Philippines - Second Grain Processing Project

FILE COPY Report No. 1045b-PH Philippines: Appraisal of the Second Grain Processing Project May 11, 1976 East Asia and Pacific Projects Department Agricultural Credit and DFC Division FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS 1/ US$1.00 - Pesos (P) 7.50 P1.00 = US$0.1333 WEIGHTS AND MEASURES METRIC SYSTEM 1 hectare (ha) = 2.47 acres 1 kilometer (km) = 0.62 miles 1 meter (m) = 39.37 inches 1 kilometer (kg) = 2.24 pounds 1 metric ton = 2.240 pounds 1 cavan (paddy) = 50 kg 2/ 1 cavan (corn) = 57 kg ABBREVIATIONS ACA - Agricultural Credit Administration BAEcon - Bureau of Agricultural Economics CB - Central Bank of the Philippines COA - Commission on Audit DBP - Development Bank of the Philippines GOP - Government of the Philippines GPD - Grain Processing Division (of DBP) HYV - High Yielding Variety IRRI - International Rice Research Institute NFAC - National Food and Agriculture Council NGA - National Grains Authority NIA - National Irrigation Administration PNB - Philippine National Bank RCA - Rice and Corn Administration UNDP - United Nations Development Programme UPCA - University of the Philippines, College of Agriculture FISCAL YEAR July 1 - June 30 CROP YEAR July 1 - June 30 1/ Floating since 1970. 2/ The former weight of 44 kg for cavan is sometimes still used in the Philippines.  FOR OFFICIAL USE ONLY PHILIPPINES APPRAISAL OF THE SECOND GRAIN PROCESSING PROJECT TABLE OF CONTENTS Page No. SUMMARY AND RECOMMENDATIONS ..................i......... i - ii I. INTRODUCTION ....... ............................... 1 II. BACKGROUND ................................. .. ...... . 2 General ................................................... 2 Economy ................................................... 2 Agricultural Sector .......................... ...... 2 Agricultural Credit ..... . . ... ...... ........* 3 Rice and Corn Production ...... O..** .......... 3 Price Policy ......... ........... * .......................... 4 Land Reform ............. ..................... 4 Masagana 99 and Masaganang Maisan .. .......... 5 Grain Processing Industry .................... 5 Milling Equipment Manufacturing Industry ..... 7 III. THE FIRST GRAIN PROCESSING PROJECT ................ 8 IV. THE PROJECT . ........................... . ............... 9 Project Description . ........................ . 9 New Features of the Project .................. 9 Project Size ................................. 11 Description of the Mills ..................... 11 Project Cost and Financing ................... 12 Sub-borrowers and Sub-loan Conditions ........ 15 Free Limit .............. ..................... 16 Procurement ................ ............................ 16 Disbursement .......................... ........ 17 Audit and Accounts . ................. .. ...... . 17 Sub-borrowers' Reports ...................... 18 DBP's Reports ................ ............ 18 V. ORGANIZATION AND MANAGEMENT ....................... 18 Development Bank of the Philippines .......... 18 Grain Processing Division ..... 0.000** ...... 20 VI. M$RKETS AND PRICES ............ ....... ............ 21 VII. BENEFITS AND JUSTIFICATIONS ................ 21 VIII1. RECOMMENDATIONS ........ .......................... 24 This report is based on the findings of a mission composed of Messrs. D. Lee, S. Ettinger (Bank), H. Kramer and R. Yamashita (Conisltants) that visited the Philippines in August/September 1975. This document has a restricted distribution and may be uwd by recipients only in the performance of their offcial duties. its contents may not otherwise be disclosed without World Bank authorization.  -2- ANNEXES 1. The First Grain Processing Project 2. The Development Bank of the Philippines (DBP) 3. Rice and Corn Production 4. Rice and Corn Processing 5. DBP's Sub-project Evaluations 6. Equipment Items and Flow Diagrams for Mills 7. Unit Costs of Sub-project Models 8. Estimated Project Cost by Input and Currency 9. Total Project Cost 10. Cash Flow Projections 11. Estimated Quarterly Schedule of Disbursements 12. Economic Analysis CHARTS I. DBP Organization Chart, WB 9981 2. Agricultural Projects Department Organization Chart, WB 15328 MAP Rice and Corn Production, and Mills Financed under the First Grain Processing Project, IBRD 12005  PHILIPPINES APPRAISAL OF THE SECOND GRAIN PROCESSING PROJECT SUMMARY AND RECOMMENDATIONS i. This report appraises a Second Grain Processing Project in the Philippines, for which a Bank loan of $11.5 million is proposed. The project would support a three-year lending program by the Development Bank of the Philippines (DBP) for rice and corn mills, including related transport, drying and storage facilities, to be owned and operated by private Philip- pine entrepreneurs. ii. The first Rice Processing and Storage Project (Loan 720-PH) for $14.3 million was initially intended to finance capital-intensive, highly integrated modern rice mills and bulk storage facilities. However, subloan demand failed to materialize, and the project was, therefore, amended to in- clude other grains, other post-harvest equipment, and more traditional but technically sound mills. The first project is now progressing satisfactorily, and is expected to be fully committed by June 1976. iii. The proposed project would be the fifteenth Bank/IDA project for agricultural development in the Philippines, and the ninth Bank project involv- ing on-lending through DBP. Government would be the borrower, and DBP, through its Grain Processing Division, would be the executing agency. DBP, a wholly Government-owned bank, is the single largest source of long-term funds in the Philippines. Since its inception, it has approved financial assistance total- ling nearly $3 billion. About 25% of its long-term loan portfolio is in agri- culture. In FY75, DBP's total lending reached $320 million, of which 23% was to agriculture. The volume and diversity of DBP's operations give it a promi- nent and unique role as the Government's arm for financing economic development. iv. Rice is the staple food for about 75% of the population, and corn for the remainder. Over the past two decades, rice production has expanded erratically, at an average of 2.5% per annum. Consumption has increased at about the same rate, leaving the country in a slightly deficit position (rice imports have averaged 5% of consumption). Corn production increase has aver- aged 5% per annum. The Philippines is self-sufficient in white corn for human consumption, but now imports yellow corn for animal feed. v. The processing of rice and corn in the Philippines needs consi- derable improvement to reduce the extensive grain losses between harvest and consumption. The main problem is outmoded drying, storage and milling facilities. About 95% of the grain is still sun-dried, and suffers sub- stantial deterioration and loss during periods of inclement weather. Much of it is stored in antiquated warehouses or storerooms, where losses from fermentation, mold formation, insects and rodents are heavy. And about 35% of the paddy is milled by old-fashioned kiskisan mills, whose recovery rates average only about 60% compared to 65% for cono mills with stone hullers, and 69% for conos equipped with rubber hullers.  - ii - vI. The project would finance about 135 rice mills and 20 corn mills, over a three-year commitment period. It would entail only a moderate expan- sion over the rate at which DBP has been approving subloans under the first project. Machinery and civil works would each account for about 30% of proj- ect costs, vehicles for 26% and working capital for the remainder. In addition, the loan would include financing of a study to determine the causes and extent of various post-harvest grain losses and to identify action programs for reducing them. Total project cost would be some $28.5 million. The Bank would meet the foreign exchange cost (39%) of the lending program, the sub- borrowers would contribute about 17% of project cost, and DBP would finance the remaining 44%. The Bank would finance, up to $300,000, the full cost of the post-harvest grain losses study. Subloans would be for a maximum of 14 years, with up to two years' grace, at DBP's regular interest rates of 12% for loans secured by land and 14% for loans otherwise secured. Subloans exceeding $600,000 would be subject to prior Bank approval. vii. Civil works with an estimated cost of $200,000 or more would be pro- cured through international competitive bidding in accordance with Bank guidelines, and those of $100,000 or more but less than $200,000 would be let through local competitive bidding. Civil works contract costing less than $100,000 would be let through ordinary commercial channels, with due regard for economy and suitability. Goods costing more than $20,000 would be procured on the basis of quotations received following international advertisement, and those costing less than $20,000 would be procured through ordinary commercial channels. Bulking of smaller contracts would not be feasible because of the geographic and temporal spread of the sub-projects, and the need to take sub-borrowers' preferences into account, including compatibility with existing equipment. viii. The estimated overall economic rate of return is 28%, and the bene- fits would consist of (i) reduced spoilage losses for rice and corn, primarily from the trucks, driers and warehouses, (ii) higher rice recovery, and (iii) induced corn production. The unquantified benefits include improving grain quality and stimulating and modernizing the rice and corn milling equipment manufacturing industry of the Philippines. Although the direct beneficiaries would be the grain millers, rice and corn farmers would benefit from increased competition among the millers, from higher milling efficiency which would tend to reduce the processing margins, and from the extension of grain production into areas where it would otherwise be unfeasible. ix. The project is recommended for a Bank loan of $11.5 million repayable over 18 years, including five years' grace period.  PHILLIPPINES SECOND GRAIN PROCESSING PROJECT I. INTRODUCTION 1.01 The Government of the Philippines has requested a Bank loan of $11.5 million to finance continuation of the ongoing Bank-financed Rice Processing and Storage Project (Loan 720-PH), which Loan is expected to be fully committed by June 1976 (Annex 1 reviews the first project). 1.02 As under the first project, the loan would be made to the Govern- ment which would on-lend the proceeds to the Development Bank of the Philip- pines (DBP) under a subsidiary loan agreement, and DBP would, out of the loan proceeds and its own funds, provide medium and long-term loans to private grain mill operators for financing of rice and corn mills, including ware- houses, grain driers, trucks and ancillary equipment (Annex 2 summarizes DBP operations). In addition, the loan would include financing of a study to determine the causes and extent of various post-harvest grain losses and to identify action programs for reducing them. The loan would be the Bank's fifteenth for agricultural projects in the Philippines 1/ and it would finance about 135 rice mills and 20 corn mills over a three-year period. The rice mills would be mainly in the 1/2 to 2 tons per hour capacity range and the corn mills in the 1 to 5 tons range. All of these are expected to make significant contributions to improving grain processing and storage. 1.03 In April 1975, DBP sent the Bank a project proposal for the Second Grain Processing Project. In August/September 1975, an appraisal mission composed of Messrs. D. Lee, S. Ettinger (Bank), H. Kramer and R. Yamashita (Consultants) visited the Philippines. The report is based on the findings of the mission. 1/ Agricultural Education Project, 393-PH, $6.0 million, 1964, UPCA, Rural Credit Project, 432-PH, $5.0 million, 1965, CB, Second Rural Credit Project, 607-PH, $12.5 million, 1969, CB, Third Rural Credit Project, 1010-PH, $22.0 million, 1974, CB, Upper Pampanga Irrigation Project, 637-PH, $34.0 million, 1969, NIA, Aurora-Penaranda Irrigation Project, 984-PH, $9.5 million, 1974, NIA (Aurora-Penaranda Irrigation Project, 462-PH, $9.5 million, 1974, NIA), Tarlac Irrigation Project, 1080-PH, $17 million, 1975, NIA, Rural Development Project, 1102-PH, $25 million, 1975, Government, Livestock I Project, 823-PH, $7.5 million, 1972, DBP, Livestock II Project, 1225-PH, $20 million, 1976, DBP, Fisheries Credit Project, 891-PH, $11.6 million, 1973, DBP, Rice Processing and Storage Project, 720-PH, $14.3 million, 1972, DBP, Magat River Multi-purpose Project, 1154-PH, $42.0 million, 1976, NIA, and Chico River Irrigation Project, 1227-PH, $50.0 million, 1976, NIA.  