Philippines - Industrial Investment and Smallholder Tree-farmers Project

Report No. 424a-PH Appraisal of FILE COPY a Loan to the Republic of the Philippines for Financing: (A) Industrial Investment and (B) Smaliholder Tree-farmers Through the Development Bank of the Philippines May 5, 1974 Regional Projects Department Asia Regional Office Not for Public Use Document of the International Bank for Reconstruction and Development International Development Association 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 It may not be published.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 EQUIVALENTS US$1 = P 6.7585 P 1 - US$0.1480 P 1 million 2 US$147,960 P 1 billion = US$148.0 million ABBREVIATIONS BOI - Board of Investments CCC - US Commodity Credit Corporation CWB - Canadian Wheat Board DAP - Development Academy of the Philippines DBP - Development Bank of the Philippines DEI - Department of Energy and Industry GSIS - Government Service Insurance System IPP - Investment Priorities Plan KfW - Kreditanstalt fur Wiederaufbau MASICAP - Medium and Small-Scale Industry Coordinated Action Program NEDA - National Economic Development Authority NIDC - National Investment and Development Corporation PDB - Private Development Banks PDCP - Private Development Corporation of the Philippines PICOP - Paper Industries Corporation of the Philippines PNB - Philippine National Bank RFC - Rehabilitation Finance Corporation SEC - Securities and Exchange Commission SSS - Social Security System FISCAL YEAR July 1 - June 30  PHILIPPINES APPRAISAL OF A LOAN FOR FINANCING INDUSTRIAL INVESTMENT THROUGH THE DEVELOPMENT BANK OF THE PHILIPPINES TABLE OF CONTENTS Page No. SUMMARY AND RECOMMENDATIONS ...........................v I. INTRODUCTION ........................................ o so ...... 1 II. THE PHILIPPINE ECONOMY AND THE INDUSTRIAL SECTOR ...... 1 The Economy . ............. *. . ................................. 1 The Industrial Sector ....... . . . .......................... *. * * 3 Industrial Finance .... S.................*... ... 5 III. DBP - ROLE IN THE ECONOMY .....*...........***.***.. . 8 Overall Operations ..... ........................ 8 Economic Contribution . .... .... . . . . . . .. . . ......... . 8 Promotion ..... ....................*.. 9 IV. DBP - THE INSTITUTION ............. .............. 10 Ownership, Organization and Management ........... 10 Staffing .............. ..... .............*.* so 10 Operating Policies ........ . . . . ................ . 11 Appraisal .................................................... 11 Follow-Up ..................................................... 12 Procurement and Disbursement .....................O 12 Financial Planning ..........** .. .#6 ...** 12 Operations ...........*. o. ......................... 12 Financial Condition ... .... . ..... . . ..... ..... . . . ..... 13 Audit ................ 0......... 0............................. 14 Resource Requirements and Prospects ........*...*... 14 V. OBJECTIVES AND FEATURES OF THE LOAN ................... 15 The Industrial Loanx ...... .......... # .... . . . . . . 15 The Tree-Farming Project ......................... 16 Main Features of the Loan ......... .... *...... 17 VI. RECO*WENDATIONS AND AGREEMENTS REACHED ................ 18 This report was prepared by Messrs. T. N. Dinh, E. Elejalde, and P. Mistry following their visit to the Philippines in January, 1974. Annex 10 (tree farming project) was prepared by Messrs. D. Harcharik (FAO consultant) and D. Steel.  -2- ANNEXES 1. DBP - Approvals of Loans, Investments and Guarantees to September 30, 1973 2. DBP - Board of Governors as of December 31, 1973 3. DBP - Statement of Operating Policies and Procedures for Industrial Financing 4. Characteristics of DBP's Financing Activities A. Iidustrial Financing B. Non Industrial Financing Appendix 1 - Comparative Statement of Industrial Loans Approved to September 30, 1973 2 - Comparative Statement of Guarantee Operations to December 31, 1973 3 - Geographical Distribution, Maturity Structure, and Currency Exposure of DBP's Regular Foreign Currency Guarantees Outstanding as of December 31, 1973 4 - Interest Rates and Other Cbarges as of December 31, 1973 5 - Summary of Equity Investments in Industrial Companies as of June 30, 1973 5. DBP - Financial Record and Position A. General B. Capital Structure C. Earnings Record D. Liquidity E. Foreign Exchange Risk F. Condition of Portfolio G. Financial Position Appendix 1 - Balance Sheets, June 30, 1970-73 and December 31, 1973 2 - Income Statement for Years Ended June 30, 1970-73 and Half-Year Ended December 31, 1973 3 - Analysis of Loans in Arrears as of June 30, 1973  -3- 4 - Sectoral Comparison of Outstanding Defauls on Guarantees, Guarantees Approved, and Guarantees Outstanding as of June 30, 1973 6. DBP - Examination of Arrears of DBP's Medium and Large-Scale Industrial Accounts 7. DBP - Sources of Capital Appendix 1 - Long-Term Resource Position as of December 31, 1973 2 - Long-Term Foreign Borrowings as of December 31, 1973 7. DBP - Prospects A. General B. Business Forecast C. Resource Requirements D. Financial Projections Appendix 1 - Projected Operations, FY74-76 2 - Projected Income Statements, FY74-76 3 - Projected Balance Sheets FY74-76 4 - Projected Cash Flow Statement, FY74-76 9. Estimated Disbursement Schedule for the Proposed Loan 10. Tree Farming Project A. Summary and Conclusions B. Background C. The Project D. Organization and Management E. Marketing F. Benefits and Economic Justification Appendix 1 - Extract from Existing Agro-Forestry Farm Marketing Agreement 2 - Yields by Site Index of Albizia Falcata 3 - Harvesting, Loading and Hauling Costs 4 - Tree Farm Cash Flows 5 - Economic Rate of Return  - 4 - CHIART'(So. 8558 DBP - Organization Chart aw of. Decere 31, 1973 NAP (No. 11008) Project. Area for Pilot. Tree Farunt.:  PHILIPPINES APPRAISAL OF A LOAN FOR FINANCING INDUSTRIAL INVESTMENT THROUGH THE DEVELOPMENT BANK OF THE PHILIPPINES SUMMARY AND RECOMMENDATIONS i. The Philippine Government has requested a Bank loan for financing through the Development Bank of the Philippines (DBP): (a) direct capital import requirements for industrial projects; and (b) credit for 1,300 smallholder tree farmers in Mindanao. This report recommends a loan of US$50 million, of which US48 million will be used for financing industry. The remaining U e pilot tree-farming project. Expenditures for the latter, would be in local currency. ii. The Philippine economy registered an impressive 10% real growth rate in 1973, shared by every sector. Along with significant increases in agricultural and industrial production export earnings rose to a record US$1.7 billion in 1973, a 55% increase over the previous year. The perform- ance of the economy and confidence in its management were reflected in a substantial pickup in investment activity. iii. Industry represents the third largest sector of the Philippine economy (after agriculture and services), accounting for 27% of net domestic product in 1973, absorbing over one third of total investment and providing employment for 15% of the total labor force. Further industrialization is a basic tenet of Philippine development strategy, providing a vehicle for meeting growing domestic demand, improving the balance of payments and generating more employment for a rapidly growing work force. Industrial growth in 1973 was recorded at 11%, a markedly higher rate than the 6% average growth rate over the last 10 years. Industrial exports, in parti- cular, grew at a rapid pace rising from a level of US$49 million in 1969 to US$200 million in 1973. They now account for 11.8% of total exports compared to around 5.7% in 1969. iv. The Philippine strategy for industrialization has been under- going a shift in emphasis from import substitution towards greater export promotion and a widening of the entrepreneurial base. Specific measures taken to achieve this include: (a) a fundamental reform of the investment and export incentives system; (b) better regulation of investments in accordance with pre-determined priorities through the Board of Investments (BOI); (c) an exchange rate adjustment in 1970 resulting in a devaluation; and (d) changes in tariff policy. These measures have gone some way in correcting previous economic distortions and making Philippine exports  - ii - more competitive. Industry's role in employment creation is also being stressed with the introduction of labor intensity criteria in determining eligibility for incentives. v. An increasing amount of industrial investment is regulated by the BOI. Most of it is financed by DBP, a wholly Government-owned development bank. DBP operates in all important sectors of the economy, with industrial financing accounting for the bulk (79%) of its activities. DBP's approvals of loans, guarantees, and equity investments to September 30, 1973, amounted to P 14.3 billion (US$2.1 billion) for over 200,000 clients. In the last four years its loan disbursements and foreign currency guarantees accounted for 11% of total fixed capital formation in the country; its industrial fi- nancing for 28% of total fixed capital formation in mining and manufactur- ing. As a matter of policy, DBP has been financing mainly industrial proj- ects registered with the BOI. This pattern is expected to continue under the proposed Bank loan. By virtue of the volume of its financing and the multiplicity of its functions, DBP has played and continues to play a promi- nent role in the economic developmetit of the Philippines. vi. DBP's total assets including its guarantees amounted to P 7.8 billion (US$1.15 billion) as of December 31, 1973; paid-in share capital and surplus amounted to P 1.9 billion. Despite recent improvements, particularly in the capital structure, DBP's present financial condition is affected by a large volume of arrears. These relate mainly to loans and guarantees made before 1970 whert DBP's appraisals were relatively weak. The devaluation of 1970 also exacerbated the debt-servicing problems of DBP's clients and worsened the arrears record. The situation is expected to improve gradually. Until an improvement in its financial condition has resulted the Government is expected, as it has in the past, to assist DBP whenever necessary. vii. Measures for accelerating the comprehensive examination of its portfolio of industrial loans and guarantees in arrears have been dis- cussed and agreed with DBP during negotiations. DBP's audit, under- taken by Government auditors, is not sufficiently thorough to allow precise judgements to be made about the soundness of DBP's portfolio. During negotiations, steps to be taken to evaluate auditing procedures and systems, identify weaknesses therein and to develop a program for remedying these weaknesses have also been discussed and agreed with DBP. viii. Since 1970 DBP's project appraisal work has improved considerably. Follow-up is still weak but satisfactory measures have been taken to effect an improvement. Industrial Projects Department I, which will be primarily responsible for processing sub-projects to be financed under the proposed loan, is to be strengthened with 25 more professional staff to-be recruited in the coming year. To provide sound and consistent principles for guiding its appraisal and follow-up work DBP has agreed to adopt a Statement of Oper- ating Policies and Procedures for Industrial Financing, the contents of which have been agreed with the Bank.  - iii - ix. In addition to helping finance Philippine industries (and small- holder tree-farmers), the proposed loan would enable the Bank, through an evolving relationship and an on-going process of sub-project review, to help in improving DBP's appraisal, follow-up and financial planning. In opening up channels of communications with DBP and, indirectly, BOI the proposed loan will also facilitate closer discussion of issues affecting industrial policy. x. For reasons outlined in paragraphs (vi) and (vii) the proposed loan would be made to the Government for relending to DBP under a suitable subsidiary loan agreement. A fixed amortization schedule of 18 years in- cluding 4-1/2 years of grace is recommended. The relending rate charged to ultimate sub-borrowers by DBP is expected to be 12% per annum (the present maximum rate applicable to secured loans in the Philippines). The Gcvern- ment would on-lend to DBP at 7-1/4%. The US$48 million component to be used for financing industry is expected to provide about 15% of DBP's re- sources required for industrial financing for the two-year period beginning July 1, 1974. The foreign exchange risk on currencies of procurement would be assumed by industrial sub-borrowers; that on currencies of obligation would be borne by the Government. To ensure that the loan proceeds would go to a relatively large number of industrial projects, a ceiling of US$5 million would be set on any industrial sub-loan made under the proposed loan. A free limit of US$1 million is recommended, with an aggregate of US$20 million; based on the average size of DBP's industrial projects, about one-half by number or three-fourths by amount of DBP's sub-loans would re- quire the Bank's prior approval. The Government would assume the full ex- change risk on the US$2 million amount for the tree-farming project to be on-lent in pesos by DBP to tree-farmers. xi. During negotiations, the Bank and DBP have discussed and agreed upon: (a) measures to augment the staff of Industrial Projects Department I (para 4.02); (b) a Statement of Operating Policies and Procedures for Industrial Financing, to be adopted by DBP's Board (para 4.03); (c) further measures for accelerating the account-by-account examination of DBP's industrial portfolio in arrears (para 4.10); (d) steps for evaluating DBP's existing audit system, identifying its weaknesses and developing a program for remedying these weaknesses (para 4.11);  - iv - (e) the substance of an agreement between DBP and the Paper Industries Corporation of the Philippines (PICOP) regarding the provision of technical assistance and seedlings by PICOP to the tree-farmers; the guarantee of a suitable minimum price by PICOP (para 5.08); and the continuation by PICOP of its insect prevention and control program (para 5.07); (f) a minimum contribution by the smallholder of 25Z of sub- project cost by way of his own labor (para 5.07); and (g) the compilation of a list of prospective borrowers in the project area (para 5.08).  PHILIPPINES APPRAISAL OF A LOAN FOR FINANCING INDUSTRIAL INVESTMENT THROUGH THE DEVELOPMENT BANK OF THE PHILIPPINES I. INTRODUCTION 1.01 In response to a request from the Government of the Philippines a Bank loan of US$50 million is recommended to provide financing for: (a) capital import requirements of industrial projects; and (b) credit for about 1,300 smallholder tree-farmers in Mindanao (Annex 10). Both project components are to be financed through the Development Bank of the Philippines (DBP). 1.02 Since 1971, the Banc has made three loans to the Government for financing agricultural projects (rice processing, livestock and fisheries) through DBP. As with those three agricultural loans, the proposed loan would be made to the Government, and re-lent to DBP under a subsidiary loan agreement acceptable to the Bank. Unlike the previous projects, the proposed project would include arrangements to strengthen DBP administratively and financially with a view to making it eligible for direct Bank loans at some future date. 1.03 In formulating the loan proposal, it has not been possible to take full account of the consequences of recent increases in petroleum prices on the projec;ted demand for DBP's financing. However, available information indicates that the proposed loan remains fully justified. II. THE PHILIPPINE ECONOMY AND THE INDUSTRIAL SECTOR The Economy -/ 2.01 Background. Prior to 1973 the performance of the Philippine economy was relatively disappointing. Its growth rate belied the poten- tial of a country with considerable natural resource endowments. Towards the end of the 1960's increasing budgetary deficits, losses of foreign reserves and the rapid accumulation of short-term foreign debt to an 1/ For a detailed discussion please refer to "Current Economic Position and Prospects of the Philippines" (Report No. 78-PH dated April 20, 1973). An economic mission is in the field to update this report.  unmanageable level compelled the Government to adopt a floating exchange rate (para 2.11) and embark on a program of stabilization in February 1970. The restrained monetary and fiscal policies introduced under the program sharply curbed both investment and growth. The adjusted exchange rate reduced export earnings, increased the import bill and resulted in a signi- ficant deterioration in the external terms of trade. The economy also experienced rapid inflation between 1969-72; prices increased by about 45% over that period, resulting in a drop in real incomes for the wage-earning group and an increase in unemployment. Economic recovery, which began slowly in 1971, was severely set back in 1972 with the worst floods in 20 years and a large drop in agricultural production. The resulting eco- nomic pressures provoked widespread civil unrest which culminated in the imposition of martial law in September 1972. 2.02 Current Performance. With the subsequent restoration of stability, the passage of economic reforms and favorable changes in world commodity prices, the economy registered an impressive 10% real growth rate in 1973. Improved performance was recorded in every sector. The agricultural sector which had suffered from adverse iweather conditions during the previous three years grew by 11%. Export earnitigs rose to a record high of $1.7 billion in 1973 (55% over 1972) reflecting increases in both traditional exports (mainly due to prices) and new exports, particularly manufactures (paragraph 2.05). Net foreign exchange reserves rose to US$835 million at the close of 1973 - the highest in Philippine history. On the domestic front, measures such as tax reforms, amnesties and improved collection resulted in a 38% increase in tax revenues in 1973. Investment activity and foreign capital inflows also rose to levels substaatially above those of 1972. 2.03 Future Directions. As outlined in the 1974-77 Development Plan the Government's economic strategy aims at increasing the long-term annual growth rate to over 7% in real terms and increasing the annual rate of employment creation to over 4%. However a slowdown in the growth of the economies of its major trading partners (viz., the USA, Japan and Europe) may dampen growth in 1974. The projected oil import bill remains a con- tinuing source of uncertainty threatening the country's reserves position. Whereas 1973 exceeded expectations, the ensuing period may be one of con- solidation with the groundwork being laid for a sustained rate of better distributed growth. 2.04 The Role of Industry. Over the long term, heavy reliance is being placed on industrial expansion in achieving income and employment growth targets. Specifically, the Government's thrust is toward the promotion of employment opportunities through the encouragement of labor intensive methods of production, increasing foreign exchange earnings through the rapid expan- sion of manufactured exports, the strengthening of intra-and inter-industry linkages and the intensification of efforts at a wider regional dispersion of investment. Accordingly, the Government has given priority to invest- ments in export-oriented projects and to the further development of small- and medium-scale industrial enterprises. 1/ 1/ A Bank loan for Small-Scale Industry has been scheduled for FY75.  -3- The Industrial Sector - 2.05 Recent growth. Industry (manufacturing, mining and construction) represents the third largest sector in the Philippine economy (after agri- culture and services), accounting for 27% of net domestic product in 1973, absorbing over a third of total fixed investment and providing employment for 15% of the total labor force. Reflecting the strong recovery of the economy in 1973, industry grew by around 11%, a markedly higher rate than the average growth rate of 6% in the 1960's and early 70's. An increasing proportion of manufacturing output was export-oriented. Non-traditional manufactures accounted for over 11,8% of total exports in 1973 compared with less than 5.7% in 1969, increasing in value from US$49 million in 1969 to US$200 million in 1973. 2.06 Structure. Manufacturing, which accounts for over two-thirds of all industrial activity, is predominantly privately owned and is generally concentrated in large-scale, vertically integrated, relatively capital- intensive units. In 1971, organized manufacturing units with kewer than 20 employees accounted for 85% of the number of enterprises but for less than 17% of industrial employment, 8% of the payroll, 4.7% of value added and 5.5% of total assets of manufacturing enterprises. By sectors, food and bev- erages represent the largest industry group, with chemicals and petrochemicals second, and textiles ranking third. Geographically, over 65% of manufacturing enterprises are concentrated in the greater Manila and southern Luzon area, with increasing industrialization taking place in Mindanao. 