bank and · the world bank for official use only report no. 33538-co international bank for...

Document o f The World Bank

FOR OFFICIAL USE ONLY

Report No. 33538-CO

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED FIRST PROGRAMMATIC BUSINESS PRODUCTIVITY AND EFFICIENCY LOAN

IN THE AMOUNT OF US$250 MILLION

TO THE

REPUBLIC OF COLOMBIA

September 27,2005

Colombia-Mexico Country Management Unit Finance, Private Sector and Infrastructure Department Latin America and Caribbean Region

This document has a restricted distribution and may be used by recipients only in the performance of their off icial duties. I t s contents may not otherwise be disclosed without W o r l d Bank authorization.

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COLOMBIA - GOVERNMENT FISCAL YEAR

AAA A I

AMUCFT

BdR CAE

CAF

CAS CFAA

CHMC Confecamams

CONFIS

CONPES

DIAN

DNP

DPL FDI FIAL

FSAL FSAP FRL FTA GDP GNI GoC

January 1-December 3 1

CURRENCY EOUIVALENTS (as o f 20 September 2005) Currency Unit = Peso

2,295 Pesos = US$1

WEIGHTS AND MEASURES Metric System

SELECTED ABBREVIATIONS AND ACRONYMS

Analytical Advisory Activities Agenda Intema para la Productividad y Competitividad de Colombia. (hemal Agenda for the Productivity and Competitiveness of Colombia) Anti Money LaunderingiCombating the Financing of Terrorism Banco de la Republica (Central Bank) Centro de Atencidn Empresarial (Centers for Enterprise Assistance) Corporacidn Andina de Foment0 (Andean Development Corporation) Country Assistance Strategy Country Financial Accountability Assessment Colombia Home Mortgage Corporation Confederacidn Colombiana de Camaras de Comercio (Colombian Confederation of Chambers of Commerce) Consejo Superior de Politica Fiscal (Senior Council on Fiscal Policy) Consejo Nacional de Politica Econbmica y Social (National Council on Economic and Social Policy) Direccion de Impuestos y Aduanas Nacionales (Tax and Customs Directorate) Departamento Nacional de Planeacidn (National Planning Department) Development Policy LoadLending Foreign Direct Investment Programmatic Fiscal and Institutional Adjustment Loan Financial Sector Adjustment Loan Financial Sector Assessment Program Fiscal Responsibility Law Free Trade Agreement (US-Andean) Gross Domestic Product Gross National Income Government of Colombia

IBRD

IADB IFC I S 0 IMF MCIT

MHCP

MSME MTEF NGO OECD

PLaRSSAL

PRAP

RED1 REIF SARC

SB

SENA

SIIF

ss sv

TAL TES UAIF

VIS WEF

lntemational Bank for Reconstruction and Development Inter- American Development Bank Intemational Finance Corporation International Organization for Standardization Intemational Monetary Fund Ministerio de Comercio, Industria y Turismo (Ministry of Trade, Industry and Tourism) Ministerio de Hacienda y Credit0 Publico (Ministry of Finance and Public Credit) Micro, Small and Medium Enterprise Medium Term Expenditure Framework Non-Govemmental Organization Organization for Economic Co-operation and Development Programmatic Labor Reform and Social Sector Adjustment Loan Programa de Renovacidn de la Administracidn Publica (Public Administration Renewal Program) Recent Economic Developments in Infrastructure Real Estate Investment Fund Sistema de Administracidn de Riesgos Crediticios (Credit Risk Management System) Superintendencia Bancaria (Banking Superintendency) Servicio Nacional de Aprendizaje (National Training Service) Sistema Integrado de Informacibn Financiera (Integrated Financial Information System) Superintendencia de Sociedades (Companies Superintendency) Superintendencia de Valores (Securities Superintendency) Technical Assistance Loan Titulos de Tesoreria (Treasury Securities) Unidad de Infomacibn y Analisis Financier0 (Financial Information and Analysis Unit) Vivienda de Interts Social (low-income housing) World Economic Forum

Vice President: Pamela Cox Country Director: Isabel M. Guerrero Director, LCSFP: Makhtar Diop

Sector Leader, LCSFP: Anna Wellenstein Sector Manager, LCSFF: Susan Goldmark

Task Team Leader: Juan Carlos Mendozmar t i n Naranjo Landerer

FOR OFFICIAL USE ONLY COLOMBIA: FIRST PROGRAMMATIC

BUSINESS PRODUCTIVITY AND EFFICIENCY LOAN TABLE OF CONTENTS

I . INTRODUCTION ..................................................................................................................................... 5

I1 . THE COUNTRY CONTEXT 6 ................................................................................................................. RECENT ECONOMIC DEVELOPMENTS .............................................................................................. 6 MACROECONOMIC OUTLOOK AND CHALLENGES ........................................................................ 8

I11 . THE OVERALL GOVERNMENT PROGRAM ................................................................................. 9 I V . KEY ISSUES AFFECTING BUSINESS PRODUCTIVITY AND EFFICIENCY ........................ -10

BUSINESS ENVIRONMENT ..................................................................................................... 12 FOREIGN TRADE AND COMPETITIVENESS .................................................................................... 16 FINANCIAL SYSTEM AND CAPITAL MARKETS ............................................................................ 17 QUALITY STANDARDS AND TECHNOLOGICAL INNOVATION ................................ INFRASTRUCTURE AND LOGISTICS ..............................................................................

V . BANK SUPPORT TO THE GOVERNMENT'S STRATEGY .......................................................... 34

LINK TO THE CAS ................................................................................................................................. 34 COLLABORATION WITH THE IMF AND OTHER DONORS AND LENDERS ................................ 34 RELATIONSHIP TO OTHER BANK OPERATIONS ........................................................................... 35 LESSONS LEARNED ......................................................................................... . 37 ANALYTICAL UNDERPINNINGS ....................................................................................................... 38

V I . THE PROPOSED PROGRAMMATIC DEVELOPMENT POLICY LOAN ................................. 39

OPERATION DESCRIPTION ................................................................................................................. 39 LOAN AMOUNT .............................................................. ............................ ................. 41 POLICY AREAS ............................................................... 41

VI1 . OPERATION IMPLEMENTATION ................................................................................................ 43

SOCIAL ASPECTS AND POVERTY IMPACT ..................................................................................... 43 SUPERVISION ........................................................................................................................................ 44 FIDUCIARY ASPECTS .................................................. ............................................................ 44 DISBURSEMENT AND AUDITING ...................................................................................................... 46 ENVIRONMENT ..................................................................................................................................... 47 R I S K S ....................................................................................................................................................... 47

ANNEXES Annex 1: Colombia At A Glance ................................................................................................................ 49 Annex 2: Le t te r Of Development Policy .................................................................................................... 51 Annex 3: Debt Sustainability Analysis ...................................................................................................... 63 Annex 4: Matrix Of Policy Actions And Expected Outcomes ................................................................. 67 Annex 5: Fund relations note ..................................................................................................................... 69 Annex 6: Financial Sector Overview ......................................................................................................... 73 Annex 7: Quality Standards And Technical Innovation .......................................................................... 78 Annex 8: Colombia's Operations Portfolio (Ibrd And Grants) ............................................................... 84 Annex 9: Statement Of IFC's Held And Disbursed Portfolio ................................................................. -85

........................................................

ACKNOWLEDGEMENTS T h e World Bank Group greatly appreciates the close collaboration o f the Government o f Colombia in the preparation of this Development Policy Loan . 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-Laurent Chatain. Marilyn Goncalves (FSEFI); Mariluz Cortes (consultant) . The team benefited from the comments from other Bank staf f including peer reviewers: August0 de la Tome (LCRCE). Patrick Honohan (OPD). and Simon Bell (SASFP) as well as Todd Crawford (LCOQE) and Harold Bedoya (OPCS) . Additional assistance was provided by Helena Issa .

This document has a restr icted distribution and may be used by recipients only in the performance of their official duties . I t s contents may not be otherwise disclosed without World Bank authorization .

LOAN AND PROGRAM SUMMARY COLOMBIA FIRST PROGRAMMATIC BUSINESS PRODUCTIVITY AND

EFFICIENCY LOAN

Borrower

Implementing Agencies

Amount

Terms

Commitment Fee Front-End Fee Tranching

Objective

Description

Benefits

Risks

Project ID No.

Republic o f Colombia

Ministerio de Hacienda y Crkdito Phblico, Departamento Nacional de Planeaci6n

US$250 mil l ion

Commitment-linked Fixed-Spread Loan (FSL), U S dollar denominated, payable in 17.5 years, including a 5.5-year grace period. Level repayments o f principal at the standard variable interest rate for U S dollar FSLs 0.85 percent on undisbursed loan balances for first four years and 0.75 percent on undisbursed loan balances thereafter 1 percent o f the loan amount paid by the Borrower upfront Single tranche for the full amount o f the loan

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. The proposed loan i s the first phase o f 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 in three 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 by businesses and improvement o f efficiency o f financial secondary markets

The proposed loan would support sustainable growth and alleviation o f poverty 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.

The proposed operation supports an institutional development effort widely perceived as n e c e k y by most politicai gctors, and that the Goverken t i s already actkely implementing. Therefore, there i s little risk that 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 proposed Development 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 measures to increase access to financial services may take a long time to produce

results 0 political uncertainty and any deterioration in the 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

PO94301

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT ON A PROPOSED FIRST PROGRAMMATIC BUSINESS

PRODUCTIVITY AND EFFICIENCY LOAN TO THE REPUBLIC OF COLOMBIA

I. INTRODUCTION

1. The Government o f 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 o f 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 o f business environment in a sample o f 145 countries. Similarly, the Financial Sector Assessment Program (FSAP) Update, carried out in late 2004, highlighted the recovery o f the financial sector since the crisis o f the late 1990s due to a broad range o f financial sector legal and regulatory reforms. The GoC has more recently embarked on a series o f policy and institutional reforms to promote greater productivity and efficiency among enterprises. A t the core o f these reforms i s a concerted effort to further improve the business environment and continue strengthening the financial sector, to enable it to fund the investment needed for productivity and efficiency gains at the firm level.

2. The Bank’s support for the GoC’s program to promote greater business productivity and efficiency would consist o f 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 o f the GoC. The f i rs t operation-the US$250 mil l ion proposed here-would support greater business productivity and efficiency through reforms in three areas: (a) enhancing the business environment through improvements in the regulatory framework and a reduction in the administrative burden on enterprises; (b) increasing the soundness and depth o f the financial system; and (c) promoting access to capital markets by f i r m s and improving the efficiency o f secondary markets. The second and third phases o f the programmatic operation would continue to support the process o f reforms initiated under this f irst operation and would consider i t s extension to other areas. Key triggers for the preparation o f the second operation include: (a) pursuit o f greater international competitiveness for Colombian businesses through the establishment o f institutional arrangements for implementing, monitoring and evaluating competitiveness plans, as well as the implementation o f a new legal framework for quality standards and technology; (b) consolidation and extension o f the financial sector reform process, to diversify the range o f financial products and foster greater access to financial services; and (c) completion o f the regulatory framework to improve access to the capital markets by the real sector.

3. Agreement on the reforms supported by the proposed operation has been reached through a broad process o f consultation that the GoC has carried out, partly under the umbrella o f negotiations for the Andean-U.S. Free Trade Agreement (FTA). The reforms thus have the backing o f key stakeholders, which reduces the r isks inherent in a program that w i l l span two presidential administrations.

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11. THE COUNTRY CONTEXT

4. Wi th 45 mil l ion 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 o f 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. In 2004, around 52 percent o f 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. Despite recent diversification, Colombia’s economy s t i l l depends on primary exports, and i s vulnerable to swings in the prices o f these. The country’s traditional exports-crude oil, coal, coffee and ferronickel-generated 46 percent o f total export revenues in 2004, while other agricultural produce and minerals (particularly cut flowers, bananas and gold) contributed a hrther 15 percent. O i l alone accounted for 25 percent o f total export revenues, and a significant part o f 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 o f 830,000 in 1999. Security improvements and enhanced contractual terms for investors have attracted significant private sector exploration investment in the last five years, but this has so far failed to produce the major discoveries needed to sustain o i l exports. For industrial exports, key sectors include textiles, food production, chemicals, plastics and vehicle assembly.

RECENT ECONOMIC DEVELOPMENTS

6. Colombia’s economy has recovered since the start o f the current Country Assistance Strategy (CAS) period (2002-2006)*. The near stagnation o f the economy during the four years prior to the CAS has since given way to a sustained economic recovery and a strengthening o f consumer confidence. The turnaround i s partly due to the much improved global economic environment: world growth has accelerated, the cost o f international credit has fallen, and the prices o f 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 reflected by an almost 1 percentage point increase in private investment as a share o f 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. Inflation has stayed under control, falling from 7.0 percent in 2002 to 5.5 percent in 2004. The annualized inflation rate during the first semester o f 2005 was 4.0 percent. Table 1 compares Colombia’s recent economic performance with that o f the other five largest countries in the region and Table 2 summarizes key economic indicators for the country itself. Annex 1 provides further economic and social data.

State o i l company Empresa Colombiana de Petroleos transferred 6.4 tril l ion pesos to the national

‘The CAS Update, Report 32999-C0, scheduled for Board discussion on Sept. 29,2005, would extend this period through the end of2007.

overnment in 2004.

6

Table 1: Comparative Macroeconomic Indicators

Source: World Bank A t a Glance indicators

Table 2: K e y 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 rapid expansion o f public spending over the past decade, (from 25 percent o f 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 o f domestic economic growth, improved international conditions, peso appreciation (which reduces the cost o f servicing foreign currency- denominated debt), and revenue-enhancing policy reforms has improved the fiscal accounts. The deficit decreased from 3.7 percent o f GDP in 2002 to 2.7 percent in 2003 and to 1.2 percent in 2004, well inside the 2.5 percent target o f 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 o f several targeted exemptions. Overall, the reform brought additional revenues o f 0.7 percent o f GDP in 2003 and about 1.1 percent in 2004.

The public sector deficit has improved, but fiscal concerns persist.

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 w i l l continue to expand over the next decade, as payouts greatly exceed new contributions. Fundamental reforms, including a rebalancing o f 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 w i l l be calculated based on the weighted average o f the previous four years’ GDP.

7

to fulfill i t s aim o f 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 o f special regimes for certain state employees and imposing ceilings on benefits in the public-sector pension system. The reform reduced the net present value o f pension liabilities by 19 percentage points o f GDP (from 162 percent o f GDP to about 143 percent). The original bill aimed for almost twice this, but the reform was watered down in Congress.

MACROECONOMIC OUTLOOK AND CHALLENGES

9. I n the absence of major external shocks, the economy i s 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 w i l l 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 o f GDP in 2005. Wh i le the same trend i s expected to continue in 2006, with a moderate appreciation o f the currency contributing to a current account deficit o f 2.9 percent o f 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 wi th the likely signing o f the FTA as well as with the enactment o f some o f 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 o f public debt, at about 46.6 percent o f GDP remains relatively high, But i t appears manageable in the near term even when considering possible adverse economic shocks. The GoC’s target i s to reduce the level o f debt to 38 percent o f 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 o f 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 o f 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 in March 2006 and presidential ones in May wil l l ikely slow the progress o f 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 run for a second consecutive term, but i t i s not clear if the country’s Constitutional Court w i l l approve the measure. Abroad, o i l prices w i l l continue to have major effects on the economy, through their impact on export and fiscal revenues and as a key determinant o f growth in Venezuela, the country’s main market after the U S for non-traditional exports. And the implementation o f the FTA, which could boost trade between the Andean countries and the US, s t i l l 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 o f 2005 first-quarter exports up 29 percent on year, and the current account deficit has remained stable. This suggests that a combination o f productivity gains and sustained

8

international demand has allowed the export sector to cushion the negative impact o f such appreciation.

111. THE OVERALL GOVERNMENT PROGRAM

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 o f 2003. I t has four overarching objectives:

Address the security needs of the population. The difficult domestic security situation exacerbated the deterioration o f social indicators triggered by the economic recession o f 1999, which reversed decades o f progress particularly in poverty reduction. Actions to reduce violence 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 o f welfare mechanisms, upgrade urban areas and promote growth in production through an integrated strategy to support Micro, Small and Medium Enterprises (MSME) development.

Increase the transparency and efJiciency of the state through profound cross- sectoral reforms and greater, more effective decentralization. This component wil l continue the process o f modernization o f the state, rationalizing its size and increasing the efficiency o f 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 in the implementation o f elements o f this Plan by fostering productivity, investment and growth in the private sector, enabling it to maximize the benefits o f increased international integration. More specifically, the reforms supported by th is DPL seek to improve the business environment, enhance international competitiveness and increase the soundness and depth o f the financial sector.

