Philippines - Small and Medium Industries Development Project (Vol. 1 of 2) : The appraisal report

Report No. 667a-PH Philippines Appraisal of a Small and Medium Industries Development Project (In Two Volumes) RETURN TO Volume 1: The Appraisal Report REPORi S DESCK April 18, 1975 EAP Projects Department Not for Public Use F 6utl [Do uineilt of lhe International Banik for Reconstruction and Developmenri Thlis rei)r;xn wa.s pri'parod 10; otfic.ral LiC' onl bv hv 1 [ank Grouip. It rmay riot tLit p,>ibli ,sk*i c I. v (I u o t li I or c ted witout l ani k (ar; I Up it,L itnor ; Iha hinn k hL.pank d0 ii' not ii. re p(i '!:Iits. tio t iw u li r on r oT rnpi ot tencSz otte rporlt  CLER0NCY EQUITVALENTS US$1 - . 97 00 Pi1 - - 143 P1 million US$1h3,000 1l billion. Us$143 million FISCAL YEAR July 1 - June 30 ABBREVIATIONS ASM - Annual Survey of Manufacturers BDT - Bureau of Dormestic Trade, Department of Trade BOI - Board of Investmaents CB - Central Bank DLC/ILD - Department of Loans and Credits, Industrial Loan Division DRBSLA - Department of Rural Banks and Savings and Loan Associations CBCI - Central Bank Certificates of Indebtedness CCC - US Commodity Credit Corporation CWB - Canadian Wheat Board CSMI - Commission on Small and Yedium Industry DAP - Development Academy of the Philippines - Development Eank of the Philippines BAAD Branches and Agencies Department IPD - Industrial Projects Department DCP - Design Center of the Philippines D3I - Department of Industry FTI - Food Terminal Incorporated GSIS - Government Servir.e Insurance System IGLF - Industrial Guarantee and Loan Funcd STD - Special Tine Deposits CPA - Counterpart Project Agreement KfW - Kreditanstalt fur Wiederaufbau MASICAP - Medium and Small InCkustry Coordinated Action Program NACIDA - National Cottage Industries Development Authority NEA - National Electrification Authority NEDA - National Economic Developpment Authority NIDC - National Investment and Development Corporation NMYC - National Manpower aiid Youth Council NPC - National Power Corporation PDCP - Private Development Corporation of the Philippines PDB - Private Development Banks PFLGC - Philippine Foreign Loan Guarantee Corporation PITC - Philippine International Trading Corporation PNB' - Philippine National Bank RFC - Rehabilitation Finance Corporation RTAC - Regional Technical Assistance Center SEC - Securities and Exchange Commission SSS - Social Security System UPISSI - University of the Philippines Institute for Small-Scale Industry  PHILIPPINES APPRAISAL OF A SMALL AND MEDIUM INDUSTRY DEVELOPMENT PROJECT (Volume 1) TABLE OF CONTENTS Page No. SUMMARY AND RECOMMENDATIONS ............................. i-vi I. INTRODUCTION ..................................... 1 II. THE ECONOMY AND INDUSTRIAL SECTOR ................. 1 III. PHILIPPINE SMALL AND MEDIUM INDUSTRIES ............ . 2 IV. THE PROJECT ....................... 8 The Project Package ........................... 8 SMI Lending through the Development Bank of the Philippines .......................... 9 The Industrial Guarantee and Loan Fund ........ 13 NEA's Industrial Co-operatives Program ........ 17 Regional Technical Assistance Centers .... ..... 18 Project Costs ................................. 19 Distribution of Sub-Loans under the Project ... 20 Project Supervision ........................... 22 V. ECONOMIC IMPACT .................................... 23 Impact of Sub-Projects to be Financed .... ..... 23 VI. OBJECTIVES AND FEATURES OF THE PROPOSED LOANi ....... 25 Objectives of the Proposed Loan .... ........... 25 Main Features of the Loan ..... ................ 26 VII. AGREEMENTS REACHED AT NEGOTIATIONS .... ............. 29 This report was prepared by Messrs. Percy Mistry, Aswin Kongsiri, and David Steel and Miss Kathleen Di Tullio following their visit to the Philippines in October/November 1974. Miss Kathleen Jordan assisted with the preparation of the economic data in Volume II.  -2- ANNEXES (Volume I) 1 - Recent Developments in the Philippine Economy, and the Industrial and Financial Sectors 2 - Government of the Philippines' Program for the Promotion of Small and Medium Industry 3 - Development Bank of the Philippines 4 - DBP - Small and Medium Industry Lending Program 5 - The Industrial Guarantee and Loan Fund 6 - The National Electrification Administration 7 - NEA Industrial Cooperatives 8 - The Department of Industry Project for the Establishment of Regional Technical Assistance Centers 9 - Costs and Risks in SMI Lending 10 - Analysis of Project Costs Eligible for Bank Financing 11 - Disbursement Schedule 12 - Analysis of Economic Impact PHILIPPINE SMALL AND MEDIUM INDUSTRIES (Volume II) Part 1 - The Role of Small and Medium Industries in the Manufacturing Sector Part 2 - Technical Assistance Programs for Small and Medium Industries  PHILIPPINES APPRAISAL OF A SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT SUMMARY AND RECOMMENDATIONS i. In response to a request from the Government, a Bank loan of US$30.0 million is proposed to assist the development of small and medium industries (SMI) in the Philippines. The loan will finance a project package with an estimated total cost of US$50.3 million, which will address two priority needs of Philippine SMI: (i) increased access to institutional sources of credit; and (ii) technical assistance aimed at directly solving the operating problems which small entrepreneurs confront. The principal beneficiaries under the proposed loan would be enterprises in the modern manufacturing sector with total fixed assets (including land) not exceeding about US$145,000 equivalent, although a small proportion of the loan (about 10%) would assist medium enterprises with fixed assets not exceeding US$570,000. The average size of sub-loan is expected to be around US$40,000 equivalent, compared to an average of about US$600,000 under the Bank's previous loans for industrial development in the Philippines. ii. Philippine SMI account for 81% of the total number of establish- ments employing 20 or more workers. They account for 27% of the labor force employed by this group and contribute 21% to gross value-added. Geographically they are clustered around principal urban centers with nearly 60% of all SMI establishments being located in Mletropolitan Manila and Cebu City where they have easy access to sources of raw materials supply, infrastructure is well developed, and supporting services are available. Records of the principal term-lending institutions show that in the past two years there has been a noticeable increase in the establishment of SMI firms in smaller regional and provincial capitals; this trend is expected to be reinforced under the proposed project. Most SMI output is aimed at local domestic markets; a small (but increasing) proportion is exported. Between 1968-71 the growth of SMI establishments was constrained by a policy environment which generally favored the development of larger, vertically-integrated and capital intensive manufacturing enterprises. Since 1971, measures have been taken to ameliorate the distortions caused by those policies and in 1973 a policy commitment was made to actively encourage SMI growth. iii. The main constraints on increased SMI productivity and growth in the Philippines are: (i) deficiencies in the-quality, quantity and suitab- ility of capital goods employed; (ii) inefficiencies caused by insufficient access to investment and working capital; (iii) lower levels of labor skills employed; (iv) deficiencies in organization and management capability; and (v) an inability to formulate investment plans in a manner acceptable to financial institutions. The Government has already embarked upon a program to alleviate these constraints. Bank participation in this program is expected to assist government efforts through: increasing the supply of long-term and working capital; encouraging greater responsiveness to SMI needs on the part of existing lending institutions; increasing the network  - ii - of commercial lending institutions which would provide assistance to SMI; supporting an innovative, experimental, co-operative approach to SMI develop- ment in rural areas; and narrowing gaps in existing technical assistance efforts. iv. Of the proposed US$30.0 million loan to the Government; US$29.3 million will be relent as follows: (i) US$15 million to the Development Bank of the Philippines (DBP) for on-lending to about 360 small and medium enter- prises; (ii) US$12 million to the Industrial Guarantee and Loan Fund (IGLF) for on-lending to about 550 small enterprises through a variety of financial institutions; and (iii) US$2.3 million to the National Electrification Administration (NEA) for financing 24 industrial co-operatives in rural areas which have already been electri fled. The balance of US$0.7 million will be channelled through the Department of Industry's (DOI's) budget for the financing of seven Regional Technical Assistance Centers (RTACs) aimed at providing direct assistance to small entrepreneurs located outside the Metropolitan Manila area. The loan would have a commitment horizon of two years (FY 76-77) and is expected to be disbursed over four years. v. DBP, with its network of 32 branches and 24 agencies, is the single largest source for term-lending to SMI. In response to a Govern- ment directive it embarked on a special SMI financing program and created a new department, Industrial Projects Department II (IPD II) to execute it. Until recently SMI lending was constrained by organizational, staffing and procedural problems, particularly in the branches, which led to long loan processing times. These problems are gradually being overcome through various actions taken by DBP's management over the past few months. Further progress is being made toward the alleviation of these problems and the re- duction of loan processing time to a maximum of 60 days for SMI loans. DBP's appraisal of SMI loans is of acceptable quality, but in many instances it tends to be unnecessarily detailed. Follow-up, on the other hand is poor and arrears on SMI loans (41.5% of principal oustanding) are unduly high. DBP's program for improving follow-up and reducing arrears was discussed during negotiations and found to be satisfactory. The volume of DBP's SMI lending has been growing; it rose from P 2.8 million in FY72 to P 40 million in FY74 and approvals have already reached P 37.0 million in the first half of FY75. DBP is expected to commit a total of about P 79 million in FY75 and nearly P 209 million between FY76-77. The US$15 million (P 105 million equivalent) coursed through DBP under the proposed loan will therefore cover about 50% of its total SMI financing requirements over that period.  - iii - vi. The IGLF is a long-term compensatory financing and guarantee fund owned by the National Economic Development Authority (NEDA) and administered by the Central Bank's (CB's) Department of Loans and Credits. After a long hiatus in its activity, IGLF was revived in mid-1973 to encourage a variety of financial institutions ("sponsoring banks") to participate in the financ- ing of SMI by providing them with special time deposits (STD's) against their SMI loans at 5% (the on-lending rate was fixed at 10% thus allowing inter- mediaries a spread of 5%) and guaranteeing up to 80% of their loans for a guarantee fee of 2% of the amount guaranteed. In the 18-month period since its re-activation, IGLF has been remarkably successful in expanding its operations through an increasing number of intermediaries. STD approvals increased from P 1.6 million in FY73 to P 5.7 million in FY74 and reached P 17.9 million in the first four months of FY75. No guarantees were pro- vided independently of STD's but the demand for guarantees combined with STD's has grown rapidly. In future, a guarantee of 60% will automatically be combined with all STD's to allow IGLF to cater mainly to the under-colla- teralized small borrower. At present appraisals under the IGLF scheme are carried out by the CB. While acceptable in quality, appraisals suffer from a lack of knowledge about local conditions. Follow-up is carried out by sponsoring banks and its quality varies widely. With the number of approvals increasing rapidly, a system of appraisals and follow-up carried out centrally by the CB is likely to prove inefficient and costly. An accreditation scheme has therefore been devised to delegate project appraisal and follow-up to sponsoring banks which would be better placed to execute these functions. Under this scheme only institutions capable of undertaking sound project evaluation and follow-up would be eligible for IGLF funding, with the CB monitoring their performance. vii. The NEA, empowered to accelerate electrification of Philippine rural areas and to develop productive programs for generating economic levels of demand for power, recently embarked on a program of industrial co-operative (IC) development, based on its success in establishing elec- tricity co-operatives in rural "barrios". Adopting a trial-and-error approach, NEA has established 5 industrial co-operatives with mixed success. However, with the rectification of earlier oversights, the program provides promising signs of viability and employment creation at a very low cost (about P 4,700 per job created). The execution of the IC program is entrusted to NEA's Power Use Directorate (PUD) a well- managed department with capable but insufficient staff. The Bank's insti- tution-building effort with NEA will be aimed at: building up PUD staff; improving the quality of feasibility studies prior to the establishment of each co-operative; and setting up an evaluation and monitoring unit to evaluate the impact of the program. In its efforts to foster the devel- opment of the 5 IC's established so far NEA has subsidized them unduly through low cost loans (6%), and indefinite management assistance on a cost-free basis. To avoid breeding inefficient production units, the NEA agreed, during negotiations, to a substantial reduction in such subsidies by in- creasing the lending rate to 12%. Cost-free management assistance would be provided for a fixed 6-month period after which assistance, if required, would be provided on a paid consultancy basis. To avoid unnecessary delays  - iv - in the establishment of IC's, the Government agreed, during negotiations, to expedite IC registration with the Department of Local Governments and Community Development (DLGCD). viii. The seven RTAC's to be established by the DOI over a 2-year period would be staffed with 6-8 professional personnel, and would concentrate pri- marily on providing direct consultancy assistance to 514 in their respective regions. The RTAC's would also provide an essential link between DOI's existing field assistance teams and its central support staff in Manila. Present plans call for these centers to be set up in Cebu, Davao, Legaspi, Cagayan de Oro, San Fernando/La Union, Tuguegarao and Tacloban. The total cost for these seven centers is expected to be about P 10.8 million. The proposed US$0.7 million for this component would cover about 45% of this amount. It would finance capital expenditures and part of the pre-oper- ating and operating budgets for the first 2 years. The RTAC's would be fully funded through the DOI budget thereafter. ix. Over 900 sub-projects and 24 industrial co-operatives would be financed under the proposed loan. When these sub-projects and co-operatives are in full operation they are expected to result in additional investment in SMI of about P 300 million (in 1975 price equivalents) and in the generation of 12,300 additional jobs, with a substantial proportion of these being in rural areas. The project is expected to result in additional annual grost, value-added of about P 150 million and additional annual returns to lr.c'r of about P 48 million. These effects are expected to increase annual SMIl employment growth rates from 0.5% to 3.0%; growth rates of value-added from 4% to 7.0% in real terms; and wage-bill growth from 0.1% to 3.0% in real terms annually over the 4-year disbursement period. At full production, growth in value-added is expected to increase to 7.5% and the wage bill to 4.5% annually. Prior calculation of individual economic rates of return for this number of diverse sub-projects is clearly not possible. Tne aggre- gate internal financial return for the roughly 900 sub-projects, however, is expected to be over 38% assuming an average 10 year sub-project life. The internal financial return for the 24 NEA co-operatives is estimated at about 32%. An evaluation and monitoring system for measuring the economic impact of the project will be implemented by DBP, CB/NEDA, NEA and DOI. Apart from substantially increasing the flow of resources to SMI, providing them with greater access to institutional credit and contributing to a greater regional dispersal of investment, the project would also achieve important institution building objectives in strengthening the capability of DBP, CB and the spon- soring banks, NEA, and DOI to service the needs of the SMI sector. x. As mentioned in paragraph (iv) the proposed loan would be made to the Government; apart from US$0.7 for the RTAC's it would be relent to B3P (US$15.0 million); IGLF (US$12.0 million); and NEA (US$2.3 million). A fixed amortization schedule of 16 years including a 4 year period of grace is recommended. The Government would relend Bank funds on the same terms to DBP, IGLF and NEA at the prevailing Bank rate of 8.5%. The on-" lending rate paid by the ultimate sub-borrower would be 12%, the statutory  - v maximum. Thus DBP would receive a spread of 3.5%. Sponsoring banks under the IGLF scheme would receive a spread of 5%, since STD's would be made available to them at 7%; IGLF would collect a further 1.2% by way of a guarantee fee. The NEA would receive a spread of 3.25%. It would re-lend to electricity co-operatives at 11.75% with the funds being on-lent to indus- trial co-operatives at 12.0%. Sub-loans under the proposed loan would finance both fixed and permanent working capital requirements of small enterprises and would be made in local currency. The foreign exchange risk on the entire loan would be borne by the Government. As with other credit loans, procurement for sub-loans and for RTAC's under the proposed loan would be in accordance with the normal procurement practices and procedures of DBP, IGLF, NEA and DOI which have been found satisfactory. The Bank would disburse against 75% of the loan amounts (or STD's) disbursed by DBP, IGLF and NEA. Disbursements for the RTAC's would be made against evidence of actual expenditures incurred by DOI. The maximum size of sub-loan to be financed would be P 2.5 million (about US$360,000) for the DBP and P 800,000 (about US$115,000) for the IGLF and NEA. xi. During negotiations the following assurances were obtained from government and the agencies concerned: (i) DBP would implement necessary actions (e.g. rescheduling, improved follow-up, longer maturity periods etc.) to achieve a reduction in arrears on SMI loans (para 4.06); (ii) the on-lending rate on IGLF backed loans would be increased from 10% to 12%; the STD rate charged to sponsoring banks increased from 5% to 7%; and an additional guarantee fee of 2% would be levied on the 60% guarantee (paras 4.09 and 6.13); *(iii) the permanent capital of IGLF would be increased by way of a cost-free Government contribution of P 30 million (para 4.14); (iv) the good quality of IGLF's portfolio notwithstanding, arrears data would be collected and compiled by CB on all outstand- ing IGLF loans within 6 months of loan signature and arrears data would be submitted to the Bank on a quarterly basis thereafter (para 4.13); (v) where necessary audits would be carried out by CB of the SMI portfolios of those sponsoring banks not audited under standards satisfactory to CB (para 4.15); * Condition for loan effectiveness.  - vi - (vi) DBP and CB would submit to the Bank monthly reports on all SNa loan approvals and all appraisal reports for loans above P 500,000 (para 6.12); (vii) NEA would ensure that the Power Use Directorate was adequately staffed at all times and would establish a project monitoring and evaluation unit within one year of loan signature (paras 4.18 and 4.24); (viii) the Government would expedite the registration of IC's with DLGCD (para 4.19); and (ix) NEA would increase interest rates on its loans to IC's from 6% to 12% (para 4.22).  PHILIPPINES APPRAISAL OF A SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT I. INTRODUCTION 1.01 In 1973 the Philippine Government (GOP) requested the Bank's participation in its newly-launched program for promoting the development of small and medium scale industries (SMI). A pre-appraisal mission was mounted in January 1974 and a field appraisal in October/November 1974. This report recommends a loan of US$30.0 million which would address two priority needs of small and medium enterprises: increased access to insti- tutional sources of credit; and technical assistance aimed at directly solving the basic problems of production, marketing and accounting that most small Filipino entrepreneurs confront. 