China - Fourth Industrial Credit (Fourth China Investment Bank) Project

Dorument Of The World Bank FOR OMCIAL USE ONLY C,4 /2(3- et" Report No. P-4452-CHA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO USt250.0 MILLION AND A PROPOSED CREDIT OF SDR 40.9 MILLION (US$50.0 MILLION EQUIVALENT) TO THE PEOPLE'S REPUBLIC OF CHINA FOR A FOURTH INDUSTRIAL CREDIT PROJECT February 6, 1987 This document has a restricted distributin and may be used by recipients only in the perrormance or their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Currency Unit = Yuan Renminbi Y) Calendar 1986 January 19B7 $1.00 = Y 3.45 $1.00 = Y 3.72 Y 1.00 = $0.29 Y 1.00 = $0.27 FISCAL YEAR January 1 to December 31 LIST OF ABBREVIATIONS AND ACRONYMS ABC - AgriculturaL Bank of China HOC - Bank of China CIB - China Investment Bank CITIC - China International Trust and Investment Corporation CNTIC - China National Technical Import Corporation DFC - Development Finance Company EDI - Economic Development Institute ICB - International Competitive Bidding ICBC - Industrial and Commercial Bank of China LIT - Limited International Tendering MOF - Ministry of Finance PBC - People's Bank of China (the Central Bank) PCBC - People's Construction Bank of China RCC - Rural Credit Cooperatives SEC - State Economic Commission SPC - State Planning Commission UNDP - United Nations Development Programme  FOR OMICAL USE ONLY CHINA FOURTH INDUSTRIAL CREDIT PROJECT (CHINA INVESTMENT BANK Iv) Loan/Credit and Project Summary Borrower: People's Republic of China Beneficiary: China Investment Bank (CIB) Amount: $300.0 million equivalent, comprising $250.0 million equivalent IBRD and SDR 40.9 million ($50.0 million equivalent) IDA Terms: Loan: 20 years, including 5 years of grace, at standard variable interest rate Credit: Standard Relending Terms: The proceeds of the loan and credit would be onlent to CIB for a 20-year term, including 5 years of grace, at a fixed interest rate of 7% p.a. CIB would pay commitment fees equal to those under the loan and credit. The Government would bear the foreign exchange risk between the US dollar and (a) the currency pool for the Bank loan; and (b) the SDR for the IDA credit. Subborrowers would pay a fixed interest rate of 8.5% p.a. and would bear the foreign exchange risk between the US dollar and the Yuan. Project Description: The project aims to assist in (a) upgrading productivity and efficiency of small- and medium-scale industries by importing modern technology, and (b) further institutional strengthening of CIB so that it can effectively perform as a model development finance institution and a catalyst in the ongoing reform of the investment design and selection system in China. The project would also enhance the capability of CIB to mobilize foreign currency resources from international capital markets to provide financing for the industrial sector. It is estimated that about 175 state and collective enterprises largely in the light industry sector would receive subloans for modernization and expansion. The project risks are minimal and mainly relate to CIB's continued and successful institution- building and its future development financing role. How- ever, the commitment of CIB management to various measures agreed with the Bank and the close supervision by Bank staff would ensure satisfactory progress in this area. Estimated Disbursement: Bank FY 1987 1988 1989 1990 1991 1992 Annual 15.0 66.0 105.0 69.0 33.0 12.0 Cumulative 15.0 81.0 186.0 255.0 288.0 300.0 Staff Appraisal No. 6412-CHA, dated January 29, 1987 Report: 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.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN AND CREDIT TO THE PEOPLE'S REPUBLIC OF CHINA FOR A FOURTH INDUSTRIAL CREDIT PROJECT (CHINA INVESTMENT BANK IV) 1. I submit the following report and recomiendation on a proposed loan and credit to the People's Republic of China to help finance a fourth industrial credit project. The loan, for $250.0 million equivalent, would have a term of 20 years, including 5 years of grace, with standard variable interest rate. The credit, for SDR 40.9 million ($50.0 million equivalent), would be an standard IDA terms. The proceeds of the loan and credit would be onlent to the China Investment Bank (CIB) with a 20-year term, including 5 years of grace, at a fixed interest rate of 7.0% p.a., plus commitment fees equal to those under the loan. PART I - THE ECONOMY 2. A country economic report, entitled "China: Long-Term Issues and Options" (No. 5206-CHA), was distributed to the Executive Directors on May 22, 1985. Basic data on the economy are given in Annex I. Background 3. Since 1978, China has initiated economic reforms in both rural and urban areas and in the external sector. Reforms have thus far progressed the farthest in the rural economy. Following some experiments with the abolition of collective farming in impoverished areas, the Government implemented a com- prehensive restructuring of rural institutions based on various forms of the "'production responsibility system". By 1983 the farm household had become the fundamental unit of management and production in agriculture, within a frame- work of collective or state ownership of land and major fixed assets. Reforms are now proceeding in the urban economy, and there have been significant changes in enterprise management and finance. The scope for collective and individual economic activities has been enlarged, and state enterprises have been allowed greater freedom in production, pricing and marketing above their mandatory plan targets. State enterprises have also been allowed to retain some profits, and investment projects are increasingly being financed on a loan rather than a grant basis. 4. In international trade and investment, China has been progressively opening up to the rest of the world. Between 1978 and 1985, the share of exports to GDP nearly doubled to about 10%, a ratio similar to other large economies such as the U.S. and Brazil. Foreign investment has been encour- aged, first through the establishment of four Special Economic Zones and the signing of joint venture contracts for off-shore oil exploration, and more recently through the opening of 14 coastal cities to foreign investment.  -2- Growth and Stabilization 5. Reforms have helped to stimulate more rapid development of the economy. Real GDP growth averaged 5% p.a. between 1978 and 1981 and 10% p.a. between 1981 and 1985. More recently, in 1985, growth accelerated to 12.3% as a result of further reforms emphasizing decentralized decisionmaking, and the expansionary macroeconomic policies of 19B4. During 1978-1985, per capita incomes in real terms more than doubled in rural areas and increased by more than 50% in urban areas. Agriculture has continued its remarkably strong performance, with gross agricultural output value (excluding ruraL industry and commerce) rising at nearly 11% p.a. between 1981 and 1985 and grain output at 8% p.a. (reaching as high as 407 million tons in 1984). Cash crops and animal husbandry, stimulated by rising demand and attractive prices, have also grown rapidly. Gross industrial output value grew at over 10% p.a. over the same period, with heavy industry growing somewhat faster than light industry (12% p.a. vs. 9% p.a.). If rural industrial output is included, gross indus- trial output value grew at close to 12% p.a. in real terms between 1981 and 1984. The energy constraint on industrial growth was eased by rising coal output (8% p.a. between 1981 and 1983), renewed increases in crude oil produc- tion (4% p.a. between 1981 and 1985) and improvements in the efficiency of energy utilization (primary commercial energy consumption grew only 601 as fast as GDP between 1981 and 1985). Manufactured exports growth, at 8% p.a. in real terms between 1981 and 1985, was slower than during the 1978-81 period in the face of worsening world market conditions. 6. The Government continues to face difficulties in combining system reform and rapid overall growth with maintenance of economic stability. During 1979 and 1980, China experienced large budget and current account deficits, combined with excessive investment and inflationary preL ires. In response, a strict stabilization program was introduced in 1981 relying mainly on administrative controls on investment spending. The program slowed growth but also helped lower the budget deficit from about 5% of GDP in 1979 to less than 1% in 1981, reduce inflation to around 2% p.a., and change China's exter- nal position to one of current account surpluses averaging nearly $4 billion during 1982-84. As a result, foreign debt and debt service ratios were still at low levels ($13.1 billion and 6.8%, respectively, in 1984), and China's foreign currency reserves rose to $17.8 billion (over 9 months' imports) by mid-1984. 