2.07 Orientation. Its growing export orientation notwithstanding, Philippine manufacturing is geared mainly to production for the domestic consumer market. This is attributable to an industrialization strategy which previously (in the 1950's and 60's) placed excessive emphasis on im- port substitution, resulting in a domestic market highly protected by both direct import controls and high tariffs. The industrial investment and output thus encouraged tapered off with the exhaustion of possibilities for easy import substitution. For a time, the protected market, the lack of any direction and regulation of investment, and cheap capital resulted in chronic overcapacity in several industries and created severe financial difficulties for several large enterprises. However, with better markets at home and abroad, a more realistic exchange rate and better regulation of investment this situation has improved considerably in the last two years. Capacity expansion is now needed in4 some previously overcrowded industries (most notably, cement). 2.08 Policies. Since 1968, the industrial sector has been affected by several policy changes. The most important of these include: (i) a 1/ The Industrial Sector is discussed in detail in a report entitled, "Industrial Development Problems and Prospects in the Philippines", dated March 19, 1974 (Report No. 280-PH).  - 4 - reform of investment and export incentives and the establishment of the Board of Investment (BOI); (ii) the exchange rate adjustment and (iii) tariff policy. 2.09 Investment and Export Incentives. The Investment Incentives Act (R.A. 5186) of 1967 reformed and subsumed the previous fragmented structure of incentives; it was supplemented by the Export Incentives Act (R.A. 6135) in 1970. Both acts were amended in 1973 with a "labor-intensity" criterion being introduced. These Acts resulted in a reduction of taxes and tariffs foregone from 20% of annual gross investments (between 1965-68) to 10% (between 1968-72) and in a change in the composition of taxes forgiven. Exemptions have emphasized income and sales tax relief (which do not discriminate against domestic products) and reduced reliance on import duty. Export incentives, which have been widely availed of, have assisted the growth of exports and the diversification of the export product range. 2.10 The Board of Investments (BOI). The responsibility for determin- ing the eligibility of and registering projects for incentives and regulat- ing private industrial investment lies with the BOI. Accordingly, it: issues an annual Investment Priorities Plan (IPP) listing those activities which qualify for incentives; determines the additional capacity required in industries; and approves individual investment projects in line with the annual IPP. The BOI also draws up a periodical list of "overcrowded in- dustries" in which the Government discourages further investments by refus- ing incentives and foreign exchange for imports. The BOI plays a central role as an "evaluation and appraisal" body which delves deeply into the technical, financial and economic viability of industrial projects. Its project evaluation is of high quality. BOI is, in addition, an active promotional agency, which by virtue of its powers to provide or refuse incentives guides investment and reshapes project design. It also assists private investors with arrangements for domestic and international marketing and subcontracting, and undertakes specific industry and market studies for them. BOI has been endeavoring to improve its operations, policies and procedures, and to that end has received, since 1972, the technical assist- ance of the UNDP in a program for which the Bank is the Executing Agency. About one-half of new industrial investment in the Philippines now goes into projects approved by BOI. From its inception in June 1968 to June 30, 1973, BOI has approved 250 projects requiring a total investment of P 7.2 billion 1/, of which about P 4.3 billion (or 60%) represents fixed invest- ment. When completed, these projects are expected to generate 46,000 addi- tional jobs. Average fixed investment per job created for BOI projects has been P 93,500 or $13,750, with a noticeable declining trend, reflecting BOI's increasing emphasis on labor-intensive industries. 2.11 Exchange Rate. The floating of the peso in February 1970 re- sulted in a large de facto devaluation of about 60% (from P 3.9 to P 6.4 to US$1). The more realistic exchange rate reduced distortions in the 1/ At current exchange rates.  - 5 - price of inputs, discouraged currency speculation through over-invoicing, and made Philippine manufactured exporrs more competitive. Unfortunately, it also hit very hard those industrial firms heavily dependent on imported inputs and with sizeable foreign debts. The problems of debt-servicing thus created are slowly being ironed out. The initial "shock" of the devaluation has now worked itself through the system and the maintenance of a more realistic exchange rate will probably have a salutary effect on future resource allocation. 2.12 Revision of Tariffs. A number of changes and improvements took place in the structure of protection with the passage of Presidential Decree No. 34 which took effect on January 1, 1973. Although introduced principally as a revenue measure, the new tariff code has simplified and re-arranged the previous structure. A minimum tariff rate of 10% is im- posed on raw materials which have to be imported and on capital goods not yet manufactured in the Philippines. Higher rates, of between 30-70%, are levied on intermediate and consumer goods, with a maximum 100% rate applied to products manufactured domestically and to luxury items. The element of protection in the tariff structure is reinforced by an import licensing system administered in consultation with BOI for industrial products and capital goods for which domestic capacity exists or is planned. BOI can also recommend changes in tariff rates for industries included in the IPP. Because of licensing and the fact that nominal rates for complete products are higher than for inputs or components, the level of effective protection for domestic finished products is generally higher than the nominal rate. 2.13 Policy-Making and Implementation. The BOI, originally designed as the principal regulatory agency which would guide industrial investment, has, by default, been increasingly involved in policy-making. To relieve it of the resulting overload two new Government agencies are expected to play an important role alongside the BOI in formulating and implementing industrial policies. The first is the National Economic Development Author- ity (NEDA). Created in 1973, NEDA is now the principal apex policy-making institution, and is responsible for the preparation of the 4-year Develop- ment Plan. The second is the newly established Department of Energy and Industry (DEI) which is expected to begin operating shortly. Industrial Finance 2.14 Investment Requirements. Total industrial investment over the 4-year period 1974-77 is expected to be around P 20 billion (in 1973 prices) 1/ or over 25% of total fixed capital formation. This represents a real increase of about 60% over the previous 4 years. Investment in manufacturing will account for over 67%, increasing in real terms by 20% between 1974 and 1975 and by 10% thereafter. The Government expects 75% 1/ FY74-77 Development Plan estimate (NEDA).  - 6 - of these requirements to be financed through domestic sources, 1/ 5% from direct foreign investment and 20% from guaranteed commercial foreign borrow- ings. This level of investment will require a doubling in resource mobili- zation from traditional domestic sources. The main sources of industrial finance are discussed below. 2.15 Development Banks. Two institutions, DBP and the Private Development Corporation of the Philippines (PDCP) are the main providers of long-term finance with DBP by far the larger of the two (paragraph 3.01). PDCP's total assets as of the end of 1973 were P 676 million, with outstand- ing loans to industry amounting to P 441 million. Its foreign resources are derived mainly from the Bank Group (US$80 million so far) and t:he Asian Dev- elopment Bank (US$45 million). 2.16 Commercial Banks. There are 35 privately-owned Filipino com- mercial banks, and two owned by the Government. Branches of four foreign banks also operate in the Philippines. Over half of the Filipino banks have been established in the last decade. They operate under a branch banking system (there are over 700 branches) and are the main sources of working capital and trading credits. The largest bank is the Government- owned Philippine National Bank (PNB). With 161 branches, it accounts for about 24% of the banking system's total assets (over P 30 billion at the end of 1973). The banking system has grown rapidly in 1972 and 1973, doubling its assets in that two-year period. Domestic credits provided by commercial banks in 1973 amounted to P 21 billion, one-half of which went to the manufacturing sector, mainly for short-term working capital. 2.17 Other Financial Institutions. Besides DBP and PDCP, several institutions provide term finance to industry. These include: (i) the National Investment and Development Corporation (NIDC), a subsidiary of PNB; (ii) private investment houses; (iii) insurance companies; and (iv) pension and trust funds including the Government Service Insurance System (GSIS) and the Social Security System (SSS), whose resources for industry are funnelled mainly through DBP. While the outstanding loan portfolios of these institutions now total over P 6 billion, the bulk of their lending is for real estate (60%) and consumer loans (25%). 2.18 Suppliers' Credits. Foreign commercial borrowings guaranteed by domestic financial intermediaries (principally DBP) have in the past accounted for 30-35% of investment in manufacturing. Prior to 1970, such borrowings were obtained on relatively hard terms. As a result of the stringent debt management measures taken since 1970 by the Central Bank which stipulated minimum terms for foreign credits, and the substantial increases in export earnings, the burden of servicing such debt has been reduced to a manageable level. 1/ Includes cash generated internally by firms, personal savings and resources mobilized by domestic financial intermediaries (DBP and PDCP) from official multilateral and bilateral aid sources.  - 7 - 2.19 The Securities Market. After a three-year slump, the Philippine stock market experienced a remarkable year in 1973. While listings continued their steady upward trend, increasing to 188 from 171 in the previous year, trading reached an all tine high with a volume of 136 million shares worth P 6 billion. This reflected a fivefold increase in volume and ninefold in value over 1972. In addition 20 companies already listed increased their capital stock from P 1.3 billion to P 3.1 billion with a much wider base of public participation. The comparatively attractive price-earnings ratios of Philippine stocks also drew funds from the Japanese and Hong Kong markets. The substantial gains in capital market activity in 1973 were attributable to several factors such as the general recovery of the economy, a decline in money market rates, and structural reforms based on the recommendations of a joint IMF-Central Bank Ccmmission. The reforms included such measures as a reduction in the stock transfer tax; exemption from capital gains on the securities of preferred productive enterprises; repatriation of foreign capital and profits; a tax amnesty wl4ich returned several hundred million pesos from the "black market" to tLe capital market; and a compulsory dividend declaration rule for companies generating profits in excess of reasonable capital expansion requirements. 