15. This program i s part o f a broader set o f policies seeking to enhance the country’s competitiveness. As the recent Colombia Country Economic Memorandum4 (CEM) highlights, competitiveness i s a broad term used to refer to the overall economic performance o f the country,

Colombia Economic Memorandum: The Foundations for Competitiveness, Report 32035C0, June 17 2005

9

particularly i t s level o f productivity, its ability to export its goods and services, and the extent to which i t can provide a good standard o f living for i t s citizens. Competitiveness therefore encompasses: a stable macroeconomic environment; the educational level and flexibility o f the labor force; the ease o f transport from ports and on roads; the efficiency o f the legal and judicial system in enforcing contracts and facilitating business activity; the quality and transparency o f corporate governance; the stability o f political institutions; the structure o f the tax system; and the conduciveness of the regulatory environment to market competition and management o f 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, reduce transaction 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 i s also pursuing a broad program o f microeconomic reforms to facilitate and promote business activity, in particular to h l l y exploit the export opportunities offered by the prospective FTA. This program i s supported by the policy actions to be covered by this DPL series, as discussed below.

IV. KEY ISSUES AFFECTING BUSINESS PRODUCTIVITY AND EFFICIENCY

17. 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 o f stimulating broad-based economic growth and maximizing the benefits o f increased international integration. The focus o f this loan i s also determined by the GoC’s specific priorities and achievements within i t s reform agenda, as well as the coverage o f complementary programs from the Bank and other international institutions.

Introduction.

18. Multiple surveys and analytical works have identified key constraints to business productivity and efficiency in Colombia, most of which the GoC i s addressing with direct or indirect Bank 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 o f 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 o f Entrepreneurs (Asociacibn Nacional de Empresarios, ANDI).

Table 3: Obstacles 1

so2

Doing Business in Colombia, in Order of

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

:e: WEF Global Competitiveness Report (2

Perceived Magnitude

104)

10

19. The presidential program to fight corruption i s moving in the right direction: focusing on the local level. Corruption, identified as the greatest obstacle in Table 3, increases costs and reduces efficiency for individuals and f i rms. A presidential program aims to tackle corruption through increasing the transparency o f 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 o f government bodies, and to call them to account. Furthermore, the reduction o f bureaucratic procedures (red tape) supported by this loan l i m i t s the scope for corruption by simplifying and accelerating such processes, allowing more o f them to be completed electronically and without personal contact with officials, and prohibiting some o f the charges associated with such procedures.

20. Policy instability i s particularly a n 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 o f 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 o f other reforms, such as to pension systems and budget processes, may also cause businesses to delay investment plans. The current system disproportionately burdens businesses, with a basic corporate income tax rate o f 35 percent. The Bank has supported, through the FIAL program, reforms that aim to broaden the tax base and reduce distortions in the 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 o f hiring apprentice workers, as well as extending the working day. I t also increased the flexibility o f the training system by allowing for greater use o f private providers o f training services. However, in the 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 in the rest o f the region, hiring new workers remains more difficult and costly in Colombia, and continuing l i m i t s on overtime employment make i t difficult to increase output using current staff. Altogether, these factors raise labor costs for f i r m s 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 wi l l probably have to be addressed by the next administration. The analytical work prepared by the Bank as part o f 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 o f additional structural reforms i s more l ikely to be successful if carried out by the government starting in August 2006 during the period o f increased political momentum that accompanies a new administration. The Bank, in the policy notes it w i l l prepare for the incoming administration, w i l l 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

Labor Market Adjustment, Reform, and Productivity in Colombia: What Report 32068-C0, June 2005

areas: (a) overall business

are the Factors that Matter?

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 program through a three-stage programmatic D P L operation. The f irst proposed DPL operation would support measures in the first three o f 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 al l five dimensions, but with a particular focus on the three areas to be supported by the f i rs t proposed loan.

Figure 1: Policy Areas for Enhancing Business Productivity and Efficiency

BUSINESS ENVIRONMENT

24. Amid limited growth in private investment since the 1999 crisis, the GoC has made it a priority to improve the country’s business environment. Despite positive macroeconomic developments, private investment has not yet recovered to pre-crisis levels. I t f e l l from almost 12 percent o f 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 o f GDP, compared with almost 20 percent in 1998 and 12.7 percent in 2000. Government efforts to facilitate a stronger private sector supply response have included the establishment o f new fiscal incentives for certain types o f private investments (Law 788 o f 2002), increases in labor market flexibility (Law 789 o f 2002), measures to facilitate foreign direct investment (Decree 1844 o f 2003), and new incentives to promote credit to the private sector (Law 795 o f 2003).

25. The enhancement of the business environment also seeks to address the problem of informality by lowering the costs of being part of the formal economy. Informality could have a significant impact on productivity and growth. Informal f i r m s have limited access to credit from formal credit institutions and other sources o f funding. They also lack the means to protect their property rights, business transactions, and contracts. Finally, informal f i r m s have fewer incentives to invest in training 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 i s as high as 40 percent for economic activity and around 60 percent for employment according to Confecamaras (National Federation o f Chambers o f Commerce, Confederacidn Colombiana de Camaras de Comercio) studies. Although tax evasion i s one o f the main incentives for informality, high transaction costs associated with, for example, licensing a 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 f i rms are created, operate, and invest. This category therefore incorporates actions to address obstacles 1,2, and 6 o f Table 3.

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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 in the world, after Slovakia. This high ranking was due to the country’s significant reforms in the 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 o f Public Administration (Departamento Administrativo de la Funcidn Phblica, DAFP), the Government has compiled an inventory o f bureaucratic procedures (trcimites), and identified those that have a direct effect on business activities: about 1,000 out o f a total o f 2,676 procedures. In policy document No. 3292, o f 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 o f inter- institutional coordination, an update o f the legal framework, the rationalization o f existing procedures, and the technological strengthening o f government agencies. By December 2004, about 150 bureaucratic procedures had been simplified and 1 8 eliminated.

28. The July 2005 approval of L a w 962 i s a significant achievement in this area. The law, drafted by the Ministry o f Interior and Justice, created a new framework for the simplification o f 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 o f them and from raising funds through charges for such processes. I t 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 collaboration with 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 de Atencidn Empresarial, CAEs) in six major cities. The design and initial implementation o f the CAE program has been supported through a grant from the Inter-American Development Bank (IADB).7 CAEs 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 o f 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 5 1 more cities to the six already covered, to further simplify the business registration process, and to expand the array o f entrepreneurial support services offered by CAEs. Table 4 summarizes the program’s results.

~

’ IADB Multilateral Investment Fund Facility TC-99-05-04-7

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Table 4: Achievements o f the CAE Program by June 2005

Cost of creating a company

1 Before program Results by June 15,2005 Target for 2007

without legal basis concipto left) eliminated Direct cost around COP930,OOO plus around average; and eliminate excess COP1 13,000 excess cost excess cost cut by around costs (mostly for conceptos)

Total costs cut by 20% on Cut total cost by 30%

COP85,400 on average

Time to set up a I 51 for individuals 1.8 business (days)

Number of times entrepreneur must meet with officials Organizations entrepreneur must deal with directly

Administrative processes entrepreneur must follow

1 55 for legal entities 4

3 1 for individuals 3.3

34 for legal entities 5 1

10 for individuals I 1

11 for legal entities 2 2 17 separate processes; 3 previous certification C a s ; 3 conceptos integrated into CAEs processes (conceptos) for eliminated in al l cities and previous which charges levied except Bucaramanga (1 certification processes

16 o f 17 integrated into A l l procedures

30. M a j o r administrative simplification efforts are also being made at the Ministry of Social Protection. These have concentrated in the unification o f the forms used by the Government agencies and private companies that collect social security and other mandatory contributions. Decrees 3667 o f 2004 and 187 o f 2005 established July 2005 as the deadline for launching an integrated system with a single form Cformulario zinico) that wil l replace the 283 different social security forms previously used by different institutions. The new system i s expected to allow for a significant rationalization o f administrative procedures in the Ministry o f Social Protection, with major benefits for individual and business users.

3 1, 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 o f 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 o f notification and enforcement, shortening these periods by 46 and 59 percent respectively. In the notification process, debtors are now informed o f court filings by a private courier company, as opposed to a court clerk. If the courier fails to reach the debtor, the notice i s published in a newspaper, and if the debtor does not show up in court, the case continues without him. The judgment stage remained unchanged. For the enforcement o f 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 o f commerce- not only the judge-can organize auctions for the sale o f assets. In the area o f property registration, dramatic improvements have put Colombia well ahead o f international averages: i t now takes just 23 days to transfer a property title from the seller to the buyer, compared to 56 days on average in Latin America, and 34 days in the OECD countries.

32. The new “Legal Stability Law” seeks to address investor concerns about legal and tax instability. Law 963 o f July 8, 2005, allows for limited guarantees o f legal, regulatory and tax stability for major investors, both foreign and local, who enter into contracts wi th the

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government for an annual fee o f one percent o f the value o f the investment. In return, the government guarantees that the project covered w i l l be exempt from any changes to applicable laws and regulations specified in the contract. Exceptions include labor and social security laws, taxes and charges introduced in a state o f 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 o f 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 o f Financial Sector Adjustment Loans (FSALs), through Anti Money LaunderingKombating the Financing o f Terrorism (AMLKFT) initiatives. These reforms are discussed in the financial sector section below. In the 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 o f large quantities o f contraband imports, a principal form o f asset-laundering through the non-financial sector. But the sale within Colombia o f 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 o f “front” companies and other illegal businesses in construction and other sectors also undercuts legal competitors. Furthermore, the entry o f extra foreign currency through money laundering contributes to peso appreciation, which diminishes the competitiveness o f exports priced in pesos (i.e. not commodities).

34. Despite important recent reforms, the Colombia business environment still presents major challenges, such as the need to facilitate bankruptcy procedures and strengthen investor rights. The country’s collateral and bankruptcy laws are less conducive to lending than those in the OECD. The average duration o f bankruptcy procedures i s three years, which i s less than the Latin American country average o f 3.7 years, but i s s t i l l high compared 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, w i l l reduce the time required for restructuring and liquidation procedures. However, due to the recent extension o f Law 550, which covers bankruptcy processes, consideration o f the new proposed legislation in Congress i s likely to be delayed. The Bank has provided analytical support in the context o f 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 o f credit, th is i s discussed further below in the Access to Finance section. Wi th respect to investor rights, Colombia has a score o f 2 on a scale o f 0 to 7 in the Doing Business index that measures the degree o f investor protection through the disclosure o f ownership and financial information. The regional average i s 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 described here. These would be: (a) the enactment o f the Ley Anti-Trhmites; (b) the issuance o f CONPES policy document 3292, establishing the strategy on inter-institutional collaboration to rationalize bureaucratic procedures particularly regarding business activities; and (c) the enactment o f the Legal Stability for Investors Law.

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FOREIGN TRADE AND COMPETITIVENESS

36. The G o C i s using a broad consultative process to develop a n inter-ministerial strategy for enhancing international competitiveness. The process aims to establish a “Internal Agenda for the Productivity and Competitiveness o f Colombia” (Agenda Interna para la Productividad y Competitividad de Colombia, AI). The motivation for this initiative i s the GoC’s view that the potential benefits o f 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 o f a set o f complementary domestic policies in the areas o f innovation, human resources, infrastructure, environment, institutional development and MSME support. CONPES policy document No. 3297 established a methodology for drawing up the A I by defining, prioritizing and building consensus around the set o f 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 in the year.

37. The A I builds upon several ongoing initiatives to eliminate obstacles to competitiveness and coordinate policies for competitiveness enhancing purposes. One o f the main initiatives i s the “Colombia Competes Network” (Red Colombia Compite), coordinated by M C I T and wi th private sector participation. This initiative i s aimed at identifying policies to deal wi th obstacles to competitiveness in ten thematic areas. Another similar initiative i s the creation o f “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 suggests that Colombia’s competitiveness has improved considerably this decade. While Colombia’s ranking in the WEF competitiveness index i s still relatively low (64‘h out o f 104 countries in 2004), th is 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 3gth percentile in 2003 and 2004 (Figure 2). In 2004, 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 i t 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 o f 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~por t i ng .~ The M C I T 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

set out in CONPES policy document 3292. The ventanilla unica i s included within the GoC’s broader strategy to reduce bureaucratic procedures, as

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Figure 2: Colombia's Competitiveness

1995 1996 1937 1998 1999 m 2001 2002 2003 2004

1 Percentage of mntries lessconpetitim than Colombia,

1

19952XM I M . .., 36 30 25

20 15

10 5 0

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 in the port o f 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 o f physical inspections o f export-bound containers, through coordinating the work o f the several Government agencies involved. This program i s being piloted at Buenaventura and Cartagena and so far has permitted the elimination o f two out o f 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 inspection process.

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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) o f 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 S Y S T E M AND CAPITAL M A R K E T S

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, implemented a successful reform program that has strengthened and stabilized the 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 o f money laundering; capital markets; and money markets development. Further background on the financial sector i s presented in Annex 6.

Recent Developments 43. Credit to the private sector has fallen as a share of GDP, and there i s little sign of a real recovery in lending to businesses. Claims on Colombia's private sector dropped steadily from 27 percent o f GDP in 2000 to 23 percent in 2004. (Figure 3a). The recent level i s higher

lo This measure was also recommended in CONPES policy document 3342.

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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 o f GDP), Mexico (17 percent) and Venezuela (1 1 percent). However, Colombia s t i l l trails behind Chile (63 percent) and Brazil (35 percent). As a share o f total domestic credit, claims on the private sector fe l l from 75 percent in 2000 to 67 percent in 2004, reflecting the credit expansion o f 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 (Figure 3b).

Figure 3: Evolution of Credit in Colombia

(a) Credit to the Private Sector (% of GDP)

Chile

g g 50% b o 6 $ 40%

I 30% 0

O H

20%

10%

1997 1998 1999 2000 2001 2002 2003 2004 I 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 f iom a slight decline in the prevalence o f bank accounts: in 2003, 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 in circulation (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 o f the monetary base and impeded the smooth functioning o f the payments system. The Carrasquilla and Zarate12 Index and the Simplified Index proposed by Vil lar et al. (2005)13, both measures of the impact o f regulatory cost on financial intermediation, show a constant decrease unti l the introduction o f 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 th i s distortionary tax and its impact w i l l be reviewed and quantified with Bank analytical support as part o f a financial sector AAA to be finished by March 2006.

Asobancaria data. l2 Regulaci6n Bancaria y Tensi6n Financiera 1998-2001. Carrasquilla A and Zarate J. In ANIF (eds.) El Sector Financier0 de Cara a1 Siglo XI, Asociaci6n Nacional de Instituciones Financieras (2002) l3 Crtdito Represi6n Financiera y Flujos de Capitales. Vil lar L, Salamanca D, Murcia A. Mimeo Banco de la Rephblica, www.banrep.gov.co (2005)

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Figure 4: The Impact of Regulatory Cost and Burden on Financial Intermediation

Source; Villar, Salamanca and Murcia (2005)’ “CrCdito, Represi6n Financiera y Flujos de 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 o f bad loans (particularly for mortgage lenders), ‘financial repression’ (Le. a term used to refer to the burden o f financial taxes, reserve requirements and directed lending programs that affect a country’s financial sector), and operational inefficiencies (overhead ratio of 5-6 percent o f 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’ o f private sector borrowing by banks holding more government securities.

Figure 5: Evolution of Colombia’s Key Rates and Yields

0.“ O0 * .p‘ 9 cp‘Jhe$‘ *.p% ,*$ ,.“‘,.p’*.p’ ,*?’ J’,.p’ *.* ,*e@ J,.s” *.p*

+Average Yield on Net Loan PorHolio (annualized) -C Net Interest Margin +Interest on 8 M a y Deposit Csrtlflcates (DTF) +Inflation Rate (mlllng 12-month average)

Source; SB, DANE. Note: N e t Interest Margin i s net interest income o f the banking sector / average assets

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Housing Finance 46. T h e mortgage sector i s recovering slowly f rom the crisis. The housing portfolio i s relatively large by regional standards, accounting for 12 percent o f GDP, against 4 percent in Brazil, 6 percent in Mexico, and 16 percent in Chile - all well below the US rate o f 70 percent. Despite a recent boom in the construction sector, Colombia still faces a large housing deficit. On the supply side, the establishment o f the Colombian Home Mortgage Corporation (CHMC, Titulizadora Colombiana) has expanded market opportunities by creating a new source o f long te rm funds for mortgage banks, through the securitization o f a large portion o f banks’ portfolios. Currently, 30 percent o f the mortgage loan portfolio i s securitized, while an additional 5 percent i s funded through bonds. On the demand side, Colombians are s t i l l reluctant to seek mortgages, after the experience o f the 1998 system collapse, when soaring interest rates caused widespread foreclosures. In the high-income segment, now recovering strongly, the mortgage industry faces increased competition from savings and remittances. Obstacles to the recovery o f 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 in 2000 imposed a ceiling o f inflation + 11 percentage points on loan rates for low-income housing (Vivienda de Inter& Social, VIS). As long as this cap applies, this segment o f the market w i l l not really recover without additional support, as banks are unable to adequately price their risks. The GoC has attempted to eliminate th is ceiling, but its room for maneuver i s limited given the court decisions.

