Sri Lanka - Development Finance Corporation of Ceylon Project

Document of The WorlRd .IBank IFOR OFFRCIAL USE ONLY REPORT AND RECOMMENDATION OF THE Report No. P-21 37-CE PRESIDENT TO THE EXECUTIVE DIRECTORS OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION AND THE BOARD OF DIRECTORS OF THE INTERNATIONAL FINANCE CORPORATION ON A PROPOSED CREDIT BY THE ASSOCIATION TO THE REPUBLIC OF SRI LANKA ON A FOURTH DEVELOPMENT FINANCE CORPORATION OF CEYLON PROJECT AND ON AN INVESTMENT BY THE CORPORATION IN THE DEVELOPMENT FINANCE CORPORATION OF CEYLON August 26, 1977 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 authorizztion.  CURRENCY EQUIVALENTS On May 24, 19769 the Sri Lankan Rupee was officially linked to a basket of currencies with the initial parity rate based on the Rupee/Pound rate at that date. Both the composition of the basket and the weights assigned to the currencies in it were revised on March 12, 1977. The current Rupee/US Dollar rate has been used throughout the report, except where stated to the contrary: US$1 = Rs 7.28 Rs 1 US$0o 137 Rs 1 M US$137,363 Most non-foodgrain imports have to pay a surcharge of 65% through the purchase of Foreign Exchange Entitlement Certifi- cates (FEECs), and most non-traditional exports receive a 65% premium over the official rate through the sale of FEECso Inward remittances of foreign private investment and repatri- ation of dividends or interest in such an investment are, under existing policy, also convertible at the FEEC rate. The premium is now fixed at 65% of the Rupee parity rate, result- ing in the following current exchange rates including FEECs: US$1 = Rs 12001 Rs 1 = US$00083 ACRONYMS AND ABBREVIATIONS ADB Asian Development Bank DFCC = Development Finance Corporation of Ceylon FEEC = Foreign Exchange Entitlement Certificate GDP = Gross Domestic Product GNP = Gross National Product IDB = Industrial Development Board SSI = Small-Scale Industry FISCAL YEARS- Government of Sri Lanka: January 1 to December 31 DFCC: April 1 to March 31  FOR OFFICIAL USE ONLY SRI LANKA - FOURTH DEVELOPMENT FINANCE CORPORATION OF CEYLON PROJECT Credit and Project Summary Borrower: Republic of Sri Lanka Beneficiary: Development Finance Corporation of Ceylon (DFCC) Amount: US$8.0 million equivalent Terms: Standard Relending Terms: The Government will relend to DFCC at the rate of 8% per annum with repayment over a period of up to 18 years, on the basis of a flexible amortization schedule reflecting the repayment terms of the sub-loans made by DFCC. The foreign exchange risk will be assumed by the Government. Project Description: The credit will meet a substantial portion of DFCC's esti- mated foreign exchange requirements over the next two years for lending to private sector industrial projects and tourism. Free Limit: US$100,000 for projects exporting less than 80% of their production and which are also either new investment projects or existing investment projects involving an increase in installed capacity of at least 10%; US$100,000 for all tourism projects; and US$400,000 for all other projects. Debt Covenant: Maximum debt:equity ratio of 7:1 as defined in the Project Agreement (Section 3.05). This document has a restricted distribution and may be usod by recipients only in the performance of their omcial duties. Its contents may not otherwise be dicbased without World Dnk authorization.  Projected Total DFCC Commitments: (In Rs millions) FY78 FY79 FY80 FY81 FY82 Foreign Currency Loans 28.0 35.0 38.2 41.2 45.4 Local Currency Loans 9.0 14.3 16.8 19.1 21.9 Foreign Currency Investments 5.0 6.5 7.0 7.3 8.1 Local Currency Investments 3.0 4.7 5.6 6.3 7.3 Total Loans and Investments 45.0 60.5 67.6 73.9 82.7 Projected Credit Utilization (In US$ millions) Bank FY 1978 1979 1980 1981 1982 Commitments 1.5 4.5 2.0 - - Disbursements 0.1 2.5 3.1 2.0 0.3 Projected Balance Sheet (In Rs millions) As of End FY FY77 FY78 FY79 FY80 FY81 FY82 (Estimated) Assets Current Asset 3.9 9.0 6.8 10.9 10.8 10.7 Loans and Equity Investments (net) 118.7 139.7 172.9 218.0 265.4 312.5 Net Fixed Assets 0.3 0.3 3.3 3.2 3.1 3.0 Total Assets 122.9 149.0 183.0 232.1 279.3 326.2 Liabilities Current Liabilities 7.4 8.1 8.3 9.1 9.9 10.3 Long Term Debt 100.4 116.0 147.1 188.4 230.5 271.2 Equity 15.1 24.9 27.6 34.6 38.9 44.7 Total Liabilities and Equity 122.9 149.0 183.0 232.1 279.3 326.2 Long-Term Debt:Equity Ratio 6.6 4.7 5.3 5.4 5.9 6.1  (In Rs millions) Projected Income Statements FY77 FY78 FY79 FY80 FY81 FY82 (Estimated) Total Revenue 11.3 15.2 19.3 24.7 30.7 36.7 Total Expenses 7.8 9.7 12.8 17.2 21.2 25.4 Profit before Taxes 3.5 5.5 6.5 7.5 9.5 11.3 Taxes 1.6 2.2 2.4 2.7 3.4 3.7 Net Profit 1.9 3.3 4.1 4.8 6.1 7.6 Net Profit as % of average net worth 13.1 16.5 15.6 15.4 16.6 18.2 Appraisal Report: Report No. 1388A-CE of August 24, 1977.   INTERNATIONAL DEVELOPMENT ASSOCIATION INTERNATIONAL FINANCE CORPORATION REPORT AND RECOIIMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS OF THE ASSOCIATION AND TO THE BOARD OF DIRECTORS OF THE CORPORATION ON A PROPOSED CREDIT BY THE ASSOCIATION TO THE REPUBLIC OF SRI LANKA ON A FOURTH DEVELOPMENT FINANCE CORPORATION OF CEYLON PROJECT AND ON AN INVESTMENT BY THE CORPORATION IN THE DEVELOPMENT FINANCE CORPORATION OF CEYLON 1. I submit the following report and recommendation on a proposed credit to the Republic of Sri Lanka for the equivalent of US$8.0 million on standard IDA terms, to help meet the estimated foreign exchange requirements of the Development Finance Corporation of Ceylon (DFCC) over the next two years for lending to private sector industrial and tourism projects, and on a proposed equity investment by the Corporation of about US$199,000 equiv- alent. 