Philippines - Fourth Rural Credit Project

Report No. 1415-PH Philippines: Appraisal of P Fourth Rural Credit Project March 7, 1977 Rural Credit and Agro-Business Division East Asia and Pacific Regional Office FOR OFFICIAL USE ONLY U 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 US$1.00 = Pesos (P) 7.5 P 1.00 = US$0.1333 WEIGHTS AND MEASURES - METRIC SYSTEM 1 hectare (ha) 2.47 acres 1 kilometer (km) = 0.62 miles 1 kilogram (kg) = 2.2 pounds 1 cavan (paddy) = 50 kg [a 1 cavan (corn) = 57 kg 1 picul (sugar) = 63.5 kg ABBREVIATIONS ACA - Agricultural Credit Administration AMDA - Agricultural Machinery Dealers Association AMTESP - Agricultural Machinery Testing, Evaluation and Standardization Project CB - Central Bank of the Philippines DBP - Development Bank of the Philippines DRBSLA - Department of Rural Banks and Savings and Loan Associations, CB IGLF - Industrial Guarantee and Loan Fund IRRI - International Rice Research Institute LBP - Land Bank of the Philippines MAU - Management Advisory Unit NFAC - National Food and Agriculture Council NIA - National Irrigation Administration PCAC - Presidential Committee on Agricultural Credit PNB - Philippine National Bank SSLA - Stock Savings and Loan Associations TBAC - Technical Board on Agricultural Credit TSEU - Technical Support and Evaluation Unit UPLB - University of the Philippines, Los Banos FISCAL YEAR Government: January 1 to December 31 CB: January 1 to December 31 Rural Banks: January 1 to December 31 SSLAs: January 1 to December 31 /a The former weight of 44 kg for cavan is sometimes still used in the Philippines.  FOR OFFICIAL USE ONLY PHILIPPINES FOURTH RURAL CREDIT PROJECT TABLE OF CONTENTS Page No. SUMMARY AND CONCLUSIONS ............................. i- iv I. INTRODUCTION ........................................ 1 II. BACKGROUND .......................................... 1 General ......................... 1 Economy ................................... . 2 Agricultural Sector ..... .............. 2 Agricultural Credit ............................ 3 III. RURAL BANKING INSTITUTIONS .......................... 6 Rural Banks .................................... 6 Stock Savings and Loan Associations .... ........ 8 IV. REVIEW OF PREVIOUS RURAL CREDIT PROJECTS ........... . 9 Performance Under First, Second and Third Rural Credit Projects .................. 9 Issues Arising From Previous Projects ........ .. 11 V. THE PROJECT ....... .............. .................... 14 Detailed Features ............... ............... 14 Cost Estimates ......................... 19 Financing .................... .................. 20 Procurement ................... ................. 21 Disbursement ........................... 22 VI. ORGANIZATION AND MANAGEMENT ......................... 22 Department of Rural Banks and Savings and Loan Associations ............................ 22 Lending Policies, Terms and Criteria .... ....... 25 Organization of Agricultural Machinery Testing, Evaluation and Standardization Project ...................................... 27 Project Monitoring ............................. 27 VII. MARKETS AND PRICES .................................. 28 Markets ........................................ 28 Prices .... 28 VIII. BENEFITS AND JUSTIFICATION .......................... 29 IX. RECOMMENDATIONS ..................................... 31 This document has a restricted distribution and may be used by recipients only in the performance | of their official duties. Its conterts may not otherwise be disclosed without World Bank authorization.  -2- ANNEXES 1. Small-Scale Agriculture in the Philippines 2. Cottage and Agro-Industries in the Philippines 3. Agricultural Credit 4. Summary of Previous Rural Credit Projects 5. Central Bank of the Philippines 6. Rural Banks 7. Stock Savings and Loan Associations 8. Farm Mechanization and Transport 9. Cottage and Agro-Industries 10. Fisheries Development 11. Livestock Development 12. Monitoring and Evaluation 13 Project Cost Estimate 14. Estimated Quarterly Schedule of Disbursements 15. Phasing of the Lending Program 16. Summary of Financial Rates of Return 17. Economic Evaluation  PHILIPPINES APPRAISAL OF THE FOURTH RURAL CREDIT PROJECT SUMMARY AND CONCLUSIONS i. The Government of the Philippines has requested a Bank loan to assist in the financing of the medium- and long-term credit program admin- istered by the Central Bank of the Philippines (CB). This would be the fourth loan since 1965 in support of this program, in which funds are on-lent through qualified rural banks and stock savings and loans associations (SSLAsi to farmers, fishermen, and rural entrepreneurs. On the basis of the findings presented in this report, a loan of US$36.5 million is recommended. ii. Seventy percent of the Philippine population of 42.5 million lives in rural areas. Agriculture accounts for 50% of total employment, 70% of commodity export earnings, and 35% of GNP. Remarkable growth was achieved in agricultural production in the 1960's (7.7% per year between 1965 and 1970), primarily as a result of improved technology and the increased use of cash inputs in rice production. After a period of adverse weather con- ditions in the early 1970's, production has again recovered. However, ade- quate supplies of production and term credit are essential to the continued growth of production and the Government has undertaken a number of special financing programs to augment private sector resources used in agricultural development. The Rural Credit Projects supported by the Bank have been the major component of Government assistance in term credit. Government goals for the agriculture sector are self-sufficiency in food grain production, expansion of agricultural exports, implementation of the Agrarian Reform Program, improvement of income distribution and nutritional level, and con- servation of natural resources. Cottage and agro-industries in rural areas are viewed as a means of diversifying the rural economy and creating pro- ductive employment. iii. Under the previous Rural Credit Projects, the first of which was undertaken in 1965, a total of 10,860 sub-loans were made for farm mechani- zation, processing and storage, transportation, minor irrigation, fisheries, livestock and cottage and agro-industries. Bank loans totalling US$40 mil- lion accounted for approximately 50% of total sub-project costs. Approxi- mately 83% of total costs were for farm mechanization sub-projects, although this share was reduced to 72% under the most recent project. The Rural Credit Prcjects have been instrumental in mobilizing domestic funds for medium- and long-term investments in agriculture and related industries. They have contributed to rural productivity and incomes and have generated  - ii - substantial employment opportunities. However, arising from experience under previous projects, the proposed project would include specific measures to affect the following: the channeling of a larger share of project proceeds to smaller farmers and entrepreneurs; a reduction in the share of project proceeds used for large-scale mechanization; improvements in the procurement practices and guidelines governing farm machinery financing; greater attention to the inter-relationship of the project with other rural credit programs; and improvements in repayment performance among sub-borrowers. iv. The proposed project would provide medium- and long-term credit (US$89.9 million) through qualified rural banks and stock savings and loan associations to about 16,000 farmers, fishermen, and rural entreprenuers for investment in: farm mechanization (US$55.3 million); light transporation (US$1.5 million); cottage and agro-industries (US$7.0 million), coastal and inland fisheries (US$17.6 million) and small-scale livestock development (US$8.5 million). In addition, funds would be included for: a study to assess the impact of farm mechanization in the Philippines; an Agricultural Machinery Testing, Evaluation and Standardization Project; training of credit personnel; and service vehicles for CB field personnel engaged in the project. v. Total project costs are estimated to be P 684.4 million (US$91.3 million). Foreign exchange costs would be US$29.4 million (32%). The pro- posed Bank loan of US$36.5 million, which would be for a period of 15 years including a 4-1/2 year grace period, would finance 40% of project costs. CB and the Government would provide 40%, rural banks and SSLAs 10% and sub- borrowers 10%. Terms and conditions for the release of project funds would be set out in the Rules and Regulations governing the project, which would be subject to Bank approval. vi. As in the Third Project, machinery and equipment, including trucks, irrigation pumps, engines and equipment for fishing boats, and machinery and equipment for cottage and agro-industries would be purchased locally by sub- borrowers under initial supervision of the on-lending institution. Suffi- cient private contractors are available for construction of boats, buildings and other civil works. The size of individual contracts would be too small for international competitive bidding and bulking of contracts would not be practicable because of their wide dispersal both in location and time. All sub-project contracts would be made through ordinary commercial channels. The purchse of service vehicles by CB would be through local competitive bidding in accordance with procedures acceptable to the Bank. The procurement of four-wheel tractors and imported power tillers would continue to be subject to ceiling price guidelines although these guidelines would be modified to reduce retail prices from present levels. vii. Disbursement of loan proceeds to CB would be as follows:  - iii - (i) 45% of the sub-loans disbursed by rural banks and SSLAs, against certified statement of expenditure; (ii) 40% of the costs of instruction, materials and rental of facilities for training and the preparation of a credit handbook, against certified statement of expenditure; (iii) 100% of the c.i.f., ex-factory cost of vehicles, or 40% off-the-shelf, against invoice; (iv) 40% of the cost of the farm mechanization study, against certified statement of expenditure; and (v) 66% of the cost of civil works and equipment contracts for the Agriculture Machinery Testing, Evaluation and Standardization Project, against invoice, to be passed on to the Department of Agriculture. viii. The Director of CB's Department of Rural Banks and Savings and Loan Associations (DRBSLA) would assume overall responsibility for imple- mentation of all aspects of the project except the Agricultural Machinery Testing, Evaluation and Standardization Project, for which funds would be channeled through the Department of Agriculture to the University of the Philippines at Los Banos. CB Agricultural Credit Supervisors or members of CB Loan Teams would assist rural banks and SSLAs to prepare sub-projects. Loan Teams would evaluate sub-projects and, if approved, would recommend to DRBSLA the transfer of Special Time Deposits to an account of the on-lending institution. Disbursement against sub-borrower contracts would be made by the on-lending institution, direct to suppliers where possible. During the project period, a gradual transfer of lending authority to qualified on-lend- ing institutions is envisaged, with technical assistance and post-approval review by Loan Teams. Monitoring, reporting and technical support would be provided by the Technical Support and Evaluation Unit of DRBSLA. In addi- tion, a Management Advisory Unit would be established in the Department consisting of a small number of experienced senior officers who would provide assistance to rural banks on managerial problems outside the regular super- vision and regulatory structure. ix. Project funds for sub-loans would be channeled through rural banks (90%) and stock savings and loan associations (10%). The system of rural banks, consisting of 786 individual banks, is the largest network of bank- ing facilities in rural areas. Two hundred and forty five of these banks participated in the Third Project. DRBSLA provides rural banks with train- ing, technical assistance, and credit facilities, and supervises all aspects of their operations. Loans by rural banks, of which 90% go to agriculture, increased over 200% between 1972 and 1975, to P 2,324 million (US$310 million), primarily as a result of Government supported food production credit programs such as Masagana 99. This rapid expansion has been accompanied by a deteriora- tion in collections; arrears were 21.4% of outstanding portfolio on December 31, 1975 compared to 16.7% a year earlier. Measures presently being taken to  - iv - improve this situation, and implications for the proposed project are dis- cussed in this report. There are 44 SSLAs in the Philippines, of which 13 participated in the Third Project. About 31% of total lending in 1975 of P 77 million (US$10 million) went to agriculture, an increase of 13% from the previous year. Collection performance is satisfactory. SSLAs are also regulated by DRBSLA and receive the same training and technical assistance services as rural banks. They do not, however, participate in special financ- ing programs other than the Rural Credit Projects. x. At full development, the project is expected to result in incre- mental production of agricultural commodities, small implements, handicrafts and rural services with a total annual value of P 379.4 million (US$50.6 mil- lion). It is expected to create 10,280 man years of employment per year, the majority of which would be unskilled. Fifty seven percent of all sub-projects other than four-wheel tractors, amounting to US$11 million of loan proceeds would accrue to smaller farmers and entrepreneurs who would derive an average net income from sub-projects of P 5,445 per year. Custom hire services would also be used primarily by smaller farmers who occupy the majority of cultivated lands and do not generally own tractors or tillers. The project would have a net foreign exchange contribution of US$9.2 million per year primarily through import substitution. Financial rates of return for sub-projects and an overall economic rate of return have been determined and are satisfactory. xi. The proposed project is recommended for a loan of US$36.5 million with a 15 year maturity, including a grace period of 4-1/2 years.  PHILIPPINES FOURTH RURAL CREDIT PROJECT I. INTRODUCTION 1.01 The Government of the Philippines has requested a Bank loan to assist in the financing of the medium- and long-term rural credit program administered by the Central Bank of the Philippines (CB). This would be the fourth loan in support of this program, previous loans having been made in 1965 (432-PH, US$5.0 million), 1969 (607-PH, US$12.5 million), and 1974 (1010-PH, US$22.5 million). The third loan was fully committed in December 1975 and is expected to be fully disbursed by the end of March 1977, 8 months before the Closing Date. The proposed loan would be the eighteenth Bank loan in support of agricultural and rural development in the Philippines. 1.02 As under the Third Rural Credit Project, the project would provide funds to CB which would on-lend, through qualified rural banks and stock savings and loan associations, to farmers, fishermen and rural entrepreneurs. However, the project would place less emphasis on farm mechanization and transportation than did previous projects and focus to a greater extent on the development of fisheries, livestock, and cottage and agro-industries. The Government has decided to place greater emphasis on the financing of smaller farmers and a quota would be established for lending to this target group. Additional funds would be provided for training of credit staff both of CB and onlending institutions, and for other project support investments. 1.03 This report is based on a project proposal submitted in March 1976 by CB and on the findings of an appraisal mission composed of Messrs. Y. Nakahara, J. Brown, D. Steel, D. Forno (Bank), H. Lapp, R. Jessup and H. Deomampo (Consultants) which visited the Philippines in May-June 1976. 1/ II. BACKGROUND General 2.01 The Republic of the Philippines, with an area of about 30 million ha, consists of more than 7,000 islands scattered along the archipelago 1/ The mission also examined issues relating to the agricultural credit sector, small-scale agriculture, and credit aspects of the Agrarian Reform Program.  - 2 - which extends over 1,600 km north and south. It is divided into three main parts: Luzon in the north, the Visayas and Mindanao in the south. The population is estimated to be some 42.5 million, growing at 2.8% per annum (at the end of 1975), of which about 70% lives in rural areas. Luzon has the largest population (53%), with about 5 million concentrated in the Greater Manila area alone, the balance being evenly distributed between the Visayas (25%) and Mindanao (22%). 2.02 The climate is tropical and characterized by high temperature, humidity and rainfall. Mean temperatures range from 21 C in January to 190C in May. Rainfall shows a wider range, from 1,000 mm in southwest Mindanao to 5,500 mm in the highlands of Luzon. Most areas lave one major rainy season but the rainfall pattern varies widely across the country. Climatically, the Philippines has high potential for agricultural production. Economy 2.03 Real gross national product has been growing at 6 percent annually in recent years, and in 1976 reached a level of $390 per capita at current prices and exchange rates. Major assets of the Philippines for economic development include relatively abundant mineral (with the exception of pet- roleum) and water resources, a climate favorable to large-scale agricultural production, a high level of general education, and a vigorous entrepreneurial class. Significant liabilities include a high population density in rela- tion to arable land and a high rate of population growth. Poverty and un- equal distribution of income are longstanding problems and a significant current problem is the large current account deficit of about $1 billion in 1976, brought about by a deterioration in the external terms of trade since 1974. The Government is attacking these problems through increased efforts in rural development, family planning and labor-intensive export-oriented nontraditional industries, In 1976, nontraditional exports increased by about 50%. The Bank, in its Basic Economic Report, and the Government regard GNP growth of 7 percent a year as a feasible objective, and that the external accounts situation is and will remain manageable provided that external debt continues to be managed carefully and that nontraditional exports continue to grow at a fairly rapid pace. Agricultural Sector 2.04 Agriculture is the most important sector in terms of employment and export earnings. It accounts for about 50% of total employment and 70% of commodity export earnings, consisting mainly of coconut and sugar- cane products. Agriculture also contributes 35% of GNP consisting of food crops (12%), export crops (9%), livestock (6%), fisheries (4%) and others (4%). 2.05 Agricultural output was accelerated during the late 1960's due largely to increased rice production, a result of introducing a new tech- nological package of irrigation, high yielding varieties, fertilizers and other farm inputs. The annual growth over 1965-70 was 7.7%. From 1971 to 1973 crops were seriously affected by adverse weather conditions and crop diseases but production has since recovered.  2.06 More than half of the total land area of 30 million ha is forest- land and about one-third is cultivated including plantations. An additional 2.5 million of fairly level or slightly sloping land is classified as avail- able for cultivation, of which 1.0 million ha is cogun grassland, difficult and expensive to reclaim. With the rate of land expansion for farm land slowing down in recent years, it has been clear that most of the increased production and farm incomes must come from higher yields, intensification of land use and cultivation of higher value crops. 2.07 The Government goals for the agricultural sector are self- sufficiency in food grain production, expansion of agricultural exports, implementation of the Agrarian Reform Program, improvement of income dis- tribution and nutritional level, and conservation of natural resources. Agricultural Credit 2.08 Agricultural credit available from both Government and non- Government institutions probably accounts for about one-third of all agri- cultural credit, the remainder being provided by traditional non-institu- tional sources. In nominal terms, institutional credit for agriculture has increased continuously. In real terms, it grew rapidly during the first half of the 1960's, decelerated during the second half and actually started to decline in the early 1970's. With the introduction of supervised food pro- duction programs, real growth has once again been substantial since 1973 (Annex 3, Tables 1 and 2). One limitation on the flow of credit to agricul- ture is the inadequate coverage of institutions serving rural areas; another is collateral requirements which preclude access to credit by a large number of small farmers. In efforts to overcome these problems, the Government is promoting the expansion of the rural banking system and has introduced special credit programs such as Masagana 99 to provide production credit to small farmers without collateral. The Rural Credit Projects and other Bank-supported projects have provided additional investment credit to rural areas. 2.09 Government Institutions. About 20% of the institutional credit to agriculture is provided by the public sector principally through the Philippines National Bank (PNB), and, to a much lesser degree, the Agricul- tural Credit Administration (ACA). 1/ In addition, the Land Bank of the Philippines (LBP) has been revitalized and is expected to play an essential role in financing land transfer under the Agrarian Reform Program and provid- ing credit, mainly to agrarian reform beneficiaries. 2.10 PNB is the largest bank with about 170 branches and 120 mobile offices. Its total assets increased from P 6.2 billion in 1973 to P 15 bil- lion (US$2 billion) in 1975. Traditionally, its agricultural lending has been to commercial farms and plantations primarily for seasonal credit for pro- duction inputs, marketing and processing. Now it also finances half of the short-term credit for food grain production under Masagana 99 and Masaganang 1/ The CB support of agricultural credit is in the form of rediscounting facilities and Special Time Deposits for other public and private institutions.  -4- Maisan. As a result, about 30% of its total lending is for agriculture. DBP provides medium- and long-term credit for a wide range of enterprises in the agricultural sector. In 1975, 23% of its loan approvals, reaching P 2.4 billion (US$330 million), was to agriculture. Since 1972, the Development Bank of the Philippines (DBP) has been the credit channel for seven IBRD agricultural projects. 1/ ACA finances production and marketing cooperatives and small farmers but, owing to lack of funds and poor loan recovery, its lending has decreased and its future role is under review. 2.11 Private Institutions. Commercial banks are the most important private institutions providing some 55% of all institutional agricultural credit, although this amounts to less than 10% of their portfolios. CB now requires that a minimum of 25% of all commercial bank lending go to agri- culture. Instead of making direct loans, many banks purchase CB Certificates of Indebtedness, the proceeds of which are used by CB to refinance agricultural loans provided by other credit institutions. About 30 commercial banks serve the agricultural sector directly, mostly in the form of short-term credit for marketing and trade financing in copra and sugarcane. 2.12 The next important private institutions are rural banks (786 in June 1976) with total assets of some US$470 million. They provide about 20% of all institutional agricultural credit, mainly under the Masagana 99 and Masaganang Maisan, and are also gradually increasing their term lending primarily under the Rural Credit Projects supported by the Bank. Although much smaller in scale, there are savings and loan associations and private development banks which lend about a third of their funds to agriculture. 