47. T h e GoC i s promoting the use of new investment vehicles for housing. To stimulate the use o f alternative sources o f financing, particularly for VIS, the Government issued Decree 1877 o f 2004. This provided the regulatory framework for real estate investment funds (REFS). REFS invest primarily (at least 60 percent o f assets) in real estate and the income stream i s derived from the rental payments that this real estate generates. To promote investments in the construction o f new VIS, the income stream from new VIS rental payments i s 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 wi l l 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 construction and acquisition o f housing since 1973, and since 1990 have been required to offer housing purchase subsides to workers earning less than four times the minimum wage. But grants o f subsidies have consistently fallen short o f projections (with 31,661 awarded in 2004 against a target o f 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 remedied this by permitting the sector to start taking deposits from members. Enactment o f Law 920/2004 allows for the provision o f housing finance by cajas to i t s affiliates in a framework o f 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 o f 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 in the previous paragraph.

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Microfin an ce

50. T h e G o C i s seeking to promote an active microfinance sector in the country. While formal lenders have been reluctant to lend to the 60 percent o f the households that earn informal incomes, unregulated micro-finance lenders are eager to do so. There are two types o f microfinance 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 o f the microfinance sector i s hampered by NGOs’ lack o f capital and the cap on interest rates for microcredits for VIS, discussed above. Microfinance lenders, as in other countries, tailor loan products and collection methods to the earnings and living situations o f 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 advantages o f their business model.

51. Through the National Guarantee Fund (Fondo Nacional de Garantias, FNG) the G o C i s seeking to support the development of microcredit in Colombia. Established in 1982, the FNG i s a government-owned company supervised by the SB. One o f FNG’s objectives i s to facilitate access to credit for MSMEs through the provision o f partial risk guaranteed4. About 93 percent o f the guarantees provided by FNG are 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, FNG has signed such agreements with 15 banks and 26 non-bank financial intermediaries. Under a 2004 agreement, Bancoldex may now offer automatic guarantee products to most o f i t s MSME clients. 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 beginning o f relationships between banks and MFIs. The prudential regulation o f FNG was strengthened by the issuance o f 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 o f decree 1324 o f 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 o f 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 o f risk-based loan classification and provisions, encompassing specific and general provisioning requirements. Risk-based regulation and consolidated supervision remain key issues going forward. The SBC, as recommended in the 2004 FSAP Update, issued norms concerning the role, duties, and responsibilities o f external auditors and internal comptrollers (revisores Jiscales), setting audit

14The guarantee 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, f ixed investment, starting a business.) Depending o n the type, the coverage o f FNG’s guarantee i s capped at between 50 percent and 70 percent o f the loan amount, for which commissions o f 1.50-3.05 percent are payable.

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standards and greatly increasing its objectivity. The Pensions Department o f the SB i s in the final stages o f the development o f an Early Warning System for the analysis, control and valuation of pension managers’ portfolios. This new system wi l l 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) wil l 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 o f supervisory responsibilities i s supported as a means to reduce interagency coordination costs. Given the dominance o f financial conglomerates in the banking system, the ground rules for cooperation should be clearly defined within the new SF. These should include specific requirements for the exchange o f information, consultation and assistance on policy, monitoring o f markets and entities, and conflict resolution processes. The new agency should define a lead supervisor within i t s organization with clear consolidation scope, responsibility and accountability conceming market, credit and liquidity risks, and stress tests, at the consolidated financial conglomerate level.

55. I t i s desirable that the merger be conducted in a way that not only limits disruption, but also promotes progress in governance and technical capabilities. The successful implementation o f the merger w i l l require that the new body receive additional resources to develop infrastructure, organizational arrangements, procedures and professional sk i l l s consistent with the new strategy. The current scheme guarantees funding for 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 w i l l be closely involved with issues associated wi th both the merger and strengthening governance and technical capabilities o f the regulator, both for the banking sector and capital markets. In particular, the forthcoming AAA financial sector program includes work on consolidated supervision that w i l l be used as input in defining the new superintendency’s responsibilities.

56. Combating money laundering and the financing of terrorism i s 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 in an institution connected with money laundering and take their business elsewhere; ii) operational, where impaired intemal processes or relations with other financial institutions impede the institution’s functions or raise i t s operating and funding costs; and iii) legal, due to the risk o f law suits, adverse judgments, unenforceable contracts, fines and penalties.

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 o f 2003). This policy stresses the significance o f the threat of money laundering and terrorist financing and enunciated GoC concems that the laundering of the proceeds o f cocaine and heroin marketing contributes to terrorism. Moreover, the Colombian

22

government emphasizes that money laundering distorts the proper functioning o f the economy as i t disrupts the foreign exchange market and other financial markets, and promotes the under- invoicing o f imports and exports and the making o f fictitious or simulated exports as a suitable mechanism for bringing il l icit money into the country with the appearance o f 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 o f 2003 and CE 34 o f 2004, on the contents and implementation o f the Comprehensive Money Laundering Prevention System (SIPLA), and CE 40 o f 2004 on the content o f suspicious transactions reports. The SV, has also modified its “Know Your Client” (KYC) ru les (obligation to identify clients and their economic activities).with CE 003 o f 2005, regarding the application o f simplified customer due diligence measures for non-resident clients. The BdR’s resolution No. 6 o f 2004 requires cross-border currency transactions above US$l 0,000 to be performed only through authorized businesses. In addition, DIAN adopted in 2002 a regulation on the prevention o f 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. I t 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. I t 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 o f work within the unit and utilize more sophisticated IT tools, including data mining software; (c) increasing levels o f 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. In 2004 the GoC’s issued Decree 3420 to reorganize and streamline the Inter-institutional Coordination Commission for AML (CCICLA), the consultative body o f the national government and coordinator o f the measures taken by the Colombian state to combat money laundering. The GoC i s also working to improve information-sharing, through the development o f a secure centralized database system that w i l l facilitate the flow o f information related to AML among the UIAF, law enforcement, regulators and supervisors and other government agencies involved. In addition, the SB, the SV and the Superintendency o f Cooperatives and Mutual Societies (Superintendencia de la Economi’a Solidaria, SES) have, with the assistance o f the Bank, formulated strategies and action plans to address operational shortcomings in AML 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 o f 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 Prepared by the Canadian government, a Colombian firm, GAFISUD, the IMF, and the U.S

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inspectors, raise awareness among supervised entities about AML/CFT and share experiences with foreign counterparts, to learn from international best 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 o f the Colombian AML/CFT apparatus and have set the following priorities: (i) adopting appropriate legislation on the financing o f terrorism, the freezing o f assets and nonprofit organizations; (ii) extending to certain non-financial businesses and professions prudential rules; (iii) enhancing the operational capacities o f supervisory agencies and the financial intelligence unit; and (iv) raising awareness of MLFT exposure. The Bank, through its Financial Market Integrity Unit, i s 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. In particular, there are concerns that proposed policy actions in the areas o f banking and capital markets development (e.g. additional risk management regulations, AMLEFT legislation) might ‘raise the hurdle’ for access to finance by SMEs in the short te rm as a result o f 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 w i l l 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 risk management methods) and can attract more domestic and foreign capital (because o f greater integrity and financial strength).

63. The first DPL would therefore include four o f the measures outlined in this section. These are: (a) the adoption of 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, o f an early warning system for pension funds; (c) issuance by the SB o f circulars 052 and 047 separating the role o f internal comptroller and external auditor and enhancing their role in risk management; and (d) the issuance o f decree 3420, reorganizing the C o m i s i h de Coordinacih Interinstitucional Contra e l Lavado de Activos.

Capital Markets 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 in market capitalization (to US$24.8 billion) over 2004. At this level, Colombia compares favorably with most Latin American peers (see Figure 10 o f Annex 6). However, primary share issues remain infrequent, with jus t two in 2004. Turnover in equities has increased, to roughly US$10 mil l ion a day in 2004 from less than US$2 mil l ion in 1998. But this remains low by international standards, and fixed income transactions s t i l l generate over 90 percent o f market activity. Overall, fixed-income securities represent 96 percent of outstanding securities, with the public sector providing 84 percent o f the total. The remaining 4 percent i s comprised o f mutual funds, derivatives and stocks. (See Figure 11 o f Annex 6). Institutional investors manage a total portfolio o f about U S 2 5 billion, more than two thirds o f this in pension funds.

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67. The SV i s ais# taking steps to attract more issuers into the market and to i m ~ r ~ ~ ? e ts fw the c tinns cos . l'hc sv 1s to SCffRC of

25

initiative o f creating an automatic prospectus-generating system i s also meant to improve competition by increasing transparency and cutting the costs o f new issuances. Prospectuses w i l l be accessible v ia internet, w i l l be automated according to the different categories o f instruments issued (common shares, preferred shares, preferred shares with voting rights, corporate bonds and commercial paper), and w i l l facilitate the standardization o f 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 o f a regulation establishing the framework to facilitate the creation o f Private Equity Funds.

68. The SV has also embarked on an educational and promotional program (Colombia Capital). The program addresses f i r m s that are potentially in a position to enter the financial markets, or that are already in them. I t aims to raise the number and size o f issues and better understand the needs o f companies, to possibly tailor new instruments accordingly. I t w i l l thus develop the SV’s knowledge base o f financial markets and create stronger l i n k s with the corporate sector. The program wi l l be launched next year.

69. In the area of capital markets, the first DPL would support three actions. These would be: (a) the enactment o f the Securities Law; that includes improved investor protection rules and upgraded supervisory powers for the SV; (b) the issuance o f 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. During the past ten years, the GoC has implemented a sound strategy for developing the local debt market as a means to diversify the sources o f public debt financing. As a result, the outstanding amount o f treasury securities (Titulos de Tesoreriu, TES) grew from US$1.8 bi l l ion in 1993 to US$18.1 bil l ion in December 2003, mostly in instruments denominated in Colombian pesos and issued at tenors greater than one year. A t 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 o f the yield curve. Indeed, the most liquid public debt instruments (denominated in pesos) are in this segment. The existence o f th is yield curve i s essential for the pricing o f private sector instruments.

71. Efficient secondary markets in government debt are essential, to prevent risk concentration in the private sector. Episodes o f market ill iquidity and vulnerability such as the domestic public debt crisis o f 2002 highlight the importance o f implementing a mutually reinforcing set o f reforms to reduce the vulnerability o f the system as money markets weakness can hinder not only the development o f the public debt market but also the stability o f the financial sector. The GoC i s aware o f the risk inherent in t h i s 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^"^,

l7 World Bank, “Reform Roadmap: Strategic Choices in Developing Colombia’s Debt Markets”. February 2003.

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developed by a multi-agency Colombian team assisted by the Bank, sets several key priorities for the improvement o f market liquidity and the reduction o f 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 o f the existing money markets, with emphasis on repos and other securities-based lending and including a diagnosis o f current restrictions for the issuance and liquidity o f 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), wi th different conventions in key areas such as “haircuts” for market risk, has also had an impact. MHCP- through both the General Directorate o f Public Credit and Treasury-is currently running a TES issuance program focused on building a benchmark curve for the short end o f the curve, in order to create a liquid indicator in short te rm markets. Efforts are concentrated on providing increased liquidity to the primary market and, in tum, to the secondary market. 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 mill ion in January 2003 to US$29.8 mil l ion 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$6.9 mil l ion per month in October 2003 to US$S9.5 mi l l ion in February 2004. This appears also to be due to the existence o f 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 o f a large number o f contracts and market practices. The three main kinds o f 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 o f monetary policy. These two agents make up more than 90 percent o f 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 f just 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 o f inadequate infrastructure for them i s reflected in low levels o f liquidity, increased r isks o f over-leveraging by market participants and in general o f mismanaging their risk positions, undermining the overall soundness and stability o f financial

Repos are financial transactions o f cash for securities, where the collateral i s kept frozen at the central securities depository (the Depdsito Central de Valores, DCV), and therefore cannot be sold or transferred further in other transactions. l9 Sell buy backs or simultaneas are a special kind o 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 i t can be used as a securities-driven instrument.

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markets. Tax, accounting, and legal uncertainties also have hindered rep0 market development. A working group from the MHCP, BdR, SB and SV i s working towards the development o f the legal and regulatory framework related to this type o f operations. I t i s assisted by a team o f international consultants financed through a FIRST initiative grant project2', and supervised by Bank staff.

75. A better framework for corporate insolvency i s necessary to facilitate the restructuring and closure of firms, and ultimately increase the provision of credit. An effective insolvency framework stimulates the provision o f credit as financial institutions expect lower net losses in case o f default. The main weakness in insolvency and restructuring proceedings i s a lack o f protection for secured creditors, who are not even considered as a separate class o f creditors. Shareholders, who are entitled to vote on restructuring plans l ike any other creditor (secured or unsecured), often end up skewing the priority rules. As a result, legal rights set out elsewhere in the law may be modified in an 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, i t 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 reorganizing rapidly.

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 o f the situation and limitations o f the existing money markets with emphasis on repos and other securities-based lending and (b) the finalizing o f a study that diagnoses current restrictions for the issuance and liquidity o f TESs in primary and secondary markets.

QUALITY STANDARDS AND TECHNOLOGICAL INNOVATION

77. The adoption of international standards by the service and industrial sectors promotes competitiveness among Colombian businesses. The wider application o f international standards can raise the quality, safety, reliability, and efficiency o f 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 o f national standards institutes, i s the principal developer o f 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. A t the end o f 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 o f the cost o f training and technical assistance projects pursuing certifications. This i s 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 in December 2004.

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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 o f certification projects. (Further details o f these programs and other aspects o f quality certification in Colombia in Annex 7 )

79. The weak link in Colombia’s quality certification system i s accreditation, for which functions are dispersed and objectivity compromised. The Division o f Technical Standards o f the Superintendency o f Industry and Trade (SIC) o f the M C I T now accredits and supervises most certification bodies (independent organizations that assess and certify conformity wi th international standards), as well as testing and calibration laboratories. This arrangement has several shortcomings: (a) the other functions o f the Division o f Technical Standards raise conflicts o f interest: i t 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 o f SIC does not guarantee that the activities o f the departments related to those other hnctions do not compromise the confidentiality, objectivity and impartiality o f i t s accreditation services. (c) Other government agencies also have accreditation functions in some areas, such as INVIMA, the National Institute for the Supervision o f 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 o f the main regional or international accreditation bodies23 and has entered only one international mutual recognition agreement, with the Andean Community. The other problems o f the current arrangement outlined above could be addressed through internal changes in SIC to separate accreditation h c t i o n s more clearly from other activities. But pursuing greater international recognition may require the establishment o f a legally separate, more autonomous accreditation body, wi th greater flexibility to enter international groups and agreements. (Government departments must pursue these-as with treaties-through the Ministry o f 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 o f 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 o f 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 Ticnicas y CertiJicacidn) 22Technical regulations 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) and the International Laboratory Accreditation Cooperation (ILAC).

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Colombia s t i l l compares poorly for indicators on productivity, s k i l l s and technology, even within the context o f Latin America, which compares poorly with other regions. While countries in the region spend an average o f 0.5 percent o f 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 o f 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 concentration o 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 benefited the 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 f i r m s (Annex 7 includes further details o f 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 o f government funds for S&T, followed by the Ministry o f Agriculture, the National University and a large number o f 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- received 74 percent o f 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 o f its parafiscal revenues to programs aimed at promoting technological development or increasing the competitiveness o f the Colombian productive sector (Law 344). The current Government mandated that 25 percent o f the resources for SENA should go to innovation and competitiveness promotion - almost US$14 mil l ion in 2003 should be allocated directly to Colciencias. In 2003, the resources obtained through SENA represented 32 percent o f Colciencias’ budget, thus compensating for a reduction in its allocation from the national budget. SENA also plays a crucial role in promoting the competitiveness o f the private sector through i t s traditional training programs. Recently, the government announced i t s intention to increase competition in the National Sk i l l s 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 M C I T manages FOMIPYME, the Colombian fund for the modernization and technological development o f MSMEs, created in 1990. In 2003, F O M P Y M E co-financed projects for about US$9 mil l ion (US$4 mil l ion in 2002). About two

24 Closing the Gap in Education and Technology. De Ferranti D, Perry G, Gill I, Guasch J, Maloney W, Sanchez C, Schady N. The World Bank (2003). 25 Science and TechnoZogy in Colombia. Agapitova N, Holm-Nielsen L, Vukmirovic G. The World Bank LCSHD Series (2002). 26 Agapitova et al. (2002).

