranche operation, provides the necessary flexibility to respond to new needs and priorities that can emerge during the implementation process while ensuring a long- term approach to a reformtheme. 111. The value of prior strong analytical work. In preparing private sector development and financial sector policy-based operations, the Bank should leadwith its comparative advantage which i s bringing to bear strong technical capacity and ample cross-country experience. The Borrower must be confident that its dialogue with the Bank will add value to its own efforts, The Bank has maintained a very fruitful dialogue with the GoC over the last five years. The analytical work carried out more recently, during FY05, includes the Country Economic Memorandum, the FSAP Update and the REDI. The authorities welcomed the analytical work which became the basis of a dialogue with the Bank to define the policy actions this DPL would support, as well as for possible future reforms. 112. The need to take into account the political economy of reform. Indesigning a policy- based operation, political factors and the legislative needs of the country need to be understood and included in the dialogue with the client, particularly if part of the implementation of the reform program will involve a future administration. The broad consultations that have been carried out by the Government in the context of the negotiations of the FTA have facilitated reaching the consensus necessary to enact reforms as the 2006 elections approach, particularly in the five areas covered by this operation. Labor and fiscal constraints are also essential impediments to business productivity and efficiency but the Bank and the GoC agreed that designinga programthat would address these at this stage would be risky and thus should be left as part of the dialogue with the new administration inmid-2006. 113. The commitment of the Government is central in ensuring the success of the program. Previous policy-based and investment operations all pointed to the important role of strong government leadership in their success. The proposed operation effectively responds to 37 the Borrower's own priorities and commitment as reflected in the actions already taken, such as the recent passage of important legislation, as well as the fact that the policy thrust supported by this operation lies directly along the key policy axes of the Government's National Development Plan. 114. Coordination with other international financial institutions, such as the IMF and the IADB, is critical to ensure a consistent policy approach towards borrowers. This proposed operation builds on close collaboration with the IMF in the FSAP as well as with the IADB, which has been conducting dialogue with the GoC in the area of competitiveness. Furthermore, CAF has become an increasingly important player in Colombia, particularly in infrastructure, and the development of this Program, particularly as it moves towards the second and third operation, will be carried out inconsultation with the CAF Colombia team. ANALYTICAL UNDERPINNINGS 115. The preparation of this operation has benefited from six key analytical documents preparedby the Bank duringthe last 18 months: (a) Country Economic Memorandum. This provides a broad overview of the constraints to competitiveness faced by Colombian firms particularly with respect to the FTA and its overall approach to the problem has beenusedinthe design of this Program. (b) Recent Economic Developments in Infrastructure (REDO. This identifies the infrastructure-related constraints to economic growth and international competitiveness. (c) Quality and Logistics Infrastructure for Competitiveness in Colombia. This provides a basis on which to designthe reform program for quality and logistics to be supported by subsequentoperations inthis DPL series. (d) Financial Sector Assessment Program Update. Jointly carried out with the IMF, this provides an overview of the main financing challenges faced by Colombian businesses and the measuresthat the Government has taken to addressthese ina sustainable manner. (e) Labor Market Adjustment, Reform and Productivity in Colombia: W%atare the Factors that Matter? This addresses the constraints to productivity derivedfrom the labor market which, though not directly addressed by this DPL series, constitute an essential element of businessproductivity and efficiency. (0 Colombia Financial Sector Stocktaking Report which analyzes the changes that took place in the financial sector since the crisis o f the late 1990s with emphasis on banks' capital adequacyratios. 116. The GoC and the Colombian academic community have also produced several analytical studies and other reports that were used in the preparation of the Program. In particular, the National Development Plan 2002-2006 (Hacia un Estado Comunitario) and several CONPES policy documents, specified inthe section on key issues for business productivity and efficiency, have helped set the framework for the development of this program. 117. The GoC has requested,inlight ofthe upcoming elections, that the Bank engage inbroad dialogue with all stakeholders-not just the current Administration-on these topics duringthe next nine months. This process was initiated in late May 2005 through a broad consultation with market participants onthe reformprogram inthe financial sector. As a result of this consultation, 38 the GoC requested the preparation of additional AAA in financial services during FY06 on topic relatedto financial deepeningthat directly support the detailed designs of reforms to be supported by subsequent operations inthis Program. VI. THE PROPOSEDPROGRAMMATICDEVELOPMENTPOLICY LOAN OPERATION DESCRIPTION 118. The development objective of this operation i s to support sustainable growth and the alleviation o f poverty by: (a) Facilitating the operation of businesses and promoting investment, to boost productivity and employment levels; and (b) Consolidating the financial sector and capital markets as pillars of economic growth to addresses the needs of individuals and the productive sector. 119. The World Bank would support this processthrough a programmatic development policy operation in three phases, which would be executed over a period of three years. The first proposed operationwould support policy and institutionalreforms inthree areas: (a) Enhancement of the business environment to improve the competitiveness of the productive sectors o fthe economy. (b) Increasingthe soundness and depth of the financial system. (c) Increasing access to capital markets by enterprises and improving the efficiency of secondarymarkets. 120. The second and third DPLs would support the completion of implementation of the reform agenda along the two other dimensions identified as necessary to enhance business productivity and efficiency (technological innovation and quality; and infrastructure and logistics). The GoC has defined this sequencing based on the availability o f the analytical work as well as the political timing associatedwith some of the reforms, issues discussedbelow inthe Risks section. The secondloan is expectedto be presentedfor Executive Board consideration in the first quarter of FY07 andthe thirdloan inthe first quarter o fFY08. 121, The GoC has completed all the previous actions for presentation of the first operation to the Executive Board, as listed inBox 1. Box 2 presents triggers for the preparation of the second operation. Inaddition, becausethe second and third loans are part of the CAS'Shighcase lending scenario for Colombia, the execution of bothof these i s conditional upon Colombia maintaining a sound macroeconomic policy framework, as this i s a requirement for remaininginthe high case. Box 1: Previous Actions for Executive Board Presentation of the First Business Productivity and Efficiency DPL Enhance the Business Environment and Promote Trade and Competitiveness 0 Reduce transactions costs and facilitate entrepreneurial activities through (a) Enactment o f a Law to Rationalize Bureaucratic Procedures (Ley Anti Tramites); and (b) Issuance of CONPES policy document 3292 dated 28 June 2004 establishing the strategy on inter-institutional collaboration to rationalize bureaucratic procedures particularly regarding business activities 0 Streamline foreign trade activities through the issuance by the Ministerio de Comercio, Industria y Turismo (MCIT) o f Decree 4149 dated 10 December 2004 establishing a Ventanilla Unica as a one-stop electronic platform to process all documentation to export and import goods and services, and simplifying container inspection processes 0 Provide a stable legal framework for direct investment through the enactment of a Legal Stability for Investors Law under which investors in major new projects can purchase government guarantees that certain applicable rules will not change 39 Increase the Soundness and Depth of the Financial System Promote sound financial access through (a) Enactment by the legislature o f Law 920/2004 allowing the provision of housing finance by Cajas de Compensacion to its affiliates in a framework o f adequate prudential regulation; (b) Issuance by MHCP o f the decree regulating the financial activities to be carried out by Cajas de Compensacidn; and (c) issuance by MHCP o f decree 1324 dated 28 April 2005 strengthening the prudential regulation o f the FNG Strengthen supervision by (a) adopting a plan, approved by MH, to support the ongoing merger process o f the SB and the SV to create a new Superintendencia Financiera (SF); (b) implementing, by SB, o f an early waming system for pension funds; and (c) issuance by SB o f circulars 047 and 052 o f 2004 enhancing the role o f intemal comptrollers and extemal auditors in risk management o f banks and other institutions supervised by SB. D Lower the impact of illegal activities on the financial sector by strengthening the AMLiCFT regulatory framework through the issuance o f decree 3420 (2004) reorganizing the Comisidn de Coordinacidn Interinstitucional Contra el Lavado de Activos Promote the Access to Capital Markets by Enterprises and the Efficiency of Secondary Markets w Strengthen capital markets development and supervision through the enactment by the Legislature of a Securities Law that includes improved investor protectionrules and upgraded SV supervisory powers D Promote new issuances and the development of new capital markets products through (a) issuance o f a resolution by the Sala de Valores establishing the framework to facilitate the creation o f Private Equity Funds and (b) implementing an automatic prospectus generating systemto lower transactions costs ofnew issuances Strengthen the domestic money markets and government debt secondary markets by (a) finalizing a study of the situation and limitations of the existing money markets with emphasis on repos and other securities-based lending and (b) finalizing a study on diagnosis o f current restrictions for the issuance and liquidity o f short term government bonds (TES) in primarv and secondarv markets Box 2: Indicative Triggers for Second Programmatic Loan I With DNP support, GoC has issued a policy document establishing the institutional arrangements for the implementation and monitoring and evaluation arrangements necessary to carry out competitiveness plans including those identified by the Agenda Intema de Competitividad GoC has drawn up and issued the necessary legal acts establishing a new institutional framework for technical standards and quality that brings Colombia into compliance with internationalbest practices including the elimination o f conflicts o f interest between quality standard issuers and certifiers The SF has been established and the integration process continues to advance in a manner consistent with the plan approved by the MH MHCP has issued a mid term road map for reform in the financial sector, supported by sound analytical underpinnings, to address the needs for increasedaccess and diversity o f financial products A bill criminalizingthe financing o f terrorism has been submitted to the legislature Issuance o f norms regulatingthe new Securities Law with respect to (a) new SF supervisory powers; (b) procedures for the custody, settlement and payment systems; (c) qualification for financial market intermediaries; (d) investor protection rules; and (e) corporate governance rules Operation and issuance by the Banco de la Republica(BdR) o f the operational manual for a new technological platform for the securities borrowing and lending facilities operation 122. Monitoring Indicators. In addition to the Program Outcomes presented in Annex 4, which will constitute the fundamental indicators to be measured during the Program, several quantitative indicators that relate to the part o f the Program supported by this loan will be monitored, bearing in mind that many o f these indicators are influenced by factors beyond the scope of this Program. 40 Table 5: MonitoringIndicators PolicyAction Area Indicators Reduce o f transaction costs and -Evolution o f the inventory o f increase efficiency o f entrepreneurial administrative procedures as defined by activities CONF'ES 3292 - Indicators reported yearly in the Enhance Business Bank/IFC Doing Business Report: Time Environment and to start a business, time to register Promote Trade property Competitiveness Streamline foreign trade activities - Percentage o f foreign trade transactions being carried out through the Ventanilla Unica mechanism Lower the regulatory risk o f new - Number o f new investment projects investments using the guarantee facility provided by the Legal Stability for Investors Law Improve financial access - Total financing to the private sector as percentage o f GDP Increase the Strengthen supervision - Prudential indicators o f the financial Soundness and system (Capital adequacy, coverage Efficiency o f the ratios) Financial System Lower the impact o f illegal activities - Number o f suspicious financial on the financial sector transactions jointly investigated by the FIUandthe SB Strengthen capital markets -New debt and equity issuances supervision and promote new -Traded volumes Promote access to issuances and the development o f new - Indicators reported yearly in the Capital Markets by capital markets products Bank/IFC Doing Business Report Enterprises and particularly regarding the Disclosure increase Efficiency Index (Corporate Governance o f o f Secondary Publicly Listed Firms) Markets Strengthen the domestic money markets and government debt -- Liquidity o f the domestic rep0 markets Liquidityo f the secondary markets secondary markets LOANAMOUNT 123. The proposed US$250 million first programmatic DPL would be disbursed in a single tranche. It i s expected that this tranche would be disbursed upon loan effectiveness in the last quarter of 2005. POLICY AREAS A. Enhancethe BusinessEnvironmentandPromoteTrade and Competitiveness 124. DescriptiodGovernmentActions. One of the pillars of the National Development Plan 2002-2006 i s the improvement of the business environment as the foundation for sustainable growth o f the country. The GoC has sought to give the state the role o f facilitator inpromoting business activity, movingaway from direct intervention. 