Sri Lanka - Third Development Finance Corporation Project

DOCUMENT OF INTERNATIONAL DEVELOPMENT ASSOCIATION Not For Public Use Report No.p-1657-CE REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF SRI LANKA FOR A THIRD DEVELOPMENT FINANCE CORPORATION OF CEYLON PROJECT June 12, 1975 This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report.  CURRENCY EQUIVALENTS (as of end 1974) Parity Rate US$1 = Rs 6.69 Rs 1 - US$0.149 Rs 1 million = US$149,000 FEEC Rate US$1 Rs 11.03 Rs 1 = US$0.090 Rs 1 million = US$90,000 The Sri Lanka Rupee, which had been linked to the U.S. dolLar from November 6, 1971, was re-linked to the Pound Sterling from July 10, 1972, onward at a parity rate of R 1.00 = Rs 15.60. Parity rates with all other currencies are established from time to time by the Central Bank. The Central Bank of Ceylon makes foreign exchange available for certain categories of imports through sale of Foreign Exchange EntitLe- ment CertifIcates (FEECs) for which a premium is charged. The same premium is offered to exporters on foreign exchange earnings from the sale o:r non- traditional goods. The net revenue from the sale of FEECs is credited to the Government's Revenue Account. The premium is presently fixed at 65 per- cent of the Rupee parity rate and results in an exchange rate of Rs 11.03 = US$1. This rate currently applies to about 20 percent of merchandise exports, about 60 percent of merchandise imports and to most invisible transactions with the exception of aid receipts. FISCAL YEAR Government: January 1 to December 31 DFCC : April 1 to March 31  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF SRI LANKA FOR A THIRD DEVELOPMENT FINANCE CORPORATION OF CEYLON PROJECT 1. I submit the following report and recommendation on a proposed development credit to the Republic of Sri Lanka for the equivalent of US$4.5 million on standard IDA terms to help meet the estimated foreign exchange requirements of the Development Finance Corporation of Ceylon (DFCC) over the next two years for lending mainly to export-oriented industries and tourism. The proceeds of the credit would be relent to DFCC at 8.5% interest per annum with repayment according to the combined amortization schedule of sub-projects up to a maximum of 15 years. PART I - THE ECONOMY 2. The latest economic report, "Recent Economic Developments and Current Prospects for Sri Lanka" (Report No. 622a-CE, February 20, 1975) was distributed to the Executive Directors on February 28, 1975. Country data are provided in Annex I. 3. The economic difficulties that have beset Sri Lanka since the late 1950's can be traced principally to two basic characteristics of the country's economic and social system: first, the specialization of produc- tion in three export crops -- tea, rubber and coconut -- and, secend, a political commitment to the welfare state. This commitment found its ex- pression in two policy tenets which for the past quarter century all Ceylon- ese governments have followed in varying degrees: the supply of mass con- sumption goods, principally food and textiles, at low prices, and the pro- vision of public services -- mainly education, health and transport -- free of charge or substantially below cost. 4. Sri Lanka's progress in social fields has been commendable. Public services are widely available at little or no cost and a more equal distribu- tion of income has been achieved by promoting high wages, subsidizing serv- ices, and distributing food free or below cost. The welfare state, however, was based mainly on the earnings of the external sector. Unfortunately, Sri Lanka experienced a pronounced weakening in the market for tea and rub- ber beginning in the mid-fifties. As a result, there has been little eco- nomic growth in the past two decades. Between 1969-70 and 1972-73 GNP in- creased at an annual rate of about 2.3% and gross income at a considerably lower rate because of a sharp decline in terms of trade. With population growing at a rate of 2% p.a., there was a decline in average annual gross income per capita. This stagnation has led to high unemployment. In 1974, 17% of the labor force were unemployed, and the number is increasing; nearly two-thirds of the unemployed have been educated beyond the ninth grade. In addition, underemployment is also high.  - 2 - 5. Against this background Sri Lanka has had to face in the past year and a half the shocks of sharply escalating costs for imported food- stuffs, which are expectied to absorb nearly two--thirds of the country's earnings from merchandise exports in 1975, a doubling of the oil import bill and sharp increases in the prices of imported raw materials, spares, and investment goods. Sri Lanka has emerged as one of the developing countries most seriously affected 'by the recent worldwide price inflation. 