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85. thirds o f the projects financed by FOMIPYME are for micro enterprises, with the remaining allocated to SMEs. Colciencias has also directed an increasing share o f i t s budget (46 percent in 2004 compared with 32 percent in 2003) to financing private sector technological development and innovation, with a large share o f the corresponding funds directed to MSMEs. In 2004, Colciencias spent more than US$11 mill ion (US$7.5 mil l ion in 2003) financing those activities, either through direct support to private companies or through Centers o f Technology Development, company incubators or other entities o f 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 in the Bank, particularly through the logistics, quality and competitiveness AAA, w i l l help to clarify needs and priorities in these areas, informing government policy design and providing a basis for future Bank support, possibly through the second loan o f this series.

I N F R A S T R U C T U R E AND L O G I S T I C S

87. M o r e reliable and affordable infrastructure, particularly as it affects logistics, i s critical for Colombia’s competitiveness and therefore to boost economic growth. The Recent Economic Developments in Infrastructure (RED127) study indicates that Colombia would need to invest around US$2.6 bil l ion per year (or 3.2 percent o f GDP) on infrastructure, to improve the productivity and competitiveness o f the country. In particular, transport sub-sectors-roads, ports, airports and inter-modal facilities-present pressing investment needs. Overall, the RED1 estimates the share o f the total infrastructure investment that could be financed directly by the private sector at around a third (or 1 percent o f GDP). However, private sector participation i s still hampered by constraints including: unclear prioritization among infrastructure projects by the govenunent; the instability o f 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 o f the problem i s geographical: production i s concentrated in the mountainous interior, while around 85 percent o f exports leave by sea. The security situation also increases the cost and risks o f transportation. But there i s still considerable scope to reduce costs and delays by improving the quality, efficiency, organization and governance o f logistics. Logistics costs in Colombia represented 18.6 percent o f sales in 2003- 2004, which i s 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 much higher in Mercosur and Chile, at 3 1.6 percent.

27 Report 30379-CO

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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 Bank Report 2005

89. Colombia’s government has made roads the main priority for 2006 infrastructure investment, but longer term funding s t i l l needs to be secured. The RED1 identified Colombia’s roads as the country’s greatest area o f competitive disadvantage, in terms o f infrastructure. The proportion o f the paved road network considered by the government to be in fair or bad condition rose from 22 percent in 1998 to 29 percent in 2003. (Around 70 percent o f the primary network and 15 percent o f the total network i s paved.) The Government’s 2006 budget proposal allocates 880 bil l ion pesos for road construction and paving, making this the largest program o f public works in recent years. A further 144 bi l l ion pesos i s earmarked for road maintenance. However, for the longer term, roads expenditure remains too dependent on budget allocations, which have tended to be both unstable and insufficient. The creation o f 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 o f truck freight i s carried on shippers’ own fleets and long-term contracts are unusual. Most trucking i s outsourced to formal transport f i rms, which usually sub-contract to informal owner-operators (82 percent o f whom own only one vehicle.) Tensions between transport f m s and operators have prompted govemment regulations to set mandatory rates for different types o f vehicles in different regions, rates which bear little relation to market levels. The recent Bank analytical work on logistics and competitiveness” included a study o f the trucking sector, to support future reforms to it. The atomized structure o f the trucking sector, as well as regulatory, insurance and other issues complicate the provision o f coordinated transport services. Colombia lacks multimodal transport systems and providers and intermodal facilities are inadequate. There i s also a real need for f i r m s to modernize their own transport and logistics systems. Some public investment in multi-modal terminals and logistics complexes w i l l be needed to complement changes in managerial practices in the private sector.

91. Projected increases in import and export volumes will put particular stress on gateways. The volume o f foreign trade i s expected to increase significantly with trade agreements and international trends towards greater economic openness and the globalization o f supply chains. World Bank projections based on DNP data suggest that import volumes w i l l grow by 9.5 percent per year until 2010, while export volumes expand at the slower rate o f 6.1

28 Quality and Logistics Infrastructure for Competitiveness, report number forthcoming.

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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. T h e 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 o f March 2005, which was prepared with Bank assistance. The central pillar o f this strategy i s the revised, more rigorous contractual arrangement that the Ministry o f Transport i s developing for the private operators o f 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 o f management and operation structures, all o f which has contributed to the varying (and sometimes poor) standards o f port operations now evident. CONPES 3342 also sets out other key improvements to be sought: the deepening o f port access channels (Barranquilla and Buenaventura) and the improvement o f land access (Buenaventura, in particular); the institutional reorganization o f the sector; facilitating the development o f private ports; and the improvement o f information systems. An earlier CONPES document (no. 3315 o f November 2004) puts port investment needs are put at US$50 mill ion a year for the period 2005-10. The bulk o f this (US$40 mil l ion a year or US$240 mil l ion in total) w i l l be sought from private operators, to increase capacity and improve performance through investments in equipment, facilities and systems. Complementary public investments are needed to improve land and sea access.

93. El Dorado i s South America’s busiest airport for cargo, handling 404,000 tons in 2002. I t processes 80 percent o f the country’s international air cargo. But cargo administration i s uncoordinated, cargo terminals have insufficient capacity and other facilities need modernizing. Cut flowers, the main product f lown out o f the capital, are generally transshipped directly from trucks to aircraft due to a lack o f appropriate warehouse facilities. Colombia’s Civ i l Aviation Administration Unit (UAEAC) i s aware o f the need to address the situation, and i s 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 in the concession process that the govemment i s preparing, with Bank advice, for the operation o f the airport’s main passenger terminal.

Bogota’s El Dorado airport needs to handle cargo better.

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 o f electricity during the serious drought in 1992/1993. Since then, the country has reduced the dominance o f hydropower from 80 percent to 66 percent o f total capacity, primarily through promoting generation fueled by natural gas. The droughts o f 199711998 and 2002/2003 passed without major economic loss. However, around 40 percent o f f i r m s surveyed for the REDI in 2004 maintained their own generation capacity, almost two thirds o f these motivated primarily by the need to ensure energy supply. Additional measures to improve supply would reassure f i rms, 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-standard distribution networks o f local utilities.

95. The reform process in infrastructure i s moving ahead, with broad Bank involvement, and i s expected to be supported by the third operation of this DPL series. The GoC i s 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 i t s dialogue with the Government, the Bank i s actively supporting t h i s process. The recent logistics and competitiveness AAA has built on the RED1 to identify bottlenecks that hinder

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Colombia’s competitiveness. All o f 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 o f capital markets backed by this operation should contribute to the provision o f long term financing, which i s key to the implementation of infrastructure projects.

V. BANK SUPPORT TO THE GOVERNMENT’S STRATEGY

LINK TO THE CAS 96. In promoting business productivity and efficiency, the proposed loan aims to foster fast and sustainable growth, the pursuit o f which i s the f irst thematic pillar o f the Bank’s Country Assistance Strategy (CAS) for Colombia. The Bank Group strategy, as expressed in the CAS report 25 129-CO dated December 24, 2002, which was discussed and endorsed by the Executive Board on January 16, 2003, has two other main pillars: sharing the fruits o f 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 o f joining the formal sector, which should help reduce informality. Joining the formal sector can bring financial and other benefits to MSMEs, employees and the self-employed. In addition, the simplification o f bureaucratic procedures contributes to better governance.

97. The design o f the proposed loan i s informed by the Private Sector Strategy, which cuts across the World Bank Group activities envisaged in the CAS. The Strategy aims overall to help foster a business environment with fewer impediments to the achievement o f the potential o f the private sector, especially in accelerating growth. It has four priority elements, o f which th is operation focuses on the f irst and third: (a) bringing about a strengthening o f the business environment through improvements in the regulatory framework and reductions in the administrative burden on enterprises; (b) improving the efficiency o f 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 o f otherwise strong private f i r m s 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 i s part o f 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 o f the subsequent two operations i s conditional upon Colombia continuing to meet these macroeconomic conditions for remaining in the high case.

COLLABORATION WITH THE IMF AND OTHER DONORS AND LENDERS 99. A new US$613 mil l ion Stand-By Agreement between Colombia and the IMF was signed at the end o f April. This Agreement covers the next 18 months (until October 2006) so as to include the transition to a new government. The agreement w i l l be treated as precautionary, as a transition to the end o f 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) o f US$2.3 billion. The govemment treated the arrangement as precautionary and did not draw on it. Colombia metlexceeded the program’s targets

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during the preparation o f this operation to ensure consistency with the benchmarks specified in the current IMF agreement wi th 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 o f Chambers o f Commerce, Confecamaras, to facilitate the streamlining o f new business registration procedures. I t has also supported the development of new businesses by providing a grant to the University o f Los Andes to provide technical and financial support to clusters o f fledgling MSMEs. The IADB i s preparing a policy-based loan in 2006 in support o f some o f the measures that the GoC w i l l take as part o f the implementation o f some o f the recommendations o f the AI (Agenda Interna) process. The Bank team preparing this operation has coordinated with the IADB carrying out the competitiveness dialogue to ensure complementarity o f the areas supported by each institution particularly with respect to the second and third operations o f this DPL.

101. The Andean Development Corporation (CAF) has concentrated i t s support to the GoC primarily in the area o f infrastructure financing for a transportation network upgrading plan which seeks to enhance overall competitiveness by addressing some o f the transportation bottlenecks in the country. The GoC and the CAF are finalizing the negotiation o f a policy-based loan that supports regulatory changes in the infrastructure sector that would directly affect competitiveness, particularly to enhance competition in the telecommunications and ports sectors. The Latin America and the Caribbean Finance, Private Sector and Infrastructure Unit o f the Bank, has reviewed these operations with CAF staff to ensure alignment o f strategies. More recently, CAF has also supported the strengthening o f the financial supervisory regime by providing technical assistance to MHCP in the process of merger o f the banking and capital markets superintendencies.

RELATIONSHIP TO OTHER BANK OPERATIONS 102. The proposed program would build on the achievements o f two recent Bank programmatic financial sector adjustment loans (FSALs), approved in April 2003 and September 2004. The first o f these followed on from an earlier FSAL (approved in October 1999) and supported advances in the process o f restoring soundness to the banking system after the crisis that started in 1998. I t 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 o f a new legal framework for managing banking risks.

103. The Bank i s also engaged in a Programmatic Labor Reform and Social Structural Adjustment Operation (PLaRSSAL) to Colombia. The Executive Board approved the first o f 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 o f reforms that w i l l 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 acceptable wages, while improving the social protection o f vulnerable workers. In particular, the approval o f 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

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modernization o f the National Training Service (SENA) has increased i t s efficiency and effectiveness.

104. By promoting the simplification o f 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 o f three fiscal and institutional structural adjustment loans (FIALs.) The FIALs’ support for stronger more transparent state functioning, particularly in the areas o f 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 in the country, as discussed above. The first o f the loans o f this program was approved in March 2003, the second in November 2003, and the third in March 2005.

105. A number o f bank projects have supported improvements to infrastructure, a key determinant for business productivity that i s not included in the current program. In the transport sector, the Bogota Urban Transport Project has led to the Integrated Mass 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 L a Guajira, while the Bogota Urban Services Project provides social infrastructure to 600,000 o f the poorest residents o f the city. This operation i s also related to several M activities discussed below under Analytical Underpinnings.

106. IFC’s work in Colombia i s directly related to the development objectives o f this loan. The IFC has focused on: (i) improving access to finance; (ii) investing in companies that promote growth and employment; (iii) infrastructure investment; and (iv) supporting environmentally and socially sustainable business practices and corporate governance. Highlights o f IFC’s recent activities include development o f the mortgage market, launching o f a number o f innovative financial products (e.g. the first Peso-denominated bond and the increased use o f partial guarantees), and support to companies in the manufacturing and financial sectors. The increased use of guarantees and the issuance o f domestic bonds have been instrumental for the development of local capital markets. They have also helped to improve the debt profile o f many Colombian companies.

107. In the mortgage sector, IFC provided a partial credit guarantee to the Colombian Housing Mortgage Corporation, a secondary mortgage company, for the issuance o f Latin America’s f i r s t non-performing mortgage loans securities. This investment has been instrumental in establishing 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 o f the portfolio also improved markedly, wi th the elimination o f nonperforming loans.

108. During the remainder o f the extended CAS period, the IFC w i l l concentrate i ts work in four areas: (i) the strengthening and deepening o f financial sector institutions and local financial markets to better serve the needs o f 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 o f infrastructure, in coordination with the Bank as warranted; (iii) the modernization o f Colombian businesses to help improve their competitiveness

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and support their expansion both domestically and abroad; and (iv) investment in extractive industries. The first three o f these areas are directly related to the objectives o f this DPL series.

LESSONS LEARNED 109. The design o f 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. In particular, lessons learned were incorporated from the Brazil First Programmatic Loan for Sustainable and Equitable Growth (Ln. 72 18-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 in February 2000 (Implementation Completion Report (ICR) issued in December 2000). The most important lessons from these operations are the 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 i s the case in this DPL series that spans across two presidential administrations. 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- te rm approach to a reform theme.

11 1. The value of prior strong analytical work. In preparing private sector development and financial sector policy-based operations, the Bank should lead with i t s comparative advantage which i s bringing to bear strong technical capacity and ample cross-country experience. The Borrower must be confident that i t s dialogue with the Bank wil l add value to i t s 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 o f 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. In designing a policy- based operation, political factors and the legislative needs o f the country need to be understood and included in the dialogue with the client, particularly if part o f the implementation o f the reform program w i l l involve a future administration. The broad consultations that have been carried out by the Government in the context o f the negotiations o f 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 designing a program that would address these at this stage would be r i s k y and thus should be left as part o f the dialogue with the new administration in mid-2006.

113. The commitment of the Government i s central in ensuring the success of the program. Previous policy-based and investment operations all pointed to the important role o f strong government leadership in their success. The proposed operation effectively responds to

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the Borrower’s own priorities and commitment as reflected in the actions already taken, such as the recent passage o f important legislation, as well as the fact that the policy thrust supported by this operation l ies directly along the key policy axes o f the Government’s National Development Plan.

114. Coordination with other international financial institutions, such as the IMF and the IADB, i s 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 o f competitiveness. Furthermore, CAF has become an increasingly important player in Colombia, particularly in infrastructure, and the development o f this Program, particularly as it moves towards the second and third operation, w i l l be carried out in consultation with the CAF Colombia team.

ANALYTICAL U N D E R P I N N I N G S

115. prepared by the Bank during the last 18 months:

The preparation o f th i s operation has benefited from six key analytical documents

(a) Country Economic Memorandum. This provides a broad overview o f the constraints to competitiveness faced by Colombian f i r m s particularly with respect to the FTA and its overall approach to the problem has been used in the design o f 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 design the reform program for quality and logistics to be supported by subsequent operations in th i s DPL series.

(d) Financial Sector Assessment Program Update. Jointly carried out with the IMF, this provides an overview o f the main financing challenges faced by Colombian businesses and the measures that the Government has taken to address these in a sustainable manner.

(e) Labor Market Adjustment, Reform and Productivity in Colombia: W%at are the Factors that Matter? This addresses the constraints to productivity derived from the labor market which, though not directly addressed by this DPL series, constitute an essential element o f business productivity 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 adequacy ratios.

1 16. The GoC and the Colombian academic community have also produced several analytical studies and other reports that were used in the preparation o f the Program. In particular, the National Development Plan 2002-2006 (Hacia un Estado Comunitario) and several CONPES policy documents, specified in the section on key issues for business productivity and efficiency, have helped set the framework for the development o f this program.

1 17. The GoC has requested, in light o f the upcoming elections, that the Bank engage in broad dialogue with all stakeholders-not just the current Administration-on these topics during the next nine months. This process was initiated in late May 2005 through a broad consultation with market participants on the reform program in the financial sector. As a result o f this consultation,

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the GoC requested the preparation o f additional AAA in financial services during FY06 on topic related to financial deepening that directly support the detailed designs o f reforms to be supported by subsequent operations in this Program.

VI. THE PROPOSED PROGRAMMATIC DEVELOPMENT POLICY LOAN

OPERATION DESCRIPTION 118. alleviation o f poverty by:

The development objective o f this operation i s to support sustainable growth and the

(a) Facilitating the operation o f businesses and promoting investment, to boost productivity and employment levels; and

(b) Consolidating the financial sector and capital markets as pillars o f economic growth to addresses the needs o f individuals and the productive sector.