125, With this aim, the proposed operationseeks to support three types of legal and regulatory reforms: 41 (a) Reduction of transactions costs and increased efficiency of entrepreneurial activities by streamlining administrative procedures, particularly those associated with business activities; (b) Streamline foreign trade activities by creating a one-stop electronic platform to process all documentation required to export and import goods and services; and (c) Provide a stable legal framework for direct investment by allowing the government to make contractual guarantees that the rules governingmajor new projects will not change. 126. Challenges. Simplifying bureaucratic procedures can be difficult as it requires coordination among multiple government (national, regional, and municipal) agencies. However, the GoC has completed a broad consultative process on policies for the enhancement of the business environment, as part of the negotiation of the FTA, which reduces risks. Establishing contractual guarantees of legal and regulatory stability i s a second best alternative to providing that stability per se, a process which i s more difficult as it involves a broader set o f stakeholders. However, this is amove inthe right direction. 127. Bank's Assessment/Recommendation. The measures taken and the results presentedin the 2005 World Bank/IFC Doing Business publication reflect the strong commitment of the GoC to carrying out the reforms to enhance the business environment. The three reforms supported here directly seek to reduce transactions costs and reduce business climate uncertainty, two of the most serious constraints to doing business inColombia. The Bank should support recently taken and imminent actions as part of this process. B. Increasethe Soundnessand Depthof the FinancialSystem 128. DescriptiodGovernment Actions. The GoC's program inthis area seeks to address the need for greater access to financial services by the productive sectors of the economy, while further strengtheningthe financial sector, to ensure sustainable growth offinancial deepening. 129. The proposed operation support reforms inthree areas of the financial sector: (a) Improve financial access by allowing the provision, under regulation, of credit by cajas de compensacion, non-profit associations for employee benefits and social services, and allowing the sustainable and market-oriented growth of FNGactivities; (b) Strengthen supervision of financial markets through the adoption of a plan to support the ongoing merger process banking and capital markets supervisors, enhancing early warning systems for pensionfunds, and improving banks' corporate governance; and (c) Lower the impact of illegal activities on the financial sector by enhancing the coordination of government agencies seeking to combat money laundering and terrorism financing 130. Challenges. The Government's fiscal requirements may continue to create a situation of crowding out, which would limit additional financing flows to the real sector. The new risk- based approach to bank provisioning requirements and the consolidation of SB and SV into a single institution are all major projects that individually require substantial resources, investment in human capital and redefinition of processes. Improved prudential regulation and a better 42 AMWCFT framework may in some circumstances actually constraint the supply of credit, however, are also pre-conditions for sustainablegrowth of the financial system. 131. Bank's Assessment/Recommendation. The GoC, with continued support from the Bank, has carried out an effective reformprocess inthe financial sector after the crisis o f the late 1990s. Colombia i s one of the pioneers inaddressingwhat appears to be the emerging challenge in the financial sector in Latin America: how to boost the growth of credit (i.e., financial deepening) without incurring in stability risks. The new generation of reforms, designed to foster the role of the financial sector as the engine of growth of the economy, i s based on solid principles and shouldbe supported by the Bank. C. Promote Access to Capital Markets by Enterprises and Increase the Efficiency of SecondaryMarkets 132. DescriptiodGovernment Actions. The GoC, with Bank support, is carrying out a reform program to foster the development of the local capital markets, to provide firms with more efficient financing mechanisms and provide both the Government and the private sector with more efficient secondary markets in which to manage their risks. This has been carried out through the enactment of the Capital Markets Law, regulatory reforms and the creation of new instruments to raise the efficiency of the markets. 133. The proposed operation will support three sets of reforms: (a) Strengthen capital markets development and supervision through the enactment of a new CapitalMarkets Law; (b) Promote new issuancesandthe development ofnew capital markets products; and (c) Strengthening the domestic money markets and government debt secondary markets. 134. Challenges. Medium-term challenges related to the activities under this first phase are related to the market response to the reforms. Although recent developments on the short-term TES market appearto support any initiative to consolidate the existence of a liquidand stable risk free reference rate, many of the reforms will need to be backed by market participants inorder to bringeffective growth inColombia's capital markets. 135. Bank's Assessment and Recommendations. Colombia has shown strong commitment to reforming its capital markets, as demonstrated by the measures taken following the FSAL program and the February 2003 reform roadmap. This reform agenda positions the country among best practices experiences in the region. The Bank should continue its support to Colombian capital markets work through this proposed operation. VII. OPERATION IMPLEMENTATION SOCIAL,ASPECTS AND POVERTY IMPACT 136. The proposed operation advances the CAS'S aim of promoting fast and sustainable growth through stimulating business activity and investment. As noted in the CAS, growth has been Colombia's most effective safety net, as on average, each percentage point increase in per capita GDP reduces poverty by 0.6 percentage points, which equates to roughly a quarter of a millionpeople. Strong and stable growth has historically helped the poor in Colombia by raising living standards, easingunemployment and increasing public resources for social spending. 43 137. The operationalso seeks to address the problemof informality, by enhancing the business environment and lowering the costs of being part of the formal economy. Lower informality could bring significant economic and social benefits. Formal firms have better access to credit from the financial system, and therefore more possibilities for investment, growth and the adoption o f new technologies - all of which can reasonably be expected to boost efficiency, productivity and economic growth. Formal firms are also likely to offer better employment conditions, including longer, more stable contracts, training, health coverage and pension benefits. However, as informality-and any decision to join the formal sector-has multiple causes, the impact on informality of the measures supported here would be extremely difficult to quantify. The Bank is, however, examining the possibility of tracking the access to credit of MSMEs, both formal and informal, as part of a forthcoming Investment Climate Assessment (ICA) of Colombia. 138. The proposed operation includes some specific measures that should benefit low-income groups, in particular by extending financial access for the poor and MSMEs. For the unbanked, gaining a bank account facilitates saving and reducesthe costs and inconvenience associatedwith financial transactions, including the payment of utility and other bills and the receipt of salaries and remittances. Also, promoting the availability of credit lines from commercial banks to micro finance institutions will make it easier for these to provide resources to entrepreneurs and MSMEs. Facilitating the creation of companies and integrating MSMEs more closely into production chains will also increase the possibilities for small businesses to provide employment and a route out of poverty. SUPERVISION 139. The MHCP will be the representative of the Republic of Colombia (the Borrower) and will be responsible for the overall implementation of this program. MHCP has designated the Enterprise Development Directorate (DDE) within the DNP as the agency coordinating the business environment enhancement component of the program. MHCP has designated the General Financial Regulation Directorate within MHCP as the agency responsible for coordinating the two other components onthe programrelatedto financial and capital markets. 140. Bank staff will monitor actions and review progress o f the implementation of the proposed operation, as well as the subsequent actions of the Government's program through frequent visits to the country and constant communication with MHCP and DNP authorities. Bank staff will focus on monitoring progress towards the indicative actions for the second programmatic loan and the overall goals of the program. Monitoring indicators are described above. FIDUCIARY ASPECTS 141, Colombia's fiduciaryenvironment for DPL is consideredadequate. Inrecent years Colombia has made important progress inits Public Financial Management (PFM) systems and improvedtransparency inpublic finance, due to reforms incritical areas also with the assistance of the World Bank and the IDB. 142. Important initiatives include adoption of the Public Administration Renovation Program (PRAP), which includes anti-corruption and fiscal responsibility measures3'. The government that took office in August 2002 has also improved the administration of publicly owned banks, 30 The government enacted an important Fiscal Transparency and Responsibility Law in 2003, and strengthened the disciplinary code for public servants. 44 clarified responsibilities for managing expenditures among different levels o f government, and introduced modern accounting concepts and procedures. These initiatives were supported by the rollout of new information systems covering the budget and local government finances, as well as the monitoring ofpublic procurement. 143. The Bank, incoordinationwith the IDB, carried out a CFAA for Colombia in2003-2004. The CFAA was coordinated with the IBRD's PER and 2003 Fiscal and Institutional Adjustment Loans (FIAL), and the IMF's May 2003 Fiscal Transparency Report on Standards and Codes (ROSC), which cover other aspects of Colombia's fiscal management. Official delivery of the CFAA to the Government took place inApril 2005, and dissemination events are being organized for the last quarter of 2005. 144. This diagnostic review pointed to a series of important advances but also remaining weaknessesinpublic sector management inColombia. 145. The country has made progress inmodernizing and automating its PFM and information systems, especially with regard to the Integrated Financial Management System (SIIF) implementation. This progress has been uneven, however, and the government lacks an integrated vision of an overall PFM system. To remedy this shortcoming, the Inter-Governmental Policy and Information Management Committee was created. 31 These problems and a lack of accountability for results have limited the quality and effectiveness of public financial management. Budget formulation i s also fragmented, which prevents the budget from beingused as a strategic governance tool. These problems have made PFM responsibilities diffuse, and duplication and overlapping agency responsibilities prevent the govemment from setting and .achieving clear PFM goals. 146. Planned revisions to the Organic Budget Code should be used to strengthen budget programming and control by establishing a new mechanism to coordinate expenditures across a medium-termframework that takes into account financial programming goals and anticipated `resource availabilities. Also, the implementation o f the single treasury account and the direct payment to suppliers would improve the management of cash on hand and inbanks, and increase the transparency of the system. 147. The Treasury Directorate's SIIF-which includes budget, treasury and accounting modules-registers and incorporates timely and reliable information on the expenditure process. The government has also developed a National Systemfor Results Evaluation (Sistema Nacional de Evaluacidn de Resultados, SINERGIA) to evaluate the results o f public expenditures, and begun implementing a program to strengthen and integrate the financial information systems for local government bodies. (Programa para el Fortalecimiento del Sistema de Informacidn Financiera Territorial, FOSIT.) Additional programs aim to track procurement and other financial information. 148. In recent years, the government has made important progress in building its debt management capacity through technical and institutional strengthening o f the Finance Ministry and implementation of a new public debt information system. The 2003 Fiscal Responsibility and Tiansparency Law strengthened regulation of sub-national government indebtedness, although this still requires attention. Furthermore, the govemment has put in place an information system to register contingent liabilities on national, sub-national, and public works 31 Decree3816, dated 12/31/03. 45 contracts. The system includes the creation and operation of contractual contingency funds. All operations are inthe public domain, and information on debt i s publishedon a regular basis. 149. Under the 1991 Constitution, fiscal control is vested inthe external and internal control comptrollers are in charge of external audits, and each public entity has an internal control unit . systems. The Comptroller General, Colombia's supreme audit institution, and the regional The fiscal control system also includes the Auditor General, who i s responsible for supervising administrative management of the regional comptroller offices. IDB i s supporting a multi-year project to modernize the Comptroller General's Office and improve its audit capacity through training and improved information technology systems. 