6. The Government responded in October 1973 by doubling the price of petroleum products, raising transport tariffs by 50% or more and making adjustments in the amounts and prices of food supplied at subsidized rates so that the cost of subsidies would be reduced. Additional measures were taken in July 1974, the most important of which were an increase in the price of flour and a virtual ban on the sale of off-ration sugar. However, as described below, the food subsidy adjustments have not proved adequate to offset the sharp increase in import prices. 7. Although stagnant, agriculture remains by far the most important sector, accounting for about one-third of GDP and employing about 2 million people or half the total labor force. Tea, rub'ber and coconuts are the principal export crops, contributing 75% of the value of exports and 25% of total employment. On a per capita basis total production of paddy and tree crops has declined since 1970. An exception to this general record of poor agricultural performance has been the success achieved in promoting production of several subsidiary food crops. Government policy and institutional short- comings have seriously affected growth of agricultural output. Among the problems that have impeded progress are inadequate attention to extension, marketing and credit services, excessive reliance on government controls and subsidies, a poor investment climate, diffused institutional responsibilities and consequent lack of a coordinated approach to the problems of the sector, depressed profits and returns on investment, and insufficient foreign exchange for necessary imports. 1/ While recently a number of positive steps have been taken in the case of food crop production (largely in the form of a crash production program), further measures to resolve these problems in both food and tree crops subsectors are essential if agriculture is to achieve a significant degree of momentum. 8. The recent sharp rises in import prices, particularly of rice, flour, sugar, petroleum and fertilizer, created serious public finance probfems and, as indical:ed above (paragraph 6), the Government introduced a series of measures to reduce the budgetary cost of the food subsidy pro- gram. It also reacted to the unexpected cost increases of imported raw materials by allowing some of the public corporations and enterprises to pass on these increases to their customers. 1/ For detailed discussion of the agricultural sector, see the latest sector report, "Republic of Sri Lanka - Agricultural Policy and Program Review" (Report No. 579a-CE, February 19, 1975), distributed to the Executive Directors on February 28, 1975.  - 3 - 9. Nevertheless, these constructive -- and politically difficult -- measures were inadequate to bring about any significant improvement in the budgetary situation in 1974. The net food subsidy was Rs. 925 million, more than twice the original estimate, because of the increase in commodity prices. Other current expenditures have also risen because of further wage increases in the public sector. Although current revenues were more buoyant than expected, they were not enough to make up for the rise in current expenditures. 10. The outlook for the 1975 budget is also not very promising. The current account surplus, estimated at Rs. 15 million would, if real- ized, provide only a negligible contribution to the financing of the capital expenditure budget. 11. Capital expenditures are now estimated to have risen in 1974 by about Rs. 140 million (12%) compared to 1973. Considering the likely rate of price increase, this probably implies a fall in real terms. Because of the lack of Government savings, capital expenditures in 1974 have been financed largely from borrowing, estimated to have risen to about Rs. 1.6 billion, 13% above the 1973 figure. About 60% was borrowed domestically, mainly from the state savings bank and pension and insurance funds, and the remainder abroad. In 1975 borrowing will increase to over Rs. 2 billion, of which the share to be borrowed externally will go up from 40% to 50%. A worrisome aspect of this picture is the rapid rise in the external debt service burden, due to increasing resort to short-term borrowing. 