Sri Lanka - Second Small and Medium Industries Project

Document of The World Bank FOR OFFICIAL USE ONLY dLE (,jp?Y Report No. P-3124-CE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR A SECOND SMALL AND MEDIUM INDUSTRIES PROJECT September 23, 1981 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. fts contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS US$1 = Rs 20.0 Rs 1 = US$0.05 Rs 1 million = US$50,000 WEIGHTS AND MEASURES 1 acre (ac) = 0.405 hectare (ha) 1 mile (mi) = 1.609 kilometers (km) ABBREVIATIONS AND ACRONYMS BOC - Bank of Ceylon DFCC - Development Finance Corporation of Ceylon EDB - Export Development Board IDB - Industrial Development Board NDB - National Development Bank PCI - Participating Credit Institution SMI - Small and Medium Industries 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. LAN-A SECOND SMALL AND MEDIUM INWDUSTRIES PROJECT Credi an. and Project Sumnsary Borrower: The Democratic Socialist RePublic of Sri Lanlka. Beneficiaries: National Development Bank (NDB) - Small and Medium Industries (SMI) Fund; Bank of Ceylon, People's Bank, Hatton National Bank, Commercial Bank of Ceylon and Development Finance Corporation of Ceylon; and small and medium industries receiving credit, technical and marketing services. Amount: SDRs 26.7 million (US$30 million e,- ivalent at the time of negotiations). Relending Terms: Government would relend IJO".WC3. million equivalent to the Natiorial Developcernc Sank for the account of the SMI Fund on the following initial terms: (i) 11% interest per annum; (ii) repayment on the basis of a fixed amor- tization schedule over a 14-year term including 4 years of grace; and (iii) Government to bear foreign exchange risk. The SMI Fund would provide refinancing to credit institutions for small and medium industry loans on the following initial terms: (i) refinancing for up to 80% of loan amount; (ii) interest per annum of 13% for sub- loans of up to Rs 500,000 and 14% for subloans from Rs 500,000 to Rs 2 million; and (iii) term of refinancing parallel to the term of the individual loans. The credit institutions would provide term credit to small and medium industries on the following terms: (i) initial interest rate of 18% per annum; (ii) term of the loan determined as appropriate for each loan, but in no case for more than 10 years, including 3 months to 2 years of grace; and (iii) minimum of 20% equity contribution. Project The project aims at increasing output, employment, effi- Description: ciency and exports of viable small and medium industries. It builds on the institutional capabilities developed under the Small and Medium Industries Project (Credit No. 942-CE), while inicreasing emphasis on exports. The prin- cipal components of the project would include: (a) term loans to SMIs from participating credit institutions (PCIs) with subproject review and partial refinance by the SMI Fund of NDB; (b) training and consultancy for the SMI Fund of NDB and the PCIs, to improve SMI and overall operations; (c) improvemenits _n the Industrial Development Board (IDB)?s promotion and extension services, through an SMI conssultancy fund to tap the expertise of the local 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.]  - ii - private sector, coaches for regional extension officers, and an expansion of engineering service facilities; and (d) financing the Export Development Board (EDB) program for promotion and supply development of light industrial exports, including consultancy and training, sales trips, policy studies, and pilot projects involving exporters and manufacturers in key light industrial groups. The benefits of the project include the provision of term credit to about 2,000 new and existing enterprises and the creation of about 23,000 new jobs. Project risks are reduced since this project would build on the organi- zation and capabilities developed under the first S-MI Project. Estimated Cost: /a US$ Million Equivalent Foreign Local Total Term loan for SMIs 17.00 33.00 50.00 IDB 0.41 0.41 0.82 EDB 0.55 0.45 1.00 Training & Consultancy for NDB and PCIs 0.19 0.14 0.33 Expansion Fund 0.22 0.13 0.35 Total 18.37 34.13 52.50 (of which taxes and duties) - 5.00 5.00 Net Project Cost 18.37 29.13 47.50 Financing Plan: US$ Million Equivalent Foreign Local Total Government - 0.50 0.50 IDA 18.37 11.63 30.00 PCIs - 7.00 7.00 SMIs - 15.00 15.00 Total 18.37 34.13 52.50 Estimated Disbursement: US$ Million Equivalent IDA FY FY82 FY83 FY84 FY85 FY86 Annual 1.9 6.8 10.0 9.0 2.3 Cumulative 1.9 8.7 18.7 27.7 30.0 Staff Appraisal Report: No. 3480-CE dated September 14, 1981 Map: No. IBRD 15823 /a Price contingencies are included in project costs.  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOM1ENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR A SECOND SMiALL AND MEDIUMi INDUSTRIES PROJECT 1. I submit the following report and recommendation on a proposed development credit to the Democratic Socialist Republic of Sri Lanka for the equivalent of US$30.0 million on standard IDA terms to help finance a Second Small and Medium Industries (SMI) Project. Of the proceeds of the credit, US$28.0 million equivalent would be relent to the National Development Bank (NDB) for the account of the Small and Medium Industry Fund at 11% interest per annum with repayment over a period of 14 years, including 4 years of grace, on the basis of a fixed amortization schedule. PART I - THE ECONOMY 1/ 2. The most recent economic report, "Sri Lanka: Policies and Prospects for Economic Adjustment" (Report No. 3466-CE, May 15, 1981), was distributed to the Executive Directors on May 26, 1981. Country data are provided in Annex I. 3. After several years of relative stagnation, Sri Lanka's economy has experienced sustained growth. This growth has been the direct result of the economic liberalization of 1977. and the development push associated with it. Until 1977, Sri Lanka's growth performance had been below both need and poten- tial. Although GDP growth in the 1960s, at 4.4% per annum, was above the average for low income countries, growth slackened sharply in the 1970-77 period to 2.9% per annum, just below the average for low income countries. Through much of this period, the terms of trade deteriorated steadily, eroding even these modest gains; as a consequence, per capita gross national income rose by a mere 0.9% per annum during the 1960-76 period. The slowdown in economic growth in the 1970-77 period is attributable to a combination of factors, including inadequate investment, poor management of the economy, and a policy environment not conducive to growth and investment; these factors were compounded by poor weather in some years and a sharp rise in the cost of imported food and petroleum. 4. The three tree crops--tea, rubber and coconuts--which are still the mainstay of the economy, suffered from low replanting and inadequate incentives. These problems were exacerbated by a dual exchange rate system, introduced in 1968, that discriminated against these crops, and by the uncer- tainties surrounding a protracted natiorialization (1972-75) of the larger estates. After the exceptional output growth of the 1960s, rice yields and 1/ This part is substantially the same as Part I of the Report and Recom- mendation of the President to the Executive Directors on a proposed credit to the Democratic Socialist Republic of Sri Lanka for a Mahaweli Ganga Development Project III (Report No. 3082-CE, dated June 1, 1981).  - 2 - cropping intensities declined in the 1970-77 period due to poor institutional support. Investment in manufacturing was also low, and the inefficiency of most public and private sector firms, nurtured in a highly protected environ- ment, resulted in growth of manufacturing of 1% per annum. The only bright spots were subsidiary food crops and industrial exports which benefited from good incentives. 5. An inadequate public savings effort, caused by inelastic revenues and uncontrolled growth in recurrent expenditures, inhibited public investment. Unfavorable policies additionally constrained private savings. The slow growth rates and changes in the structure of output provided neither the jobs nor the employment structure for a growing labor force. Low output growth, the excessive capital intensity of investment, the mismatch between the job aspirations of those with post-primary education and the jobs available to them, the post war demographic bulge, and rising female participation rates contributed to a massive increase in open unemployment, estimated at over 1 million, or some 18% of the labor force in 1977. 