1/ The proceeds of the credit would be relent to DFCC at 8.0% per annum with repayment over a period of up to 18 years, on the basis of a flexible amortization schedule reflecting the repayment terms of the sub- loans made by DFCC. PART I - THE ECONOMY 2. The latest economic report, "Sri Lanka: Country Economic Memorandum" (Report No. 1425-CE, February 28, 1977) was distributed to the Executive Direc- tors on March 1, 1977. Country data are provided in Annex I. 3. Sri Lanka's economic performance in recent years has been character- ized by a moderate rate of growth of gross national product and an impressive attempt to establish welfare programs providing goods and services either free or at lost cost. Over the past decade (1966-76), economic growthi has averaged 3.9% per annum. With population growing at 2.0% per annum, real per capita GNP has been rising at 1.9% per annum. While the second half of the past decade has seen a deceleration in growth of population (1.6% per annum), GNP growth slowed down more sharply (to 3.0% per annum) so that per annum growth in per capita GNP fell to 1.4%. The deceleration in economic growth is attributable to four factors. First, performance in the agricultural sec- tor has been sluggish. Persistent drought conditions have plagued both field and tree crops. Despite considerable 'government efforts to stimulate food- grains production, output has remained well below domestic requirements, necessitating heavy reliance on imports of rice and wheat flour. Second, industrial activity has been depressed, reflecting declining levels of public and private investment, shortages of domestic and imported raw materials and deficiencies in management in an expanding public sector. Third, Sri Lanka's 1/ IFC proposes to subscribe to up to 23,861 DFCC common shares at the price of par Rs 100 each. The exact dollar equivalent of the Rs 2,386,100 would depend on exchange rates prevailing at the time of IFC's investment.  - 2 - terms of trade, which have been declining steadily since the mid-fifties, worsened sharply after 1972 following increases in imported foodgrains, fertilizer and petroleum prices. This put enormous pressure on the balance of payments until the terms of trade swung back in Sri Lanka's favor in the second half of 1976. Finally, the emphasis on welfare policies has contri- buted to a marked rise in the share of consumption in gross national product with a corresponding decline in the levels of savings and investment. 4. Sri Lanka's achievements in the social field have been impressive. This reflects the pursuit by successive governments over the past quarter century of two policy goals: the supply of wage goods, principally food and textiles, at low prices; and the provision of public services, mainly educa- tion, health and transport, free of charge or substantially below cost. In- come distribution data, relating to 1973, suggest that income in Sri Lanka is more evenly distributed than in many developing countries. Food subsidies cover the entire population, and health and education are provided at virtually no cost by the state. An effective family planning program, the relatively good health standards of the population and high literacy levels have contri- buted to the decline in birth rates, while good medical care has contributed to the low death rates. The fall in birth rates, together with repatriation of Indian immigrants, accounts for the slackening in the population growth rate noted in paragraph 3 above. These gains, however, must be set against a serious and growing unemployment problem. Open unemployment is esvuLaLed at 20%; a high proportion of the unemployed are educated to secondary school level or above. 5. Gross national product, adjusted for thie improvement recorded in the terms of trade, expanded by 4.0% in 1976, as against 0.8% in 1975. Severe drought conditions caused a decline in value added in agriculture, and paddy production remained well below peak output levels realized in 1970 and 1974. Over the past several years, the basis has been established for a substantial rise in paddy production by improvements in irrigation works, institutions, pricing, seed varieties, fertilizer availability, and rural roads. With good weather conditions, Sri Lanka now has the productive poten- tial to meet at least three-quarters of its rice requirements. Results have so far been poor, however, though prospects for 1977 are good (para. 10). 6. Tree crop production in aggregate declined in 1976, as severe drought affected production of tea and coconuts, and the sector as a whole suffered from post-nationalization uncertainties. Among the sector's major problems are the fragmentation of management arrangements after takeover and the related poor management conditions on a substantial number of estates, especially those run by cooperatives. A large proportion of the tea acreage (45%) and two- thirds of output is accounted for by two major public sector corporations, the State Plantation Corporation and Janawasama, and a further 15% of the acreage is under cooperatives (Janawasas). The management problems of the estates for all tree crops are aggravated by the backlog of maintenance and investment by previous owners anticipating nationalization. The rise in export prices, however, has greatly eased the post-nationalization problems of the estates. Despite rising prices in 1976, all three major tree crops experienced a sharp fall in replanting rates. However, tea replanting rates have been falling  since 1971. With only 12% of the area under tea replanted, the long run production potential is not being increased adequately. Although 60% of the area under rubber has been replanted, replanting rates remain well below requirements. 7. The real value of industrial output rose by 1.2% in 1976, with the increase in output mainly in the public sector. This stagnation reflected the fall in tea and coconut processing activity. Although private sector investment activity as a whole has been slack, there has been an impressive expansion of industrial exports in recent years. Industrial exports taken together with other non-traditional exports, such as gems, now account for 30% of Sri Lanka's exports as against 12% in 1970. The DFCC IV credit addresses the problem of expanding export-oriented capacity to enable this growth to be sustained. The previous Government's somewhat ambivalent attitude to the private sector, which had been responsible for an unattractive investment climate, changed somewhat after the 1976 budget when the Government announced it would undertake a determined effort to improve private investment. The recently elected Government has yet to define its policies. 8. The Government's budgetary position deteriorated considerably in 1976, with the overall deficit amounting to 12% of GNP. The growth in the deficit reflects the unresponsiveness of tax revenues to economic growth and an inability to control current expenditures as a result of rising food subsi- dies and transfers to loss-making public corporations. The deficits were financed largely by borrowings from the banking system. This, together with the increase in net foreign assets, contributed to a 33% expansion in domestic liquidity in 1976, as against a 5% expansion in 1975. Prices, therefore, remain under pressure. Although the Colombo consumer price index rose by just over 1% in 1976, the underlying rate of inflation, taking into account free market prices, is estimated by the Sri Lankan Government at 10% in 1976. 