Philippines - Investments Systems Organization Project

Document of FILE COPy The World Bank FOR OFFICIAL USE ONLY Report No. P-2289-PH REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE PHILIPPINE NATIONAL BANK TO BE GUARANTEED BY THE REPUBLIC OF THE PHILIPPINES FOR THE PHILIPPINE INVESTMENTS SYSTEMS ORGANIZATION (PISO) PROJECT April 11, 1978 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 = P 7.50 /1 P 1 = US$0.133 P 1 million US$133,300 ABBREVIATIONS ADB - Asian Development Bank BOI - Board of Investment DBP - Development Bank of the Philippines IGLF - Industrial Guarantee and Loan Fund NEDA - National Economic Development Authority PICA - Private Investment Company for Asia (PICA) S.A. PISO - Philippine Investments Systems Organization PDCP - Private Development Corporation of the Philippines PNB - Philippines National Bank FISCAL YEAR January 1 - December 31 /1 This is the exchange rate that prevailed at the time of apraisal in July/August 1977. The current exchange rate is $1 = P 7.40. As the difference is not likely to affect significantly the project, the figures have not been revised.  Foa oFnCL USE ONLY PHILIPPINES PHILIPPINE INVESTMENTS SYSTEMS ORGANIZATION (PISO) PROJECT LOAkN AND PROJECT SUMMARY Borrower: The Philippine National Bank (PNB) Beneficiary: Philippine Investments Systems Organization (PISO) Guarantor: Republic of the Philippines Amount: $15 million equivalent Terms: The proposed loan will bear interest at 7.50% p.a. Flexible amortization to conform substantially to the aggregate of the repayment schedules applicable to the specific investment projects financed out of the proceeds of the proposed loan. Relending Terms: PNB would relend the proceeds of the proposed loan to PISO at an interest rate of 7.50% plus a handling fee of 0.75% p.a., on the outstanding amount, but otherwise on the same terms as those for the Bank loan. PISO would onlend to sub-borrowers at an interest rate of 12-14% p.a. (including all service fees) for a maximum term of 15 years, including a grace period of 3 years. Prolect The project is designed to assist the Philippine Description: Government in realizing its objective of expanding and diversifying the institutional capacity of financial intermediaries capable of mobilizing and allocating medium- and long-term resources to development projects in the industrial sector. In particular, it would develop the capacity of PISO, a private financial insti- tutiLon, to initiate and expand its medium- and long-term lencling operations. The proposed loan will be used by PISO for making sub-loans to finance foreign exchange requirements of projects mainly in manufacturing. In addition to the institutional improvements for which this project provides, there are a number of financial and industrial sector issues which the Government wouLd need to address within the next few years. The effectiveness of PISO in mobilizing and allocating financial (particularly local) resources will, to an important degree, depend on the policy adjustments which the Government makes in the coming years. Apart from these broader sectoral concerns, there are no special risks associated with the project. Ths dtocument ha a restricted dstribution and may be used by recipients only in the perfofmance of theif official dutiea Its contenu may not otherwise be disclosed without World Dank authorization.  Estimated Disbursements: ($ million) Bank FY 79 80 81 Annual 4.4 8.2 2.4 Cummulative 4.4 12.6 15.0 Staff Appraisal Report: No. 1900-PH dated April 3, 1978.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE PHILIPPINE NATIONAL BANK TO BE GUARANTEED BY THE REPUBLIC OF THE PHILIPPINES FOR THE PHILIPPINE INVESTMENTS SYSTEMS ORGANIZATION (PISO) PROJECT 1. I submit the following report and recommendation on a proposed loan to the Philippine NationaL Bank with the guarantee of the Republic of the Philippines for the equivalent of $15.0 million. The loan would be at an interest rate of 7.50% p.a. The proceeds of the loan would be relent to the Philippine Investment Systems Organization (PISO) at an interest rate of 7.50% plus a handling fee of 0.75% on the outstanding amount, but otherwise on the same terms as those of the Bank loan, for onlending to specific productive enterprises. The loan would be repaid in accordance with the composite amorti- zation schedules of PISO's subloans which will have a maximum repayment period of 15 years, including a maximum grace period of three years. Sub-borrowers would assume the foreign exchange risk. PART I - THE ECONOMY /1 2. An economic mission visited the Philippine in July/August 1977 and its report, "The Philippines: Country Economic Memorandum" (No. 1765-PH of October 26, 1977), was distributed to the Executive Directors under Secretary's Memorandum PHL77-2 on October 27, 1977. A basic economic report, entitled The Philippines: Priorities and Prospects for Development (SecM-76/366), was previously distributed to the Executive Directors on May 18, 1976. Macroeconomic Performance 3. During the 1960s, the Philippine economy grew in real terms at an annual rate of about 5-1/2%. However, the rate of growth was less than what might have been achieved if the country's considerable natural and human resources had been utilized more effectively. The benefits of growth were also distributed relatively unevenly, both with respect to regions and income classes. While overall agricultural growth was reasonably satisfactory, repeated food deficits were experienced. The growth of productive employment opportunities failed to keep pace with the expansion of the population and labor force. Low levels of taxation resulted in inadequate public expenditure for necessary infrastructure and social services. Poor export performance combined with the heavy import dependence of domestic industry led to chronic weakness in the balance of payments. 4. The growth of the Philippine economy accelerated slightly to an annual rate of 6% in the 1970s. Fluctuations, however, have been significant. In the period 1970-72, when the effects of a balance of payments stabilization program initiated in 1970 were being felt, the economy grew less rapidly, exports and imports of goods and services were roughly equal, and the shares of public and private fixed investment in GNP were stable at still relatively low levels. Economic growth was unusually good in 1973 as sharply higher prices for traditional export commodities stimulated demand, agricultural production rebounded strongly from the natural disasters of the previous /1 This section of the report is the same as that of the Rural Electrification Project (SecM/78-63), which was approved by the Executive Directors on April 4, 1978.  -2- year, and the balance of payments registered a substantial current account surplus. The export-led income boom of 1973 was followed by an investment boom. The resulting high investment rate, together with favorable sugar prices, temporarily sheltered the economy from the impact of the oil price increase in late 1973 and the following world recession, and real GNP growth was maintained at 6% in 1974-75. The first half of the 1970s also saw significant structural changes in the economy, the most important of which were an increase in the level of public investment, financed in large part by a greater tax effort, a recovery in export growth, a shift of the domestic terms of trade in favor of agriculture, and the slowing of the population growth rate. 5. The collapse of sugar prices in late 1975, following earlier declines in the prices of other major export commodities, altered the external situation dramatically. The terms of trade dropped by 23% in 1975, and as a result the current account deficit rose to 6% of GNP, and the overall balance of payments deficit to $500 million. Thus, the necessity of restoring balance to the external accounts was superimposed on the Government's longer-term objectives of faster economic growth and a better distribution of its benefits. To maintain the momentum of growth and investment, the Government adopted a policy of increasing capital inflows in the near term to finance the resulting expanded current account deficits while accelerating export growth in the longer term. In 1976-77, the economy - led by exports, public investment, agriculture and construction - has continued to grow at 6% per year. Unfor- tunately, much of the stimulus from an expansion in export volume was offset by further deterioration in the terms of trade. However, inflation, which reached a peak of 31% in 1974 as a result of externally generated pressure on domestic prices, has slowed to a rate of about 7% because of the deceleration in international inflation and a conservative monetary-fiscal policy. Development Strategy 6. The Government's development objectives and policies, which were recently set out in a Five-Year Development Plan for the period 1978-82, call for further acceleration of economic growth, first to 7% and then to 8%. The development strategy focuses on an expansion of more productive employment opportunities at a rate of 3.6% per annum, reduction of income disparities, greater selfsufficiency in food and energy, strengthening the balance of payments, and increased development in rural areas. In addition, the Plan includes strategies for development in each of the country's thirteen regions. In general, the Plan is an elaboration of the policy directions pursued by the Government in recent years. It is also broadly consistent with the Bank's basic economic report, although investment, manufacturing output, and exports are projected to grow more rapidly than visualized therein. It should be feasible to accelerate the overall growth rate to 7% as the terms of trade stabilize, but more rapid expansion of manufacturing is necessary to do so, and effort needs to focus on improving the efficiency of investment. Agriculture 7. For a country with fairly good soils and a reasonably literate rural population, agricultural yields in the Philippines are relatively low. Possible reasons for this situation are the low quantity and quality of  -3- irrigation facilities and high vulnerability to weather risks; land tenure patterns; and weak agricultural credit, extension, and other supporting services. Agricultural production has, nevertheless, grown at an average rate of 4-1/2% per year in the 1970s. The performance of the sector was exceptionally strong in 1976 and 1977, as production increased by 7%, and the Philippines has been virtually self-sufficient in rice, its main staple, for the past three years. 8. The Government gives high priority to agriculture and rural development. It has undertaken a number of steps to increase the availability of irrigation and supporting services, and has also expanded programs to improve living conditions in rural areas, including rural electrification, health and family planning, and rural roads. However, while irrigation investment has been raised substantially, improvements in the quality of supporting services - particularly credit and extension - are necessary. 9. For historical reasons, land ownership in the Philippines is inequitably distributed. The land transfer program, which has been in operation for five years and covers rice and corn growing areas, proceeded quite rapidly when larger landholdings were the focus of concentration, but progress has been slower recently as the focus has been on a larger number of medium-sized holdings, which often belong to middle-class landowners. As of June 1977, an estimated 120,000 tenants, or 30% of the total tenants under the program, had received Certificates of Land Transfer, which established their claim to the land. Despite the difficulties in the process of implemen- tation, the transfer program remains an important part of the Government's rural development strategy. Industry 10. During the 1960s, Philippine industrialization was promoted by high tariff protection and subsidized finance, and consequently industrial growth was primarily in the area of import-substitution with a high capital intensity. Performance was disappointing with respect to employment, exports, and the overall rate of growth of output. In the early 1970s the Government floated the exchange rate, which then depreciated significantly, and introduced policy changes to reduce tariffs and realign industrial incentives. Further efforts to reduce remaining biases in favor of import substitution and capital intensity will still be needed, however, to accelerate the rate of industrial growth as projected in the Five Year Development Plan. 11. Manufacturing industry has grown at a relatively slow average rate of about 6% in the 1970s. Moreover, due to the slow increase in national income and demand because! of the decline in the terms of trade in the last two years, manufacturing growth has also slowed, and investment has stagnated. On the other hand, industries producing nontraditional exports have expanded rapidly from a very low base as their exports increased almost fivefold in the four-year period 1973-76 in response to exchange rate adjustment and special measures designed to alleviate existing restrictions on imports and thus reduce the bias towards production for the domestic market. As noted above, further efforts in this clirection will be needed if industrial exports are to continue to grow at a rapid rate. The construction industry has also grown  - 4 - rapidly as the expansion of relatively construction-intensive public investment and large tourism investments in the Manila area raised construction expendi- ture from 6% of GNP in the early 1970s to 12% in 1976. Employment, Incomes and Population 12. Employment increased by about 4.6% annually during 1973-76, a considerable improvement over the historical growth rate of 2.4%, and was able to keep pace with the rapid growth of the labor force. Particularly noteworthy was the growth of employment in manufacturing, which essentially stagnated during 1970-74, but grew by 8% annually during 1975/76, resulting in part from the growth of labor-intensive production for export. However, because manufacturing's share of total employment is small, agriculture and services continue to function as residual sources of employment and account for most of the growth in total employment. 