Document of The World Bank FOR OMCIAL USE ONLY C A. 's ^ Report No. 4982-NEP STAFF APPRAISAL REPORT NEPAL INDUSTRIAL DEVELOPMENT PROJECT November 12, 1984 South Asia Projects Department Industrial Development and Finance Division This document has a resticted distribuion nd may be used by recipients only in the perormance Of their offici dnti. Its contents may na oherwise be dicosed without Wod Bank authokriuion. CURRENCY EQUIVALENT Currency Unit = Nepalese Rupees (Rs.) US$ = Rs. 17.3 Rsl = US$0.0578 ABBREVIATIONS BANSBARI - Bansbari Leather and Shoe Factory, Ltd. FITA - Foreign Investment and Technology Act ELI - Hetauda Leather Industries HMG - His Majesty's Government of Nepal ICICI - Industrial Credit and Investment Corporation of India IDA - International Development Association IDP - Industrial Development Project IEA - Industrial Enterprises Act IEF - Import/Export Facility ISC - Industrial Services Centre KfW - Kreditanstalt fur Wiederauftan LICC - Leather Industries Coordination Cell MOI - Ministry of Industry NBL - Nepal Bank Ltd. NIDC - Nepal Industrial Development Corporation NRB - Nepal Rastra Bank RBB - Rastriya Banijya Bank ;RCDC - Raw Hide Collection and Development Company ENAC - Royal Nepalese Airlines Company TPI - Tropical Products Institute UNDP - United Nations Development Programe USAID - United States Agency for International Development FISCAL YEAR 1MG/Financial Institutions: July 16 to July 15 FOR OMCIAL USE ONLY NEPAL INDUSTRIAL DEVELOPMENT PROJECT CREDIT AND PROJECT SUMMARY Borrower: The Kingdom of Nepal Beneficiaries: Nepal Industrial Development Corporation (NIDC) and private industrial enterprises and leather/leather goods manufacturers and exporters. Amount: SDR 7.5 million (US$7.5 million equivalent) Terms: Standard Relending Terms: Government would on-lend US$6.5 million to NIDC at minimum interest rates of 7% for fixed investment subloans and at 10% for permanent working capital subloans repayable over 18 years including a grace period of 5 years; NIDC would on-lend to subborrowers at 12% and 15% for fixed investment and working capital subloans. respectively. During the first two years of project implementation, the Government would utilize US$1.0 million of the US$6.5 million to be on-lent to NIDC as its contribution to an Import/Export Facility to be established in the Nepal Ractra Bank. Foreign exchange risk would be borne by the Government. uS$1.0 million in technical assistance would be provided to implementing agencies as grants. Proiect Description: The Project is part of IDA's continuing efforts in assisting government to promote industries in Nepal with greater private sector participation. Project components are: (a) a line of credit to NIDC to finance industrial investment projects; (b) technical assistance and training to NIDC in strengthening operational standards and procedures particularly in project implementation and supervision and management information; (c) consultancy and advisory services to improve formulation and implementation of industrial and export incentives, tourism promotion, and efficiency and quality of leather goods production and to assist in formulating a development program for the light engineering subsector; (d) foreign exchange funds to establish an Import/Export Facility for export oriented enterprises. The project does not contain any unusual risk. This document has a restricd distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. -ii- US$ Million Equivalent I. Estimated Cost: F:reign Local Total A. Sui4loan Component 6.5 2.8 9.3 B. Import/Export Facility 1.5 - 1.5 C. Technical Assistance 1.0 0.2 1.2 Total 9.0 3.0 12.0 US$ Million Equivalent II. Financing Plan: Foreign Local Total A. Government 1.5 0.2 1.7 B. IDA 7.5 - 7.5 C. Sponsors - 2.8 2.8 Total 9.0 3.0 12.0 III. Estimated Disbursement US$ Million Equivalent IDA FY FY85 FY86 FY87 FY88 FY89 FY90 FY91 Annual 1.0 0.7 1.4 1.7 1.2 0.9 0.6 Cumulative 1.0 1.7 3.1 4.8 6.0 6.9 7.5 -iii- NEPAL APPRAISAL OF AN INDUSTRIAL DEVELOPMENT PROJECT TABLE OF CONTENTS PAGE NO. I. INTRODUCTION ...........................1.................. II. SECTORAL FRAMEWORK ................. . ................ . 2 A. Economic Environment ................ .. ............ 2 B. Industrial Sector ...... ............................... 4 - Industrial Structure ................................ 4 - Export Patterns .................................... 4 - Industrial Policy ...... ............................. 