7. This comfortable balance of payments position disappeared rapidly during the course of 1984 and early 1985. Partly as a result of decentraliza- tion of decisionmaking and the lack of effective indirect policy instruments, there was a rapid acceleration of investment and consumption during late 1984 and the first half of 1985, causing the economy to overheat. Real GDP grew by 12% during 1985, while average wages in state-owned enterprises rose by 20%, and domestic credit grew by 22%. The retail price index rose by 8.8Z in 1985. There was also a rapid expansion in consumer goods imports. As a result, foreign exchange reserves had fallen to $13.2 billion by the end of 1985 (equivalent to 4.2 months of imports), and the current account deficit for the year was $12 billion, much of which was financed by an increase in foreign borrowing. China's external debt by end 1985 reached $20 billion, up from $13.1 billion in 1984 and the debt service ratio (including short-term debt)  - 3 - rose to 82. The Government responded by launching a strict stabilization program that aims to control imports and borrowing and includes further increases in interest rates as well as a series of administrative directives governing bank credit and project approval. Most recently, in JuLy 1986, the Renminbi was devalued from Y 3.2 to the US dollar to Y 3.7, and a program to improve controls over external borrowing was introduced. As a result, aggre- gate credit and investment as well as new import orders have begun to slow. The balance of payments in 1986 is likely to show an improvement, albeit small from 1985. Recent Reforms 8. The Central Commitcee of the Chinese Communist Party issued a major document on "reform of the economic structrre" in October 1984, whose provisions have been embodied in the Seventh Five-Year Plan. These include: (a) state enterprises should be made fully independent units which pursue profits and are responsible for losses; (b) the scope of mandatory planning should be reduced and replaced by indicative planning, while the focus of planning should shift from annual to medium- and long-term guidance planning; (c) a more rational price system should be introduced, reducing the role of state-controlled prices and increasing the role of "floating" and free market prices; and (d) the tax system should be improved, finance and banking should be reformed, and a larger role should be given to indirect macroeconomic regu- lation through indirect instruments such as tax, credit and pricing policy. 9. Rural reforms have continued to progress more rapidly than reforms elsewhere in the economy. There has been a remarkable spread of nonagricul- tural activities like processing, transport, and commerce. "Specialized households" (which concentrate on cash crops, animal husbandry, or nonagri- cultural activities) and pooling of capital by small groups of households in various types of ventures are becoming increasingly common forms of economic organization in China's rural areas. Wholesale markets for some agricultural products have emerged. To encourage investment in land improvement and devel- opment, farming contracts between collective and peasant households for the use of land (which typically had been fixed for no more than 3-5 years) can now be extended to as long as 15-20 years. In early 1985, the system of agricultural procurement was changed. Previously the Government purchased quota output of grain and other crops at relatively low prices and stood ready to purchase all above-quota output at a higher price. Under the new system, procurement up to a certain amount (below former quota procurement) is based on contracts concluded voluntarily between peasants and procurement agen- cies. Prices for these purchases are based on the relatively high average price of past years. Output above the contracted amount must be sold by peasants directly on the free market, but the Government will intervene to purchase grain if the price falls to the original quota procurement price. Thus, a considerably larger portion of basic crop production will be produced for and traded on markets with flexible prices. 10. The momentum of urban reforms has continued with significant progress on several fronts. In enterprise management, the focus has been on broadening and delineating the decisionmaking authority of urban enterprises. Profit retentior. now extends to virtually all state-owned industrial  - 4 - enterprises and to nonindustrial sectors like transport, commerce, construc- tion, and other services. Urban collectives and individual enterprises, as well as a variety of joint ventures between them and state enterprises, have grown rapidly (the number employed in urban individual enterprises rose from 150,000 in 1978 to 3.4 million in 1984). 11. In financial reforms, the most important new development has been the implementation of a prafit tax system to replace profit remittances by state enterprises to the government budget. Though moat enterprises have switched to this system, the benefits have been limited because financial discipline at the enterprise level remains weak. Efforts have been made to strengthen accounting and auditing systems and more strictly enforce existing financial regulations, but the expectation resains strong that the Government will subsidize losses. 12. Progress has also been made with price reform. The majority of agriculture commodity prices were decontrolled even before the recent change in pricing and procurement of grain. Prices of many consumer goods are also set by negotiations between producers and commercial units. "Floating prices" (up to 20% above or below official prices) are now allowed for many industrial producer goods (either for all output or for output above the mandatory plan target). Price adjustments for key energy products and raw materials (which in many cases are severely underpriced) and for subsidized basic consumer goods like grain and edible oil have proven more difficult to implement, hindered by the potential impact of price changes on urban living standards and on the finances of energy-using enterprises. Nevertheless, some price rises have occurred (e.g., for coal and petroleum), and, moreover, the share of free-market transactions, at largely uncontrolled prices, has increased in recent years. Gradually over time, a two-tier system is emerging; a large but shrinking share of the total supply of most important goods is subject to mandatory plan allocation and administratively set prices, while at the margin a substantial and growing share is allocated by the market mechanism, largely at flexible prices. This pattern may permit China to "grow out of the plan" in a relatively smooth transition, though there are obvious threats to this strategy arising from the strong incentive for arbitrage between planned and unplanned realms. 13. The Government recognizes the need to develop new tools of indirect macroeconomic management and has taken some steps to do so. The People's Bank of China was established as a separate central bank at the beginning of 1984, with its commercial banking functions taken on by the newly created Industrial and Commercial Bank of China. In 1985, new methods of credit planning and control were introduced and redeposit requirements were introduced for the specialized banks. Interest rates (including deposit rates) were also raised in 1985, with some move toward unification of rates and development of a term structure resembling that in other countries. Technical transformation loans with a maturity less than one year and loans for working capital now carry the same 7.9% interest rate while loans of longer maturity carry higher rates, up to 10.8% for 10-year loans. However, interest rates on budgetary capital construction loans (formerly grants) remain low, and there is a variety of directed credit schemes. On the external side, greater use is now being made of the exchange rate. The old internal settlement rate was abolished at the  - 5 - beginning of 1985, and between January 1985 and the present, the Rerminbi has been devalued three times, most recently in July, by 16X against the US dollar. Despite these changes, progress in perfecting new indirect levers of control has been slow. Recent difficulties in securing macroeconomic balance highlight the need to strengthen institutions and macroeconomic management tools (including monetary, fiscal, and exchange rate instruments) for a decentralized and more market-oriented economy. Long-Term Issues and Prospects 14. In April 1986, a national Party conference adopted the new Seventh Five-Year Plan covering the period 1986-90. The Plan reaffirms the commitment to economic reform and provides guidelines for future reform and development. Target growth rates (7% p.a. for industry, 6Z for agriculture, 7.5Z for CNP) are below rates of growth achieved with the Sixth Five-Year Plan, investment is to be restrained in the next few years, and emphasis is to be placed upon quality rather than quantity of output. It is thought that slower growth will facilitate reform and help maintain macroeconomic balance. 15. The Plan identifies three main areas of reform. First, enterprise management and incentives are to be improved by: giving enterprises greater autonomy in production, pricing, and employment decisions; lowering and equalizing taxes; increasing competition; increasing accountability for performance; and reforming personnel procedures. In addition, more small state enterprises will be turned over to collective or individual management through contracts or leases. Second, the role of the market is to be further extended, and market networks strengthened. The scope of mandatory planning will be further reduced, and markets for capital, technology, and labor will gradually be developed. Third, the emphasis of planning will shift from detailed administrative control to indirect macroeconomic control through economic policy. To this end a series of mutually reinforcing reforms in the planning, pricing, fiscal, banking, and labor and wage systems will be intro- duced during the plan period. 16. Specific policy measures will take time to design and implement, however. Many of the reforms required will be d5fficult. Since reforms in different areas are closely interrelated, appropriate sequencing and coordina- tion are essential. For example, price reform in the absence of improvements in enterprise financial discipline will have limited benefits, yet tighter financial discipline and more profit-oriented behavior would exacerbate the adverse impact of distorted prices. Similarly, reform of the labor allocation system to promote greater labor mobility will be incomplete without eliminat- ing many of the "social responsibilities" of enterprises (which now provide housing, medical care, and pensions for their workers and in many cases educa- tion and jobs for workers' children) and replacing them with Government- supported social service programs. 