2.13 Cooperatives have begun to assume an important role in the flow of credit to small farmers, particularly agrarian reform beneficiaries. Membership in a Samahang Nayon (pre-cooperative at the village level) is a pre- requisite of credit for agrarian reform beneficiaries, and is encouraged for all small borrowers. Samahang Nayons in turn become shareholders in market- ing, processing and service cooperatives usually established at the pro- vincial level. Samahang Nayons may acquire up to 40% equity in rural banks and one bank has now been established in Nueva Ecija under full cooperative ownership. Government training courses for members and management are mandatory prerequisites for any financial undertakings by Samahang Nayons. At the end of March 1976, about 17,000 Samahang Nayon had been organized and 90 cooperatives organized at higher levels. At that time, total sav- ings of Samahang Nayons amounted to P 29 million. It is too early, however, to predict the success of this program but it is evident that assistance in financial management and control will be essential to members' confidence in the success of cooperatives. 1/ Rice Processing and Storage Project, Loan 720-PH, US$14.3 million First Fisheries Project, Loan 891-PH, US$11.6 million First Livestock Development Project, Loan 832-PH, US$7.5 million First Industrial and Small Holder Tree Farmers Project Loan 998-PH, US$50.9 million (US$2.0 million for tree farming) Second Livestock Development Project, Loan 1225-PH, US$20.0 million Second Grain Processing Project, Loan 1269-PH, US$11.5 million Second Fisheries Projects, Loan 1270-PH, US$12.0 milli-on  -5- 2.14 Interest Rates. The annual interest rate for credit from Govern- ment sources is normally 12% for loans secured by land, and 14% for others. An exception is the 12% interest rate for supervised credit made available under Masagana 99 and other Government food grain production credit programs for which real estate collateral is not required. Recently the Monetary Board has raised the ceiling interest rates to 17% for loans less than two years and 19% for loans over two years which is not applicable to rural banks 1J. The effective cost of credit from agricultural input suppliers is between 15% and 25% per annum; from private moneylenders the cost is much higher. 2.15 Development Policies for the Agricultural Credit Sector. In September 1975, the Presidential Committee on Agricultural Credit (PCAC) and its working group, the Technical Board on Agricultural Credit (TBAC) were established. 21 Their establishment and composition attest to the Government's intention to address carefully and vigorously issues surrounding the future of this sector. TBAC has its own staff of about 30 persons who conduct studies of various aspects of the rural credit sector under the direction of the Board and review studies conducted by CB, Government agencies and special committees. Over the past year a useful dialogue has been established between members of these units and representatives of the Bank, and attention is now being given to issues which ought to determine the nature of future Bank support for the sector. Among these are; the identification of target groups with clearly defined credit needs, determination of the most suitable long-term roles for various credit institutions, the coordination of credit and technical assist- ance to borrowers, new sources of funds such as supplier's credit, and the financing of marketing and storage facilities. 1/ These ceiling interest rates include commissions, premiums, fees, and other charges of 3%. Loans over two years may not exceed 80% and 100%, respectively, of time deposits and deposit substitutes with a remaining maturity of more than two yeats. 2/ The members of PCAC are: Governor, Central Bank (Chairman); Secretary, Department of Agriculture (Vice-Chairman); Director-General, National Economic and Development Authority; Secretary, Department of Local Govern- ment and Community Development; Secretary, Department of National Resources; Secretary, Department of Agrarian Reform; President, Philippine National Bank; Chairman, Development Bank of the Philippines; and President, Land Bank of the Philippines. The members of TBAC are representatives of: Central Bank (Chairman), Department of Agriculture (Vice-Chairman), Department of Local Government and Community Development, Department of Natural Resources, National Economic and Development Authority, Philippine National Bank, National Food and Agriculture Council, Department of Agrarian Reform, Agricultural Credit Administration, Development Bank of the Philippines, Land Bank of the Philippines and a separate representative from the DRBSLA, Central Bank.  - 6 - III. RURAL BANKING INSTITUTIONS 3.01 Although commercial banks provide over one half of the insti- tutional credit for agriculture, the rural banking system (presently with 786 individual banks) has the largest network of banking facilities serv- ing the rural areas and is capable of financing a large number of medium and small farmers. In providing medium- and long-term loans for rural development, rural banks and SSLAs, which supplement the rural banking system to extend its coverage to rural areas, have proved successful as credit channels for the three Rural Credit Projects and would continue to be the credit channels for the proposed Fourth Project. 3.02 Rural banks and SSLAs are private banks, supervised by CB's Department of Rural Banks and Savings and Loan Associations (DRBSLA)O Most are established, capitalized and managed by close family groups, although cooperatives are now entitled to acquire shares of rural banks up to a maximum of 40%. In some cases, banks and SSLAs are owned by the same group of investors. Rural Banks 1/ 3.03 Organization. Establishment of rural banks is authorized by the Monetary Board and the Government may at the time of establishment assist them by subscribing in the form of preferred shares up to an amount equal to shares subscribed by private individuals. At the end of 1975, shares held by the Government had decreased to 26% of paid-in capital through acquisition by private shareholders. DRBSLA provides rural banks with train- ing for management and staff, technical assistance in lending and administra- tion, and funds through Special Time Deposits. It also supervises and examines their operations. Funds are also provided by CB's Department of Loans and Credits (DLC) through rediscounting facilities. During the first two years of a Four-Year Development Program for the rural banking system (1974-77), 140 new rural banks were established compared to a target of 100 each year for the plan period. This very rapid expansion has placed a heavy bur- den on training and supervision staff of CB. Rural banks are typically established by prominent financial or professional members of the smaller communities they serve. Their investment portfolios, which average P 3 mil- lion, consist of loans to borrowers within a small radius, perhaps concentra- ted within 20 km. Staffed by a manager, an accountant, a cashier, one or two technicians, and support staff, they rely heavily on an intimate knowledge of local conditions and borrower reputations to protect the quality of their portfolios. Types of loans reflect the predominant credit needs of the respective communities, but, in the main, short-term agricultural production loans constitute the majority of their portfolios. i/ A more detailed description of rural bank operations appears as Annex 6.  -7- 3.04 Financial Resources. As of December 30, 1975, rural banks' total resources were P 2,749 million (US$377 million), consisting of P 276 million (US$38 million) in paid-capital, P 150 million (US$20 million) in surpluses, reserves and undistributed profits, P 678 million (US$93 million) in deposits, and P 1,489 million (US$204 million) in borrowing, the bulk from CB. In the past three years, total liabilities more than tripled from P 694 million at the end of 1972 to P 2,323 million at the end of 1975. This increase was primarily due to the introduction of the food grain production programs (Masagana 99 and Masaganang Maisan) and to increased disbursements under the Rural Credit Projects. 3.05 A large portion of borrowings is made through CB's rediscounting facilities. CB rediscounts promissory notes up to 100% of face value under supervised production schemes (rice, corn and sugar) a: 1% per year and (80% at 5% per year for non-supervised ordinary schemes), with a limit of 500% of the borrowing bank's net worth plus 100% of its average monthly saving deposits over the preceding four months for supervised ciredit (100% and 50% respectively for non-supervised credit). The terms are up to 180 days for commercial loans, 270 days for agricultural and industrial loans, and 360 days for loans to cooperatives. Another facility provided by CB is the advancement of funds as Special Time Deposits to finance special programs including the Rural Credit Projects. These deposits are secured by promis- sory notes from the recipient banks. 3.06 Deposits are another major source of funds for rural banks auth- orized by the Monetary Board. Annual interest rates as of January 1976 vary from 7.5% for savings deposits to 9% and 12.5% for time deposits of 90 days and 2 years, respectively. National and regional savings campaigns supported by CB in the past year have been very successful. 3.07 Lending Operations. The loan portfolio of rural banks increased rapidly in recent years; from P 770 million (US$103 million) at the end of 1972 to P 2,324 million (US$310 million) at December 31, 1975; an increase of over 300%. More than 90% of these loans were to agriculture. The number of loans exceeded 1,000,000 in both 1974 and 1975 and the average loan size in 1975 was P 2,220 (US$296). Medium- and long-term financing is limited almost entirely to that supported by the Bank through the CB:IBRD program and accounts for less than 10% of rural bank loan portfolios. 3.08 Arrears. The overdues position of rural banks is not satisfactory. As of December 31, 1975, arrears amounted to 21.4% of outstanding portfolio, an increase from 16.7% at December 31, 1974. In absolute terms, arrears increased from P 287.0 million at the end of 1974 to p 503.4 million at the end of 1975. During the appraisal of the proposed project a more detailed analysis was conducted of 268 banks, including those participating in the Third Project as of December 31, 1975. As of March 31, 1976, overdues among these banks accounted to 36% of demand. Only 111 were below the 20% criterion which was to have been introduced April 1, 1976, had funds not been fully committed prior to that date. In the case of 112 banks arrears were found to exceed 40% of demand. Measures presently being taken to improve this situa- tion and implications for the proposed projects are discussed in para 6.09.  - 8 - 3.09 Profits. Although rural banks' income and expenditure both increased by about three times, net income and return to common stocks have shown some improvement in 1974 and 1975. However, the profitability of individual banks seems to differ widely, even without considering adequacy of reserves for bad debts. The generally high level of returns to common stock despite serious arrears problems is a reflection of the very high degree of leverage encour- aged by the present CB financial assistance to the system. Commitments to re- ducing arrears can be expected to increase meaningfully only as CB credit facilities are more stringently tied to collection performance. Stock Savings and Loan Associations (SSLAs) 1/ 3.10 Organization, SSLAs are registered as stock corporations after approval by the Monetary Board and the Securities and Exchange Commission. They can accept deposits from the public and make loans to the public. They are now classified as banking institutions and, unlike rural banks, may open branch offices with approval of the Monetary Board. They do not enjoy exemption from taxes and Government fees and charges and cannot receive capital assistance from the Government. At the end of December 1975, there were 44 SSLAs (compared with 67 non-stock savings and loan associations), including about 20 in the Greater Manila area. 3.11 Financial Resources. At December 31, 1975, the total paid-up capital of all SSLAs was P 54.4 million (17% of total resources). The main source of funds is savings and time deposits collected from stock- holders and the public. Savings contributed about a half of total resources while time deposits contributed 18%. SSLAs insure their savings and de- posits with the Philippine Deposit Insurance Corporation and, in addition, they have organized their own Guaranty Fund to ensure the liquidity of individual associations. Borrowings were mainly from CB for participation under the Rural Credit Projects (11% of total resources). 3.12 Lending Operations. In the past, SSLAs lent prlrLarily for commercial and housing purposes, but lending to agriculture has gradually increased during 1974 and 1975 (13% in 1974; 31% in 1975). About two- thirds of SSLA loans are secured by collateral. 3.13 Collection and Profits. Collection of loans to date is satis- factory. Net income of all SSLAs is improving gradually and in 1975, it was P 4.5 million or 8% of the paid-up capital compared to P 1.7 million (5% of paid-up capital) in 1972. 1/ A more detailed description of SSLA operations appears as Annex 7.  -9- IV. REVIEW OF PREVIOUS RURAL CREDIT PROJECTS a. Performance under First, Second and Third Rural Credit Projects 4.01 First Rural Credit Project (Loan 432-PH). This loan of US$5.0 million assisted in establishing for the first time a nationwide system to channel medium- and long-term credit through the rural banks to farmers and fishermen. Between 1965 and 1969, 148 rural banks participated in the project and financed about 2,600 farmers for the purchase of farm machinery and irrigation pumps, and for development of fisheries and livestock as in the following table: No. of Amount in Amount as Average Category Sub-loans Million Pesos % of Total Sub-loan Size Farm Machinery 2,118 19.1 89.3 9,000 Irrigation Pumps 279 1.0 4.6 3,600 Fisheries, Livestock 197 1.3 6.1 6,600 Total 2,594 21.4 100.0 8,250 4.02 Second Rural Credit Project (Loan 607-PH) This loan of US$12.5 million financed basically the same sub-loan categories as the First Project but included, in addition, storage and processing facilities and on-farm transportation equipment. Because of the low demand for term credit during the initial stage of project implementation, caused primarily by the effect of the peso devaluation as well as several natural disasters, final disburse- ment was completed in June 10, 1974, a delay of 18 months. From 1969 to 1974, project funds were channeled through 228 rural banks to about 4,000 farmers. The breakdown by major components is given in the following table: No. of Amount in Amount as Average Category Sub-loans Million Pesos % of Total Sub-loan Size Farm Mechanization 2,997 109.1 74.3 35,400 Processing & Storage 161 4.7 3.2 29,200 Transportation 229 12.8 8.7 55,900 Fisheries 265 9.1 6.2 34,350 Livestock 413 11.1 7.6 26,900 Total 4,065 146.8 100.0 36,100 4.03 Third Rural Credit Project (Loan 1010-PH). Under this loan of US$22.5 million a number of new sub-loan categories were added, the major additions being farm machinery repairshops, reconditioned trucks, fishmeal plants and woodcraft plants. Other new categories were fishpens and small  - 10 - dairy farming. Stock savings and loan associations (SSLAs) were included to provide additicnal channels to project beneficiaries. The strong demand for tractors, power tillers and trucks continued under the third loan and CB fully committed project funds during December 1975, about 18 months ahead of schedule. Sub-loans were provided to 4,200 farmers through about 245 rural banks and 13 SSLAs as in the following table: No. of Amount in Amount as Average Category Sub-loans Million Pesos % of Total Sub-loan Size Farm Mechanization 2,930 182.3 72.4 62,200 Farm Transportation 566 40.5 16.1 72,700 Farm Support Facilities 293 4.9 1.9 16,600 Fisheries 184 10.4 4.1 57,000 Livestock 213 13.0 5.2 60,900 Cottage and Agro- Industries 25 0.7 0,3 26,600 Total 4,211 251.9 100.0 60,000 4.04 Regional Distribution of Proceeds. The flow of funds under the three projects has been concentrated in Luzon as shown in the following table, although there is a trend toward more even distribution among regions. First Loan Second Loan Third Loan No. Amount No. Amount No. Amount Luzon 66% 66% 61% 66% 50% 50% Visayas 18% 17% 20% 22% 23% 30% Mindanao 16% 17% 19% 12% 27% 20% 4.05 Financing Pattern. Under the First Project, the Bank's share in total cost of sub-projects was limited to 55%, rural banks were required to contribute 10% and sub-borrowers, 30%. In the Second and Third Projects, the Bank's limit was reduced to 50%, the rural banks' contribution was the same 10%, and sub-borrowers' contribution was lowered to 10%. The following table presents the actual shares in sub-project financing: First Loan Second Loan Third Loan IBRD 55% 47% 47% Central Bank 25% 28% 27% Rural Banks /a 5% 9% 9% Sub-borrowers 15% 16% 17% /a Rural bank contributions did not reach the required minimum 10% because the condition was waived during project implementation (the First and Second Projects) and because contributions in some cases was mistakenly calculated on the basis of sub-loans instead of total sub-project costs (the Third Project).  - 11 - 4.06 Participation of On-Lending Institutions. Participation under the Rural Credit Projects was constrained primarily by arrears criteria and by the operating radius of Loan Teams (nine operated under the Third Project) to process sub-loans. Actual participation under the three projects was as follows: First Loan Second Loan Third Loan Rural Banks 148 228 245 SSLAs - - 13 b. Issues Arising from Previous Projects 4.07 Overall Assessment. The Rural Credit Projects have been instru- mental in mobilizing domestic funds for medium- and long-term investments in agriculture and related industries. As a result of previous projects, rural banks began term lending, and the rules and operations of rural banks generally have been improved. Farm mechanization under previous projects has increased crop yields and cropping intensity by facilitating the adoption of improved technology and efficient use of irrigation facilities. Farm incomes and rural employment opportunities have been increased among the beneficiaries. However, progress in lending to smaller farmers has been disappointing. While large- scale mechanization is an important factor in the growth of the rural economy, the distribution of project proceeds among sub-loans categories has been heav- ily weighted in favor of four-wheel tractors and due attention does not appear to have been given to other categories. The impact of previous projects on participating institutions has been positive and there is scope for the use of this mechanism to further strengthen the lending capacity and procedures and the financial control of on-lending institutions. It is difficult to assess with any precision the extent to which project funds have been additional or substitutive. However, in view of the fact that rural banks depended almost entirely on previous projects for term-lending resources and recognizing the shortage of investment credit in rural areas, it is reasonable to assume that funds have been additional. Substitution may have occurred in the case of some sugarcane tractors, and this category would be reduced under the proposed project. 4.08 Project Beneficiaries. Recipients of sub-loans have usually been owners of 5 ha to 50 ha, the upper limit of farm size for which rural banks are authorized to extend credit. The majority of sub-loans have gone to bor- rowers at the upper end of the size spectrum whose business contacts afford them the best knowledge of credit opportunities and whose financial position enables them to provide the most attractive collateral. The major benefit of previous projects to small farmers has been the custom hire services, parti- cularly in land preparation, which are offered by the recipients of sub-loans. The credit needs of small farmers are difficult to serve through private, commercially-oriented credit systems such as the networks of rural banks and  - 12 - SSLAs, and due regard must be given to the financial strength and development of the onlending institution. 1/ Nevertheless there are financially viable investments which can be tailored to the needs of small entrepreneurs. The nature and size of most components of the proposed project have been determined with this objective in mind and, in addition, it is proposed that a minimum share of project proceeds be directed to this target group (para 5.02). 2/ 4.09 Sub-Loan Components. The financing of four-wheel tractors has dominated previous projects to a significantly greater degree than projected during appraisals, reflecting only in part the financial merits of such investments. Other factors have been the relative ease of processing such sub-loans, the aggressive promotional activities of the industry, the attractiveness of a chattel mortgage on tractors in terms of ease and value of resale, and the prominance of typical tractor purchasers in the rural communities. Efforts on the part of the Bank to encourage the promotion of other investments have not succeeded in overcoming these forces and, in order to provide for the financing in greater numbers of other types of investments, the proposed project would limit the funds available for four- wheal tractors (para 5.03). 4.10 Farm Mechanization. Under certain conditions it has been demon- strated that some types of farm mechanization displace labor, an economic consideration the more serious by virtue of the fact that it is generally unskilled labor with few alternative employment opportunities that is effected. Mechanization in the Philippines has been introduced primarily in land prepar- ation and evidence available to date indicates that in fact the result has been to increase labor requirements over the total cropping operation. In- creased yields, cropping intensity and area have been facilitated, thereby generating additional employment in planting, harvesting and post-harvest operations. Land preparation and harvesting typically occur at the same time in multiple cropping areas, and mechanization has to some extent alle- viated labor shortages in land preparation when priority for manual labor must be given to harvesting standing crops. The extent of the labor im- pact of mechanization in the Philippines and the most appropriate types of mechanization from an employment standpoint have not been adequately examined as a basis for long-term investment policy, however, and the proposed project would include such a study (para 5.10). 4.11 Tractor and Tiller Prices. During appraisal of the proposed proj- ect it was a matter of concern that tractor and tiller prices had risen rapidly in recent years. While this reflects to some extent increases in 1/ OED Report, Agricultural Credit Program, November 1976, ... the farm development strategy must not succeed at the expense of the channel's capacity for effective performance", p. 76. 2/ Annex 1 presents a survey of small-scale agriculture in the Philippines and develops the definition of the proposed target group for the project.  - 13 - the c.i.f. prices of this imported equipment, CB ceiling price policy and its administrative supervision of machinery procurement for financing under the CB:IBRD program were found to be unsatisfactory. One detrimental effect of high prices in addition to the impact on sub-borrowers has been the attraction into the industry of a large number of brands and agencies competing for small shares of a relatively small, scattered market. The resulting diseconomies, in terms of dealer network, for example, are significant. Under the proposed proj- ect ceiling price guidelines for tractors and imported tillers would be modi- fied (para 5.19) and procurement practices improved (para 5.18). 4.12 Interdependence with Other Credit Programs. With the diversific- ation of lending under previous projects and the increased total flow of credit to agriculture the interdependence of the CB:IBRD program and other credit programs, both production and term, has greatly increased in recent years. Financing under the proposed project must be monitored in the context of the total impact of credit programs on the financial well-being of on- lending banks and sub-borrowers. Institutional aspects of the project such as training, CB organization, bank eligibility, and sub-borrower appraisal would be modified to insure that they complement and take into consideration the impact of other credit programs on banks and sub-borrowers participating in the proposed project (Chapter VI). 