Sri Lanka - Private Finance Development Project (PFDP)

Documet of fhe World Bank FOR OFICIAL USE ONLY 6?/Z ZyjS/- ciz Repst No. P-5996-CE MEMORANDUM AND RECOMMENDATION OF THE PRESIDENt OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 43.2 MILLION TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LAK FOR A PRIVATE FINANCE DEVELOPM PROJECT MARCH 19, 1993 6,.T 2P(.sJPII{ f .:r (; Y 1R9F'.rt N;,. :F - ; 5199) CE Type: (pW Title.: F'iRVATE DJTNANCIAI- lVFIC-iMFiT- Aut.hoi- HAFP'E7,. . ')1J T Tbis document has a restricted distribution and may be used by recipients only in the performance of their offcial duties. Its contents may not otherwise be disclosed without World Bank authorization.  (As of Dcembc 1992) Sri Lanka Rupee (Rs) * 100 palas U8$1.00 - Rs 46.0 Re 1.00 - U8$0.022 Government of Ori Lanka January 1 to December 31 Commercial Banks January 1 to December 31 DPCC April I to March 31 National Developmant Bank January 1 to December 31 ABBRgVIATIONS AND PRINCIPAL ACROUS t ADS - Asian Development Bak AYPR - Average Weilhted Prie Rate ANDR - Averaga Weighted Deposit Rate BDD - Banking Devalopenet Depatment BI8 - Bank for Iaternational Settlements BOC - Bank of Ceylon BSD - Bank Supervision Department C05C - Coaercial Bank of Ceylon C55L - Central Bank of Sri Lanka CI - Central Environmental Authority slBSL - Credit Information Bureau of Sri Lanka DFCC - Development Finance Corporation of Ceylon DPI - Development Fiaence Institution ZIA - Environmntal Impact Assessment EMS - Environmental Management Strategy EPP - Employees' Provident Fund 8PL - Environmental Protection License EPZ - Export Procesaing Zone Wm - Employees' Trust Fund FM51 - Forein Currency Banking Unit 1ID - Foreign Direct Investment VW - Fore4n Inveatmant Advisory Service OCEC - Greater Colombo Econamic Commission Cam - Governat of Netherlands GM51 - Government of Sri Lanka EnS - Eatton National Bank ICASL - Inatitute of Chartered Accountants of Sri Lanka ICSL - Insurance Corporation of Sri Leaka IDA - International Developmnt Association M1 - Monetary Board MEIP - metropolitan Environmental mprovement Progrm HIPA - Ministry of Environment and Parliamntary Affair. IIO - Piniatry of Finance SBFISD - Non-Bank Financial Institutionc Supervision Department NDB - National DevelopmeLnt Bank of Sri Lanka asSC - National Envionmental Steering Committee RGO - Non-Govenaet Organizations NIC - Nawly Industrialized Country RSB - National Savings Bank Ps - People's ank PCOP - Pollution Control and Abatement Fund PCI - Participating Credit Institution PIEs - Public Manufacturing 8nterpriass PIEC - Public Manufacturing Enterprises Adjustment Credit RaDS - Regional Rural Development Banks SgB - State-Owned Commercial Bank SCOPE - Sceme for Control of Pollution from Existing industries SKI - Small and Medium Industry SmIB - State Mortgage and Invstment Bank SOB - Statement of Expenses TA - Technical Asistance TAP - Technical Assistance fund TOR - Terms of Refer"e WA - Urban Development Act URDP - United Nations Delopment Progrm  FOR OMCIAL USE ONLY SRIA PRIVATE FIRANCE DNVEL0PHMEJTJ,goET Credit nd Prosect Summary Borrower: Democratic Socialist Republic of Sri Lanka Beunefciaries: Private development finance institutions (DPI)s and private domestic commercial banks meeting the eligibility critoria for participation. The credit component will support private enterprises, without limitation to their size or subsector. A technical assistance (TA) component will assist selected agencies and the participating credit institutions (PCIs) in implementing the key elements of the Project, including development of financial markets and implementation of envwronmental standards. Amount: SDR 43.2 million (US$60 milli-= equivalent). Termss Standard IDA terms with 40 years maturity. Relendina Terms: The Government of Sri Lanka (GOSL) will on-lend the credit proceeds to PCIs for up to 15 years, including a maximum five-year grace period, at a variable rate equivalent to the Average Weighted Deposit Rate (AWDR). The PCIs will have full autonomy to price the loans to enterprises according to perceived risk, maturity and to cover their intermediation costs. Financuit Plan: USS Million IDA 60.0 Co-financiers 12.0 PCI. 38.3 Entrepreneurs 43.3 Total 153.6 Staff Am,raisal Report: Report Number 11572-CE Hav: IBRD Number 23009 This document has a restricted distribution and m-y be used by reci,vients only in the performance of their official duties. Its contents may not otherwise be disclosed w.thout World Bank authorization.  