12. Sri Lanka has not been able to take full advantage of rising world commodity prices because of the difficulties faced in increasing the volume of exports of her traditional commodities. Replanting has been particularly inadequate despite a considerable increase in tea prices in 1974 and favora- ble price expectations for 1975; the volume of tea exports actually declined by 11% in 1974 and is expected to remain at this level in 1975, the lowest since 1960. Rubber exports responded well to sharp price increases in 1973, but, despite further price improvement, the volume of rubber exports in 1974 declined by 10%. Only a small increase in rubber exports is expected in 1975. The exceptionally low volumes of exports of coconut products in 1973 and 1974, which was caused by severe drought, limited the benefit from the very high world prices, particularly in 1974. Although coconut exports are expected to increase significantly in 1975, the foreign exchange earnings from this source-are likely to remain at the 1974 level because of declining prices. A significant development in 1973 was the sharp increase in the share of non-traditional exports. An encouraging feature of the Government's policies towards exports in 1974 was the increased emphasis on incentives to counter adverse effects of increasing input costs and to promote diversification of exports. To this end, mostly fiscal and financial, rather than price, incentives were used. 13. The composition of imports has undergone significant changes in recent years. Because of recent increases in prices of food, petroleum and fertilizer, their share of the import bill increased to 65% in 1974 compared to 47% in 1972. The 1975 import program allows only a 15% increase for  - 4 - imports other than food, petroleum and fertilizer. Since this increase is likely to be more than absorbed by price increases, the volume of capital equipment and raw materials imports may decline during 1975. 14. The composition of capital movements showed significant changes in 1974 compared to the earlf 1970's. The share of the current account deficit financed by grants and long-term loans has declined sharply. Sup- pliers' credits and short-term loans, which were negligible in 1971 and 1972, rose to $83 million in 1974. One significant consequence of these develop- ments is the increasingly unfavorable maturity structure of Sri Lanka's external debt. Debts with one to five vears maturity increased from 2% of total debt at the end of 1973 to over 10% by end-June 1974. For 1974, owing to the relatively sharp increase in foreign exchange earnings mainly as a result of price increases, the debt service ratio for debt of over one year maturity remained just below 13%, almost the same as in 1973. In 1975, however, the debt service ratio is projected to rise to 17%. 15. The Government's balance of payments projection for 1975 indi- cates that Sri Lanka would need a net capital inflow of about $300 million in order to finance the current account deficit. Taking into account re- payment obligations on all debt, short and long-term, the gross foreign exchange requirement is a little over $500 million. Spillover from past commitments and prospective disbursements under 1974 pledges is expected to be about $115 million, leaving a financing gap of about $385 million to be covered by new commitments made or to be made during the present calendar year. 16. An Aid Group for Sri Lanka, for which the Bank acts as the Chairman, was formed in 1965 and has held eleven meetings. At the eleventh meeting held in Paris in April 1975 the members recognized Sri Lanka's need for generous assistance, particularly in agriculture, and gave indications of assistance of over $200 million for 1975, compared with aid indications of $163 million and $67 million made at the mneetings in 1974 and 1973, respectively. 17. There remains, therefore, a substantial financing gap. It is hardly possible to cut the additional finance requirement by reducing the current account deficit to any significant extent vwithout further serious- ly disrupting the economy. The net external reserve position is so weak that no part of the additional financing can be expected to come from it. Since servicing of short-term indebtedness is now imposing a large burden on the payments position, it is essential to adopt policies to improve the balance of payments. It is important that the additional finance required should be obtained as far as possible in the form of fast disbursing assist- ance and on concessional terms.  - 5 - PART II - BANK GROUP OPERATIONS IN SRI LANKA 18. Since the beginning of its operations in Sri Lanka in 1954, the Bank Group has made seven loans totalling US$73.5 million and seven credits totalling US$49.6 million (net of cancellations) in support of thirteen projects. About 50% of Bank Group assistance has been for power, 35% for agriculture (irrigation and dairy development) and the remainder for DFC operations, highways, and most recently, a program credit (mainly imports of raw materials for industry). Three early power projects and the first DFC project were satisfactorily completed and the loans fully disbursed by 1970. A credit for highways was cancelled in 1970, after disbursement of US$0.6 million, at the request of the Borrower following Government's decision to make major changes in the scope of the project. The remaining nine loans and credits have all been made since 1968. Implementation of ongoing proj- ects has suffered delays, due in large part to the civil disturbances of 1971, but is proceeding satisfactorily at this time. IFC's only invest- ment in Sri Lanka, US$3.25 million Pearl Textile Mills, Ltd. (Ceylon), was made in January 1970 but cancelled the same year at the request of the Company. Annex II contains a summary statement of Bank Group operations as of April 30, 1975, and notes on the execution of ongoing projects. 