Philippines - Fourth Small and Medium Industries Development Project

Document of The World Bank FOR OFFICIAL USE ONLY AlV Report No. P-5020-PH MEMORANDUM 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 US$60 MILLION TO THE REPUBLIC OF THF. PHILIPPINES FOR THE FOURTH SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT MARCH 15, 1989 This document has a restricted distributon and may be used by recipients only In the performance of thdir official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (as of November 30, 1988) US$ 1.0 G P 21.4 P 1.00 = USS 0.0467 P 1 million = US$ 46,729 3 1 billion - US$ 46.7 million ABBREVIATIONS ADB - Asian Development Bank AJDF - ASEAN Japan Development Fund BETP - Bureau of Export Trade Promotion (ITG/DTI) BOC - Bureau of Cust-ms BOI - Board of Invest.nents DTI - Department of Ttade and Industry ITDI - Industrial Tecbnology and Development Institute IGLF - Industrial Guarantee and Loan Fund PCR - Project Completion Report PFI - Participating Financial Institution SMI - Small and Medium Industry FISCAL YEAR Government: January 1 to December 31 IGLF: January 1 to December 31  FOR OFCFICIL USE ONLY PHILIPPINES FOURTH SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT Loan and Project Summary Borrower: Republic of the Philippines Beneficiaries: Industrial Guarantee and Loan Fund (IGLF) and accredited financial institutions. Amount: US$60.0 million equivalent Terms: 20 years including 5 years of grace at the Bank's standard variable interest rate. Financing Plan: US$ million Sulloan beneficiaries 80.0 T.A. beneficiaries 0.1 Participating Financial 28.0 Institutions IGLF 47.0 ADB 100.0 ASEAN Japan Development Fund 40.0 Japan Grant Facility 3.6 IBRD 60.0 Total 358.7 Economic Rate of Return: n.a. Staff Appraisal Report: Report No. 7531-PH This document bas a estricted distribution and may be used by tcipients only in the performancj of their offcial dutbs. Its contents may not otherwise be disclosed without World Bank a_ddion.  MEMORANDUM AND RECOMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE MECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF THE PHILIPPINES FOR THE FOURTH SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT 1. The following memorandum and recommendation on a proposed loan to the Republic of the Philippines for US$60 million is submitted for approval. The proposed loan would be for 20 years including 5 years grace at the standard variable interest rate and would help finance the development of small and medium i-ndustries. The proposed Project would be cofinanced by ADB for US$100 million, the ASEAN-Japan Development Fund for US$40 million, and the Japan Grant Facility for US$3.6 million equivalent. 2. Background. The Small and Medium Industry '(SM) sector, comprising firms with less than P20 million in assets and 200 employees, is an important contributor to the manufacturing sector, accounting for about 21X of value-added and 432 of employment. SMI firms are important in a wide range of manufacturing subsectors contributing over 301 of value added in food processing, machinery and equipment, chemicals, rubber, printing, plastic products, furniture and wood products, and wearing apparel. Recently, the SMI sector, and SMI exporters in particular, are being viewed as the catalyst to promoting economic recovery and export growth. 3. Like many other countries, SMI firms in the Philippines have been faced with important barriers to their development. Restrictive trade policies and fiscal incentives worked against SMI firms and exporters by encouraging large capital intensive and import substitution industries and by cumbersome and costly procedures which limited SMI access to incentives. There were several special incentives provided for cottage industries which, in practice, tended to inhibit the growth of potentially efficient firms. These biases, together with the banking sector's cautious approach to lending to poorly collateralized and small and new firms have also meant that SMIs have had difficulty obtaining finance through traditional banking channels. 4. In the past few years, the Government has made significant progress in reducing some of these biases. Since 1980, it has been implementing far reaching tariff and trade reforms. The special incentives for cottage industry were abolished. BOX incentives were restructured, making them more neutral among different types and sizes of firms. Some steps have been taken to try to increase the registration of SMI firms for incentives. The Government has provided a major channel for financing the investment needs of SI firms through the Industrial Guarantee and Loan Fund (IGLF). The Government has also sponsored a range of technical assistance and training programs for SMI firms. S. The IGLF is a government-owned fund, administered by the Central Bank. IGLF operates as an apex unit channeling funds through accredited financial institutions to SMI firms in the manufacturing sector. The IGLF has been funded primarily by external donors although the Government has p nvided some equity funds. The Government takes the foreign exchange risk u. externally borrowed funds and lends them to IGLF. IGLF then refinances term loans of accredited financial institutions made to their SMI clients.  -2- 6. The World Bank has supported IGLF in three previous projects (Loans 1120-PH, 1727-PH and 2169-PH). Under these loans the Bank approved US$187 million, the IGLF portions of which have been fully disbursed (net of cancellations). The IGLP credit components of these loans have generally performed well and achieved their objectives of channeling substantial term credit to SMIs, increasing the number of financial instizutitns participating in the program and operating with low arrears and high collection ratios. 7. While these all represent major steps forward, a number of important issues remain that restrict SMI firms' access to finance and incentives. The interest rate arrangements under the IGLF program have lagged behind changes in the overall interest rate regime in the Philippines, which is now largely market determined with floating interest rates the norm. As such, the IGLF program is exposed to considerable volatility and fails to cover adequately the Government's interest, and foreign exchange risks. SMI access to credit is restricted because of the lack of interest by the banks in lending to SMIs, due to weak collateral and the higher cost and efforts of credJt appraisal of small firms. A government sponsored credit guarantee program has not been effective in offsetting these constraints. Domestic financial resources are still not being allocated in significant amounts for term lending to SMI firms. Access to incentives is still a problem for SMI firms, especially exporters. Complex administration and costly procedures exclude most SMI exporters from obtaining adequate duty rebate or exemption on their imported inputs. Short term pre-shipment export finance is difficult for SMI exporters to obtain because of the highly restricted coverage of the existing pre-shipment guarantee. 8. Rationale for Bank Involvement. The main rationale for continuing Bank involvement in the SMI sector is to help Government address these constraints on SMI firms. This will require modification in existing programs, introduction of new policies and operational measures, and institution building. In preparing this proposed Project, the Bank has given particular attention to eliminating interest rate distortions undermining the IGLF program. In this regard, the proposed Project would address an important issue raised more generally in the Bank's recent Financial Sector Report (August/88), which recommends that the Government accelerate the move towards market-determined lending terms for directed credit programs. While the proposed Project would address only the IGLF subsector, it nonetheless could have a broader impact by demonstrating the viability of market-based lending for directed programs. 9. In addition, the proposed Project would also begin to address some of the important constraints facing SMI exporters by following up on the broad recommendations of the Bank's Industrial Sector Report (July/87). The Project also provides an important vehicle for the Bank to continue its dialogue with the Government on key export policy and institutional issues, which we hope to build on in a comprehensive export project.  10. Project Objectives. The basic objectives of the proposed SMI IV Project are to provide employment opportunities, improve income distribution and regional development, and provide a catalyst for promoting general economic growth and exports. The proposed Project specifically would help to ensure thatt (a) long-term resources continue to be available for long- term financing needs of the SMI sector; (b) the access of SHI firms to finance is improved by strengthening the IGLF guarantee; (c) short-term pre- shipment export finance, along with a strong pre-shipment export finance guarantee, becomes more widely available to direct and indirect SMI exporters; (d) SMI exporters have improved acoess to inputs at world prices through streamlined and simplified duty drawback and exemption systems; (e) key technical assistance programs to SMI firms are continued and user cost-sharing is introd"-ed; and (f) institutional and policy reforms related to SMI exporters are identified and appropriate z.easures designed. 