13. Preliminary survey data show that the share of income received by the poorest 40% of families, which remained constant during the 1961-71 period, increased from 12% in 1971 to 15% in 1975. The income share of the top 20% of families remained about the same as in 1971, while that of middle income families declined correspondingly. Due to the improvement in agricul- ture' s terms of trade, the growth of agricultural production, the decline in urban real wages following the devaluation in 1970, and the stagnation of industrial employment until 1975, the ratio of the average rural income to the average urban income rose from 48% in 1971 to 57% in 1975. Real per capita consumption increased by about 2% annually in 1971-75. Hence, after allowance for price increases, real incomes in rural areas, where most of the poor live, have probably increased somewhat, while real urban incomes have remained about the same. 14. The population is estimated at 43.3 million in 1976 and is currently growing at 2.8% as compared to a 3.0% growth rate during the 1960s. The Philippines has an active family planning program registering approximately 650,000 new acceptors per year. Although the number of new acceptors has reached a plateau as the program faces the increasingly difficult problem of reaching rural areas, the estimated proportion of married women of reproductive age practicing family planning increased from 20% in 1974 to 25% in 1977. Investment and Savings 15. Due largely to the buoyant export performance in 1973 and the subsequent increase in incomes, investment boomed in 1974-75. Private investment rose from 14% of GNP in the early 1970s to 20% in 1975. Public investment was raised from 2% to 4% of GNP with the growth in revenue from international trade taxes, improvements in tax administration, and improved project implementation capacity. Subsequently, public investment has been raised further to an estimated level of 6-1/2% of GNP in 1977. The private investment rate, on the other hand, has fallen somewhat to an estimated 18% of GNP. Although the private investment rate is well over the 14% average of the early 1970s, the revival of private investment is an important short-term problem. Furthermore, the high incremental capital-output ratio, the relatively modest growth of manufacturing output and employment, and the structural underutilization of capacity in some industries suggest that the efficiency of investment also needs to be improved.  - 5 - 16. Aggregate savings performance has improved during the last decade and is comparable to that of other countries at a similar stage of economic development. In 1976-77, gross domestic savings maintained the level of 25% of GNP achieved in 1975 and financed about 80% of total investment, with the balance coming from foreign savings. In order to increase the efficiency of financial markets in intermediating between savers and investors, the Govern- ment has made significant improvements in financial policy. Organized banking institutions have been strengthened. Interest rates were realigned in 1976 and again in 1977 to encourage a greater flow of financial savings into time and savings deposits relative to short-term deposit substitutes, and to reduce the spread between borrowing and lending rates. Further reforms are required to increase the availability of long-term domestic currency resources. Special credit programs have been adopted to expand lending to the credit-short agricultural sector and rural areas and to serve the needs of medium- and small-scale industries. However, a deterioration of loan recovery rates has been experienced by all government financial institutions and credit programs, creating a difficult policy dilemma. On the one hand, the programs have become costly means of achieving their objectives, and the growth of arrears reduces the overall efficiency of resource mobilization and allocation. On the other hand, the programs do redress imbalances in the availability of credit so that arrears have to be reduced without closing necessary credit channels. Government Expenditures and Revenues 17. Public expenditures and revenues have historically claimed a much smaller share of national resources in the Philippines than in many other developing countries. In the early 1970s, general government expenditure averaged only 12% of GNP, public investment was strikingly low at about 2% of GNP, and tax revenues stood at 11% of GNP. Government expenditures were dominated by general administration and social services, particularly education. This situation had resulted from a variety of factors including difficulties in raising tax revenue and weak implementation capacity in the public sector. Since th,e early 1970s, the Government has taken steps to correct the situation and raise both the overall level of expenditures and the share going to economic services and public investment. By 1977 govern- ment expenditures had reached an estimated 18% of GNP, and public investment, which has risen very rapidly in the last two years, equaled about 6-1/2% of GNP. 18. Recognizing that a large increase in tax revenues would be required to finance expansion of the public investment program, the Government has undertaken a comprehensive program of tax reform to raise the needed revenues equitably and efficiently. In the short term, needed revenues have been raised through revisions in inclirect taxes. In the long term, structural changes are to be made to raise the built-in elasticity of the tax system, to reduce distor- tions in economic incentives and dependence on cyclically volatile taxes on international trade, ancd to improve equity by increasing the proportion of revenues coming from direct taxes. The Government has increased the ratio of domestic taxes to GNP by an impressive 1.5 percentge points between 1975 and 1977 through new tax measures and vigorous efforts to improve taxpayer compli- ance and collection performance. However, much of the success in mobilizing  -6- revenue from domestic sources has been offset by a sharp decline in the yield of export taxes and import duties due to cyclical fluctuations. Total tax revenues, which had been raised from 11% of GNP to 13.6% by 1975, rose to only an estimated 14.1% in 1977. Greater resource mobilization by government financial institutions and government corporations, whose investment programs have grown rapidly, is also needed. External Trade and Capital Flows 19. Largely as the result of a 23% decline in the terms of trade in 1975, the current account recorded a deficit of $900 million, or 6% of GNP. To meet the immediate payments problem, the Government drew down its international reserves, obtained loans under various IMF facilities, and expanded its borrowing program to finance necessary imports. For the longer term, a strategy was adopted of accelerating export growth both to hold the current account deficit about constant, while it declined relative to GNP, and to meet the debt service payments on the higher level of external borrowing. 20. Some progress in these directions was made in the last two years. In 1976, in spite of a further 11% deterioration in the terms of trade, a substantial increase in export volume and slow growth of import payments narrowed the trade deficit and partly offset the higher net interest payments. Although somewhat larger than in 1975, the current account deficit was stabil- ized at 6% of GNP. Net capital inflows were nearly doubled to $1.1 billion. Most of the inflow was from medium- and long-term loans, two-thirds of which were public loans reflecting in part increased disbursements from official sources. Estimates for 1977 show a further substantial expansion in export volume which, with little expected change in the terms of trade, import volume, services or transfers, would reduce the current account deficit to 4% of GNP and eliminate the overall payments deficit. Hence, on the whole, the balance of payments position has strengthened significantly. 21. To achieve a 7% growth rate in real GNP, as projected for the period 1978-82, imports will have to grow faster than they have recently and a net capital inflow of at least $1 billion per year will be required. Assum- ing continued sound debt management and the maintenance of a balanced maturity structure of foreign borrowings, the overall level of external debt of the Philippines is expected to remain within reasonable limits. The ratio of debt service payments to exports and nonfactor services would average about 19%, of which 7% would be public debt service, during the plan period (1978-82). 