II. BACKGROUND General 2.01 The Republic of 2he Philippines consists of over 7,000 islands with an area of 300,000 km and a population of some 43.3 million (end of 1975) growing at 3.0% per annunm. Some 71% of the population is rural. The country is divided into three main parts: Luzon in the north (53% of the population), the Visayas in the middle (25%), and Mindanao in the south (22%). Migration from the densely populated Visayas to more sparsely inhabited Mindanao continues. 1/ About 5 million people live in greater Manila. The climate is tropical, and is characterized by high temperature and humidity and heavy annual rainfall, which ranges from 1,000 mm in Southwest Mindanao to 5,500 mm in the Luzon highlands. Most areas have one major rainy season, but the rainfall pattern varies widely across the country. Economy 2.02 Real gross national product (GNP) has grown at an average of 5-6% over the past decade, and per capita GNP reached US$300 in 1974. The Philippines has weathered the international economic crisis well, primarily due to high prices for its major exports in 1973 and 1974. In late 1973, inflation became a major problem, and the annual rate rose to 34% in 1974. The inflation abated as a result in part of government anti-inflationary measures, and the rate for 1975 was only about 10%. At the same time, how- ever, prices for Philippine exports have fallen, creating balance-of-payments problems. Agricultural Sector 2.03 Agriculture accounts for about 50% of total employment, 70% of commodity export earnings, and :35% of GNP. The 35% share is made up of food crops (12%), export crops, consisting mainly of sugar and coconut (9%), livestock (6%), fisheries (4%), and others (4%). Due largely to the increased rice production occasioned by the introduction of high-yielding varieties (HYVs) and an improvedl package of inputs, agricultural output accelerated during the 1960's, with an annual average growth rate of 4.7% over 1965-1970. It was set back during the following three years by adverse weather conditions and widespread tungro virus diseases, but has since recovered. 2.04 Of the Philippines' total land area of 30 million ha, more than half is forestland and only about one-third is cultivated (including plan- tations). An additional 2.0-2.5 million ha of fairly level land is still available for crops, although much of this would be expensive to reclaim. 1/ Mindanao's share of total population was 15% in 1948, 20% in 1960 and 22% in 1970. The Visayas' share dropped from 34% to 29% and then 25%.  -3- 2.05 The Government goals for the agricultural sector are self-suffi- ciency in rice and corn, expansion of agricultural exports, intensification of land reform and redistribution, and conservation of natural resources. Agricultural Credit 2.06 Institutional sources probably supply about a third of all agri- cultural credit, with fertilizer dealers, farm machinery suppliers, market- ing and processing firms, shopkeepers, landlords and private moneylenders providing the remainder. Apart from the Central Bank, which only refinances, about 20% of the institutional credit is from the public sector, primarily from DBP (see Chapter V), the Philippine National Bank (PNB) and the Agricul- tural Credit Administration (ACA). In addition, the Land Bank of the Philip- pines (LBP) is being revitalized and is expected to play an important role in financing land transfers from former landowners to former tenants and pro- viding general agricultural credits including production credits. PNB, the largest bank, has 171 branches and total assets of some P15 billion. About 30% of its total lending is for agriculture, primarily as seasonal credit for production inputs, marketing and processing. In addition to financing com- mercial farms and plantations, PNB has financed half the loans in the national rice and corn programs (Masagana 99 and Masaganang Maisan, respectively). ACA finances production and marketing cooperatives and small farmers, but owing to lack of financial resources, its lending has greatly decreased and its future is uncertain. 2.07 Among the private institutions, commercial banks are the most im- portant, providing some 55% of all institutional agricultural credit, even though less than 10% of their funds have gone to agriculture. The Central Bank of the Philippines (CB) now requires that a minimum of 25% of all com- mercial bank lending go to that sector. About 30 commercial banks lend for agriculture, mostly short-term for marketing. There are now over 700 private rural banks with combined assets of some $280 million. Although their lend- ing has been mainly for the Masagana 99 program, they are increasing their term lending, primarily under the Bank's Agricultural Credit I, II and III loans, and provide in total about 20% of all institutional agricultural credit. In addition, there are some 32 private development banks, hitherto inactive in agricultural fields but now extending their lending for farm mechanization and processing facilities. 2.08 Prevailing annual interest rates from government sources are nor- mally 12% for loans secured by land, and 14% for others. The effective cost of credit from agricultural input suppliers is 15-20% per annum and from pri- vate lenders it is much higher. Rice and Corn Production 2.09 Rice. Rice is the staple food for about three-fourths of the popula- tion, and corn for the balance (Annex 3 discuss grain production in detail). During most of this century, rice production has merely kept pace with popula- tion growth. Between 1920 and 1960, yields stagnated, but production in- creased with the extension of the cropped area. Since 1960, on the other hand,  - 4 - yields have risen, primarily due to the introduction of HYVs, but the growth in cropped areas has ceased. The high yields of 1969-71 led to a belief that rice self-sufficiency had been achieved. The disastrous harvests of 1972-73, however, necessitated large scale rice imports and created a new sense of urgency. This led the government to institute, among others, the Masagana 99 program aimed at providing credit to rice growers to enable them to apply inputs more adequately. In the past two years, rice yields have recovered and expansion of harvested area has resumed. There is considerable potential for sustained increase in rice production, but the realization of this poten- tial would require (i) steacdy expansion of the irrigated area, (ii) increased use of HYVs, (iii) improvement of extension services, water control practice and seed selection, and (iv) introduction of a price policy designed to main- tain prices of fertilizer and rice in a relationship conducive to more eco- nomic fertilizer use. Despite the considerable increase in paddy production that is expected to occur during the forthcoming years, however, it will be difficult to meet the demand increase of about 40% projected for the next decade. 2.10 Corn. Corn is consumed mainly in the Central Visayas, by Cebuanos who have migrated from there, and by others across the country who are too poor to afford rice (corn grits cost about 30% less than rice, per kg). The Philippines has long been self-sufficient in white corn for human consumption, but has imported considerable yellow corn for animal feed in recent years. Corn production is concentrated in Mindanao, and has expanded rapidly the past two years, after three years of stagnation. It is a low-cost, low-yield pro- duction system, still profitable in areas of abundant land not suitable for rice or sugar. Efforts to introduce HYVs have been hampered by disease (especially downy mildew), but new varieties may overcome this problem. Price Policy 2.11 The rice and corn processing and trading industry is regulated by the National Grains Authority (NGA) which succeeded the Rice and Corn Admini- stration (RCA) in 1972. The government has long tried to guarantee simulta- neously fair farmgate floor prices to the farmers for paddy and corn, and stable and reasonable consumer price ceilings for corn grits and rice. For this purpose, NGA operates a buffer stock scheme, buying local grain at a floor price, and, on a much Larger scale, importing rice and yellow corn to meet grain shortfalls. At present, the legal minimum farmgate prices are P1.00/kg for paddy (clean ancd dry) and PO.80/kg for corn, and the retail price ceilings are P1.90/kg for rice and Pl.40/kg for corn grits. Land Reform 2.12 Under the Presidential Decree No. 27 (October 21, 1972), a country- wide program of land reform involving extensive expropriation of tenanted rice and corn lands for distribution to tenants is being carried out. The land transfer program affects all tenanted rice and corn lands of holdings  - D - exceeding 7 hectares, with exceptions being granted to qualified L1a,Quwiers of holdings not exceeding 24 hectares. The practical program target now appears to be to effect land transfer of 825,000 ha (about 20% of the Philip- pines' total rice and corn land) to some 425,000 tenants from 57,000 land- owners. It is still premature to determine how much of this target will be achieved. Masagana 99 and Masaganang Maisan 2.13 In 1973, the Government launched a program of supervised credit for rice farmers called Masagana 99, and followed it later in the same year with a similar program for corn growers, Masaganang Maisan. Masagana 99 was con- sidered to be successful in its first year (1973-74) in increasing yields by enabling farmers to procure more fertilizer and other inputs and by improving extension work. Although the following year it ran into difficulties such as poor loan collections, shortage of technicians, and the greatly increased fertilizer prices, the program still can play an important role in increasing rice production. Masaganang Maisan, on the other hand, has had only limited impact to date. Grain Processing Industry 2.14 Despite the apparent adequacy in terms of its notional capacity, the grain processing industry in the Philippines needs substantial invest- ment for expansion and improvement (Annex 4 discusses the grain processing industry in detail). For failure to reduce the moisture content of the grain adequately after harvest, much grain is lost and damaged because of fermenta- tion and mold growth. In addition, when the harvest is good, transportation bottlenecks develop and an acute shortage of grain storage is widely felt. Moreover, much of the grain milling industry is made up of inefficient rice mills (kiskisans and cono mills without rubber hullers). 2.15 Ownership of Processing Facilities. Rice and corn mills (and ancillary driers, trucks, and warehouses) are predominantly in private hands, although NGA is starting to build up its own capacity. The millers are virtually all small- to medium-sized local entrepreneurs, operating usually one and seldom more than 2 to 3 mills. Even the larger mills are generally family operations because of the complete trust necessary between the grain procurement, milling and sales managers. The main division is between the very small millers (rice kiskisans and corn grinders, primarily) who process grain for a fee, and the larger millers who trade in grain. The latter often provide credit to farmers and small grain traders as means of helping ensure an adequate supply of grain. Because there are many relatively small mills, which need to procure adequate grain for efficient operation, the industry is generally competitive, with mills often sending their trucks long distances to procure paddy and corn. 2.16 Grain Driers. The prevailing moisture content of paddy and corn immediately after harvest ranges from 24 to 28%. To prevent loss and damage by fermentation and mold formation, the moisture must be reduced to about 18%  - 6 - within about 48 hours and further to 14% before storage and milling. In the Philippines, about 95% of the grain is solar dried, on mats, concrete floors and road surface. Since solar drying is impractical in rainy weather and often results in high grain losses, the need for on-farm mechanical grain driers has long been felt. So far, however, small mechanical grain driers have proven financially unviable, and the best prospect for expanding mecha- nical drying appears to be in providing larger units at rice and corn mills (see Annex 5). 