Report No.677-BR

BrazilIndustrial Development Issuesof the Northeast(In Two Volumes) Volume 1: Summary ReportFebruary 25,1987

Projects DepartmentLatin America and the Caribbean Regional Office

FOR OFFICIAL USE ONLY

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FOR OFFICIUL USE ONLYABBREVIATIONS AND A'RONYMS

BB Banco-do Brasil(Bank of Brazil)

BEFIEX Comissao para Concessao de Beneficios Fiscais aProgramas Especlais d6 Exportasao(Special Program of Fiscal Incentives for Exporte's)

BNDES Banco Nacional de Devenvolvimento Economico e Social(National Bank for Economic Development)

BNDESPAR BNDES Participacoes S.A.(BNDES Equity Participations)

CACEX Carteira de Comercio Exterior(Foreign Trade Agency)

CDI Conselho do Desenvolvimento Industrial(Industrial Development Council)

CEBRAE Centro Brasileiro de Apolo a Pequens e Media Empresa(Agency for Technical Assistance to Small and MediumEaterprises)

CPA Comissao de Politica Aduanera(Tariff Policy Commission)

FINAM Fundo de Investimentos da Amazonia(Amazon Investment Fund)

FINAME Agencia Especial de Financiamento Industrial(Agency for Industrial Financing)

FINOR Fundo de Investimentos do Nordeste(Northeast Investment Fund)

FISET Fundo de Investimentos Setorlais(Sectoral Investment Fund)

GTDN Grupo de Trabalho para o Desenvolvimento do Nordeste(Working Group for Northeast Development)

IBGE Instituto Braslleiro de Geografla e Estatistica(Brazilian Institute of Geography and Statistics)

ICM Imposto sobre Circulaqao do Mercadorias(State Value Added Tax)

IPI Imposto de Productos Industrializados(Federal Industrial Product Tax)

ORTN Obrlgacoes do Tesouro Nacional(Indexed Treasury Bonds)

This document hiks a festdcted distdbution and may be used by recipients only in the performanceof their official dutie. Its contents may not otherwise be discload without Wodd Bank authorafitkn

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PIN Programa de Integrasao Nacional(National Integration Program)

PNAD Pesquisa Nacional por Amostra de Domicilios(National Household Survey)

MOC Programa de Operacoes Coniuntos(Credit Program for Small and Medium Enterprises)

POLONORDESTE Programa de Desenvqlviwento de Areas Integradas doNordeste(Development Program for Integrated Areas in theNortheast)

PROALCOOL Programs Nacional de Alcool(National Alcohol Program)

PROMICRO Programa de Apoio a Microempresas(Credit Program for Very Small Enterprises)

PROTERRA Programs de RedistrIbuIlao de Terras e de Estimulo aAgro-Industria(Land Redistribution and Agroindustrial ModernizationProgram)

SEPLAN Secretaria de Planelamento(Federal Ministry of Planning)

SSE Small-scale Enterprise

SUDENE Superintendencla de Desenvolvimento do Nordeste(Northeast Development Superintendency)

INDUSTRIL DVU!U ISSUES OF THE NORTHEAST

TAStE Or CONTENTS

SMAY lU-SRTPage No.

INTRODUCTION

ABSTRACT................................. . 1

NORTHEAT INDUSTRIAL GROWl AND STUCZURAL CAG..........2

Regional Disparities ti 2ra d.l............................ 2

Current Situation of Northa.t Iduatiy...............e.e....... 4

Northeast Industrial Growt6 ........................ . .. 6

The Sources of Northeest Industrial Gro .. . 8

POLICIES AND INCENTIVES FOR NOITNEAST INDUSTRY ....................... 11

Northeast Industrial Detelopment Strategy.......................... 11

Industrial Fi1ancing. .***.**......... ..e................ ... 12The FINOR Program . ......................................... 14

Fiscal Incentives for Northeast Industry.......................... 20

Regional Incidence of Non-special Ine e ntlves 20

=RECOMMENDATIONS.e.******....***....***o..***..........e...*....*.... 22

Industrial Financinge...........g.g. ... 22

Institutional Arrangem_ts of Development Financing ............ 23

The FINOR Program .......... .... . 24

Fiscal Incentives and Import ?tOt5Cti@U.g........ge-....-.... 28

This report is based on the flodngs of a Vorld Bank wission which visited

Brazil in July/August, 1985. The mission consisted of Ernst Bolte (Chief

of Mission), Mahmood Ayub, Carl Dabluen, Paul Popiel and Lorene Yap of the

World Bank, a-d Ronaldo LocatelU (Consultant) of Fundalao Joao Pinheiro.

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INTRODUCTION

This report summarizes the findings of a World Bank mission which

visited Brazil in July/August 1985. Thie main purpose of the mission was to

review Northeast industrial development policies and their impact on

regional industrial output, employment and efficiency. In addition, the

report reviews the main features of Northeast industry, including its

current structure and past performance.

The report is organized in three separate parts. The first

part, comprising the Summary Report, contains the most important results of

the analysis and the recommendations for improving the industrial incentive

programs. The focus of the policy analysis and the recommendations is on

the FINOR program.

The second part, conta 4-ning the Analytical Report, presents the

supporting analysis for the recommendations in the SUmmary Report and a

detailed description of Northeast industrial growth and industrial

development policies. The first section of the Analytical Report addresses

the issue of regional disparities, and estimates the sources of regional

industrial demand and supply growth. The second section of the Analytical

Report quantifies costs and impact of main incentive programs. This

section presents a detailed analysis of the FINOR program and estimates the

incidence of Brazil's sectoral incentives on Northeast industry.

The third part of the report contains the statistical appendix

and four technical studies. The technical studies cover the methodology of

the regional sources of demand growth estimations; public industrial

investments in the Northeast; a summary of public industrial credit lines;

and an analysis of industrial projects which received FINOR financing.

ABSTRACT

(1) This report analyses past Northeast industrial growth and reviewsthe Policles and incentives for Northeast industry. The analysis ofNortheast industrial growth concludes that regional lndustrial outputincreased at extremely hlgh rates over extended periods of time.Industrial employment generation was less impressive than productiongrowth, but was stlll satisfactory, given the small si2e and structuralweaknesses of Northeast industry. The Northeast has now a relatively broadbased industrial sector, which operates with modern production methodscomparable to those employed in the more developed parts of the country.The remaining structural weaknesses of relatively high capital intensityand a considerable number of enterprises which may not be economicallyviable seem t'- result from deficient operation of industrlal policyinstruments. Overall, there is, however, lIttle reason for disappolntmentwith the performance of Northeast industry Plnce 1960.

(ii) The review of industrial policies concludes that the past

strategy of transferring scarce resources of capital, entrepreneurship and

management capabilities to the Northeast was approprIate. Given thecontinued high disparities In economic activlty and standard of living

between the Northeast and the more developed reglons of Brazil, thetransfer of resources needs to be continued. The large number ofindustrlal incentive programs, however, require restructuring in order tosupport Northeast industrial development more effectlvely. On themacroeconomic side, the Northeast would benefit from less differentiatedimport protection levels. This measure would promote regional agriculture,eliminate the remaining implicit discrimlnation against regional Industryand reduce the anti-employment bias of overall Northeast developmentpolicies. While the crucial FINOR program should be malatained at aboutits current volume of operations, the large number of credit programsshould be consolidated and additional credit resources should be channeledto small enterprises. The main industrlal incentive programs are also not

operated effectively. In particular, the FINOR program, which largelydetermines the allocation of Investment resources in Northeast Industry,should be reorganized for achieving a substantlally higher costeffectiveness than currently.

(iii) The proposals for Improving thi allocation of investmentresources for Northeast industry and for strengthening the operations ofincentlve programs are in paragraphs 59 to 79 of this Summary Report. Theycover the following aspects:

(a) Industrial Financing: Establish additional credit lines forsmall enterprises and for enterprises receiving FINOR fundsto partially substltute the equity financing component;reduce further the remaining interest subsidies of currentcredit programs;

(b) Institutional Arrangements for Public Industrial Flnancing:Separate, to the extent possible, the administration of

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FINOR from the other activities of SUDENE, which shouldInvolve a larger role of BNB in FINOR operations; strengthenthe development function of Banco do Nordeste (BNB) byproviding federal funding;

(c) The FINOR Program: Introduce conventional project appraisalprocedures, including economic project analysis andfinancial forecasting; reduce the use of FINOR funds forexpansion projects, public sector projects and agriculturalprojects; limit the maximum share of FINOR equity financingin total project cost to 35%; reorganize SUDENE's operationsdepartments, train existing staff In project appralsal andsupervlsion, hire new staff with experience in project work,and strengthen the role of BNB in project appraisal andsupervision; initiate study of FINOP capital marketoperatlon by lndependent experts with a view to conducting aradical reform of the current ineffectlve system;

(d) Fiscal Incentives and Import Programs: Integrate currentfiscal lncentives provided by states and municlpalities Intothe federal incentives; establish an employment relatedincentlve by exempting industrial enterprises from socialsecurity payments for employment of additional workers;establish one or more export processing rones on the largeunused areas existing In most Northeast industrialcompleces..

NORTHEAST INDUSTRIAL GROWTX AND STRUCTURAL CHANGE

Regional Disparities in Brazil

1. The Northeast Region of Brazil Includes nine of the country's23 states and covers about 1.5 million square kilometers, over 18% ofBrazil's total area.}/ In spite of considerable intraregional differencesof climate and social and economic structures, important economic issuesfacing the nine states are broadly similar. It is therefore appropriate totreat the Northeast, for purposes of economic analysis, as one largelyhomogeneous region.

