Report No: 117304 FINANCE & MARKETS GLOBAL PRACTICE TOWARDS A MORE EFFECTIVE BNDES June 2017 Prepared by: Claudio Frischtak Ceyla Pazarbasioglu Steen Byskov Adriana 1 Hernandez Perez Igor Andre Carneiro Standard Disclaimer: This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Copyright Statement: The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development/ The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://www.copyright.com/. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org. 2 Table of Contents Executive Summary ................................................................................................................................................................. 6 1. Criteria for Access to BNDES Resources ............................................................................................................... 6 2. Instruments............................................................................................................................................................ 8 3. Funding of BNDES ................................................................................................................................................. 8 4. Provision of Finance for Infrastructure ............................................................................................................... 9 5. BNDES Governance ............................................................................................................................................. 10 BNDES Action Matrix............................................................................................................................................................. 11 BNDES Action Matrix (cont.) ................................................................................................................................................. 12 I. An Overview of BNDES .................................................................................................................................................. 14 Introduction .................................................................................................................................................................. 14 BNDES support modalities ............................................................................................................................................ 15 BNDES funding .............................................................................................................................................................. 16 BNDES assets ................................................................................................................................................................. 18 Technical assistance and coordination with other public entities ................................................................................ 19 Reforming BNDES’ operational policies ........................................................................................................................ 20 II. The Basis for BNDES Lending: A Conceptual Approach ............................................................................................... 21 Market failures .............................................................................................................................................................. 21 Externalities................................................................................................................................................................... 23 Selecting beneficiary firms ............................................................................................................................................ 23 Selection of sector and industries.................................................................................................................................. 26 III. Applying Fundamental Economic Concepts to BNDES Operations ............................................................................... 29 Assessing BNDES products ............................................................................................................................................ 29 A preliminary exercise in assessing lending activities ................................................................................................... 30 Developing an externality and an additionality decision stream ................................................................................. 34 Additional streams for alternative objectives ............................................................................................................... 37 IV. BNDES in Transition....................................................................................................................................................... 38 Changing the balance of instruments ........................................................................................................................... 41 Adjusting the funding of BNDES.................................................................................................................................... 42 Transitioning BNDES’ role in infrastructure finance ..................................................................................................... 43 BNDES Governance ....................................................................................................................................................... 46 V. Conclusions ....................................................................................................................................................................... 46 3 Annex 1: BNDES Basic Statistics ........................................................................................................................................... 49 Annex 2 – BNDES Main Products .......................................................................................................................................... 53 Annex 3 – BNDES Programs .................................................................................................................................................. 58 Annex 4 – BNDES Main Funds under Operation/Management............................................................................................ 64 Annex 5 - Market and Policy Interest Rates.......................................................................................................................... 71 Annex 6 – BNDESPAR and Capital Markets Resources ......................................................................................................... 72 Annex 7A – BNDES’ 2016 Operational Policy Details ............................................................................................................ 82 Beneficiaries..................................................................................................................................................................... 82 Firm sizes ......................................................................................................................................................................... 83 Eligible financing items .................................................................................................................................................. 83 Non-eligible items .......................................................................................................................................................... 84 Types of operations ........................................................................................................................................................ 84 Interest rates.................................................................................................................................................................... 86 Maximum BNDES participation and terms.................................................................................................................. 87 Guarantees....................................................................................................................................................................... 88 Annex 7B – BNDES New Operational Policies ....................................................................................................................... 89 Annex 8 - Data Description ................................................................................................................................................... 97 4 CURRENCY EQUIVALENTS (Exchange Rate Effective December 31, 2016) Currency Unit = Brazilean Real BRL 3.12 = US$1 FISCAL YEAR January 1 – December 31 ABBREVIATIONS AND ACRONYMS APEX - Brasil Agência Brasileira de Promoção de Exportações e Investimentos (The Brazilian Trade and Investment Promotion Agency) BNDES Banco Nacional de Desenvolvimento Econômico e Social (National Bank for Economic and Social Development) BNDESPAR Bndes Participacoes S.A. CEF Caixa Econômica Federal EMDE Emerging Market and Developing Economies FA Fundo Amazônia FAT Fundo de Amparo ao Trabalhador FI-FGTS Fundo de Investimento do Fundo de Garantia do Tempo de Serviço Mercante FINAME Financiamento de Máquinas e Equipamentos FINEP Financiadora de Estudos e Projetos FMM Fundo Marinha Mercante da Authority (Funding for Studies and Projects INFRAERO Empresa Brasileira de Infraestrutura Aeroportuária LCA Letras de Crédito do Agronegócio (Agribusiness Credit Bills) MPMEs Micro, Pequenas e Médias Empresas ( MSMEs) OPs Operational Policies PMAT Modernização da Administração Tributária e da Gestão dos Setores Sociais Básicos SEBRAE Serviço Brasileiro de Apoio às Micro e Pequenas Empresas (Brazilian Micro and Small Enterprises' Support Service) SELIC Interbank overnight policy rates negotiated at the Sistema Especial de Liquidação e Custodia SME Small and Medium-sized Enterprises SUS Sistema Único de Saúde TJLP Taxa de Juros de Longo Prazo (Long-Term Interest Rates as determined by the National Monetary Council) 5 Executive Summary1 1. Founded in 1952, the National Bank for Economic and Social Development (BNDES) is a financial entity fully owned by the Brazilian government. It is in the process of redefining its priorities and its role going forward. New operational policies (OPs) published on January 5, 2017, mark an important milestone. This report aims to contribute to the improvement of BNDES OPs and, more generally, provide a medium- to long-term view of BNDES’ role in the Brazilian economy. It provides a conceptual framework to establish BNDES as a development bank that aims to offset market failures that impose a wedge between private and social rates of return and limit access to term finance. The framework differentiates credit- constraining factors from the presence of externalities. The former might justify facilitating access to long-term financing; only the latter might justify subsidies. The paper then applies the framework and methodology to BNDES’ operations and finds that BNDES has in the past provided financing to many firms that have access to alternative sources and subsidies beyond what could be reasonable in economic terms. The paper provides recommendations to establish BNDES as a more effective and focused development bank, less dependent on the government for funding, and less subject to interference by improving its governance. 1. Criteria for Access to BNDES Resources 2. BNDES can help address certain market failures. Due to lack of market financing at reasonable terms, firms may supply a socially insufficient amount of goods and services with high positive externalities. Some firms, mainly SMEs, may be constrained in accessing term finance in view of informational asymmetries due to their age (young); industry (high growth or under sharp transformation); nature (entrepreneurial, pioneering in a domestic or export market, innovative); or type of activity (associated with a discovery process). In addition, long-term finance may be limited due to macroeconomic and regulatory uncertainty, which takes a particular toll on SMEs. 3. However, the presence of a market failure does not necessarily imply the presence of an externality that justifies subsidized lending. All externalities result from missing or thin markets. The reverse is not true: Not all market failures imply an externality. Moreover, not all externalities justify subsidized lending. 4. Among credit-constrained SMEs, BNDES may better leverage its limited capital by targeting the most progressive firms and growth-enhancing projects. This is particularly relevant in the context of a low- productivity economy, with many firms (SMEs and others) clustered at the low-productivity end of the distribution. BNDES may currently lack the right instrument mix to address the low-productivity conundrum (it does not, for instance, provide technical assistance and consultancy). But this does not imply a need for across- the-board and non-discretionary support for SMEs. In fact, many SMEs are relatively good risks, particularly those in protected markets that have undergone marginal changes over the years. Insofar as they remain in the market for a relatively long period, these firms should be relatively less constrained as more information about them is available to banks and other financial institutions. In these cases, it does not seem reasonable to use scarce public resources to support them. SMEs already benefit from friendly tax and related policies that may be biasing firms’ growth decisions and BNDES may not want to reinforce such biases. 1 The report was prepared by a team composed of Claudio Frischtak (lead author), Ceyla Pazarbasioglu, Steen Byskov, Adriana Hernandez Perez and Igor Andre Carneiro. Contributions from Eva Gutierrez and Heinz Rudolph are gratefully acknowledged. 6 5. BNDES can build two separate decision streams, one to establish the eligibility of projects and the other to determine which should receive subsidized funding (Figure 1). A well-defined methodology, applied in a monitoring and evaluation framework, will be critical to improving resource allocation and maximizing BNDES’ development impact.  An externality stream to identify high-quality (well-designed, properly priced, and well-governed) projects with significant positive externalities that might justify subsidized BNDES credit. These resources should be allocated to well-defined areas or activities judged to bring measurable external gains and projects that pass the externality test.  An additionality stream to identify strong projects from eligible firms that justify BNDES support at (notional) market rates, reflecting BNDES’ cost of funds as it issues bonds and taps capital markets. The additionality test attempts to answer the counterfactual: In the absence of BNDES, how would the firm finance the project? What alternatives are available? This would lead to a selection of a subset of projects by firms without access to long-term finance due in particular to information asymmetries. Typically, these would be young, high-impact firms in terms of sale and employment growth, with limited borrowing capacity due to a short track record. BNDES would provide access to term finance for such firms at market rates. The filter would exclude older, family-owned, low-growth, and relatively low productivity firms, and those clustering in mature sectors. Most of these firms would have access to at least moderately competitive market alternatives, making BNDES intervention unnecessary. Figure 1 – Simplified Decision Process of BNDES Operational Policies 6. In addition, BNDES may wish to develop targeted, industry-specific programs to address coordination externalities. Coordination failures may be of a nature that requires a dedicated program. For example, individual projects in the sector – even though potentially highly meritorious – may remain non-viable because they depend on the presence of an ecosystem (as in the case of the health services/neglected diseases drug cluster). In these cases, a program fostering coordination may be effective. For an intervention of this nature to 7 be well-grounded, such industries would need to be potentially competitive. The program can involve a proactive role for BNDES in designing public-private compacts to address coordination externalities plus the provision of technical assistance and consultancy services directly or with the support of other entities. 2. Instruments 7. With capacities on par with other significant development banks, BNDES has most of the instruments required to carry out its mandate, but it relies mainly on lending operations. Among other products, BNDES offers capital market operations and investments in externally managed funds by BNDESPAR. The main reason for the strong preference for regular lending operations is the access to low-cost TJLP funding, which provides a substantial subsidy relative to market rates. In addition, the transfers from FAT that BNDES receives on a quasi-automatic basis create a strong inertia that may push BNDES towards an overly “conservative� asset portfolio. 8. Guarantees are sparingly employed in direct operations, while warranties – though available – have been left dormant for over a decade. Thus, BNDES is not “leveraging� its funds effectively. In its indirect operations, BNDES utilizes a guarantee fund (FGI) geared toward supporting SMEs borrowing BNDES funds from second-tier institutions. As market rates become dominant, third-party funding will become more prevalent, and products such as guarantees – if correctly priced – will become a normal complement to credit, mainly in view of the fact that increasingly younger, high growth progressive firms will be the ones risked out of the market. In this case, guarantees might be the preferred instrument Further, when the choice of instrument is not regular loans, it would strongly enhance BNDES’ ability to use instruments that leverage third-party funds. The aim of BNDES would be to address market failures by developing financial solutions that crowd-in private sector players. 9. The outstanding missing element in BNDES’ portfolio of services is technical assistance and consultancy. BNDES has significant staff, mostly well-trained and sufficiently competent to provide solid consultancy and assistance. It could be instrumental in combining finance and technical assistance to subnational governments, which generally have a deficit of competence at the technical level to address the challenges of designing and effectively deploying new projects. For SMEs, it might be more efficient for BNDES to coordinate with other government institutions that provide such services (such as SEBRAE and APEX). 3. Funding of BNDES 10. Over the medium term, BNDES needs to shift away from an excessive dependence on FAT constitutional transfers and issue bonds to build a yield curve, while strengthening its capital base to allow for greater use of guarantees. By issuing bonds, BNDES will be able to establish a yield curve of notional market rates. This would provide the basis for what BNDES charges for most of its loans, with TJLP used parsimoniously. This process will gain traction with macroeconomic normalization, lower nominal and real policy rates, and the shift in BNDES operational policies to charging market rates as a rule. BNDES would offer what is truly scarce: guarantees and long-term credit for deserving credit-rationed firms. 8 11. Tapping domestic and international capital markets has multiple advantages . First, it shifts the pressure away from fiscal sources at a time when Treasury transfers are (for now) eliminated. Second, and conversely, the quasi-automatic nature of FAT constitutional transfers constitutes an incentive for BNDES to use TJLP beyond what might be economically grounded. Third, capital markets provide BNDES with access to a very large pool of resources; issuing bonds of different maturities allows it to build a yield curve, providing a BNDES-specific (and realistic) notional market rate that will allow BNDES to correctly price its loans. In fact, SELIC is a poor substitute for the market rate, especially when BNDES has the means, ability, and reputation to calculate its true opportunity cost. It is against this opportunity cost that all current and future operations should be measured in establishing the cost to BNDES, and to the country, of BNDES´ operations. Finally, and possibly most important, an adequate pricing of BNDES loans and a far less elastic supply of subsidized resources will serve as a powerful tool – and incentive – to reassess BNDES products and programs, their costs and benefits, and the extent to which such a complex structure is needed to attain BNDES ends. A more focused bank, in turn, will likely allow for a lower spread and a more competitive cost to the borrower, consistent with overall market conditions. Thus, over time, with the resumption of growth and investment, BNDES will be in a position to respond to new demands to the extent that it can tap market resources while changing its liability structure to accommodate greater use of guarantees and related products which would need to be funded with equity or grants. At the same time, below-market rate lending will be progressively scarcer, a reflection of a stricter fiscal regime that will impose additional requirements to ensure that credit and other subsidies are rationed effectively. 4. Provision of Finance for Infrastructure 12. BNDES has an important role in providing finance for infrastructure by leveraging its resources and crowding-in the private sector:  First, BNDES could assume a catalytic role in bringing resources from institutional investors into public infrastructure in the form of PPP contracts. BNDES should select a financial vehicle that initially can attract the interest of the large long-term investors, with the aim of attracting international investors in the medium run. The use of standardized debentures that provide guarantees during the construction period and pay interest during the life of the bond may prove effective in attracting a massive amount of private resources to the financing of public infrastructure.  Second, BNDES can support the development of the private debt securities market by ensuring that concessionary companies looking for its support access capital markets by issuing private papers. BNDES could provide credit enhancements on loan securitizations or undertake a supportive role as medium-sized firms issue corporate bonds.  Third, BNDES can assume a leading role in syndicating loans (as IFC has done historically) and promoting financing structures with efficient risk allocations among stakeholders (sponsor, financiers, and insurers). The introduction of project financing will be essential to ensure broad participation of domestic and international concessionary companies. 13. BNDES support for the PPI – the Infrastructure Investments Program – needs better targeting. The program offers positive substantive and procedural points, which support continuing involvement of BNDES in 9 financing the sector. The use of subsidized finance should be parsimonious and strictly related to the presence of significant sectoral externalities, such as urban mobility, water/wastewater disposal, treatment/solid waste disposal and utilization, and renewable energy. Even in these instances, the externality test should be applied to ensure a clear rationale for implicit or explicit subsidies. 5. BNDES Governance 14. BNDES governance can be improved by enhancing the effectiveness of its board. Statutorily, the board only provides guidance (orientação superior), which has allowed significant government interference in BNDES policies and operations. The federal government holds 100% of the shares and appoints all 12 board members. International good practices suggest effective diversity of the board, with the presence of highly qualified and vocal independent members. This could be accomplished with a change of the BNDES statute along the lines of the efforts to improve governance at Petrobrás and Eletrobrás. 15. The presence of minority shareholders may further improve BNDES governance. The government may want to invite other first-rate development banks (multilateral or even bilateral) to capitalize BNDES and dilute the union – up to say a 25% share of the capital. This strategic change would represent a step toward a more balanced board, with representatives of shareholders and independent members, both domestic and international, committed to modernizing BNDES following best corporate practices in terms of governance, management, and operations. This move would provide BNDES with the guarantee that management will continue to have a mandate to pursue long-term development goals, with a focus on the more severe credit and capital market failures that hamper the Brazilian economy. 10 BNDES Action Matrix (*) ST: short term (< 1 year); MT: medium term (1-2 years); LT: > 2 years Policy Area Key Recommendations Time Frame* I. Eligibility Criteria Consider introducing the following screening devices, with the support of the new M&E Department: Maximize BNDES economic impact; 1. Externality Test ST limit use of subsidized credit; redirect 2. Additionality Test resources to areas of high social return 2.1 SME Substitute ST and to high-impact entrepreneurial 2.2 Counterfactual Test MT firms; revisit BNDES programs though 3. Information Asymmetry Test: focus on LT the Industry Test; design and pioneering firms, entrants in new markets implement a monitoring and evaluation 4. Industry Test (coordination externalities) MT framework II. Funding Diversify BNDES sources of funding, 1. Issue BNDES bonds of different ST/MT reducing dependence on FAT maturities in domestic markets resources, while exhausting 2nd tier 2. Issue BNDES bonds of different MT institution rents captured through ad- maturities in international markets hoc risk premia being charged to 3. Define a schedule to reduce FAT ST SMEs; establish a market determined dependence price for BNDES resources in the 4. Launch a “central credit line� based on MT context of a new key credit line BNDES-specific notional market rates Consider changing BNDES liability obtained from BNDES bond yields structure by moving away at the margin 5. Auction off BNDES resources to 2nd tier ST from debt into equity as guarantees and institutions like instruments play a more relevant 6. Conduct a study of BNDES future capital ST role requirements and liability structure III. Instruments BNDES mainly lends directly or 1. Introduce a new set of products MT through banks and counts with most associated with guarantees and warranties instruments, but has not utilized at the time of the launch of the “central guarantees and warranties and does not credit line� provide technical assistance 2. Establish a TA/Consultancy Unit to ST assist subnational governments in designing and carrying out high social-impact projects 11 BNDES Action Matrix (cont.) IV. Infrastructure Support BNDES should take a leading role in 1. Securities: promote new issues of ST developing markets and crowding-in standardized, low-value, and accessible other financial institutions infrastructure debentures, with tranches of different risk profiles 2. Bid-out one or more funds of BNDES- ST held infrastructure securities for private management, ensuring liquidity in the corresponding shares or quotas. 