KEMORAIDUM AND RECOMMENDATION OF TUI PRESIDENT OF THE INTERNATIONAL DEVELOPMNWT ASSOCIATION TO THE EZECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEMOCRATIC SOCILIST REPUBLIC OF SRI LNA FOil A PRIVATE FINAXCE DEVELOPMENT PROJECT 1. I submit for your approval the following memorandum and recommendation on a proposed development credit to the Democratic Socialist Republic of Sri Lanka for SDR 43.2 million (US$60 million) to help finance a private finance development project. The proposed credit would be on standard IDA terms, with a maturity of 40 years. 2. Economic Performance and Cballenaes. For over fifteen years, Sri Lanka has tried to dismantle the inward-looking development strategy that followed independsuce. After the initial reform push of 1977, economic management oscillated between periods of slow and more rapid reform, but both state ownership and intervention in economic activity remained extensive. Throughout the 1980s, the Government maintained a strong role in the economy, dominating the import substituting industrial sector, employing half of the non-agriculture labor force and accounting for half of GDP. Reform efforts accelerated after 1989 and substantial progress has been achieved since. 3. Background. The Government's reform program in the financial sector aims at increasing the role of private financial institutions, improving prudential regulations and supervision, and increasing the efficiency of financial intermediation. Important elements of the program are increased reliance on domestic resource mobilization for productive investments, development of primary and secondary markets for public and private debt instruments and introduction of effective asset management techniques in contractual savings institutions. The GOSL has also decided to privatize the state-owned insurance corporations. 4. The commercial banking system comprises more than 20 banks including six domestic banks, two of which are state-owned. The two DIls, the -UDI and the DFCC, are a small but expanding segment of the financial sector providing a majority of all formal term lending for productive investment. The private domestic banks, that have steadily been increasing their market share, are also diversifying gradually into a broader range of activities, including term lending for investment. 5. Although the financial performance of DFCC and NDB has been commendable, they have remained dependent on the GOSL and multilateral donors for funding. While they made limited progress in broadening their resource base, further diversification of their activities was constrained by the GOSL's dominant shareholding in MDB and DFCC. In 1991, public sector ownership in DICC was further reduced to 30 percent and in March 1993, MDB was privatized by reducing GOSL's ownership of MDB to 39 percent. The terms of IMB's sale require that GOSL's ownership is further reduced to less than 20 percent at the time of conversion of the convertible debentures. S. A major concern in the financial sector is the performance of the two state-owned commercial banks (SCBs) that dominate the banking system in terms of size and act as market leaders. Based on t 1991 external audit, it is estimated that an infusion of more than Re 24 billJon is required to recapitalize these two banks to internationally accepted standards. Political constraints bave, so far, prevented the GOSL from privatizing the SCBs. While  -2- this remains a medium-term objective of the GOSL, the GOSL has decided to undertake a number of interim measures with a view to lending a commercial focus to the operation of SCBs, and legal and administrative reforms are being implemented. 7. The ongoing reforms are expected to help address some of the problems facing the SCBs, but are unlikely to remove the major causes of poor performance, particularly government interference. Therefore, the SCBs will not be eligible for participation under the proposed credit. A number of the remaining private commercial banks and the two privatized DFYs are sufficiently strong and experienced in investment finance to carry out the objectives of this project. This will also assist the private commercial banks and the DFI. to increase their market share of profitable commercial term lending. 