Philippines - Industrial Investment and Smallholder Tree-farmers Project

FILE COPY DOCUMENT OF INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT Not For Public Use Report No. P-1455-PH REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF THE PHILIPPINES FOR AN INDUSTRIAL INVESTMENT AND SMALLHOLDER TREE-FARMERS PROJECT THROUGH THE DEVELOPMENT BANK OF THE PHILIPPINES May 30, 1974 This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report.  Currency Unit = Peso (P) US$1 = 6.729 P 1 = US$.149 P 1,000 = US$149 P 1,000,000 = US$149,000 Fiscal Year July 1 to June 30  REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE FXECUTIVE DIRECTORS ON A PROPOSED LOAN TO WE REPUBLIC OF THE PHILIPPINES FOR AN INDUSTRIAL IMVESTMENT AND SMALLHOLDER TREE- FARMERS PROJECT TtiROIJGH THE DEVELOPMENT BANK OF THE PHILIPPINES 1. I submit the following report and recommendation on a proposed loan to the Republic of the Philippines for the equivalent of $50.0 million. The loan would be repayable over 18 years, including 4-1/2 years of grace, and at an interest rate of 7-1/4% per aninum. The proceeds of the loan would be relent to the Development Bank of the Philinpines on the same terms as those of the Bank loan for onlending to specific productive enterprises. PART I - THE ECONOMY 2. The most recent Economic Report - "Current Economic Position and Prospects of the Philippines" (No. 79-PI4 of April 20, 1973) was circulated to the Fxecutive Directors on May 2, 1973 (R73-85). An economic mission visited the Philippines in April and its preliminary conclusions are incorporated below. The full report of the mission will be distributed to the Executive Directors in due course. Annex I contains country data. Recent Developments 3. Since 1972, the Government has re-formulated its development strategy by introducing a number of important and potentially far-reaching economic and social reforms through decrees in such areas as agrarian reform, taxation, customs administration and tariffs, banking and government organi- zation. These reforms provide an opportunitv to improve the performance of the Philippine economy. Aided by the recent commodity boom in the inter- national markets, economic activity in the Philippines has increased consid- erably. The growth in real GNP, which had been about 5% a year for more than a decade, is estimated to have doubled and reached 10% in 1973. However underemployment and unemplovment remain quite high, and in common with most other countries the rate of inflation has increased appreciably in the past year. These problems and the long-term implications of the energy crisis for domestic production, the balance of payments, costs and employment are now being examined by the economic mission. 4. The strong recovery of the economy in 1973 resulted from increased agricultural production, a recovery in the industrial sector including manufactured exports, a boom in export incomes and an expansion in public and private investment. The agricultural sector, which had suffered from adverse weather conditions during the previous three years grew by 11% in 1973. Rice production in the present crop year is estimated to have increased bv 30% over the level of the previous year when floods reduced production levels. This increase has been mainlv due to favorable weather conditions, increased use of fertilizers, more supervised credit and increased investments  - 2 - in supporting rural services as part of a general drive for rice self- sufficienci. The Government has vigorously implemented a program of agrarian reform amorg rice and corn tenants concentrating mainly on the larger holdings in the first phase. Titles are being transferred to tenants and supporting services improved. 5. The increased activity in agriculture has provided the base for renewed exDansion of the industrial sector. The growth of industrial produc- tion for exports has also been stimulated by the Government's industrial export drive which included a range of export incentives. Nontraditional industrial exports, which have been increasing since 1970, are estimated to have doubled in 1973 to about $200 million. The prospects of increased profitability are attracting a large amount of new investment into industries such as plywood, textiles and garments, handicrafts, light consumer durables and electronics. 