150. Based on the CFAA conclusions, Colombia's country fiduciary risk rating i s moderate. The CFAA examined the risks posed by weaknesses inpublic financial management systems, the way inwhich public resources flow in the system, and the strength and reliability of the control framework appliedto financial transaction^^^. 151. The administration of projects financed with Bank and IDB resources has generally been satisfactory, although government fiscal adjustments cause problems in providing counterpart resources, and restrictions inexpenditure and cash flow management. 152. PFM improvements already under way in Colombia or triggered by the CFAA action plan recommendations, and the implementation of the Bank-financed Public Financial Management Project I1(MAFP II), are all consistent with the Government's long-term focus to improve and modernize public sector management and are expected to contribute reasonable fiduciary assurance as the Bank shifts increasinglyto development policy lending. 153. The Bank has reviewed the IMF's latest assessment of the borrower's Central Bank, which shows that the control environment of the BdR i s satisfactory. No remedial actions are necessaryinterms o f foreign exchange fiduciary arrangements. DISBURSEMENTAND AUDITING 154. The IMF Safeguards Assessment of the BdR concluded that the control environment, procedures and regulations governing the bank's operations are generally adequate. The Bank will disburse the loan proceeds into an account o f the Central Bank denominated inU S dollars. The Central Bank will immediately credit the disbursed amounts to the Ministry of Finance's Treasury Account, thus becoming available to finance budgeted expenditures. Within a week of the disbursement, the Ministry will accordingly provide the Bank written confirmation of the transaction. If, after deposit in the Central Bank, loan proceeds are not treated as described above, the Bank will requirethe Government to promptly refund the disallowed amount. 155. The administration of this Loan will be the responsibility of the MHCP. Although an audit of the deposit account will not be required, the Bank reserves the right to require audits at any time. 32The moderate rating is based on a fiduciary risk assessment framework o f 10 good practice principles and 20 benchmarks for assessing adherence to them developed by Britain's Department for International Development (DFID). The CFAA team assessed how actual practice in Colombia measures against the benchmarks for eachprinciple. 46 ENVIRONMENT 156. The reforms supported by the proposed Loan are not expected to have any significant effect on the environment. RISKS 157. The proposed operation supports an institutional development effort widely perceived as necessary, and which the Government i s already actively implementing. Therefore, there i s little risk that the actions requiredfor presentation to the Executive Board are not taken and that the indicative triggers for the preparation of the next operationare not reached within the twelve months following the effectiveness of this proposed operation. However, there are some risks associated with the effective implementation of the institutional and regulatory reforms supported by the proposed DPL. The most relevant risks are the following: 158. There i s the risk that effective implementation of mechanisms for inter-institutional collaboration and coordination in support of entrepreneurial activities will be hampered by inter-agency rivalries. This risk i s mitigated by the strong commitment o f the Government to the rationalization of bureaucratic procedures, as demonstrated by steps already taken to streamline export and business procedures. Also, under the proposed operation, the GoU would commit to prepare semi-annual reports on the progress of streamliningbureaucratic procedures. 159. There i s the risk that the merger of the Superintendency of Banks and Superintendency of Securities into one Financial Superintendency will prove to be a difficult and lengthy exercise. There are usually difficulties involved in merging independent bureaucracies with different cultures and approaches to supervision. There i s also the risk that other important projects, such as the SARC project, are halted or would not receive enough attention or resources from the financial sector authorities, and the risk that, after the formal institutional merger, efforts to complete the much more difficult stage of mergingthe supervision processes fade away. However, there i s strong consensus on the advantages of having one regulatory agency for the financial sector inColombia. 160. There i s the risk that measures to increase access to financial services will take a long time to produce results. Increasing access to financial services by the poor and MSMEshas proved to be very difficult inmost developing countries. The proposed operationwould support some initial actions towards this objective. The policy dialogue that accompanies the preparation of this DPL series and the concurrent financial sector AAA i s supporting the GoC's efforts to buildingthe consensus among different stakeholders on a roadmap of reforms to increase access and diversity of financial products that will lead to specific policy actions to be supported under the next two loans o f this DPL program. 161. There i s the risk that political uncertainty produced by the upcoming elections and adverse developments in the security situation will delay the implementation of important institutional and regulatory reforms. Presidential elections will take place in May 2006. By November 2005, the Constitutional Court will decide on the validity of the approval process for the recent constitutional amendment to allow presidential reelection. Ifthe amendment i s deemed valid, Congress will still have to discuss the electoral rules to which the incumbent president will be subject. But if the Court overturns the amendment, political uncertainty will increase, and the search for candidates within the parties will have higher stakes attached. Furthermore, most analysts expect at least a moderate deterioration of the security situation inthe period leading to the elections. 47 162. And finally, there is a riskthat Colombia's currentlevelof public debt could pose a risk for macroeconomicstability. On the basis of the sustainability analysis undertaken here, levels appear to be manageable in the near term, even when considering possible adverse economic shocks. And the debt level has fallen from a peak of 54 percent of GDP in2002 to 46.6 percent now. But current levels remain high, imposing a heavy fiscal cost and exposing the country to financing vulnerabilities. 163. A mitigating factor with respect to this uncertainty is that the reform program supported by this proposedDPL has, in good part, been widely discussed with key stakeholders under the umbrella o f discussions carried out duringthe negotiations of the TLC. Thus, even ina potential climate of political uncertainty, the social and political commitment exists to complete this reform agenda. 48 Annex 1: ColombiaAt A Glance Latin Lower- POVERTYand SOCIAL America middle- Colombia 8 Carib. income I Developmentdiamond' 2004 Population,mid-year(millions) 45.3 534 2,655 Life expectancy GNI percapita (Atlas method, US$) 1,920 3,260 1,480 GNI (Atlas method, US$billions) 87.0 1,741 3,934 T Average annual growth, 1998-04 Population(%) 1.8 1.5 0.9 Laborforce (%) 2.5 2.1 1.2 GNI per Most recent estimate (latest year available, 1998-04) capita Poverty(% ofpopulationbelownationalpovertyline) 64 Urban population(% of totalpopulation) 77 77 50 Life expectancyat birth (years) 73 71 69 1 Infantmortality(per 1,000live births) 23 28 32 I Child malnutrition(% of childrenunder5) 7 11 Access to improvedwater source Access to an improvedwater source (% ofpopulation) 91 86 81 -- Illiteracy(% ofpopulation age 15+J 8 11 10 Gross primaryenrollment (% of school-age population) 112 129 112 Colombia Male 112 131 113 i - Lower-middle-incomegroup Female 112 126 111 KEY ECONOMIC RATIOSand LONG-TERMTRENDS 1984 1994 2003 2004 Economicratios. GDP (US$ billions) 38.3 81.7 80.0 97.4 Gross domestic investmentlGDP 19.0 25.5 18.1 19.0 Exportsof goodsand servicedGDP 11.9 15.0 20.4 20.5 Trade GrossdomesticsavingslGDP 18.4 19.6 15.7 17.1 Gross nationalsavingslGDP 15.2 21.2 15.6 16.6 T Currentaccount balancelGDP -5.4 -4.5 -1.5 -1.1 InterestpaymentdGDP 1.6 1.8 2.6 2.0 Total debtlGDP 31.5 26.9 41.3 40.4 Total debt serviceiexports 33.8 45.3 52.4 39.6 Presentvalue of debtlGDP Presentvalue of debtlexports Indebtedness 1984-94 199404 2003 2004 2004-08 (average annualgrowth) GDP 4.3 1.5 4.0 4.0 4.0 UUI Colombia GDP percapita 2.3 0.3 2.3 2.3 2.6 Lower-middle-incomearow Exportsof goods and services 9.4 4.2 4.6 9.2 1.3 STRUCTUREof the ECONOMY (% of GDP) Agriculture 17.8 16.1 12.1 11.5 Industry 34.0 31.4 29.3 30.7 *O Manufacturing 22.6 16.1 14.2 14 3 Services 48.2 52.5 58.6 57.8 ::: Privateconsumption 70.6 65.7 63.6 62.4 401 General govemmentconsumption 11.0 14.7 20.7 20.5 Importsof goods and services -GDI - O ' G D P 1984-94 lgg4-04 2004 I Growth of exports and imports (%) laveraoe annual-arowth). Agricuiure 2.2 -0.2 2 4 industry 4 2 -0.3 6.3 Manufacturing 2 4 0.2 3.5 4.1 Services 4.2 5.4 3.2 4.0 Privateconsumption Generalgovemmentconsumption Gross domestic investment 5 1 -33 216 133 --Exports -+-Imports Importsof goods and services 105 0 0 101 167 Note: 2004 data are preliminaryestimates. *The diamonds show four key indicatorsin the country (inbold) comparedwith its income-group average. If data are missing,the diamondwill be incomplete. 49 Colombia PRICES and GOVERNMENTFINANCE 1984 1994 2003 2004 Domesticprices inflation (Oh) 1 (% change) Consumer prices 16.0 22.6 6.5 5.5 Implicit GDP deflator 22.2 45.4 8.2 7.0 Governmentfinance (% of GDP, includes current grants) Current revenue 7.8 11.6 13.7 14.4 99 W 01 02 03 Current budget balance -1.2 1.5 -4.6 -4.9 Overall surplusldeflcit -2.6 -1.4 -5.3 -5.5 -GDP deflatar e C P I TRADE 1 1984 1994 2003 2004 (US$ millions) Exportand import levels (US$mill.) Total exports (fob) 3,728 8,816 12,812 16,216 I R nnn _,___- Coffee 1,765 1,990 806 950 16,000 Petroleum 480 1,313 3,383 4,180 14,OW Manufactures 638 2,803 4,801 6,413 12,OW 10,ow Total imports (cif) 4,492 11,927 12,792 15,324 8.000 Food 207 923 1,417 1,554 6,000 Fuel and energy 468 308 239 262 4,000 "1 Capital goods 1,587 5,072 3,671 4,110 2,000 0 , . . Export price index (1995=100) 14 85 90 92 96 99 W 01 02 03 Importprice index (1995=100) 13 86 95 89 IW Exports W Imports Terms of trade (1995=700) 102 100 94 103 BALANCE of PAYMENTS I 1984 1994 2003 2004 (US$ millions) Current account balanceto GDP (%) Exportsof goods and services 4,557 10,630 15,572 19,146 * T Importsof goods and services 5,407 13,914 16,650 19,737 Resourcebalance -850 -3,284 -1,078 -592 Net income -1,537 -1,453 -3,446 -4,185 Net currenttransfers 309 1,069 3,334 3,667 Current account balance -2,078 -3,668 -1,191 -1,110 Financingitems (net) 2,470 3,474 1,375 -1,431 Changesin net reserves -392 194 -184 2,541 Memo: Reservesincluding gold (US$ millions) .. 7,862 10,921 13,540 Conversionrate (DEC, local/US$) 100.8 826.5 2,877.7 2,628.6 EXTERNAL DEBT and RESOURCE FLOWS 1984 1994 2003 2004 (US$ millions) Composition of 2004 debt (US$ mill.) Total debt outstandingand disbursed I 12,039 21,940 33.011 39,359 IBRD 1,578 2,829 3,241 3,490 IDA 19 12 5 5 G 3,865 A 3,490 Total debt service 1,623 5,570 8,824 8,152 IBRD 274 1,054 344 346 IDA 1 1 1 1 Compositionof netresourceflows Official grants 15 45 0 0 Official creditors 618 -467 1,168 242 F 15,133 D 15,639 Privatecreditors 748 2,284 -1,981 -2,145 Foreigndirect Investment 584 1,446 837 1,265 Portfolioequity 0 478 E 1227 I World Bank program Commitments 740 159 905 687 A IBRD - ~ E Bilateral Disbursements 462 310 948 491 B IDA D Other multilateral F Private Principal repayments 153 837 224 206 C IMF -- G Short-term --- Netflows 308 -527 724 285 interest payments 121 218 121 141 Nettransfers 187 -745 603 144 50 Miniftcrio do Hucienda y CrtditoPirbku DcpattamentoNncional de Ptncrcibn Bogota O.C., September 16,2005. Mr. PAUL WOLFOWITZ President World Bank Washington, D.C. DearMr. Wolfowitz: The Govemment of Colombia remains fully committed to the integration of the country into the world economy through bilateral and multilateraltrade agreements. This process also requires a series of domestic reforms which, with the support of the I multilateral banks, will make it possibleto establish the financial, regulatory and business environment best suited for honing the competitiveness and productivity essential for performing effectively in the international markets. More specifically,the Government is committed to developing policies for promoting business development, enhancing the efficiency of the financial sector and expandingaccess to both the capital market and the secondarymarket. Inthis way, the ProgramLoan in Support of the Development and Efficiencyof the Business Sector will be converted into one of the most importanttools for actually bringing these changes about. From the start of the present administration, the business and financial sectors have played a major role in devising a strategy which, together with economic and fiscal stability, will help to improve the population's living standards by heighteningthe tempo of economic activity and that of the capital market, thereby helping to redistributeresources,increaseemployment and lower the poverty indexes which have been risingin recent years. Internal security, the building of social equity, and economic recovery are the Government's highest priorities and for their accomplishment it is necessary to continue supporting the concluding of trade agreements and, consequently, the construction of a morecompetitiveeconomy. All of this must be done as part of the presidential strategy set forth inthe DevelopmentPlanand with due and strict observance of the principlesof fiscal austerity and institutional strengtheningwhich have characterized this Government from the momentit took office. 