6 - Industrial Finance ...... ....................... 7 III. THE PROJECT .............................................. 8 A. Scope and Objectives ...... ............................ 8 B. Credit Component ...... .......................... 8 C. Technical Assistance Component . . . 11 D. Summary of Components and Costs ................... .... 15 IV. NEPAL INDUSTRIAL DEVELOPMENT CORPORATION (NIDC) 15 A. Institutional Aspects ................................. 15 B. Policies and Strategies ............. .. ................ 17 C. Standards and Procedures ..... ......................... 18 D. Operational Performance ............. .. ................ 21 E. Financial Performance .............. .. ................. 24 F. Projected Operations ................. ................. 25 V. LEATHER DEVELOPMENT PROGRAM ............................... 27 A. Subsector Focus/Program ...... ......................... 27 B. Leat'her Sector Projects ............................... 28 - Bansbari Modernization Subproject .... ............... 28 - Hide Collection Expansion and Upgrading Subproject .. 29 C. Technical Assistance Components ..... .................. 31 VI. THE PROPOSED CREDIT ...... ................................ 33 A. Credit Arrangements ................................... 33 B. Major Terms and Conditions ..... .................... I.. 34 VII. BENEFITS AND RISKS ....................................... 35 VIII. RECOMMENDATIONS .......................................... 36 This report was prepared by C.A. Punsalan, J. Balkind, and K.J. Hong folloving their appraisal mission to Nepal in November, 1983. Messrs. Peter P. Street (Consultant), J. Berg (UNIDO), and J. Simmons (former Bank Tourism Advisor) also participated in the preparation of the project. -iv- LIST OF ANNEXES 1. NEPAL: The Leather and Leather Goods Subsector 2. NEPAL: Interest Rate Structure 3. NIDC: Statement of Investment and Operational Policies 4. NIDC: Strategy Statement 5. NIDC: Organization Chart 6. NIDC: Summary of Operations 7. NIDC: Industrial Distribution of Outstanding Loans 8. NIDC: Income Statements, FY79 - FY84 9. NIDC: Collection Performance/Arrears Position 10. NIDC: Balance Sheet Statements, FY79 - FY84 11. NIDC: Projected Loan Operations, FY85 - FY88 12. NIDC: Projected Income Statements, FY85 - FY88 13. NIDC: Projected Cashflow Statements, FY85 - FY88 14. NIDC: Projected Balance Sheet Statements, FY85 - FY88 15. Estimated Disbursement Schedule 16. Supporting Documents Available in Project File MAP Number 18038: Nepal: Industrial Development Project NEPAL INDUSTRIAL DEVELOPMENT PROJECT STAFF APPRAISAL REPORT I. INTRODUCTION 1.01 Nepal's industrial sector is small; prospects for growth in industrial output and exports are constrained by geographical location, limited resources, a small domestic market, and inadequate industrial manpower. However, there is scope for industrial development in selected product groups including light engineering products, leather and leather goods, handicraft products, agroprocessing, building materials, and some basic consumer goods. The deteriorating balance of payments position highlights the need to develop viable import-substitution and export-oriented ventures. In 1982, His Majesty's Govern- ment (HMG) of Nepal adopted a new Industrial Policy which emphasizes the promo- tion of local and foreign private investment in manufacturing and exports. Simultaneously, an Act relating to Foreign Investments and Technology, (FITA) and the Industrial Enterprises Act (IEA) were enacted to provide the framework for achieving HMG's industrial objectives. The Bank Group's sector work and lending is supporting HMG in meeting these objectives by providing term finance for viable industrial activities, providing technical assistance in implementing policy reform, and assisting HNG in strengthening commercial and promotional services, particularly in promising export product groups. The proposed Industrial Development Project (IDP) is an integral part of this effort. 