4.13 Institutional Development. Measures under previous projects such as the establishment of the Technical Support and Evaluation Unit and Loan Teams and the expansion of Agricultural Credit Supervisors in the field have resulted in substantial enhancement of CB's capacity to develop and supervise term credit portfolios in rural banks and SSLAs. However, the expanding number and diversity of sub-loans placed an increasing burden on CB. With the accu- mulation of experience in term lending on the part of on-lending institutions, it is feasible now to begin a transfer of more responsibility directly to them. With the Government's desire to promote this development, a number of training and organizational measures under the proposed project would assist in a gradual transfer of lending authority to rural banks and SSLAs (para 5.12 and Chapter VI). 4.14 Repayment Performance. The Government and CB have now acknowledged that every effort must be made to reduce high arrearages, and a number of remedial actions have been taken. The National Commission on Countryside Credit and Collection (NCCC) chaired by CB's Governor, has been established to review the large overdues existing under Government-assisted lending programs. Together with its working unit established in CB, it is expected to assist banks in their collection efforts and to formulate educational programs to improve repayment habits in rural areas. CB is implementing a special scheme under which teams of one examiner and one agriculturist would reside in local areas to strengthen supervision and technical assist- ance to four and eight rural banks, respectively. CB has also decided to deny, as of November 1, 1976, all rediscounting facilities to rural banks with arrears in excess of 25% of their loan portfolio. 1/ This is not a new 1/ As a result of this action, 257 rural banks were temporarily disqualified from rediscounting on November 1, 1976.  - 14 - criterion although it has not been enforced with respect to food production loans since 1973. It is also proposed that Government undertakes a detailed study of the causes of arreazs to assist in the developing measures for their reduction. Together with improved financial management assistance to banks, it is expected that these measures will reduce present arrears substantially. Arrears criteria for the proposed project are discussed in para 6.09. V. THE PROJECT 5.01 The project would be a continuation of the Third Rural Credit Proj- ect to provide medium- and long-term credit for another three years. Quali- fied rural banks and SSLAs would lend project funds to about 16,000 farmers and rural entrepreneurs for investment in: (a) farm mechanization; (b) light transportation; (c) cottage and agro-industries; (d) coastal and inland fish- eries; and (e) small-scale livestock development. The project would also include funds for: (f) a study to assess the impact of farm mechanization in the Philippines; (g) an Agricultural Machinery Testing, Evaluation and Standardization Project to standardize the quality of farm machinery; (h) a training program to improve the lending capability of CB and rural bank staff; and (i) service vehicles for CB field staff engaged in the project. 5.02 Emphasis would be given to increasing the share of project proceeds accruing to smaller borrowers above that realized in previous projects. Assur- ances were obtained that a minimum of US$11 million I/ of loan proceeds would be on-lent to small beneficiaries whose total self-earned income per year is less than P 7,500 2/, or whose total self-earned income per year is P 7,500 or more and who earn 75% or more of such income from one of the following: a land holding, owned or leased, of not more than seven ha; a fishing enterprise, operated on the basis of ownership or leasehold, consisting of not more than five ha of fishponds or fishpens, or not more than one fishing vessel, such vessel not to exceed five tons; or a cottage or agro-industrial enterprise owned and operated by them, and consisting of fixed assets of less than P 100,000, excluding the value of land. Detailed Features (a) Farm Mechanization (Annex 8) 5.03 Four-Wheel Tractors. The project would finance about 1,775 tractors and implement packages for rice, corn and sugarcane farmers. The trend toward the purchase of larger tractors in the Philippines has resulted in excess 1/ Equivalent to 56.6% of proceeds allocated to sub-projects other than four- wheel tractors or 30.6% of total sub-loan proceeds. 2/ Financing under the project of a small-scale livestock enterprise of not more than 10 sows, 200 layers, 400 broilers, or five cattle or carabaos would usually be for this category of small beneficiaries.  -15 - power and reduced cost effectiveness of tractor investments, particularly in rice and corn areas (Annex 8, para 18). Under the Third Project a limit of 80 hp was placed on tractors to be financed, irrespective of crops cultivated. To further reduce the financing of excess capacity, tractors to be used in rice and corn production, where draft requirements are significantly less, would be limited to a maximum of 68 hp under the proposed project. However, this limitation would be imposed only after a period of 18 months from the date of the Loan Agreement or after the financing of 1,000 units of tractors in excess of 68 hp each, whichever should occur first, in order to facilitate the adjustment of the trade and the reduction of present inventories of large tractors. Assurances were obtained that financing of four-wheel tractors in excess of 68 hp each would be limited to 1,000 units, of which a maximum of 450 units would be financed to be used in sugarcane growing areas, where pur- chasers are typically in a better position to use alternative sources of financing, 1/ and that loan proceeds used to finance four-wheel tractors irrespective of horsepower would be limited to US$16.5 million. 2/ One addi- tional limitation would be imposed on tractor financing: for tractors to be eligible for financing under the project, retail prices would not be permitted to exceed ceilings presented in the discussion of procurement (para 5.19). These limitations would be monitored by Loan Teams and the Technical Support and Evaluation Unit (TSEU). 5.04 Power Tillers. About 7,800 tillers would be financed under the project. The financial viability of small cultivators is marginal in terms of additional output under normal conditions. However, a major advantage, although difficult to quantify, is the assurance of cultivation capacity in contrast to the uncertainty resulting from the vulnerability of draft animals to debilitating diseases and their need for prolonged periods of rest. This protection can be afforded by the smaller locally manufactured units and the evaluation of higher cost imported models has been subjected to more stringent financial criteria. At present price levels, purchase of imported models cannot be justified, and financing under the project would be limited to those which conform to ceiling price guidelines presented in procurement paragraph 5.19. This limitation would be monitored by Loan Teams and TSEU. 5.05 Other Farm Mechanization. Other items would include about 400 small irrigation units, 600 portable threshers of 100-300 cavans per hour capacity, about 240 implement packages for owners of tractors purchased outside of the project, and a small allocation for miscellaneous equipment such as back-pack sprayers. Demand for small-scale irrigation facilities is limited at the present time because of uncertainty surrounding water rights and the absence of detailed groundwater surveys. Some of this limited demand is now being met by Government agencies such as the National Irrigation Authority, the Farm Systems Development Corporation and the Public Works Department through separate programs offering credit on more lenient, inexpensive terms than can be offered by commercial credit 1/ Under the Third Project, it is estimated that about 600 tractors were financed for sugarcane growers. 2/ US$16.5 million, consisting of $14.0 million base cost estimate plus a maximum share of price contingencies of $2.5 million.  - 16 - institutions. In the case of portable threshers, technical merit in terms of recovery rates is not reflected in large demand since minimum utilization rates to assure viability generally require the grouping of farmers or ex- tensive custom work. For both irrigation pumps and portable threshers, our estimates of units to be financed reflect these limitations despite the potential contribution to increase production. (b) Light Transportation (Annex 8) 5.06 This category would include about 400 light trucks having a gross vehicle weight of less than 2,500 kg which would be used in rural areas as cargo vehicles for small-scale entrepreneurs and for transportation of mixed cargo and passengers. These multi-purpose vehicles, owned and operated by local entrepreneurs, are the traditional means used by small farmers to market their produce and to transport production inputs to their farms. No financ- ing of light trucks would be undertaken in the Greater Manila area, to mini- mize the likelihood of project vehicles being used exclusively for passenger transportation. Despite an apparent need for more cargo transportation capa- city in most areas in the Philippines, financing of heavy and medium trucks would be discontinued under the project because of the relatively good finan- cial position of cargo businesses, enabling them to use other sources of financing. (c) Cottage and Agro-Industries. (Annex 9) 5.07 This category would include about 225 sub-projects covering a wide range of cottage and agro-industries such as rice milling, farm implement manufacturing, woodworking, handicrafts and manufacturing of concrete pipes and tiles. It would enable rural banks to diversify their lending operations and serve a wider segment of the rural population. The Bank's Small and Medium Industries Development Project (Loan 1120-PH, US$30.0 million) also provides funds for agro-industries through rural banks but the scale of sub- loan under the proposed project would be smaller. The number of rural banks able to extend and supervise smaller sub-loans would be significantly higher than those eligible to participate in the Bank's Small and Medium Industries Development Project through CB's Industrial Guarantee and Loan Fund (IGLF). (d) Coastal and Inland Fisheries. (Annex 10) 5.08 Fisheries sub-projects would include about 45 small coastal fishing boats (basnig boats ) and equipment, and about 1,200 inland fishponds and fishpens with a total area of 6,000 ha. Boats of simple traditional design would be manufactured in small local yards, purchased by local entrepreneurs, and crewed by local fishermen usually on a catch-sharing basis. The maximum size of a boat financed would be increased from 20 gross tons under the Third Project to 40 gross tons in order to permit access to better, more distant fishing grounds. The average size of fishponds and fishpens would be 5 ha. The Bank's Second Fisheries Credit Project (Loan 1270-PH, US$12.0 million) presently administered by DBP would finance larger boats (of 45 gross tons and above) and fishponds (an average size of 24 ha) and would have no over- lap with the proposed project.  - 17 - (e) Small-Scale Livestock Development. (Annex 11) 5.09 About 3,240 small-scale livestock sub-projects (1,240 for poultry, 1,000 for pig and 1,000 for cattle breeding and fattening) would be included under the project to meet the cost of initial stock, pens and shelters, feed and other inputs. Poultry and pig sub-projects financed under the project would generally be smaller than those to be financed by the Bank's Second Livestock Project (Loan 1225-PH, US$20.0 million) administered by DBP. The scale of backyard cattle breeding/fattening farms financed under the project would be similar to that under the Livestock Project but only 200 such sub-loans are included under the latter project, and geographic coverage by rural banks, being more extensive than that of DBP branches, would permit the proposed project to meet demand not served through the Livestock Project. (f) Study of Farm Mechanization (Annex 12) 5.10 The benefits of farm mechanization in terms of increased food pro- duction have been demonstrated in some countries to be offset to some extent by detrimental economic and social effects, particularly the displacement of unskilled labor. Economic and social patterns within the area in question and the nature of mechanization taking place are key determinants of these undesirable effects, and evidence that has been acquired for the Philippines suggests that labor displacement on an annual or area basis is not taking place. However, a thorough study of the impact of mechanization, both its advantages and disadvantages, has not been conducted on a sufficiently large scale to form the basis for long-term Government policy on mechanization. The project would therefore include a study to assess the financial, economic and social impact of farm mechanization. Assurances were obtained that quali- fied consultants would be engaged on terms and conditions acceptable to the Bank to conduct this study and that terms of reference for the study would be acceptable to the Bank. Also, a preliminary draft of the study would be sub- mitted to the Bank for its comments. (g) Agricultural Machinery Testing, Evaluation and Standardization Project (Annex 8) 5.11 With the rapid expansion of farm mechanization in recent years, there has been a proliferation of local manufacturing firms and importers. The proposed project would include an Agricultural Machinery Testing, Evalua- tion and Standardization Project to set quality standards for agricultural machinery and to conduct performance testing against such standards. The Project would be located on the campus of the University of the Philippines at Los Banos (UPLB) and be directed by a senior member of the Department of Agricultural Engineering. The following would be the principal objectives and activities: (i) develop quality and performance standards for Philippines farming conditions and types of equipment used in the Philippines; (ii) con- duct field, shop and laboratory testing of equipment to determine capacity and conformity with relevant standards; and (iii) evaluate post-purchase parts and service support. The Project would issue its factual results in bulletin form and would not recommend any products or processes. Assurance were  - 18 - obtained that the Project would be established at UPLB with organization, staff and facilities acceptable to the Bank, and would thereafter be main- tained beyond the period of the proposed Bank project. (h) Training 5.12 The project would provide funds to augment the ongoing training programs of CB for its own staff and staff of rural banks and SSLAs. Areas of concentration under the project would include: the evaluation of cottage and agro-industrial sub-projects, for which courses would be designed for both CB and on-lending bank staff; and farm budgeting and plan- ning, for the technical staff of on-lending banks. Courses would be designed and conducted by CB with the use of non-CB resource staff as appropriate. A handbook would also be prepared for the field staff of on-lending banks and CB, covering all phases of lending operations. The purpose of this handbook would be to standardize the quality and nature of design, appraisal and supervision of production and term credit loans. Assurances were obtained that qualified consultants would be engaged on terms and condition acceptable to the Bank to assist in preparation of the handbook and that the outline of the handbook would be acceptable to the Bank. A preliminary draft of the handbook would also be submitted to Bank for its comments. (i) Service Vehicles 5.13 Under the Second Loan in 1969, 61 service vehicles were financed for CB field staff. Since that time, field staff have more than doubled, and an additional sixty vehicles would be provided to meet the needs of these officers in their bank and sub-project review work. Summary of Sub-Loan Items 5.14 The following summary of sub-loan items is presented in terms of December 1975 prices.  -19 - Number of ------ Total Cost ---------------- Items Units Million Pesos Million US Dollars Tractors 1,775 259.9 34.7 Power Tillers 7,800 64.8 8.6 Portable Threshers 600 8.0 1.1 Irrigation Pumps 400 7.0 0.9 Other Implements 240 6.8 0.9 Light Trucks 400 8.8 1.2 Coastal Fishing Boats 45 13.4 1.8 Fishponds 1,165 80.0 10.7 Fishpens 50 6.3 0.8 Poultry 1,240 20.1 2.7 Pigs 1,000 22.0 2.9 Cattle Breeding/ Fattening 1,000 5.3 0.7 Cottage and Agro- Industries 225 39.2 5.2 Total 15,940 541.6 72.2 Project Area 5.15 The project would be country-wide in scope although coverage in terms of individual communities would depend on participation by rural banks and SSLAs. Only about 100 rural banks are expected to participate in the project during the first six months as a result of the enforcement of arrears criteria. Participation may be expected to increase gradually as more rural banks reduce arrears to acceptable levels (para 6.09). The distribution of on-lending institutions will remain approximately as it was under the Third Project: two-thirds in Luzon, and the balance evenly dis- tributed in the Visayas and Mindanao. The expanded coverage of cottage and agro-industries is likely to induce greater participation among SSLAs in the small municipal centers of the country. Cost Estimates 5.16 Total project cost is estimated to be US$91.3 million. To ensure sufficient funds for a steady flow of sub-projects over the pro- posed three year period, a price contingency of 13.7% has been added to the December 1976 base cost estimates. I/ The estimated foreign exchange component is US$29.4 million (32%). 1/ Financial and economic evaluation has been conducted on the basis of cost prevailing at the time of project preparation, December 1975. How- ever, for this aggregate cost table, the base cost estimate has been adjusted to December 1976 levels by adding estimated cost increases of 9% for equipment and 11% for civil works. To December 1976 costs, price contingencies have been added as follows: 1977 1978 1979 i. Equipment 8% 8% 8% ii. Civil works 11% 12% 12% Commitment Ratio 80:20 65:35 55:45 (i:ii)  - 20 - Million Pesos Million US$ Foreign Local Foreign Total Local Foreign Total Exchange Farm Mechanization 228.8 154.9 377.7 29.7 20.7 50.4 42 Light Transportation 5.8 3.8 9.6 0.8 0.5 1.3 40 Fisheries Development 94.3 15.4 109.7 12.6 2.0 14.6 14 Small-Scale Live- stock Development 46,7 5.2 51.9 6.2 0.7 6.9 10 Cottage and Agro- Industries 31.7 11.7 43.4 4.2 1.6 5.8 27 Sub-Total 401.3 191.0 592,3 53.5 25.5 79.0 32 Training 1.8 - 1.8 0.2 - 0.2 0 Study 0.7 - 0.7 0.1 - 0.1 0 Vehicles 1.6 1.7 3.3 0.2 0.3 0.5 50 Agricultural Machinery Testing, Evaluation 3.1 0.7 3.8 0.4 0.1 0.5 19 and Standardization Project Sub-Total 7.2 2.4 9.6 0.9 0.4 1.3 24 Base Cost Estimate 408.5 193.4 601.9 54.4 25.9 80.3 32 Price Contingency 56.1 26.4 82.5 7.5 3.5 11.0 32 Total Project Cost 464.6 219.8 684.4 61.9 29.4 91.3 32 Financing 5.17 Total project costs of US$91.3 million equivalent would be financed as follows: Million US$ Million Pesos Percent IBRD 36.5 273.8 40 CB/Government 36.6 273.8 40 Rural Banks/SSLAs 9.1 68.4 10 /a Beneficiaries 9.1 68.4 10 Total 91.3 684.4 100 /a Average figure. Rural Banks in operation for less than three years and with a net worth not exceeding P 500,000 may be authorized to contribute only 5%.  - 21 - Bank funds would be lent to CB. Together with the Government and CB contri- bution, loan proceeds would be onlent to rural banks and SSLAs in the form of Special Time Deposits. A minimum contribution of 10% would be required of rural banks and SSLAs except in the case of recently established rural banks with limited resources (net worth less than P 500,000), in which case the minimum contribution would be 5%. The minimum sub-borrower's contribution would be 10%. Terms and conditions for the release of project funds would be set out in the Rules and Regulations governing the program, and assurances were obtained that the Rules and Regulations, and changes thereto, would be subject to Bank approval. Funds for AMTESP would be transferred from CB to the Department of Agriculture which would in turn allocate them to AMTESP. Procurement 5.18 As in the Third Project, machinery and equipment, including trucks, irrigation pumps, engines and equipment for fishing boats, and machinery and equipment for cottage and agro-industries would be purchased locally by sub- borrowers under initial supervision of the on-lending institution. There is adequate representation of major international manufacturers. Sufficient private contractors are available for construction of boats, buildings and other civil works. Building materials, including lumber and cement, are pro- duced locally. The size of individual contracts would be too small for inter- national competitive bidding and bulking of contracts would not be practicable because of their wide dispersal both in location and time. All sub-project contracts would be made through ordinary commercial channels and assurances were obtained that at least three price quotations would be required for all sub-project contracts in excess of P 10,000 except in remote areas where supplier representation is insufficient, in which case a certified statement to that effect by the financing institution would be required. The purchase of service vehicles by CB would be through local competitive bidding in accord- ance with the procedures acceptable to the Bank. 5.19 CB would modify its present ceiling price guidelines on four-wheel tractors and imported power tillers so that the maximum retail prices to be considered for financing under the project would be 170% of the bodega (ware- houses) cost for four-wheel tractors and 175% for imported power tillers, the bodega cost being defined as the sum of (a) c.i.f. Manila, (b) 30% of c.i.f. Manila (42% for imported power tillers) primarily to cover duties and taxes but also including miscellaneous costs, and (c) the direct cost of local content 1/, Prices would vary by models. Monitoring of these tractor and tiller prices would continue to be the responsibility of DRBSLA. 1/ The approximate effect of these price revisions would be to reduce tractor prices on average by 11% and imported tiller prices on aver- age by about 15%.  - 22 - Disbursement 5.20 Disbursement of loan proceeds to CB would be as follows: (i) 45% of the sub-loans disbursed by rural banks and SSLAs, against certified statements of expenditures; (ii) 40% of the costs of instruction, materials and rental of facilities for training and the preparation of a credit handbook, against certified statements of expenditures; (iii) 100% of the c.i.f., ex-factory cost of vehicles, or 40% off-the-shelf, against invoice; (iv) 40% of the cost of the farm mechanization study, against certified statements of expenditures; and (v) 66% of the cost of civil works and equipment contracts for the Agriculture Machinery Testing, Evaluation and Standardi- zation Project, against invoice, to be passed on to the Department of Agriculture. 5.21 In the case of disbursement against certified statements of expenditures, supporting documentation would not be submitted for review but would be retained by CB and available for inspection by the Bank during the course of project supervision. An estimated quarterly schedule of disburse- ments appears in Annex 14. VI. ORGANIZATION AND MANAGEMENT 6.01 The credit component of the project together with related training and support facilities would, as with previous Rural Credit Projects, be the responsibility of CB's DRBSLA. Funds for the Agricultural Machinery Testing, Evaluation and Standardization Project would be channelled through the Department of Agriculture to the University of the Philipines at Los Banos (UPLB). Department of Rural Banks and Savings and Loan Associations. 