1 19. The World Bank would support th i s process through 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 in three areas:

(a)

(b) (c) Increasing access to capital markets by enterprises and improving the

Enhancement o f the business environment to improve the competitiveness o f the productive sectors o f the economy.

Increasing the soundness and depth o f the financial system.

efficiency o f secondary markets.

120. The second and third DPLs would support the completion o f implementation o f 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 th i s sequencing based on the availability o f the analytical work as well as the political timing associated with some o f the reforms, issues discussed below in the Risks section. The second loan i s expected to be presented for Executive Board consideration in the first quarter o f FY07 and the third loan in the first quarter o f FY08.

121, The GoC has completed all the previous actions for presentation o f the first operation to the Executive Board, as listed in Box 1. Box 2 presents triggers for the preparation o f the second operation. In addition, because the second and third loans are part o f the CAS’S high case lending scenario for Colombia, the execution o f both o f these i s conditional upon Colombia maintaining a sound macroeconomic policy framework, as this i s a requirement for remaining in the 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 o f 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 o f a Legal Stability for Investors Law under which investors in major new projects can purchase government guarantees that certain applicable rules w i l l not change

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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 i t s affiliates in a framework o f adequate prudential regulation; (b) Issuance by M H C P o f the decree regulating the financial activities to be carried out by Cajas de Compensacidn; and (c) issuance by M H C P 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 b y 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 o f a

Securities Law that includes improved investor protection rules 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 system to lower transactions costs o f new 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 wi th 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

I Box 2: Indicative Triggers for Second Programmatic Loan

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 international best 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 m id term road map for reform in the financial sector, supported by sound analytical underpinnings, to address the needs for increased access and diversity o f financial products

A bill criminalizing the financing o f terrorism has been submitted to the legislature

Issuance o f norms regulating the 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 w i l l constitute the fundamental indicators to be measured during the Program, several quantitative indicators that relate to the part o f the Program supported by th is loan w i l l be monitored, bearing in mind that many o f these indicators are influenced by factors beyond the scope o f this Program.

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Table 5: Monitoring Indicators

Streamline foreign trade activities

Lower the regulatory r isk o f new investments

Improve financial access

Strengthen supervision

Lower the impact o f i l legal activities o n the financial sector

Strengthen capital markets

Enhance Business Environment and Promote Trade

Competitiveness

property - Percentage o f foreign trade transactions being carried out through the Ventanil la Unica mechanism - Number o f new investment projects using the guarantee facil i ty provided by the Legal Stability for Investors L a w - Total financing to the private sector as percentage o f GDP - Prudential indicators o f the financial system (Capital adequacy, coverage ratios) - Number o f suspicious financial transactions jo in t ly investigated by the FIU and the SB -New debt and equity issuances

Increase the Soundness and

Eff iciency o f the Financial System

Strengthen the domestic money markets and government debt secondary markets

Promote access to Capital Markets by

Enterprises and increase Eff iciency

o f Secondary Markets - Liquidity o f the domestic rep0 markets

- Liquidity o f the secondary markets

Policy Action Area Reduce o f transaction costs and increase efficiency o f entrepreneurial activities

Indicators -Evolution o f the inventory o f administrative procedures as defined by CONF'ES 3292 - Indicators reported yearly in the Bank/IFC Do ing Business Report: T ime to start a business, t ime to register

supervision and promote new issuances and the development o f new capital markets products

-Traded volumes - Indicators reported yearly in the Bank/IFC Do ing Business Report particularly regarding the Disclosure Index (Corporate Governance o f Publicly Listed Firms)

LOAN AMOUNT 123. The proposed US$250 mil l ion 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 o f 2005.

POLICY AREAS

A. Enhance the Business Environment and Promote Trade and Competitiveness

124. DescriptiodGovernment Actions. One o f the pillars o f the National Development Plan 2002-2006 i s the improvement o f 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 in promoting business activity, moving away from direct intervention.

125, reforms:

With this aim, the proposed operation seeks to support three types o f legal and regulatory

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(a) Reduction o f transactions costs and increased efficiency o f 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 governing major new projects w i l l not change.

126. 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 o f the business environment, as part o f the negotiation o f the FTA, which reduces risks. Establishing contractual guarantees o f legal and regulatory stability i s a second best alternative to providing that stability per se, a process which i s more difficult as i t involves a broader set o f stakeholders. However, this i s a move in the right direction.

Challenges.

127. Bank’s Assessment/Recommendation. The measures taken and the results presented in the 2005 World Bank/IFC Doing Business publication reflect the strong commitment o f 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 o f the most serious constraints to doing business in Colombia. The Bank should support recently taken and imminent actions as part o f th is process.

B. Increase the Soundness and Depth of the Financial System

128. DescriptiodGovernment Actions. The GoC’s program in this area seeks to address the need for greater access to financial services by the productive sectors o f the economy, while further strengthening the financial sector, to ensure sustainable growth o f financial deepening.

129. The proposed operation support reforms in three areas o f the financial sector:

(a) Improve financial access by allowing the provision, under regulation, o f credit by cajas de compensacion, non-profit associations for employee benefits and social services, and allowing the sustainable and market-oriented growth o f FNG activities;

(b) Strengthen supervision o f financial markets through the adoption o f a plan to support the ongoing merger process banking and capital markets supervisors, enhancing early warning systems for pension funds, and improving banks’ corporate governance; and

(c) Lower the impact o f illegal activities on the financial sector by enhancing the coordination o f government agencies seeking to combat money laundering and terrorism financing

130. Challenges. The Government’s fiscal requirements may continue to create a situation o f crowding out, which would l imit additional financing flows to the real sector. The new risk- based approach to bank provisioning requirements and the consolidation o f SB and SV into a single institution are all major projects that individually require substantial resources, investment in human capital and redefinition o f processes. Improved prudential regulation and a better

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AMWCFT framework may in some circumstances actually constraint the supply o f credit, however, are also pre-conditions for sustainable growth o f the financial system.

13 1. Bank’s Assessment/Recommendation. The GoC, with continued support from the Bank, has carried out an effective reform process in the financial sector after the crisis o f the late 1990s. Colombia i s one o f the pioneers in addressing what appears to be the emerging challenge in the financial sector in Latin America: how to boost the growth o f credit (i.e., financial deepening) without incurring in stability risks. The new generation o f reforms, designed to foster the role o f the financial sector as the engine o f growth o f the economy, i s based on solid principles and should be supported by the Bank.

C. Promote Access to Capital Markets by Enterprises and Increase the Efficiency of Secondary Markets

132. DescriptiodGovernment Actions. The GoC, with Bank support, i s carrying out a reform program to foster the development o f the local capital markets, to provide f i r m s 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 o f the Capital Markets Law, regulatory reforms and the creation o f new instruments to raise the efficiency o f the markets.

133. The proposed operation w i l l support three sets o f reforms:

(a) Strengthen capital markets development and supervision through the enactment o f a new Capital Markets Law;

(b) Promote new issuances and the development o f new 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 appear to support any initiative to consolidate the existence o f a liquid and stable risk free reference rate, many o f the reforms w i l l need to be backed by market participants in order to bring effective growth in Colombia’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 o f 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 o f a mil l ion people. Strong and stable growth has historically helped the poor in Colombia by raising living standards, easing unemployment and increasing public resources for social spending.

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137. The operation also seeks to address the problem o f informality, by enhancing the business environment and lowering the costs o f being part o f the formal economy. Lower informality could bring significant economic and social benefits. Formal f i r m s have better access to credit from the financial system, and therefore more possibilities for investment, growth and the adoption o f new technologies - all o f which can reasonably be expected to boost efficiency, productivity and economic growth. Formal f i r m s 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 jo in the formal sector-has multiple causes, the impact on informality o f the measures supported here would be extremely difficult to quantify. The Bank is, however, examining the possibility o f tracking the access to credit o f MSMEs, both formal and informal, as part o f a forthcoming Investment Climate Assessment (ICA) o f 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 reduces the costs and inconvenience associated with financial transactions, including the payment o f uti l i ty and other bills and the receipt o f salaries and remittances. Also, promoting the availability o f credit lines from commercial banks to micro finance institutions w i l l make i t easier for these to provide resources to entrepreneurs and MSMEs. Facilitating the creation o f companies and integrating MSMEs more closely into production chains will also increase the possibilities for small businesses to provide employment and a route out o f poverty.

SUPERVISION

139. The MHCP wi l l be the representative o f the Republic o f Colombia (the Borrower) and w i l l be responsible for the overall implementation o f this program. MHCP has designated the Enterprise Development Directorate (DDE) within the DNP as the agency coordinating the business environment enhancement component o f the program. MHCP has designated the General Financial Regulation Directorate within MHCP as the agency responsible for coordinating the two other components on the program related to financial and capital markets.

140. Bank staff w i l l monitor actions and review progress o f the implementation o f the proposed operation, as well as the subsequent actions o f the Government’s program through frequent visits to the country and constant communication with MHCP and DNP authorities. Bank staff w i l l focus on monitoring progress towards the indicative actions for the second programmatic loan and the overall goals o f the program. Monitoring indicators are described above.

FIDUCIARY ASPECTS

141, Colombia’s fiduciary environment for DPL i s considered adequate. In recent years Colombia has made important progress in its Public Financial Management (PFM) systems and improved transparency in public finance, due to reforms in critical areas also with the assistance o f the World Bank and the IDB.

142. Important initiatives include adoption o f 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 o f 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 o f new information systems covering the budget and local government finances, as well as the monitoring o f public procurement.

143. The Bank, in coordination with the IDB, carried out a CFAA for Colombia in 2003-2004. The CFAA was coordinated with the I B R D ’ 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 o f Colombia’s fiscal management. Official delivery o f the CFAA to the Government took place in April 2005, and dissemination events are being organized for the last quarter o f 2005.

144. weaknesses in public sector management in Colombia.

This diagnostic review pointed to a series o f important advances but also remaining

145. The country has made progress in modernizing and automating i t s 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 o f an overall PFM system. To remedy this shortcoming, the Inter-Governmental Policy and Information Management Committee was created. 31 These problems and a lack o f accountability for results have limited the quality and effectiveness o f public financial management. Budget formulation i s also fragmented, which prevents the budget from being used 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-term framework 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 o f cash on hand and in banks, and increase the transparency o f 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 System for 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 o f a new public debt information system. The 2003 Fiscal Responsibility and Tiansparency Law strengthened regulation o f although th is s t i l l requires attention. Furthermore, information system to register contingent liabilities on

sub-national government indebtedness, the govemment has put in place an

national, sub-national, and public works

31 Decree 3816, dated 12/31/03.

45

contracts. The system includes the creation and operation o f contractual contingency funds. All operations are in the public domain, and information on debt i s published on a regular basis.

149. Under the 1991 Constitution, fiscal control i s vested in the external and internal control systems. The Comptroller General, Colombia’s supreme audit institution, and the regional comptrollers are in charge o f external audits, and each public entity has an internal control unit . The fiscal control system also includes the Auditor General, who i s responsible for supervising administrative management o f 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 in public financial management systems, the way in which public resources flow in the system, and the strength and reliability o f the control framework applied to financial transaction^^^.

15 1. The administration o f projects financed with Bank and IDB resources has generally been satisfactory, although government fiscal adjustments cause problems in providing counterpart resources, and restrictions in expenditure and cash flow management.

152. PFM improvements already under way in Colombia or triggered by the CFAA action plan recommendations, and the implementation o f 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 increasingly to development policy lending.

153. The Bank has reviewed the IMF’s latest assessment o f the borrower’s Central Bank, which shows that the control environment o f the BdR i s satisfactory. N o remedial actions are necessary in terms o f foreign exchange fiduciary arrangements.

DISBURSEMENT AND AUDITING

154. The IMF Safeguards Assessment o f the BdR concluded that the control environment, procedures and regulations governing the bank’s operations are generally adequate. The Bank wil l disburse the loan proceeds into an account o f the Central Bank denominated in U S dollars. The Central Bank w i l l immediately credit the disbursed amounts to the Ministry o f Finance’s Treasury Account, thus becoming available to finance budgeted expenditures. Within a week o f the disbursement, the Ministry w i l l accordingly provide the Bank written confirmation o f the transaction. If, after deposit in the Central Bank, loan proceeds are not treated as described above, the Bank w i l l require the Government to promptly refund the disallowed amount.

155. The administration o f this Loan w i l l be the responsibility o f the MHCP. Although an audit o f the deposit account wil l not be required, the Bank reserves the right to require audits at any time.

32 The moderate rating i s 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 each principle.

46

ENVIRONMENT 156. effect on the environment.

The reforms supported by the proposed Loan are not expected to have any significant

R I S K S 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 required for presentation to the Executive Board are not taken 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 proposed operation. However, there are some risks associated with the effective implementation o f the institutional and regulatory reforms supported by the proposed DPL. The most relevant r i sks 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 o f streamlining bureaucratic procedures.

159. There i s the risk that the merger of the Superintendency of Banks and Superintendency of Securities into one Financial Superintendency wi l l prove to be a difficult and lengthy exercise. There are usually difficulties involved in merging independent bureaucracies wi th 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 o f merging the supervision processes fade away. However, there i s strong consensus on the advantages o f having one regulatory agency for the financial sector in Colombia.

160. There i s the risk that measures to increase access to financial services wil l take a long time to produce results. Increasing access to financial services by the poor and MSMEs has proved to be very difficult in most developing countries. The proposed operation would support some initial actions towards th i s objective. The policy dialogue that accompanies the preparation o f this DPL series and the concurrent financial sector AAA i s supporting the GoC’s efforts to building the consensus among different stakeholders on a roadmap o f reforms to increase access and diversity o f financial products that w i l l lead to specific policy actions to be supported under the next two loans o f th i s DPL program.

161. There i s the risk that political uncertainty produced b y the upcoming elections and adverse developments in the security situation will delay the implementation of important institutional and regulatory reforms. Presidential elections w i l l take place in May 2006. By November 2005, the Constitutional Court w i l l decide on the validity o f the approval process for the recent constitutional amendment to allow presidential reelection. If the amendment i s deemed valid, Congress w i l l still have to discuss the electoral ru les to which the incumbent president w i l l be subject. But if the Court overturns the amendment, political uncertainty wil l increase, and the search for candidates within the parties w i l l have higher stakes attached. Furthermore, most analysts expect at least a moderate deterioration o f the security situation in the period leading to the elections.

47

162. And finally, there i s a risk that Colombia’s current level of public debt could pose a risk for macroeconomic stability. On the basis o f 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 o f 54 percent o f GDP in 2002 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 i s that the reform program supported by this proposed DPL has, in good part, been widely discussed with key stakeholders under the umbrella o f discussions carried out during the negotiations o f the TLC. Thus, even in a potential climate o f political uncertainty, the social and political commitment exists to complete th i s reform agenda.

48

Annex 1 : Colombia At A Glance

70.6 65.7 63.6 62.4 11.0 14.7 20.7 20.5

POVERTY and SOCIAL Colombia

401 -GDI - O ' G D P

2004 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNI (Atlas method, US$ billions)

Average annual growth, 1998-04

Population (%) Labor force (%)

Most recent estimate (latest year available, 1998-04)

Poverty (% of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition (% of children under 5) Access to an improved water source (% ofpopulation) Illiteracy (% ofpopulation age 15+J Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

GDP (US$ billions) Gross domestic investmentlGDP Exports of goods and servicedGDP Gross domestic savingslGDP Gross national savingslGDP

Current account balancelGDP Interest paymentdGDP Total debtlGDP Total debt serviceiexports Present value of debtlGDP Present value of debtlexports

(average annual growth) GDP GDP per capita Exports of goods and services

1984

38.3 19.0 11.9 18.4 15.2

-5.4 1.6

31.5 33.8

1984-94 199404

4.3 1.5 2.3 0.3 9.4 4.2

45.3 1,920 87.0

1.8 2.5

64 77 73 23 7

91 8

112 112 112

1994

81.7 25.5 15.0 19.6 21.2

-4.5 1.8

26.9 45.3

2003

4.0 2.3 4.6

Latin America 8 Carib.

534 3,260 1,741

1.5 2.1

77 71 28

86 11

129 131 126

2003

80.0 18.1 20.4 15.7 15.6

-1.5 2.6

41.3 52.4

2004

4.0 2.3 9.2

Lower- middle- income

2,655 1,480 3,934

0.9 1.2

50 69 32 11 81 10

112 113 111

2004

97.4 19.0 20.5 17.1 16.6

-1.1 2.0

40.4 39.6

2004-08

4.0 2.6 1.3

I Development diamond'

Life expectancy

T

GNI

capita per

I 1 Access to improved water source

Colombia i -- - Lower-middle-income group

Economic ratios.