17. China's objective of quadrupling the gross output value of industry and agriculture between 1980 and 2000 (which means GDP growth of well over 6% p.a.) will require significant improvements in efficiency as well as continued high saving and investment rates. The Plan recognizes there must be major structural changes in the economy over the next two decades, including a  reduction in the share of agriculture, a rise in the share of industry and services (which at present is unusually low), and substantial urbanization. There will also be a shift within agriculture, away from grain and basic crops and into cash crops and animal husbandry. The new plan will emphasize development of the service sector, mainLy through removing restrictions on collective and individual activity. Urban development will focus on small and medium-sized cities and towns, while restrictions on growth of large urban areas will continue. 18. Certain physical/technical constraints will hinder the attempt to achieve China's targets for the year 2000 and its longer-term goal of catching up with developed countries. Despite rapid growth and substantial improve- ments in efficiency in recent years, agriculture may again become a constraint on overall growth, since land in China is severely limited. In energy, short- ages of fuel (primarily coal) and electricity may continue to constrain growth of transport and commercial infrastructure. Without large new investments and improved efficiency, economic growth will lag. In mobilizing resources in all these areas, China could profitabLy make use of foreign borrowing. Finally, the rising share of the elderly in China's population (related to the slowdown in population growth) means that more resources will have to be devoted to maintaining their consumption levels, especially in the decades after 2000. 19. Poor motivation and inefficient utilization of labor in the state sector of the economy are major problems which can be solved only by coordi- nated reforms in labor allocation, the wage system, enterprise management, and social services, among other things. Reforms in the system of education and training to develop China's "human capital" potential also are crucial. Back- ward technology and inefficient use of existing technology must be addressed by a combination of reforms, appropriately directed investment, and transfer of advanced foreign technology. Irrational location of factories, suboptimal scale of many plants, and poor utilization of physical capital in general are related problems. 20. If reforms successfully transform the economic system, with a bene- ficial impact on growth and efficiency, a new set of issues will come to the fore. Management of a reformed economy with indirect fiscal, monetary, and other instruments is a major issue (see para. 15 above). In this context, maintaining an adequate saving rate (since the Government no longer accounts for the bulk of aggregate saving) and avoiding inflation (as well as deep cyclical downturns) will be major goals. Assuring an adequate minimum standard of living for the population and an appropriate level of social services will become a major challenge, as enterprise and rural communal responsibilities in these areas are reduced. The problem of poor, backward rural areas in various parts of the country will continue to require atten- tion. Redistributing financial resources to these areas through the fiscal system, easing restrictions on migration out of the poorest areas, and lower- ing nonagricultural wages to make investment in them more attractive are some options for alleviating poverty. 21. In order to mobilize the external resources needed for rapid, sustained growth the Plan calls for export growth of 40-50% over the next five years to reach $38 billion; greater efforts to attract foreign investment; and  increased but cautious commercial borrowing. Imports are expected to reach $45 billion by 1990, implying a fairly slow growth rate of 4% per annum but on a very high base volume of imports in 1984-86. By implication, the Plan calls for continued borrowing on the world capital markets through the end of the decade. Under this scenario China's current account deficit would average around $7-8 billion p.a. during the remainder of this decade, equivalent to about 1-2% of CNP. This implies that the present debt service ratio would increase by 1990, although it would remain below the 15% ceiling given in the Plan. If China's exports grew more slowly, imports would probably have to be cut back, because a higher borrowing target although feasible, might not be comfortable in terms of debt service indicators. This highlights the need for continued export growth in order to meet other Plan objectives and to service present and future commercial borrowing. The Plan recognizes that flexible use of exchange rate and pricing policies will be needed to encourage export growth. 22. Even with continued good export performance, China will have substantial external capital requirements during the remainder of the decade, and access to concessionary capital will continue to play an important role in sustaining China's growth. China is still one of the poorer countries of the world, but its access to concessionary capital for financing development and modernization is limited. Apart from Bank Group funds, a significant amount of concessionary capital is likely to come only from Japan and a few other bilateral donors and will probably average no more than $500-600 million p.a. during the rest of the 1980s. PART II - BANK GROUP OPERATIONS 23. To achieve the target growth rates envisioned in the Seventh Five- Year Plan, to increase efficiency, and to maintain equity in distribution, China will need continuing economic reforms. China will need to import more technology, increase trade, and expand investment. In the next few years, therefore, the Bank can best assist China by increasing its access to foreign technology and capital and supporting the implementation of reforms that will help to increase the efficiency of resource use and reduce poverty. 24. To address China's objective of updating technology, the Bank will play the role of an i rmediary. In transportation, energy, industry, agri- culture and social set :s, the Bank will contribute to technology transfer by bringing the Bank's exzj1rience to bear on project design and implementation and by helping China to seek appropriate technical solutions through interna- tional competitive bidding, training, and foreign technical assistance. 25. Bank assistance will be closely linked with the Government's reform efforts. There are five major elements common to both rural and urban reform in China that will be the focus of the Bank's involvement. First, institu- tional change, involving both the separation of economic and administrative functions and further decentralization of decisionmaking, will extend to every sector in which the Bank is involved. Second, financial sector reform, primarily development of financial institutions, has become a focus of Bank  - 8 - assistance. Third, improving planning and project analysis will be critical to reform in sectors such as agriculture and industry, where decisions are now being made by household. and independent enterprises, as well as in infra- structure where direct government involvement will be required. The Bank vill therefore continue its emphasis on introducing appraisal methods and financial planning as well as analysis of intersectoral issues. Fourth, the Bank will be involved in the Covernment's major program of price reform and development of indirect levers such as control via money, credit and fiscal policies. And finally, the Bank will support reforms in health, education and other social services and measures, in particular, to address the problems of poor regions. Economic and Sector Work 26. The Bank's economic and sector work in China aims at expanding the understanding of the structure and direction of the Chinese cLconomy and of the tools of economic management. This work provides a foundation for Bank Group lending and for the dialogue with the Government on development options and policies. The Bank's program of economic and sector work in China is in four main areas. The first consists of studies aimed at providing timely advice on the macrosystemic elements of economic reform. Past work has included two major economic reports, and a third will be produced this year based on the findings of an FY86 mission which studied the evolving processes of mobiliza- tion, intermediation and allocation of investment resources in China. A study on policy options to reform China's external trade and borrowing regimes is now underway and will be completed in FY87. 27. A second area of the program is concerr-d with macroeconomic manage- ment. Working in close cooperation with the IHF, the Bank will assist China in examining mediumrterm macroeconomic prospects, with particular attention to fiscal, balance of payments and external debt trends and related policy issues. The Bank will also continue to organize seminars on macroeconomic issues. 