1.02 Previous Industrial Bank Group Operations. The first credit line to Nepal Industrial Development Corporation (NIDC) of US$4.0 million was made in 1978; IDA also executed UNDP financed technical assistance projects involving a policy advisor and an accounting/management information advisor who were assigned to NIDC for two years each. The Bank Group is supporting a Cottage and Small Industries (CSI) Project, with a US$6.5 million IDA Credit (1191-NEP) and a US$2 million UNDP financed, Bank executed technical assistance project. This project provides credit to CSIs and related commercial concerns through the two commercial banks and the Agricultural Development Bank; product development and export promotion services focusing on promising CSI product groups; training and technical services to upgrade CSI production skills. IFC has assisted a hotel and a magnesite mining project with financial commitments of US$3.1 million and US$5.6 million respectively; an IFC commitment of US$3.0 million has recently been approved for a lead/zinc project; and IFC currently is considering pulp/paper project and small iron/steel foundries. 1.03 Industrial Development Proiect. The proposed project is designed to promote industrial investments and exports in Nepal, primarily in the private sector. NIDC, the only industrial development bank in Nepal, would be supported with IDA's financing of eligible subprojects and technical assistance to achieve further improvements in NIDC's operations. Funds would be available for a train- ing course to upgrade quality of industrial project appraisal and supervision. Implementation of Credit 705-REP was delayed principally due to NIDC's inadequate local currency resources and some institutional weaknesses (para. 4.01). NIDC, -2- with the assistance of HMG/NRB, however, has adopted a satisfactory program to ensure availability of local currency resources and has taken appropriate actions to upgrade its operations. Under the IDP, technical assistance and training would be provided to build on the institutional improvements made under IDA's first credit line to NIDC focusing on the areas of financial and resource plan- ning, project impiementation and arrears management. The project would make financing available for an integrated leather development program which would help improve efficiency and quality of output at each stage, expand hide and skin collection capacity, and enhance value added in this important export subsector. Work will be initiated under the IDP to develop a similar program for light engineering, which could be pursued in a subsequent project. Technical assis- tance would be provided in implementing HMG's industrial and export incentive schemes and in strengthening promotion of tourism. In addition, the project would facilitate exports and related imports by funding an Import/Export Facility. This report outlines a US$12.0 million project with IDA providing US$6.5 million for subloans to industry and for the foreign exchange facility for exporters, and US$1.0 million in technical assistance. II. SECTORAL FRAMEWORK jj A. Economic Environment 2.01 Nepal launched the Sixth Plan for the period of FY81 to FY85 under the unfavorable conditions. There had been three poor monsoons, long-term agricul- tural productivity was stagnant, and a disappointing economic performance during the preceding Plan period. The GDP growth rate reached 5.6% (in real terms) in FY81 as the economy recovered from the severe and wide-spread drought of FY80. In FY82, GDP grew at a slower rate of 3.8%, but which was still higher than the average 2.1% p.a. growth achieved in the preceding Plan period. High population growth of 2.6Z p.a. over the past decade eroded gains in per capita GDP. However, during the first two years of the Sixth Plan period, per capita GDP rose to US$150 (FY81), with GDP growing more rapidly than population. 2.02 Agriculture accounts for 62% of GDP, roughly two-thirds of export earn- ings and about 90% of employment. The manufacturing, mining and construction sectors together account for only 9% of GDP. Following the severe drought of FY80, the Government made a strong effort to improve the supply of agricultural and manufacturing inputs. These efforts, aided by favorable weather, resulted in some gains in output, revenues and exports in FY81 and FY82. In the following year, however, Nepal experienced yet another drought-induced setback. Compared to the previous year, agricultural and overall production declined, the budgetary 1J A more detailed assessment of Nepal's economy is contained in the Bank's latest economic report, "NEPAL: Recent Developments and Selected Issues in Trade Promotion", Report No. 4663-NEP dated October 14, 1983. -3- situation deteriorated, inflation accelerated and the balance of payments recorded an unusually large overall deficit. 