2.17 Rice Mills. There are four different milling techniques employed in the Philippines: (i) hand pounding, (ii) kiskisan mills, sometimes called Engelbergh mills, (iii) cono mills, and (iv) modern mills with rubber hullers. Hand pounding is still practiced but it covers probably less than 5% of paddy production. Of the mechanically milled paddy, about 35% is done by some 10,000 kiskisans, and the remainder by some 2,700 cono mills and a small number of modern rice mills with rubber hullers. 2.18 Clean paddy consists of white rice (71-72% in weight on average), bran (7-8%) and hull (20-22%). The milling consists of first removing the hulls and then polishing or whitening the brown rice by removing the bran. Mill efficiency is usually measured in terms of milling recovery rates, i.e., the percentage by weight of milled rice recovered from paddy input. The recovery rates vary considerably from one milling technique to another. 2.19 Kiskisans. The kiskisan is the oldest mechanical rice mill. It is relatively small, and, unlike other types of rice mill, it removes the hull and bran in a single operation without separating one from the other. The kiskisans on average have recovery rates of about 60%, producing as by- product a mixture of bran and hulls, called rough bran. Recoveries of the kiskisans are so low because they must exert a pressure strong enough to re- move hull and bran simultaneously. Due to the pressure and the heat generated, they break the grains excessively, and, in the process, small bits of white rice fall through the sieve along with the bran and the ground up hulls. The kiskisans normally mill the grain owned by the farmers, either charging a fixed fee (P2.75/50 kg) or keeping the rough bran. The operation is so simple that many of the kiskisans are run almost on a self-service basis. Despite their poor recovery rates, they remain popular in rural areas especially among those who have only one to two sacks of paddy to mill. However, their low re- covery rates make them unsuitable for commercial rice milling. Some promising experiments are being conducted to see if the kiskisan can be used only as the polisher, combined in tandem with a small rubber huller. Should this prove practical, recoveries could increase sharply with small incremental investment. 2.20 Cono Mills. Cono mills first remove the hulls from the brown rice rice by means of an underrun disk huller, and then polish the brown rice through a cone shaped polisher (whitener) in a separate operation. As a re- sult, they do not grind up the rice grains as much as the kiskisans do, and they produce relatively pure bran which can be sold to feedmills. Their average recovery rate is about 65%. Normally, the cono millers mill the paddv they own, and much of their profLt comes from trading paddy. They  - 7 - usually operate their own trucks, warehouses and solar driers, and an in- creasing number of them are purchasing mechanical driers. 2.21 Modern Mills with Rubber Hullers. To reduce the grain breakage and losses, the modern mills, and now some cono mills, use rubber hullers, in which the paddy passes between two rubber cylinders rotating at different speeds, and the hulls are twisted off by friction. Mills with rubber rollers obtain average recoveries of 69%. Despite the high recovery rates and the ability to turn out finished rice with less broken grain, the acceptance of rubber hullers has been slower in the Philippines than elsewhere in Asia. As a result in part of the first grain processing project, however, the number of rice mills equipped with rubber hullers is steadily increasing. 2.22 Corn Milling. About 90% of the corn grown in the Philippines is white corn, which is ground into grits for human consumption. Shelled corn is made up of peel (20% on average in terms of weight), germ (10%), and ker- nel (70%). About one-third of the milling is done by some 1,800 one-step grinders (akin to kiskisans) and the remainder by 1,100 two-step roller mills similar to conos. The roller mills first remove the peel and germ, and then grind the corn into grits, which are separated by size for human consumption, while the peel and germ are sold to feed mills for livestock feed. The grinder mills, like the rice kiskisans, do mainly custom milling for subsistence pro- ducers. Because their grits contain too much peel and germ, and are not graded by size, grinder mills are not suitable for commercial production. 2.23 Total corn-milling capacity is probably just about adequate for present production. The need for additional mills will continue to be pri- marily in Mindanao, where corn production is increasing rapidly. At present, much of Mindanao's production is shipped by barges and milled in Cebu (Central Visayas), the main consuming area. However, it would be more efficient for the mills to be in the producing area because (i) earlier drying would reduce fermentation, and (ii) relocation would greatly reduce the trans-shipment cost now necessary for bringing the corn to Cebu for milling and then ship- ping some of the finished products to Manila. Milling Equipment Manufacturing Industry 2.24 The Philippines has developed efficient cono rice mill and roller corn mill manufacturing industries, the former centered on Manila, and the latter scattered across the Visayas and Mindanao. Domestic mills cost about half as much as imports of comparable capacity, because of savings on trans- port, duty, labor and raw materials costs. Although the local mills are bulkier and less sophisticated than the imported ones, they are quite satis- factory. Rubber hullers and other components are still imported.  - 8 - III. THE FIRST GRAIN PROCESSING PROJECT 3.01 The Rice Processing and Storage Project, which became effective May 19, 1971, provided for a $14.3 million loan to GOP, to be onlent to DBP to help finance construction of integratd modern rice processing plants. The project called for very modern mills, including bulk silos and automated grain handling facilities. There were to be about 30 small facilities with a milling capacity of 1.2 tons of paddy per hour with a bulk storage capacity of 2,000 tons, and six large facilities with a 4 ton per hour capacity with a bulk storage capacity of 5,000 tons, costing $270,000 and $800,000 per unit, respectively. In addition, the project provided funds for expansion of 30 existing small mills at $200,000 per unit. To provide technical support, the project included a training course in grain milling, run jointly by the United Nations Development Prograrmme (UNDP) and the University of the Philippines College of Agriculture (UPCA) at Los Banos, and engineering con- sultants to DBP on rice milling. 3.02 The original design of integrated mills, which initially consti- tuted the core of the project, proved to be too large and too capital-inten- sive for the Philippine context. Furthermore, Philippines' rice production dropped sharply in the two years following project effectiveness. As a result, demand for sub-loans did not materialize, and the Bank therefore agreed in March, 1972, and in May, 1974, to permit improvement of existing rice and corn mills, financing of other post-harvest equipment, smaller sub-loans, and sub-loans for individuals and specified public entities. 3.03 Sub-loan approvals began almost immediately under the revised project, and hdve continued at a rapid pace. As of February 20, 1976, DBP had approved 132 sub-loans amounting to P91.8 million ($12.2 million), had disbursed P28.3 million ($3.8 million), and had in the pipeline 30 new sub-loan applications for P31.8 million ($4.3 million). As the Bank reimburses 90% of DBP's disbursements, this means that 79% of the $13.9 million of Bank funds available for sub-loans under the project ($0.4 million having been disbursed for consultant services) has already been committed and a further 28% applied for, although only 25% has been disbursed by DBP. The level of disbursement is low because most sub-loans, especially the large ones, have only recently been approved. As of March 24, 1976, total Bank disbursements were $3.3 million, or 23% of the Bank loan. The project is expected to be fully commit- ted by June 30, 1976, and fully disbursed by the revised Closing Date, June 30, 1977. 3.04 Of the total amount of tie sub-loans approved, 49% (P45.3 million) is for three large corn silo/feedmill complexes, 39% is for rice mills, 10% for corn mills and 2% for small feed mills. From its own funds, DBP has also approved working capital loans of P38.0 million to project sub-borrowers. >'i1st xr the sub-projects appear likely to be successful. 3.05 The consultants performed the work required of them with respect to assisting DBP to prepare tne design, specifications and tender documents, but. with the shift in emphasis of the project, their usefulness diminished sharply.  - 9 - Their contract was terminated, therefore, at the end of 1974. The training program was implemented successfully by UNDP and UPCA, reaching over 200 students annually completing the four to ten week courses. However, it had little practical bearing upon the project proper because very few sub- borrowers participated. UPCA is continuing the grain milling training course on its own now, in collaboration with NGA. 3.06 The project has met the immediate and foreseeable need for bulk silos for feedmill complexes and has enabled rice and corn production to expand into new areas, especially in Mindanao where lack of adequate drying, transport, milling and storage facilities was a major constraint. In addi- tion, it has supported the expansion and modernization of the domestic rice and corn-mill construction industry. In particular, some mill construction firms now offer rubber hullers as optional equipment for their mills, and the spread of rubber hullers beyond project sub-borrowers is an important ancil- lary benefit of the project. IV. THE PROJECT Project Description 4.01 The project would be a continuation of the first Rice Processing and Storage Project, and would consist of a credit through DBP for the con- struction and equipment of modern rice and corn processing facilities to be owned and operated by private Philippine entrepreneurs active in grain milling and trade. The facilities would include rice and corn mills, mechanical and solar driers, warehouses, trucks and ancillary equipment. The objective of the proposed project would be to increase the supply of grain in the Philippines by financing modern rice and corn mills. Some of the rice mills would replace old, inefficient mills with low recovery rates of white rice from paddy. The remaining rice mills and most of the corn mills would help meet the milling requirements of areas with rapidly increasing grain produc- tion or areas with inadequate milling capacity. Some corn mills, especially those in Mindanao, would make corn production feasible in areas where the absence of processing facilities was the major factor inhibiting production. In addition, the project would include financing of a study to be carried out under the direction of the Secretary of Agriculture to determine the causes and extent of various post-harvest grain losses and to identify action pro- grams for reducing them. New Features of the Project 4.02 Although this project would be essentially a continuation of the first project, it would embody a number of modifications found desirable in the light of experience and changed circumstances. The principal changes can be grouped into three categories: (i) changes in items to be financed, (ii) changes in financing arrangements, and (iii) intensified monitoring requirements.  - 10 - 4.03 Changes in Items to be Financed. The project would de-emphasize the large integrated rice mills which originally constituted the core of the first project, and would exclude financing of large grain silos associated with feed manufacturing, and small on-farm grain driers. Large integrated rice mills have tended to be financially unprofitable in the Philippines because of high capital costs and the difficulties in procuring adequate paddy. The emphasis, therefore, has been shifted to medium-size, more con- ventional cono mills, but equipped with high recovery rubber hullers and related accessories. The large silos have been eliminated because the fore- seeable need has already been fully met under the first project, and any unanticipated future need could be met under another Bank-financed project (Second Industrial Loan). The small on-farm grain driers have been found financially unviable because of the greatly increased oil prices. These changes make it no longer necessary for DBP to retain expatriate consultants to assist it in designing large integrated mills or to carry out a special training program for those who were to operate complex integrated mills. Moreover, since the small on-farm driers have been excluded, and mill- construction costs have increased with inflation, the minimum subloan size would be increased from $2,000 to $4,000, and local governments and the National Grains Authority, which were made eligible to borrow in the revised first project mainly for the purpose of promoting the on-farm grain driers (and also, in NGA's case, for large bulk silos) would be ineligible to borrow under the second project. Although there was a suggestion that NGA be re- tained as eligible to borrow under the project, it was excluded because any program likely to be promoted by it would be for bulk grain handling facili- ties and it had not formulated any concrete investment plan for such facilities for consideration by DBP. 4.04 Changes in Financing Arrangement. Because of the emphasis on large integrated rice mills, the first project had a large foreign exchange compo- nent; however, this component would now be greatly reduced because much of the investment goods for the second project would be locally manufactured. The Bank, therefore, in continuing to meet the estimated foreign exchange cost, would reimburse only 56% of DBP's disbursements (excluding working capital), instead of the 90% under the first project. Another change is that while, under the first project, all sub-borrowers for purposes defined as "expansion and rehabilitation," as distinguished from "new mills," were exempted from the 20% cash contribution, the distinction in practice has been found arbitrary and unwarranted, and, therefore, every sub-borrower under this project would be required to make a 20% cash contribution. Finally, the $600,000 free limit would be retained, but the definition would be broadened to include explicitly DBP's working capital loans. 4.05 Intensified Monitoring. Greater monitoring would be required under the second project, including (i) sub-borrowers' reports on their capacity utilization, (ii) more extensive and properly organized record keeping by DBP's Grain Processing Division on sub-borrower's applications and loans, (iii) more detailed DBP reports to the Bank on procurement matters, and (iv) reports on amortization collections and status of arrears, including  - 11 - write-offs and rescheduling. This information would not only assist the Bank in project supervision and evaluation, but should be of great assistance to GPD itself in project implementation. Project Size 4.06 The project is expected to finance about 135 rice mills and 20 corn mills over a three-year commitment period, and would entail only a very moderate expansion over the rate at which DBP has recently been ap- proving sub-loans under the first project. The actual sub-project commitments under the first project and the projections for the second project are summ- arized below: First Project Second Project Calendar Years Fiscal Years 1973 1974 1975!_ 1976/77 1977/78 1978/79 Total Rice Mills 9 19 44 40 45 50 135 Corn Mills 1 4 5 6 7 7 20 Feed Mills - - 6 - - - - Total 10 23 55 46 52 57 155 /a Excludes 35 small loans of less than P 60,000, all of which are loans for minor mill components. In view of the attractive financial rates of return projected for the project facilities, and, on the basis of the recent experience under the first project, it is safe to assume that there would be adequate demand for sub-loans. 4.07 The distribution of mills by size under the second project is also expected to follow closely that of the first project. About half of the rice mills are expected to be in the medium size range of about one ton per hour capacity (in terms of grain input), and the remainder divided about equally between half-ton and two-ton mills. Most of the corn mills are also expected to be in the one-ton range, but about half a dozen would have capacities of some five tons per hour, as they would be oriented mostly towards inter-island trade (from Mindanao to the Visayas). Description of the Mills 4.08 The half-ton rice mills would be designed primarily to serve the local needs of a small area. As it is estimated that about half their business would be custom milling (i.e., milling someone else's rice for a fee), their need for drying and storage facilities would be only about one-fourth that of the one-ton mills, whose operators would own virtually all the rice they  - 12 - milled. The half-ton mills would also rely on hired transport, as it would not be profitable for them to operate their own trucks. Therefore, their investment cost per unit milled would be considerably below that of the larger, more integrated mills (Annex 7). 4.09 All the rice mills wou:Ld be cono types consisting basically of paddy cleaners, hullers and polishers with separators and ancillary equip- ment (Annex 6). The half-ton mills would mostly use only stone hullers, but all the larger ones would have rubber hullers as well. Despite the higher recoveries of rubber hullers, many mills are not yet ready to rely exclusively on them (Annex 4, paras 18-19), and, therefore, they would be encouraged to experiment with and use the rubber and stone hullers in what- ever arrangements they preferred.. The mills would not contain automated grain-handling equipment. Such modern equipment, although used extensively in Japan and the U.S., has not proved suitable for the Philippines where it is often more economic to use unskilled labor than expensive machinery. Almost all the mills under the project would be of local manufacture. 4.10 The corn mills would consist of cleaners, peeler/degermers, corru- gated mills (to grind the corn into grits), separators, and ancillary equip- ment. They would be similar to existing mills, and would be locally made. 4.11 All the mills would have solar driers, which are still the most efficient driers for removing most of the moisture from the paddy or corn on sunny days. The one-ton rice and corn mills would have, in addition, small mechanical batch driers, and the two-ton rice mills and five-ton corn mills would be equipped with larger continuous-flow driers. (These are only in- dicative configurations, since the mechanical drying capacity needed would vary with location as well.) 4.12 All the mills would require their own warehouses, on average sufficient to hold one-fourth of the mills' annual throughput. These would generally be conventional sack warehouses. Although bulk storage facilites would not be ruled out, most millers (except the largest) have no experience with them, and would not be storing enough grain or holding it long enough to make bulk storage advisable. 4.13 Except for the half-ton rice mills, the mills would rely primarily on their own trucks for hauling paddy from the farmgate to the mills, and the milled rice to the market. Almost all medium and large mills have found it necessary to have their own trucks so that they could obtain grain when and where it was available, instead of having to hope that hire trucks would be available when needed. 4.14 The rice mills are expected to operate an average of 2,000 hours per year, about the present national average for cono rice mills. The com- bined paddy throughput of the mills under the project would be about 300,000 tons of paddy per year, equivalent to about 4.3% of the Philippines' projected 1979 output, and 33% of the projected incremental 1976-79 production. The corn mills would probably average about 2,500 hours per year (vs. the present average of 2,900 hours for roller mills) and, thus, mill some 110,000 tons of  - 13 - grain per year, equivalent to 3.7% of the projected 1979 output and 37% of the expected incremental 1976-79 production. Most of the projected corn mills would be in Mindanao where the potential for corn production is greatest and the more even rainfall permits longer harvesting periods and hence higher mill utilization. The rice mills would be more widely spread about the country. 4.15 The project would finance about 20% of new rice and corn milling capacity over 1976-79. (Although the project's capacity would equal some 33% of incremental 1976-79 production, about 60% of the rice mills would be replacing less efficient mills.) The remainder of the new capacity would be financed by millers' retained earnings or by shorter-term funds from com- mercial sources. The project would enable small entrepreneurs lacking ade- quate capital to expand and modernize their operations. It would also enable grain traders to integrate into processing. In almost all cases the sub-loans would go to entrepreneurs already established in the grain industry in the local area, as outsiders would lack the necessary procurement conections. Project Cost and Financing 4.16 Total project cost is estimated at $28.5 million (P214.1 million), of which foreign exchange costs would be $11.2 million, or 39% of the total. The estimated costs for the different types of mills are given in Annex 8 and summarized as follows: Number of Units Local Foreign Total Local Foreign Total (P Millions) ($ Million) Grain Mills Rice mills Half-ton 34 4.0 2.4 6.4 0.6 0.3 0.9 One-ton 68 38.5 25.2 63.7 5.1 3.4 8.5 Two-tons 33 33.5 21.9 55.4 4.5 2.9 7.4 Sub-total 135 76.0 49.5 125.5 10.2 6.6 16.8 Corn mills One-ton 14 8.2 5.4 13.6 1.1 0.7 1.8 Five-tons 6 13.2 8.8 22.0 1.7 1.2 2.9 Sub-total 20 21.4 14.2 35.6 2.8 1.9 4.7 Base Cost Estimate 97.4 63.7 161.1 13.0 8.5 21.5 Expected Price Increases (31.%) 30.7 20.0 50.7 4.1 2.6 6.7 Total Expected Cost of Grain Mills 128.1 83.7 211.8 17.1 11.1 28.2 Grain Losses Study 1.5 .8 2.3 .2 .1 .3 Total Expected Cost of Project 129.6 84.5 214.1 17.3 11.2 28.5  - 14 - 4.17 Machinery and civil works would each account for about 30% of project costs, trucks for 26% and working capital for the remainder. The estimates and the foreign exchange component of each are as follows: Share Foreign Foreign lotal Cost in Total Exchange Exchange ($ million) % ($ million) (%) Machinery 8.48 30.0 4.45 52 Milling machinery 4.35 15.4 1.91 44 Engines and motors 1.96 6.9 1.30 66 Mechanical driers 1.24 4.4 0.70 56 Ancillary equipment 0.93 3.3 0.54 58 Trucks 7.41 26.3 4.19 57 Civil works 8.53 30.2 2.46 29 Buildings 7.91 28.0 2.37 30 Solar driers 0.62 2.2 0.09 15 Working capital 3.78 13.5 - _ Grain mills total 28.20 100.0 11.10 39 4.18 The Bank would meet the foreign exchange costs of the project ($11.1 million), and the full cost of the grain losses study ($.3 million). Sub-borrowers would be required to provide in cash at least 20% of the cost of the investment project (defined as the project cost excluding the cost of land and working capital). DBP would finance the remainder from its own resources. The total financing would therefore be as follows: Investment Working Grain Losses Total Project Project Capital Study Cost ($million) (%) ($million) (%) ($million) (%) ($million) (%) Sub-borrowers 4.9 20 - - 4.9 17 DBP 8.4 35 3.8 100 - - 12.2 43 IBRD 11.1 45 - - .3 100 11.4 40 Total 24.4 100 3.8 100 .3 100 28.5 100 4.19 The Bank loan would be made to GOP for 18 years, including five years' grace, at standard Bank lending rate of interest. With a 4 year sub- loan disbursement period, allowing for possible slippage, a five year grace period should be adequate. It is not expected that there would be any signifi- cant rollover. GOP would bear the foreign exchange risk and would onlend the proceeds to DBP on the same tenns under a subsidiary loan agreement. This agreement would specify the main operating procedures to be followed under the project, including the establishment of a separate project account in which  - 1 5 - all receipts and payments for or in connection with project implementation would be recorded. Execution of a subsidiary loan agreement between the Government and DBP, satisfactory to the Bank, would be a condition of ef- fectiveness of the Bank loan. Sub-borrowers and Sub-loan Conditions 4.20 Eligibility for sub-loans would be limited to individuals and pri- vate corporations with prior experience in the grain industry. Each subloan application would be filed either with the nearest DBP branch or the head office. The application would give details of the applicant's past experience in grain milling and trading, the status of his processing and storage opera- tions and facilities, the purpose of the loan and the collateral offered. The information would be sent to DBP's Grain Processing Division (GPD) for further investigation. The subloans would be approved by DBP's Board of Governors, on the basis of the findings of GPD regarding such factors as applicant's mana- gerial and technical competence, prior grain processing or trading experience, and grain availability (Annex 5). 