Trade

T

Indebtedness

Colombia Lower-middle-income arow

UUI

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Private consumption General govemment consumption Imports of goods and services

Manufacturing

17.8 16.1 12.1 11.5 34.0 31.4 29.3 30.7 22.6 16.1 14.2 14 3 48.2 52.5 58.6 57.8

*O

:::

1984-94 lgg4-04 2004 I Growth of exports and imports (%) laveraoe annual arowth) - . Agricuiure industry

Services

Private consumption General govemment consumption Gross domestic investment Imports of goods and services

Manufacturing

2.2 -0.2 2 4 4 2 -0.3 6.3 2 4 0.2 3.5 4.1 4.2 5.4 3.2 4.0

5 1 -33 216 133 --Exports -+-Imports 105 0 0 101 167

Note: 2004 data are preliminary estimates. *The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will

be incomplete.

49

Colombia

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeflcit

TRADE

(US$ millions) Total exports (fob)

Coffee Petroleum Manufactures

Total imports (cif) Food Fuel and energy Capital goods

Export price index (1995=100) Import price index (1995=100) Terms of trade (1995=700)

BALANCE of PAYMENTS

(US$ millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, local/US$)

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Composition of net resource flows Official grants Official creditors Private creditors Foreign direct Investment Portfolio equity

World Bank program Commitments Disbursements Principal repayments Net flows interest payments Net transfers

1984 1994 2003 2004 inflation ( O h ) 1 16.0 22.6 22.2 45.4

7.8 11.6 -1.2 1.5 -2.6 -1.4

1984 1994

3,728 8,816 1,765 1,990

480 1,313 638 2,803

4,492 11,927 207 923 468 308

1,587 5,072

14 85 13 86

102 100

1984 1994

4,557 10,630 5,407 13,914 -850 -3,284

-1,537 -1,453 309 1,069

-2,078 -3,668

2,470 3,474 -392 194

.. 7,862 100.8 826.5

1984 1994

12,039 21,940 1,578 2,829

19 12

1,623 5,570 274 1,054

1 1

15 45

748 2,284 584 1,446

0 478

618 -467

740 159 462 310 153 837 308 -527 121 218 187 -745

6.5 5.5 8.2 7.0

13.7 14.4 -4.6 -4.9 -5.3 -5.5

2003 2004

12,812 16,216 806 950

3,383 4,180 4,801 6,413

12,792 15,324 1,417 1,554

239 262 3,671 4,110

90 92 95 89 94 103

2003 2004

15,572 19,146 16,650 19,737 -1,078 -592

-3,446 -4,185 3,334 3,667

-1,191 -1,110

1,375 -1,431 -184 2,541

10,921 13,540 2,877.7 2,628.6

2003 2004

33.01 1 39,359 3,241 3,490

5 5

8,824 8,152 344 346

1 1

0 0 1,168 242

-1,981 -2,145 837 1,265

905 687 948 491 224 206 724 285 121 141 603 144

99 W 01 02 03

-GDP deflatar e C P I

1 Export and import levels (US$ mill.)

I R nnn - _,___ 16,000 14,OW 12,OW 10,ow 8.000 6,000 4,000 2,000

0 , . .

"1 96 99 W 01 02 03

I W Exports W Imports

Current account balance to GDP (%)

* T I

Composition of 2004 debt (US$ mill.) I G 3,865 A 3,490

F 15,133 D 15,639

E 1227

I A ~ IBRD B - IDA D - Other multilateral F - Private C - IMF

E - Bilateral

G - Short-term

50

Miniftcrio do Hucienda y Crtdito Pirbku Dcpattamento Nncional de Ptncrcibn

Bogota O.C., September 16, 2005.

Mr. PAUL WOLFOWITZ President World Bank Washington, D. C.

Dear Mr. Wolfowitz:

The Govemment of Colombia remains fully committed to the integration of the country into the world economy through bilateral and multilateral trade agreements. This process also requires a series of domestic reforms which, with the support of the multilateral banks, will make it possible to 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 expanding access to both the capital market and the secondary market.

I

In this way, the Program Loan in Support of the Development and Efficiency of the Business Sector will be converted into one of the most important tools 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 heightening the tempo of economic activity and that of the capital market, thereby helping to redistribute resources, increase employment and lower the poverty indexes which have been rising in 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 more competitive economy. All of this must be done as part of the presidential strategy set forth in the Development Plan and with due and strict observance of the principles of fiscal austerity and institutional strengthening which have characterized this Government from the moment it took office.

5 1

Kcpliblrca de (:olombia Ministerio de Hncicndn y CrCdito Pliblico

Departamento Nacional 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 reflects the commitment of each of the entities in striving toward accomplishment of the goals and encourages the country to embark upon similar programs that will also have a favorable impact in a time of fiscal adjustment and 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 reforms in 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 Program Loan in Support of the Development and Efficiency of the Business Sector in an amount of US$250 million for fiscal 2006.

Sincerely,

ALBERT0 CARRASQUILLA BARRERA Minister of Finance and Public Credit

SANTIAGO MONTENEGRO TRUJILLO Director General

National Planning Department

52

REPUBLIC OF COLOMBIA

Ministry of Finance and Public Credit National Planning Department

Letter of Policy PROGRAM LOAN IN SUPPORT OF THE DEVELOPMENT AND

EFFICIENCY OF THE BUSINESS SECTOR

Bogoti D.C., September 16,2005

53

TABLE OF CONTENTS

I. The Macroeconomic Situation.. ............................................................... .5

11. T h e 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 M a r k e t and Efficiency of the Secondary M a r k e t .............................................................................. 12

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I. The Macroeconomic Situation

1, After passing through a severe recession in 1998 and 1999, the Colombian economy has been experiencing a rapid recovery that i s reflected in the increased rate o f growth o f the domestic product and the dynamism o f the private sector. In addition, the reduction o f the total public debt33 over the past two years has improved the solvency o f 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. During 2003 the growth o f the economy gathered momentum, rising from 1.9 percent in 2002 to 4.1 percent in 2003. This growth i s consistent with the economy’s potential long-term growth. For its part, economic growth in 2004 was also 4.1 percent.

4. This level o f growth was spurred in large part by the dynamism o f domestic demand. In point o f fact, in 2003 domestic demand posted an increase o f 5.2 percent and repeated th is vigorous performance in 2004 with 5.3 percent. The rise in domestic investment coupled with the favorable external economic conditions benefited all sectors o f 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 o f 14.2 percent.

5. For 2005 it i s expected that the favorable conditions that prevailed in the preceding two years w i l l remain in effect and wil l help consolidate the growth o f domestic demand, which, combined with the robust performance o f the external factors connected with demand and terms o f trade, would enable the economy to grow by 4 percent.

6. The dynamic growth has not created excessive pressures in either the market for goods or as regards external financing. In the case o f the market for goods, inflation in 2004 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 o f GDP in 2004, hence lower than the 1.5 percent o f GDP posted in 2003. These factors make i t likely that the reactivation process will continue in a sustainable fashion.

7. The fiscal deficit dropped from 2.7 percent o f GDP in 2003 to 1.3 percent o f GDP in 2004, in other words i t 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 al l the public sector bodies and agencies. Special mention must be made here o f 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.

33 The total public debt takes into account both explicit and implicit debts. In the latter category the largest debt i s that formed by pension obligations, the recent evolution o f which served to consolidate the reduction o f the total debt.

55

8.

9.

The positive results flowing from the fiscal policy applied played a very important role in the accomplishment o f a better macroeconomic equilibrium and in the meeting o f the fiscal targets. This made it possible to achieve the goal set in the agreement with the IMF o f bringing the Consolidated Public Sector deficit down to 1.3 percent o f GDP. The increase in GDP, the vigor o f the public sector primary balance and the positive impact on interest rates as a consequence o f the preceding two factors brought about a reduction o f the net debt in external financial assets o f 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 projected in the medium-term fiscal planning.

This reduction o f the Non-Financial Public Sector debt as a percentage o f 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 o f international reserves, which stood at US$15,285.66 mill ion on September 7, 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 o f the savings in the FAEP deriving from higher o i l prices.

12. The fiscal deficit target agreed with the IMF for 2004, namely 2.2 percent o f GDP, was met; at the close o f the year a cumulative Consolidated Public Sector deficit o f 1.3 percent o f GDP was posted. This was the outcome o f the continuation o f the Central National Government’s adjustment policy and o f an improvement in the Decentralized Public Sector. For i t s part, the Central National Government ran a deficit o f 5.5 percent o f GDP, which reflected a more vigorous tax collection effort.

13. The fiscal target for 2005 has been set at 1.6 percent o f GDP. This target i s consistent with the reduction o f the Debt/GDP ratio o f the Non-Financial Public Sector which permits attainment o f sustainability o f the public finances in the medium term.

14. In 2005 a deficit o f 5.5 percent o f GDP i s expected for the Central National Government. This higher deficit compared with 2004 i s attributed to the larger outgoings on pensions as a result o f the exhausting o f the Social Security Institute’s reserves. In contrast, a reduction o f 0.6 percent o f GDP i s projected for operating costs and capital expenditure, as part o f the Government’s fiscal adjustment policy.

15. For 2006, a Consolidated Public Sector fiscal deficit in the region o f 2.0 percent o f GDP i s 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 w i l l continue implementing the measures required for these objectives to be achieved within a context o f macroeconomic stability underpinned by prudent monetary policies and the strengthening o f the financial system, in conjunction with social assistance programs. Coverage in education and health wil l also be increased and steps wil l be taken to mitigate the impact o f higher tariffs for public services on the poorest segments o f the population.

56

17. The Government i s therefore aware o f the urgent necessity o f moving ahead with the structural-reform plan, which i s designed to ensure continuity o f the policy o f gradual fiscal adjustment and guarantee that adequate primary surpluses are obtained that w i l l 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 i t s final reading on June 17, 2005, include:

- Establishing 25 current legal minimum wages as the ceiling amount for a

- Elimination o f the excepted and special pension systems with the exception o f pension with effect from July 3 1,20 10.

the one applicable to law enforcement personnel, with effect from July 3 1, 2010.

- Elimination o f the 14th Month for new pensioners, except for persons who receive a pension equal to or less than three (3) current monthly legal minimum wages, i f such pensions go into effect prior to July 3 1, 20 1 1.

- Anticipation of the termination of the Law 100 transitional 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

the entry into effect of the Legislative Act in question, for whom said system would be maintained up till the year 2014.

upon

57

19. The legislative agenda for matters other than pensions have considered certain other important topics such as:

- Analysis and approval o f the initiative by means o f which rules w i l l be laid down for standardizing the State’s portfolio.

- Law on Juridical Stability (Law 963, july 8, 2005).

- Law on Stock Market (Law 964, july 8, 2005).

11. The First Program Loan in Support of the Development and Efficiency of the Business Sector

A. Objectives

20. The purpose o f the program for the development and efficiency o f the business sector, to be financed with non-earmarked funds from the World Bank, i s to assist the Government o f Colombia in supporting the productive sector in modernizing and strengthening its productive capacity and facilitating access to technology, sources o f financing and markets for i t s products.

21. To accomplish this objective, the Government i s implementing a set o f structural measures that w i l l make i t possible: (i) to support the business recovery process, and (ii) to consolidate the process o f adjustment and modernization o f the productive sector by preparing i t to meet intensifying international competition.

B. Development of the Business Sector

22. One o f the current administration’s policy objectives i s to ensure a more competitive and dynamic economy that w i l l be capable o f 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 o f 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 o f market weak points, provision o f public goods and, in the specific sphere o f business development, to the creation o f an environment conducive to private sector development.

24. The State’s intervention in business development i s focused on preservation o f an environment that favors productive investment in enterprises and fosters their efficient functioning. To th is 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 o f financing and markets for their products.

58

25. To maximize the benefits from the implementation o f business support policies, in April 2004 the document Conpes 3280 was submitted. I t sets out the strategy for improving the competitiveness o f Colombian enterprises and the steps which the National Government should take, which include the following:

1. Public support for restructuring and modernizing the productive apparatus. 2. Promotion o f investment, by means of: (i) submission o f a draft law requiring

adoption o f international accounting standards; (ii) submission o f a draft law to bring the institutional and regulatory framework o f the capital market into l ine with present-day requirements; and (iii) promotion o f investor participation by means o f an Investor Protection Law.

3. Optimization o f the public business support programs, based on inter-institutional coordination, development o f evaluation and monitoring systems and better targeting o f interventions.

26. In addition and in pursuance o f the role o f state intervention, the National Government has sought to establish a favorable environment for productive development. Along these lines the establishment o f 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 o f 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 o f the officials, citizens or entrepreneurs concerned. Rationalize the formalities that adversely impact the efficiency and management o f 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 o f convenience for the authority concerned and for the user, can be completed, fully or partially, by electronic means.

28. As a result o f the Government’s action in this matter, the proposed Anti-Formalities Law was submitted to Congress and approved as Law 962 o f July 2005. Establishment o f the implementing regulations for this law i s a priority action step for accomplishment o f the objectives o f 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 o f 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 o f soundness and solvency, warranting the assumption that the system can today be considered stable with positive growth prospects for the future.

30. This trend has been consistent with the performance o f the Colombian economy, which has continued to gain strength within the context o f a favorable external environment. The National Government's unremitting efforts to foster reactivation o f the various sectors o f the economy and o f the financial sector in particular have been key factors in this respect.

31, The Ministry o f Finance and Public Credit has undertaken various actions, adopting certain measures o f a regulatory nature and conducting analyses and evaluations concerning a number o f 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 in the financial entities.

32. In this context, the oversight and control o f the financial apparatus which seeks to verify compliance with the body o f organizational, economic and prudential rules laid down in connection with the financial institutions to ensure the proper functioning o f the payments system and the very stability o f the institutions, while also assuring that the rights o f private individuals are not violated, has become a priority o f the Government's policy.

33. This being so, the supervision exercised implies for the State the instituting o f a system for monitoring the evolution o f each one o f the credit institutions and o f the system as a whole to verify that their operations are above board and to be certain o f their financial stability. A t 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. In our market the actions o f the different Superintendencies are overlapping, which gives r ise to undesirable regulatory trade-offs and differentiated treatments for parties who, while admittedly o f differing natures, perform very similar activities. Clear evidence o f this situation i s h i s h e d by the present regulatory differences with respect to the administration o f collective portfolios by the trust companies, in their capacity as entities overseen by the Superintendency o f Banks, and the activity o f the stockbrokerage companies, which are supervised by the Superintendency o f Securities.

35. In light o f the foregoing, the Government, through its competent agencies, conducted a review o f the financial supervision system. Subsequently, and on the basis o f the findings o f the studies made, i t decided to merge the Superintendency o f Banks and the Superintendency o f Securities, implementing a set o f actions necessary for integrating supervision o f the market, whether its activities are carried out through intermediaries or not, in order to have a consolidated system o f oversight and supervision.

60

36. An init ial stage has been completed and it i s now clearly apparent that the benefits o f combining the two Superintendencies are to be found in economies o f scale and scope for the parties and for the State itself as regards exercise o f the supervision function. In addition, having a single supervisory entity w i l l facilitate oversight o f 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 w i l l be reflected in benefits 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 o f our economy, with the aim o f democratizing credit, protecting the savings o f the public and investors, and endowing the market, whether operating through intermediaries or not, wi th a body o f stable and clear rules that further the attainment o f the objectives o f intervention.

38. This being the case, the technical parameters have been established for determining the minimum solvency ratio, technical capital and technical reserves o f the National Guarantee Fund. Establishing the parameters, while bearing in mind that the purpose o f the Fund i s to guarantee the lending operations o f the financial institutions with the users o f their services, entailed establishing specific definitions concerning these aspects and regarding the market r isks and guarantees and their administration systems.

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 o f the financial system. Principles and ru les have accordingly been established which ensure their efficiency, security, integrity, reliability, technological development, interconnection, transparency, free competition, and respect for and equal treatment o f consumers.

40. The Colombian authorities have also continued working on verifying and updating the regulations connected with prevention, detection, and control o f asset laundering, in order to strengthen the mechanisms in place for the purpose.

41. Finally, and after monitoring and support activities over an extended period o f time, the Government’s Equalization Fund bill has been converted into a Law o f the Republic (Law 920 o f 2004). This law includes topics o f great importance for the Government, particularly as regards the points connected with the funds’ financial activity, given their dynamism in the market as instruments for assistance to low-income groups. It was therefore necessary to implement the prudential rule applicable to these types o f entities, which constitute specialized savings and loan sections, in order to make the law applicable.

42. This being so, the authorities have been working on regulation o f the points relating to minimum capital requirements, solvency ratios, credit and market risks, classification and weighting o f assets, liquidity funds, and other related ru les that w i l l enable these entities to operate in conditions o f security and transparency.