22. In order to ensure that the long-term capital transfer is commensu- rate with the level of development expenditures which will be required during 1978-82 and that debt service obligations remain within reasonable limits, the Government sought commitments of official assistance of $750-800 million in 1978 at the meeting of the Consultative Group for the Philippines, held in Tokyo on December 1 and 2, 1977. This amount is likely to be available. However, since many of the planned projects which are to be financed from external sources have a low foreign exchange component, some local cost finan- cing is necessary, in appropriate cases, to meet the Philippines' external financing requirements.  -7- PART' II - WORLD BANK OPERATIONS 23. As of March 31, 1978, the Philippines had received 51 Bank loans (of which two were on Third Window terms) amounting to $1,332.5 million and three IDA credits amounting to $32.2 million./l At that date, IFC investments totalled $96.3 million. I'he share of the Bank Group in total debt disbursed and outstanding is about 11% and its share in total debt service is about 5%. These ratios are expected to increase to about 19% and 8%, respectively, by the end of the present decade. Annex II contains a summary of IDA credits, Bank loans and IFC investmnent as of February 28,1978 as well as notes on the execution of ongoing projects. 24. The Bank Group has financed projects in virtually all sectors of the economy with particular emphasis on agriculture and basic infrastructure which have each accounted for about one third of total Bank Group lending. In agriculture, emphasis has been given to expanding irrigation systems to increase food production and to credit programs to support food grain produc- tion and processing, livestock and fisheries production and tree farming. Support has also been provided for integrated rural development projects in low income areas. The Bank Group also provided large amounts of assistance in developing power and transportation because substantial improvement in basic infrastructure has been needed to compensate for many years of past neglect and to provide the basis for future growth of the productive sectors. In the industrial sector, the Bank's main thrust has been on strengthening the capacity of public and private development finance institutions with increasing attention given to meeting the needs of small and medium industries. In the social sectors, the Bank Group has provided support for education programs, designed to improve the quality of primary and secondary education and to meet trained manpower requirements in agriculture and industry. In urban areas, assistance has been provided for water supply projects and for programs to upgrade living conditions in low income urban areas and to develop low cost sites and services. Support has also been provided to the Philippines population program through assistance for the construction of multipurpose rural health units and for training of family planning staff. 25. There has been a marked improvement in the execution of Bank financed projects in the last five years compared with the experience in the late 1960s, when there were serious problems caused by a shortage of peso counterpart funds and weak administration. Almost all ongoing projects are now being implemented reasonably well and the results of supervision and project completion reports indicate that the economic benefits for most projects are likely to be in line with appraisal estimates. However, the overall rate of disbursernent is marginally below what would be expected given the generally good project implementation and the Government is currently reviewing disbursement performance on an agency-by-agency basis to identify possible reasons for disbursement lags and to find appropriate solutions. /1 Since then, a loan of $60 million for rural electrification was approved by the Executive Directors on April 4 and an IDA credit of $28 million for a rural infrastructure project on April 11.  - 8 - 26. As noted in Part I of this report, the Government's Five-Year Devel- opment Plan highlights a strategy which focuses on the expansion of productive employment in agriculture and industry, reduction in income disparities, greater self-sufficiency in food and energy and increased development in rural areas. The Bank Group's future lending program has been designed to assist the Government in achieving these objectives. Agriculture and rural development will account for the largest part of future lending, with continued emphasis on food production and increasing the productivity and incomes of small farmers. However, the program provides for several new initiatives, including a first loan to support the strengthening of the national agricul- tural extension service and a first loan for developing multiple cropping systems in rainfed areas, where there is substantial rural poverty. Increased support will also be provided for integated rural development projects which will support the Government's objectives of redressing regional imbalances in income. Substantial assistance will also continue to be given to industry with special attention being given to expanding the development of labor- intensive, small and medium industries outside the Metropolitan Manila area. The share of lending for social sector projects is expected to continue to increase as a result of greater emphasis on construction of urban water supply and sewerage systems and further assistance to the lower income urban areas through low cost sites and services projects. The Bank Group will also continue to provide support for improving the quality of education and for expanding the Government's population program in rural areas. While the Bank Group will continue to provide support for transportation and power infrastruc- ture projects needed to support the Philippine development effort, the share of Bank lending for these sectors will decline somewhat in the years ahead primarily because alternative sources of financing are available to finance a large part of the power generation program. 27. As noted in Part I, the Philippines has experienced a serious deterioration in its international terms of trade in the last several years which has necessitated substantial foreign borrowing. While the overall level of debt remains manageable, the Philippines will need to obtain substan- tial amounts of foreign assistance on concessional terms to support its expanding development program. In view of this consideration, the per capita income of the country and the generally good management of the economy, a limited amount of IDA financing will be proposed for the Philippines; the first IDA credit since 1974 was recently presented to the Executive Directors and a second is scheduled for FY79. 28. This is the seventh loan to be presented to the Executive Directors this fiscal year and would bring total lending to the Philippines to $208 mil- lion. Loans for development finance, urban development, water supply and a multipurpose dam projects are expected to be ready for presentation within the next few months.  - 9 - PART III - THE ]:NDUSTRIAL SECTOR AND INDUSTRIAL FINANCE /1 29. The industrial sector (defined as manufacturing, mining and con- struction) in 1976 accounted for about one third of GDP and 15% of total employment. Manufacturing is by far the largest component of the industrial sector accounting for about one quarter of GDP and about 11% of employment. Food and beverages are the largest manufacturing group followed by chemicals and textiles. Manufacturing enterprises are predominantly privately owned and generally concentrated in large capital-intensive units. 30. Industry grew alt a rate of about 6% per annum between 1955 and 1971. Its growth rate accelerated in the early 1970s. However, as the Philippine economy was adversely affected by the worldwide economic slowdown and the sharp deterioration in the Philippines' terms of trade, the growth rate declined to 4.6% within the last three years. Capital investments for plant and equipment increased by only 5% in 1976 and are estimated to have increased at about the same rate in 1977. However, assuming the Philippines' terms of trade are stabilized in 1978, as expected, exports and growing government expenditures should give increased stimulus to the economy and contribute to an expansion in the rate of industrial growth and investment. The longer-term prospects for industrial growth are favorable because of the good natural and human resources of the Philippines and its active private sector. 31. There are, however, a number of important issues confronting the industrial sector. Historically, Philippine industrial production was geared primarily to the needs of the domestic market and there has been heavy reliance on protection policies applied through the tariff system and some degree of import control.. In the late 1960s, the Government became aware of the problems implicit in this approach and through the Investment Incen- tives Act of 1967 and the Export Incentives Act of 1970 has sought to expand the nontraditional industrial base and to expand exports and industrial employment. In addition to the incentives provided under the Export Incentives Act, the peso was devalued in 1970, an Export Processing Zone was established and an Export Council was created to make recommendations on various aspects of export promotion. Partly in response to some of these measures, nontraditional manufacturing exports grew very rapidly during the period 1973-77. However, Philippine industry still remains heavily protected and differential rates of protection combined with selective export incentives to various industries are still producing less than optimal industrial and export growth. To rationalize the industrial sector and to provide the basis for future growth, it will be necessary for the Government to move toward a less restrictive trade regime by gradually removing import restrictions and reducing tariffs. The Government, with the assistance of a Bank-financed consultant, is undertaking a major review of industrial protection and incentives and is /1 This section is substantially the same as that of the President's Report on the Private Development Corporation of the Philippines (PDCP) Project (SecM/R78-14), which was considered by the Executive Directors on January 31, 1978.  - 10 - considering a major tariff reform. Further stimulus could be provided through continuing analysis and information programs on foreign market potential, simpler export procedures, larger credit programs and establish- ment of trading houses. 32. Philippine industry has contributed relatively little towards alleviating the problems of unemployment and underemployment. Between 1960 and 1974, manufacturing employment grew at an annual rate of about 2.5%. The rate of employment generation, however, has markedly improved during the last two years as employment in manufacturing grew at an annual rate of 8% in 1975 and 1976, partly as a result of Government's programs designed to foster the growth of small and medium industries which have considerable employment potential. 33. Manufacturing enterprises remain heavily concentrated in the greater Metro-Manila Area which accounts for about 40% of such enterprises. The problem of the geographic concentration of industry is receiving increasing Government attention. Measures already taken in this regard include provision of incentives for projects located in less developed areas, promotional measures by the Board of Investments and its practice of negotiating the location of the project before its approval, a ban on new plant establishment within 50 km of Manila (except export-oriented projects) and a requirement that the Industrial Guarantee and Loan Fund (IGLF) and the Development Bank of the Philippines (DBP) direct at least 60% of their small-scale lending outside Metro-Manila. Further decentralization of industry will be encouraged by the Government's rapidly expanding public infrastructure program (particu- larly roads and rural electrification), major regional planning and development efforts, and a planned program of regional industrial estates. 34. The Government's Five-Year Development Plan (1978-82) projects that the manufacturing sector will grow at an annual rate of 9% during the Plan period and that manufacturing investment will grow at an annual rate of 15.5% (from $1.7 billion in 1977 to nearly $3 billion in 1982). The Government's plan calls for the rapid growth of labor-intensive, small and medium industries producing both for domestic and export markets, and the establishment of some large, resource-based projects to deepen the industrial structure and develop further the country's natural resources. An example of such a project is the planned construction of a copper smelter to process copper concentrates that are currently exported. Industrial Finance 35. The core of the Philippine financial system is a large commercial banking sector, both local and foreign, that operates under the branch banking system and is the main source of working capital and trading credit. In addition to the commercial banks, there are a number of investment houses, savings and loan associations, rural banks and regional development banks. The Government Insurance System and the Social Security System are active in real estate and mortgage financing. Investment houses operate in the active short-term money market. In late 1976, the Government allowed foreign bank branches or offices to establish Off-Shore Banking Units (OBUs) and expand the Foreign Currency Deposit UJnits to undertake foreign currency credit operations.  - 11 - The Government-owned Development Bank of the Philippines (DBP) and the Private Development Corporation of lthe Philippines (PDCP) are the only two specialized long-term lending institutions. 36. As noted in para. 16, the aggregate savings performance in the Philippines has improved generally during the last decade and is comparable to that of other countries at a similar stage of economic development. Since 1975, gross domestic savings have been at a level of 25% of GNP and financed approximately 80% of total investment. However, in order to reach a gross investment level of more than 31% of GNP by 1982 and reduce the country's dependence on foreign savings, the Five-Year Development Plan (1978-82) calls for an increase in gross domestic savings to a level of more than 28% of GNP at the end of the Plan period. To achieve this objective, the savings of the householid sector, which is expected to contribute approxi- mately 40% of the total domestic savings requirement, will need to increase by more than 17% per annum during the next five years. 