4.21 On the basis of the past experience, the 14-year maximum repayment term effective for the first project appears to be appropriate for the pro- posed project. However, the grace period permitted for the subloans under the first project has been only for "the construction period of approximately one year", and this has been found to be too short as the sub-borrowers were required to commence payment of amortizations when their cash requirement for mill operation was at a peak, and, therefore, the maximum grace period would be extended to two years under the proposed project. DBP would exercise its discretion in determining the subloan terms, within the maximum permitted, taking into account the debt service capacities of sub-projects. For cash- flow analyses, an eleven year amortization has been postulated. 4.22 Based upon the interest schedule agreed at the negotiations for the Second Industrial Investment Project, DBP would charge 12.0% per annum for the loans secured by land and 14.0% for loans otherwise secured. Any future change in the rates DBP charges on its loans in general would be made applicable to commitment of sub-loans under the project. Since the cost of the money to DBP would be about 8.6%, 1/ the margin would be a minimum of 3.4% and there would be an additional 2.0% to cover the risks on loans not secured by land, these rates should be adequate and, at the same time, pro- vide, in view of the Philippines' projected long-term inflation rate of 7.5%, an acceptable real rate of interest of 4.5 to 6.5%. The borrowers would be required to pay other additional charges, such as (i) a one-time application fee of P60 to P500 depending on the amount of subloan, (ii) penalty interest charges of 2.0% per month on arrears of 90 days or more (this 2.0% is 1/ 56% of DBP sub-loans would be reimbursed by the Bank at 8.5% annual interest; the remainder would be covered by DBP's local funds with marginal annual interest cost of 8.75%. The local funds come largely from the public sector in the form of deposits, debentures and bonds.  - 16 - scheduled to be raised to 3.0% effective June 30, 1977), and (iii) DBP's appraisal and supervision costs for sub-loans exceeding P3.0 million, not to exceed 2.0% per annum on the loan outstanding, etc. DBP normally finances up to 85% of the appraised value of the collateral offered. 4.23 The permanent incremental working capital requirements of the pro- ject facilities would be about $3 million (in 1975 prices), equal to two weeks' (120 hours) grain throughput. D)BP would finance this out of its own resources. An additional $10 million, equal to a further six weeks' peak season through- put, would be needed for the peak working capital requirement just after harvest. Only some of the sub-borrowers, primarily the larger ones, would be able to finance this from commercial banks, large grain wholesalers, or their own funds. Therefore, DBP, on a selective basis, would meet these additional requirements if its investigations revealed that the sub-borrower did not have access to other funds for this purposes. DBP currently makes working capital loans for nine months, renewable five times but each time the borrower is required to repay one-sixth of the original loan. Thus the total period is 4-1/2 years. Interest rates would be the same as for investment project subloans. Free Limit 4.24 Any subloan which, together with any other subloan or working capital loans to the same sub-borrowers under the first and second Bank- financed projects, exceeds $600,000 would be subject to the Bank's approval. Such subloans would be submitted to the Bank together with DBP's project feasibility study demonstrating the technical, managerial, financial and economic viability of the sub-project. The form of these reports would be substantially the same as those submitted under the first project, and the reports would include the information on applicant's experience, qualification, financial position, etc. listed in Annex 5. Procurement 4.25 Civil works contract with an estimated cost of $200,000 or more would be awarded on the basis of international competitive bidding in accord- ance with Bank guidelines. DBP would be permitted to use prequalification, but the list of prequalified contractors would be updated at intervals of not more than eighteen months. The text of invitations for prequalification, the procedure to be followed for international advertisement, and the final deci- sion on the prequalification of contractors would be subject to prior Bank consent. In addition, bid invitations, specifications and contract awards relating to international competitive bidding would be subject to prior Bank consent. 4.26 Most of the sub-projects would be too small to attract foreign con- tractors not already established in the Philippines. Bulking would not be suitable, as the sub-projects would be scattered across the country and spread over different times, and their configuration would vary considerably from one to another. Civil works contract with an estimated cost of $100,000 or more but less than $200,000, therefore, would be let through local competitive  - 17 - bidding in accordance with procedures acceptable to the Bank, and civil works contract costing less than $100,000 would be through ordinary commercial channels. 4.27 The procurement procedures for equipment need to take into account sub-borrowers' justified preferences for equipment and to permit them to purchase spare parts and improvements to their existing equipment or choose the most efficient new equipment for the quality of processed grain needed by their markets. International competitive bidding could not take full account of these factors. To take advantage of international competition, however, equipment contract with an estimated cost of $20,000 or more would be awarded on the basis of quotations received from internationally pre- qualified suppliers, taking into account the technial suitability of equip- ment chosen by the sub-borrowers and suppliers' ability to provide service and spare parts. For this purpose, DBP would prepare an annually updated list of qualified suppliers, on the basis of an international advertisement inviting firms to indicate their capabilities and interest in being included in the list of qualified suppliers of goods likely to be financed under the project. 4.28 For equipment estimated to cost $100,000 or more, DBP and the sub- borrower would together establish the design criteria and performance speci- ficiations required, and send to the Bank copies of (i) the bid invitations sent to suppliers, (ii) the bids submitted, and (iii) the awards made, with an explanation of any award not made to the lowest bidder. For equipment costing more than $20,000, DBP would send the list of qualified suppliers to the sub-borrowers and require them to obtain written quotations from at least three of the qualified suppliers and to justify to DBP any award not made to the lowest bidder. Sub-borrowers would be permitted to obtain quotations, and to procure from any other suppliers if the terms and conditions were more advantageous. Procurement of equipment costing less than $20,000 would be through ordinary commercial channels, with due regard for economy and suitability. Disbursement 4.29 The Bank would reimburse: (i) 56% of DBP's disbursements for invest- ments project sub-loans (excluding working capital), representing the estimated foreign exchange component, upon submission of documentation by DBP supported by statement of expenditure, and (ii) 100% of expenditure, up to $300,000, on items to be agreed upon between the Bank and the Borrower, for the post-harvest grain losses study. Supporting documentation would be retained by DBP (for sub-loans) and the Borrower (for the study) for review during the course of project supervision. An estimated quarterly schedule of disbursements appears in Annex 11. Audit and Accounts 4.30 Under the Second Industrial Investment Project through DBP (Loan No. 1190-PH), a series of measures were agreed by DBP and the Commission on Audit (COA) which are expected to result in substantial improvements in the quality and coverage of the audit. In particular, COA will now undertake a thorough review of DBP's portfolio with a view to determining its quality and  - 18 - recommending appropriate corrective actions. Satisfactory progress is being made in this direction and COA has already submitted an audit report for FY75 in the form required by the Bank. The report is under review. Further- more, records and accounts pertaining to all Bank-financed agricultural proj- ects would be kept and audited separately; the depth and coverage of this audit would be satisfactory. A copy of the audited report would be sent to the Bank within three months of the close of the fiscal year until full dis- bursement of the loan. Sub-borrowers' Reports 4.31 In order to ensure that the subloans were being effectively utilized, DBP would obtain semi-annual reports from all project sub-borrowers, showing, on a monthly basis, the utilization of milling, storage and drying facilities. The form of these reports would be agreed with DBP, and the information would be forwarded to the Bank with DBP's quarterly reports (see para 4.31). In addition, under subloan contracts, sub-borrowers would be required to main- tain financial records that would be available upon request to DBP, which would be empowered to have sub-borrowers' accounts audited by independent accountants or its own staff. DBP's Reports 4.32 DBP would submit to the Bank quarterly progress reports, within 30 days of the end of the quarter. These reports would include data on subloan applications, approvals and disbursements, on working capital loans, machinery and civil works procurement, as well as utilization and repayment of the subloans. 4.33 DBPF's Grain Processing Division would keep a register of all contacts made by potential sub-borrowers showing (i) date of first contact, (ii) form of contact, (iii) project envisioned by potential sub-borrower, (iv) date of acceptance of application, or if rejected, reason for rejec- tion, (v) date and amount of loan recommendation by GPD, (vi) date and amount of approval by DBP's Board, showing purpose of loan, type and size of facilities to be procured, amount approved for civil works, machinery, vehicles and working capital, (vii) dates and amounts of disbursements, (viii) manufacturers and specifications of machinery procured, (ix) super- vision visits made and problems encountered, and (x) dates and amounts of payments of interest and principal. The information to be included has been agreed upon at negotiations. The register would be open for inspection by the Bank. V. ORGANIZATION AND MANAGEMENT Development Bank of the Philippines (DBP) 5.01 DBP was established in 1958 (Republic Act No. 85) as an auto- nomous government-owned development bank for supplying credit to industry  - 19 - and agriculture. 1/ It is the single largest institutional source of long- term funds in the Philippines. Since its inception, it has approved financial assistance totalling nearly $3 billion. The volume and diversity of its operations give it a prominent and unique role as the Government's arm for financing economic development. The bulk of its activities has been in loans and guarantees for industry and agriculture. 5.02 Overall management of DBP is entrusted to a nine-man Board of Governors consisting of the Chairman (who is chief executive officer), four full-time Supervising Governors (one position is now vacant) with responsibility for different departments of DBP, and four part-time Governors (presently the former Executive Secretary to the President, the Secretary of Industry, a private lawyer, and one vacancy). One of the Supervising Governors is Vice-Chairman of the Board. The present Chairman, Leonides S. Virata, was appointed in February 1970. 5.03 DBP's operating core consists of three broad departmental groupings (Industry, Agriculture and Community-Development) each under the direction of a Supervising Governor. In the past two years, DBP has concentrated its efforts on consolidation. As a result, noticeable improvements in the functioning of individual departments and in inter-departmental coordination have taken place. DBP has a total staff of about 3,000, 55% of whom are located in the 35 branches and 24 agencies. The staff is of generally good calibre. Salaries are competitive with other Government financial institutions, and above those of the general civil service. 