3. Commercial Banks’ Credit: Syndicate ST/MT market-based loans to major commercial banks, with BNDES at least initially assuming a coordinating role 4. Project Finance Structures: set up a ST working group with representatives from commercial banks, insurance companies, regulators, and legal experts to propose changes in policies, regulations, legislation, and norms to encourage the use of off- balance sheet structures to finance infrastructure projects 5. PPI: BNDES should ensure the judicious ST use of subsidized finance, which would be allocated only to sectors or activities that pass unambiguously the externality test V. BNDES Governance A strengthened board of directors 1. Revise board rules to ensure that it is an ST would improve the operational effective, independent body that provides – independence of BNDES, pushing it to beyond “guidance� – constructive criticism the frontier of best practices among and ensures that BNDES adheres to the development banks highest governance standards 2. Reorganize board composition to ensure MT independent members invited to join the board have a significant voice 12 VI. BNDES Capital Structure Examine possibility of introducing new 1. Commission study to establish the legal, ST managerial methods and standards, regulatory, and normative implications for providing greater autonomy and BNDES to open up its capital to the minimizing political interference by participation of multilateral and other admitting new BNDES shareholders public interest institutions, with the signing of a shareholders´ agreement 13 I. An Overview of BNDES Introduction 16. Founded in 1952, the National Bank for Economic and Social Development (BNDES) is a financial entity fully owned by the Brazilian government.2 BNDES is subordinated to the Ministry of Planning, Development, and Management, with a mission to foster sustainable and competitive development, generating employment while reducing social and regional inequalities. BNDES’ operational autonomy has at times been adversely impacted by political interference. 17. In the 1950s and 1960s, BNDES played a key role in financing the country’s infrastructure. In the following two decades, its emphasis shifted to support Brazilian industry. Since the 1990s BNDES efforts have targeted infrastructure and industry, while supporting SMEs mostly through second-tier institutions. At the same time, BNDES also finances innovation, and manages an important fund to contain deforestation and promote sustainable development in the Amazon region. 18. BNDES is the major supplier of long-term financing in the country, mostly in the form of credit. It also offers equity (and quasi-equity) instruments and, in some special cases, grants. According to the Central Bank of Brazil, BNDES provided approximately 70% of long-term bank credit (defined as loans with over three-year repayment period) during 2013-15. In November 2016, the average maturity of new loans from “free� or non- directed resources was 38 months, compared with 100.5 months for BNDES and 177.9 months for directed credit operations as a whole. In 2015 alone, BNDES disbursed R$135.9 billion in 954,208 operations for 221,114 clients.3 In the first half of 2016, disbursements stood at R$40.1 billion, a decline of 42% from the same period in 2015. Disbursements reached a record in 2013-14, and they have since declined due to fiscal retrenchment on the supply side and the continuing recession on the demand side. 19. By company size, disbursements to large firms (by BNDES definition) reached 60.3% in the first half of 2016, compared to 65% in the same period 2015. The decline is a result of an attempt to progressively shift BNDES loan portfolio to firms that in principle have more limited credit access. During the first half of 2016, BNDES carried out 324,426 transactions, with more than 96% of them directed to micro, small, and medium enterprises (SMEs). Most transactions (243,000, or 74.9%) were undertaken with the use of BNDES credit cards and corresponded to disbursements of R$3.3 billion (8.2% of total disbursements). 2 BNDES has three subsidiaries: BNDES Participações (BNDESPar), which undertakes capital market transactions, mostly in the form of equity and quasi-equity contributions to firms (see Annex 6 for a detailed description); FINAME, which comprises different products (and credit lines) that fund the acquisition of machinery, equipment, and other capital goods; and BNDES Limited, which finances the internationalization of Brazilian firms. 3 See Annex 1 for basic BNDES statistics: financial highlights; key ratios; loan structure and disbursement patterns; credit risk policies; and equity portfolio. 14 BNDES support modalities 20. At the end of 2016, and prior to the new 2017 operational policies, BNDES offered 10 so-called products and managed 40 programs and 10 funds.4  Products finance eligible firms, items, activities, industries or sectors under a set of general rules, with the support of varied types of credit lines under pre-specified conditions (such as interest rate and payment term). In some cases, the rules are non-discriminatory; in most instances, however, BNDES offers more affordable terms for SMEs. Some products are for the exclusive use of SMEs.  Programs are supposed to be temporary support mechanisms for specific sectors, although many have not been discontinued after their expected life.  Funds offer further options for financial support to clients and beneficiaries, may have individual statutory or legal bases, and are governed by their own rules. 21. BNDES is a wholesale bank, with no branches and limited capillarity. As a result, it operates to a significant degree (over 42% of its loan portfolio as of mid-2016) through a network of second-tier accredited financial institutions (Graph 1.1), with most Brazilian banks offering BNDES products (on-lending or indirect operations). Graph 1.1: Loan Portfolio Breakdown (R$ million)* * Net of allowances for loan losses 22. BNDES’ indirect operations (on-lending) have certain obvious advantages in terms of capillarity gains as well as some drawbacks. Commercial banks access inexpensive BNDES funds and charge “what the market will bear� risk premia that might not necessarily reflect the underlying transaction risk.5 BNDES does not have programs in place to evaluate and measure the impact on beneficiary firms of its on-lending operations. 4 Annexes 2, 3, and 4 present a summary of BNDES’ products, programs and funds, respectively. 5 If rents are being made in the process of on-lending funds from BNDES, the auctioning of such funds to accredited institutions should be considered as a means to exhaust such rents (see section IV). 15 BNDES funding 23. BNDES has access to below-market funding resources, which allow it to offer subsidized loans.6 Funding sources include loans from the National Treasury (such transfers were discontinued in 2015) and constitutionally mandated transfers from the Fundo de Amparo ao Trabalhador (FAT). In addition, BNDES has in the past issued debentures and other instruments, and borrowed internationally, mostly from multilateral institutions. Still, as of mid-2016, 84% of BNDES funding came from the Treasury and FAT (Tables 1.1 and 1.2). Table 1.1: BNDES - Consolidated Liabilities and Shareholders’ Equity Source: BNDES (2016) 6 Funds from the National Treasury and FAT (and PIS-PASEP) is provided at a below market rate called the TJLP ( Taxa de Juros de Longo Prazo). The Central Bank policy rate (SELIC) serves as the benchmark for the country’s private credit markets. The difference between SELIC rate and TJLP is an indication of the magnitude of subsidies provided by BNDES. See Annex 5 for further details. 16 Table 1.2: BNDES’ Funding Structure (as of June 30, 2016) Source Description Subsidized Rate Funding Structure National Treasury Loans from the National Treasury Yes – TJLP 56.1% 1988 Constitution pledges to BNDES 40% of all revenues from FAT/PIS-PASEP Fund (a payroll tax Fundo de Amparo ao Trabalhador ranging from 1.0-1.5% to finance unemployment Yes TJLP if loan in R$ 24.3% (FAT) insurance and once a year transfers to low-wage LIBOR is loan in US$ public and private employees equivalent to 1- month salary) Net Worth Profits from past lending No 3.9% Funds from the PIS-PASEP assigned to BNDES in PIS-PASEP addition to the 40% already established by the Yes – TJLP 3.6% Constitution Finances the purchase and repair of vessels Fundo da Marinha Mercantil (FMM) Yes – TJLP 2.6% undertaken in Brazilian shipyards. International Bond Issuance Bonds issued in the international market No 2.5% Loans from international and multilateral Multilateral Institutions - Depends on the institutions such as the World Bank, KFW, IDB 2.4% International Loans loan and others Letras de Crédito do Agronegócio Agribusiness Credit Bills (LCA) No 2.4% (LCA) Domestic Bond Issuance Bonds issued in the domestic market No 1.0% (BNDESPAR) Not a regular source of income. Funds used for FI-FGTS Yes – TJLP 0.6% infrastructure projects. Resources from foreign governments and Petrobras to contain deforestation in the Fundo Amazônia (FA) Amazon region. The Fund promotes the Grants 0.6% conservation and sustainable use of natural resources in the Amazon Biome Source: BNDES (2016) 24. Due to both their cost and volume, the most significant and controversial of the incoming flows were from the Brazilian Treasury. This practice began in earnest in 2008 and ended in 2015 (see Graph 1.2), but the fiscal costs and economic consequences will be felt for many years to come. Two point are worth noting: (i) the large wedge between Treasury´s borrowing costs (SELIC, at 10.25% end May 2017) and the basic rate in most BNDES lending operations (TJLP, at 7%) and (ii) the sheer volume of these transfers (the mid-2016 BNDES Treasury liability constituted more than 8.7% of GDP). 17 Graph 1.2: BNDES Funding Structure: 2002-16 Source: BNDES 25. The use of subsidized Treasury financing to fund BNDES generated substantial distortions. First, the fact that Treasury had to issue new debt to finance these transfers ended up increasing the level and cost of public debt, potentially pushing up interest rates, increasing Treasury borrowing costs as well as costs for other financial system agents. Second, the growing extent of subsidized credit impervious to changes in monetary policy became an impediment to the central bank carrying out its mandate in full. Finally, the massive Treasury transfers to BNDES and across-the-board subsidized lending led to poor investment decisions and no significant productivity gains, with private agents borrowing at negative real interest rates, replacing internally generated funds which otherwise would be directed to investment (often reassigned to dividends) and in a number of instances leading to investing in equipment with limited economic rationales.7 Capital misallocation was not an exception. 26. At the same time, BNDES’ relatively easy access to resources translated into a very limited use of capital markets as a funding source, which could have had several advantages. Raising funds in the capital market would allow BNDES to play a more effective development role, establishing the effective opportunity costs of its funds, stimulating TJLP to be used parsimoniously. With an appropriate transition period, this process will gain traction with macroeconomic stabilization, lower nominal and real policy rates, and the shift in BNDES operational policies to charge market rates as a rule. BNDES assets 27. Fundamentally, loans, securities, cash, and equity investments comprise BNDES assets (Table 1.3). The non-performing loan ratio is quite low – 1.38% as of June 30, 2016, with 2.45% for direct operations and a negligible 0.003% for repasses interfinanceiros, or credit operations with second tier financial institutions.8 7 See, for instance, M. de Bolle, “Do Public Development Banks Hurt Growth? Evidence from Brazil,� Petersen Institute Development Economics Policy Brief, September 2015; M. Bonomo, R. Brito, and B. Martins, “The After Crisis Government Driven Credit Expan sion in Brazil: A Firm-Level Analysis,� Journal of International Money and Finance 55 (2015) 111-134. 8 Information on non-performance rates for indirect or second-tier operations is not publicly available. 18 These low rates are consistent with the practice of BNDES asking for considerable collateral in its operations and offering subsidized credit – it stands to reason that other financial institutions would be affected first. Still, the presumption behind the stability in the quality of its portfolio is that economy does not deteriorate further.9 Similarly, BNDES’ equity investments depend on the state of the economy, although they are highly concentrated in Petrobrás (38.5% of the total) and therefore depend heavily on its recovery under new and improved governance and management. Table 1.3: BNDES’ Consolidated Assets Source: BNDES (2016) Technical assistance and coordination with other public entities 28. In emerging market and developing economies (EMDEs), BNDES stands out as one of the largest development banks (along with the China Development Bank), and its toolbox contains at least as many instruments as its counterparts. One exception is the unavailability of technical assistance and consultancy services, which could be partly offset with improved coordination and communication with other institutions in Brazil that offer such services (e.g. SEBRAE, APEX, and the S-System organizations). This gap may at times constrain BNDES effectiveness mainly with respect to SME support (the focus of SEBRAE activities), exports (APEX centers its efforts in export promotion for SMEs), and technology upgrading (industry-led SENAI having a significant role, particularly within the business managed S-System). 9 In fact, recession affected in a considerable way BNDES loan portfolio. Between June 2015 and June 2016, the amount of renegotiated credit operation increased over sevenfold – from R$2,299 billion to R$16,366 billion, or 4.438% of BNDES’ loan portfolio for non-financial entities. 19 29. A separate but related issue facing BNDES is the operational overlap with other public sector banks and related institutions. These include Banco do Brasil, Caixa Econômica Federal (CEF), and FINEP (which finances scientific research, technology development, and innovation) as well as the regional development banks, particularly Banco do Nordeste and Banco da Amazônia (financing firms in the Northeast and in the statutorily defined Amazon region, respectively). Many of these institutions went through a phase of government-mandated rapid growth, and they are now undergoing adjustment. In a number of ways, changes in BNDES operational policies cannot ignore the policies and practices of those institutions. At the same time, it should not be dependent upon them to make BNDES more effective as a development bank, while over the medium to long term some consolidation of these functionally overlapping public sector institutions would make good sense. Reforming BNDES’ operational policies 30. In recent years, two issues have adversely affected the image of BNDES and prompted a review of its operational policies (OPs).10 These include:  The PSI “investment support� program, no longer in operation, but which left a significant and controversial legacy. The program aggressively disbursed resources at highly subsidized rates, often with no gains in terms of investment and economic efficiency. Funded by Treasury resources, it vastly expanded BNDES balance sheet, with credit extended through direct and indirect operations. Regarded by some in BNDES as being “imposed� by the previous government, the PSI’s economic and fiscal costs in all likelihood far outweigh its benefits.  The widespread use of TJLP in BNDES products and programs, even when there is no apparent justification. BNDES supported firms clearly able to access credit from banks and resources from capital markets. Yet, the use of TJLP raises other questions. Even with additionality, is BNDES offsetting a real market failure? And what is its nature? What types of firms, activities, and industries should BNDES be targeting? How can BNDES better leverage its limited resources? 31. BNDES is in the process of redefining its priorities and its role going forward. OPs published on January 5, 2017, mark an important milestone. This report aims to contribute to the improvement of BNDES OPs and, more generally, provide a medium- to long-term view of BNDES’ role in the Brazilian economy. The next section presents a conceptual framework to establish BNDES as a development bank that aims to offset market failures that both impose a wedge between private and social rates of return, and limit access to term finance. The framework differentiates credit-constraining factors from the presence of externalities. The former might justify facilitating access to long-term finance, by providing credit and increasingly guarantees; only the latter might justify subsidies. In sections 3 and 4, the paper applies the framework and the associated methodology to BNDES’ operations and finds that BNDES has in the past been providing finance to many firms that have access to alternative sources and granting subsidies beyond what could be reasoned in economic terms. In section 4, the paper provides recommendations to establish BNDES as a more effective and focused 10 Further details on BNDES OPs are presented in Annexes 7A and 7B, which respectively describe the OPs that prevailed until 2016 and the new set of OPs announced on January 5, 2017. 20 development bank, less dependent on the government for funding and less subject to interference by improving its governance. Section 5 draws the main conclusions. II. The Basis for BNDES Lending: A Conceptual Approach 32. As a development bank, BNDES faces the challenge of defining, through its operational policies and screening processes, why a specific firm, project, or industry should be supported. Market failures 33. The first justification for BNDES lending relates to market failures, particularly those affecting firms’ ability to borrow long term at competitive rates. In low-savings environments or where the savings-to- investments channels are clogged due to policy, institutional, or economic barriers, credit markets may be missing or might be too thin to respond to demand, giving rise to credit rationing. 34. Credit rationing in Brazil is in large part a product of macroeconomic imbalances and instability as well as policy and regulatory measures that distort savings and credit markets.11 In addition, firms are credit- constrained due to classic lender-borrower informational asymmetries and, arguably, limited competition in the banking sector.12 35. To design effective BNDES interventions, it is important to have a better understanding of why markets fail. What distortions increase transaction costs and impede those markets from existing or functioning efficiently? Do these distortions affect primarily credit markets? How important is credit rationing? The cause of the market-failure has important implications for identifying the type of firms BNDEs should support and the choice of instruments, with the latter affecting the risk profile of BNDES and its risk management functions. 36. Assuming the scarcity of long-term credit (and guarantees) is a first-order problem, does it hold for firms of all sizes, across all sectors and types of projects? To address this question, we use the additionality test and answer the counterfactual: What would happen in the absence of government (BNDES) intervention?13 One possible reason for the shortage of long-term funding in Brazil is that private financial intermediaries (and hence their clients) cannot access sufficient long-term funding (which is the traditional justification for development banks existence). Note that in this case even mature firms can be credit-rationed and hence virtually all firms could pass the additionality test. An alternative reason has to do with the risk associated with long-term lending14. With high macroeconomic and institutional uncertainty (including weak contract 11 See, for instance, Ceyla Pazarbasioglu, Steen Byskov, Marco Bonomo, Igor Carneiro, Bruno Martins, and Adriana Perez, “Brazil Financial Intermediation Costs and Credit Allocation,� World Bank Finance & Markets Global Practice, Draft Discussion Paper, August 15, 2016. 12 See, for example, Leonardo S. Alencar, “Revisiting Bank Pricing Policies in Brazil: evidence from loan and deposit markets,� Banco Central do Brasil, Working Paper Series 235, March 2011. 13 According to Sergio Lazzarini et al, “What state-owned development banks do? Evidence from Brazil , 2002-2009� in World Development No. 66:237-253, subsidized loans extended by BNDES in 2002-09 were not going to companies facing financial constraints or having difficulties obtaining market financing. 14 In most emerging markets the traditional funding rationale for a development bank is no longer present or is the wane, and hence development banks are reforming their operations. Such a transition is also being observed in Brazil insofar as BNDES seems able to develop a yield curve and fund itself in capital markets, as are large private banks and firms. 21 enforcement), lenders shift the burden of risk to borrowers by issuing short-term credit (exposing borrowers to roll-over risks) with a view to reduce risk of changes on borrowers default probabilities. In this case, BNDES should increase its guarantee programs as opposed to the provision of funding, so as to address a market failure related to the inability of financial intermediaries to diversify away from and mitigate unquantifiable risk (i.e., uncertainty). 37. It may be assumed that long-term finance, particularly for SMEs, is indeed unavailable, scarce or very costly when available.15 At the same time, there may be no alternative other than a second-best BNDES intervention – in the form of credit and increasingly guarantees - because of the difficulties arising from informational or other “distortions� leading to high transaction costs that thin out long-term credit markets. 38. None of this implies that BNDES should lend on a subsidized basis.16 In other words, the fact that certain markets fail does not necessarily mean the presence of an externality that might justify subsidized lending. All externalities result from missing or thin markets. The reverse is not true: Not all market failures imply or are a byproduct of an externality. 39. Thus, BNDES might be justified in acting as a substitute for quasi-missing long-term credit markets based on firms’ inability to raise financing due to significant economy-wide uncertainty and/or firm or project-specific information asymmetries. If BNDES can raise funds on a competitive basis in terms of cost and duration and on-lend them at notional market rates17 (plus a del credere and a correctly priced risk premium), the institution would be fulfilling an important development role. Resources being finite, BNDES might give preferences to firms with certain characteristics – young, fast growing, entrepreneurial, innovative, entrants in emerging sectors or export markets – that would be screened out of the private market for lack of a track record. Older, slow-growing firms, incumbents in traditional sectors – even if credit constrained – might not justify being supported by BNDES (although it is important to recognize the positive transaction costs of targeting firms with certain desirable characteristics).18 15 In fact, SMEs are on average more credit constrained, and for them additionality is easier to show. This is one reason why many development banks focus on SMEs. 16 In “The Role and Impact of Development Banks� (mimeo, July 2016), Aldo Musacchio, Sergio Lazzarini, Pedro Makhoul , and Emily Simmons indicate that “the average interest rates charged by development banks are largely in line with the rates in the dome stic markets�, 10-year bond yields, “the best proxy for long term lending rates�. They also find that “in Brazil, [t]he average rate charged by BNDES is significantly below long-term market rates, reflecting heavy government subsidization. While in the other selected countries (Chile, Canada, Germany, Korea and, China) we note that the development banks’ interest rates are slightly above the bond yields� (p. 33). 17 Such notional market rates (provided, for instance, by BNDES ’ long-term bond yield curves) would translate into a deep discount from what would be potentially available in the market if a firm attempted to borrow long-term from a private financial institution. BNDES would be using a mix of real and implicit guarantees of being a well-recognized government institution to access funds on a competitive basis. 18 See Marcela Eslava and Xavier Freixas, “Public development banks and credit market imperfections,� mimeo, May 31, 2016. The authors show that underprovision of credit is more accentuated for high added value projects when commercial banks employ costly screening technologies to make credit decisions. With proper corporate governance to avoid political targeting, a public development bank should lend directly – and preferentially – to high value added firms (as opposed to SMEs, young firms etc.). 22 Externalities 40. The second justification for BNDES lending is the presence of externalities. As noted, the fact that markets fail – irrespective of the reason – does not imply externalities are present. Only when (positive) externalities are demonstrably present, with a significant divergence between private and social rates of return, build a case for subsidies to ensure the socially optimum level of output. 41. The “externality test� for BNDES lending is construed here as a multi-stage process. Stage 1 assesses whether the project seeking funds commands an externality and its magnitude. Having determined externalities are indeed present and significant, stage 2 inquires whether an alternative solution could be found – other than lending, offering guarantees, or injecting equity – to cause production of this externality at a lower cost. Would an intervention at the point of distortion – by another entity or even BNDES itself – allow addressing or compensating for such externality? Because of the complementary nature of economic activities, would a socially optimal level of output be produced irrespective of the intervention? 42. If not, then the issue is how to calibrate the subsidy in a way that the maximum gain is extracted at the least cost. It is important not to succumb to the notion that practically any activity generates external economies that would validate BNDES support. Credit subsidies should, by definition, be scarce; and BNDES must have the instruments to ensure that only projects that are effectively eligible obtain them. 43. So far, we discussed the case for BNDES intervention in credit markets due to thin or nonexistent markets or the presence of significant externalities. A particular case of an externality is a public good, characterized by non-excludability (leading to the free-rider problem) and non-rival consumption (exclusion would actually be inefficient). Not all externalities give rise to public goods – in fact, only a few do; however, all public goods reflect the presence of an externality.19 Would this be sufficient to justify BNDES funding? 44. National defense and other classic public goods are in most countries financed by taxation or public debt. To the extent that macroeconomic stability is a public good, however, BNDES’ countercyclical role could be justified (as it was in 2009) on grounds that the state is able over time to diversify and smooth the risks associated with extending credit in times of distress. Another relevant scenario for BNDES involvement would be the experiment of a novel PPP administrative arrangement to increase the level of efficiency in delivering public services. In this case, the rationale for BNDES support has to do with the potential innovation or novel ways of the private production of a public good, with such innovation freely disseminated to other potential providers. Selecting beneficiary firms 45. What type of firms should BNDES be financing? Many, if not most, development banks focus on medium, small and sometimes micro firms (SMEs). Establishing this priority rests on the view that a market failure leaves the SMEs credit-rationed. But why would credit (and related) markets fail in case of SMEs and constrain their access to finance? Fundamentally, the problem is asymmetric information. This would lead to an inability of the lender to correctly assess risk-adjusted expected returns. The presumption behind the hypothesis of 19 See Kenneth Arrow, “Political and Economic Evaluation of Social Effects and Externalities,� in J. Margolis, The Analysis of Public Output, NBER, 1970. 23 asymmetric information is that borrowers know more than lenders about their true state, but they are unwilling or unable to communicate to lenders, resulting lenders to undersupply credit. 46. Some of the firms’ characteristics might lead to this outcome despite relatively deep financial markets:  The age of the firm or the markets to which they are catering. Younger, entrepreneurial firms, entrants in new sectors or export markets, with a lesser track record, obviously face greater informational constraints to signal their actual (and not perceived) risks. They are also firms that tend to be “high impact� in terms of growth and employment.  