19. The Bank Group's strategy is focussed on the agricultural sector. It is designed to help alleviate the foreign exchange constraint by support- ing measures to increase agricultural output, both for import substitution and export expansion, and also to help stimulate other foreign exchange earnings sectors, such as industry and tourism. A proposal for an agri- cultural development credit has recently been appraised and is being con- sidered for presentation to the Executive Directors in the first half of FY76. A project for the rehabilitation of existing irrigation schemes and the expansion of the Mahaweli Ganga Irrigation scheme (in part a follow-on project to Loan 653/Credit 174), which has been prepared with the assistance of the FAO/IBRD Cooperative Programme, has also recently been appraised and is being considered for presentation in FY76. A project for diversification of crops on lands under marginal tea cultivation, presently being prepared by the FAO/IBRD Cooperative Programme, is under consideration for FY77, together with a second land reclamation and drainage project and an agricul- ture credit project. 20. The Bank Group presently accounts for about 11% (and the Bank alone for about 7%) of Sri Lanka's total external debt outstanding and about 7% (with IDA negligible) of debt service. It is projected that the Bank Group's share in total external debt will decline slightly over the next three years (and the Bank's share alone to fall to less than 4%), while the Bank and IDA shares in the debt service will show a slight increase.  - 6 - PAIRT III - INDUSTRY AND TOURISM Indus try 21. The industrial sector contributes about 13% of GDP and provides employment for about 410,000 people or about 11% of total employment. In- dustrial activity is primarily directed towards meeting consumer demand and to supplying a modest range of engineering goods. In 1973, food processing represented 50% of total industrial value added and textiles 14%, compared with 11% for capital goods. 22. During 1973 and 1974 growth in the sector was negligible and there was very little new investment. This stagnation resulted mainly from the shortage of foreign exchange coupled with the slow overall growth in the economy and the uncertainty surrounding the role of the private sector. In recent years, industrial exports have assumed more importance. From a small base, export of industrial goods more than tripled between 1971 and 1973 (reaching $15 million), and recorded further gains, although modest, in 1974. Among items which have shown particularly high export growth were gemls, garments and fabrics, leather goods, vegetable oil products, rubber products (footwear, tires, etc.), processed sea food and some engineering goods. 23. The Government's strategy for industrial development places primary emphasis on reorienting industrial activity towards exports, promoting labor- intensive projects and encouraging the small scale sector. Because of the acute foreign exchange situation, priority is given at present to the pro- motion of exports. The recent growth in industrial exports has been in response to an elaborate system of incentives introduced by Government in the past few years. In particular, exporters are entitled to tax holidays and investment relief, as we Ll as a 65% premium over the official exchange rate for their export sales; thay can also retain 5%' of export sale pro- ceeds in foreign exchange fojr their own use. Exporters are given priority in obtaining foreign exchange allocations for their raw material imports. 24. Excess industrial capacity is a serious problem in Sri Lanka but its importance varies among industries and firms; it reaches more than 50% in some cases. The problem is attributed largely to the shortage of for- eign exchange, which makes it particularly difficult to import raw materials and spare parts, and to slow over-all growth of the economy. IDA made a US$15 rmillion program credit to Sri Lanka in September 1974 to ease the shortage of raw materials and spare parts; this credit has been fully disbursed. 