2. The population of the Northeast was about 35 million in 1980, or29% of Brazil's total population. About 50% of the regional populationlives in urban areas, compared to 68% for the whole country. In 1984, theNortheast's Gross Domestic Product (GDP) reached about US$30 bIllion, which'is 16% of Brazil's GDP. The Northeast's GDP per caplta was US$800,compared to US$1,430 for total Brazil. With an average GDP share in recentyears of about 20%, agriculture is the most Important goods producing

1/ The nine states are Maranhao, Piaui, Ceara, Rio Grande do Norte,Paraiba, Pernambuco, Aldgoas, Sergipe and Bahia. The island of Fernandode Noronba and the northern part of the State of Minas Gerais are alsoconsidered part of the Northeast.

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sector in the Northeast, while industrialization lags behlud the nationallevel. DurIng the early 1980s, manufacturing accounted, on average, for171 of regional GDPi compared to 29% in total Brazil.

3. The Northeast accounts for the largest concentration of povertyin Brazil. The high-although diminIshing-incole disparity between theNortheast and the more prosperous regions in the South of Brazil is themost striking indicator of the concentration of poverty in the Northeast.Income surveys have demonstrated that more than one-half of the Northeastpopulation Is poor and that 54% of all Brazilian poor llve in theNortheast. However, social and economic progress in the Northeast duringthe 25 years since 1960 has been considerable. GDF per capita rosefour-fold between 1960 and 1984. The major part of this increase occurredafter 1970, when the Northeast entered a period of exceptionally highgrowth. Trends in other economlc indicators, such as number of householdsconnected to electricity and uaing refrigerators, television and radicreceivers, support the impression of substantially improving standards oflivlng in the Northeast. The economic progress in the Northeast has beenaccompanied by improved social welfare conditlons, supporting a rise inlife expectancy at birth from 41 years In 1960 to 51 years in 1980 and adecline of infant mortality from 166 per thousand in 1960 to 125 perthousand in 1980.

4. Economic and social dIsparities between the Northeast and theCenter-South of Brazil started to develop in the late 1800s, when the sugarbased Northeast lost ground to the Center-South, which benefitted fromthe growing world market demand for coffee. Several factors,includIng recurrent droughts, social structures unfavorable to economicdevelopment and an economic policy focusing upon the more dynamicCenter-South, contributed to a rapidly growing economlc and social gapbetween the Northeast and the Center-South. The long-term relativeeconomlc decline of the Northeast was stopped only during the 1960s, whenthe Government initiated broad-based measures to support development of theregion. These policy measures helped to stabilize the Northeast economyand modernize the industrial sector. Since the mid-1970s the reglonaldisparity has be_-n dimlnishing. The Northeast's share in Brazil's GDP,which had reached its lowest level of about 13% durlng Lhe early 1970s,rose to over 16% In 1984. GDP per capita of the Northeast was only 44% ofthe national average in 1970, but rose to about 56% in 19a4.

5. After a century of relative economic decline of .-he Northeast, asingle decade of above average growth may not provide conclusive evidencethat a reversal of the long-term declining trend has taken place. However,the Northeast economy has improved its structure during the past decade,modernized substantially and gained In overall competitiveness with respectto the rest of the country. There are also indications that the Northeasteconomy gained a momentum for growth which is, to some degree, independentof national economic development. This is evidenced by the fact that,durlng the economic crisis of Brazil in 1981 to 1984, which coincidedpartly with a maJor drought in the Northeast, the regional economy hasshown a high degree of resilience. The economic and social disparitiesbetween the Northeast and rest of Brazll would continue to diminish

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rapidly, if regional development policies would focus on maintaining thedevelopment momentum by supporting the efficient use of regional economicresources.

6. The issue of economic a-.l social disparity Is principally one ofinter-personal income differences which are great in all parts of Brazil.However, the high regional concentration of poverty in the Northeast alsohas important economical and political implications. The low income levelof the region's population has prevented the establishment of industriesdependent upon a large regional market. Post consumer goods industriesare, therefore, located in the Center-South, which has the highestconcentration of purchasing power. Regional economic disparities in Brazilhave a political dimensIon, as well. The large concentratlon of poverty inthe Northeast has always been considered a threat to national unity andinternal security. The consideration that political and social stabilityrequires a regionally balanced economic development also seems to have beenan important reason for establishing a system of fiscal transfers andregional Incentive programs which favor the Northeast.

Current Situation of Northeast Industry

7. After a period of high growth during the 1970s, the importance ofregional manufacturing Increased considerably. However, a large gap stillexists between the levels of industrialization In the Northeast and in therest of Brazil. Influenced by the sectoral allocation of financial andfiscal incentive programs, the structure of industry in the Northeast haschanged conslderably In recent decades. Food, chemicals and textiles werethe three largest industries in terms of value added during the wholeperiod 1959-1980, although the relative importance of each sector changeddrastically. Food and textiles accounted together for over half of theregional manufacturing value added in 1959, but their total share declinedto only about 25X in 1980. This Was less than the 1980 value added shareof chemicals, which have emerged as the largest Industry In the Northeast.The regional production of capital and durable consumer goods has alsoexpanded rapidly since 1959, but their total value added share was stillsmall in 1980 at less than lOX. The focus of industrial incentive programson medium and large enterprlses supported the development of a Northeastindustrial structure, which tended to become more similar to Center-SouthIndustry, In terms of level of technology, capltal intensity, and laborproductivity. Nevertheless, as indicated In the table below, there arestill substantial structural differences between the industrial sectors ofthe Northeast and total Brazll. A reform of regional Incentive programswould support the development of structural differences that reflectregional comparatlve advantages.

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Structure of Manufacturing Value Added, 1980

Northeast Brazi1

Non-durable Consumer Goods 30% 24XIntermediate Goods 62% 48%Durable Consumer and Capital Goods 8% 28%

Total 100% 100%

(Manufacturing Shares in GDP) (17%) (29%)

Source: Annex Table 3.2

8. The relatlve neglect of small scale and informal industry, whichIs more i-portant in the Northeast than in other parts of Brazil, hasreduced labor absorption of Northeast Industry, and the number ofIndustrial jobs created during 1959-1980 remalned below the regionalpotential for employment generation. Subsldized credit and other incentiveprograms reduced the cost of capital, creating an anti-labor bias inNortheast industrial policies. The Industrial incentive programb alsosupported the concentration of Northeast industry In the State of Bahia.The economy of Bahia, particularly its industry, is now integrated to ahigher degree with the Center-South t'tan wlth the other eight states of theNortheast. Finally, interregional trade has become lmportant in recentyears for the Industrial development of the Northeast, while the role ofoverseas trade has somewhat declined during the second half of the 1970s.In particular, many plants establlshed under the reglonal lncentlve schemestend to import major shares of their production Inputs from theCenter-South and to export thelr output to extraregional markets. Theregional trade balance with the rest of Brazil showed high deflelts, whilethe Northeast's trade balance with the world continued to be stronglyposltive. The total regional trade balance has tended to be negative inrecent years (about US$1.5 billion in 1980).

9. Recent studies have concluded that past Northeast Industrialdevelopment was non-autonomous. Accordlng to these studies, the currentNortheast industrlal structure is characterlzed by dependency andcomplementarity with respect to enterprises located in the Center-South.Northeast industry is characterized as largely dependent upon extraregionalownership, product markets and sources of machinery and production inputs.Reglonal industry would operate also in complementarity with Center-Southindustry by produ:ing intermediate inputs for further processing Inextraregional industries while lacking integration with the regionaleconomy. The analysis in the Analytical Report confirms that much of theNortheast industrial investment that occurred since the Implementation ofregional incentive programs In 1960 benefitted from the Inflow ofextraregional capftal and entrepreneurship. A large number of the recentlyestablished industrial enterprises also use extraregional production inputsand sell their output on extraregional markets. There are, however, nolndlcations that the Increase in extraregional ownership, sale of outputand aupply of inputs represent excessive "dependency" that could have a

detrimental ii'pact upon regional economic development. The Northeastcontinues to need extraregional entrepreneurship and capital for highfuture Industrial growth. Northeast Industry needs also extraregionalmarkets for developing its growth potential. Finally, growth andmodernization of regional Industry would he impossible without Imported andextraregional machinery and equipment. Therefore, In order to realize thedesired high growth, Northeast Industry should continue the process ofintegration with the Industry in the Center-South of Brazil.

Northeast Industrial Growth

10. The economic decline of the Northeast during the first half ofthis century and tne improvements in the regional economy since the early1970s have been closely related to the performance of the regionalindustrial sector. The first industrial census In Brazil, conducted in1907, indicated that the Northeast had a marginally higher share innational industrial production than the State of Sao Paulo. However,industrialization in Sao Paulo benefited from ample Investible funds,entrepreneurship, skilled labor and an expanding regional market, whichwere all lacking in the Northeast. Furthermore, exchange rate, importprotection policles and industrial inceutlves focussed upon supportingIndustrial expansion in Sao Paulo. By 1970, about 58% of Brazil's industlywas concentrated in Sao Paulo, compared to only 6% in the Northeast.