The product or service the firm is launching (or developing) and its underlying technology. The process of discovery implies significant uncertainty regarding the viability of new products, services, and technologies under development or adoption. Pioneering firms in emerging industries typically have not generated enough information that would help assess their credit worthiness or viability. 47. Would older SMEs, incumbent in mature industries, using standard technologies, and producing “run-of- the-mill� products and services for the domestic market – with a long history or a proven track record – face the same information problem? Arguably not. In the market for many years, their financial and operational data are less uncertain. They may still be credit-constrained and face unreasonable rates, especially in Brazil’s strongly segmented credit markets, but ceteris paribus the obstacles aren’t as large. In principle, such firms would not be as good candidates for BNDES on-lending – unless BNDES loans or guarantees were to encourage a structured effort to improve productivity, introduce environmentally friendly (social) technologies, or gain a competitive edge. Otherwise, BNDES would be contributing to the stacking up of less productive firms in the economy, congealing capital in outdated activities (or older industries). During the transition period, however, there could be a justification for continued support to, on average, less productive SMEs as well as support for labor- intensive projects in poorer regions and urban agglomerates on the basis of positive social externalities. 48. Currently, approximately one-third of BNDES´ total disbursements are allocated to SMEs, fundamentally on the basis of the size criterion, although a subset of those are also in targeted sectors or activities. SMEs are supported under generous terms:20  Financing cost of TJLP;  BNDES spread of 1.5% generally, with a minimum of 1.2%;  A risk premium for the first-tier or direct operations or a financial intermediation fee of 0.1% for second-tier or indirect operations, with the second-tier institution charging a freely negotiated risk premium according to its own risk assessment.  An 80% maximum share of the project. 49. BNDES support is grounded on two different rationales:  SMEs face a credit-rationed environment, and BNDES should compensate by facilitating access; 20 See BNDES, “Políticas Operacionais – Resumo Executivo,� September 14, 2016. 24  Second, SMEs command some type externality or a social benefit (not made explicit), which would justify an across-the-board credit subsidy for all SMEs, irrespective of their characteristics. Neither case for support seems obvious. 50. There are certainly instances that justify subsidies to support firms with projects commanding significant, measurable externalities on the presumption that, absent the subsidies, the firm would not produce a socially valuable good or service – or at least not in the amounts desired. Yet, this conclusion requires caution. Moreover, it is far from clear that the presence of SMEs per se generate positive external benefits. If this cannot be shown, BNDES operational policies regarding SMEs seem to be erring by providing unwarranted subsidies. 51. To offset limited access, BNDES would fill the gap with guarantees or credit in amounts and durations demanded by bona fide agents shut out of the market. Credit guarantees may be a better instrument if the credit rationing reflects economy-wide uncertainties or informational asymmetries. BNDES rarely makes use of guarantees, and credit and guarantees clearly are not perfect substitutes. The support should reflect the fact that rationing is typically for long-term credit. 52. BNDES should charge notional market interest rates, adjusted to reflect the operation’s risk. A missing market may imply that a market rate cannot be observed; in this case, a notional rate must be established based on BNDES’ market-funding costs. BNDES should ensure that it facilitates rather than undermines well- functioning markets. Note that subsidies are not provided in well-managed microcredit market operations. Interest rates reflect the risks and costs of operation, repayment rates are high, and pioneers in this market had an important “discovery� and market development role. 53. BNDES does not have unlimited capital. Even if SMEs do face credit constraints, BNDES should give priority to supporting firms with the most progressive, entrepreneurial-based, productivity-enhancing, and growth-related projects. This is particularly relevant in the context of a low-productivity economy, with many firms (SMEs and others) clustered at the distribution’s low-productivity end.21 BNDES might currently lack the right instrument mix to address the low-productivity conundrum (it does not, for instance, provide technical assistance and consultancy), but this does not seem to be a reasonable rationale for across-the-board, non- discretionary support for SMEs. 54. Many SMEs that are relatively good risks, doing business in protected markets, undergoing only marginal changes over the years, and being only moderately credit constrained. Insofar as they remain in the market for a relatively long period, these firms should be relatively less constrained as more information about them is available to banks and other financial institutions. SMEs already benefit from preferential tax treatment22 and related policies that may be biasing firms’ growth decisions. BNDES may not want to reinforce such biases. 21 See the presentation by Fernando de Holanda Barbosa at the BNDES Seminar “Indústria Brasileira: Desafio de Políticas para o Aumento da Competitividade� (Roundtable 1), October 14, 2016. The author presents evidence that Brazilian firms are unusually clustered at the low-end of the (labor) productivity spectrum. The “thick tail� suggests that tax and credit policies – among others – may be allowing low-productivity firms to remain in the market for longer, constituting an exit barrier. 22 The Simples tax system allows SMEs to combine different taxes (corporate income, social security, turnover, services) into a single payment at a significant lower aggregate rate. 25 55. For BNDES, transaction costs must also be an important consideration. They may be high enough to justify non-discriminatory support for SMEs on efficiency grounds – using second-tier institutions in particular - on the fair presumption that SMEs are the firm group that has greater propensity of being rationed out of the market. In addition, there are many positive firm characteristics highly correlated with size that might justify tilting toward SMEs to economize on transaction costs. For example, many entrepreneurial firms are SMEs during their high- growth stage, and they face major constraints to access finance at a time when they may also require other types of support (more often than not, management consultancy, marketing advice, product development assistance). In this early stage, they also tend to generate significant employment growth and, if they are pioneers, produce information that may attract other firms to an emerging industry. By the same token, many – if not most – innovative firms are SMEs, and access to finance tends to be critical for them. BNDES may step in (including through BNDESPAR), although market-based solutions (angel finance, VC funds) should at least complement BNDES’ role.23 Finally, some type of support for SMEs might also be warranted on the basis of “equality of economic opportunity,� a common rationale for SME support among development banks. Selection of sector and industries 56. Having defined why a specific project should be financed, the types of firms that might be targeted, and the relevance of size as a criterion, it is a germane question if a sector or an industry is an economically legitimate object for BNDES support. 57. Historically, BNDES has been an important instrument for industrialization and promotion of specific sectors. As an instrument of government policy, BNDES has since its beginning been involved in supporting broad areas deemed important for Brazil’s economic development – for example, infrastructure at its genesis, then the industrial sector in the 1970s. It was in the context of the Second National Development Plan (1974-79) that BNDES began targeting in a systematic way the wholesale build-up of major product groups, such as capital goods and intermediates. 58. The rationale for such action was grounded on the notion that the more capital- and knowledge- intensive sectors could be construed as infant industries, with local industrialists facing steep entry barriers. BNDES´ role was in some instances to support entry and expansion of firms as a means to substitute imports; in others, it was to finance the purchase of goods produced domestically by entrants and/or incumbents (as in the case of FINAME).24 To a great measure, BNDES has been an effective instrument of promotion and protection of domestic industry and support for specific segments. 59. The concept of “effectiveness� might, of course, be challenged. After six decades of import- substitution policies and four decades of active BNDES support, Brazilian industry appears to require continued support to face competitors in the domestic market. Clearly, the infant industries aged and possibly so have the policies and instruments that ultimately were not designed to bring firms closer to – and eventually push out – the productivity and innovation frontier. 23 As noted in Annex 6, BNDESPAR is a limited partner in 43 funds, including 14 of them geared toward innovation, nine for infrastructure, and three for clean technologies. 24 The capital goods industry was regarded as a center for the generation and diffusion of innovation. 26 60. BNDES does not make policy; however, it provides a menu of financial instruments to support government policies. In lending and/or investing and setting the specific terms of each transaction, BNDES uses a number of filters codified in its operational policies. 61. BNDES has 36 credit “lines,� which can be loosely defined as the means BNDES uses to adjust financing terms and conditions to its priorities and guidelines. It offers 10 “products� that may rely on one or more credit lines (for example, FINAME or BNDES Card). It has 40 structured programs offering different instruments to suit borrowers’ needs and a number of “funds� with different financial conditions and access channels.25 The funds have very distinct purposes, some meritorious and others questionable. The Amazon Fund, for instance, uses resources from Nordic countries to address extremely relevant issues concerning deforestation and sustainability in the Amazon region, working through NGOs and local governments. On an ex-ante basis, few institutions in government appear as well-equipped as BNDES to host a fund of this nature. BNDES also operates a well-regarded guarantee fund to support lending operations for SMEs (FGI). Other funds might raise doubts – in terms of their objectives, time in operation, or the magnitude of their results. 62. Like many other development banks, BNDES offers better transaction terms as a way to target specific types of activities and projects, certain types of firms, and increasingly important sectors. Any statement regarding the appropriateness of a product or of a specific program would need a closer look at its rationale; i.e., what it is trying to achieve. In particular, a project should go forward only if the objective is feasible and fulfills a development need, if the means supplied are what are effectively required to reach the stated goals, and if the corresponding transaction passes a cost-benefit analysis. 63. The previous discussion established that BNDES would have legitimate reason to support activities or projects that pass the externalities test. Under normal market conditions, firms would supply an insufficient amount of certain goods and services with highly positive externalities. This is due to certain economic characteristics that private financial markets fail to fully recognize, leaving these activities systematically underfinanced. BNDES may also be justified in supporting firms that are credit constrained – thus passing the additionality test – and face economy-wide uncertainties and sharp informational asymmetries the latter typically due to their age (too young); industry (high growth or under sharp transformation); nature (entrepreneurial, pioneering in a domestic or export market, innovative); or type of activity (associated with a discovery process). These firms tend to be SMEs. 64. Can a similar rationale apply for a specific sector or industry? In other words, are there inherent characteristics that justify their targeting – beyond the more obvious cases? For instance, enhancing the water sector tends to be uncontroversial because of the substantial positive externalities associated with the production and consumption of clean water and the disposal (and reuse) of wastewater. A strong case can also be made for improving urban mobility by financing mass transportation systems. In energy, renewable and other low-carbon emission projects are solid candidates. Reforestation, low-carbon agriculture, recycling, and industries with a direct and significant link to sustainable development paths are supported by many governments, directly and/or through development banks. 25 See Section I Annexes 3, 4, and 5 for a more detailed description of BNDES’ scope of activities. 27 65. In perusing BNDES products, programs, and funds, such relatively clear-cut cases of high positive externalities with strongly dominant social returns are less obvious. 66. In particular, BNDES programs have a set objective, a budget, a small staff to manage them, and a mission to support specific industries. They are also time-bound in the sense that they are supposed to provide support for a set period, lasting only until the targeted industry achieves maturity. 67. BNDES prides itself on what are perceived to be relatively successful programs, designed on the basis of internal studies that pointed to both social and economic needs, and to market opportunities. However, not all programs were generated internally. In BNDES’ portfolio, a number of programs were proposed by the government, including the extraordinarily fiscally expensive PSI and all programs geared toward agriculture. Most were motivated endogenously, such as ProFarma and ProSoft.26 Even so, they should all be subject to periodic assessments. 68. Under what circumstances BNDES would be justified targeting a sector? Coordination externalities may be so large that short of a “program� targeting a sector, individual projects in that sector – even though potentially highly meritorious and well supported – would remain non-viable because they depend on the presence of an ecosystem. 69. The case of BNDES Profarma is instructive. The Ministry of Health in Brazil is a major buyer of drugs for the public health system (SUS – Sistema Único de Saúde), many to treat so-called neglected (tropical) diseases. While the country has accumulated significant scientific and technological knowledge in this area, it is not yet a cost-effective producer of drugs targeting those diseases. In this instance, BNDES seems to be playing important roles through ProFarma: one is explicit, supporting in a coordinated way key components of this segment; the second is implicit, providing a credible link between potential (government) demand from another government entity (Ministry of Health) and a BNDES-supported latent competitive supply. 70. Obviously, this and other programs would need to be evaluated on their own merits to warrant continued existence. Yet this program seems to illustrate the specific circumstances in which BNDES might be justified in taking a programmatic approach. 71. The following conditions may be used as criteria to establish the economic rationality of targeting a specific sector. It is likely that some industries currently supported would pass these sequential requirements; others might not.  First, the existence of fundamental endowments – in science, technology, human, and/or natural resources – that provides the grounds to supply domestic and/or foreign markets on a competitive basis. In the absence of such endowments, public (and eventually private) resources would go to waste.27  Second, credible studies must show that demand captured by entrants would have the scale to sustain the targeted segment. Further, the studies should indicate that producers would attain a competitive standing 26 See Section I, Annex 3 (“Main Current Programs�). 27 An illustrative example where there appears to be a case of investing without respecting the endowment constraint is CEITEC, one among a number frustrated initiatives to create a base for the production of integrated circuits (ICs) in a country notoriously short of scientists and engineers in the area. 28 in a relatively short time, suggesting the relevance of offering time-bound – as opposed to open-ended – incentives.  Third, it is critical to demonstrate that BNDES intervention is necessary to overcome coordination externalities among producers and/or between producers and buyers that would impede the emergence of the industry. Just as important, it should be shown that BNDES is uniquely equipped to address such externalities, credibly supported by complementary policy initiatives. 72. This section attempted to establish the economic foundations that provide the rationale for BNDES ’ role as a development bank: market failures that result from missing (credit) markets or associated with significant externalities. The implications for BNDES products and priorities and, more generally, the way it conducts its business will be the subject of Section III. III. Applying Fundamental Economic Concepts to BNDES Operations 73. To establish the implications of the economic concepts and approach developed in Section II to BNDES operations, it is important to initially define the objects of BNDES’ current support mechanisms. They are fundamentally two:  Firms that BNDES supports directly and through its second-tier financial agents with one or more products.  Industries, some targeted directly by BNDES programs28 and indirectly by its products (by financing the acquisition of capital goods, for instance). Assessing BNDES products 74. Each product was instituted on the basis of a certain logic or rationale. All implicitly presume that firms are credit constrained. 75. An analysis of BNDES products shows that:  A significant number – a large proportion of FINEM operations, FINAME in its three modalities (regular, agrícola, and leasing), BNDES Automático, BNDES Cartão – are offered though second-tier accredited institutions. What economically grounded filters do those institutions impose?  BNDES operations tend to benefit large firms (as BNDES defines them), with the exceptions of Cartão BNDES, FINAME Agrícola, and the Não Reembolsável (grants). Is there evidence that such firms are effectively credit constrained? Or are they basically looking for and benefitting from a relatively inexpensive source of credit – as the literature has suggested?29 28 There are also instances in which BNDES is an agent of a government fund targeting a specific sector, such as the support to the shipbuilding industry provided by Fundo de Marinha Mercante (FMN). 29 See M. Bonomo, R. Brito, and B. Martins, “The after crisis government-driven credit expansion in Brazil: A firm level analysis,� Journal of International Money and Finance 55 (2015), and S. Lazzarini, A. Musacchio, R. Bandeira-de-Mello, and R. Marcon, “What do development banks do? Evidence from BNDES 2002-2009, World Development 66, 237e253. 29  BNDES offers quasi blanket subsidized credit on a fairly non-discriminatory basis.30 What is the possible rationale? It does not seem that most products offering subsidies are targeting projects and activities with large externalities. It should be pointed out, however that positive and significant externalities can be associated with firms of all sizes, being basically dependent on the nature of the activity undertaken or the project being financed. 76. As a development bank, BNDES aims to address key market failures in support of and complement to other government policies. The section below offers a preliminary exercise in assessing BNDES key lending activities and attempts to identify ways to enhance the bank’s operational policies. A preliminary exercise in assessing lending activities 77. As noted in Section I, BNDES has a very significant role in development finance. To establish the economic logic of BNDES lending, this paper adopts a simple strategy: It uses firm size as a proxy for the degree of credit constraint, the premise being the smaller the firm, the more constrained it is. And it uses the firm or the project’s sector as an indication of the presence of externalities. This is a simplification, but it serves the purpose of establishing orders of magnitude when it comes to assessing BNDES operations. 78. From this perspective, it appears first, that most BNDES resources currently go to credit-unconstrained firms31 – those that would have access to other alternatives in credit and capital markets (although, certainly, some larger firms face long-term credit rationing to finance investment due – inter alia – to their risk profile). In 2015, BNDES lent mostly to large and medium-large firms, which combined received 73% of disbursements (67% in the first half of 2016), with no demonstrable additionality. In contrast, micro and small firms absorbed 27% of disbursements (26.5% in the first half of 2016).  SMEs tend to have a higher propensity to be credit-constrained. For the purpose of this assessment, it will be taken as a given that SMEs are indeed credit constrained, although lending is generally undertaken without sufficient information to establish the market failure that might justify BNDES intervention. 79. Second, BNDES resources seem to be directed to activities either with no clear externalities or still-to-be- ascertained ones, with a smaller proportion to areas commanding significant externalities (see Annex Table 3.1). In 2015:  Activities with identifiable externalities were responsible for 22.3% of total disbursements, adding to R$30.34 billion. These include water and sewage; health services and pharmaceuticals; education; arts, 30 There is also a high degree of standardization that reduces BNDES ’ ability to charge a premium proportional to the risk posed by the operation and the services that are being provided to borrowers, combined with a fairly narrow set of instruments, basically tapping BNDES’ own resources. 31 This paper uses two sources of data to assess BNDES lending: (i) yearly volume of disbursements and (ii) automatic and non- automatic loan contracts. Volume of disbursements is the benchmark statistics for the banking business; however, contract level data, with credit terms and investment projects’ descriptions for first tier and second non -automatic loans, allows for a more in- depth analysis. Annex 8 provides detailed information about the database used in this paper. 30 culture and sports; urban mobility; low-carbon agriculture; renewable energies; innovation; and public administration.32  Activities with “rule-of-reason� externalities (i.e., those needing to be ascertained) absorbed 28.6% of total disbursements (R$38.87 billion). Some of those activities might have significant external effects, others might not. All non-automatic operations disbursed in 2015 (1,301 projects), plus programs with clear externalities (such as low-carbon agriculture), were examined on a case-by-case basis, and relevant exceptions were picked out of the electricity and gas, transportation, agriculture, and fisheries sectors.  Finally, activities with no clear externalities – including the extractive industries, oil and gas, commerce, services, among others – were responsible for the largest share of disbursements in 2015 at 49.1% (or R$66.73 billion). 80. Is there a discernible relation between degree of additionality (indicated by firm size) and levels of externality? Table 3.1 presents an initial indication of the distribution of BNDES disbursements according to both variables.  Large and medium-large companies have the largest share of disbursements in activities with clear externalities – 90% of the total (R$27.2 billion). The share is reduced to 56% for activities with externalities to be ascertained (R$21.7 billion) and 72% for activities with no externalities in principle, a figure that matches the share in total disbursements (72%). Conversely, SMEs appear to show a somewhat lower propensity to engage in activities with significant externalities (Annex Table 3.1 has detailed information). Table 3.1: BNDES Disbursements by Size and Level of Externality 2015, in R$ Billion (shares in %) Share of Large and Share of Large and SME med-large All SMEs med-large enterprises companies Activities with clear positive externalities 3.1 27.2 30.34 10 90 Activities with externalities to be ascertained 17.2 21.7 38.87 44 56 Activities with no clear externalities 18.76 47.97 66.73 28 72 Total 39.10 96.85 135.94 Share 28 72 100 Source: BNDES, authors’ calculations. 81. Third, BNDES loans (and grants) signed and contracted directly and indirectly (on a non-automatic basis) in 2015 enable a project-by-project assessment,33 which makes it possible to assess whether new loans point to a 32 A list of such sectors is found in Annex Table 3.3. 33 BNDES database on automatic loans does not include the projects’ description, which would allow for a finer disaggr egation of the firms’ activities. Only direct and indirect non-automatic loans have the projects’ description. Smaller firms tend to use automatic loans. 31 different pattern of disbursements, one more consistent with an institution bent on maximizing its development impact (see Annex Table 3.1).  Sectors or activities associated with significant externalities made up 39% of the total value of non- automatic loans signed;  Sectors or activities with uncertain (rule-of-reason) externalities were responsible for 23% of the value of those loans; and  Activities with no significant demonstrable externalities still corresponded to 38% of the value of non- automatic transactions. 82. The data suggest that BNDES lending rates are only partly linked to the presence of externalities for such contracts (Annex Table 3.2).  For economic activities with no demonstrable externalities, an estimated 50% of loans are indexed to TJLP, 15% are based on fixed rates (which vary widely), 18% are based on SELIC, 1% are grants, and 16% are based on other indices.  For rule-of-reason externalities, the distribution is 51% for TJLP, 1% for fixed, 20% for SELIC, 0% for grants, and 27% for other indices.  For high externality activities, the distribution is 90% for TJLP, 0% for fixed, 6% for SELIC, 2% for grants, and 1% for other indices. 83. The amount of loans indexed to TJLP awarded to activities with no or low externalities (50%) seems unwarranted. At the same time, only 19% of these loans are indexed to market-based SELIC, with 20% based on other indices. 84. Two elements stand out in a first assessment of BNDES products:  First, it is highly unlikely that most firms receiving BNDES support would be eligible on credit- rationing grounds. Resources are still steered towards large firms, which generally do not exhibit the characteristics of credit constrained firms. Even for products explicitly targeting SMEs, BNDES does not appear to employ filters capable of sifting through the data and arriving at the subclass most eligible to receive support.  Second, it is even less likely that the vast majority of firms – SMEs, medium-large, and large – receiving credit subsidies would be eligible for such support on externality grounds. From this perspective, BNDES products are providing subsidies for too many firms. If the externality test were employed to filter activities and projects deemed worthy of BNDES backing, as suggested in Section II, only a limited number of firms and projects would in all probability justify subsidies. 