6.02 Organization. DRBSLA is headed by a Director who is supported in overall department management by an Associate Director. The Department's eight operating divisions responsible for supervision and sub-loan assistance under special schemes are grouped according to geographic jurisdiction and, together with the Accounting and Special Services Division, are placed under one of the three Assistant Directors. DRBSLA is the largest department in CB with over 700 staff. Its functions are distinguishable broadly into two dis- tinct categories; credit activities, and audit and examination of rural banks and SSLAs. Although present policy within CB limits management of departments  - 23 - to only one Associate Director, the size and nature of DRBSLA's responsibili- ties appears to warrant positions for two Associate Directors. Field-based staff such as Agricultural Credit Supervisors and members of Loan Teams are under the direct supervision of the Division responsible for the territory to which they are assigned. Training, legal services, statistical operations and other required services are separately managed within the Department. The Technical Support and Evaluation Unit was established under the Third Project in the Office of the Director. Members of the Unit have developed good work- ing ties with field staff, particularly Loan Teams, and this organizational arrangement would continue under the proposed project. 6.03 Project Implementation. The Director, DRBSLA would assume overall responsibility for implementation of all aspects of the project except AMTESP (para 6.12). At the outset, the following cycle and responsibilities would apply to sub-loans: a technician of the on-lending institution would prepare the sub-project, generally with the assistance of a CB Agricultural Credit Supervisor or Loan Team member; the on-lending institution would conduct credit and collateral checks, assemble the sub-loan application and supporting documentation, and submit these to the Loan Team; the Loan Team would conduct an appraisal of the proposal and, if it is approved, would submit its recommendation to DRBSLA together with documents of obligation on the part of the on-lending institution; upon release of Special Time Deposits by the Accounting and Special Services Division, which would be released under the proposed project by four Loan Teams located at three regional offices and at headquarters, in the name of the on-lending institution, disbursement against sub-borrower contracts would be made by the on-lending institution, direct to suppliers where possible. The authorities and responsibilities described above would change gradually under the project as the Department begins to introduce more decentralized decision-making and administrative processes. 6.04 Decentralization of DRBSLA Operations. It is the intention of the Department to decentralize its operations increasingly to regional offices of CB in order to expedite the release and recovery of funds and improve the supervision of financial institutions. In the context of term lending opera- tions and the CB:IBRD program, decentralization would take several specific forms. (a) Evaluation of sub-loan proposals would be gradually transferred to selected rural banks from Loan Teams. This transfer must be gradual, establishing in effect free limits for qualified banks within which they would be authorized to approve specific types of sub-loans, subject to technical support and post-approval audit by Loan Teams. Such authority would be granted and amended on a bank by bank basis by the Director, DRBSLA, acting on recommendation of the Loan Team of the region. Assur- ances were obtained that steps would be taken to imple- ment this tranfer.  - 24 - (b) Funding authority under the program is to be decentralized to the four Loan Teams located at the three CB regional offices and at headquarters to reduce delays in the flow of funds which tend to arise as a result of fund releases taking place in Manila. Supervision of sub-loan collections from banks would be undertaken by Loan Teams. In effect the role of Loan Teams is to shift toward program management and technical back- stopping from the present function of direct operational involve- ment with each sub-loan application. 6.05 Loan Teams. The number of Loan Teams would be the same, but the number of officers in each would increase from three to six (eight for Teams in charge of issuing Special Time Deposits). In addition, one clerical position would be created in each Team. Although actual sub-loan appraisal will grad- ually become the responsibility of the financial institutions, the work of the Loan Team will become increasingly important in on-the-job training of rural bank and SSLA appraisal and supervision staff. The technical expertise required for individual Teams will vary depending on the prevalent types of sub-loans being extended within respective regions. The composition of Loan Teams would also shift to include a higher calibre of financial management to perform the program management functions envisaged for the Teams in the long run. 6.06 Technical Support and Evaluation Unit (TSEU). TSEU's role with respect to the CB:IBRD Program would continue to be essentially one of mon- itoring, evaluation and technical support for field operations. The Unit has developed a high standard of work. Under the Fourth Project the Unit would, in addition to its ongoing supervision, oversee requirements with respect to the share of loans extended to small farmers, and the regional distribution of sub-loans. To date the work of TSEU has been limited to term lending under the CB:IBRD program. In keeping with the objective of integrat- ing all credit operations in the Department, and to meet a growing need for staff support of CB representation in multi-agency credit bodies, assurances were obtained that the Unit would, coincident with the beginning the Fourth Project, undertake responsibility for staff support pertaining to the Depart- ment's short-term production credit activities as well. This would include the following functions: (a) to serve as a permanent secretariat for the Department's representative to the Technical Board on Agricultural Credit, the National Food and Agriculture Council and the National Commission on Countryside Credit and Collection. This function will be particularly important in the pre- paration of background papers in support of CB positions to be taken in these bodies. Such work is now done on an ad hoc basis by staff borrowed from operating divisions. (b) to develop operating policies and procedures for special financing schemes for which the Department is charged with implementation responsibility.  - 25 - (c) to evaluate on-going and pilot schemes such as the Inte- grated Agricultural Financing scheme which is now under trial through 18 rural banks. 1/ 6.07 Management Advisory Unit (MAU). This Unit would be established to provide assistance to rural banks in areas of management in which widespread or critical weaknesses have been encountered. It would not assume routine supervisory responsibilities but rather would work closely with field and head office staff to identify problems for its attention and would respond to requests by rural bank or SSLA management for special assistance on an individual basis. Despite the fact that CB staff, as representatives of the regulatory and major financing agency of rural banks, would probably en- counter difficulty in gaining the confidence and candor of rural bank managers, there are several problem areas in which such a Unit could provide effective assistance, for example: budgeting, solicitation of deposits, cash management and cash flow projections, staff utilization, sub-loan supervision, and col- lection procedures. MAU, to be responsible to the Director, DRBSLA, would be headed by an Assistant Director. A Technical Assistant, three officers of the rank of Division Chief (two certified public accountants and one agricultura- list) and four to eight additional officers plus two clerical support positions would comprise the Unit. It would be essential to the effectiveness of the Unit's work that officers of these senior ranks be selected on the basis of extensive experience in the managerial problems of rural banks. Assurances were obtained that this Unit would be established and staffed by experienced officers and would thereafter be maintained. Lending Policies, Terms and Criteria 6.08 CB has established minimum standards for the participation of rural banks and SSLAs in the Rural Credit Projects. The criteria include: (a) character, competence and integrity of officers; (b) past performance as to soundness of investments and compliance with the law, regulations and generally accepted banking practice; (c) soundness of financial position, based on liquidity, adequacy of equity and profitability; (d) period of operation not less than one year; (e) rediscounting facilities with CB not withdrawn; and (f) maximum arrears limitation. 1/ Under this scheme the overall credit needs of individual farmers are provided on the basis of a farm plan and continuing evaluation and supervision in contrast to the traditional crop- or project-specific extension of credit.  - 26 - 6.09 The arrears criteria for participation under the proposed project would be specified as maximum allowable percentages of arrears to total loan portfolio and of arrears to demand on medium- and long-term loans. Assurances were obtained that the following criteria would be applied without prejudice to efforts to further reduce levels of non-payment: (i) arrears not exceeding 25% of total loan portfolio; (ii) arrears on term loans not exceeding 30% of demand, arrears being defined as "amounts due at the end of a twelve month period as a percentage of demand", and demand being defined as "principal and interest falling due during the period plus overdues at the beginning of the period"; (iii) effective January 1, 1978, arrears not exceeding 25% of demand as defined above (ii); and (iv) effective July 1, 1978, arrears not exceeding 20% of demand, as defined above (ii). Assurances were obtained that the Government would undertake a detailed study of the causes of arrears in rural bank and SSLA portfolios and that this study would be completed and made available to the Bank for discussion by December 31, 1977, together with a plan of action for the reduction of these arrears. 6.10 The Bank loan would be for a period of 15 years, including a four and one-half year grace period, at standard Bank rate of interest. The pro- posed grace period would be appropriate, allowing for a four and one-half year disbursement period and possible slippage in project implementation. The lend- ing rate to the ultimate beneficiaries would be 14%, 2% higher than the rate charged under Government supervised food grain production credit programs, with the exception of 12% to agrarian reform beneficiaries. The participating institutions would be charged a blended rate of not less than 9%, with the exception that, for sub-loans to finance agrarian reform beneficiaries, the rate would be 7%, thus maintaining a margin of 5%. This spread is reasonable to cover the high administrative cost of dealing with small term loans. The period of CB loans to participating institutions would coincide approximately with those for sub-loans to the ultimate beneficiaries. Foreign exchange risk would be born by CB, while the financial risk of sub-loans would be the res- ponsibility of the participating financial institution. The amount of sub- loans would not exceed 70% of the value of titled properties or 50% of the value of untitled properties offered as security. 6.11 Audit. Auditing procedures are satisfactory with respect to the enforcement of regulations and accounting practices. However, there is scope for improving the effectiveness of CB auditing as a means of improving management information in rural banks and advising on the use of available information in portfolio management. As required by law, DRBSLA would audit each rural bank and SSLA every year; special examinations would also be con- ducted of rural banks and SSLAs with serious operational difficulties or  - 27 - management problems. In addition, the resident examiner system under imple- mentation now would allow monitoring of operations on a daily basis as well. The records of audit of participating banks would be retained on file at CB. Organization of Agricultural Machinery Testing, Evaluation and Standardization Project (AMTESP) 6.12 AMTESP would be operated as a separate activity of the Department of Agricultural Engineering, the University of the Philippines at Los Banos (UPLB) and would be governed by a Board of Trustees or Advisory Council consisting of representatives of UPLB, Department of Agriculture, International Rice Research Institute, Agricultural Machinery Dealers Association, and Government financial institutions engaged in the financing of farm machinery. The Project, to be located at UPLB, would be managed and operated by UPLB under a budget and policy decisions set by the Board (Council) and using full and part-time staff appointed by the University's Department of Agricultural Engineering. Funds for the Project would be channeled through the Department of Agriculture budget which would also provide counterpart funds. Quarterly payments would be made by the Department against the Project's approved budget, adjusted for short- falls in actual expenditure. Proceeds of the Bank loan would be used to finance equipment and civil works. Assurances were obtained that the Project would be established with organization, staff and facilities acceptable to the Bank and would thereafter be maintained beyond the period of the proposed Bank project. Project Monitoring 6.13 The reporting of progress under the Third Project by DRBSLA was generally satisfactory and the overall pattern of reporting would continue unchanged. However, assurances were obtained that TSEU would undertake a review of present reports and propose changes as appropriate for discussion with the first Bank supervision mission with respect to the following consid- erations: (i) Improvements in the procedures for data collection and the report formats themselves to reduce the large volume of paper flow and the extent of duplication in report content; (ii) Inclusion of pre-investment characteristics of sub- borrowers in routine reporting; and (iii) Increased timeliness of reporting of project accounts in individual banks. TSEU would also be responsible for the monitoring of sub-loans to res- tricted categories, to ensure compliance with price ceilings on tractors and tillers, volume limitations on tractors, and the requirement that a minimum of US$11 million of sub-loan proceeds accrue to the small beneficiaries defined in para 5.02.  - 28 - VII. MARKETS AND PRICES Markets 7.01 The Philippines is expected to continue to be a net importer of rice during the project period. Prices for domestic rice have more than doubled in the past five years and now often exceed the floor price of P 1.00 per kg. imposed by the National Grains Authority. Domestic production of white corn for human consumption is sufficient to meet present demand, but substantial imports of yellow corn will continue to be required to meet rapidly increasing feed grain requirements. In 1974, the Government assumed monopoly control of sugar marketing, establishing The Philippine Exchange Company (Philex) as the sole exporter of sugar. Sugar production has increased steadily in recent years and at the present time there is a surplus of sugar in the Philippines. However, this surplus is primarily a result of marketing and shipping problems. Philippine sugar exports go primarily to the United States and it is reasonable to assume that sales to the country in the near future could rise above present levels. Domestic demand for livestock products is expected to grow at 6% per year over the next few years and production based on present investment pro- grams would not keep pace (Annex 11). The same is true of fisheries production, although it has doubled in the past ten years (Annex 10). Prices 7.02 Prices used in the financial evaluation of sub-projects are those which prevailed in December 1975, unless otherwise stated on grounds of abnormal prices during that period. These market prices of inputs and outputs have also been used in the economic analysis of the proposed project although adjustments were made in investment costs to reflect estimated duties and taxes. The relative prices of factors and products have been assumed constant. Item Price (farm gate or ex-factory depending on model) Rice (palay) P 50/cavan (P 1.00 per kg) Corn (yellow) P 45.6/cavan (P .8/kg) Sugarcane P 158.25/ton (cane equivalent) Beef P 6/kg (liveweight) Pork P 7/kg (liveweight) Feeder Hogs P 180 each (at 60 days) Broilers P 8/kg (dressed weight) Eggs P .40 each Fish: Assorted open sea - P 3,000/ton Average fishpond/fishpen - P 4,000/ton Shrimp - P 10,000/ton  - 29 - VIII. BENEFITS AND JUSTIFICATION 8.01 Production. Project investments in farm mechanization and live- stock and fisheries development would result in substantial increases in the production of a number of agricultural commodities, notably rice, for which Government policy is directed at attaining self-sufficiency. Investments in cottage and agro-industries would expand production of a range of consumer and small capital goods for domestic and export markets, and transportation and machinery sub-projects would provide needed services in rural areas. Total annual incremental output at full development (ranging from four to ten years) is summarized in the following table: Incremental Gross Value Production Million Pesos Million US$ Rice 39,825 tons 39.8 5.3 Corn 7,130 tons 5.7 0.8 Fish 18,326 tons 85.4 11.4 Eggs 1,102 tons 8.8 1.2 Poultry Meat 1,799 tons 14.4 1.9 Pork 150 tons 1.1 0.1 Beef 847 tons 5.1 0.7 Weanlings 67,000 heads 12.1 1.6 Cottage & Agro-Industries (various) 98.3 13.1 Services Land Preparation 314,130 ha 97.9 13.0 Transportation (Excluding passengers) 4.8 million 1.4 0.2 ton/km Rice Threshing 144,000 tons 7.2 1.0 Rice Milling 37,500 tons 2.2 0.3 Total Value 379.4 50.6 8.02 Financial Viability. Financial rates of return on sub-project categories other than power tillers range from about 13% to over 100%. As discussed in para 5.04 the financial return on tiller investments under normal conditions is not attractive, estimated at 8.2%. However, protection against probable incapacitation of the alternative animal draft power is a major advantage which has not been quantified in our model due to the wide range of reasonable assumptions which might be made. To illustrate the possible impact, however, an assumption that one-half of one crop could not be planted due to animal power shortage one out of five years would result in a rate of return, ceteris paribus, of 43%. Rates of return on tractors are lower than those which may be realized since they are based on 1,500 hrs annual use whereas actual utilization is often 1,800 hrs or more. Rates of return on fixed investments are very high for poultry, cattle, and cottage and agro-industrial sub-projects. However, net cash flows for these sub- projects are reasonable when viewed in terms of owner/operator labor  - 30 - and management inputs and the total fixed and working capital at risk in these ventures. A summary of estimated financial rates of return is presented in the following table: Category Financial Rate of Return Tractor - sugarcane 17% - rice 13% Power Tiller 8% Portable Thresher 58% Fishing Boat 31% Fishpond 31% Fishpen 45% Backyard Cattle Raising over 100% Piggery 36% Poultry - 200 Layers over 100% - 400 Broilers over 100% Cottage and Agro-Industries 44% to over 100% The results of sensitivity analysis on these models is presented in Annex 16. 8.03 Economic Viability. Economic costs of investment have been derived by deducting duties and taxes from financial investment costs. Such duties and taxes range between 10% and 20% on the landed cost of imported items, and we estimate them to amount to 8% of total project cost, equivalent to about 25% of the foreign exchange component. Market prices of fertilizer and petro- leum products approximate their economic costs and no shadow pricing of these commodities has been undertaken. Similarly, unskilled labor has been costed at its market rate since the majorty of the project's employment creation would occur in accordance with the crop cycle, the primary determination of employment in the rural Philippines. Including contingencies and the costs associated with all supporting services financed by the project, and overall economic rate of return of 21% has been estimated. A 10% increase in operating costs would reduce the rate to 16% (Annex 17). 8.04 Foreign Exchange Impact. The foreign exchange cost of the project would be about US$29.2 million. In addition, spare parts, fuel and lubricants would be about US$7.5 million per year. The project would generate some ex- ports from cottage industries, about US$ 3.7 million per year. However, the Philippines is a net importer of rice and fish, and the project's major contri- bution to the balance of trade would be reduction in the import requirements of these commodities. At a c.i.f. Manila price of $230 per ton, rice production under the project would save about US$9.2 million per year in foreign exchange. Assuming that only one-third of project fish production would substitute for imported products a further US$3.8 million per year would be saved. On the basis of these assumptions, the project would have a net impact on foreign exchange of about US$9.2 million per year. 8.05 Employment Effect. The project would create about 10,280 jobs as a direct result of sub-loan investments. Indirect employment through intensified agricultural production would be substantial - 4,600 man-years  - 31 - per year in rice production alone - and productivity of labor would also be increased. The majority of direct employment and all indirect agricultural employment would be of an unskilled nature and therefore potentially avail- able to the lowest income groups in the rural areas. 8.06 Benefits to Small Farmers and Fishermen. Fifty seven percent of all sub-projects other than tractors, amounting to about 31% of total sub-project costs would go to small beneficiaries defined in para 5.02. Direct employ- ment associated with these sub-loans would be about 2,200 man-years per year. The total net income per year to these owners at full development is expected to be P 54 million, or an average of P 5,445 per owner. In addi- tion, a major benefit to smaller farmers under the project would be increased availability of custom hire services, primarily for land preparation. We estimate that the majority of the 310,000 ha per year custom hire capacity generated by the project would be utilized on farms of less than seven ha. 8.07 Institutional Development. The project would strengthen the capacity of CB to provide technical and managerial support for the term credit opera- tions of on-lending institutions. This assistance, together with project supported training, would enhance the ability of participating institutions to undertake sound appraisal and supervision of their own term credit loans. In addition, more intensive supervision of rural banks would result on im- proved overall portfolio management. 8.08 Project Risks. Since this would be the fourth in a series of proj- ects implemented through CB and rural banks and the second in which SSLAs have participated, we do not envisage procedural delays in project imple- mentation. The estimated schedule of disbursements takes into consideration the likely effect of the enforcement of arrears criteria on the number of rural bank participation in the project. Realization of the specific bene- fits attributed to the proposed project however would depend on the extent to which the Government and on-lending institutions can affect the following shifts in emphasis from previous projects; an increase in the share of pro- ceeds accruing to smaller borrowers, and greater sub-loan appraisal and super- vision capacity on the part of on-lending institutions. These are difficult undertakings and, while risks have been minimized in project design, success will depend primarily on continuing commitment and effort on the part of those responsible for project implementation. IX. RECOMMENDATIONS 9.01 Assurances were obtained from CB on the following matters: (a) That at least US$11 million of loan proceeds would be extended to small beneficiaries as defined in para 5.02 for purposes of the proposed project (para 5.02); (b) That the financing of four-wheel tractors would not exceed (para 5.03):  - 32 - (i) US$16.5 million in loan proceeds for tractor sub- loans; and (ii) 1,000 units of tractors in excess of 68 hp each; (c) That qualified consultants would be engaged on terms and conditions acceptable to the Bank to conduct a study of the financial, economic and social impact of farm mechanization, that terms of reference for the study would be acceptable to the Bank, and that a preliminary draft of the study would be submitted to the Bank for its comments (para 5.10); (d) That Rules and Regulations governing the use of proj- ect proceeds, and changes thereto, would be acceptable to the Bank (para 5.17); (e) That the maximum retail prices for four wheel tractors and power tillers, including their optional equipment and implements, would be determined in accordance with guidelines set out in para 5.19 (para 5.19); (f) That necessary steps would be taken to gradually transfer lending authority, including evaluation, approval and supervision of sub-loans to qualified rural banks and SSLAs (para 6.04); (g) That the Technical Support and Evaluation Unit would be expanded to function as the departmental planning unit covering both short- and long-term lending programs (para 6.06); and (h) That a Management Advisory Unit would be established in DRBSLA and staffed with experienced senior officers, and would thereafter be maintained (para 6.07). 