28. The third area is sector analysis to provide support to the reform process at the sectoral and micro levels, to strengthen sector planning and to underpin the development of the Bank's lending program. Emphasis will be given to sector work in industry, energy and transport, reflecting priorities identified for the Seventh Five-Year Plan. 29. The fourth area of economic and sector work is continued collabora- tive economic study with the Chinese Academy of Social Sciences and other Chinese research institutions. This type of collaboration has proven to be an effective means of introducing Chinese academics and technicians to modern research concepts and techniques. A study of state enterprise management has been completed, and work is now underway on a similar study of township and village collective enterprises, which are expected to become increasingly important industrial organizations in the reformed system. Lending Operations 30. Since China's change of representation in the Bank Group in May 1980, 43 projects involving lending of $4,266.1 million to China have been  .- 9 - approved. Of the project., thirteen have been in the agriculture sector, eleven in cnergy, six in transport, four in industry, four in education, two each in health and technical cooperation and one in water supply. In FY85, IFC made its first investment in China of $17.02 million for automoblle manufacturing. 31. In addition to the already approved Red Soils Area Development and Shuikou Hydroelectric Projects and the proposed project, we expect to present to the Board this year projects in port development, machine tools, agriculture, urban sanitation and highway development. For FY87 and beyond, we expect the lending progrsm for China to continue to grow from current levels. Infrastructure projects in energy and transport will remain priorities. Technical renovation of enterprises, particularly in industry, will be given greater attention and support as will the regional approach to project development, which is the basis of a proposed project to meet the needs of Gansu province. 32. In the energy sector, future Bank lending will be aimed at improving efficiency of energy consumption and expanding energy production. For example, in the coal subsector, we will assist in upgrading the facilities and operations of existing mines and in transferring improved technology for mines under construction or in operation. In power, we will assist China in tech- nology transfer, system planning, staff training and institution building. In the petroleum subsector, the rationale for project involvement will lie in the identification, packaging and transfer of specialized technologies as well as in the strengthening of investment planning and management capabilities. 33. Future transport projects will be aimed at contributing to China's efforts to efficiently meet the transport requirements of its growing economy. In roads, major changes in organization and financing will be required as a result of administrative decentralization and introduction of the production responsibility system in rural areas. In railways, we will focus on technologies to improve domestic production of railway equipment and materials in addition to our work on line construction and electrification. We also intend to broaden our involvement in ports to include coastal shipping and inland water transport. For all transport subsectors, we will support efforts to improve financial analysis and investment planning. 34. Bank lending in industry will continue to support financial interme- diaries which provide credit to state and collective enterprises. In addi- tion, we will expand lending through direct and subsector operations to upgrade technology, conserve energy, and improve overall organization and management, particularly in fertilizer, cement, machine tools and other capital goods industries. 35. Agriculture lending will focus on developing institutions to provide services to individual farmers and to monitor and stimulate change in the pace and pattern of agricultural development. The shift from grant to loan finance and the increased autonomy of the rural banking system will continue to be supported through rural credit projects. We will also assist with the train- ing, research, extension, and other service activities of the ministries concerned with agriculture. In addition, we expect to finance programs for  - 10 - specialized agricultural development such as livestock and for irrigation and area development. 36. Bank lending in education will suppport China's efforts to expand and improve the quality of higher education, develop technical and vocational education and strengthen basic education by improving training of teachers and administrators, increasing domestic capacity to produce teaching materials and educational equipment, and raising the quality of schools administration at the provincial level. 37. Project preparation in the urban sector is currently concentrated in Shanghai on efforts to improve services, especially in environmental upgrad- ing, and development of municipal institutions. Future lending is expected to include support for development of medium-size and small urban areas in specific provinces. In addition, we expect to continue lending for rural water supply. Bank Lending in health will provide access to new medical technologies for more efficient heaLth care in both the lingering problems of communicable disease, particularly in poor rural areas, and the emerging problems of chronic disease. This will involve further support for medical training and planning and management of service delivery systems. Projects will also support the reform of systems for supplying and financing health services. 38. Cofinancing with multilateral and bilateral agencies has been arranged for projects in coal, power, transport, agriculture and rural water supply and will remain a feature of our assistance program. We will explore further options fcr cofinancing with export credit agencies. Commercial bank cofinancing and the use of B-loans also appear viable, particularly as China increases the overall volume of its foreign borrowing. In technical assist- ance, we will continue to incorporate into projects components for training, overseas study, and access to foreign expertise. In addition, we will continue our close collaboration with UNDP particularly through our role as executing agency for a second UNDP umbrella project in China. EDI activities remain an important element of the Bank's program and in coming years will provide an extensive program of policy seminars for senior Chinese officials, and economic and financial management courses and sector-specific training for officials from core and Line agencies. Implementation 39. Project implementation is generally proceeding well. Most project agencies, as well as the Ministry of Finance and the State Planning Commission, have established and staffed offices to handle Bank projects. Disbursement performance has also been satisfactory. Special accounts have been established for a majority of the approved projects and have helped to speed disbursements. In October 1985, the Bank opened a resident office in Beijing to support further expansion of the lending program, accelerate project preparation, improve project implementation and further economic and sector work.  - 11 - PART III - THE INDUSTRIAL AND FINANCIAL SECTORS The Industrial Sector 40. Structure and Performance. China is one of the world's ten leading industrial producers and provjler of the largest full-time industrial employ- ment. Its industrial sector - is the most important productive sector and source of development and represents over one third 7f GDP. The industrial sector comprises 437,200 enterprises, mostly small 2 (99%), employing 63.4 million workers (13% of China's total labor force). State enterprises constitute the sector's core, with 64,000 enterprises employing 35.9 million, and producing 74% of total industrial output. Other industrial enterprises comprise mainly urban and rural "collective" enterprises; these 352,000 units, with an average employment of about 50 workers, are responsible for one-fourth of total industrial output. Small private enterprises and village industries have emerged in recent years as significant producers, with a contribution of 7.5% to total industrial output. Gross industrial output value of Y 875.9 billion ($296 billion equivalent) in 1985 was shared almost equally by the light (47%) and heavy (53%) industry subsectors. 41. Growth of industrial output has accelerated, from 8.7% in 1980 to 14.0% each in 1984 and 1985, averaging 11.6% p.a. (in real terms) over the 1981-85 period. Investment in industry (including energy) increased from Y 38.04 billion ($22.3 billion) in 1981 to Y 65.35 billion ($28.2 billion) in 1984. Light industry has received on average 22% of total industrial investment, and has grown at an average rate of 9.4% p.a. (in real terms) over 1981-84. In 1984, output of collective enterprises increased in real terms by 28%, compared with the growth of state-owned industry by 11Z; growth in 1984 was evenly balanced between heavy and light industry, but the latter's growth was slightly faster in 1985. 42. Manufacturing output per worker is low in China. It averaged Y 11,090 ($3,960) in 1984, which was only one fourth of the average for middle income countries and about 4% of that for industrialized economies. Perfor- mance in terms of overall labor productivity and profit rate varies signifi- cantly between state and collective enterprises and between light and heavy industries. Light industry, which accounts for only 29Z of total operating capital (net fixed assets and working capital) in the industrial sector, has shown the highest returns (profits and taxes) on capital. In terms of trends, 1/ In Chinese statistics, industry comprises manufacturing, energy (coal, petroleum, power) and mining. It is divided between heavy industry (energy, mining, metallurgy, building materials and most chemical and engineering industries) and light industry (textiles and clothing, food industries, light chemical and metal industries, and miscellaneous). 