1.02 The Bank Group has long been associated with the development of the Philippine industrial sector. Five Bank loans totalling US$145 million have been made for industrial investment through both the Private Develop- ment Corporation of the Philippines (PDCP) and the Development Bank of the Philippines (DBP). In addition the International Finance Corporation (IFC) has provided a total of US$76.2 million by way of eleven loans and seven equity investments in privately owned Philippine enterprises. This assist- ance of over US$220 million to industry has been primarily directed to medium and large scale industrial undertakings in need of foreign exchange for the importation of capital goods in both import-substituting and, more recently, in export-oriented enterprises. Sub-loans financed by the Bank Group through PDCP and DBP have averaged around US$600,000 in size. These loans have generally gone to finance enterprises with total fixed assets of well over US$2 million. With the proposed project, Bank assistance, for the first time in the Philippines, would be directed towards a much smaller size of enterprise, with maximum fixed assets of about US$145,000 1/ and with sub- loans averaging around US$40,000. Such enterprises would generally be more widely dispersed throughout the Philippines serving essentially local markets and would generate a significantly higher number of jobs at a lower capital cost than their larger counterparts. II. THE ECONOMY AND INDUSTRIAL SECTOR 2.01 The latest Bank economic report was distributed to the Executive Directors on November 7, 1974. In addition to summarizing recent develop- ments in agriculture and manufacturing, the report analyses the major eco- nomic problems confronting the Philippines at the moment (viz. a high rate 1/ In a few instances, medium-sized enterprises with maximum fixed assets of US$570,000 would also be financed through the DBP. Financing for such projects is unlikely to exceed US$5.0 million.  - 2 - of inflation, the balance of payments impact of increased oil prices and an abrupt deterioration in the external terms of trade) and their implications for future economic policy. A Basic Economic Mission which will undertake an in-depth analysis of the Philippine economy and development strategy has just returned from the field. Annex 1 briefly outlines key characteristics of the Philippine economy and the industrial and financial sectors. III. PHILIPPINE SMALL AND MEDIUM INDUSTRIES 3.01 Definition: Small and medium industries (SMI) in the Philippines are defined by the Government as those with total fixed assets (including land) of between P 100,000 and P 4,000,000 1/. Using this definition, there were 1,654 firms in the 1971 Annual Survey of Manufactures (ASM) which fell in this category 2/. Together they accounted for 81% of the total number of establishments in the "modern sector" 3/ (i.e. with 20 or more workers). In, that year thev employed 27% of the manufacturing labor force and contributed 21% to gross value added (Table 1). Their characteristics and role are more fully discussed in Volume II of this report. 1/ The term "small" covers firms with total fixed assets between P 100,000 and P 1,000,000 while "medium" covers firms with total fixed assets between P 1,000,000 and P 4,000,000. An analysis of the ASM for 1971 shows that in employment terms small firms employed between 20-99 workers while medium firms, employed between 100-199. 2/ The total number of firms considered eligible for financing under the proposed loan would, however, be significantly higher. Allowing for: (i) the effects of inflation; (ii) the net entry of new SMI establish- ments during the past year, following the Government's policy emphasis on SMI; and (iii) the inclusion of small and medium firms in the construction sector and in the transport related services sector, the total number of eligible firms would be between 4,000 - 4,500. Analysis in this report is concentrated on small and medium firms in the manufacturing sector since these are expected to absorb most of the resources provided under this project. 3/ The "modern" sector is defined in this report as establishments with 20 or more workers while the "organized' sector is defined as those with 5 or more workers.  - 3 - Table 1: CONTRIBUTION TO THE MODERN MANUFACTURING SECTOR BY SIZE OF ESTABLISHMENTS, 1971 (Current Prices) (P million) Gross Average-_ Definition Scale Establishments Employment Value-Added Fixed Assets Workers No. % No. % Amount % Assets (P 000's) (No.) Small 100-1,000 20-99 1,363 66.7 56,489 16.0 693.2 9.7 0.47 Medium 1,000-4,000 199-199 291 14.2 40,222 11.4 790.3 11.1 1.93 Large 4,000+ 200+ 391 19.1 256_297__Z 72.6 5,640.6 79.2 14.59 Total 2,045 100.0 353,008 100.0 7,124.1 100.0 3.38 /1 Book Value 3.02 Factor Proportions and Use: As the table below shows, Philippine SMI are more labor intensive than large industries. Labor employed per unit of capital is highest in the smallest firms and declines with an increase in establishment size. Capital, on the other hand, is employed most productively by medium size firms, while small firms are only marginally better than large firms in this respect. Labor productivity, which is lower in SMI than in large firms, accounts for the gap between percentage of manufacturing employ- ment in SMI and contribution to gross value added. While labor productivity and average wage rates are lower in small industries, the wage content of gross value added is higher, suggesting that SMI contribute to better income distribution. Table 2: LABOR INTENSITY AND FACTOR PRODUCTIVITY IN MANUFACTURING, 1971 Size of Firm Capital Labor Labor Output Output Labor Capital Output Capital Labor Small 11.4 .088 .082 1.1 12.3 Medium 14.0 .072 .051 1.4 19.6 Large 22.3 .045 .045 1.0 22.0 Total 19.6 .051 .050 1.0 20.2 3.03 Regional Distribution: SMI show a marked tendency to cluster in urban areas close to principal sources of supply and major consumption mar- kets, and where infrastructure facilities and other services are well developed. The Metropolitan Manila area alone accounts for 52.5% of all SMI establish- ments, with a further 6.9% located in or around Cebu City. (Volume II,  -4- paragraph 1.05). Smaller firms in the Philippines find it costly to locate outside urban areas. Communications, infrastructure, and power facilities are inadequate; supporting services such as those provided by banks, suppliers, consultants, transporters, wholesalers, and other industries for intermediate and finishing processes and maintenance are difficult to find in areas other than Manila, Cebu and Davao. If the objective of decentralizing industrial activity through the SMI vehicle is to be achieved, concomitant developments in other sectors will need to keep pace. The programs combining financial and technical assistance to SMI in the regions under this project, coupled with development of other sectors, are expected to assist in the decentral- ization of Philippine industry. 3.04 Markets: The output of Philippine SMI is aimed principally at meeting domestic market requirements (Volume II, paragraph 1.08). Small firms usually sell directly to local markets and reach regional markets through middlemen who purchase at the factory gate for transport and resale. A small share of SMI output in industries such as furniture, specialized textiles, leather, wood products, and prepared foods, is exported. There has been a noticeable increase in export demand in these and other manu- factured goods (e.g., garments, handicrafts, and small electrical machinery and appliances) over the last 2 years. At present SMI firms confront several production problems, especially with product design and quality, and they are generally considered incapable of reliably supplying large batch orders for export. These (design, quality, and quantity) problems are compounded by a lack of know-how in dealing with export markets. Under this project, and through other independent efforts, SMI would be provided with assistance in improving product quality and efficiency and in marketing arrangements and export financing, which would enable them to increase their exports. 3.05 The Role of SMI in Manufacturing. The growth pattern and impact of SMI as compared to large scale manufacturing have changed substantially between 1962-1971 (Volume II, paragraphs 1.10-1.15). As Table 3 below shows, between 1962 and 1968 the growth of SMI far exceeded the growth of large firms. Between 1968 and 1971, however, there was a reversal in the growth pattern. Small industries showed an absolute decline and medium sized firms grew very slowly. The relatively higher growth rate of SMI in the mid 1960's was reflected in their increased share of manufacturing employ- ment (in the modern sector) from 29% in 1962 to 33% in 1968; of output from 25% to 30%; and of gross value added from 19% to 25%. Between 1968 and 1971, however, the share of SMI in manufacturing employment fell to 27%; gross output to 25%; and value added to 21% (Volume II, paragraph 1.11). Although at the aggregate level it would be reasonable to expect a relative diminution in the share of SMI concomitant with an acceleration in the growth of large-scale industries, these declines in the Philippine case have been large and appear to have been encouraged by the introduction of investment and export incentives which, by their very nature, have been more beneficial to large, capital-intensive industry (paragraph 3.06).  - 5 - Table 3: AVERAGE ANNUAL RATES OF GROWTH IN MAkNUFACTURING, 1962-68 AND 1968-71 (1965 constant prices) Scale Establishments Employment Gross Output Gross Value Added 62-68 68-71 62-68 68-71 62-68 68-71 62-68 68-71 Small -0.5 -8.0 2.2 -6.5 4.8 -2.0 4.2 -2.7 Medium 3.0 1.5 2.9 1.6 7.4 4.6 10.0 1.1 Large 1.0 3.3 -0.7 5.6 2.0 8.9 0.7 10.8 Total 0.8 -5.0 0.2 2.8 3.1 6.8 2.0 7.8 However, with recent efforts being directed towards support for SMI through the provision of greater access to institutional credit and technical assist- ance, small and medium sized firms are expected to reassert their role in industries in which economies of scale are not of critical importance. In the mid-1960's the share of SMI in employment and production increased notably in manufacture and sub-assembly for capital goods industries (transport equipment, electrical and non-electrical machinery, appliances and apparatus), and to some extent in intermediate goods (rubber products, chemicals and chemical products) and consumer goods (food and textiles). The growth of SMI in these major product groups can be explained, in part, by the relative scope for import substitution and the levels of protection. During the 1960's the ratio of imports to domestic availability was relatively high in these product groups, but at the same time the effective rate of protection realized was higher than the effective rate for all manufacturing 1/, thus making these industry groups more attractive for entry and growth of SMI (Volume II, paragraph 1.14). 3.06 Policy Framework. The industrialization policies and practices adopted in the Philippines through the 1960's militated against the growth of SMI firms. These conditions notwithstanding, SMI succeeded in penetrat- ing certain markets but their position in these markets was unstable. Industrialization policies which unwittingly discriminated against small scale, labor intensive manufacturing resulted in the concentration of production in large-scale, capital intensive firms that benefited from inducements (e.g. artificially suppressed interest rates, an unrealistically low exchange rate and easy access to credit) which effectively made the scarce factor, capital, artificially cheap and encouraged the indiscriminate import of capital goods. These policies resulted in the creation of excess capacity, accelerated capital labor substitution, and favored the vertical integration of manufactured goods production that could otherwise have been efficiently carried on in smaller independent units. In the early 1970's there was a basic shift in the policy environment with various measures being taken (e.g. the devaluation of the peso, import controls, tariff 1/ IBRD Report No. 78a-PH, entitled "Current Economic Position and Pros- pects of the Philippines" dated July 25, 1973, Volume II, pg. 17.  -6- reforms, and the introduction of labor-intensity criteria in the granting of incentives) to correct some of the distortions caused by previous policies. These measures represent major steps in the right direction. 3.07 Constraints on SMI productivity: The relatively less efficient use of capital and lower labor productivity in the smaller Filipino enter- prises are attributable, at least in part, to: (i) deficiencies in the quality and suitability of capital goods employed; (ii) inefficiencies (e.g. low equipment utilization) caused by a lack of access to external sources of both investment and working capital; (iii) lower levels of skills employed; and (iv) inefficiencies caused by lack of expertise in organization, manage- ment and choice of technology. The alleviation of these constraints in the shortest possible period of time requires a package of services to be provided to ensure that small firms have access to financial and technical assistance through an efficient delivery system. Long term capital is needed to replace outmoded and inappropriate machinery to permit the manufacture of products of good quality and design, and for expansion in the same or related lines of production where demand is increasing. A large proportion of SMI firms have underutilized capacity because of a shortage of permanent working capital to build up inventories of materials and finished goods beyond one production run. Confronted with restricted access to institutional sources of financing SMI have been forced to rely heavily on insufficient internal resources, or short term borrowing from non-institutional sources at rates averaging 5-10% per month (depending on the amount). This has severely restrained the ability of existing small firms to modernize or expand, and of new firms to get established. Tech- nical assistance aimed at better management, simple improvements in plant layout and advice on inventory control and accounting is needed by small entrepreneurs to better marshal and manage their resources. Technical assist- ance is also required to assist small entrepreneurs with the more general and immediate problems they face in firming up project ideas, preparing feasibility studies, and organizing their information in a form which meets the minimum requirements of financing institutions. 3.08 The Interest Rate Structure as a Constraint: As previous Bank economic and appraisal reports have noted, the structure of deposit and lending rates in the Philippines have been out of line with the estimated opportunity cost of capital. This distortion has inevitably resulted in an excess of demand for credit over the supply of loanable funds. The Anti-Usury Law of 1916 (now amended) previously limited lending rates to 12% and 14% per annum on secured and unsecured loans respectively without specifying any rigid limits for add-on charges 1/. With compensatory balance requirements and advance interest collection practices effective lending rates on commercial bank loans, however, nave been and continue to be 4 to 6 1/ These additional charges have now been limited to a maximum of 2% of the loan amount for secured and 3% for unsecured loans.  -7- points higher than these nominal rates. In the past, statutory interest rate limits on deposits and loans resulted in distorting both the mobilization and allocation of capital resources and led to the growth of an unorganized "private" market. With a rate of inflation varying between 10-15% in the 1970-73 period and jumping to 36% in 1974 depositors have received a negative rate of interest I/ with a consequent depression in the flow of private savings to the banking system. Although the rate of inflation is expected to subside to around 20-25% in 1975 it is unlikely that banking institutions will be able to mobilize a significantly greater volume of domestic savings even with the recent increases in deposit rates. 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%. Although the Monetary Board is now empowered to adjust interest rates to prevailing economic conditions, the structure which persists does not allow the interest rate mechanism to play any alloca- tive role. The resulting availability of credit has had the unintended effect of discriminating against small-scale labor-intensive enterprises. This is because financial institutions in providing loans have tended to rely heavily on collateral and co-makers' guarantees rather than on the potential earning capacity of viable projects. With an excess demand for funds and little opportunity for preferential yields on higher risk clients who also have to be served at an inevitably higher administrative cost, the institutions have tended to lend to the larger well known corporations that are established low-risk clients. As a result of this distribution of credit there has been an acknowledged underinvestment in small-scale regionally dispersed enterprises. 3.09 The Governmment's Program for SMI. The potential of Philippine SMI in employment creation and in assisting more equitable income distribu- tion has been recognized by Government and by external advisory agencies 2/. A draft program (Annex 2) for promoting the development of SMI was prepared 1/ Until 1974 the rate on savings deposits was 6% while time deposits ranged between 6.5% to 8%. In July 1974, the Monetary Board raised time deposit rate ceilings for commercial banks and established a range from 8% (for 90-day deposits) to 11% (for 2-year deposits). Thrift banks were permitted to offer 0.5% more than commercial banks on all deposit rates. Ceilings on deposit rates for deposits of over 2 years were removed altogether, but the Monetary Board's resolution did not specify a concomitant removal of the ceiling on inrerest rates for loans with maturities of over 2 years. 2/ The role of small and medium modern manufacturing units was recently stressed by the ILO employment mission in their report (the Ranis report) titled: Sharing in Development: a programme of employment, equity and growth for the Philippines (1974)  -8- in September 1973 and adopted in early 1974. The main elements of the program were substantial increases in SIMI lending through DBP and the Industrial Guarantee and Loan Fund (IGTF) and the provision of technical assistance through the Department of Industry (DOI). A Commission on Small and Medium Industries (CSMI) has been established with the major task of implementing and coordinating programs of such assistance to SMI, especially those located in the regions. The basic approach is to reach small and medium firms at their places of business. Field teams of generalists have been formed which are responsible for assisting entrepreneurs with project feasibility studies, loan applications and the many other time consuming steps which often pose the greatest bottlenecks in moving a project a,long. These teams are supported in their efforts by a central support unit in DOI. This unit is being equipped to provide more specialized assistance directly from its own staff resources and, where necessaryi to tap the re- sources of other appropriate agencies with the required expertise. Thus far the field program, which was started in late 1973 on a modest experi- mental basis to determine the real assistance needs of small entrepreneurs in the regions, has proven successful. Experience gained from this effort suggests that another link in the technical assistance chain is required. Accordingly the establishment of seven small Regional Technical Assistance Centers (RTACs) has been proposed for financing in the start-up phase under this project. These centers would provide greater depth and breadth in the technical services provided to entrepreneurs located outside Manila. The organization and role of the DOI and CSMI and the functions and performance of the field assistance teams are discussed in more detail in Volume II, Part 2 of this report. 