25. Institutions in general have not played a rnajor role in financing industrial development in Sri Lanka, the larger part of financing coming from enterpreneurs' own funds. DFCC is the only institution specializing  -7- in providing long-tenn capital for private industry and the only one having direct access to foreign exchange. The Government intends to establish a National Development Bank (NDB) which would specialize in providing long- term capital to public sector enterprises while DFCC would continue financing private sector enterprise as well as moving gradually into small scale sector financing. Given the increasing importance of the public sector, the pro- posed NDB could be a vital mechanism for promoting industrial development. Tourism 26. The tourism sector in Sri Lanka has achieved a rapid growth since the mid-1960's. Tourist arrivals increased from 19,000 in 1966 to 78,000 in 1973, an average annual growth of 22%. This compares with an average increase of 13% for the South Asia region and 7% for the world over the same period. While the growth rate in 1974 has declined to an estimated 9% (85,000 arrivals) mainly because of the world-wide economic recession, this must still be regarded as a satisfactory performance when compared with the zero growth for world travel as a whole. Foreign exchange receipts from tourism more than doubled from US$7 million in 1972 to US$15 million in 1974. This expansion has been made possible by a substantial increase in hotel rooms, from 770 in 1967 to 1,890 in 1972 and 2,660 in 1974. Most hotels are privately owned and Government has supported their development through various fiscal incentives, including tax holidays for new hotels and investment relief for shareholders in hotel companies. About half of the total number of rooms are located at beach resorts on the West and South coasts and the balance are divided about evenly between Colombo and the inland ancient cities and the hill country. Western Europe is the major source of tourist traffic, accounting for about two-thirds of all arrivals. Visitor arrivals are quite seasonal, being concentrated from November to March. Average occupancy rates are therefore low, about 43%; however, as a result of relatively low investment and operating costs, hotel operations appear to be financially attractive. 27. The overall prospects for the tourism sector in Sri Lanka are reasonably good. Despite the effect of the world energy crises on world- wide tourism, a recent Bank mission which reviewed Sri Lanka's tourism sector estimates tourist arrivals to increase by 45% over the next three years reaching 122,000 in 1977. Currently there are 52 hotel projects with a combinad capacity of 2,690 rooms which have been approved by Government. If all of these projects are completed on schedule, Sri Lanka's total hotel capacity would expand to 5,350 rooms by the end of 1976. However, since Government expects to withdraw graded classification from 560 existing hotel rooms by 1977, the total number of rooms effectively available to the inter- national tourist trade in that year would reach 4,790. At the expected traf- fic level of 122,000 these hotels would operate with reasonable profitability at a 45% average occupancy in 1977. 28. Growth of Sri Lanka's tourism sector has occurred largely in the absence of guidance by appropriate hotel construction or operating stand- ards. It would therefore be desirable that the capabilities of the Ceylon  - 8 - Tourist Board, the Government agency responsible for tourism planning and development, be strengthened to provide these services. The Government has agreed that a tourism advisor will be employed by the Tourist Board, by December 31, 1975, for drawing up and administering a hotel construction and operating code, for hotel classification, and for planning and imple- mentation of tourism development programs (Section 4.02 of the draft Devel- opment Credit Agreement). The Government expects to obtain UNDP financing for this purpose. PART IV - THE PROJECT 29. The proposed project was appraised in June 1974 and incorporates the findings of the economic and tourism missions which visited Sri Lanka in December 1974. A report enti tled "Sri Lanka - Appraisal of a Third Development Finance Corporation of Ceylon Project" (No. 731-CE of June 11, 1975) is being distributed separately to the Executive Directors. Negotiations were held in Washington May 13-16, 1975. The Borrower was represented by Dr. Austin Fernando, Director of ExternaL Resources, Ministry of Planning and Economic Affairs, and DFCC by its Chairman, Mr. William Tennekoon. A credit and project summary is attached as Annex III. 30. The Bank has been closely associated with DFCC since 1967, when the Bank made its first loan of US$4 million to it. A second loan of US$8 million was made in 1969. The second loan was provided before the first one was fully committed in anticipation of a greatly increased industrial activity at the time. Hrowever, a change in Government in 1970 brought with it a different attitude towards the private sector which created uncertainty in the private investment climate. The Government cancelled some projects which its predecessor had approved, and some clients withdrew projects for which they had applied for financing from DFCC. As a result, utilization of