9. Sri Lanka's terms of trade in 1976 rose markedly from an all time low of 46 in 1975 to 62 in 1976, thus reversing a steady decline which began in the mid-1950s. The improvement was on account of higher prices for tree crop exports, particularly rubber and tea, and low prices for imports of food and textiles. However, because of supply constraints, export volumes were lower for all three tree crops, and hence for exports as a whole. Export earnings, therefore, showed no growth over 1975. Import payments, however, fell sharply, due mainly to lower food prices. This caused the current account deficit to fall from $186 million in 1975 to $64 million in 1976. A high level of capital inflows caused international reserves to rise for the first time since 1973. 10. Sri Lanka's economic performance is likely to improve in 1977. Agricultural production is expected to increase considerably. The paddy crop could exceed 80 million bushels, a 33% increase over 1976. Tea and rubber production is also expected to rise in 1977. As a result of record commodity prices, particularly of tea and rubber, export earnings are expected to in- crease by over 40%. This development encouraged the Government to revalue  - 4 - the rupee by an average of 20% against major currencies on March 12, 1977, in order to translate what it considered to be excessive windfall profits to the producers of these commodities into benefits to the consumer in the form of lower prices for imports. The impact of the revaluation on the demand for funds from private investors, particularly in non-traditional exports, has been carefully reviewed, and the amount of the credit has been adjusted to take into account the possible adverse impact. The impact will vary from industry to industry. While the adverse effect of the revaluation will be undoubtedly cushioned partly by the current high profit margins in some key industries such as garments, it is difficult to reconcile the revaluation with the long-term developmental needs of an economy that has suffered from inade- quate savings to finance investment, that must continue to diversify its exports and that demands continuing attention to the adequacy of incentives to agricultural production. In this area, as in others, the resolution of the conflicts between short-term benefits to the consumer and the long-term needs of the economy, remains urgent. 11. At the thirteenth meeting of the Aid Group for Sri Lanka, held in Washington in April 1977, the members welcomed the improvement in Sri Lanka's terms of trade and emphasized the opportunity this presented to pursue a much-needed program to increase savings and investment and raise the rate of economic growth. They also expressed concern that recent policy measures may make more difficult the task of reconciling the competing claims on resources of Sri Lanka's social aspirations and need for more rapid economic growth. The members indicated their intention to contribute aid of about $250 million, which was considerably higher than aid indications in 1976. However, actual new commitments by the Aid Group in 1976 at $120 million were considerably below the indications of $180 million at the 1976 meeting. Aid disbursements from all sources in 1976 totaled $149 million as against $202 million in 1975. 12. Sri Lanka's dependence on foreign capital has risen sharply since 1973. Although concessional aid flows have risen significantly, they were supplemented by a sizeable increase in short and medium-term borrowing. This was responsible for the marked deterioration in the debt service ratio from 12% in 1974 to 20% in 1975 and 1976. However, the expected rise in export earnings in 1977 is likely to cause a significant fall in the debt service ratio. PART II - BANK GROUP OPERATIONS IN SRI LANKA 13. Since the beginning of its operations in Sri Lanka in 1954, the Bank Group has made eight loans totalling $73.4 million (net of cancellations) and twelve credits totalling $112.3 million (net of cancellations and exchange adjuBtments) in support of 18 projects. About 30% of Bank Group assistance has been for power, 50% for agriculture (irrigation and agricultural and dairy development), and the remainder for Development Finance Company opera- tions, highways, a program credit (mainly involving the import of raw materials for industry), and water supply. Three early power loans, the Mahaweli Ganga Development credit, and the program credit were satisfactorily completed and  - 5 - fully disbursed. Of the two DFCC loans, $6.8 million of the $12.0 million available was cancelled by DFCC due to a sudden deterioration in the private investment climate resulting from a change of governments in 1970. At the request of the Borrower, a loan/credit for highways was cancelled in 1970, after disbursement of $0.8 million of the credit, following the Government's decision to make major changes in the scope of the project. The IFC's only investment in Sri Lanka, $3.25 million to the Pearl Textile Mills, Ltd. (Ceylon), was approved by IFC's Board of Directors in January, 1970, but cancelled the same year because Government approval for the project was withdrawn. Annex II contains a summary statement of Bank Group operations as of July 31, 1977, together with notes on the execution of ongoing projects. 14. The Bank Group's current strategy is focussed on the agricultural sector to support Government efforts to increase food production and reduce its dependence on rice/flour imports, and to improve productivity in the tree crops subsector. Projects to support industry and basic infrastructure are also included. A proposed project for diversification of crops on mar- ginal lands now under tea and rubber is being prepared by the Government together with an FAO/UNDP team with IDA assistance. Preparation is also underway on an integrated rural development project for the Kurunegala District and on a tree crop rehabilitation project aimed at maintaining quantity and quality of Sri Lankan tea output as some tea lands are diverted to other uses. In addition, projects in other fields, including irrigation and drainage and dry farming, are being prepared for possible IDA financing. 