2.03 The manufacturing sector, contributing about 5% of GDP, grew at an average annual rate of 2.3% (in 1974/75 constant prices) during the Fifth Plan period. Manufacturing output in 1980/81 declined due to shortages of raw materials and power. These constraints have eased with improvements in raw material supply and the completion of the Kulekhani I hydroelectric project. Since 1981, production and capacity utilization have increased, notably for sugar, jute goods, cement and fertilizers. On the policy front, the Industrial Enterprises Act and the Foreign Investment and Technology Act of 1981 provide additional incentives and emphasis on local as well as foreign private invest- ment, and simplification of industrial licensing procedures. Since the new policy announcement, a number of private and joint public-private ventures are being undertaken, including a spinning and a coarse cloth mill, magnesite, lead and zinc mines, a small paper mill, a dry cell battery plant, and new food processing plants. 2.04 In FY83, Nepal suffered a large balance of payments deficit of about US$36 million compared to a surplus of about US$39 million in FY82. Histori- cally, Nepal has had large trade deficits, which were partly offset by surpluses from invisibles. The current account deficit, which averaged about 4% of GDP from FY79 to FY82, has traditionally been more than matched by inflows of offi- cial grants and concessionary loans, leading to a surplus in the overall balance of payments. In FY83, the overall balance shifted to a deficit of about US$36 million, reflecting a sharp decline in agricultural exports and large increases in food related imports. Official capital inflow continued to increase but not enough to offset the huge deficit. Gross international reserves, tradi- tionally maintained at relatively high levels in Nepal, declined to the equiv- alent of four months' imports by the end of FY/83. jJ Over the last five years, the external public debt, including credit from the IMF, rose from 7% of GDP to an estimated 12%. As virtually all loans have been concessional, debt service payments, including payments to the IMF, have remained small in relation to exports of goods and services, rising from 4Z in FY79 to an estimated 7% in FY83. 2.05 Nepal has made several changes in its exchanRe rate system. Prior to 1978, an Exporters Exchange Entitlement Scheme (EEE) was operational which allowed the trading of foreign exchange entitlements gj resulting in premiums of about 30-40Z above the official exchange rate. In March, 1978 the EEE scheme was replaced by a dual exchange rate whereby exporters received NRs 16 for each dollar of export earnings compared to the official rate of NRs 12:US$1.00. In September 1981, this dual exchange rate system was unified at NRs 13:US$1.00; in addition, the Nepalese Rupee was pegged to the Indian Rupee at the fixed rate A] NRB estimates its reserves to have further declined to about three months of imports in December, 1983. .ai Provided to exporters to third countries (other than India). -4- of NRs 1.45:IRs 1.00. In December 1982, the Nepalese Rupee1 depreciated against the US Dollar by about 8% to NRa 14.00:US$1.00. In June 1983, the duas peg arrangement was replaced with a trade-weighted basket peg with the US Dollar as the intervention currency. The current exchange rate is NRs 17.3:US$1.00. B. Industrial Sector Industrial Structure 2.06 About 70% of industrial value-added comes from formal manufacturing, and mainly from public sector enterprises, producing construction materials, tex- tiles, footwear, processed food and some simple assembly items. The other 30% comes from mainly rural, household-level, cottage and small industries. Avail- able data indicate that the formal private sector constitutes approximately 3,600 manufacturing establishments employing over 60,000 workers. About 75% are class- ified as small-scale establishments, jj employing on average about 10 workers, and fixed assets of about Rs 500,000. Industrial productivity is low, partly due to the labor intensity of most processes, coupled with shortages of raw material, spare parts and technical and managerial know-how. These private sector enterprises are predominantly in agro-processing, furniture manufacturing, printing, and brick/tile processing. The Sixth Plan emphasizes greater par- ticipation of the private sector and the development of other industrial products such as pharmaceuticals, concrete blocks, light metal products and agricultural implements. Export Patterns 2.07 Nepal's merchandise exports in the period FY76 