6. In sharp contrast to this poor economic performance, Sri Lanka's social achievements in relatiotn to per capita income have been outstanding. Sri Lanka has about one and one-half times the life expectancy, almost thrice the literacy, one-quarter the infant mortality and half the birth rate that would be expected for a country at its per capita income level. Nutrition levels have been adequate, and in the 1960s paralleled gains in income distri- bution. These improvements in the quality of life, in particular the rise in health standards, the spread of education and the availability of subsidized food, have been important factors in the decline in mortality. The increasing age of marriage, the spread of female education and employment, and a vigorous family planning program, have also contributed to a sharp decline in fertility. As a consequence, population growth, net of migration, has dropped steadily, from 2.7% per annum in the 1953-63 intercensal period to 2.2% per annum in the 1963-71 period, and 1.7% per annum during 1971-81. 7. Favorable initial conditions induced these social gains. Compulsory primary education was introduced as early as 1901. The food ration was intro- duced in 1942. Thus, at the time of Independence in 1948, Sri Lanka already enjoyed high levels of adult literacy and life expectancy. These initial gains were consolidated and expanded in the post-Independence period through large expenditures on social services and the food subsidy, expenditures which accounted for two-fifths to one-half of government revenues in the 1960s and early 1970s. These expenditures were traditionally financed by capturing the surpluses of the three major tree crops, which provided the Government with easy sources of revenue and foreign exchange. These surpluses began to decline in the late 1960s as government policies discriminated against tree crops and export unit prices weakened. As growth in other productive sectors also decelerated in the 1970-77 period, the budgetary resources available for social programs were squeezed between inelastic revenues and rapid inflation. As a consequence, expenditures for social services other than the food subsidy began to decline as a proportion of total current expenditures and of GDP, threatening the hard-won gains in health and education. In short, the economy could no longer generate the resources needed to sustain a large program of welfare expenditures. Moreover, the very size of those programs reduced the scope for policy makers to shift resources to development.  - 3 - 8. The policy changes introduced in 1977, following the election of the United National Party, were intended to break this vicious circle. The new Government identified its objectives as the sustained revival and resus- citation of the economy and increased employment through (i) increased capa- city utilization in the productive sectors, (ii) stimulation of savings and investment, and (iii) efforts to encourage exports, and import substitution in foodgrains. A program of policy reforms was developed in close consultation with the IMF. These reforms were supported initially by an IMF standby arrangement covering 1978 for SDR 93 million. On January 26, 1979 the Fund's Executive Board approved an SDR 260 million Extended Arrangement to cover the 1979-81 period. The principal aim of the reform program was to dismantle controls over resource allocation and initiate price adjustments with a view to establishing more realistic relative prices. By 1980, these goals had largely been achieved. 9. The program of reforms comprised a number of major policy initia- tives. The exchange rate was unified 1/ on November 16, 1977 at a depreciated rate of Rs 16 = US$1.00 and allowed to float. This implied a depreciation of 46% against the official rate prevailing prior to unification, and 11.2% with respect to the Foreign Exchange Entitlement Certificate rate. The trade and payments regime was liberalized. Public sector import monopolies were almost entirely terminated. Prior licensing of imports was abolished for all but a handful of commodities. The tariff structure was revised and simplified. Other budgetary taxes and subsidies were adjusted to reflect the change in trade and exchange rate policies. In particular, rice and sugar rations were confined to the poorer half of the population, and the food subsidy was eli- minated through a series of adjustments in administered prices. On September 1, 1979 the Government introduced a system of food and kerosene stamps for families with monthly incomes less than Rs 300, to replace specific subsidies and food rationing, and to target benefits to the poor. To help offset the adverse impact of these changes on real incomes, public sector wages were periodically adjusted upwards. Public corporations were asked to pass on cost increases, except for fertilizer, petroleum, milk, and public transport, for which price increases were initially deferred to cushion the impact on consumers. The Government subsequently eliminated the overall subsidy on petroleum products and made sizable adjustments in bus and train fares, electricity, and fertil- izer prices. The burden of selected subsidies and transfers, as a consequence, fell from around 9% of GDP in 1978 to around 5% in 1980. These changes, and higher aid receipts, have helped permit a sizable increase in capital expendi- tures. 10. Agricultural pricing policies have changed dramatically. The domestic support price for paddy was increased by 21% in November 1977, by 25% in November 1980, and by a further 5% in February 1981 following a sub- stantial increase in fertilizer prices. With the related increase in flour 1/ Prior to unification, all exports other than tea, rubber and coconut products and all imports other than food, fertilizers and drugs were channelled through the certificate market. Since November 1972, the FEEC rate was maintained at a 65% premium over the official rate.  - 4 - prices, incentives for paddy and other flour substitutes benefited. At the same time there occurred a large policy-induced decline in the role of the state in domestic rice trade. Fresh coconut prices were also increased and the export duty on coconut products was appropriately adjusted. While the unification of the exchange rate ended formal discrimination against tree crops, high export duties, particularly on tea, continued to siphon off most of the operating surplus for the Government. As tea prices fell and produc- tion costs rose in 1978-79, the Government responded to the reduced producer margins by lowering taxes on tea. The Government also ended most price controls, and reformed the interest rate and tax systems. The burden of company and personal taxation was lowered, and the taxation system was rationalized to increase revenue elasticity; nevertheless, the overall revenue elasticity to economic growth and domestic inflation remains low as taxes on slowly growing tree crop exports have averaged over 30% of current revenues. Interest rates were also raised sharply to encourage savings and discourage speculative imports. However, inflation eroded these rates and in April 1980 further upward adjustments were made. 11. These economic reforms were accompanied by a major effort to step up public investment. The Government's capital expenditures jumped from 6% of GDP in 1977 to an average of 13% in 1978 and 1979, and 19% in 1980, as govern- ment departments responded to the initial improvement in the budgetary resource position and embarked on long overdue replacement investments and new projects that had been shelved earlier for lack of resources. At the same time, the Government undertook three major new programs which are to be the lead projects in a five-year rolling public investment program. These are: (i) accelerated implementation of the Mahaweli Ganga Development Program, by far the largest multi-purpose river basin development program ever undertaken in Sri Lanka; (ii) a 200 square-mile free trade zone north of Colombo under a newly consti- tuted Greater Colombo Economic Commission which has established the first of several Investment Promotion Zones near Colombo's international airport and by end-1980 had signed agreements with 64 investors involving a total investment of USQ130 million; and (iii) a massive housing and urban renewal program with its main focus on the Colombo metropolitan region, including the construction of a new capital complex at Kotte, a suburb of Colombo. Budgetary expenditures on these three programs will amount to Rs 34 billion, or 52% of projected budgetary resources over the 1981-85 period. The underlying public investment strategy seeks to balance the large investment requirements of the Government's high priority programs with the urgent rehabilitation and fresh investment needs in other sectors. The main thrust of the public sector program is to lay the foundation for longer term development, both by encouraging efficient use of existing infrastructure investments and by expanding the longer term growth capacity of the economy. The strategy thus implicitly relies on the private sector to respond to the economic reforms and the stimulus of the public sector investment program, and provide much of the short-term growth. Private fixed investment has so far responded well, increasing from about 7% of GDP in 1977 to 15% by 1980, and helping overall fixed investment to exceed 33% of GDP in 1980.  - 5 - 12. In response to the policy reforms and the accompanying acceleration in investment, economic growth in 1978-1980 averaged an impressive 6.8% per annum. This growth was shared by almost all sectors of the economy, particu- larly construction and services. The only major exception has been the tree crop sector. The impressive performance is due to a number of factors includ- ing the improved availability of inputs following import liberalization, an increased role for the private sector in distribution, and the removal of price controls. Although there is little data available on employment, Cetntral Bank estimates suggest that unemploymernt dropped from 18% of the labor force to 15% between 1977 and 1979. 13. Despite this strong performance, major weaknesses in economic performance emerged in 1980. In particular, the national savings effort has not matched the rapid rise in investment. Gross national savings fluctuated around 15% of GDP during the 1978-80 period, while recourse to foreign savings to finance the higher investment rose from 4.5% of GDP in 1978 to 19.5% in 1980. Although the Government has succeeded in containing the costly consumer subsidy and transfer programs, expenditures on which declined as a percent of GDP (para 9), relatively inelastic revenues combined with steadily rising other recurrent expenditures and declining terms of trade resulted in hardly any public savings over the 1978-80 period. As a result, the Government has financed its rapidly rising capital expenditures thirough foreign aid, and increased its domestic borrowings. Initially the Government met its domestic financing requirements through non-expansionary borrowings from captive finan- cial institutions, which could mobilize increased private savings following the interest rate reform. However, resources mobilized through these channels have not grown as rapidly as the budgetary deficit, and the Government has been increasingly forced to undertake expansionary borrowings from the Central Bank. Between 1978 and 1979, these rose from 0.4% to 1.2% of GDP and in 1980 increased sharply to 10.5% of GDP. 14. Inflation has also increased sharply since 1977. The exchange rate adjustment, the other policy-induced price increases and related wage increases, the removal of price controls, and the build-up of external assets, which added to the money supply, contributed significantly to irnlationary pressures in 1978 and 1979. However, these were moderated by bumper paddy harvests, increased capacity utilization in the economy, increased availability of imports, and the beneficial effects of competition from imports and in domes- tic distribution. Since then, rapid growth in the broad money supply--38% in 1979 and 32% in 1980--has added a sizable "built-in" increase to the system. Together with the corrective price increases designed to reduce budgetary subsidies and keep pace with rapid increases in international petroleum, wheat and sugar prices, these pressures have caused inflation (as measured by the Colombo Consumer Price Index) to accelerate from an average of 11% in 1978 and 1979, to 26% in 1980. 15. Rapid expansion in economic activity has been reflected most vividly in the balance of payments. Import volume growth since 1978 has averaged 15%. Between 1978 and 1980, the net petroleum import bill more than tripled and increased from 11% to 36% of non-petroleum exports, while capital goods imports more than doubled in response to the acceleration in investment. However,  -6- exports have shown barely any volume growth as declining tree crop export volumes offset the strong growth in garments exports and petroleum re-exports. These adverse trade volume trends were compounded by a 20% terms of trade deterioration over the same period. The rapid growth in tourism receipts and private remittances from abroad in this period failed to offset the deter- ioration on the trade account and the current account deficit rose from $124 million (4.5% of GDP) to $805 million in 1980 (19.5% of GDP). In 1978 and 1979, rapidly rising non-monetary capital inflows due mainly to increased net aid disbursements more than offset the current account deficit and Sri Lanka continued to add to its net international reserves, albeit at a declining rate. In 1980, however, net international reserves fell by $220 million, and by end-1980 gross international reserves stood at $377 million, or equivalent to less than nine weeks of imports of goods and non-factor services. With the rapid drawdown in reserves, the public sector, especially the public cor- porations, have begun to make significant use of commercial foreign financing. 16. The Government, realizing in early 1981 that continuation of the 1980 trends would risk continued high inflation and unsustainable pressures on the balance of payments, took corrective steps. The 1981 budget proposes to reduce government capital expenditures from 19% of GDP in 1980 to 14% of GDP in 1981, and the overall budgetary deficit was reduced from 21% to 15% between 1980 and 1981. In addition, the Government has moved to limit public sector purchases of equipment and construction of new buildings and taken steps to raise additional resources and impose a control mechanism over capital expenditures by public corporations. Nevertheless, continued strong measures will be required throughout the medium term to ensure that public sector investment is consistent with available resources, as many of the large development schemes the Government has initiated are only now gathering full momentum. i7/ Aid donors have responded enthusiastically to the Government's development initiatives, the average level of aid commitments in 1978-80 was almost 120% higher in nominal terms and almost 40% higher in real terms than in 1975-77, Most of the growth came in project aid, reflecting the Govern- ment's efforts to increase investment, particularly in the Accelerated Mahaweli Program. Since public investment is already over-programmed, continued high levels of aid will depend upon donors' abilities to shift from project to non-project aid and to finance a sizable portion of local costs; the Govern- ment will need to maintain donor confidence in its economic policies and management through a vigorous domestic resource mobilization program and continued restraint on government expenditures. Despite recent measures to support its investment program, Sri Lanka's budgetary situation remains tight. The adverse impact on revenues of slowly rising export prices and volumes, and rapidly rising import prices, has increased budgetary pressures. Local cost financing, in support of Sri Lanka's own resource mobilization efforts will not only provide valuable relief to these budgetary pressures but also supplement foreign exchange resources needed in support of balance of payments. 18. External public debt outstanding and disbursed stood at US$1,335 million at the end of 1980, amounting to about 35% of GDP. However, this is almost all long-term concessional debt. As a result, the debt service burden is relatively low; debt service ratio in 1980 excluding IMF repurchases stood at 9.3% of exports of goods and non-factor services, declining from 13.3% in  - 7 - 1977. While this sustained decline is due in part to improved export earnings, the main cause has been a decline in outstanding short- and medium-term com- mercial borrowings. Unless the ratio of the current account deficit to GDP improves, Sri Lanka will again have to begin undertaking significant shorter maturity commercial borrowings to fill the gap between the current account deficit and likely concessional aid flows. In that case, the debt service * ratio could increase quickly. PART II - BANK GROUP OPERATIONS IN SRI LANKA 19. Since the beginning of its operations in Sri Lanka in 1954, the Bank Group has approved eight loans totalling US$72.9 million (net of cancellations) and 29 credits totalling US$529 million (net of cancellations and exchange adjustments) in support of 35 projects. About 54% of Bank Group assistance has been for agriculture (irrigation, agricultural, and dairy development), 13% for power, 12% for transport, and the remainder for development finance company operations, a program credit (mainly involving the import of raw materials for industry), water supply, telecommunications and small and medium industries. Eight loans and eight credits have been fully disbursed so far. Annex II contains a summary statement of Bank Group operations as of June 30, 1981, together with notes on the execution of ongoing projects. 