51 Ministerio de Hncicndny CrCditoPliblico Kcpliblrcade (:olombia DepartamentoNacional de PLneacMn libertod y Orden Under the current administration, the World Bank has supported the country in setting up and implementing both specific and general investment programs, which have generated significant impacts in the process of strengthening of the market economy in different sectors. As a result, and with the backing of the sector program and of other subprograms, this administration, and more specifically the entities involved in the business and financial reform process, feel justifiably proud of the success posted in the implementation of the policy measures applied in this first phase of the program. The foregoing reflectsthe commitmentof each of the entities in strivingtoward accomplishment of the goals and encourages the country to embark upon similar programs that will also havea favorable impact in a time of fiscal adjustmentand restraint. The annexed document is designed to set out for the Bank the progress achieved under each of the policy measures, together with the new initiatives that are being implemented in the sector. It is truly gratifying for the Government to complete the third year of its term of office with the assurance of the support of the World Bank for the reformsin place and with great expectations of those yet to be carried out. In conclusion, the Government is committed to the program presented in this document and is most appreciative of the World Banks assistance and financial support. The Government will be grateful for prompt consideration by the Banks Executive Board of a ProgramLoaninSupport of the Developmentand Efficiencyof the Business Sector in an amount of US$250millionfor fiscal 2006. Sincerely, ALBERT0 CARRASQUILLABARRERA MONTENEGRO TRUJILLO Ministerof Financeand PublicCredit SANTIAGODirector General National PlanningDepartment 52 REPUBLIC OF COLOMBIA Ministryof FinanceandPublic Credit NationalPlanningDepartment Letterof Policy PROGRAMLOANINSUPPORT OF THE DEVELOPMENT AND EFFICIENCY OF THE BUSINESS SECTOR BogotiD.C., September 16,2005 53 TABLE OF CONTENTS I. TheMacroeconomicSituation.. ............................................................... .5 11. The Program Loan in Support of the Development and Efficiency of the Business Sector ..................................................... ..8 A. Objectives.,, ....................................................................... 8 B. Development of the Business Sector. .................................... 8 C. Deepening and Efficiency of the Financial System.. ...............10 D. Access to the Capital Market and Efficiency of the Secondary Market .............................................................................. 12 54 I. The MacroeconomicSituation 1, After passing through a severe recession in 1998 and 1999, the Colombian economy has been experiencing a rapid recovery that i s reflectedinthe increasedrate of growth of the domestic product and the dynamism of the private sector. Inaddition, the reduction of the total public debt33over the past two years has improvedthe solvency of the public sector. 2. This process has also been fostered by the significant achievements in the fiscal sphere, which have been reflected in the improvement in financial terms and conditions and have restored investors' confidence. 3. During2003 the growth of the economy gathered momentum, rising from 1.9 percent in2002 to 4.1 percent in 2003. This growth i s consistent with the economy's potential long-term growth. For its part, economic growth in2004 was also 4.1 percent. 4. This level of growth was spurred in large part by the dynamism of domestic demand. In point of fact, in 2003 domestic demand posted an increase of 5.2 percent and repeated this vigorous performance in 2004 with 5.3 percent. The rise in domestic investment coupled with the favorable external economic conditions benefitedall sectors of the economy and also had a positive impact in the employment arena; the 2004 unemployment rate was 13.6 percent, i.e. down from the 2003 figure of 14.2 percent. 5. For 2005 it i s expected that the favorable conditions that prevailed inthe precedingtwo years will remain in effect and will help consolidate the growth of domestic demand, which, combined with the robust performance of the external factors connected with demand and terms of trade, would enable the economy to grow by 4 percent. 6. The dynamic growth has not created excessive pressures ineither the market for goods or as regards external financing. Inthe case of the market for goods, inflation in2004 was running at 5.5 percent, which was one percentage point below the 2003 rate. On the domestic financing side, the current account deficit stood at 1.1 percent of GDP in 2004, hence lower than the 1.5 percent of GDP posted in2003. These factors make it likely that the reactivation process will continue ina sustainable fashion. 7. The fiscal deficit dropped from 2.7 percent of GDP in2003 to 1.3 percent of GDP in2004, in other words it shrank by 1.4 percent from the one year to the next. These results as regards the fiscal deficit were the product o f the great effort made by all the public sector bodies and agencies. Special mention must be made here of the unusually high surplus posted in the regions and local governments sector, which was due to an improvement in tax revenues and the sums brought in by royalties, plus a lower execution rate o f local government expenditures. 33The total public debt takes into account both explicit and implicit debts. Inthe latter category the largest debt is that formed bypension obligations, the recent evolution of which served to consolidate the reduction ofthe total debt. 55 8. The positive results flowing from the fiscal policy applied played a very important role inthe accomplishment of a better macroeconomic equilibrium and in the meeting of the fiscal targets. This made it possible to achieve the goal set in the agreement with the IMF of bringingthe Consolidated Public Sector deficit down to 1.3 percent of GDP. The increase in GDP, the vigor of the public sector primary balance and the positive impact on interest rates as a consequence of the preceding two factors brought about a reduction of the net debt in external financial assets of the Non-Financial Public Sector, which declined from 54.1 percent o f GDP in 2002 to 51 percent in 2003 and 46.6 percent in 2004, i.e. to 4 percentage points below the level projectedinthe medium-termfiscal planning. 9. This reduction of the Non-Financial Public Sector debt as a percentage of GDP signaled a break in the trend posted in recent years which, if it had continued unchecked, would have represented a serious threat to the Government's solvency. 10. On the external front Colombia's position remains sound, which has made it possible to maintain the current account balance and increase the country's holdings of international reserves, which stood at US$15,285.66 million on September7, 2005. 11. The fiscal deficit target, which was 2.5 percent for 2004, was revised downward to 2.2 percent o f GDP as a result of the savings inthe FAEP deriving from higher oil prices. 12. The fiscal deficit target agreed with the IMF for 2004, namely 2.2 percent of GDP, was met; at the close of the year a cumulative Consolidated Public Sector deficit of 1.3 percent of GDP was posted. This was the outcome of the continuation of the Central National Government's adjustment policy and of an improvement inthe Decentralized Public Sector. For its part, the Central National Government ran a deficit of 5.5 percent of GDP, which reflected a more vigorous tax collection effort. 13. The fiscal target for 2005 has been set at 1.6 percent of GDP. This target i s consistent with the reduction of the Debt/GDP ratio of the Non-Financial Public Sector which permits attainment of sustainability of the public finances inthe mediumterm. 14. In2005 a deficit of 5.5 percent of GDP i s expected for the Central National Government. This higher deficit compared with 2004 is attributedto the larger outgoings on pensions as a result of the exhausting of the Social Security Institute's reserves. Incontrast, a reduction of 0.6 percent of GDP i s projected for operating costs and capital expenditure, as part of the Government's fiscal adjustment policy. 15. For 2006, a Consolidated Public Sector fiscal deficit in the region of 2.0 percent of GDP is expected. 16. The Government's program remains aimed at ensuring fiscal sustainability, restoring security, recovering economic growth and increasing social equity. To this end it will continue implementing the measures required for these objectives to be achieved within a context of macroeconomic stability underpinned by prudent monetary policies and the strengthening of the financial system, in conjunction with social assistance programs. Coverage in education and health will also be increased and steps will be taken to mitigate the impact of higher tariffs for public services on the poorest segments o f the population. 56 17. The Government is therefore aware o f the urgent necessity o f moving ahead with the structural-reform plan, which i s designed to ensure continuity of the policy of gradual fiscal adjustment and guarantee that adequate primary surpluses are obtained that will make the long-term debt sustainable. 18. 18. In this context the legislative agenda aims to tackle the main fiscal risk, which i s pensions. The steps envisaged to bring this risk under control are aimed at containing the expenditure pressures by making modifications to the pension system in order to prevent future fiscal stresses. The important points contained in the Legislative Act which had its final readingon June 17, 2005, include: - Establishing25 current legalminimumwages as the ceiling amount for a -pensionwithofthe exceptedand special pensionsystems with the exceptionof effect from July 31,20 10. Elimination the one applicable to law enforcement personnel, with effect from July 31, - 2010. Elimination of the 14thMonth for new pensioners, except for personswho receive a pension equal to or less than three (3) current monthly legal -minimum wages, if suchpensions go into effect prior to July 31, 2011. Anticipationof the termination of the Law 100transitional system on July 31, 2010, with the exception of workers covered under said system and who will have contributed for at least 750 weeks or the equivalent in service time upon the entry into effect of the LegislativeAct in question, for whom said system would be maintainedup till the year 2014. 57 19. The legislative agenda for matters other than pensions have considered certain other important topics such as: - Analysis and approval ofthe initiative bymeans ofwhich rules will be laid -downon Juridical Stability for standardizing the State's portfolio. Law - (Lawon Stock Market 963, july 8, 2005). Law (Law 964, july 8, 2005). 11. The FirstProgramLoaninSupport of the Development andEfficiencyofthe BusinessSector A. Objectives 20. The purpose of the program for the development and efficiency of the business sector, to be financed with non-earmarked funds from the World Bank, i s to assist the Government of Colombia insupporting the productive sector inmodernizing and strengthening its productive capacity and facilitating access to technology, sources of financing and markets for its products. 21. To accomplish this objective, the Government i s implementing a set of structural measures that will make it possible: (i) to support the businessrecoveryprocess, and (ii) consolidate to the process of adjustment and modernization of the productive sector by preparing it to meet intensifying internationalcompetition. B. Developmentofthe BusinessSector 22. One o f the current administration's policy objectives i s to ensure a more competitive and dynamic economy that will be capable of driving sustainable economic growth and strengthening the regional capabilities for meeting competition in both the domestic and external markets, generating employment and promoting greater social cohesion. 23. With the liberalization of the markets for goods and financial services coupled with the opening up to international capital flows, state intervention has been channeled toward regulation and control, the elimination or reduction of market weak points, provision of public goods and, in the specific sphere of business development, to the creation of an environment conducive to private sector development. 24. The State's intervention in business development i s focused on preservation of an environment that favors productive investment in enterprises and fosters their efficient functioning. To this end the National Government has implemented policies and strategies that provide entrepreneurs the support they need for modemizing their enterprises and strengthening their productive capacity while facilitating access to technology, know-how, sources of financing and markets for their products. 58 25. To maximize the benefits from the implementationof business support policies, inApril 2004 the document Conpes 3280 was submitted. It sets out the strategy for improving the competitiveness of Colombian enterprises and the steps which the National Government should take, which include the following: 1. Public support for restructuring and modernizingthe productive apparatus. 2. Promotion of investment, by means of: (i)submission of a draft law requiring adoption of internationalaccounting standards; (ii) submission of a draft law to bring the institutional and regulatory framework of the capital market into line with present-day requirements; and (iii) promotion of investor participation by means of an InvestorProtectionLaw. 3. Optimization of the public business support programs, based on inter-institutional coordination, development of evaluation and monitoring systems and better targeting o f interventions. 26. In addition and in pursuance of the role of state intervention, the National Government has sought to establish a favorable environment for productive development. Along these lines the establishment of a more efficient State through the Public Administration Renewal Program (PRAP) and specifically the Business Formalities Rationalization Program seeks to reduce the costs incurred by enterprises in having to wade through needless procedures and formalities for the establishment, functioning and operation, and shutting down of enterprises. 27. The formalities rationalization and automation project set forth in document Conpes 3292 outlines the following strategies: Evaluate and eliminate the formalities for which there i s no legal justification and which generate additional costs for entrepreneurs and citizens, while being time- consuming or conducive to dishonest behavior on the part of the officials, citizens or entrepreneursconcerned. Rationalize the formalities that adversely impact the efficiency and management of the entity or agency (bottlenecks, duplicated information requirements or additional costs). Rationalization o f a formality presumes redesign o f the procedures, reducing to a minimum the requirements and burdens for citizens in terms o f both time and money. Automate those formalities which for legal and technological reasons and on grounds of convenience for the authority concerned and for the user, can be completed, fully or partially, by electronic means. 