Sri Lanka - Small and Medium Industry Project

Document of The World Bank FOR OFFICIAL USE ONLY FILE CrPY Report No. 2485-CE STAFF APPRAISAL REPORT SRI LANKA SMALL AND MEDIUM INDUSTRY PROJECT June 8, 1979 Industrial Development and Finance Division Projects Department South Asia Regional Office 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 authoriation.  CURRENCY EQUIVALENT Currency Unit = Sri Lanka Rupee US$1.00 = Rs 15.6 Rs 1.00 = US$0.064 ABBREVIATIONS ADB - Asian Development Bank BOC - Bank of Ceylon BRI - Building Research Institute BTT - Business Turnover Tax CBOC - Commercial Bank of Ceylon CISIR - Ceylon Institute for Scientific and Industrial Research DFCC - Development Finance Corporation of Ceylon DSI - Department of Small Industries GCEC - Greater Colombo Economic Commission GOSL - Government of Sri Lanka HNB - Hatton National Bank ICICI - Industrial Credit & Investment Corporation of India IDB - Industrial Development Board IDBI - Industrial Development Bank of India IPZ - Investment Promotion Zone MINSA - Ministry of Industry and Scientific Affairs MRI - Ministry of Rural Industrial Development MTI - Ministry of Textile Industries NAB - National Apprenticeship Board NDB - National Development Bank NERD - National Engineering Research Department NIBM - National Institute of Banking Management of India NIM - National Institute of Management NSB - National Savings Bank PMB - Paddy Marketing Board RRI - Rubber Research Institute Umbrella - United Nations Multi-Sectoral Program of Project Preparation UNDP - United Nations Development Programme FISCAL YEARS Government of Sri Lanka = January 1 to December 31 Commercial Banks = January 1 to December 31 DFCC = April 1 to March 31  FOR OFFICIAL USE ONLY SRI LANKA APPRAISAL OF SMALL AND MEDIUM INDUSTRY PROJECT Table of Contents Page No. I. BACKGROUND ........................................... 1 , II. SECTORAL BACKGROUND ............... 3 A. Economic Setting ................................ 3 B. Industrial Structure and Performance .... ........ 3 C. Characteristics and Role of SMI .... ............. 4 D. Industrial Policy Framework ..................... 6 E. Financing SMI .10 F. Technical Service Agencies .12 III. KEY SMI SUBSECTORS - PERFORMANCE, PROSPECTS, NEEDS ... 13 A. Rubber Products .14 B. Foundries and Light Engineering .15 C. Garments and Handloom Products for Export .16 D. Construction and Building Materials .18 E- Agroindustries ............................ 19 IV. THE PROJECT ............................ 21 A. Objectives, Scope, and Institutional Arrangements ..................... 21 B. Credit Component ...... ............... 24 1. NDB - Small and Medium Industry Fund .24 2. Special Facilities .29 3. Participating Credit Institutions .30 C. Technical, Marketing and Management Components 34 1. Industrial Development Board .35 2. Other Technical Service Components .38 3. Preparation, Coordination, and Monitoring 39 V. THE CREDIT .40 VI. PROJECT BENEFITS AND RISKS .44 VII. RECOMMENDATIONS .46 This report is based on the findings of an appraisal mission which visited Sri Lanka during March 1979. The mission comprised N. Barry, C. Bam, V. Goel, S. Kandel (Bank), C. Ahrens and L. Jordan (consultants). D. Cook, N. Barry, T. Russo (Bank), W. Armstrong, L. Jordan, M. Patel and P. Viloria (consul- tants) participated in the project preparation mission of November 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.  Table of Contents (continued) Annex 1 - Supporting Tables Table 1 - Indicators of Performance in Large, Medium and Small Industries Table 2 - Demand for Credit by Small and Medium Industry (1979-83) Table 3 - Interest Rate Structure of Credit Institutions Table 4 - Financial Projections Table 5 - Projected Disbursement Schedule Table 6 - Costs and Sources of Finance for Technical Service Components Annex 2 - Supporting Documents Available in Project File  SRI LANKA SMALL AND MEDIUM INDUSTRY PROJECT STAFF APPRAISAL REPORT I. BACKGROUND 1.01 The Government of Sri Lanka's recent policy reforms and increased * emphasis on expanding the private sector have created a climate in which prospects for efficient small and medium industry (SMI) development can be exploited. Accordingly, the Industrial Sector mission of April 1978 con- ducted initial analysis of the main SMI subsectors and institutions, and prepared an SMI Project Identification Report. An IDA credit was proposed to finance SMI subloans through commercial banks and to provide technical services in selected SMI subsectors through the Industrial Development Board (IDB) and other SMI institutions. In September 1978, GOSL requested an IDA mission to assist in the preparation of the SMI project. The mission of November 1978 found significant potential for expansion and upgrading in several SMI subsectors, and reached understandings with relevant ministries and potential implementing agencies on the design and organization of an SMI project which would address key constraints. The appraisal mission of February/March 1979 completed the necessary subsector and institutional analysis; reviewed the programs and organizational arrangements planned by the proposed implementing agencies; and reached tentative agreement on com- ponents, costs, and institutional responsibilities for the SMI project, sub- ject to review by IDA management. Negotiations were completed in May 1979. 1.02 The principal objective of this credit would be to address con- straints hindering rapid growth and productivity improvement of SMIs in order to increase their contribution to efficient and low cost employment genera- tion, export expansion and economic growth. This report appraises a credit of US$16 million; US$12 million would provide partial refinance for term loans made to SMIs, and US$4 million would finance (a) services to SMIs in selected subsectors, (b) training and advisors to build capabilities of credit and SMI technical service institutions and (c) policy studies on issues affecting expansion, export and efficiency prospects of SMIs. The project has major institution-building objectives. To increase viable SMIs' access to credit, an SMI Fund within the newly-created National Development Bank (NDB) would be established with the structure and resources to refinance SMI loans; the five major credit institutions would develop or expand SMI units at headquarters and in key branches with trained, specialized staff in SMI project appraisal and supervision; and attractive spreads and a modified credit guarantee scheme would increase incentives for credit institutions to expand SMI lending activity. Under the project, the main technical service agencies would focus on providing effective technical, marketing and management services to SMIs in subsectors with expansion potential. The IDB would upgrade its regional extension network, start a subcontracting exchange to link small manufacturers with public procurement and private contracts, and build subsector-specific schemes, staff and technical facilities in three major SMI subsectors. Three other technical service agencies would implement discrete subsector-specific components and provide management training.  - 2 - 1.03 Since success of the project would depend on capabilities and moti- vation of key personnel in the credit and technical service organizations, US$175,000 of the UNDP Multi-Sectoral Program of Project Preparation (Umbrella) has been allocated for short-term training prior to implementation of the SMI project. Selected staff of the financial institutions are receiving training on simplified SMI appraisal and supervision, and staff of IDB and other technical service institutions will be trained in subsector-specific extension methods. 1.04 Past Bank Group support for the industrial sector in Sri Lanka has comprised two loans and two credits to the Development Finance Corporation of Ceylon (DFCC), 1/ IFC equity in DFCC, and a recent IFC loan to the Bank of Ceylon. IFC has also recently approved investments in a synthetic textile mill and in polypropylene bag manufacturing plant. The Asian Development Bank (ADB) also has made a loan to DFCC. IDA and ADB loans to DFCC have been designed primarily to meet the credit needs of medium and large private indus- try, although recent loans have included components for smaller enterprises. The IFC US$2 million loan to the Bank of Ceylon is to finance enterprises with plant and equipment valued at less than Rs 6 million (US$385,000); 25% of the IFC loan is allocated to firms defined by GOSL as small enterprises. The IFC project encompasses organizational improvements in the Bank of Ceylon including the introduction of a management consultancy cell within the newly created Industrial Projects Department (para 4.22). 1.05 The SMI project would provide an opportunity to address several areas highlighted in a recent Industrial Sector Mission 2/ by financing studies to develop an appropriate tariff system and to extend export incen- tives; improving technical and financial assistance in construction and engineering industries; and providing technical assistance to the NDB. 1/ Credit 566-CE ($4.5 million) was fully authorized by December 31, 1977. Disbursements as of May 1, 1979 were $3.7 million, and the credit is expected to be fully disbursed by the closing date, September 30, 1979, with the exception of one subproject. The utilization of Credit 742-CE ($8 million) has been affected adversely by the unification of the rupee exchange rate in late 1977 (after the effectiveness of the credit), which reduced DFCC's exposure limit by almost 50%. Nevertheless, due to the positive private sector investment climate and DFCC's strong efforts, as of May 1, 1979, 37 subprojects for $5.5 million had been authorized, and the credit should be fully authorized by the final date, December 31, 1979. Disbursements as of May 1, 1979 at $2 million, were as projected at time of appraisal. DFCC's average equity and loan assistance per sub- project during 1978 and the first quarter of 1979 was Rs 1.3 million. 2/ The report of this mission expected to be available shortly for distribu- tion to the Executive Directors.  -3- II. SECTORAL BACKGROUND A. Economic Setting 2.01 While Sri Lanka has made substantial progress in the social fields, its ability to sustain these programs has been strained by low real GDP growth of about 3% p.a. during 1970-77. The poor economic performance during these years was due largely to inadequate investment in the key productive sectors, deteriorating terms of trade and inefficiency of public and private sector firms nurtured in a highly protected environment. Taking advantage of the post-1976 improvements in the trade balance arising from higher international prices for tea and rubber, the present Government, which assumed office in July 1977, liberalized the foreign trade and payments system, unified the exchange rate at a depreciated level, and encouraged the growth of the private sector by lifting many price controls. Response by the economy has been favorable with real GDP growing by an estimated 8.2% in 1978. The economic revival was broad based and diversified. Besides a record paddy crop, substantial gains were registered in manufacturing and construction output. However, gains in plantation crops and associated processing industries were lower than growth in real GDP. In 1978, coconut production was still some 20% below the average level of the 1960-65 period, largely as a result of inadequate producer incen- tives and declining fertilizer application. With the continuation and rein- forcement of economic reforms, prospects for higher rates of expansion in the medium term are good, provided adequate resources are available to finance the substantial public and private investment program. Acceleration in eco- nomic growth is a prerequisite for alleviating the serious unemployment problem which Sri Lanka is facing. B. Industrial Structure and Performance 2.02 Although Sri Lanka continues to be heavily dependent on agriculture, which in 1978 accounted for one-third of GDP and over one-half of employment, the potential of manufacturing industry, contributing about 13% to GDP and 10% to employment, has not been exploited fully. Industry comprises a regis- tered segment consisting of 29 large public sector enterprises and 7,700 private firms (of which only 5% have plant and equipment with book value of over Rs 1 million) 1/, and of an unregistered segment of some 20,000 small and cottage industries. Contributions to the total industrial value added are divided fairly evenly among public sector corporations (33%), private registered firms (33%) and unregistered small and cottage industries (34%). The largest product groups within the manufacturing sector are textiles, food processing and chemical industries, which in 1977 accounted for 74% of indus- trial value added of registered firms. 2/ The registered segment depends to 1/ Ministry of Industries, Private Sector Industries Approved up to December 31, 1978. 2/ Central Bank of Ceylon, Review of the Economy, 1977.  -4- a large extent on imported raw materials; for public sector enterprises and registered private firms, imports account for about 65% of the total value of raw materials used. The unregistered small and cottage industries are less dependent on imported inputs, since they produce a variety of goods which utilize domestic resources such as coconut fiber, rubber, wood and clay. Total manufacturing employment is estimated at 400,000 of whom about two thirds are in the unregistered segment. 2.03 After high growth in the late 1960s, based on import substitution, manufacturing output grew by only 1.8% p.a. in real terms during 1970-77. In the same period, construction activity registered an average negative growth rate of some 2.6% p.a. The poor growth performance of private industry during these years is attributed primarily to domestic market constraints and severe foreign exchange scarcities. The imposition of import controls and tight import rationing which favored public corporations further reduced growth in private industrial investment. At the same time, performance in public sector enterprises was constrained by overstaffing and poor management decisions stemming from excessive government involvement in day-to-day operations. 2.04 The major reforms introduced by the present Government already have removed some of the more serious obstacles to industrial growth and improved the investment climate. In 1978, real growth in industrial production, exclud- ing tea, rubber and coconut processing industries, was around 11%. Construc- tion activity grew by an estimated 28%. The recent industrial sector mission concluded that an industrial real growth rate of some 6-9% p.a. should be sustainable over the medium term, provided that: (a) further policy adjust- ments are made regarding trade and fiscal incentives, provision of industrial finance, and efficient administration of public sector enterprises; (b) gov- ernment planning and implementation capabilities are strengthened; and (c) priority is placed on the expansion of subsectors in which Sri Lanka has comparative advantage, particularly through the promotion of labor-intensive industries. In support of this development strategy, the proposed project 'would promote and help finance the creation, expansion, efficiency and exports of small and medium-scale industrial firms (SMIs). Emphasis on SMIs is warranted in view of their predominance in private industry, strong links with agriculture and other sectors, relative labor intensity, and potential for diffusing industrial development and diversifying exports. Furthermore, specialized systems for assisting SMIs are needed due to their more limited access to credit and need for management, marketing and technical services. C. Characteristics and Role of SMIs 2.05 Definition. For the purpose of fiscal incentives (para 2.12), GOSL presently defines SMIs as enterprises with less than Rs 1 million ($64,000) in plant, equipment, land and buildings, valued at original costs. The Ministry of Industries is proposing to change this definition to Rs 1 million ($64,000) excluding investment in land and buildings. This increase is considered to be  - 5 - justified and provides a sound definition for the SMI target group of the pro- posed project 1/ since: (a) cumulative inflation over the past years makes a definition of Rs 1 million in total fixed assets too restrictive for efficient operations in some SMI product groups; (b) expansion of existing SMIs should be encouraged; and (c) SMIs with up to Rs 1 million in plant and equipment are judged to be those for which simplified appraisal techniques and outside tech- nical services are relevant. Based on this new definition, the SMI sector - would include some 90% of registered private firms and all unregistered firms, account for about three-quarters of industrial employment in Sri Lanka and contribute over one-half of industrial value added. The same definition is appropriate for SMIs in construction contracting and quarrying, which are not covered by fiscal incentives. 2.06 Geographical Distribution. About 70% of the registered SMIs are in and around Colombo, with secondary concentrations in the Kalutara, Kandy, Matara, Jaffna, Galle and Kurunegala districts. Unregistered small and cottage industries are more widely dispersed among small towns and villages, the Colombo district representing only about 30% of the total. Regional industrial dispersal is one of the prime objectives of the present Government. However, potential in rural areas is limited largely to agro-industries, construction, and some cottage industries; potential in secondary towns is greater if access to institutional finance and technical and marketing services is increased. 2.07 Subsectoral Distribution. The principal SMI subsectors, which together account for 88% of employment and 84% of investment in registered SMIs, are textiles and garments, light engineering, paper products, rubber and chemical products, food manufacturing and wood products (Annex 1, Table 1). Subsector distribution of unregistered small and cottage industries is similar although their products are simpler, e.g. handloom textiles, jaggery, bricks, pottery, wood and coir items. SMIs presently account for roughly 80% of employment and 70% of investment in private construction contracting. 2.08 In most of these subsectors, significant expansion opportunities exist for SMIs in selected products or services (Chapter III), based on export potential and increased domestic demand for consumer goods and construction materials with the higher rate of economic expansion. Prospects in several SMI subsectors with growth potential are linked closely with other sectors of the economy. For example, potential for significant expansion of agro- processing activity is linked to increased paddy production and availability of coconut husks and seafood. Similarly, the extensive public investment in agriculture is expected to generate additional demand for tools, spares, repair services and construction contracting. Subcontracting between SMI firms and larger private and public sector enterprises, which is less devel- oped, has considerable potential. 1/ For the purposes of this IDA project, SMIs include those in manufacturing, quarrying, construction, agroprocessing, cottage industries and certain industrial services. SMIs eligible for subloans are those with original cost of plant and equipment below Rs 1 million.  2.09 Export Potential. Dependence on exports of tea, rubber and coconut has been decreasing in the past years. Nevertheless, non-traditional industrial exports in 1978 accounted for only 9% of the total value of exports although this represented an increase from 6% in 1977. 1/ The share of SMIs in the total value of non-traditional industrial exports increased from 7% in 1977 to 10% in 1978. Although many SMIs produce goods which could be internationally competitive, they find it difficult to establish direct contacts with foreign buyers and to obtain adequate information on export market requirements. However, SMIs have significant potential as indirect exporters, manufacturing components and finished products for larger manufacturing and marketing con- cerns. 2.10 Performance and Efficiency. In 1977, SMIs on average made gross earnings roughly equivalent to 34% of total sales 2/ and 40% of total investment. 