to FY82 grew at an average of about 3% in nominal terms; the highest exports were achieved in FYB1, when exports totalled Rs 1.6 billion (US$134 million equivalent) which was an increase of 40% over FY80. However, exports decreased by 7Z in FY82 to Rs 1.5 billion, due to market difficulties for most of Nepal's exports as well as difficulties with input supply. Exports have remained a small portion of GDP, and declined slightly from 6.8% in FY76 to 4.8% in FY82. Sales to India still account for the bulk of Nepal's exports. India's share declined from about 84% in FY75 to about 45% in FY80, but increased to about 66% in FY82 due to an overall decline in exports to other countries and a 75% increase in food, live animal, and crude material exports to India. 2.08 Although total merchandise exports showed a fluctuating and low average growth, manufactured exports grew at a higher rate of 14% p.a. reaching Rs 282.5 million (US$21.7 million) in FY82. Consequently, the proportion of manufactured exports to total merchandise exports grow from 11% in FY76 to 19% in FY82 and was /j Small : Rs 500,000 to Rs 2.0 million fixed assets Medium: Rs 2 million to Rs Rs 10 million fixed assets Large : Above Rs 10 million -5- as high as 30Z in FY80. Three product groups account for the bulk of manufac- tured exports: leather, handicrafts and carpets. These products were also exported to countries other than India. IDA's Small and Cottage Industries Project is focusing on the development of handicrafts and carpets, and the proposed IDP contains major elements to promote exports of leather and leather goods. 2.09 Leather Subsector. The leather subsector accounts for 10% of industrial output; in recent years the leather group has accounted for 27% to 47% of manufactured exports, with fluctuations reflecting changes in world leather market. Due to its use of local raw materials, labor intensity and export-orientation, the leather group plays an important role in Nepal's industrial output and exports. While the subsector has been affected by world recession, there are reasonable prospects that the industry will recover and regain its importance in exports. The structure, composition, and performance of the industry is discussed in Annex 1. 2.10 In FY80 leather exports reached a peak of Rs 198.7 million (US$14.2 million), with the dominant group being wet-blue goatskins (Annex 1, Table 2). From a base of Rs 55.1 million in FY77 leather export earnings, grew at 55% per annum in nominal prices over FY77-FY79, and volume grew at 40% p.a. During this period, exports of hide leather, mainly buffalo sole leather, grew most rapidly, but goatskin leather exports still represented about 90% of exports. Due to the prolonged recession, particularly for consumer fashion goods such as kid glove leather, the value of Nepal's leather exports declined by 50% in FY81; this trend continued in FY83 as exports dropped to Rs 49 million, with the goatskin sector being particularly hard hit. 2.11 The demand for all types of footwear in Nepal is currently estimated at 1.3 million pairs p.a. (Annex 1, Table 1); about 20% is met by domestic produc- tion of leather footwear, 20% is imported from India, while the remainder is either met by imports of other types of footwear or is left unsatisfied. Thus there is significant scope for import substitution and local value added in leather footwear manufacture. 2.12 Recognizing the present and potential role of the leather subsector in Nepal's industrial output and exports, IDA financed a subsector study jj which formulated ar integrated development program for the leather industry, a portion of which is included in the proposed project (Chapters 3 and 5). The study also provided detailed industry data and analysis. V/ Under the proposed IDP, a leather development program would be financed to improve the subsector's efficiency and expand its capacity to collect and process leather for exports. j/ Tropical Products Institute/Industrial Services Center, Leather and Leather Products Subsector Study March 1981. j/ The Leather Sector; Mission Working Paper Numbers 1-3,, April 1983 (Project File). -6- Industrial Policy 2.13 In 1981, HNG adopted a new Industrial Policy which provides for a greater participation of the private sector in industry including private foreign invest- ments and joint ventures; compared to previous policy statements, the new Industrial Policy also provides clearer definitions of industry groups and