2/ In China, enterprises are classified as large, medium, or small but the size (defined in terms of plant capacity or value of fixed assets) varies from one industry to the other.  -- 12 - heavy industry in recent years (1981-84) has improved its efficiency in the use of production factors, with labor productivity increasing by 8.5% p.a.; on the other hand, light industry has had only a marginal increase of 2.12 p.a. in labor productivity despite large increases in operating capital, and its global productivity of factors has declined. This reflects the need for application of more modern and sophisticated technology and improvement of efficiency in light industry. 43. Chinese industry has remained essentially inward-oriented to meet the rapidly growing demand of the domestic market for consumer goods in par- tict.lar. The export/output ratio averages about 4.7% for manufacturing. The overall growth rate of manufactured exports decreased in 1981-84 over 1978-81 period but exports have begun to grow rapidly in recent years and reached Y 31.6 billion ($13.6 billion) in 1984 (+27% over 1983), with light industries showing more rapid growth (+34% over 1983). 44. Issues. Growth of the industrial sector in China faces a number of constraints. About 80% of industrial fixed assets are obsolete or outdated, resulting in technical inefficiencies, including relatively high consumption of raw materials and energy. There has been also a lack of incentives for efficient use of inputs due to uneconomically low prices of energy supplies and basic industrial intermediates. Chinese industrial organization is characterized by planned production, decentralized control and poor communi- cations, which create a highly complex and diversified system. However, the availability and dissemination of relevant statistics and information are often insufficient for effective detailed planning, and horizontal links between ministries and enterprises at the central and provincial levels are inadequate. As a result, supply and demand are often mismatched, and short- ages of key inputs (e.g., energy supplies, raw materials, transport, qualified managers and engineers) constrain production. Also, the overemphasis on self-sufficiency at national and provincial levels has allowed the installa- tion of costly plants of uneconomic size. Furthermore, the excessive focus of the government plans on physical output and quantitative targets has Gften led enterprises to neglect product quality and variety and to continue producing substandard or outdated goods. As many prices were set in the 1950s (by central or provincial authorities) and have changed little since then, the structure of industrial prices is often at variance with today's production costs or market scarcities. In general, consumer goods of light industries are priced relatively high compared to basic, intermediate, and machinery products of heavy industry. 45. Continuing major efforts and policy reforms are needed to resolve industrial sector issues. The basis of industrial growth has to shift from capital accumulation to efficient use of available inputs, to free more resources for other sectors (e.g., transport) and consumption. At the same time, industry must remain a principal source of employment, and seek to expand exports in more competitive world markets to pay for imports of modern foreign technology and machinery. Also, the sector must respond to rising living standards and a more sophisticated consumers' demand through improved quality and variety of industrial products, as well as expanded production volume.  - 13 - 46. Government Policies and Strategy. Recognizing the production inefficiencies and technological backwardness of industry in China, the Covernment introduced in 1979 an economic strategy which has emphasized tech- nical updating of existing enterprises, particularly through importation of foreign technology; development of more efficient light (consumer) industry and of manufactured exports; and energy and materials conservation in industry. The adjustment has been rather successful, particularly in shifting emphasis towards light industry (which helped reduce energy consumption) and in shifting investments from new capital construction towards modernization projects. The Government has also approved, in October 1984, a broad frame- work for industrial reform, to be progressiveLy implemented over the coming years. The main thrust of the reform is to decentralize economic decision- making and to separate it from administration and to rely more on the market to provide incentives and guide decisions (see para. 8). These priorities have been reiterated in the Seventh Five-Year Plan (see paras. 14-16). The Financial Sector 47. Role. China's financial system is relatively underdeveloped because until 1978 most fixed investment and even working capital were financed through the budget. Under these conditions, the financial system served mainly to channel budgetary funds for approved purposes and to help control state and collective enterprises. More recently, increased attention has been paid to using banks to mobilize savings, increase investment efficiency, and provide a detailed review of project proposals independent of the enterprises and their supervisory agencies. 48. Institutional Structure. China's banking system consists of a small number of nationwide specialized banks with extensive branch networks, under the supervision of the People's Bank of China (PBC) which serves as the country's central bank (see para. 13). The Industrial and Commercial Bank of China (ICBC), established at the beginning of 1984, accepts deposits and provides short-term working capital loans and medium--term modernization loans in local currency. The Bank of China (BOC), also under the aegis of PBC, serves as a commercial bank for foreign exchange transactions and provides loans in foreign exchange. The Agricultural Bank of China (ABC) performs banking and financial administration functions similar to ICBC's but serves mainly China's rural areas. The People's Construction Bank of China (PCBC), under the aegis of the Ministry of Finance, is the nation's investment bank specialized in financing capital construction projects with budget appropr- iations and loans. Finally, the China Investment Bank (CIB), created in 1981 under the aegis of the Ministry of Finance and PCBC, is the only industrial development finance institution in China which bases its investment decisions on generally accepted project appraisal criteria. While different banks are specialized in terms of activities and clientele, there is some overlap, particularly in financing of fixed investment in industry. This overlap is leading to increasing competition among different banks to finance attractive industrial projects. 49. Investment Finance. Fixed investment in China is financed from a variety of sources: state budget grants, extra-budgetary funds of various government agencies, internal resources of enterprises, domestic bank loans  - 14 - and foreign loans. The share financed by state budget grants has fallen sharply from 75% in 1970 to 45% in 1980 and 35Z in 1984. Correspondingly, the share of self-financing by enterprises, local authorities, and other agencies rose from 241 in 1970 to 37% in 1980 and 431 in 1984. Domestic currency bank loans, negligible in the late 1970s, have been financing an increasing share of fixed investments, reaching about 15% in recent years; foreign currency loans, also negligible in the late 1970s, accounted for 6-71 of the total in 1982-84. 50. BOC is the primary source of foreign exchange loans for Chinese enterprises. Its foreign exchange loan approvals and disbursements were $3.36 billion and $3.25 billion, respectively, in 1985. CIB's foreign exchange loan approvals and disbursements at $295.3 million and $117.7 mil- lion, respectiveLy, in 1985 were a small fraction of BOC's lending. Substan- tial financing of imported equipment is also made through conversion of domestic currency loans from PCBC and ICBC into foreign exchange using government resources. Two main issues concerning the foreign exchange lending system are the loan repayment in foreign exchange and the foreign exchange retention system. Project entities borrowing from certain sources of foreign exchange, including CIB, must repay in foreign currency, from either their own export earnings or those of a parent or other related organization having foreign exchange. However, other projects, financed under special or directed credit programs, often on concessional terms, may be exempt from this require- ment. Similarly, the policy to allow local governments and, to a lesser extent, enterprises to retain a portion of their foreign exchange export earnings, and to allocate "quotas" to draw foreign exchange from BOC to pay for their imports, has also contributed to excessive compartmentalization and consequently to inefficiencies. These issues are being addressed in the context of the Bank's policy dialogue with the Government; the completion of a financial sector report later this year will offer a further opportunity to discuss them. 51. Interest Rates. Nearly all domestic interest rates in China are set by administrative decree, with some variation permitted within an allowed band. Lending rates to industry have been generally positive in real terms and were increased substantially in 1985 to make enterprises more conscious of, and sensitive to, the cost of capital. Except for the low rates of 2.4% to 4.2% p.a. charged for construction investments (typically civil works for infrastructure development), domestic interest rates have had, since April 1985, a rational term structure with a rising yield curve. Deposit rates for enterprises and agencies are 1.8% p.a. for demand deposits and 4.3% to 5.76% p.a. for time deposits, depending on maturity. Working capital loans carry a rate of 7.92% p.a. and loans for modernization have rates ranging from 7.92% p.a. for a one-year term to 10.80% p.a. for 10-year or longer terms. 