15. The Bank Group presently accounts for nearly 13% (Bank 5%; IDA 8%) of Sri Lanka's total external debt outstanding, and about 5% (almost totally Bank) of debt service. It is projected that the Bank Group's share in total external debt will decline to about 9% by 1980 (with the Bank's share declin- ing to about 2%). The Bank and IDA shares in the debt service will also show a slight decline. PART III - INDUSTRY AND TOURISM IN SRI LANKA 16. The industrial sector in Sri Lanka accounts for about 13% of GDP and provides employment for about 350,000-400,000 people, or 10% of total employ- ment. While around 70% of the total industrial workforce is employed by a large number (perhaps 35,000-50,000) of small, mostly non-corporate units (cottage industry), the organized sector employs about 110,000 people, yet accounts for 70% of total value added in manufacturing. The majority of units in the organized sector are also small; in 1975, 900 out of approxi- mately 1,500 units had output of less than Rs 250,000. Nevertheless, com- panies with output of more than Rs 2 million account for 85% of production in the private sector. Industry in Sri Lanka primarily consists of consumer goods; the largest sub-sectors are food and beverages (50% of industrial value-added), chemicals, plastics and petroleum (16%), and textiles and gar- ments (14%). The public sector corporations account for about 50% of total production in the organized manufacturing sector.  - 6 - 17. In constant prices, the output from the organized manufacturing sec- tor increased by 2.3% in 1974 and 15.5% in 1975. In the latter year, growth came largely from the private sector with the production of the public sector corporations growing by only 1%. By industry (public and private), the growth was highest for textiles, garments and leather (51% in constant prices), paper and paper products (32%), and food and beverages (29%). As a result of this growth in production, total industrial employment in the organized sector increased by 12%, while private sector employment alone grew by 17%. The main reasons for this increase in production and employment are better use and availability of domestic raw materials, and higher foreign exchange allocations for imported raw materials. 18. Excess industrial capacity is a serious problem in Sri Lanka among local market industries, but it varies widely in importance among industries and firms. Growth in production in 1975 was accompanied by an improvement in capacity utilization, from 40% in 1974 to 54% in 1975. This is still low, however, and is primarily due to the shortage of foreign exchange to pay for the import of spare parts and raw materials, coupled with the small size of the domestic market resulting from the inability of many consumers to afford the goods produced. 19. From a very low base, industrial exports (excluding petroleum prod- ucts) have been expanding rapidly since 1972, growing from $9 million to $39 million in 1976 (in current prices). Private sector exports accounted for about 70% of non-petroleum exports in 1973 and 1975, though somewhat less in 1974 due to high public sector exports of cement in that year. The improve- ment in exports reflects the Government's incentives for export-oriented industries and the relatively easy access to imported raw materials for these industries. 20. The tourism sector in Sri Lanka has achieved rapid growth since the early and mid-sixties. The number of arrivals (business and pleasure) in- creased from 19,000 in 1966 to 78,000 in 1973. Despite the general drop in world travel in 1974, the number of arrivals increased by 9% to 85,000, and increased further to 103,000 in 1975 and 119,000 in 1976. The Ceylon Tourist Board expects the number of arrivals to continue to grow to reach 166,000 in 1978, which is attainable. From 1971 to August 1976, the number of rooms in graded establishments grew from 2,055 to 4,220. The increase in capacity was especially large in the latter two years, causing the average recorded room occupancy to fall from 42.2% in 1973 to 36.8% in 1975. Due to the seasonality of the traffic, the maximum average annual room occupancy for Sri Lanka is considered to be around 55%. However, there are wide regional discrepancies and many established hotels have been enjoying higher than average occupancy rates. It is expected that these rates will now improve, since capacity is expected to increase at a less rapid pace than the traffic. 21. The previous Government's basic industrial development policies placed primary emphasis on export-oriented and labor-intensive projects, and on those minimizing foreign exchange requirements for capital goods and raw materials. Additional Government goals were equalization of the distribution of income and wealth and continued Government control over the private sector.  - 7 - Consequently, immediately after coming to power in 1970, the previous Govern- ment announced that the heavy and capital goods industries and other suitable basic industries would be state-owned, while other industries would be assigned to cooperatives and private enterprises. Further, the "Business Undertakings (Acquisition) Act" was passed in 1971, under which the Government is empowered to take over any private firm at its discretion. As a result of such pro- nouncements and other measures, private sector confidence was severely shaken and investments declined sharply. However, in practice not many enterprises were taken over, and the Government's policy of maintaining or introducing various incentives indicated a recognition of the role of the private sector. As a result, private sector investment interest gradually improved. The 1976 budget placed increased emphasis on the role of the private sector, although not all measures promised were introduced. The 1977 budget speech contained no major changes for the private sector except the Government's intention to nationalize the three privately held foreign banks. This did not materialize, however. The new Government's policies towards the private sector have not yet been formalized. 