5.04 The Bank has so far approved eight loans totalling $213.4 million, all since 1971, for on-lending through DBP. 2/ In addition, the Second Fisheries Project for $12.0 million has been appraised recently, and the Second Shipping Project will be appraised soon. 5.05 Through FY74, the large majority of DBP's financial assistance consisted of the guaranteeing of foreign loans - in FY74, this was 88% of all operations (by amount). In FY75, however, there was a dramatic change as DBP's loan approvals rose from P0.3 billion in FY74 to P2.4 billion, while its guarantees fell from P2.8 billion to P0.8 billion. As of June 1/ For more comprehensive description of DBP, see Appraisal of a Second Loan to the Republic of the Philippines for Industrial Financing through the Development Bank of the Philippines, Report No. 872a-PH, 1975. 2/ Rice Processing and Storage Project, 720-PH, $14.3 million, Fisheries Credit Project, 891-PH, $11.6 million, (First) Livestock Develoment Project, 823-PH, $7.5 million, Second Livestock Development Project, 1225-PH, $20.0 million, (First) Industrial Investment and Smallholder Tree-Farmers Project, 990-PH $50.0 million, Second Industrial Investment Project, 1190-PH, $75.0 million, Shipping Project, 1048-PH, $20.0 million, and Small and Medium Industries Development Project, 1120-PH, $15.0 million (out of a country-wide $30.0 million).  - 20 - 1975, DBP's total assets stood at P7.84 billion, an increase of 48% from P5.28 billion a year earlier. DBP's liquidity position is reasonably sound (current ratio of 2.1) as is its present long-term capital structure (total debt/equity ratio of 4.5:1). At negotiations f'or the Second Industrial Investment Project, DBP gave assurances that it would take a number of agreed steps to strengthen its financial position. 5.06 DBP's net income for FY75 was P71.4 million, 21% below its FY74 net income. This decline is in sharp contrast to the rising performance trend of FY73 and FY74. Since DBP's financial statements are prepared on an adjusted cash rather than on an accrual basis, the decline in income reflected mainly a decline in collections as a result of adverse economic conditions which affected many of D)BP's clients, and rapidly rising expenses. In judging its financial performance, it is essential to recog- nize that DBP is a government-ownecd development-oriented institution and that its earnings performance is not strictly comparable to that of private profit-oriented institutions. Nevertheless, the continuation of the present income trend on its loan portfolio can only increase DBP's reliance on con- tinual government assistance. A low level of collections and the magnitude of its arrears continue to pose the! main financial problems for DBP. At negotiations for the Second Industrial Investment Project, DBP agreed to a number of measures to improve its income, including higher interest rates and better loan-collection efforts (Annex 2, paras 15-16). 5.07 DBP has been a major source of credit for the grain milling and trading sector. Unfortunately, due to the poor appraisal standards and inadequate supervision and collection efforts, many of the loans have had poor repayment performance, and DBP has virtually stopped lending in that sector except for the Bank's first Rice Processing and Storage Project (Loan No. 720-PH). As of December 31, 1975, DBP had 806 Loans outstanding for rice and corn trading and milling, totalling P97.8 million of which P52.7 million (53.8%) was overdue. This arrears position marked a slight improvement over the previous year, but the collection rate was still only 21%. In addition, DBP has had to advance over P50 million on two rice mills whose suppliers' credits it guaranteed, and is liable for an additional PIO million. As both of these mills are operating far below capacity and are beset by continuing difficulties, DBP is likely to lose all or most of its P60 million guarantees. Under the proposed project, intensified efforts would be made to improve the collection performance by institutinag a system f'or monitoring and supervising sub-projects more closely. In addition, as stated in Annex 2 para 18, DBP is already taking steps to improve its arrears position. Grain Processing Division 5.08 To implement the first project, a Grain Processing Division (GPD) was created in DBP. Together with the Grain Production Division, it forms the Cereals Group, one of the main tnits of the Agricultural Projects Department (Chart 2). The head of the Cereals Group is the designated Administrator of the first project, and was appointed in consultation with  - 21 - the Bank. He reports to the Manager of the Agricultural Projects Department, who is under the Supervising Governor responsible for agriculture and the branches. 5.09 Under the first project, GPD has been gaining valuable experience in project implementation, and its appraisal standards have been improving. It was strengthened in early 1975 by the addition of three engineers, in line with the recommendation of a Bank supervision mission, and it now con- sists of four engineers, two financial analysts and one economist, in addi- tion to the division head. It needs further strengthening in dealing with the economics/marketing aspects, and assurances have been obtained that DBP would employ at least two additional professionals for strengthening its economics/marketing staff. VI. MARKETS AND PRICES 6.01 Since the Philippines is expected to continue to import rice and corn, no major problems in marketing project output are anticipated. Prices of paddy and corn have more than doubled over the past five years. Market prices of paddy often exceeded the NGA floor price of P1.00/kg, and those of corn remained around P0.80 kg, the NGA floor price. 6.02 Rice is at present generally sold by retailers at the P1.90/kg retail price ceilings, or even above. The ex-mill rice price used in the financial analysis, P1.75/kg, corresponds to a cif price of $230/ton. This is well below the average 1975 cif cost of $300/ton (for Thai 30% brokens), but almost exactly equals the Bank's average projected price (converted to cif Manila, September 1975 prices) over the life of the project (Annex 12, Appendix 1). 6.03 Corn grits are sold retail at about P1.30/kg, or P0.10 below the retail price ceiling of P1.40/kg, and P1.20/kg has been used in the financial analysis as the mills' sales price. Since corn grits are not traded extensively internationally, the price comparison must be made be- tween local and imported corn grains. The farmgate price of P0.80/kg for corn corresponds to a cif price of about $110/ton, which is somewhat below the average 1975 cif cost of $135/ton, but just equals the Bank's average projected price over the life of the project. VII. BENEFITS AND JUSTIFICATIONS 7.01 The proposed project would facilitate the introduction of modern high recovery mills to replace or improve old inefficient ones, and would help meet the milling requirements of new rice and corn production in the Philippines. The principal investment would be for (i) rice and corn mills, (ii) mechanical grain driers, (iii) grain storage, and (iv) trucks. The  - 22 - mills would raise both the quantity and quality of the grain produced and allow better utilization of by-products. The driers would be helpful in reducing the post-harvest grain losses which are at times quite extensive, and in facilitating the spread of high yielding varieties maturing in the wet season. The grain storage would support efficient milling and marketing and also reduce grain losses. The trucks would alleviate the transportation bottlenecks in the harvest season and help the millers to procure sufficient grain, even in remoter areas. Generally, the project is expected to contri- bute significantly to rural growth in the Philippines by providing more secure and competitive outlets for rising paddy and corn production of farmers, many of whom are small--scale. 7.02 When all the 135 rice mills and 20 corn mills financed under the project are operational, they are expected to process annually 300,000 tons of paddy, turning out 207,000 tons of milled rice with a total wholesale value of $48 million, and process 110,000 tons of corn into 72,000 tons of corn grits valued at $11.4 million. In addition, 60,000 tons of by-products (mainly bran) with an estimated wholesale value of $6.7 million would be produced for the feed industry. 7.03 The project would yield three kinds of quantifiable benefits: (i) reduced post-harvest grain losses, that is, the losses prevented by providing efficient transport, mechanical drying, and appropriate storage (these losses are now particularly heavy for the wet season harvests and the grains that are stored in the open or in antiquated facilities), (ii) higher rice milling recoveries that would be achieved as a result of the more efficient milling techniques introduced by the project (the medium and larger-size rice mills with rubber hullers would obtain average recoveries of 69%, and the small cono mills of 65%, compared to 60% from the kiskisan mills they would tend to replace), and (iii) induced corn production, in areas where it would not take place unless adequate processing facilities were available.  - 23 - 7.04 The detailed estimates of annual gross benefits from the three sources are given in Annex 12 and summarized below: Rice Mills Milled Rice By-product (Bran) tons value ($) tons value ($) Post-harvest losses prevented 8,280 1,930,000 960 100,000 Incremental milling recoveries 10,300 2,400,000 (6,480) (690,000) Total 18,580 4,330,000 (5,520) (590,000) Corn Mills Corn Grits By-products tons value ($) tons value ($) Post-harvest losses prevented 5,700 910,000 2,800 330,000 Incremental production induced /a 14,300 2,290,000 7,000 820,000 Total 20,000 3,200,000 9,800 1,150,000 /a Gross value of corn grits and by-products (see Annex 12, para 18). 7.05 As summarized below, the estimated financial rates of return on investments range from 25% to 28%, and corresponding economic rates of return range from 16% to 30%, with a weighted average of 28% (Annex 12). The rates of return on equity would range from 48% to 61%. Rates of Return Financial Economic Rice Mills 1/2 ton per hour model 27% 16% 1 ton per hour model 25% 27% 2 ton per hour model 27% 30% Corn Mills 1 ton per hour model 28% 29% 5 ton per hour model 28% 30% Weighted Average 27% 28% In addition, since the Philippines is expected to import rice and corn for quite some time to come, part of the benefit would take the form of a foreign exchange saving equivalent to $6.0 million per year.  - 24 - Environmental Effects 7.06 Rice and corn milling entail virtually no pollution of the envi- ronment. The only waste disposal problem is the rice hulls, which are often piled in mounds near the mills. They can be unsightly, but are usually inconspicuous, and eventually decay and return to the soil. In any case, the mounds would be there even without the project, given the expanding paddy production and the increased use of cono mills. Promising experiments are being carried out to see if rice hulls could be used as fuel for mechanical grain driers, and, if these shou'ld succeed, the grain mills would have ab- solutely no negative environmental effect. Moreover, DBP would continue to require_certification from the Air and Water Pollution Commission of adequate anti-pollution measures for all sub-projects. VIII. RECOMMENDATIONS 8.01 The proposed project is suitable for a Bank loan of $11.5 million at standard Bank lending rate of interest repayable over 18 years, including 5 years' grace period. 8.02 The condition of effectiveness would be execution of a subsidiary loan agreement between DBP and GOP satisfactory to the Bank. 8.03 Assurances have been obtained at negotiations that DBP would collect semi-annual reports, in a form agreed upon, from all project sub-borrowers, showing, on a monthly basis, the utilization of project facilities, and sub- mit to the Bank summaries of such impact data along with its quarterly progress reports (para 4.30), and that DBP would include in its quarterly progress reports data on sub-loan applications, approvals, disbursements, repayments and arrears (para 4.31). 8.04 Assurances have been obtained that DBP would make its best efforts to reduce arrears and would undertake and complete a comprehensive portfolio re- view program and prepare a detailed plan of action for improving repayment collections for discussion with the Bank not later than June 30, 1977 (para 5.07). 8.05>-- Assurances have been obtained at negotiations that DBP would strengthen the technical capability of the Grain Processing Division by the addition of at least two specialists for sub-project appraisal (para 5.09).  