52. Lending rates on foreign currency loans are set partly by reference to international costs. BOC provides some loans at interest rates that fluctuate with rates in the international markets. Its present six-monthly adjustable interest rate (effective October 1986) for 5-year US dollar denominated loans is 7.43%. BOC also lends substantial amounts at low subsi- dized rates out of special allocations made by the Government for specific high priority projects. The China Investment Bank, which makes mediumrterm  - 15 - loans at fixed interest rates, increased its rate from 81 p.a. to 8.5% p.a. in July 1986; this rate would also be applicable to the proposed project (para. 67). Foreign capital from concessionary bilateral sources is generally passed on to Chinese project entities at the same interest rate that China pays to the foreign lender. Despite the progress made in rationalizing and unifying the structure of interest rates for deposits and domestic currency loans, China still needs to further develop a more consistent interest rate policy, in particular for foreign exchange loans, as part of its financial, banking and other economic reforms. This too will be further addressed following completion of the financial sector report (para. 50). Bank Group Objectives and Role 53. The Bank Group's principal objective in industry and finance is to support the program of adjustment and reform by concentrating on areas where the Bank Group has extensive prior experience and expertise. The focus is on improving policies and institutions, upgrading technology, conserving energy and materials, and promoting exports. So far, the Bank Group's industrial lending operations have included-(i) three industrial credit projects (CIB I, Credit 1313/Loan 2226-CHA, for a total of $70.6 million equivalent approved in June 1984; CIB II, Credit 1491/Loan 2434-CiA, for a total of $175 million equivalent approved in June 1984; and CIB III, Credit 1663/Loan 2659-CHA, for a total of $100 million equivalent approved in March 1986) and (ii) a loan of $97 million approved in May 1985 (Loan 2541-CHA) for chemical fertilizer plant rehabilitation and modernization, with particular emphasis on energy savings. The utilization of industrial credits is generally satisfactory and CIB has made considerable progress since its foundation (paras. 62-64). Other industrial projects in an advanced stage of processing include the moderniza- tion of the machine tools subsector in Shanghai, the upgrading of technology in cement production, and the development of rural light industries in Gansu, one of the poorer provinces of China. The Governm ent has indicated its interest in further expanding Bank Group financing for projects in industry during the Seventh Five-Year Plan period (1986-90). The industry program is being supported through both sector studies and collaborative research (para. 26-29). PART IV - THE PROJECT Background 54. CIB was established by the Government with advice and assistance from the Bank primarily for financing small- and mediur-sized projects for industrial modernization. It has received so far three loans/credits from the Bank Group in an aggregate amount of $345.6 million equivalent. The last project (CIB III) was approved by the Executive Directors in March 1986 as an interim operation to meet the urgent short-term foreign exchange needs of CIB. This fourth loan to CIB was planned in the context of discussions on a number of institutional changes and issues relating to CIB's long-term financial planning. CIB has now taken several measures toward institutional strengthening and improved financial planning and, in consultation with the Bank, is developing an operational plan to include additional measures (see  - 16 - paras. 57, 59, 62, and 65). The proposed project was appraised in July 1986. Negotiations were held in Washington from January 9 to 15, 1987 with the Chinese delegation headed by Ms. Sheng Jinsia of the Ministry of Finance. A Staff Appraisal Report (No. 6412-CHA) dated January 29, 1987 is being distributed separately. Project Objectives and Description 55. The basic purpose of the proposed project is to assist the Govern- ment to promote and implement technology upgrading and modernization in industry, to build up sound procedures and competent staff for project appraisal and investment financing, and to improve financial intermediation practices. The project would also further strengthen the role and influence of CIB in the decisionmaking process of concerned government agencies and industrial enterprises relating to industrial investments. More specifically, the project objectives would be to: (a) guide and assist CIB in its further institutional development and, thus, to enable it to efficiently carry out its operations and to effectively perform as a model and catalyst in the ongoing reform of the investment design and selection system in China; and (b) continue financing high priority industrial investments through a general line of credit, and provide CIB with assistance and guidance in its project selection and appraisal work. 56. In order to achieve the above objectives, the proposed project includes a line of credit of $299.3 million for CIB and technical assistance of $700,000 to support the implementation of a mediumr-term program of training abroad for CIB's staff. During negotiations, appropriate assurances were obtained from CIB for the implementation of its operational plan for institu- tional development. China Investment Bank (CIB) 57. The Institution: CIB is a government-owned development finance institution with a paid-in capital of Y 900 million ($243 million equiva- lent). It is administratively under the leadership and supervisory responsi- bility of HOF and remains closely tied with PCBC, from whom most of its internal staffing, both at central and provincial levels, has been drawn. Its organization consists of Ci) a head office in Beijing which performs an admin- istrative and supervisory role for its entire operation, and (ii) provincial branch offices, which have the direct responsibility for screening, appraisal and supervision of projects. The branch offices have expanded from three in 1982 to 19 at present and some have also established subbranches. All final decisions on loan approvals are taken at the head office. While this should lead to consistency in the quality of appraisal and uniformity in decision- making, it may also result in over-concentration of authority at the head office and possible delays in project financing. CIB therefore needs to grant limited authority to branches, based on their individual capability, for decisions on individual loans, and this is included in its operational plan (para. 56).  - 17 - 58. CIB's 33-member Board of Directors has remained structurally the same since 1983; it is chaired by the President of PCBC and is represented by the Government departments and banks concerned. The Board meets once a year and has delegated most of its operational decision making authority to a Managing Committee consisting of the Board Chairman, the three Deputy Chairmen and eight Managing Directors. 59. Until recently, day-to-day management of the CIB head office was the responsibility of the two Vice Presidents. They worked in close coordination under the general guidance of the President who was also a Vice President of PCBC. In August 1986, CIB appointed a fulL-time President as the chief execu- tive officer (CEO). The two Vice Presidents continue to have the responsi- bility of supervising specific departments. Each branch office is also headed by a President (also a Vice President of the local branch of PCBC) but in general the day-to-day management rests with a Vice President (exceptions are two branches where presidents are full-time CEOs). For the future, while CIB should maintain close operational cooperation with PCBC as it continues to develop, it should also become more and more administratively independent at the branch level by having full-time top management which focuses exclusively on CIB affairs. CIB's operational plan (para. 56) therefore provides for the eventual appointment of full-time presidents; this would be accomplished in 1987-88. The total number of staff at the head office has increased from 33 in 1984 to 66 in mid-1986. Similarly, the staff at the branches has also increased from 84 to 490 during the period. The staff includes 77 engineers and 266 economists/financial analysts, who are directly involved in project appraisal and supervision work. According to its operational plan CIB would increase its staff at the head office and branches to 130 and 770, respective- ly, by the end of 1988. The staff size would be adequate to cope with CIB's growing operations. However, middle level managers and professional staff generally lack advanced financial skills and experience and thus need intensive training (para. 63). 60. CIB's major operational and financial policies are outlined in its Policy Statement, and specific areas of emphasis for 1986-88 are given in its Development Strategy Statement. CIB will continue to focus on small- and mediumr-sized projects aimed at expansion, modernization and technical trans- formation of existing enterprises, particularly in the light industry sec- tor. It has been agreed that its total foreign currency lending to any one project would not exceed $15 million and total local currency lending would not exceed Y 30 million ($8.1 million equivalent). For larger projects, CIE would seek cofinancing with other lending institutions in China or abroad. 