2.20 Interest Rates. The Anti-Usury Law of 1916 previously limited lending rates to 12% and 14% per annum on secured and unsecured loans respectively. Effective lending rates on some commercial bank loans were however 4 to 6 points higher with add-on charges, compensatory balances r,nd advance interest collection. In the past few years these rigid legal limits have resulted in distorting both the mobilization and allocation of capital resources and led to the growth of an unorganized "private" market. On the deposit side, with the rate of price increases averaging about 12-13% annually in the recent past, depositors have received a negative rate of interest (present deposit rates are 6-8%) and the flow of private savings to the banking system has been depressed. With these rates of inflation it is unlikely that financial institutions will be able to mobilize a significantly greater volume of domestic savings without increasing their deposit and (consequently) lending rates from current levels. Up to now they have not been in a position to compete for funds with the money market (whose rates are not covered by the Law) or even with short-term Government instruments which yield between 12 and 14%. The Law has been amended recently to empower the Monetary Board of the Central Bank to raise lending rate ceil- ings in accord with prevailing economic conditions. The Monetary Board, however, has not yet done so. 2.21 Prospects. Plan expectations are that corporate savings and personal savings channelled through the capital market will provide about 45% of total industrial financing requirements. In the light of current levels of profitability and capital market activity (paragraph 2.19) these expectations are reasonable. Financial intermediaries are expected to mobilize a further 30% (or P 6 billion) over the 4-year period, including  -8- foreign borrowings from aid and commercial sources 1/, and domestic savings (paragraph 2.20). The remaining 25%, expected to come from direct and in- direct foreign investment (guarantees), represents a reduced reliance on guarantees (paragraph 2.18), a desirable but uncertain prospect. III. DBP-ROLE IN THE ECONOMY Overall Operations 3.01 Including the operations undertaken by its predecessor (the Re- habilitation Finance Corporation) 2/ aggregate approvals by DBP of loans, guarantees, and equity investments through September 30, 1973 amounted to P 14.3 billion (US$2.1 billion). Foreign currency guarantees accounted for P 8.8 billion (US$1.3 billion) or 62% of total approvals as of September 31, 1973. Loans, equity investments, and domestic guarantees accotnt for 33%, 4% and 1%, respectively. By sectors, the bulk of DBP's financing has gone to industry. 3/ Including guarantees 4/ and equity investments, industry has received P 11.3 billion or 79% of total approvals, agriculture 10%, real estate 7%, and other sectors, including the private development banks, the balance of 4%. As of December 31, 1973, DBP's overall outstanding portfolio of loans, guarantees and equity investments stood at P 6.6 billion, for over 100,000 accounts. DBP's financing in the past four years accounted for about 11% of total fixed capital formation in the Philippines; its industrial fi- nancing for 28% of total fixed capital formation in manufacturing and mining. Annex 1 smmarizes DBP's overall operations. Economic Contribution 3.02 By virtue of the sheer size of its financing and the multiplicity of its activities, DBP's role in the economic development of the Philippines is self-evident. Unfortunately, it is virtually impossible to quantify the overall economic contribution of the industrial projects it has financed. DBP has not systematically collected the necessary data on these projects to enable such an evaluation to be made. Projected economic data on a re- presentative sample of 45 BOI-registered projects financed by DBP (through 1/ These sources can be expected to provide P 2-3 billion (US$300-400 mil- lion) between 1974-77. 2/ DBP was established by statute in 1958 as a successor to the Rehabili- tation Finance Corporation (RFC), which was created in 1947. 3/ "Industry" includes manufacturing, mining, transportation and shippings, electric power, agro-industries, etc. 4/ Of total foreign currency guarantees approved, 93% for industry, 4% for real estate and 3% for agriculture.  -9- loans and foreign guarantees) in FY72 and FY73 do, however, provide a par- tial measure of the economic benefits of these projects. DBP's financing, amounting to P 592 million (US$87 million), was part of a total investment of about P 1.2 billion, of which P 810 million represented fixed investment. The additional direct employment generated by these projects, when completed, is estimated at about 8,300. Net foreign exchange earnings/savings by these projects are estimated to amount annually to US$50 million. The average financial rate of return of these projects was 20%; the average economic rate of return, 14%. The average cost of fixed investment per worker is about US$14,000, about the same as the average for all BOI projects. As in the recent past (paragraph 4.08), DBP is expected to continue financing mainly those industrial projects approved by BOI. Promotion 3.03 DBP does not play a direct role in the promotion of medium- and large-scale industries since this would merely duplicate work now being done adequately by the BOI (paragraph 2.10). DBP has, however, been actively en- gaged in promoting and financing broadly based development in rural areas. Its 32 branches and 24 agencies have been organized into eight "regional action groups" to undertake economic surveys and identify potential projects. These groups have already completed a number of feasibility studies (several more are under preparation), including those on mango development, tuna fishing, tractor drum wheel, paddy thresher, and corn husker-sheller manu- facturing. DBP's "countryside development program", has since its inception in 1971, resulted in its making about 44,000 loans amounting to P 357 million, for agriculture (67%), small industries (17%) and other activities (16%). In the last year DBP has been actively assisting the Government in formulating a comprehensive national program for the development of small- and medium- scale industries which will attempt to integrate the provision of both fi- nancial and technical assistance to these enterprises along with specialized marketing and promotional services. 3.04 DBP has also devoted its resources and manpower to several non- profit developmental undertakings. Most recently it has played a central role in establishing, in 1973, and helping operate, the Development Academy of the Philippines (DAP), a multi-disciplinary institute oriented toward applied research in economic development. A notable undertaking by DAP is a Medium and Small-Scale Industry Coordinated Action Program (MASICAP) which attempts to identify specific small industrial projects, seeks out entre- preneurs to implement those projects, and provides them with technical assistance. Since the program was launched a mere six months ago it is dif- ficult to gauge its success. From the evidence available so far, it has pro- mising prospects.  - 10 - IV. DBP - THE INSTITUTION -Ownership, Oranization aud Maae 4.01 DBP was established in 1958 and is fully owned by the Government. Its organization (Chart 8558) which reflects the diversity of its activities has recently undergone a major change that resulted in noticeable improve- ments in its efficiency, particularly in its industrial operations. Over- all management is entrusted to a nine-member Board of Governors (Annex 2) appointed by the President of the Philippines for 7-year terms. Presided over by a full-time Chairman, who is also the chief executive officer, the Board has four full-time Governors with executive authority and four part- time Governors chosen from senior levels of Government. The present chairman - Mr. Leonides S. Virata - was appointed in February 1970. Along with re-organizing DBP, he has gradually built up a capable and effective management team which is beginning to make a large and complex organization much more tractable. DBP's industrial financing operations are now con- centrated in three departments, Department I dealing with large loans (above P 1 million), Department II with small loans (below P 1 million) and Department III with public utilities and transport loans (any size). This represents a marked change from the previous concentration in two departments, one dealing with loans and guarantees and the other with equity investments and "package financing" arrangements, each department having entirely differ- ent appraisal procedures. The present arrangement, emphasising "client specialization", appears more responsive and efficient. The proposed Bank Loan will be handled principally by Department I, a well-managed though presently under-staffed unit (paragraph 4.02). This Department (as the other two) undertakes both appraisal and follow-up work on its loans. Staffing 4.02 As of December 31, 1973, DBP's total staff numbered 2,249, of whom 1,055 were professionals. The staff, of generally good calibre, are evenly divided between headquarters and DBP's widespread network of 32 branches and 24 agencies. The latter account for about 75% of DBP's total agricultural financing and for less than 10% of its industrial lending, most of which is small-scale. Department I has 29 professional staff members of -r?horn 3 are supervisory, 10 are engineers and the rest, financial analysts. Most of them have worked at DBP for over 5 years. In view of projected levels of activity, management is aware that the Department is, at present, considerably understaffed, and plans to strengthen it in the coming year with 25 more professionals. This expansion should enable the Department to strengthen both its appraisal and follow-up work (paragraphs 4.04 and 4.05). DBP's plans for augmenting Department I's staff have been discussed at negotiations. DBP has made satisfactory arrangements to ensure that sufficient staff will be available when the proposed loan becomes effective and that recruitment thereafter will keep pace with requirements.  - 11 - Operating Policies 4.03 Apart from its Charter, which provides a few policy directions and stipulates limits (e.g. a 10:1 debt/equity ratio), DBP has no policy statement to guide operations. In most instances operations are guided by policy precedents established on an ad hoc basis. To lay down sound and consistent principles for guiding appraisal and follow-up work DBP has agreed, in its discussions with the appraisal mission, to adopt a Statement of Operating Policies and Procedures for Industrial Financing. The contents of this statement (Annex 3), have been discussed and agreed upon at negotia- tions. Appraisal 4.04 DBP's industrial project appraisal has improved substantially in quality since the visit of the Bank's reconnaissance mission in May 1972, which at the time identified and discussed specific appraisal weaknesses with DBP's management. The improvement is particularly noteworthy since before 1970 DBP carried out virtually no appraisal other than an evaluation of the client's credit standing. There is, however, room for further improve- ment, particularly with respect to the evaluation of a project's economic merits. As a first step toward remedying this weakness DBP has undertaken to establish an economic evaluation unit within Department I. Since most of the sub-projects expected to be financed under this loan will be registered with the BOI, DBP will, in the interim, incorporate BOI's economic evaluation (which is satisfactory) whenever appropriate in its appraisal reports and will take into account the economic rate of return as a factor in its lending decisions. These qualitative improvements in DBP's appraisal will need to be matched with improved procedural arrangements. At present each of the technical/financial, marketing and creditworthiness aspects of appraisal are undertaken separately by three separate departments 1/. The final document presented to the Board for decision-making is usually only a descriptive project summary devoid of essential judgement and critical analysis. It rarely reflects the underlying appraisal work that has actually been carried out. The appraisal mission has discussed these matters in depth with DBP's management, who have agreed to make appropriate substantive, procedural and presentational improvements 2/. 1/ Technical and financial analysis is carried out by the industrial department concerned (paragraph 4.01) while marketing and credit- worthiness analysis are carried out by the Economic Research Unit and Credit Department respectively. 2/ In addition to establishing the economic evaluation unit and in- corporating BOI's evaluation, DBP has also agreed to pay more atten- tion to project merits in its reports and to change their format. As DBP's underlying appraisal work is sufficiently thorough, many of these changes are merely presentational and should be easy to implement.  - 12 - Followugt 4.05 DBP's management has readily acknowledged that its follow-up work is weak and has already taken steps to strengthen it. Apart from increasing follow-up staff, systematic procedures for supervision are to be instituted along with comprehensive reporting requirements from borrowers in addition to their annual reports and Board minutes. Plant and site visits for supervision purposes are to be stepped up; findings concerning progress in project implementation along with judgements on the continuing viability of the borrower and project on the basis of these visits are to be regularly recorded. Financial statements including annual reports are to be more systematically reviewed. DBP is also sending its managers to development finance companies with good follow-up procedures and experience to learn from them and adopt systems appropriate for DBP's follow-up needs. The appraisal mission has reviewed these arrangements with DBP's management and found them to be satisfactory. Procurement and Disbursement 4.06 DBP's procurement practices are adequate. Although DBP does not routinely require its borrowers to invite bids on an international basis, it usually requires firms applying for a foreign currency loan or guarantee to submit two or more alternative proforma contracts and/or quotations. The price and suitability of the equipment proposed to be purchased is subject to a careful check by DBP's staff. DBP's disbursement procedures are also adequate. Loans are disbursed against supporting documents, fol- lowing physical inspection by the staff of progress of construction or com- pletion of the project. Financial Planning 4.07 DBP has not undertaken any advance financial planning up to the appraisal mission's visit. Although short-term (12-month) budget and re- source forecasts were prepared, the absence of planning over a longer time perspective did not permit timely anticipation of resource needs. To remedy this situation a Financial Planning Committee has been established to pre- pare three-year business forecasts and financial projections. The Committee is suitably constituted and on the basis of discussions held in the field, substantial improvement in planning may reasonably be expected over the next year. 92erations 4.08 The growth of DBP's operations since its inception (paragraph 3.01) took place mainly during the 1960's, with a shift in emphasis from direct lending in the early years to guarantees in the late 1960's. The shift reflected mainly the inadequacy of resources to meet the substantial increase in financing requirements. After a marked slowdown during 1971 and 1972, a result of the unfavorable economic situation and of DBP's serious liquidity problems brought about by clients' defaults (paragraph 4.10), operations started to pick up in 1973. Loan approvals during FY 73  - 13 - totalled P 220.3 million, compared to P 157.8 million during FY 72 and P 50.1 million during FY71, but were still well below the annual level of P 450 million in FY70. Loan disbursements also increased to P 372.6 million in FY73 compared with P 232.4 million in FY72, P 289.1 million in FY71 and P 398.9 million in FY70. Approvals of foreign currency guarantees amounted to US$214 million in FY73, compared with US$155 million in FY72, US$75 mil- lion in FY71 and US$278 million in FY70. DBP's response to the pickup in investment activity in 1973 was enabled by new borrowings (Annex 7, para 6) and its stronger financial and liquidity position (Annex 5, paras 3, 4 and 5). The upturn has continued into FY74, with loan approvals amounting to P 139 million, and approvals of foreign guarantees totalling US$140 million during the six-month period ended December 31, 1973. Annex 4 describes DBP's financing activities in greater detail. Financial Condition 4.09 In judging DBP's financial position, it is essential to take into account the fact that DBP is a Government-owned development institution which is relied on heavily to undertake priority investments. When necessary, the Government has shown itself willing to assist DBP with servicing its debt and maintaining a desirable volume of financing. The most recent example of such support was the conversion in 1973 of P 1.3 billion of debt owed to the Gov- ernment and Central Bank into DBP equity. DBP's present financial problems are mainly the result of client defaults on loans and guarantees made during 1968-70 when its appraisal work was very weak. Several marginal projects were badly hit with the peso devaluation of 1970, especially those which were heavily dependent on imports. A large number of firms were unable to gener- ate enough cash to service their increased debts. Many of these clients are only just beginning to overcome these difficulties and improvements in DBP's finances can be expected once their cash generating capacity is restored. Recent improvements in DBP's profitability, liquidity and capital structure (see Annex 5) are expected to continue. 4.10 Although a slight improvement is discernible, its large volume of arrears will continue to pose the main financial problem facing DBP for some time. With the improvements expected in DBP's appraisals, in clients' ability to service their debts and in collections 1/ the arrears situation is expected to improve gradually. It will not be possible to estimate DBP's likely losses on existing arrears until the detailed examination of DBP's portfolio, which has already begun, has been completed. This account-by- account examination of industrial loans and guarantees in arrears has been undertaken with a view to determining the repayment capacity of each borrower so that appropriate decisions can be taken on further action, i.e. restruc- turing of accounts, rescheduling, or legal action. When completed the analysis 1/ A recently issued Presidential Decree has considerably strengthened DBP's collection efforts. The Decree compels mandatory foreclosure for all loans on which arrearages (interest and penalties included) amount to 20% or more of total outstanding obligations.  - 14 - will provide a clearer picture of the condition of DBP's industrial portfolio and the appropriate level of provisions for possible losses. This matter has been discussed with DBP at negotiations, and a suitable program of further action has been agreed upon (Annex 6). Audit 4.11 Under DBP's Charter, its accoumts are audited by DBP's Audit Department, consisting of Government auditors responsible to the Commission on Audit of the Government. Although the audit is generally thorough, it does not allow conclusive judgements to be made about DBP's present financial position since it does not comment on the quality of the portfolio and the adequacy of provisions made for doubtful accounts. At negotiations, the Bank and DBP discussed, and agreed upon, steps to be taken for: evaluating the present audit thoroughly; identifying its weaknesses; and implementing meas- ures for strengthening it. At DBP's request the Bank has agreed to provide assistance with the audit evaluation. 4.12 Until DBP's arrears are analyzed, suitable provisions for possible losses are made and a suitable program for remedying audit deficiencies is under way, the proposed loan should be made to the Government for relending to DBP, rather than directly to DBP. Resource Requirements and Prospects 4.13 Annex 7 gives details on the sources of DBP funds. DBP's capacity to mobilize domestic resources from the public will remain limited as long as the present lending rate ceilings are in force; till then it will be unable to compete for funds with the money market or with short-term Govern- ment instruments (paragraph 2.20). Consequently it will continue to rely heavily on the Government and its agencies for peso resources. In the past, DBP has obtained such resources, largely on an ad hoc basis, to meet emer- gencies, as in 1970-72 when DBP faced serious liquidity problems because of massive defaults on foreign guarantees (Annex 5, paragraph 5). As noted in paragraph 4.07, DBP has now begun to prepare long-term financial projections, which should enable it to plan its operations and anticipate resource needs on a more systematic long-range basis. 