8. Lessons Learned from Previous Ogerations. A 1991 OED report' noted that the Sri Lanka Small and Medium Industry (ZMI) projects had sueceedeSd in attaining the anticipated flow of credit to the target group of borrowers and generated a high level of resource additionality to the sector. Apart from the Second $M1 Project (Cr. 1182-CE) which was affected by civil disturbances in the southern provinces and initial problems with loan pricing, all of the projects have beeu disbursed ahead of schedule, with a collection rate of more than 80 percent. These projects were instrumental in creating more than 65,000 jobs at a relatively low capital cost, particularly in areas of non-traditional exports. 9. The last of the intermediation projects (SMI-IV, SDR 33.3 million) became effective on September 30, 1991. Although the two state-owned banks (SCBs) have not been eligible since April 1992 from further commitments of subprojects from SMI-IV because of their failure to satisfy the capital adequacy requirements, both commitments and disbursements have been proceeding ahead of schedule (over 50 percent is committed and more than 20 percent disbursed). In addition, several policy reforms including: (i) reduction of SCB's shareholding in DFCC; (ii) provisioning policies to be adopted by the PCIs; (iii) introduction of Average Weighted Deposit Rate (AWDR) as a reference rate; (iv) removal of legal constraints to debt recovery; (v) refining refinaucing and reserve requirements; (vi) establishing a credit information bureau; and (vii) strengthening of the accounting regulatory framework have already been completed. Other reforms such as the privatization of 1DB, rationalization and restructuring of NSB and the ICSL, and strengthening Bank supervision and regulation are progressing satisfactorily. This project builds upon the mechanisms developed in previous projects. TA is not overly ambitious and data from previous operations is considered in determining on-lending terms and conditions. 10. Rationale for IDA's Involvement. IDA has been pursuing a policy reform dialogue with the GOSL aimed at further strengthening of the financial sector for some time. The Finarcial Institutions Study conducted by IDA in 1991, and interim reports of the %OSL's Presidential Commission on Banking and Finance, further defined the changing role of the financial sector and outlined the necessary sequence of reforms. Although a number of important I World Bank Support for Small and Medium Scale Industry in Selected Countries.  actiors have already been taken, further reforms are needed to increase mobilzxation of domestic resources for term investments by the private sector, reduce the detrimental effects of Treasury borrowings at managed rates tad deepen the financial sector. 11. IDA's assistance strategy to Sri Lanka was summarized in the CAS document 'Report No. P-5777-CE) discussed by the Executive Directors on December 10, 1992. Recent support to the Government9s overall economic reform program has been provided through two adjustment operations (ERC 1 and PMEAC). A proposed ERC 2 would continue this support, particularly in the areas of privatixation and restructuring of public enterprises, trade policy and public expenditure. This Project will support reforms of the policy and regulatory environment in the financial sector, especially the revitalization of non-bank financial Institutions, the development of an efficient market for public and private debt instruments and the expansion of the private banking sector. 