6. The growth in production was also assisted by the sharply acceler- ated public development outlays in 1973 made possible by a significant im- provement in the financial position of the Government. The Government has implemented a series of long-needed tax reforms and improvements in tax administration, such as customs and tariff reform, tax amnesties, reforms in corporate and local taxation, continuation of the export tax, and increased taxation on luxury items and on gasoline. These reforms resulted in a 37% increase in tax revenues in FY 1973, and an estimated 40% this fiscal year. As a result the ratio of Central Government tax revenues to GNP has increased from an average of 9% in recent years to an estimated 12% this fiscal year. 7. High prices for the Philippines' chief exports, including coconut products, sugar, copper and wood products, were largely responsible for an increase in merchandise receipts of almost 70% in 1973. The merchandise trade account recorded a surplus of about $270 million, as compared with a $120 million deficit in the previous year. International reserves rose by $594 million during the year and stood at $876 million, equivalent to about five months of imports, at the end of the year. 8. However, in the latter part of 1973 inflation emerged as a major problem in the Philippines. Since mid-1973 consumer prices have been rising at an annual rate of more than 40%. This has been caused by the higher rate of world inflation, by higher export prices, by domestic food shortages, and more recently by the increased cost of petroleum. Provided the Government obtains sufficient cereal imports for the coming July-September lean period for domestic supplies, and provided there is a good harvest later in the year, the rate of inflation should moderate in 1975, but it probably will take 1-2 years for the price effects of the energy crisis to work themselves out fully. The rapid inflation has also exacerbated the decline in real wages which fell by a total of about 25% between 1969 and 1973. The urban wage earners have been most affected. In the past year, agricultural incomes have improved verv substantially, while, with some exceptions, entrepreneurs have been able to pass on increased costs. Money wages will have to be raised in the near future if further deterioration in the living standards of wage earners is to be avoided.  -3- The Energy Crlsis 9. Imported petroleum provides some 93% of the Philippines' total energy requirements. In 1973 the equivalent of 71 million barrels of petroleum crude and other petroleum products were imported at a cost of about $230 million c.i.f. When the energy crisis developed late last year, it looked as though economic activity in the Philippines would be severely disrupted. There were temporary dislocations while reduced quantities of petroleum were available, but the Government moved quickly with conservation measures to reduce non-essential consumption. By March these problems had been overcome and the Philippines is now obtaining sufficient petroleum for its needs. In 1974 imports of petroleum and products are likely to be about 73 million barrels at a cost of about $820 million c.i.f. 10. In response to the energy crisis the Government has decided to accelerate the development of local energy sources, especially hydropower and geothermal energy. These will be supplemented with nuclear energy in the 1980's. The transport sector, which now accounts for 40% of total energy consumption, is likely to continue to be the major consumer of energy. The growth in demand for energy will therefore be influenced by policies that affect the pattern of expansion in this sector. In any event, total demand for energy is expected to grow at about 10 percent a year, and even with more rapid development of natural power sources, petroleum would still account for 85% of total energy needs by 1980. The Philippines does not have any commercial oil fields, but the Government has recently taken steps to encourage more exploration. Growth Prospects 11. Earlier this year the Government decided that, despite the energy crisis and ranid inflation, the growth momentum built up last year should be maintained, to provide for a continued increase in employment and to ensure that export income expands rapidly enough to meet most of the country's foreign exchange needs. The labor force will continue to grow at almost 3% a year for .nother decade. Providing half a million new jobs a year as well as dealing with unemployment and underemployment will be a major task. 12. The economy has the potential to continue growing at 7-8% a year in real terms. This growth is not likely to be seriously constrained by lack of foreign exchange, for despite the big increase in the cost of petroleum and other imports, continued high prices for major export commodities will result in another overall balance of payments surplus this year. Moreover, the rapid increase in export prices at a time when external debt has not been changing, has resulted in a sharp fall in debt service from 23% of export earnings in 1972 to an estimated 14% this year. There has also been a sub- stantial improvement in the climate for private investment in the Philippines, especially in exports. Unless there is a calamitous drop in export prices, the Philippines should be able to maintain a reasonable balance of payments position throughout the rest of the decade. There will probably be a substan- tial increase in financing requirements, but with rising domestic incomes and  - 4 - a substantially improved capacity to borrow abroad, it should be possible to mobilize the needed resources. 