3/ SMIs can be efficient in several labor-intensive product lines for which no major economies of scale exist. In the principal subsectors, SMIs compare well with larger private and public firms in terms of efficient use of capital and labor. Capital/labor ratios in all major SMI subsectors are lower (Annex 1, Table 1) and value added per unit of labor and capital cost 4/ higher than in the larger firms. Nevertheless, many SMIs will need to upgrade productivity, product quality and capacity utilization to operate profitably in a liberalized environment. For this purpose, SMIs will require: better access to credit for inputs and fixed investments; and technical assistance to plan investments, improve production methods and take advantage of domestic and export market opportunities. The proposed project is designed to help SMIs overcome these constraints. D. Industrial Policy Framework 2.11 The Government is aware of the need to supplement the reforms it has introduced with further policy measures to stimulate more rapid growth of out- put, savings and exports. The medium-term development strategy outlined in the 1978 Budget Speech and in the Medium Term Development Plan (1979-1983), affords industry and specifically SMIs an important role. A detailed review of Sri Lanka's industrial policies was made by the 1978 industrial sector mis- sion. The Government has indicated its broad concurrence with the mission's recommendations for further policy adjustments and already has taken a number of steps to implement suggested changes, e.g. reductions in import tariffs and 1/ Commerce Department, Ministry of Trade, Trade Statistics 1978. 2/ While this figure appears high, it is important to note that some SMIs employ several family members who are paid out of profits rather than receiving wages. 3/ Total investment equivalent to fixed investment and permanent working capital. 4/ Assuming a cost of capital of 15%.  - 7 - commitment to developing a more rational tariff structure (para 2.18), moves to equalize export incentives to firms on and off the Investment Promotion Zone (IPZ) (para 2.15), and development of the proposed SMI project which was identified during the Industrial Sector mission. General policy areas of relevance to SMIs and proposed studies to be financed under the SMI project, summarized below, were discussed during negotiations. 2.12 Fiscal Incentives. A major problem with the fiscal incentive system prior to 1978 was its complexity, resulting from a multiplicity of over- lapping incentives, the high level of the Basic Corporate Tax, and the cascad- ing effect of the Business Turnover Tax (BTT). The present system, which already incorporates some of the 1979 Budget proposals, is simpler. Within the system, features of relevance to SMIs are: a five-year tax exemption on profits of up to Rs 200,000 for new SMIs outside municipalities, an eight-year tax exemption on export profits for firms established after 1972, and a duty rebate on imported components of exported items. 1/ The Ministry of Indus- tries recently proposed some differential incentives for SMI. 2/ However, such differential incentives are likely to encourage inefficiency and diminish the positive impact of import and price liberalization on the domestic allo- cation of resources. During negotiations, GOSL confirmed that it would continue to exchange views with IDA regarding the development of incentives affecting SMI. 2.13 Instead of introducing differential incentives for SMI, the present system of fiscal incentives could be extended to include tax exemptions on a portion of profits of (a) existing SMIs outside municipalities which expand, provided they still qualify under the agreed SMI definition; (b) industries established prior to 1972 if they expand or modernize to meet export orders; and (c) local manufacturers supplying components or finished products to manufacturing or commercial exporters, based on their relative shares in the domestic value added of the exported goods. Also, import duty rebates and refund of the BTT could be extended to SMIs subcontracting to exporters. 3/ The proposed project would finance outside assistance to analyze the admin- istrative and technical feasibility of extending fiscal incentives to firms 1/ The total amount of customs duties levied on raw materials imported to manufacture an export product is expressed as a percentage of the FOB value of the product so exported, and this amount is refunded. 2/ Including preferential pricing in public procurement, reserved product groups, and scaling of fiscal incentives according to SMIs' location in four regional development zones. 3/ The refund of the BTT on export sales and its general reduction from a maximum of 35% to a maximum of 10% of sales have been proposed in November 1977.  - 8 - which expand and to subcontractors providing components or finished products to exporters. 1/ 2.14 Export Promotion. To encourage direct and indirect exports by SMIs, intensified export promotion policies are necessary. At present, there are numerous agencies involved in export promotion and regulation. To consolidate these efforts, the Sri Lanka Export Development Board was established recently under the chairmanship of the President. The Board, which is expected to have wide powers and substantial human and financial resources, should help overcome some of the problems of small exporters. Export market studies already planned by the Board include major SMI subsectors as well as potential sub- contracting links between exporters and local SMIs. 2/ 2.15 A further element in the Government's export strategy was the estab- lishment of the IPZ in 1978, aimed at attracting foreign investors by granting a generous package of incentives. The initial response to the IPZ has been good, with 118 inquiries and 48 approvals during 1978. A few firms have already begun operations. Subcontracting by SMIs to firms within the IPZ offers limited promise in the short run since most IPZ firms will have international procurement and sales contracts. However, subcontracting opportunities are expected in certain product groups, and SMIs would need better information on IPZ requirements, and increased access to fiscal incentives to compete with duty free imports of inputs into the IPZ. 2.16 Public Sector Procurement and Subcontracting. Within the present industrial structure in Sri Lanka, considerable potential exists for SMIs to expand markets through increased access to public sector procurement and through subcontracting to larger private manufacturers and commercial firms. Analysis conducted by the appraisal mission indicates that SMI access to public sector purchasing contracts and tenders could best be increased by improved information about public procurement opportunities and by helping SMI improve the quality of their products, rather than through preferential pricing for SMI products. In supplying the public sector, SMIs could increase their sales of such items as equipment spares, educational supplies, and building materials. In subcontracting to private firms, major potential exists in garment accessories, construction contracting, and rubber products. Under the proposed project, IDB would establish a subcontracting exchange to 1/ Terms of reference and administrative arrangements for this study were discussed during negotiations; timing, terms of reference, and admin- istrative arrangements will be finalized after GOSL takes decisions on revisions of the Business Turnover Tax and fiscal incentives, which are under preparation. The estimated requirement for outside technical assistance is one manyear. 2/ The Export Development Board already has arranged financing for export studies and promotion through the Swedish International Development Agency (SIDA); if additional financing is required for export studies relating to major SMI subsectors (e.g. rubber products) this could be covered from the discretionary fund of the SMI project (para 4.04).  9 help link SMIs with government and private purchasers (para 4.39). Management of the IPZ has agreed to communicate to IDB details on the quantities and quality of input requirements by firms on the IPZ. 2.17 Rationalization in Public Sector Enterprises. Several public sector enterprises are engaged in jobbing operations with short production * runs or subsidiary activities which require excessive management time. Some of these activities could be performed more efficiently by private SMIs. The Ministry of Industries would need to analyze the production mixes of selected public sector corporations (e.g., Hardware, Steel, Leather, Ceramics) to determine the degree to which they could concentrate on major items requiring long runs and large equipment. This could increase the efficiency of the corporations while expanding the scope for private SMIs. Rationalization could be an important aspect of a larger strategy and efficiency study on selected public sector corporations; this is planned as part of the IDA industrial sector work program. 2.18 Import Liberalization and Tariff System. During 1970 to 1977, the exchange and trade system, which was introduced in the late 1950s to promote import substitution, depended primarily on severe quantitative restrictions imposed through import licensing. Since late 1977, quantitative restrictions were removed for the majority of imports and protection was based mainly on tariffs. The new schedule includes a low duty band covering essential con- sumer goods, most raw materials, spares and machinery, a common "revenue rate," a high duty band for goods for which adequate production capacity in Sri Lanka exists to meet domestic demand, and a prohibitive rate on certain luxury goods. Although the overall level of nominal protection has been reduced significantly, protection still remains high. 1/ 2.19 Designing an appropriate tariff system has been a major concern of the new Government. A Tariff Review Committee, set up in October 1977, has been reviewing selected industrial duty rates and making subsequent adjust- ments based on justified representations by domestic producers, importers and consumers. However, the Committee has not yet done a systematic evalua- tion of the representations. In late 1978, the establishment of a Presidential Tariff Commission with a permanent Secretariat was approved by the Cabinet, with the objective of designing a tariff system based primarily upon the principle of effective protection. Financing is provided under the proposed * project for 2 manyears of outside assistance to the Commission. 2/ Work on the tariff system should be closely coordinated with the Sri Lanka Export Development Board, since the terms of reference of these two central agencies overlap on all issues regarding export incentives and promotion. Discussions 1/ When the group averages of nominal rates are weighted -by their corres- ponding import volumes and aggregated, the overall weighted nominal rate is about 50%. 2/ During negotiations, terms of reference for the study were discussed and agreement was reached on timing for the study and the substance of the terms of reference.  - 10 - between the appraisal mission and a large number of small entrepreneurs, the Tariff Review Committee and other government agencies, indicated that SMIs have responded well to import liberalization. Nominal rates of return were in most cases above 25% before tax, indicating that further reductions in protective tariff rates would be feasible. Better access to imported raw material and equipment and the buoyant domestic market generally have compen- sated for any reductions in output prices to compete with imports. Only a. small number of SMIs involved either in inefficient assembly operations (e.g., bicycle assembly) or in uncompetitive production processes (e.g., standard handloom cloth for local markets) are experiencing serious difficulties. E. Financing SMI 2.20 Since import liberalization, demand for credit by all sectors of the economy has increased rapidly. During 1978, total credit by the banking system rose by 44%, whereas total deposits increased by only 30%. In addition to the sharp increase in the financing needs for trade and imports of raw materials and intermediate goods, bureaucratic delays in the disbursements from the Central Bank's refinancing scheme and the the contractionary effect of government operations contributed to a significant liquidity squeeze in the second half of 1978. As a result, the banks' loan/deposit ratio increased from 0.85 at the end of 1977 to 0.94 at the end of 1978 with most banks exceed- ing their credit ceilings with the Central Bank. In 1978, total industrial credit expanded sharply and accounted for 27% of total credit. However, due to heavy bank lending to public sector corporations, lending to private industry decreased from 55% of total industrial credit in 1977 to 45% in 1978. 2.21 Of the institutional finance in Sri Lanka, about 85% of industrial lending is provided by commercial banks, the remaining 15% being supplied by the Development Finance Corporation of Ceylon (DFCC) and smaller finance com- panies. Of the 11 commercial banks operating in Sri Lanka, 4 are domestic and 7 are foreign. 1/ The two state-owned commercial banks, People's Bank and Bank of Ceylon (BOCT, have extensive branch networks and account for more than 90% of industrial credit by the banking system. The two principally private domestic banks, Hatton National Bank and Commercial Bank of Ceylon, are much smaller but expanding. Most of the industrial credit is in the form of short-term loans and overdrafts, with medium and long-term lending amounting to about 20% of the total. 2.22 The Government recently has passed legislation establishing a new National Development Bank (NDB); its primary roles are to finance public sector enterprises directly and to promote small enterprise lending. GOSL intends to use NDB to provide more objective and systematic evaluation of investment proposals by public sector corporations and to review appraisals and provide refinance for SMI loans by the credit institutions. The chairman and general 1/ The foreign banks concentrate mainly on foreign trade financing.  - 11 - manager have been appointed and are working on organization, staffing and operational policies and on selecting key managerial and technical staff. The proposed project is designed to assist the NDB in developing its SMI refinancing activities and overall operations (paras 4.06-4.17). 2.23 For the past three years, People's Bank and BOC have been partici- pating in a Joint Credit Scheme with the IDB. Under this scheme, IDB has formulated and appraised projects, and recommended them for bank financing. While the scheme has helped to improve access to credit by a number of SMIs, it has not proved satisfactory and would be terminated with the initiation of the project. The participating banks are critical of the lack of objec- tivity and thoroughness of IDB's appraisals, since they carry the risk of the loans. Most commercial bank lending to SMIs has been independent of the IDB Joint Scheme. In their own lending decisions, commercial banks use fairly conservative lending criteria based more on collateral than on project evaluation. As a result, SMIs have difficulties in securing credit. Due to its limited rupee resources and lack of a branch network, DFCC has con- centrated mainly on lending foreign exchange resources to the larger firms although DFCC has been increasing its SMI lending activities (para 1.04). 2.24 In response to the liberalized investment environment, credit to SMIs, which accounts for about 7% of lending to private industry, increased by some 50% in 1978, mainly for working capital. An estimate of potential demand for financing by SMIs has been made in Annex 1, Table 2, based on conservative assumptions regarding the economic rate of growth of the sector (6.5% p.a.), the incremental capital/output ratio (ICOR) and permanent working capital requirements. Total investment requirements by SMIs are estimated to be about Rs 2.8 billion from 1979-83. In the past, credit institutions covered about 20% of private industries' financing requirements, with a traditionally high percentage of self-finance. 1/ Assuming that the proposed project would increase access to institutional credit by SMIs, it would be reasonable to anticipate that about one-third of total SMI financing require- ments could be covered by the credit institutions. Taking into account anti- cipated levels of international and domestic inflation, credit demand by SMIs could amount to roughly US$12 million per year in current prices. 2.25 In 1978, commercial banks and DFCC lent about US$3 million to SMIs in term credit. The banking system's resource constraints and increased requirements for other purposes are expected to limit its ability to sustain a significantly higher level of SMI lending in the medium-term, particularly since it will take time to change conservative banking attitudes and increase SMI project appraisal capabilities. Assuming that the banking system will be able to maintain its present level of financing in real terms from its own 1/ The 1966/67 investment survey by the Central Bank showed that excluding stocks and trade credits, self-finance accounted for about 63% of invest- ments, while the banks accounted for 21%. While these figures clearly are out of date, interviews with businessmen and banks suggest that pri- vate industry, and especially SMIs, still rely heavily on self-financing.  -12 - resources (i.e., on the average US$4.5 million per year in current prices), the financing gap could amount to US$7.5 million per year, or US$22.5 million over the period 1980-82. The project would provide US$12 million to cover only part of this potential financing gap since the banks and technical service agencies need to build progressively their capacity to handle a higher level of operations. Subsector analysis indicates that most demand for credit is expected to be generated in construction and building materials, metal and rubber products, and agro-industrial SMIs. 2.26 Interest Rates and Inflation. Annex 1, Table 3, shows the present interest rate structure in Sri Lanka. As part of the recent policy reforms, interest rates were raised substantially to prevent possible capital outflow after the liberalization of foreign exchange controls, to reflect the higher rates of inflation expected during the transition to a more open economy, and to stimulate medium-term private savings. Commercial banks now pay 7.2% on savings deposits and 8.5% to 15% on time deposits. I/ Due to liquidity prob- lems and the rising cost of funds, most banks increased their effective lending rates during 1978. In most cases, they charge 13% to 18% on industrial term loans, including loans to SMIs. 2.27 Several price indices are used in Sri Lanka. According to the most reliable one, the unpublished Central Bank index, between December 1977 and December 1978 the inflation rate amounted to some 14%, mainly reflecting the reduction in food subsidies, relaxation of domestic price controls, and increased cost of some imports following the devaluation of the rupee. With further price adjustments on the producer and consumer levels and subsidy reductions planned by the Government in the next three years, it is expected that the annual rate of inflation will decline gradually to international levels by 1981. At the projected rates of inflation, on-lending interest rates of the major credit institutions are expected to remain positive in real terms. F. Technical Service Agencies 2.28 Sri Lanka has a number of institutions which provide managerial, technical, and training assistance to SMIs. While their services are useful, the effectiveness of these agencies is constrained by unclear assignment of responsibilities, shortages of trained personnel, and inadequate technical service facilities. The IDB, an agency of the Ministry of Industries and Scientific Affairs (MINSA), is the principal SMI development institution responsible for promoting and assisting all SMI subsectors other than tex- tiles and cottage industry. The IDB is a well-established agency, but needs to strengthen promotional activities and subsector services at headquarters 1/ The highest desposit rate is 18%, offered by the National Savings Bank (NSB) on 18 month's term deposits. The resources of the NSB are loaned to the Government at a negative spread to finance the public investment program.  - 13 - and key districts, moving from its recent focus on loan-related activities. 