12. Project Objectives. The proposed project seeks to: (a) improve the efficiency of financial intermediation in Sri Lanka by supporting policy and regulatory reforms in the financial sector; (b) assist in domestic resource mobilization for long-term investment by stimulating the development of local bond markets; (c) enable the private sector to respond to the changing economic environment by providing investment finance; and (d) help deepen the financial system and strengthen the key players including the contractual savings institutions, the CBSL, the MOP, the GOSL, the ICASL and the PCIs. 13. Pro4ect Descrigtion. To achieve these objectives, the Project cotaprises: (a) Improvemwnts in Policy Pramw orks The Project will support wide ra"ing reform of the policy and regulatory environment in the financial sector, especially in areas affecting mobilization of domestic resources for investments through commercial channels. S.gnificant elements being supported through this project Includes (i) development of market procedures for the issuance of longer-dated public debt itntrumento, development of trading and settlements infrastructure and deepening of primary and secondary dealing in debt instruments; (ii) assisting the public contractual savings Institutions to develop portfolio management skills and reducing the process of reverse term transformation by these institutions; (iii) development of monitoring and enforcement mechanisms for the already adopted International accounting and auditing standards; (iv) strengthening supervision activities of the Central Bank, introduction of asset-based capital adequacy requirements and increasing the coverage and coordination of supervision activities; and (v) further strengthening of the debt recovery legislation. (b) Invewtment Credit Component (US$57.5 million equivalent): The credit component will make funds available to the PCIs to provide term loans to private enterprises. Funds will be on-lent by the GOSL directly to the PCIs, on a variable rate basis, at the Average Weighted Deposit Rate  -4- (AWDR) reset every three or six months. The on-lending rate will be reviewed periodically and changed to the Treasury bill rate when a vell established secondary market for Treasury bills develops. The PCIs will be free to determine the final variable rate to sub-borrowers. The project will increase the extent to which the PCIs are to mobilize domestic resources by financing only 60 percent of the loan amount. Although the direct Zoreign exchange risk will be carried by the GOSL, a variable and market-determined final lending rate will transfer the risk to the sub-borrowers. Subloans in excess of the free limit specified for each PCI will require IDA's clearance. IDA participation in a specific subloan will be limited to US$2.0 million. Repayment by the PCIs to the QOSL will be based on a composite subproject amortization schedule not exceeding 15 years, with a maximum of five years grace. (c) Technical Assistance Component (US$2 5 million equlvalent): This component, will provide assistance for the preparation and implAmentation of various policy reforms noted in (a) Above. The TA funds will be primarily used to assist MOP, CBSL, ICASL, state owned insuranwe corporations and the PCIs. 14. Environmental Issues. Sri Lanka has enjoyed a long history of attention to the environmental impact of industrial development. With IDA assistance, GOSL prepared a National Environmental Action Plan in 1991, to establish a more coordinated approach to environmental planning and implementation. The plan is being implemented with the active support of the donor community and non-government organize.tions. IDA has had satisfactory experience with the GOSL in carrying out previous industrial projects, including, most recently, SMI-IV in 1991. The proposed project has an overall environmental rating of "B", although the environmental impact from subproject to subproject will vary. To minimize the risk of adverse environmental effects, all subprojects will be required to conform with the general environmental guidelines issued by the GOSL In October 1992 and monitored by the Central Environmental Authority. 15. The project will support setting up of a Pollution Control and Abatement Fund (PCAU) to provide investment funds to existing industries to help them comply with environmental standards. Financing for this component is expected from the Government of Netherlands (GON) on a grant basis. Sponsors will also be able to engage specialized TA from the PCAP to reformulate the project proposal to include measures necessary to comply with the CEA's environmental guidelines. The subloans from this component will be provided at zero real interest rates, determined at the time of the first disbursement of the subloan based on the latest published rate of inflation (inflation was 11 percent at the end of December 1992). The nominal interest income will be earmarked for monitoring compliance with environmental standards. 