clarifies institutional arrangements for licensing and registration. To help implement this policy, HMG promulgated two Acts - the Industrial Enterprises Act (IEA) and the Foreign Investment and Technology Act (FITA). jj These Acts provide fiscal and monetary incentives to private industry. These include: income tax holidays, sales tax and excise duty exemptions; provisions for repatriation of profits and dividends by foreign investors; and some simplifica- tion of licensing and documentation procedures. The Industrial Promotion Board, headed by the Minister for Industry and Commerce, continues to coordinate and monitor the industrial development policy with the Department of Industries acting as the Board's Secretariat. The Director General of the Department of Industries coordinates a separate committee, consisting of high-level officers of various ministries, whose main function is to design operating rules and proce- dures and to ensure the efficient implementation of the services and facilities provided under the Acts. HMG has initiated the process of formulating these rules and procedures and has recently announced additional incentives such as duty drawback and tax rebate on export profits to promote exports. These new schemes could assist in correcting the anti-export bias present in other measure.. 2.14 While HMG through the IEA and FITA, has provided for an overall framework to implement its industrial policy, much more needs to be done in the development of the rules and procedures to ensure effective implementation. It is important also to reevaluate policy alternatives in relation to their impact on HNGEs revenues and resources and on private sector investments and exports. Given the physical constraints and undeveloped state of industry in Nepal, the package of incentives needs to be redefined and focused to effectively promote efficient import-substitution and exports; under the IDP, technical assistance would be provided to re-examine Nepal's industrial and export-incentives (para. 3.08). To complement the incentive package, the IDP would also provide adequate credit facilities to industry (paras. 3.02 - 3.08) as well as technical assistance to promote and improve operations of specific subsectors with poten- tial, including light engineering (para. 3.09), tourism (para. 3.10) and leather/leather goods (para. 3.11). J A more detailed discussion of the provisions of these Acts is contained in Chapter 5 of the Bank's latest economic report, No. 4663 dated October 14, 1983. -7- Industrial Finance 2.15 Nepal's organized financial sector consists of: two commercial banks; two specialized financial institutions, one for agriculture and one for industry; and a provident fund corporation and an insurance company. The two commercial banks jJ (Nepal Bank Ltd. and Rastriya Banijya Bank) dominate the financial sector, accounting for 75% of total assets and virtually all deposits. Deposits of the commercial banks showed a high growth rate of about 22Z over FY78-FY83, reaching Rs 5.6 billion or 16% of GDP. Over 45% of deposits have been in maturities of 2 years and longer which provides a reasonably stable deposit base. Commercial banks have been the major source of working capital to industry while NIDC has been the primary source of term credit for fixed investments, although commercial banks have responded well under the CSI project, increasing term financing for cottage and small industry. 2.16 Commercial banks are mandated to finance priority sectors (agriculture, cottage and village industries, services) to the extent of 7% of total deposits. While commercial banks have improved their financing for cottage industry, they are still conservative aud reluctant to make term loans on the basis of project evaluation rather than collateral. Commercial banks still have limited exposure to and expertise in industrial lending, particularly for term loans to larger firms. As recommended by IDA, HME recen ly abolished the registration fee on collateral for industrial loans by the commercial banks, which had discouraged industrial borrowings. In line with HMG's Industrial Policy of 1982, appropriate measures should be taken to: promote co-financing schemes between financial institutions which would help meet NIDC's local currency requirements, and encourage commercial banks to lend to industries without relying on guarantees of HMC, NRB or NIDC. These should include allowing financing institutions to share collaterals jointly and allowing registration of second mortgages. (para. 3.02). 