11. Since the lnitiation of a regional development policy In 1960,the growth performance of Northeast industry has improved substantially.The table below indicates that, during the early 1960s, regional industrialgrowth continued to be less than national growth, as the depressed state ofNortheast industries required a focus on rehabilItation rather thangrowth. Also, the regional industrial incentive program, Introduced in1960, required a very long period before it effectively contributed togrowth. During Brazil's 'economic miracle' from 1967 to 1973, Northeastindustry initlated a long period of extremely high growth of about 14%p.a., which lasted until 1980. Northeast industrial growth was generallyhigher during this period than in the rest of Brazil. The regionalchemical ard textile industries made major development leaps and theeffectiveness of the regional incentive programs improved during the1970s. Furthermore, the discriminating-impact of macroeconomic policy onthe Northeast seems to have declined considerably In the second half of the19709, as the structure of its industry adjusted to the policy incentives.Northeast industrial production fell during the economic crisis of 1981 to1984 by a total of about 8%, which was slightly more than the decline ofnational industrial production. Brazil's economic recovery of 1985 helpedalso to improve the conditions of Nortbeast industry, and the currentindustrial actIvlty is at about the level reached before the economiccrisis,

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Stages of Northeast Industrial Growth, 1950-1984(Average Annual Percentage Rates)

ManufacturingValue Added Growth GDP Growth

Period Northeast Brazil idortheast BrazilPre-Regional Polity

1950-1959 5.0 8.0 4.7 5.6Econoriac Adjustment

1960-1967 4.2 6.5 5.2 4.4"Economic Miracle"1968-i973~ 13.6 13.4 7.2 112

Oil Price Shock1974-1980 14.9 9.8 9.0 7.1

Economic CrIsis1981-1984 -1.8 -1.6 6.0 0.1

Total Period1950-1984 7.4 7.8 6.4 6.3

Source: Annex Table 2.2

12. Past industrial employment generation in the Nortc-ieast, which wasa major objective of the regional policies lltiated In 1960, has been lessimpressive than productlon growth. Total manufacturing empltoymentgeneration of 330,000 Jobs between 1960 and 1980 was only about 7% of theIncrease in the region's labor force during this period. Manufacturingemployment growth in the Northeast was less than the national average until1970, but higher during 1970 to 1980, wnen the capacity of 1iortheastIndustry to create jobs improved considerably (see table below).

Northeast Employment Growth, 1950-1980

AverageAnnual

Growth Rate1950 1960 1970 1980 1960-1980

Labor Force(Mlllion Workers) 6.7 8.3 10.6 13.1 2.2%Manufacturing Employment

(No. of Workers) 216,000 208,000 263,000 538,000 4.6%

Share of Manufacturing 3.2% 2.5% 2.5% 4.1%

Source: Annex Table 3.18

13. Glven the hlgh production growth rates durlng 1968 to 1980, V't;iereis little reason for dlsappolntment with the past performance of Northeastlndustry. Industrial employment generatlon was far below the levels that

were expected in the report prepared In 1959 by the Northeast Study Group

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(GTDN), although these expectatlons were set unrealistically high for thesmall and structurally weak Northeast industrial sector existing in 1959.The analysis of the Analytical Report also demonstrates that laborabsorption lndlces of manufacturing (employment elasticities) increased Inrecent years to about the national levels. This would indlcate thatNortheast Industry has currently a much Improved capabillty to generatejobs.

14. Low capital productivity appears to be the major weakness of pastindustrial performance in the Northeast. The Analytlcal Report providesstrong indicatious that public iicentive and financing programs may notalways have directed investments to their most productive uses in theregion. In particular, inadequate project evaluation procedures In themajor investment incentIve programs (FINOR, CDI programs, BNDES lenilngprograms) within an environment of strong macroeconomic policy distortions,may have contributed to the establish3ent of a considerable number ofindustrial plants whlch do not reflect the regional comparative advantage.Incremental capital output ratios (ICORs) indicate that industrialinvestment resources were used much less efficiently in the Northeast thenIn the rest of Brazil. Given the current limitations in the volume ofincentives which can be made available within the national policies offiscal austerity for Northeast industrial development, a return to the highindustrial output growth of the 1970s will require greater efficiency inthe use of investment resources. Both public and private industrialinvestments need to be guided by signals and incentives that better reflectthe opportunity costs of resources and the benefits to society.

The Sources of Northeast Industrial Growth

15. Which factors determined past growth of Northeast industrialproduction and employment? Aa analysis of this issue may help to designeffective policies for future high reglonal industrial growth. TheAnalytical Report attempts to euantify the main sources of growth,distinguishing between factors that influenced the growth of demand forNortheast industrial products and factors that directly supportedIndustrial production. The supply-oriented analysIs of sources of regionalindustrial growth attempts to quantify the impact of the region'sindustrlal structure and the impact of regional Incentive policies uponIndustrial output and employment. The demand-oriented analysis quantifiesthe roles of Import substitution, export expanslon and regional demandexpansion. While both types of analysis are well established, the regionaltrade and production statistics used have broad ranges of uncertainty. Theresults of the analyses should, therefore, be taken as providlng only broadquantitative Indicstions.

16. Uatil the beginning of the Brazilian 'economic miracle" in 1968the Northeast industrial structure was highly unfavorable to outputgrowth. The traditional Northeast industries of food and textiles facedserious productlon and market constraints during this perIod. Anindustry-mdx similar to the national industrial structure would haveenabled industry in the Northeast to grow nearly twice as fast as Itactually did until 1968. During the high growth period of 1968 to 1980,

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the reglonal industrial structure changed toward hlgher shares offast-growing industrles, and the region's industry mix was au importantcontributing factor in the high output growth. The establlshment of thechemical industry in the Northeast during this period had a major role Inchanging the regional industrial structure toward higher productiongrowth.

17. The conclusion of the Analytical Report that the structure of:.ortheast Industry has improved In recent times and, therefore, contributedto regional industrial growth requires two qualifieations. First, theimproving structure supported output growth, but tended to reduceemployment generation below a level that would have been feasible under anunchanged structure with higher shares of the Northeast's traditionalindustries. There seems to have existed a trade-off between employmentgeneration and production growth In the Northeast industrial development.Industrial policies, concentrating thelr support on "dynamic industries(chemicals, capital goods) at the expense of traditional industries (food,textiles), tended to prefer implicitly production growth over employmentgeneration. Second, the development of a new industrial structure in theNortheast occurred under a given system of national industrial policies andincentlves. Industries receiving the highest incentives at national level(mostly In the form of import protection) also had the highest productiongrowth rates at both national and regional levels. Therefore, thestructural analysis of Northeast industrial growth measures, to a largeextent, the adjustment of Northeast industry to the national incentives.Since national policies have not always promoted efficient resource use,the emerging structure of Northeast industry may have important componentswhich had satisfactory growth of output, but are not economically viable.

18. In addition to quantifying the impact on growth of the changingregional industrial structure, the analysis of the supply-oriented sourcesof Northeast industrial growth attempts to provide a quantification of theeffects of regional policies. The analysis demonstrates that, until theearly 1970s, the regional industrial development programs, which went intooperation in 1961, had no measurable impact on industrial production growthand employment generation. During the period 1961 to 1973, regionalpolicies are characterized by the effort to rehabilitate the Northeasttextile industry, but they did not provide much development support toother industrial sectors. The strengthening of the crucial FINOR equityfinancing scheme in 1974 and the allocation of increased shares of majornational development programs to the Northeast seem to have providedmoderate support to regional industrial productlon and employmentgeneration. The reduction of the discriminatory impact of macroeconomicpolicy on Northeast industry may have also zontributed to regionalindustrial growth.

19. As a rough quantification of the regional policy Impact by 1980,the analysis attrlbutes to reglonal policies annual production of aboutUS$3.0 billion, or 20% of total regional industrial production, and a netamount of about 60,000 jobs, or slightly more than 10% of total regionalindustrial employment. The number of industrial jobs attributable toregional pollcies is much less than SUDENE attributes to the FINOR program

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(SUDENE estimates that FINOR helped to create over 360,000 industrial Jobsbetween 1963 and 1983). The two estlmates of policy related employmentgeneration are, however, not comparable. The estimate of FINOR-relatedemployment generation simply aggregates the employment in allFINOR-financed industrial projects, Irrespective of whether or notemployment would have been generated without the Incentlve. The analysisin the Analytical Report seems to Indicate that most of production andemployment increases, which are attributed to regional incentive programs,would have, in fact, occurred without these incentives. The most importantachievement of the FINOR program was the modernization of Northeastindustry by transferring entrepreneurshlp and technology to the region.Its contribution to employment generation and productien growth was lessImportant.

20. The analysis of the regional Policy impact suggests that the costeffectlveness of the regional incentives has been quite low and thatcurrent incentlve levels could achleve a substantially higher developmentimpact. Based on the quantitative results of the sources of supplyanalysis, the creation of an industrial job requlred over US$80,000 ofFINOR incentives. If other incentives for Northeast industry are alsotaken into account, the incentives per job created would Increase further.Since FINOR has financed, on average, less than 40% of total project cost,the total investment cost per job created by reglonal incentives was overUS$200,000, which is extremely high for most industries, except verycapital intensive activities. As mentioned before, the numerical resultsof the sources of growth analysis provide only very rough estimates of theregional policy impact on production and employment. Nevertheless, theyprovide clear indications for the need for substantial efficiencyimprovements in the regional incentive systems. Furthermore, incentlveresources should be shifted from programs which reduce the cost of capitalto programs whlch support directly the creation of jobs by reducing thecost of labor.