1/ The Department of Small Industries (DSI), responsible for cottage industry development, recently has been shifted from MINSA to the newly established Ministry of Rural Industrial Development (MRI); DSI, which will continue to concentrate on household industries, could improve its impact by providing services to craftsmen rather than limiting its efforts to DSI-owned produc- tion facilities (para 4.42). The Ministry of Textile Industries (MTI) formulates policy and implements programs in the textile and garment sub- sector; the Department of Textile Industries (DTI) under MTI, which is responsible for development of the handloom industry, plans to increase collaborative arrangements with private exporters (para 4.41). These are the principal agencies currently providing technical services 2/ to SMI, although other ministries are providing some assistance to agro-based indus- tries. Training programs are concentrated in two main agencies: the National Institute of Business Management (NIBM), under MINSA, provides production and financial management courses; and the National Apprenticeship Board (NAB), under the Ministry of Youth Affairs and Employment, arranges supervised, paid apprenticeships with private industry in a range of trades. The SMI project would help increase the effectiveness of these agencies, and improve deline- ation of responsibilities and coordination among credit and SMI technical service institutions. III. KEY SMI SUBSECTORS - PERFORMANCE, PROSPECTS AND NEEDS 3.01 A major objective of the proposed SMI project is to address speci- fic technical, marketing and management problems of SMIs in subsectors with sig- nificant expansion potential and economic impact. Identification, preparation and appraisal missions conducted detailed analyses in major SMI product groups: rubber products, foundries and light engineering, construction and building materials, garment ancillaries and handloom products for export, and selected *agroindustries. The purpose of these subsector analyses was to: (a) assess the role, performance and potential for SMIs in these product groups; (b) determine major constraints hindering growth; (c) analyze the existing policies and institutional constraints affecting the subsector; 1/ IDB's heavy involvement in credit operations has diverted staff attention from IDB's primary role in promotion and technical assistance to SMIs. 2/ Several research institutions have equipment and some staff that could be useful in SMI development. However, the orientation and experience of most staff is academic, morale is low, and the practical output of these organizations is limited; while an SMI program should improve coordination between technical assistance and research and development (R&D) agencies, these agencies as presently structured have limited potential for direct assistance to SMIs.  - 14 - (d) develop technical and marketing components to assist viable SMIs in selected subsectors; and (e) estimate the demand for institutional term credit for SMIs. 3.02 This work indicated that in several product groups, SMIs could be efficient and labor intensive in meeting increased local or export demand provided that specific constraints were alleviated. The proposed SMI project, outlined in Chapter IV, would address several of these technical, marketing, and management problems, building on some existing programs of IDB and other agencies. This Chapter summarizes the missions' findings on performance, prospects, needs and existing programs in these subsectors. Estimates of demand for institutional credit by subsector are provided; the credit compo- nent would help fill a significant portion of potential credit needs of these subsectors, estimated at US$12.0 million p.a. No subsector allocations are proposed under the credit component of the SMI project; credit would be available to SMIs in a broad range of product and service groups, provided they meet financial and economic viability criteria (para 4.11). Detailed working papers on each subsector are available in the project file. A. Rubber Products SMIs 3.03 Performance and Prospects. Less than 3% of Sri Lanka's rubber output is used by local rubber product manufacturers, in spite of Sri Lanka's comparative advantage in rubber product manufacture. There are about 200 registered private firms, of which all but 7 are SMIs, and several hundred unregistered units. 1/ SMIs account for over 80% of output and employment. Most units have less than Rs 200,000 invested in plant and equipment; fixed costs (book value) per job average about Rs 6,000; and value added/capital averages 2.1 vs. 1.2 in larger units (Annex 1, Table 1). Registered private units produced over Rs 90 million of rubber products in 1977, mainly tubes, footwear, rubber toys, and rubberized coir products. Exports totalled about Rs 10 million in 1977, up from Rs 2.5 million in 1976 and Rs 0.2 million in 1975. Imports in 1977 were about Rs 22 million. 3.04 Sri Lanka has a comparative advantage in the manufacture of latex and dry rubber products derived from low labor costs and easy access to rubber. Labor-intensive processes are suitable for most non-tire products; fixed costs per job would be well under US$1,000 for new or upgraded firms. With a 4:1 ratio of unskilled to skilled workers, absorption of unskilled labor is high with expansion. Raw materials represent 55-60% of costs in most rubber products, of which 60-85% is dry rubber or latex. Dry rubber and latex are available locally at about 50% of international prices, and with liberalization non-rubber inputs can be imported with 5% duty. With planned expansion of centrifuged latex capacity, there should be no constraints on the availability of industrial rubber. While rubber must compete with synthetics 1/ IDB Survey of Rubber Product Industries, 1976-77.  - 15 - in some product groups, rubber has superior characteristics for several items (e.g., sporting goods, gloves, rubber bands), and in areas of substitutability, the increased costs of petroleum-based synthetics often give advantages to using natural rubber. SMIs can be efficient export-oriented units for a range of items including footwear, toys, sporting goods, gloves and rice rollers. There also is untapped potential for upgraded SMIs to substitute for at least half of rubber product imports. The minimum economic size for units making most molded rubber and latex products is Rs 300-700,000 in plant and equipment. 3.05 Needs to be met for SMIs to realize these export and import substi- tution possibilities are technical, input supply, marketing and credit. In a survey by IDB, about 90% of rubber product SMIs expressed a need for technical advice and product testing facilities. With liberalization, imports of non- rubber raw material are permitted, but quantities required by SMIs often are too small for direct imports to be economical; also, most small firms do not have mixing mills and require outside services for supply of properly mixed compounds. In marketing, medium scale industries could export directly if quality, packaging and market information were improved, but smaller units will depend upon subcontracting links with larger manufacturers or commercial exporters; it probably is advantageous for the smallest units to build quality through efficient import substitution first, becoming attractive as export subcontractors in the future. Finance for modernization, expansion and working capital was a felt need for about 70% of the rubber product SMIs covered in IDB's survey; most firms are undercapitalized, having had to improvise with local equipment during the period when imports were restricted. 3.06 Service and Financing Requirements. IDB has initiated sales of quality rubber and latex compounds to small units and specialized technical services on mold use, methods and product upgrading. IDB's program is new, with about 60 SMIs receiving technical assistance and about 25 buying com- pounds and centrifuged latex. In the past, IDB has utilized the facilities of Ceylon Institute for Scientific and Industrial Research (CISIR) and the Rubber Research Institute (RRI), but these facilities are inadequate for rubber product testing, institutional priorities focus on theoretical research and as a result, there are considerable delays in servicing private industry. The Cabinet has approved the establishment of a Rubber Products Technical Service Center under IDB which could more than triple the coverage of the raw material supply program, provide facilities suitable to SMI material and product testing needs, and have more trained staff to increase effectiveness of specialized technical and marketing services. The SMI project would help finance this Center (para 4.36). With the impetus of these technical, raw material supply, and marketing services, it is anticipated that in 1979-83, roughly US$1 million p.a. would be required in institutional credit to meet fixed and permanent working capital requirements for new rubber products firms and expansion of existing units which expand. B. Foundries and Light Engineering SMIs 3.07 Performance and Prospects. In most metal product groups, SMIs con- stitute over 70% of output, investment and employment. There are about 1,000  - 16 - registered metal product SMIs, mainly making fabricated metal products, trans- port equipment spares, electrical goods, and foundry products. 1/ These units employ about 20,000, with average fixed investment (book value) per job of Rs 4,400 in fabricated metal products, Rs 4,800 in transport spares, and Rs 4,500 in electrical goods. In addition, there are over 2,000 unregistered 2/ metal product firms, mainly blacksmiths (60%) and repair workshops. In fabri- cated metal products, electrical accessories, and transportation equipment and spares, registered SMIs have significantly higher value added/capital ratios. Findings of preparation and appraisal missions indicate that signi- ficant expansion or upgrading potential exists in: ferrous and non-ferrous foundries; repair workshops; and firms making motor and textile machinery spares, agricultural implements, water pumps and electrical fittings. Prospects are based on growth in local demand (with increased industrial, construction, and agricultural activity), provided that productivity, price and quality of local products are improved. Most metal product SMIs have established wholesale channels; there is some scope for facilitating public procurement and private subcontracting. Export potential is limited since metals are imported and competing countries have production and marketing economies of scale. 3.08 Service and Financing Requirements. In ferrous and non-ferrous foundries, technical facilities and services are required to improve quality control, material use, and patterns. These needs could be met by IDB in cooperation with the newly established Foundry Association, composed of large, medium and small foundries. SMIs making motor spares, which will continue to meet needs of older vehicles, require technical extension and selective mod- ernization to upgrade quality and reduce costs. In implements (hoes, shovels and wheelbarrows), quality is poor and with expanded demand in public works, construction and agriculture, expansion and quality improvement are priorities. Promotion of regional repair workshops is needed to cope with increased demand for servicing vehicles and agricultural equipment. While other organizations can offer useful R&D, IDB is the organization best suited to provide common facilities and technical services to metal product SMIs; the proposed SMI project would help build these services (para 4.37). Credit requirements from 1979-83 could be about US$1.5 million p.a. C. Garments and Handloom Products for Export 3.09 Garments - Performance and Prospects. Sri Lanka's garment industry consists of about 60 medium and large scale units and over 1,000 small garment and tailoring operations. In addition, 26 of the 46 projects approved for the IPZ and about 10 of the 26 approved joint ventures outside the IPZ are export-oriented garment manufacturers. Over the last five years, Sri Lanka's garment exports have increased rapidly from Rs 6.2 million in 1972 to about 1/ IDB, 1976-77 Survey of Registered SMIs. 2/ IDB, 1975-76 Survey of Unregistered SMIs.  - 17 - Rs 300 million in 1978, mainly in shirts and blouses. However, existing and threatened quotas make future growth prospects uncertain. Smaller, locally owned units account for about 20% of exports. While perhaps 100 SMIs could be efficient export-oriented subcontractors with marginal upgrading, rapid increases in large scale garment production are likely to cause a decrease in SMI export share; established garment manufacturers are experiencing an exodus of supervising staff, cutters, pattern-makers and sewers to the IPZ and other new firms. Potential appears greater for promotion of SMI ancillaries to make non-textile inputs for garments (buttons, zippers, hangers, labels, packing materials) since an average of 40% of raw material costs for garments is in non-textile inputs. At present, all but polyethylene bags are imported; labor, representing 15-20% of production costs, constitutes the only significant value added locally in garment making. 3.10 Service and Financing Needs. The rapid expansion of the garment industry will necessitate training, particularly for production foremen, cut- ters and pattern-makers. The Ministry of Textile Industries (MTI) plans to establish a Textile Research and Training Institute which would incorporate training and technical assistance to small, medium and large garment units. This garment training center would receive support under the SMI project (para 4.40). It is likely that over the next four years, at least 400 cut- ters, 200 pattern-makers and 300 production supervisors could benefit by short, practical training in basic skills and upgrading of methods. Ancillary industries manufacturing inputs for garments could require roughly US$1 mil- lion p.a. of institutional credit p.a. between 1979-1983. 3.11 Handloom Products - Performance and Prospects. With elimination of previous protection for handloom products, many units find it difficult to compete with imported and local milled cotton and synthetics for standard cloth requirements. The Department of Textile Industries (DTI) estimates that only 30% of the total 150,000 weavers are working, each producing an average of 580 yards a year, with monthly earnings of about Rs 100. It is likely that handloom products will continue to have difficulty competing for standard cloth requirements, particularly with private management contracts and replacement of equipment in the mill sector. DTI projects stagnation in local sales of handloom cloth, with about 35 million yards annually from 1979 to 1982. Export prospects for higher quality handloom products for specialized markets look more promising. Cotton has proved resilient in the battle with synthetics and India has enjoyed a 700% increase in handloom product exports during the last five years. However, India has a mixed reputation for quality and reliability and its product mix is narrow; since handloom production is limited largely to South Asia, there is scope for Sri Lanka to share in this market. One major potential market is handloom cloth for Sri Lanka's garment export industry which uses Indian handloom fabrics for about 15% of its cloth needs. 3.12 Service and Financing Requirements. At present, exports of hand- loom goods from Sri Lanka are limited to about 10 private firms concentrated in and around Colombo. Unlike India, there is no well-established network of private exporters, middlemen and master weavers providing orders and tech- nical and raw material organization; DTI's attempts to provide such services  - 18 - have had limited success due to constraints in staffing and rapid decision- making within a government department. It would be useful to mobilize market- ing and technical expertise of the leading handloom exporters to extend the production network to rural areas. DTI is proposing that a private limited company with minority government shares be established for this purpose (para 4.41). It probably would be sensible to set up or expand rural units to 25-50 looms due to warping equipment and overhead economies. Estimates indicate that such ventures could have a return on capital of at least 20%, with cloth priced competitively. Export handloom product firms could require roughly US$0.5 million p.a. of institutional term credit from 1979-83. D. Construction and Building Materials 3.13 Performance and Prospects. Programs under the Medium Term Devel- opment Plan and the Government's policies toward private investment have resulted in a considerable increase in demand for construction contracting and building materials. While construction experienced a real decline of 2.6% p.a. in 1970-77, value added exceeded Rs 1.5 billion in 1978, up more than 20% in real terms over 1977. 1/ Public sector entities accounted for about one third of the Rs 3 billion of gross output of construction during 1978; the remaining two thirds was divided among roughly 6 large, 15 medium, 200 small and 5,000 own-account contractors. Similarly in building materials, public corporations are dominant in some basic items (e.g., cement, steel and plywood), but private building material firms consist almost entirely of SMIs. Small industries are particularly active in the manufacture of bricks, tiles and tools, and in the extraction or processing of sand, gravel, and rocks. To meet the Rs 39 billion demand for construction implicit in the Medium Term Development Plan, the 1978 construction output would have to be tripled by 1983 and value added increased annually by 18% in real terms. GOSL expects construction activities to generate over 200,000 jobs in the same period. Growth in the public sector is constrained by several factors and most increases in construction capacity is expected to come from the private sector. Small contractors and building material manufacturers could have a major role in this growth. The Accelerated Mahaweli Ganga Development Program and other irrigation programs will require large quantities of small tools and wheel- barrows and thousands of contract groups removing trees, digging channels, rocklining spillways and building shelters. To meet demands of GOSL's program for 100,000 houses and private residential and factory construction needs, SMI contractors and building material manufacturers will need to expand, improve methods and increase access to credit and contracts. 3.14 Services and Financing Needs. From 1970 to 1977, stagnation in the construction industry resulted in little new investment and poor maintenance of equipment. With their eroded asset and savings base, most SMIs cannot finance expansion internally and find it difficult to meet credit institutions' collateral and equity requirements. In addition to credit, SMI contractors need training and advice on works management and methods improvement. Infor- mation networks and tendering procedures need to be improved to increase SMI's 1/ A summary review of structure and prospects in-the construction industry is available in the Project File.  - 19 - access to public and private contracts. Among building material SMIs, produc- tion is limited by inefficient labor utilization and lack of some basic pieces of equipment. 1/ In rock, gravel and sand extraction, improved methods for initial processing and stockpiling during the dry seasons are needed. Organi- zation among building material manufacturers appears lacking; small producers could form associations for purchasing raw materials and arranging direct sales to contractors. In building materials, skill training and advice in establishing, expanding and operating SMIs are of importance. Since raw materials, unskilled labor and a sizeable portion of projected demand for construction and building materials are outside the main towns, the network for technical extension will need to encompass selected rural areas. 