the two loans slowed down considerably and the unutilizedl portion (US$1.8 million) of the first loan was cancelled as was part (US$5 million) of the second loan. Helped by Government's incentives to export industries and tourism, commitments under the remainder of the second loan picked up in 1973 anci were completed last December. Tlhere is scope for utilizing another US$4.5 million of foreign exchange over the next two years, mainly f'or export and tourism oriented activities. The proposed credit would bring total Bank Group assist- ance to DFCC to US$9.7 million net of cancellations. Ownership Role and Development Impact 31. DFCC was establishecd in 1955. It is a broadly owned company with 46% of the shares held by 289 private Ceylonese investors, 29% by 26 for- eign investors (mostly banks), and the remain>tg 25% by Government-owned institutions. DFCC's operations have undergeila wide fluctuations since FY70 reflecting changes in the private investrment climate. Its commitments of loans and investments rose sharply in the past two years (to an average of Rs 18 million a year) mostly because of an increase in tourism financing in response to new incentives offered by the Government. About half of  -9- DFCC's assistance has been allocated to food processing, chemicals, textiles, and tourism projects. The rest has been reasonably well diversified among various other industries. 32. DFCC's loans and investments have been of relatively medium and small size as have been the recipients of its lending. As at September 30, 1974, 60% of DFCC's operations represented individual loans and investments of less than Rs 0.5 million (US$77,000) and 82% were for individual loans and investments of less than Rs 1 million (US$155,000). DFCC's Act and Policy Statement were amended in 1974 to enable it to extend assistance to proprietorships, partnerships, and cooperatives, in addition to limited liability companies, and its minimum loan size was reduced from Rs 100,000 to Rs 75,000 (from US$15,500 to US$11,600) to enable it to finance smaller enterprises. There is no official definition of small-scale enterprise in Sri Lanka, but these have sometimes been defined in terms of enterprises whose fixed assets do not exceed Rs 200,000 (US$31,000). DFCC intends to start financing small-scale units of this size in the next two years, and it has been agreed that US$200,000 of the Credit would be specifically allo- cated for this purpose. DFCC intends to move slowly into this type of financing in view of its small staff and its limited experience in this field which requires close supervision and concentrated provision of ancillary services. It will collaborate with the Industrial Development Board (a statutory body under the Ministry of Industries) which undertakes feasibility studies of small industrial projects and provides technical services to such projects. 33. Lack of projects resulting from uncertainty in the private invest- ment climate in the country has principally constrained the development impact of DFCC. DFCC's efforts have focused on financially attractive projects with the intention of building a strong portfolio and maintaining a sound financial position. DFCC management is conscious of the need to make additional efforts to identify and promote projects and to assist in the formulation of indus- trial policies. DFCC's development strategy in the next two to three years is to continue focussing its financing in export-oriented industries and tourism and to start a limited association with small-scale enterprises. DFCC also intends to play a promotional role in helping in the regional distribution of industry, in identifying, improving and screening project and policy ideas emanating from the private sector, and in advising the Government on these ideas. DFCC should thus become a useful and effective channel of communication between the private sector and the Government. Management and Staff 34. DFCC is well managed, and despite an increasing Government role in the economy, it has preserved its operational autonomy. A new Chairman has taken over DFCC's leadership and a second Government director has been added to DFCC's Board, which should improve contacts between DFCC and the Ministry of Industries and Scientific Affairs. Since 1970, with the drop in its volume of business, DFCC lost a number of professional staff, but the remaining 12 professional staff are competent and their number is adequate  -10 - for the current level of operations. DFCC intends to recruit a market analyst and a junior executive during the current year, as well as strengthen its tourism projects expertise. Project Appraisal 35. In general, DFCC's appraisal of projects is satisfactory in respect of assessing the financial, technical, marketing and managerial aspects of projects, but its econonic analysis leaves room for improvement. An under- standing has been reached with DFCC that it will cover the economic impact of projects more thoroughly in its appraisals and in particular calculate the economic rate of return for all projects costing Rs 1 million or more, and the domestic resource cost per unit of foreign exchange earned/saved for all projects costing between Rs 0.5 and Rs 1.0 million. DFCC has three staff who have been trained at the EDI and should be able to carry out these evaluations. Also, since many industries at present are suffering from low utilization of existing capacity, DFCC intends to pay particular attention to this aspect in its project appraisal to ensure that its financing does not create additional excess capacity. 