ANNEX 1 Page 1 PHILIPPINES SECOND GRAIN PROCESSING PROJECT The First Grain Processing Project 1. The Rice Processing and Storage Project, (Loan 720-PH) which was signed February 4, 1971, and became effective May 19, 1971, provided for a $14.3 million loan to GOP, to be onlent to DBP to help finance construction of integrated modern rice-processing plants. The project called for very modern mills, including bulk silos and automated grain handling facilities. There were to be about 30 small facilities with a milling capacity of 1.2 tons of paddy per hour having a bulk storage with a static capacity of 2,000 tons, and six large facilities with a 4 tons per hour capacity having a bulk storage with a static capacity of 5,000 tons, costing $270,000 and $800,000 per unit, respectively. In addition, the project provided funds for expan- sion of 30 existing small mills at $200,000 per unit. To provide technical support, the project included a training course in grain milling, run joint- ly by the United Nations Development Programme (UNDP) and the University of the Philippines College of Agriculture (UPCA) at Los Banos, and engineering consultants to DBP on rice milling. 2. The original design of integrated rice mills, which initially con- stituted the core of the project, proved to be too large and too capital- intensive for the Philippine context. Furthermore, Philippines' rice pro- duction dropped sharply in the two years following project effectiveness. As a result, demand for sub-loans did not materialize, and the Bank there- fore agreed to permit loans for improvement of existing rice and corn mills (March 1972), financing of other post-harvest equipment, smaller sub-loans, and sub-loans for individuals and specified public entities (May 1974). The project has met the foreseeable need for bulk silos for feed mill complexes and has enabled rice and corn production to expand into new areas, particu- larly in Mindanao. In addition, it has also supported the expansion and modernization of the domestic rice and corn mill equipment manufacturing industry. 3. Sub-loan approvals began almost immediately under the revised project, and have continued at a rapid pace. As of February 20, 1976, DBP had approved 132 sub-loans amounting to P91.8 million ($12.2 million), had disbursed P28.3 million ($3.8 million), and had in the pipeline 30 new sub- loan applications for P31.8 million ($4.3 million). As the Bank reimburses 90% of DBP's disbursements, this means that 79% of the $13.9 million of Bank funds available for sub-loans under the project ($0.4 million having been disbursed for consultant services) has already been committed and a further 28% applied for, although only 25% has been disbursed by DBP. The level of disbursement is low because most sub-loans, especially the large ones, have only recently been approved. As of March 24, 2976, total Bank  ANNEX 1 Page 2 disbursements were $3.3 million, cr 23% of the Bank loan. The project is expected to be fully committed by June 30, 1976, and fully disbursed by the Closing Date, June 30, 1977. 4. Of the total amount of the sub-loans approved, 49% (P45.3 million) is for the three large corn-silo/feedmill complexes, 39% is for rice mills, 10% for corn mills and 2% for small feed mills. Most sub-projects appear likely to be successful. 5. The 76 rice mills 1/ are scattered across the country, with 12 in the Cagayan Valley region, 15 in Central Luzon, 9 in Southern Tagalog, 4 in Bicol, 9 in the Visayas, and 13 in Mindanao. On the other hand, 5 of the 6 feed mills are in Southern Tagalog (with the 3 large complexes just outside Manila), and 8 of the 11 corn mills are in Mindanao. Of the total amount sub-loans, 75.7% is in the Luzon regions including Mindoro and Palawan), 5.3% is in the Visayas and 19% in Mindanao. Excluding the 3 large feedmill/ silo complexes which would draw grain from all over the country to service Manila, the distribution by amount of lending becomes: Luzon 52.5%, Visayas 10.3% and Mindanao 37.2%. The lending level is low in the Visayas because existing capacity there is generally adequate, and grain production there has been growing only slowly, as little new land is available for development. Of the first 61 sub-loans approved, 42% of the funds were for civil works, 14% for trucks and 44% for machinery; excluding the large feed mills, the figures are 29%, 28% and 43% respectively. From its other funds, DBP has also approved working-capital loans of P33.7 million to project sub-borrowers, of which P18.7 million went to two of the feed-mill/silo complexes. 6. Five of the early sub-borrowers imported complete rice mills from Japan, but all of the others have purchased locally-made mills. However except for small rice mills (capacity of a half ton per hour, or less, which are replacing kiskisans) all the rice mills have imported rubber hullers, as required under the project. About half of the mills have purchased mechanical driers; the remainder are relying on solar drying. 7. Under the Loan Agreement, DBP is required to send to the Bank for approval all sub-projects involving sub-loans exceeding $400,000. So far, 5 projects - 3 feed mills, 1 rice mill and 1 corn mill have been sent and approved. In addition, Bank consent is required for the bidding docu- ments and awards for all contracts for civil works exceeding $100,000. This clause has also been applicable so far only to the same 5 sub-projects as above. So far, tender documents and bid awards have been approved for 3 sub-projects. 1/ Including 4 loans in 1976, but excluding some 35 sub-loans below P60,000, all of which are sub-loans for minor mill components.  ANNEX 1 Page 3 8. Both the costs and the benefits of grain milling increased sharply over the life of this project. For example, the average cost of mill build- ings and sack warehouses was P210/m2 at the time of appraisal (late 1970), but had risen to about P500/m2 five years later. (The increase in dollar terms was somewhat less - from $35/m2 to $67/m2 - due to the Peso devaluation from P6.00 = $1.00 to P7.50 = $1.00.) Imported Japanese trucks increased even more sharply over the same period - from about P56,000 ($9,333) to P145,000 ($19,333) - due largely to exchange rate changes. On the other hand, grain prices - and millers' margins - also rose. 9. The consultants performed the work required of them in regards to assisting DBP to prepare the design, specifications and tender documents, but, with the shift in emphasis of the project, their usefulness diminished sharply. Their contract was terminated, therefore, at the end of 1974. 10. The training program was implemented successfully by UNDP and UPCA, reaching over 200 students annually completing the four to ten week, courses. However, it had little practical bearing upon the project proper as very few sub-borrowers participated because: (i) the training program began well before any sub-loans were finally made; (ii) most sub-borrowers could not spare the time to go or to let their employees go; (iii) the course was more academic and less applied than would be suitable for most mill operators, and therefore was attended by people mostly from the public and academic sectors; and (iv) most sub-borrowers had considerable experience in grain milling, and felt they could obtain adequate training in operating their new mills from the mill supplier's representatives (the suppliers generally provide this training as part of the purchase price). UNDP in- volvement ended with the program's completion, but UPCA, in collaboration with NGA, is continuing the grain milling training program. 11. To implement the project, a Grain Processing Division (GPD) was created in DBP. Together with the Grain Production Division, it forms the Cereals Group, one of the main units of the Agricultural Projects Department (See the Organization Charts, Annex 2). The head of the Cereals Group is the designated Administrator of the project, and was appointed in consultation with the Bank. He reports to the Director of the Agricultural Projects Department, who is under the Supervising Governor responsible for agriculture and the branches. 12. Under the project, GPD has been gaining valuable experience in project implementation, and its appraisal standards have been improving. The division was strengthened in early 1975 by the addition of three engineers, in line with the recommendation of a Bank supervision mission. The Division now consists of four engineers, two financial analysts and one economist, in addi- tion to the division head. It needs further strengthening in dealing with the economics/marketing aspects. In addition, it needs to expand its monitoring of sub-loans.  ANNEX 1 Page 4 13. The project has met the immediate and foreseeable need for bulk silos for feedmill complexes and has enabled rice and corn production to expand into new areas, especially in Mindanao where lack of adequate drying, transport, milling and storage facilities was a major constraint. In addition, it has supported the expansion and modernization of the domestic rice and corn-mill construction industry. In-particular, some mill con- struction firms now offer rubber hullers as optional equipment for their mills, and the spread of rubber hullers beyond project sub-borrowers is a major ancillary benefit of the project. EAP Projects Department March 26, 1976  ANNEX 2 Page 1 PHILIPPINES SECOND GRAIN PROCESSING PROJECT The Development Bank of the Philippines (DBP) Background 1. DBP was established in 1958 (Republic Act No. 85) as an autonomous government-owned development bank for supplying credit to industry and agri- culture. It succeeded the Rehabilitation Finance Corporation, created in 1947 primarily for post-war reconstruction. DBP is the single largest in- stitutional source of long-term funds in the Philippines. Since its incep- tion it has approved financial assistance totalling nearly $3 billion. The volume and diversity of its operations give it a prominent and unique role as the Government's arm for financing economic development. 2. Under its Charter, DBP is empowered to engage in a wide range of financial activities, including: (i) granting loans for the establishment or development of any agricultural or industrial enterprise, including public utilities, mining, livestock, fisheries, and home financing; (ii) purchasing equity investments in any agricultural or in- dustrial enterprise; (iii) guaranteeing loans and other obligations incurred for the development of agriculture or industry; and (iv) granting loans to provincial and municipal governments for self-liquidating or income-producing projects; The bulk of its activity, however, has been in loans and guarantees for industry and agriculture. About 25% of the long-term loan portfolio is in agriculture. In 1964, it was also given the responsibility of assist- ing in the establishment of smaller private development banks throughout the Philippines. Management and Staffing 3. Overall management of DBP is entrusted to a 9-man Board of Governors consisting of the Chairman (who is chief executive officer), 4 full-time Supervising Governors (one position is now vacant) with responsibility for different departments of DBP, and 4 part-time Governors (presently the former Executive Secretary to the President, the Secretary of Industry, a private lawyer, and one vacancy). One of the Supervising Governors is Vice-Chairman of the Board. The present Chairman, Leonides S. Virata, was appointed in February 1970.  ANNEX 2 Page 2 4. DBP's present organization (Chart No. 9981) dates from September 1973. The operating core consists of three broad departmental groupings (Industry, Agriculture and Community Development) each under the direction of a Supervising Governor. A fourth grouping of central support departments is under the direct control of the Chairman. In addition, two other offices, Legal and Audit, are linked loosely to the organization, although these offices are under the functional jurisdiction of respective independent bodies, i.e., the Department of Justice, and the Commission on Audit (COA). In the past two years DBP has concentrated its efforts on consolidation. As a result, noticeable improvements in the functioning of individual departments and in inter-departmental coordination have taken place. 