21. The anslysis of the sources of demand growth of Northeastindustry generates a number of Interesting results. First, the importanceof overseas trade, during the 1960s and 1970s, was relatively high forNortheast industry. The Northeast benefitted, therefore, from the lessrestricted trade pollcies which were in effect during the period 1967 to1975. Second, trade relations with other regions In Brazil were alsoimportant for Northeast industrial growth, although less than could beexpected from a regional economy, which was Increasingly integrated withthe rest of the country. There were only six industries in the 1970s, of atotal of 19, In which exports to other regions of Brazil contrlbuted about20% to growth of their industries. The majority of these industriesbenefitted from regional incentives. This would Indicate that thedependency of Northeast Industry on extraregional markets is smaller thanexpected. Third, the expansion of regional demand was the most Importantstimulating factor of Northeast Industrial growth in the recent period,although regional incentive programs tended to focus on large industrialprojects producing for extraregional markets. Small and medium enterprisesproducing largely for the regional market have a high growth potential,which should be realized by directing a larger share of the incentives tothis category of firms.

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POLICIES AND INCENTIVES FOR NORTHEAST INDUSTRY

Northeast Industrial Development Strategy

22. The GTDN report of 1959 prepared the first government supportedcomprehensive economic development program for the Northeast. Industry wasto play a crucial role in this strategy, placing the emphasis upon anautonomous development, based upon regional human and natural resources aswell as regionally generated investment resources. The impact of the GTDNreport on Northeast industrial development was considerable, although onlypart of the basic concepts were accepted and few of the specific measuresrecommended were implemented. Rather than for its strategy and policyproposals, the GTDN report was important for calling attention to thewidening socioeconomic disparities between the Northeast and theCenter-South in the preceding years, and for demonstrating that a majorcause of the widening gap was the macroeconomic policies geared towardssupporting industrial development in the Center-South. Both argumentsprovided the political and economic justification for a forced transfer ofpublic and private resources to Northeast industry. Much of the industrialdevelopment policy in the Northeast during the 1960s and 1970s was relatedto the management of these resource transfers.

23. Northeast industrial growth after 1960 differed strongly fromwhat had been projected in the GTDN report. Most importantly, theobjective of the GTDN strategy to establish in the Northeast an 'autonomouscenter of manufacturing expansion' could not be realized. Given theregional inadequacies of humar and financial resources at the time ofdesigning the GTDN strategy, actual industrial development of the Northeastduring the 1960s and 1970s was characterized by increasing integration withthe Center-South. Another important objective of the GTDN industrialstrategy to "absorb large masses of labor' in new Northeast industry alsoturned out to be unfeasible. Job creation in Northeast lndustry was onlymoderate, although more could have been achieved by eliminating theanti-labor bias from the incentive programs. Finally, the direct role inNortheast industrial development attributed to the public sector was muchsmaller than foreseen in the GTDN report. FINOR and the public developmentbanks which provided considerable financing through equity participationand credit lines operated practically without project appraisal.Industrial investment in the Northeast was, therefore, largely determinedby the private sector in the context of the overall policy and Incentiveenvironment.

24. The increased emphasis on development planning in Brazil underthe democratic government has provided the opportunity to design newindustrial policies for the Northeast. SUDENE is currently working out thedetails of a regional development plan (which forms part of the nationaldevelopment plan), but a broad outline of the new regional industrialstrategy is already available. The new development strategy returns to thebasic concepta presented in the GTDN report. The main objectives areelimination of the disparities with the rest of Brazil and employmentgeneration. By the year 2000, the regional share in national GDP Is to

- 12 -

rise to 26%, which would raise the Northeast GDP per caplta to the national

average. Employment generation is to reduce the current 50% rate of un-

and underemployment to 5% by the year 2000. SUDENE proposes -assive

investments in the Northeast to achieve these ambitious taru, _s. Industry

Is again the priority sector for absorbing increased investment, generatlng

employment and raising production to eliminate the disparlty.

25. FINOR and a new incentive fund (Fundo de Incentivos) for small

and medium enterprises would be the main policy instruments forimplementing SUDENE's industrial strategy. SUDENE expects that the

resources of PIN and PROTERRA, which were part of FINOR until 1970, would

return to the Investment fund by 1987. This would raise the total amount

available to FINOR for industrial investment from currently about

US$300 million to about US$1000 milllon per year. SUDENE intends to use

the additional funds iu three ways: the major part would be used to

incre&se the resources of the current FINOR fund; a second part would be

employed, over a three-year period, for the rehabilitation of FINORsupported projects which are currently not operating; the third component

of the additional funds would provide the resources for the proposed

Incentive fund for lending to small and medium enterprises.

26. The past development strategy of transferring to Northeast

Industry scarce resources - equity and long-term credit funds,entrepreneurship, managers and technicians - was overall successful in

helping to achieve high output growth and establishing a relatively broad

based industrial sector in the Northeast. SUDENE's new industrial

development strategy is, therefore, overall appropriate, although the

balance of incentive measures should be shifted more toward the direct

support of industrial employment generation. The target of eliminating

regional income disparities and underemployment by the year 2000, however,

while desirable, does not appear achievable. It would require that annual

economlc growth of the Northeast would be about four percentage points

higher than the Brazilian average during the remaining 15 years.Furthermore, SIJDENE's emphasis on increasing the resources available to the

FINOR program does not address the crucial issues facing the most important

Northeast developmentt programs. The operations of the FINOR program

require major streamlining and reform, in order to provide more effectively

equity funds, entrepreneurship and modern technology to Northeast

industry. While it is not possible to determine the level of resource

transfers and incentives that would be required for FINOR and other

regional development programs to achieve an acceptable rate of reduction of

the regional disparities, the improvement of the cost effectiveness of

these programs should have the highest priority.

Industrial Financing

27. The Government has used monetary and credit policies to direct

more private bank credit to the Northeast than would have been allocated

under a neutral policy. Banks located In the Northeast benefit from lower

statutory reserve ratios, but they faced also limits on the transfer of

deposits outside of the region. As in the other regions of Brazil, private

bank credit is only short-term commercial lending. By keeping their

- 13 -

borrowing and lending to very short maturitles, they limited their exposureto the considerable variations of longer-term inflation rates. The recentstabilization measures may provide an incentive to private banks toIntroduce 4 -m financing. Such a measure would, however, require aprolonged period of low and stable inflation. The expected sharp reductionof inflation would also eliminate, to a large extent, the Inflation rentobtained by commercial banks. These banks can be expected to take measuresfor reducing operating costs, including the consolidation of the agency

network. Small-scale enterprises in small Northeast locations could facereduced access to conmercial bank credit, if agencies in the region wouldbe closed. The importance of official industrial lending programs forsmall firms in the Northeast would rise accordingly.

28. Credit by pullic banks i8 mostly at medium and long-term, and hascurrently a more important role in industry than in other sectors of the

Northeast's economy. Taking into account the equity financing provided byFINOR, the industrial sector has obtained on average about US$600 millionp.a. of concessional public financing. This is estimated to have satisfied40% to 50% of past annual financial requlrements of Northeast industry.Current public financing for NTortheast industry does not appear to beefficiently allocated over different size categories of Northeastenterprises. FINOR and the bulk of public credit flnancing are for mediumand large enterprises. Small firms receive probably less thanUS$50 million p.a. of public financing, which is not sufficient to permitdevelopment of the full growth potential of these enterprises.

29. There appears to be room for a strengthening of officialIndustrial credit programs for Northeast industry. Because equityparticipation through the highly subsidized FINOR system is the main source

of funding, and because the same enterprises usually also have access tofavorable financing from official credit lines, medium and largeenterprises absorb most of the industrial financing available in theNortheast. In contrast, small enterprises suffer from a shortage of creditand equity funds, since they do not have access to FINOR, while the volumeof official credit for such enterprises is small. As a result, medium andlarge industrial enterprises in the Northeast tend to operate atexcessively high capital labor ratios, while small enterprises, whichcould contribute substantially toward regional income and employment, arefinancially distressed and unable to raise production and employment.

30. The existing public financing schemes for small enterprises haveserious deficiencies. The PROMICRO program of BNDES, suffers from (a)inadequate funding (US$12 to 15 million per year); (b) is only available onan irregular basis which affects investment planning; and (c) is tied to

excessive administrative, technical assistance and guarantee requirements.The POC program, which Is also sponsored by BNDES vla financial agents,

suffers from excessive complexity for small enterprises and operates creditprograms In accordance with national rather than regional requirements andcapabilitl es.

31. The total 1984 volume of public industrial credit subsidy in

Brazil is estimated to have been about US$100 million, of which about US$40

million was for industry located in the Northeast. While the overall level

- 14 -

of industrial credit subsidization is currently small, there Is nojustification for maintainlng interest rates below economic cost of creditwith the possible exception of credit for small firms in the Northeast. Inthe past, subsidized funds gave Northeast industry wrong signals about theavailability and cost of financial resources. It contributed to therelatively high capital intensity of Northeast industry, which is not inline with regional factor endowment. Industrial employment generation inthe Northeast could have improved with public financing provided atInterest rates that reflect more the scarcity of capital in Brazil. Theprovision of subsidized funds over a long period has also created thecurrent perception among Northeast entrepreneurs and investors thatIndustrial investments in the region are only viable at subsldizedfinancing. Small enterprises are therefore reluctant to use the onlymoderately subsidized public credit programs, such as POC. They believealso that they should have access to a heavily subsidized source offinance, like the FINOR program. It is, therefore, important that thesubsidies of the FINOR program be substantially reduced. A highlysubsidized credlt program, as is currently planned by SUDENE, would bedetrimental to efficient growth of small enterprises in the Northeast.