13. A substantial increase in both public and private investment to support the growth and employment strategy is required, with priority being given to increasing food production, to export ventures and to selective import-replacing investments. The Government plans to spend about P 17 bil- lion on infrastructure and other public investments during FY 1974-77; about 40% of the proposed investment program would be allocated to the transport sector, 21% to power and 13% to irrigation. This would mean doubling the pro- portion of these expenditures to GNP from 1.7% in FY 1968-72 to about 3.5% in FY 1974-77. To finance this program, the ratio of taxes to GNP would have to be increased to 15-16%, and public savings would have to be raised from the present level of 1.4% of GNP to beyond 2% in the next few years. With the Government's program for further tax reforms, there are reasonable prospects for achieving these objectives. Even so, it would mean continued heavy reliance on public borrowing from the local market and from abroad. Implementing this program would also call for continued improvements in public sector management which has already been strengthened by the Government reorganization. 14. The improved climate for private investment is attributable to the strong performance of the economy in 1973 after three years of stagnation, the current higher prices for many commodities, and the efforts of Govern- ment to attract more foreign investment. A number of big projects are proposed in mining, wood processing, fertilizer, steel, aluminum and other industries which seem likely to push up the private investment rate from recent levels of about 167 of GNP to perhaps 22% by the latter part of the decade. A large portion of the funds for these projects is likely to come from abroad. Even so, the supplv of long-term funds from domestic sources will need to increase substantially. Balance of Payments 15. Because of continued high prices for major export commodities, ex- port receipts are expected to increase by 33% this year to $2.5 billion. Merchandise imports are likely to increase bv about 66% to $2.6 billion, largelv because of the increased cost of petroleum. In response to the energy crisis the Central Bank negotiated a series of standby credits with various foreign commercial banking grouns earlier this year. However, be- cause of the improved outlook for export receipts, these standby credits may not be used this year. The economic mission estimates that the overall balance of payments will record a surplus of about $250 million this year, with international reserves increasing to about $1.1 billion, the equivalent of ahout 3-1/2 months of imports. With export prices continuing at relatively high levels, a small deficit in the overall balance of payments is likely in 1975.  - 5 - 16. After allowing for continued reserve accumulation and repayment of loans, the zotal foreign exchange requiements for the period 1975-79 would be about $7 billion. About $2.5 billion would be provided by remittances, official grants, direct investment, and short-term trade finance. The re- maining $4.5 billion would have to come from foreign borrowing. Last year the Bank estimated total requirements for 1974-78 at about $4 billion. In June 1973 thie Consultative Group for the Philippines met and accepted the need for rising levels of commitments for development projects to support the Philippines' increased development program. The increased estimate of re- quirements reflects the effects of inflation, the more optimistic outlook for growth in the Philippines, and the improved capacity to carry foreign debt. 17. Borrowing on this scale would not pose serious problems for balance of payments and external debt management. At the end of 1973, the Philippines' medium and long-term external debt stood at about $1.9 billion, of which pub- lic debt was 44%. Because the Government has exercised strict control over the amount and type of new external borrowings, the total amount of debt out- standing has not increased much since 1970, and the maturity structure has improved. Moreover, the debt service ratio is expected to remain at about 14% in 1975. With this moderate debt burden the Philippines will be able to contract substantially larger amounts of external debt which would probably lead to a small increase in the debt service ratio, perhaps to about 14-15% by the earlv 1980s. 18. The Philippines' development program will continue to require re- sources in excess of the foreign capital which will become available for fi- nancing the import component of development projects. Some financing of local currency expenditures will be justified, especially for projects of economic and social importance which need only limited amounts of foreign exchange. PART II - BANK GROUP OPERATIONS IN THE PHILIPPINES 19. The Philippines has received 23 Bank loans and three IDA credits totalling $394 million, net of cancellations. About 56% of the Bank/IDA lending or about $225 million has been for infrastructure projects in power, transportation, water supply and for education. The remainder has been divided between agriculture and industry. About $104 million of this