11. Project Description. The proposed Project would have the following componentss (a) a Credit Component (comprising 99Z of total project cost) channeled through IGLF to accredited financial institutions in support of SMI long-term investment and short-term export financing needs during 1989-1991. The Goverment will take the foreign exchange risk on the World Bank loan and lend the proceeds in domestic currency to IGLF on World Bank terms. IGLF will relend at domestic market rates to accredited financial institutions which in turn will on- lend to SMIs at freely determined competitive rates. (b) an Export Component, which would provide consultancy assistance and training, equipment and related supplies and services, and administrative expenses to improve the access of SMI exporters to duty drawback/exemption, export finance/guarantee, product design, marketing and technology assistance, and trade information services; and (c) a Department of Trade and Industry (DTI) Support Component, which would provide training and equipment to strengthen DTI's regional offices, especially as they support export marketing programs, and technical assistance for policy formulation and program design in export development. 12. The total cost of the proposed Project is estimated at US$358.7 million equivalent with a foreign exchange component of US$162.1 million (45Z). Retroactive financing of up to US$ 6 million is proposed for the Credit Component to fund IGLF loans made after December 1, 1988. A breakdown of costs and financing plan are shown in Schedule A. The disbursement schedule is shown in Schedule B. A timetable of key project processing events and the status of Bank Group operations in the Philippines are given in Schedules C and D, respectively. The Staff Appraisal Report, No. 7531-PH dated March 15, 1989, is being distributed separately.  - 4 - 13. Actions to be Agreed. It was agreed during negotiations that a revised IGLF Policy Mannal would include, provisions for: (a) the rate to final beneficiaries would be determined by participating financial institutions (PPXs) based on market conditions with no prespecif Led spread; (b) the rediscount rate from IGLF to PFIs would be based on domestic market rates and offered to the PFIs on either fixed or variable terms; (c) maximum subloan size of Peso 20 million; (d) eligible firms being in manufacturing or related service sectors with assets between Peso 50 thousand and Peso 20 million (before financing); (e) PFI's to contribute from their own fundA at least 10? of each subloan; and (f) subloans being in compliance with environmental laws. Other agreements reached include: (g) the preferential interest rate to depressed regions would be limited to an average reduction of 2? for designated regions, which are estimated to comprise about 72 of the IGLF program; (h) the phasing-out of the preferential interest rates for depressed regions according to an agreed schedule; (i) establishment of a reserve account in IGLF for foreign exchange losses; (j) a timetable to implement new measures to simplify and expedite claim procedures under IGLF guarantees; and (k) adoption of institutional and operational measures to expand significantly the coverage of the export pre-shipment guarantee facility. 14. Benefits. The proposed Project woule facilitate the continuation of term financing for the SMI sector as well as support increased short- term lending to SMI exporters. In addition to providing needed financial assistance, the proposed Project would foster technical, administrative and policy measures to help offset the constraints on SMI firms, especially exporters, and facilitate their potential contribution to the Philippines' objective of increasinlg non-traditional exports. 15. The Bank loan would increase the long-term resources available for SMI lending. It is expected that about 3,000 investment subprojects will be financed, with subproject costs, including sponsors' equity, of about P 7.6 billion (US$355 million) and an average subloan size of about P 2.5 million (about US$120,000). These subloans are expected to generate incremental direct employment of about 60,000. Since individual subprojects to be financed under the loan are not yet identified, quantification of their economic impact is not possible. However, under the Bank's past SMI financing the ex ante financial rates of return have been robust. Further, under the second SMI loan (1727-PH) an ex post analysis of a sample of firms indicated an average 172 return on equity and showed that 902 of IGLF sub- borrowers were profitable after full implementation. 16. Risks. There are no unusual project risks. With respect to the Credit Component, demand will be subject to the overall performance of the economy. However, the demand projections are reasonably conservative and are well within the historical growth performance of IGLF since 1980. The introduction of market-based interest rates will also help to ensure that credit demand is not subject to wide swings due to distortions in admAinistered rates, as occurred in the past.  17. Recommendation. I am satisfied that the proposed loan would comply with the Articles of Agreement of the International Bank for Recon6truction and Development and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Attachments Washington, D.C. March 15, 1989  -6- Schedule A Republic of the Philippines Fourth Small and Medium Industries Development Project Estimated Costs and Financing Plan Estimated Costta/ Local Foreign Total -- (USS million)