85. BNDES Programs. The BNDES portfolio currently includes 40 programs (see Section I, Annex 3), some targeting a given sector from a multiplicity of “angles� (for example, agriculture and agroindustry, or capital goods and vehicles). Other programs focus on a cluster of activities (such as health); or have an industry- 32 specific emphasis, such as software, plastics, and paper. Finally, a few programs provide support for the subnational public sector (states and municipalities), and others have an anti-crisis and countercyclical function. 86. A preliminary assessment of the programs shows:  There are 15 programs supporting agriculture and agroindustry, only two of which appear to address significant externalities – namely, low-carbon agriculture and agriculture research, which combined absorb 10.2% of the pre-allocations (dotação) for agriculture. Note that 11 of the 15 programs offer loans indexed by TJLP.  Innovation is the object of two additional programs, extending finance to SMEs (MPME Inovadora) and offering quasi-equity (THAI). In addition, eight other programs arguably command significant externalities: Profarma and Saúde in the health cluster; Procult for the creation and production of cultural goods; and Fundo Clima, targeting climate change.  There are five countercyclical programs with R$21 billion pre-allocated and 10.6% of disbursements in 2016, led by Progerem (for working capital). Other programs are Giro PSI Pró Caminhoneiro (working capital for beneficiaries of PSI loans for acquiring trucks), Pro CDD Cartão (to refinance BNDES credit- card borrowers), Micro e Pequena Empresa Pequeno Aprendiz (to support employment), and Programa de Incentivos à Revitalização de Ativos Produtivos (to promote the restructuring and transfer of viable assets).  Three programs support subnational entities – Propae, PMAT Automático, and PER (directed to municipalities affected by natural disasters). Arguably, modernization of these entities is a legitimate priority because poor public sector management on top of significant fiscal constraints have a direct and material impact on the population’s economic welfare.  Finally, 15 programs have various objectives, most of them targeting certain industries, such as plastics (Proplastico); consumer goods (Prodesign); paper (Propapel); software (Prosoft); capital goods (Pro BK, Procaminhoneiro, and Moderfrota, the latter a significant program which finances tractors, combines, and other vehicles directed to agricultural activities). 87. Is there an economic justification for supporting these industries? There are basically two arguments for targeting an industry: first, infant industry grounds, or some derivative notion;34 second, significant externalities constraining output. The latter includes either positive external economies that lead to differences in private and social rates of returns, or the relatively less obvious coordination externalities.  The concept of infant industry presupposes a time dimension. Support would be centered on young or emerging industries on the premise that the progressive acquisition of technological competences and/or learning-by-doing would drive costs down, allowing the industry (and most firms within it) to approach the frontier. Yet an examination of BNDES programs – with the possible exceptions of pharmaceuticals and software – disallow the presumption that these mechanisms can be justified on infant-industry grounds because most targeted sectors may be regarded as mature. 34 For example, path dependence in activities characterized by myopia and increasing returns may “lock in� certain industries (and countries), generating an “equilibrium� which fails to exploit their true potential comparative advantage. See the seminal papers by Brian Arthur (1985) and Paul David (1985, 1986). 33  The need for BNDES to intervene to ensure that industry-wide coordination externalities are internalized could justify a program targeting an emerging industry. It would be hard to go beyond the health-related cluster and possibly – at an earlier stage – the software industry to find a potential demand-supply disconnect or the imperative of establishing an ecosystem for the industry to flourish.35 Developing an externality and an additionality decision stream 88. BNDES can build two separate decision streams to (i) establish the eligibility of projects and (ii) determine whether they should receive subsidized funding. A well-defined methodology, coupled with a monitoring and evaluation framework, will be critical to improving resource allocation and maximizing the development impact of BNDES.  An externality stream to identify high-quality (well-designed, properly priced, and well-governed) projects with significant positive externalities might justify subsidized credit from BNDES. These resources should be allocated to well-defined areas or activities judged to bring measurable external gains and pass the externality test. 89. Not all firms or projects bring significant positive external effects. This section established an initial classification to assess what proportion of loan values signed in 2015 are directed to firms in sectors or areas where externalities are arguably significant. The analysis indicated that BNDES has been awarding a significant amount in loans, indexed in TJLP, to borrowers in sectors or activities that do not show demonstrable externalities on an ex-ante basis. 90. BNDES operational guidelines should ensure that the scope for subsidized lending is in line with activities providing significant external effects. In all probability, this is a far narrower set of projects than BNDES currently finances. This will allow BNDES to delimit the relevant subsidy component, be more selective in its lending, avoid crowding out commercial banks, and lead to a better pricing of risks. 91. Credit-rationed loan applicants (and those that did not pass the externality test) would enter the second decision stream.  The additionality stream identifies strong projects from eligible firms that justify support by BNDES at (notional) market rates, reflecting BNDES cost of funds as it issues bonds and taps capital markets. This would be a subset of firms shut out of the market for long-term finance due to specific market failures that typically – but not only – penalize young, high-impact firms (in terms of sale and employment growth), pioneers in emerging sectors, with limited borrowing capacity due to a short track record. BNDES would provide access to term finance for such firms (credit and guarantees) at market rates.36 The filter would exclude older, family-owned, slow-growth, low productivity firms, and those clustering 35 This is an actual example mentioned in Section II. Coordination is certainly required and the activity most likely merits support based on positive social impact from investment for the research, development, and manufacture of drugs (and their inputs) targeting the so-called neglected (tropical) diseases. Yet coordination externalities may not require subsidized finance; to the contrary, BNDES might actually charge a premium for creating the conditions – or the ecosystem – for firms to productively transact with each other and connect themselves to demand. 36 As discussed in Section IV, BNDES would do well to tap both capital markets and private banks in the process of attracting private capital, syndicating with the use of the so-called B-loan structures. 34 in mature sectors. Most of these firms would have access to at least moderately competitive market alternatives, so BNDES intervention would not be necessary. 92. The question is how to define eligibility in the additionality stream. Which firms should access BNDES finance and under what terms? How do they compare with the firms currently being supported? Are those firms indeed credit constrained? And for what underlying reason? What is the nature of the market failure – if any – they face? 93. In Section II, this paper initially suggests the additionality test as the filter. It ultimately attempts to answer a counterfactual: In the absence of BNDES, how would the firm finance the project? What alternatives are available? It stands to reason that most large firms have at least moderately competitive alternatives, so BNDES intervention would not be necessary. Thus the focus here on size as a criterion, based on the highly simplified premise that the vast majority (if not all) SMEs are indeed credit constrained. 94. Going forward, this selection strategy might continue to be employed because it also saves on administrative costs and allows for a decentralized operation using second-tier institutions. However, the additionality test might be insufficient to identify firms that are credit constrained from a significant market failure – economy-wide uncertainties (from macro instability and regulatory failures) coupled with information asymmetries, that shut them out of the market despite their positive role of entering and interjecting dynamism into markets, bringing productivity gains to the economy, promoting growth, and creating jobs. With this in mind, further steps might be needed to establish eligibility for BNDES support as the bank transitions to new ways to foster the development of the Brazilian economy. The emphasis would be on a subclass of firms – generally SMEs – that more often than not are hampered by such market failures. From this perspective, firms could be ranked or classified by: 1. Age, with young firms (say, less than 5 years old) having less of an observable track record and, therefore, being more credit constrained than mature firms. 2. Nature, with entrepreneurial firms facing greater credit restrictions – due to a greater dependence on a single individual, or a small number of individuals – compared to more established firms and those in the public market. 3. Growth trajectory, both in terms of sales and productivity, with high-growth firms likely to face stronger information asymmetries because of the shifting nature of their market positions and riskier bets than firms with a steadier path (although some high-growth firms are attractive to VC funds and other capital-market instruments). 4. Activity, with pioneering firms in emerging sectors facing greater financing restrictions than their more mature followers. 95. In all four instances, eligible firms – younger, entrepreneurial, high growth, and pioneering in emerging sectors – arguably face significant credit constraints. Private markets tend to be less responsive, and BNDES would be justified in providing credit and guarantees, among other instruments. It should be noted that these characteristics tend to be highly correlated with size; with eligible firms tending to be SMEs (although the reverse is not true – all SMEs are not eligible according to the criteria). 35 96. Figure 3.1 depicts a relatively simplified but essentially correct way to visualize the decision process or algorithm that would be embedded in BNDES operational policies. To save on transaction costs, the additionality test in the short to medium term would resort to a simple size criterion. Over time, however, BNDES may shift its emphasis to increasingly support credit constrained, high-impact, pioneering, entrepreneurial firms which would be mostly – but not only - SMEs. 36 Figure 3.1 – Simplified Decision Process of BNDES Operational Policies Additional streams for alternative objectives 97. In addition BNDES supporting firms on externality and additionality/impact grounds, should specific industries be the object of intervention? Are there economic circumstances that might justify some form of targeted action by BNDES? Or should sector-specific programs (and funds) be discontinued? 98. As previously discussed, an industry to be the targeted would need to command a significant, classical positive externality. It might be related, for example, to better stewardship of the environment, improvements in public health, the dissemination of cost-effective gains in education, and improved access to cultural goods. Or an intervention might be justified if the industry fails to emerge or develop due to coordination problems. This might be the case of a gap between supply and demand, or a chicken-and-egg situation between input providers and output producers, ending in a low-level activity equilibrium that might be broken by an “honest broker.� 99. Those are, of course, very different types of externalities, and each would call for different types of BNDES interventions. Classical positive externalities might justify subsidies on the presumption that firms should be incentivized to produce at the socially optimum level. Firms in these industries would be potentially eligible by passing the externality test, and there would be no need for an industry eligibility window.  The latter would only be open for emerging and potentially competitive industries that present significant and verifiable coordination externalities (with or without infant-industry aspects). Internalizing them might require BNDES’ programmatic action to overcome what might still be determined a market failure. It could well involve a proactive role for BNDES in designing public- private compacts to address coordination externalities, perhaps augmented by technical assistance and consultancy services, either directly or with the support of other institutions. It remains to be established that BNDES has a clear comparative advantage in this regard. 37 100. BNDES intervention that pushes an emerging industry to attain a competitive standing would not necessarily involve subsidies.37 Importantly, for an intervention of this nature to be well-grounded, such industries would need to be potentially competitive once relieved of a potential lack of coordination among agents. In particular, prior to any support, it would need to be established:  The presence of certain fundamental endowments that constitute the underlying comparative advantage for this industry (knowledge, human resources, raw materials).  Demand for the targeted industry can be tapped.  Entrepreneurs, firms, and groups are able to credibly supply goods and services on a competitive basis with the BNDES intervention – and within a specific time horizon. 101. In sum, these hurdles suggest there might be relatively few cases for industry-specific support, which would need to be justified on clear grounds: (i) classical positive externalities; (ii) infant/emerging industries; or (iii) coordination externalities that would hamper the industry’s existence. These are necessary but not sufficient conditions. For a program targeting a new industry, the remaining conditions for BNDES to consider might include basic endowments, a demand that can be effectively captured, and agents willing to commit their own resources. IV. BNDES in Transition 102. BNDES is changing its approach – simplifying processes, increasing its focus on SMEs and on infrastructure projects in sectors commanding the largest externalities, supporting innovative firms, and promoting better capital-market practices. At the same time, BNDES must deal with a legacy of investments and lending operations that in retrospect might not have been the best use of public money. Their performance has been made worse by the current recession. 103. In 2015, only 15% of BNDES loans (in value terms) went to firms that were credit constrained, and in sectors or engaged in activities with significant externalities (Table 4.1). Conversely, firms that on a prima facie basis were neither credit-rationed nor engaged in activities producing significant externalities received about 31.5% of the loans. Finally, SMEs in other sectors comprised 24.8% of the total, while large and medium-large firms in the externality stream added to 28.6%. BNDES could have redirected nearly a third of the loans to other borrowers, ensuring greater additionality and addressing the key market failures discussed in Sections II and III. Table 4.1: Distribution of Signed Contracts’ Value per Stream 37 In the presence of coordination externalities, the focus of BNDES program should be to bridge this market gap, providing (and eventually charging for) coordination services. 38 2015, in % and R$ Million Non Additionality Additionality Stream Stream Large and Sum of Medium SMEs Total contract's Large Firms value Externality Stream 28.6 15.0 43.6 33,532 Non Externality Stream 31.5 24.8 56.4 43,301 Total 60.1 39.8 100.0 Volume of resources 46,203 30,631 76,833 Source: Authors’ estimates and calculations based on BNDES data. The following simplifying assumptions were made: (i) all SMEs belong to the additionality stream; (ii) all automatic contracts are for SMEs; (iii) all non-automatic contracts refer to large and medium-Large companies; (iv) ABC (low-carbon agriculture) and INOVAGRO programs are included as low-carbon agriculture, with loans from indexed to TJLP and directed to SMEs; (v) loans for innovation are of the same order of magnitude as 2015 disbursements for such activities (R$5.5 billion), and they are indexed by TJLP and segmented between SMEs and large and medium-large firms according to BNDES 2015’s disbursements mix. Note that the project description of no n-automatic contract loans allowed adding two additional categories to the externality stream: Urban Mobility (Metro, LRT) and Renewable Energy (solar, wind power, and biomass) projects. 104. Projects that fail to satisfy both the externality and additionality tests are supported at subsidized rates (Table 4.2). If the simple operational rule described above were used, loans for projects undertaken by credit- rationed firms commanding no externalities would not be indexed by TJLP, nor would projects that do not fit either stream. Table 4.2: Distribution of Signed Contracts’ Value per Stream and Financial Cost 2015, in % Non-Additionality Stream Additionality Stream Large and Medium-Large Firms SMEs Fixed Other Fixed Other TJLP Selic Grants Total TJLP Selic Grants Total rates* index rates* index Externality 92.1 0.3 5.1 1.4 1.1 100 46.4 45.2 6.8 0.0 1.6 100 Stream Non externality 42.0 11.4 21.9 1.1 23.6 100 15.2 69.2 13.9 0.0 1.7 100 Stream Total 65.8 6.2 13.9 1.2 12.9 100 27.0 60.1 11.2 0.0 1.7 100 39 Overall Source: Authors’ estimates and calculations based on BNDES data 105. Out of R$38.7 billion of TJLP-indexed loans signed in 2015 (representing 50.4% of total loans), over a quarter (26.3%) were allocated to operations outside the externality and additionality streams (Table 4.3). This is twice as much as operations characterized by both positive additionality and externalities (13.8%). Most loans paying TJLP went to credit-unconstrained firms operating in sectors characterized with significant external economies (52.3%), with the remainder (7.5%) going to SMEs not engaged in externality-generating activities. Table 4.3: 2015 Loans Paying TJLP per Stream Total Amount Total Amount % of % of % in Loan Indexed % in Loan Indexed Total total TJLP Amount by TJLP TJLP Amount by TJLP Loans Loans (in R$ ) (in R$) (in R$) (in R$) E+ A- 92.1 21.97 20.23 52.3 E+A+ 46.4 11.52 5.35 13.8 E-A- 42.0 24.20 10.16 26.3 E-A+ 15.2 19.06 2.90 7.5 Total Overall 65.8 46.2 30.4 78.6 27.0 30.6 8.3 21.3 Source: Authors’ estimates and calculations based on BNDES data. There may be rounding-up errors. Note: E+ positive externalities; A+ positive additionality; (-) absence of. 106. In sum: BNDES is lending to firms that do not seem credit constrained on a prima facie basis, and it is subsidizing activities without a clear economic rationale. 107. In coming years, BNDES is likely to have two fundamental roles: • Financing projects that effectively command large externalities. It is possible that the imperative of sustainable development will take a “front seat� in BNDES priorities, most likely in renewable energy; water, sewage, and solid waste disposal and recycling; urban mobility; and new low-carbon activities and technologies. 108. From an operational perspective, BNDES should continuously reassess its policies to ensure that only sectors or activities that clearly command significant externalities will be granted credit subsidies, subject to passing the externality test. In principle, there should be no material reason to postpone implementation of this policy. • Offering long-term credit and guarantees to bona fide firms excluded from the market due to informational asymmetries and other relevant credit-market failures (as systemic uncertainty), including the need to help solvent and viable firms to restructure. . Economic reforms and the return to macroeconomic normalcy will gradually deepen credit markets, and credit constraints will become less relevant over time. 40 109. Nonetheless, this paper recognizes that targeting a certain class of firms has costs, so it may be more efficient for an initial period to assume that all SMEs are credit-rationed. This would be due to macroeconomic uncertainty and risk, regulatory barriers in the allocation of credit, and credit-market failures – all of which can differentially affect SMEs. BNDES would then have a legitimate role to step in and fill this gap at least while parallel reforms in the system of credit allocation take place and macroeconomic uncertainty is reduced. Over the longer term, as reforms take hold and markets develop, including capital markets, BNDES will veer toward financing high-impact, entrepreneurial firms, and pioneers in new markets. 110. It is important to stress the importance of establishing a monitoring and evaluation framework that will help refine the processes that make projects eligible for BNDES finance. In an important development, the new operational policy announced on January 5, 2017, was accompanied by BNDES management’s decision to establish a Monitoring and Evaluation Department, an important signal to markets and civil society that the concept of analyzing projects from a cost-benefit perspective and the practice of impact evaluation will increasingly become the BNDES norm. In fact, this mindset should be extended to all public-sector expenditures, transfers, and subsidies, including those associated with directed credit. 111. Finally, as already noted in Section I, BNDES uses extensively a network of second-tier agents to pass on resources and provide subsidized TJLP-based lending. Insofar as the credit risk is with the agent, they charge a “what the market will bear� risk premium. BNDES should assess the possibility of exhausting such rents by auctioning off its funds to qualified agents, adding a premium according to the intermediary’s risk profile. Changing the balance of instruments 112. With capacities on par with other significant development banks, BNDES has most of the instruments required to carry out its mandate. The key difference would be in the limited use of financial instruments other than regular lending operations – outside of capital market operations and investments in externally managed funds by BNDESPAR (see Annex 6). In particular, guarantees are sparingly employed in direct operations, while warranties – though available – have been dormant for over a decade (in fact, since 2002). For indirect operations, BNDES has a guarantee fund (FGI) geared toward supporting SMEs that borrow BNDES funds from second-tier institutions.38 In this sense, BNDES is not “leveraging� its funds; it is enhancing access for firms deprived of, or unwilling to offer, solid or real guarantees. 113. The basic reason for such a strong preference for regular lending operations relate ultimately to their cost and the wedge between market rates and TJLP. In addition, BNDES receives transfers from FAT on a quasi- automatic basis, creating a strong inertia that pushes BNDES into a “conservative� course on its asset structure. 38 In indirect operations, BNDES FGI functions as a support for SME borrowers, complementing normal guarantees and facilitating access to finance with longer maturities, lower entry requirements, and lower interest rates (see Annex 7). FGI guarantees 20% to 80% of the total credit provided, with its cost – the Guarantee Grant Fee (ECG) – depending on the amount financed, the percentage guaranteed by the fund, and the maturity of the contract. In 2015, BNDES FGI conducted 2,711 operations, guaranteeing R$350.9 million out of R$465.3 million in credit, or 1.52% of the value of operations signed with SMEs in that year (R$30,631 million). Thus, even BNDES FGI appears to have a very limited role in the enhancement of credit for SMEs. 41 114. However, this will likely change in coming years as BNDES shifts policies to ensure that subsidized credit is used with a solid externality-related rationale, and TJLP progressively converges to market rates39. At the same time, resorting to market finance for BNDES’ operational needs and creating a BNDES-specific notional market rate will help crowd-in the private sector. Under these conditions, the use of guarantees, warranties, and similar instruments will become more attractive from the borrowers’ perspective. As market rates become dominant, third-party funding will become more prevalent, and products such as guarantees – if correctly priced – will become a normal complement to credit. When the choice instrument is not (only) regular loans, leveraging third-party funds would strongly enhance BNDES ability to support investment.40 The provision of market-driven solutions to firms’ financing needs implies a goal of reducing direct lending in favor of guarantees and second-tier operations. From this perspective, BNDES’ should aim at addressing market failures by developing financial solutions that crowd-in private sector players41. 115. The outstanding missing element in BNDES’ portfolio of services is technical assistance and consultancy, the kind offered, for example, by Chile’s CORFO and CDB. BNDES has a significant staff, most well-trained and sufficiently competent to provide solid consultancy and assistance. These assets could be instrumental in combining finance and technical assistance to subnational governments, which generally have a deficit of competence at the technical level to address the challenges of designing and effectively deploying new projects. For SMEs, it might be more efficient for BNDES to reach out to other government institutions that provide such services, such as SEBRAE and APEX. Adjusting the funding of BNDES 116. Will there be enough resources for BNDES to fulfill its role in the coming years? Clearly, the recession has adversely impacted the demand for financing (except for refinancing existing loans and providing working capital, to which BNDES is responding effectively). Over the medium and longer term, with the resumption of growth and investment, BNDES will be in a position to respond to the extent that it can tap market resources while changing its liability structure to accommodate greater use of guarantees and related products which would need to be funded with equity or grants. At the same time, below-market rate lending will be progressively scarcer, a reflection of a stricter fiscal regime that will impose additional requirements to ensure that credit and other subsidies are rationed effectively. 117. More generally, BNDES will need to shift away from excessive dependence on FAT constitutional transfers. Instead, in addition to strengthening its capital base, it should issue debt of different maturities – BNDES bonds – to build a yield curve. In so doing, BNDES will be able to establish what its notional market rate is. This is the financial cost it would be charging for most of its loans, with TJLP being used 39 To the extent that is the case, BNDEs credit lines at market rates would only be useful for smaller financial intermediaries, typically non-bank institutions. Note that as BNDEs migrates from granting credit lines to commercial banks to granting credit lines to small financial intermediaries (as larger part of its funds are granted at market rates) then credit risk assessment of financial intermediaries may need to be strengthened and credit risk premium pricing sharpened. Still, when providing subsidized funding lines (on the basis of externality arguments), it is important to ensure those resources are auctioned off so banks` monopolistic rents are extracted. 40 A number of development banks make regular use of guarantees, such as CORFO and Germany´s KFW, the former with a focus on SMEs, the latter focusing on start-ups (firms with less than five years of existence). 41 In other emerging markets, provision of credit lines is useful to support small and specialized SME financial intermediaries (e.g. leasing, factoring and asset base lending intermediaries) that help complement markets and introduce competition. 