36. In view of DFCC's increasing role in tourism financing, DFCC has agreed to strengthen its capacity for appraisal and supervision of hotel projects. DFCC will, by December 31, 1975, either recruit a tourism spe- cialist or make arrangements for training of a DFCC staff member (Section 2.10 of the draft Project Agreement). The cost of short term training abroad would be eligible for financing out of the proceeds of the credit (Section 2.03(a) of the draft Development Credit Agreement). Policies and Procedures 37. DFCC usually lends at maturities ranging between 5 and 16 years. It normally requires a primary mortgage on the borrowing company's fixed assets; the loan is usually limited to 75% of the value of land and build- ings and 60% of the cost of machinery to be acquired. In investments, DFCC limits its share in a single enterprise to below 25% of the enterprise's issued share capital or 10% of DFCC's equity (plus the outstanding amount of the subordinated Government loan), whichever is lower. Also, the aggregate of its share of investments is not allowed to exceed the sum of its equity and the oustanding amount of the subordinated Government loan. These exposure limits are reasonable and all DFCC's investments have been within them. DFCC will limit exposure in respect of hotel projects to 45% of its portfolio. For procurement of foreign machinery, DFCC usually requires the prospective investor to obtain several quotations from well-known foreign suppliers. The quotations are examined mainly for pricing, delivery, quality of equipment, availability of spare parts, warranty conditions and the supplier's ability to furnish technicians for installation and training of local staff. These procedures are satisfactory.  - 11 - Lending Rates and Resource Mobilization 38. DFCC's lending rates for both rupee and foreign currency loans are presently 10.5% p.a. The rupee rate is in line with those of other financial institutions in Sri Lanka. Government is aware that rates in the country are generally low, and the Central Bank is currently reviewing their struc- ture. DFCC rates for local currency loans might be adjusted upward as a result of this review. Given the scarcity of foreign exchange, there is need to encourage a more economic use of foreign currency resources. It has therefore been agreed that DFCC's foreign currency rate under the proposed credit be increased to 12% p.a. Ilowever, in order to help encourage the development of small-scale enterprises, it was also agreed that DFCC would lend to enterprises whose fixed assets do not exceed Rs 200,000 (US$31,000) at a special rate of 10% p.a., which is in line with Government policy. Since only a small portion of the Credit (see para. 32) would be relent at this concessionary rate, the weighted spread to DFCC on the proceeds of the proposed IDA credit would be about 3.4X. The spread on DFCC's overall debt resources (including the interest-free Government loan) would be 4.2% in FY79. The Government would continue to take the exchange risk. 39. DFCC has been dependent on IBRD loans for its foreign currency resources (total net amount of US$5.2 million) and on the Government, the Central Bank and conmercial banks for its rupee resources. Because of a sharp rise over the past two years in rupee lending, DFCC faced some rupee resource constraint. At the end of FY74, it had overcommitments of Rs 10.2 million. More than half of this amount, however, was expected to be re- financed under a Central Bank refinance facility. In October 1974, DFCC negotiated an overdraft facility of Rs 6.5 million with the Bank of Ceylon which is being converted into a long term credit. DFCC will continue to make efforts to tap other sources of funds. Profitability and Financial Position 40. Despite the decline in its portfolio over the past several years, DFCC has been able to maintain a reasonable level of profitability mainly by reducing its administrative expenses. Net profits amounted to 8.4% of average net worth in the past two years and 12.2% of year-end share capital. It has paid dividends at 8% since FY68. DFCC's long-term debt/equity ratio, as defined in the last IBRD loan agreement, varied between 2.1 and 2.8 over the past five years against a contractual limit of 3.0. The present pro- posal sets a new long-term debt/equity ratio of 7:1 based on a new definition (Section 3.05 of the draft Project Agreement). 