20. An IFC equity investment of about US$100,000 equivalent in the Dev- elopment Finance Corporation of Ceylon (DFCC) and two IFC lines of credit totalling US$7.0 million have been made to the Government-owned Bank of Ceylon (BOC). The first IFC loan to BOC, made effective in 1979, consisted of US$2 million for term loans to firms with fixed assets of below Rs 6 million (US$385,000); the second IFC loan of US$5.0 million is geared to larger enter- prises with eligible subloans ranging from US$83,000 to US$1 million. IFC also approved an investment of US$3.68 million in a synthetic textile mill, and US$986,000 in a polypropylene bag manufacturing plant in FY79. During FY80, IFC approved an increase in equity investment of about US$51,000 equivalent in DFCC and an investment of US$260,000 in an equipment leasing company. In FY81, IFC approved an investment of about US$0.7 million in equity and about US$17 million in loans for a new hotel project in Colombo. 21. The Bank Group's current strategy focusses on the agricultural sector. It aims to support Government efforts to increase food production and reduce dependence on food imports, and to raise productivity, employment, incomes and living standards of the rural population in Sri Lanka. This strategy includes projects to support basic infrastructure. In addition to providing financing for the Second and Third Mahaweli Ganga Development Projects and the Mahaweli Ganga Technical Assistance Project, the Bank Group is assisting the Government in accelerating the implementation of the Mahaweli Ganga Development Program principally through coordinating external assistance. The Board approved a Village Irrigation Rehabilitation Project on June 16 and the Third Mahaweli Ganga Development Project on June 23, 1981. Currently under appraisal are a second tea rehabilitation project, and a Mahaweli Power Transmission Project.  - 8 - 22. The Bank Group presently accounts for 9.7% (IBRD, 2.3%; IDA, 7.4%) of Sri Lanka's total debt outstanding and disbursed, and 6.5% (over 80% IBRD) of debt service on medium and long term debt. The projected Bank Group's share in total existing external debt outstanding and disbursed will increase to 17% by 1985 (with the IBRD's share declining to 1.3%). The Bank and IDA portions of this debt service are expected to decline to about 4% by 1985. PART III - THE SECTOR 23. Manufacturing accounts for about 14% of GDP and consists of 29 public sector corporations; about 9000 registered private factories composed largely of small and medium industries; and over 20,000 unregistered small and cottage industries. Industrial growth slowed from 7.8% in 1978 to 4.6% in 1979, and to about 0.8% in 1980. However, this deceleration has been due to weak performance in many public sector enterprises and in tree crops processing industries. Growth of private sector manufacturing has continued to be buoyant during the 1977-80 period; "factory industry" grew at an average annual rate of nearly 7% and annual growth of unregistered small and cottage firms averaged over 9%. Construction and mining/quarrying, in which small firms have a major role, grew by 20% and 9% annually during the 1977-80 period. By 1980, manufac- turing, mining, and construction constituted about 29% of GDP, nearly equal to the 28% share of agriculture and related sectors. Measures to increase private industrial output and exports while controlling public expenditures will remain important in addressing problems with inflation, trade, and budgetary deficits. 24. Manufactured exports, excluding petroleum, almost doubled in value between 1978 and 1979, with the growth rate slowing to about 30% in 1980. Growth in garment exports dominated in both years. In 1979, seafoods, ceramics, rubber and metal product exports also showed substantial growth from a low base. In 1980, however, seafood exports declined and exports in the smaller light industrial groups stagnated. Garment industries may be started with relative ease, but significant growth in other promising light industrial product groups will require systematic promotion, technical and marketing services. Policy FramewQrk 25. Most private industrial firms appear to have benefitted from libera- lization of imports and improved export incentives. The rapid increase in approvals for establishing industrial enterprises and the sharp expansion in demand for term loans by SMIs reflect the ability of most firms to meet com- petition from imported finished products. However, the needed move toward efficient enterprise has been hampered by the unequal, and often high, levels of protection through the tariff system. A study of the tariff system, financed under the first SMI Project, indicates a wide variation in effective protection rates (EPR), ranging from -50% to over 1,000%. The study team is preparing recommendations for phased revisions in the tariff system to reduce this variation in EPRs, beginning with the extremes. In addition, the EPRs could provide a more accurate basis for determining value added in non- traditional export industries, under the recently approved Export Expansion Scheme (para 44).  - 9- Characteristics and Role of SMIs 26. SIls continue to dominate private manufacturing, accounting for over 90% of private industrial units, over 70% of employment and over 50% of value added in private manufacturing. In 1978, only 5% of the 9,000 regis- tered private firms had fixed assets of over Rs 1 million; none of the 20,000 unregistered firms exceeded this investment amount. In the 1978-80 period, the Local Investment Advisory Committee (LIAC) approved nearly 5,000 indus- trial investments averaging Rs 600,000 (US$30,000) per unit. About 65% of registered SMIs are in and around Colombo; unregistered small and cottage industries are more widely dispersed among small towns and villages, with the Colombo district holding only about 30% of the units. The main SMI product groups are textiles, light engineering, rubber and chemical goods, wood and paper products. Most LIAC approvals during 1978-80 have been for these groups and for building materials as a response to rapid growth in public and private construction. Institutional Finance for SMIs 27. From June 1979 to June 1980, institutional credit to the private sector increased by nearly 70% in nominal terms; however, a large portion was in trade financing, particularly for imports. Industrial credit represented about 25% of total commercial bank advances as of June 1980; while short-term advances continued to dominate, medium- and long-term credit showed a modest increase in share, from 19.6% of industrial advances at June 1979 to 21.4% by June 1980. The present Government has initiated several measures to facilitate growth in industrial and export credit. The National Development Bank (NDB) launched operations in late 1979; NDB has made a number of term loans to lar- ger industrial firms and has established a successful program for review and refinance of SMI subloans made by the four local commercial banks and DFCC. During 1980, the Government approved opening of Sri Lankan operations by for- eign banks; to date these banks have concentrated on trade financing, foreign exchange operations, and term financing of joint ventures. Also during 1980, the Sri Lanka Export Credit Insurance Corporation was launched to facilitate pre- and post-shipment credit, and the Central Bank initiated a refinance scheme for export enterprises. These measures aim to increase the availabil- ity of short and long term industrial finance, particularly for non-traditional export enterprises. 