42 parsimoniously. This process will gain traction with macroeconomic normalization, lower nominal and real policy rates, and the shift in BNDES operational policies to charging market rates as a rule. The goal will be to offer what is truly scarce: in addition to guarantees, long-term credit for credit-rationed firms. 118. Tapping resources in domestic and international capital markets has multiple advantages. First, it shifts pressure away from fiscal and quasi-fiscal sources. For now, Treasury transfers are eliminated, but nothing guarantees that the same deleterious and distortionary practice will not someday return under a populist government. Second, and conversely, the quasi-automatic nature of FAT transfers gives BNDES the incentive to use TJLP beyond what might be economically grounded, creating a vicious cycle. Third, capital markets provide BNDES access to a very large pool of resources; issuing bonds of different maturities allows it to build a yield curve, providing a BNDES-specific (and realistic) notional market rate that BNDES can use to correctly price its loans. In fact, SELIC is not the market rate, but a poor substitute, especially when BNDES has the means, ability, and reputation to calculate its true opportunity cost. It is against this opportunity cost that all current and future operations should be measured in establishing the cost to BNDES, and to the country, of BNDES’ operations. Finally, and possibly most important, an adequate pricing of BNDES loans and a far less elastic supply of subsidized resources will serve as a powerful tool – and incentive – to reassess BNDES products and programs, their costs and benefits, and the extent to which such a complex structure is needed to attain BNDES ends. A more focused bank, in turn, will likely allow for a lower spread and a more competitive cost to the borrower, consistent with overall market conditions. Transitioning BNDES’ role in infrastructure finance 119. In recent years, BNDES assumed a dominant role in supporting infrastructure investment. In 2014, more than one-third of total resources committed to the sector originated from BNDES (Table 4.4). Table 4.4: Source of Resources for Infrastructure Investment 2014, in R$ billion R$ billion % of total Federal government 5.35 3.4 Subnational state 7.73 4.9 government Federal and state governments budgets, Federal-level public and public companies’ equity 11.57 7.4 enterprises Subnational public 8.20 5.2 companies Subtotal 32.85 21.0 BNDES 55.21 35.3 Financing from public sector banks; loans CEF 8.12 5.2 with Treasury guarantees; and other public Loans 3.99 2.6 sources Special funds 1.70 1.1 FI-FGTS 2.68 1.7 Subtotal 71.7 45.9 Investment funds 0.25 0.2 Private funding Infrastructure 10.04 6.4 43 debentures Equity 41.49 26.5 Subtotal 51.78 33.1 Total 156.33 100.0 Source: Authors’ calculations 120. Excluding budgetary support for infrastructure investment and equity contributions from public and private firms, BNDES’ role was absolutely dominant, being responsible for 67.3% of the resources allocated by banks and capital markets (Table 4.5). The immediate question is: Which institutional arrangement could substitute – at least in part – for BNDES in coming years as the demand for infrastructure funds increases with the imperative of modernizing the country´s infrastructure? Table 4.5: Infrastructure Financing 2014 2014, R$ billions R$ billions % of total BNDES 55.21 67.3 CEF 8.12 9.9 Government financing with treasury Loans 3.99 4.9 guarantee Special funds 1.70 2.1 FI-FGTS 2.68 3.3 FIPs 0.25 0.3 Private funds Infrastructure 10.04 12.2 debentures Total 81.99 100.0 Source: See Table 4.4 121. Even as private investment takes up a greater role, it is unlikely that non-government sources of finance will assume a dominant position in the foreseeable future. Commercial banks will continue to find it difficult to rival the public sector’s highly competitive funding (constitutional FAT transfers to BNDES, FGTS), while pensions, insurance companies, and investors that might be interested in the sector have the option of a safe, liquid, and high-return alternative in buying Treasuries.42 At the same time, it is equally unlikely that the BNDES and CEF balance sheets will be able to grow in line with the long-term financing needs for infrastructure. After all, there is an overriding imperative of financing in the upcoming years nominal deficits close to 9% of GDP and primary deficits of over 2% of GDP. 122. What should BNDES’ role be in this context? There is no immutable scenario. Progressively, a new fiscal regime will be put in place, resulting in an increase of public savings and a fall in both policy and market interest rates. This will put less pressure on institutional and family resources, which will be redirected toward other investments. At the same time, BNDES should support the development of private debt-securities market 42 This would also apply to commercial banks, particularly for longer tenors. 44 by, first, ensuring that companies looking for its support access capital markets issuing private paper.43 BNDES could provide credit enhancements on loan securitizations or undertake a supportive role as medium-sized firms issue corporate bonds. Second, BNDES should assume a leading role in syndicating loans – as IFC has done historically – and attracting pension funds, crowding-in these important sources of finance on the premise that BNDES will transition toward market-based operations in most cases.44 In both instances, there is a need to define of more robust systems of guarantees in the construction phase of infrastructure projects. Third, BNDES is in a differentiated position to encourage project finance structures in which risk is effectively shared between the sponsor, creditors, and insurance companies, especially in its critical phase.45 123. Finally, BNDES has been called upon to support the PPI – The Infrastructure Investments Program, made into law (13,334/2016). The program offers a number of positive substantive and procedural points, and calls for continuing BNDES involvement in financing the sector. The earlier discussions in this paper established that the use of subsidized finance should be parsimonious and strictly related to the presence of significant sectoral externalities. The point certainly bears repeating. Take one example: Brazil privatized four airports on a stand- alone basis in 2017: Porto Alegre, Florianopolis, Salvador, and Fortaleza.46 It is unclear why privatizing airports should involve subsidies to the groups acquiring the right to operate and modernize them. Airports are structured not only as logistics operations for passengers and cargo, but as real estate investments (parking, hotels, office parks) and one or more self-contained shopping centers. Clearly, when well-managed, they are profitable operations. Moreover, airports serve a segment of the population that cannot be equated with the poor or the very poor, even if air travel has become more inclusive in the past decade or so. Finally, even with a “social tariff� for low-income air travelers, this would not imply that credit subsidies should be granted to future operators. This same reasoning applies to most infrastructure assets and operations – with very few exceptions, such as urban mobility, water/wastewater disposal and treatment/solid waste disposal and utilization, and renewable energy. And even in these instances, the externality test discussed in Sections II and III of this paper should be applied to make sure there is clear additionality in using TJLP or similar financing. Arguably, this transition should not take long. In fact, BNDES has already successfully changed the operational rules in the case of electricity transmission, deciding correctly not to offer subsidized credit in two significant and highly successful concession auctions in late 2016 and 2017. Now is the time to extend the new approach to other infrastructure assets and related transactions. 43 The government would do well to contemplate norms that stimulate the issuance of standardized and low-value securities that are easily analyzed by investors; help in organizing a secondary market for debentures; and improve the legal security for the paper- taker, with the change in risk allocation between shareholder and creditor. 44 To reverse the limited participation of private banks in the financing of infrastructure projects, it is necessary to structure a broad and liquid secondary market for banks’ long-term funding instruments; to update legislation to give priority to the preservation of the company/asset as a way to reinforce the legal security of long operations; and rebalance the rights and obligations of shareholders and creditors, still strongly biased towards the former. 45 In this regard, reforms are needed in the insurance market to attract insurance companies willing to provide effective performance bonds (in contrast to what has been the rule up to now in many projects), thereby taking an active role in structuring non-recourse financing and being awarded step-in and other related rights to assure the continuity of the project if sponsors and equity holders fail to fulfill their obligations. 46 The operator will not be obliged to absorb regional airports currently operated by Infraero, the government owned airport operator, some of which might not be able to cover current costs – although even that is not obvious under a new management. 45 BNDES Governance 124. Many of the legacy problems facing BNDES might have been averted if an effective governance structure had been present. In fact, BNDES has historically functioned more as an instrument of government, although its permanent staff has at times blocked certain initiatives that were regarded as deleterious to BNDES. Still, several factors have opened the door to significant interference by governments in BNDES policies and operations. These include the loss of institutional memory with the retirement of a still relatively young and productive staff, the hiring of a large contingent of new professionals, and a board restricted by statute to only providing guidance (orientação superior). It is not known, for instance, the board questioning the large Treasury transfers to BNDES, or the quality of many of its operations supporting “national champions� (as in the case of JBS and the meatpacking industry), or still contractors domestically or abroad, despite the significant cost-related and other discrepancies of such projects with respect to market references, a distortion now being corrected by new management. 125. BNDES governance can be improved by enhancing the effectiveness of its board. The fact that statutorily, the board only provides guidance has allowed significant government interference in BNDES policies and operations. The federal government holds 100% of the shares and appoints all 12 Board members (employees have an elected representative also appointed by the President of the Republic). International good practices suggest effective board diversity, with the presence of highly qualified and vocal independent members. This could be accomplished with a change of the BNDES statute along the lines of the efforts to improve governance at Petrobrás and Eletrobrás. 126. The presence of minority shareholders may further improve BNDES governance. The government may want to dilute its position by inviting other first-rate development banks (multilateral or even bilateral) to capitalize BNDES – up to, say, a 25% share of the capital. By itself, this strategic change would rebalance the board with the presence of representatives of shareholders. They would be complemented with independent members, both domestic and international, with a commitment to modernize BNDES by following best corporate practices in terms of governance, management, and operations. This move would provide BNDES with the guarantee that management will have a mandate to pursue long-term development goals, with a focus on the more severe credit and capital market failures that hamper the Brazilian economy. V. Conclusions 127. Brazil has a complex system of directed credit, which has gained even more relevance as directed credit’s share of total banking credit increased from 35.6% in 2007 to 50.1% in 2016. Among the main agents, three federal banks stand out: Banco do Brasil, Caixa Econômica Federal and BNDES. 128. BNDES has 60-plus years of supporting infrastructure and promoting industry. Its mandate was vastly expanded in 2009 with the government’s decision that public banks – and BNDES in particular – should play a decisive countercyclical role. With its expanded mandate, BNDES received massive transfers of resources from the Treasury, which continued until 2014 even though the Brazilian economy has rebounded and in fact grew by 7.53% in 2010. 46 129. In many ways, such transfers distorted BNDES policies and practices, overextending its reach with new externally driven programs and expanding its balance sheet at an unsustainable rate, leading to many possibly unjustified transactions. The ethos of the period was to push credit out; approve operations without additionality (that is, to borrowers with viable funding alternatives); and use subsidized credit for borrowers engaged in largely unwarranted activities – namely, projects commanding no significant externalities. 130. This period is over. New management is in the process of redirecting BNDES, dealing with the legacy of the past decade and redefining its operational policies. This paper is an attempt to guide BNDES’ future as a development bank by providing some conceptual underpinnings and implications for its operational policies. 131. The paper argued that BNDES is justified to step in to address fundamentally two types of market failures: 132. First, credit rationing arising out of (i) informational asymmetries that penalize younger, high-impact firms, entrants in new domestic or export markets, and enterprises engaged in innovation; and, under current circumstances, (ii) macroeconomic imbalances and regulatory distortions that make it more difficult firms – particularly (but not only) SMEs – to access guarantees and long-term credit, with a tighter constraint for infrastructure projects. As previously emphasized, missing or imperfect finance markets do not necessarily imply an externality and should not be associated with a subsidy. 133. A second rationale is the presence of significant positive externalities, which drive a wedge between social and private rates of return. As a principle, subsidies should be used with parsimony. Externalities must be significant, and credit or other BNDES-specific instruments must be effective to compensate for the market distortion at the lowest cost. 134. An examination of BNDES’ 2015-16 disbursements and 2015 contracts show that most operations were directed to large and medium-large firms with limited or no additionality, or to firms not engaged in activities or sectors commanding significant externalities. However, it should be acknowledged that a closer look would be needed for rule-of-reason cases, including the potential presence of cluster and network economies, and territorial externalities. The analysis also shows that most subsidized credit could not be rationalized in terms of external economies. 135. From this perspective, BNDES may consider changes in its operational policies to ensure a more effective use of resources, including the introduction of the previously discussed additionality and externality tests to filter applicants. There are also a limited number of industries or sectors with significant coordination externalities; in this context, BNDES could promote the clustering of activities or ensure that complementary investments (e.g., infrastructure) occur in the proper sequence and time frame. 136. This paper also stresses the importance of a different funding structure for BNDES, more consistent with the use of guarantees and related instruments (which requires a shift in its liability structure to more equity), and one less dependent on the government or constitutionally mandated transfers. As an alternative, BNDES should tap the resources of domestic and international capital markets. This will allow the bank to price its products more efficiently and ensure a more sustainable balance sheet. It would be to BNDES advantage to issue papers of different maturities to build a BNDES-specific yield curve, thereby establishing a notional market rate for its loans. The use of TJLP should be far more selective on the presumption that the critical failure in Brazilian 47 credit markets is the lack of long-term finance. By relying more on domestic (and international) capital markets, BNDES could fill the market void without appealing to the government for funds. 137. Over the medium to longer term, BNDES is likely to become a more focused development bank, engaged in two core activities: (i) offsetting certain market failures with guarantees and long-term credit, whichever is a binding constraint and (ii) helping to promote the development of security markets and attract commercial banks, insurance companies, and investment, pension, and other funds to provide market-driven solutions to the financing needs of Brazil’s firms and subnational governments. In this regard, BNDES will need to increase the use of guarantees, warranties, and similar instruments to provide market-based solutions that crowd-in the private sector. 138. Many of the proposed changes in this paper are already being introduced or considered by current management. The modernization of BNDES, however, will likely need a step further, moving forward with an improved governance structure featuring a differently composed board of directors, with independent members and the ability to support management in its decisions that target the long-term sustainability of BNDES. 139. Finally, this paper suggests the government should seriously consider a capital increase by inviting multilateral development institutions to become new shareholders, diluting the union from its current 100% to, say, 75%. The goals would be consolidating the notion and practice of a new governance structure while contributing new ideas, technologies, and practices for a more effective BNDES as a 21st century development bank. 48 Annex 1: BNDES Basic Statistics 1. Financial highlights (June 30, 2016).  Total Assets: US$291.4 billion  Disbursements:47 US$ 10.9 billion  Shareholders’ Equity: US$11.5 billion  Net Income:7 US$-677 million  ROAA:7 -0.23%  RAE:7 -5.43%  BIS Total Capital ratio of 16.1%  NPL ratio at 1.38% 2. BNDES key ratios. 3. Loan structure and disbursement patterns: BNDES provides loans either directly or indirectly (on- lending operations). It usually provides direct financing to large projects; it provides indirect financing through a network of accredited financial intermediaries, including the largest banks in Brazil. Most commercial banks in Brazil operate and on-lend BNDES credit lines. BNDES assumes the financial intermediary’s credit risk, but BNDES has direct recourse to the assets of the final borrower in the case of insolvency of a financial intermediary. 47 Disbursements, net income, ROAA, and ROAE are on a six-month basis. 49 Diversification of BNDES’ Portfolio: 50 4. Credit risk policies. BNDES states that it has rigorous and transparent risk procedures that assure loan- portfolio quality, even under stress scenarios. The non-performing loan rate is low at 1.38% of loan portfolio 51 Loans require repayment capacity and collateral. The bank offers full allowance coverage of past-due loans with low liquidity risk; maturity of liabilities is substantially longer than that of the assets. It also has low market risk, matching assets and liabilities through on-lending and short-term investments. As for derivatives, they are used for hedge purposes only. 5. BNDES equity portfolio. The market value of BNDES portfolio is US$ 18.3 billion, with direct stakes in 47 funds and more than 150 firms. The bank acts as a long-term and minority investor, seeking to strengthen corporate governance while supporting innovative firms. 52 Annex 2 – BNDES Main Products Interest Rate (avg. cost per Disbursements product. Some % of % of BNDES Product Type in 2015 Firm Size credit lines in Maturity What is it? Finances What? Tier Product (R$ million) each product may differ slightly) Investments for 0.1% 0.1% Micro 86 TJLP (7.5%) + implementation, BNDES fee (1% - expansion, 0.1% 0.1% Small 6.36%) recovery, and 52 ----------------------- modernization of 0.7% 0.7% Medium 50% TJLP + 50% fixed assets in: 1 458 market rate 1) infrastructure direct Medium- Benchmarks + (energy, logistics, IT, 4.3% 3.8% 2,638 Large BNDES fee (1.9 - and P&G); 6.36%) Grace and 2) industry, trade, 94.7% 83.2% Large 58,087 amortization services, and periods are agriculture sectors; 61,321 100% 87.8% SUBTOTAL determined 3) Social and urban Investments project according to development; financing for above 0.1% 0.0% Micro the 4) 10 TJLP (7.5%) + R$20 million borrower's Internationalization; FINEM BNDES fee ability to pay, 5) Innovation; 1.0% 0.1% Small (1.6%) + financial (for a few exceptional 88 project 6) Environment; 29 different credit agent fee cases, may be lower nature and 7) Capital Goods. lines segmented 0.0% 0.0% Medium (negotiated) than R$20 million, by various sectors - the economic such as innovation; group Specific financing (stated in the last TJLP (7.5%) + R$1m, Forest Medium- items include: column) 10.3% 1.3% BNDES fee (2%) Management - R$5m, 875 Large Some credit studies and 2 + financial agent Energy Efficiency - lines may projects; civil works; on- fee (negotiated) R$5m and a few extend up to assemblies and lending ---------or-------- others) 30 years installations; 70% (50%) TJLP + furniture and 30% (50%) utensils; training; 88.5% 10.8% Large market rate 7,513 pre-operating Benchmarks + expenses; new BNDES fee (2%) national machinery + financial agent and equipment fee (negotiated) accredited by the BNDES; and 8,486 100% 12.2% SUBTOTAL imported machinery and TOTAL 69,807 100% equipment without national match 14.0% Micro 3,473 TJLP (7.5%) + BNDES fee 12.8% Small (1.6%) + financial 3,182 agent fee (negotiated) 16.0% Medium The following may 3,976 1 - 5 years Financing for the be financed: depending, production and FINAME 2 TJLP (7.5%) + Medium- on the credit acquisition of on- 12.6% BNDES fee (2%) 1) Machinery & 3,128 Large line and item domestic machinery 3 main credit lines lending + Financial agent equipment; to be and equipment fee (negotiated) 2) Computer and financed accredited by BNDES ---------or-------- automation goods 70% TJLP + 30% Market rate 44.7% Large Benchmarks + 11,125 BNDES fee (2%) + financial agent fee (negotiated) 53 TOTAL 24,884 100% Investments for 36.2% Micro implementation, 4,254 TJLP (7.5%) + expansion, BNDES fee recovery, and 9.8% Small (1.6%) + financial 1,149 modernization of agent fee fixed assets as well (negotiated) 13.7% Medium as research, 1,613 development, and TJLP (7.5%) + innovation in the 2 Medium- BNDES fee (2%) sectors of industry, on- 9.1% 1,065 Large + financial agent infrastructure, lending fee (negotiated) trade, services, ---------or-------- agriculture, 70% (50%) TJLP + forestry, fisheries, 30% (50%) and aquaculture. 31.2% Large Market rate 3,661 Benchmarks + Priority Sectors: BNDES fee (2%) capital goods + financial agent industry; generation fee (negotiated) of renewable energy and energy renewable steam (biomass, solar and AUTOMATICO other alternative sources); rail and 3 main credit lines waterborne Investments project (1 for MSMEs; 1 transport modes; financing equal to or for MLE/LEs - water supply, below R$20 million Priority Sectors; sanitary drainage, and 1 for MLE/LEs industrial effluents - Other Sectors) and waste and municipal solid waste; and structuring projects for urban mobility Specific financing TOTAL 11,742 100% items include: studies and projects; civil works; assemblies and installations; furniture and utensils; training; pre-operating expenses; new national machinery and equipment accredited by the BNDES; and working capital toward the investment project (up to 30% of the financing value) Changes monthly New goods, 64.1% Micro The BNDES Card is a 7,210 October 2016 - authorized inputs product that, based 1.2%/month and services, on the concept of a ranging from CARTÃO BNDES 25.7% Small credit card, aims at 2 2,894 (since its launch computers to financing investments on- in 2002, rates 3 - 48 months motorcycles, trucks, BNDES "credit of micro, small, and lending have varied and vehicles card" medium enterprises between 10.2% Medium (MSMEs) and 1,149 0.86%/month to Can NOT be individual 2.17%/month. financed with microentrepreneurs Last 12 months BNDES Card: 54 avg. = financial 1.27%/month) restructuring, working capital, Medium- weapons, imported 0.0% - Large goods (except machinery and 0.0% Large equipment - imported in the clothing and clothing sector), inputs not authorized by BNDES, services, and purchase of TOTAL 11,253 100% real estate or land Credit limit up to R$ 1 million for each client, by issuing bank. The following items 49.5% Micro for the agricultural, 3,873 TJLP (7.5%) + forestry production, BNDES fee Amortization: fisheries, and 32.9% Small (1.6%) + financial 2,573 7.5 years; aquaculture are agent fee 2 allowed for (negotiated) Financing for the FINAME on- 9.6% Medium Grace: 1 to 2 financing: 753 acquisition of AGRICOLA lending years, machinery, equipment depending on 1) machines and Medium- TJLP (7.5%) + and computer goods Agriculture credit 1.9% the item equipment; 149 Large BNDES fee (2%) and new domestic line 2) agricultural + financial agent automation inputs; 6.1% Large fee (negotiated) 3) trucks and 476 related components; TOTAL 7,824 100% 4) computer and automation goods LIBOR or US 0.2% 0.2% Micro 12 Treasury Bonds or Euro Area Available financing 0.1% 0.1% Small Yield Curve or for: 6 EURIBOR + 0.0% 0.0% Medium BNDES fee (at 1) domestically 1 least 1.5%) + manufactured Medium- credit-risk fee (to goods, such as 0.0% 0.0% - Large be defined machinery 1 according to the Up to 15 EXIM equipment, direct structure of the years consumer goods 7 different credit transaction and and services lines for export the current associated with 99.7% 82.5% Large promotion 5,601 credit policy) them; Financing the export 2) national services, Other fees may of domestic goods and 3 post-shipment such as apply associated services (tier 1) construction, 3 pre-shipment engineering, and 5,620 100% 82.8% SUBTOTAL (tier 2) architecture, 1"automatic" (tier TJLP (7.5%) + information 2) 0.0% 0.0% Micro BNDES fee technology (among - (1.6%) + financial others); 0.1% 0.0% Small agent fee Depends on 3) domestic 1 manufactured 2 (negotiated) the credit on- ---------or-------- line; aircraft and civil lending LIBOR + BNDES may go up to aircraft engines and fee (0,4% - 5 years parts, associated 2.9% 0.5% Medium 35 1,35%) + parts and services financial agent fee (negotiated) 55 TJLP (7.5%) + Medium- BNDES fee (2%) 11.9% 2.1% 140 Large + financial agent fee (negotiated) ---------or-------- LIBOR + BNDES 85.1% 14.7% Large fee (0,4% - 995 1,35%) + financial agent fee (negotiated) 1,170 100% 17.2% SUBTOTAL TOTAL 6,790 100% Resources from 0.2% Micro BNDESPAR are 7 intended for 0.0% Small business plans that 1 are in accordance with the strategic 6.7% Medium guidelines and 198 priorities of BNDES Medium- and intended to CAPITAL MARKET 2.1% 61 Large finance: (Mercados de BNDES, through its Capitais) wholly owned 90.9% Large 1) investments in 2,680 subsidiary BNDES fixed assets; Modalities: Participações SA 2) working capital - Direct 1 (BNDESPAR), supports for firm investment in direct Brazilian firms development; firms through equity 3) research and - Investment instruments in development; funds addition to its 4) consolidations, - Corporate debt financing products mergers and securities 2,947 100.0% acquisitions, where the scale and scope arising from consolidation are important to drive further growth; 5) growth restructure and stretching debts Financeable items 36.7% Micro 136 include: 14.3% Small 1) fixed 53 investments; 2) 1 25.3% Medium acquisition of direct 94 machinery and GRANTS Medium- Non-refundable 5.2% equipment, (NÃO 19 Large support (grant) for including the REEMBOLS�VEL) social, cultural, purchase of 18.5% Large environmental, or 68 machinery and - FUNTEC innovation/ equipment - FUNDO SOCIAL technological imported in - RESTAURAÇÃO development projects national similar ECOLÓGICA aimed at generating acquired - FUNDO employment and domestically and CULTURAL income used machinery and TOTAL 370 100% equipment; 3) training; 4) working capital; 5) pre- operating expenses; and 6) other items that are considered 56 essential to the achievement of support goals established by the Social Funds 0.9% Micro Entrepreneur: 3 Up to Directly Financing of up to 4%/month, negotiated R$20,000 to formal 1.6% Small 5 including all with and informal Working capital and MICRO CREDIT charges borrower microentrepreneurs investments in civil (MICRO CRÉDITO) 1 3.3% Medium works, purchase of direct 10 Microcr. Institution: machinery and new Modalities: Medium- Funding from R$1 or used equipment, - Entrepreneur 0.0% TJLP (7.5%) + Amortization: - Large million to and purchase of - Microcredit BNDES fee 6-8 years; microfinance supplies and institution (1.5%) + risk fee Grace: 3-5 institutions wishing to materials. 