32. Under current institutional arrangements development financing inthe Northeast cannot perform its function effectlvely. In the course ofcentralizing economic policy making during the past military governments,the administration of funds for regional development was passed to federalbanks. By 1969, BNB had lost all federal funding and FINOR remained theonly industrial financing system controlled by a regional institution(SUDENE). Thus, during the 1970s and 1980s industrial developmentfinancing in the Northeast was conducted by BNDES, whose national focusdoes not lend itself to addressing the specific financial needs of regionalindustry, and by SUDENE, which is not organized to administer financingprograms. BNB and the state development banks, which were established,organized and staffed for regional development financing activities, on theother hand, operate federal credit program as agents (repasadora) andhave expanded into commercial banking in competition with Banco do Brasiland private commercial banks operating in the Northeast. Thedecentralization of economic decision making under the democraticGovernment and the on-going reforms of Brazil's financial sector and fiscalincentives provide an opportunity for restructuring industrial developmentfinancing in the Northeast. A reorganization of the regional financialsector should aim at improving the provision of public financing, mainly byincreasing the cost effectiveness of existing financing programs which mayrequire an instltutional change of responsibility for the major flnancingprograms.

The FINOR Program

33. Importance of FINOR for Northeast Industry. Industrial projectsin the Northeast may benefit from a number of incentives, of which FINOR isthe most important ln terms of both volume and impact. In addition, once aproject receives FINOR support, it often tends to get many other -incentives. The FINOR incentive allows a company located anywhere inBrazil to apply up to 25% of its corporate taxes for investments in theNortheast through FINOR. These resources are used by the FINOR fund to

- 15 -

finance an equity particlpation of up to 60% of the Investment cost ofprojects located In the Northeast. The company that opts for FINORrecelves a certificate of investment. This certificate is then used toobtain stocks in companies financed by the FINOR fund. FINOR is a fiscalincentive for the firws that contribute to the Fund, but a financialincentlve for the projects that receive the funds.

34. FINOR has financed about 20% of industrial capital formation inthe Northeast over the last two decades. The projects supported appear tobe responsible for almost half the lndustrial value added and employment ofthe region. They have helped to drastically change the type and size ofindustry located there and to integrate it with the rest of the economy interms of ownership, source of inputs, and destinatior. outputs. Moreover,contrary to the pattern for Northeast industry as a whole, the incentivatedprojects appear to have a positIve trade balance both with respect to therest of Brazil and with the foreign sector, Because of its importance forthe industrial development of the Northeast and the serious problems withthe administration and operational mechanisms of the system the AnalyticalReport analyzes the FINOR system in some depth.

35. FINOR resources have decreased since 1970 in real terms and havebeen transferred by the Federal Government to SUDENE on an irregular basis,both with respect to their amount and their timing. This has been highlydisruptive as far as SUDENE's investment planning is concerned.Statlstical data provided by SUDENE show that, in 1970, the FINOR programchanneled the equivalent of about US$400 million to Northeast industry,while in 1984 these funds had decreased to about US$200 milliou. In 1985,the FINOR program amounted to about US$300 million.

36. Operations of FINOR. The FINOR system is extremely complex. Theattached chart presents a complete picture of the different components ofthe system. The paragraphs below describe the system's main features.SUDENE is in charge of the admlnistration of FINOR. SUDENE analyzes andapproves projects submitted for FINOR fundlng, supervises theimplementation of the projects benefitting from those funds, authorizes BNBto disburse FINOR funds in exchange for stocks to firms whose projects havebeen approved, and deals with the economic policy aspects of FINOR. BNB isin charge of the operation of the FINOR fund. It receives the tax andother resources allocated to the FINOR Fund, converts the value of the taxoptions into certificates, emlts the certIficates to the firms that optedfor FINOR, and keeps records and accounts of the transactions involved. Asthe legal representative of FINOR, it subscribes to the stocks of thecompanies that receive FINOR funds and administers the portfolio of thosestocks. The latter functlon includes following the flancial condition ofthe flrms In its portfolio and periodically promotlng special auctions ofthe stocks of those companles.

PICrOIAL B_EMATICII OF F!aR SBSTHK

wE dstreios

Be tranfer. ftnor essrvrked tax collection to Lnor. .ms retlve. noor optiot of

to iB as thoritzed by CDE. 7;;m tax revsaa end tease

B > certifcates of tnesat#nt to

Me isafes Ct to fine that opted for Flnor. taxpae who opted for neor.

Flm-pay

Oorporate E_om aeSs tbrewh 3r~~~~~~~~~~d party project

BB. haya th h.e ted

_ ~~~~~~~~~~~to 9oee forB.

T[pe Is &v am project rIn N.E. - can opt

y

for Arteice 18 1rtl1 _ _ -: ShUDO dwecides which projects am approved and the bdemn authorize 1In to

- J ~~~~~Pwecets : abae of ntor fuMb 1nt project4 NMftor projeets buy stacks to epprowd Fnaor fund

s la progta and suftorias disburenmt of Fnor projects tn pr. ss.

t RS. A. Caht MI ca use cash

. _ r~~~~~~~~~~~~~~~~~~~~eedfed ftr Pinr

opttoi for free utll Ite

, Finor F undfta t n e to In exchn for stocks. ho to fis It to buy

TPe 2: Dn't bae am stocks la c_nas

project tn N.A. irtacle

t8 project S cgted ty Sademe.

"Av to prtici- "proved by Wdea Coemany _ends Ftnor Rod the stocks.

pate va the B. Stocks: Cf coalnes

capital imiket. , a@5 prOjects ae

Me 2 hrns have Type I copy sears Fner Fund tts Cls in erchng for Cowered through Aticle

3 "ptie: Is.

- - -the stodks Finer purchaed In tte Article 18 project,

C. Stodw of acoaes

OotX A option B Fine C Inoects cash in coopany In for stocs,. tOs projects in U.S.

t et-o 7p ie tos Istouse ho be bean epproved by

Cle for Cis for Cl to 3td party projects

lotr ase cb. boy fior approved by Sodene. sempany _ la ttr POd the stocks.

stock of-_ _

thgdr dwt __

eps CI . .

for later l w

-e. igSpeca nor n ecton inr sends stocks of 50-100 3rd party firm.

|bld about 8 tises a -lyear. arrncy umd inoer receives Cis fr booers in excha_ for stocks It sell at wetlns.

i |ot ceten t t | - ---- ---- --t---o"

i kee ttl" of Qs*

Po emb i -- for Cisto be and

Auctions.

Other parti b Wy elected 4L= -PI nari stuckthbowbekr.

- 17 -

37. The certificates represent shares In the FINOR fund. The equityand the market value of these certificates are quoted daily. The equityvalue Is computed by BNB by adding up the total value of all the stocksowned by the FINOR fund and dividing it by the number of certificatesoutstanding. The certificates may be traded freely in the stock market.The market rate for the certlficates depends upon the demand and supply ofcertlficates on any given day.

38. Two categories of projects can be distingulshed, corresponding tothe two types of corporate taxpayers that opt for FINOR. The first couldbe called Article 18 projects. They are those projects in which the optingfirms have some ownership participation. The legislation speclfies thatthe opting firm or group of firms must have, together or separately, atleast 51X of the voting capital of the company beneflted by the incentive.In those cases, the beneficiaries of the FINOR funds are linked directly tofirms already existing in Brazil. Sice the opting firms receive freeFINOR resources for their project equal in value to their certificates,they receive a subsidy equal to the value of tax funds injected into theirproject by FINOR. Article 18 enterprises short-circuit the capital marketaspect of FINOR In order to have direct control of where their funds go.This can be done by a single firm, but it is more common among groups ofenterprises.

39. The second category of FINOR projects could be called third partyprojects. They are projects presented by individuals without affiliationto the opting firms. Once approved by SUDENE, they beneflt from thecaptive capltal market created by FINOR, since a FINOR particlpationreduces the volume of own resources needed for a given project. Thesubsidy element obtained by this project category Is defined by thedifference between what project sponsors would have had pay to obtain theequivalent funds from other sources and the dividends that they will haveto pay on the stocks they have to issue in return for the FINOR funds.The stocks of this project category are sold at the special FINORauctIons.

40. The auctions of stocks of third party firms purchased by theFINOR fund are held about eight times a year at special after hour sessionsof the stock market. They are held In the stock markets of different statecapitals In order to give greater exposure to the public. Normally, stocksfrom 50 to 100 firms are put up for sale at any given auction. The specialFINOR auctions have two characteristics that distinguish them from regularstock markets. First, in order to participate in the special FINORauctions, it is necessary to have certificates, whlch can be obtained fromown options or from purchases in the certificate market. The equity facevalue and the market value of certificates are determined daily. Second,in the special auctions the certificates are worth their full face value,although they may be purchased for as low as 25% of face value in theregular stock market.

41. Issues of FINOR Operations. SUDENE determines the levels ofprlority of different projects on the basis of a polts system, dependingmainly on type of industry, project location and generation of employment

- 18 -

and foreign exchange. The highest priority projects are entitled to equityfinancing of 60% of project costs, while those recelving the minimumnecessary points receive 24%. Furthermore, a significant share of theFINOR resources are being used to finance expansion and modernizationprojects, particularly those of larger firms. Most of these firms alreadybenefitted from FINOR participation when they were originally establishedor when they undertook a previous expansion. The share of FINOR projectfinancing determined by the current points system is extremely high (thenormal share is over 50%), since most projects receive the highest numberof points.