22. Private sector companies rely to a considerable extent on self- financing for industrial development, supplemented by long-term funds from DFCC and the commercial banks. In December 1975, total industrial loans outstand- ing of more than five years from the commercial banks (excluding rollover of short-term credits) were Rs 66 million, compared to Rs 94 million in loans and investments outstanding from DFCC as of March 1976, almost all of which were for private enterprises. This makes DFCC the leading industrial term lending institution in Sri Lanka, and it is also the only institution provid- ing foreign exchange for industrial investment in the private sector. Public sector corporations normally obtain their requirements directly from the Government. PART IV - THE PROJECT 23. The proposed project was appraised in August/September 1976. A re- port entitled "Sri Lanka - Appraisal of a Fourth Development Finance Corpora- tion of Ceylon Project" (No. 1388A-CE of August 24, 1977) is being distributed separately to the Executive Directors. Negotiations were held in Washington, from June 27 to July 1, 1977. The Borrower's delegation was led by Mr. A. Mohamed, Additional Director of External Resources, External Resources Divi- sion, Ministry of Planning and Economic Affairs. A credit and project summary prefaces this report. History and Past Operations 24. DFCC was established in 1955 by an Act of Parliament to finance private enterprises (defined as enterprises in which Government ownership does not exceed 20%) in industry, agriculture and commerce, including hotels, transportation and construction. It does not finance enterprises engaged solely in trading activities. DFCC was established in response to recommen- dations of an IBRD economic survey report published in 1952. In the early  years, it was felt that DFCC did not need Bank assistance and, for a period of about four years from 1961, the country's economic policies precluded Bank Group assistance. In the late sixties, IBRD made two loans to DFCC for $4 million and $8 million, respectively, part of which were cancelled when the investment climate deteriorated and demand for funds proved to be less than expected (para. 13). Improved investment interest from 1973 led to a third DFCC project, Credit 566-CE for $4.5 million in 1975, to be utilized primarily for export-oriented industry and tourism. Of this credit to date, subprojects for $4.0 million have been approved and $2.9 million disbursed (Annex II). 25. DFCC's net commitments of loans and investments averaged Rs 18 million in DFCC's fiscal years (April 1 to March 31) 1973 and 1974, dropped to Rs 9 million in FY75 (due to continued political uncertainties and DFCC's lack of foreign exchange resources in that year) and rose to Rs 43 million in FY76. During FY76, foreign exchange loans and investments were 38% of total net commitments and accounted for about 20% of the total outstanding portfolio. Tourism projects account for 35% of DFCC's total outstanding portfolio. This share may increase somewhat as present commitments are dis- bursed, but is thereafter expected to decline. Other significant sectors in the portfolio are textiles, engineering, and food processing industries, but none of these account for more than 10% of the total portfolio. Except for its relatively high exposure in tourism, DFCC's portfolio is well diversified. 26. DFCC's operations are heavily concentrated in the medium-scale sec- tor of Sri Lanka; in FY76, 80% of approvals of loans and investments by number (62% by amount) went to clients with fixed assets of less than Rs 10 million ($0.8 million equivalent). Small-scale industries (SSIs) in Sri Lanka are now defined as enterprises with less than Rs 500,000 (about $42,000 equivalent) of investment in machinery and equipment. DFCC has done little lending to SSIs, since the commercial banks are better placed for SSI lending in view of their branch network, working capital lending, and other banking services. Under Credit 566-CE, $200,000 was earmarked for lending to SSIs, of which about $107,000 has been utilized to date. With a view to increasing its lending to the small-scale sector, DFCC has entered into a scheme with the Industrial Development Board (IDB) and the two largest commercial banks, the People's Bank and Bank of Ceylon (Section 2.10 of the draft Project Agreement). Applications under the scheme will be received and processed by IDB and one or the other of the commercial banks. The IDB will provide technical assis- tance to the clients while rupee financing will be provided by either of the banks. Applications for foreign exchange will be submitted to DFCC which normally will undertake only a desk review, based on simplified appraisal requirements. DFCC's foreign exchange loans under the scheme will be guar- anteed by the participating commercial bank. Under the proposed credit, DFCC will be permitted to engage in refinancing for SSI units through the commercial banks which would eliminate the need for the client to establish loan documents with more than one institution. Details of the scheme, which are acceptable to IDA, are included in Schedule 1 of the draft Project Agreement.  -9- Capital Structure and Resources 27. DFCC's authorized share capital is Rs 24 million. Its initial paid- in share capital was Rs 7.1 million which was increased to Rs 8.0 million in 1967. DFCC's current ongoing capital increase of Rs 8.0 million will increase its share capital to Rs 16.0 million. Of this, domestic sources have taken up Rs 5.6 million and IFC proposes to invest in Rs 2.4 million in shares (paras. 41-44). More than Rs 3.0 million has already been paid in, with the balance to be paid in two calls in 1978. DFCC's ownership is fairly broadly based by local standards; after the share capital issue, the private sector will con- trol 51%, foreign investors (including IFC) 30%, and the public sector 19%. DFCC intends to continue to increase its share capital in the future in order to maintain DFCC's debt-equity ratio within the contractual limit of 7:1, and also to provide resources for its rupee lending. In FY76, a dividend of 9% was declared, up from 8% for the previous years. The DFCC Act limits the dividend to a maximum of 12%. Due to the low dividend, DFCC's shares are quoted at about Rs 90 (par value is Rs 100). A higher dividend rate (up towards the legal maximum) would have increased the market value of DFCC's shares somewhat, but would not have substantially affected the response to DFCC's recent share issue. 