28. As a result of the Government's action inthis matter, the proposed Anti-Formalities Law was submitted to Congress and approved as Law 962 of July 2005. Establishment of the implementing regulations for this law i s a priority action step for accomplishment of the objectives of public support for the business sector. 59 C. Deepening and Efficiency of the Financial System 29. With effect from 2002 the financial sector has demonstrated a significant recovery following the difficult situation experienced at the end of the 'nineties. As a result, it can now be asserted that the risks inherent in financial business have diminished and that the financial sector has achieved appreciable levels of soundness and solvency, warranting the assumption that the system can today be considered stablewith positive growth prospects for the future. 30. This trend has been consistent with the performance of the Colombian economy, which has continued to gain strength within the context of a favorable external environment. The National Government's unremitting efforts to foster reactivation o f the various sectors o f the economy and of the financial sector inparticular have been key factors inthis respect. 31, The Ministry of Finance and Public Credit has undertaken various actions, adopting certain measures of a regulatory nature and conducting analyses and evaluations concerning a number of aspects considered highly important for modernizing and strengthening the financial system, injecting flexibility into the current rules and regulations and introducing new instruments to protect public confidence inthe financial entities. 32. In this context, the oversight and control of the financial apparatus which seeks to verify compliance with the body of organizational, economic and prudential rules laid down in connection with the financial institutions to ensure the proper functioning of the payments system and the very stability of the institutions, while also assuring that the rights of private individuals are not violated, has become apriority of the Government's policy. 33. This being so, the supervision exercised implies for the State the instituting of a system for monitoring the evolution of each one of the credit institutions and of the system as a whole to verify that their operations are above board and to be certain of their financial stability. At the same time, the State must also adopt any corrective measures called for and penalize behaviors inconsistent with the legal and financial rules laid down. 34. Inour market the actions of the different Superintendencies are overlapping, which gives rise to undesirable regulatory trade-offs and differentiated treatments for parties who, while admittedly of differing natures, perform very similar activities. Clear evidence of this situation is h i s h e d by the present regulatory differences with respect to the administration of collective portfolios by the trust companies, in their capacity as entities overseen by the Superintendency of Banks, and the activity of the stockbrokerage companies, which are supervised by the Superintendency of Securities. 35. In light of the foregoing, the Government, through its competent agencies, conducted a review of the financial supervision system. Subsequently, and on the basis of the findings of the studies made, it decided to merge the Superintendency of Banks and the Superintendency of Securities, implementing a set of actions necessary for integrating supervision of the market, whether its activities are carried out through intermediaries or not, inorder to have a consolidated system o f oversight and supervision. 60 36. An initial stage has been completed and it is now clearly apparent that the benefits of combining the two Superintendenciesare to be found ineconomies of scale and scope for the parties and for the State itself as regards exercise of the supervision function. In addition, having a single supervisory entity will facilitate oversight of the financial groups as a whole, reduce trade-offs in regulation and supervision without departing from the parameters established in our rules, and give the market greater transparency and responsibility, among other things, which will be reflectedinbenefits for the system. 37. Also with a view to deepening and strengthening the financial system, rules have been introduced that will help to bring the financial legislation into line with the market's requirements, taking into account international practices and the conditions of our economy, with the aim of democratizing credit, protecting the savings of the public and investors, and endowing the market, whether operating through intermediaries or not, with a body of stable and clear rules that further the attainment of the objectives of intervention. 38. This being the case, the technical parameters have been established for determining the minimum solvency ratio, technical capital and technical reserves of the National Guarantee Fund. Establishingthe parameters, while bearing inmindthat the purpose of the Fund is to guarantee the lending operations of the financial institutions with the users of their services, entailed establishing specific definitions concerning these aspects and regarding the market risks and guaranteesand their administrationsystems. 39. On the other hand, the entities which administer small-payments systems have been made subject to inspection, supervision, and control as well, with a view to ensuring that their operations are carried out in a suitably secure and transparent fashion and that no risks are involved that could affect the stability of the financial system. Principles and rules have accordingly been established which ensure their efficiency, security, integrity, reliability, technological development, interconnection, transparency, free competition, and respect for and equal treatment of consumers. 40. The Colombian authorities have also continued working on verifying and updating the regulations connected with prevention, detection, and control of asset laundering, in order to strengthen the mechanisms inplace for the purpose. 41. Finally, and after monitoring and support activities over an extended period of time, the Government's Equalization Fund bill has been converted into a Law of the Republic (Law 920 of 2004). This law includes topics o f great importance for the Government, particularly as regardsthe points connected with the funds' financial activity, given their dynamism inthe market as instruments for assistance to low-income groups. It was therefore necessary to implement the prudential rule applicable to these types of entities, which constitute specialized savings and loan sections, inorder to make the law applicable. 42. This being so, the authorities have been working on regulation of the points relating to minimum capital requirements, solvency ratios, credit and market risks, classification and weighting of assets, liquidity funds, and other related rules that will enable these entities to operate inconditions of security and transparency. 61 D. Access to the Capital M a r k e t and Efficiency of the Secondary M a r k e t 43. The phenomenon of the globalization of markets requires that the regulation of them be brought into line with international practices and trends. In the same way, the competition and the new technologies in the information technology and communications spheres have enabled a breathtaking development of stock markets worldwide, bringing with it in its turn the need to adjust the regulatory arrangements to the new forms o f business and the new risks involved. 44. Accordingly, the Ministry o f Finance and Public Credit, through the Directorate General of Financial Regulation, took responsibility for steering through Congress the proposed Stock Market Law, which regulates the management, use and investment o f the public's funds through securities and i s designedto provide the Colombian stock market with an appropriate and efficient regulatory framework that will permit greater levels of growth, alternatives to the traditional sources of business financing and, principally, with a clear frame of action for all participants coupled with the legal security necessary for bringing national and foreign investors together plus the needed flexibility for facilitating adjustment of the rules and regulations to the continuous innovations inthe market. 45. The proposed law was adopted by Congress and is today a law of the Republic. Work i s currently inprogress on identifying the articles and aspects that will have to be regulated in order to make them applicable to many of the points contained in the law, and especially those relating, inter alia, to supervision, the integrated information and contributions system, the system for clearing and settling operations and the depositing of securities, and the arrangementsfor protecting investors. 46. Inaddition, attention has been paid to developing strategies connected with the supply of and demand for securities and the prudential rules applicable to the entities subject to inspection and supervision by the Superintendency of Securities. An important rule issued by the Superintendency of Securities is the one relatingto private capital funds. 47. With the aim of spurring the development and enhancing the efficiency o f the mechanism for attracting and administering funds inthe public securities market, regulations have been laid down connected with funds basedon securities and investment funds while the private capital funds have been established to meet the need for developing a new investment vehicle and devising alternative mechanisms for business financing. In this connection, the general requirements have been established for creating these funds, the minimum amount to be contributed and provisions concerning corporate governance, among other things. 48. Furthermore, work has been underway, in coordination with the Superintendencies of Banks and Securities and the Bank o f the Republic, on the revision and standardization o f the market for loans, repossession and temporary transfer o f titles, and also on expansion of the short-term return obtainable on same. This, because the Colombian money market i s very small and devoid of dynamism due to people's lack of confidence insuch transactions, which has prevented more vigorous development of the derivatives market since one of the prerequisites for such development i s the presenceof sufficient underlyingliquidity. 62 Annex 3: Debt Sustainability Analysis Debt Sustainability Analysis. Colombia's present level of public debt, at about 46.6 percent of GDP (down from a peak of 54 percent in 2002) remains relatively high. But it appears manageable in the near term even when considering possible adverse economic shocks. Many recognize (including the government) that debt needs to decline further as a share of GDP, due to its high fiscal cost and the financing vulnerabilities to which it exposes the county. The government's target i s to reduce the level of debt to 38 percent of GDP by 2015. We analyze the debt prospects in four different ways: i)a baseline projection with historical average values of key parameters; ii)an analysis of policy responsesthat would be necessary for the government to meet its debt reduction target in the face of possible economic shocks; iii)projections of what would happen to debt ratios if economic shocks hit but there were no fiscal policy response, and iv) an analysis of the sustainability of total public plus private extemal debt. (A full description of the analytical work is available from the CMU). The baseline scenario makes the following key assumptions: 0 Historical average real GDP growth of 3.2 percent, which i s below last year's growth of 3.7 percent 0 A primarybalance o f2.1 percent. Last year it was 2.9 percent, but this includes one percentage point surplus from subnational governments and public entities, which i s not be readily available to service the debt 0 30 percent depreciation of the real exchangerate, bringingit back to its historical average over a five year period beginningin200534 0 An average implicit real interest rate on domestic and extemal debt of 6.3 percent, which i s currently 6.4 percent. Inthis scenario, the government achieves its target ofreducingthe debt ratio to 38 percent inten years. The second and third sets of scenarios add three adverse shocks to this baseline: an immediate depreciation of the real exchange rate by 30 percent in 2005 (instead of spread over 5 years), a reduction of growth to -2.1 percent for 2005 (two standard deviations from the average), gradually returning to its average by 2009; and a rise in the real interest rate to 8.6 percent in 2005, returning gradually to 6.3 percent by 2009. And there is also the combination shock, where all three adverse shocks occur. Ifthe government still wants to meet its target debt ratio for 2015, it will have to tighten fiscal policy from the baseline primary balance of 2.3 percent, up to 3.7 percent inthe case o fthe combination shock. Table 6 summarizes these different scenarios. 34 Since about half of Colombia's debt is foreign, mostly in U S $, the exchange rate has a large and instantaneous impact on the debt ratio. Inthe decline o f the debt ratio from its peak o f 54 percent o f GDP in2002 to 47.5 percent at the endof2004, the 30 percent real appreciationofthe exchange rate accounts for six o f the eight percentage points o f decline. The exchange rate is unlikely to retain all of this recent appreciation, so the government should continue with fiscal caution, despite the decline of the debt ratio. 63 Table 6 Debt Sustainabilitywith Shocks and Policy Adjustment Type of shock Primarysurplusrequiredto achieve the target debt ratio (38 percentby 2015) Baseline scenario (see above) 2.1% Real effective exchangerate depreciation o f 30 percent in 2005 with maintenance of other variables at the values 2.5% described inthe baseline scenario GDPgrowth shock: in2005 of historical growth average minustwo standard deviations (implies -2.1 percent growth). In2006, historical average minus one standard deviation (implies 0.5 percent growth). In2007, a growth 2.6 rate o f 1.5 percent is assumed, with 2008 of 2.5 percent. Afterwards the historical growth rate is assumed. All other variables are kept at the values o f the baseline scenario. Real interest rate shock. In2005, we assumea real implicit interest rate of 8.6 percent. Afterwards, it gradually declines to 6.3 percent. All o f the other variables are kept 2.4% at the values described inthe baseline scenario. Combination o f all three shocks 3.6% Ifthese shocksmaterialized andpolicyremainedpassive, with primary balancesunchanged at 2.3 percent, debt ratios would jump initially and then decline, but the government would not achieve its original target for reducing the debt ratio. With each of the individual shocks, the debt ratio would be below 45 percent by 2015. With the combination of all three shocks, the ratio would peak at close to 62 percent of GDP in 2008, then slowly fall to about 58 percent in 2015. This level of debt i s certainly high and would put considerable fiscal pressure on the government, but it is not explosive and could be contained by maintaining a primary balance of 2.1 percent of GDP, which is within the historicalexperience of Colombia (See Figure 8). 