3.10 Other Initiatives: Various other initiatives towards the develop- ment of SMI are being taken. One such effort is an innovative and promising program launched by the National Electrification Administration (NEA) to establish industrial co-operatives in rural areas to reach unemployed and underemployed rural families dispersed throughout the country. One of NEA's criteria in establishing such co-operatives is the availability of local skills and a traditional base on which to build the production effort. As a result, workers in rural areas who are engaged in cottage type manufac- turing usually on a part-time basis with low productivity and wages would be absorbed into full-time and more productive jobs in these new projects. The NEA experiment is expected to establish a practical approach of assistance to organizing fragmented cottage industry activity into viable small co- operative production units. This program, which is proposed as a component of this project, is fully described in Annex 7. IV. THE PROJECT The Project Package 4.01 The proposed project package calls for a Bank loan of US$30.0 mil- lion equivalent to the Philippine government. Apart from a small element (US$0.7 million) to be retained for the Department of Industry, the proceeds of the loan would be relent as follows:  -9- (i) US$15 million equivalent through DBP: for financing over 360 small and medium enterprises. (paragraphs 4.02 to 4.08 below and Annexes 3 and 4). (ii) US$12 million through IGLF: for on-lending to about 550 small entrepreneurs through a network of various qualified financial institutions (paragraphs 4.09 to 4.16 below, and Annex 5). (iii) US$2.3 million to NEA: to help finance the establishment of 24 small industry producer co-operatives under its power-use program (paragraphs 4.17 to 4.24 below, and Annex 6). The remaining US$0.7 million will be channelled through the DOI budget for financing 7 Regional Technical Assistance Centers (RTAC's) to be established under the DOI (paragraphs 4.25 to 4.27 below, and Annex 8). SMI Lending through the Development Bank of the Philippines (DBP) 4.02 Until 1973 DBP 1/ was virtually the sole institutional source of term credit for small entrepreneurs. At present, it remains the single largest provider of long-term resources to the SMI sub-sector 2/. DBP's ownership, overall organization, and management are discussed in Annex 3, 1/ DBP is the largest term-financing institution in the Philippines. It is a wholly Government owned multipurpose development bank which finances virtually every sector of economic activity. DBP's institutional characteristics have been fully described in a report to the Executive Directors entitled "Appraisal of a Loan to the Republic of the Philip- pines" (Report No. 424a-PH, dated May 5, 1974) and are summarized in Annex 3. As of December 31, 1974 DBPts total assets amounted to P 6.75 billion and it had additional contingent liabilities of over P 3.0 billion through its guarantee operations. SMI loan approvals totalled nearly P 40 million in FY74, and a further P 37.0 million in the first half of FY75. SMI operations accounted for about 7.6Z of total loans outstanding as of end FY74 and for 13.6% of loan approvals in that year. In the first half of FY75, SMI approvals accounted for 7.1% of total loan approvals. 2/ DBP does not have data available on loans by size of clients' assets. On the basis of a survey of its appraisal reports the mission arbitra- rily chose cut-off points at P 50,000 as the "floor" for SMI lending and P 2.5 million as the "ceiling". Loans below P 50,000 are classified as "cottage industry loans" and those above P 2.5 million as "large industry loans".  - 10 - paragraphs 2 and 3. Its lending to small industry is done principally through Industrial Projects Department II (IPD II) at its Head office in Manila and through its network of 32 branches and 24 agencies whose activities are co- ordinated by a Branches and Agencies Department (BAAD) at the Head Office. Until recently DBP confronted problems in staffing and organization in IPD II, BAAD and the branches (Annex 3, paragraph 4). These problems, although not serious, resulted in operational inefficiencies and constrained the growth of DBP's SMI lending. In September 1974 DBP stepped up its program for recruiting additional qualified staff and noticeable progress had been made by December in strengthening both IPD II and the branches. DBP's plans for effecting further organizational and staffing improvements were discussed during negotiations and were found to be satisfactory. Loans to medium scale firms are handled by IPD I, a well managed department which is currently en- trusted with handling the Bank loan of US$48 million for large industrial investment. 4.03 DBP's SMI project appraisals in general are of acceptable quality despite difficulties in obtaining accurate data on clients' operations and on local market conditions. In content, reports tend to be detailed and descriptive with a heavy emphasis on collateral evaluation, but often fail to reflect the quality of analysis or the judgements exercised on project merits. Several recommendations made by the appraisal mission for achiev- ing substantive improvements in appraisal and the presentation of appraisal reports have been discussed with and accepted by DBP's management (Annex 4, paragraph 19). A major weakness in DBP's present SMI lending operations is inadequate follow-up. Required information is submitted on a regular basis by only a few clients; when submitted it is of poor quality and is reviewed on a systematic basis by DBP staff only when the client is badly in arrears. Project site vists are rarely undertaken. Recognizing the importance of follow-up in reducing high default rates and of developing closer rela- tionships with SMI clients DBP's management has begun taking steps toward overhauling its supervision mechanism in accordance with the mission's recommendations (Annex 4, paragraph 21). Its present plans call for the installation of a sound follow-up system by December 1975. 4.04 DBP's loan processing procedures are complicated and centralized. In the past, it has taken an average of 8-9 months to approve SMI project applications (vs. 3-4 months for medium/large loans). Processing delays, which resulted in project cost increases of 40-70% in some instances, were mainly due to insufficient delegation of authority and the shortage of qualified industrial project appraisers in the branches (Annex 4, paragraph 14). Following a review of its procedures with the appraisal mission DBP's management has implemented a program to reduce loan processing time to a maximum of 60 days by June 30, 1976. DBP's lending policies for SMI were liberalized in 1973. DBP has since taken steps to ensure that existing policies (particularly on collateral) are fully implemented and to further modify policies on working capital, cost overrun financing, and loan/equity proportions.  - 11 - 4.05 The volume, distribution and nature of DBP's lending to SMI is shown in Annex 4, Appendices 1 to 8. SMI lending has picked up recently from P 2.8 million in FY72 to nearly P 40 million in FY74 with approvals being distributed across a broad range of industries (although two, food processing, and apparel and footwear, accounted for over 38% of approvals between FY72-74). Geographically, DBP's SMI loans are becoming increasingly diversified with the share of investment in Greater Manila dropping from nearly 84% in FY72 to 48% in FY74. The average size of DBP's SMI loans in FY74 was about P 320,000 (roughly US$45,700 equivalent) with loans in the Manila area being somewhat larger (P 372,000 average) than those outside (P 260,000). Total SMI loan approvals in FY74 grew by 125% over FY73; on the basis of performance in the first six months approvals are expected to double in FY75. 4.06 DBP's financial position and performance (Annex 3, paragraphs 10 and 11) improved significantly in FY74. DBP's capital structure is sound (long-term debt/equity ratio 1.06:1) 1/ and it is sufficiently liquid (current ratio 2.45:1). However, accumulated provisions for doubtful accounts still seem inadequate, although provisions set aside in FY74 exceeded those made in the previous year by 190%. Net income after taxes and provisions also rose significantly to a level of 4.9% of average out- standing assets (compared to 2.9% in FY73). In a year of rampant inflation DBP managed to hold administrative costs down to 1.2% of average assets, with such costs showing a decline of 6.2% over the previous year. Adminis- trative costs on its SMI lending operations were far higher, a conservative estimate 2/ (Annex 9) being 2.35% of average SMI loans outstanding. With the implementation of more intensive follow-up on SMI loans, these costs are expected to rise to over 3%. DBP's cash flow improved remarkably in FY74 with a much higher level of collections. Consequently debt service coverage rose from 0.88 in FY73 to 2.55 in FY74. DBP's arrears position as of June 30, 1974 is analysed in Annex 4, paragraphs 5 and 6. The table below summarizes the arrears situation and indicates the magnitude of arrears among various types of industrial loans: 1/ Inclusive of contingent liabilities the ratio is 2.59:1. 2/ As DBP does not have its income or expenses broken down on a profit center basis, earnings or costs related to specific activities are difficult to establish with any accuracy; this estimate was based on rough assumptions about the allocation of indirect costs which tended to underestimate the share attributable to SMI operations.  - 12 - DBP'S INDUSTRIAL LOAN ARREARAGES AS OF 6/30/74 /a (figures in parenthesis relate to Head Office loans) (Pesos in millions) Loans Principal Outstanding In Arrears Affected iio Amt io %/b Amt. /b Am t ./ "Cottage" 4,068 16.40 n.a. n.a. 8.07 49.2 n.a. n.a. (up to P 50,000) (2,017) (8.04) (1,901) (94.2) (5.09) (63.3) (7.14)(88.59) SMI (P 50,000- 1,090 362.46 n.a. n.a. 150.36 41.5 n.a. n.a. P 2.5 million) (893) (334.70) (683) (76.5)(141.52) (42.3)(254.79)(76.1) "Large" (P 2.5 119 1,003.43 71 59.7 144.66 14.4 534.65 53.3 million +) (119)(1003.43) (71) (59.7)(144.66) (14.4)(534.65)(53.3) Total 5,277 1,382.29 4,294 81.4 303.09 21.9 817.24 59.1 (32029)(1,346.17)(2,655) (87.7)(291.27) (21.6)(796.58)(59.2) /a Some breakdowns were not available for Branch arrearages; data relating to Read Office operations have therefore been provided in parenthesis for illustrative purposes. DBP has agreed to provide the Bank with a full breakdown of arrears by May 1975. /b As a percentage of outstanding industrial loans in each category. As these figures show, amounts in default on SMI loans are three times those for larger loans, while those for cottage industry loans are still higher. Although S,ka as a group pose a higher lending risk than larger established firms for any financial institution (Annex 9) these arreages reflect an abnormal situation exacerbated to some extent by DBP's own past practices. Most of DBP's SMI clients face genuine and constant cash flow difficulties caused by unrealistically tight amortization schedules. Furthermore with all their collateral pledged to DBP, these firms are in a poor position to raise much needed working capital to keep their plants fully utilized. DBP's own working capital loan policies are not liberal enough to accommodate the special problems small firms face. As a result of these factors, combined with an absence of good follow-up on DBP's part to provide early warning that clients may be getting into difficulties, arrears of this magnitude were almost inevitable. At negotiations DBP agreed to reduce arrears through: timely reporting; improved project follow-up and loan collec- tions; realistic rescheduling of existing loans; setting more appropriate maturity periods in the future; and liberalizing its working capital loan policies. Its plans were fully discussed during negotiations and found to be realistic and satisfactory.  - 13 4.07 DBP's loan commitments for SMI projects are expected to total about P 209 million in the FY76-FY77 period. The expected distribution of its lending is shown in Annex 4, Appendices 1-7 and is further analyzed in paragraphs 4.29 to 4.31. DBP will require mainly peso resources but they will finance projects in which the estimated direct and indirect foreign exchange component is about 64% of total project cost (Annex 10). These requirements, together with DBP's other long-term peso requirements, are expected to total between P 1.5 to 2.0 billion in the next 2-year period. It is unlikely that DBP can raise more than 25-30% of this amount from the private capital market on a long-term basis 1/. It has already taken steps to issue "country-side development bonds" totalling P 500 million (9% tax free, 5 year maturity) in FY75. It will have to rely for the remainder on traditional government sources 2/ and on external official assistance sources. Tie proposed Bank loan of US$15 million will meet 50% of DBP's total resource requirements for SMI lending over the next 2-year period (Annex 3, paragraph 13). 4.08 At the time of the Bank's last industrial loan to DBP (May 1974), it was agreed that an audit evaluation of DBP would be undertaken with assis- tance from the Bank and that a mutually agreed upon program for effecting any necessary improvements would be implemented by DBP shortly thereafter. An auditing expert appointed by the Bank accompanied an appraisal mission to DBP in May 1975 and undertook the agreed upon evaluation. Steps to be taken for implementing the required changes will be discussed with DBP as soon as his final report has been reviewed within the Bank. The Industrial Guarantee and Loan Fund (IGLF) 4.09 IGLF is a long-term compensatory financing and guarantee fund owned by NEDA and administered by CB. It was established with USAID assis- tance in 1952 to encourage private banking institutions to provide long- term financing to small entrepreneurs. Its compensatory financing function is discharged through a special time deposit (STD) provided to sponsoring banks (paragraph 4.16) at an interest rate of 5% (to be on-lent at 10%) with the same maturity as the loan made to the ultimate borrower and repayable according to the same amortization schedule. IGLF also provides, jointly with or separately from the STD, a guarantee for up to 80% of the amount being loaned. Sponsoring banks are allowed to lend guaranteed loans at 12%. The guarantee is provided at a cost of 2% of the amount guaranteed 1/ Its ability to do so is constrained by the absolute size of the private market, its competitive position vis-a-vis other financial institutions, and a regime of constrained interest rates which discouraged investment in long-term issues. 2/ In particular the Government Services Insurance Scheme (GSIS) and the Social Security System (SSS).  - 14 - which accrues to the IGLF. This cost was formerly borne by the sponsoring bank but is now passed on as an additional cost to the borrower. During negotiations assurances were obtained that the on-lending rate charged by sponsoring banks to the ultimate sub-borrowers would be increased from 10% to 12%. The borrower would also be required to pay a guarantee fee (2% of the guaranteed amount) for an automatic 60% guarantee. This would effec- tively result in an interest rate of 13.2% for the proposed combined STD/ Guarantee. 4.10 The administration and mechanics of IGLF lending are fully detailed in Annex 5, paragraphs 6 and 7. Loan processing procedures were rationalized earlier in 1974 and are now quite efficient. Project appraisals have, so far, been carried out by the Industrial Loans Division (ILD) in CB's Department of Loans and Credits. ILD is a well managed unit with a staff of 16 competent and qualified professionals. Staff strength has tripled over the past year to cope with the increase in applications (paragraph 4.12). however, as proposed in paragraph 4.16 below, ILD staff efforts will now be changed from evaluating applications to reviewing and monitoring the performance of sponsoring banks. Project appraisals carried out by ILD staff have gen- erally been adequate. As with DBP, appraisal reports have tended to be descriptive rather than analytic; along with the usual problem of unreliable or unavailable data they have suffered from a remoteness from local conditions which have led judgements to be somewhat rigid and standardized (Annex 5, paragraphs 9-12). Follow-up work is carried out by sponsoring banks but its quality varies widely and is generally restricted to clients in arrears. At present only commercial banks and larger well-established rural banks are geared towards adequately analyzing the operating problems of small entre- preneurs or providing them with needed advice. In discussions with the appraisal mission CB and NEDA officials felt that the alternative of a large central bureaucracy created to appraise and supervise IGLF financed projects was clearly less desirable than entrusting these functions to individual spon- soring banks which had the required capability. The banks have closer con- tact with clients, more direct knowledge of local conditions and greater opportunity for close follow-up. The implications of this transfer of the appraisal and follow-up burden from the CB to sponsoring banks is further discussed in paragraph 4.16. 4.11 IGLF financing is guided by NEDA's Four Year Development Plans and the investment priorities of the BOI, with emphasis ork projects which are labor intensive, export-oriented or located outside the major urban areas. Through its guarantee mechanism IGLF aims at channelling funds toward collateral deficient entrepreneurs with sound projects. Its pol- icies on interest rates, maximum loan sizes, maturity periods and loan/ equity proportions were reviewed and the changes suggested by the appraisal imission (Annex 5 paragraphs 34 and 35) have been made. 4.12 IGLF's operations are analyzed in detail in Annex 5, paragraphs 13-19. As of October 31, 1974 financial assistance totalling nearly P 193 million for 375 projects had been approved with STD approvals accounting for 92% of the total (P 177.3 million) and guarantees for the remainder.  - 15 - Roughly P 154 million was approved prior to the restructuring of IGLF in July 1973. Approvals averaged roughly P 10-12 million annually between 1952-1965 but fell off sharply to P 2-3 million annually between 1965-72. Total approvals in FY73 amounted to P 1.63 million for 4 projects. In contrast approvals in FY74 were P 5.65 million for 31 projects and nad climbed to P 17.88 million for 97 projects in the first four months of FY75. As Annex 5, Appendix 2 shows, the average size of STD prior to FY73 was about P 660,000. IGLF assistance was directed to a number of industries (5 industries 1/ however, accounted for nearly 60% of approved assistance) but was geographically concentrated in the Manila area. Since FY73 the average size of STD has dropped to P 183,000. STDs are now more concentrated in three or four industries but are geographically more widely dispersed; in the first 4 months of FY75 less than 49% of all investments were in the Ianila area compared to over 76% in the period before the re- structuring of IGLF. IGLF's straight guarantee operations have been insig- nificant. Only 13 straight guarantees totalling P 15.7 million were approved in IGLF's 22 year history. However guarantees provided together with STD's have increased substantially. Prior to 1973, combined STD/G's accounted for about 8.5% of STD approvals by number and 8.1% by amount over the entire period. In FY74 they accounted for 42% of STD approvals by number and 19.4% by amount and in the first 4 months of FY75 these proportions had risen to 51.5% by number and 59.9% by amount. Total guarantee cover provided since July 1, 1973 amounted to about P 9.4 million. In the future a guarantee of 60% will automatically be combined with all STD's to allow IGLF to cater mainly for the under-collateralized small borrower. 4.13 IGLF's portfolio has been of remarkably good quality because spon- soring banks are required to repay their STD's whether or not their own clients default. Very little historical information is available on the default rates of IGLF financed projects 2/ since most previously financed accounts are no longer outstanding while most newly approved projects have not yet entered the repayment phase. Sponsoring banks do not at present compile such data separately from their other accounts or provide them to CB. At negotiations it was agreed that CB would collect and compile arrears data on all outstanding IGLF financed projects within six months of loan signature and on a quarterly basis thereafter. 1/ Food processing, textiles, wood and wood products, metal products, and non-metallic minerals. 2/ The appraisal mission's discussions with a few sponsoring banks which previously used IGLF facilities suggest that default rates (i.e. prin- cipal and interest in arrears) on their IGLF backed loans ranged between 30-40% of total amounts outstanding at any given time.  - 16 - 4.14 IGLF's resource requirements for the 2-year period July 1, 1975- June 30, 1977 are estimated to be about P 110-120 million (Annex 5, para- graph 20). The expected distribution of its loans over the commitment period is shown in Annex 5, Appendix 3 and is analyzed further in para- graphs 4.29 to-4.31. As of January 1975, IGLF had virtually exhausted its resources and its requirements between January-June 1975 are being covered by a special GOP loan. The US$12 million (about P 84 million equivalent) provided under the proposed Bank loan would cover about 70% of IGLF's FY76- 77 requirements. The government has indicated its willingness to provide a further P 30 million as a cost free contribution to IGLF's permanent capital. This was confirmed during negotiations and is a condition of loan effectiveness. 4.15 IGLF's portfolio and finances are audited by the Auditor GeneraLl's Office in accordance with the strict internal auditing standards of the CB. Sponsoring banks are subject to varying types of audit. Private commercial banks and larger non-bank financial institutions are generally audited by qualified auditing firms that apply acceptable auditing standards. Rural banks and private development banks generally are not audited by private firms but are stubject to the CB's close scrutiny. At negotiations it was agreed that the SMI portfolios of sponsoring banks would be subject to an audit by CB over and above any other audits that are conducted unless CB was satisfied that "normal" audits adequately covered these portfolios. 