94.2% Large (0.1%) years 287 be transfer agents of the BNDES TOTAL 304 100% Microcredit Program 0.0% Micro - 2.2% Small 1 TJLP (7.5%) + Financing the The following may 2 5-10 years purchase of be financed: BNDES fee (2%) on- 6.6% Medium depending on machinery, 2 + financial agent FINAME LEASING lending the item equipment, computer, 1) Machinery & Medium- fee (negotiated) 8.4% and automation goods equipment; 2 Large intended for financial 2) Computer and 82.9% Large or operating leases automation goods. 20 TOTAL 24 100% 57 Annex 3 – BNDES Programs Original Max. Internal Disbursement Disbursement Maturity Interest Rate BNDES Program Allocation Objective Begin End BNDES or 2015 2016 (months) (Financial Cost) (R$ million) Input External (R$ million) (R$ million) Financial support for agricultural and non-agricultural TJLP (7.5%) activities to implement, expand, or modernize the PRONAF June 30, BNDES fee (0.9%) 1,619 1,187 1,324 structure of production, processing, industrialization, and June 28, 1996 180 100% E Investimento 2017 Financial agent fee (2.9%) services in the rural establishment or in nearby rural Risk rate (2.9%) community areas (family agriculture) Financial support for agricultural and non-agricultural activities and for the processing or industrialization of own June 30, BNDES fee (0.9%) PRONAF Custeio 33 412 825 March 8, 2007 11 100% E or third parties’ production within PRONAF (family 2017 Financial agent fee (4.3%) agriculture) Acquisition of tractors and associated implements, TJLP (7.5%) harvesters and their cutting platforms, equipment for the June 30, MODERFROTA 2,527 4,758 4,740 Jan. 19, 2000 96 BNDES fee (0.9%) 90% E preparation, drying, and processing of coffee, and self- 2017 Financial agent fee (2.8%) propelled sprayers (agriculture) Support the developing sustainable agriculture; increasing the agricultural production capacity of agricultural TJLP (7.5%) June 30, MODERINFRA 502 345 530 producers; and constructing and expanding facilities for July 14, 2003 144 BNDES fee (0.9%) 100% E 2017 the storage of machinery and agricultural implements and Financial agent fee (2.8%) the storage of agricultural inputs (agriculture) Support and promote the production, processing, and storage of various agriculture chains; encourage actions related to animal defense and the implementation of an TJLP (7.5%) June 30, MODERAGRO 332 447 540 animal traceability system for human consumption; and July 14, 2003 120 BNDES fee (0.9%) 100% E 2017 support the recovery of soils through financing for Finan. Agent fee (2.8%) acquisition, transportation, and application of agricultural correctives (agriculture) To increase the competitiveness of the agro industrial TJLP (7.5%) complex of Brazilian cooperatives through the June 30, BNDES fee (0.9%) PRODECOOP 1,263 702 2,180 July 29, 2002 144 90% E modernization of production and marketing systems 2017 Financial aent fee (2.8%) (agriculture) Risk Rate (2.8%) Promote the recovery or restructuring of agricultural, agro- TJLP (7.5%) industrial, aquaculture, or fishery production cooperatives June 30, BNDES fee (0.9%) PROCAP-AGRO 1,363 947 2,120 and provide resources for the financing of working capital Aug. 11, 2009 72 100% E 2017 Financial agent fee (2.8%) to meet the immediate operational needs of the Risk Rate (2.8%) cooperatives (agriculture) Reduce emissions of greenhouse gases from agricultural activities; reduce deforestation; increase agricultural TJLP (7.5%) production on a sustainable basis; adapt rural properties to June 30, ABC 517 977 1,390 Oct. 14, 2010 180 BNDES fee (0.9%) 100% E environmental legislation; expand the area of cultivated 2017 Financial agent fee (2.8%) forests; and stimulate the recovery of degraded areas (agriculture) 58 Original Max. Internal Disbursement Disbursement Maturity Interest Rate BNDES Program Allocation Objective Begin End BNDES or 2015 2016 (months) (Financial Cost) (R$ million) Input External (R$ million) (R$ million) Support development and modernization of the national TJLP (7.5%) MSMEs storage sector, carried out by cereal firms or cooperatives BNDES fee (1.9-6.36%) 80% that work directly with rural producers and cooperatives; March --or-- CEREALISTAS 399 64 500 April 8, 2008 120 I expand the national storage capacity in the segment that 31, 2018 70% TJLP + 30% Market Others directly serves the rural producer, minimizing logistic BNDES fee (1.6-6.36%) 70% pressures that occur in harvest periods (agriculture) Neg. financial agent fee Increase sugarcane production in the country by financing TJLP (7.5%) January 3, Dec. 31, PRORENOVA 635 261 1,000 the renovation and insertion of new plantations for sugar 72 BNDES fee (1.5%) 70% I 2012 2016 and ethanol producers (agriculture Financial agent fee (2.5%) Promote development of productive rural activities of medium-sized rural producers by increasing income and TJLP (7.5%) PRONAMP June 30, 1,093 1,702 2,450 generating employment in rural areas, using credit for Jan. 10, 2012 96 BNDES fee (0.9%) 100% E Investimento 2017 fixed and semifixed investments in goods and services Financial agent fee (2.8%) related to agricultural activity (agriculture) Agricul. Promote development of productive rural activities for 24 TJLP (7.5%) PRONAMP medium-sized rural producers, increasing income and June 30, 33 44 43 Oct. 16, 2012 BNDES fee (1%) 100% E Custeio generating jobs in the field through credit for costing 2017 Livestock Financial agent fee (3%) (agriculture) 12 Production Increase competitiveness in the Brazilian aquaculture TJLP (7.5%) sector; increase the supply of fish in Brazil through BNDES fee (1-2.5%) aquaculture; encourage increasing productive capacity and Neg. financial agent fee Dec. 31, 60 – 144 Proaquicultura 6 1 500 the modernization of facilities in the aquaculture sector; Oct. 2, 2012 80% I 2017 support the increase of competitiveness of firms in the Working Capital aquaculture sector through financing for productive TS (14%) capacity and organizational improvements (fisheries) BNDES fee (0.5-6.18%) Neg. financial agent fee Support investments necessary for the incorporation of technological innovation in rural properties, aiming at TJLP (7.5%) increasing productivity, adopting good agricultural June 30, INOVAGRO 285 450 595 July 9, 2013 120 BNDES fee (0.9%) 100% E practices and rural property management, and the 2017 Financil agent fee (2.8%) competitive insertion of rural producers in different consumer markets (agriculture) To support investments necessary to increase storage TJLP (7.5%) capacity through the construction and expansion of June 30, BNDES fee (0.9%) PCA 917 734 700 July 9, 2013 180 100% E warehouses for storing grains, fruits, tubers, bulbs, 2017 Financial agent fee (2.8%) vegetables, fibers, and sugar (agriculture) Risk rate (2.8%) TJLP (7.5%) Contribute to the development of the national information BNDES fee (1- 6.36%) Corp. technology (IT) software and services industry by: Neg. financial agent fee Restruc (i) strengthening national firms; and --or-- March 15, June 30, 90% PROSOFT 313 112 5,000 (ii) attracting multinational firms that position Brazil in its 48 50% TJLP + 50% Market I 1997 2017 global development strategies, with significant aggregation BNDES fee (1.9-6.36%) Others of local value and/or exports from the country Neg. financial agent fee 80% (IT/software) --or-- Corporate restructure 59 Original Max. Internal Disbursement Disbursement Maturity Interest Rate BNDES Program Allocation Objective Begin End BNDES or 2015 2016 (months) (Financial Cost) (R$ million) Input External (R$ million) (R$ million) 100% market BNDES fee (1.9-6.36%) Biotech & Innovation TJLP (7.5%) Biotech BNDES Fee (1 – 5.86%) Increase the competitiveness of the Industrial Health 180 Biotech Complex (IHC); contribute to the sustainability of the Production Innov. Unified Health System (SUS); articulate the Industrial Policy March 29, June 30, Innov. TJLP (7.5%) 80% PROFARMA 142 38 5,000 and the National Health Policy in force; stimulate the I 2004 2017 144 BNDES fee (1.6-6.36%) construction of productive capacity, training, and Neg. financial agent fee Prod. innovation in biotechnological products and processes in Prod. --or-- 90% the IHC; and others (medical/health industry) 120 100% market BNDES fee (1.6-6.36%) Neg. financial agent fee TJLP (7.5%) --or-- 75% TS - 50/50% TJLP/TS Increase production, employment, and wage mass through --or-- Dec. 31, PROGEREN 1,597 2,103 10,000 financial support for working capital (general June 22, 2004 60 TS (14%) - I 2017 industry/commerce/services) + (for all modalities) BNDES fee (2%) Neg. financial agent fee Finance the acquisition and leasing of trucks, chassis, truck- TJLP (7.5%) Dec. 31, Procaminhoneiro 198 30 250 tractors, carts, trailers, semi-trailers, and truck bodies, new June 8, 2010 96 BNDES fee (1.6%) 80% I 2017 or used, of national manufacture (truck industry) Neg. financial agent fee TJLP (7.5%) Contracting of credit operations for the acquisition of Not BNDES fee (0.5%) PROVIAS 59 5 1,000 national machinery and equipment for interventions on April 25, 2006 operating 54 100% E Neg. financial agent fee public roads and highways (roads) (no more than 3%) TJLP (7.5%) BNDES fee (1 – 6.36%) Neg. financial agent fee --or-- To finance investment projects and business plans of firms 50/50% TJLP/TS belonging to productive chains of the culture economy, June 30, PROCULT 148 157 2,000 Oct. 19, 2006 120 BNDES fee (1.9-6.36%) 80% I such as audiovisual, publishing, music, electronic games, 2017 Neg. financial agent fee and visual and performing arts (culture industry). --or-- 100% market BNDES fee (1.9-6.36%) Neg. financial agent fee TJLP (7.5%) BNDES fee (1.1-6.36%) To finance national engineering, aiming to stimulate the March Neg. financial agent fee PROENGENHARIA 12 65 5,000 improvement of skills and knowledge in the country June 2, 2009 - 80% I 31, 2018 --or-- (engineering industry). 100% market BNDES fee (1.5-6.36%) 60 Original Max. Internal Disbursement Disbursement Maturity Interest Rate BNDES Program Allocation Objective Begin End BNDES or 2015 2016 (months) (Financial Cost) (R$ million) Input External (R$ million) (R$ million) Neg. financial agent fee TJLP (7.5%) BNDES fee (0.5-6.36%) Neg. financial agent fee Contribute to the development of the plastic production June 30, PROPL�STICO 74 38 1,300 June 8, 2010 120 --or-- 100% I chain (plastic industry). 2017 100% Market BNDES fee (1.5-6.36%) Neg. Financial agent fee TJLP (7.5%) BNDES fee (1.6-6.36%) Encourage investments that contribute to excellence in Neg. Financial agent fee design, fashion, product development, differentiation, and --or-- strengthening brands in textile and clothing production September Dec. 31, 50/50% TJLP/TS PRODESIGN 192 95 1,000 chains, footwear, furniture, personal hygiene, perfumery 60 80% I 24, 2013 2016 BNDES fee (1.9-6.36%) and cosmetics, household goods, toys, sanitary metals, Neg. financial agent fee jewelry, watchmaking, packaging, home appliances, --or-- ceramic coatings, glasses, and others (general industry) 100% market BNDES fee (1.9-6.36%) To increase the competitiveness of micro, small and medium enterprises (MSMEs) by financing investments MPME Innovation TJLP (7.5%) necessary for introducing of innovations in the market in INOVADORA 120 BNDES fee (0.4% for micro articulated way with the other actors of the National November 26, Sept. 30, 3 24 300 & small firms and 1.3% for 90% I Innovation System, contemplating continuous actions of 2016 2017 (Innovative Working medium firms) incremental improvements in its products and/or MSMEs) capital 36 Neg. financial agent fee processes, in addition to improving their skills, structure, and technical knowledge (MSME’s competitiveness). TJLP (7.5%) Promote the strengthening of the credit union's credit Dec. 31, BNDES fee (1.6%) PROCAPCRED 5 38 500 structure through the granting of financing directly to the June 1, 2006 72 80% I 2017 Financial agent Fee cooperative (general credit). (up to 3%) Improve product quality and productivity in Brazil’s paper industries; contribute to the strengthening of the sector’s TJLP (7.5%) trade balance; strengthen the position of the national BNDES Fee (1-3%) Dec. 31, PROPAPEL 0 5 500 company in the economic, administrative-financial, May 27, 2014 120 Financial agent Fee 80% I 2017 commercial, and technological aspects; and encourage the (up to 3%) integration of new paper-making units to market pulp Risk rate (0.5-2.87%) manufacturers (paper industry). Innovation Innovat. TJLP (7.5%) & Encourage increased production capacity and service PRO-BK BNDES Fee (1.4-5.86%) Produc. delivery, modernization of facilities, mergers and October 7, Dec. 31, 6 69 1,500 60 Production/working capital 80% I acquisitions, and innovations in the capital goods sector 2014 2017 (Capital Goods) TJLP (7.5%) (capital goods). BNDES Fee (1.6-6.36%) Work. Neg. Financial Agent Fee Capit. 61 Original Max. Internal Disbursement Disbursement Maturity Interest Rate BNDES Program Allocation Objective Begin End BNDES or 2015 2016 (months) (Financial Cost) (R$ million) Input External (R$ million) (R$ million) --or-- 50% 100% Market BNDES Fee (1.6-6.36%) Neg. financial agent fee Promote the development of the fixed income securities TJPL (7.5%) market by increasing TJLP's participation in the concession Dec. 30, PRO-LOG�STICA 0 0 2,000 May 19, 2015 - BNDES fee (depends on 100% I projects of logistics and transport infrastructure, subject to 2016 project finance) its issuance (logistics) MSMEs TJLP (7.5%) Financing working capital for end beneficiaries that have BNDES fee (1.6%) Giro PSI- financing operations contracted under the BNDES Neg. financial agent fee Dec. 30, PROCAMINHONEI 0 0 1,000 Programs of Investment Support - BNDES PSI and BNDES of June 7, 2015 18 --or-- - I 2016 RO Financing to Truckers - BNDES Procaminhoneiro (truck Large enterprises industry) SELIC (14%) BNDES fee (2.5%) Neg. financial agent Fee Through the subscription by BNDESPAR subordinated participatory debentures, support of innovation projects Dec. 31, TJLP (7.5%) THAI 0 0 500 with technological and market risk, such as the Nov. 19, 2015 300-420 50% I 2020 BNDES fee (1 – 5.18%) development of new products and the scheduling of new processes (business innovation) TJPL (7.5%) Financing the composition of debts arising from credit April 30, Pro-CDD Cartão 0 8 2,000 April 5, 2016 48 BNDES Fee (3.4%) - I operations contracted through the BNDES Card 2017 financial agent fee (7%) TJLP (7.5%) BNDES fee (1.3-2.7%) Depends Support the implementation and consolidation of self- Neg. financial agent fee June 30, on PACEA 0 0 200 managed enterprises that have sustainability in the Dec. 6, 2005 --or-- 70% I 2017 payment industrial sector (general industry) 100% Market capacity BNDES fee (1.6-3.5%) Neg. financial agent fee TJLP (7.5%) To strengthen the capacity of care of the Unified Health --or-- Financial SUS System (SUS), supporting the modernization of the 50/50% TJLP/TS Reestrut. 100% network of Health Institutions with Social Assistance --or-- Sept. 30, 120 SAÚDE 376 97 3,500 Benefit Entity Certificate and the expansion of projects to June 8, 2010 100% market I 2018 Institut. support the institutional development of that System Others + (for all modalities) Develop. through the Institutional Development Subprograms and 144 BNDES fee (1.3 - 2%) 50% SUS Service (health industry) Neg. financial agent fee To support investment projects (and acquisition of machinery and related equipment) of the Municipal Public TJLP (7.5%) Mar. 30, PMAT Automático 27 43 1,000 Administration aimed at modernizing the tax Nov. 3, 2010 96 BNDES Fee (1.5-2.5%) 80% I 2018 administration and improving the quality of public Negot. financial agent fee spending (public management upgrade) PER 323 90 500 Support the resumption of economic activity in Oct. 11, 2011 Dec. 31, 120 TJLP (7.5%) 100% I 62 Original Max. Internal Disbursement Disbursement Maturity Interest Rate BNDES Program Allocation Objective Begin End BNDES or 2015 2016 (months) (Financial Cost) (R$ million) Input External (R$ million) (R$ million) municipalities affected by natural disasters (natural 2016 BNDES fee (1.3%) disasters recovery) Negot. financial agent fee 10 sub-programs; Support the implementation of firms, the acquisition of each with dif. conditions. machinery and equipment, and technological development Financial cost varies from Dec. 16, Fundo Clima 75 32 560 related to the reduction of greenhouse gas emissions and Nov. 1, 2011 144-300 0.1% to 7%; 90% I 2016 adaptation to climate change and its effects BNDES fee averages 1% (environmental) Financial agent fee averages around 3% To support productive investments and infrastructure improvements in states affected by the measures provided for in Resolution 13/12 of the Federal Senate, with the Dec. 31, TJLP (7.5%) PROPAE 612 396 7,500 July 3, 2012 264 100% E financing of current expenditures or debt not contracted 2016 BNDES fee (0.8%) with the granting institution itself (infrastructure investment) Contribute to maintaining the level of employment in the TJLP (7.5%) Micro and Small country and promote the social and professional inclusion Mar. 30, BNDES fee (1.5%) Business - 0 0 3,000 May 3, 2016 36 100% I of teenagers and young people (Business Young 2018 Neg. financial agent fee (up Apprentice Professional Program) to 8%) Encourage the transfer of productive and economically Incentive Program viable assets, including equity interests ("Target Assets") 100% market for the August 17, Aug. 31, 0 0 5,000 held by firms in economic-financial crisis ("Sellers") or by 120 BNDES Fee (1.6-2%) 100% I Revitalization of 2016 2017 their controlling shareholders to firms that wish to acquire Negot. financial agent fee Productive Assets them ("Purchasers") 63 Annex 4 – BNDES Main Funds under Operation/Management To support its activities, BNDES requires adequate resources. The particularities of Brazil’s domestic credit supply, concentrated in the short term, led the government to seek alternative solutions to raise funds to support long-term investment projects in the form of fund institutions. This annex presents information on the main funds under BNDES’ purview. In some cases, an effective inflow of financial resources supports investment projects; in other situations, the funds promote the complementation of guarantees. GUARANTEE FUNDS BNDES FGI - Investment Guarantee Fund The Investment Guarantee Fund (FGI), established on June 30, 2009, through a decision of the BNDES Board of Directors is a private fund administered by the bank to facilitate credit acquisition by micro, small, and medium-sized enterprises (MSMEs). In addition, fund benefits individual entrepreneurs and autonomous truckers, supporting them in their growth and modernization. FGI operates by guaranteeing BNDES financing for working capital, acquisition of national machinery and equipment, projects to expand production units, acquisition of national software, export-oriented production, among others. The federal government, BNDES, and public and private financial institutions are among the fund’s shareholders. BNDES Export Guarantee Fund - FGE The Export Guarantee Fund (FGE) was created by Provisional Measure No. 1,583/1997, and, after consecutive reissues, was converted into Law 9,818/1999. It is an accounting fund, linked to the Ministry of Finance, and aims to cover guarantees provided by the federal government in export credit insurance (SCE) operations. The purpose of the SCE is to insure Brazilian exports of goods and services against commercial, political, and extraordinary risks that may affect the economic and financial transactions related to export credit operations. Decree 3,937/1997 and subsequent amendments regulate SCE, insurance firms operating in the segment, the guarantee given by the Union and the FGE. The Brazilian Agency for the Management of Guarantors and Guarantees SA (ABGF) was created by Decree 7.976/2013. It is a public company linked to the Ministry of Finance in the form of a corporation responsible for, among other things, the execution of all services related to SCE with FGE ballast. The fund’s initial equity was established through the transfer of 98 billion registered preferred shares issued by Banco do Brasil SA and 1.2 billion nominative preferred shares issued by Telecomunicações Brasileiras SA (TELEBR�S). 64 Resources of the FGE are:  The proceeds from the sale of shares;  The reversal of unapplied balances;  Dividends and share capital remuneration;  The result of the financial investments of the resources;  Commissions arising from the provision of security; and  Funds from the Treasury. BNDES is the manager of the FGE, pursuant to Article 8 of Law 9,818/99, ratified by Decree No. 4,929/2003. OTHER GOVERNMENTAL FUNDS PIS-PASEP Fund and the Worker Support Fund - FAT PIS-PASEP is the result of the unification of programs constituted with funds from the Social Integration Program (PIS) and the Program for the Formation of Public Servants’ Equity (PASEP). Since 1974, the collections related to these programs have been a source of funds for BNDES. PIS-PASEP is a social fund linked to the Ministry of Finance, with the following objectives:  Integrate employees into the life and development of enterprises;  Ensure employees and public servants the usufruct of progressive individual equity;  Stimulate savings and correct distortions in the distribution of income; and  Make possible the parallel use of accumulated resources to favor economic- social development. The Worker Support Fund (FAT) is a special fund of an accounting and financial nature, linked to the Ministry of Labor and Employment. FAT resources are intended to cover unemployment insurance and salary bonuses as well as economic development programs through BNDES, in a minimum of 40% of this collection. Its main source of funds derives from the contributions of PIS and PASEP. Until 2009, a significant part of the bank's financing structure was concentrated in two government funds: PIS-PASEP and FAT. In 1988, the Federal Constitution determined that 40% of the PIS-PASEP collection should be used to finance economic development programs through BNDES, not only to protect unemployed workers but also to generate employment opportunities. In 1990, with the end of the PIS-PASEP Fund and the creation of FAT, the collection of PIS-PASEP contributions was shifted to the FAT, which became one of the main sources of BNDES funds. 65 The funds raised through this constitutional determination are called Constitutional FAT and are remunerated by the TJLP in the case of financing in reals or Libor plus dollar variation in the case of export financing. There is no provision for repayment of the principal – except in case of insufficient cash to cover the unemployment insurance and salary bonus programs. The periodic payment of interest (semiannually) is required. The balance of the Constitutional FAT is considered subordinated debt and is computed in the calculation of BNDES Reference Equity. It is a permanent and safe source of financing, with costs compatible with the long-term financing of investments in productive activities. Constitutional FAT allows BNDES a free decision on the application of its resources, provided it involves economic development programs as determined by the Federal Constitution. In addition to the constitutional transfers, BNDES funds the FAT with so-called FAT Special Deposits, which are remunerated by TJLP from the release of the loans to the final beneficiaries and by the same criteria applied to the Treasury’s cash resources. In addition to the remuneration, a percentage of amortization is paid monthly. Funds raised as FAT Special Deposits are applied in specific programs and sectors, previously determined and approved by the Executive Secretariat of the FAT Deliberative Council. The balance of FAT resources as of June 30, 2016 was R$ 226.8 billion. From this total, R$212.9 billion constituted the balance of the Constitutional FAT, with R$13.9 billion of the balance in FAT Special Deposits. In the first half of 2016, R$10.9 billion of FAT funds were invested, with R$10.6 billion related to the Constitutional FAT. The balance of resources of the PIS-PASEP Fund as of June 30, 2016 was R$34.0 billion. PIS-PASEP funding has not been realized since the fund's extinction in 1990. Merchant Marine Fund (FMM) The Merchant Marine Fund is designed to provide resources for the development of the Merchant Navy and the Brazilian shipbuilding and repair industry. The Ministry of Transports administers the FMM through the Directorate of the Merchant Marine Fund (CDFMM). FMM’s main source of funds is the Merchant Marine Renewal Freight (AFRMM), a tribute established in 1987. Its legal nature is that of contribution of intervention in the economic domain (CIDE), and its objective is to support the Brazilian naval sector. As stipulated by Decree No. 5,543/2005, BNDES, as the FMM’s financial agent, has the following responsibilities:  Analyze the technical and economic feasibility studies aimed at obtaining FMM support;  Negotiate the conditions for contracting financial support operations in compliance with the requirements stipulated by the National Monetary Council;  Approve and contract the financial support operations of the FMM, respecting the internal rules of the financial agent applicable to the subject; 66  Credit the FMM, on the due dates, the amounts corresponding to payments related to the return of financing (excluding the remuneration of the financial agent) and to pay the disbursements required by contractual events; and  Monitor and supervise projects benefiting from FMM resources and financed by the financial agent. Activities include financing Brazilian shipyards for projects of implantation, expansion, and modernization and for construction and repair of ships and to national navigation companies for ordering vessels and equipment, repairs, and jumborization next to Brazilian shipbuilders and the Navy. On June 30, 2016, the FMM’s total resources in BNDES were R$19.1 billion. In the first half of 2016, resources of R$818 million were added (R$3.3 billion in 2015). FI-FGTS The FI-FGTS is a private fund created in 2007, governed by its own regulations and acting in accordance with determinations established by its deliberative collegiate bodies – FGTS Curatorial Council and FI-FGTS Investment Committee. The fund’s purpose is to use its resources for construction, renovation, expansion, or implementation of infrastructure projects in highways, ports, waterways, railways, energy, sanitation facilities, and airports. The convergence of interests between FI-FGTS and BNDES results from adherence between the bank's role as an important financier of the country's infrastructure projects and the fund's objectives. Through Resolution 577 on October 30, 2008, the FGTS Board of Trustees amended IF-FGTS regulations to include the possibility of the fund acquiring, on an exceptional basis, simple debentures from BNDES or its subsidiaries, issued specifically for its acquisition, up to a limit of R$7 billion. At the end of December 2008, the R$7 billion funding operation was completed. On May 2015, a new adjustment was approved in the FI-FGTS regulations, which included the possibility of the fund acquiring, on an exceptional basis, simple debentures from BNDES or its subsidiaries, issued specifically for its acquisition, up to the limit of R$10 billion. The FI-FGTS does not represent a regular source of resources for BNDES. In December 2008, R$7 billion was invested in infrastructure projects that fell within the fund’s mandate. There was no funding from FI-FGTS in the first half of 2016. On June 30, 2016, the balance of FI-FGTS resources was R$3.9 billion. Fund for the Technological Development of Telecommunications – FUNTTEL An accounting nature characterizes the Fund for the Technological Development of Telecommunications (FUNTTEL). Objectives include: (i) stimulating technological innovation, (ii) encouraging the training of human resources, (iii) fostering job creation, and (iv) increasing the competitiveness of Brazil’s telecommunications industry by promoting the access of small and medium-sized enterprises to capital resources. FUNTTEL’s main sources of funding include: 67  Appropriations included in the annual Budget Law and its additional credits;  Contribution of half of the gross revenues of companies providing telecommunications services in public and private systems;  Contribution of 1 percent due by the institutions authorized under the Law, on the gross collection of participatory events carried out through telephone calls; and  The product of the remuneration of resources passed on to the agents. FUNTTEL’s s financial agents – BNDES, FINEP, and the CPqD Foundation’s Center for Research and Development in telecommunications – must apply these resources exclusively in the telecommunications sector’s programs, projects, and activities. Beneficiaries of this fund include:  Non-profit educational institutions, public or private, in Brazil;  Non-profit national research institutions, public or private;  Brazilian firms providing telecommunications services; and  Brazilian firms supplying goods and services for the sector – as long as they are engaged in effective production in the country. Operations using FUNTTEL funds must comply with the following conditions:  Grace period: up to 30 months from the date of legal formalization of the operation;  Amortization: up to 72 months, counted after grace period;  Participation: up to 80 percent of the project value to be financed;  Charges: fixed in TR, plus risk commission from 1% to 4% per annum. The obligations of the financial agents before FUNTTEL can be highlighted as main: Regarding administration, FUNTTEL is subordinated to a Management Council made up of a representative of each of the following organizations or entities, designated by the Minister of Communications:  Ministry of Science, Technology, Innovation and Communications (MCTIC);  Ministry of Industry, Foreign Trade and Services (MDIC);  National Telecommunications Agency (ANATEL);  National Bank for Economic and Social Development (BNDES);  Funding of Studies and Projects (FINEP). 