9.02 Assurances were obtained from the Government on the following matters: (a) That an Agricultural Machinery Testing, Evaluation and Standardization Project would be established at UPLB with organization, staff and facilities acceptable to the Bank, and would thereafter be maintained beyond the period of the proposed Bank project period (para 5.11); and  - 33 - (b) That a detailed study would be conducted of the causes of arrears in rural bank and SSLA portfolios and that this study would be completed and made available to the Bank for discussion by December 31, 1977, together with a plan of actions for the reduction of these arrears (para 6.09). 9.03 The proposed project is suitable for a Bank loan of US$36.5 million at standard Bank lending rate of interest repayable over 15 years, including a grace period of 4-1/2 years.   ANNEX 1 Page 1 PHILIPPINES FOURTH RURAL CREDIT PROJECT Small-Scale Agriculture in the Philippines I. Background 1. The Rural Sector. About 71% of the Philippine population lives in rural areas. While there is a slow steady decline in this proportion, the actual rural population is increasing at an annual rate of 2.7% standing at approximately 30 million in 1975, of whom almost 20 million are engaged in agriculture and 2 million in fisheries and forestry. Average rural family income in 1971 was P 4,400 (US$680), about 75% of the national average. At the same time, the share of earnings of the 40% of rural families with the lowest incomes amounted to only 13%, while the earnings of the highest 20% amounted to 51%. More recent data are not available but there is no evidence of improved equity in income distribution. There are approximately 3 million families engaged in agriculture in the Philippines (45% of total population) of which 1.8 million are classified in the lower 40% income bracket; 1.4 million self-employed and 0.4 million wage earners. 2. Farming Pattern. There are about 6.7 million ha under cultiva- tion in the Philippines (1974), of which about 30% is fully irrigated. 10.1 million ha are devoted to agricultural crop production. As shown in Table 1, rice is the major crop, occupying 33% of total area, followed by corn and coconuts. Together, these crops account for 93% of total area under agricultural production. 1/ 3. The preponderance of small farmers grow rice or corn as their primary crop, the former if irrigated, the latter otherwise. These serve subsistence needs and may yield sufficient surplus for cash sale, particu- larly if there is sufficient moisture for double cropping. Otherwise, cash income is generated by a crop with lower moisture requirement that may be grown immediately after harvest of the rice or corn. Particularly in Luzon, vegetables are fitted into the cropping pattern in this manner, although corn is also widely used as a second crop after rice. 4. Farm Size. Current data on farm size are not available. Figures presented in this section should be viewed in the context of a historical trend toward increased numbers and smaller sizes of farm holdings. The Agrarian Reform Program will accelerate this trend. 1/ Figures refer to total area planted to individual crops in a one-year period.  ANNEX 1 Page 2 Distribution of Farm Holdings by Size (1960) Number of Farms Total Area ('000) % ('000 ha) % Under 1 ha 250 11.5 125 1.6 1 - 1.9 ha 642 29.6 796 10.2 2 - 4.9 ha 864 39.9 2,426 31.2 5 - 9.9 ha 290 13.4 1,845 23.7 10 -24.9 ha 109 5.0 1,396 10.0 Over 25 ha 12 0.6 1,184 15.3 2,167 100.0 7,772 100.0 5. Forty-one percent of the total number of farms in the Philippines were less than two ha in size and occupied in total only 12% of the cultivated area. In the opposite extreme, 0.6% were more than 25 ha and accounted for 15% of the total cultivated area. More than 86% of farm holdings fell within the limit of 7 ha placed on rice and corn lands under the Agrarian Reform Program, and these account for 53% of cultivated area. More than 90% of farms on which rice or corn are the major crop are less than 7 ha in size. 1/ 6. Land Tenure. Approximately 45% of agricultural land holdings in the Philippines are owner-operated (based on most recent census data, 1960) and these account for 53% of total area. Forty percent are tenant-operated, accounting for 26% of area. Tenant cultivation, however, is much more pre- valent in rice and corn areas where 46% and 51% of holdings, respectively, are operated in this manner. Land Tenure Pattern (1960) Number of Farmers Total Area ('000) % ('000 ha) % Owner 968 45 4,133 53 Part Owner 311 14 1,140 15 Tenant 864 40 2,000 26 Other 23 1 499 6 Total 2,166 100 7,772 100 1/ This survey was conducted 12 years before the 7 ha limit on rice and corn holdings was announced under the Agrarian Reform Program; data are not so likely therefore to be misrepresentative.  ANNEX 1 Page 3 7. Since the 1960 census, two pertinent developments have taken place: the continued slow increase in total number of holdings as a result of lands being divided among heirs; and, the introduction of agrarian reform legisla- tions, RA 3844 in 1963 and Presidential Decree 27 (P.D. 27) in 1972. 8. As of December 31, 1975 only 354 tenants had entered into purchase agreements with the Land Bank of the Philippines (LBP) for lots totalling 279 ha under RA 3844. As of the same date, 17,941 tenants had received Certifi- cates of Land Transfer in respect of a total area of 34,229 ha under P.D. 27. Based on 1960 data, this represents less than a 2% shift in both numbers and area from tenancy to ownership. It should be noted that Operation Land Transfer under P.D. 27 is accelerating; by May 15, 1976, total area financed was 65,514 ha and the number of beneficiaries was 30,528. The area implicitly covered by P.D. 27 is 780,000 ha with an estimated tenant family population of 418,000. The average size of new owner holdings to date under P.D. 27 is 2.1 ha although, in the event all areas and tenants are covered, this would be reduced to 1.9 ha. II. The Small Farmer - A Problem of Definition 9. There is a host of definitions of the small farmer in the Philippines. For example: Rural Banks Act (RA 720) Section 5 - "Loans or advances extended by Rural Banks.. .shall be primarily for the purpose of meeting the normal credit needs of any small farmer or farm family owning or cultivating, the aggregate, no more than fifty hectares of land devoted to agricultural production..." Agrarian Reform Law (P.D. 27) - "... one who is the actual tiller whether owner, amortizing owner or lessee, of not more than 7 hectares of rice or corn land". Land Bank of the Philippines - "... a small farmer ... owns, leases or holds a Certificate of Land Transfer to the land he tills and ... is dependent for his survival on more than one agricultural or agriculture-based activities. On average he tills an area of not more than 7 hectares and earns a dis- posable income of not more than F 3,000 per annum". Lower 40% - On the basis of population, average income, and income distribution figures for 1971, the income limit to define the lower 40% in rural areas would be about F 2,100 per annum. Were size of land holding to be taken as a proxy for the earning potential of cultivators, the lower 40% would be defined as those whose holdings are less than two hectares.  ANNEX 1 Page 4 Minimum Needs - Minimum cash requirements for a rural family of six in the Philippines, assuming staple foods are home grown, amounts to about P 4,000. Such a figure inevitably sparks con- troversy because of regional variations and the concept of what constitutes minimum needs. After rather extensive 4inquiry around the Philippines we are satisfied that it is at least an appro- priate order of magnitude. On the basis of models presented elsewhere in this report we estimate that net income of P 4,000 would require 4 ha of single crop corn land or 1 ha of double crop rice land, assuming the availability of appropriate seed, fertilizer, water, and technical assistance inputs as well as timely cultivation. (We have omitted the potential for non- farm income). These areas would represent minima beneath which both cultivation and development programs would have to focus on off-farm income opportunities. 10. These examples hint not only at the difficulty of arriving at a general purpose definition of the small farmer, but also perhaps at the meaninglessness of trying to do so. Definitions ought to be geared to specific purposes. The Bank's Rural Development Sector Policy Paper points out that, "The notion of target groups ... provides that necessary focus on groups of the rural population in terms of whose well being ... program can be designed and evaluated." It is at this point that we revert to the project context in which our work was undertaken and develop a definition of the small farmer for purposes of the Fourth Rural Credit Project. We hasten to add however, that several of the considerations used in arriving at this dcfini- tion may well be appropriate for other Bank lending for agricultural credit in the Philippines. Small Farmer Definition for Fourth Rural Credit Project. 11. Considerations: (i) Our purpose is to identify a group of potential borrowers at the lower end of the income scale to whom project bene- fits can be directed in greater measure than has been achieved in the past. (ii) The project will finance primarily medium- and long-term credit needs. The greatest need of most of the smallest cultivators at present is production credit and the pro- vision of term credit to them may well be a financial disservice. (iii) Rural banks and savings and loan associations are private, commercially oriented institutions, the inherent character- istics of which do not suit them to serve as channels for programs primarily of a social or economic nature.  ANNEX I Page 5 (iv) The scope for introducing meaningful substitutes for conventional loan collateral is very limited at present, and financial intermediaries will continue to depend heavily on real estate and chattel mortgages. (v) To avoid undue risk in the portfolio of financial inter- mediaries, a significant portion of loans must not be directed to borrowers whose holdings do not afford them a measure of financial stability. The target group must be sufficiently broad to record economic success without foreshadowing financial failure. (vi) The break-even point for many of the investment items in greatest demand exceeds the volume of work to be performed on the smaller holdings. Time available for custom hiring is limited, as is the requisite entrepreneurial skill, among the smaller cultivators. (vii) The limits incorporated in the definition must describe an enterprise which constitutes the primary source of income. 12. Definition. For purposes of directing the CB:IBRD program more toward small-scale agriculture, it is proposed that about 31% of sub-loan proceeds under the Fourth Rural Credit Project be designated for the follow- ing small beneficiaries: (i) A sub-borrower whose total self-earned income per year is less than P 7,500 1/, or (ii) A sub-borrower whose self-earned income per year is P 7,500 or more and who earns 75% or more of such income from the following: - agricultural operations carried out on a total land- holding, owned or leased, of less than 7 ha; - a fishing enterprise, owned or leased and operated by him, an consisting of not more than 5 ha of fishponds or fishpens, or of not more than one fishing vessel, such vessel not to exceed 5 tons; or - a cottage or agro-industrial enterprise, owned and operated by him, and consisting of fixed assets of less than P 100,000, excluding the value of land. 1/ A small scale livestock enterprise of not more than 10 sows, 200 layers, 400 broilers or five cattle or carabaos would usually be for this category of small beneficiaries.  ANNEX 1 Page 6 13. Scope of Definition. While data are not precise and current, the definition would include the following approximate percentages of total agri- cultural enterprises in the Philippines: - 99% of rice farms - 90% of corn farms - 60% of sugar farms - 65% of coconut farms - the majority of livestock operations outside Greater Manila - 69% of fishpond operations - 70% of fishpen operations - 99% of fishing vessel operations 14. In its simplicity, the proposed definition clearly ignores a number of factors other than total size of enterprise which affect income: for example, quality of soil, seeds, or water; whether land is irrigated or not; etc. However, these omissions are intentional. We believe that a simple definition is much more readily implemented and monitored, and since such constraints on lending have not previously been imposed, ease of enforcement will be critical to any effective redirection of the CB:IBRD program. 15. Comment. Unfortunately, no data have been compiled on the size of enterprise to which sub-loans were made under the previous three Rural Credit Projects. However, the size of sub-loans gives a fairly clear picture that, despite the overwhelming size of the proposed target group, small farmers did not benefit substantially from the previous loans, other than through custom services. For example, under the Second Project, 56% of total loans were in excess of P 16,000 ($2,105) each; 27% were in excess of P 40,000 ($5,480) each, and only 20% were less than P 8,000 ($1,095) each. Adjusted to mid-1975 price levels, these figures would be approximately doubled. Under the Third Project, the average size of sub-loans (through December 31, 1975) was more than P 59,800 ($7,970). Statements of objectives for these previous projects were consistent with Bank policies at the time of appraisal. However, the sub-loan size figures above indicate that a change in project design and the introduction of limits on certain categories will be necessary if significant results are to be achieved in our present efforts to extend greater assistance to small-scale agriculture. Under the Fourth Project, the average size of a sub-loan is projected to be P 42,280 ($5,637), and a limit on the total volume of larger sub-loans for tractors would also be imposed. 16. Credit. 1/ The total supply of institutional credit to agriculture has fluctuated during the last ten years with insignificant overall growth in real terms. In current dollar terms credit rose by about 60% between 1972 and 1974 primarily as a result of the introduction of Masagana 99 and Masaga- nang Maisan - supervised crop production credit programs. About 45% of the 1/ An overview of the agricultural credit sector in the Philippines is presented in the Philippines Basic Economic Report, Vol. II, pp. 123-130.  ANNEX 1 Page 7 funds of these programs are channeled through rural banks and 50% through Philippine National Bank (PNB). As a result of their participation in these programs, the share of rural banks in total lending rose from 16% in 1972 to 22.9% in 1974. PNB's participation in these programs appears to have been at the expense of increases in other lending since its share of total lending remained approximately the same (26% in 1972; 27% in 1974). The majority of lending by commercial banks has been for sugar production and the financing of sugar and copra stocks. 17. Availment of institutional credit by small farmers has been very limited, the majority constraint being lack of real estate or acceptable chattel collateral. The introduction of supervised credit together with concommitant guarantee schemes was intended to compensate for the inadequacy of collateral on the part of small borrowers. However, private financial institutions have been reluctant to set aside collateral requirements and where this has been done preference has been given to larger borrowers. For example, the average size of holding financed under Masagana 99 (rice) is 2.5 ha compared to the average size of rice farm of 1.7 ha. The guarantee system has not functioned effectively. Despite compulsory participation in the scheme and widespread repayment default, approved bank claims under the scheme are very small (P 13 million in 1975, or 1.6% of the value of loans guaranteed). 18. It has been estimated that about 2/3 of all credit for agriculture comes from non-institutional sources. While some credit from relatives is free of interest, traditional practice involves rates as high as 300% per year equivalent, often paid in kind. It is to these sources of funds that most small farmers must resort. Despite the high rates of interest and, frequently, the tying up of product marketing on very poor terms, there are significant advantages to the use of this credit: it is available on short notice with few or no formalities, it may be used for a wider range of production and consumption needs, and repayment periods are often flexible. It is highly unlikely that non-institutional credit sources could be rendered obsolete by changes in the modus operandi of credit institutions. Nevertheless, the credit needs of small farmers could be met to a much greater extent in the formal sector. Desirable Characteristics of Credit for Small Farmers 19. The financial affairs of the great majority of small farmers in the Philippines have traditionally been overseen by a landlord or merchant with whom the borrower usually has a lasting business tie. Despite the advantage which might be taken of the borrower in such situations, he has not developed in many cases even rudimentary money management skills. He has a very high time preference for money and inadequate knowledge of cash flow and repayment capacity. The concept of voluntary repayment has been obviated by the forceful presence of the lender at the time loans fall due. The first and most difficult feature of a good credit system for small farmers is therefore that it be accompanied by practical education in the use of credit.  ANNEX l Page 8 20. To the extent that smaller farmers have been able to avail them- selves of institutional credit, a somewhat surprising problem has arisen, namely that they have been able to obtain too much credit, and the debt burden on a great many farmers now exceeds repayment capacity within a reasonable pe- riod of time. It is not uncommon for example to find small farmers who, in addition to land amortization payments under the Agrarian Reform Program, are carrying a current crop loan under Masagana 99 as well as one or two restruc- tured crop loans from previous seasons, and a medium-term loan for a power tiller. The total annual payments in such a situation would range between P 9,000 and P 12,000 for a 2 ha farm. Additional unfinanced production expenses could be as high as P 2,000-P 3,000 depending on the availability of family labor. When compared with an estimated gross income of about P 15,000 assuming appropriate inputs and average good yields, net income would range from 0 to P 4,000, the latter just equalling the estimated family requirements for mini- mum essential purchases. Despite the desirability and public appeal of extend- ing credit to small borrowers, a good credit program must recognize and avoid the disservice inherent in excessive debt burden. 21. Another essential feature of effective small farmer credit is that it provides the appropriate balance of production and term credit. In many cases, where financial stability of an enterprise is limited as is the scope for diversification (for example, a small holding of a cultivator who has depended heavily on a now displaced landlord and has therefore not developed financial and technical skills) the appropriate balance for a number of years may be 100% production credit. Capital goods typically require more sophisticated management, a longer time perspective, ability to plan, and the assured timely supply of a number of production inputs if they are to be financially successful. In the absence of these, capital assets may become a serious unproductive burden. Power tillers and backyard livestock facilities are among the investments most commonly failing in this respect, despite their potential utility in elevating the standards of small farmers under the appropriate conditions.  ANNEX 1 Table 1 PHILIPPINES FOURTH RURAL CREDIT PROJECT Area and Production of Major Crops (1974) Area % of Total Production (Million ha) Quantity Value (Million M.T.) (Billion Pesos) Rice 3.4 33 5.6 5.0 Corn 2.8 28 2.3 1.5 Coconut 2.2 22 Various 1.7 Sugar .5 5 3.4 3.0 Vegetables .2 2 Various .5 Abaca .2 2 .1 .4 Tobacco .1 1 .06 .3 Coffee .1 1 .1 .3 Banana .2 2 1.2 1.0 Other Fruits and Nuts .1 1 .9 1.1 Other Crops .3 3 Various .3 Total 10.1 100 17.5 17.8 Source: Department of Agriculture  ANNEX 2 Page 1 PHILIPPINES FOURTH RURAL CREDIT PROJECT Cottage and Agro-Industries in the Philippines The Manufacturing Sector 1. Of the 10,248 firms covered in the 1971 Annual Survey of Manufac- tures (ASM), 8,203 (80%) were cottage industries made up largely of handi- craft and traditional nonfactory units. They employed 16% of the labor force and, with a notably low level of labor productivity, contributed slightly less than 5% to gross value added in manufacturing. The ASM data on cottage industries, however, are not complete, and do not include the smallest "unorganized" firms with 1-4 workers. Unofficial estimates 1/ indicate a much larger role of cottage units in manufacturing employment (75%) and value added (10%). The data are very weak for comparative pur- poses. The remaining 2,045 establishments, those with 20 or more workers, covered in the 1971 ASM make up, in contrast to the cottage sector, the "modern" manufacturing sector. TOTAL MANUFACTURING BY SIZE ESTABLISHMENTS, 1971 ASM (Current Prices) Gross Labor Scale Establishments Employment Value Added Productivity No. of Workers No. % No. % R Million % (Annual Value per Worker in P) Cottage 5-19 8,203 80.0 68,209 16.2 324 4.3 4,750 Small 20-99 1,363 13.3 56,489 13.4 693 9.3 12,270 Medium 100-199 291 2.8 40,222 9.6 790 10.6 19,650 Large 200+ 391 3.8 256,297 60.8 5,641 75.7 22,010 Total 10,248 100.0 421,217 100.0 7,448 100.0 17,680 1/ Estimated by Ranis Mission for the ILO Report, Sharing in Development, Geneva, 1974 (p. 142).  ANNEX 2 Page 2 2. More reuant data on small industries as a group (here defined as all firms with less than 50 workers) show that in 1973/74, they employed nearly I million people or 68% of the total industrial labor force, and accounted for 12-13% of total industrial value added. Of this share of total industrial value added, about 6% was accounted for by firms with 1-4 workers, 3% by firms with 5-19 workers and 3-4% by firms with 20-49 workers. The respective shares of the same groups in total industrial employment were estimated at 60%, 5.5% and 2.5%. Historical Trends 3. In the 1956-73 period, the importance of cottage industries employ- ing 1-4 workers declined steadily in terms of industrial value added and employment, while that of firms with 5-19 workers stagnated. However, during the 1962-68 period (Table 5), firms with 5-19 workers grew at 13.8% in gross value added compared to 8.2% for large-scale industry, at 5.8% compared to 2.2% in labor productivity, at 3.4% compared to 1.5% in number of establish- ments, and at 6.3% compared to 5.9% in employment. Firms with 1-4 workers grew at 1.3% per year in employment during those years but declined by 3.0% per year thereafter. But in spite of the reversal of the 1962-68 period, which appears to have been caused by special incentive laws passed at the same time and a relaxation of foreign exchange controls, firms with less than 20 workers not only declined in terms of their relative share in manu- facturing compared to large-scale industries, but in the aggregate experienced a decrease in their absolute rates of growth. 