has been for irrigation, livestock, fisheries, rice processing and rural credit and about $65 million for industry in three loans to the Private Development Corporation of the Philippines. There has been a marked improvement in the way Bank Group projects in the Philippines have been executed in the last two or three years compared with experience in the 1960's when shortages of peso counterpart funds combined with poor administration caused serious problems. Apart from the rice processing project, where the scope of the project has been revised because of changed circumstances (see Annex II), all our projects are now going well. Annex II contains a summary statement of Bank loans and IDA credits as of April 30, 1974 and IFC investments as of Mlarch 31, 1974, and notes on the execution of ongoing projects.  - 6 - 20. The size of the Bank's lending program will increase substantially this year reflecting the ambitious development program of the Government and its improved capacity to prepare and implement projects. With the loans for the proposed project and for the third rural credit project being presented to the Executive Directors in June, our lending in FY 1974 would be $165.1 million, compared to an average of about $30 million a year in the previous five years. Future Bank lending will continue to concentrate on public infra- structure and agriculture. We will also continue to help industry and pro- vide more assistance for projects in the social sectors. 21. The following projects are among those which may be ready for Board consideration in FY 75 - Population, Power VI, Inter-Island Shipping, Tarlac Irrigation, Mindoro Rural Development and Small Industry. The population project would strengthen the delivery of family planning and other health services to the rural areas, mainly by constructing and staffing new rural health units. The sixth power loan would help the National Power Corporation (NPC) to expand its power generating and transmission facilities in Luzon, while the loan for inter-island shipping would be relent through DBP to private shipping companies for the acquisition of new and used ships and con- version and repairs of existing ships of the inter-island fleet. The Tarlac Irrigation project would help rehabilitate irrigation systems in a heavily tenanted area of Central Luzon, while the Rural Development project would help finance a range of rural investments designed to promote the integrated development of the island of Mindoro. The small industry loan would provide funds for relending to small firms and technical assistance to help strengthen the institutions serving these firms. 22. Since 1972 the Philippines has received a limited amount of assist- ance from IDA, but on the basis of a reappraisal of the prospects for the Philippines' balance of payments in the light of changes in commodity prices, and in view of the sharply increased needs of the poorer members of IDA for concessional assistance, further IDA lending to the Philippines does not appear to be justified. The Philippines now has the capacity to borrow larger amounts abroad to meet the needs of the increased investment program now planned. The Bank's share in this higher level of foreign borrowing will be reviewed in the light of the findings of the recent economic mission. At present, the Bank/IDA share in total debt outstanding is about 9% and its share in debt service is about 5.5%. Since the Philippines will have the capacity to service more commercial debt in future, it is unlikely that the Bank's share in debt service will rise even with a higher level of lending. 23. IFC has made commitments in the Philippines totalling $68.0 mil- lion for investments in ten companies in the fields of development banking, power, telecommunications, ceramic tiles, paper, petroleum products, nickel mining and refining, chemicals and synthetic fibers. Of these investments, as of March 31, 1974, $18.2 million have been sold, $0.4 million cancelled and $1.6 million repaid, leaving a net portfolio of $47.8 million. On the same date $13.2 million was undisbursed. Preliminary proposals have been received for an aluminum smelter and other projects in the pulp and paper, dinner ware, metal alloys and shipbuilding fields.  - 7 - PART III - THE INDUSTRIAL SECTOR AND INDUSTRIAL FINANCE 24. Industry (manufacturing, mining and construction) is the third largest sector in the Philippine economy (after agriculture and services). It accounted for 27% of net domestic product in 1973, absorbing over one- third of total fixed investment and providing employment for 15% of the total labor force. Since the early 1970's Government has placed increasing emphasis on industrial growth to expand and diversify exports, meet growing domestic demand, and provide increased employment opportunities. 