64 Figure 8: Debt SustainabilityEvenWithout a PolicyResponseto Shocks. 65.0% 60.0% 55.0% n 0 '6 1e!50.0% N ri 8 L --,45.0% P 2 40.0% 35.0% m 30.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Analyzing the sustainability of the external debt requires a model that incorporates another set of key macroeconomic variables, such as Colombia's current account, and allows us to model another set o f different shocks, particularly one to inward international capital flows. Total external debt service (public and private) remains one of the highest levels, as a percentage of exports of goods, services, and income, in Latin America. It has fallen from a high of above 67 percent in 2002 to more manageable levels of less than 40 percent now, but it i s still just below Argentina's 42 percent. Nonetheless, Colombia's total external debt profile (public and private) i s likely to be sustainable. Total external debt i s expected to decline to 36.1 percent of GDP under our baseline scenario. The primary risk associatedwith external debt sustainability i s exchange rate risk. A depreciation of the real exchange rate inexcess o f 30 percent within one year would increase the total external debt to GDP ratio from about 42 percent currently, to over 50 percent, generating a significant risk of market closer in the near term. A two-standard deviation drop in international capital inflows from the historical average would generate an increase inthe external debt to GDP ratio to about 46 percent, but this i s unlikely to generate a debt crisis. Total external debt reached nearly 48 percent in 2001 without a crisis, in an economic environment that was less favorable than today. A transitory peak of 46 percent total external debt would put pressure on financing, but i s expectedto be manageable. 65 - -I c a 66 5e, .-c 39h + a b s Y .- -a a b 67 t 68 Annex 5: Fundrelations note Public Information Notice (PIN) No. 05/62 International Monetary Fund May 9,2005 700 19thStreet, NW Washington, D.C. 20431 USA IMF Executive Board Concludes 2005 Article IV Consultation with Colombia On April 29,2005, the ExecutiveBoard of the InternationalMonetary Fund(IMF) concluded the Article IV consultationwith Colombia.' Background Since 1999 Colombia's economic policies have sought to strengthenthe economy inthe aftermath of the country's worst economic crisis in30 years. The strategy focused on fiscal consolidation, lowering inflation, and strengthening the financial system. The government that took office in August 2002 improved the fiscal positionthrough severalrevenue measures(a one-time wealth tax, an income tax surcharge, and a broadening of the VAT base) and expenditure restraint. Two pensionreforms were also adopted, reducingthe actuarial deficit o f the pensionsystemfrom 207 percent o f GDP to 187 percent of GDP. Other reforms focused on restructuringand downsizing the nonfinancial public sector, improving financial supervision, andprivatizing or liquidating the remaining public banks. Congress also approved inDecember 2002 a labor market reform to encourageemployment inthe formal sector. Inaddition, this administration established a policy knownas democratic security to try to resolve the civil strife. Initially the recoveryproceeded slowly but in2003-04 economic performance improved significantly: * Real economic growth recoveredto 4 percent a year in2003-04. The national unemployment rate declined from 20 percent at end-2000 to 12 percent at end-2004, while the poverty rate declined from almost 60 percent in 1999 to 52 percent in2003. - The combinedpublic sector deficit was reduced from 3.4 percent of GDP in2000 to an unexpectedly low 1.3 percent of GDP in2004, reflecting anunanticipatedrise inthe export price of oil to US$36 perbarrel and anunusually large surplus of the autonomous local and regional governments. This outturr-together with the real appreciation of the peso during2004-helped reduce public debt to 53 percent of GDP by end-2004. Also, public sector deposits reached 10.5 percent o f GDP by end-2004. Inflationdeclined to 5.5 percent during2004-the lowest level indecades-owing to the effective Q implementationof the inflation targeting framework. * The external sector strengthened, ledby sustainedgrowth inexports and a recoveryincapital inflows. During2004, the peso appreciated by 11percent inreal effective terms, prompting the central bank to purchase US$2.9 billion (about one-third o f the stock of base money) to limit the appreciation. By end-2004, net international reservesreached US$13.2 billion (123 percent of short- term external debt on a remaining maturity basis). - The healthof the financial system continuedto improve. The solvency andprofitability of the banking systemhave recovered, reflecting economic growth, a successful recapitalizationscheme, and improved supervision. Nonperforming loans declinedto 3.6 percent of total loans by late 2004 69 and were fully covered by provisions. The bank restructuring agency (FOGAFIN) continued to trim the government's participation inthe banking systemby selling several banks that were intervened in 1999.Progress continued inimplementingrisk-based financial supervision and actions to combat money laundering. Executive BoardAssessment Executive Directors commended the authorities' pursuit of sound macroeconomic policies and structuralreforms inrecent years, which has contributed to a significant improvement inColombia's macroeconomicperformance and social indicators despite a difficult security environment. Economic growth has rebounded; inflation, unemployment, and the public debt have declined; the balance of payments positionhas improved, inpart becauseof buoyant export growth; and confidence inthe economy has strengthened, as reflectedinincreased capital inflows, the appreciation of the domestic currency, and a lowered country riskpremium. At the same time, Directorsnotedthat unemployment, poverty, and the public debt remainhigh.In addition, while welcoming the reductioninthe foreign currency component of the public debt through the issuance of peso-denominated bonds ininternational capital markets, Directors emphasized that external vulnerabilities still loomlarge due to rollover and foreign exchange risks. They therefore welcomed the authorities' intentionto maintainthe strategy of fiscal consolidation and steadfast pursuitof structural reform inthe coming years, inorder to strengthen the foundations for economic growth and to further reduce inflation and the ratio o f public debt to GDP. Directors agreedthat the authorities' mainchallenge inimplementingthe economic strategy will be to maintain the pace of fiscal reforms. They considered the reforms currently before Congress-the revisedbudget code and the pension reform-to be important for containing expenditure growth and increasing the flexibility of expenditure management. However, they stressedthat several other reforms will be neededover the mediumterm, on bothrevenue and expenditure. Onrevenue, Directors welcomed the authorities' intention to continue to build support for a more efficient tax system while broadening the tax base and improving tax administration. They encouragedthe authorities to slow the increases inrevenue transfers from the central administration to subnational governments, and to strengthen fiscal coordination among the different levels of government. On expenditure, Directors called for a streamlining o f current expenditure to make roomfor more productive capital expenditure. They welcomed efforts to increasethe effectiveness of social spending through better targeting of subsidies to the poor. They also urgedadditional pensionreformto limit the expected rapidrise innet pensioncosts, and gradual deregulation of the domestic prices of gasoline and diesel over the mediumterm. Directors encouraged further improvements indebt management, especially by increasingreliance on domestic currency borrowing, to reduce vulnerabilities. Directors commended the prudent conduct o f monetarypolicy. They noted that the inflation targeting framework has helpedlower inflation expectations, and welcomed the authorities' commitment to reduce inflation to the range o f 2-4 percent a year over the mediumterm. Directors considered that the flexible exchangerate regime has served Colombia well. It has helpedmaintain Colombia's external competitiveness, as evidenced by the broad-based growth o f exports and the sustainable level o f the external current account deficit. Most Directors urgedthe authorities to guard against excessive foreign exchange intervention aimed at curbing the appreciation of the currency, as this could createuncertaintyregarding the objective of monetary policy, generate inflationary pressures, and raise quasi-fiscal costs through sterilization operations. They encouraged 70 the authorities to phase out, as planned, the temporary capital controls instituted inDecember 2004. Directors welcomed the improved managementof foreign exchange riskby the private sector, and encouraged the authorities to continue to facilitate the development of market-based hedging mechanisms. Directors commended the government's financial restructuring operations, which have helped strengthen the financial systemsince 1999.They encouraged continued efforts to improve financial supervision, as recommended inthe Financial System Stability Assessment Report. Key measures would include provision of sufficient autonomy to the Superintendency of Banks and adoption of risk-based regulations inline with the Base1I1core principles. Directors encouragedthe authorities to continue to reduce the role of the public sector inthe banking system, and, inthis regard, commended the decision to divest one large state-owned bank and to consider the divestment of another state-owned bank. They considered the new securities market law to be an important step toward deepening the domestic capital market, and urgedthe phase-out ofthe financial transactions tax and the bank stamp tax to promote financial intermediation. Directors welcomed Colombia's acceptance of the obligations of Article VIII, Sections 2, 3, and 4. They urgedthe authorities to establish a timetable for removingtwo remainingexchange restrictions. Colombia: SelectedEconomicIndicators 2000 2001 2002 2003 Prel. Proj. 2004 2005 (Annual percentage change, unless otherwise indicated) Nationalincomeandprices Real GDP 2.9 1.5 1.9 4.0 4.0 4.0 Consumer prices (end-of-period) 8.7 7.6 7.0 6.5 5.5 5.0 Nominal exchange rate (depreciation+, end o f period) 19.0 2.8 25.0 -3.0 -14.0 ... Real effective exchange rate (depreciation-) -2.6 1.5 -17.4 -5.2 11.4 ... Money and credit 11 Broad money -2.1 7.0 5.3 6.5 16.7 11.1 Credit to the private sector -8.6 1.7 4.0 9.2 12.2 14.6 Real interest rate (90-day time deposits; percent per year) 4.2 3.6 0.7 1.4 2.2 ... (Inpercent ofGDP, unless otherwise indicated) Externalsector Current account (deficit-) 0.9 -1.4 -1.7 -1.5 -1.0 -2.8 External debt 46.1 47.5 52.3 46.0 37.1 35.9 Ofwhich: public sector 26.3 28.5 31.9 29.6 24.1 22.7 Net official reserves (inmonths o f imports o f goods and 6.6 7.8 7.6 6.5 7.1 6.5 services) Savings and investment Gross domestic investment 13.7 14.5 14.2 14.9 14.0 15.3 Gross national savings 14.6 13.2 12.6 13.5 12.9 12.5 Public finances Combined public sector balance -3.4 -3.2 -3.7 -2.7 -1.3 -2.5 Nonfinancial public sector balance -3.5 -3.5 -4.2 -3.2 -1.7 -2.5 Central administration balance -5.7 -5.7 -6.4 -5.4 -5.5 -6.1 Public sector debt 2131 47.7 51.8 60.2 56.0 52.9 50.4 71 Sources: Colombian authorities; and IMF staff estimates and projections. 1/All annual changes inforeign currency stocks valued at constant exchange rate. 2/ Includesbonds issuedto recapitalize financial institutions. 3/ Program definition. Assumes no purchasesunder the current SBA. Includes valuation changes. Under Article IV of the IMF'sArticles of Agreement, the IMFholds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion o f the discussion, the Managing Director, as Chairman of the Board, summarizes the views ofExecutive Directors, and this summary is transmitted to the country's authorities. IMFEXTERNALRELATIONS DEPARTMENT Public Affairs: 202-623-7300 - Fax: 202-623-6278 MediaRelations: 202-623-7100- Fax: 202-623-6772 72 Annex 6: Financial Sector Overview Banking system 1. Colombia's banking sector has recovered from the severe crisis of 1998 both from the prudential and profitability angles. The GoC implemented, with Bank support, a successful reform program following the crisis. These reforms helped avert a generalized banking sector collapse at the time of the crisis, and have provided the Government with more effective tools to prevent or manage another crisis, thus minimizing direct fiscal costs or contingent liabilities from such an event. The reformprocess has beenanchored inthe passage of Law 795/2003 which included banking governance reforms and set the basic framework for the Banking Superintendency (Superintendencia Bancaria, or SB) to carry out consolidated supervision o f financial groups. The increased emphasis on risk-based supervision and the new requirements for banks to implement better credit risk management (Sistemade Administracion de Riesgos or SARC) and the improved macroeconomic environment have resulted in a banking sector that i s more highlyprovisioned, capitalized, profitable and liquid than before the crisis. Table 8: Key Banking Sector Indicators (Perm) 1598 1959 2coo 2001 2002 2003 20042 Capitaladequacyratio (withmarket risk) 3/ n.a 11.3 13.2 13.0 12.6 13.1 141: RegulatoryTierIcqital torisk weigbtedassets n.a 8.0 9.2 9.3 9.7 10.5 Ili Capitalto s e t s 10.6 11.0 11.3 11.2 1I.o 11.5 11: "paforming loansnet ofprovisions to capital 4' 27.2 35.9 15.6 5.6 1.I -3.8 -IO! Nmpaformingloanstototal loans 4'51 9.1 12.4 10.6 10.2 9 2 6.8 31 Cheitiedloans 51 n.a. 18.1 18.7 18.1 16.0 12.1 7: Specific p.wisimstoclasifiedloans and leases n.a 25.3 27.7 37.5 43 .O 47.6 541 Sectoral distributionofloans tototalloans51 commm i aI 53.O 55.2 58.7 58.4 6 19 62.8 651 COWUIIIR 17.9 13.4 14.1 15.6 15.6 18.0 19. housing 29.1 31.4 27.2 26.0 21.7 18.1 14. Fmign cwency ~oansto total loans 11.9 9.0 8.1 7.0 7A 4.7 5: Returnm averageequity -32.6 -20.7 1.1 9 6 17.0 23: Returnm averageaeets -3.5 -2.3 0.1 I.I 1.9 2.' lntemt margin to gross income 41.O 30.7 38.1 32.7 355 37.4 39. Nmintaest expenses to gross income 83.5 95.4 93.7 85.6 80.7 69.8 59; Pnsonnelexpensato mnintaes incane 43 .O 38.6 36.2 37.3 383 38.4 41. Sp.eadb e t w mreferencelending anddeposit rates 9.7 4.4 6.6 8.3 74 7.4 7. Liqllid s e t s to total aeets 61 10.0 11.9 12.9 16.5 19.7 18.7 181 Liquid s e t s to short-term liabilities 71 17.3 19.2 20.4 25.2 302 29.0 28. CIStOmRdepositstototd(nmintettank) loans 93.8 107.5 122.3 136.1 136.1 136.0 126. Fmigncurrency liabilities to total liabilities 12.1 9.4 9.1 8.6 7.O 6.2 61 Net openposition inforeign exchange to capital 5.1 -0.1 -I.4 4.8 7.8 4.3 4. Sources: Supaintendencia Bancda; IFS; andFmdstaff estimates. I/Excludingndtunionsandpublicsectuspecialinstitutions(l0E). Y Datato Sep. 2004 excep data on foreign cumcy loans andliabilties, whichare to Jme 2004. R e " are annualized asnecessq. 