37. In addition to raising the level of savings, there is also a need to increase the maturity of financial assets. While the gross acquisition of financial assets by the private sector rose from approximately 7% of GDP in 1965 to over 12% in 1974, the relative share of short-term assets increased from only 17% to more than 40% during the same period. This was mainly due to statutory limits on deposit rates of credit institutions while no ceilings existed for money market rates. Given the needs of the investment program for long-term finance, the present preference for financial assets with shorter maturities represents an important issue for the Government's financial policy. With a view to lengthening the average maturity of financial instru- ments and to encouraging the mobilization of savings through banking institu- tions, ceilings on bank rates on savings deposits were raised from a range of 6-6.5% to 7-7.5% and on time deposits from a range of from 8-11% to 8.5-12%. Ceilings on interest rates for loans with maturities exceeding two years were raised from 12-14% to 19% in January 1976. As the rate of inflation has been about 7%, the real interest rates are all positive. In June 1977, a 35% withholding tax on interest paid on short-term financial instruments was introduced, while a 15% withholding tax on interest paid on savings and time deposits was set. These measures have resulted in a 36% increase in real terms in savings and time deposits in 1977. 38. The Philippine financial system does not yet include an effective bond market mainly because longer-term interest rates have been statu- torily controlled. An additional constraint is the dominance of the term market by Government financial institutions because of the preferential treat- ment given to their debt instruments. Only very limited capital expansion is being financed through the stock exchange partly because private owners are reluctant to share control over their enterprises and prefer financing through borrowing. Recently, however, a 5% tax was introduced on closely held corporations to encourage them to go public. 39. Financial institutions and credit programs in the Philippines have experienced deterioration of loan recovery rates during recent years which has seriously affected their financial performance. This is due, in part, to the  - 12 - rapid expansion of credit programs to the productive sectors and to interna- tional economic conditions which have had an adverse effect on some domestic enterprises. The Government is devoting increased attention to the problem of arrears so that loan recovery can be expected to improve. 40. It is important for the Government to adopt a systematic long-term plan to develop the Philippine financial sector along rational lines. An aide memoire focusing on the issues relating to the financial sector is being prepared by Bank staff and will form the basis of a policy discussion between the Government and the Bank within the next few months. A financial sector mission is scheduled to visit the Philippines in the fall of 1978. The Bank's Role 41. The Bank Group has assisted industrial development in the Philippines by providing financial and technical assistance to financial intermediaries to help them expand and improve their medium- and long-term lending programs to productive enterprises. Bank Group lending for the sector so far has been channelled through the Private Development Corporation of the Philippines (PDCP), the Development Bank of the Philippines (DBP) and the Industrial Guarantee and Loan Fund (IGLF), a compensatory financing and guarantee fund which is administered by the Central Bank. Total Bank Group lending has amounted to about $280 million, including a loan of $30 million for the Fifth Private Development Corporation of the Philippines (PDCP) Project, which was signed on February 9, 1978. Increasing attention has been given in recent years to the needs of small and medium industries as $55 million of the proceeds of Bank loans is being used for financing such enterprises. 42. Progress under the ongoing industrial projects financed by the Bank is generally satisfactory. With the exception of the Fifth PDCP Loan, which was approved only recently, most of the funds under previous loans have been committed. Results of post-implementation analyses indicate that both the financial and economic rates of return of subprojects financed are well above the opportunity cost of capital in the Philippines. 43. In addition to the proposed loan, we hope to be able to present to the Executive Directors within the next few months a third loan to DBP for large, small and medium industries. A second loan to help support the IGLF program of financing small and medium industries through privately owned financial intermediaries is scheduled for presentation in FY79. These projects have been designed to meet the medium- and long-term capital requirements of industries of all sizes and to strengthen the institutional capability of public and private lending institutions. 44. The proposed loan would be the first to the Philippine Investments Systems Organization (PISO) and would enable it to undertake long-term industrial lending. The project is designed to support the Philippine Government's objective of increasing the rate of industrial growth to 9% per annum (para. 34). In order to achieve this objective, it will be necessary to increase substantially the long-term resources available for industrial development and to diversify the sources of such financing, particularly in the private sector. Long-term loans currently account for less than 20% of  - 13 - the investment required by the industrial sector; 95% of such loans are provided by two institutions: DBP and PDCP. The Government has therefore requested the Bank to make a loan to PISO with a view to helping develop its capacity for long-term lending for private sector development projects. The Government selected PISO because of its relatively diverse ownership and the high quality of its management and staff. PART IV - THE PROJECT 45. The proposed loan would be the first to assist PISO in developing an effective program of medium- and long-term lending to private sector enterprises. The project was appraised in July 1977 and negotiations were held in Washington in Marchi 1978. The Philippine negotiating team was led by His Excellency, Eduardo Z. Romualdez, the Philippine Ambassador to the United States, and Mr. Vicitor S. Barrios, Chairman and President of PISO. A Staff Appraisal Report, entitled "Staff Appraisal Report on the Philippine Investments Systems Organization" (No. 1900-PH), is being distributed separ- ately. Supplementary project data are provided in Annex III. 46. The proposed loan would be made to the publicly owned Philippine National Bank (PNB), which would relend the proceeds to PISO under the same terms and conditions as that of the Bank loan, except that PNB is expected to charge PISO a handling fee of 0.75% p.a. on the amount outstanding. The relending arrangement through PNB is necessary because the Philippine law provides that the Governmnent can only guarantee the obligations of publicly owned institutions. 