3.15 IDB's regional network places it in a relatively strong position to provide technical advice and demonstrations in areas where construction activity would be concentrated. IDB already has provided thorough project profiles for use by bank branch staff in appraising SMI projects in bricks, tiles and stone crushing; IDB plans to establish work centers to demonstrate construction and building material methods. The Building Research Institute of the State Engineering Corporation can provide back-up research services to IDB. The proposals for rapid expansion of short term on-the-job training by the National Apprenticeship Board in construction and materials should be supported strongly. It is estimated that small and medium scale construc- tion contractors and building material units could require roughly US$3.5 million p.a. in fixed investment and permanent working capital financing between 1979 and 1983. E. Agroindustries 3.16 Problems, potential, credit and other assistance requirements have been analyzed for: coconut-based industries, rice milling, fish-related industries and processing of manioc, fruits, spices and soybeans. This analysis indicates that, in the short term, sizeable expansion potential or viable modernization prospects exist for: white and brown coir fiber SMIs; rice milling; and fish-related enterprises, particularly ice plants. Expan- sion and modernization in coconut oil and desiccated coconut are limited by policies and raw material availability; with policy revisions, the scope for investments in balancing and modernization would increase. Problems in fruit processing, essential oils and manioc are primarily in improving the produc- tion base, which would fall outside the scope of an SMI project. Large scale processing is appropriate for soybeans. 3.17 Rice Milling - Performance and Prospects. Rice, the most important foodgrain crop in Sri Lanka, has accounted for 15% of agricultural GDP. Paddy production increased from 40 million bushels in 1960 to 77.5 million in 1970. 1/ Productivity among brick and tile manufacturers could be improved sig- nificantly by introducing pugmills, screw presses and material moving carts.  - 20 - From 1970 to 1977, production dropped below the trend line but 1977 witnessed a record crop of 80 million bushels and this upward trend is expected to con- tinue with improved varieties, increased fertilization, and new irrigation schemes. The Paddy Marketing Board (PMB) handles about one third of national paddy production, of which its 28 mills process 15%, the remaining 85% being handled by about 400 private "quota millers" registered with PMB; these quota millers have an annual rated capacity of 540,000 tons, but actual milling is below this level. The remaining two thirds of paddy production are milled by about 1,500 private non-quota mills. A portion is retained by farmers for household consumption, with custom milling by village units which can handle about 10 bushels per hour; the remainder is channelled to larger millers who sell in the open market. 3.18 Expansion Requirements. On the basis of projected increases in paddy production, by 1982 an estimated additional 350,000 tons of paddy will need to be milled annually by private millers. Assuming registered mills will achieve 65% capacity utilization by the end of 1979 and that 60 one-ton parboiling mills will come on stream in 1979 with anticipated utilized capa- city of 48,000 tons/year, more than 100 new one ton/hour private mills will be needed by 1983. In addition, a sizeable number of village custom millers will need financing. Requirements for new mills will be influenced by: future PMB procurement and processing; the Food Commissioner's policies; capacity utili- zation by existing rice mills; and actual increases in paddy production. The demand for quality rice will increase as the ration system diminishes; millers will be under pressure to upgrade facilities with polishers, cleaners, separa- tors, and parboiling tanks. Financing requirements from 1980 through 1983 are estimated to be about US$2 million p.a. for new mills and US$1.5 million p.a. for modernization. 1/ 3.19 Coir - Performance and Prospects. The coir industry is well suited to rural SMIs; dispersed land, water and raw material availability, and economic advantages of proximity to supplies militate against large scale operations. In 1978, white fiber production was 6,600 tons vs. 96,300 tons of brown fiber. About 2,100 tons of white coir yarn were exported during 1978, earning Rs 13.5 million in foreign exchange. An estimated 60% of green nuts used for human consumption are not utilized for coir; in white coir, this is due to inadequate retting facilities, the distance between nut supply and existing retting pits, and alternative uses of husks as fuel. In the south alone, it could be possible to collect as many as 80 million additional-green husks economically for use in white fiber. 3.20 Service and Financing Requirements. Brown coir fiber units require financing for balancing and modernization to improve quality and productivity in order to meet export requirements. Increased manufacture of white fiber yarn and finished products would lift rural incomes and export earnings 1/ Fixed investment costs are based on locally manufactured equipment. The appraisal mission inspected the facilities of local rice mill manufacturers and found the quality of workmanship to be high.  - 21 - provided that several improvements are made: (a) introduction of husk crushers to reduce the retting period from 8-9 months to 3-4 months; (b) selective introduction of decorticators and mechanical fiber beaters; (c) expansion of improved household spinning units; (d) expansion of both craft units and medium scale powerloom factories manufacturing standard mats; and (e) improved coordination in the various stages of processing. In the past, DSI programs have been limited largely to about 30 craft production workshops and 80 i affiliated cooperative societies making mats. Annual worker earnings have been low, averaging Rs 1,255 due to insufficient or highly priced raw materials and irregular orders. Recently, DSI has initiated vertically integrated operations with an investment of about Rs 1.1 million in DSI retting, fiber extraction and household spinning to supply existing DSI finished product centers. DSI estimates that these activities will generate a surplus of about 250 tons of yarn for sale to the private sector in 1979. These facilities have been established mainly for demonstration purposes, to encourage selec- tive modernization by the private sector. The DSI plans to shift its orien- tation to technical and organizational assistance to private units. The DSI could act as a catalyst by: (a) encouraging private retters/extractors to introduce husk crushers, decorticators and fiber beaters; (b) assisting in subcontracting arrangements to household units with improved spinning equip- ment; and (c) supplying designs. The SMI project would provide consultancy services and training to DSI in this white coir extension program (para 4.42). Roughly US$1 million of credit p.a. is expected to be needed for moderniza- tion and expansion of brown and white coir processing facilities. IV. THE PROJECT A. Objectives, Scope and Institutional Arrangements 4.01 The principal objective of the proposed SMI project would be to address constraints hindering rapid growth and productivity improvement of SMIs, particularly in the key subsectors outlined in Chapter III, to increase their contribution to efficient and low cost employment generation, export expansion, and economic growth. To meet these objectives, this US$28 million project would have two major components, with IDA providing US$12 million for credit and US$4 million for technical services. 4.02 The project would be national in scope; while attention would be given to strengthening services for SMIs outside Colombo, a significant portion of the growth is expected in Colombo and secondary industrial towns. New and existing SMI firms engaged in a wide range of small industrial activ- ities would be eligible for credit, provided their projects are financially and economically sound. Firms eligible for finance under the project would be those with plant and equipment (original cost) of less than Rs 1 million before the subloan, with a maximum subloan size of Rs 1 million. The target group for technical services would be firms with less than Rs 2 million in plant and equipment; most technical and management assistance components would concentrate on key SMI subsectors with significant expansion potential.  --22 - 4.03 Credit Component. Under the credit component, responsibility for subproject appraisal, on-lending and supervision would lie with the five major credit institutions: the two public commercial banks, Bank of Ceylon and People's Bank; the two locally controlled private commercial banks, Hatton National Bank and Commercial Bank of Ceylon; and DFCC. Under the project, their SMI activities would be encouraged and supported by: (a) supplying US$12 million equivalent to help fill the gap between SMI term lending requirements and available resources for credit to SMIs (para 2.25); (b) building a separate SMI Refinancing Fund within the National Development Bank to do rapid subproject review and partial refinance of subloans made by the five credit institutions to SMIs which meet financial and economic eligibility criteria (paras 4.06-4.17); (c) improving capabilities of the five credit institutions to do appraisal-based lending, by: assigning SMI specialists to headquarters and key branches; providing SMI specialists and management with training in simplified SMI appraisal and supervision; and introducing systems and tools to facilitate this work (paras 4.20-4.32); and (d) providing inducements to the credit institutions to increase financing of viable SMIs, through provision of attractive spreads, a credit guarantee scheme and a special capital facility for entrepreneurs unable to meet the normal equity requirements but with subprojects of strong economic merit (paras 4.1.3, 4.18, 4.19). 4.04 Technical Service Component. The technical, marketing and management service component would: (a) reinforce IDB's promotion and technical service programs for SMIs by improving IDB's regional extension network, starting a subcontracting exchange, and establishing subsector schemes, staff and technical facilities in rubber products, building materials, foundries and light engineering (US$1.9 million, paras 4.33-4.39); (b) improve the focus and effectiveness of certain other SMI technical service agencies by providing finance for (i) programs in garment training and export organization for handloom products, sponsored by the Ministry and Depart- ment of Textile Industries and (ii) extension programs in white coir extraction and processing, under DSI (US$960,000, paras 4.40-4.43);  23 - (c) finance outside consultants (36 manmonths) for policy studies on export incentives and an appropriate tariff system, which are issues affecting SMI efficiency, expansion, and export prospects (US$250,000, paras 2.13 and 2.19); (d) fund training and advisors for NDB and the participating credit institutions to improve SMI lending and general operations (US$590,000, paras 4.17 and 4.28); and (e) provide a discretionary fund to cover unforeseen cost overruns and additional training and technical assistance (US$300,000, para 4.45). 4.05 Financing Plan. The total costs for the SMI project would be about US$28 million, 1/ of which IDA would cover US$16 million (i.e. 57%). For the credit component, the IDA US$12 million would cover 100% of the refinance for SMI term loans, which would represent an average of 56% of subproject costs. Under the technical service elements, the IDA US$4 million portion would cover costs of equipment, training and advisors to implement the subsector schemes, upgrade the financial institutions, and execute policy studies. GOSL's contribution of about Rs 18 million (US$1.2 million) would cover incremental staff and increased salary expenditures, overheads, and the cost of land and buildings for facilities associated with the subsector schemes. The following table summarizes project costs and sources of finance: 1/ Total project costs include an amount of US$190,000 to provide a con- tingency against cost increases or unforeseen changes in respect of GOSLts contribution to the technical service component. The estimates for the elements of the technical service component to be financed by IDA already include amounts for contingencies against cost increases. The discretionary fund would provide for additional contingencies arising out of unforeseen changes.  - 24 - Project Financing Plan (in US$ million) GOSL/NDB/ Credit IDA TA Agencies Institutions SMIs Total Credit Component (a) Term credit for SMIs 12.00 3.00 6.45 21.45 (b) Special Capital Fund - 0.51 - 0.51 (c) NDB - admin. and revolving fund - 0.79 - - 0.79 Subtotal credit 12.00 1.30 3.00 6.45 22.75 Technical Services (a) IDB 1.87 0.43 - - 2.30 (b) Other technical services 0.90 0.44 - - 1.34 (c) Policy studies 0.25 0.09 - - 0.34 (d) Consultancy services and training for NDB and credit institutions 0.68 - - 0.68 (e) Discretionary/ Contingencies 0.30 0.19 - - 0.49 Subtotal, services 4.00 1.15 - - 5.15 TOTAL 16.00 2.45 3.00 6.45 27.90 B. Credit Component 1. Small and Medium Industry Fund - NDB 4.06 The National Development Bank (NDB) was established on January 5, 1979, 1/ to provide term finance to public and selected large private firms and refinance loans to small enterprises. Its Board of Directors comprises representatives of the Central Bank, the two state-owned commercial banks and the Ministry of Finance and Planning. The Secretary of Finance is now NDB's chairman and the former director of the Development Finance Department of the Central Bank has been appointed general manager. Steps have been taken to recruit the deputy general managers and other key staff; it is anticipated that major posts will be filled by mid-1979. 1/ The authorized share capital is Rs 2 billion (US$128 million) of which Rs 600 million has been issued to GOSL (67%), the Central Bank (17%) and the two state-owned commercial banks (16%). Rs 450 million of GOSL's contribution was paid in and Rs 150 million left on call.  - 25 - 4.07 Under the Act, 1/ NDB may establish separate administered funds to channel outside resources to industry, agriculture, or commercial enterprises. The SMI Fund would be established under this provision with separate policies, staffing, financial resources and accounting. Staff of the SMI fund would: review SMI appraisals and refinance sub-loans submitted by the five major credit institutions 2/; monitor appraisal, supervision and collection stan- dards; collect repayments of refinanced amounts; and administer project funds for technical service components to SMIs (para 4.31). 4.08 Organization and Staffing. The SMI Fund of NDB would be headed by a deputy general manager, 3/ assisted by an outside adviser financed under the project. The Fund would consist of three main sections: Analysis and Review, with a department head and four analysts; Reporting and Liaison, with a depart- ment head and two analysts; and Finance and Disbursements, with a department head, an accountant, a disbursement officer and three clerical assistants. Two additional staff, one professional and one clerical, would be attached to Finance and Disbursements to administer the technical service component. 4/ Professional staff of the SMI Department should total 13 by January 31, 1980; in addition, the SMI Fund would draw on the services of an economist and engineer of NDB. This number of staff is considered adequate and NDB has given priority to recruiting SMI Fund staff; NDB has advertised for profes- sional staff of the SMI fund and candidates for key positions have been identified. During negotiations the Sri Lankan delegation informed the Association that prior to credit effectiveness the NDB would have appointed at least the following staff of the SMI Fund, with qualifications and exper- ience satisfactory to NDB and the Association: the Deputy General Manager; the heads of the Analysis and Review, Reporting and Liaison, and Finance and Disbursement Sections; subproject review officers; and the professional staff member overseeing the technical service component. This minimum staffing would be satisfactory for effectiveness (para 7.02(i)). NDB intends to have the head and at least three staff members of the Analysis and Review Section receive outside training in subproject review and refinance prior to credit effectiveness (para 4.44). 1/ Section 31 of the National Development Bank Act, No. 2 of 1979. 2/ Bank of Ceylon, People's Bank, Commercial Bank of Ceylon, Hatton National Bank and Development Finance Corporation of Ceylon. 3/ In the initial period, direct responsibility for the Fund would be assumed by the general manager of NDB, who will delegate his authority after a suitable period. 4/ The SMI Coordinating Committee (para 4.45) would review progress of of the technical service components, make recommendations on use by the discretionary fund, and help resolve problems of coordination. 5/ Training in SMI project review, monitoring and refinance would be pro- vided, probably by IDBI and the State Bank of India for six members of the Fund staff prior to effectiveness. Ongoing training needs would be met under the technical service component of the IDA project.  - 26 - 4.09 Policies and Procedures. A draft statement of policies and pro- cedures for the SMI Fund which sets out the objectives, eligibility criteria and review procedures was agreed in substance during negotiations. The state- ment specifies on-lending and refinance rates and provides guidelines for the special-capital facility and the Fund's monitoring role. The statement also outlines initial operating procedures, which were discussed and agreed in substance during negotiations. In addition, the statement defines the key items to be included in the participation agreements between each of the five credit institutions and the Fund (para 4.20). This draft statement of policies and procedures provides a satisfactory basis for the SMI Fund's operations (see Project File). The statement will be adopted by NDB's Board in a form satisfactory to IDA prior to effectiveness and any subsequent modifications would require IDA approval. 4.10 The Analysis and Review Section would review subproject appraisals prepared by the credit institutions. 1/ For subloans below Rs 500,000 (US$32,000), refinance would be granted on the basis of the credit institu- tions' appraisals, provided the subprojects meet eligibility criteria, are financially viable, and have appropriate terms. A more detailed review of subloans would be done on a sample basis to ensure that standards are main- tained. Subloans above Rs 500,000, would be subject to a more detailed review of the technical, financial, marketing and economic aspects. To ensure that subloans are reviewed expeditiously, the participation agreements between the SMI Fund and the credit institutions would state the intention of the Fund to complete reviews within two weeks. The Reporting and Liaison Section would monitor the SMI lending activities of the participating credit institutions. Quarterly reports from the credit and technical service institutions would be received, reviewed and aggregated for submission to IDA. Supervision stan- dards would be monitored through reports and by occassional field visits to a sample of subprojects. 4.11 Eligibility for Refinance. Credit institutions eligible for refinance would be those which have signed a participation agreement accept- able to IDA, with the NDB (para 4.20). Subprojects eligible for refinance would involve the creation, modernization or expansion of productive facil- ities of a private or cooperative enterprise involved in manufacturing, mining, construction, agroindustry, fish processing, handicraft production or industrial services. 2/ The SMI Fund would provide up to 80% refinance for subloans to existing and new small and medium industries having total fixed assets, excluding land and buildings, with original cost of up to Rs 1 million 1/ To ensure appropriate appraisal standards, the SMI Fund will set out standardized forms to be used in refinanced subloans with simplified forms for subloans up to Rs 500,000 and a more comprehensive form for subloans above Rs 500,000; draft appraisal and supervision forms were prepared during the appraisal mission. 2/ Defined as: transport and other services which are a part of an industrial enterprise; repair workshops and other services which add value to a product.  - 27 - (US$64,000) prior to the proposed subloan. The SMI Fund would refinance sub- loans of up to Rs 1 million for fixed assets l/ and permanent working capital, for subprojects not larger than Rs 2 million (US$128,200). 