3/Maketrish reqllirements,effectivemlyasof2MI, areweighted6Phmtil2003, 80% in2033, and 103% theafter. 41 Loanspastdu: 90 day ormore (120daysor moreinthe case ofmutgages) 51Loandataincludeslea~esasof2004. 61 Liquidassetsinclude cash,dqosits andsecurities held fortrading. 71Cusomm deposits usedasproxy for short-term liabilities. 73 2. Banking sector consolidation over the last few years has reduced the number and importance of specialized credit institutions. As can be seen inthe Table below, only around one half o f the 105 credit intermediaries at the end of 1998 were still inexistence as of mid-2005. The remainder had beenmerged, purchasedby commercialbanks or closed, primarily as a result o f the crisis. Most of the burden of adjustment fell on the smaller and more specialized entities (e.g. financing and leasing companies, financing corporations and housing banks) that followed very distinct and heterogeneous business models. It is also worth noting that the assets of the banking sector fell by 15 percent of GDP during this period, and only began to recover in2004. Table 9: The Structureof Colombia'sBankingSector I 1998 1999 2000 2001 2002 2003 2004 2005 (May) Number of Banking InStitUtiOnSI/ 105 82 71 65 61 59 58 Commercial Banks 30 24 24 22 22 22 22 Private domestic 13 10 10 10 10 10 10 Public 2/ 3 3 3 3 3 3 3 Foreign 14 11 11 9 9 9 9 HousinaBanks 8 8 6 6 6 6 6 Finance Corporations 16 11 8 8 5 4 4 Financingand Leasing Companies 50 38 32 28 27 26 25 Cooperativesof SuperiorGrade 1 1 1 1 1 1 1 Share of Total Assets (%I Commercial Banks 57 56 59 61 62 64 64 65 Private domestic 27 32 34 36 37 38 Public 11 12 29 11 12 12 12 12 Foreign 28 18 17 18 12 18 16 16 15 15 Housing Banks 26 27 25 24 24 23 22 21 Finance CorporaUons 11 11 11 11 9 7 8 7 Financing and Leasing Companies 6 5 4 4 4 5 6 7 Cooperativesof SuperiorGrade 0 0 0 0 0 0 0 0 Total BankingSector ASS& (COP$ billion) 79,395 80,046 80.390 84,244 89.176 97,403 114,934 119,405 % of GDP 57% 53% 46% 45% 44% 42% 45% n.a. 3. The Colombian banking sector is dominated by financial conglomerates that mostly belong to large domestic mixed-activity groups. Two local economic groups (Aval and Sindicato Antioqueiio) own many large credit institution^^^ and, as of May 2005, together representedas much as 47 percent of the banking sector assets37,up from 31 percent as of the end of 1998. A process of restructuring and consolidation i s underway in these and other mixed groups38to allow them to compete more effectively inthe more international environment that the prospective FTA would allow. The ongoing process of creatinglarger universal banks i s likely to leadto efficiency gains inthe banking sector becauseo f the greater economies o f scale and scope arising from operational integration. 36 In addition, each of these groups has a significant presence in other financial sectors (e.g. private "ensionssimplicity, and insurance) and incommercial activities. For the two groups' financial accounts are calculated simply as the sums of the accounts of the individual group entities, raising the possibility of some double-counting due to intra-group transactions. 38 For example, Grupo Sindicato recently announced the merger o f its three main banking operations (Commercial bank Bancolombia, financing corporation Corfinsura, and housing bank Conavi). In addition, Grupo Aval intends to merge its two financing corporations (Corfivalle and Corficolombiana) while the two bank holdings o f Grupo Social (Banco Caja Social and Banco Colmena) have agreed to merge. 74 Table 10: Colombia's 10LargestCreditInstitutions(May 2005) (COP$ billion) Total Assets Market Share Ownership Bancolombia 14,488 12% Grupo Sindicato Bogota 11,270 9% Grupo Aval BBVA Ganadero 7,104 6% Foreign-owned Banagrario 6,874 6% State-owned Granbanco 6,514 5% State-owned Davivienda 6,468 5yo Grupo Bolivar Occidente 6,102 5yo Grupo Aval Popular 5,721 5% Grupo Aval Conavi 4,498 4yo Grupo Sindicato Corfinsura 4,060 3yo Grupo Sindicato Source: Superintendencia Bancaria 4. The size and complexity of financial conglomerate structures, as well as the fact that they are controlled by groups with significant commercial interests, demand a strong consolidated supervision framework. Law 222 defined corporate control and the concept of an economic group, and imposed related party firewalls and consolidated financial statements. Articles 81 and 82 of Law 795 of 2003 empowered the SB to do monitoring and on-site supervision o f entities that are not under its direct control but meet the presumptions required for consolidation. Additional executive decrees and Circulars (especially Circular Bancaria Contable y Financieru 100) have established credit limits, consolidation rules and capital adequacy standards for conglomerates and related entities. The authorities are also making progress with a Securities bill that would strengthen the corporate govemance requirements for listed companies, and a draft bill on the adoption of intemational standards on accounting and auditing that would enhance transparency. However, important legal modifications covering the definition of a financial conglomerate (Le. presumptionof subordinationor 'dominant influence') as well as the scope and conduct o f consolidated supervision (e.g. development of a comprehensive and consistent risk assessment methodology) will be necessary in order to fully attain this objective. 5. As a result of the presence of financial conglomerates, market concentration i s considerably greater than conventional measures would suggest. Concentration, as measured by the HerfindahlIndex (HI) of asset share at the individual credit institution level, increased from 362 to only 513 between end-1998 and mid-2005, which i s significantly below the level o f a concentrated market39. In addition, only Bancolombia (Sindicato Antioqueiio) held a market share above 10 percent in assets, loans or deposits, making Colombia one of the least concentrated banking markets in Latin America. However, this calculation ignores the presence of financial conglomerates and public sector ownership o f four credit institutions accounting for around 15 percent of total assets. Taking the largest four financial groups (Aval, Sindicato, 39The HI i s a measure of market concentration, which is calculated as the sum of the squares of relative shares and lies between 0 and 10,000. According to the merger guidelines of the U.S. Department of Justice, a post-merger HI of 1,800 and over indicates a concentrated market, an HI between 1,000 and 1,800, moderately concentrated, and an HIbelow 1,000, not concentrated. 75 Bolivar and Social) into account and treating the public-owned banks as one group, the adjusted HIfor May 2005 risesto 1454, indicatingamoderately concentratedmarket. Figure9: Compositionof DomesticCredit andInternationalComparison of Public Sector Debt (a) Compositionof Banks' Assets (b) PublicBanks' Composition of Assets 68.0% , 30.0% 75.0% 1 45.0% 66.0% - -- 25.0% 64.0% . 25.0% 62.0% . 20.0% 60.0% - I ..15.0% 550%- 15.0% 58.0% - 50 0%. 20.0% 56.0% - -- 10.0% 45 0% , 15 0% 54.0% . .5.0% 52.0% - 50.0% 4 I10.0% ~ 04/95 04/96 04/97 04198 04199 04/00 04101 04/02 04/03 04/04 04105 04/55 04/96 04197 04158 04/95 04/00 04101 04/02 04103 04/04 04/05 -Gross Loans /Assets -hvestmnts in Nbiic R b t l Assets -hMc Banks Gross LoansIArsels Wtlc Banks hverlmntsinN b t teblI Assels (c) Public Debt as a Percentageof Banks' Investment (d) Percentageof DomesticCredit Goingto the 1 Portfolios Public Sector (2003) 80% , Argent na 70% n CoMex co omba 00 ivia VenezLe a 50% n Canada SOLlnAfr ca m a ana UnteaSiaies TLn s a Malatsa I 0% 20% 40% 60% 80% 6. Post-crisis risk aversion has led to an increase in exposure to government bonds and a move away from the real sector. After the crisis, banks found themselves unwilling to lend but extremely liquid. At the same time, the Government, after confronting the contingent liabilities generatedby the financial sector inthe crisis, increased its demands for financing. The resultant replacement of private sector loans with government bond holdings in bank balance sheets has altered the nature of the risk confronting the banking sector and represents a lingering legacy of the crisis. The fiscal costs of the crisis and the lower demand for credit, as elsewhere in Latin America, have increasingly transformed credit risk exposure into sovereign risk exposure, as there are elements of crowding out by the public sector (Figure 9(c)). Giventhe predominance of banks among government debt holders, the successful extension of government debt maturities has, to a large extent, resulted in an increase of the interest rate risk bore by the banking sector. Since the financial crisis, bank's portfolios were reallocated in favor o f investments in public debt, Public banks' portfolio reallocation was clearly more aggressive. Duringthe crisis the risk adjusted return of the loans portfolio decreasedmarkedly. The reallocation inthe bank's portfolio reflects the decline on the risk-return profile of loans, the lower costs of managing investments and the reduction of the deposit rates. CapitalMarkets 7. Colombia's stock market capitalization i s high for the region after a surge in 2004. Domestic equity market capitalization surged by 75 percent in2004, to reach US$24.8 billion, or 76 30 percent o f GDP. That compares with levels of below 10 percent for Argentina, Bolivia, Ecuador and Venezuela (see Figure 10.) For Chile, however, the figure was 69 percent. Figure 10: Market Capitalization (2004, YOof GDP) 68 5% 7.0% Source: Federaci6nIberoamericanade Bolsas (FIB), www.fiabnet.org 1 8. Public fixed income securities, TES treasury bills in particular, dominate Colombia's total portfolio of financial assets. Public fixed-income securities account for 84 percent of outstanding securities, while TESs alone make up 76.5 percent. Intotal, fixed-income securities represent 96 percent of the portfolio, with the remainder comprised o f mutual funds, derivatives and stocks. Figure 11:Breakdownof outstandingsecuritiesinColombia (2004) a) Total assets (b) PublicFixed Income 84.1% I 11.3% w Publc Fixed Incom 0 PrNak Fixed lncom 0 Mutral Funds W TES Nominatedin PESOSpxed ab) 0 TES Nominatedin Pesoa (UVR) 0 DerNaCves Sbck 0 PUbllC Bonds oTES Nominatedin PESOS(IPC) TES Nominatedin US mllars Bi mer 77 Annex 7: Quality Standards And TechnicalInnovation 1. Colombia has the second highest number of ISO-certified companies in Latin America. At the end of 2003, 2,659 companies had obtained the I S 0 9000 certification:' 15 times more than in 1997. Within Latin America, Colombia trails only Brazil (4,012 I S 0 9000 certificates). Colombia represents 21 percent of the total number of I S 0 9000 certificates in the entire region (Figure 12(a)). While I S 0 9000 i s the most widely used international quality standard, other quality certifications have also experienced significant growth in Colombia. Figure 12(b) presents the evolution inthe number of certificates issued by ICONTEC, the local non-profit internationally recognized certificationbody. ICONTEC accounts for about 70 percent of internationalcertificates issued inthe country. Figure 12: The growth of quality certification in Colombia (a) Expansionof I S 0 9000 certification (b): Certifications granted by ICONTEC certifications: certifications: IS0 14000,CIS 9000, IS0 9000 25% 14o HACCP, OHSAS __ T 9001 Colombia (leftaxis) ,j 20% 30 700 600 Colombia as proportion 15% 25 1,500 of LAC total (right axis) 20 500 10% 400 1000 15 300 5% 10 200 5 100 0% 0 0 1992 1994 1996 1996 2000 2002 2004 I I L I Source: The I S 0 Survey o f I S 0 9001:2000 Source: ICONTEC and I S 0 14001 Certificates 2. The growth in the number of quality certified companies i s largely due to significant Government support provided through various M S M E development programs Since the year 2000, the national government has provided considerable financial support to the quality certification o f private companies - particularly MSMEs - using various programs managed by the Ministry of Trade, Industry and Tourism (MCIT, Ministerio de Comercio Industria y Turismo), as well as by the National Training Service (SENA, Servicio Nacional de Apredizaje) and Colciencias (Instituto Colombian0 para el Desarrollo de la Ciencia y la Tecnologia). Support to the quality upgrading o f MSMEs i s justified on the grounds that those companies suffer more than large companies from information asymmetries regarding the benefits of quality certification. Public support can also bejustified on the basis of the strong links between quality and innovation investments, and onthe spillovers that tend to be generatedby the latter. 3. Several programs have been developed to support certification, particularly among MSMEs. One o f the most important programs in this field has been MCIT's PNAC (Programa Nacional de Aseguramiento de la Calidad), through which SENA co-finances up to 50 percent of the cost of training and technical assistanceprojects aimed at obtaining internationally recognized quality certifications. PNAC has supported the certification of 561 companies since 1999, 57 percent of which are small, 37 percent medium-sized and 6 percent large. Another important program has been CYGA ("Programa de Calidad y Gesti6n Ambiental en la PYME") developed by ICONTEC with support from the IADB. Over four years, 924 companies received audits for 40 I S 0 (2003) TheIS0 Survey ofIS0 9001:2000 and IS0 14001 Certfficates- 2003. 78 either I S 0 9000, I S 0 14000 or product quality certifications (of which the great majority reportedly achieved certification), 337 companies were pre-audited, 526 received technical assistance and 708 received training. A third program, through FOMIPYME financed up to 65 percent of 155 projects aimed at obtaining quality certifications in 2001-2004. The program supported 155 companies, of which 72 percent were micro-enterprises, and 28 percent small and medium companies. 