47. The proposed Bank loan and the subsidiary loan to PISO would have flexible amortization schedules reflecting the aggregate of repayment schedules for subloans made by PISO which will have a maximum term of 15 years including a grace period of up to three years. Most of PISO's subloans are expected to have maturities of 5-12 years with an appropriate grace period. PISO plans to charge interest aLt 12-14% (including all service fees) on its subloans. PISO's "free limit" would be established at $750,000 and which in aggregate would not exceed $5 million. Subloans falling above these limits would require Bank approval (Section 2.03(b) of the draft Loan Agreement). Institutional Aspects 48. PISO was incorporated on March 1, 1974 as a privately owned Invest- ment House. Its charter contains all the provisions normally associated with development financing/investment banking institutions. Its authorized share capital is P 100 million, and as of December 31, 1977, subscribed and paid-in share capital amounted to P 23.6 million (about $3.1 million). In addition, accumu- lated retained earnings as of the same date were about P 4.2 million, bringing the total equity to about P 27.8 million ($3.6 million). The sole foreign shareholder is the Private Investment Company for Asia (PICA) S.A.,/l which owns 33.6% of the outstanding stock. The largest domestic shareholder (the Inco Mining Corporation) owns about 19.5% of PISO's outstanding stock. /1 A Singapore-based multinational investment corporation with the objective of promoting privately owned productive industrial enterprises in Asia.  - 14 - 49. Given its relatively short operating life and the constraints on mobilizing long-term sources of funds, PISO's activities to date have been zonfined mainly to short-term financing operations, money market transactions and syndications. Short-term trading assets constitute the bulk of PISO's portfolio and are financed by short-term borrowings and equity. As of December 31, 1977, PISO's short-term investments and cash in hand and other current assets totalled P 119 million ($15.9 million equivalent) and consti- tuted about 95% of PISO's total assets. PISO has not yet undertaken any significant amount of long-term lending operations. It has, however, managed and/or participated in 11 syndications of long-term loans and has made one equity investment. In four of these syndications, it has approved loans from its own resources totalling P 21.3 million of which about P 7.1 million remained outstanding as of December 31, 1977. Of the 11 projects, 7 were new and 4 were "pioneering" ventures in product lines not previously established in the Philippines. PISO has also privately placed or underwritten common stock issues of a total value of P 8.7 million for three companies and has guaranteed part of three commercial loans for a total amount of P 7.5 million. 50. To provide the basis for an expanded long-term lending program, PISO has agreed to increase its net worth (share capital plus retained earnings) by at least F 10 million, which would increase its net worth to about P 37.8 million (Section 6.01(c) of the draft Loan Agreement). Concurrently, PICA's shareholding would be reduced to 30%. To encourage wider participation, individual domestic shareholding would be restricted to 15%. The Land Bank of the Philippines (LBP) is expected to subscribe to the new share issue (14.6%). LBP's participation is expected to be an interim measure to help PISO launch its expanded lending program. The Land Bank intends to divest its shares within the next 3-5 years and PISO's management plans to list publicly and trade its shares as soon as practicable within the same period. 51. Project Evaluation, Procurement and Disbursement Procedures. On the basis of a review of all of PISO's project appraisal reports and special market studies, the existing project evaluation capabilities appear to be of high quality. The reports reviewed, however, did not include economic evaluation of projects financed. Agreement was reached during negotiations that PISO would undertake economic rate of return analysis for all projects requiring investment of $750,000 and above (Section 2.02(b)(ii) of the draft Project Agreement). Apart from this, all appraisal reports would contain the usual partial economic indicators (i.e. value added, employment generated, foreign exchange savings realized, etc.). Consideration of technical aspects of projects requires strengthening and PISO plans to concentrate on improving this aspect of appraisal, using consultant services when necessary. While PISO's experience in supervision has been in the past relatively limited, its supervision procedures are soundly conceived and reports prepared are of good quality. PISO's procurement procedures help ensure that the right type of machinery and equipment is purchased at a reasonable price. It usually requires at least three competitive quotations, and its staff carefully checks the suitability of equipment. Disbursements are made after detailed scrutiny of supporting documents.  - 15 - 52. Management and Staff. PISO's Board of Directors comprises 11 seats, of which 9 are presently filLed. All board members are well qualified and complement each other in tenns of their individual and collective experience, industrial interests, and links with financial/business groups. The Chairman of the Board, Mr. Victor S. Barrios, who is also PISO's President and chief executive officer, is a prominent member of, and a leading spokesman for, the Philippine financial community. He has had considerable experience in development banking (for several years as a senior staff member with PDCP) and his ability and commitment to development finance are respected in both the private and public sector. He is supported by a well qualified top management team. 53. PISO's total staff numbered 55 as of March 15, 1978, with profes- sional and support staff being distributed on a roughly 7:3 basis. Since September 1976, PISO has been able to slow the relatively high turnover of staff by periodic adjustment of salaries and the provision of more diversified work assignments. PISO's staff are judged to be of high quality; its number has been increased by seven officers during the last six months which will enable PISO to deal with project evaluation/supervision workload likely to result from the availability of the proposed Bank loan. PISO expects to strengthen its staff further by recruiting approximately 8-10 additional employees by the end of FY78. Policies and Corporate Strategy 54. Since its incorporation, PISO has gradually been developing and refining a policy framework to guide its operations. With broad guidelines for corporate activity having been established at the outset by the Board, a series of specific policies governing day-to-day operations continues to be developed. These policies, however, are not embodied in PISO's present Policy Statement. PISO's management recognizes the usefulness of refining and expanding its Statement to incorporate and expand upon existing policies relating to the conduct of its operations and regulation of its financial affairs. Accordingly, PISO has revised its Policy Statement which was adopted formally by its Board on March 29, 1978. The revised Policy Statement outlines in specific terms PISO's operating and financial policies and procedures. This document is supplemented by a Corporate Strategy Statement which outlines the directions PISO proposes to take in the next three years and what it hopes to achieve in this period. The main features of PISO's strategy are to: (a) maintain its character as an investment house but with increasing emphasis on long-term financing; (b) increase the proportion of long-term assets to total assets from 2% in 1976 to about 50% by 1981; (c) diversify its portfolio with respect to industrial, geographical, and regional distribution and to restrict its exposure in any single industry to 30% of its outstanding long-term portfolio; (d) closely monitor security market conditions with the intent to list publicly its shares and widen its domestic ownership base; (e) diversify its long-term foreign and domestic resources; and (f) evaluate the contribution of all projects to the Philippine economy and where possible stress such particular development objectives as employment creation, export promotion and regional dispersal of industries.  - 16 - Financial Position and Performance 55. As of December 31, 1977, PISO's total assets stood at about P 125.5 million (about $16.7 million equivalent), of which almost all assets (95%) were classified as current assets. Its term loan portfolio remains relatively insignificant, accounting for only 5.7% of total assets. PISO's current ratio stood at 1.3:1 as of December 31, 1977, and its total debt/equity ratio at 3.8:1. Net income after provisions and tax was P 3.5 million which represents an increase of 49% over 1976 after a sharp reduction in 1976 of 22% from 1975. Return on average assets was 2.9% in 1977 as compared with 2.1% in 1976. PISO paid a 6% dividend (on par value) in both 1975 and 1976, and as of June 30, 1977, the book value of a PISO share was about 18% above par, after a stock dividend of 15%, reflecting PISO's retained earnings of about P 4.2 million. Since PISO has virtually no long-term portfolio, it has had no significant experience in dealing with the problem of arrears. However, it has adopted a prudent stance in determining the level of provisions for doubtful accounts and intends to increase the level of provisions annually at a rate commensurate with portfolio growth until the provisions correspond to at least 1.5% of total loan portfolio by 1981. Projected Operations 56. PISO's projected commitments for loans are expected to grow from P 8.8 million in 1977 to about P 42.8 million in 1978 and to P 180 million in 1981, while total commitments including guarantees and syndications are expected to grow from P 251.3 million in 1977 to P 416.3 million 1981. These projected targets are considered attainable, given PISO's institutional capability and its plans for staff increases. PISO's share of the market for long-term loans (from its own and borrowed funds) would gradually increase from 0.2% in 1978 to 1.5% in 1981. 57. On the basis of these projections, PISO's long-term loans would increase from only 4.2% of its total assets in 1977 to about 52% in 1981. Both its Policy and Strategy Statements call for the support of new entre- preneurs, of small-scale enterprises and of clients who do not enjoy ready access to financing elsewhere. However, as a newcomer to long-term financing, PISO will inevitably start with modest targets and will have to rely to a considerable extent, in the initial stages, on the financing of larger established companies. PISO expects to expand gradually its assistance to small-scale enterprises; while annual commitments to such enterprises are only expected to average 4.6% of total loan commitments, their share in terms of number of operations will increase substantially. This level of small business lending is considered reasonable at this stage of PISO's development.  - 17 - Resource Requirements and Projected Financial Position 58. During the period 1978-1981, additional domestic resources of about P 60 million are expected to be required and would be financed through additional paid-in capital, net collections, internally generated funds and refinancing from the IGLF for small enterprises financed under this facility. Foreign resource requirements during the period 1978-1979 are expected to be about $21 million (about P 157.5 million). The proposed $15 million Bank loan, and $2 million from the US Eximbank would meet the bulk of PISO's foreign currency requirements over that period. 59. PISO's total assets are expected to grow at an average annual rate of nearly 50% between 1978, and 1981, reaching P 626.3 million ($83.5 million equivalent) in 1981. PISO's total debt equity ratio will be below 10:1 up to 1981. According to the projections, the current ratio is not expected to fall below 1.2:1 while the debt service cover ratio is expected to decline from 3.1 in 1978 to 2.0 in 1981. Assurances have been obtained at negotiations that PISO would maintain a long-term debt equity limit of 4:1 and a total debt/equity ratio of 10:1 (Section 3.03 of the draft Project Agreement). In addition, PISO would continue to maintain debt service and interest coverage at satisfac- tory levels and would use as a guideline a 10% margin for the current debt service and interest coverage ratios. Net income is expected to increase from P 3.5 million in 1977 to about P 16.6 million in 1981, reflecting a yearly average increase of about 48%. The income contribution from the long-term portfolio is expected to increase from 8.8% of total income in 1977 to 67% in 1981. PISO's projections show gradually increasing net returns on average equity from about 13.3% in 1977 to about 25.7% in 1981. PISO intends to retain at least 40% of its net average earnings to strengthen its capital base, and its proposed dividend policy has been set accordingly. Justifications and Risks 60. The project wouLd help provide the needed resources for industrial development in the Philippines and would strengthen PISO's capacity for longer-term development lending. Although most of the proceeds of the proposed loan would be on]Lent to medium- and large-scale modern enterprises, the project would create the institutional basis enabling PISO in the longer run to expand its lending to more small-scale industrial projects. Apart from the normal difficulties that may arise in project implementation, because PISO is a relatively new entity, there are no special risks associated with the project. 61. The effectiveness of PISO and other development finance companies in the Philippines in mobilizing and allocating medium- and long-term finan- cial resources for the industrial sector, will depend to an important degree on the adequacy of measures, which the Government will need to adopt within the next few years, to resolve the broader financial and industrial sector issues referred to in Parit III. These sectoral concerns will form an important part of the continued policy discussions between the Government and Bank staff within the next year or two.  - 18 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 62. The draft Loan Agreement between the Bank and PNB, the draft Guarantee Agreement between the Republic of the Philippines and the Bank, the draft Project Agreement between the Bank and PISO, and the Report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement of the Bank are being distributed separately to the Executive Directors. 63. Special conditions of this loan are referred to in Section III of Annex III. An increase in PISO's equity by P 10 million has been made an additional condition of effectiveness of the proposed loan (Section 6.01(c) of the draft Loan Agreement). 64. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATIONS 65. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara by I.P.M. Cargill Vice President, Finance Attachments April 11, 1978  ANNEX I TABLE 3A Page 1 of 4 pages PHILIPPINES - SOCIAL INDICATORS DATA SHEET LAND AREA (THOU KM2) ------------------------ - -- _--------------- - ------------PHILIPPINES REFERENCE COUNTRIES (1970) TOTAL 300.0 MOST RECENT AGRIC. 109.6 1960 1970 ESTIMATE THAILAND IURKEY KOREA SOUTH ** _ _ -------------_------ --------__ ---_ ------_ ---_ --- -----_ _-_ ----__-- GNP PER CAPITA (USS) 140.0* 230,0* 410.0*/a 210.0 * 500.0* 280.0* POPULATION AND VITAL STATISTICS