4. As Table 5 indicates, during 1968-73, despite the stagnation in out- put and the decline in employment, the number of firms with 5-19 workers rose sharply; it grew at a rate of 4.3% a year compared to 3.4% in 1962-68 and 2.7% in 1956-62. Between 1956 and 1973, the size of an average firm employing 20 or more workers doubled in employment terms (from 82 to 156 workers), and grew 250% in terms of gross value added (from P 836,000 to P 2,043,000 at con- stant 1967 prices). During the same period, the average firm in the small- scale group (5-19 workers) declined in size from 10.2 to 7.6 workers in terms of employment and from P 34,000 to P 20,000 in terms of gross value added. There are no data available on firms with 1-4 workers. The increasing number of small-scale firms, their diminishing average size, and the absolute decrease in cottage industry employment noted in paragraph 3 seem to reflect the exist- ence of both favorable and unfavorable factors: a continuous effort to improve the industrial climate and encourage the emergence of vigorous local entrepre- neurs, but at the same time a policy-induced proliferation of inefficient units and the lack of a normal process of consolidation and growth from small- to medium-sized units. Factor Use ;5. As in these and other countries, there is a definite pattern in industries' proportional use of productive factors in the Philippines, depending on the size of firm. The larger a firm, the more capital inten- sive (in terms of fixed capital per worker) it tends to be and the higher  ANNEX 2 Page 3 level of labor productivity (in terms of value added per worker) it tends to have. FACTOR INTENSITY AND PRODUCTIVITY IN MANUFACTURING 1971 Size of Firms Capital per Value Added per Capital Value No. of Workers Worker P'000 Worker P'000 Added Ratio /a 9- 19 5.1 5.9 0.85 20- 99 11.4 12.3 0.9 100-199 14.0 19.6 0.7 200+ 22.3 22.3 1.0 /a Book value of fixed assets. Source: CSO 6. The effect of the size of the firm on its capital productivity (fixed capital needed to produce one unit of value added) is not clear above. But when fixed assets are expressed in terms of replacement costs instead of book value, small-scale firms definitely tend to need less capital for the same amount of output. 1/ Regional Distribution 7. Industry (except mining) and commerce are overwhelmingly concen- trated in Region IV, which includes Metropolitan Manila (44.7% of GDP). There is no other comparable concentration of activity, Small- and medium-scale industries, which tend to cluster close to supply and demand and suitable infrastructure and other services, are even more highly concentrated. About 65% of these firms are in Region IV, and of the balance 23% are found in the five regions of greatest overall economic activity and urbanization. Firms with 1-4 workers are by far the most dispersed. They are less dependent on power and tend to process locally available materials for local markets. Approximately three quarters of these smallest firms are in the food indus- tries (milling, bakeries, etc.) and wearing apparel (garments, dressmaking, etc.). There are fairly large numbers (about 5% of the total) in the textiles, metal products, electrical machinery and transport equipment and repair shops where they provide services as well as fabricating small parts and components. Constraints on Cottage Industry Development 8. In addition to the industrial policy constraints under which larger scale industries have easier access to financial incentives and to industrial financing and high levels of protection and inducements enabling the import 1/ See ILO Report, Sharing in Development, Geneva, 1974 (p. 144).  ANNEX 2 Page 4 of capital goods, components, and industrial raw materials at concessionary rates, firms with less than 20 workers face problems of market accessibility, domestically and in exporting, a frequent lack of adequate infrastructure and support services, and have to meet complicated institutional requirements to incorporate and to obtain financing and technical assistance. 9. These constraints have been recognized by the Government and, in keeping with the new policy of encouraging the growth of small-scale and cot- tage industry in less developed regions, both financial and technical assist- ance programs are now in operation and appear to be fairly effective, where they reach the entrepreneurs. A major financing difficulty which remains is the insistence by banking institutions on adequate collateral requirements. Although the Department of Industry (DOI) has done notable work in implement- ing technical assistance programs for small- and medium-scale industry, other Government departments such as the Department of Trade, the Design Ceniter of the Philippines, and the National Cottage Industries Development Authority (NACIDA) have lacked the staff and funding to date to energetically improve their technical assistance services particularly for export and national marketing assistance, product quality and design standardization and in easing institutional requirements for the establishment of a business firm. In par- ticular, the separation of cottage industries administered by NACIDA and small and medium industries in general, has left largely ignoted the need to multi- ply the linkages between small- and large-scale industries, and has effectively excluded cottage industries from the Government's SMI program. Thus, questions on the organization of cottage industries, the need for industrial estates programs, the value of producers and marketing cooperatives have been ignored until very recently. In recent years the Government has greatly accelerated its program to improve and develop basic infrastructure and supporting services. Major highways and farm to market roads, ports, inter-islands shipping and shipbuilding, rural electrification, water development and manpower training are all being vigorously pursued. Much of the progress to date, has been making good on the low levels of public investment which prevailed in the 1960s, but it should provide the necessary conditions under which the Govern- ment's programs of industrial dispersal and small industry development can succeed. Conclusions 10. It is clear from the previous discussion that the cottage and small-scale industrial subsector has been and will remain an important component of Philippine industry. The development of these sectors is highly desirable on the grounds of their low capital use, their favorable produc- tivity, and their role in maintaining the level of existing employment and in generating new employment. A variety of policy, institutional and other measures need to be changed, accelerated or begun. To revive and sustain the growth in modern small-scale industries and to maintain the present employment level in the cottage industry sector, policies will have to be developed that eliminate the artificially-induced distortions in factor use and which do not hinder Government programs to promote and develop small  ANNEX 2 Page 5 and medium industry. The cottage industry sector itself will have to receive greater attention in order to find out where the potentials for sound growth lie and which production units should be supported by Government programs if the declining trend in this subsector is to be arrested. For it must be clearly understood that the potential for growth in the cottage industry subsector is very limited and that cottage industry cannot assume a major role in future industrialization. In many fields of production, cottage industry is not adequately suited to provide goods and services at a cost and of a quality competitive with larger scale manufacturers using more efficient production methods. If cottage industry is on balance able to maintain its present employment levels over the next 10 years, itself an optimistic assumption, it would result in a sharp drop in the subsector's relative share in total industrial employment from 60% in 1974 to 42% in 1985.  PHII.IPPINES FOURTH-RURAL CREDIT PROJECT Investment and Gross Output for Large Manufacturing Industries by Size of Establishment Based on Employment 1962, 1968, 1971, 1973 (percentages) Scale Number of Establishments Gross Output Fixed Assets at Book Value Net Investment 1962 1968 1971 1973 1962 /a 1968 1971 1973 1962 1968 1971 1973 1962 1968 1971 1973 Small Scale 20-49 Employees 58.1 52.2 46.7 48.9 7.1 7.3 4.6 5.8 6.7 5.8 4.6 3.2 11.5 3.8 2.1 3.7 50-99 16.9 21.2 19.9 20.4 7.2 8.5 7.6 8.5 7.7 7.4 4.7 5.5 7.7 4.6 4.6 5.4 Subtotal 75.0 73.4 66.6 69.3 14.3 15.8 12.2 14.3 14.4 13.2 9.3 8.7 19.2 8.4 6.7 9.1 Medium Scale 100-199 Employees 10.3 11.7 14.2 11.7 10.8 13.8 13.0 13.1 11.0 14.5 8.1 7.5 16.9 8.1 8.4 7.2 Large Scale 200-499 Employees 10.8 9.1 11.1 9.1 48.3 30.5 29.2 28.1 49.7 28.8 30.5 39.2 36.6 21.5 32.6 25.0 500 and above 4.0 5.8 8.0 9.9 26.6 39.9 45.5 44.5 24.9 43.5 52.1 44.6 27.3 62.0 52.3 58.7 Subtotal 14.8 14.9 19.1 19.0 74.9 70.4 74.7 72.6 74.6 72.3 82.6 83.8 63.9 83.5 84.9 83.7 Grand Total All Manufacturing 100.1 100.0 99.9 100.0 100.0 100.0 99.9 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 /a Unadjusted, therefore it excludes work in progress which is included in the data in later years. Sources: Bureau of the Census and Statistics, Annual Survey of Manufactures: 1962, 1968 and 1971, Manila, Philippines. Bureau of the Census and Statistics, Preliminary Report on Annual Survey of Manufactures: 1973, Manila, Philippines. November 17, 1976 -P  PHILIPPINES FOURT11 RURAL CREDIT PROJECT Employment and Wages for Large Manufacturing Industries by Size of Establishments Based on Employment 1962, 1968, 1971, 1973 Payrolls & Extra Benefits Wages per Worker /a Wages as % of Value Scale Employment (as X) for Paid Employees (%) (P '000) Added 1962 1968 1971 1973 1962 1968 1971 1973 1962 1968 1971 1973 1962 1968 1971 1973 Small Scale 20-49 Employees 10.6 10.6 7.9 9.8 7.3 7.4 5.4 6.8 1.6 2.2 2.9 3.2 33.1 31.5 30.5 26.2 50-99 " 8.4 10.7 8.1 9.3 7.1 9.1 6.6 7.5 2.0 2.7 3.6 3.8 32.9 31.5 24.o 24.5 Subtotal 19.0 21.3 16.0 19.1 14.4 16.5 12.0 14.3 1.8 2.4 3.3 3.5 33:0 31.5 26.6 25.2 Medium Scale 100-199 Employees 10.1 11.8 11.4 10.8 10.0 11.7 10.5 10.2 2.3 3.1 4.0 4.4 32.9 22.8 20.3 19.9 Large Scale 200-499 Employees 42.8 21.2 20.1 19.1 45.7 23.1 22.2 21.3 2.5 3.5 4.8 5.2 23.7 21.3 20.2 16.6 500 and above 28.1 45:6 52.5 51.0 29.9 48.7 55.3 54.2 2.5 3.4 4.6 5.0 24.6 24.4 21.4 19.7 Subtotal 70.9 66.8 72.6 70.1 75.6 71.8 77.5 75.5 2.5 3.4 4.6 5.1 24.0 23.3 21.0 18.7 Grand Total All Manufacturing 100.0 99.9 100.0 100.0 100.0 100.0 100.0 100.0 2.4 3.2 4.3 4.7 25.7 24.3 21.5 19.5 /a Based on current prices. Sources: Bureau of the Census and Statistics, Annual Survey of Manufactures: 1962, 1968 and 1971, Manila, Philippines. Bureau of the Census and Statistics, Preliminary Report on Annual Survey of Mlanufactures: 1973, Manila, Philippines. November 17, 1976  PHILIPPINES FOURTH RURAL CREDIT PROJECT Contribution to Value Added, Factor Intensity and Productivity for Large Manufacturing Industries By Size of Establishments Based on Employment, 1962, 1968, 1971, 1973 (In thousands pesos based on current prices) Scale Census Value Added (%) Value Added per Fixed Assets (O/K) Value Added per Worker (O/L) Fixed Assets per Worker (K/L) 1962 1968 1971 1973 1962 1968 1971 1973 1962 1968 1971 1973 1962 1968 1971 1973 Small Scale 20-49 Employees 5.7 5.7 3.8 5.0 1.1 1.1 0.8 1.4 4.9 7.0 9.6 12.o 4.3 6.6 11.3 8.6 50-99 " 5.5 7.0 5.9 6.0 1.0 1.0 1.3 1.0 6.0 8.5 14.9 15.5 6.2 8.4 11.4 15.7 Subtotal 11.2 12.7 9.7 11.0 1.1 1.0 1.1 1.1 5.4 7.8 12.3 13.8 5.1 7.5 11.4 12.0 Medium Scale 100-199 Employees 7.9 12.4 11.1 10.1 1.0 0.9 1.4 1.2 7.1 13.7 19.6 22.3 7.4 15.0 14.0 18.4 Large Scale 200-499 Employees 49.6 26.4 *23.6 25.1 1.3 1.0 0.8 0.6 10.6 16.2 23.7 51.4 . 7.9 16.6 29.8 54.3 500 and above 31.3 48.5 55.6 53.8 1.7 1.2 1.1 1.1 10.1 13.8 21.4 25.1 6.0 11.7 19.4 23.1 Subtotal 80.9 74.9 79.2 78.9 1.5 1.1 1.0 0.8 10.4 14.6 22.0 26.8 7.1 13.2 22.3 31.6 Grand Total All Manuifacturing 100.0 100.0 100.0 100.0 1.3 1.1 1.0 0.9 9.1 13.0 20.2 23.8 6.8 12.2 19.6 26.4 Sources: Bureau of the Census and Statistics, Annual Survey of Manufactures: 1962, 1968 and 1971, Manila, Philippines. Bureau of the Census and Statistics, Preliminary Report on Annual Survey of Manufactures: 1973, Manila, Philippines. November 17, 1976 r:r z {5 w  PHILIPPINES FOURTH RURAL CREDIT PROJECT Basic Data for Large Manufacturink Industries by Size of Establishments Based on Employment, 1973 (current prices) (In thousand pesos) Payrolls Working Production and and Extra Fixed Fixed Number of Owners and Related Workers Total Benefits for Assets at Assets per Net Gross Census Establishments Unpaid Family Plus Others Employment Paid Employees Book Value Establishment Investment Output Value Added Small Scale 20-49 Employees 1,453 888 43,615 44,605 82,574.1 318,439.8 333.1 23,086.2 858,579.0 270,262.1 50-99 606 141 42,770 42,411 101,611.6 323,059.4 793.8 51,502.0 *1,419.072.2 422,960.9 Subtotal 2,059 1,029 86,385 87,016 184,185.7 641,499.2 470.6 74,588.2 2,277,651.2 693,223.o Medium Scale 100-199 Employees 349 18 48,554 49,172 160,230.7 562,163.7 1,931.8 93,993.6 2,425,205.5 790,328.4 Large Scale 200-499 Employees 272 7 87,289 87,096 340,323.9 2,108,464.3 9,247.6 362,588.1 5,431.021.6 1,680,300.4 500 anid above 293 70 232,536 232,609 845,946.9 3,597,624.8 22,071.3 581,320.4 8,470,499.2 3,960,343.3 Sujbtotal 565 77 319,825 319,705 1,186,270.8 5,706,089.1 14,593.6 943,908.5 13,901,520.8 5,640,643.7 Grand Total 2,973 1,124 454,764 455,893 1,530,687.2 6,909,752.0 3,378.8 1,112,490.3 18,604,377.5 7,124,195.1 Sources: Bureau of the Census and Statistics, Annual Survey of Manufactures: 1971, published 1973, Manila, Philippines. Bureau of the Census and Statistics, Preliminary Report on Annual Survey of Manufactures: 1973, Manila, Philippines. November 17, 1976 H1  PHILIPPINES FOURTH RURAL CREDIT PROJECT Growth of Manufacturing Industries, 1956-73 Annual Growth Rates (in percent) Category 1956 1962 1968 1973 1956-62 1962-68 1968-73 1956-73 Number of firms 20 or more workers 1,833 2,180 2,385 2,912 2.9 1.5 4.1 2,8 5-19 workers 5,375 6,289 7,673 9,469 2.7 3.4 4.3 3.4 Total 7,208 8,469 10,058 12,381 2.7 2.9 4,2 3.2 Employment (in thousands) 20 or more workers 150.9 230.5 325.1 454.4 7.3 5.9 6.9 6.7 5-19 workers 54.9 48.0 69.2 72.4 -2.2 6.3 0.9 1.6 1-4 workers 829.2 845.5 912.7 788.2 0.4 1.3 -3,0 -0.3 Total 1,035.0 1,124.0 1,307.0 1,315.0 1.4 2.5 0.1 1.4 Value added (in millions of pesos at 1967 prices) 20 or more workers 1,532.8 2,769.9 4,457.2 5,948.0 10.3 8.2 5.9 8.3 5-19 workers 181.8 132.3 266.9 191.3 -5.4 13.8 -7.0 0.3 Total 1,714.6 2,902.2 4,724.0 6,139.3 9.2 8.5 5.4 7.8 Value added per worker (in thousands of pesos at 1967 prices) 20 or more workers 10.2 12.0 13.7 13.1 2.8 2.2 -1.0 1.5 5-19 workers 3.3 2.8 3.9 2.6 -3.0 5.8 -7.3 -1.4 Average 8.3 10.4 12.0 11.7 3.8 2.4 -0.5 2.0 Note: The implicit GDP deflator from the national accounts (revised April 23, 1975) was used in value added computations. Sources: Bureau of Census and Statistics (BCS), Annual Survey of Manufactures, 1969; preliminary results of the Annual Survey of Manufactures, 1973; and national accounts. November 17, 1976 X Z ,_m (D n  1HI11LIPPINES FOURTH RURAL CREDIT PROJECT Total Lending and Loans Granted to Agriculture, Fisheries and Forestry by Principal Lending Institutions 1973-75 (Pesos Million) 1973 1974 1975 Loans to Loans to Loans to Agriculture Agriculture Agriculture Total Fisheries & Percent Total Fisheries & Percent Total Fisheries & Percent Institutions Lending Forestry of Total Lending Forestry of Total Lending Forestry of Total Commercial Banks I 31,745.1 2,026.8 4.0 56,592.4 3,261.2 5.8 n.a. n.a. n.a. Philippine National Bank 3,782.4 901.2 24.0 10,060.4 1,954,2 19.4 18,554.4 2,182.5 11.8 Rural Banks 1,073.7 976.9 91.0 1,824.7 1,669.5 91.5 2,310.2 2,117.5 91.7 BANCOM and Private Development Corporation 2,132.4 22.4 1.0 3,002.0 44.3 1.5 3,678.6 26.8 0.7 Development Bank of the Philippines 248.4 119.2 48.0 731.5 195.2 26.7 2,633.0 727.2 27.6 Private Development Banks 326.5 160.2 49.1 122.8 60.5 49.3 189.9 95.2 50.1 Stock Savings and Loan Associattons 149.7 8.4 5.6 221.1 29.0 13.1 343.8 107.8 31.4 Agricultural Credit Administration 55.6 55.6 100.0 64.3 64.3 100.0 40.7 40.7 100.0 Total 39,513.8 4,270.7 10.8 72,619.2 7.278.2 10.0 27,750.6 5,297.7 19.1 Source: Central Bank of the Philippines, Annual Reports; Philippines National Bank, Annual Reports; CB, DRBSLA Statistics on Stock Savings and Loan Associations, Rural Banks and CB-DER. I/ Credits granted by commercial banks in 1974 (January-September). Commercial bank figures in all yeara include large volume of trade financing in sugar and copra. EAP Projects Department July 6, 1976  FOURTH RURAL CREDIT PROJECT Percentage of Agricultural Credit Lending by Principal Institutions 1973 1974 1975 Including Excluding Including Excluding Excluding Commercial Commercial Commercial Commercial Commercial Bank Bank Bank Bank Bank Government Agencies Philippine National Bank 21.1 40.1 26.9 48.7 41.2 Development Bank of Philippines 2.8 5.3 2.7 4.9 13.7 Agricultural Credit Administration 1.3 2.5 9 1.6 8 Sub-total 25.2 47.9 30.5 55.2 55.7 Private Institutions Commercial Banks 47.4 - 44.8 Rural Banks 22.9 43.5 22.9 41.5 40.0 Private Development Banks 3.8 7.2 8 1.5 1.8 Bancom and Private Development Corporation of the Philippines 5 1.0 6 1.1 5 Stock Savings and Loan Associations 2 4 4 7 2.0 Sub-total 74.8 52.1 69.5 44.8 44.3 Total 100.0 100.0 100.0 100.0 100.0 1/ Data not available for commercial banks. EAP Projects Department October 13, 1976  ANNEX 4 Page 1 PHILIPPINES FOURTH RURAL CREDIT PROJECT Summary of Previous Rural Credit Projects The First Rural Credit Project 1. IBRD contributed US$5.0 million to the First Rural Credit Project (Loan 432-PH), which became effective on January 27, 1966 and was fully disbursed by September 30, 1969. The project was a breakthrough in pro- viding farmers, through qualified rural banks, with medium- and long-term loans under supervised credit for the purchase of tractors, power tillers and farm implements; swine, poultry and fishery development; and the con- struction of private on-farm irrigation systems. Sub-projects with a total cost of P 38.5 million were financed for about 2,600 farmer beneficiaries through 148 rural banks. IBRD contributed P 21.4 million (55.4%) to project cost, the Government and CB P 9.7 million (25.0%), rural banks P 1.8 million (4.8%) and farmers and others P 5.7 million (14.8%). Of IBRD's contribution, P 19.1 million (89.3%) was for 2,118 farm mechanization sub-loans and the balance for irrigation, livestock and fishery development sub-projects. The Second Rural Credit Project 2. Loan Purpose and Volume. To continue the First Project, a second IBRD loan of US$12.5 million was provided under the Second Rural Credit Project (Loan 607-PH) which became effective on August 14,1969. The loan components remained basically the same with some diversification to enlarge the number of crops to be financed and to include such items as storage and processing facilities, which were introduced during project implementation. As of the Closing Date, June 30, 1974, total credit extended through 228 participating rural banks to 4,065 farmer-borrowers amounted to P 146.8 million, summarized as follows: Total Amount of Sub-loans % of Total (P'000) Farm Mechanization 105,387 71.8 Irrigation 2,911 2.0 Spraying Equipment 763 .5 Storage 4,658 3.2 Transportation Equipment 12,813 8.7 Livestock 11,098 7.6 Fisheries 9,132 6.2 146,762 100.0  ANNEX 4 Page 2 3. Project Financing. The total cost of sub-projects under the Second Project amounted to P 174.6 million of which the Bank contributed P 82.2 mil- lion (47%), Government and CB P 49.1 million (28%), rural banks P 15.5 million (9%), and borrowers P 27.8 million (16%). Rural bank contributions amounted to less than the original 10% requirement primarily because during the course of project implementation, the requirement was waived to encourage wider par- ticipation by rural banks. The Third Rural Credit Project 4. Loan Purpose and Volume. A third loan of US$22.0 million (1010-PH) became effective on August 27, 1974. The project included financing of far- mers, fishermen and rural entrepreneurs for farm mechanization, transporta- tion, farm support facilities, coastal and mainland fisheries, small-scale livestock and cottage industries. Funds were also provided for a study of the financial and economic impact of the Rural Credit Projects. Closing Date of the project is to be December 31, 1977, although final disbursement of funds will probably precede that date, all funds having been committed by the end of December 1975. Despite rapid price increase during the proj- ect period demand for tractors and trucks far exceeded appraisal estimates. Intensive promotion efforts by farm machinery dealers resulted in a shift of project emphasis away from other components with the result that final results of the project did not reflect the degree of diversification sought at the time of appraisal. Total Amount of Sub-loans % of Total (P'000) Farm Mechanization 182,329 72.4 Irrigation 2,527 1.0 Sprayers, Driers and Threshers 1,345 .5 Storage 753 .3 Repair and Machine Shops 234 .1 Transportation Equipment 40,513 16.1 Livestock 12,975 5.2 Fisheries 10,497 4.1 Cottage/Agro-Industries 666 .3 251,839 100.0 Fifty percent of all sub-loans, accounting for 50% of total loan value, were extended to sub-borrowers in Luzon; 23%, accounting for 30% of total value, went to sub-borrowers in Visayas; and 27%, accounting for 20% of total value were in support of projects in Mindanao.  ANNEX 4 Page 3 5. Project Financing. The total cost of sub-projects under the Third Project was P 342.7 million (US$46.9 million). The Bank contributed P 159.6 million equivalent (US$21.8 million) to sub-projects amounting to 47%; the Government and CB, P 94.7 million or 27%; financing institutions, P 309 mil- lion or 9%; and sub-borrowers, P 57.5 million or 17%. 6. The maturities of the notes executed by a rural bank in favor of CB corresponded approximately to the schedule of repayment by end-user borrowers; the maximum period varied from 2 to 10 years, depending on sub-loan purposes as follows: Farm Implements 2-4 years Light Machinery 3-5 years Heavy Machinery 7 years Light Trucks 5 years Irrigation Equipment 5 years Irrigation Civil Work 10 years Livestock Development 3-7 years Fishing Boats 10 years Fishponds and Fishpens 3-10 years Agro-Industries 7 years Cottage Industries 3-5 years 7. Disbursement. Full disbursement is expected to be completed soon. As of January 31, 1977, IBRD disbursements amounted to about US$21.98 mil- lion. The balance outstanding of about US$20,000 is the unused portion of funds allotted for the study to evaluate the impact of the CB:IBRD program. A request for transfer of these funds to the sub-loan category is expected shortly. Therefore, the original Closing Date of December 31, 1977 is ex- pected to be accelerated to March 31, 1977. Repayments under Previous CB:IBRD Projects 8. As of April 30, 1976, arrears amounted to 24.6% of total outstand- ing loans under the program (Table 3). Eighteen hundred and seven borrowers were delinquent, about 950 of those under the Third Project representing about 28% of borrowers under that project. The balance of 857 were borrowers under the First and Second Projects and arrears under those projects account for 70% of all arrears under the program. The major category of arrears is tractor loans, accounting for 50% of arrears by number and 67% by amount. While these numbers approximate the share of tractor loans in total financing, such a default rate warrants serious examination. Borrowers for tractors are usually large-scale entrepreneurs and farmers with more stable income from several sources; custom hire service generates substantial cash flow. In short, it is difficult to understand these high arrears without presuming willful default.  ANNEX 4 Table 1 PHILIPPINES FOURTH RURAL CREDIT PROJECT Summary of Previous Rural Credit Project Summary of Sub-loans Released Under Second Rural Credit Project (607-PH) 1/ (August 1969 - June 30, 1974) No. of % of Total Category Sub-Loans Amount Amount (F' 000) Farm Development Four-Wheel Tractors 1,694 92,910 63.3 Power Tillers 942 12,477 8.5 Irrigation Pumps 313 2,687 1.8 Spraying Equipment 43 763 .5 2,992 108,837 74.1 Storage and Processing 161 4,658 3.2 Wells and Distribution Works 5 225 .2 Cargo Trucks and Trailers 229 12,813 8.7 395 17,696 12.1 Livestock Development Poultry 188 5,334 3.6 Service 225 5,764 3.9 413 11,098 7.5 Fisheries Development Fishing Boats 35 1,844 1.3 Fishponds 230 7,287 5.0 265 9,131 6.3 Total 4,065 146,762 100.0 1/ Source: Central Bank of the Philippines.  