25. Manufacturing, which accounts for over two-thirds of all indus- trial activity, is predominantly privately owned, and generally concentrated in large scale, vertically integrated, capital-intensive units. In 1971, organized manufacturing enterprises with fewer than 20 employees accounted for 85% of the number of enterprises but for less than 17% of industrial employment, 4.7% of value added and 5.5% of total assets of manufacturing enterprises. By sectors, food and beverages are the largest group, with chemicals and petrochemicals second and textiles ranking third. Geographic- ally, over 65% of manufacturing enterprises are concentrated in the greater Manila and southern Luzon area, although more recently increasing industrial- ization has been taking place in northern Mindanao and the Visayas. 26. Philippine industrial production has up to now been geared pri- marily toward meeting the needs of the domestic consumer market. Reliance on the industrial sector as a major vehicle for enhancing export earnings is a relatively recent development signalled by the introduction of the Export Incentives Act in 1970 and by other policy measures such as the float- ing of the peso resulting in a sizable devaluation which made Philippine in- dustrial exports much more competitive in international markets. The rapid increase in industrial exports in the last two years reflects both the suc- cess of these measures and favorable changes in world market demand for Philippine products. The encouraging performance so far has led the Govern- ment into establishing a special duty-exempt Export Processing Zone at Mariveles to attract foreign and domestic investment into manufacturing for export. 27. Both the Export Incentives Act and the earlier Investment Incen- tives Act of 1967, which reformed the previous cumbersome structure of in- centives, are administered by the Board of Investments (BOI) - the principal industrial regulatory agency. Its main functions are to: (a) issue an annual Investment Priorities Plan (IPP) - the current IPP is the sixth - listing those industries or product lines which qualify for incentives; (b) determine the additional capacity required in these industries to meet domestic demand and/or take advantage of export possibilities; and (c) approve individual projects in line with the annual IPP. The BOI also draws up a list of "overcrowded industries" in which further investments are discouraged by denying access to incentives and foreign exchange for imports. In addition to its regulatory functions, BOI is an active promotional agency, which  - 8 - undertakes specific industry and market studies, and publishes information useful to industrialists. About one-half of new industrial investment in the Philinpines goes into BOI-registered projects. Between June 1968 and June 30, 1973, BOI approved 250 projects requiring a total investment of $1.1 billion. W4hile BOI is primarily responsible for regulating investment, industrial policy formulation is the responsibility of the National Economic and Development Authority (NEDA). A newly established Department of Energy and Industry (DEI) (expected to be in full operation by mid 1974) will also play a prominent role in coordinating industrial policy formulation and im- plementation, covering whatever gaps exist under the present institutional arrangements. 28. Tne Four-Year Development Plan for FY74-77 estimates total indus- trial investment in the period to be in excess of $3 billion. Investment in manufacturing is expected to account for about two-thirds of the total. This level of investment will require a large increase in domestic resource mobilization, as well as a sustained inflow of foreign capital on reasonable terms. 29. Two institutions, the Development Bank of the Philippines (DBP), the government's principal development financing institution, and the Private Development Corporation of the Philippines (PDCP) are the main providers of long-term industrial finance. DBP is much the larger of the two. Foreign commercial borrowings guaranteed by domestic financial intermediaries (princi- Dally DBP) have in the past accounted for 30-35% of investment in manufactur- ing. These guarantees have in the last three years been subject to stringent Central Bank regulations designed to ensure appropriate terms. Besides DBP and PDCP, several commercial banking and other financial institutions also provide term finance to industry, covering less than 5% of total needs. Working capital needs are covered mainly by commercial banks, which in 1973 provided $3.1 billion in domestic credit, half of which went to the manufactur- ing sector. The remaining gaps in financing are covered by internally-generated funds and byr equity financing through the capital market. 