61

D. Access to the Capi ta l M a r k e t and Efficiency o f the Secondary M a r k e t

43. The phenomenon o f the globalization o f markets requires that the regulation o f them be brought into l ine 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 o f stock markets worldwide, bringing wi th i t in i t s turn the need to adjust the regulatory arrangements to the new forms o f business and the new r i sks involved.

44. Accordingly, the Ministry o f Finance and Public Credit, through the Directorate General o f 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 designed to provide the Colombian stock market with an appropriate and efficient regulatory framework that w i l l permit greater levels o f growth, alternatives to the traditional sources o f business financing and, principally, with a clear frame o f action for all participants coupled with the legal security necessary for bringing national and foreign investors together plus the needed flexibility for facilitating adjustment o f the ru les and regulations to the continuous innovations in the market.

45. The proposed law was adopted by Congress and i s today a law o f the Republic. Work i s currently in progress on identifying the articles and aspects that w i l l have to be regulated in order to make them applicable to many o f 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 o f securities, and the arrangements for protecting investors.

46. In addition, attention has been paid to developing strategies connected with the supply o f and demand for securities and the prudential rules applicable to the entities subject to inspection and supervision by the Superintendency o f Securities. An important ru le issued by the Superintendency o f Securities i s the one relating to private capital funds.

47. Wi th the aim o f spurring the development and enhancing the efficiency o f the mechanism for attracting and administering funds in the public securities market, regulations have been laid down connected with funds based on 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 wi th the Superintendencies o f 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 o f the short-term return obtainable on same. This, because the Colombian money market i s very small and devoid o f dynamism due to people’s lack o f confidence in such transactions, which has prevented more vigorous development o f the derivatives market since one o f the prerequisites for such development i s the presence o f sufficient underlying liquidity.

62

Annex 3: Debt Sustainability Analysis

Debt Sustainability Analysis. Colombia’s present level o f public debt, at about 46.6 percent o f GDP (down from a peak o f 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 o f GDP, due to i t s high fiscal cost and the financing vulnerabilities to which i t exposes the county. The government’s target i s to reduce the level o f debt to 38 percent o f GDP by 2015. We analyze the debt prospects in four different ways: i) a baseline projection with historical average values o f key parameters; ii) an analysis o f policy responses that would be necessary for the government to meet i t s debt reduction target in the face o f possible economic shocks; iii) projections o f what would happen to debt ratios if economic shocks hit but there were no fiscal policy response, and iv) an analysis o f the sustainability o f total public plus private extemal debt. (A full description of the analytical work i s available from the CMU).

The baseline scenario makes the following key assumptions:

0

0

Historical average real GDP growth o f 3.2 percent, which i s below last year’s growth o f 3.7 percent A primary balance o f 2.1 percent. Last year i t 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 30 percent depreciation o f the real exchange rate, bringing i t back to its historical average over a five year period beginning in 200534 An average implicit real interest rate on domestic and extemal debt o f 6.3 percent, which i s currently 6.4 percent.

0

0

In this scenario, the government achieves i t s target o f reducing the debt ratio to 38 percent in ten years.

The second and third sets o f scenarios add three adverse shocks to th is baseline: an immediate depreciation of the real exchange rate by 30 percent in 2005 (instead o f spread over 5 years), a reduction o f growth to -2.1 percent for 2005 (two standard deviations from the average), gradually returning to its average by 2009; and a r ise in the real interest rate to 8.6 percent in 2005, returning gradually to 6.3 percent by 2009. And there i s also the combination shock, where all three adverse shocks occur. If the government s t i l l wants to meet i t s target debt ratio for 2015, i t w i l l have to tighten fiscal policy from the baseline primary balance o f 2.3 percent, up to 3.7 percent in the case o f the combination shock. Table 6 summarizes these different scenarios.

34 Since about half of Colombia’s debt i s foreign, mostly in U S $, the exchange rate has a large and instantaneous impact on the debt ratio. In the decline o f the debt ratio from i t s peak o f 54 percent o f GDP in 2002 to 47.5 percent at the end o f 2004, the 30 percent real appreciation o f the exchange rate accounts for six o f the eight percentage points o f decline. The exchange rate i s unlikely to retain al l o f this recent appreciation, so the government should continue with fiscal caution, despite the decline o f the debt ratio.

63

Table 6 Debt Sustainability with Shocks and Policy Adjustment

Type of shock

Baseline scenario (see above)

Real effective exchange rate depreciation o f 30 percent in 2005 with maintenance o f other variables at the values described in the baseline scenario

Primary surplus required to achieve the target debt ratio (38 percent by 2015)

2.1%

2.5%

GDP growth shock: in 2005 o f historical growth average minus two standard deviations (implies -2.1 percent growth). In 2006, historical average minus one standard deviation (implies 0.5 percent growth). In 2007, a growth rate o f 1.5 percent i s assumed, with 2008 o f 2.5 percent. Afterwards the historical growth rate i s assumed. All other variables are kept at the values o f the baseline scenario.

Real interest rate shock. In 2005, we assume a real implicit interest rate o f 8.6 percent. Afterwards, it gradually declines to 6.3 percent. All o f the other variables are kept at the values described in the baseline scenario.

2.6

2.4%

I f these shocks materialized and policy remained passive, with primary balances unchanged 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. Wi th each o f the individual shocks, the debt ratio would be below 45 percent by 2015. Wi th the combination o f all three shocks, the ratio would peak at close to 62 percent o f GDP in 2008, then slowly fall to about 58 percent in 2015. This level o f debt i s certainly high and would put considerable fiscal pressure on the government, but it i s not explosive and could be contained by maintaining a primary balance o f 2.1 percent o f GDP, which i s within the historical experience o f Colombia (See Figure 8).

Combination o f al l three shocks

64

3.6%

Figure 8: Debt Sustainability Even Without a Policy Response to Shocks.

65.0%

60.0%

55.0% n 0 ’6 e! 1 50.0%

8 ri

N

45.0% - P , L - 2

40.0%

35.0%

30.0% m 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Analyzing the sustainability o f the external debt requires a model that incorporates another set o f key macroeconomic variables, such as Colombia’s current account, and allows u s to model another set o f different shocks, particularly one to inward international capital flows. Total external debt service (public and private) remains one o f the highest levels, as a percentage o f exports o f goods, services, and income, in Latin America. It has fallen from a high o f above 67 percent in 2002 to more manageable levels o f less than 40 percent now, but it i s s t i l l just below Argentina’s 42 percent.

Nonetheless, Colombia’s total external debt profile (public and private) i s l ikely to be sustainable. Total external debt i s expected to decline to 36.1 percent o f GDP under our baseline scenario. The primary risk associated with external debt sustainability i s exchange rate risk. A depreciation o f the real exchange rate in excess 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 o f market closer in the near term. A two-standard deviation drop in international capital inflows from the historical average would generate an increase in the 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 o f 46 percent total external debt would put pressure on financing, but i s expected to be manageable.

65

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66

9 3 h

a +

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c 5 .-

a Y

.- - s

a b

b

6 7

Annex 5: Fund relations note Public Information Notice (PIN) No. 05/62 May 9,2005

International Monetary Fund 700 19th Street, NW Washington, D.C. 20431 USA

IMF Executive Board Concludes 2005 Article IV Consultation with Colombia

On April 29,2005, the Executive Board o f the International Monetary Fund (IMF) concluded the Article IV consultation with Colombia.'

Background

Since 1999 Colombia's economic policies have sought to strengthen the economy in the aftermath of the country's worst economic crisis in 30 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 position through several revenue measures (a one-time wealth tax, an income tax surcharge, and a broadening o f the VAT base) and expenditure restraint. Two pension reforms were also adopted, reducing the actuarial deficit o f the pension system from 207 percent o f GDP to 187 percent o f GDP. Other reforms focused on restructuring and downsizing the nonfinancial public sector, improving financial supervision, and privatizing or liquidating the remaining public banks. Congress also approved in December 2002 a labor market reform to encourage employment in the formal sector. In addition, th is administration established a policy known as democratic security to try to resolve the civi l strife.

Initially the recovery proceeded slowly but in 2003-04 economic performance improved significantly:

* Real economic growth recovered to 4 percent a year in 2003-04. 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 in 2003.

- The combined public sector deficit was reduced from 3.4 percent o f GDP in 2000 to an unexpectedly low 1.3 percent o f GDP in 2004, reflecting an unanticipated rise in the export price o f o i l to US$36 per barrel and an unusually large surplus o f the autonomous local and regional governments. This outturr-together with the real appreciation o f the peso during 2004-helped reduce public debt to 53 percent o f GDP by end-2004. Also, public sector deposits reached 10.5 percent o f GDP by end-2004.

Q Inflation declined to 5.5 percent during 2004-the lowest level in decades-owing to the effective implementation o f the inflation targeting framework.

* The external sector strengthened, led by sustained growth in exports and a recovery in capital inflows. During 2004, the peso appreciated by 11 percent in real effective terms, prompting the central bank to purchase US$2.9 bi l l ion (about one-third o f the stock o f base money) to l imit the appreciation. By end-2004, net international reserves reached US$13.2 bil l ion (1 23 percent o f short- term external debt on a remaining maturity basis).

- The health o f the financial system continued to improve. The solvency and profitability o f the banking system have recovered, reflecting economic growth, a successful recapitalization scheme, and improved supervision. Nonperforming loans declined to 3.6 percent o f total loans by late 2004

69

and were fully covered by provisions. The bank restructuring agency (FOGAFIN) continued to trim the government's participation in the banking system by selling several banks that were intervened in 1999. Progress continued in implementing risk-based financial supervision and actions to combat money laundering.

Executive Board Assessment

Executive Directors commended the authorities' pursuit o f sound macroeconomic policies and structural reforms in recent years, which has contributed to a significant improvement in Colombia's macroeconomic performance and social indicators despite a difficult security environment. Economic growth has rebounded; inflation, unemployment, and the public debt have declined; the balance o f payments position has improved, in part because o f buoyant export growth; and confidence in the economy has strengthened, as reflected in increased capital inflows, the appreciation o f the domestic currency, and a lowered country risk premium.

At the same time, Directors noted that unemployment, poverty, and the public debt remain high. In addition, while welcoming the reduction in the foreign currency component o f the public debt through the issuance o f peso-denominated bonds in international capital markets, Directors emphasized that external vulnerabilities still loom large due to rollover and foreign exchange risks. They therefore welcomed the authorities' intention to maintain the strategy o f fiscal consolidation and steadfast pursuit o f structural reform in the coming years, in order to strengthen the foundations for economic growth and to further reduce inflation and the ratio o f public debt to GDP.

Directors agreed that the authorities' main challenge in implementing the economic strategy w i l l be to maintain the pace o f fiscal reforms. They considered the reforms currently before Congress-the revised budget code and the pension reform-to be important for containing expenditure growth and increasing the flexibility o f expenditure management. However, they stressed that several other reforms w i l l be needed over the medium term, on both revenue and expenditure.

On revenue, 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 encouraged the authorities to slow the increases in revenue transfers from the central administration to subnational governments, and to strengthen fiscal coordination among the different levels o f government. On expenditure, Directors called for a streamlining o f current expenditure to make room for more productive capital expenditure. They welcomed efforts to increase the effectiveness of social spending through better targeting o f subsidies to the poor. They also urged additional pension reform to l imit the expected rapid r ise in net pension costs, and gradual deregulation o f the domestic prices o f gasoline and diesel over the medium term. Directors encouraged further improvements in debt management, especially by increasing reliance on domestic currency borrowing, to reduce vulnerabilities.

Directors commended the prudent conduct o f monetary policy. They noted that the inflation targeting framework has helped lower inflation expectations, and welcomed the authorities' commitment to reduce inflation to the range o f 2-4 percent a year over the medium term. Directors considered that the flexible exchange rate regime has served Colombia well. I t has helped maintain 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 urged the authorities to guard against excessive foreign exchange intervention aimed at curbing the appreciation o f the currency, as this could create uncertainty regarding the objective o f 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 in December 2004. Directors welcomed the improved management o f foreign exchange risk by the private sector, and encouraged the authorities to continue to facilitate the development o f market-based hedging mechanisms.

Directors commended the government's financial restructuring operations, which have helped strengthen the financial system since 1999. They encouraged continued efforts to improve financial supervision, as recommended in the Financial System Stability Assessment Report. Key measures would include provision o f sufficient autonomy to the Superintendency o f Banks and adoption o f risk-based regulations in line with the Base1 I1 core principles. Directors encouraged the authorities to continue to reduce the role o f the public sector in the banking system, and, in this regard, commended the decision to divest one large state-owned bank and to consider the divestment o f another state-owned bank. They considered the new securities market law to be an important step toward deepening the domestic capital market, and urged the phase-out o f the financial transactions tax and the bank stamp tax to promote financial intermediation.

Directors welcomed Colombia's acceptance o f the obligations o f Article VIII, Sections 2, 3, and 4. They urged the authorities to establish a timetable for removing two remaining exchange restrictions.

Colombia: Selected Economic Indicators 2000 2001 2002 2003 Prel. Proj.

2004 2005 (Annual percentage change, unless otherwise indicated)

National income and prices 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 Credit to the private sector

-2.1 7.0 5.3 6.5 16.7 11.1 -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 ... (In percent o f GDP, unless otherwise indicated)

External sector 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 (in months 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 Gross national savings Public finances Combined public sector balance Nonfinancial public sector balance Central administration balance Public sector debt 21 31

13.7 14.5 14.2 14.9 14.0 15.3 14.6 13.2 12.6 13.5 12.9 12.5

-3.4 -3.2 -3.7 -2.7 -1.3 -2.5 -3.5 -3.5 -4.2 -3.2 -1.7 -2.5 -5.7 -5.7 -6.4 -5.4 -5.5 -6.1 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 in foreign currency stocks valued at constant exchange rate. 2/ Includes bonds issued to recapitalize financial institutions. 3/ Program definition. Assumes no purchases under the current SBA. Includes valuation changes.

Under Article IV of the IMF's Articles o f Agreement, the IMF holds 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 o f the Board, summarizes the views o f Executive Directors, and this summary i s transmitted to the country's authorities.

IMF EXTERNAL RELATIONS DEPARTMENT Public Affairs: 202-623-7300 - Fax: 202-623-6278

Media Relations: 202-623-7 100 - Fax: 202-623-6772

72

Annex 6: Financial Sector Overview

Banking system

1. Colombia's banking sector has recovered f rom 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 o f 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 reform process has been anchored in the passage o f 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 (Sistema de Administracion de Riesgos or SARC) and the improved macroeconomic environment have resulted in a banking sector that i s more highly provisioned, capitalized, profitable and liquid than before the crisis.

Table 8: Key Banking Sector Indicators

Capitaladequacyratio (withmarket risk) 3/

RegulatoryTierIcqital torisk weigbtedassets Capital to s e t s "paforming loansnet ofprovisions to capital 4'

Nmpaforming loansto total loans 4'51 Cheitiedloans 51 Specific p.wisimstoclasifiedloans and leases Sectoral distributionofloans tototalloans51

comm m i a I

COWUIIIR

housing F m i g n cwency ~ o a n s to total loans

Returnm averageequity Returnm averageaeets lntemt margin to gross income Nmintaest expenses to gross income Pnsonnelexpensato mnintaes incane

Sp.ead b e t w m reference lending anddeposit rates

Liqllid s e t s to total aeets 61 Liquid s e t s to short-term liabilities 71

CIStOmRdepositstototd (nmintettank) loans F m i g n currency liabilities to total liabilities

(Perm) 1598 1959 2coo 2001 2002 2003 20042

n.a 11.3 13.2 13.0 12.6 13.1 141: n.a 8.0 9.2 9.3 9.7 10.5 I l i 10.6 11.0 11.3 11.2 1 I .o 11.5 11: 27.2 35.9 15.6 5.6 1 .I -3.8 - IO !

9.1 12.4 10.6 10.2 9 2 6.8 31 n.a. 18.1 18.7 18.1 16.0 12.1 7: n.a 25.3 27.7 37.5 43 .O 47.6 541

53 .O 55.2 58.7 58.4 6 1 9 62.8 651 17.9 13.4 14.1 15.6 15.6 18.0 19. 29.1 3 1.4 27.2 26.0 2 1.7 18.1 14.

11.9 9.0 8.1 7.0 7 A 4.7 5:

-32.6 -20.7 1.1 9 6 17.0 23: -3.5 -2.3 0.1 I .I 1.9 2 .'

41 .O 30.7 38.1 32.7 355 37.4 39. 83.5 95.4 93.7 85.6 80.7 69.8 59; 43 .O 38.6 36.2 37.3 383 38.4 41. 9.7 4.4 6.6 8.3 7 4 7.4 7.