1/ The quality of DFCC's 1/ In the last IBRD agreement, the portion of the Government subordinated loan which falls due after the last maturity of the IBRD loan is ex- cluded from debt and included in equity. The present agreement in- cludes the entire subordinated loan as debt in order to better reflect the actual leverage on DFCC's real equity. Using the new definition, the long-term debt/equity ratio during the past five years varied between 4.2 and 5.3 to 1.  - 12 - portfolio is good. It had four companies in arrears of Rs 490,000 at the end of September 1974 while it had provisions against bad debt of Rs 1.4 million. Only one of the nine companies in which DFCC has an investment was operating at a loss at the end of last September and DFCC has ample provisions against bad investments (Rs 650,000 at the end of FY74) to cover the possible loss of Rs 50,000. Projected Operations and Resource Requirenents 41. While the investment climate in the private sector is still uncertain, Government incentives for export-oriented industries and hotel projects have stimulated interest from private entrepreneurs. There is also some demand from existing industries for replacement, balancing and moderni-- zation of equipment. DFCC expects to commit Rs 45 million over the two years through March 1977: Rs 29 million (US$4.5 million) in foreign currency loans and Rs 16 million in rupee loans and investments. By January 1975, DFCC had identified 54 projects with a foreign exchange component of about US$7 millioii. Of this amount about 30% was for export-oriented projects, 40% for tourism and 30% for import substitution projects. However, because some of these projects are in a preliminary stage of preparation and some may drop out, it is likely that DFCC will be able to commit not more than US$4.5 million in foreign exchange over the next two years. DFCC has no other foreign exchange resources for new commitments, and an IDA credit of US$4.5 million would cover its estimated foreign exchange requirements through March 1977. The Proposed Credit 42. The proposed credit would be used mainly to meet the direct c.i.f. cost of capital goods imported for projects financed by DFCC. In the case of tourism projects, the credit would also cover 65% of the cost of imported capital goods purchased localLy, which would represent their average foreign exchange component. US$15,000 of the credit would be made available for short-term tourism training abroad of a DFCC staff member. (Sectioin 2.03 of the draft Development Credit Agreement.) 43. The proceeds of the credit would be relent by the Government to DFCC through a subsidiary loan agreement on terms and conditions satisfactory to the Association (Section 3.01 of the draft Development Credit Agreement). DFCC would pay 8.5% p.a. interest on the outstanding balance and would repay the Government within 15 years according to the composite of repayment schedules of its borrowers. The Government would continue to take the foreign exchange risk.. It has been agreed that DFCC would submit to the Association for prior approval projects using US$150,000 or more of the proposed credit (Section 2.03(e) of the draft Development Credit Agreement).  - 13 - PART V - LEGAL INSTRUIENTS AND AUTHORITY 44. The draft Development Credit Agreement between the Republic of Sri Lanka and the Association, the draft Project Agreement between the Association and DFCC, the Recommendation of the Committee provided for in Article V, Section 1(d) of the Articles of Agreement, and the text of a draft resolution approving the proposed credit are being distributed to the Executive Directors separately. 45. Special features of this credit are referred to in paragraphs 28, 36, 40, 42 and 43 of this Report. 46. Execution of the Subsidiary Loan Agreement on behalf of the Borrower and DFCC is an additional condition of effectiveness (Section 6.01(b) of the draft Development Credit Agreement). 47. I am satisfied that the proposed development credit would comply with the Articles of Agreement of the Association. PART VI - RECOMMENDATION 48. I recommend that the Executive Directors approve the proposed credit. Robert S. McNamara President by B. Chadenet Attachments June 12, 1975   ANNEX 1 Page 1 of 3 Pages SODEUNTR DATA - 210 IANKA AREA POPULATIOYN DENSITY g33to hi -13.2 ilin(mid-1972) 3,0~ Psr hintf a-ble land SOCIAL INDICATORS Refer.... Countries Sri Lanka inAe Piipie alyi 1960 1970970 2W97 ONP PER CAPITA U5$ (ATLAS RAnIS) /1 90 ab 1. no iio ae 220 /e 630a DETOORAPKIC Ornde birth rate (per thousand) 36 30 3L6,. 65L.X 36L Cr.de death rate (per thousan d) 9 La 1 di 2L