30. For some years we have been exploring with the Government whether we could chalnnel funds for industrial investment projects through DBP to suoplement 'Bank Group financing provided through PDCP. Lending through DBP for industr-,al sub-projects raises somewhat broader institutional issues than our three agricultural loans made through DBP for Rice Processing, Live- stock and Fisheries. In the case of the agricultural projects, the relending activities c:ould be well defined in advance and restricted in scope. Indus- trial relencling involves a far wider range of activities and, hence, greater reliance on DBP's judgement and competence in the selection, appraisal and supervision of sub-projects. We therefore agreed with the Government to postpone our first industrial operation through DBP until DBP's operating capability had improved to a point where we had no reservations about its ability to use the funds to finance projects of high economic priority. This point has now been reached and the project described below represents a fuirther stage in our developing relationship with DBP.  - 9 - PART IV - THE PROJECT 31. The proposed loan follows a series of four Bank Group loans for financing industrial investment in the Philippines through the privately- owned Private Development Corporation of the Philippines (PDCP). The most recent of these was a $15.0 million loan from IFC in 1973. A Bank mission appraised the project in January 1974 and negotiations were held in April 1974. The leader of the Government's negotiating team was Undersecretary of Finance Mr. Pio de Roda. The Appraisal Report (No. 424-PH) on the project is being distributed to the Executive Directors separately. Annex III provides a loan and project summary. 32. The proposed loan of $50.0 million includes $48.0 million for industrial financing and $2.0 million for the pilot tree-farming project. The purpose of the industrial portion of the loan is to finance direct imports for medium and relatively large industrial sub-projects. Recent Government initiatives (see paras 25 and 26) have laid a sound basis for the industrial sector to play an important role in furthering Government income, employment and export policies. As noted earlier a possible Bank loan to assist small industry is being discussed with the Government and may be presented to the Executive Directors in FY 1975. 33. The proceeds of the loan would be onlent by DBP. The Government attaches great importance to DBP as a principal source of finance for Philippine industries. A second purpose of the loan is to enable the Bank, through normal advice and guidance, to help DBP improve the standards of its operation in such areas as project appraisal and follow-up, financial plan- ning and audit. 34. DBP was established in 1958 as a wholly Government-owned develop- ment bank. It operates in all important sectors of the economy, although industrial financing in the past accounted for the bulk (79%) of its total financing, followed by agricultural financing (9%), with the balance of 12% going for municipal lending, lending to private development banks and for real estate. Apart from retained earnings, DBP's principal domestic source of funds is the Government. It does not have any foreign exchange resources specifically for relending, and therefore has been financing industry mainly by guaranteeing foreign supplier credits. Its financing is made in the form of loans, guarantees and equity investments. DBP's financing in the past four years accounted for 11% of total fixed investment in the Philippines and its industrial financing for 28% of total investment in the industrial sector. Because of the size of its financing and the wide variety of its activities, DBP has played and is expected to continue to play a central role in the economic development of the Philippines. 35. DBP's present management has endeavored, with some success, to reorganize the institution and to raise the standards of its operations. DBP's Industrial Department, which woulcd have the main responsibility for handling sub-projects to be financed uncler the proposed loan, was recently  - 10 - reorganized and now has the capability to undertake thorough and detailed project appraisal. DBP also draws upon BOI's high quality project evaluation work (see pars 26). DBP's tollow-up work is still weak but more systematic follow-up procedures are now 'Oeing introduced. DBP's management plans to increase the staff of the Industrial Department by adding 25 professionals, with a view to further strengthening appraisal and follow-up work. To lay down sound guidelines for its industrial financing, DBP has agreed with the Bank a Statement of Operating Policies and Procedures which has now been adopted (see Section 3.03 of the Loan Agreement). This will supplement the policy guidelines provided by DBP's charter. To improve financial planning DBP established a Financial Planning Conmittee in September 1973 primarily to prepare three-year business forecasts and financial projections. With these improvements underway and to be continued, DBP has the operational capability to make good use of Bank funds for industrial projects. 36. In the recent past 80% of the industrial projects financed by DBP have been registered with BOI under either the Investment Incentives Act or the Export Incentives Act. DBP has financed a wide range of industrial activities, including food manufacturing, paper, cement, textiles and the engineering industry. It is expected that an even higher proportion of the proceeds of this loan would go to BOI-registered projects which are increasing- ly labor intensive and export oriented. BOI's project evaluation work is of high quality, and this plus DBP's own appraisal work and the Bank's review of sub-projects, will ensure that Bank funds go to industrial projects which are economi:ally as well as financially sound. 