68 National Climate Change Fund - FNMC The National Fund on Climate Change (FNMC) is an accounting fund, linked to the Ministry of Environment (MMA), and it aims to secure resources to support projects or studies aimed at mitigating climate change and adapting to climate change and its effects. Funding sources include: appropriations in the annual Budget Law of the Union and in its additional credits; donations from national and international entities, public or private; resources derived from interest and amortizations of financing as well as other modalities determined in Law 12,114/2009. The FNMC provides resources in two modalities: reimbursable, controlled by BNDES, and non-reimbursable (grants), handled through MMA. Amazon Fund (FA) The Amazon Fund aims to raise donations for non-reimbursable investments for actions to prevent, monitor, and combat deforestation and to promote the conservation and sustainable use of the Legal Amazon. The Amazon Fund supports projects in the following areas:  Management of public forests and protected areas;  Control, monitoring, and environmental inspection;  Sustainable forest management;  Economic activities developed from the sustainable use of vegetation;  Ecological and economic zoning, territorial planning, and land regularization;  Conservation and sustainable use of biodiversity; and  Recovery of deforested areas. The Amazon Fund can devote up to 20% of its resources to support the development of systems for monitoring and controlling deforestation in other Brazilian biomes and in other tropical countries. In addition to the reduction of greenhouse gas emissions, thematic areas proposed for Amazon Fund support can be coordinated to contribute to the achievement of significant results in the implementation of its objectives of preventing, monitoring, and combating deforestation and promoting conservation and sustainable use of forests in the Amazon biome. The Amazon Fund is managed by BNDES, which is also responsible for raising funds, contracting, and monitoring projects and actions supported. The Amazon Fund has a Steering Committee (COFA), charged with determining its guidelines and monitoring the results obtained, and a Technical Committee (CTFA), appointed by the MMA to certify emissions from deforestation in the Amazon. On June 30, 2016, total resources of the Amazon Fund were R$2.5 billion for the financing of projects to prevent, monitor, and combat deforestation and promote the 69 conservation and sustainable use of Amazon Biome forests. In the first half of 2016, R$88.8 million were added (R$504.8 million in 2015). Sectorial Audiovisual Fund - FSA The Sectorial Audiovisual Fund (FSA) is a specific programming category of the National Fund of Culture (FNC), linked to the Ministry of Culture. Its objective is the articulated development of the entire productive chain of audiovisual activity in Brazil. The main objectives are: increased cooperation between various economic agents; expansion and diversification of the infrastructure of services and exhibition rooms; strengthening research and innovation in audiovisual subjects; sustained growth of the market share of national content; and development of new means of diffusion of Brazilian audiovisual production. Six budgetary actions were created for the fund’s implementation, four geared toward development and two focused on administration of applied resources. The four development actions are:  Support for specific audiovisual projects;  Equalization of financial charges on financing operations;  Investments in firms and projects; and  Financing to the audiovisual sector. The FSA's resources come from contributions collected by market players, mainly from the Contribution for the Development of the National Cinematographic Industry (CONDECINE) and from the Telecommunications Inspection Fund (FISTEL). The FSA operates through a Management Committee, whose duties are to define the guidelines and annual investment plan, monitor the implementation of the actions, and evaluate the results achieved annually. The fund also has the National Cinema Agency (Ancine) as Executive Secretariat; as financial agent, BNDES and other financial institutions accredited by the Management Committee play a major role. 70 Annex 5 - Market and Policy Interest Rates Main Interest rates in Brazil 71 Annex 6 – BNDESPAR and Capital Markets Resources Through its wholly owned subsidiary BNDES Participações S.A. (BNDESPAR), BNDES supports Brazilian firms through variable-income instruments (in addition to the bank’s financing products). BNDESPAR support is present at all stages of firms’ growth. It supports start-ups, early-stage firms and so on, with a strong innovative bias through investment funds run by market managers chosen through a rigorous selection process. Firms in more advanced stages of maturity can be aided through private-equity funds or the subscription of securities (direct participation), such as convertible shares or debentures. BNDES also encourages initial public offerings (IPOs) on the main Brazilian stock market, Bovespa Mais (or another access market with similar characteristics). Firms that already have their capital stock can receive support through structured private operations or through the participation of BNDESPAR in public offerings. The following figures illustrate the performance of BNDESPAR in all stages of a firm’s growth. 72 BNDESPAR AS AN INVESTOR IN PRIVATE EQUITY  Mission: to aid in the capitalization and development of Brazilian firms and contribute to the strengthening and modernization of the securities market.  BNDESPAR invests in national companies directly through minority and temporary stakes in the form of stocks or convertible bonds and indirectly through investments in third-party managed funds.  Joint strategic goals and guidelines are drafted between BNDESPAR and BNDES in an effort to develop local enterprises and stimulate innovation. 73 SUPPORT MODALITIES Direct investments Through the subscription of shares, BNDESPAR invests in Brazilian firms, becoming a minority share partner. BNDES’ resources are intended for business plans that fit with the strategic guidelines and priorities of the BNDES system and involve processes of:  Modernization and expansion of installed capacity;  Innovation;  Consolidation and/or internationalization of Brazilian firms;  Strengthening productive chains and setting up business complexes; and/or  Restructuring. Direct investment in equity participation may occur in the scope of a public offering or private issuance. The latter case may involve the assignment of preemptive rights by shareholders of the firms to allow BNDES to enter the firms’ capital. In addition to the subscription of shares, another variable income instrument used by BNDESPAR to support Brazilian firms is the convertible debenture, a debt securities that guarantees the holder an option to convert the debtor balance into shares of the issuer at a pre-defined rate. BNDESPAR investments are always preceded by analysis of several key factors – among them, an economic and financial evaluation of the firm and its projects, the firm’s market performance, its governance and management, and risks and their mitigating factors. After its initial investment, BNDES monitors the investees and seeks to guide the adoption of best practices in management, governance, and sustainability as well as the strengthening of innovative capacity. In some firms, for example, the bank has the right to appoint members to the boards of directors and/or fiscal councils, ensured by agreements with the main shareholders that govern their relationships, rights, and obligations, avoiding conflicts and guaranteeing better governance practices. Investment funds BNDESPAR resources may support start-ups and emerging firms through investment funds managed by selected market managers chosen through a rigorous selection process. BNDESPAR's activities through investment funds aim to develop innovative firms and productive chains considered a priority by the bank while stimulating entrepreneurship, encouraging the adoption of best practices in management and corporate governance, and spreading the culture of venture capital in Brazil. Investments should also present prospects for a return above BNDESPAR’s cost of raising funds, contributing to the risk diversification of its asset portfolio. As an investment fund quota holder, BNDESPAR analyzes the investment proposals brought by managers just as it does direct investments, contemplating such aspects as the firm’s economic and financial condition and projects, its market, governance and management, risks and mitigating factors, and the structure of the proposed operation. 74 After the selection process, the winning bid is submitted to the BNDES system framework of operations. Once framed, the proposal goes to the analysis phase, where legal and managerial aspects are discussed as well as fund regulation. The feasibility of the proposal is checked, and the winning manager has the burden of justifying it. Subsequently, the winning proposal has its contracting submitted to the BNDESPAR board. Corporate debt securities Corporate debt securities are securities issued by firms that seek to raise funds to finance their investments and activities. To support the development of capital markets and complement financing options for Brazilian firms, BNDES has products and programs that encourage the issuance of fixed-income corporate bonds, such as simple debentures. The bank supports the issuance of corporate debt securities through the subscription of simple debentures and the acquisition of securities issued by Brazilian capital firms. It offers three different modalities:  Market debentures: to develop the secondary market of debentures and encourage the substitution of indexes for rates more appropriate to long-term financing;  Infrastructure project debentures: for structuring investment funds in debentures of the infrastructure sector;  External debt securities: for the acquisition of external bonds to support the strategies of growth and international insertion of Brazilian companies. Further details for each modality below: Market Debentures Objectives  Develop the secondary market for debentures;  Encourage the replacement of the one-day DI-Over indexer with rates more adequate for long-term financing;  Support long-term investments, especially in infrastructure;  To shorten the BNDES analysis period, adapting it to the market needs. Mandatory allocation criteria  Average minimum term of 48 months;  In the deed of issue, the series under analysis may only contain an anticipated redemption forecast – at the issuer's sole discretion – in the last year before the maturity of the debenture;  The debentures should have pricing and distribution defined through clear and transparent procedures, preferably through the collection of investment intent (bookbuilding);  The deed of issue should only allow the possibility of renegotiation of the debenture’s terms after 48 months from date of issue. Percentage of resource allocation 75 The maximum percentage of BNDES participation in issuing debentures will be 30% in the series under analysis. Additional mandatory criteria  Minimum participation of 20% of shareholders’ funds in the financing of the project;  Commitment to include in the debenture’s deed of issuance an early maturity clause due to default of financial obligations the issuer assumed or will assume in financing agreements entered into with BNDES; and  Maturity of six years or more. Infrastructure Projects Debentures Description and Objectives Seeking the feasibility of future structuring on investment funds in debentures for the infrastructure sector, this modality seeks to compose a fixed-income securities portfolio through the subscription by BNDES of simple debentures issued in public offerings of up to R$300 million. At the same time, it is also a complementary source of long-term resources for infrastructure projects. Allocation  R$5billion, rotating. Beneficiaries Special purpose vehicles (SPVs); concessionaires of public services, authorized or permission holders; or SPM holding companies or holders of concessions, authorizations, or permissions, active in the following sectors:  Logistics and transportation;  Urban mobility;  Energy;  Basic sanitation. Remuneration The remuneration of the debentures will be determined based on market rates for compatible fixed-term and fixed-income securities. Maturity period  It may not be less than four years. External Debt Securities Objectives Acting in the international primary market for acquisition of bonds issued by firms with Brazilian capital and in the trading of these securities in the secondary market, this modality aims to support Brazilian firms’ strategies of growth and international insertion, alternatively or complementary to other BNDES products/programs. Beneficiaries  Firms with headquarters and administration in Brazil and national control;  Foreign companies whose shareholder with the largest voting capital and exercising dominant influence over the activities performed therein, according to the judgment to be made by the BNDES, is: 76 o A legal entity directly or indirectly controlled by an individual or group of individuals domiciled and resident in the country; or o A firm controlled by a legal entity governed by public law. Allocation  US$ 1 billion for the constitution of the foreign securities portfolio.  The total value of the portfolio may exceed the expected amount because of the valuation of external securities. Characteristics of titles Non-convertible or exchangeable debt securities issued on the international primary market may be acquired with the following characteristics:  Shall be denominated in US dollars, euros, pounds sterling, Japanese yen, Canadian dollars or Swiss francs;  May have floating or pre-fixed rates;  Shall be admitted to trading on a stock exchange and registered in a system of registration, custody and financial settlement of the European Union, the United States, Singapore, or Japan;  Shall be governed by English or New York law; and  Cannot be of the subordinate species. Allocation of resources Investments in foreign securities should be directed to firms that operate in sectors supported by BNDES to finance:  Investments in fixed assets in Brazil and abroad;  Working capital required for the development of the issuing company;  Research and development;  Mergers and acquisitions in Brazil and abroad in cases where scale and scope gains arising from consolidation are important to boost subsequent growth;  Restructuring and extension of debts for as long as necessary for the development of the issuing firm; and  Purposes other than those described in the preceding paragraphs, provided that it is justifiable for the development of the issuing firm. Maximum participation of BNDES  BNDES 'participation in the acquisition of foreign securities will be up to 20% of the total amount of the issue.  BNDES may only acquire foreign securities in the amount equivalent to 20% of the allocation of this modality by the economic group of the issuing firm. Maturity period  There are no restrictions on the maturity of external securities. Warranties External securities may be collateral (real, personal, or floating) or not, excluding subordinated securities. In the case of securities issued by companies incorporated abroad, these must be fully and jointly guaranteed by the parent firm in Brazil. 77 BNDESPAR as a LP: Investment Funds Investment Ecosystems in Brazil 78 BNDESPAR Investments in Innovation through Funds Funds focused on defined goals and externalities 79 New Funds in due diligence What BNDES is planning for the following years  Active role on Market Gaps;  Expansion of all segments with different Focus on each case 80 81 Annex 7A – BNDES’ 2016 Operational Policy Details BNDES’ financial support instruments are regulated and consolidated in the operating policies (OPs), updated regularly. OPs consist of general and specific guidelines. The general guidelines apply to most supported operations. Certain credit lines and programs, as well as funds, have specific guidelines with their own regulations and conditions. General operation policy guidelines for BNDES’ products include the following categories: Beneficiaries BNDES financing instruments are intended for beneficiaries with certain characteristics, including:  Firms based in Brazil;  Individual entrepreneurs (households or firms);  Individual micro entrepreneurs (firms);  Public entities or agencies – direct and/or indirect administration from the federal, state, municipal, and federal district levels;  Foundations and associations of private law;  Cooperatives;  Households domiciled and resident in the country, provided they exercise economic activities and are properly recorded, such as truck drivers and farmers;  Consortia and condominiums engaged in productive activity; and  Unions and clubs. To request funding with BNDES, the beneficiary must meet the following minimum requirements:  Be in good standing with tax and social obligations;  Present a satisfactory cadastre;  Demonstrate the ability to pay;  Have sufficient risk guarantees for the operation;  Not be registered in the credit recovery regime;  Comply with the import legislation in cases of financing for imports of machinery and equipment;  Comply with environmental legislation. Beneficiaries (households or firms) are not eligible for BNDES funding if they:  Have defaulted with the BNDES system or are part of an economic group that has defaulted with BNDES;  Have a protesting title (unless, by discretion of BNDES, the protest is justified); 82  Are involved in a court case that, by discretion of BNDES, may compromise the compliance capacity of its obligations to the bank;  Have cadastral notes indicating contumacious default or restrictions on their suitability; or  Are in the process of bankruptcy or judicial or extrajudicial recovery. Firm sizes BNDES classifies its beneficiaries by size to allow actions appropriate to the characteristics of each segment, recognizing that specific conditions impact offers of credit lines and programs. BNDES, for example, considers support for MSMEs a priority, offering special conditions with the goal of facilitating their access to credit firms. The size classification is carried out according to gross operating income for firms or annual income for households. The classification: BNDES client classification Annual gross operating income (firms) or Classification annual income (households) Micro firm Less than or equal to R$2.4 million Greater than R$2.4 million and less than or equal Small firm to R$16 million Greater than R$16 million and less than or equal Medium firm to R$90 million Greater than $90 million and less than or equal to Medium-large firm R$300 million Large firm Above R$300 million Eligible financing items The beneficiary may use BNDES financing for specific purposes, such as:  Investments for implementation, expansion, modernization and/or recovery of firms, infrastructure, firms and public and private institutions, including studies, projects, civil works, installation, training;  Production or acquisition of new machinery and equipment (including commercial vehicles, buses, trucks, and aircraft), national and accredited by BNDES;  New goods, supplies, services, software;  Working capital;  Export of domestic goods and services; and  Purchase of imported goods and services and internalization costs (through specific credit lines and conditions for this purpose), provided evidence of the lack of a similar national product. Accreditation of machinery and equipment To be financed by BNDES funds, machinery, equipment, systems, and components must be registered in the bank’s Computerized Supplier Registration (CFI) and must 83 present a minimum nationalization index of 60% in value and weight, calculated according to criteria defined by BNDES, or comply with the Basic Productive Process (PPB). New goods, supplies, software, and services can be financed through the BNDES Card to MSMEs. The BNDES Card has its own accreditation system. The accredited items and accreditation information can be found on the BNDES Card Operations Portal. Non-eligible items Non-eligible sectors:  Arms trade;  Motels, saunas, and spas;  Gambling;  Banking/financial activity, except for the support of microcredit. Non-eligible projects:  Developments in the mining sector that incorporate basic process of mining;  Social actions and projects included with tax incentives; and  Real estate, such as residential buildings, commercial buildings for resale, commercial enterprises for office rentals, timeshares, hotel residences, and housing developments. Non-eligible items:  Land acquisition and expropriation;  Any expenses involving remittance of foreign currency, including franchise fees paid abroad; and  Purchase of animals for resale. Types of operations Beneficiaries may request funding directly from BNDES (direct support) or through accredited financial institutions (indirect support or on-lending). The type of support depends on the purpose and value of funding. In indirect support/on-lending, partner financial institutions to BNDES act as intermediaries in providing financing and assuming the credit risk (risk of non-payment by the customer), completely or in part. As BNDES does not have branches, on-lending allows resources to reach beneficiaries in all Brazilian municipalities through financial institutions. Usually on-lending is used to support all financing operations for isolated purchases of machinery and equipment; lower funding amounts – up to R$20 million; the implementation, modernization, and expansion of projects; and other initiatives. Above R$20 million, beneficiaries can deal directly with BNDES. In specific cases, some credit lines and programs allow direct support on loan amounts below R$20 million. 84 Indirect support/on-lending The beneficiary searches for a BNDES-accredited financial institution (financial agent). It is important to specify the investment amount, where items (spending) the funds will be used, the purpose of the investment, and its location. The accredited financial institution will review the necessary documentation, examine the possibility of extending credit, and negotiate the financing conditions and guarantees. BENEFICIARY In indirect operations, the analysis of the financing is done by the accredited financial institution, which assumes the non-payment risk of the operation. Therefore, the institution may accept or reject the application for credit. It also negotiates with the client on the terms of financing, respecting certain rules and limits set by BNDES (required term of payment and guarantees). There are two types of indirect operations: Automatic: The beneficiary does not need a prior assessment by BNDES. The funding request is received and analyzed by the accredited financial institution, which then requests release of funds to BNDES. Automatic financing operations include transactions with an amount up to R$20 million. Non-automatic: A prior consultation to BNDES is required, with the accredited institution forwarding the application to the bank for analysis. In this case, the financing operations are individually assessed and approved by BNDES. The minimum value for this form of support is R$20 million. Direct support Direct support requests must be sent to the Department of Priorities (DEPRI/BNDES) through financing models request templates available on the BNDES website. LOAN 85 Direct financing for investment projects REQUEST is carried out through the BNDES Finem product. Some funding programs that target specific economic sectors or certain types of investments also offer direct support. To request direct support, it is necessary, in general, that the funding amount be over BENEFICIARY R$20 million. Both BNDES Finem and certain programs allow, in some specific cases, direct support for funding values below this limit. Interest rates The composition of the interest rates applicable to the beneficiary varies depending on the type of support. Indirect support/on-lending In indirect support operations, the final interest rate reflects the sum of the following items: Financial cost + BNDES fee (basic BNDES fee + financial intermediation rate) + fee of the financial agent (remuneration of the financial institution + credit risk rate) Direct support In direct support operations, the final interest rate reflects the sum of the following items: Financial cost + BNDES fee (basic BNDES + credit risk rate) Financial cost Reflects the cost of funding from BNDES in its various sources of funds. Determined by each product, credit line, or program; it may be composed of one or more rates – among others, TJLP and SELIC rates indexed to the IPCA (inflation). The rates can be varied over the financing contract, generating a monetary restatement of contracted amounts. Basic BNDES fee Reflects the remuneration of BNDES activity, covering administrative and operating expenses. The Basic BNDES fee established in each product, credit line, or program is a minimum benchmark. Credit risk rate Reflects the possibility of losses due to non-payment of part or all of the amounts owed by the beneficiary (default). The customer risk rating is defined by the BNDES credit policy as follows: a) For transactions secured by bank guarantee, the credit risk rate will be 0.5% per year. 86 b) For operations with states, federal districts, and municipalities, the credit risk rate will be 1% per year. c) No credit risk rate will be charged in transactions where the credit risk is assumed by the union. In indirect operations, the fee of the accredited financial institution covers the credit risk because this lender bears the risk of the operation. Financial intermediation rate Reflects the systemic risk of accredited financial institutions; i.e. the possibility of BNDES suffering losses due to the crisis in the financial system. It is limited to 0.1% per year for MSMEs and 0.5% per year for larger firms. Accredited financial institution remuneration (fee) Reflects the credit risk assumed by accredited financial institutions in indirect operations as well as the remuneration of its activities. The remuneration is determined at the sole discretion of the financial institution at the time of the transaction, and its value is negotiated between the institution and the client. Other fees/charges In addition to the interest rates associated with the credit lines and programs, BNDES may apply fees and charges for services rendered (see BNDES’ website for further details). There is also a fee charged for not using the outstanding balance of the financing contract, called charge by credit reserve (0.1% for 30 days or incident fraction of the value of credit or unused balance). Maximum BNDES participation and terms The maximum contribution corresponds to the limit on the portion that BNDES may finance in the total amount of the items that can be purchased (and is, therefore, characterized as a percentage of the value of eligible items). It is defined by each product line or funding program. 