2.17 Interest Rates and Inflation. Annex 2 shows the deposit and lending rate structure in Nepal. Lending rates range from 11% to 17% depending on the purpose of the loans and size of borrowers. These rates have been effective since June 15, 1983, and reflect an acrosc-the-board increase of 1% from prior rates. NIDC's interest retes for term loans to industry are 12% for fixed investment and 15% for working capital and these would be applicable under the IDP and consis- tent with rates charged by the commercial banks. In the period FY79 to FY83, inflation in Nepal averaged about 10%. Current projections of Nepal's inflation are in the range of 6% to 9Z p.a. for FY84 to FY89. Thus, present lending rates are expected to remain positive in real terms. 2.18 Recent developments in the financial sector include the initiatives to allow branches of foreign banks, establishment of a privately owned commercial bank, studies on export credit and export guarantees. These moves are consistent jj Nepal Bank, Ltd. (NBL) and Rastriya Banijya Bank (RBB) are owned by EMC to the extent of 51% and 100% respectively. -8- with HMG's continuing efforts to improve resource mobilization, foreign trade services, and the overall efficiency of financial institutions. III. THE PROJECT A. Scope and Obiectives 3.01 The proposed Industrial Development Project (IDP) in Nepal is part of IDA's continuing effort to assist MwG in promoting private industrial investments and in generating foreign exchange resource. The IDP would pursue industrial and export policy initiatives, continue institution-building assistance for NIDC as the main source of development finance for industries, and address quality and efficiency problems in the leather group as a key export subsector. Technical assistance under the project would: (a) help improve formulation and implementa- tion of industrial and export incentives; (b) improve the efficiency, and product quality and value-added in the leather group; (c) formulate a development program for light engineering; and (d) seek to increase foreign exchange flows from tourism by introducing a more dynamic approach to promotion. In addition to providing long-term funds through NIDC to finance fixed assets and working capi- tal for the establishment and expansion of private industrial enterprises, tech- nical assistance would build on the institutional improvements in NIDC initiated under Credit 705-NEP. An importlexport facility under the IDP would support EMf's policy to promote manufactured exports. B. Credit Component 3.02 NIDC Subloans. An IDA Credit of US$7.5 million equivalent is proposed for the IDP of which US$5.5 million would fund NIDC subloans to small, medium and large private 11 industrial enterprises, with a maximum subloan size of US$1 million. These subloans will finance the foreign exchange cost of imported goods and services; 70Z of goods locally procured representing an average foreign exchange content of such goods; and initial working capital in the form of imported material inputs. The new feature of the credit components is the financing of forei2n exchange portions of working capital requirements provided this is part of a fixed investment subloan (i.e. subloans for working capital only would not be eligible). NIDC's working capital finance has been constrained mainly due to resource difficulties. Short-term credit from commercial banks is available but limited, and the banks rely excessively on fixed asset collateral, with a bias for a few well established industrial enterprises. In some cases, these loans are covered by NIDC guarantees instead of fixed asset collaterals; however, this increases the cost to the borrower, since NIDC charges a 2.5Z guarantee fee. During the preparation of the IDP, HMG abolished the registration fee on mortgages of commercial bank loans to industry. This had made the cost of these loans even higher. Understandings with HMG and NRB have been reached that 11 Possible subloans to Bansbari and REHCDC, under the leather development program would be treated as an exception (para. 3.05). -9- appropriate measures would be taken to allow the commercial banks to accept collaterals on joint mortgages and registration of second mortgages (para. 2.16). While these measures and the improvements in the commercial banks project-based lending capabilities under the Cottage and Small Industries Project Vill help improve access to working capital, NIDC's medium- and larger-scale clients will continue to face difficulties in securing adequate working capital finance from the commercial banks in the short- to medium-term. Relending terms for NIDC's working capital finance will be at the prevailing market rate for working capital with a maximum maturity of 7 years and grace period of up to 3 years; these loans would complement commercial bank financing and equity resources. 