16. Prolect Administration. The design of the proposed project doea not require full Apex arrangements. The administrative responsibilities will be performed by an Administrative Unit in the NDB on behalf of the COSL on a fee basis. The Unit will also administer the technical assistance component funds and the Pollution Control and Abatement Fund (PCAF). Coordination for the implementation of policy reform will done by the Committee for Financial Sector Reforms in the Ministry of Finance.  - 5 - 17. Pro1iet SustainabilitZ. The policy reforms bei_g supported through this project focus on eliminating the obstacles to domestic resource mobilization for productive investments so that financial markets can continue to operate efficiently. These reforms, together with the TA, will also increase the abllity of the PCIs to appraise subprojects and provide finance for term investments in an environmentally sound manner. 18. Cofinancing. Cofinancing of about US$12 million, on a grant basis, from the USAID and CON is expected to be mobilized for this project. USA$D is providing about US$7 million to finance the TA supporting the development of the bond market and upgrading the enforcement of accounting and audlit standards. The GON will fiuance the environment component. 19. Agreed Actions. During negotiatimn, key agreements reached with the GOSL includes (a) a draft letter of financial sector policy laying out, later ails: its commitment to the introduction of variable rate lending; measures to further strengthen debt recovery legislation; steps to improve enforcement of accounting and auditing standards; a program for improved banking supervision and regulation; procedures for rational asset management of the contractual savings institutions (EPF, ETP, NSB and ICSL); steps for lengthening the maturity structure of competitively priced treasury securities and promoting a secondary market in those instruments; the approach for reducing public sector role in the DMI.; and literim measures designed to lend a greater commercial focus to thu operations of the SCBs; (b* the use of the average weighted deposit rate (AWDR) of interest- bearing term deposits as the initial on-lenditg reference rate for the credit component and the adoption of a market-based benchmark, such as the Treasury bill rate, after the market is developed; and (c) conditions of PCI participation, including compliance with risk asset classification and provisioning requirements for non- performing loans, collection ratios, profitability, capital adequacy, management capacity and audit and accounting requirements. 20. Benefits and Risks. With recent increases ln private sector investment in manufacturing, and prospects for continuation of this trend, the country's financial sector is experiencing a shortage of funds for term lending. While this is partly due to large government demand for loanable funds, it is also due to lack of investment skills by institutional savers, and insufficient efforts to mobilize term resources by financial intermediaries. The proposed project will not substitute for the necessary efforts to mobilize domestic resources but will enaourage and complement these efforts. The provision of term finance to the private sector will enable these enterprises to take advantage of the changing economic environment and retool their operations, improve efficiency and expand their markets. The project will lay the groundwork for the development of new financial instruments, including medium- and long-term bonds, and will encourage the existing financial institutions to diversify their funding sources. It will also provide assistance for the restructuring of the SCBs and support the GOSL's efforts to improve financial sector efficiency. TA and credit to firms for environmental investments will help ease the environmental burden of the  -6- country'. Industrial sector, particularly In tLe Greater Colombo area. 21. The main risks to the project's success lie In the overall investment climate in Sri Lanka. If the ethnic disturbances escalate significantly, comitment and disbursement rates for the project would suffer, and repayment rates of subloans to the PCIs could also be adversely affected. However, private investment In recent years has been high and the PCIs forecast a rising demand for inveotment finance. Sustaitable improvements In the PCIs' ability to mobilize domestic resources vill depend on the GOSL's success with maintaining macroeconomic stability, containing the public sector's borrowing requirements and pricing public sector borrowing at market- determined rates. 