87 Note: Bankable investments, which are paid to BNDES by the customer before the grant application protocol, may be considered in calculating the contribution of “own resources� and should be part of the sources for the project, as follows:  For micro firms, bankable investments paid in the 12 months prior to the grant application protocol may be considered in calculating the contribution;  For other firms, bankable investments paid within six months prior to the protocol may be considered in calculating the contribution. As for funding term (maturity), this will be determined according to the beneficiaries’ ability to pay, the firm, and the economic sector the firm belongs. Guarantees In indirect operations, guarantee requirements are negotiated between the accredited financial institution and the beneficiary. In direct operations, beneficiaries must provide collateral (such as mortgage, pledge, fiduciary property, receivables, etc.) and/or personal guarantees (such as a security or bond). In general, BNDES requires real guarantees of 130% on the financed amount, but the rate may be reduced to 100% when the beneficiary demonstrates a risk-rating level higher than the minimum established at the discretion of BNDES and meets the following conditions:  Public firm with shares traded on the São Paulo Stock Exchange (BOVESPA), preferably listed on the Novo Mercado, or at levels 1 and 2 of corporate governance;  BNDESPAR equity interest because, through the shareholders' agreement and/or participation in similar representative board of directors or committee, BNDESPAR effectively participates in the strategic decisions of the firm; or  Submits financial statements verified by an independent auditing firm, registered with the Securities and Exchange Commission. In the case of exports, through the BNDES Exim product, the beneficiary may provide guarantees in banks overseas. Investments Guarantee Fund - BNDES FGI BNDES FGI is an instrument used to complement guarantees of indirect financing operations, with the main objective to helping MSMEs as well as individual entrepreneurs and self-employed truck drivers obtain credit. It also allows financing to have better conditions, with longer maturities, lower entry requirements, and lower interest rates. For a loan with the guarantee of BNDES FGI, the beneficiary looks for a bank authorized to operate with the fund's guarantee. The cost to use the BNDES FGI guarantee is called the Guarantee Grant Fee (ECG), and its size depends on the amount financed, the percentage guaranteed by the fund, and the maturity of the contract. 88 Annex 7B – BNDES New Operational Policies On January 5, 2017, BNDES announced its new operational policies with the criteria for approval of new financing and the conditions for future loans. With this annoucement, the bank concluded the process of reviewing its operational policies. New conditions for airport and road modalities and for sanitation, mobility, and energy has been established in September 2016. The new policies reflect the changes in BNDES’ performance in its role as inducer of sustainable development and the adoption of best practices in supported firms. The priority is to grant greater incentives, with TJLP financing, to investments with returns to society superior to those obtained by private investors, reconciling support for projects that are relevant to the recovery of growth with significant social returns, regardless of the sector in which they originate. The changes are expected to contribute to increased productivity and competitiveness of firms, economic growth, and job creation. They are also expected to (i) increase transparency in funding criteria; (ii) improve project management; (iii) simplify forms of support, with consolidation of programs and credit lines; (iv) become more agile in lending processes; (v) provide feedback of the bank's activities through the measurement and evaluation of projects; and to (vi) strengthen governance in BNDES- supported institutions. Operational policies will be reviewed annually. The transition aims to ensure that all funding conditions are focused on the types of projects and not the sectors. The new financing conditions begin to reflect attributes/qualifiers of supported projects and no longer the sectorial logic the bank has been using. This is a relevant change that reflects a horizontal performance of BNDES in its operational policies, affirming the bank's priority of financing projects that present benefits to society and not only to investor/borrower. The change is in line with the process of convergence among the different sectors, which makes it increasingly difficult to define boundaries and, therefore, use sectoral criteria in the granting of credit. Highlights for the new operational policies include:  Maximum BNDES financing participation: 80% of the investment;  Limitation on the payment of dividends and interest on equity above 25% in financing, with 50% or more in TJLP;  Expansion of access to government capital with direct operations (without financial agent intermediation) for financing starting at R$10 million;  Expansion of access to credit;  Expansion of access to guarantees;  Maximum term for acquisition of machines and equipment extended from 60 to 120 months. 89 PRIORITIES Investments in education, health, innovation, export, SMEs, and the environment, as well as infrastructure projects, are priorities. The projects that fit these qualifiers will receive better financing conditions (interest and terms). As a result, projects from different sectors will receive similar conditions as long as they fall under the same concept of defined qualifiers. Similar projects can be treated differently depending on their environmental impact. An example is the production of diesel engines in relation to the production of the same biodiesel equipment. BNDES’ emphasis on supporting environmentally clean projects has already been reflected in ending financing for coal-fired power plants; with the new measures, it is now present in the larger portion of TJLP credit given to investments with green technology. Hybrid, electric, or clean-fuel buses and trucks, for example, will have up to 80% TJLP financing. Financing for the commercialization of the same diesel-powered vehicles will be a maximum of 50% in TJLP in 2017, decreasing over the next two years to a maximum of 40% in 2018 and 30 % In TJLP in 2019 (for large firms). TJLP TJLP financing will have a greater selectivity to ensure better conditions for investments with relevant impacts on job creation, productivity increases, and improvements in the the population’s quality of life. Support for TJLP-funded projects will be conditional on generating economic, social, environmental, and regional benefits. MONITORING & EVALUATION To improve the measurement of the new impacts that BNDES hopes to achieve, the bank created a Monitoring and Evaluation Department. All projects will have a “results framework,� which will be previously defined goals to be achieved in financed projects. These goals will be measured and, at the end, the project will have its impact assessed. The bank will also use external evaluation services for large-scale infrastructure projects (financing over R$1 billion), a practice already adopted by other international development banks, and for projects in other sectors with loans exceeding R$500 million. REVIEW OF PROCESSES Funding processes are being reviewed and simplified, with more intensive use of technology. With this, the bank seeks to reduce the internal-processing time, giving greater agility to the operations. KEY STRATEGIC GUIDELINES 90  Infrastructure - Participation remains relevant, with emphasis on sanitation and transportation projects due to their great socio-environmental externalities and impacts in increasing the country's competitiveness and productivity;  Industry and Services - BNDES maintains its support to the industry, focusing on initiatives aimed at increasing productivity, competitiveness, innovation, and technology diffusion. The support will be horizontal, without distinction of sectors, but with a focus on the project;  Export - Emphasis on the insertion of Brazilian firms into global value chains, stimulating productivity and competitiveness;  Privatization - BNDES will act as the structuring body for the concession or privatization of federal and state assets. In this role, it will bring new financiers to make viable operations;  Strengthening capital markets and corporate governance - Encouraging the development of Brazilian capital markets through instruments, such as debentures and funds, and promoting better corporate governance practices;  Environment - Emphasis on alternative energies and environmental protection. Priority for highly effective projects that combine impact dimensions and economic, social, and environmental sustainability;  Regional development - Objective is to increase BNDES presence in territories with large shares of the low-income population and the North and Northeast regions. MAIN OPERATIONAL POLICIES CHANGES 1 – New credit lines for financing BNDES now has two credit lines for direct and indirect non-automatic financing of major projects in the Brazilian economy – the “incentivized line� (Linha Incentivada) and “standard line� (Linha Padrão), both subdivided into incentive A and B and standard A and B. Financing for infrastructure projects and indirect automatic financing are not included in the two new lines. The simplification of BNDES operational policies resulted from the consolidation of the various financing instruments. The result was greater transparency in the bank's various available credit options. In addition to eliminating overlaps of programs, products, and credit lines, the merger allowed for greater synergy and use of resources. Incentive Line - With the creation of this line, BNDES makes explicit the investments considered priorities because of their greater positive impact on society. Ooperations included in the incentivized line A will have the bank’s lowest cost of financing, with a maximum of 80% of TJLP; investments in incentivized line B will have a maximum of 60% in TJLP. Standard Line - This line covers all the projects not included in the incentivized line – i.e., those with less expressive social returns. Standard A will provide financing of up to 91 30% at the cost of TJLP. Standard line B operations will not have access to TJLP credits and will receive resources at market rates. BNDES FINEM // Financing equal to or greater than R$20 million Credit Maximum TJLP Qualifiers Lines Participation* Investment Projects Innovation Environment A 80% MSMEs projects Education, health, safety, and social assistance (public Incentivized services) Modernization of Public Administration Territorial development of states, federal districts, and municipalities Education, health, and culture (private services) B 60% Technology diffusion industry and services Knowledge-intensive industry and services Food production and biofuels A Expansion of productive capacity 30% Standard B Other investments 0% * It is possible to complement the financing up to 80% of the investment using market rate. Infrastructure Credit Line - During 2017, this credit line will partly continue with a sectoral logic, although the energy sector has already been advanced by differentiating the financing conditions for solar, hydro, and wind. New conditions are being announced for: project financing railways, waterways, transport and distribution of gas and biofuels, oil transportation, ports, and information and communication technology. The current disclosure complements the already announced conditions for sanitation, energy, highway, and airport projects. BNDES FINEM // Infrastructure Maximum TJLP Participation* Segments From To Sanitation** 80% Solar energy ** 70% Mobility - rail and BRT system ** 80% 80% Logistics - railways and waterways 80% Gas transportation 70% 92 Transport of biofuels 70% Wind energy, biomass, cogeneration, SHPs ** 70% 70% Logistics – ports 70% 60% Gas distribution Hydroelectric power (UHEs) ** Thermoelectric power and natural gas (UTEs) ** 70% 50% Highway - 1st cycle ** Mobility - other segments ** Airports - 1st cycle ** 40% 40% Transportation of oil 70% 30% ICT (Information and communication technologies) 25% Distribution of electricity ** 35% 25%*** Transmission of electricity ** 50% 0% * It is possible to complement the financing up to 80% of the investment using market rate, except Infrastructure - PPI. ** In the case of infrastructure - PPI, there may be supplementation with debentures, respecting the limit of maximum participation. *** Participation in TJLP conditioned to equal or higher market share. 2 – Strengthening corporate governance BNDES will encourage financed firms to adopt good corporate practices. The effort should cover issues related to improvements in firms intangible assets – among others, governance, transparency, social and environmental management and practices, human capital, innovative skills, and relationships with customers and suppliers. The initiative extends credit operations to BNDESPAR's successful experience in creating value in the capital market by encouraging best governance practices. 3 – Change in the size classification of MSMEs The change in the MSMEs size classification – from R$90 million to R$300 million in annual gross operating revenue – will increase this segment’s access to credit. It is estimated that around 1,500 firms will be able to obtain financing under BNDES’ new size classification. In terms of MSMEs, here are some highlights for better access and simplification of procedures:  Change in the size classification of up to R$90 million for up to R$300 million of gross operating revenue;  Access to financing of up to 80% of the investment in TJLP;  Agility in the concession and improvement in the processes, a reduction from 30 to two days until the end of 2017;  BNDES Card: expansion of the credit limit from R$1 million to R$2 million;  Extension of FGI guarantees;  New distribution channels (second half of 2017); 93  Launch of the BNDES Agro Card for rural producers, including households (second half of 2017);  Expansion of access to working capital associated with purchases of machines and equipment;  Launching of the BNDES MSME app (first quarter of 2017);  Launching of an Internet portal for entrepreneurs (first half of 2017). 4 – Dividend distribution limitation The new policy establishes restrictions on the payment of dividends – in addition to the legal minimum of 25% – on the part of beneficiaries of TJLP loans equal to or greater than 50% of total financing obtained. If the proportion of credit exceeds 50% of the total in market cost, there will be no restriction on the payment of dividends. One of the objectives is to ensure that BNDES financing generates additionalities in investments – i.e., to drive good projects that would not happen without the bank’s resources. The decision assumes that by accessing the bank’s credit, investors do not have their own resources to finance the project and, therefore, cannot distribute dividends beyond the legal minimum percentage. 5 – Working Capital – Progeren The banking system’s reduction of credit supply for working capital led BNDES to expand the “Support to Strengthening the Generation of Employment and Income (BNDES Progeren)� line. Suppoer is now also available in the direct modality, without the intermediation of financial agents. The new line has a budget of R$5 billion and is effective, in principle, until the end of 2017. The minimum amount of financing is R$10 million per operation. The new modality seeks to preserve economic activity and jobs in firms with limited access to short-term credit. The line can also be accessed by anchor companies to finance the development of supply chains and franchisees. BNDES PROGEREN (DIRECT AND INDIRECT) // Working capital financing Firm Financing Grace Firm Size Financial Cost Term Limit Period MSME (up to R$90 million of gross operating revenue, or 100% TJLP R$70 million or GOR) 20% of firm’s GOR Up to Medium Sized (GOR between from previous Up to 24 50% TJLP + 60 R$90 million and R$300 fiscal year months 50% market months million) (whichever is Large (GOR above R$300 lower) 100% market million) 94 6 – Receivables as collateral BNDES may accept the provision of collateral on receivables, including credit card receivables, to increase access to credit for segments with a strong employment impact that face constraints in obtaining financing (since having the actual guarantees is usually required). This analysis will consider the risk of the firm/operation and the predictability of its sales revenue. BNDES AUTOMATIC (operations with values less than R$20 million) Consolidation of previous programs into four financing lines:  1 - Micro, Small, and Medium Enterprises, which will have priority financing of up to 80% in TJLP;  2 - Large Incentive Company, with BNDES participation of up to 60% in TJLP if the project is in the incentive segments (energy, education, health, sanitation, food production, capital goods, and production of biofuels);  3 - Large Standard Enterprise, with maximum participation of 80% at market rates, valid for all projects not included in the incentivized line;  4 - Emergency Line, aimed at the economic resumption of firms located in municipalities affected by natural disasters, with 100% financing of TJLP investment. These changes took effect from the issue of a circular letter to financial institutions in early 2017. During the transition process, there will be no discontinuity of ongoing operations. BNDES AUTOMATIC (INDIRECT) // Financing less than R$20 million Maximum Grace Term Credit Line TJLP Period Conditions Participation* MSMEs 80% Incentivized* up to 240 60% Large * months up to 36 Standard 0% months Emergency Line (in case of public 100% up to 90 months calamity) * It is possible to complement the financing up to 80% of the investment using market rates. ** Incentives for large companies: sanitation, renewable energy, railways, waterways and ports, education and human health, agriculture, livestock, fisheries, aquaculture, food products manufacturing and storage of items from these sectors, biofuel production, and capital goods (except the manufacture of motor vehicles). BNDES FINAME The financing term has been extended to 10 years, up from the previous five years. The financing of machinery and equipment will have only three lines: acquisition of capital goods, production, and modernization. FINAME will incorporate the FINAME 95 Agrícola product and extinguish FINAME Leasing. The cost will be fully in TJLP, and the maximum BNDES participation will vary according to the priorities defined below.  For acquisition of capital goods by large firms, the standard condition becomes the maximum participation of 60% in TJLP. The incentive conditions (maximum participation of 80% of TJLP) will be allocated exclusively to energy-efficient goods, including hybrid, electric, or clean-fuel buses and trucks.  In the case of large firms’ acquisition of buses and diesel-powered trucks, the bank will gradually decrease its maximum TJLP participation from 50% in 2017 to 40% in 2018 and at most 30% in 2019. The objective is to encourage purchases of trucks and buses that are less polluting and use cleaner fuels, such as electric and hybrid vehicles. The same measures apply to MSMEs, but with different conditions for the gradual reduction of participation in TJLP financing. The bank will reduce the TJLP maximum for the purchase of diesel-powered buses and trucks from 80% in in 2017 to 70% in 2018 and 60% in 2019. Technology will maintain the maximum participation of 80% in TJLP. BNDES FINAME (INDIRECT) // Financing of machinery and equipment Credit Lines Maximum TJLP Participation* Term BK - Purchase and Commercialization 80% in 2017 Buses and trucks (diesel) 70% in 2018 MSMEs 60% in 2019 Other capital goods 80% Energy-efficient capital goods; Hybrid, electric, or clean 80% up to 120 fuel-powered trucks and months Large firms buses Other capital goods 60% 50% in 2017 Buses and trucks (diesel) 40% in 2018 30% in 2019 BK - Production MSMEs 80% up to 30 months Large firms 60% BK - Modernization Up to 60 MSMEs 80% months for owner; Up to 30 Large firms 30% months for service provider * It is possible to complement the financing up to 80% of the investment using market rates. Grace period: 24 months 96 Annex 8 - Data Description The BNDES contract-level data provide information on loans signed for (i) first-tier loans and second-tier non-automatic products; and (ii) second-tier automatic products. While data are available for contracts signed from 2002 to 2016, we have constrained our analysis to 1,301 non-automatic contracts signed in 2015. Available data for 109,776 automatic contracts do not provide information need to calculate the size distribution of firms and an equivalent level of sectoral disaggregation (they only record which of the following products a loan is linked to – FINAME, FINAME Agricola, FINAME Leasing, BNDES Automático). Both data provide information on loans interest rates, loans basic interest rate indexes (whether it was TJLP, SELIC market rate, fixed rates or others), warranty type, loan value, borrower identification, date and value of loan contract, terms and grace period, borrower’s economic activity, and second-tier financial intermediary. 97 Annex Table 3.1: Distribution of BNDES Disbursements by Level of Externalities and Firm Size 2015, in R$ billion and % Large and Share of Share of SME med-large All large and SMEs companies med-large companies Activities with clear positive externalities 3.1 27.19 30.34 10% 90% Water sewage and solid waste 0.2 0.99 1.15 14% 86% Health, social services 0.7 0.80 1.52 47% 53% Drugs 0.1 0.39 0.46 15% 85% Education 0.3 0.52 0.78 33% 67% Arts, culture, and sports 0.2 0.01 0.17 94% 6% Urban mobility a 0 8.50 e 8.50 0% 100% Renewable energy b 0 7.90 e 7.90 0% 100% Low-carbon agriculture c 0.22 0.57 f 0.80 28% 72% Innovation a 1.55 3.94 f 5.54 28% 72% Public administration 0.0 348 3.52 1% 99% Activities with externalities to be ascertained 17.19 21.68 38.87 44% 56% Electricity and gas 0.50 13.90 14.40 3% 97% Land transport 4.86 4.79 9.65 50% 50% Waterborne transport 0.06 0.83 0.89 7% 93% Air transport 0.00 1.02 1.02 0% 100% Agriculture and Fishery 11.76 1.15 12.91 91% 9% Activities with no clear externalities d 18.76 47.97 66.73 28% 72% Total 39.10 96.85 135.94 Share 28% 72% 100% Source: BNDES Notes: (a) BNDES press release (http://www.bndes.gov.br/wps/portal/site/home/transparencia/estatisticas- operacionais/desempenho/desembolsos-2015); (b) Data from Folha de São Paulo, 21/01/2016 (link http://www1.folha.uol.com.br/mercado/2016/01/1733141-energia-e-infraestrutura-devem-receber-r-35-bi-do- bndes-em-2016.shtml); (c) data from INOVAGRO and ABC BNDES programs; (d) according to BNDES, disbursements in 2015 reached R$6 billion and were mostly directed to electronics, air transport, and drugs; (e) disbursements for urban mobility and renewable energy activities are assumed to be directed to large and medium-large companies; 72% of low carbon and innovative activities are assumed to be performed by large and medium-large firms. 98 Annex Table 3.2: Distribution of BNDES Loans by Type of Interest Rate and Level of Externalities Non-Automatic Loans, 2015 R$ Mi Loans Share of Share of Loans Loans Share of Share of Loans indexed loans Share loans with with Total loans loans indexed by SELIC Grants with of with fixed other Loans indexed with by TJLP market fixed Grants other rate* indexes by TJLP SELIC rate rate indexes Activities with clear positive externalities 16252 65 1133 300 239 17990 90% 0% 6% 2% 1% Water, sewage and solid waste 1227 22 103 42 1394 88% 2% 7% 0% 3% Health, social services 423 3 457 57 940 45% 0% 49% 6% 0% Pharmaceutical products 19 19 100% 0% 0% 0% 0% Education 67 18 12 98 69% 0% 19% 12% 0% Arts, culture and sports 32 32 0% 0% 0% 100% 0% Urban mobility 6609 35 325 6969 95% 1% 5% 0% 0% Renewable energy 7509 4 148 10 174 7846 96% 0% 2% 0% 2% Public administration 398 82 189 23 692 57% 0% 12% 27% 3% Activities with externalities to be ascertained 5449 156 2139 2929 10672 51% 1% 20% 0% 27% Electricity and gas 4087 140 2028 1014 7269 56% 2% 28% 0% 14% Land transport 646 646 100% 0% 0% 0% 0% Water transport 1844 1844 0% 0% 0% 0% 100% Air transport 458 23 480 95% 0% 5% 0% 0% Agriculture and fisheries 258 16 89 70 434 60% 4% 20% 0% 16% Activities with no clear externalities 8714 2613 3169 258 2786 17541 50% 15% 18% 1% 16% Note: * Loans with fixed rates range from 0 to 10% interest rate per year. 99 Annex Table 3.3 – Rationale or Grounds for Establishing Level of Sectoral Externalities48 Activities with clear positive externalities Water, sewage and solid waste Public health; productive spillovers Environmental related activities Public health; global warming Health Services and Drugs Public health; productive spillovers Education Productive spillovers and equity Sports, arts and cultural activities Productive spillovers and crime reduction Urban mobility Productive spillovers Renewable energy Public health and productive spillovers Public administration Productive spillovers and equity Activities subject to a rule of reason appraisal Electricity and gas Productive spillovers Land, waterborne and air transport49 Productive spillovers Activities with no significant externalities Extractive industry Beverages; rubber and plastics; cellulose and paper; clothing and accessories; coke, oil and fuel; leather, artifact and footwear; informatics, electronic and optical equipment; tobacco; printing; wood; maintenance, repair, installation; machinery, electric appliance; machines and equipment; metallurgy; non-metallic minerals; furniture; other transportation equipment; metal products; food products; other products; chemicals; textile; vehicles, trailers and bodywork Accommodation and food; aux transport and delivery activities; finance and insurance; real estate, professional and management activities; trade; construction; information and communication; telecommunications; other services 48 See link with the description of all the CNAE economic activities in http://cnae.ibge.gov.br/?view=divisao&tipo=cnae&versao=9&divisao=52. 49 The transport-related activities division was not included because it includes activities related to the movement and storage of cargo, either before or after its transportation, or between transport segments of different modalities, the auxiliary activities of the various modes of transport involving the operation of the support infrastructure on the highways, railways, airports, ports, bridges, tunnels, etc. and transportation agency activities. This division also includes activities related to the organization of cargo transportation. Such activities do not present clear positive externalities. 100