4. Further development of the quality regime can be supported by enhancing the Government's accreditation functions. The Division of Technical Standards of the Superintendency of Industryand Trade (SIC) of the MCIT i s the main institution responsible for accrediting and supervising all certification bodies41, as well as testing and calibration laboratories. SIC has accredited more than 70 institutions, and has about seven new clients per year. However, more than one third of SIC'S clients are bodies in charge o f certifying compliance with technical regulations (mandatory measures required by the Government to ensure products do not adversely affect legitimate public policy concerns such as the protection o f human health and safety and the environment.) This is not in accordance with international practice, as the norm i s that such organizations are not accredited but rather authorized by the Government to perform such certification processes. More importantly, other government agencies also have accreditation functions insome specific areas, which has hampered the growth in SIC'S accreditation activities. Examples include ANVISA, for food and pharmaceutical products, and the Colombian Agricultural Institute. That the different responsibilities and attributions of the various institutions with accreditation functions are not clearly established creates uncertainty for potential "clients" and generates conflicts between the various agencies involved inthe accreditation process. 5. To better perform its accreditation functions SIC would need to be granted additional financial resources and other functions of SIC would have to be better separated from that of accreditation. Since 1997 the Colombian Government has not allocated any new resourcesto support the accreditation functions of SIC. This i s reflected inthe fact that Colombia employs far fewer skilled technical evaluators than Argentina, Brazil and Mexico. The effectiveness of SIC'S accreditation activities i s also hindered by conflicts of interest derived from the fact that the institution i s also mandated to enforce mandatory technical regulations, as well as offering calibration services. Moreover, the current organization of SIC does not guarantee that that the activities of the departments related to those other functions do not compromise the confidentiality, objectivity and impartiality of its accreditationservices. 4'Certification bodies are independent organizations that assess and certify conformity with international standards. 79 Figure 13: Membership of International Accreditation Organizations And MutualRecognition Agreements Source: web sites o f IAF, ILAC, IAAC, EA, APLAC, PAC. ~~ 6. To provide more valuable services to Colombian exporters, SIC would also need to enter into international mutual recognition agreements, which inturn may require creating a new separate legal entity to act as accreditation body. SIC i s not a member of the main regional or international accreditation entities and has little participation in international mutual recognition agreements (MRA). Thus Colombia is not a member of the Inter American Accreditation Cooperation (IAAC), the International Accreditation Forum (IAF) or the International Laboratory Accreditation Cooperation (ILAC). Its only MRA i s with the Andean Community, to which only 20 percent of its exports are destined. This situation of international isolation is depicted in Figure 13. As a result, the accreditation services offered by SIC to its clients have no value in most of Colombia's export markets. The first prerequisite to enter into International Accreditation Organizations or Mutual Recognition Agreements is the approval by the National Congress of a law to provide SIC with the budgetary resources to pay membership fees. Moreover, SIC'S accreditation body may need to be revamped as a new independent legal entity, able to sign international contracts, and possibly subject to private law. This new legal organization would also have to be such that impartiality and political independence are guaranteed. 7. Besides continuing the efforts to upgrade the quality of products and services, Colombia needs to improve the private sector's ability to adopt and develop new technologies. Latin America has sizeable deficits in productivity, skills and technology, but Colombia still compares poorly within that context. While countries in the region spend an average of 0.5 percent of GDP on research and development (R&D), Colombia spends only 0.2 percent.42 Similarly, Colombian R&D expenditures per worker (US$lO) are less than a third of the region's average. The country i s also below regional norms for the years of schooling of its population, the share of capital good imports to GDP, and the number of domestic and US. patents granted to local inventors. Within Colombia, there is a considerable regional 42 De Ferranti et al. (2003). 80 concentration o f the resources spent on science and technology, with 80 percent going to Bogota.43 8. Colombia's Innovation Policy encompasses fiscal incentives to research and development (R&D) activities, financing mechanisms for universities and other research centers and programs to fund R&D activities in private firms. Law 29 of 1990 and Decree 585 of 1991 created the current basic legal framework for Colombia' innovation policy. In particular, Colciencias, the Colombian Institute for the Development of Science and Technology (S&T), was designated the agency in charge of implementing the country's innovation policy. Colciencias acts as the technical and administrative secretariat for the National Council of S&T, which i s integrated with representatives from the private and public sectors as well as the academic community. It sets down the general guidelines for the country's S&T policy. While Colciencias has been the top recipient of government funds for S&T, its share of those resources was only 27 percent in 1995-1997, with the Ministry of Agriculture receiving another 25 percent and the National University coming inthird place, with 12percent of the government's budget for S&T. The rest i s divided among a large number of educational institutions, technology development centers and other researchinstitutes. 9. However, most of the tax deductions for R&D activities are used by public organizations. Colciencias manages the fiscal incentives created inthe early 1990s to stimulate R&D activities. Investments and donations for R&D activities can be used to claim income tax deductions, while imports of R&D equipment for universities and technology centers are subject to exemptions to the value added tax. Both tax incentives are managed by Colciencias. Although according to the law, all organizations can enjoy tax deductions, the public sector - including publicly supported Technology Centers, Government Agencies and public universities - benefits the most, accounting on average for 74 percent o f tax deductions in 1995-1999.44 10. Colciencias' direct funding of scientific R&D activities i s articulated in two main programs aimed respectively at financing research projects at universities, and at strengthening Centers of Excellence in academic research. The financing of R&D projects at universities and other researchcenters has beenthe main policy instrumentusedby Colciencias to promote scientific research in the country. Calls for projects are made annually, along eleven strategic research lines - or "S&T national programs" - defined by Colciencias. Projects are selected by research councils established for each of the corresponding programs, on the basis of the quality and pertinence of the research proposals. A second newly implemented program to support academic R&D aims at strengthening six centers of excellence in scientific research. These "centers" were chosen on the basis of their experience and academic strength in areas which are considered of strategic importance for the country - e.g. tropical diseases - and taking into consideration the presence o f links or alliances with weaker research institutions located in the less developed regions of the country, as well as the potential sustainability o f their programs. 11. Existing mechanisms to promote private R&D include matching grant funds and credit lines for technology development projects. The resources involved in the promotion of R&D and innovationby the private sector have represented about 32 percent of the total budget o f Colciencias, which between 2002 and 2004 represented an average o f US$ 26 million. These resources have been used to fund a matching grant fimd that co-finances up to 70 percent (50 percent in the case of large companies) of R&D projects involving both private companies and universities or other research institutions (including Technology Centers). Together with two 43Agapitovaet al. (2002). 44Agapitovaet al. (2002). 81 second-tier development banks - Bancoldex and Finagro - Colciencias also manages a program that subsidizes up to the first 50 percent of the cost of credit for projects with a significant technological development component. The subsidy i s higher for SMEs and for projects aimed at export markets. 12. Two newly created financing mechanisms subsidize high risk technology development projects and the cost of obtaining local or foreign patents. The first credit line i s aimed at innovation and technology development projects with high technical and commercial risk to be carried out by SMEs. Depending on whether the project is successful or not, Colciencias supports between 50 and 80 percent of the company's loan. Incases of technical or commercial failure, the subsidy is of between 20 and 40 percent of the cost of the project. Similarly, in the case of patent applications, Colciencias subsidizes up to 80 percent of the total cost o f the process, conditional on the patent being granted. For unsuccessful applications Colciencias still pays for 40 percent of the cost ofthe project. 13. The Government has also supported a small group of company incubators and a large network of technology development centers (TDCs). Colciencias supported 12 company incubators, o f which only 5 are now operational, two of them in Bogota. As reported by Colciencias, this institution i s phasing out its support to those incubators, for which additional funding is expected to be provided by SENA. As for TDCs, their main functions are to provide technology extension services to the private sector, and to facilitate technology transfer from academia to productive companies. There are currently 45 technology development centers in Colombia, o f which 21 operate in the industrial sector, 11 in agriculture, 10 are related to new technologies - e.g. biotechnology- and 3 are inthe service sector. Bogota hosts 42 percent of the centers, with other three regions - Antioquia, Valle del Cauca and Santander - responsible for another 47 percent. Almost 98 percent of the clients o f TDCs are private companies. About 60 percent of the services provided are training activities, but TDCs also offer technology services (19 percent o f their activities), technical assistance(11 percent) and R&D (10 percent). 14. The financial self-sustainability of TDCs i s still weak, due to the relatively low demand for their services. Colciencias and SENA provide respectively 14 and 11percent of the financing of those activities, while private companies and industry associations contribute with another 49 percent. The remaining 26 percent of the funding comes from local and national government agencies (13 percent), financial institutions (6 percent), and intemational technical cooperation agencies (3 percent), among other sources. Between2000 and 2003, TDCs generated 38 patents, about 2000 product and process innovations, they generated more than 500 alliances with universities, 2,553 publications, they offered 9,5 14 courses and seminars, and they developed 2,159 projects with private companies. Despite these impressive outcomes, the prospects for the financial sustainability of many TDCs are still not clear. Thus, even if TDCs were to increase and diversify their services to the private sector, and they were to reduce some of their fixed costs, Colciencias estimatesthat between 15 and 30 percent of their budget would still needto be financed with public resources. 15. The National Training Service (Servicio Nacional de Aprendizaje, or SENA) plays an important role in the support of innovation and competitiveness among MSMEs. A 1996 Law mandates SENA to devote 20 percent of its parafiscal revenues to programs aimed at promoting technological development or increasing the competitiveness of the Colombian productive sector (Law 344), particularly in the MSME segment. The current Government mandated that 25 percent of the resources for SENA should go to innovation and competitiveness promotion - almost US$14 millions in2003 should be allocated directly to Colciencias. In2003, the resources obtained through SENA represented 32 percent o f Colciencias' budget, thus 82 compensating for a reduction in its allocation from the national budget. SENA also plays a crucial role inpromoting the competitiveness of the private sector through its traditional training programs. Recently, the government announced its intention to increase competition in the National Skills Formation System by mandating that SENA earmark an increasing share of its budget to fund privately provided training services (70 percent by 2006), and by reallocating SENA's accreditationandregulatory functions to other government agencies. 16. All the Government programs that support technology adoption and innovation are targeted mostly at MSMEs. The MCIT manages FOMIPYME, the Colombian fund for the modernization and technological development of MSMEs, created in 1990. In 2003, FOMIPYME co-financed projects for about US$9 million (US$4 million in 2002). About two thirds of the projects financed by FOMIPYME are for micro enterprises, with the remaining allocated to SMEs. Colciencias has also directed an increasing share of its budget (46 percent in 2004 compared with 32 percent in 2003) to financing private sector technological development and innovation, with a large share of the corresponding funds directed to MSMEs. In 2004, Colciencias devoted more than US$11 million (US$7.5 million in 2003) to financing those activities, either by means of direct supports to private companies or through Centers of Technology Development, company incubators or other entities of the National Innovation System. 83 .. 00 84 .-d h m I `ii w3 v, z v, 0 0 N 0" m L c 3 i 85