42. The efficiency of FINOR operations could be improvedsubstantially. At present, no financial forecasts and no sensitivityawalysis are prepared. SUDENE does not calculate either a financial or aneconomic rate of return for the projects under consideration for FINORfinancing. In addition, when a project has been analyzed and approved attechnical level in SUDENE, it is forwarded to SUDENE's superintendent forfinal approval and board presentation. The project cycle does not includea 'project committee" of senior SUDENE staff, which could help to reducesubjectivity in the project analysis and ensure uniformity of technicalstandards within SUDENE.

43. Many of the projects which bave run into difficulties duringproject implementation had loose financing arrangements. In most cases,the financing plan submitted at the time of project appraisal bad not beenfirmly established. The only sources of funds which had been assured werethe FINOR funds. Delays in project financing jeopardized the smoothexecution of the projects and generally liacreased project costs, which mayhave led to bankruptcy in some cases. SUDENE needs to ensure that theproject financlng plan has been firmly established before approving andcommitting FINOR resources.

44. FINOR funds are dlsbursed to approved projects In an irregularfashion, without regard to project requirements, In order to avolduncertainties and delays which disrupt the financial plans of the firmimplementing the project, SUDENE's dlsbursement procedures need to berevised. Moreover, SUDENE's project monitoring and supervision system isinadequate as indicated by high project cost overruns, excessive projectImplementation periods and a high failure rate of projects underimplementation.

45. After 20 years of staff erosion, SUDENE's staff operating theFINOR system is inadequate in number, training and qualification. In orderto improve thls situation SUDENE will have to develop programs to traiaexistIng staff. This alone, hovever, will not be sufficient to fullyupgrade SUDENE's performance; SUDENE will have to hire new staff. Thisshould be feasible with the newly decreed status of SUDENE as an "autarquiaespeclal," which gives it more autonomy in hlring and permits it to paymore competitive salarles to attract qualified staff.

46. FINOR funds can be used in both industrial and agriculturalprojects. Roughly 142 of the funds and 39% of the projects approved

- 19 -

through 1984 were agricultural projects. It appears that there have beenhigh fallure rates as well as a considerable misuse of funds among theagricultural projects. It is alleged that a major part of FINOR funds foragricultural projects have been used for land acquisitions. A Governmentstudy group is currently analyzing whether or not the use of FINORIncentives for agricultural projects should be limited to corporateenterprises that can issue equity shares.

47. There is also eviden_e that a significant shere of the FINORresources are being used to finance expanslon and modernization projects,particularly of larger plants. Some plants have had up to seven or eightexpansions financed with FINOR partlcipation. This is a questIonablepractice in light of the original objecties of the system, which was meantas an incentive to reduce the entry barrier to bringing new entrepreneursand capital to the Northeast. Once enterprises are established in theNortheast, know the local circumstances, and presumably are operatingprofitably, there is little reason for contlnued subsidizatlon. Inaddition, the possibillty of repeated access to FINOR funds for expansionsand modernlzations inhlbits firms from graduating to the capital market.This defeats one of the principal objectlves of the reform of the FINORsystem in 1973, which was to develop an active capital market through theuse of the flscal incentive.

48. A significant share of the FINOR funds have been allocated tostate owned telecommunlcation projects. It makes little sense for thegovernment to give incentives for its own - jects, particularly when theobjective of the lncentives is to stimula- )rivate projects.

49. The capital market side of the FINOR system has a series ofproblems which impair its proper functionlng. Poor marketability of theshares of companies supported by FINOR is one of the principal problems.Potential purchasers have insufficient information on which to make arational choice of stocks to purchase. The vast majority of the companiesare unknown and do not publish financial statements, although they arerequired to submit informatIon to BNB. The shares of FINOR enterprlses arenon-transferable for a period of four years. This reduces theirattractiveness to potential purchasers, who may not be willing to hold anilliquid Investment for such a long period of time. The stocks are alsopreferential shares without votlng rights during this four year period ofnon-transferability. This implies that mlnority shareholders have norecourse against the management during this perlod, if it is performingpoorly. The law creating FINOR specifically excluded it from theapplication of Brazil's stock company law, which further reduces theattractiveness of FINOR shares to potential purchasers. Finally, more than90% of the companies supported through the incentive system are closedcapItal companies, and only a handful of the more than 1,400 firms whoseprojects have been completed are being regularly traded on the Brazilianstock exchange. Consequently, even after the four years of non-transferability dlsposal of the shares is likely to be difficult. Thecombination of the above factors makes FINOR stocks risky and unattractive,except for buyers with inside information who are frequently reaping hugeprofits from investing in FINOR shares. As presently constituted, thecapital market of FINOR begs abuse.

- 20 -

Fiscal Incentives for Northeast Industry

50. Three different categories of fiscal incentives for NortheastIndustry have been In place in recent times. First, sectoral incentiveshave been provided at national level with highly differentiated incldencewithin the regions of the country. Trade protection and export incentiveschemes were the most important components of the sectoral fiscal incentivesystem affecting Northeast industrial development. Sectoral productionincentives provided at the national level differ in their regionalincidence because the regional output structure may differ from thenational structure. Second, there is a broad array of fiscal incentlvesdeslgned specifically to support Northeast industry. The most importanttax incentive provides exemptlon of corporate taxatlon to enterprisesduring their initial 10 to 15 years of operation in the Northeast. ForNortheast industry, the FINOR program is mainly a financial, not a fiscalincentive scheme, since its impact upon corporate tax levels occurs largelyoutside of the Northeast. Finally, fiscal transfers by the federalgovernment support Northeast industrial development indirectly since theyprovide for a major part of the fiscal means of state and municipalindustrial incentives as well as for infrastructure investments and forpublic services required by industry.

51. The Analytical Report provldes a detailed estimate, for 1980, ofthe value of regional and non-regional fiscal incentives for Northeastindustry (including import duty exemptions). -The total incentive amount iseetimated at US$376 million, corresponding to roughly 2.5% of regionalmanufactured output. Total fiscal incentives for industry in the rest ofBrazil should be at about the same percentage level. Fiscal Incentives,which may have strongly discrimInated against Northeast industry during the1960s and 1970s, were at similar levels in the different parts of Brazil inthe early 19809.

Reglonal Incidence of Non-spacial Incentives

52. Analysis of the regional incidence of non-spacial incentivesconfirms the above conclusion that production incentives in Brazil(excluding investment incentives, like FINOR) no longer discriminatesigniflcantly against Northeast industry. The Analytical Report estlmatesthe regional incidence of effective protection, which provides a zeasonablemeasure of non-spacial production incentives, by applying the regionalindustrial structure to the national effective protection averages. Whileearlier studies concluded that, during the 1970s, the protection systemstrongly dlscriminated against Northeast Industry, the analysls in theAnalytical Report indIcates that the macroeconomic policy discrimlnationagainst Northeast industry may have been eliminated by 1980 or was, atleast, much smaller. Discrimination against the Northeast economy as awhole, however, remained substantial In 1980, due to the relativeimportance of Northeast agriculture which continued to be stronglyunprotected.

53. During the 1960s and early 1970s, substantlal natlonal industrialpolicles supported import-substltutlon industries and selected capital and

- 21 -

intermediate goods industries, most of whlch were not well represented inthe Northeast. The regional discrimination resulting from the highlydifferential sectoral incentives, however, may have helped to bring aboutIts own eliminatiou by contributing to a change in the industrialstructure. Resources were pulled into Northeast industrial subsectorsreceiving high sectoral Incentives, whlle they were withheld from industryreceiving low levels of incentives. In particular, high incentive levelswould help to explain the large volume of resources that flowed Into thehigaly protected Northeast chemical industry. The long-term relativedecline of the Northeast food products and textile industrles may also havebeen partly caused by below-average levels of non-spacial incentives.Furthermore, the extremely high growth rates of the small Northeastmachinery sad electrical equipment industry may be related to higheffective protection rates, while the Northeast metallurgical and transportequipment industries, which have low or negative effectlve protection,stagaated In the second half of the 1970s.

54. The analysis of incentives provides the basls for a number ofImportant conclusions on recent Northeast Industrial development. Thediscriminatory nature of Brazil's non-spaclal industrial lncentives seemsCo have contributed strongly to the growth of benefiting industries, butmay have pulled resources into subsectors without regional comparativeadvantage and Into projects which are not economically viable. There arealso indications that the non-spacial industrial incentlves werepartieularly high for those activlties which are intensive in physical andhuman capital. Accordingly, unskilled labor which is more abundant in theNortheast than In other parts of Brazil was unprotected. The bias towardcapital intensive Investment projects and the depressed levels of wages inthe Northeast can, therefore, be related to the non-spacial incentlvestructure.

55. Recent studies have concluded that interregional trade betweenthe Northeast and the rest of Brazll would result in resource losses forthe Northeast. In principle, it Is assumed that the Northeast would exportproducts receiving few incentives, while regional imports would bepenalized by high protection In Brazil. In particular, the protectlonsystem would force the Northeast to purchase expensive machinery andproduction inputs in the Center-South, while Northeast intermediate goodsexports to the Center-South would frequently be prevented, by exportcontrols, from achieving higher prices on overseas export markets.

56. The analysis in the Analytical Report demonstrates that thehypothesis of resource transfers through interregional trade cannot beconfirmed. In llne with the structural change of Northeast industry towardsubsectors receiving hlgh incentlve rates, interregional exports of theNortheast coutained an Increasingly large share of highly protectedproducts, while producto with low or negative protection were increasinglyimported. In 1980, 731 of extraregional exports were attributed to fourproduct categories (metallurgical products, chemicals, plastics andtextiles), of which only one - metallurgical products - had an Implicittariff at below the national average. On the import side, the additionalNortheast expenditures for the purchase of high cost machinery and

electrical equipment fropn extraregional sources were largely compensatedfor by implicit subsUlea received thr%iugh the large import volumes offood products, which have higher world market than domestic prlces.