61. CIB's project appraisal is undertaken in accordance with the Industrial Projects Appraisal Manual which has been prepared with Bank assist- ance. While considerable progress has been achieved by CIB in the short time since its inception in evaluating and appraising investment projects, the quality of appraisal continues to be uneven, particularly with respect to the analysis of markets and considerations relating to the scale of investment, which, as proposed is often too small to realize full scale economies. These problems often reflect constraints as perceived by the manufacturer or the local planning office (whose sponsorship and approval of the proposed invest- ment is also required). The project supervision of CIB follows its Project  - 18 - Supervision Manual and is quite intensive. It includes frequent staff visits to projects and periodical reports by enterprises to CIB to facilitate the monitoring of progress on project implementation and operations. 62. Since its establishment in 1981, CIB has made considerable progress in its institutional development. It has adopted effective lending proce- dures, modern project appraisal techniques and comprehensive project implemen- tation and supervision guidelines. However, the large expansion of CIB's branch network and lending operations within a short period of time have worked against a balanced institutional growth and maintenance of consistent quality standards in operations. CIB has to alleviate these problems through further institutional strengthening. It has already taken several measures in this regard, including the reorganization of the head office in late 1985, resulting in the establishment of separate departments for economic, financial and market evaluation, technical appraisal, and supervision of projects; appointment of a full-time President; appointment of a new Vice President with overall responsibility for lending operations; filling of some of the manage- rial vacancies; increase in staff at both the head office and branches; training of staff in financial institutions in other countries; preparation of a new financial management information system; and introduction of medium-term financial planning. Additional measures to be taken by CIB include: (i) filLing of the remaining vacancies of heads of Supervision, Planning and TechnicaL Departments, appointment of one more well-experienced person for the financial management information system and a full-time internal auditor by June 30, 1987; (ii) adoption of the new financial management information system, taking into account the Bank's comments; (iii) establishment of a separate unit for economic and research work with a clearly defined role and adequate staff by June 30, 1987; and (iv) implementation of a medium-term program of training abroad for its staff, agreed with the Bank. Items (i), (iii) and (iv) above are included in CIB's operational plan (para. 56) while item (ii) would be a condition of effectiveness. The training program would provide for practical training for up to six months for 38 staff at selected foreign institutions, including development banks and commercial banks, and advanced training ranging from six months to two years for 30 staff. The total foreign exchange cost of the program is estimated at $1 million. An amount of $300,000 was already provided in CIB I and $700,000 is proposed as technical assistance in CIB IV. Operations and Financial Position 63. CIB's foreign exchange loan approvals in 1985 increased by 225% (from $66 million in 1984 to $215 million in 1985) and its local currency loan approvals increased by 140Z (from Y 139 million in 1984 to Y 334 million in 1985). The loan demand has continued to increase, and the approved subproject pipeline was $137 million as of June 30, 1986. CIB's foreign currency loan approvals were projected to decrease slightly (-21) in 1986 ($95.5 million in January-June 1986) due to a resource constraint, but would increase by about 9.3% p.a. in 1987-90. The local currency loan approvals would also decrease (-10%) in 1986 (Y 109.6 million in January-June 1986) but would increase by 10.7% p.a. in 1987-90.  - 19 - 64. CIB's net profit was Y 5.7 million in 1984 and Y 17.7 million in 1985, and was based on an average spread on all foreign exchange and local currency loans in 1985 of around 4%, compared with administrative expenses representing only 0.41 of its total assets. The high spread on local currency loans (8x) made out of cost-free capital resources more than offset the low spread (0.62) on foreign currency loans made out of CIB I and II. However, the faster increase in foreign currency portfolio in 1986 would bring down the average spread to 1.4%. It would, however, improve gradually in later years reaching 2.9% in 1990 due to higher onlending rates for subsequent loans. CIB's long-term debt to equity ratio was 1.2:1 at the end of 1984 and 1.7:1 at the end of 1985, well within the 5:1 limit provided under CIB I and II. CIB's debt service coverage ratio at the end of 1985 was 5.9 times. CIB's projected financial statements for 1986-90 show that its net income after taxes will increase irom Y 23.0 million to Y 31.1 million during the period. The rate of return on average equity would decline from the range of 3.0-4.2% during 1985-87 to 1.8-2.2% during 1988-90 due to payment of income tar starting in 1988 after a tax hoLiday of five years. CIB's low return is basically attributable to the fact that CIB's equity base is extraordinarily large and the Government does not want CIB to maximize its profit. During 1986-90, the average growth of CIB's long-term loan portfolio would be 33.2% p.a. (from Y 1,511.3 million to Y 4,813.0 million), while its long-term debt would increase by 38.5% p.a. (from Y 1,321.0 million to Y 4,864.9 million). The quality of portfolio would continue to be satisfactory. Long-term debt to equity ratio would change from 1.5:1 in 1985 to 1.9:1 in 1987 and to 2.5:1 in 1990 which would still be well within the limit of 5:1 as agreed between the Bank and CIB. The projections indicate that CIB's financial position would remain strong during 1986-90. Resource Position 65. As agreed under CIB III, CIB entered the foreign capital market in 1986 and borrowed Yen 10 billion (about $60 million equivalent) in Japan. The Yen loan and CIB III ($100 million equivalent) are expected to be fully committed by the end of 1986 on the basis of CIB's subloan approvals. The local currency resources would have an uncommitted balance of Y 43.3 million at the end of 1986. CIB would need $490 million in 1987-88 to make foreign exchange loan approvals in the two years, and to meet the resource gap ($30 million on approval basis) expected at the end of 1986. CIB plans to meet these foreign exchange requirements through the proposed Bank loan and credit (CIB IV) totalling $300 million equivalent (of which $50 million is expected to be used in early 1989), borrowings of $130 million in the inter- national market, and relending of foreign exchange loan recoveries of $65.6 million. In addition, CIB will be able to release $46 million out of its foreign exchange working capital for lending operations in 1987-88. The borrowing of $130 million in the international capital market in 1987-88 and the utilization of Bank funds over the 2-1/2-year period covered by the pro- posed loan is included in CIB's operational plan. CIB's local currency needs will be met by the Government through share capital increase.  - 20 - Utilization of Earlier Loans/Cnedits 66. As of June 30, 1986, approvals under CIB I and CIB II totaled $238.7 million for 209 subprojects. Both loans/credits have been fully committed. Disbursement, after a slow start in 1983 and 1984, accelerated markedly in 1985 and 1986 and reached a cumulative total of $156.7 million at the end of June 1986 and were 69% and 45%, respectively, of the committed amounts of CIB I and II. The average size of all the Bank-financed subloans is $1.2 million. The subloans are for 3-10 years, including grace periods from one to three years. Most subborrowers are state enterprises, with a few urban collectives. The projected economic rates of return range from a minimum of 12% to 45Z and the financial rates of return from 13% to 35%. CIB III ($100 million) became effective on July 3, 1986 and commitments and disbursements amounted to $28.7 million (for 40 subprojects) and $7.4 million, respectively, as of September 30, 1986. The overall utilization of loans/credits by CIB is satisfactory. Hain Features of the Proposed Loan/Credit 67. The People's Republic of China will be the borrower of the proposed loan/credit of $300 million equivalent. The Government will onlend the proceeds of the Loan/credit to CIB under a Subsidiary Loan Agreement, satisfactory to the Bank/Association, the signing of which would be a condition of loan/credit effectiveness. State Council approval of the Development Credit Agreement and the Loan Agreement would also be conditions of effectiveness. As under previous CIB operations both the Bank and IDA funds would be onlent by the Government to CIB for 20 years, including five years of grace, with CIB allowed to rollover the funds. The repayment period for subloans shall normally not extend beyond seven years, and, in any case, shall not exceed 12 years. The Government will charge CIB a fixed interest rate of 1% p.a. and the Bank and IDA commitment charges, thus bearing the variable interest risk as under earlier loans/credits to CIB. CIB will onlend the loan proceeds to the final borrowers at a fixed interest rate of 8.5% p.a. The subsidiary loan to CIB and the subloans will be denominated in US dollars valued at the date of withdrawal. The Government will thus bear the foreign exchange risk between the US dollar and (a) the currency pool index (for the Bank loan portion) and (b) the SDR (for the IDA credit portion). The subborrowers will carry the foreign exchange risk between the US$ and the Yuan. Appropriate assurances on these onlending and relending terms were obtained from the Government and CIB at negotiations. 