28. The first SMI Project (Credit of US$16 million, July 24, 1979) con- tributed substantially to establishing SMI loan refinancing activities of NDB; the project also helped build project appraisal and term lending capabilities of the four local commercial banks and DFCC, which participated in the project. Commitments under the first SMI Project are one year ahead of appraisal esti- mates; NDB's refinance approvals totalled Rs 142.0 million (US$7.1 million) as of July 31, 1981, with full commitment of the US$12 million lending component expected by October 1981. NDB's disbursements totalled Rs 102.9 million (US$5.2 million) on July 31, 1981, and full disbursements are expected one year ahead of schedule. As of July 31, 1981, about 1,500 subloans averaging US$9,500 equivalent had been approved, with fixed costs per job of under US$1,000. Major subsectors financed have been building materials, agro- industries, and light engineering. Over 80% of the approved subprojects are totally dependent upon local raw materials.  - 10 - 29. Prior to the implementation of the first SMI Project, under a joint scheme between the two public banks and the Industrial Development Board (para 31), IUB appraised SMI projects and recommended them for commercial bank financing; the banks had veto power only; and responsibilities for subproject supervision were unclear. The scheme did not work well; the banks, reluctant to take risks on subprojects appraised by another institution, rejected the majority of IDB's proposals; and the split of responsibilities resulted in high arrears. Under the first SMI Project, the participating credit institu- -ions (PCIs) were given full responsibility for appraisal and supervision of SMK subloans; performance by the PCIs has been satisfactory. Bv the end of CYS8, the PCIs expect to have about 200 full-time SMI officers. The proposed Second SMI Project incorporates measures to ensure that the PCIs maintain full responsibility for SMI lending (para 45). 30. Credit for SMIs, which accounts for about 10% of lending to private industry, has increased in response to the favorable investment climate and improved term credit facilities. With sizeable growth prospects in agro- industries, light engineering, and construction as well as other export-related product lines, demand for term credit by SMIs is expected to continue to be strong. The analysis of potential demand for term credit by SMIs during the period of FY82-85 indicates that roughly US$370 million equivalent could be needed. The proposed project would provide US$35 million, with US$28 million in IDA financing for term loans for SMI. Other institutional sources, includ- ing rollover of repayments under the SMI Projects, are expected to meet about US$67 million of SMI term financing requirements during the FY82-85 period, with the remainder provided from equity and other sources. The size of the subloan component of the Second SMI Project reflects the credit institutions' appraisal and supervision capacities; the PCIs have about US$5 million in their pipeline of SMI loans under appraisal. SMI Technical Service Institutions 31. The Industrial Development Board (IDB), an agency of the Ministry of Industries and Scientific Affairs, is the major SMI development institution, responsible for promoting and assisting all SMI subsectors except textiles and cottage industries. The Ministry of Textile Industries (MTI) formulates policies and implements programs for the textile and garments subsector; the Department of Textile Industries (DTI), under MTI, is responsible for develop- ment of small scale hardloom and powerloom units. The Department of Small Industries (DSI), under the Ministry of Rural Industrial Development, provides services to cottage industries; most of DSI's programs deal with promotion of handicrafts for local sale. The Export Development Board (EDB) is the develop- ment arm of the Export Council of Ministers, headed by the President. EDB was established to: advise the Government on formulation of export development policies and programs; do research and development on export products and markets; and act as the central agency for export and related supply develop- ment, coordinating the activities of key public and private agents. Several private associations and advisory committees of exporters and manufacturers in major product groups have been organized; EDB intends to use these private groups to implement subsector development schemes. 32. Under the first SMI Project, IDB has been responsible for implement- ing technical service programs in rubber products, building materials and light  - 11 - engineering; IDB also is launching a subcontracting exchange to facilitate links between small and larger firms. The MTI is responsible for the Garment Training Institute, with participation of outside consultants and the Garment Manufacturers' Association. DTI has played a catalytic role and is a share- holder in the establishment of Lanka Handloom Export Private Ltd., for export of decentralized handloom production. As expected, implementation of these product development programs has been slower than progress of the lending component, since sites needed to be located, facilities constructed, consul- tants hired, and local staff trained. Steps have been taken to ensure that these programs are fully operational during CY81. PART IV - THE PROJECT 33. The proposed project builds on institutional capabilities devel- oped and components prepared during the first SMI Project. The project was appraised in February 1981. Negotiations were held in Washington D.C. from August 17-21, 1981. The Borrower's delegation was led by Mr. C. Chanmugam, Deupty Secretary of the Treasury, Ministry of Finance and Planning. A staff appraisal report (Report No. 3480-CE, dated September 14, 1981) is being distributed separately to the Executive Directors. Annex III presents a timetable of key events relating to the project and special conditions of the Credit. Project Objectives and Scope 34. The objectives of the proposed project are to increase output, employ- ment, efficiency and exports of viable small and medium industries. To meet these objectives, the project is designed to improve SMIs' access to term credit by providing refinance to the PCIs, and by strengthening staff capabil- ities in appraisal and supervision of SMI subprojects. Public and private technical and commercial services to SMIs would be improved. Modifications in the tariff system and export incentives are expected to accelerate growth in output and exports in promising light industrial products. 35. The Second SMI Project would consist of two major components: (a) Term loans to SMIs. The SMI Fund of the NDB would provide * partial refinance of eligible SMI subloans made by the parti- cipating credit institutions. In addition to funding sub- loans, the project would involve institution building of NDB and the PCIs, through provisions for increased staffing, funding of training and consultancy, and improvements in SMI credit guarantee coverage and procedures; and (b) Technical and marketing services. IDB's promotion and exten- sion programs would be strengthened with improved organization, and financing for: coaching of regional extension officers, an SMI consultancy fund to tap local private expertise, and expansion of engineering service facilities. The EDB would be supported in its program of export promotion and supply  - 12 - development in key light industrial product lines, through practical consultancy and training, sales trips, policy studies and pilot projects; exporters and manufacturers would be major participants in implementing these elements. A small amount of funding would be provided for the expan- sion of successful subsector schemes launched under the first and Second SMI Projects. 36. The project would be national in scope (Map No. IBRD 15823). While no allocations by subsector would be made for the credit component, agroindus- tries, light engineering and building materials are expected to remain the major product groups. With technical services under the first SMI Project becoming operational, lending to rubber products, handloom and subcontracting firms is expected to increase. IDB would continue its subsector services to SMIs and would strengthen extension at the regional level. The export promo- tion and supply development programs of EDB would focus on promising light industrial enterprises, regardless of size. Credit and Credit Institutions 37. Under the Second SMI Project, the SMI Fund of NDB would refinance eligible term loans to SMIs by the participating credit institutions. The PCIs would have inducements to lend on the basis of subproject viability rather than collateral, with the proposed project providing: refinance to the PCIs on attractive terms; training in SMI subproject appraisal; and effective credit guarantee coverage. Staff of the SMI Fund, increased to 19 professionals, would: review the PCIs' project appraisals and approve refinance; supervise SMI operations of the PCIs; perform subsector analysis; provide SMI training to the banks; and consolidate reporting to the Associa- tion. As a condition of credit effectiveness, modifications, satisfactory to the Association, in organization, staffing and statement of policies and operating procedures, of the SMI Fund would be made (Section 6.01(a), draft DCA). NDB would apply procedures and criteria satisfactory to the Associa- tion in subproject review (Section 3.07(a), draft DCA) and would refinance loans on terms and conditions satisfactory to the Association (Section 3.07(b) and Schedule 3, draft DCA). 