4.16 A wide range of financial institutions are presently eligible to become sponsoring banks under IGLF (Annex 5, paragraphs 28-31), the princi- pal exceptions being non-bank financial intermediaries (e.g. DFC's, investment houses, savings and loan associations etc.). Despite open eligibility only a handful of commercial, rural and private development banks have used IGLF facilities so far mainly because of IGLF's previous image as a bureaucracy ridden entity. Present eligibility criteria stress the establishment of as wide a network of sponsoring banks as possible. While coverage and "reac:h" are clearly important considerations, the present criteria do not suffi- ciently stress the ability of such institutions to finance and administer SMI portfolios on a sustained basis. Accordingly, accreditation criteria have been drawn up (Annex 5, Appendix 6) which would ensure that only insti- tutions capable of appraising, supervising and financing a reasonable number of SNI projects on a sustained basis would be eligible for using IGLF facil- ities. Such institutions would include non-bank intermediaries. The accred- itation scheme has been designed to restrict eligibility to those institutions which presently have, or can readily develop SMI lending capabilities without heavily backed central administrative support. Under these criteria it is expected that most commercial banks (with their extensive branch networks) would qualify immediately along with several non-bank financial intermedi- aries and some of the larger rural banks. Many of the latter are already being provided with assistance from the CB's Department of Rural Banks and Savings and Loan Association (DRBSLA) to develop the requisite capabilitiLes. With accreditation being based on the capacity of sponsoring banks to ade- quately appraise and supervise projects, CB staff would be expected to con- centrate on: evaluating sponsoring banks' capabilities; auditing their SMI  17 - portfolios, and monitoring their performance; conducting ex-post reviews of appraisal reports on a sample basis; and reporting periodically to the Review Committee and to the Bank on the utilization and allocation of IGLF funds. NEA's Industrial Co-operatives (IC) Program 4.17 The IC program is one of two major experimental power-use programs (irrigation being the other) which NEA (Annex 6) has launched to generate minimum economic levels of demand for electricity and to create productive employment and raise income levels in rural areas. The 5 IC's established so far by the NEA show promising signs that such units can be financially and economically viable and can generate employment at a low capital cost. 4.18 NEA's administrative and organizational framework is discussed in detail in Annex 6, paragraphs 1 to 3. Responsibility for the IC pro- gram rests with the Power Use Directorate (PUD), a small but rapidly growing department which is well managed and staffed with qualified and well trained personnel. With a present staff complement of 32, PUD carries out feasibility studies prior to co-operative establishment, provides man- agement teams to run co-operatives in their early stages, and supervises co-operative loan accounts. NEA plans to build PUD's staff strengthi up to 75 within a year to cope with a greater number of co-operatives and to im- prove its planning and project evaluation and monitoring capabilities. PUD's feasibility studies deal principally with the potential for economic produc- tion of specific products in areas where electricity co-operatives have been established. In its future studies NEA has decided to take detailed account of specific problems in: organization and transition between the phasing out of NEA's management team and take-over by local IC officials; marketing finished products; specific production processes; and training both produc- tion workers and IC managers. 4.19 The process of IC establishment, organization and registration is fully dealt with in Annex 7, paragraphs 3 to 6. At present, NEA provides substantial inputs into the formation of IC's, assistance with the appoint- ment of management and with organizing (in concert with other GOP agencies) training programs for IC members and managers. NEA's experience in co-op- erative organization notwithstanding, ICs have to be registered with the Department of Local Government and Community Development (DLGCD). DLGCD's registration procedures and requirements have been a major bottleneck in the establishment of the existing co-operatives. At negotiations the gov- ernment agreed to expedite the registration of NEA's industrial co-operatives with DLGCD. In future an industrial co-operative would be registered within 30 days of NEA's Board approving its support for that co-operative. 4.20 Over the FY76-77 period NEA plans to establish a further 24 IC's dispersed throughout the Philippines (Annex 6, paragraph 16) mostly in poorer rural regions. The IC program is expected to create roughly 5,800 new jobs over this period at a total capital cost of P 27 million, an aver- age of P 4,700 per job. Of this amount about 20% would be contributed by  - 18 - the co-operative members and 80% would be financed by an NEA loan. The pro- posed Bank loan would be disbursed against 75% of NEA's disbursements and would thus finance roughly 60% of total project costs for each cooperative. 4.21 NEA's financial position is sound (Annex 6, paragraph 7). Its resource requirements for the industrial co-operatives program over the next 2 years will be about P 22.0 million (Annex 6, paragraph 11). Taking account of what NEA expects to receive from GOP, it will be faced with a resource gap of P 16.0 million which would be covered by the re-lent proceeds of the proposed Bank loan (US$2.3 million). 4.22 The 5 IC's which have been established by NEA so far have been heavily subsidized by way of interest rate subsidies (funds are provided at 6%) and by substantial inputs of technical/managerial assistance from the NEA for which the co-operatives are not charged any fees (Annex 6, para- graph 14). Continued provision of such assistance on preferential terms for indefinite periods would run the risk of breeding a large number of ineffi- cient production units not capable of standing on their own feet and with- standing the normal pressures of a business environment. At negotiations it was agreed that IC's would be required to pay a 12% interest rate (the statutory maximum) on NEA loans. Free technical assistance would be pro- vided by NEA for a 6-month start-up period during which IC management counterparts would be appointed and trained by NEA's management teams. After 6 months, consulting services would be provided by NEA on a cost- paid basis. Co-operatives have also been subsidized indirectly by delib- erately lax collection procedures. Following discussions with the appraisal mission NEA has begun to apply its normal rigorous collection practices and levy its standard penalty charges on amounts in default. 4.23 Procurement of equipment and machinery has, so far, been directly undertaken by IC management under the loose guidance of NEA's large procure- ment staff. On the basis of its previous experience NEA has decided to exercise much tighter control over procurement by co-operatives, including the checking of specifications for equipment suitability, and by requiring IC's to request at least 3 competitive quotations from local suppliers before authorizing purchase. Disbursement would continue to be made against evi- dence of actual purchase and installation which would be checked on site. 4.24 In view of the experimental nature of the IC program, a sound project monitoring and evaluation mechanism would be needed. Accordingly, at negotiations NEA agreed that it would establish a project monitoring and evaluation unit in PUD within one year of the date of loan signature. Regional Technical Assistance Centers (RTAC's) 4.25 Seven RTAC's (Annex 8) are to be established by DOI between July 1, 1975 and June 30, 1977. These centers, staffed with between 6-8 professional personnel, would concentrate primarily on providing direct consultancy assistance to small and medium enterprises in their regions  - 19 - (Annex 8, paragraphs 3 to 6). Assistance directly provided by RTAC's would initially be restricted to addressing production, financial/accounting, and marketing problems of a fairly general nature which are experienced by most small firms in all industry branches. Specialized problems with production processes or marketing/export would be referred by RTAC's to DOI's central support staff in Manila and consulting experts in specialized fields would be hired on an ad-hoc basis to assist particular clients who would have to pay for their services. RTAC's would also serve as a hierarchical link between DOI's MASICAP field teams (Volume II, Part 2) and its central staff in Manila. 4.26 The organization, staffing pattern and budgets of the RTACs are discussed in Annex 8, paragraphs 11 to 19. In the initial phases, the Institute for Small Scale Industries (ISSI) and the Development Academy of the Philippines (DAP) would be expected to provide training and support services on a contractual basis far training RTAC personnel before start up and for consulting assistance in the operating stage. 4.27 The total cost for the seven RTACs is expected to be about P 10.8 million, inclusive of pre-operating and first 2-year operating costs (Annex 8, paragraph 16). The proposed Bank loan would cover about 45% of total costs, the balance being funded by GOP. Bank financing would cover all capital expenditures excluding the cost of land, and would cover roughly half of the pre-operating and first 2-year operating budgets. RTAC's would be fully funded through the DOI budget thereafter. Project Costs 4.28 The project as described above has a commitment horizon of 2 years (the proposed loan is expected to be disbursed within 4 years) during which financing would be provided for over 900 sub-projects (360 through the DBP and 550 through the IGLF); 24 industrial co-operatives under NEA's program; and 7 RTAC's, at a total cost of P 352.4 million (approximately US$50.3 million equivalent). Project costs would be financed in accordance with the following table:  - 20 - (Pesos in Millions) Entrepreneurs GOP/Agency IBRD Total Amount % Amount % Amount % Amount % DBP Loan 35.0 20.0 35.0 20.0 105.0 60.0 175.0 100.0 IGLF 28.0 20.0 28.0 20.0 84.0 60.0 140.0 1100.0 NEA Loan 5.3 20.0 5.3 20.0 16.0 60.0 26.6 1100.0 RTAC's __ __ 5.9 54.8 4.9 45.2 10.8 100.0 Total /a Total 68.3 19.4 74.2 21.0 209.9-/59.6 352.4 100.0 /a US$30.0 million equivalent. The Bank loan would cover about 60% of the total cost of sub-projects or slightly less than their estimated foreign cost component (64%). Distribution of Sub-Loans under the Project 4.29 Projections of sub-loan demand and the distribution of sub-loans made by DBP (Annex 4, Appendices 1-7) and IGLF (Annex 5, Appendix 3) have been based on their firm pipeline of projects and augmented by specific knowledge of projects (being developed by DOI's field teams) which are now in the identification, feasibility analysis and preparation stages. On an industry basis sub-loans are expected to be distributed fairly widely across a range of projects in manufacturing (90% of total commitments) and in the construction and service sectors (10%). Eight industry branches (shown below) are each expected to account for more than 5% of total SMI invest- ment under the proposed project; together they account for over 70% of the total:  - 21 - Employment (1971) Value-Added (1971) % of Total % of % of % of % of Industry Branch Investment SMI /a Industry /b SMI /a Industry /b Food Processing 20.2 11.4 16.6 11.4 9.4 Footwear & Apparel 11.2 8.4 38.8 2.8 34.7 Wood & Cork Products 9.1 9.3 23.7 4.9 24.7 Non-Metallic Minerals 8.3 2.9 14.6 1.6 6.9 Chemicals and Chemical Prod. 5.5 10.6 42.2 23.3 35.7 Basic Metals 5.5 4.0 34.7 3.5 29.5 Metal Products 5.5 7.6 48.4 5.7 39.8 Furniture and Fixtures 5.1 2.9 66.6 0.1 59.7 /a Percent share of total employment or value-added in the SMI sector. /b Percent share of total employment or value-added in the Industry Branch. SMI investment demand in food processing reflects the growing tendency to localize such activity in the major food producing areas and is expected to assist the regional dispersal of investment. Investment in the footwear and apparel, wood and cork, and furniture and fixtures industries are all expected to result in export oriented output while investment in the re- maining four industries will expand the role of SMI in the production of intermediate goods for the domestic market. The two industries which are expected to attract less than 1% of total investment, beverages (0.6%) and tobacco (0.6%), are those in which economies of scale are critical. 4.30 Geographically the distribution of investment under the proposed loan will represent a marked shift away from Manila into other parts of Luzon and in the Visayas and Mindanao.  - 22 - % of SMI Concentration (No. of Est.) 1971/ Investment % of SMI % of Industry Greater Manila 37.8 52.5 50.0 Luzon (excl. Manila) 32.0 27.2 27.8 Visayas 15.6 12.9 13.5 Mindanao 14.6 7.4 8.6 /a Concentration in terms of numbers of establishments is a proxy measure for existing investment. However, this measure understates the levels of investment in Manila (where land values tend to be much higher and the average size of establishment much larger) and overstates it in other areas, particularly the Visayas and Mindanao. Apart from these broad regional shifts, the geographic distribution of in- vestment within these areas is expected to favor the underdeveloped regions. In Luzon, the bulk of the investment is expected to shift from Southern Tagalog to the Northern and Central Regions; in the Visayas from Cebu to the Western and Eastern islands; and in Mindanao from the Southern to the Northern and Western parts of the island. 4.31 No discrimination in favor of any particular geographic areas or towards specific industry branches is proposed under this project. The implementation capacity of the local intermediaries is considered to be satisfactory and is not expected to pose a constraint to nationwide cover- age. However, under the Government's proposed program which sets the guidelines for DBP and IGLF lending, preferential treatment (in terms of lower collateral requirements, higher loan/equity proportions, etc.) will be given to SMI investment outside the major urban centers of Manila, Cebu and Davao. No basis presently exists for discriminating in favor of devel- oping SMI in any particular industrial branch. The DOI is presently under- taking studies in various industrial sectors one of the aspects of which will be to determine the potential for SMI development within particular sectors and to establish whether special incentives will be required in the future for such development to take place. Project Supervision 4.32 The proposed project is expected to have a wide impact and yield substantial benefits (paragraphs 5.01-5.06) but there are'associated costs and risks which need to be recognized at the outset (Annex 9). Minimizing these risks will require substantial supervision and monitoring effort on the part of the financial intermediaries coupled with intensive efforts by the DOI in the provision of technical assistance. Moreover, close super- vision will be required by the Bank in the early stages of project implement- ation to ensure sound resource allocation and good follow-up by all inter- mediaries involved. This supervision effort will probably require an estimated 35 man-weeks of Bank staff time in the first year. The large number of sub-loans involved, the nature of lending to small enterprises,  - 23 - and the need for speedy approval and commitment of SMI loans will require the use of monitoring devices other than the free limit to ensure quality control in project appraisal. The Bank appraisal mission was satisfied that the appraisal standards of intermediaries under the proposed loan were adequate and that prior approval of small sub-loans would not be necessary. 1/ Instead of a free limit, DBP and IGLF would be required to submit monthly data on loan approvals together with appraisal reports for all sub-loans over P 500,000. 'NEA would be required to submit feasibil- ity studies for all its co-operative loans. A review of these reports cou- pled with frequent and intensive supervision missions would suffice to ensure that resources were being soundly allocated. V. ECONOMIC IMPACT Impact of Sub-Projects to be Financed 5.01 Over 900 sub-projects and 24 co-operatives would be financed under the proposed loan. Estimates of the direct impact of World Bank funds on total investment in SMI, employment, and annual output generated when these sub-projects and co-operatives are in full operations are as follows: Total Additional Capital Investment in SMI P 305 million (approx) Annual Additional Gross Output P 475 million ( " ) Annual Additional Gross Value Added P 150 million ( " ) Annual Additional Returns to Labor P 48 million ( " ) Additional Employment Generated 12,300 jobs ( " ) 1/ In DBP, Industrial Projects Department I, which will handle all loans above P 1 million is already entrusted with a free limit of US$1 mil- lion under a previous Bank loan. Sponsoring banks under IGLF will be restricted to maximum loan sizes of P 800,000 and will be accredited on the basis of their appraisal and follow-up capability. Their appraisals will be closely monitored by the CB (which has satisfac- tory standards) and by the Bank. On the basis of these considerations the supervision mechanism proposed above is felt to be the most effi- cient for this type of project.  - 24 - 5.02 The accelerated SMI financing program, which will make available a significantly greater amount of funds than previously, coupled with great- er efficiency in the use of these resources, is expected to increase pre- viously modest SMI annual employment growth rates from 0.5% to 3.0%; value added from 4% to 7.0% in real terms; and the wage bill from 0.1% to 3.0% Ln real terms annually over the 4 year disbursement period. Thereafter, when projects are in full production the rate of growth of value-added is expected to increase to 7.5% and the wage bill to 4.5% annually. As the funds will be directed primarily to less-developed regions, the increased growth in SMI will effect a more equitable regional distribution of jobs and income, in terms of returns to labor as well as to small investors. In addition, the availability of manufactured goods and services in closer proximity to local markets will benefit the consumer in the form of lower prices. ' 5.03 Prior calculation of individual economic rates of return for this number of different sub-projects is cl'arly not possible. Tne aggregate internal financial rate of return for these sub-projects is estimated at over 38% (Annex 12). The rate of return for the 24 NEA industrial co-opera- tives is estimated to be nearly 32%. These rates of return are based on in- cremental gross output resulting from additional capital investment under the proposed project as the principal benefit versus investment and produc- tion costs over a conservatively estimated average life of 10 years for all sub-projects. To monitor the economic impact of the project, the mission has recommended that an evaluation system be implemented, whereby a sample of sub-projects would be earmarked for follow-up in the field by the Busi- ness Research Department (BRD) in DBP and by the Bank's supervision missions. The 24 co-operatives would be similarly evaluated by NEA. In addition, data submitted periodically to the Bank as part of normal reporting requirements from DBP, IGLF and NEA would also enable evaluations of economic impact from time to time. The Information and Planning Unit in the DOI's Commission on Small and Medium Industries would also assist in collecting economic data and conducting periodic analyses. 5.04 A project monitoring and evaluation system has also been recom-- mended for the Regional Technical Assistance Centers. The direct and in-- direct impact of these centers (which would provide technical services in a variety of fields to both new and established firms) on increased employment, productivity, sales, and efficiency cannot yet be estimated. The proposed evaluation system is expected to facilitate planning for future expansion into services most in demand and to derive estimates of the direct impact of such services.  - 25 - VI. OBJECTIVES AND FEATURES OF THE PROPOSED LOAN Objectives of the Proposed Loan 6.01 With the proposed loan the Bank would play a useful and timely institution-building role and contribute to the achievement of GOP's small and medium industry development objectives. In terms of resource transfer, the proposed loan would enable GOP to: (i) substantially increase the flow of resources to SMI: over the next 2-year period direct investment in SMI under the proposed project alone would total over P 340 million; (ii) provide SMI with greater access to institutional credit: between FY76-77 lending to SMI through DBP would be almost double the total amount lent between FY72-75 while lending through IGLF would have quadrupled. In addition the number of financial institutions lending to SMI under IGLF and their "reach" would be increased substantially; (iii) contribute to a greater regional dispersal of investment: in FY74 about 48% of DBP's loans to SMI and 57.4% of IGLF's STD's were provided for projects in the Manila area. By FY77 these proportions are expected to fall to 37% and 40% respectively. This would mean a fivefold increase in the amount invested outside Manila between FY74 and FY77 compared to a tripling of investment in the Manila area. The NEA co-operative program would be a further step towards attempting a unique approach to the development of modern small industry in rural areas. (iv) contribute significantly to employment creation: The roughly 900 sMI sub-projects financed through DBP and IGLF are expected to result in the creation of 6,500 additional jobs, whilst NEA's industrial co-operatives will add a further 5,800. 6.02 Under the proposed loan GOP and the Bank would expect to see the following institution-building objectives achieved. (i) DBP: reductions in loan processing time and improvements in operational efficiency; improvements in the management of SMI lending operations; improved organizational arrange- ments at head office and in the branches; improved appraisal and follow-up; improvements in DBP's information and record- keeping system for SMI operations; qualitative and quantitative strengthening of staff in IPD-II, BAAD, and in the branches; improved implementation of existing policies and a gradual  - 26 - re-orientation of present lending policies for SMI loans especially those concerning collateralization and working capital financing. (ii) IGLF: a restructuring of IGLF's existing operating mechanism; encouraging the building up of more widespread SMI lending capabilities in a variety of financial institutions through a sound accreditation system; improved appraisal and follow-up practices coupled with improvements in local financial services available to smaller entrepreneurs located outside Greater Manila; further streamlining of CB's monitoring and review procedures; and improvements in record-keeping and SMI project monitoring through the compilation of better information on arrearages. (iii) with the industrial co-operatives: greater systematization in NEA's approach to the establishment of industrial co-operatives through improved planning and more sharply focussed feasibility studies; qualitative and quantitative improvements in PUD staff; a lessening of co-operatives' dependence on indefinite NEA assistance; elimination of interest-rate subsidies; improve- ments in co-operative management; improvements in procurement practices; and improvements in monitoring and evaluating the process of co-operative development. (iv) with RTAC's: creation of an institutional framework for providing technical assistance to smaller entrepreneurs outside Greater Manila; and improvements in DOI's technical assistance and support capabilities both in Manila and in the regions. 6.03 At a more general level, the Bank, through its involvement with several agencies in the SMI sub-sector, can also hope to contribute to better inter-agency co-ordination at policy making levels and render more effective the functioning of the Commission on Small and Medium Industries (CSMI) on which these agencies are represented. Main Features of the Loan 6.04 Form of Bank Lending: The proposed loan of US$30.0 million would be made to GOP which would relend the proceeds to DBP (US$15 million), IGLF (US$12 million), and NEA (US$2.3 million). The remaining US$0.7 million for financing the RTAC's would be retained by the Government and appropriated as an addition to the DOI budget. 6.0 Purposes of the Loan: Sub-loans financed through the proceeds of the proposed loan would be used to finance both fixed assets and permanent  - 27 - working capital 1/ for a wide range of SMI sub-projects in manufacturing, agro-industries, transportation services, engineering repair facilities of various types and small construction industries (paragraph 4.29). However, this loan would not be used to finance projects already covered by other IBRD loans through DBP (viz. grain processing, livestock, fisheries and medium/large industries) 2/ and the rural credit loans through CB. Loans to medium sized firms (i.e. sub-loans over P 1 million) would be made only by DBP and would absorb up to a maximum of US$5 million (P 35 million) or about 17% of the proposed loan amount. 6.06 Currencies: As virtually all goods to be financed under the pro- posed loan would be locally procured (paragraph 6.08), sub-loans advanced by the DBP, IGLF and NEA would be made in local currency. The portion ear- marked for the RTAC's would also finance local currency expenditures. 6.07 Foreign Exchange Risk: In this instance it would be difficult to pass on the foreign exchange risk to sub-borrowers who will be borrowing in local currency to make purchases locally. Although local purchases are ex- pected to have a lhigh import content (80-85% for equipment and machinery; 55-60% for buildings and civil works) most items when purchased would al- ready have been imported and the exchange risk incurred by the importer/ distributor. In accordance with normal Bank lending practices the financial intermediaries would not bear the exchange risk. As with the livestock, grain-processing and fisheries loans through DBP and the rural credit loans through CB the risk would be borne entirely by the Government. 6.08 Procurement: The Bank's normal requirements for international competitive bidding (ICB) would be clearly inappropriate for application to the sub-projects financed under this loan. The diversity of sub-projects across industry branches, their geographic dispersal and differences in the timing of investment also militate against the possibility of bulked pro- curement. DBP and IGLF (and sponsoring banks under IGLF) have adequate procedures to ensure that purchases from their sub-loans are made with due regard for economy and efficiency. For the industrial co-operatives the Bank would require NEA to apply its normal practices for close supervisory control over procurement by the co-operatives. The Government's procure- ment procedures, which are satisfactory to the Bank, would be applied for the procurement of office equipment and vehicles for the RTAC's. 1/ Defined as capital requirements for "the initial stock of raw mate- rials and supplies needed for the commencement of operations or the increase in such stock needed for the expansion of operations". 2/ The issue of overlap between the proposed loan and the previous DFC type loan of DBP for industrial investment is further discussed in Annex 4, paragraph 26.  - 28 - 6.09 Proportion of Bank Financing and Disbursement: The estimated foreign exchange component of sub-projects (including co-operatives) to be financed under this project is an average 64% of total cost (Annex 10). Under the proposed loan the Bank would finance 60% of total project cost, the financial institution 20%, and the entrepreneur (or co-operative mem- bers) 20%. For administrative simplicity disbursements would be made against 75% of the value of DBP's and NEA's loans and IGLF's STD's against supporting evidence of disbursements by DBP, IGLF and NEA on a quarterly basis. Disbursements for the RTAC's would be made on a direct expenditure basis upon submission of satisfactory evidence by DOI. The estimated dis- bursement schedule for the loan is shown in Annex 11. 6.11 Amortization. with over 900 sub-loans the administrative com- plexities involved in an amortization schedule based on an aggregate of the amortization schedules of individual sub-loans would be considerable. Consequently, a fixed amortization schedule stretching over a 16-year period with a 4-year period of grace has been recommended. Sub-loans under the project would have a maximum maturity of 12 years with a maximum grace period of 2 years. It is expected that the proceeds of the proposed loan would be committed in 2 years and disbursed within 4 years of the signing of the loan. 6.11 Sub-Loan Sizes: The maximum size of sub-loan to be financed under the proceeds of the proposed loan would be P 2.5 million (about US$360,000 equivalent) for the DBP (paragraph 6.05) and P 800,000 (about US$115,000 equivalent) for the IGLF and NEA. Average sizes of loans however are ex- pected to be about P 390,000 (or US$55,000 equivalent) for the DBP and P 210,000 (or US$30,000 equivalent) for the IGLF. 6.12 Free Limits: As indicated in paragraph 4.32 the free limit mechanism is not considered to be an appropriate mechanism for project monitoring or for influencing the quality of appraisals under the pro- posed loan. Instead, DBP and IGLF would be required to submit monthly summary statements of loans approved along with key information on such approvals, together with appraisal reports for all loans above P 500,000 which would be reviewed on a post approval basis. These reviews coupled with more frequent supervision missions in the early stages of project implementation should suffice to ensure that sub-loan approvals are based on sound financial, technical, market and economic considerations. 6.13 Relending and On-lending Rates: Sub-loans under the proposed loan would be on-lent to ultimate borrowers at 12%, the statutory maximum applicable to secured long-term loans in the Philippines. The re-lending rate between GOP and the intermediary financing institutions would be the prevailing Bank rate of 8.5%. The spread on Bank funds to the DBP and to sponsoring banks under IGLF would be 3.5%. The spread to NEA would be 3.25% since loans to industrial co-operatives would be made through the electricity co-operatives for a fee of 0.25 % (Annex 6, paragraph 15). In the event of an increase in the statutory ceiling on interest rates, DBP, IGLF and NEA would consult the Bank on the new on-lending rate to be charged to ultimate borrowers and on the disposition of the increased spread.  - 29 - 6.14 Spread to Sponsoring Banks undder IGLF: Although the spread to sponsoring banks on Bank funds would be 3.5%, such funds would be blended with a cost free GOP contribution to IGLF's permanent capital to make STD's available to sponsoring banks at an average 7% thus providing them with an overall spread of 5%. This size of spread is considered the minimum margin necessary to induce sponsoring banks to absorb bothi tiie much higher adminis- trative costs and default rates associated with SHI lending (Annex 9). VII. AGREEMENTS REACHED AT NEGOTIATIONS 7.01 During negotiations the following assurances were obtained from representatives of GOP (i.e. DOI and-NEDA), DBP, and NEA: The Government agreed to: (i) increase the on-lending rate to be paid by ultimate sub-borrowers for IGLF backed loans from 10% to 12% (paragraph 4.09); (ii) charge an additional guarantee fee of 2% of the amount guaranteed to be paid by the ultimate sub-borrower for the automatic 60% guarantee coverage (paragraph 4.09); the guarantee would accrue to IGLF with the sponsoring bank acting as its collection agent; (iii) increase the interest rate on STD's charged to sponsoring banks from 5% to 7% resulting in a 5% spread for sponsoring banks (paragraph 6.13); and (iv) expedite the registration of NEA's industrial co-operatives with DLGCD (paragraph 4.19). DBP agreed to: (i) reduce arrears on SMI loans; improve arrears reporting by branches (paragraph 4.06); and to submit complete data on SMI loan arrearages to the Bank on a quarterly basis; and (ii) submit to the Bank monthly reports (by IPD-II) on all loan approvals, and appraisal reports for all loans over P 500,000 (paragraph 6.12).  - 30 - With respect to IGLF, assurances were also obtained on: (i) the collection and compilation of arrears data by CB's Industrial Loans Division on all out- standing IGLF backed loans (paragraph 4.13) and submission to the Bank of such data within six months of loan signature following which arrears would be reported on a quarterly basis; (ii) audits of the SMI portfolios of sponsoring banks being carried out by CB in those instances where CB felt that coverage in a sponsoring bank's normal audit was not adequate (paragraph 4.15); and (iii) submission of monthly reports by CB's Industrial Loans Division on all loan approvals under IGLF and of all appraisal reports for loans over P 500,000 (paragraph 6.12). In addition iNEA agreed to: (i) increase interest rates on NEA loans to industrial co-operatives from 6% to 12% (paragraph 4.22); and (ii) set up and staff a project evaluation and monitoring unit in PUD within 12 months of loan signature (paragraph 4.24). Condition of Loan Effectiveness Prior to the loan being declared effective, the Govern- ment agreed to increase by P 30 million IGLF's permanent capital as of December 31, 1974 through a cost-free government contribution (paragraph 4.14).  ANNEX 1 Page 1 RECENT DEVELOPMENTS IN THE PHILIPPIIE ECONOMY, MD THE INDUSTRIAL AND FINANCIAL SECTORS A. The Philippine Economy 1/ 1. background. In contrast with the economy's sluggish performance prior to 1972, the last two years have seen a sharp increase in economic activity in the Philippines. In 1973 real GNP grew by 10%, double the 5.6% average for the preceding decade; despite turbulence in the international economy the growth momentum was maintained in 1974. Economic recovery in the Philippines resulted from the combined effect of increased export prices in 1973, a strong recovery in agricultural and industrial production for the domestic market and an expansion in public and private investment. However, in 1974, external terms of trade deteriorated abruptly, the rate of infla- tion rose appreciably, and unemployment and underemployment continued to pose serious problems. The Government's record in introducing a number of needed social and economic reforms has been impressive, particularly in land and agrarian reform, taxation, customs administration, tariff revision and the restructuring of banking and government organization. It will be some time, however, before the full impact of these measures is felt. Action remains to be taken in other policy areas, for instance in revising the dis- torted interest rate structure which has effectively blocked the development of an efficient market for the mobilization of long-term resources. 2. Current Performance. In 1974 real GNP grew by 5.9%. Favorable price trends caused a 47% increase in export receipts to US$2,504 million, despite a reduction in volume. Non-traditional exports increased by 45%. Imports, however, doubled to US$2,877 million with substantial price and volume increases being recorded in raw materials imports and machinery and equipment. The merchandise trade deficit of US$373 million (compared to a surplus of US$293 million in FYi3) was offset by substantial increases in invisible transactions and foreign capital inflows resulting in a balance of payments surplus of nearly US$70 million. International reserves as of December 31, 1974 stood at US$1,150 million, the increase of US$274 million in FY74 being largely derived from the Central Bank's (CB's) compensatory borrowings amounting to US$204 million. The growth performance of major economic sectors was mixed. Growth in manufacturing, mining, construction and commerce slowed down considerably while growth in the agricultural and services sectors (particularly tourism) increased. Agricultural crop pro- duction continued to grow at an annual rate of 10%. Tre freely floating I/ For a detailed discussion please refer to the latest economic report entitled "Current Economic Position and Prospects of the Philippines" (Report No. 568-PH dated November 7, 1974).  AeNEX 1 Page 2 peso dropped in value against the dollar from an average of P 6.72 to 12 7.07 in November 1974 (a depreciation of 4.5%) at which level it has since stayed. Investment continued at high levels in 1974, with a 20% increase in durable equipment purchases. Prices, however, continued their climb at a steep rate, the CPI rising at an average annual rate of 36% in 1974. Toward the end of the year inflation showed some signs of abating with the CPI in December reflecting a year-to-year increase of 27.3%. 3. Future Directions and Prospects for Growth. The Government remains committed to its strategy for a continued increase in incomes and employment. As enunciated in the 1974-77 Development Plan its objectives are to achieve a long-term annual growth rate of 7% coupled with an annual rate' of employ- ment creation of 4%. Priority is being given to: achieving self-sufficiency in food production; export production; and accelerating the development of local energy resources. The achievement of GNP growth at 7% annually through the rest of the decade depends largely on the domestic market. Tile bank's recent economic mission considers prospects bright for a 4-5% increase in agricultural output with a concomitant increase in real agricultural incomes. This together with continued expansion in public and private investment: should help sustain industrial output expansion, although perhaps at lower than 1973 rates. To ensure a stable climate for continued growth the Government has given top priority to reducing the present rate of inflation. With its pol- icy of absorbing excess liquidity and with the passage of the worst cost- push pressures from higher import prices, the rate of domestic inflation is expected to subside to 20-25% by early 1975. Monetary policy will probably continue to be directed at countering undue expansion in domestic liquidity and holding down price increases. B. The Industrial Sector 1/ 4. The Role of Industry. Over the long-term, heavy reliance is being placed on industrial expansion in achieving income and employment: growth targets. In view of the failure of the industrial sector over the past decade to provide employment opportunities commensurate with levels of investment, the Government's thrust is toward the promotion of employ- ment opportunities through the encouragement of labor intensive methods of production, increasing foreign exchange earnings througJh 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 high priority to in- vestments in export-oriented projects and to the further development of small- and medium-scale industrial enterprises. 1/ The Industrial Sector is discussed in detail in IBRD Report No. 280-PH "Industrial Development Problems and Prospects in the Philippines", dated March 19, 1974.  ANNEX 1 Page 3 5. Recent Growth. Industry (manufacturing, mining and construction) represents the third largest sector in the Philippine economy (after agri- culture and services), accounting for 28/o of net domestic product in 1974, absorbing over a third of total fixed investment and providing employment for 15% of the total labor force. Reflecting tne 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. Faced with higher production costs and declining domestic demand industrial growth was arrested in 1974. An increasing proportion of manufacturing output is export-oriented. Non-traditional manufactures accounted for over 11.8% of total exports in 1973 and 15.5% in the first six months of 1974 compared with less tnan 5.7% in 1969. The value of such exports increased from US$49 million in 1969 to US$200 million in 1973 and US$190 million in the first semester of 1974. 6. 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 between 3-19 employees accounted for 80% of the total number of registered enterprises but for less than 17% of industrial employment, 8% of the payroll, 4.3% of value added and 5.5% of total assets of manufacturing enterprises. Within the group of establishments with more than 20 workers small and medium scale industries (i.e. establishments with between 20-199 employees) accounted for 81% of the number of establishments, employed 27% of manu- facturing labor and contributed 21% to gross value-added. By sectors, food and beverages represent the largest industry group, with chemicals and petrochemicals secohd, and textiles ranking third. Geographically, over 60% of manufacturing enterprises are concentrated in the Greater Manila and Southern Luzon area, with increasing industrialization taking place in Mindanao. 7. 