ANNEX 4 Table 2 PHILIPPINES FOURTH RURAL CREDIT PROJECT Summary of Previous Rural Credit Project Summary of Sub-loans Released Under the Third Rural Credit Project (1010-PH) 1/ (As of April 30, 1976) No. of % of Total Category Sub-Loans Amount Amount (F'000) Farm Mechanization Tractors 1,761 157,900 62.7 Power Tillers 1,169 24,429 9.7 2,930 182,329 72.4 On Farm Transportation Equipment New Trucks and Trailers 550 39,444 15.7 Reconditioned Trucks 16 1,069 0.4 566 40,513 16.1 Farm Supplies, Facilities & Equipment Storage Facilities 10 753 0.3 Private Irrigation Facilities Including Pumps 218 2,527 1.0 Sprayers, Grain Driers, Threshers 59 1,345 0.5 Farm Machine Service & Machine Shops 6 234 0.1 293 4,859 1.9 Fisheries Development Coastal Fishing Boats 28 1,893 0.7 Fishponds & Fishpens 156 8,604 3.4 184 10,497 4.1 Small-Scale Livestock Farm Development Poultry Facilities & Initital Stock 64 4,976 2.0 Swine Facilities & Initial Stock 149 7,999 3.2 213 12,975 5.2 Cottage Agro-Industries F-Meal Plants w/ or w/o Feed Mix Equipment 13 150 0.1 Woodcraft Manufacturing Facilities 12 516 0.2 25 666 0.3 Total 4,211 251,839 100.0 1/ Source: Monthly Status Report on the CB:IBRD Agro-Industrial Financing Program, DRBSLA.  ANNEX 4 Table 3 PHILIPPINES FOURTH RURAL CREDIT PROJECT Summary of Previous Rural Credit Project Arrears of Previous Projects as of April 30, 1976 No. of Original No. of Percent Delinquent Amount Amount Delinquent Total of Borrowers of Loans Outstanding Amortizations Past Due Arrears (P'000) (P'000) (P'000) Tractors 909 59,007 51,670 1,883 13,529 67 Tillers 366 16,469 13,674 769 2,232 11 Trucks 126 7,640 6,027 128 1,323 6 Threshers 29 521 406 52 180 0 Irrigation Pumps 145 1,764 1,410 218 437 2 Rice Mills 13 725 577 35 286 1.4 Poultry 30 1,162 696 53 236 1.2 Piggery 92 2,727 2,384 171 731 3.7 Fishponds 82 2,994 2,328 163 357 1.8 Fishing Boats 25 2,001 1,706 33 487 2.4 Other 15 345 307 29 167 .8 Total 1,807 95,355 81,185 3,534 19,965 100.0  ANNEX 5 Page 1 PHILIPPINES FOURTH RURAL CREDIT PROJECT The Central Bank of the Philippines A. Organization and Management 1. The Central Bank of the Philippines (CB) is a governmental fiscal institution established and governed by the Central Bank Act (Republican Act No. 265, as amended) to administer the monetary, banking and credit system of the Philippines. Its major objectives are defined to: (a) main- tain internal and external monetary stability; (b) preserve the international value of peso and its convertibility into other freely convertible currencies and (c) foster monetary, credit and exchange conditions conducive to a bal- anced and sustainable growth of the economy. 2. CB is governed by a seven member Monetary Board composed of the Governor of CB as chairman, the Secretary of Finance, the Director General of the National Economic Development Authority, the Chairman of the Board of Investments, and three part-time members from the private sector. The chief executive is the Governor, who is assisted by a Senior Deputy Governor, up to five Deputy Governors, and staff at headquarters in Manila and three regional offices in Cebu, Davao and La Union. 3. According to Section 46 of the Central Bank Act, the Commissioner of Audit acts as the ex-officio Auditor of CB and is authorized to appoint a representative as the Auditor of CB. The Office of the Auditor now employs a total staff of about 110 auditors, of which two are posted at the Depart- ment of Rural Banks and Savings and Loan Associations (DRBSLA), the depart- ment responsible for the administration of the Rural Credit Projects. The salaries and other expenses of maintaining the Office are paid by CB. The audit performed is considered satisfactory. B. Operational Aspects 4. The paid-up capital is still P 10 million as at inception, but the total net worth has increased to P 341 million at the end of December 1975. During the preceding four years, liabilities increased to P 25,633 million, while assets increased to P 25,974 million, an increase of almost four times reflecting the rapid expansion of CB money supply. The major changes are the increase of international reserves to P 10,205 million (570% increase), and loans and advances to P 5,516 million (330% increase). The most signifi- cant growth in liabilities has been in Certificates of Indebtedness, which  ANNEX 5 Page 2 rose to P 7,110 million (1,685%). Demand deposits from banking insti- tutions also increased to P 3,648 million (300%). 5. CB supports the supervised credit schemes mainly for food grain production, by advancing Special Time Deposits (STDs) or by providing rediscounting facilities to eligible banking institutions. The release of STDs and provision of rediscounting in 1975 were as follows: Special Time Deposits Rediscounting ------------Pesos Million------------ Masagana 99 209.6 567.0 Masaganang Maisan 22.7 24.2 Vegetable 14.7 - Livestock 97.4 269.3 Cotton 0.7 - Tobacco 6.7 0.8 Coconut - 88.7 Fiheries - 24.9 Abaca - 1.5 Sugar - 51.7 Others 3.7 257.3 Total 355.5 1,285.4 C. Department of Rural Banks and Savings and Loan Associations (DRBSLA) Organization 6. DRBSLA regulates and supervises the activites of rural banks and savings and loan associations. With a reorganization implemented in 1976, DRBSLA established three Supervised Credit Groups responsible for lending operations on a regional basis. There were previously two function-wise Groups, one responsible for short-term credit, and the other medium- and long-term lending programs. The new structure is expected to unify and improve departmental supervision of individual rural banks. Each Group is headed by an Assistant Director and organized into several Divisions again primarily along regional lines. In the context of the proposed project, the Agricultural Credit Supervisors who would assist in the preparation of farm and home plans and feasibility studies for loan proponents and the Loan Teams who would be engaged in processing and sanctioning loan applications are among the staff of these Groups. 7. In addition to lending operations, one of the Groups also includes the Accounting and Special Services Division and the Technical Evaluation and Support Unit (TSEU) is responsible directly to the Office of the Director.  ANNEX 5 Page 3 The former would be responsible for handling of counterpart funds, claim for reimbursements from the bank and preparation of periodic reports on progress of project implementation and collection of overdues. (Release of funds under the proposed project to participating banking institutions is to be trans- ferred from the Division to four Loan Teams located at the three regional offices and at headquarters). The latter is the planning unit of the Depart- ment. Other Divisions and units in the Department would supervise and audit rural banks and stock savings and loan associations (SSLAs) participating under the Rural Credit Projects and would provide other necessary supporting services such as training and legal services. Management and Staff 8. DRBSLA is managed by a Director and an Associate Director with sub- stantial experience in dealing with rural banks and SSLAs. They are assisted by twelve Assistant Directors and a staff of about 700. DRBSLA is the largest department in CB and its functions are distinguishable broadly into two dis- tinct categories; credit activities, and audit and examination of rural banks and SSLAs. Although present policy within CB limits management of departments to only one Associate Director, the size and nature of DRBSLA's responsibil- ities appears to warrant positions for two Associate Directors. 9. The three Supervised Credit Groups have a total staff of about 200, of which about 70% are stationed in the field as Agricultural Credit Super- visors, and members of Loan Teams. There are now nine Loan Teams, including the Manila Loan Team responsible for areas not covered by the eight Loan Teams stationed in Cauayan for Isabela and the Cagayan Valley; San Fernando (La Union) for Pangasinan, Tarlac and Ilocos; Cabanatuan City for Nueva Ecija; Naga City for Bicol; Bacolod City for Negros; Iloilo City for Panay; Cebu City for eastern Visayas and northern Mindanao; and Davao for southern Mindanao. Loan Teams presently process and sanction loan applications filed to partici- pating banking institutions, Each team is headed by a Loan Officer who is a certified public accountant with considerable experience in banking; other members include one or two Loan Processors who are also certified public accountants, and one or more Loan Evaluators who are usually agriculturalists or agricultural engineers. Under this project, CB is planning to provide addi- tional staff to Loan Teams to improve project implementation and supervision. 10. At present, about 110 Agricultural Credit Supervisors are located in the field besides those at headquarters; most are agriculturalists although some are trained in agro-industries, fisheries, livestock and engineering. Their qualifications and capability are considered satisfactory and DRBSLA recruited 80 Supervisors in 1975 for replacement and expansion of this com- plement. Nevertheless, the adequacy of technical field staff to cope with the expected increase of participating banks and loan applications will depend on the effective use of Government technical services and the gradual transfer of lending authority to participating banks. In particular, increased employment of technicians by participating banks to take over field work presently carried out by CB staff would be essential to maintain the quality of lending under the project.  ANNEX 5 Page 4 Loan Processing Procedures 11. Under the Rules and Regulations enforced by CB, applicants would file loan applications on a prescribed form with a qualified rural bank or SSLA , preferably the one nearest the project to be financed. The bank conducts the initial investigations (i.e. verification of the project to be financed, and inspection and assessment of the collateral offered) and, when satisfied with the findings, requests CB Agricultural Credit Supervisors to prepare farm and home plans and feasiblility studies. The application is then submitted to the Loan Team assigned to the area, together with the bank report on collateral and a complete set of support- ing documents (including statements of financial condition and income and expenditure of the bank). The Loan Team first checks the current eligibilty of the bank to participate in project financing by examining for example its arrears position. The application and supporting documents are scrutinized and a member of the Team may visit the proposed project site. The Loan Officer will finally sanction or reject the application without reference to headquarters. On his notification, the Loan Teams located at the three regional office and headquarters will release funds for the sub-loan to the bank according to the approved disbursement schedule, which under previous projects had been released by the Accounting and Special Services Division in headquarters. 12. Under the Third Project, rural banks and SSLAs were authorized to process and approve loan applications of less than P 10,000. The preparation of farm plans and feasibility studies by their own technicians has become a feature of many participating institutions, but loan approvals have been very few. Several reasons were given for this: the present maximum ceiling of P 10,000 excluded most items to be financed; Loan Teams were not enthusiastic in promoting this approach because of the immediate need for intensive checking of individual banks with their limited staff; and while banks were willing to process applications there seemed to be reluctance to hire or train techni- cians to the level of competence upon which investment decisions could be risked with review by CB staff. 13. CB is now aware that to serve the increasing number of partici- pating banks and loan applications, it would require an unacceptable staff expansion to continue under the present system. Therefore, it has been agreed to promote the transfer of lending authority to participating banks as rapidly as they become qualified. Additional training for CB and bank staff to this end would be financed in part under the project. The first step would be to require all the participating banks to prepare the farm and home plans and feasibility studies using their own technicians. Then lend- ing authority would be gradually transferred according to the capability of individual participating banks. Those banks without a technician would be required to agree to hire one on their own. Loan Teams would be expected to provide intensive assistance for this development and to gradually reduce their direct involvement in loan processing. They would also be expected to prepare annual plans for this transfer to banks in their respective areas, including required strengthening of individual banks, measures to be taken by Loan Teams, and target levels of authority for transfer to banks probably by type and complexity of sub-loans.  ANNEX 5 Page 5 14. Loan Teams would be strengthened and their expertise adjusted toward program management to enable them to perform these functions. As the banks become capable, field supervision by CB staff would be less fre- quent and at the final stage only random post-investment audit would be required. 15. Management Advisory Unit. (MAU) In addition to provision of adequate incentives to encourage voluntary participation in the program, there is a need to provide assistance to rural banks in areas of management in which widespread or critical weaknesses have been encountered. Despite the fact that CB staff as representatives of the regulatory and major financ- ing agency of rural banks would probably encounter difficulty in gaining the confidence and candor of rural bank managers, there are several problem areas in which such a Unit could provide effective assistance, for example: budget- ing, solicitation of deposits, cash management and cash flow projections, staff utilization, sub-loan supervision, and collection procedures. MAU, to be responsible to the Director, DRBSLA, would be headed by an Assistant Director. A Technical Assistant and three officers of the rank of Division Chief (two CPA's one Agriculturalist) and four to eight additional officers plus two clerical support positions would comprise the Unit. It would be essential to the effectiveness of the Unit's work that officers of these senior ranks be selected on the basis of extensive experience in the managerial problems of rural banks. Professional credibility alone will gain the confidence of bankers in this service. 16. Technical Support and Evaluation Unit. (TSEU) TSEU's role with respect to the CB:IBRD program would continue to be essentially one of mon- itoring, evaluation and technical support for field operations. The Unit has developed a high standard of work. Under the Fourth Project the Unit would, in addition to its ongoing supervision, oversee requirements with respect to the share of loans extended to small farmers, and the regional distribution of sub-loans. To date the work of TSEU has been limited to term lending under CB:IBRD projects. In keeping with the objective of inte- grating all credit operations in the Department, and to meet a growing need for staff support, the Unit would, coincident with the beginning the Fourth Project, undertake responsibility for staff support pertaining to the Department's short-term production credit activities as well. This would include the following functions: (a) to serve as a permanent secretariat for the Department's representative to the Technical Board on Agricultural Credit, the National Food and Agriculture Council and the National Commission on Countryside Credit and Col- lection. This function will be particularly important in the preparation of background papers in support of CB positions to be taken in these bodies. Such work is now done on an ad hoc basis by operating Divisions.  ANNEX 5 Page 6 (b) to develop operating policies and procedures for special financing schemes for which the Department is charged with implementation responsibility. (c) to evaluate on-going and pilot schemes such as the Integrated Agricultural Financing scheme which is now under trial through 18 rural banks. Service Vehicles 17. Under the Second Rural Credit Project, 61 vehicles were financed for the CB field staff and still operating to make visits to sub-borrowers and participating rural banks. As CB technicians stationed in the field have been increased by 80 in 1976, additional vehicles has become necessary to continue effectively the field operation, in particular supervision and on- the-spot check required with the transfer of lending authority. It was agreed that about 60 vehicles would be financed under this project. Training 18. DRBSLA provides and organizes several training courses mainly for the staff and management of rural banks and SSLAs such as a special three- week course for officers and employees of new rural banks (usually followed up by a short on-the-job training program), a six-week basic banking course for rural bank staff, a supervised credit course for rural bank technicans and a one-week management seminar for directors and managers. These courses have contributed significantly to the success of rural bank and SSLA opera- tions, but additional training programs are needed in certain subject areas such as term lending. 19. Under the project additional training would focus on improving the term lending capability of CB and rural bank credit staff. The program would include preparation of a credit handbook (covering the necessary steps for lending, from project identification to preparation, processing, approval, fund disbursement, supervision and repayment). In addition to its use as a textbook for training, this handbook would serve as a manual for field staff of CB and rural banks. After completion of the handbook, a series of train- ing courses would be organized by regions or provinces to introduce to or review with rural bank and SSLA credit staff the methods and procedures recommended. 20. Lending Terms. For this project, the Bank would contribute 40% of total project costs, the Government and CB 40%, rural banks 10% and ultimate beneficiaries 10%. Bank funds would be onlent to CB at 8.5%, 1/ and, Govern- ment counterpart funds at no interest; therefore an average cost of 4.25% to CB. Rural banks and SSLAs would be charged a rate of 9.0%, with the exception of 7% for sub-loans financing agrarian reform beneficiaries, for funds onlent by 1/ For illustration, the interest rate for the third quarter of 1977FY is used.  ANNEX 5 Page 7 CB's interest margin would be 4.55%. Including the returns from the First, Second and Third Projects, this margin should be sufficient to cover admin- istrative expenses. 21. Maturities of sub-loans to rural banks approximately coincide with those to the ultimate beneficiary so that rural banks would be required to repay CB immediately after collection. CB may relend principal repayments received from rural banks not required to amortize Bank loans under the First, Second, Third or proposed Projects. 22. CB would establish Rules and Regulations governing the Fourth Rural Credit Project in agreement with the Bank. Such Rules and Regulations estab- lish criteria for participation by rural banks and SSLAs (Annexes 6 and 7, respectively) and regulate the administration of the project. Any change of the Rules and Regulations would be subject to approval by the Bank. 23. Examination and Auditing. Under the provisions of the Rural Banks Act, and the Savings and Loan Associations Act, the Monetary Board has the power to supervise the businesses and corporate operations of rural banks and SSLAs. More than 170 staff of DRBSLA are engaged in examination and auditing of rural banks and SSLAs. A regular audit is supposed to be carried out at least once a year. However, this goal was not achieved in 1975. Out of 760 rural banks, 315 were audited and 30 SSLAs were audited out of a total of 44. The new concept of resident examiners aims to implement the required audit frequency. Special examinations are conducted whenever CB deems it necessary to check cash or other transactions, to follow up corrective measures recom- mended during the previous audit or to investigate irregularities in the operations of the institutions. In 1975, DRBSLA made 855 special examina- tions: 852 for rural banks and 3 for SSLAs. By the end of 1975, 37 rural banks were found to be in need of rehabiliation or liquidation; 15 were under close supervision, 6 under CB management, and 16 under receivership, or liquidation. The records of participating rural banks and SSLAs would be retained on file at GB.  ANNEX 5 Table 1 PHILIPPINES FOURTH RURAL CREDIT PROJECT Comparative Statement of Condition of the Central Bank of the Philippines November 30, i973 to December 31, 1975 (Pesos Million) 11/30/1973 12/31/1974 12/31/1975 ASSETS International Reserv s 6,117 10,629.5 10,204.9 Domestic Securitiea7 3,534 4,144.7 4,426.5 Loans and Advances- 1,684 3,428.6 5,516.2 Special a/c - Foreign Exchange Differentials 1,361.2 1,414.5 Account to Secure Coinage 34 34.5 34.5 Govtt. Note - Treasury Cert. Account 24.3 27.3 Bank Premises, Furniture, Equipment 191 321.9 665.1 Monetary Adj. Account - Gov't. Note 88.1 330.9 Other Assets 2,240 1,237.9 3,354.3 Total Assets 132801 21,273.6 25,974.2 LIABILITIES Currency Issue 3,645 4,975.5 5,644.6 Demand Deposits 3,384 Banking Institutions 2,629.7 3,647.7 International Monetary Fund 1,245 1,074.9 2,135.4 National Gov't. 3,367.7 1,250.1 IBRD and IDA 118 - - Other Deposits - 66.2 74.0 Asian Development Bank - Account F 0 - - Allocation of Special Drawing Rights - 439.5 453.1 Notes and Loans Payable 1,656 2,930.5 4,509.1 Revaluation of Int. Reserves 308 311.9 193.0 CB. Cert. of Indebtedness 2,340 4,006.5 6,006.8 CB. Cert. of Indebtedness (F. Currency) - 595.6 1,103.8 Other Liabilities 592 549.4 615.2 Total Liabilities 13,288 20,947.4 25,632.8 NET WORTH Capital 10 10.0 10.0 Surplus 279 283.2 290.1 Reserve for Currency Insurance 4 5.2 - Reserve for Refund of Margin Fee 0 0.3 - Undivided Profits 219 27.5 41.3 Total Net Worth 513 326.2 341.4 Total Liabilities and Net Worth 13,801 21,273.6 25,974.2 - Excluding Treasury note and bonds against RP-Japan commodity loan b/ but including Gov't. note on TCA (1975 and 4/31/76). - Including advances under the repurchase agreements starting June 1974. Source: Central Bank of the Philippines, Annual Report 1975  PHILIPPINES FOURTH RURAL CREDIT PROJECT Central Bank Partial Structure of Department of Rural Banks and Savings and Loan Associations (Supervised Credit Groups) | Director Associate Director Management Technical Suppor Advisory Unit- |& Evaluation Unit ~~~~AdIsrUi - _& | Assistant l l Assistant Assistant Director Director Director Agricultur Loan Agricultur Accounting Loan Agriculture Loan D.visions Teams Divisions Division Teams Divisions Teams I Cagayan IV Manila VI Iloilo II Cabanatuan V Naga VII Bacolod III San Fernando (La Union) VIII Cebu Davao rtaF -To be established under the Fourth Project. n  ANNEX 6 Page 1 PHILIPPINES FOURTH RURAL CREDIT PROJECT Rural Banks A. Background, Organization and Functions of the Rural Bank System History 1. The Rural Bank Program is the culmination of almost half a century of Government sponsored efforts to establish a banking system that would provide credit facilities to small farmers and small commercial and industrial entrepreneurs in rural areas. Since 1907, some 15 legislative measures have been adopted by the Government, among which were those authorizing the estab- lishment of Agricultural Credit Banks (1908), a system of agricultural credit cooperative associations (1915), the Philippine National Bank (1916), and rural banks and commodity corporations which engaged mostly in marketing loans. On June 6, 1952, the Congress of the Republic of the Philippines passed the Rural Banks Act 1/, the foundation for the present rural banking system, which has become an effective instrument for the provision of banking facil- ities to a large number of producers in rural areas. Objectives and Legal Basis 2. The Rural Banks Act states the Government's policy to "promote and expand the rural economy on an orderly and effective manner by providing the people in the rural communities with the means of facilitating and im- proving their productive activities and to encourage cooperatives. Towards this end, the Government encourages and assists in the establishment of a system of rural banks which will place within the easy reach and access of the people credit facilities on reasonable terms". In addition, Presiden- tial Decree No. 27 of November 19, 1972 on agrarian reform requires rural banks "to provide immediate source of funds to augment loans/credits to be made available to the tenants and/or farmers cooperatives..." 