38. The structure of the refinancing rates would provide higher margins to PCIs for lending to smaller SMIs, enabling the PCIs to cover proportionally higher lending costs; the PCIs would receive spreads of 5% for subloans of up to Rs 500,000 and 4% for subloans of Rs 500,000 to Rs 2,000,000, the maximum eligible subloan size (Para D2, Schedule 3, draft DCA). Although other insti- tutions also could be eligible, subject to agreement by the Government, NDB and the Association, the PCIs are expected to continue to be the two public commercial banks (People's Bank and Bank of Ceylon), the two local privately controlled commercial banks (Hatton National Bank and Commercial Bank of Ceylon) and the Development Finance Corporation of Ceylon. New participation agreements would be needed to: reflect the increase in the maximum subloan size and in the interest rates; specify increased SMI staffing requirements; and contain policy statements on SMI lending by each PCI. The participation agreements would specify the responsibilities of the PCIs and the SMI Fund; terms, conditions, and eligibility criteria; minimum staffing requirements;  - 13 - and policies to be followed in SMI lending. It would be a condition of credit effectiveness that at least two PCIs had signed participation agreements (Sections 3.09 and 6.01(d), draft DCA). 39) To encourage the credit institutions to re-uce ,-eiiance on collateral in SNIP lending, the Central Bank would continue to provide partial credPit gua- rantee coverage. The SMI Credit Guarantee Scheme would cover all SMI sublo&ar- refinanced under the proposed project, with coverage increased to the lower of 60% of the subloan amount or Rs 800,000. Guarantee premia, which would be taken from the PCIs' spread, would be 1% of the guaranteed amount. Modifica- tions in the existing scheme would be required to streamline procedures and reflect the increased size of eligible SMI subloans. These changes would be made, satisfactory to the Association, as a condition of credit effectiveness (Section 6.01(b), draft DCA). 40. Over 100 officers and 30 -middle managers of the PCIs -were trairied in SMI appraisal and supervision prior to implementing the first Project, and NDB and the PCIs have provided training to over 80 additional SMI staff during implementation. About 150 officers are working full time on SMI lending from the head office SMI units and key branches. This SMI staffing has proved in- sufficient to appraise and supervise the larger than expected volume of SMI lending activity under the first SMI Project. As a condition of its partici- pation in the Second SMI Project, each PCI would increase the trained SNI staff by an agreed number. The training units of the SMI Fund of NDB and the PCIs would provide continuous training. 41. The first SMI Project included finance for technical assistance to NDB. The Industrial Credit and Investment Corporation of India (ICICI) and an advisor assisted in establishing procedures and systems for NDB's opera- tions in direct loans for larger industrial borrowers. The credit also funded an advisor and training to help establish SMI Fund operations. The proposed project would fund consultancy to continue this institutional assistance from ICICI (US$90,000); assist in the SMI Fund's subsector analysis (US$50,000); and provide coaching to SMI Fund staff in appraisal and supervision (US$60,000). The project also would finance consultancy for PCIs interested in improving management information systems (US$60,000) and would fund training of 30 to 35 key officers of the SMI Fund and PCIs (US$70,000). Technical and Marketing Services 42. Under the proposed Second SMI Project, IDB would continue to build its technical and managerial services for SMIs. As a complement to the subsector-specific programs being implemented under the first Project, the Second SMI Project would concentrate on strengthening IDB's general extension services at the regional level by: developing more attractive career paths for extension officers; consolidating field services at the regional level; and providing intensive coaching of extension officers. The proposed project would finance about five manyears of coaching by extension specialists. With this practical training, IDB's regional extension officers would be in a better position to assess the problems of their SMI clients, and to help resolve their simpler management difficulties, More trained and experienced consultants are needed to tackle some special technical problems, but IDB expects to continue  - 14 - facing difficulties in attracting and retaining a suitable number of experi- enced technical staff, since they have good options in the growing private sector. Therefore, under the proposed Second SMI Project, IDB would establish an SMI consultancy fund, to hire local private consultants to help address the technical problems of IDB clients. Funding would be provided for about 200 manmonths of local consultancy to assist about 400 firms. A Statement of Policies and Operating Procedures for this SMI Consultancy Fund has been rati- fied by IDB's Board of Directors. Prior to disbursements for the IDB component, agreed modifications in policies, organization and personnel management would be made and at least three coaches for the regional offices would be hired; (Schedule 1, para 4(b), draft DCA). The proposed Second SMI Project also would fund the second phase in the expansion of IDB's engineering service facilities. Phase I is being implemented under the first Project; disburse- ments for Phase II would be made only once the initial phase is satisfactorily completed (Schedule 1, para 4(b) (ii), draft DCA). 43. The Second SMI Project also would support EDB in export promotion and related supply development in selected product lines. The following pro- ducts, for which market prospects and comparative advantages exist, would receive priority attention: rubber, wood, handloom, coir and marine products; gems and jewelry; and light engineering goods. Ancillary firms providing components or back-up facilities to export-oriented enterprises also would receive attention, as would key agrobusinesses including fruits and vegetables, cut flowers and plants, spices and essences. EDB would provide services to exporters and manufacturers in these lines in adapting products, improving quality and expanding the supply base, in response to concrete market opportun- ities. Eligible expenditures within this program would be: practical consul- tancy; pilot projects; training and service facilities; sales and exposure trips; and advisory services to assist in improving export policies and proce- dures. The Board of Directors of EDB has ratified a Statement of Policies and Operating Procedures for this program. Prior to disbursements for this compo- nent, EDB would finalize a year one (1982) action program, satisfactory to the Association (Schedule 1, para 4(b)(iii), draft DCA). IDB and EDB would send to the Association draft annual action programs for concurrence by November 1 of the previous year. (Section 3.11(a), draft DCA). Policy Modifications 44. The Second SMI Project would encompass work related to the tariff return and export incentives to reflect value added. The Government would, by June 30, 1982, review the effective protection study (para 25) with a view to developing a phased action program based upon this review (Section 4.03, draft DCA). The EDB would,by June 30, 1982, submit to the Association, for its review and comment, a report analyzing the appropriateness of using effec- tive protection rates to calculate value added under its Export Expansion Scheme (Section 4.04, draft DCA). Implementation 45. The implementing agencies would