57. An important reservatlon habs to be made on the calculations ofLet resource flows. The high extrareglonal imports of machinery,electrical equipment and transport equipment ara largely Induced by the lowusage of Northeast manufacturers of the BEFIEX import scheme. This schemeprovides access to specific products, for which quality differences aremost important. However, these quality differences between domestic andimported products are not captured by Implicit tariff rates derived from,direct price comparisons. Therefore, the additional cost to the Northeastresulting from domestic purchases of machinery and electrical equipmentwould be higher than indicated. The resulting increase of the net resourcelosses of the Northeast through interregional manufactured trade by takingquality differences into account, however, would probably not besubstantial.

58. Overall, interregional trade does not penallze the Northeast.Therefore, there exists no Possibility to Improve the Northeast's balanceof payments by following the optimum currency argument and establish aregional currency area. Similarly, protective restrictions oninterregional trade, which were recently recommended by a leading Brazilianeconomist, would not provide benefits to the Northeast.

RECOMMENDATIONS

Industrial Financlng

590 Severa: measures should be taken to improve tne currentallocation of financlal resources in the Northeast. The first measure isto channel additional financial resources to small enterprises. A newcredit line for small firms would complement the existing national creditprograms for this enterprise category (mainly POC and PROMICRO), and wouldhelp to compensate for the possible reduction of SSE lending by commercialbanks. The new credit linie should be operated by BNB in order to addressthe speciflc financial and techalcal assistance needs of regionalenterprises more directly than is possible under the existing nationalprograms. This program should also provide assistance, to the extentpossible, to enterprises operating In the informal sector. The secondrooosed measure is to establish a credit program linked directly to theprovision of FINOR equity fiauncing. This program would not represent anaddition to the total financing available for Northeast industry, but wouldreplace ftuds currently provided through offIcial credit lines at thenatlonal level (FIWAME, POC, dIrect lending by B.NDES). The main purpose ofthis credit line would be to facilitate the preparation of fiaancing plans

for FIMOR-supported projects. The credit program for FINOR-supportedenterprises would also help to achieve a better balance between debt andequity financing by reducing the equity share in FINOR-financed projects.

- 23 -

60. The subsIdizatioa of credit sud equity financiug programs forNortheast industry should be further tetuced to the extent possible. Themost iwportant measure would be to

the development impact of the programe Ia particular, the reductlon ofFINOR subsidies would contribute nuch toward reducing the preseure forhlghly subsIdized credit programs by enterprises wdthout access to PINOR.Furthermore, Interest rates of public credlt programs fo� medium aad larseellte , shouldbe' ra'I'sed. Thi8 increase of interest rstes would spply msinly to FINAME

. yw

fizanclag and direct lending by BNDES. This measure would help to improvelong run resource allocation In the Northesst (and ia the rest of Brazil).The current moderate alement of iaterest subsidization of credit for smalleRterprises, however, could be maSutaiaedEdurln8 a brief traositiQu periodfrom an eavironmeat of high credit subsidisation to wore xarket orientedinterest rates. A highly subsidized credit program, a8 i8 currentlyplanned by SUDENE, would, however, be detrime tal to efficient growth ofgmall enterarises in the _ortbeast.

Instltutional Arrangements of Deve pment Flnancing-=

6i. Nhile efficiency improvements in the allocatlon of FINOR funds-ouid be achieved by transferring the program to a federal institutlonlocated outside of the region, thls institutional change would benconsistent with the government policles of devolution of power to theotates It would also tend to lntroduce into F}NOR the deficiencles of theother federally administered progrsms whlch cannot tske iDto account the-peciflc reglonal conditions of lndustry. Therefore, FINOR should beJperated ht a regissul_agency. although SUDENE, as currently costltut d,does not aPPear to be most suitable regional instItution to admbnister a. . .financing program. SUDENE operates as a development Instituelon which waseqtablfshed and organized to prepare regioual development plans, supervisefederal asslstance programs and administer regionsl fiscal incentives. Inline slth these terms of reference, SUDENE considers the FINOR equityfinancing program as a fiscal incentive scheme which does not require adetalled technical evaluatlon and supervision of enterprises and projectsreceiving the fund8. ProJece analysis snd supetvision, however, are neededfor the efficient use of FTNOR equity financing.

62. There exist, therefore, three options for the institutionalarrangements which would permit efficient operations of the FINOR system.First, a transfer of the responsibilitles for FINOR to BNB would be aneffective solution for the system's operational problems. 'BNB ie organizedand staffed to perform an investment banking function and 8 transfet ofPINOR to BNB would therefore, tend to make FTNOR's operation substantiallgmore effectIve. A second option, whlch would permit operations of FINOR atmuch improved levels of cost effectiveness, *ould involve the establishmentof the program as a separate agency. The management of the PINOR agencywould continue to be responsible to SUDENE's board of governors (conselhotelIberatlvo), but operations would be separate from those of SUDENE andBNBe Establishment o$ a new sgency for FINOR would have the advantage ofpermittlng a relatively rapid trsnsltion to more efficient FINOR

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operations, as suitable staff could be hlred or transferred from BNB andSUDENE within a short period of time. Also, procedural changes needed for

effective operations could be introduced rapldly without the need to amendother adminlstrative procedures of SUDENE. The third solution for making

FINOR more effective, would be to Introduce the required procedural changes

under the existing organizational arrangements of FINOR In SUDENE.This istihe most difficult and time-consuming of the three options for improvingthe organization of FINOR, since it presents the task of establishing an

investment banking function within a development planning institution.However, this task would be facilitated if MND's role In project evaluationand supervision would be expanded. This could be achieved by transferringthese activltles to BNB or by establishing cooperative units of BNB andSUDENE staff. The three options for organizing FINOR described above

present a difficult choice with Important economic implications for the

Northeast. Given the large amounts of valuable tax resources allocated to

FINOR, it is important that the program be organized for effectiveoperation.

63. The decentrallzation of economic decislon making provides the

opportunity for strengthening BNB's development banking function. Twomeasures should be taken toward this goal. First. BNB should obtainfederal funds for maintaining its financial viabairit and reestabllshlngterm lending to industry. Allocations to BNB of part of the PIN andPROTERRA funds could perform this function in 1987, but the Impact of theGovernment's recent anti-inflation measures, which deprive BNB of the

revenues derlved from the non-adjusted federal deposits, would require thefinancial strengthening of the bank with public funds at an earlier pointin time. Given the potential loss of annual revenues of US$15 to 20milllon from FINOR and other federal deposits, BNB needs a new source of

funding to maintain its viability. Over time, however, BNB should aim for

financial independence from federal funding and raise the resources for theterm lending operation on the capital market which can be expected todevelop In an environment of stable prices. Second, BNB should establishand administer an industrial credit program hich would be tailored to thespecific requirements of Northeast industry Gliven that a major part ofthe financial requlrements of small and medium enterprlses In the Northeast

is unsatisfied, a program directed toward these firms would be the mostsuitable for strengthening BNB's development banking activitles. Such a

program would also replace the small enterprises' credit program whichSUDENE intends to establish with part of PIN and PROTERRA funds. SUDENE i1unsuitable to perform this development banking function effectively, whileBNB is organized and staffed to operate successfully a lending program forsmall and medium enterprises.

The FINOR Program

64. The principal recommendation for improvIng the operatlon of the

FINOR program is to Introduce economic analysls as an integral part of the

project appraisal procedure. Such a measure would increase economicefflcienAy In the allocation of scarce FINOR resources. Use of shadow

prices could give proper consideration to speciflc objectives such as

employment generation and Increased exports. Projects passing the cutoff

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point given by a minimum economic rate of return could then be consideredfor approval, depending upon the overall development strategy establishedfor the Northeast.- State and even sectoral quotas set within the contextof the overall regional development plan could be used, subsequent toappraisal, to further allocate funds among projects that pass the cutoffpoint. It is recommended that, in additlon to the preceding, the overallprocedures be thoroughly assessed, ti order to identify and strengthenpossible weak points In appraisal In areas such as pricing, technology,financial management, and marketing. Thorough project evaluationprocedures should be applied, in particular, to financial and technicalrestructurlng of paralyzed projects, which SUDENE intends to perform usingpart of the FINOR resources of 1986 and 1987. This project category can beexpected to have a particularly high share of non-viable enterprises, whlchcan only be identified wlth a careful analysis.

65. A second area of concern relates to the frequent lack of viablefinancing plans for FINOR-approved projects and the problems that resultfrom the slow and erratic disbursement of FINOR funds. It is recommendedthat the gap between the FINOR funds required for proper project executionand the funds available be reduced. The first recommendation foraccomplishing this is the same as in the preceding paragraph, i.e., torequire FINOR financing to be made also also on economic, rather thansolely financial criteria. Requiring projects to have a minimum economicrate of return would reduce the number of projects that qualify forapproval, thus reducing the pressure on the resources of the FINOR Fund,whlle, at the same time, insuring economic efficiency In the use of thefunds.