28. Until recently, DFCC has depended exclusively on IBRD/IDA for its foreign exchange resources. However, DFCC obtained approval in December 1976 from the Asian Development Bank (ADB) for a $5 million loan. The ADB loan is to the Government, for relending to DFCC at 8.9% per annum. It is a general purpose loan, though it excludes lending for tourism, where ADB feels IDA has more expertise, and for equity investments, in line with ADB general policy. Ten percent of the loan is allocated for lending to small-scale in- dustry. The Government will bear the exchange risk under the loan and there is a minimum average spread of 3.75% on the ADB funds. 29. Of DFCC's rupee resources as of June 30, 1976, equity accounted for 14%, provisions for 3%, a Government subordinated loan for 15%, Central Bank refinancing for 34%, Bank of Ceylon credit facilities for 24%, and the National Savings Bank for 10%. In addition to its recent capital increases (para. 27), DFCC is also making other efforts to diversify its sources of rupee funds by obtaining deposits of "blocked funds" (funds owned by residents of foreign countries) and, possibly, funds from the Ceylon Insurance Corporation or via debentures. DFCC's domestic resources position is expected to remain comfortable. Institutional Aspects 30. DFCC is well managed, and despite an increasing Government role in the economy, it has preserved its operational autonomy. The present Chairman has taken a keen interest in day-to-day operations, giving DFCC a more dynamic attitude, and the General Manager is an experienced banker. DFCC's organiza- tional structure is appropriate, consisting of five departments with clearly defined responsibilities. Its professional staff was increased by 50% from September 1974 to September 1975 and remained almost constant at 20 until  - 10 - recently when eight additional officers were recruited. This should satisfy most of DFCC's staff requirements for the near future. The staff is of good quality. Operating Policies and Procedures 31. DFCC's appraisal and follow-up standards are generally good. For most projects, DFCC is now calculating the economic rate of return and the domestic resource cost per unit of foreign exchange earned/saved. DFCC will make more use of economic calculations in project analysis, and will also pay more attention to capacity utilization questions. DFCC tries to visit projects under construction every quarter, projects in operation once a year, and problem projects as and when necessary. Because of staff constraints, DFCC has not been able, in the past, to fulfill this schedule, but should be able to do so now with the addition of three project implementation officers recently recruited. DFCC generally requires that procurement under its foreign currency loans be based on three quotations from foreign suppliers; for rupee loans, DFCC tries to obtain alternative quotations wherever possible. DFCC's procurement and disbursement policies are satisfactory. 32. Over the past two years, DFCC's normal local currency lending rate has gone up from 10.5% to 12.0%. DFCC's normal foreign currency lending rate is 12.5% which would be increased to 13% under the proposed credit. This would give DFCC a spread of 5% which is not excessive in view of the need for it to build up its equity. 33. By amount, 82% of DFCC's gross approvals in FY75, and 68% in FY76, were for maturities of ten years or more. Although the average maturity of loans has been reduced some in recent years, DFCC still has a tendency to grant its clients somewhat long repayment periods. DFCC intends to reexamine its repayment period policy. In investments, DFCC normally limits its hold- ings in a single enterprise to 25% of that company's ordinary share capital or 10% of DFCC's equity plus the outstanding amount of the subordinated Government loan to DFCC, whichever is lower. At present, DFCC's aggregate share investments are limited to the sum of its equity and the outstanding amount of the subordinated Government loan. DFCC has suggested, and IDA has agreed, that this may be changed so that the aggregate of DFCC's ordinary and non-redeemable preference share investments may not exceed 50%, and the aggregate of its redeemable preference share investments may not exceed 75%, of this sum. DFCCGs total exposure in an individual company normally cannot exceed 20% of the sum of its equity and the outstanding amount of the subor- dinated Government loan. DFCC's exposure limits are reasonable. Financial Position 34. DFCC's profitability has improved gradually over the past few years as a result of the increased level of activity and higher returns on equity investments. Net profit increased from Rs 0.99 million in FY73 to Rs 1.24 million in FY75, or from 8.3% of average equity to 10%, respectively. FY76 profit increased to Rs 2.03 million, a return on equity of 15.2%, but the improvement was in part due to the absence of a provision for doubtful loans  - 11 - in that year. DFCC's long-term debt:equity ratio was 5.4:1 as of March 1976, against a contractual limit of 7.0:1 as set in Credit 566-CE (defined to include the subordinated loan to the Government as debt rather than equity) and maintained under the proposed credit (Section 3.05 of the draft Project Agreement). This limit is appropriate for DFCC. The quality of DFCC's investment portfolio is good, and the debt-service coverage ratio over the past four years has remained satisfactory at between 1.2:1 and 1.7:1. DFCC's accounts have always been approved without qualifications by DFCC's auditors, and their long-term audit report is of good quality. Projected Operations and Resource Requirements 35. DFCC's development strategy for the next few years is a broad one. In line with Government policies, DFCC will concentrate on projects which maximize employment generation and on projects earning foreign exchange. Other priority projects will be those utilizing local raw materials, balanc- ing, replacement, and modernization projects, and finally, essential import substitution projects. At the same time, DFCC will also endeavour to increase its promotional activities. As a condition of credit effectiveness, DFCC's Board will approve a Strategy Statement acceptable to IDA (Section 6.01(c) of the draft Development Credit Agreement). 