carry out their specific activities and responsibilities, within the framework of objectives, guidelines and pro- cedures agreed between the Government and IDA under the Credit and Subsidiary Loan Agreements. The proposed project includes provisions to ensure that the  - 15 - PCIs retain full responsibility for all SMI lending (Section 3.02(d), draft DCA). The SMI Coordinating Committee chaired by the Additional Secretary, Ministry of Industries and Scientific Affairs, and consisting of representa- tives of the implementing agencies and the private sector, has met about once a month during implementatior of the first Project. Under the proposed pro- ject, a representative of the EDB would join the SMI Coordinating Committee. The Coordinating Committee would continue to review quarterly reports prepared by the implementing agencies, examine operational problems and make recommenda- tions on improving implementation (Section 3.02(a), draft DCA). By June 30, 1982, IDA and the implementing agencies would conduct a joint review to deter- mine which subsector development schemes implemented under the first and Second SMI Projects have been successful and require funds for expansion (Section 3.10, draft DCA). Monitoring and Evaluation 46. Each implementing agency would submit quarterly progress reports to NDB; NDB would submit these and NDB's own quarterly reports to IDA not later than 45 days after the end of each quarter (Section 3.11(b), draft DCA). The review section of the SMI Fund would continue to monitor the quality of the PCIs' appraisals; the supervision section would make field visits to monitor the SMI lending operations of the PCIs; and the subsector analysis section would use project data and market information to develop norms and review the economic impact of subprojects. The SMI Fund would review in detail the PCIs' appraisals of subloans of over Rs 50,000. In addition to reviewing quarterly reports and conducting regular supervision, the Association would review pro- ject appraisals and the SMI Fund report for subloans in excess of Rs 1,000,000, before authorizing disbursements. Costs and Financing 47. The total project cost is estimated at US$52.5 million equivalent, including roughly US$5.0 million in taxes and duties. The project incorporates US$50.0 million equivalent for investment in SMIs and US$2.5 million for tech- nical and marketing services. The foreign exchange component is estimated at US$18.4 million or about 35% of the total project cost; the proposed IDA credit of US$30 million equivalent would finance the full foreign exchange cost of the project and about US$11.6 million equivalent of the local costs. Price contingencies were calculated on the following basis: 23% in 1981, 17% in 1982, 14% in 1983, 12% in 1984 and 10% in 1985. 48. The US$28.0 million subloan component of the proposed Credit would be onlent by the Government to NDB via a subsidiary loan agreement for the account of the SMI Fund on the following terms: (i) loan denominated in Sri Lanka Rupees, with Government bearing the foreign exchange risk; (ii) initial interest of 11% per annum; (iii) fixed amortization schedule of 14 years, including 4 years of grace (Para A of Schedule 3, draft DCA). The SMI Fund would provide refinancing to credit institutions for eligible SMI subloans on the following terms: (i) refinancing for up to 80% of loan amount; (ii) initial interest per annum of 13% for loans of up to Rs 500,000 and 14% for  - 16 - loans of Rs 500,000 to Rs 2 million; (iii) maturity for a maximum of 10 years, including 2 years of grace (Para B of Schedule 3, draft DCA). The credit institutions would make subloans to eligible SMIs on the following terms: (i) maximum subproject size of Rs 4 million excluding permanent working capital; (ii) maximum subloan size of Rs 2 million including permanent working capital; (iii) initial interest of 18% per annum with review of the interest rate every six months, and automatic revision if commercial bank rates on term loans to large industrial borrowers change; (iv) up to 10 years maturity, with grace periods of 3 months to 2 years; and (v) sponsors' equity contribution of at least 20% of sub-project amount (Paras C and D of Schedule 3, draft DCA). In the event that the final onlending rate to SMIs changes, the SMI Fund of NDB spread would remain at least 2% to 3% and the PCIs' spreads at least 4% to 5% depending upon subloan size (Para D2, Schedule 3, draft DCA). The remaining US$2.0 million of the Credit would finance technical services component of the proposed project. 49. Commercial bank lending rates increased during 1979-80, reflecting accelerated inflation. Interest rates to prime industrial borrowers increased from 15% in late 1979 to 18%-19% at the time of negotiations. NDB and DFCC have kept their rates at 17%. Inflation during 1980, using the GDP deflator, averaged 24%. The Government has taken several measures to curb inflation, cutting or deferring expenditures on public development projects and reducing spending by public corporations. Provided continued measures are taken, infla- tion could decline over the next three years to an average of 16%-17%. Initial interest rates for SMI term loans would be set at 18%, with rates reviewed regularly and revised automatically if prime industrial rates change. Any modifications in the onlending rates would affect only new subloans. Procurement 50. Through the participation agreements with the credit institutions, NDB would ensure that: (i) goods and services procured locally for projects requesting refinance under the SMI Fund be purchased at reasonable and com- petitive prices, and (ii) the contracts for goods procured outside of Sri Lanka and estimated to cost US$10,000 or more would be let through interna- tional shopping procedures on the basis of at least three price quotations (Section 2.03(a), draft DCA). The SMI Fund and IDA supervision missions would continue to review these procedures, which have been satisfactory under the first Project. Procurement of equipment, vehicles, materials and consultants for the technical services component would be in accordance with Government procedures, which are satisfactory to the Association. Authorization and Disbursement 51. Disbursements would be made for: (i) 100% of the portion of the loan amounts refinanced by the SMI Fund; (ii) 100% of foreign expenditures, 100% of local expenditures ex-factory, or 80% of other local expenditures for equipment, vehicles, and materials for the technical services component; and (iii) 100% of total expenditures for consultants, technical services and training. Disbursements under (i) would be made against statements of expenditure for any subloan with a refinanced amount not exceeding US$40,000. The records of expenditures made on account, wherein withdrawals are requested on the basis of these statements of expenditure, would be retained until one year after the closing date of the IDA Credit. All other disbursements would  - 17 - be made against full documentation. Prior to submitting the relevant disburse- ment requests, the Government would submit for review and authorization by the Association: (i) a summary description of each subproject to be refinanced Lmder the SMI Fund; and (ii) a summary description of expenditures to be tinanced and thelr intended uses in the technical services component. 52. Accounts and Auditing. 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 satis- factory to IDA not later than six months after the close of each fiscal year; project accounts of each implementing agency also would be audited (Section 4.01(c), draft DCA). The annual report of the auditors would include a sepa- rate opinion with respect to expenditures and relevant withdrawals made from the Credit on the basis of statements of expenditure. 53. Bridge Financing. Full commitment by NDB of the US$12 million subloan component of the first Project is expected by October 1981. NDB would provide temporary bridge funding to cover SMI refinancing require- ments for subloans under the proposed project between Credit signing and effectiveness. Benefits and Justification 54. The proposed project addresses key constraints to more rapid development of SMIs. It provides term credit to over 2,000 new and existing enterprises, meeting a sizeable portion of the financing gap for this sector and further strengthening SMI term lending operations of the participating credit institutions. The subprojects financed are expected to result in about 23,000 new jobs, with incremental fixed investments (including buildings but excluding land) per job of about US$1,600. The average subloan size is expected to be about Rs 300,000 (US$15,000), about one and a half times the average of approved subloans under the first SMI Project. 