66. The second modification is to reduce the share of FINOR financingfor most projects. FINOR-financed enterprises appear to have far belowaverage debt to equity ratlos because as much as 60% of total investmentcost is financed by FINOR. It is doubtful that such high levels of FINORequity participation are required to attract enterprises to the Northeast,as is evident from the excess demand for FINOR funds. The thirdmodification is to abolish the polnts system. The points system wasintroduced to determine the amount of FINOR financing for each project,based upon employment, location, use of local inputs and other projectcharacteristics. However, the points system does not provide a consistentset of criteria for determining the value of a project. It is, therefore,recomended that the points system be replaced by providing FINOR funds foreconomically viable projects in accordance with the project's financialrequirements for equity financing. The shares of FINOR financing in totalproject cost should rary for all project categories within a relativelynarrow range of 25% to 35%. These reduced shares would provide foradequate financial structures of new enterprises; help to reduce the numberof projects which may not be vlable; and support improvements in the costeffectiveness of the incentive.

67. The fourth modification is to integrate FINOR into a completepackge of project financIng. Currently, FINOR funds are provided Involume and timing largely independent of other sources of projectfinancing, which adds to the uncertainties prevaillng during project

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implementation. An integrated approach to project financing would requirea close cooperation among all institutions participating in projectfinancing. The establishment of a credit line for FINOR projects,recommended in the preceding section, would facilitate the preparation of

project financing packages.

68. The fifth modification is to reduce substantially the use ofFINOR funds for expansion and modernization of projects that have already

received FINOR funds at their establishment. Generally, scarce FINOR fundsshould not be used for further expansion of FINOR-supported projects, whichshould be self-sustaining after having received a first injection ofequity-financing through FINOR. The repeated access to cheap financingfrom FINOR has reduced the incentive for Northeast enterprises to haverecourse to the capital market and so prevented them from fostering aregional capital market, as was intended when the FINOR system wasestablished. The sixth modification Is to exclude publlc utlityenterprises from the FINOR system. FINOR's objective is to attractinvestments to the Northeast by providing public funds for projectfinancing. This function can be performed only for private investments.The seventh modiflcation is to limit FINOR financing for agriculturalprojects to a small number enterprises, which can be formed intocorp:rations.

69. Another area of concern is the lack of a monitoring system totrack the performance of firms that have benefited from FINOR. It isrecommended that project supervision be continued until commercial

operation is achieved. Introduction of penalties for the Improper use of

FINOR funds would help to make project supervision more effective and wouldminimize the risk of misuse of FINOR funds. 1

70. A systematic ex-post evaluation of FINOR financed projects shouldalso be introduced. This would permit an analysis of the actual impact of

these projects on employment generation and production and would feed pastexperlence Into appraisal of new projects. Furthermore, it is recommendedthat an overall evaluation of the performance of FINOR-financed projects be

undertaken. Determinlng the domestic resource cost of productlon of

FINOR-supported enterprises would be an important objective of this

performance evaluatlon. The evaluation should also help to determine howthe system can be further improved as well as to identify the industrialsectors which provide high economic returns to investments.

71. If SUDENE is to remain responsible for FINOR, the precedlngrecommendations of strengthened project analysis and improved projectimplementation and monitoring procedures in SUDENE can be made effective by

reorganizing SUDENE's operations departments, training existing staff andhiring new staff with- experience In project work, and strengthening the

role of BNB as recommended in paragraph 62. The main component of an

effective organization of SUDENE's operational departments would be theestablishment of a projects committee which would scrutinize the staff

appraisal reports of all projects with respect to their analytical qualityand consistency wlth procedures as well as the suitability of projects forthe overall FINOR financing program. Projects that would be found

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acceptable to the projects committee would be passed on to SUDENE'ssuperintendent and supervisory board (conselho deliberativo). As long asthe effective demand for FINOR financing exceeds the available resources, adisbursement committee should decide upon FINOR disbursements. Currently,each projects department obtains an annual allocation of FINOR funds.Disbursements from these subfunds are then performed without taking accountof the changing requirement for funds of the departments during the year.Establishment of a disbursement committee would, therefore, avoid thecurrently prevailing segmentation of FINOR and allocate scarce funds tothose projects which have the most pressing need for financing.

72 For directing the required training and hiring of staff, SUDENEshould establish a detailed plan which would determine the staffingrequirements of the oPerations departments and prepare a program for stafftraining and hlring. SUDENE should seek assistance from otherinstitutions, Including BNB and ENDES, for the preparation of staffingplans and training programs.

73. The capital market operation of the FINOR system should bereformed. Elimination of the four-year period of non-transferability ofthe stocks auctioned by FINOR, provision of voting rights to shares after afew years of initial operations, obligation of companies that receive FINORfunds to become open capital companies, and creation of an over-the-countermarket for stocks of companies that have received fiscal incentlves wouldbe helpful for improving he capital market side of the system. However,such changes may still be insufficient to really make the capital marketwork. A more drastic reform of FINOR's capital market operations,including the eliination of the tax certificates, may be necessary forachieving better allocation of the benefits of the system. Such changes inthe capital markets operation can only be introduced for all fiscal funds(including FINOR and FINAM) at the same time. It is, therefore,recommended that a more detailed evaluation of the capital market aspectsof the fiscal funds be undertaken, and that alternative means of channelingthe corporate income tax funds to projects in the Northeast and theNorthwest be considered.

74. Finally, it is recommended that the Government determine for eachyear in advance the amount that should be channeled through FINOR toindustry in the Northeast. This would facilitate the programing of FINORproject finan!ing as well as help to determine appropriate volumes of thecredit programs which complement FINOR. The annual amounts allocated tothe FINOR system should be based upon the volume of such financing that canbe absorbed effectively by new industrial projects In the Northeast, ratherthan by the options for FINOR of Brazilian corporations, as is currentlythe case. Past total industrial investments id the Northeast have variedbetween US$1.0 billlon and US$1.5 billion per year, of which medium andlarge enterprises which could obtain financing from FINOR may have had ashare of up to 80%. It is, therefore, improbable that Northeast industrycan absorb FINOR financing of more than US$300 million per year, given therecommended average FINOR share in total project cost of 30%. In order tolimit the amount of uncontrolled spending by FINOR of valuable fiscalresources under inadequate project evaluation procedures of SUDENE, it is

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recommended that the current volume of FINOR financing be temporarJlymaintained. Plans t_ transfer funds from PIN and PROTERRA programs toFINOR should, therefore, not be implemented. Once thorough projectevaluation procedures are applied by SUDENE, the volume of viable projectswould determine the appropriate size of the FINOR fund, which could well beless than US$300 million per year.

Fiscal Incentives and Import Protection

75. The volume of regional fiscal incentives is small, but they forman important part of the overall i centive package for Northeast industry.In spite of a number of deficiencies of the corporate tax exemption,(discriminatior. against existing enterprises, problems of administration)It is recommended that it be maintained, for new projects located in theNortheast but that control of the system should be strengthened. ReceitaFederal, instead of SUDENE, should be put in' charge of granting theincentive and of monitoring its expiration.

76. The fiscal incentives of states and municipalitles representLargely ineffective measures of investment promotion. States andmunicipalities in Brazil are competing against each other for attractingindustry to a specific location, which ralses the cost of incentives.Furthermore, utilities provided at below cost support an noneconomlc use ofscarce resources. The fiscal resources for state and municipal Incentivesare provided by transfers from the Federal Government. It would,therefore, improve the efficiency of the fiscal incentive system if suchreional fiscal incentives were to be abolished or integrated into thenational Incentive system. The provisiona of iudustrial land andinfrastructure, at cost covering prices, is, however, best performed bystates and municipalities.

77. The introduction of economic project evaluation in the FINORscheme and major credit programs would reduce the anti-labor bias of thetotal incentive package for Northeast industry. Nevertheless, the majorityof the incentive programs would continue to lower the cost of capitalrelative to labor and capital intensive projects would continue to be moreattractlve to investors than labor intensive projects. It is, therefore,proposed, that the authorities consider, after careful study, to introducean employment incentlve, which could use part of the fiscal resources spentineffectively by states and munlcipallties. The proposed Incentive wouldaim at reducing the cost of employing additional workers by exempting thelremployers from social security payments (payments to INPS, PIS, PASEP andFGTS) for a period of, say, ten years. This measure would reduce the laborcost of additional workers by about one-third and, if applied to alladditional employees registered with the social security system in theNortheast (currently about 25,000 per year), would cost about US$15 millionduring the first year of operation. An effectlve system, however, shouldbe restrlcted to workers with low wages. The employment incentive systemwould, therefore, cost probably less than US$10 million during the firstyear of operation and a maximum of US$100 million per year after ten yearsof operatlon. This amount would correspond to the estimated current costof the ineffective state and municipal incentives.

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78. The Nortbeast would benefit from less differentiated Importprotectlon levels, which would incentivate lreional agriculture,eliminate thle remainiing impliclt discrimination against reglonal industryand reduce the anti-labor bias. A sharp reduction in number and volume ofthe special import progrims, whicb help to determine the effectiveprotection levels In Brazil, would go a long way in reducing differentiatedimport protection. In the absence of measures to reduce protectiondifferences at the national level, crucial import programs could beredesigned with a view to broaden their sectoral coverage.

79. As a means to stimulate regional industrial output and employmentgrowth It is recomended to establish after careful Stud on or moreexport processing zones (EPZ) on the large unused areas existing in mostNortheast industrial complexes. Enterprises In the EPZ would operate underfree trade conditions with a minimum of regulatory and taxationrequirements. In exchange for such privileged treatment, firms operatingIn the EPZ would be required to export 100% of their output. EPZ wouldgenerate industrial employment, increase regional manufactured exports andstrengthen the industrial development of neighboring areas. Regionalenterprises supplying intermediate products to manufacturers located In theEPZ could then benefit from the duty drawback and BEFIEX programs.