2/ Sponsors would be required to provide at least 20% of total subproject cost in equity, but as credit institutions would need to ensure that sub-borrowers have a sound struc- ture, it is expected that on average sponsors will contribute 30% of project cost. All subprojects would have to be shown to be financially viable. 4.12 Eligible subprojects should also be economically viable. For all subprojects, banks would assess whether the subproject will improve quality, price competitiveness, or production of an item for which demand can be established. For smaller more common subprojects 3/ the credit institutions would use standard project profiles prepared by the IDB. 4/ Subloans of above Rs 500,000 would be subject to a more detailed review by the NDB; at the outset NDB would be responsible for calculating the domestic resource cost (DRC) ratio of the larger subprojects. The NDB would also do economic subsector analysis and review IDB's project profiles. Over time, the credit institutions would be expected to develop increased competence in economic evaluation of subprojects. 4.13 Refinance Arrangements. The SMI Fund would refinance 80% of the subloans to eligible subprojects by the participating credit institutions. On average, the equity participation is expected to be about 30%, refinance 56%, and credit institutions 14%. The credit institutions would assume full repayment risk on refinance, repayable to the Fund on a fixed schedule deter- mined at the time of approval for refinance. To help ensure that a significant proportion of the project's resources are made available to smaller enter- prises, the credit institutions would receive differential spreads, designed to cover administrative costs based on the size of the subloan. The refinance rate would be adjusted to provide a spread to the credit institution of (i) 5% p.a. in cases of subloans up to Rs 100,000; (ii) 4% for subloans of between Rs 100,000 and Rs 500,000; and (iii) 3% for subloans of between Rs 500,000 and Rs 1 million. 1/ Land and buildings would be financed only if they are necessary com- ponents of the subproject. 2/ In the case of existing SMIs, "subproject" includes subloan and equity portions, excluding working capital, for balancing, modernization and expansion; it does not include assets of the firm prior to the subloan. In the case of a Rs 2 million subproject, the subloan could cover up to Rs 1 million, equity covering the remainder. 3/ E.g. rice-milling, repair workshops, brick and tile manufacture. 4/ IDB has prepared expanded project profiles for 5 major project types and plans to prepare an additional 10 prior to credit effectiveness; these profiles would include financial, technical and market information as well as describe employment and net foreign exchange effects.  - 28 - 4.14 Terms and Conditions. Refinance granted by the SMI Fund would be denominated in rupees and onlent by the credit institutions at 15% p.a. for all subloans refinanced. 1/ This rate is reasonable in view of current interest rates being charged by commercial banks in Sri Lanka (Annex 1, Table 3) and represents a positive real rate of interest (para 2.26). The final onlending rate and the spreads would be reviewed periodically and adjusted if circumstances change significantly. Since refinance would be used only for term loans, maturities on eligible subloans would be 3-10 years, including a maximum two years' grace; credit institutions would establish appropriate maturities and grace periods for each subloan based on the sub- project's debt service ability and the Fund would review the periods selected. 4.15 SMI Fund Resources. The SMI Fund's resources would comprise the US$12 million IDA credit component plus an initial NDB contribution of Rs 20 million (US$1.3 million). Approximately 5% of the Rs 20 million NDB contribu- tion would be used to cover the Fund's initial operating neeeds in the first 1-2 years; Rs 8 million would be used to establish the Special Capital Facility (para 4.18) and the balance would cover the lag between NDB's disbursements and reimbursement by IDA. The Rs 20 million is an initial estimate and during negotiations agreement was reached that NDB would provide resources as needed to cover additional operating expenditures of the SMI Fund. It is estimated that roughly 50% of total subproject financing would be for imported equipment and inputs. 2/ 4.16 Projected Financial Results. It is proposed that the SMI Fund's spread be set at about 2% p.a. This spread is appropriate in view of the Fund's operating costs and NDB's contribution. It is expected that, after the second year of operations, the Fund would begin accumulating operating cash surpluses; before this, the low level of average outstandings and deferral of interest on Special Capital Facility loans would result in small operating cash losses, which would be partially offset by income from the investment of the unutilized portion of the NDB contribution. It is anticipated that, by the third year, average outstandings will total Rs 114 million (US$7.3 million) and, by the time the credit component is fully disbursed in the fourth year, outstandings will average about Rs 140 million (US$8.6 million) and a cash surplus of Rs 1.0 million (US$64,000) would be earned by the Fund. This sur- plus would represent a return on the NDB contribution of around 8%. A detailed financial projection has been prepared and is summarized in Annex 1, Table 4. 4.17 Institutional and Training Needs. The NDB would need to take a number of steps prior to project effectiveness. In particular, suitable staff need to be recruited and trained for the SMI Fund. Training, financed under the UNDP "Umbrella" would be arranged for 6 SMI Fund Staff at IDBI and the State Bank of India, with 4 trained before project effectiveness (para 4.44). 1/ Credit institutions would be obliged to charge the fixed rate on the full subloan (including the 20% not refinanced) and lend on the same terms and conditions. However, they would not be bound by this rate on short-term advances. 2/ The estimate is based on an analysis of patterns in existing SMIs and recent SMI loans by the credit institutions.  - 29 - Ongoing training needs, financed under the technical service component, would provide overseas training for 3-5 SMI Fund staff per annum. The SMI Fund would have to have a number of qualified staff acceptable to IDA prior to credit effectiveness (para 4.08). Policies and initial operating procedures for the Fund have been developed and agreement in substance on these policies and procedures was reached at negotiations. Other institutional support will include the appointment of an outside advisor for the SMI Fund who will assist in developing the Fund and implementing procedures. In addition, a top level advisor and consultancy services, financed under the project, would assist in the establishment of NDB's overall operations. Candidates for the top level advisor position were discussed during negotiations; it was agreed that the Association would arrange for the election of a suitable candidate acceptable to GOSL and the NDB, and second him to Sri Lanka. Discussions have taken place with the Industrial Credit and Investment Corporation of India (ICICI) in India on providing consulting services to assist NDB in setting up pro- cedures, establishing systems for finance, supervision and management information, and offering training and assistance in appraising initial projects of public sector corporations. One general advisor for two man- years and 24 manmonths of consulting assistance in these general aspects are provided. 2. Special Facilities 4.18 Special Capital Facility. It is proposed that Rs 8 million (US$510,000) of the Rs 20 million NDB contribution to the SMI Fund be allocated to a Special Capital Facility to assist entrepreneurs who are unable to put up the minimum equity participation. Under guidelines which have been dis- cussed and which form part of the SMI Fund's draft policy statement, the facility would be used only in exceptional cases covering no more than 5% of the subprojects refinanced, and finance would be available only for subprojects of high economic and financial merit. Loans would be limited to a maximum of 10% of total subproject cost with equity participation of at least 10%. Loans under the Special Facility would bear interest at an onlending rate not differing markedly from commercial rates, with a maximum maturity of 10 years, but allowing up to five years' grace during which time interest could be capitalized. Applications and recommendations of the credit institutions would be reviewed by the Fund, with special consideration to subprojects which also receive recommendations by IDB. 4.19 Credit Guarantee Scheme. To encourage credit institutions to relax collateral requirements for subloans refinanced by NDB, the Central Bank would modify the existing Small Industries Credit Guarantee Scheme to accommodate subloans refinanced by the SMI Fund. The existing scheme is administered by the Central Bank and is restricted to projects under the IDB Joint Scheme; with the modified scheme, the credit institutions would apply for partial guarantee of subloans without requiring a recommendation by IDB. The coverage would be altered to provide SMI subloans with a guarantee of the lower of 60% of the subloan or Rs 400,000. A 1% p.a. premium on the outstanding amount guaranteed would be payable by the institution out of its spread. Applica- tions for coverage would be made separately, but approval of the subloan  - 30 - by the SMI Fund would facilitate rapid review of the application by the Central Bank. Once the default experience is known, premiums would be adjusted accordingly. The above mentioned aspects of the existing guarantee scheme which require modification were discussed at negotiations and agree- ment reached on changes required from GOSL. A modified scheme with character- istics acceptable to IDA would need to be in place by credit effectiveness. 3. Participating Credit Institutions 4.20 The terms and conditions of participation by the five credit insti- tutions (para 4.03) are to be governed by individual agreements, which will set out duties, responsibilities and obligations of NDB and the respective credit institution. Each agreement would stipulate the institution's duty to: (i) recruit, assign and train suitable SMI staff; (ii) prepare appraisals of a satisfactory standard for each subloan; (iii) supervise subprojects to ensure that funds have been properly utilized and progress is satisfactory; (iv) adhere to the terms of lending and repayment of refinance; 1/ (v) ensure that procurement and disbursement standards are met; and (vi) submit quarterly reports on SMI activity, subproject portfolio and arrears in a format suitable to the NDB. The features of the participation agreements were discussed with management of NDB and the credit institutions during the appraisal mission. Draft participation agreements were discussed during negotiations and agree- ment was reached on the substance of these agreements. Participation agree- ments will include placement of an agreed minimum of trained SMI appraisal and supervision staff at head office and key branches; SMI staff commitments by each credit institution are noted in paras 4.22-4.27. At least two credit institutions would need to sign a participation agreement prior to effective- ness; one agreement would need to be with People's Bank or Bank of Ceylon, and the other with Hatton National Bank, Commercial Bank of Ceylon, or DFCC. NDB's statement of policies and procedures would specify that credit insti- tutions eligible for refinance from the SMI Fund are those which have signed a participation agreement satisfactory to IDA. 4.21 The State Banks. Both state banks, Bank of Ceylon (BOC) and People's Bank, have extensive branch networks covering urban and rural areas: BOC has 11 regional offices, 24 district offices and 92 branches, while People's Bank has 16 regional offices and 217 branches. 2/ Together, BOC and People's Bank account for about 86% of commercial bank lending in Sri Lanka. 3/ Roughly 80% 1/ Repayment schedules for refinance would be established for groups of sub- loans submitted together by each credit institution, i.e., repayments for a given group would be made quarterly at the same time. 2/ In addition, BOC has 450 agricultural service centers and pay offices and People's has 277 savings branches. These offices are not full service branches and function largely as deposit and repayment col- lection centers. 3/ At December 31, 1977; loans and advances include trade bills but exclude guarantees and acceptances.  - 31 - of both banks' lending is short term 1/, although many of the short term advances are rolled over regularly into what is effectively long term finance. Lending policies still rely heavily on collateral, but the banks have realized the need to base credit decisions on project appraisals. This shift has been delayed, however, due to lack of trained personnel. The expansion of the branch network and the increase in business, particularly since liberalization, has put a strain on the banks' staff. These constraints also have made the introduction of formal systems of loan supervision and procurement difficult. Both banks are attempting to overcome these weaknesses through a program of staff recruitment and training. Bank of Ceylon, with IFC assistance, has made some progress in decentralizing lending decisions, developing appraisal procedures, and establishing an Industrial Projects Department at headquarters. The proposed project would assist the banks in improving project-based lending by helping establish sound appraisal, procurement and supervision practices and standards for SMI lending, which could influence other areas of operation. Both banks would have an SMI unit at head office and designate officers at key branches who would be responsible for the appraisal and supervision of SMI subprojects. 4.22 Bank of Ceylon. Industrial lending accounted for 26% of total BOC loans and advances outstanding at December 31, 1977, and although no separate figures are maintained for SMIs, a survey of major branches indicates that SMI loans account for 4% of industrial advances. Industrial lending is under the overall control of an assistant general manager at head office with three professional staff with some experience in project appraisal. The BOC plans to increase the size of this unit by a further 8-10 officers, through recruit- ment and internal promotion. These officers, supervised by a senior officer responsible for SMI lending, will form the head office SMI unit. In addition, SMI officers of submanager or assistant manager status would be trained and assigned to the 24 key branches for appraisal and supervision of SMI loans. SMI officers, their regional and branch managers, and industrial appraisal personnel from the head office unit are to undergo training in SMI lending (para 4.28) and BOC has undertaken to assign them to SMI work for a suitable period. BOC's regional and branch managers' delegated approval limits are appropriate to this project, being Rs 400,000 in subloan size for regional offices and Rs 150,000 for larger branches and district offices. Members of the head office SMI unit will conduct the appraisals for subloans larger than Rs 400,000. In addition, the head office unit will be responsible for assist- ing branches on complicated projects and supervising the branch SMI staff. The BOC also intends to appoint a qualified engineer, who will be available to assess technical aspects of larger SMI projects. IFC's $2 million loan to BOC for small and medium industries 2/ would also be handled by the industrial unit at head office. IFC is providing institutional support to BOC; a pre- liminary reorganization approach paper has been completed, and a three year 1/ Short term is defined as up to one year; medium term is classified as 1-5 years and long term as over 5 years. 2/ This loan provides financing for firms with up to Rs 6 million in assets and therefore will mostly be used for firms larger than those covered under the proposed SMI project.  - 32 - program to analyze and implement needed changes in organization, procedures and management information systems is being developed. The proposed SMI project could finance some consulting assistance to BOC for this work, through use of the discretionary fund (para 4.45). Two UNDP-financed advisors will be supplied to assist with project appraisal and supervision procedures and business advisory services; the late arrival of these advisors has delayed credit effectiveness of the IFC loan but the loan should be effective shortly. Under the proposed IDA project, it is anticipated that BOC will process roughly 350 subloans over the three year commitment period, of which 280 are expected to be approved at branch or regional level (47% by value) and 70 at head office level. 4.23 People's Bank. Industrial advances accounted for about 37% of total outstandings of People's Bank at June 30, 1978. Available figures for lending to SMIs indicate that advances in 1978 were mainly in short term loans and overdrafts. People's collateral requirements are less stringent than BOC's but the majority of advances are made on the basis of security. The Small Industries Unit of the Development Department is to be expanded to a manager and four officers who will appraise subloans above Rs 400,000 and oversee SMI lending. activity. People's also intends to appoint an engineer who would be available to the SMI unit. Twenty key branches, which are expected to account for at least 80% of SMI business, will each have an officer assigned to SMI appraisal and supervision; in the case of the larger branches, a second officer will be assigned as needed. These officers, their branch managers and head office staff are to undergo training (para 4.28) and will be assigned to SMI duties. Further institutional support would be provided under the project for a study of staff development policies and management information systems (para 4.29). Delegated approval authority is presently being increased from Rs 10,000 to Rs 50,000 for branch managers and to Rs 400,000 for regional managers, which would be appropriate for this project. It is anticipated that roughly 350 subloans will be appraised at regional and branch levels of People's Bank under the proposed project. The head. office unit, which will .appraise the larger projects, supervise the branch staff and appraise subloan proposals from branches that exceed delegated authority, is expected to process a further 50 subloans. 4.24 The Private Banks. The two Sri Lankan controlled private banks, Hatton National Bank (HNB) and the Commercial Bank of Ceylon (CBOC) 1/ have a restricted branch network concentrated in the urban areas: HNB has 23 operating branches, of which 19 are outside Colombo, and has permission to open three more; CBOC has nine branches, three of which are in Colombo. In total, the two banks account for 11% of commercial bank credit in Sri Lanka. 2/ In the past, the private banks have concentrated on trade and commercial lending, particularly export financing, but both banks have made 1/ Both banks have overseas banks as minority shareholders: Grindlays (UK) has 27% of HNB and Standard Chartered (UK) has 40% of CBOC. 2/ CBOC accounted for 6% and HNB for 5% at December 31, 1977.  - 33 - policy decisions to expand their limited lending to SMI. Both banks recog- nize the need for and have begun using appraisals as a basis for credit decisions. They also have been able to institute a formal system of subloan supervision and adopt relatively good procurement standards for the few loans handled by each branch. Both banks are vulnerable to high staff turnover, primarily to Lne Middle East, due to the sound training they provide in export financing and foreign exchange operations, and both are facing staff constraints. A number of the staff of both banks have undergone training in appraisal and supervision of small industry projects. 4.25 Hatton National Bank. Industrial lending accounted for 27% of HNB's total advances in 1978 but only a small portion was loaned to SMIs. To imple- ment the proposed project and increase SMI lending, a head office SMI unit will be formed, with two officers under the deputy general manager. In addi- tion, two officers will be assigned to SMI lending at each of the four key branches expected to account for the bulk of SMI lending. These officers and the branch managers will participate in the SMI training program. HNB proposes to delegate approval authority of Rs 100,000 to branch managers and larger subloans will be approved at head office. It is anticipated that HNB will account for about 10% of the proposed credit, approving about 50 subloans at branch level and 45 at head office. 