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 import 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 possibili- ties for easy import substitution. For a time, the protected market, the lack of any direction and regulation of investment, and cheap capital re- sulted 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 three years. With the exception of a few sectors, mainly linked to weakening export markets (e.g. the wood industry), industry has been operating at relatively high levels of capacity utilization throughout 1974. Increased investments will be needed to meet the expected growth in demand for a wide range of consumer and intermediate goods in the next few years. Moreover the rapidly increasing cost of  ANNEX 1 Page 4 many imported goods has broadened the range of possibilities for further import substitution. The current emphasis is on the more effective use of installed capacity and on promoting the development of small and medium scale modern enterprises to produce for both domestic and export markets. Hiowever, as the recent economic report has pointed out, growing export demand also seems to justify a wider range of investments in the! late 1970's in large-scale, capital intensive projects, particularly in the mineral-based processing industries. The development of such large scale strategic industries would not only strengthen industrial linkages but also reduce dependence on imported capital and intermediate goods over the long run as well as expand the industrial export base. The Government plans to locate these lafge industrial projects on estates to facilitate the development of satellite medium and small service industries. Tne total cost of such major projects in the pipeline (which include copper and aluminum smelters, iron ore sintering, ship building, an integrated steel mill, fertilizer plants and wood processing) is expected to exceed US$3 billion (in 1974 prices). 8. Employment in Industry. Pnilippine industrialization through the 1960's and early 1970's contributed disappointingly little toward alleviating the persistent problems of unemployment and underemployment Between '960-71 emr.ployment in manufacturing grew at an annual rate of .flout 2.5%; in 1972 it fell by 0.3% and again in 1973 by 3.3%. The share of manufacturing in total employment has actually dropped from 12.1% in 1960 to 10.7% in 1973. The distribution of manufacturing employ- ment in the Pnilippines is unusually dualistic in its concentration in the "unorganized" cottage sector and in very large firms. Employment growth in the former has been very slow (1.6% annually) while in the latter it nas been moderately rapid (5.4% annually). However large-scale firms are unlikely to make a significant contribution to the surplus labor problelm because of their capital intensity. The recent Ranis mission 1/ which has focused on employment concluded that ---- "if the manufacturing sector is to play its assigned role in the missionts employment strategy, much more of the employment growth must come from modern small and medium sized firms". 9. Policies. Since 1968, the industrial sector has been affected by several policy changes. The most important of these include: (i) a reform of investment and export incentives and the establishment of the Board of Investments (B OI); (ii) the exchange rate adjusthent; and (iii) tariff policy. In July 1974, a new Department of Industry (DOI) was created to develop and co-ordinate policies in the industrial sector and to monitor industrial performance. DOI's organization and functions are detailed in Volume II of this report. 1/ ILO Report entitled Sharing in Development: A programme of employment, equity and growth for the Philippines, 1974. (esp. pp. 141-148).  ANNEX 1 Page 5 10. 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"1 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. 11. The Board of Investments (BOI). Tne responsibility for deter- mining the eligibility of and registering projects for incentives and regulating 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 capac- ity required in industries; and approves individual investment projects in line with the annual IPP. The BOI also draws up a periodical list of "over- crowded industries" in which the Government discourages further investments by refusing incentives and foreign exchange for imports. The BOI plays a central role as an "evalution 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 in- centives guides investment and reshapes project design. It also assists private investors with arrangements for domestic and international market- ing 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 assis- tance of tine 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. 12. Exchange Rate. The floating of the peso in Februarv 1970 resulted in a large de facto devaluation of about 60% (from p 3.9 to P 6.7 to LUS$1). Since then the peso has been allowed to float freely. Toward the end of 1974 it depreciated further against the dollar, the present exchange rate being P 7.07 = US$1.00. Tne more realistic excaange rate has reduced dis- tortions in the price of inputs, discouraged currency speculation through over-invoicing, and made Philippine manufactured exports more competitive. The original devaluation also hit very hard those industrial firms heavily dependent on imported inputs and with sizeable foreign debts. The problems of debt-servicing thus created have slowly been ironed out. The initial 'ishock" of the devaluation has now7 worked itself through the system and the maintenance of a more realistic exchange rate will probably have a salutary effect on future resource allocation.  ANNEX 1 Page 6 13. 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 princi- pally as a revenue measure, the new tariff code has simplified and re- arranged the previous structure. A minimum tariff rate of 10% is imposed 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. Tne 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. 14. 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 Industry (DOI). 15. Industrial Investment. Manufacturing investment maintained the real growth rate of about 9% recorded in 1973 through 1974. The paid-in capital of newly registered manufacturing firms in the first half of 1974 increased by 77.3% over a similar period in 1973 to P 146.1 million. In- vestments in 1301 registered firms nearly tripled to P 876.5 million over the first half of 1973 with an increasing share being channeled to agro- based industries, mineral processing, and metal based industries. Direct foreign investments in the Philippines grew by about 170% to P 567.8 mil- lion between January-June 1974. There was a significant increase in Japanese foreign investment which accounted for nearly 40% of total foreign investment in the period. Domestic investment increased by 235% over the first half of 1973 to P 308.7 million. NEDA's tentative development plans call for total industrial investment over the 4-year period 1975-78 to be around P 25 billion (in 1974 prices) or over 27% 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 an average of 13% annually between FY75-78. The Govern- ment expects 79% of these requirements to be financed through domestic sources, 1/ 2% from direct foreign investment and 19% from guaranteed com- mercial foreign borrowings. This level of investment will require more 1/ Apart from cash generated internally by firms, and personal savings this figure also includes foreign resources mobilized by domestic financial intermediaries such as (DBP, CB and PDCP) from official multilateral and bilateral aid sources.  ANNEX 1 Page 7 than a doubling in resource mobilization from traditional domestic sources, the prospects for which, under the present interest rate regime, are not particularly bright. Tne main sources of industrial finance are discussed below. C. The Financial Sector 16. Overview. The Philippines has a relatively well developed finan- cial system with Manila becoming a regional financial center of increasing prominence. The core of the system is a large and sophisticated commercial banking sector regulated by the Central Bank of the Philippines (CB). There are in addition a variety of specialized financial institutions e.g. indus- trial term financing institutions, investment houses, and savings and loan associations. The Land Bank was recently revitalized to finance the Gov- emmnent's agrarian reform program. Over the last 5-6 years the Government has encouraged the rapid development of a network of small independently owned and operated rural banks and private development banks which would concentrate on providing needed financial services to their localities. There is also a well-developed (perhaps over developed) short-term money market on which a variety of good quality commercial and industrial issues circulate. The present statutory ceilings on long-term interest rates however have prohibited the development of a sound long-term capital market. Although two stock exchanges exist, activity on them is heavily concentrated on speculative issues. 17. Commercial Banks. There were, as of December 31, 1974, 30 pri- vately-owned Filipino commercial 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 oper- ate under a branch banking system (there are over 720 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 40 billion at the end of 1974). 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 1974 amounted to nearly P 27 billion, about one-third of which went to the manufacturing sector, mainly for short-term working capital. To strengthen and rationalize the commercial banking system, CB has instituted a program aimed at doubling the capital base of the commercial banking system to P 3 billion by end-1975. This would be achieved through: an increase in paid-in capital; merger and consolida- tion; and foreign equity participation. So far commercial banks seem to have opted for the first and last of these courses, with very few mergers. A large amount of foreign equity has been attracted to the banking sector. In the 15-month period ending April 1974, 18 foreign banks had arranged to contribute a total of US$75 million to the capital of local banks.  ANNEX 1 Page 8 18. Development Finance Institutions, Two institutions, DBP and the Private Development Corporation of the Philippines (PDCP) are the main providers of long-term finance with DBP (total assets of P 6.75 bil- lion) by far the larger of the two. PDCP's total assets as of the end of 1974 were P 747 million, with outstanding loans to industry amounting to P 580 million. Its foreign resources are derived mainly from the Bank Group (US$110 million so far) and the Asian Development Bank (US$45 mil- lion). 19. Other Term-Financing Institutions. Besides DBP and PDCP, several institutions provide term finance, a very small proportion of whichl goes to industry. These include: (i) the National Investment and Development Corporation (NIDC), a subsidiary of PUIB; (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 insti- tutions now total over p 8 billion, the bulk of their lending is for real estate (60%) and consumer loans (25%). 20. Rural Banks. There are now about 690 rural banks established all over the Philippines with, total assets of about P 1.6 billion and a deposit base of about P 0.8 billion. These institutions are generally small regional "unit banks" (average paid-in capital of about P 350,000) that lend mostly to local farmers (average loan size of P 1,000) who account for 87.2% of their total business and businessmen (average loan size P 1,200) who account for 12%. The growth of these institutions is being fostered by the Central Bank's Department of Rural Banks and Savings and Loan Association (DRBSLA). Under a 4-year development plan for rural banks, their number is expected to increase to 1,015 by 1977 and their loaning capability is expected to grow from P 1.2 billion to P 3.1 bil- lion. Rural banks receive counterpart equity contributions, loans and technical assistance from CB along with tax exemption privileges and special rediscounting schemes to supplement their credit extension abilities. 21. Private Development Banks (PDBs). These institutions, of which there are now 32, have been promoted by DBP in various regions (with much the same assistance as provided by CB to rural banks) to specialize in the mobilization and lending of long-term resources for small local ventures. As of June 30, 1974, total assets of PDB's amounted to about P 243 million and they had a deposit base of about P 130 million. Loan investments of PDB in 1974 totalled about P 65 million, 75% of which were in the form of medium and long-term loans. Agricultural loans (average size P 7,400) accounted for about 50% of total lending while industrial loans (average size P 12,700) accounted for a further 30%, the remainder being for trading/ commercial firms. 22. Savings Banks. There are 10 savings banks in the Philippines with a network of 56 branches. Drawing funds mainly from households and individual savers in the form of time, deposits these thrift institutions  AXUEX 1 Page 9 had aggregated total assets of P 1,047 million and deposits of P 853 mil- lion as of June 30, 1974. Of all financial institutions, savings banks have exhibited the fastest rate of asset growth over the last 4 years (an average 23% per annum) as a result of their aggressive marketing campaigns aimed especially at lower income groups. They lend mostly for housing and real estate, although in the past 2 years an increasing proportion of their resources have been channelled into Government securities. 23. Savings and Loan Associations (SLA's). SLA's, of which there are over 100, can be either "stock" (36) i.e. they can engage in deposit and banking business with the public at large or "non-stock" (66) when they are limited in their banking transactions to members only (credit unions). Two thirds of all SLA's are located in the Greater Manila area. As of June 1974, SLA's had total assets of about P 230 million and a deposit base of P 121 million. Most of the business of "stock" SLA's is in the fi- nancing of home mortgages while non-stock associations specialize in per- sonal consumption loans. With the assistance of CB, SLA's are beginning to diversify their lending operations into financing agricultural and small aome-based cottage industries. 24. Investment Houses. Defined in Presidential Decree No. 129 as any enterprise which engages in the underwriting of corporate securities an investment house is prohibited from engaging in deposit banking busi- ness. However, it can engage in "quasi-banking" operations through the generation of deposit substitutes. The minimum paid-in capital require- ment for an investment house is P 20 million and the majority must be owned by Filipino nationals. Although there are now 14 investment houses, 5 institutions dominate the industry. Most are linked with major interna- tional financial institutions and with large local commercial banks. Their operations and revenues so far have been heavily based (about 80% on aver- age) on money market activity rather than on development of the securities market or the provision of corporate merchant banking services. Total assets of the investment houses amounted to about P 2.0 billion at the end of 1974. 25. Finance Companies. There are 198 finance companies registered with the SEC, the 25 largest accounting for 70% of their business. These companies, mostly subsidiaries of major commercial banks, are heavily engaged in financing consumer durables on installment payment plans, short and medium term credits for local manufacturers or-traders for fi- nancing inventory, receivables or transport equipment. A few such com- panies have diversified into equipment leasing. Such firms typically rely on paid-in capital and direct borrowings for cash generation; a few have successfully placed medium term debentures with the public. L6. 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  AiNEX 1 Page 10 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. DBP's outstanding guarantee (contingent) liabilities presently stand at close to P 3 billion and account for over 70% of its financial assistance to large industries. 27. The Money Market. The Philippine money market provides the mechanism through which commercial banks and large corporations keep their liquidity positions in balance. There are basically three spe- cialized sub-markets: (i) interbank; (ii) government securities; and (iii) inter-company. The government securities market is the principal segment with the government being the largest trader in funds. The main security instruments traded in this market are short-term Treasury Bills, medium-term Central Bank Certificates of Indebtedness (CBCI's) and Treasury Notes, a5>-!i long-term Progress Bonds issued by DBP. Direct trading in Treas- ury Bills is generally quite heavy; trading in lbnger term securities howq- ever is mainly "indirect" i.e. the securities themselves are not traded, they serve as collateral for "repurchase" agreements between sellers and buyers. Participation in the intercompany market is restricted to finan- cial and non-financial public firms with prime credit ratings. A major deficiency in the money market is the absence of a secondary market for dealing in and discounting commercial paper. Interest rates on short- term transactions are not regulated and rates on the money market have fluctuated between 10-25% in the past year. 28. The Securities Market. There are two stock exchanges in the Philippines, one in Manila (established in 1930) and the other located in the Makati financial district (established in 1963). Trading is heavily oriented towards speculative mining and mineral issues although the more stable financial and industrial stocks are slowly gaining in prominence. After a remarkable recovery in 1973 (following a three year slump between 1969-72) when trading reached an all time high of over P 6 billion, the stock market slumped again reflecting the steady worsening of the world economy, and the problem of rapid inflation wlhichl nas de- pressed corporate performance and profits. 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 Commission. The reforms included such measures as a reduction in tie stock transfer tax; exemption from capital gains on the securities of pre- ferred productive enterprises; repatriation of foreign capital and profits; a tax amnesty which returned several hundred million pesos from the "Dlack market" to the capital market; and a compulsory dividend declaration rule for companies generating profits in excess of reasonable capital expansion requirements. With the stock market on the decline the Philippine Securi- ties and Exchange Commission (SEC) banned "short-selling" in July 1974 to stop the further erosion of confidence in the stock market. The SEC is considering the introduction of a new system of "matching" (i.e. matching demand and supply for a particular stock on a daily basis) instead of the  ANNEX 1 Page 11 present system of "posting"' so as to systematize local trading operations, streamline the trading process and minimize the potential for irregular trading practices. 29. Recent Developments in the Financial Sector. Three major devel- opments have-taken place in the financial sector over the last year. In July 1974 the CB raised interest rates on time deposits for up to 2 years by between 2-3% and removed the ceiling altogether for deposits of over 2 years. Moreover thrift institutions were allowed an 0.5% interest advan- tage over commercial banks. CB also placed a ceiling of 2% for commercial banks and 3% for thrift banks on financial charges other than interest rates, with the intention of substantially reducing effective rates charged by fi- nancial institutions (add-on charges formerly went as high as 67.). The second major development was the establishment of a Philippine Foreign Loan Guarantee Corporation (PFLGC) with an authorized and subscribed capital of P 1 billion. Its main role will be to alleviate the contingent liability burdens presently carried by DBP and NIDC and to ensure a steady availabil- ity of foreign supplier's credits on reasonable terms. PFLGC, in addition to directly guaranteeing foreign loans, will also be able to counter guaran- tee the guarantees of other private financial institutions. Lastly, in August 1974 a special bank - the Philippine Amanah Bank - was created to serve the interests of the Moslem community. EAP Projects Department February 24, 1975  ANNEX 2 Page iL PHILIPPINES Government of the Philipines' Program For the Promotion of Small and Medium Industry 1. Background. In August 1973, at the direction of the President, the BOI drew up a program of assistance for ESMI. The main objective of the program was to coordinate and integrate the activities of the various agencies involved with the development of SMI; it also set out the Government's definition of small and medium industry and proposed certain policy guidelines for providing assistance to SMI. Only a few of the original proposals have been implemented and some are already out-of-date. Nevertheless, the Government's program is important in that it sets out the Government's policy towards SMI, and has already influenced the way in which the various agencies have set up their own programs for assistance to SMI. The full text of the Government's program is attached as Appendix 1. The following is a synoptic presentation of the mission's assessment of the program in the light of developments since it was first drawn up. 2. Location and _Tpe of SMI to be Promoted. The Governmentts program places heavy emphasis on promoting rural and labor-intensive SMI. While this emphasis is justified in terms of better income and employment distribution, the mission feels that it should not be at the expense of ignoring the legitimate needs of established SMI in the urban areas. Most SMI are presently located in the Greater Manila and other urban areas, and many of them are in urgent need of assistance to improve their financial structure, production and management methods,and physical plant and machinery. The mission's view is that while the various agencies should be encouraged to develop special programs with liberalized policies to promote SMI growth in rural areas, as is already being done, direct financial and technical assistance should be provided to both rural and existing urban SMI. Ihe Government's original criterion for labor intensity (less than F12,00C worth of imported equipment per worker), was recognized as a loose criterion which would be difficult to apply. It has since been dropped. 