37. D3P has experienced severe financial difficulties in recent years principally because heavy debt service obligations were incurred as a result of guarante-ing a large amount of private foreign borrowing between 1965 and 1970. These prohlems arose partly because DBP's appraisal work was weak, partly because many foreign suppliers' credits guaranteed by DBP had excess- ively short maturities and partly because many borrowers defaulted after the de facto peso devaluation in February 1970 leaving DBP to make good on its guarantees. Since then, DBP's appraisal standards have been considerably improved, and the Central Bank has established guidelines to ensure that foreign credits made to Philippine companies have appropriate terms. Despite some recent improvement, which is expected to continue, DBP's arrears remain serious. But they now relate mainly to those foreign currency guarantees made bv DBP prior to the de facto devaluation of 1970. As of June 30, 1973, total arrears on the total loan portfolio, including interest, amounted to about $84 million or 24% of the portfolio. Defaults on guarantees currently falling due are now at a level of 61% compared with a level of about 80% during the previous two years. S'ich defaults amounted to $278 million as of June 30, 1973, of which $79 million had been repaid and a further $42 million converted into long-term loans, leaving a balance of $157 million outstanding. To reduce arrears further, DBP intends to undertake an account-by-account examination of the portfolio industrial loans and guarantees in arrears, so that management can take appropriate action. 38. DBP's accounts are audited by Government auditors whose reports, although thorough in some respects, do not cover certain essential aspects of DEP's financial condition, namely, the condition of the portfolio and the  - 11 - adequacy of provisions made for doubtful accounts. It is not possible, therefore, to make a precise judgment on DBP's financial condition. Because of this deficiency, it has been considered more appropriate to make the present loan to the Government, for relending to DBP, rather than directly to DBP. The Bank would provide an auditing expert to help DBP identify the main weaknesses in its existing audit system and develop, in collaboration with the Commission on Audit, a program of action to achieve appropriate improvements. The Bank would also assist DBP with a training program involv- ing visits by DBP officers and auditors to selected Development Finance Companies. It is hoped that with this assistance, DBP in future will reach a point where it can borrow directly from the Bank. 39. T)IP expects to commit industrial loans and guarantees totalling $350 million during the two-year period from July 1, 1974. This excludes some mining projects (requiring very heavy investment). The proposed Bank loan would provide about 15% of DBP's foreign currency resources required for industrial financing during that period. DBP would finance the balance required from abroad mainly by guaranteeing foreign suppliers' credits, as it has done in the past. It is expected that, as in the past, the Government will continue to provide DBP with the resources required both to sustain a desirable volume of financing and to meet DBP's debt service requirements. 40. The proposed loan of $50.0 million, including the pilot tree- farming component, would be made to the Government, which would relend the proceeds on the Bank terms to DBP under a subsidiary loan agreement. This procedure has been used under three previous Bank loans through DBP for agriculture. $48.0 million would be for foreign exchange costs of indus- trial sub-projects, and $2.0 million for local costs of the tree-farming project. The loan would be for a term of 18 years, including a grace period of 4-1/2 years. The relending rate, charged by DBP to sub-borrowers, is exnected to be 12% per annum, the legal maximum rate for secured loans in the Philippines. The Government is considering now raising the ceiling on interest rates, because of the rapid rate of inflation. If interest rates are raised for medium and long term loans, DBP would raise the relending rate to sub-borrowers accordingly. Industrial sub-loans would be committed over two years and disbursed over four years. They would be for a maximum term of 16 years. Sub-borrowers would assume the foreign exchange risk on the currencies of the countries from which goods and services are procured. The Government would bear any residual exchange risk between the currency of procurement and the currency of obligation. A ceiling of $5 million would be set for any industrial sub-loan made by DBP under the proposed loan (see Section 3.04 of the Loan Agreement). Industrial sub-loans of under $1 million w