4.26 Commercial Bank of Ceylon. The CBOC has made relatively few industrial loans and has only advanced Rs 1.8 million to SMIs, mostly on overdraft. To increase this lending and to implement the project, CBOC would establish a head office unit with two industrial appraisal officers reporting to the deputy general manager, and would place SMI appraisal officers in two key branches; a third branch would be added at a later date. SMI officers and branch managers are to participate in the training program. Initially, branch managers will have approval authority for subloans up to Rs 50,000; larger projects will be approved at head office. The CBOC is expected to account for roughly 10% of the credit in about 100 subloans. 4.27 Development Finance Corporation of Ceylon. The DFCC is a privately owned 1/ DFC which has received a total of $24.5 million in four loans and credits from IBRD/IDA and $5 million from the Asian Development Bank, which is currently considering a further loan of up to $10 million. Although DFCC concentrates on loans to and investments in medium to larger scale companies, it has 78 loans outstanding to small scale industries amounting to Rs 19.7 million. The DFCC proposes to establish a separate SMI unit which will also handle small scale loans under the ADB and other IDA lines of credit. The unit wiil be headed by a senior loan officer reporting to the general manager, with four SMI officers and access to DFCC's engineering staff. The staff is well qualified and will upgrade SMI appraisal and supervision skills further in the SMI training program. 1/ DFCC's shares are held 45% by Sri Lankan companies and individuals, 25% by State owned bodies and 30% by foreign shareholders, including a 10% holding by IFC.  - 34 - 4.28 Training and Institutional Needs. Local and overseas training, financed under the UNDP "Umbrella," is to be provided, with Indian institu- tions being the major source of assistance (para 4.44). Overseas training for appraisal staff of headquarters' SMI units will be provided by the State Bank of India between July 1 and September 1, 1979; 12 appraisal staff will receive 8 weeks' training and apprenticeship in SMI appraisal and supervi- sion. Training in Sri Lanka by the National Institute of Banking Management (NIBM) of India in cooperation with the Central Bank has been launched. From June 15-September 15, NIBM will conduct and supervise four three-week courses on SMI project appraisal and supervision for 100 SMI appraisal officers selected for key branches and head offices of the five credit institutions. Course materials are based on cases and project profiles; standard appraisal and supervision forms are to be utilized in training sessions. In addition, three one-week appreciation courses for branch managers are planned for June-September. The two state banks have been allocated 35 positions each on the three-week course, 20 each on the appreciation course and 4 each on the overseas program. The private banks and DFCC each have 10 positions for the two local courses and 2 positions for overseas training. Ongoing training needs would be met from funds allocated under the technical service component. 4.29 A major institutional benefit of the credit component is the assist- ance it will give to the commercial banks in introducing project appraisals as the basis of credit decisions; it is anticipated that this shift in approach and building of skills will have a direct influence on credit policy in other lending areas. Other requirements, particularly for regular supervision of subloans and detailed management reporting, are also expected to influence the practices and procedures at the banks. The project would finance one manyear of consultancy services to help improve staff development policies and management information systems in People's Bank. These studies would parallel similar efforts by IFC with the Bank of Ceylon and would represent the first stage in an institutional upgrading program for People's Bank. C. Technical, Marketing and Management Component 4.30 Elements of the technical service component, outlined in para 4.04, would: (a) strengthen subsector-specific and general technical, managerial and marketing assistance to SMIs; (b) finance training, advisors and studies for NDB and the five financial institutions (paras 4.17, 4.28 and 4.29); and (c) fund studies on export incentives and effective protection, which involve policy issues affecting SMIs (paras 2.13 and 2.19). The following section outlines the roles of the technical service agencies under the project, describes training and advisory assistance financed under the UNDP "Umbrella" to prepare the implementing agencies for these roles, and describes mechanisms to ensure effective coordination. 4.31 Requests for authorizations and for disbursements from the IDA Credit would be channelled through the SMI Fund of NDB; a cell within the Disbursement Unit of the Fund would vet requests from the implementing agencies for pre-allocated portions of the technical service component, submit them to IDA, and prepare reports on planned vs. actual implementation. The SMI  - 35 - Coordinating Committee (para 4.45) would meet at least quarterly to review progress on the technical service component, discuss requests, decide on the use of the US$300,000 discretionary and contingency fund, and discuss any problems of policy or project implementation. The technical service agencies would prepare an overall implementation plan and annual work programs satis- factory to IDA and submit quarterly progress reports through NDB. These reports would include status of GOSL budget allocations for the program, actual technical staffing and consultancy relative to the number and quali- fications outlined in the detailed implementation plan, physical progress on installing and operating necessary technical service facilities, and coverage and impact of the major elements (paras 4.35-4.43). The implementation plan was agreed in substance during negotiations. 4.32 Most technical service elements would address specific problems of SMIs in priority subsectors with local or export market expansion potential. IDB would be the major SMI technical service agency, with responsibility for general and most subsectoc-specific promotion and extension schemes. The project would assist IDE in expanding and upgrading its organization and staffing, make extension work more systematic, and provide financing for training, specialists and technical facilities. In addition, DSI and MTI would implement certain subsector schemes and NIM would expand its management training programs for SMI. The project would increase the effectiveness of these agencies by clearly delineating responsibilities and providing mechanisms for policy and working level coordination (para 4.45). The elements, costs and sources of finance for the technical service component are summarized below and detailed in Annex 1, Table 6. 1. Industrial Development Board 4.33 Responsibilities. As the principal SMI technical service agency, IDB would shift emphasis from credit appraisal activities and would be responsible for: (a) providing SMI project identification, promotion and extension services in the regions; (b) implementing subsector schemes to meet specific needs of SMIs in rubber and metal products, construction materials and selected agroindustries; (c) establishing a subcontracting exchange to assist SMIs in obtaining procurement and private subcontracting orders; and (d) preparing and updating expanded project profiles for use by the credit institutions in subproject appraisal. 4.34 Financing. IDA financing for these IDB programs is estimated to be about Rs 29 million for equipment, foreign training and consulting ser- vices. GOSL financing, to cover incremental staff, other recurrent costs and investments in land and buildings associated with technical service elements, is expected to total about Rs 10 million over a 3 year period. Most components are designed to be self-supporting within three years of commencement of operations (Annex 1, Table 6). 4.35 Organization and Staffing. To implement these programs, IDB management has prepared an organization and staffing plan which involves: reorganizing at headquarters along subsector lines; increasing the number of head office specialized staff positions; providing short term outside  - 36 - training to about 30 technical specialists before and during project imple- mentation; and upgrading salary levels of both regional extension staff and technical officers at headquarters. During project preparation and appraisal, IDB (with the missions) developed detailed programs, organization and staffing to implement the regional, subsector and subcontracting schemes. Details were discussed during negotiations and agreement in principal reached on sequencing of staffing, training, and investments to help ensure successful implementa- tion; these steps were recorded in the minutes of negotiations. Subsector departments at headquarters would have a core of technical specialists, strengthened initially by advisors; these departments would prepare project profiles for use by the banks in appraisal, provide technical advice to firms on improvement of productivity and quality, assist in marketing, and manage common service facilities. In the regional and district offices of IDB, the project would not require additional staff above those in IDB's 5 year plan; however, the coverage and effectiveness of regional promotion and extension programs is expected to increase markedly with training and since IDB staff would no longer be directly involved in SMI loan appraisals, which have absorbed 70-80% of regional staff time during the last 3 years. During negotiations, the Sri Lankan delegation confirmed that regional staff would be trained in promotion and extension by Technonet Asia before and during the project (para 4.44), that merit and general salary and benefit increases would be introduced, and that a monitoring and evaluation system would be installed. 4.36 Rubber Products. To meet the needs outlined in paras 3.05 and 3.06, the SMI project would finance a Rubber Products Service Center under IDB to provide: (a) advice on production methods, management and marketing; (b) pro- duct testing and development facilities and (c) supply of rubber compounds and latex. The Center would be headed by a director, reporting to the general manager, with broad responsibilities for semi-autonomous administration of the center. Technical staff would include a marketing officer, product development officer, quality control officer, extension officer and other technical and support staff. Technical officers would receive short-term overseas training .before or during project implementation, and an advisor would be financed for about three years. The Center would require about Rs 16 million: Rs 4.5 million in expatriate technical assistance and training; Rs 10.2 million in equipment; and Rs 1.2 million in land and buildings. Incremental operating costs, covered by GOSL during the first two years, would be about Rs 500,000. After year two, revenues from tests and sales of rubber compounds and indus- trial latex are expected to be sufficient to cover recurrent costs of the Center and to begin accumulating surpluses for recovery of fixed investments. 4.37 Foundries and Light Engineering. IDB would establish an Engineering Technical Service Department at headquarters, consolidating the operations of the engineering workshop and engineering section of the extension services department. This department would: (a) manage workshop, foundry and electro- plating common facilities servicing SMIs in Colombo and adjacent districts, (b) provide consulting and training to new and existing metal product SMIs, and (c) offer back-up services to technical facilities managed by the regional offices. Estimated costs for additional equipment would be Rs 3.6 million for the workshop, foundry and electroplating facilities; costs for outside training of staff and consultancy would be about Rs 3.0 million. An advisor  - 37 - would spend one year helping establish the Engineering Center, and specialists in heat treatment and electroplating would be hired for one to two months each. The SMI project also would finance common service facilities at Matara and Jaffna; 1/ IDB's surveys indicate that sufficient demand exists for common services in engineering and heat treatment in these two areas. These centers would be managed by the regional offices of IDB to assure rapid response to client needs. Costs for each center would be about Rs 1 million in equipment and Rs 525,000 in land and buildings, with an estimated Rs 50,000 in annual incremental operating costs. 4.38 Construction Materials. The Industrial Development Board would have major responsibilities in technical and marketing assistance for building materials and construction SMIs. IDB would establish a Center under the Construction Materials, Chemicals and Minerals Department which would be responsible for: (a) developing improved products and processes for brick and tile manufacture, raw material extraction and processing and other key construction materials in conjunction with BRI, (b) providing assistance to regional work centers and (c) conducting demonstrations and training programs for firms in and around Colombo. Regional IDB work centers would be estab- lished; at the outset, about four centers would provide demonstration and training to private entrepreneurs and to voluntary groups which have networks for diffusing improved methods to village groups. Estimates for equipment costs are Rs 600,000 for headquarters and Rs 300,000 for each work center. An advisor financed under the UNDP "Umbrella" would assist in detailed plan- ning for the centers, and the IDA project would finance one manyear of consul- tancy services. 4.39 Subcontracting Exchange. The marketing department of IDB would organize a subcontracting exchange to (a) assist SMIs in gaining knowledge of potential public procurement or private orders, (b) communicate to large enterprises the production capabilities of potential SMI contractors, and (c) assist SMIs in meeting required quality standards and delivery schedules -(para 2.16). The subcontracting exchange would be operated by a deputy director of marketing, with an assistant director and two development officers responsible for the data bank and contacts; and a mechanical engineer and two technical assistants responsible for ascertaining production capabilities of potential SMI subcontractors and assisting them with production and quality problems. 1/ This staff would be expected to be in place prior to the arrival of the consultant and the equipment for the subcontracting exchange. Total staffing costs including administrative, technical and clerical staff would be Rs 100,000 annually. IDA would finance the cost of equipment (Rs 100,000), training and consultancy services, probably from the Bombay Subcontracting Exchange (about Rs 1.5 million). The consultant, hired for 9 months, would help set up the data bank, sponsor the assistant director for 3 months' apprenticeship in Bombay and assist in implementation of the exchange. 1/ in cases of rubber and metal products and construction materials, the subcontracting exchange would liaise closely with marketing officers in the specialising departments.  - 38 - 2. Other Technical Services 4.40 Garment Training. The Ministry of Textile Industries (MTI) would establish a Garment Training Center to provide training and plant level tech- nical assistance to small, medium and large garment units in cutting and pattern-making, production supervision and quality control (para 3.10). The Center would be part of the planned Textile Research and Training Institute, and would be staffed with; (a) 3 expatriate specialists in cutting room training, production supervision and quality control, for 2 years each and outside training (Rs 4.9 million); (b) permanent MTI training and administra- tive staff (Rs 300,000 annually) and counterparts seconded from private manufacturers to help give courses (Rs 300,000 annually in fees). Fixed costs are estimated to be Rs 2.5 million in equipment and vehicles, and Rs 600,000 for land and buildings. IDA would cover costs of expatriate staff, equipment and vehicles. Actions expected before arrival of consultants and installation of equipment would be allocation of funds by GOSL to cover staff, overhead, land and buildings, and recruitment of permanent and local consultancy personnel. 4.41 Handloom Products. DTI plans to promote and participate in a private limited handloom production and export company with majority private shares (para 3.12). The private shareholders and board members would be leaders in production and exports of high quality handloom fabric and finished products. The company would select about 50 largely defunct handloom cooperatives and DTI centers in rural areas primarily in Puttalam, Kurunegala, Gampaha and Kalutara districts which are relatively accessible to Colombo, are near finishing facilities planned for completion in mid-1980, and have rela- tively strong traditions in making quality handloom products. In year 1, the centers would operate about 15 looms each in existing buildings; in year 2, buildings would be expanded for 50 looms to achieve an economic size to cover minimum overheads. By the end of year 3, employment is expected to be about 2,200 with significant increases in weavers earnings at a fixed cost per job of Rs 3,000. Estimated capital costs for the 3-year implementation period would be about Rs 6 million, with about Rs 2 million for broad looms and other equipment and Rs 4 million for additional buildings. IDA would finance up to Rs 5 million in equipment, vehicles and materials representing part of the investment of MTI/DTI in the handloom production and export company. The remainder would be financed through private and government equity contribu- tions and bank loans. The Minister of Textile Industries has given basic approval to establishing this private limited company and the leading handloom products exporters have expressed considerable interest in participating. Conditions for disbursement for the handloom company would be: (a) legal establishment of the company with statutes and participation satisfactory to IDA; and (b) issuance of implementation and financing plans agreeable to IDA. The statutes for the company are under preparation and on basic elements of the implementation plan were discussed during negotiations. 4.42 Coir Products - DSI. The Department of Small Industries (DSI) plans to: (a) refocus its efforts on promotion and extension to private household industries rather than limit activities to DSI-owned or affiliated facilities  - 39 - and (b) avoid overlap with IDB by focussing on very small household enterprises. Under the project, DSI would be strengthened to provide extension services to the white coir industry. Staff would be hired, redeployed and trained to provide extension services in white coir retting, extraction and spinning. The project would promote introduction of husk crushers, decorticators, and mechanical fiber beaters, improved household spinning units, and handicraft units, and would encourage links with private powerloom firms and organization among various stages. The DSI and the Ministry of Rural Industrial Development plan to have the coir extension unit headed by an assistant director, assisted by 2 fiber technologists, 17 supervisors, 30 demonstrators and support staff * with redeployment of the 30 coir demonstrators by January 1980. The UNDP "Umbrella" would finance initial training, probably in India and the proposed IDA project would finance additional training and an expatriate specialist for one year, for a cost of about Rs 2 million. Incremental costs of about Rs 100,000 annually would be financed out of the budget of the Ministry of Rural Industrial Development. Steps necessary prior to the arrival of the advisor would be completion of redeployment and recruitment of DSI extension staff to implement the coir extension component. 