3. The Rural Banks Act requires the Monetary Board of the Central Bank of the Philippines (CB) to formulate Rules and Regulations governing the establishment and operations of rural banks. Pursuant to this power, the Monetary Board has promulgated several sets of Rules and Regulations which are intended to implement the Rural Banks Act and which, together with the Monetary Board's letters of instruction and CB circulars, form the bank's main opera- tional basis. The provisions of the General Banking Law and the Central Bank Law are also part of the laws governing rural banks in so far as they are applicable and not in conflict with any provision of the Rural Banks Act. 1/ Republic Act No. 720 of June 6, 1952, as amended.  ANNEX 6 Page 2 As rural banks are organized in the form of stock corporations, the provi- sions of the Law on Private Corporations are supplementary to the above laws. The Role of the Central Bank 4. CB acts as a refinance institution of rural banks (paras 15-16) and through DRBSLA provides them with technical assistance, training of management and staff, and supervises and examines rural bank operations (Annex 5, paras 6-19 and 23). Privileges and Exemptions 5. Privileges. Rural banks enjoy the advantage of free training of officers and employees (Annex 5, paras 18-19) and free technical assistance to accounts staff and inspectors when opening a bank. Since the intro- duction of supervised credit, agricultural and fisheries technicians, directly or indirectly paid for by CB, assist rural banks in processing loan applications and supervise the use of funds by borrowers. The Depart- ment of Agriculture, the Department of Natural Resources, the Department of Trade and Tourism and other appropriate Government agencies are enjoined to cooperate with rural banks and provide advice to their borrowers. Up to January 1973, rural banks did not share in the cost of supervision by DRBSLA, but since then they have been required to pay, as any other bank, an annual fee not exceeding 1/20% for their assets (excluding cash reserves). Financial privileges comprise the provision of supplemental capital in the form of pre- ferred stock (para 12), liberal rediscounting facilities (para 15) and the participation in special financing programs (para 16). 6. Exemptions. Rural banks and their borrowers or mortgagors are exempted from any fees, charges and documentary stamp taxes relative to loans or transactions of less than P 5,000. In addition, the Rural Banks Act grants rural banks absolute exemption from any taxes, charges and fees if the bank's net assets do not exceed P 1 million (excluding paid-in Gov- ernment counterpart capital). If the net assets are between P 1 and 3 mil- lion, the taxes, charges and fees are levied in proportion to the excess  ANNEX 6 Page 3 over P 1 million. Rural banks with net assets of more than P 3 milion pay taxes and fees like any other bank. 1/ Number and Distribution of Rural Banks 7. As of December 31, 1975, there were 768 licensed rural banks. Seven hundred and thirty-two of these were active and under regular exam- ination. These figures compare to 622 and 606 respectively at the time of appraisal cf Third Project, October 31, 1973. The Four-Year Development Pro- gram for the rural banking system (1974-77) provides for the establishment of an additional 100 rural banks annually. One hundred and forty-six were established during the first two years of the program. Out of the 704 rural banks operating over one year, 245 (35%) were participating in the CB:IBRD program as of December 31, 1975. The breakdown by region was as follows: Total No. No. of Participating Rural Banks Rural Banks Luzon 458 159 (35%) Visayas 148 55 (37%) Mindanao 98 31 (32%) Total 704 245 (35%) The Rural Bankers Association of the Philippines 8. In 1955, 18 banks formed an unincorporated association which in 1975 was incorporated as the Rural Bankers Association of the Philippines (RBAP) and almost all rural banks now belong to the Association. There is a Rural Bankers Federation in most provinces, representing the link between individual banks and the Association. RBAP actively represents its members' 1/ (a) Under the Internal Revenue Code, the income tax rate for domestic corporations is 25% of the taxable net income up to P 100,000 and 35% of that over and above P 100,000. (b) The Privilege Tax on Business and Occupation for banks is a fixed amount of P 500 a year. (c) The Tax on Banks is 5% of gross receipts derived from interest, discounts, dividends, commissions and other gross income realized during the calendar year. (d) The annual Residence Tax amounts to P 5.00 plus a tax not exceeding P 2,000 on the basis of (a) P 2.00 for every P 5,000 worth of real property and P 2.00 for every P 5,000 gross receipts or earnings derived by the corporation dur- ing the preceding year.  ANNEX 6 Page 4 point of view in all dealings with CB and the Government and participates in the formulation of laws and policies affecting rural banks. It liases with organizations such as the Agricultural Machinery Dealers Association (AMDA) and plays an important role in public relations on behalf of its members. It organizes seminars and training courses for the staff and management of mem- ber banks, drawing resource people from Government agencies such as CB, from universities, and from the private sector. B. Organization and Operations of Rural Banks 9. Persons of Filipino citizenship and/or cooperatives or barrio asso- ciations 1/ can establish a rural bank, provided that a majority of stock- holders are actual residents of the community where the bank is to be located and own the controlling stock therein. The initial authorized capital must be at least P 100,000. No individual family group can own more than 20% of the voting shares, no interlocking directorate with other rural banks is allowed, and the directors and key officers should not be relatives within the third degree of consanguinity or affinity. 10. Rural banks are stock corporations, managed by a board of 5-11 directors who must be Filipino citizens and shareholders of voting common stock. The executive officers are the president, vice-president, man- ager, treasurer or cashier, and secretary. To ensure managerial qualifica- tions, the Monetary Board requires directors to be at least 25 years old, college graduates or having at least 5 years of business experience or an acceptable banking training. The president is the chief executive and pre- sides over all stockholders' or directors' meetings, unless the bank has elected a chairman of its board; if the bank is small, the president may also be concurrently the manager. Financial Resources 11. The resources of rural banks consist of their own capital (preferred and common stock and reserves), deposits from the public, and borrowings from CB through rediscounting of notes and participation in special financing pro- grams. 12. Preferred Stock. The Development Bank of the Philippines (DBP) holds preferred stock in rural banks, because CB cannot directly invest in stock cor- porations. 2/ Its purpose is to match the private investment with Government 1/ A barrio (village) association or Samahang Nayon is a form of a pre- cooperative; membership is mandatory for participation in the Agrarian Reform Program. 2/ DBP is still appointed as the Government's agent for this purpose but preferred stock issued prior to 1972 has been transferred to the Land Bank of the Philippines (LBP).  ANNEX 6 Page 5 counterpart capital assistance up to a 50:50 ratio at the time of establish- ment. DBP, subject to availabillty of funds, furnishes this supplementary capital not exceeding P 1 million per bank, and the rural bank issues the preferred stock. The capital assistance is to be utilized solely for lend- ing under supervised credit programs. The banks, within three years from the start of operations, must set up a sinking fund for the retirement of the preferred shares. DBP or LBP is entitled to dividends of not more than 2% each time the bank declares dividends on common stocks. If, in the Monetary Board's opinion, a rural bank has accumulated enough capital strength, or the private sector offers to replace the Government investment, the Monetary Board may require the retirement of preferred shares. 13. Common Stock. As required by the Corporation Law, incorporators must subscribe to at least 20% of the authorized capital stock (minimum P 100,000). Only common stockholders exercise management, proprietary and remedial rights. A recent development initiated by the Govenment is that barrio associations and cooperatives may buy shares in existing rural banks. The aim is to broaden the capital basis of the banks and to change their gen- erally conservative attitude towards lending to small farmers. The extent to which cooperative organiztions may buy shares in any existing bank may not exceed 40%. Five percent of the value of Masagana 99 loans through rural banks is placed in the rural bank as a special deposit in the name of the borrower's Samahang Nayon (cooperative). One of the purposes of this fund is the acquisition of Government-owned shares in the rural bank. 1/ 14. Deposits. Rural banks are entitled to accept savings and time de- posits (with the exception of about 50 authorized by 1972, rural banks can no longer accept demand deposits in accordance with Presidential Decree No. 77), after having received specific authority from CB to do so. Banks with a paid-in capital of not less than P 100,000 and adequate facilities and staff normally qualify. The maximum rate of interest is 7-1/2% p.a. for savings deposits and up to 12-1/2% p.a. for time deposits of two years. Demand deposits do not earn any interest. There are three measures to protect rural bank depositors: (a) deposit accounts not exceeding P 10,000 per depositor must be insured with the Philippine Deposit Insurance Corporation; (b) the bank must maintain reserve against deposit liabiliites (14% of demand deposits, 12% of savings deposits and 10% of time deposits); and (c) it must maintain a minimum capital of 10% of its assets (excluding cash reserves, contingent assets and supervised (guaranteed) credit). Although interest rates do not seem very attractive in a country with very high interest rates for non-institutional credit, rural banks suceeded in obtaining a total of 1/ To date, no such acquisition has taken place. Rural bankers are reluctant to release deposits while Masagana 99 arrears are high and they do not want cooperative ownership in their banks (another decree gives coopera- tives third priority after existing shareholders and displaced land owners for stock purchases). For their part, cooperatives prefer to establish their own rural banks. One cooperative rural bank was established at Cabanatuan in December 1974, and began operations in early 1975.  ANNEX 6 Page 6 P 678.3 million in deposits (83% of which was savings deposits) as of December 31, 1975 compared to P 577.5 million as of December 31, 1974, and increase of 17%. 15. Rediscounting. CB rediscounts eligible papers (promissory notes) up to 80% of the outstanding balance of the unpaid portion of such papers at the time of rediscounting. The rediscount rate charged for non- supervised loans is 5% p.a. For supervised production loans for rice, corn and sugar, the maximum amount granted may be 100% and the rediscount rate charged is 1% p.a. In addition, banks are required to set aside the equiv- alent of 2% p.a. of rediscounted loans to meet the cost of supervision. The use of new supervsion funds has not been policed satisfactorily in the past but a proposal is now under consideration to require the separate accounting of such moneys. A rual bank may not rediscount with CB more than 500% of its net worth plus 100% of its monthly average savings deposit liabilities for the four months preceding the date of rediscounting in the case of supervised credit (100% and 50% respectively in the case of non-supervised credit). Officially, rural banks with past due loans exceeding 25% of their total out- standing loans (exclusive of loans granted to beneficiaries of the Agrarian Reform Program and under the Agricultural Guarantee and Loan Fund and CB:IBRD programs) are disqualified from rediscounting. However, this restriction has not been enforced with respect to rediscounting food production loans for several years. A circular was issued in June 1976, announcing CB's intention to enforce it again as of November 1, 1976. 16. Special Financing Programs. CB channels funds for short-term (up to 1 year), medium-term (1-5 years) and long-term (over 5 years) loans through qualified rural banks under special financing programs. The funds are lent to the banks as Special Time Deposits secured by promissory notes. The first of such programs was the First Rural Credit Project (Loan 432-PH), followed by the Second (Loan 607-PH) and the Third (Loan 1010-PH). Other special programs - mostly with USAID participation - include the Agricultural Guarantee and Loan Fund (AGLF) for medium- and long-term loans for farmers and cooperatives, which also protects participating banks against losses (up to 70%); the Small Fisherman's Special Credit Fund for the acquisition of fishing boats, engines, accessories, nets and other fishing gear by small marine fishermen; the Special Agricultural Loan Fund for granting produc- tion loans for a maximum period of three years to farmers who form a "compact farm" 1/ of at least five farmers who assume joint and several liability for the loan; the Agricultural Loan Fund for agrarian reform beneficiaries 1/ Unregistered group of farmers with contiguous farms of approximately equal productive capability, fully irrigated, for purposes of consol- idating individual resources, methods and activities by cultivating the aggregate consolidated area as one unit under a single management. This concept has not been adopted on any significant scale since its introduction.  ANNEX 6 Page 7 organized in cooperatives or "seldas" 1/; Guarantee Fund for loans and guarantees to rural banks/farmers in areas affected by the devastating floods and drought of June and July 1972; the Agricultural Loan (Calamity) Fund - Hand Tractor and Work Animal Loan Program for loans to farmers for the purchase of hand tractors and work animals; the "Masagana 99" Rice Production Program, for the production of high yielding rice varieties in 43 major rice producing provinces covering more than 500,000 ha of irri- gated and 100,000 ha of rainfed lands during the crop year 1973/74; and the Industrial Guarantee and Loan Fund for the establishment, expansion or refinancing of small-scale export-oriented or cottage industries, Each of these programs has a set of rules and regulations governing its administration. 17. Status of Financial Resources. The rural banking system continues to show growth (a statement of comparative balance sheets, 1970-1975, is attached as Table 1 and income statements for the same period appear as Table 2). The status as of December 31, 1975 is summarized as follows:. Amount Capital P M (US$ M) % of Total Preferred Stock 56.7 2% Common Stock 219.4 8% Surpluses, Reserves, Undivided Profits 149.9 6% 426.0 (58.4) 16% Liabilities Demand, Savings and Time Deposits 678.3 25% Central Bank and Other Banks 1,645.0 2,323.3 (318.3) 59% 84% Total 2,749.3 (376.7) 100% The increase of total resources over December 31, 1974 amounted to P 638.6 million (US$85.1 million) or 30% during the 12 month period. Rural banks' own resources increased by about 18% annually over the five years ending December 31, 1975 while total liabilities increased at a simple rate of 88% annually during the same period. The rapid increase in liabilities was primarily due to the introduction of the "Masagana 99" Rice Production 1/ Synonymous with compact farm, except that members cultivate their farms separately and individually. Serious repayment problems have arisen with this concept with the willful default of one or more of the coop- erators.  ANNEX 6 Page 8 Program and the resultant rise in CB notes payable from P 123.7 million at December 31, 1970 to P 1,009.9 million at December 31, 1975. Lending Operations 18. Limitations. According to the Rural Banks Act, loans and advances by rural banks must be primarily for the purpose of meeting the credit needs of small farmers or farm families (defined as those owning or cultivating, in the aggregate, not more than 50 ha of land dedicated to agricultural pro- duction). They may also attend to the normal credit needs of cooperatives and small merchants and small business enterprises whose capital invested does not exceed P 50,000 (under review to be increased to P 100,000) and the needs of "essential rural industries" irrespective of capital investment. (Essential rural industries are those the goods and services of which are needed by and normally purchased by low income groups). Medium- and long-term loans may be extended by banks with an unimpaired capital of not less than P 100,000 and savings and time deposits of at least P 100,000, Investment in equities of other enterprises are only allowed for minority holdings in allied undertakings up to 25% of the banks net worth. Otherwise, rural banks provide normal banking facilities as required by rural communities. For the purpose of determining the need for prior authority from CB, rural bank lend- ing is classified into ordinary and special. Newly organized rural banks are authorized to make ordinary short-term loans without the need of further CB authority, whereas for special medium- and long-term loans, such permission is required. Apart from the normal requirements for ordinary lending, rural banks have to fulfill additional conditions before they qualify to participate in the various special financing programs (paras 16 and 24). 19. Volume. Total lending operations by the rural banking system have increased substantially over the last five years. The following table highlights the expansion from 1970 to 1975. (Sector-wise details for 1975 appear as Table 3):  ANNEX 6 Page 9 Number of Loans Loan Amount ('000) (Pesos Million) Increase (Decrease) Increase Against Increase Against Increase During Previous (Decrease) During Previous (Decrease) Year Year Year % Year Year ____% 1970 437.5 15.6 3.7 558.8 86.6 18.3 1971 371.7 34.2 7.8 678.7 119.9 21.5 1972 527.9 56.2 11.9 785.2 106.5 15.7 1973 749.3 221.4 41.9 1,073.7 288.5 36.7 1974 1,045.6 296.3 39.5 1,824.7 751.0 69.9 The table illustrates the accelerated increase in the number of loans made as well as in the amount lent. Average loan size increased during the period from about P 1,275 to about P 2,220 between 1970 and 1975. The dramatic increase in lending beginning in 1973 is primarily a result of the introduction of Masagana 99, the supervised credit program for rice pro- duction. 20. Distribution. Lending in 1974 and 1975 to different sectors of the economy is summarized in the following table: 1974 1975 No. % of Amount % of No. % of Amount % of '000 Total P M Total '000 Total P M Total Agricultural Loans 972.4 93.0 1,669.5 91.4 966.2 92.9 2,117.5 91.7 Commercial Loans 53.2 5.1 108.9 6.0 53.3 5.1 131.0 5.7 Industrial Loans 8.4 .8 32.6 1.8 9.4 .9 44.9 1.9 Other Loans 11.6 1.1 13.7 .8 10.8 1.1 16.8 .7 Total 1,045.6 100.0 1,824.7 100.0 1,039.7 100.0 2,310.2 100.0 21. Loan Sizes. A total of about 749,300 loans were granted by all rural banks in 1973 (the last year for which size data are available) for an aggregate amount of about P 1,074 million. A classification of loans according to size is provided in the following table (data for 1970 through 1973 are shown in Table 4).  ANNEX 6 Page 10 No. % of Amount % of 1973 ('000) Total (E M) Total Total Loans Granted 794.4 100.0 1,073.7 100.0 Cumulative up to P 2,000 (US$ 295) 629.3 84.0 524.7 48.9 Cumulative up to P 5,000 (US$737) 726.3 96.9 843.0 78.5 P 5,000 to P 10,000 (US$737 to 1,475) 16.7 2.2 109.9 10.2 P 10,000 and above (US$1,475 and above) 6.3 .9 120.8 11.3 About 96.9% of all loans, accounting for 78.5% of the total amount advanced during the year, were made in small loan amounts of up to P 5,000. This illustrates that rural banks in fact reach a large number of small operators and fulfill their role of serving the less affluent sections in rural com- munities, apart from assisting larger and progressive farmers with a higher absorptive capacity. The pattern of loan distribution by size has been fairly constant in recent years. 22. Securities. The following table shows, in a summarized form, loans granted in 1973 by type of security (details for 1970-1973 appear in Table 4): Type of Security No. of Loans % of Total Amount P M % of Total Real Estate Mortgage 384,300 51 680.9 63 Chattel Mortgage, Guarantees, Sureties, Bank Deposits, Pledges of Crops 306,400 41 332.5 31 Unsecured 58,600 8 60.3 6 Total 749,300 100 1,073.7 100 This demonstrates the generally conservative attitude of rural bankers con- cerning collateral but also indicates their flexibility in granting loans on securities other than land and even in advancing unsecured loans. 23. Loan Periods. In 1974, the last year for which data are available, rural banks made an estimated 970,000 loans amounting to P 1,577 million for short-term agricultural purposes. This amounted to 93% and 86% of loan numbers and loan amount, respectively, in their portfolios. There were about 4,200 agricultural loans for medium- and long-term purposes amounting to about P 85 million, almost all of which were funded through the CB:IBRD program.  ANNEX 6 Page 11 Medium- and long-term agricultural loans amounted to 0.5% and 5% of total loans and amounts, respectively, in rural bank portfolio. 24. Qualifications for Participation in CB:IBRD Lending. According to the Rules and Regulations governing loans under the CB:IBRD project, DRBSLA evaluates the creditworthiness of rural banks that wish to participate in the project, taking into account the following: the bank must have been in operation for at least one year; it must have sufficient liquidity to meet obligations to creditors and depositors; have sound loan investments as to collateral, capacity to pay and character of borrowers; arrears may not exceed specified limits 1/; has established a credit reputation with CB; has a management of competence and integrity; and has sufficient unimpared capital and adequate reserves as well as positive operating results. Qua- lified banks enter into a credit line agreement with CB. Each rural bank assumes the credit risk of sub-loans extended by it. The bank executes a promissory note covering each loan received from CB and, as security for such sub-loans, endorses in favor of CB promissory notes executed by individual borrowers covering the total amount borrowed from the bank. 25. Interest Rates. Recently the Monetary Board has raised the ceil- ing interest rates, which are not applicable to rural banks, to 17% for loans less than two years and 19% for loans over two years 2/. But the annual interest rate for credit made available under Masagana 99 and other Government food grain production credit programs is 12%. The effective cost of credit from agricultural input suppliers is between 15% and 25% per annum and it is much higher from private moneylenders. C. Operational Results Repayments 26. Collections from Sub-Borrowers. Agricultural credit has a poor recovery record in the Philippines. Not only do collections from farmers leave much to be desired, but, consequently, also repayments by rural banks to CB (para 29). Collections for all rural banks' operations show a con- tinous decline as illustrated in the following table. As of December 31, 1975, arrears amounted to 21.5% of portfolio (Table 5). This figure would be higher were it not for rapid portfolio expansion and widespread avail- ment of restructuring privileges for production loans (para 27). 1/ The arrears limits proposed for this project are: (i) arrears not exceeding 25% of total portfolio, and (ii) arrears on terms loans not exceeding 30% of demand; reducing to 25% from January 1, 1978 and 20% from July 1, 1978 (para 6.09). 2/ These interest rates include a 3% charge or fee. The higher rate for loans over two years can only be charged when such loans are matched by time deposits in excess of two years.  ANNEX 6 Page 12 Year Total Demand Total Recoveries Recoveries/Overdues