36. As of June 1977, DFCC had received applications for foreign ex- change financing of $14.0 million for 62 projects with a total foreign ex- change requirement of $26.3 million. Much of the balance is expected to be financed from such sources as foreign banks and collaborators, free foreign exchange, convertible rupee accounts, and supplier's credits. In terms of the amount of DFCC foreign exchange assistance, export-oriented industries account for 40% of the pipeline, local market industries for 38%, tourism projects for 15%, and miscellaneous projects for 7%. By number, two-thirds of the export- oriented projects are new, while about half of the local market projects are new, and the others are for expansion, balancing, modernization, and replace- ment. The question of utilization of existing capacity is not a problem for export industries in Sri Lanka, but must be reviewed on a case-by-case basis for local market industries. DFCC has agreed to strengthen its capacity uti- lization analysis (para. 31), and the free limit is structured to permit IDA closer contact with projects where capacity utilization could be a problem (para. 38). DFCC's project list is far from definite, and it is likely that a number of projects either will drop from the pipeline, or be rejected by DFCC during appraisal. On the other hand, this is expected to be offset by other projects coming forward during the commitment period of the proposed credit (through December 1979). At present, DFCC has foreign exchange re- sources available for commitment of $2.7 million; $0.5 million and $2.2 million yet to be committed from Credit 566-CE and the ADB loan, respectively. As DFCC expects to have no other foreign exchange resources over the commit- ment period of the proposed project, an IDA credit of $8.0 million would help cover its estimated foreign exchange requirements through December 1979. The Proposed Credit 37. The proposed credit of $8.0 million would be used to meet up to 100% of the foreign exchange costs of capital goods and services imported for  - 12 - projects financed by DFCC. Eligible enterprises would be broadly defined to include manufacturing, agro-industries, tourism, mining and transportation, among others. 38. The credit would be made to the Government to be relent to DFCC through a subsidiary loan agreement on terms and conditions satisfactory to the Association (Section 3.01 of the draft Development Credit Agreement). DFCC would pay the Government interest at the rate of 8.0% per annum with repayment over a period of up to 18 years, on the basis of a flexible amorti- zation schedule reflecting the repayment terms of the sub-loans made by DFCC. DFCC would also pay to the Government a commitment fee of 0.75% on the undis- bursed amounts, to be passed on to DFCC's sub-borrowers. As under the two previous IBRD loans and one IDA credit to DFCC, the foreign exchange risk would continue to be assumed by the Government. This is in view of the uncer- tain foreign exchange situation and the small size of many of DFCC's clients. The free limit (Section 2.03 (d) of the draft Development Credit Agreement) would be: (a) $100,000 for projects exporting less than 80% of their pro- duction and which are also either new investment projects or existing invest- ment projects involving an increase in installed capacity of at least 10%; (b) $100,000 for all tourism projects; and (c) $400,000 for all other projects. Project Benefits and Risks 39. As DFCC is the leading industrial term lending institution in Sri Lanka and the only institution providing foreign exchange for private invest- ment, the proposed credit is expected to facilitate expansion of the private industrial sector. The project is expected to contribute to mobilization of domestic resources for investment and to generation of employment opportuni- ties. In the past, DFCC's foreign exchange financing has generated about 2.7 times its rupee equivalent in local currency investments. Tentative employment figures available for about 70% of the projects in the pipeline show an expected creation of about 7,300 new jobs, with an estimated total cost per job of $4,800 equivalent. In addition, the proposed credit would reinforce DFCC in the important role it has been playing in the promotion of investment in Sri Lanka through its contacts with businessmen and poten- tial investors. These promotional activities would be expanded under the project and DFCC expects to encourage actively foreign investment through collaboration with local entrepreneurs. The proposed credit would also con- tribute to further strengthening of DFCC as an institution through improvement of appraisal standards. 40. The primary risk associated with the proposed credit concerns the private investment climate. A new Government was recently elected which has yet to clarify its policies towards the private sector. A more restrictive attitude, such as in the early 1970s, could bring a sharp decline in invest- ment interest once again, but the chances of this do not seem great.  - 13 - PART V - THE IFC INVESTMENT 41. It is proposed that IFC subscribe for cash up to 23,861 ordinary shares of DFCC of par value of Rs 100 each at the price of par for a total investment of up to approximately US$199,000 equivalent, pursuant to a Subscription Agreement to be entered into with DFCC. After completion of the proposed share issue, IFC would hold up to 15% of DFCC's share capital. The Government of Sri Lanka and DFCC's management attach great importance to IFC's proposed investment and the latter has expressed the desire that IFC be represented on DFCC's Board. IFC, through appropriate representa- tion on the Board, could contribute significantly to DFCC's investment policies and generally assure close relations between DFCC and the Bank Group. I intend, therefore, to nominate a suitable person to represent IFC on the Board of DFCC. 42. The proposed IFC investment in DFCC would be the Corporation's first in Sri Lanka since 1970 (para. 13). The potential financial return on the IFC investment is modest, although share book value as of April 30, 1977, was Rs 171. Prior to FY76, DFCC's return on equity was 8-10%. An increase to 15% in FY76 was achieved in part because no provision for doubt- ful accounts was made in that year. Dividends are expected to continue in the range of 8-9% of par and are limited by provisions of the DFCC Act to 12% of par. DFCC shares are quoted in local markets at Rs 90 per share and, on the basis of current dividend expectations, have only limited appreciation potential. IFC is prepared to proceed in order to support a developmental institution and to establish relationships which will benefit the growth of future IFC activities in Sri Lanka. 