4.43 National Institute of Management (NIM). Under the SMI project, NIM plans to provide short technical and management training sessions to small enterprises in the regions. Sessions would be practical, utilizing case and incident studies. Participants, selected by IDB regional managers, would be from similar SMI subsectors to facilitate exchange of ideas. NIM would offer about 50 such training sessions each year. NIM would use technical specialists from IDB and the private sector to complement NIM's management/accounting focus. Members of the Small Industry Chamber of Commerce would be used in these sessions. Under the UNDP "Umbrella" Project, funds have been allocated for NIM to prepare the structure, content and materials for these sessions and to identify with IDB key areas and subsectors. The SMI project could finance part of the costs for the actual training from the discretionary fund, if NIM can justify to the SMI Coordinating Committee the need for partial subsidies. 3. Preparation, Coordination and Monitoring 4.44 UNDP "Umbrella". An estimated US$175,000 of the UNDP Multi-sectoral Program of Project Preparation has been allocated to provide short term training and consultants to NDB, participating institutions and SMI technical service agencies to prepare staff and components for project implementation. The numbers, duration, and sources of this training have been noted in the credit and technical service component sections. About 185 staff of the financial and SMI technical service institutions will receive local training; 40 will receive short term training with appropriate Asian institutions, mainly in India; and about 15 manmonths of foreign and local consulting will be financed. Training and consulting services are expected to take place between April 15 and September 30. Final arrangements have been made for several of the com- ponents; for others training would begin in June. IBRDI/IDA is the executing agency for the "Umbrella". The Director of Planning of the Ministry of Finance and Planning (MINFIN) has agreed to be responsible for administrative arrange- ments and accounting; staff from MINFIN have been deployed and an administra- tive officer has been hired for this purpose.  - 40 - 4.45 Coordination and Monitoring. The implementing agencies would carry out their specific activities and responsibilities autonomously within the broad framework of objectives, guidelines, and procedures agreed between GOSL and IDA in the Credit and Subsidiary Loan Agreements, participation agreements, and implementation plan. In view of the complementary nature of the activities of the various agencies, mechanisms would be established to allow for adequate coordination at district and headquarters levels. At district and regional levels, coordination would be achieved by/providing for regular meetings between the regional and branch managers of banks and the regional managers of IDB; the field staff of other relevant agencies would be consulted. At headquarters level, an SMI coordinating committee would be established, which would meet quarterly or more freqeuently if necessary. The core members would comprise: the additional Secretary, MINSA; General Manager, NDB; Director of Planning, MINFIN; Chairman, IDB; and a private representative of SMI. 1/ These members would invite representatives of other agencies to attend (e.g. DSI, DTI, the financial institutions, Plan Implementation) depending upon the matters to be discussed. One professional and one clerical staff of the SMI Fund of NDB would handle routine requests for withdrawals for pre-allocated technical service components and would supply the coordinating committee with quarterly progress reports on credit and technical service components. The role of the SMI coordinating committee would be to: (a) review quarterly progress reports prepared by NDB, IDB and the other implementing agencies; (b) examine operational or coordination problems raised by any of the imple- menting agencies; (c) make recommendations for action by the responsible agency to improve the efficiency and effectiveness of project implementation, overcome administration problems and ensure achievement of agreed project objectives; (d) decide on use of the US$300,000 discretionary and contingency fund, based upon requests by the implementing agencies; and (e) make recom- mendations of policies affecting SMI. Since this committee would deal with multi-agency coordination and monitoring, quarterly meetings are considered sufficient. Much of the coordination will be handled on an agency-to-agency basis, with regular meetings as required. During negotiations, agreement .was reached on coordinating mechanisms and on the composition and responsi- bilities of the SMI coordinating committee; the SMI coordinating committee would be established not later than 30 days after credit effectiveness. V. THE CREDIT 5.01 Lending Arrangements. The proposed credit of $16 million, including a $12 million credit component and a $4 million technical assistance component, would be made to the Government of Sri Lanka on standard IDA terms and condi- tions. The credit is expected to be committed in about 3 years and disbursed in about 4 years. Annex 1, Table 5 shows the estimated schedule of disburse- ments. GOSL would onlend the proceeds of the credit component to NDB for the account of the SMI Fund to cover the Fund's disbursements for refinancing 1/ The private SMI representative is likely to be the chairman of the Small Industry Chamber of Commerce.  - 41 - eligible SMI subloans made by the participating credit institutions (4 com- mercial banks and DFCC) under terms and conditions outlined in a Subsidiary Loan Agreement. These proceeds would be loaned to NDB in rupees, with GOSL bearing the foreign exchange risk on repayments to IDA. The SMI Fund would pay to GOSL an interest charge of 9% on the rupee amounts of the credit component disbursed and outstanding to its account. Repayment to GOSL for the credit component would be on the basis of a fixed amortization schedule. The SMI Fund also would be responsible for administering disbursement of the tech- nical service component, the bulk of which would be preallocated to cover specific items of training, technical and advisory services and equipment for the participating institutions or for specific consultant studies (Annex 1, Table 6). The proceeds of the technical service component would not be repay- able to GOSL, although the participating agencies are expected to recover part of the costs incurred by charging fees for some of their technical services to SMI. 5.02 Onlending Terms. The credit institutions would charge a standard interest rate of 15% to SMI subborrowers on subloans refinanced by the SMI Fund. At present and projected rates of inflation, this rate of interest would be marginally positive in real terms and is similar to the rates commer- cial banks charge to larger clients on term loans made out of their internal resources. The interest rates on refinanced amounts charged to the credit institutions by the SMI Fund would vary between 10% and 12% depending on subloan size, so as to encourage lending to smaller projects and reflect the relatively higher costs and risks involved. Thus the SMI Fund would earn an average spread of about 2% p.a. on its refinancing operations, which would be adequate to cover administrative costs and yield an appropriate return on its capital. The framework of rates and spreads proposed is shown in the table below. The continued appropriateness of these rates and spreads would be monitored during the commitment period, and they could be revised, with agreement of GOSL and IDA, in light of operating experience and to reflect changes in market conditions. PROPOSED LENDING RATES AND SPREADS /a Size of Credit Institution's Subloan Less than Rs 100,000- Rs 500,000- Rs 100,000 Rs 500,000 Rs 1 million Final onlending rate 15 15 15 Spread to the credit institution 5 4 3 10 11 12 Spread to SMI Fund 1 2 3 Interest to GOSL 9 9 9 /a All rates in percent per annum. 5.03 Capital Contribution to SMI Fund. For the purposes of the proposed project, an initial capital contribution of Rs 20 million would be made by NDB to the SMI Fund. The uses of this contribution are outlined in para 4.15. Additional resources would be made available to the SMI Fund by NDB as needed. The surplus generated by the Fund after the second year of operation would help restore and protect the real value of this capital.  - 42 - 5.04 Subloan Sizes and IDA Review. The maximum size of subloan for any subproject eligible for refinancing would be Rs 1 million ($64,000). The SMI Fund would refinance 80% of the amount of eligible subloans. The average subloan size, for subprojects requiring financing for fixed assets and per- manent working capital and costing Rs 50,000 to Rs 2 million, is expected to be about Rs 200,000; about 1,000 subprojects in this size range are expected to receive financing under the proposed credit. In view of the large number and relatively small sizes of subloans, simplified review and approval procedures would be used to keep administrative costs and processing times within rea- sonable bounds. The SMI Fund would review in detail only the appraisals of subprojects requiring subloans in excess of Rs 500,000. On refinancing appli- cations for smaller subloans, a more rapid review and approval procedure would be used, designed to check that adequate information has been provided to justify the eligibility of the subproject, its financial viability and the adequacy of proposed subloan terms. Periodically, the SMI Fund would under- take sample analyses of appraisal reports submitted for the smaller refinanced subloans to check that appropriate appraisal standards are being maintained. Prior review and approval of subprojects by IDA would not be required. Author- ization to make withdrawals from the credit account regarding subloans of up to Rs 750,000 would be granted by IDA following receipt of periodic statements briefly describing subprojects approved by the SMI Fund for refinancing during the preceding period. However, authorization requests regarding subloans in excess of Rs 750,000 would be accompanied by a copy of the credit institu- tion's appraisal and the SMI Fund's review memorandum, for vetting by IDA on a post-authorization basis. This procedure is expected to result in detailed review by the SMI Fund of about 150 subprojects, of which about 40 would be checked by IDA. In addition, selected samples of appraisals and reviews covering all five credit institutions would be examined by IDA during field supervision missions. 5.05 Procurement. The credit institutions would be responsible for ensuring that procured items for subprojects are suitable, reasonably priced and that sponsors have canvassed main sources of supply. For subloans above Rs 750,000 ($48,000), the SMI Fund also would review this aspect. Imported items costing over US$10,000, would be procured on the basis of several quotations, in accordance with standard practice for DFC projects. However, as it might be difficult and costly to obtain several quotations for many of the smaller orders, this procedure would be required only in the cases of these larger procurement contracts. Credit institutions would be required to maintain records of the method of procurement and to monitor the utilization of subloan funds through their regular supervision activities. These procure- ment procedures are considered to be satisfactory, SMI Fund staff and IDA field supervision missions would review implementation of these procedures as part of the regular supervision of the project. Procurement of goods under the technical services component would be in accordance with GOSL procedures satisfactory to IDA. 5.06 Disbursement Procedures. All subloan disbursements, for both for- eign or local expenditures, would be eligible for refinancing by the SMI Fund up to 80% of the total subloan amount. IDA would disburse 100% of the subloan amounts refinanced by the SMI Fund. Since sponsors are expected to contribute  - 43 - an average of 30% of subproject costs (minimum sponsors contribution 20%), IDA financing would cover about 56% of total subproject costs (para 4.13). Since the average foreign exchange content of subprojects is estimated at 50% (para 4.15), IDA funds would cover a small proportion of local costs. In view of the large number of subprojects involved and small subloan size, the normal DFC procedures of disbursing against documented expenditures on individual subproject accounts would be inappropriate for most subprojects. Accordingly, in the case of subprojects with refinanced amounts equivalent to US$40,000 or less, the Fund would claim reimbursement from IDA for refinance to subloans on the basis of periodic certified statements of expenditure itemizing its dis- bursement to credit institutions for authorized subprojects. For these smaller subprojects, documentation would not be submitted to IDA for review but disbursement by the SMI Fund would be made subject to receipt of document- ation evidencing subproject expenditures (excluding permanent working capital) and would be limited to expenditures incurred up to 90 days prior to receipt of the refinance application by the SMI Fund. This documentation would be retained by the SMI Fund for inspection during IDA supervision missions. During credit negotiations, agreement was reached that all statements of ex- penditure, together with supporting documentation, will be audited at least annually. For subprojects with refinanced portions above US$40,000, full documentation of expenditures on fixed assets (excluding permanent working capital) would need to be submitted to IDA. In the case of the technical service component, IDA would disburse (a) 100% of foreign expenditures for equipment imported directly and for locally manufactured equipment purchased directly from a factory; (b) 80% of expenditures for other equipment procured locally; and (c) 100% of total expenditures for consultant's services and overseas training. For the amounts allocated for preidentified items, with- drawal applications would be submitted directly to the SMI Fund. Prior approval of the SMI coordinating committee would be required for use of the discretionary funds to finance additional items or cost overruns (para 4.45). Authorization by IDA for financing of goods and services under the technical service component would be required; requests for disbursement by IDA would be fully documented. 5.07 Repayment Schedule to GOSL. The maximum maturity for subloans refinanced by the SMI Fund would be 10 years, including 2 years of grace. As the commitment period for subloans will be about 3 years, repayments by the credit institutions would stretch over about 13 years. A fixed amortiza- tion schedule for repayment of the $12 million credit component from the SMI Fund to GOSL is proposed, with a 13 year term including 4 years of grace (the expected disbursement period). The alternative of repaying GOSL on the basis of a composite schedule made up of the sum of amortization schedules of the individual subloans would be overly complex to administer for such a large number of subloans. Since the average maturities of subloans will be less than 10 years (probably 5-7 years), in the initial years the SMI Fund will receive an excess of repayments from the credit institutions over the repay- ments due to GOSL. Such an excess would be used to augment refinancing operations, and provide a valuable cushion to enable the Fund to continue its operations if there are delays in obtaining additional resources when the proposed IDA credit is fully committed.  - 44 - 5.08 Reporting, Accounts and Auditing. The SMI Fund would submit quarterly reports on its activities to IDA. The main report would be an aggregation of the individual quarterly reports by participating credit institutions-covering activity, portfolio data, collection and arrears performance and supervision results. In addition, the SMI Fund would submit a quarterly statement of its own activity in refinance and details of disbursements against the technical assistance component. Both sets of reports would have a content and format satisfactory to IDA and would be accompanied by an overall review of the SMI sector in Sri Lanka. A separate detailed statement of account for the Fund as a whole, prepared by the Finance and Disbursement Section also would be submitted. An annual statement of accounts for NDB including the SMI Fund would be audited by the Auditor General of Sri Lanka, or a designated private firm, which would submit a report in a form satisfactory to IDA not later than three months after the close of each fiscal year. If the Auditor General designates a private firm to audit the accounts of the Fund, the appointment would be for at least the duration of the project to ensure continuity. VI. PROJECT BENEFITS AND RISKS 6.01 Benefits. The proposed SMI project would address the major con- straints hindering more rapid expansion and productivity improvements by SMIs. Access to term credit would be increased for a wide range of small and medium scale manufacturing and service industries. The IDA credit would fill a sig- nificant portion of the gap in resources available for SMI lending. It is anticipated that about 1,000 subprojects would be financed, with subproject costs, including sponsors' equity, totalling Rs 335 million (US$21.5 million) and an average subloan size of Rs 200,000 (US$11,800). Roughly 50% of sub- loans are expected to be below Rs 100,000 (US$6,500), 35% between Rs 100,000 and 500,000; and 15% for Rs 500,000 to Rs 1,000,000. These subloans, which would be extended to new and existing SMIs, are expected to result in incre- mental direct employment of at least 20,000, since in most SMI subsectors incremental fixed cost per job averages well under US$1,000, and in coir, handlooms and several building materials product groups fixed costs per job average below US$500. 6.02 Although the technical, marketing and management service components are expected to have a significant impact on growth and productivity of SMIs in priority subsectors, benefits are difficult to quantify. Coverage under the technical service component is expected to include but not be limited to SMIs receiving credit under this project. In the case of IDB, it is likely, that 600-1,000 firms in rubber products, engineering and construction will benefit from specialized services and the subcontracting exchange, and that an additional 1,000-1,500 firms would benefit from the improved district level promotion and extension network. These programs are expected to result in improved productivity, sales and employment; IDB and the appraisal mission have devised a system to monitor coverage and impact. The handloom export company is expected to result in a significant increase in earnings for at least 2,000 rural weavers when fully operational. The Garment Training Center could cover about 900 production supervisors, cutters and pattern- makers in three years, as well as providing inplant advice.  - 45 - 6.03 One of the major anticipated benefits of the project is its institution-building impact. Policies, procedures and staffing arrangements would be implemented to enable the SMI Fund of NDB to provide rapid subproject review, refinance and monitoring of SMI subloans made by the five major credit institutions of Sri Lanka. The project would seek to improve attitudes and capabilities of these credit institutions in making loans available to eco- nomically and financially viable SMIs, on the basis of project evaluation rather than collateral. The Industrial Development Board would shift its focus from aparnisnl of subloans, reorganizing at headquarters along subsector lines to provide effective assistance to firms in priority product groups. 6.04 Risks. The National Development Bank only recently has been estab- lished, and top management is iust now recruiting key staff. The success of the SMI refinance scheme will depend upon relatively rapid establishment of effective policies, procedures and staff wTithin the SMI Fund of the National Development Bank. However, while the NDB is new, GOSL has decided that NDB will be the refinancing agent for industrial loans, and steps taken and planned in licate that the SMI Fund will be able to execute its responsibilities under tti?e roject. The previous director of the Central Bank Development Finance DePart-ent has been appointed General Manager of NDB and top management expects that kev positions will be filled by early July. Some strong can- didates with requisite experience have been identified for positions of deputy general manager and unit chiefs, and training with IDBI in India will be provided before project effectiveness and during implementation. The project would finance an outside advisor for the SMI Fund and four manyears of outside assistance to NDB to help launch its overall operations. 