10.0 11.9 12.9 16.5 19.7 18.7 181 17.3 19.2 20.4 25.2 302 29.0 28. 93.8 107.5 122.3 136.1 136.1 136.0 126. 12.1 9.4 9.1 8.6 7 .O 6.2 61

Net open position i n foreign exchange to capital 5 .1 -0.1 -I .4 4.8 7.8 4.3 4.

Sources: Supaintendencia Bancda; IFS; and F m d staff estimates.

I/ E x c l u d i n g n d t unions andpublic sectuspecial institutions(l0E).

Y Data to Sep. 2004 excep data on foreign cumcy loans and liabilties, which are to Jme 2004. R e " are annualized asnecessq. 3 / M a k e t r i s h reqllirements,effectivemlyasof2MI, areweighted6Ph mti l2003, 80% in2033, and 103% theafter. 41 Loanspastdu: 90 d a y ormore (120 daysor more in the case ofmutgages) 51Loandataincludeslea~esas of2004. 61 Liquidassetsinclude cash,dqosits andsecurities held fortrading.

71 Cusomm deposits used asproxy 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 in the Table below, only around one half o f the 105 credit intermediaries at the end o f 1998 were s t i l l in existence as o f mid-2005. The remainder had been merged, purchased by commercial banks or closed, primarily as a result o f the crisis. Most o f the burden o f adjustment fe l l 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. I t i s also worth noting that the assets o f the banking sector fe l l by 15 percent o f GDP during this period, and only began to recover in 2004.

Table 9: The Structure of Colombia's Banking Sector

I 1998 1999 2000 2001 2002 2003 2004 2005 (May)

Number of Banking InStitUtiOnS I/ Commercial Banks

Private domestic Public 2/ Foreign

Housina Banks

105 82 71 65 61 59 58 30 24 24 22 22 22 22

13 10 10 10 10 10 10 3 3 3 3 3 3 3

9 9 9 9 8 8 6 6 6 6 6

11 11 14

Finance Corporations 16 11 8 8 5 4 4 Financing and Leasing Companies 50 38 32 28 27 26 25 Cooperatives of Superior Grade 1 1 1 1 1 1 1

Share of Total Assets (%I Commercial Banks

Private domestic Public Foreign

Housing Banks Finance CorporaUons Financing and Leasing Companies Cooperatives of Superior Grade

65 57 56 59 61 62 64 64 32 34 36 37 38

12 12 15

27 11 12

15 28 12 16 12

16 18 11

18 18 17 29 12

22 21 25 24 24 23 11 11 11 11 9 7 8 7 26

6 5 4 4 4 5 6 7 0 0 0 0 0 0 0 0

27

Total Banking Sector 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 i s 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 o f May 2005, together represented as much as 47 percent o f the banking sector assets37, up from 3 1 percent as o f the end o f 1998. A process o f restructuring and consolidation i s underway in these and other mixed groups38 to allow them to compete more effectively in the more international environment that the prospective FTA would allow. The ongoing process o f creating larger universal banks i s l ikely to lead to efficiency gains in the banking sector because o 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

" For simplicity, the two groups' financial accounts are calculated simply as the sums o f the accounts of the individual group entities, raising the possibility o f 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 i ts 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.

ensions and insurance) and in commercial activities.

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Table 10: Colombia's 10 Largest Credit Institutions (May 2005)

Total Assets Market Share Ownership (COP$ billion)

Bancolom bia Bogota BBVA Ganadero Banagrario Gran banco Davivienda Occidente Popular Conavi Corfinsura

14,488 11,270 7,104 6,874 6,514 6,468 6,102 5,721 4,498 4,060

12% 9% 6% 6% 5% 5 yo 5 yo

4 yo 3 yo

5%

Grupo Sindicato Grupo Aval

Foreign-owned State-owned State-owned Grupo Bolivar Grupo Aval Grupo Aval

Grupo Sindicato Grupo Sindicato

Source: Superintendencia Bancaria

4. The size and complexity of financial conglomerate structures, as well as the fact that they are controlled b y groups with significant commercial interests, demand a strong consolidated supervision framework. Law 222 defined corporate control and the concept o f an economic group, and imposed related party firewalls and consolidated financial statements. Articles 81 and 82 o f Law 795 o f 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 l imi ts , consolidation ru les 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 o f intemational standards on accounting and auditing that would enhance transparency. However, important legal modifications covering the definition o f a financial conglomerate (Le. presumption o f subordination or 'dominant influence') as well as the scope and conduct o f consolidated supervision (e.g. development o f a comprehensive and consistent risk assessment methodology) w i l l 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 Herfindahl Index (HI) o f asset share at the individual credit institution level, increased from 362 to only 5 13 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 o f financial conglomerates and public sector ownership o f four credit institutions accounting for around 15 percent o f total assets. Taking the largest four financial groups (Aval, Sindicato,

39 The HI i s a measure o f market concentration, which i s calculated as the sum o f the squares o f relative shares and lies between 0 and 10,000. According to the merger guidelines o f the U.S. Department o f 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 HI below 1,000, not concentrated.

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Bolivar and Social) into account and treating the public-owned banks as one group, the adjusted HI for May 2005 rises to 1454, indicating a moderately concentrated market.

Figure 9: Composition of Domestic Credit and International Comparison of Public Sector Debt

(a) Composition of Banks' Assets (b) Public Banks' Composition of Assets 68.0% , 30.0%

66.0% - 64.0% . 62.0% . 60.0% -

58.0% -

-- 25.0%

.. 15.0%

25.0%

62.0% 20.0%

15.0%

-- 10.0% 56.0% -

54.0% . 52.0% -

. 5.0%

50.0% 4 ~ I 1 0.0% 04/95 04/96 04/97 04198 04199 04/00 04101 04/02 04/03 04/04 04105

-Gross Loans /Assets -hvestmnts in Nbiic R b t l Assets

(c) Public Debt as a Percentage of Banks' Investment Portfolios

80% ,

n 70% 1 n 50%

75.0% 1 45.0%

550%-

50 0%.

45 0% , 20.0% I 15 0%

04/55 04/96 04197 04158 04/95 04/00 04101 04/02 04103 04/04 04/05

- h M c Banks Gross Loans IArsels Wtlc Banks hverlmnts in N b t t e b l I Assels

(d) Percentage of Domestic Credit Going to the Public Sector (2003)

Argent na Mex co

Co omba 00 ivia

VenezLe a

Canada SOLlnAfr ca

m a ana Un teaSiaies

TLn s a Malatsa

I 0% 20% 40% 60% 80%

6. Post-crisis risk aversion has led to a n increase in exposure to government bonds and a move away f rom 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 generated by the financial sector in the crisis, increased its demands for financing. The resultant replacement o f private sector loans with government bond holdings in bank balance sheets has altered the nature o f the risk confronting the banking sector and represents a lingering legacy o f the crisis. The fiscal costs o f 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 o f crowding out by the public sector (Figure 9(c)). Given the predominance of banks among government debt holders, the successful extension o f government debt maturities has, to a large extent, resulted in an increase o f 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. During the crisis the risk adjusted return o f the loans portfolio decreased markedly. The reallocation in the bank's portfolio reflects the decline on the risk-return profile o f loans, the lower costs o f managing investments and the reduction o f the deposit rates.

Capital Markets

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 in 2004, to reach US$24.8 billion, or

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30 percent o f GDP. That compares wi th levels o f below 10 percent for Argentina, Bolivia, Ecuador and Venezuela (see Figure 10.) For Chile, however, the figure was 69 percent.

68 5%

Figure 10: Market Capitalization (2004, YO of GDP)

w Publc Fixed Incom

0 DerNaCves Sbck

0 PrNak Fixed lncom 0 Mutral Funds W TES Nominated in PESOS pxed ab) 0 TES Nominated in Pesoa (UVR) 0 PUbllC Bonds o TES Nominated in PESOS (IPC)

TES Nominated in US mllars Bi mer

7.0%

1 Source: Federaci6n Iberoamericana de Bolsas (FIB), www.fiabnet.org

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 o f outstanding securities, while TESs alone make up 76.5 percent. In total, fixed-income securities represent 96 percent o f the portfolio, with the remainder comprised o f mutual funds, derivatives and stocks.

Figure 11: Breakdown of outstanding securities in Colombia (2004)

a) Total assets 84.1%

11.3%

(b) Public Fixed Income I

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Annex 7: Quality Standards And Technical Innovation

1. Colombia has the second highest number of ISO-certified companies in Lat in America. At the end o f 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 o f the total number o f 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 in the number o f certificates issued by ICONTEC, the local non-profit internationally recognized certification body. ICONTEC accounts for about 70 percent o f international certificates issued in the country.

Figure 12: The growth of quality certification in Colombia

(a) Expansion of I S 0 9000 certification

25%

Colombia (left axis) ,j 20%

15%

10%

Colombia as proportion of LAC total (right axis) 1,500

1000

5%

0% 1992 1994 1996 1996 2000 2002 2004

(b): Certifications granted by ICONTEC certifications: certifications:

IS0 14000, CIS 9000, HACCP, OHSAS

I S 0 9000

T 9001 1 4o __

700 600 500 400 300 200

30

25

20

15

10

5 100 0 0

I I L I

Source: The I S 0 Survey o f I S 0 9001 :2000 and I S 0 1400 1 Certificates

Source: ICONTEC

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 o f 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 e l 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 o f quality certification. Public support can also be justified on the basis o f the strong l i n k s between quality and innovation investments, and on the spillovers that tend to be generated by 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 o f the cost o f training and technical assistance projects aimed at obtaining internationally recognized quality certifications. PNAC has supported the certification o f 561 companies since 1999, 57 percent o f 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) The IS0 Survey ofIS0 9001:2000 and I S 0 14001 Certfficates - 2003.

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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 o f 155 projects aimed at obtaining quality certifications in 2001-2004. The program supported 155 companies, o f 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 o f Technical Standards o f the Superintendency o f Industry and Trade (SIC) o f the M C I T 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 o f 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 i s 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 in some 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 o f the various institutions with accreditation functions are not clearly established creates uncertainty for potential “clients” and generates conflicts between the various agencies involved in the accreditation process.

5. To better perform i t s accreditation functions S I C would need to be granted additional financial resources and other functions of S I C would have to be better separated f rom that of accreditation. Since 1997 the Colombian Government has not allocated any new resources to support the accreditation functions o f SIC. This i s reflected in the fact that Colombia employs far fewer skilled technical evaluators than Argentina, Brazil and Mexico. The effectiveness o f SIC’S accreditation activities i s also hindered by conflicts o f 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 o f SIC does not guarantee that that the activities o f the departments related to those other functions do not compromise the confidentiality, objectivity and impartiality o f i t s accreditation services.

4’ Certification bodies are independent organizations that assess and certify conformity with international standards.

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Figure 13: Membership o f International Accreditation Organizations And Mutual Recognition 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 in turn may require creating a new separate legal entity to act as accreditation body. SIC i s not a member o f the main regional or international accreditation entities and has l i t t le participation in international mutual recognition agreements (MRA). Thus Colombia i s not a member o f the Inter American Accreditation Cooperation (IAAC), the International Accreditation Forum (IAF) or the International Laboratory Accreditation Cooperation (ILAC). I t s only MRA i s with the Andean Community, to which only 20 percent o f i t s exports are destined. This situation o f international isolation i s depicted in Figure 13. As a result, the accreditation services offered by SIC to its clients have no value in most o f Colombia’s export markets. The f irst prerequisite to enter into International Accreditation Organizations or Mutual Recognition Agreements i s the approval by the National Congress o f 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 s i g n 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 o f 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, sk i l ls and technology, but Colombia s t i l l compares poorly within that context. While countries in the region spend an average o f 0.5 percent o f 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 o f the region’s average. The country i s also below regional norms for the years o f schooling o f its population, the share o f capital good imports to GDP, and the number o f domestic and US. patents granted to local inventors. Within Colombia, there i s a considerable regional

42 D e Ferranti et al. (2003).

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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 o f 1990 and Decree 585 o f 1991 created the current basic legal framework for Colombia’ innovation policy. In particular, Colciencias, the Colombian Institute for the Development o f Science and Technology (S&T), was designated the agency in charge o f implementing the country’s innovation policy. Colciencias acts as the technical and administrative secretariat for the National Council o f S&T, which i s integrated with representatives from the private and public sectors as well as the academic community. I t sets down the general guidelines for the country’s S&T policy. Wh i le Colciencias has been the top recipient o f government funds for S&T, i t s share o f those resources was only 27 percent in 1995-1 997, with the Ministry o f Agriculture receiving another 25 percent and the National University coming in third place, with 12 percent o f the government’s budget for S&T. The rest i s divided among a large number o f educational institutions, technology development centers and other research institutes.

9. However, most of the tax deductions for R&D activities are used by public organizations. Colciencias manages the fiscal incentives created in the early 1990s to stimulate R&D activities. Investments and donations for R&D activities can be used to claim income tax deductions, while imports o f 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 o f R&D projects at universities and other research centers has been the main policy instrument used by 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 o f the corresponding programs, on the basis o f the quality and pertinence o f the research proposals. A second newly implemented program to support academic R&D aims at strengthening six centers o f excellence in scientific research. These “centers” were chosen on the basis o f their experience and academic strength in areas which are considered o f strategic importance for the country - e.g. tropical diseases - and taking into consideration the presence o f l i n k s or alliances with weaker research institutions located in the less developed regions o f 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 o f R&D and innovation by the private sector have represented about 32 percent o f 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 o f large companies) o f R&D projects involving both private companies and universities or other research institutions (including Technology Centers). Together with two

43 Agapitova et al. (2002). 44 Agapitova et al. (2002).

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second-tier development banks - Bancoldex and Finagro - Colciencias also manages a program that subsidizes up to the first 50 percent o f the cost o f credit for projects with a significant technological development component. The subsidy i s higher for SMEs and for projects aimed at export markets.

12. T w o newly created financing mechanisms subsidize high risk technology development projects and the cost of obtaining local o r foreign patents. The first credit l ine 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 i s successful or not, Colciencias supports between 50 and 80 percent o f the company’s loan. In cases o f technical or commercial failure, the subsidy i s o f between 20 and 40 percent o f the cost o f the project. Similarly, in the case o f patent applications, Colciencias subsidizes up to 80 percent o f the total cost o f the process, conditional on the patent being granted. For unsuccessful applications Colciencias s t i l l pays for 40 percent o f the cost o f the 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 o f them in Bogota. As reported by Colciencias, t h i s institution i s phasing out its support to those incubators, for which additional funding i s 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 in the service sector. Bogota hosts 42 percent o f the centers, with other three regions - Antioquia, Valle del Cauca and Santander - responsible for another 47 percent. Almost 98 percent o f the clients o f TDCs are private companies. About 60 percent o f the services provided are training activities, but TDCs also offer technology services (1 9 percent o f their activities), technical assistance (1 1 percent) and R&D (10 percent).

14. The financial self-sustainability of TDCs i s s t i l l weak, due to the relatively low demand for their services. Colciencias and SENA provide respectively 14 and 1 1 percent o f the financing o f those activities, while private companies and industry associations contribute with another 49 percent. The remaining 26 percent o f the funding comes from local and national government agencies (1 3 percent), financial institutions (6 percent), and intemational technical cooperation agencies (3 percent), among other sources. Between 2000 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 o f 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 o f their fixed costs, Colciencias estimates that between 15 and 30 percent o f their budget would s t i l l need to be financed with public resources.

15. The National Training Service (Servicio Nacional de Aprendizaje, or SENA) plays a n important role in the support of innovation and competitiveness among M S M E s . A 1996 Law mandates SENA to devote 20 percent o f i t s parafiscal revenues to programs aimed at promoting technological development or increasing the competitiveness o f 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 in 2003 should be allocated directly to Colciencias. In 2003, the resources obtained through SENA represented 32 percent o f Colciencias’ budget, thus

82

compensating for a reduction in i t s allocation from the national budget. SENA also plays a crucial role in promoting the competitiveness o f the private sector through i t s traditional training programs. Recently, the government announced i t s intention to increase competition in the National Sk i l l s 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.

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 o f MSMEs, created in 1990. In 2003, FOMIPYME co-financed projects for about US$9 mil l ion (US$4 mill ion in 2002). About two thirds o f the projects financed by FOMIPYME are for micro enterprises, with the remaining allocated to SMEs. Colciencias has also directed an increasing share o f its budget (46 percent in 2004 compared with 32 percent in 2003) to financing private sector technological development and innovation, with a large share o f the corresponding funds directed to MSMEs. In 2004, Colciencias devoted more than US$11 mill ion (US$7.5 mil l ion in 2003) to financing those activities, either by means o f direct supports to private companies or through Centers o f Technology Development, company incubators or other entities o f the National Innovation System.

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