22. Recommendation. I am satisfied that the proposed development credit would comply with the Lrticles of Agreement of the Association and recommend that the Executive Directors approve the proposed credit. Lewis T. Preston President Attachments Washington D.C. March 19, 1993  SCOEDVLE A PRIVATE Ei3&NCB DEVELOPHINT PROJECT Estfimated Costs aqd 1iosnanLng Plea (US$ million) Local Foreign Total Credit Component 78.7 61.2 139.9 Technical Assistance 2.9 10.8 13.7 Total 81.6 72.0 153.6 Financing Plant IDA 0.0 60.0 60.0 Co-financiers 0.0 12.0 12.0 PCIs 38.3 0.0 38.3 Entrepreneurs 43.3 0.0 43.3 Total 81.6 72.0 153.6  PRVT FACI DIlVELOUIE PROET (US$ million) Procurment gthodA Prolect Elsmnts Other' 1 Subproject Investment 57.5 57.5 Technical Assistance (TA) 2.5' 2.5 60.0 60.0 Cateftory Amunt Eendi=tures to be Finaned Subloans 57.5 60S of smounts disbursed by the PCIs. TA 2.5 1001 of local comeulting expenditure; 1001 of foreign expenditure; 701 of civil work. (uazlrukm of US$200,000); 1001 of ex-factory cost of local expenditure; and 80S of other local expenditure. Disbursementsa IDA Fiscal Year: FY94 FY95 FY96 FY97 FY98 _____ ----- __ __ -_____-_ Annual 6.6 13.8 21.0 13.2 5.4 Cumulative 6.6 20.4 41.4 54.6 60.0 Percentage llS 34S 691 91S 1001 1 Procurement would be o-i the basis of established comercial practices which have been reviewed and are acceptable to IDA. Contracts for good. coating less than US$50,000 and not exceeding US$1 million in agr.egote, may be procured throtugh local shopping. All procurement exceeding US$1 million will be subject to international competitive bidding procedure. 2 Consulting services would be procured in line with the World Bank's Guidelines for the Use of Consultants.  -9, PRIVATR- PtCU S_DVXLOPM FsOJCT TImtable of NU PwI ect Ptocegata Iyyetl Tim taken to prepare thb project I May 1992-May 1993 Prepared by I Participating Institutlons with IDA easestance First IDA miosion I June 1992 Appralsol mission departure * December 1992 Negotiations X March 1993 Planned dots of effectiveness X July 1993 List of relevant PCR. and PPARn I SMW II Project (Cr. 1182-CE) PPAR Datet June 1991 PCR Date: February 1992  Ee. tl a | 1} J Ii~~~~~~~~~~~~~~~~~~~~~I 01 |!~ ~~1 |111 0g 00 liiis3 j ISE I 01 . . . .. .i.. bg~~~~~~~~~ I I il30||a2"|1| 0 1| X~~~ g ""111 !!!IIBBB666B666 III  - 11 - SC ~D Page 2 of 2 THE STATUS OF BANK GROUP OPERATIONS IN SRI LANKA B. STATEMENT OF IFO INVESTMENTS (As od Oesombe 31. 1092) Amount (ntdiUkae Date Borows, Purpose Loan Equty ToWal 1i0 Pearl Textile Mll Teile & Fibers 2.50 0.78 3.26 10781101 Oevelpment Finance ODeopmnent Finance 040 0.40 Cop_ation of Ceylon 1078181 BanS of Ceyblo Oevlc pment Fnae 7.00 7.00 1is Mlkeedus industes Uritld & Ceylon Paper Sam Ltd. Woven Polypropylene ags 0O 0.09 00 *81 Ceylon Syeto Towxle Textiles& Fibers 3.18 0M4 8A0 19804486 Lanka o Leasing Co 'td. Capil Market 3.00 0.34 3.34 1081 Lanka Hotels Tourbm 10.30 0.70 20.00 Is" UAL Money & Capitd Market 0.46 0.48 1031 CDIC Developent Finano 3.05 3.05 1t02 CKN FUND MGMT Capita] Mat 0.00 0.00 1092 PYRAMID TRUST Capit Mat 0.25 0.2 10h3 Lanka Cellular T.1oommunicadons 1.36 1i Tota Gross Commmn_t 35S4 8.06 4.11 Las Canceatons. Temon Exchanoes Adjustments. Prepaym and Sale Writef and SW"il 316.6 Todl Commitn now held by IPC .0 Tot Undidsrsed (Includin pardtcpants' portion) 4.41  IBRD 23009 SRI LANKA 0 owerucArMi NORTHERN Say Of tm CENTRALS?. S NORTH P06anm 1jR1 > ( < Mbb WESTRNTERN-. Arabian f i % V~~~~ ~ ~ ~ ~~~~~~~~~~~~~~~~~~~~~~~~ 7 r .PAi X, Gampb UVA-*u4 . . r ,J > % ~~~~~Ng,wmo i< V COLOMBOg 0 J2N0 t4 iU Klo 20 33TruUo z i | l t I I k sSOUTHERNHh e to le soa 0X MAY 1991