3. Financial Assistance. The Government has,since the drafting of the proposed program,also accepted the view that rather than having small firms deal with a multiplicity of financial institutions meeting specific financing needs (i.e. long-term or short-term)it would be better to have all lending institutions providing both fixed and/or working capital loans to SMI enterprises. Commercial banks, with the help of ILF, would be encouraged to undertake term-lending to SMI. 4. Rural and Private Development Banks. With the present definition of small-scale industry the mission feels that there is little scope for rural and private development banks to participate effectively in financing 13MI. Very few of them are likely to have the resources and the technical skills required to undertake project appraisal and follow-up for these sizes of projects. Since "cottage industry" now includes units capitalized up to  ANNEX 2 Page 2 F100,000, the mission's view is that rural and private development banks should, with the assistance of NACIDA (National Cottage Industries Develop- ment Authority), concentrate on this credit segment in their industrial lending. Howiever some of the larger and better managed rural and private development banks may be able to obtain accreditation under the proposed GILF scheme (Annex 5) and thus become involved in SMI financing. 5. Technical Assistance. The program correctly identifies the technical assistance needs of SEE entrepreneurs. As envisaged by the program, the Department of Industry has established field teams (MASICAP) to assist pro- spective entrepreneurs in conceptualizing, organizing and preparing pro- jects for presentation both to DBP and to IGLF-sponsored institutions. A new development since the program was drafted, is the introduction of the Reglwonal Technical Assistance Centers which will be set up under the pro- posed loan (Annex 8). 6. Marketing Assistance. The program identifies the marketing and purchasing problems of SMI and their causes and makes several concrete proposals for action. However, it seems unlikely to the mission that the efforts of the GMTFM (Greater Manila Terminal Food Market, since renamed the Food Terminal Incorporated), and the actions proposed on the export front will have more than a marginal impact on alleviating the marketing problems of SMI. Following discussions with the appraisal mission, the DOI and the agencies concerned felt that the marketing problems of SMI were perhaps b-est approached on an industry-by-industry basis rather than uniform solutions being developed to address essentially different types of problems encountered in different industries. 7. Promotion Programs. The program deals adequately with the necessary elements of a promotional campaign at the apex. The more difficult but vital task of building up a 'grassroots' promotional organization in the provinces has not been dealt with, despite the Government's recognition of its importance Support of the provincial governments has been sought in establishing inter- agency coordinating committees on which would be represented the financial and technical assistance agencies together with local administration officials. These committees would use area studies already conducted by DBP and UPISSI to identify and develop sound project possibilities and 'marry' them to available local entrepreneurial talent, perhaps with the help of MASICAP teams. This approach represents a useful starting point for strengthening support at the local level and needs to be actively pursued if the objectives of SMI dispersion are to be achieved. EAP Projects Department February 241, 1975  ANNEX 2 Appendix 1, Page 1 FROMOTION AND DEVELOPMNT OF SMALL- AND- IVEDIUM-SCALE INDUSTTlIES (SMSI) IN RURAL AREAS The President directed the formulation and recommendation of a comprehensive program to encourage, assist and accelerate the establishment of small- and medium-scale industries in the rural areas. This responds to that directive. - Most of the elements of this program derive from the suggestions and proposals received from various agencies of government, including: Central Bank Bureau of Internal Revenue NEDA Bureau of Customs SSS Department of Labor GSIS NMYC PNB Department of Trade NACIDA UP-ISSI BOI DBP A. Coverage: What is a small or medium scale enterprise? It is proposed that the following definitions be observed for the purpose of determining the coverage of the program, noting however that applicability of some assistance schemes will be limited to certain categories of enterprises within the program's coverage. According to the NACIDA Law (R.A. 5326) a cottage industry is one with capitalization or not more than P15,000 the work is basically performed in the home of the owner, and he himself, perhaps with his family, is engaged in the production activity. Under R.A. 5326, certain incentives are provided to the cottage industry, including exemption from business taxes and from the Minimum Wage Law. It is proposed that all enterprises complying with the definition of a cottage industry in RA 5326, and with total assets up to P100,000 be considered cottage industries. It is further proposed that once assets reach P50,000 it shall be given a period of three years within which phase-out of exemptiun from business taxes and the Minimum Wage Law shall take place, provided that when their assets reach P100,000 at any time they cease to become cottage industries and lose all rights to the exemptions provided under the NACIDA Law. It is further recommended that BIR, Customs, Department of Labor and NACIDA be directed to jointly draw up the implementing guidelines and amending legislation to effect the foregoing. Cottage industries are the responsibility and are under the supervision of NACIDA, so that they wlil not be further touched upon in this proposal, which will consider as small- and. medium-scale industry enterprises whose total assets exceed P100,000.  AN1IEX 2 AppendTx 1, Page 2 It is proposed to consider in terms of total assebs: Small-scale industries -- l00,000 to ?1,000,000 Medium-scale industries -- Pl,000,O0O to -P4,000,000 The million peso mark may be considered a convenient dividing kine An enterprise with total assets less than a million pesos is pro- posed to be considered as small-scale industry. On the other hand, con- sidering the rule of thumb that equity investment (i.e., owner's share of capital) should be a minimwu of 25% of total assets, a medium-scale industry is one where total assets exceed Pl million but is less than F4 million and owners equity in the venture is hence expected to be not more than one million pesos. Further distinction in degree of assistance to be extended will be made between "rural" and"urban" medium- and small-scale industries. It is proposed that "urban" include those located: a. Within the Greater Manila area. Definition of this area needs to be made, for this purpose. b. Within the city boundaries of Cebu City and Mandaue City. c. Within specified districts of Davao City. d. Other localities that may be added from time to time. 'Rural" industries would be those not located in "urban" areas, as above defined. It is also proposed that only SMSI's which are labor-intensive, be considered to fall within the assistance program. Although exceptions may later be made for different categories of needed projects, is proposed that SMSI's which will require more than P12,000 worth of equipment of imported origin to employ one worker be considered to fall outside the financial assistance program. B. Financial Assistance The funds to be made available for establishment and expansion of SMSI's (small- and medium-scale industries) may be considered of two types: a. Fixed capital b. Working capital It is proposed that bouh the fixed capital and working capital loan requirements for establishment of new SMSI' s be borne by LBP and other develop- ment banking institutions since these funds should normally be supplied as term loans ranging from 5 to 10 years. Investment houses, such as PDC?, Bancon and others should be invited to participate in the capital raising effort, especially for the medium-scale industries. Further working capital loan needs should be borne by the banking system--commercial, savings and rural baxks,  ANNEX 2 Appendix 1, Page 3 with the assistance of Central Bank, as will be later illustrated. This suggestion is not meant to exclude banking institutions other than iBP from providing long-term loan funds. It is anticipated, however, that banlcing institutions, whether commercial banks, rural banks or savings and loan associations -would rarely be willing to grant loans with terms as long as 5 years. B.1 Term Loans The funding for term loans to SMSI's should not be a problem over the next year. In its SMSI loan program in FY72-73 (with a P500,000 loan ceiling) DBP approved P55.2 million in industrial loan to 277 borrowers, an average loan per borrower of P200,000. Even if there should be a four- fold increase in such loans for FY73-74, because of the program, this increase would be easily handled by DB?, especially if supported by funds deposited by SSS and GSIS, and not taking into consideration possible reiending lines from World Bank and Japanese loans later during the fiscal year. It is proposed that the SSS small industries loan fund be merged with DBP's. This is a 10 million fund, established in 1970 of which P1.7 million has already been lent. The ceiling for any single loan from this fund is P100,000. Repayment experience is reported by SSS as "somewhat satisfactory"l. In its report, DBP cites the liberalizations already made in its collateral and equity requirements. Further liberalization of these requirements is proposed for the rural small-scale industries (P100,000 to 31,000,000 total assets), and to become uniform with the SSS small-industries loan fund requirements as follows: a. Loan value of up to 90% (instead of 80%) or real estate appraised value. b. Loan value of up to 80% (instead of 60%) on machineries and equipment. c. Loan value of up to 80% on plant buildings. The rural small-scale industry on this plan would be likely to obtain a portion, though possibly not all, of its working capital requirements as a long-term loan. It is proposed that the term loans to urban small-scale industry and to medium-scale industry continue with the same requirements as now imposed by DBP on its small-scale industry loans (F500,000 ceiling). Future liberalizations may be considered as IBP's experience with the rural small- scale industries new financing plan may indicate to be appropriate. B.2 Working Capital Loans Tne supplementary loans for working capital of new SMSI's, and for the expansion of operations of existing small-scale and rural medium- scale industries should be obtained through the commercial and rural banking  ANNEX 2 Appendix 1, Page h system as suggested by the Central Bank. These loans would be guaranteed by the Industrial Guarantee and Loan Fund, to the extent of 85%. Hence, the coliateral requirement for these working capital loans would be significantly reduced. Central Bank indicates the need to establish a seed fund of up to P50 millioni which would initially be deposited as special time deposits -with participating banks for these SMSI loans. Further fundiing would be provided by CB's rediscounting the SMISI promissory notes. The financing assistance scheme of Central Bank should not preclude supporting term loans by the banking institutions for both equipment and working capital. B.3 Supervised Industrial Credit The more liberal collateral regulations, Central Bank redis- counting and the promotional efforts to be mounted to encourage establish- ment of SMSI's, wJll attract the "hi-fi" and "quick buck" operators. The possibility also exists that some banking institutions-will attempt to represent as loans to SMSI's what are actually loans to its stockholders, or loans for real estate, or speculative ventures, in order to be entitled to liberalized rediscounting privileges and/or the Industrial Guarantee and Loan Fund. For this reason, the banking institutions participating in the Central Bank SMSI financing program should be required to employ Supervised Industrial Credit technitcians, much in the same manner that Supervised Agricultural Credit techniicians are used for the rice production program. DBP will also need to supervise its atSI credits more closely and train employees for this function. This poses another training need. It is suggested that because of the specialized training needed, such be done at the Development Academy. B.4 The RaiLsing of Equity by SMSI's The foregoing measures will operate to reduce the collateral and equity needed to be raised by SMSI1s. It would seem unsound, however, to dispense entirely with collateral and equity requirements. It is axiomatic that the owners of a business must have some stake in it. Other- wise their interest and their determination to make the business succeed will be considerably lessened. I The question is often raised that marn' entrepreneurs may have project ideas and managerial capabilit,ies but no capital. The avenue is always open to them of interestirg someone in the community to go into partnership with them or to form a corporation, contributing to the equity of the enterprise at least the land on which the factory will stand. It is possible to devise corporate structures by which the entrepreneur becomes an industrial partner, gets a share of the corporate profits, and uses this to gradually build up his ow-nership of the corporation until the  ANNEX 2 Appendix 1, Page 5 pre-agreed proportion is reached. Brochures can be issued to suggest alternative schemes for this purpose. B.5 Organizational Changes: have been suggested to be necessary in the financial institutions which will participate in the SMSI financial assistance program. a. DBP believes it necessary to establish a separate department for small-and medium-scale industries, which will be oriented to the requirements of these smaller industries and towards promoting SMSI projects. b. It may be advisable for Central Bank to require banks participating in its SMSI financing program to require the banks to have special units or sections with competent, trained personnel to handle the program for the bank, including Supervised Industrial Credit technicians. C. Technical Assistance Professional assistance is required by the SNSI at each of the three stages of development of the SMSI project: a. At conceptualization--for investigating the project feasibility and drawing up the project stuyr. b. At organization--to advise on appropriate capital structure, sources of funiding, management organization, staffing, worker recruitment and training, seiecting channels of distribution purchasing of materials, pricing of products, establishing books of account and accournting systems, and other aspects of starting the business. c. Upon operation--for improving the production and marketing operations, financial management, worker training management development, product design, etc. C.1 At Project Conceptualization Both DBP and SSS have observed that the small-scale entrepreneur especially from the rural areas finds great difficulty in organizing his information. Often he will be relatively familiar, or even experienced, in one aspect of the business, which will most often be either in pro- duction or marketing. He will rarely have sufficient expertise in finance, Since, however, he will have ultimately to cast the project in financial terms, in a logical project package, he will need assistance to do so, and to examine the other aspectE of the project which his background does not permit to do with adequate competence.  ANNEX 2 Appendix 1, Page 6 The entrepreneur's first need, therefore, is for assistance in documenting the project concept, and organizirng its elements: a. to presenttheimarket for the product, the prices at which it can be sold, and the customers who will buy it. b. to present the facilities (equipment, buildings and land) required to produce the product, the costs of raw materials, supplies, utilities such as power and water labor costs and worker requirements, depreciation, maintenance, administrative overhead and other elements of cost. c. to present the capital requirements to acquire and biLld production facilities, working capital to get the project started, the estimated income from operations, payments of interest and loan amortizations--what are often referred to as income and cash f-low projections. The above process can be made easier if a brochure describing a similar project is available to the entrepreneur and those assisting him. Although he can not just copy the figures in the brochure for his own study of the project, the brochure will provide a model, or matrix into which the entrepreneur's own estimates can be factored. In many cases, he will still need professional assistance, but the assistance work can thus be considerably lessened, because the brochure will have pre-done some of the work. C.2 At Project Organization Once the project study has beern completed, and the project is proven to be technically and economically feasible, it is still necessary to assist the entrepreneur in obtaining necessary loans, suggest means of raising equity, and in generally orgarnizing his proJect to the point where he can satisfy his potential lenders and investors that they should invest their money in the project and that there is a concrete and practical plan of operation. Once the funds necessary for the project are committed, the entrepreneur then has to start purchasing equipment, constructing plant, recruiting supervisors and workers, preparing for plant operation, buing raw materials, and arranging for the marketing of those products. It is often necessary at this stage for him to be able to avail of expert counsel to discuss with him the various alternatives that he may have to solve the various problems which now confront him. C.3 Upon Project Operation Once the project is operating the entreprenuer-manager faces different problems, and he would benefit from having a professional. group from whom he could seek advice and assistance as he needs to solve newi problems he has not faced before.  AM EX 2 Appendix 1, Page 7 C.4 Organization for Technical Assistance Technical assistance for project conceptualization and proiect organization will have to be provided by a group separate from the bank which will lend money to the project, or else check and balance would not exist. Besides, if the bank provides these types of pre-operational technical assistance, it is likely to become so identified and involved with the project that it could not take measures that a bank must be able to use if the project becomes a financial failure. It is proposed, therefore, that an organization be created, separate from but coordinating with DBP branches, to provide technical assistance to prospective entrepreneurs for project conceptualization and organization. Units of this organization would be located in the sane localities as DBP branches. These units would report to a head office staffed with various specialists, to whom the local units could ref er problems which may be too technical for the local unit to handle successfully. Assistance to the project during its operation could be handled jointly by the DBP branch and the technical assistance organization. The DBP branch would be responsible for loan supervision, and avail of the expertise of the technical assistance organization to help the entrepreneur solve operating and management problems and improve operations. The training would be focused on: 1. The entrepreneur--for the development of entrepreneurial skills and attitudes. 2. The managers and supervisors--for management and supervisory skills imprcvements. 3. The workers--for the development of technical skills and work proficiency. Liaison must be established not only at the level of the head office, but more importantly at the level of the branch office, among DBP, ISSI, and NMYC for the selection of trainees, the formulation of the training curriculum, and the measurement of training effectiveniess. Conscious effort should be made to draw in the commercial bank branches in the area which have loans to SMSIPs, to identify enterprises which would benefit from the consultancy and training programs. In addition, the Supervised Industrial Credit technicians employed by the banking institutions participating in the CB's program for SMSI financing should themselves be able to avail of the services of the technical assistance organization for improvement of their own client SYSI's. It is proposed that the technical assistance organization referred to in this section be part of the Department of Industry.  