5. DBP has a total staff of about 3,000, 55% of whom are located in the 35 branches and 24 agencies. The staff must have civil service eligibility and is of generally good calibre. Salaries are competitive with other Government financial institutions, and above those of the general civil service structure. Bank Lending to DBP 6. The Bank has so far approved 8 loans totalling $213.4 million, all since 1971, for on-lending through DBP: 1/ In addition, the Second Fisheries Project for $12.0 million has been appraised recently, and Shipping II will be appraised soon., Operations 7. Through FY74, the large majority of DBP's financial assistance consisted of the guaranteeing of foreign loans - in FY74, this was 88% of all operations (by amount). In FY75, however, there was a dramatic change, as DBP's loan approvals rose from P0.3 billion in FY74 to P2.4 billion (of which 23% was to agriculture), while its guarantees fell from P2.8 billion to P0.8 billion (Table 1). Part of the lending increase (F0.9 billion) was for a special program of hotel construction (geared in part to the IBRD/IMF Annual Meeting in Manila in October 1976), but other lending rose sharply as well, due largely to the increased availability of funds from the Bank, Central Bank of the Philippines (CB), Department of Finance, and commercial banks, which enabled it to substi- tute direct lending for a substantial proportion of its guarantee opera- tions, chiefly of suppliers' credit for capital goods imports. In addition, 1/ Rice Processing and Storage Project, 720-PH, $14.3 million, Fisheries Credit Project, 891-PH, $11.6 million, (First) Livestock Development Project, 823-PH, $7.5 million, Second Livestock Development, 1225-PH, $20.0 million, (First) Industrial Investment and Smallholder Tree-Farmers Project, 998-PH, $50.09 million, Second Industrial Investment Project, 1190-PH, $75.0 million, Shipping Project, 1048-PH, $20.0 million, and Small and Medium Industries Development Project 1120-PH, $15.0 million (out of a country-wide $30.00.  ANNEX 2 Page 3 the Credit Guarantee Corporation took over part of DBP's role as a guarantor. Equity investment approvals, mainly in government enterprises, rose to P 212 million from P 79 million in FY74. Financial Position 8. As of June 30, 1975, DBP's total assets stood at P7.8 billion (over US$1 billion) up from P5.3 billion a year earlier (Table 2). DBP's liquidity position is reasonably sound (current ratio 2.1) as is its present total debt/equity ratio of 4.5:1 (long-term debt being inclusive of contingent liabilities). 9. An increasing proportion of DBP's long-term local currency loans, however, is being financed with short-term funds. This should be corrected to ensure DBP's future ability to service its debts. In particular, a large part of the hotel financing program approved by DBP in FY75 is to be financed by a one-year securities repurchase agreement with CB, which would be rolled over for at least five years. Furthermore, the approval of most of DBP's domestic currency industrial and agricultural loans in FY75 has been based on an increase in its short- and medium-term holdings of deposits from the Treasury and other government financial in- stitutions. A part of these deposits might be rolled over and, therefore, considered long-term, but there is no certainty as to the amounts or the length of time the rollover might be permitted. 10. DBP's management recognizes the need to increase its long-term domestic resources. In the first nine months of FY75, DBP issued P500 million in medium-term notes (5 years, 9%) and plans to raise another P1 billion between FY77-81 through a savings bond scheme. These actual and planned efforts will go some distance toward establishing an adequate long-term resource base. However, DBP will still need additional long-term funds to support its existing commitments. Financial Performance 11. DBP's net income for FY75 was P71.4 million, 21% below its FY74 net income. This decline is in sharp contrast to the rising performance trend of FY73 and FY74. The decline in income reflected mainly a decline in collections and rapidly rising expenses, which included a depreciation charge of P42 million on its assets acquired through foreclosures. In judging DBP's financial performance, it is essential to recognize that DBP is a government-owned development-oriented institution and that its earnings performance is not strictly comparable to private profit-oriented institu- tions. At negotiations for the Second Industrial Investment Project, DBP undertook to take steps to improve its financial position, and these would include (i) an across the board upward revision of interest rates (within ceilings presently allowed by the Monetary Board for those loans not covered by specific statutes), guarantee fees and associated charges on all future loan accounts, (ii) radical measures to improve its collections performance, including better follow-up, and (iii) an increase in its penalty charges on overdue accounts.  ANNEX 2 Page 4 Arrears and Collections 12. A low level of collections and the magnitude of its arrears continue to pose the main financial problem for DBP. As of June 30, 1975, 60% of the accounts, totalling 46.8% of principal outstanding, were in arrears, with overdue principal and interest amounting to 15.5% of the outstanding portfolio. Development Bank of the Philippines Arrears Position on Loans as of June 30, 1974 and 1975 1974 1975 No. of accounts in arrears as Z of total number of accounts 56.6% 60.0% Amount in arrears as % of principal outstanding 23.5% 15.5% Principal affected by arrears as % of principal outstanding 58.7% 46.8% 13. DBP has not always made adequate efforts to improve its collec- tions performance. However, judgments about DBP's arrears situation have to be tempered by the recognition that (i) as the major financier of entire industries, 1/ DBP is highly vulnerable to changes in the economic conditions affecting these industries, and in view of the wide repercussions of any actions it takes, DBP does not have complete freedom of maneuver in dealing w'th its arrears problem, and (ii) the peso devaluation in 1970 caused outstanding obligations of foreign currency borrowers to increase by about 70%; given the economic conditions prevailing, most borrowers were unable to service the additional debt along with previous amortization schedules. With DBP's reluctance to reschedule loans, these accounts simply kept piling up arrears. 14. Delinquencies on DBP's guarantee portfolio are also a major cause for concern, with about 50% of DBP's guarantee portfolio being affected by arrears. Defaults on guarantees have required DBP to advance an average of about P400 million a year over the last 4 years to honor foreign obligations. These advances, which are immediately due and payable by clients, have also accumulated extensive arrears. DBP has reduced these arrears primarily by converting them into long-term loans: 1/ At present, DBP has provided, through loans and guarantees, more than 50% of the term finance needed to purchase the assets of the following entire industries: textiles, wool products, pulp and paper, cement, coconut oil milling, sugar, steel and shipping.  ANNEX 2 Page 5 Development Bank of the Philippines Arrears on Guarantee Accounts (Amount in P million) FY73 FY74 FY75 Advance on guarantees during period 442.9 323.4 375.2 Less: Repaid to DBP during period 128.6 146.1 68.4 Less: Converted to long-term loans 165.3 367.1 539.2 Less: Transferred to litigation accounts or acquired assets, etc. 1.3 89.9 6.1 (a) Advances outstanding at end of period 1,066.6 786.9 548.4 (b) Guarantees outstanding at end of period 2,566.3 2,999.7 3,514.6 (c) (a) divided by (a+b) 41.6% 26.2% 13.5% 15. Reflecting the Government's concern over arrears, a Presidential Decree (P.D. 358) was passed in January 1974, requiring government financial institutions (in particular DBP) to mandatorily foreclose on loans and ad- vances for which arrears exceeded 20% of outstanding obligations. In the wake of this measure, DBP's loan collection efforts were stepped up; unfor- tunately, with the economic downturn in FY75 which affected several major Philippine industries (particularly the export oriented ones), DBP had to slacken its pressure on borrowers to repay. This factor notwithstand- ing, the main reasons for the high level of arrears are: (i) the inade- quacy of DBP's system and practices for recording and reporting arrears; (ii) poor follow-up and collection practices; (iii) low penalty rates which make it profitable for borrowers to postpone repayments, placing their funds instead in the money market; and (iv) overdues on several large industrial accounts which should have been rescheduled two or three years ago. 16. Steps are now being taken to reduce arrears by rescheduling those major accounts on which such action is warranted and overdue. Follow-up and collection practices are also gradually being improved. To bring this per- sistent and serious problem under control, agreement was reached at the Second Industrial Financing Project negotiations that DBP would, inter alia, reschedule all accounts in need of such action by March 31, 1976; increase penalty charges; and intensify follow-up and collection efforts. The Government also  ANNEX 2 Page 6 agreed that it would protect DBP against the risk of default or loss on all accounts which DBP finances at the Government's request (e.g. the hotels). Furthermore, in view of information available about the quality of its portfolio, agreement was reached on DBP's making adequate provisions for reserves against losses on doubtful accounts, or from possible currency fluctuations on loans on which DBP bears the foreign exchange risk. Audit 17. An evaluation of DBP's audit was undertaken in conjunction with the appraisal of the Second Industrial Investment Project. The audit, carried out by the Commission on Audit (COA), was found to be thorough as far as the test- ing of detailed transactions went. However, it was found to lack analytical content and to include no analysis of DBP's portfolio; nor was it suffi- ciently supported by adequate documentation. Moreover, unqualified audit opinions did not point out: (i) --hat DBP's financial reporting differed in material respects from "generaLly accepted accounting principles" as applied in the Philippines; and (ii) that the audit was not conducted fully in accordance with "generally accepted auditing standards". DBP's manage- ment and COA staff expressed a willingness to incorporate necessary changes in present auditing practices and appropriate qualifications in audit reports to meet the Bank's requirements. At negotiations of the Second Industrial Financing Project agreement was reached on the following: (i) submission to the Bank of an annual audit report on DBP prepared in accordance with the Bank's "Illustrative Form of Audit Report for Development Finance Companies"; (ii) inclusion of a thorough portfolio analysis in COA audit reports; and (iii) submission to the Bank of a separate audit of DBP's portfolio carried out by CB, within four months of the end of each fiscal year. Implementation of the agreement should materially improve the quality of the COA's audit. Grain Milling and Trading Portfolio 18. DBP has been a major source of credit for the grain milling and trading sector. Unfortunately, many of the loans have had poor repayment performance, due mainly to the poor appraisal standards, and inadequate supervision and collection effort. DBP virtually stopped lending in that sector except for the Bank's first Rice Processing and Storage Project (Loan No. 720-PH). Excluding this project, as of December 31, 1975, DBP had 806 loans outstanding for rice and corn trading and milling, totalling 97.8 million of which 52.7 million (53.8%) was overdue. This arrears position marked a slight improvement over the previous year, but the collection rate was still only 21%. The collection performance is shown in Table 3; the portfolio is analyzed by size of loan and by region in Table 4.  ANNEX 2 Page 7 Grain Milling Guarantees 19. In addition, DBP has had to advance over P50 million to two rice mills whose supplier's credits it guaranteed, and is liable for an additional PIO million. (Furthermore, as of June 30, 1975, the interest due DBP on its advances to those companies totalled P28 million.) As both of these mills are operating far below capacity and are beset by continuing difficulties, DBP may lose all or most of its P60 million guarantee. DBP has also made advances totalling P1.8 million on 3 smaller guarantees. EAP Projects Department March 26, 1976  ANVF:,:x 2 PI U LTPIT I%FES SECC3'D GPAT! PROCAINI ; P. "JCT DEVELOPMENT BANK OF THE PHILIPPINES Loans, Investments and Guarantees Approved, FY 72-FY 75 (Amounts in P million) FY72 - 'f73 -r PIt' 75 11ur;lber An;ourt Iu!o:, Ar!1o'jrt '.rler