4 14 Annex 8 provides forecasts of DBP's operations for FY74 through FY76 including its financial projections. Excluding some mining projects, requiring very large amounts which will not be financed under the proposed loan, DBP expects to commit industrial loans and guarantees for a total of US$$350 million during the two-year period beginning July 1, 1974. The industrial component of the proposed Bank loan (US$48 million) would provide about 15% of DBP's resources required for industrial financing during that period, and would permit DBP to avoid guaranteeing this amount of more ex- pensive foreign suppliers' credits. Defaults on new guarantees (which would account for the remainder of its financing) are expected to be minimal mainly because DBP's appraisals are considerably stronger, and the terms of guaran- tees are now vetted by the Central Bank. DBP's liquidity position is expected  - 15 - to continue improving and its debt service cover is expected to increase from 0.9:1 in FY73 and FY74 to above unity in FY75 and thereafter (see Annex 8, paragraph 8). V. OBJECTIVES AND FEATURES OF THE LOAN The Industrial Loan 5.01 Project Description. The industrial portion of the loan (US$48 million) would finance medium and relatively large industrial sub-projects. As with other Bank loans to development finance companies, eligible enter- prises would be broadly defined to include manufacturing, as well as agro- industries, mining, ocean-shipping 11, hotel projects, etc. The projects financed under this loan are expected to be consonant with the country's investment priorities and development objectives (para 3.02). 5.02 The main beneficiaries under this loan will be medium- and large- scale firms, which for some time, will continue to provide the main oppor- tunities for increasing both employment and export earnings; the Govern- ment's principal industrial development objectives. The recent restructur- ing of incentives to encourage greater labor-intensity and export orientation implicitly recognizes this. In the past, such enterprises have generally been financed with loans from foreign commercial sources, on relatively hard terms. Since the proposed loan will replace such commercial borrowings, it is expected to relieve pressure on the Philippine balance of payments in the future. 5.03 DBP as the Intermediary. Since 1962, the Bank Group has assisted Philippine industry with four loans totalling US$80 million channeled through the Private Development Corporation of the Philippines (PDCP). The proposed loan has been prompted by a Government request to the Bank to also consider using DBP as an intermediary for financing industry, in view of both its considerably greater overall impact and the scope for further institution- building. 5.04 Objectives. DBP, in the mission's view, has the capability of meeting the principal objective of the proposed loan i.e. to efficiently allocate Bank funds in the industrial sector. Further institutional improve- ments in DBP's standards and procedures are also specific objectives under the proposed loan, as are improvements in its planning and audit. The Bank's institution-building impact on DBP is expected to deepen with a continuing relationship and through the sub-project review process. In view of DBP's role and its close working relationship with BOI (para 3.02), the proposed loan also provides the Bank with a useful vehicle for discussion of broader policy issues affecting the Philippine industrial sector. 1/ A Bank loan specifically for Philippine inter-island shipping is under appraisal.  - 16 - 5.05 Justification. An.ex ante calculation of the economic rate of return for this part of the project is not possible, since the specific sub-projects to be financed are not yet identified. As noted in para- graph 3.02, a representative sample of DBP-financed projects is estimated to yield an average economic rate of return of around 14% and an internal financial return of around 20%. T Tree-2arming Project 5.06 In response to a Government request for Bank assistance through DBP to smallholder tree farmers, the proposed loan also includes a component for this separate and unrelated project. The small size of the project, its timing and the fact that it would be channelled through DBP, make it adminis- tratively simple and more convenient to deal with it as part of the proposed loan. 5.07 -Project Description and. Obectives. An amount of US$2 million of the total loan will be used by DBP for a pilot smallholder tree-farming proj- ect, described in some detail in Annex 9. The project calls for the planting in Mindanao by about 1,3D0 participating smallholders of a fast growing pulp- wood species (Albizi-a falcata) which takeo about eight years to mature. Sub-loans made by DBP to individual smallholders would be disbursed over a period of about four years, _but would have an eight year grace period so that repayments would begin after the first harvest. The term of sub-loans would be 15 years. The pulpwood will be purchased by the Paper Industries Corpora- tion of the Philippines (PICOP), which would also provide seedlings (at cost) and technical assistance.toamallholders. It would also continue its-present program of insect cont:rol (Annex 10, pars 16). Al1though the amount for this project is relatively :sall the Govarment eand DBP strongly requested the Bank to participate in the prqjact. This pxLtot project As expected to make a substantial contribution to %the annual income of the ~amalholdera concerned,, who are expected to contribute at least 25% of project cost by way of their own labor (Annex 10, para 19). The project will Also provide the Bank with useful experience in dealing with similar projects in the Philippines and elsewhere in the world. -At present prices paid by :COP -the financial rate of return for a five and ten hectare tree-farm would be 25%. The economic rate of return is estimated,at about 14%. 5.08 To ensure an adequate income to smallholders., and more.generally the adequate implementation of the project, there is a need for an agree- ment between DBP and PICOP regarding the.guarantee by P-ICOP of a suitable minimum stumpage price (Annex 10, paragraph 79), which should be renego- tiated annually, and the provision of technical .assistance and seedlings by PICOP to the tree-farmers (Annex 10, paragraph 22). DBP has recruited a qualified forester for project implementation (Annex 10, paragraph 21) and is compiling a list of prospective borrowers in -the project area (Annex 10, para 10). Arrangements for the above have been discussed and.agreed upon at negotiations.  - 17 - Main Features of the Loan 5.09 Form of Bank Lending. The proposed loan, like previous Bank agri- cultural loans for DBP, would be made to the Government, which would relend the proceeds to DBP, The main features of the loan would otherwise be in line with standard Bank loans to development finance companies. 5.10 Currencies. The industrial portion of the loan (US$48 million) would be used by DBP to make sub-loans for financing direct imports for industrial projects. The US$2 million portion earmarked for the tree farming project would finance local costs, since this project does not need import financing. If the total amount to be withdrawn by DBP from the loan for the tree farming project is below US$2 million, the unused balance would revert to the loan for industrial financing. The estimated disbursement schedule under the loan is shown in Annex 9. 5.11 Foreign Exchange Risk. Industrial sub-borrowers would bear the foreign exchange risk on the foreign currencies of procurement; the Govern- ment has proposed that it bear the exchange risk on the foreign currencies of obligation. Under the tree farming project, since DBP's sub-loans to smallholders would finance local costs, the Government would bear the total foreign exchange risk. 5.12 Amortization Schedule. For the sake of administrative simplicity, and at the Government's and DBP's request, it is recommended that the loan have a fixed amortization schedule. The term would be 18 years including a grace period of 4-1/2 years. The maximum term of sub-loans would be 16 years including grace. - 5.13 Free Limit. A free limit of US$1 million for industrial sub- loans, with an aggregate of US$20 million, is recommended. It is expected, on the basis of the average size of DBP's sub-loans, that under this free limit, about one-half by number or three-fourths by amount of DBP's sub- loans will require the Bank's prior approval. 5.14 Ceiling on Industrial Sub-loans. To ensure that DBP will on-lend the proceeds of the proposed loan to a relatively large number of industrial projects, a ceiling of US$5 million (i.e. 10% of the loan amount) is recom- mended for DBP's sub-loans to be made under the loan. 5.15 Relending Rate. DBP will charge an interest rate of 12% per annum to sub-borrowers. This is the maximum legal rate applicable to secured loans in the Philippines (para 2.20). As with the previous Bank agricultural loans for DBP, the Government is expected to charge DBP the same rate as the Bank's lending rate (7-1/4%). If DBP is allowed to increase its lending rate, the Bank will be consulted on the resulting spread.  - 18 - VI. RECOMMENDATIONS AND AGREEMENTS REACHED 6.01 During negotiations the following matters were discussed and agreed with DBP: (a) for the industrial loan: (i) the staffing of Industrial Projects Department I (para 4.02); (ii) Statement of Operating Policies and Procedures for Industrial Financing (para 4.03); (iii) plans for accelerating the account-by-account examination of industrial accounts in arrears being undertaken by DBP and determining a suitable level of provisions for likely bad debts (para 4.10)i (iv) steps for evaluating DBP's existing audit system and identifying its weaknesses, and undertaking a program for remedying these weaknesses (para 4.11); (b) for the forestry loan: (i) the agreement between DBP and PICOP with respect to: technical assistance and seedlings to be provided by PICOP to the tree-farmers (para 5.08); the guarantee of a suitable minimum stumpage price PICOP to the tree farmers (para 5.08); an.d the continuation by PICOP of its insect prevention and control program (para 5.07); (ii) the appointment by DBP of a qualified forester to ensure efficient project implementation (para 5.08); (iii) a minimum contribution by the smallholder of 25Z of sub-project cost by way of his own labor (para 5.07); and (iv) the compilation of a list of prospective borrowers in the project area (para 5.08).  