55. Improvements in IDB's regional extension programs are expected to result in management assistance to roughly 1,500 SMIs over the three year commitment period. The impact of these services on productivity, sales, and employment would be monitored. The SMI consultancy fund would ensure that local private sector expertise would be used in addressing technical problems of about 400 to 500 SMIs in areas requiring specialized skills. Thus, the 1SMI consultancy fund would encourage establishment of private sector firms specializing in consultancy to SMI5 The export and product development programs of the EDB would be expected to result in increased, diversified exports and growth in value added among key light industrial products. The proposed project would help exporters and manufacturers upgrade skills, increase quality control, improve commercial organization of the decentral- ized production base, and promote exports. Risks 56. The success of the lending component would depend on the effective operation of the SMI Fund. Satisfactory policies, procedures and standards have been tried and established. The key would be NDB's ability to attract  - 18 - qualified staff for expanded refinance operations, while increasing attention to monitoring and supervision of SMI operations of the PCIs. NDB already has hired most of the needed staff and this problem would be addressed by: (a) requiring a minimum number of trained SMI lending staff as a condition of credit effectiveness; and (b) providing for on-the-job training and consul- tancy. A further risk is that the credit institutions, particularly the public banks, may be unable to fulfill their staffing commitments. Under the proposed project, placement of a minimum number of trained staff would be a condition of participation in the project. Each PCI would need to reaffirm its commitment and allocate additional SMI staff as required. A risk asso- ciated with the IDB component is that the intensive field-level coaching might not be effective due to inadequate qualifications and motivation of extension staff. However, substantial modifications in IDB's salary structures, promo- tional policies and field organization would be in place before this coaching begins. This should help IDB attract, retain, motivate and manage qualified extension officers. The Second SMI Project would build on organizational arrangements and capabilities developed under the first Project. However, continued improvements would be needed in the services provided by the parti- cipating institutions. PART V - LEGAL INSTRUMENTS AND AUTHORITY 57. The draft Development Credit Agreement between the Democratic Socialist Republic of Sri Lanka and the Association and the Recommendation of the Commit- tee provided for in Article V, Section l(d) of the Articles of Agreement are being distributed to the Executive Directors separately. 58. Special conditions of the Credit are listed in Section III of Annex III. Additional conditions of credit effectiveness include: (i) modification of policies and operating procedures, organizational structure and staffing of the SMI Fund of NDB satisfactory to the Association (para 37); (ii) signing of a subsidiary loan agreement between the Government and NDB for the use of the funds for the lending component; (iii) signing of participation agreements with at least two participating credit institutions for access to the SMI Fund (para 38); and (iv) modification of the Credit Guarantee Scheme (para 39). 59. I am satisfied that the proposed Credit would comply with the Articles of Agreement of the Association. PART VI - RECOMMENDATION 60. I recommend that the Executive Directors approve the proposed Credit. A. W. Clausen President Attachments September 23, 1981  - 19 - ANNEX I Page 1 TABLE 3A SRI LANKA - SOCIAL INDICATORS DATA SHEET SRI LANKA REFERENCE GROUPS (WEIGHTED AV AGES LAND AREA (THOUSAND SQ. KM.) - MOST RECENT ESTIMATE) a TOTAL 65.6 MOST RECENT LOW INCOME MIDDLE INCOME AGRICULTURAL 25.8 1960 /b 1970 /b ESTIMATE /b ASIA & PACIFIC ASIA & PACIFIC GNP PER CAPITA (US$) 60.0 100.0 230.0 232.3 1136.1 ENERGY CONSUMPTION PER CAPITA (KILOGRAMS OF COAL EQUIVALENT) 114.4 143.3 140.2 499.4 1150.6 POPULATION AND VITAL STATISTICS POPULATION, MID-YEAR (THOUSANDS) 9889.2 12514.0 14542.0 URBAN POPULATION (PERCENT OF TOTAL) 17.9 21.9 26.1 17.3 40.8 POPULATION PROJECTIONS POPULATION IN YEAR 2000 (MILLIONS) 21.3 STATIONARY POPULATION (MILLIONS) 31.0 YEAR STATIONARY POPULATION IS REACHED 2065 POPULATION DENSITY PER SQ. KM. 150.8 190.8 221.7 153.6 373.1 PER SQ. KM. AGRICULTURAL LAND 507.0 518.0 552.9 360.3 2382.8 POPULATlON AGE STRUCTURE (PERCENT) 0-14 YRS. 42.1 41.9 36.9 37.4 39.8 15-64 YRS. 54.3 54.5 59.0 59.2 56.7 65 YRS. AND ABOVE 3.6 3.6 4.1 3.5 3.5 POPULATION GROWTH RATE (PERCENT) TOTAL 2.5 2.4 1.7 2.1 2.3 URBAN 4.7 4.4 3.6 3.4 3.8 CRUDE BIRTH RATE (PER THOUSAND) 35.5 29.7 27.6 27.7 29.7 CRUDE DEATH RATE (PER THOUSAND) 9.1 6.8 7.4 10.2 7.5 GROSS REPRODUCTION RATE 2.5 2.3 1.8 2.5 1.9 FAMILY PLANNING ACCEPTORS, ANNUAL (THOUSANDS) .. 55.3 113.0 USERS (PERCENT OF MARRIED WOMEN) .. 8.2 41.0 20.4 44.1 FOOD AND NUTRITION INDEX OF FOOD PRODUCTION PER CAPITA (1969-71-100) 93.0 103.0 140.0 107.1 123.7 PER CAPITA SUPPLY OF CALORIES (PERCENT OF REQUIREMENTS) 97.0 108.0 96.0 98.6 112.6 PROTEINS (GRAMS PER DAY) 44.0 47.0 43.0 56.9 62.5 OF WHICH ANIMAL AND PULSE 13.0 13.0 7.0 14.2 19.7 CHILD (AGES 1-4) MORTALITY RATE 5.8 4.8 3.4 14.6 4.8 HEALTH LIFE EXPECTANCY AT bIRTH (YEARS) 62.0 63.5 65.6 57.7 64.0 INFANT MORTALITY RATE (PER THOUSAND) 55.0 51.0 49.0 89.1 50.2 ACCESS TO SAFE WATER (PERCENT OF POPULATION) TOTAL .. 21.0 20.0 30.1 45.9 URBAN .. 46.0 45.0 65.8 68.0 RURAL .. 14.0 13.0 20.1 34.4 ACCESS TO EXCRETA DISPOSAL (PERCENT OF POPULATION) TOTAL .. 64.0 59.0 17.6 53.4 URBAN .. 76.0 68.0 71.0 71.0 RURAL .. 61.0 55.0 4.8 42.4 POPULATION PER PHYSICIAN 4493.1 6610.7 6751.2 3857.7 4428.7 POPULATION PER NURSING PERSON 4150.0 2258.0 2055.0 6411.8 2229.7 POPULATION PER ROSPITAL BED TOTAL 319.0 322.0 342.0 1132.8 588.5 URBAN .. 217.6 241.1 322.3 579.6 RURAL .. 569.6 584.2 5600.5 1138.5 ADMISSIONS PER HOSPITAL BED .. 56.5 51.3 HOUSING AVERAGE SIZE OF HOUSEHOLD TOTAL 5.4/c 5.8 URBAN 6.3/c 6.3 RURAL 5.27 5.5. AVERAGE NUMBER OF PERSONS PER ROOM TOTAL 2.0/c 2.5 URBAN 2.17E 2.7 RURAL 2.0/c 2.5 .. ACCESS TO ELECTRICITY (PERCENT OF DWELLINGS) TOTAL 7.5/c 9.0 .. URBAN 35.9/c 34.5 .. RURAL 2.3/c 3.0 ..  -20 -NX I Page 2 TABLE 3A SRI LANKA - SOCIAL INDICATORS DATA SHEET SRI LANKA REFERENCE GROUPS (WEIGHTED AV,ERACES - MOST RECENT ESTIMATE)- MOST RECENT LOW INCOME MIDDLE INCOME 1960 /b 1970 /b ESTLMATE /b ASIA & PACIFIC ASIA & PACIFIC EDUCATION ADJUSTED ENROLLMENT RATIOS PRIMARY: TOTAL 95.0 99.0 94.0/6 85.9 99.8 MALE 100.0 104.0 98.0/d 94.4 100.6 FEMALE 90.0 94.0 90. 0/d 64.5 98.8 SECONDARY: TOTAL 27.0 47.0 52.0 38.0/aa 53.5 MALE 38.0 46.0 63.0 34.6/aa 58.4 FEMALE 16.0 48.0 40.0 18.07i. 48.6 VOCATIONAL ENROL. (C OF SECONDARY) .. 1.0 1.0 3.8 21.1 PUPIL-TEACHER RATIO PRIMARY 31.0 .. 32.0 32.8 34.2 SECONDARY .. .. .. 19.9 31.7 ADULT LITEKACY RATE (PERCENT) 75.0 /e 77.6 85.0 52.8 86.5 CONSUMPTION PASSENGER CARS PER THOUSAND POPULATION 8.0 7.0 6.8 1.7 12.7 RADIO RECEIVERS PER THOUSAND POPULATION 35.8 40.0 71.2 35.3 174.1 TV RECEIVERS PER THOUSAND POPULATION .. .. .. 3.7 50.6 NEWSPAPER ("DAILY GENERAL INTEREST") CIRCULATION PER THOUSAND POPULATION 36.0 48.9 *- 14.6 106.8 CINEMA ANNUAL ATTENDANCE PER CAPITA 3.0 .. 4.7 3.4 4.3 LABOR FORCE TOTAL LABOR FORCE (THOUSANDS) 3390.9 4186.9 5011.4 FEMALE (PERCENT) 22.6 23.7 24.4 29.3 37.4 AGRICULTURE (PERCENT) 56.3 55.1 54.3 69.8 50.2 INDUSTRY (PERCENT) 13.5 14.4 14.1 14.1 21.9 PARTICIPATION RATE (PERCENT) TOTAL 34.3 33.5 34.5 39.7 40.2 MALE 50.8 49.1 50.7 51.5 49.8 FE4MALE 16.2 16.5 17.3 23.3 31.1 ECONOMIC DEPENDENCY RATIO 1.3 1.4 1.2 1.1 1.1 INCOME DISTRIBUTION PERCENT OF PRIVATE INCOME RECEIVED BY HIGHEST 5 PERCENT OF HOUSEHOLDS 26.4 18.2 18.6 HIGHEST 20 PERCENT OF HOUSEHOLDS 52.1 43.4 42.8 LOWEST 20 PERCENT OF HOUSEHOLDS 4.5 7.5 7.3 LOWEST 40 PERCENT OF HOUSEHOLDS 13.7 19.2 19.3 POVERTY TARGET GROUPS ESTIMATED ABSOLUTE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN .. .. .. 134.1 248.6 RURAL .. .. .. 111.6 193.7 ESTIMATED RELATIVE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN .. .. .. .. 249.8 RURAL .. .. .. .. 234.3 4 ESTIMATED POPULATION BELOW POVERTY INCOME LEVEL (PERCENT) UKBAN .. .. .. 41.7 21.2 KURAL .. .. .. 51.7 32.2