43. The main conditions for payment by IFC of the subscription price will be that repatriation and other rights, including the entitlement of IFC's investment in DFCC to the preferential exchange rate under the Foreign Exchange Entitlement Certificate Scheme be granted to IFC. Investment laws of the Republic of Sri Lanka which are applicable to IFC's investment are contained in Annex IV. 44. Deutsche Gesellschaft fur Wirtschaftliche Zusammenarbeit (DEG), a West German Government-owned development institution, has been discussing with the Government of Sri Lanka and DFCC an equity investment in DFCC. The Sri Lankan Government has approved a total equity investment of up to 15% of DFCC's share capital for IFC and DEG combined. DEG and DFCC have not yet agreed on the amount and terms of DEG's investment. IFC is therefore pre- pared to take up the entire 23,861 shares available for subscription and has indicated to DFCC and DEG its willingness to subscribe to a lesser amount, if an investment by DEG is agreed upon before the completion of IFC's sub- scription. Alternatively, IFC would take up the entire 15% to complete DFCC's share capital increase and would be prepared to sell a portion to DEG.  - 14 - PART VI - LEGAL INSTRUMENTS AND AUTHORITY 45. The draft Development Credit Agreement between the Republic of Sri Lanka and the Association, the draft Project Agreement between the Association and DFCC, the Recommendation of the Committee provided for in Article V, Sec- tion 1(d) of the Articles of Agreement, and the text of two draft resolutions approving the proposed credit and IFC investment, respectively, are being distributed to the Executive Directors separately. In accordance with Section 3 (ii) of Article III of the Articles of Agreement of the Corporation, the Government of the Republic of Sri Lanka has been notified of the proposed investment. 46. Special conditions of this credit are listed in Section III of Annex III. 47. Execution of the Subsidiary Loan Agreement on behalf of the Borrower and DFCC is a condition of effectiveness (Section 6.01(b) of the draft Develop- ment Credit Agreement). 48. I am satisfied that the proposed development credit would comply with the Articles of Agreement of the Association and that the proposed investment by the Corporation complies with the Articles of Agreement of the Corporation. 49. The Republic of Sri Lanka has signed the International Centre for Settlement of Investment Disputes Convention. However, in the context of the proposed investment, there are no arrangements between the Republic of Sri Lanka and a private investor which might give rise to an investment dispute. PART VII - RECOMMENDATION 50. I recommend that the Executive Directors of the Association approve the proposed credit and that the Board of Directors of the Corporation approve the proposed investment on substantially the terms outlined above. Robert S. McNamara President by I.P.M. Cargill and M.A. Qureshi Attachments August 26, 1977  Pag-e 1 of L, pages TABLE 3A SRI LANKA SOCIAL INDICATORS DATA SHEET LAND) AREA (THOUI KM-2)-- - - - - - - - - - - - - - - - - - - - - - - - --------------- ~~~~SRI LAK REFERENCE COUNTRI ES (1970) TOTAL 65.6 MOST RECENT AGRIC. 24.2 1 960 1970 ESTIMATE TANZANIA PHILIPPINES MOALAYSIA GNP PER CAPITA ( US$) 100.0 ii 170.0 250.0/a: 100.0 230. O'G 440.0 POPULATION AND VITAL STATISTICS POPULATION (MID-YR. MILLION) 9.9 1 2 .5 13.' /a 1 2 .9 /a 36. 9 10. 4 POPULATION DENSITY PER SQUARE KM. 1 5 1.0 191i. 0 210.0. Ia 1 4 .0 123.0 32.0 PER SQ. KM. AGRICULTURAL LAND 507.0 518.0 571. 7oTa 25.0 375.0 179.0 VITAL STATISTICS CRUDE BIRTH BATE (/THCU, AV) 37.6 33.1 28.2 50.5 44.2 4 2. 2 CRUDE DEATH BATE (/THOU,AV) 10.7 8.0 7.9 23.0 13.2 12.9 INFANT MiORTALITY RATE (/THOU) 5 2.0 50.0 45.0 160.0 /b 80.0 40.9 IA LIFE EXPECTANCY AT BIRTH (YRS) 60.5 65.6 670 f 41. B- 55.6 56.7 /a DROSS REPRODUCTION RATE 2.5 2.3 .l2 3.2 3.3 2.6 ' POPULATION GROWTH BATE (%) TOTAL 2.0 2 .4 1.7 lb 3.0 /a 3. 0 2.6 URBAN 4.8 4.5 3 .7 7r 5.6 4.0 26.9 URBANJ POPULATI1ON )% OF TOTAL) 17.9 22.0 24.3 5.5 27. 6 26.9 AGE STRUCTURE (PERCENT) 0 TO 14 YEARS 41.5 /a. 40.0 39.3 /C 44.4 45.6 44. ,7 Ia 15 TO 64 YEARS 54.3/a 56.0 56.47- 53.0 7 51.6 52.1 7a- 65 YEARS AND OVER 4:2 a~ 4.0 4.3 7-C 2.6T7h 2.8 3.-2 -/a AGE DEPENDENCY RATIO 0.8 Ia 0.8 0.8 Ic 0.9 lb 0.9 0.9 /a ECONOMIC DEPENDENCY RATIO 1.5 _ 1.4 1.2 T 1.2 7a,b 1.5 1.67a FAMILY PLANNING ACCEPTORS (CUMULATIVE, THOU) . 215.3 431.5 354.0 222.2 USERS (% OF MAARR IED WOMAEN) . 7.0 9.9.. 2.0 8.0 ETMPLOYM1ENTF TOTAL LABOR FORCE (THOUSAND) 3500.0 Ia 4100 0 4800 0 5600.1/a bi2400 0 2900 0 Ia LABOR FORCE IN AGRICULTURE () 49.0 520 Ia 55 Ie 91. 55.o I 43:0 7 UNEMBOYEDI% OF LABOR FORCE) 4.0~ 9:0 / 11.0 . 7.6 6.0 b INCOME DISTRIBUTION % OF PRIVATE INCOME RECOD BY- HIGHEST 5% OF HOUSEHOLDS 26.4 18.8 18.8 33.5.. 28.3 HIGHIEST 20% OF HOUSEHOLDS 52. 1m 45.6 42.8 63.3 5 6.0 LOWEST 20% OF HOUSEHOLDS 4. 5 a 7.4 7.3 2.3.. 3.. LOWEST 40% OF HOUSEHOLDS 13.7 __ 17.9 19.3 7.8.. 11.2 DISTRIBUTION OF LAND OWNERSHIP % OWNED BY TOP 10% OF OWNERS ... .... % OWNED BY SMIALLEST 10% OWNERS . HEALTH AND NUTRITION POPULATION PER PHYSICIAN 4600.0 IC .. 3980.0 21570.0 Ia o POPULATION PER NURSING PERSON 4170.0 7-C2730o 0 2010.0 4890.0,a POPULATION PER HOSPITAL BED 290.0 7-, 330.0 0 330.0 700.0__ 850.0, 270.0' /a PER CAPITA SUPPLY OF - CALORIES (% OF REQUIREMENTS) 92.0 101.0 97.0 73.0 93.0 110.0 PROTEIN (GRAMS PER DAY) 45.0 50.0 48.0 43.0 45.0 49.0 Ic -OF WHICH ANIMAL AND PULSE 15.0 18.0 15.0 23.0 22.0 20.0 7__ DEATH RATE (/TFHOU) AGES 1-4 . 16.8.. 6.6 5.5 EDUCATI ON ADJUSTED ENROLLMENT RATIO PRIMAARY SCHOOL 95.0 99.0 86.0 35.0 11 3. 0 89.0c Ia SECONDARY SCH1OOL 27.0 51.0 Id 59.0 3.0 49. 0 34.0 __J YEARS OF SCHOOLING PROVIDED (FIRST ANO "FCOND LEVEL) 12.0 12.0 12.0 13.0 10.0 13.0 Ia VOCATIONAL L..kOLLMENT/ (% OF SECONDARY) . 1.0 /d 1.Q 10.0 6.0 lb 3.0 Ia ADULT LITERACY RATE (% 61'.0 Ia 78,1.. . 55.0 HOUSING PERSONS PER ROOM (URBAN) 2.1 /a 2.7 Ic. 2.1 2.3 Ia OCCUPIED DWELLINGS WITHOUT PIPED WATER (%) 80.9 /a .. 68.8 Ic 30.0 /b,e 76.0 65.0C / ACCESS TO ELECTRICITY _ (% OF ALL DWELLINGS) 7.5 Ia . . 9. Ic,, 23.0 43.0 Ia RURAL DWELLINGS CONNECTED TO ELECTRICITY (%) 2.3 Ia . 3.0 Ic.. 7. 0 30.0 /a CON SUMPT I ON RADIO RECEIVERS (PER THOU POP) 36.0 41.0 . 11.0 45 0 41.0 PASSENGER CARS (PER THOU POP) 8.0 7.0 7.0 3 .0 8.0 27.0 ELECTRICITY (KWH/YR PER CAP) 31.0 65.0 77.0 31.0 235.0 382.0 NEWSPRINT (KG/YR PER CAP) 1.2 1.5 0.7 0.1 2.0 14.0