DEVELOPhENT BANK OF THE PHILIPPfNES Approvals of L.ans.Investments and Guarantees to September 30 1L973 Cumulative January 2, 1947 to FY 1971 FT 1972 57 19.7?3 July li-Septenber 30, 1973 September 197 3 No. Amount 7. No. Amount h No. Amount 7 No. Amount % No. Amount 7. LoanS (P million) industrial 99 9 18.0 246 61 38.6 277 55 25.0 39 23 34.8 18,074 2,622 55.2 Agricultural 5,032 24 48.0 8,840 55 34.8 12,858 109 49.5 4,367 24 36.4 191,629 1,146 24.1 Real estate 1,399 9 18.0 1,768 22 14.0 3,437 38 17.3 959 8 12.1 48,927 693 14.6 Government projects 4 2 4.0 5 8 5.1 8 5 2.3 1 9 13.7 675 172 3.6 Private development banks 31 6 12.0 56 12 7.5 79 13 5.9 14 2 3.0 636 119 2.5 Total 6,565 50 100.0 10,915 158 100.0 16,659 220 100.0 5,380 66 100.0 259,941 4,752 100.0 Equity Tnvestme ts FP million) Preferred shares Private companies - - - - - - - - 31 207 36.4 Government cofnpanies _5 100._ 3 182 32.0 Private development banks - - - - - - - - - - 31 29 5.1 Conua shares (private companies) 2 149 100.___ _ _ - 3 150 26.5 Total - - - 2. 149 100.0 - _ _ 1 5 100.U 68 568 100.0 DomesticCurrency Guarantees (P million) 5 14 100.0 5 11 100.0 4 16 100.0 1 1 100.0 48 104 100.0 Foreien rErbanee Guarantees (US$ million) Regular guarantees 1/ 30 29 38.7 56 98 63.2 78 145 67.8 13 32 76.0 502 1, 0o6 84-4 CCC aid CWB Credits 127 46 61.3 100 57 36.8 139 69 32.2 19 9 22.0 429 203 15.6 Total 157 75 100.0 156 155 100.0 217 214 100.0 32 41 100.0 931 1,299 100.0 = = = _=_ = = = _ _ Grand Total (P-million equivalent) 2/ 554 1,372 1,691 346 14,257 I/ Rates used were the ones current during the period emcept cum-lative data which were converted at rates prevailing as of September 30, 1973 2/ P6.4 - $1.0 for FY71; P6.8 = $1.0 for other years. Regional Projects Department Asia Regional Office February 7, 1974  Annex 2 DEVEOIPMRET BANK OF THE PHILIPPINES Board of Governors as of December 31, 1973 Name 1/ Functions and Background Leonidas S. Virata Chairman of Board of Governors. Former Secretary of Commerce. Director of Economic R?esearch of the newly established (1949) Central Bank; acting Deputy Governor and member of Monetary Board until 1952. Financial Vice-President and Vice- Chairman of the Philippine American Life Insurance Company. President, 1965-66, of the Philippine Chamber of Industries. Member, Philippine Tourism Authority. Member, Cement Industjr Authority. Member, Iron and Steel Authority. Jose R. Tergco Full-time Governor, supervising the Agricultural Projects Department and the Branches and Agencies Department. Represents DBP in DBP-financed private firms. Former Assistant Vice-President of the Philippine Bank of Commerce. Recio M. Garcia Full-time Governor, supervising the Acqinired Assets Management Department, Real Estate & Government Loans Department and, the Departement of Development and Rural Banks. Represents DBP in DBP-financed private firms. Former Chairman and President, Quezon City Development Bank. Vice-Chairman, Homeowners Finance Corpora- tion and Citizens Development Inc. Leon 0. Ty Part-time Governor. Member of the Philippine Bar. Alejandro Melchor Part-time Governor. Corcurrently Executive Secretary to the President of the Philippines. Alternate Director of the Asian Development Bark. Chairman, Power Development Council. Directorate Chairman, Fational Compuiter Center. Member of the Board, National Power Corporation. Member of the Board, Philippine National Oil Company. Presidential Action Officer for Foreign Loan- Funded Projects. Member of the Board, Career Executive Services. Member of the Board of MERALCO. '/ Two full-time Governor positiors and two part-time Governor positiors are vacart. Regioral Projects Department 'sia RPgional Office 'bnruary 7, 1974  ANNEX 3 Page 1 DEVELOPMET BANK OF THE PHILIPPINES Statement of Operating Policies and Procedures for Medium- and Large-Scale Industrial Financing Approved by the Board of Governors on , 1974 1. The policies, criteria and procedures set forth below will guide IBP's medium- and large-scale industrial operations--particularly those undertaken by Industrial Projects Department I and irrespective of the sources of funds used for financing these operations. 2. Objectives of Industrial Financing To assist the development of the country by providing financial and technical assistance for the establishment of new industries as well as for the balancing, modernization and expansion of existing industries. 3. Basis for Investment Decisions DBP will make investment decisions on the basis of sound investment criteria and standards, and after careful project evaluation. Financial assistance will be provided to those projects which are financially and economically viable and technically feasible, and for the implementation of which satisfactory organizational and managerial arrangements have been made. 4. Method of Financing IBP will provide finance according to the requirements of each project, in one or several of the following forms: (a) direct loans in local currency, for financing local expenditures on fixed assets and where appropriate for working capital; (b) direct loans in foreign currencies, for financing imports of equipment and/or new materials; (c) guarantees of domestic currency and/or foreign currency credits made on suitable terms; (d) loans fully or partly convertible into stock; (e) in exceptional and highly meritorious cases, direct eqluity investments and underwriting of share issues. 5. General Investment Policies (a) Financing will be provided to projects which are in line with the investment priorities of the Government; preference being given to projects registered with the Board of Investments (BOT)  ANNEX 3 Page 2 under the Investment Incentives Act or the Export Incentives Act, or with other pertinent Government regulatory agencies. (b) In accordance with normal banking practice, adequate security will be required to cover the loans and guarantees, but the main considerations will be the merits of proposed projects, their repayment prospects and the soundness of management of the enterprise. (c) DBP will not seek a controlling interest in any enterprise in which it has invested, or any other interest which would give it responsibility for management, except when in its judgement its investment is in jeopardy, in which case DBP reserves the option of taking such action as may be necessary to protect its interests. 6. Project Appraisal Guidelines (a) Each investment decision will be made on the basis of a thorough project evaluation, reflected in an appraisal report, which will be a self-contained and comprehensive document outlining facts, analyses and judgements on the essential aspects (including technical, marketing, management, financial and economic) of the project as well as recommendations on special contractual arrangements. In appropriate instances, the report will incorporate essential complementary elements of the BOI's appraisal work, in particular its economic evaluation and marketing analysis. These inclusions not- withstanding, DEBP's appraisal reports will in any event include DBP's own judgements on these matters as well. (b) Project appraisal will generally include the calculation of the internal financial and economic rates of return for projects of which the total project cost exceeds US$2 million equivalent. If the economic rate of return is below 10%, special justification will be required in the appraisal report which recommends a decision to finance the project. (c) Each appraisal report will provide in detail the estimated cost of the project, including working capital requirements and adequate contingencies. Prior to committing its own funds DBP will satisfy itself that funds expected from sources other than DBP (i.e. borrower's own contribution, plus borrowings fromother lending institutions) will be avaLlable in sufficient amounts when needed to cover the total financing requirements of the project. 7. Lending Terms (a) Each industrial loan will be made on a term and with a grace period consistent with the repayment capacity of the enter- prise based on projected cash-flows, and related to the useful life of the assets financed by the loan.  ANNEI 3 Page 3 (b) Each investment project f: nanced by DBP will normally have an equity capital equivalemt to 25% of total project cost. In the case of an expansion project of an existing enterprise, funds generated internally- are considered as equity for this purpose. (c) DBP will take steps adequ;.te to protect itself against the foreign exchange risk on :.ts lending operations and guarantees. 8. Project Supervision Guidelines It is the policy of DBP to: (a) undertake systematic follow-up on the progress and operation of the projects financed by it, in order to establish whether the actual developments correspond with the expectations and projections on the basis of which the investment decision was made, ajnd to keep DBP's management currently informed of the project status so that it may take timely and appropriate action. Accordingly DBP requires its borrowers to submit regular periodical reports on the physical and financial progress of the project, and on its operational and financial performance. Fwuthermore projects are visited at appropriate intervals to confirm the state of progress, to check on the efficiency, organization and management of the project, and to discuss problems of mutual concern with the borrower's management. (b) maintain close scrutiny of its accounts in arrears. Each individual account in arrears is analyzed in detail at least once annually in order to identify the causes for arrears and to determine the repayment capacity of the enterprise. On the basis of this analysis DBP's management takes appropriate measures (including legal action), for collection, rescheduling, or restructuring of the account. t,   ANNEX 4 Page 1 DEVELOPMENT BANK OF THE PHILIPPINES CHARACTERISTICS OF DBP's FINANCING ACTIVITIES Industrial Financing 1. Local currency_and import financing. Until 1965 straight loans represented the only form of industrial financing by DBP. All loans were made in domestic currency. Many of DBP's peso loans were used by borrowers to purchase foreign exchange from the Central Bank to finance imports. From 1965, after DBP began to guarantee foreign credits (paragraph 2), it stopped making peso loans for financing imports. Since then, peso fi- nancing by DBP (loans, equity investments, and domestic guarantees), for financing local expenditures of the industrial sector, amounted to P 1.8 billion through September 30, 1973, accounting for 18% of total industrial financing of P 10 billion during that period. 