ANNEX 2 Appendix 1, Page 8 D. Marketing and Purchasing Among the major handicaps for the small- and medium.-scale industry in the rural areas, is the increased difficulty and cost in purchasing needed materials and supplies and in marketing its products. This handicap arises because it is far from centers of commerce and shipping, and also because it is small. l.hile large-scaie comparnies maintain offices in the Greater Manila area to facilitate purchasing, the SM3SI can not afford this. Furthermore, since the SMSI's monthly materials requirements are relatively small, and its working capital limited, the volumes of materials purchased by the S3NSI and delivered to it at any one time may not be sufficient to warrant direct purchases from the manufacturers of the purchased items. In many cases, the S33SI firnds itself buying from sub-wholesalers and incurring the extra cost of the profit margins on its purchase as a result of having gone through the extra layers of distribution. This higher cost of its materials already places the SMSI at a disadvantage vis-a-vis the large firm. Marketing is also a difficult problem for the rural SSIL. The marketing difficulties vary with the final destination of the product. D.1 The Rural SMSI Selling to the Market of its Region: has to contend with a distributidn structure established and operating to sell goods from the metropolitan centers. This structure is geared to receiving (importing) goods from outside the egion. Generally, the distributors of the region receive credit from the Manila (or Cebu) wholesalers, and have long-established relationships with them. Assistance is, therefore, needed by the rural SMSI for marketing of this product, more particularly as the jobber or manufacturer's whole-saler, which will buy the product fror. the rural SSi43 and distribute it to the sub-wholesalers and retailers of the region. It is proposed that the GMITFN consider extending its operations of buying agricultural produce to certain other urban centers besides Greater Manila, and as a corollary operation, also perform distribution functionls for rural SMSI's selling consumer products for either the regional or the metropolitan Manila market. However, it is doubtful whether the rural 314SI' s could be expected to carry on sign-.icant produc tion for the metropolitan markets, with the important exception of the agricultural processing industries, such as animal feeds, coconut coir, dressed chickens and other meats, etc. D.2 The Rural SMSI Producilng for the ExporT Market: has more com- plex problems. The exports market of manufactured products is such that often very large aminzts are required to serve even individual orders. We are aware of instances where large orders for such items as abaca slippers, prelabricated components for housing garmen-ts, knit goods, etc. were not accepted by Philippine export firms because the production and product gatnering/purchasing capabilitles required were greater than possessed boy the export firm receiving the inquiry. In other cases, although the production capabilities were available, the financing and raw materlals purchasing capabilities to supply the required inputs to the producers were not big enough to enable handling the order.  ANNEX 2 Appendix 1, Page 9 The r ural SAST -finds difficulty with expert products for reasons other than financing and production capabilities. It needs quick and frequent contacts with foreign buyers, with internaTional market trends, with quality requirements for exujort products. It needs to conti-nually iqnrove product designs and product qualities. It needs to meet precise delivery schedules, packaging standards, requirements for proper export documentation. These are tasks beyond the sophistication level of aLnost all rural SSTI's. Most rural STSI's producing export products do so for export traders, but these products are mainly handicrafts at the present time. The export traders in manufactured products are generally located in Manila, some in Cebu, and a few in the region where their export products (mainly handi- crafts) are produced, such as abaca handicraft export traders in Legaspi. D.3 Export Trading Firms: must, thereF ore, be relied upon by the rural SMSI's to find, and ship to, export markets for their products. Three measures are recormended to develop the marketing/purchasing assistance which the rurai SMSI's will need: 1. Encourage formation of more Filipino (including joint- venture) export trading firms which will develop export; markets and place orders with rural SNSI's, induced by the export incentives under the Export Incentives Act, and assisted by special loan assistance to the extent that their exports are purchased from rural SMSI's, and they have to extend financial assistance to these SM3I's. 2. Form a strong export marketing division within the Philippine International Trading Corporation (PITC), with the directive to develop supplies from rural SlMSI's, and obtain export orders for their products. This subject needs more extensive treatment which will be done in a subsequent report on the PITC. 3. Attract foreign companies to establish offices in such cities as Cebu, Davao, Cagayan de Oro which will act as buyers for handicrafts and non-traditional manufactured exports, so as to create outlets for rural SMSI's. If we allow a few additional U.S., European and/or Japanese trading companies to establish branches here on the condition that they will also establish such buying offices in designated towns and cities, this might serve as a strong inducement. The additional condition could be that they must progressively attain desired ratios between import sales and exports of products from rural SMSI's. The export trading firms -would normally also assist the smail- and mediwn-scale industries to purchase their material needs. D.4 Design of Export Products Mention should also be made of the valuable contribution that the Design Center project (of the First Lady) could make towards generatirg more marketable designs for export products of rural SMSI's and improving quality of exports of both manufactured products and handicrafts.  ANNEX 2 Appendix 1, Page 10 E. Promotions Much needs to be done irn the way of generating interest among our middle and upper-middle classes towards establishing SMSI's in the non- metropolitan areas. The thrusts suggested to generate this interest are two: 1. 'Glamorize'":the rural SIvSI. 2. Publicize SMSI "success stories". The "glamorization" of the rural SMSI could be done through media, the schools and civic groups. Publicity of SMSI success stories could also be done through media. These aspects will be worked out with the Department of Public Information. As suggested previously, momentum could be generated to accelerate format,ion of rural SMSI' s through publicizing the approval of DBP loans and the establishment of DBP-assisted SMSI's. This sePies of stories could be weekly for the first three months, then twice a week for the next three months, or a total of 39 projects within a six-monith period. There is a sufficient inventory of projects on application, or approved but funds not yet released, with DBP to provide the material for this series. It is, of course, not enough to generate interest in establishing SMSI's. It is also necessary to provide concrete outlets in the forrm of project possibilities. Towards this end, it is proposed ;o prepare and distribute SMSI project brochures. These brochures would contain generalized feasibility studies on SMSI projects which could be established in various places in the Philippines. The project broch-ures would be prepared on the basis of information available in DBP records, and incorporate the experience of ongoing similar projects financed by DBP. The Asian Institute of Manage- ment is willing to cooperate in this effort, and there are 32 graduate students who have volunteered to do this work. Arrangements can be made to have these students work with DBP for this purpose. F. Coordination Mechanism It is presumed that coordination of this program and its overall success will become the responsibility of the Department of Industry, although the different tasks are operational responsibilities of various agencies of government. In order for the Department of Industry to exercise this coordination, it is proposed that there be: 1. A class statement of responsibilities of each of the agencies involved with the program. 2. Formulation as early as possible of quantitative targets for attainment at specified dates, say by the end of each calendar quarter. Targets should be set at least once each  ANNlI X Appendix 1, Page 11 year and may be moditied by the agency concerned. 3. A system of reporting progress of work, achievements versus targets, and problems encountered. The format of the reports shall be standardized and recipients of the reports pre- determined. The report would be made by the head of agency concerned and submitted to the President. Department of Industry would get a copy of all reports, and submit its evaluation of program progress and actions required. Coordinat- ing meetings of the heads of agencies involved shall meet at least once each quarter. Minutes of these meetings shall be furnished the Execu live Secretary. The manner of coordination suggested above does not vest formal authority in any agency to give orders to any other. However, because of the interdependence of the performances of the different agencies on each other, it is expected that they will find it to their advantage to coordinate actions, rather than create situations in which the President will find it necessary to intervene and give direct orders that individual agencies take specific steps. Upon the President's approval of the different facets of this program proposal, the agencies concerned can meet to draw up the above mentioned statements of responsibility, formulate targets, draw up in more detail their respective programs of activity, which will become integrated into a master program. The program could in the meantime be started off selectively inaugurating those activities, such as financing, which are nearly ready for implementation. It is appropriate to mention that sections A,B, and C of this draft have already been referred to DBP, Central Bank, Department of Labor, and NEDA, and cormments received from the first two have already been reflected in this report. EAP Proj*cts Dpartzent February 24, 1975  ANNEX 3 Page 1 PHILIPPINES DEVELOPMENT BANK OF THE PHLIPPINES The Institution and its Characteristics 1. Background. The Development Bank of the Philippines (DBP), a development finance institution wholly owned by the Government, was established in 1958 as a successor to the post-war Rehabilitation Finance Corporation. Under its Charter the DBP is empowered to engage in a wide range of financial activities, including the following; i) the granting of loans for the establishment or development of any agricultural or industrial enterprise, including public utilities, mining, livestock and fisheries, and for home financing projects. ii) the purchase of equity investments in any agricultural or industrial enterprise. iii) the guarantee of loans and other obligations incurred for the development of agriculture or industry. iv) the granting of loans to provincial and municipal governments for self-liquidating or income producing projects. The bulk of its activities, however, has been in loans and guarantees for industry and agriculture (para. 5). Since 1971 DBP has acted as the financial intermediary for IBRD loans for grain processing, livestock, fisheries, medium- and large-scale industrial investment, and shipping. DBP's bonds and other debt instruments, which may be issued upon recommenda- tion of the Secretary of Finance and with the approval of the President, are exempt from taxation and fully guaranteed by the Government. However, such obligations may not exceed an aggregate amount equivalent to ten times DBP's paid-in capital and surplus. 2. Management. Overall management of DBP is entrusted to a Board of Governors consisting of the Chairman and eight other members (four full- time and four part-time) appointed by the President for seven-year terms. The present Chairman of the Board of Governors, who is also the chief executive officer, Mr. Leonides S. Virata, was appointed in February 1970. With the help of able advisers, the Chairman has continued his efforts to strengthen DBP's management and staff and to improve its organizational structure. However, DBP is a large and unwieldy institution. Much still needs to be done to improve its efficiency and make it more responsive  ANEX:_ Page 2 to its clients' needs. Under the executive supervision of the Chairman and four full-time Governors are eighteen departments covering the wide range of activities undertaken by DBP (Chart No. 9380). DBP also has a widespread network of 32 branches and 24 agencies (para. 4). The number of branches will be increased to 34 by June 30, 1975. 3. Organization. Following a reorganization of Head Office departments in October 1973, industrial financing operations are handled by three industrial projects departments grouped under one full-time Governor. Industrial Projects Department I (IPD I) handles large loans (over P 1 million), and IPD II small loans (below P 1 million). IPD III handles loans (any size) for utilities and transportation services operating under a public franchise. These include transportation, communications, electric power and uater systems. In addition to IPD II, DBP's Branches handle a small but rapidly growing proportion of DBP's lending to small-scale industry, although their main orientation has traditionally been towards agricultural financing. Loans processed by the Branches which exceed the Branch manager's commitment authority Cpr.estly P20,000) are reviewed by the respective projects departments in Head Office before submission to the Board of Governors for approval. Administrativelr, supervision of the Branches is the responsibility of the Branches and Agencies Department (BAAD). The proposed Bank loan will be handled principally by IPD II and the Branches, and to a lesser extent by IPD I.1/ IPD II's management is relatively new but staff are generally experienced. Since its establishment the department has made good progress in developing the required capability to manage the small industry financing program. The quality of management in the Branches is varied; for the most part branch managers and senior staff are competent and experienced. The Branches have until very recently been handicapped by inadequate staffing (Annex 4, para. 15), and they continue to operate with cumbersome procedures (Annex 4, paras. 14-15), and insufficient authority (Annex 4, para. 15). IPD I is well-managed and the IBRD loan for industrial investment which it is already administering is progressing smoothly. The projects departments and Branches are responsible for both appraisal and follow-up work on thei.r loans. 4. Staffing. As of December 31, 1974, IBP had a total staff of 2,843, of whom 2,32 were in professional and sub-professional categories. T'he staff, who must have civil service eligibility to be recruited, is of generally good calibre. Salaries are competitive with other Government financial institutions, and above those of the general civil service structure. IPD II has a budgeted staff complement of 60 professionals and 15 support staff. As of December 31, 1974, all of the professional positions were filled. Of these 22 are industrial appraisers (15 with engineering backgrounds), and 35 are financial analysts with backgrounds in accounting and commerce. DBP's Branches have a total staff of 1,559 of whom 339 are in the Investment and Project Development Division and 111 are in the Project Supervision and Acquired Assets Division. Between 1/ IPD I will handle all loans above P1 million (i.e. principally to medium sized enterprises).  Page 3 September and December 1974, 33 additional engineers were recruited for placement in the Branches as industrial project appraisal staff. As of January 1975 Branches are expected to have between 2-5 appraisal staff working full-time on SMI lending operations. The organization and staffing of IPD II and the Branches are further discussed in Annex 4, paras.16 and 17. 5. Overall Operations. In FY74 DBP approved 18,234 loans for agriculture, industry, real estate and provincial and mwnicipal governments totalling P262.6 million. It approved four equity investments totalling P78.5 million, foreign guarantees amounting to US$409.1 million and domestic guarantees of P12.0 million. As shown in Table 1 below, industrial lending accounted for 3.8% of the total number of loans and 36.1% of the total loan amount in FY714, compared with 1.7% and 26.6% respectively in FY73. There was a sharp drop in the average size of DBP's industrial loarns, from about P250,000 in FY72 to P200,000 in FY73 and to about P140,000 in FY74 reflecting mainly the increasing proportion of S14I lending in total industrial lending operations. Between July 1 - December 31, 1974 (FH75), DBP approved a further 10,984 loans totalling P519.8 million an increase of nearly 300% over FY74 on an annual basis. In this period it also made t-wo equity investmen-s totalling P60 million and guaranteed 21 loans and credits for a further P312.36 million. The average size of loan in FH75 shot up to P680,000 as MP substituted direct lending (from the recent IBRD loan of US$48.0 million) for operations which previously it was forced to guarantee. This has been reflected in the very low level of guarantees for the period (para. 6). Table 1. DBP - Loans and Guarantees APproved FY72-FH7~ (P million) _ Y72 FY73_ FY7 July-Dec.'74 No. Amt. No. Akt. No. Amt. No. Amt. Loans Agriculture 8,840 54i7 12,858 109.5 13,706 120.4 9,303 129.4 Industry 246 61.4 277 55.2 684 94.9 472 322.7 Real Estate 1,768 21.8 3,437 38.3 3,834 33.7 1,207 61.3 Government 5 8.0 8 4.9 ,l0 13.6 2 6.4 Capital Subscriptions and Advances to Rural and Private Development Banks 143 16.3 429 25j 338 3.4 63 13.4 Total 11,002 162.2 17,009 233.6 18,572 293.0 11,047 533.2 Equity Investment 2 149.0 - - _ 4 78.5 2 6o. Grand Total 1100 3 17,029 233.6 !8.576 2.1L5 11,049 593.2 Guarantees Foreign (US$ million) $201.9 $233.9 $409.1 $37.5 Domestic (P million) 10.4 16.7 12.0 12.0  ANNEX 3 Page 4 6. Guarantees. rBP's foreign currency guarantees increased by 75g in FY74 compared with a moderate increase of 16% in FY73 but dropped sharply by 81% in the first six months of FY75. DBP's 'regular' foreign guarantees (those generally relating to private suppliers' credits for importation of industrial capital goods) more than doubled between FY73 and FY74 ($164W.8 million to $397.8 million), while foreign currency guarantees administered by DBP under the U.S. Commodity Credit Corporation (CCC) and Canadian Wheat Board (CWB) credits mainly for imports of raw cotton, tobacco and wheat, flour declined from $69.1 million to $11.6 million. In FH75 regular foreign currency guarantees fell to $29.2 million while CCC and CWB credits act,ually increased (on an annual basis). Domestic currency guarantees in FH75 wrere doubled the level for a similar period in the previous year. 'Lhe fall-off in regular foreign currency guarantees has been due both to the substitution of guarantees by direct lending (para. 5) and to the establishment of a new guarantee corporation (para. 10) which is expected to assume a larger share of the guarantee burden. 7. Industrial Loans. Of the 684 industrial loans approved in FY74, 503 were in the very small loan and cottage industry category (i.e. loans below P50,000) and accounted for only F3.1 million in loan amount; the average loan size in this category was only F6,oo0 compared with an average of over P500,000 for the remaining 181 loans. The latter amounted to P91.8 million of which the bulk went to cement (32%), ice plants and cold storage (11%), food processing (12%), and apparel (7%). A breakdown of approvals by industry branch is sho-rn in Table 2. The four equity investments were in banking (F5.0 million), housing (F37.5 million), air transportation (F20.0 million) and a steel mill (F16.0 million). In comparison, in FH75, of the 475 industrial loans approved 312 (66%) were below P50,000 in size, and accounted for P2.7 million in amount (or 0.8% of the total amount approved). The average size of loan in this category was P8,600, compared to an average of P2 million for the remaining 160 loans. Regional and industry breakdowns for approvals in FH75 were not available. Table 2. DBP - Industrial Loans Approved FY72-74 (P million) FY72 FY73 FY7 No. Amt. No. Amt. No. Amt. Food 3 0.2 14 8.0 18 :Lo.8 Beverage & Tobacco 1 0.2 - - 1 2.3 Textiles 2 o.6 3 0.4 3 2.7 Footwear & Apparel 1 0.1 1 0.3 18 6.3 Wood & Cork - - 1 1.8. 2 1.0 Furniture & Fixtures 5 0.4 9 1.2 16 3.0 Printing - - 4 0.5 2 0.4 Leather 1 - 4 0.8 12 2.8 Rubber - - 1 0.2 2 0.9 Chemicals - - - - 1 0.4 Non-Metallic 21 34.3 40 16.5 31 32.1 Metal 1 19.5 2 o.6 6 1.7 Non-electrical Machinery - - 10 1.5 23 4.8  ANNEX 3 Page5 Electrical Machinery - - 2 0.2 3 0,3 Transport Equipment & Repair 3 ).1 16 2.4 7 4.2 Miscellaneous 1 0.3 12 4.4 7 1.3 Mining 4 1.6 6 1.7 1 0.4 Public Utilities & Services!/ 5 1.6 11 .2