68. The onlending rate of 8.5% p.a. would be positive in real terms over the life of CIB's subloans, given projected world and domestic inflation rates. China's inflation rate was about 3Z p.a. in 1981-84, 8.8% in 1985, and is projected to be 51 in 1986, 7% in 1987, 6.5% in 1988-90 and 4.5% in 1991-95. The onlending rate would also be consistent with the interest rate charged by other financial institutions in China on US dollar denominated foreign currency loans. During negotiations, assurances were obtained that: (a) CIB would afford the Bank an opportunity to exchange views with it prior to making any change in its interest rates; and (b) from time to time at the request of any party, the Government and CIB would exchange views with the Bank on the interest rates to be charged by CIB in its lending operations in  - 21 - light of CIB's cost of funds and profitability and of movements ir interest and inflation rates in China and internationally. 69. All subprojects to be financed under the loan/credit will meet the following eligibility criteria: (i) subprojects will pertain to the manufac- turing subsectors; (ii) subprojects in heavy industry wiLl be only for moder- nization and energy/material saving; (iii) the beneficiary enterprises will have a satisfactory projected financial situation; and (iv) the subprojects will have a minimum FRR and ERR of 12Z. As provided in its Development Strategy Statement, CIB may onlend in foreign exchange up to $15 million for an individual subproject but the average subloan size is estimated at about $1.7 million. 70. As agreed under earlier credits/loans to CIB, the free limit would relate to each branch. Under CIB II and III, the Shanghai and Tianjin branches had a free limit of $2 million and other branches had a free limit of $1 million. On the basis of quality of appraisal and the size of subprojects in the pipeline at each branch, the free limit is proposed to be set at $2.5 million for Shanghai, Tianjin and Jiangsu branches, and at $1.5 million for Hebei, Hubei, Fujian, Liaoning, Anhui and Zhejiang branches. All other branches (10) would have a free limit of $1 million. The aggregate free limit would be $150 million. The first three subprojects proposed to be financed by a new branch, regardless of size, would be treated as above free limit and would need the prior approval of the Bank. An estimated 35% of subprojects by number and 60% by amount would be above the free limits. The last date of submission of subprojects will be June 30, 1989. Procurement and Disbursements 71. Individual contracts of $4 million equivalent and above would be awarded after international competitive bidding (ICB) has been carried out according to the Bank Procurement Guidelines. Local bidders would be granted the standard preference, equivalent to custom/import duties or 15% of cif cost, whichever is lower. Contracts below $4 million would be awarded after evaluation and comparison of quotations solicited from at least 3 qualified suppliers. The Bank's standard review and approval (from bidding documents to contract awards) would be confined to ICB packages of above $4 million. Pro- curement contracts between $1 and $4 million would be subject to post-review by the Bank, and CIB would maintain all relevant documents in its records for this purpose. Only about half a dozen contracts are expected to exceed $4 million. 72. Disbursements would be made against standard documentation for 100% of: (a) foreign expenditures on goods and services for subprojects; (b) the ex-factory price of locally manufactured equipment procured through ICB; (c) interest during construction on subloans payable by an investment enterprise; and (d) expenditures on overseas training. Disbursements for contracts of or above $2CO,ODO will be made against full documentation. Disbursements for contracts of less than $200,000 and for overseas training will be made against statements of expenditures, with the full documentation held by CIB for review by Bank supervision missions. Disbursements are expected to be completed by June 30, 1992. In order to allow CIB to use more of its own working capital  - 22 - in foreign exchange for lending purposes, and to facilitate project disbursements, a special account to be maintained in US dollars with an authorized allocation of the US dollar equivalent of SDR 12.3 million would be established under the loan/credit in a bank on terms and conditions satisfactory to the Bank/Association. Applications for replenishment will be submitted quarterly or when the amounts withdrawn are equal to 50% of the initial deposit, whichever comes sooner. Audit and Accounts 73. CIB would submit to the Bank/Association (i) detailed semiannual reports on its operations and its financial results and situation; (ii) progress reports on all subprojects under implementation and a list of subprojects in the pipeline; (iii) an annual audit report on CIB's accounts, and Special Account and Statements of Expenditure audited by independent auditors acceptable to the Bank/Association, within six months after the end of each fiscal year; and (iv) a project completion report within six months after completion of disbursements of CIB IV. Semiannual reports would also be submitted to the Bank on completed subprojects during the first three years of subprojects' operations. CIB's accounts are now being audited by the State Audit Administration which has received technical assistance from the Bank Group for conducting audit. Its audit report on CIB is generally satisfactory. Benefits and Risks 74. CIB is the only development finance institution in China whose investment decisions are guided by comprehensive appraisal of projects includ- ing economic cost-benefit analysis. It is still a relatively new institution, though its growth--both in terms of organizational structure and level of operations--has been very rapid. In order to avoid the adverse effect of rapid growth on the quality of operations, CIB needs to further develop its management and staff capability, improve its financial planning, strengthen its management information system, and enhance its resource mobilization efforts by tapping the international capital markets. The project would help the institutional strengthening of CIB, particularly in the above areas, through technical assistance, various measures agreed between the Bank/Association and CIB during project preparation and supervision by Bank staff, including review of above-free limit subprojects. CIB's appraisal and supervision work would also have positive demonstration effect in the long term on central and local planning agencies and other banks engaged in similar activities in China. 75. The main beneficiaries of the credit line would be small- and medium-sized projects in the light industry category. This industry is rela- tively more labor-intensive but its labor productivity has shown only a margi- nal increase and its global productivity of factors has been negative in recent years. The project would provide foreign exchange for the import of modern technology which would help to improve the productivity and efficiency of light industry. The project would also contribute to material and energy savings by assistance to subprojects in the heavy industry category. The total number of beneficiary subprojects is estimated at about 175.  - 23 - 76. The direct project-related risk, are minimal and mainly relate to the implementation of CIB's institution-building program. However, the com- mitment of CIB management to various measures agreed with the Bank/Association and the close supervision by Bank staff would ensure uatisfactory progress in this area. The long-term indirect risks relate to the future role of CIB which, in turn, is directly influenced by the Government's economic reform policies. The Government has followed more liberal investment and enterprise management policies since 1979 and these enable CIB to take autonomous decisions on selection and financing of projects, following generally accepted evaluation criteria. A reversal in the Government's policies is unlikely and this was reconfirmed by the Government at the time of introduction of the Seventh Five-Year Plan (1986-90). The Government's support to CIB is also evident from the fact that CIB is one of the three financial institutions in China which have been authorized recently to borrow in foreign exchange from international capital markets. PART V - RECOMMENDATION 77. I am satisfied that the proposed loan and credit would comply with the Articles of Agreement of tht Bank and the Association and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President February 6, 1987 Washington, D.C.  -24 - -24- A~~~~~~~~NNEX I Ta-e 1 of ~3 POpu1aEtJM.,.. 1,01 miLliLD (mid-1953) CNG per rap .a: SVfiq .2983) CHINA - ECONINlC INDICATORS Amu"OJh - 19B5 _ Annual srouth ratds (2) (ol1'inw;US$ at Actual Projected 1ndicotar cm- * price).'b tMlTr 11 1982 1983 19U ^ 198S m6 -1 T987 1989 1990 NATIONAL ACCOUNTR /a Cross dosea.c product -265.300 6.6 4.9 7.0 9.6 14.0 12.3 6.8 b.8 6.8 6.8 6.8 Agr