2. Guarantees. DBP's foreign currency guarantees fall under two cate- gories. Guarantees termed "regular" are those given by DBP to cover private foreign suppliers' credits, generally for importation of industrial capital goods. From 1965 through September 30, 1973, approvals of these foreign currency guarantees have totalled US$1.1 billion or 84% of DBP's total foreign guarantee operations. The second category consists of guarantees given by DBP, as administering agency, under the CCC and CWB bilateral credits for the importation of raw cotton, tobacco, and wheat flour (Annex 6, para 6). Through September 30, 1973, approvals of CCC and CWB guarantees amounted to US$203 million or 16% of foreign guarantee approvals. In addition to its foreign currency guarantees, DBP also guarantees peso credits extended by local banks to local enterprises, usually for working capital; outstanding amounts as of December 31, 1973 stood at P 48.5 million. 3. Size. The average size of DBP's industrial loans since 1947, made generally to finance local expenditures, is relatively small, P 155,000. On the other hand, that of foreign guarantees is quite large. Regular foreign guarantees average US$4.5 million per project 1/. The large average size of DBP's foreign guarantees is due to the fact that, as the principal source of industrial finance in the country and as a matter of Government policy, DBP was called upon to finance a number of projects deemed to be of national importance, some requiring DBP's financing for an amount as large as US$100 million equivalent. 4. Sectoral distribution. As can be seen from Appendices 1 and 2, DBP's assistance has gone to almost all industrial sectors including mining and 1/ As of September 30, 1973, 243 projects had been financed through regular foreign guarantees.  ANNEX 4 Page 2 utilities. Loan approvals have gone to food manufacturing and rice and corn industries (24%), public utilities including shipping (17%), textiles (14%), steel and other metal industries (8%), cement (7%), mining (5%), lumber, woodwork and furniture manufacturing (4%), and chemicals (3%). DBP's guar- antees are also well diversified by sectors. Taking all guarantees together (Annex 5, Appendix 4) food manufacturing accounts for 20% of approvals, with the balance going to textiles (18%), cement (12%), metal industries (11%), mining (10%), public utilities (10%), and paper (9%). The bulk of industrial projects, about 80% by amount, financed by DBP since 1972 is registered with BOI under either the Investment Incentives Act or the Export Incentives Act. 5. Geographic distribution. The geographic distribution of DBP's loans (Appendix 1) and guarantees (Appendix 3) reflects the distribution of Philippine industry: over 50% of approvals have gone to projects in the Manila and Luzon areas. In September 1971, DBP's Board of Governors approved a set of guidelines for a countryside development program (para- graph 3.03 of text) emphasizing lending for agriculture, cottage industries, and small- and medium-scale industries in the provinces. This emphasis is reflected in loan approvals since FY72 (Appendix 1) which show a proportionate increase in lending outside the Manila and Luzon areas. 6. Terms of financin&. Interest rates and other charges are given in Appendix 4. DBP generally charges an interest rate of 12% 1/ per annum on larger loans, and 9% per annum on small loans (i.e. below P 5,000). On its foreign currency guarantees, DBP charges a guarantee fee of 1.5% per annum on amounts outstanding, plus an initial one-time fee of 1% on the guaranteed amount which together give DBP an overall fee of approximately 1.6% per annum. Maturities of industrial loans range from one to five years for working capital loans, and five to 15 years for long-term loans. Repay- ment terms on foreign credits guaranteed by DBP were previously usually very short, generally about one year for suppliers' credits covering imported raw materials and less than five years for imported machinery and equipment. In 1970 the Central Bank established minimum repayment periods on all foreign credits, ranging from 5 to 12 years. Interest rates charged by the suppliers now range from preferential rates for tied bilateral credits to 2 points above the prime rate of the lending country. 7. Securities investments. As of June 30, 1973, outstanding securi- ties investments amounted to P 598.3 million (US$88 million); of these, P 90.2 million or 15% represented preferred share investments in 18 private industrial corporations; P 103.9 or 17%, common stock investments in 3 pri- vate industrial corporations; P 196 million or 33%, stocks of Government- owned or -controlled corporations; and P 208.2 million or 35%, represented fixed income debt instruments 1/. Appendix 5 gives data on DBP's equity 1/ DBP's investments in private development banks and rural banks are not included in these investments and are discussed in paragraph 11 and Annex 6, paragraph 5.  ANNEX 4 Page 3 investments in industrial enterprises. The bulk of DBP's industrial portfolio of common shares (P 103.9 million) is concentrated in a single enterprise, Marinduque Mining and Industrial Corporation, in which DBP has shares amounting to P 81.3 million at cost. Sales by DBP of some Marinduque shares during FY73 yielded a capital gain of 120%. The preferred shares portfolio is not as good, with about one-half of the companies making profits. However, realizable capital gains from the sale of DBP's common stock portfolio would more than offset possible losses on its preferred shares portfolio. The dividend yield on DBP's equity portfolio during FY73 was 6%. Non-industrial Financing 8. Agricultural Loans. DBP's agricultural lending has mainly been to small- and medium-size concerns. Up to September 30, 1973, agricultural loans totalling P 1,146 million had been approved for 191,629 projects, re- presenting an average of about P 5,980 per project. Loans for agriculture cover a broad spectrum: food crops, principally rice and corn; commercial crops, principally sugar and coconut; livestock, principally poultry and hogs; and fisheries. The distribution by amounts has been 39% food crops, 35% commercial crops, 18% livestock and 8%fisheries. Terms of loans range from one year for production credits, e.g. paddy and fertilizer, to 10 years for capital investments. Interest rates were 9% and 10% per annum on loans under P 100,000 and above this amount respectively, but were increased uni- formedly to 12% per annum in 1970. Collateral requirements are usually strict. 9. Real estate loans. As of September 30, 1973, DBP had approved 48,927 real estate loans totalling P 693 million, or an average size per loan of P 14,165. Some 50% of approvals had been for large residential buildings, 25% for commercial buildings including schools and hotels, 12% for low-cost residential buildings, 8% for hospital buildings, 3% for building repairs, and 2% for Government buildings and other investments. DBP has in recent years been stressing lending for low-cost housing projects. In the last five years hotel financing (38 loans amounting to P 40 million) has accounted for 28% of real estate lending. 10. Government Loans. This category consists of loans made for the financing of income-producing projects of municipal and provincial govern- ments, such as markets, slaughterhouses, waterworks, power plants, telephone systems and transportation projects. As of September 30, 1973 DBP had approved 675 such loans for a total amount of P 172 million. These loans are usually guaranteed by the local governments, and DBP has a claim on these government's share of the federal income. As a matter of administrative procedure, the prior approval of the Finance Secretary is required for the creation and financing of local government projects. 11. Private development banks. DBP's charter entrusted to it the specific functions of promoting and establishing private development banks in the provinces and cities. The objective was to bring financing facilities to small agricultural and industrial enterprises in remote localities. DBP's financial assistance to private development banks consists of equity  ANNEX 4 Page 4 investments in preferred shares (generally about one-half of share capital) and rediscounting facilities. As a substantial shareholder, DBP is repre- sented on the boards of private development banks and has a voice in select- ing their managers, but otherwise is not directly involved in their manage- ment. DBP also provides some technical assistance in the form of training facilities. So far, DBP has established 31 private development banks, made equity investments in these institutions amounting to P 29 million and provided them with rediscounting facilities totaling (on a cumulative basis) P 119 million. As of June 30, 1973 the total outstanding financial assistance by DBP to private development banks amounted to P 60.4 million of which P 24.4 million represented investments in preferred shares, P 31.9 million outstanding rediscounting and P 4.2 million savings and time deposits maintained by DBP in these banks. The private development banks' importance as a source of finance remains negligible. As of June 30, 1973, their total assets amounted to P 217 million, with a combined loan portfolio of P 163 mil- lion. Total lending by private development banks in FY73 amounted to P 57 million, representing an average annual lending amount of P 1.8 million ($0.27 million equivalent) for each institution. Their financing has gone to agriculture to the extent of 60%, and to industry for about 30%. Although DBP has been given a special role in fostering and financing private develop- ment banks, DBP's investment and influence in them is still small and the volume of business of these institutions remains insignificant. The slow expansion of private development banks is due partly to the present ceiling of P 25 million set by DBP's Charter on its total equity investments in their share capital. This ceiling is expected to be raised to P 50 million shortly. 12. Miscellaneous operations. As a key government financial institu- tion, DBP has also been directed by the Government from time to time to carry out special operations. Although some of the equity investments in Government-owned and controlled corporations are large, the special lending programs such as loans to typhoon victims and college students represent a very small proportion of DBP's overall financing activity. Regional Projects Department Asia Regional Office April 22, 1974  04 000 00000 00 0I0orCnsr 0004400000000004 '0 aZCC 040000-5 0 0 000 0 0CC COO OCCCCCCOOCC0 CCC CoC C OCCOOCCOC OCOoCOCo CC C00  Ca C 0000  0040 C C C 04CC CCC 00 00000" - 00 0 COoCCo .CHC000000CC C 0-000CC C C .0 C OCCOC-CO C C C C 000CC C C C C C 0 00000 0C0 C CC CC -.CC CCCC CCCC 4CCoOCo C C C'CCCCC4 0 MC CC C 0000 0 - CC CC C 0 - 0000 C0CCo,C,C,.0 00 00.  . CO 0 00 COCO CoCO . CCC CC 0  0.-oC CC 04000 000 ,C. C - CCC OC 0 COC.CCC C CCOCCC C . o-,oC00o 0.0000 0o0.0C0 00C0CCCC COOCOIC C CCC COCCO 00 0 -00