6.05 Another risk is that the credit institutions will be slower than expected in moving from collateral to appraisal-based lending and that access to credit, particularly to smaller borrowers, will be limited. However, the structuring of differential spreads, the scope of the credit guarantee scheme, the emphasis on short-term practical training for branch-level staff and the diffusion of simplified project profiles are expected to help increase the credit institutions' willingness and ability to make small project loans. 6.06 Other risks are associated with the innovative and ambitious nature of the technical service components. Successful implementation of the sub- sector schemes will require a significant reorientation by IDB and the other technical service agencies, and a sizeable increase in coverage and impact of IDB's staff and programs. The project involves a number of steps to increase IDB's ability to attract and retain qualified staff by introducing merit increases, incorporating short term local and foreign training opportun- ities, and increasing the use of local and outside consultants. Specific sub- sector programs, organizations and staff requirements have been developed to provide a focus for the technical service efforts. Mechanisms for coordina- tion and monitoring of the technical service components have been incorporated into the project to help ensure successful implementation of the various components.  - 46 - 6.07 Finally, the rapid development of SMIs envisioned with this project depends on the continuation of the favorable private investment environment. GOSL has taken a number of steps to "free the economy"; reintroduction of controls would tend to retard development in the SMI sector. However, this is unlikely in view of GOSL's policy statements. VII. RECOMMENDATIONS 7.01 During negotiations, agreement was reached between IDA and the Government of Sri Lanka on: (i) onlending terms, conditions, margins and subproject eligibility criteria (paras 4.11, 4.13, 4.14, 4.17); (ii) administrative arrangements and financing of advisors and consultants, including substance of terms of reference and timing for engagement of consultants (paras 4.17, 4.28, 4.36-4.42); (iii) implementation program and timetable for technical service components (para 4.31); (iv) GOSL's budgetary allocations of about Rs 18 million (US$1.2 million) to cover incremental costs for staff, overheads, land and buildings for the technical service components over the three-year commitment period (para 4.05) and steps planned to upgrade salary and benefit levels of IDB's technical and managerial staff at headquarters and regional offices (para 4.35); (v) GOSL's consideration of suggested modifications in policies affecting SMI; IDA and GOSL maintaining a dialogue on development of incentives for SMI (para 2.12); and agreement on administrative arrangements and timing for completion of terms of reference for carrying out two major policy studies; (paras 2.13 and 2.19); (vi) institutional responsibilities and mechanisms for coordination and monitoring (paras 4.03, 4.04, 4.45); (vii) procedures for procurement, disbursement, reporting, accounting and auditing (paras 5.01, and 5.04-5.08). 7.02 Conditions of effectiveness would be the following: (i) establishment of the SMI Fund by NDB, including NDB Board approval of a statement of policies and procedures for the SMI Fund agreeable to IDA, paying in of an initial Rs 20 million capitalization, and recruitment and training of agreed minimum staff (paras 4.07-4.17);  - 47 - (ii) incorporation by the Central Bank of modifications in the SMI Credit Guarantee Scheme (para 4.19); and (iii) signing of participation agreements, satisfactory to IDA, between NDB and at least two credit institutions (para 4.20); (iv) signing of a subsidiary loan agreement, satisfactory to IDA, between GOSL and the NDB (para 5.01). 7.03 Conditions for disbursement from the IDA Credit to cover a portion of MTI's investment in the handloom production and export company to be promoted by GOSL would be: legal establishment of the company with statutes and participation satisfactory to IDA and issuance of implementation and financing plans agreeable to IDA (para 4.41). 7.04 The proposed project constitutes a suitable basis for an IDA Credit of $16 million with standard terms, on conditions outlined in Chapter V.  SRI LANKA INDICATORS OF PERFORMANCE IN LARGE INDUSTRIES AND SMIs Share in % of total -/ Ratio in Rupees Value Added per Number Value Fixed Fixed Investment Value Added Rupee of Fixed of firms Added Investment Employment per Employee per Employee Investment Textiles and Garments 36 27 35 32- 7,400 1.64 Large 2 8 26 10 17,300 10,900 0.63 SMIs 34 19 9 22 2,800 12,700 4.56 Light Engineering 25 15 19 26 5,200 8,400 1.63 Large 3 6 6 7 6,700 13,400 2.00 (Electrical appliances) (0.5) (4) (2) (2) (7,300) (30,400) (4.18) (Mechanical machinery) (0.2) (1) (1) (1) (3,200) (8,300) (2.60) (Metal products) (1.6) (1) (2) (2) (9,200) (5,600) (0.62) (Transport equipment) (0.4) (-) (1) (1) (6,000) (8,000) (1.33) (Scientific equipment) (0.2) (-) (-) (-) (18,500) (6,200) (0.33) SMIs 22 9 13 19 (4,600) 6,700 1.45 (Electrical appliances) (4) (3) (3) (4) (4,500) (10,500) (2,33) (Mechanical machinery) (3) (2) (5) (7) (4,300) (4,600) (1.07) (Metal products) (10) (2) (3) (4) (4,600) (7,100) (1.53) (Transport equipment) (3) (1) (2) (3) (4,800) (5,100) (1.07) (Scientific equipment) (2) (1) (-) (W) (7,000) (3,400) (1.66) Paper Products and Printing 3 9 4 3 8.800 40,900 4.65 1 Large - 2 1 - 11,100 61,900 5.60 ZI SMIs 3 7 3 3 8,300 8,300 4.38 Wood Products 6 3 2 6 2,700 8,200 3.00 Large - - - - - - - SMIs 6 3 2 6 2,700 8,200 3.00 Rubber Products and Chemicals 11 15 20 15 9,300 14,600 1.57 Large 2 7 12 5 15,500 18,700 1.21 SMI8 9 8 8 10 6,000 12,300 2.08 Food Manuifacturing 8 24 15 11 9,100 30,800 3.39 Large 1 22 11 6 11,700 48,100 4.10 SMIs 7 2 4 5 5,300 5,300. 1.09 Basic Metal Products 1 21 1 1 3,700 44.500 12.00 Large 0.3 1 - - 4,700 51,800 11.00 SMIs 0.7 1 1 - 3,700 41,900 12.50 Non-metallic Mineral Products 6 2 2 5 3,200 4,700 1.47 Large 0.4 1 1 0.3 4,500 5,200 1.14 0 SMIs 5.6 1 1 0.7 2,500 4,400 1.75 c Other Subsectors 5 1 2 2 8,200 9,300 1.14 e . Large - - - - 13,200 6,600 1.00 SMIs 5 1 2 2 7,700 9,600 5,00 Total 100 100 100 100 6,800 14,000 2.06 Large 8 47 57 30 12,700 21,400 1.69 SMIs 92 53 43 70 4,200 10,800 2.56 1/ Figures do not add to 100 due to rounding Source: Ministry of Industries and Scientific Affairs, 1977 Annual Survey of Approved Industries; only 2428 firms were covered, about 40. of the total registered firms in 1977.  SRI LANKA DEMAND FOR CREDIT BY SMIs (1979-1983) (in millions of Rupees) IN 1978 PRICES 1/ 2/ 3/ GDP at Factor Cost Manufacturing GDP at Factor Cost Construction and Quarrying GDP Total of Manufacturing and Construction GDP at Factor Cost at Factor Cost 1978 34.903 5,247 1,660 6,907 1983 45X617 7,021 92,i88 709 Incremental value 1979-1983 10,714 1,774 1,028 2,802 Share of SMIs in Manufacturing and Registered SMIs Unregistered SMIs Construction SMIs Total of Manufacturing and Construction in Construction SMIs 1. 1978 876 1,747 747 3,370 2. 1983 1,173 2,337 1,231 4,741 3. (2-1) Incremental value 297 590 484 1,371 1979-1983 4. Assumed ICOR 5/ 2 0.5 1 1 5. (3 x 4) Total fixed investment 594 295 484 1,373 6. Assumed ratio: fixed investment/ -/ permanent working capital 1 I 1 1 7. (5 x 6) Total permanent working capital 594 295 484 1,373 8. (5 + 7) Total investment 1,188 590 968 2,746 9. Credit financing in percent -/ 40 30 30 34 10. (8 x 9) Credit demand 475 177 293 945 II. Credit demand in US dollars 8/ 30.5 11.3 18.8 60.6 1/ ALL GDP estimates are based on Central Bank figures made available to the Appraisal Mission. Revised figures, based on a new methodology for compiling national accounts, have been produced recently, which indicate a somewhat larger contribution by industry. However, these revised figtures have not been used in this table since the new methodoloay is still beine chacked for accuracv and consistencv. 2 Assuming a real growth rate of 6.04 p.a. slightly higher than growth of GDP. 3/ Assuming a real growth rate of 10.5% p.a. 4/ The share of SMIs in manufacturing GDP has been estimated at 16.5% of total for registered firms and 33% of total for unregistered ones. This coincides with the Industrial Sector Report. The share of SMIs in construction is assumed to be 45% and is based on detailed analysis by the SMI mission and by previous consultants. These shares are assumed to remain constant over the period 1979-83. 5/ Since a large part of future investment will have to be for replacement of worn out equipment as well as for expansion, the assumed ICORs are probably underestimates, The ICOR for the economy has been estimated at 3.7 and for industry at 3.0. 61 Based on analysis of some 500 SMI subprojects. Although the statistical basis available indicates significantly higher ratios, this conservative assumption has been adopted due to the usually heavily depreciated book value of fixed assets. 7/ Taking into account the traditionally high level of self finance in industry and the limited access to trade credit and bank loans by SMIs in Sri Lanka, credit demand has been estimated at 34% of total investment requirements on the average. 8/ Assuming a constant exchange rate of Rs.15.6 per US$.  SRI LANKA INTEREST RATE STRUCTURE (in percent) A. DEPOSIT RATES Treasury Savings Fixed Deposits Bills Deposits 3 months 6 months 9 months 12 months 1. People's Bank 9.0 7.2 8.5 11.0-12.0 12.5-13.5 14.0-15.0 2. Bank of Ceylon 9.0 7.2 8.5 11.0-12.0 12.5-13.5 14.0-15.0 3. Hatton's Bank 9.0 7.2 8.5 11.0-12.0 12.5-13.5 14.0-15.0 4. Commercial Bank of Ceylon 9.0 7.2 8.5 11.0-12.0 12.5-13.5 14.0-15.0 5. DFCC 1/ - _ 6. National Savings Bank - 8.4 - 12.0 15.0 0 B. LENDING RATES Large Public Prime Rate for SMIs Industries Corporations Private Borrowers Secured Unsecured 1. People's Bank 14.5 14.5-17.5 14.5-15.0 14.0 14.0 2. Bank of Ceylon 14.0-14.5 14.5-17.5 14.0-15.5 13.0-14.0 14.5 3. Hatton's Bank 15.0-17.0 15.0 - 14.5 4. Commercial Bank of Ceylon 16.0-17.0 18.0-20.0 15.0-18.0 - 15.0 14.0 5. DFCC 12.0-12.5 - 13.0-13.5 - - || Source: Information supplied to the SMI appraisal mission by commercial banks, DFCC and Central Bank of Ceylon. 1/ NSB's rates are 18% for 18 month fixed term deposits.  -51- ANNEX 1 Tabl e 4 (Page 1) SRI LANKA SMI PROJECT FINANCIAL PROJECTIONS A. ASSUMPTION5 1. Number of sub-loans by size of sub-loans: O-luO,000 50% 100-500,00u 35% 500-1,000,000 15% 100% 2. Amount ,f refinance: Sub-Loan Subproject Average Sub- Average Average Category Size * Project Size Sub-Loan Refinance 0-100,000 0-143,000 89,000 62,500 50,000 100-500,000 143-714,000 357,000 250,000 200,000 500-1,000,000 714-1,429,000 1,072,000 750,000 600,000 * Assuming 30% average sponso, participation. 3. Number of Sub-loans: Breakdv,, Average Size of Weighted Total Credit Number of C.atorory by NuabeI Refinance Average Allocation Sub-Loans 0-10n,300 50 50,000 2.5m 13.5 25.272 505 100-500,OoO 35 200,000 7.Om 37.8 70.762 353 500-1 ,000 , 0C 1i 60(,0)0 9.0m 48.7 91.166 152 100 18.5m 100.0 187.2 *a 1,010 -12 millior at $1 - Rs 15.6 Also vx4Saes that Special Capital F,cility paid out of Y10B contribution. A'e,age iae: Rs 185,350. 4. Utilization: by commitment 1st year 25% - 46.8m 337 2nd year 35% - 65.5m 337 3rd year 40% = 74.9m 336 187.2m 1,010 projects 5. Disbursements assumed at 80% in year of commitment and 20% in following year. 6. Average maturity: 7 years including grace. 7. Special Capital Facility: Disbursement in same year as commitment Utilization: 1st year 30%; 2nd year 40%; 3rd year 30%. Maturity: 10 years with 5 years grace. 8. NDB-SMI Fund admini3trative expenses: Pre -operating (1/2 year) 1.0 Aauual: lst year 1.3 2rd year 1.4 ( 3rd year 1.6 6th year 1.7 (See attacned) * 10% p.a. escalation. S). lechnical Service Component Disbursements: Local costs: total Rs 3 m all ir year 1. Foreign coacs: Rs 59.4(%) v. 10. Credit Institutiana' share of refinance Number of Subprojects, 0-100,000 100-500L020 500-1,000, 0o People's 45 35 30 BOC 30 35 40 DFCC 5 12 10 HUB 10 9 10 CBOC 10 9 10 l00% 100% 100%  - 52 - ANNEX 1 Table 4 (Page 2) B. CALCULATIONS 1. Repayments lst year 18,5 2.6 2.6 2.6 2.6 18.5 - 2.7 2.7 2.7 2nd year 31.5 - 4.5 4.5 4.5 31.5 - - 4.5 A.5 3rd year 36.5 - 5.2 5.2 36.5 - - 5.2 4th year 7.5 - - 1.1 7.5 188.0 2.S 9.8 19.5 25.8 2. Jutstandinge - Refinance: Disbursements 37.1 62.1 73.0 15.0 Repayments 2.6 9.8 19.5 25.8 NET MOVEMENT 34.5 52.3 53.5 (10.8' Cumulative 34.5 86.8 140.3 129.5 AVERAGE OUTSTANDING 17.3 60.7 l3.6 134.9 3. Outstandings - SEcial Capital Facilty: Disbursements 2.3 3.2 2.3 Repayments - Cumulative 2.3 5.5 7.8 7.8 AVERAGE OUTSTANDING 1.2 3.9 6.7 7.8 4. Income to the SMI Fund: On refinaa.ce @ 22 p.a. .35 1.21 2.27 2.70 On SCF @ 15% p.a. deferred!!/ r.52 I, 1.l7 CASn INFLOW .35 1.21 2.27 2.70 5. Net Cash Position of the SYT Fund Incomie .35 1.21 2.27 2.70 Costs l.0'/ 1.3 1.4 1.6 1.7 (1L0) (.95) (.19) .67 1.00 Cumulative (1.0) (1.95) (2.14) (1.47) (.47) 6. NDB Revolving nd Coutributtion EstimateAd ReqIireme- 20.0 17.70 14.5 12.2 Less SCF disbursements 2.3 3.2 2.3 - 17.70 14.5 12.2 12.2 T,wo mentai lat on: Refinance disbursements (incr.) 6.2 10.3 18.9 22.2 T.A. disbursements (local' _/ 3.l - - Inverted 8.5 4.2 (6.7) (10.0) c .apitalized for up to 5 years. 2/ Assuming thaL cash surpluses are not applied to further SCF disbursements. 2! Assumes local costs all in first year - foxeign.  -53 ANNEX Table 4 (page 3) 7. Income from Invested Funds at 10 p.a. .85 .42 8. Overall Cash/Profit Position Cash Profit/Loss (1.0) (.95) (.19) 67 1.00 Invested income .85 .42 - - (1.0) (.10) .23 .67 1.00 Cumulative (1.0) (1.10) (.87) (.20) .80 9. Share of ProJects (Number) 0-100,000 100-500,000 500-1,000,000 Total People's 227 124 46 397 BOC 152 124 61 337 DFCC 25 42 15 82 HNB 51 32 15 98 CBOC 50 31 15 96 Total 505 353 152 1,010 10. Share of Projects (Value)I/ Average Size X People's 160.5 11.3 24.8 27.6 63.7 34 BOC 204.7 7.6 24.8 36.6 69.0 37 DFCC 227.4 1.2 8.4 9.0 18.7 11 HNB 183.2 2.5 6.4 9.0 17.9 10 CBOC 184.4 2.5 6.2 9.0 17.7 9 Total 25.3 70.6 91.2 187.1 100 i1. Ase!y_efinan Rate and _pread 0-100,000 25.272 x 5 126.36 100-500,000 70.762 x 4 . 283.0g. 500-1,000,000 91.166 x 3 - 273.50 187.200 682,90 Spread = 3.6% weighted average .Refin. rate 11.4% on average. 12. Forecast Profit and Loss/Cash Flow Statemenc 1st Year 2nd Year 3rd Year 4th Year Income: Refinance spread @ 2% ,35 1.21 2.27 2.70 SCF interest @ .5% .18 .59 1.01 1._1 Operating Income .53 1.80 3.28 4.41 Interest on funds invested .85 .42 - - Total Income 1.38 2.22 3.23 4.41 Expenses: Administrative Costs 1.30 1.40 1.60 1.70 Pre-operating Costs 1.00 - - _ Total Costs 2.30 1.40 1.60 1.70 Profit -/|Loss (.92) .82 1.68 2.70 Cash Flow: Deduct SCF interest deferred .18 .59 1.01 1.71 Operating Cash Flow (1.20) .23 .67 1.00 1/ Tax exempt for the firGt 10 years. 1/ Based on average sizes in A2. 2/ Tax exempt for the first 10 years.  ANNEX 1 _ 54 _ Table 5 SRI LANKA SMALL AND MEDIUM INDUSTRY PROJECT EST'ILATFD SCHEDTLE OF DISBURSEMENTS FOR ThE PROPOSED CEEDIT Disbursements IDA Fiscal Year and Quarter By Quarter Cumulative kUS$ ' 030) FYS0 To December 31, 1979 180 180 March 31, 1980 800 980 June 30, 1980 .L,OCO 1,980 FY81 To September 30., 1980 1,200 3,180 December 31, 1980 1,200 4,380 March 31, 1981 1,500 5,880 June 30, 1981 1,500 7,380 FY82 To September 30, 1981 1,500 8,880 December 31, 1981 1,500 10,380 March 31, 1982 1,400 11.780 June 30, 1982 1,200 12.980 FY83 To September 30, 1982 1.100 14,3e0 December 31, 1982 1,1CC 15,180 March 31. 1983 340 13,520 June 30, 1983 300 820 FYL4 To Septembet 30, 1983 '68C l0,  ANNEX I Table 6 SRI LANKA SMALL AND MEDIUM INDUSTRY PROJECT COSTS AND SOURCES OF FINANCE FOR TECHNICAL SERVICE COMPONENTS (Rs '000) Cost and Source of Finance Responsible Institution Purpose Element IDA GOSL/Agency Total 1. Industrial Development Board Rubber Products Technical a) Advisor - 3 manyears 3,930 - 3,930 Service Center b) Outside training - 24 manmonths 570 - 570 3 c) Equipment / 10,200 - 10,200 d) Land and buildings - 1,200 1,200 e) Staff and other operating expenses - 500 500 Subtotal, Rubber 14,700 1,700 16,-40 Engineering Technical Service a) Advisor - 1 manyear 1.500 - 1,500 Centers b) Outside training - 40 manmonths 1,500 - 1,500 c) Equipment for headquarters 1/ 3,600 - 3,600 d) Equipment for regional centers 2,000 - 2,000 e) Land and buildings - 1,050 1,050 f) Staff and other operating expenses - 1,400 1,400 Subtotal, Engineering 8,600 2.450 11,050 Construction Material - a) Advisor - 1 manyear 1,500 - 1,500 Technical Service and Work b) Outside Training - 24 manmonths 750 - 750 Centers c) Equipment for headquarters 1/ 600 - 600 d) Equipment for regional centers 1/ 1,200 - 1,200 e) Land and buildings - 900 900 f) Staff and other operating expenditures - 1,050 1,050 Subtotal, Construction 4.050 1,950 6,000 Subcontracting Exchange a) Advisor ( 9 msanmonths) 980 - 980 b) Outside training - 10 manmenths 520 _ 520 c) Equipment 1/ 100 - 100 d) Staff and other operating costs - 500 500 Subtotal. Subcontracting Exchange 1,600 500 2,100 2. Ministry of Textile Industries Garment Training Center a) Consultants (72 manmonths) 5,800 - 5,800 b) Equipment 1/ 2,500 - 2,500 c) Land, buildings - 600 600 d) Staff and other operating costs - 1,500 1,500 Subtotal, Garments 8,300 2,100 10,400 3. Peivate Ltd. Co. with Department of Textile Industries as shareholders Handloom production and export Equipment, vehicles and materials 3,700 4,500 8,200 company Subtotal, handlooms 5,700 4,500 8,100 4. Department of Small White coir extension services a) Advisor (12 manmonths) 1,310 - 1,310 Industries b) Staff training 690 - 690 c) Staff and other gperating expenditures - 300 3C0 Subtotal, Coir 2.000 300 2,300 5. National Development Bank Training and technical assistance a) General advisor to NDB (24 mannooths) 2,600 - 2,600 b) SMI advisor (24 manumonthe) 2,600 - 2,600 c) Consulting to NDB (24 mannunths) 2,600 - 2,600 d) Consulting to People's Bank (12 manmonths) 1,300 - 1,300 e) Training for SMI Fund (15 manmonths) 470 - 470 f) Training for credit institutions and local 930 1,410 2,340 Subtotal, WIR ans ereftt Tnstturtions 19.500 1,410 11,010 6. Permanent Tariff Review Commission Study to develop appropriate a) Consultant (24 manm-nths) 2,620 - 2,620 Tariff System 7. Ministry of Industries/ Study on eaport incentives a) Consultant (12 manmonths) 1,310 - 1,310 Finance 8. NDB/CGordiating Coitte a) Discretionary Fud/Contingencie- 4,680 3,000 7 Total Technical Service Components A06_ a912 .92297 1/ List of equipment and estimated costa available.  56 - ANNEX 2 Page 1 SRI LANKA APPRAISAL OF SMALL AND MEDIUM INDUSTRY PROJECT Supporting Documents Available in Project File A. The Manufacturing Sector and Financial System Al. Central Bank of Ceylon-Review of the Economy (1977). A2. Selected tables and extracts from the Surveys of Manufacturing Industry by the Ministry of Industry and Scientific Affairs and from the Survey of Unregistered Industries by the Industrial Development Board. A3. Background papers on principal SMI subsectors: a) Metal Products; b) Rubber Products; c) Selected Agroindustries; d) Construction Contracting and Building Materials; and e) Textiles and Garments. B. Reports and Draft Documents Relating to the Project Bl. Draft amendments to Small Industry Credit Guarantee Scheme of the Central Bank of Ceylon. B2. National Development Bank-Draft Statement of Policies and Procedures for the Small and Medium Industry Fund. B3. Draft Participation Agreement between the National Development Bank and Credit institutions. B4. Draft terms of reference for studies to develop an appropriate tariff system based on the principal of effective protection.  ANNEX 2 Page 2 - 57 - C. Selected Working Papers Prepared by Bank Staff Cl. Proposed changes to organization, staffing, programs and budgets of the Industrial Development Board, Department of Small Industries, and Department of Textile Industries to implement subsector specific technical service schemes under the Project. C2. Outline of training and technical aspistance program under the UNDP Umbrella Project and the SMI Project. C3. Working papers and background information on Credit Institutions participating in the Project. I