3.03 Import/Export Facility (IEF). The IDP would assist in setting up an Import/Export Facility in Nepal Rastra Bank (NRB) with an initial capitalization of US$1.5 million of which US$1.0 million would be funded by IDA under the proposed Credit and US$0.5 million by HMG/NRB. The IEF would represent an appropriate and timely support to HMG's export promotion policy and would con- stitute part of IDA's continuing efforts in this area. AI The facility would assist EMG in implementing its recently announced policy of allowing export industries to apply directly to NRB for their foreign exchange requirements, equal to about 15% of their export earnings. The IEF is expected to relieve exporters of the long process of securing needed imported inputs. Without out- side assistance, problems with inadequate foreign exchange reserves of HMG are likely to reduce the effectiveness of this policy; HM's reserves currently constitute only about 3 months of imports compared to over 6 months in most previous years. The proposed IEF would address this problem by earmarking for- eign exchange funds to meet the needs of exporters; the exporters would "buy" this foreign exchange with N. Rupee with working capital loans from NIDC/commercial banks or their own resources. 3.04 The Ministry of Industry (MOI) would be the implementing agency, but transactions under the IEF would be handled by NRB's Foreign Exchange Department. 1DI would be responsible for developing and implementing appropriate policies and procedures for the utilization and operation of the IEF with prior consultation with the Nepal Rastra Bank (NRB) and IDA. MOI would also be responsible for the monitoring/evaluation and reporting requirements of the IEF. The policies and procedures to be finalized would cover the following principles and guidelines: (a) through the IEF, NRB would make available convertible foreign exchange for procuring imported inputs required for export production by industrial if Under Credit 1191-NEP (Cottage and Small Industries Project), IDA has initiated specific measures to develop and promote Nepal's exports. Under the IDP, an Industrial Incentives Study is to be undertaken which will examine Nepal's export policies, incentives systems, and procedures; the TA under the IDP would also provide training in the administration of the industrial incentive program (para. 3.08). In addition, the IDP will finance a Tourism Promotion Study, to assist in formulating policies and programs to increase the flow of tourist arrivals as a means of boosting foreign exchange earnings (para. 3.10). -1D- enterprises in Nepal; (b) the processing of applications of exporters for alloca- tion of convertible foreign exchange and corresponding import license in respect to their export production, would be streamlined. The facility will be used exclusively to fund the convertible (excluding Indian Rupees) foreign exchange 11 required to import inputs of industrial enterprises with exports in convertible foreign exchange. Eligibility criteria for use of the facility would be that: (a) exports would need to be evidenced by a letter of credit/firm export con- tract; (b) foreign exchange advanced will not exceed six-months of imported input requirements for export production; and (c) foreign exchange extended would be net of any amounts available from other sources such as the initial working capital loans under the proposed Credit. Z/ MDI would be encouraged to establish a prequalified list of eligible exporters. The list would also indicate the materials to be imported, quantity, and amount equivalent to a maximum of six-months requirements and the estimated timetable of the proposed importation. MOI would provide the list which would be updated regularly, to NRB and the Ministry of Commerce. The exporters' could simultaneously file their application to NRB, Ministry of Commerce and the commercial banks; the latter would open the L/C's and probably provide the working capital financing. 3.05 IDA's portion would be disbursed in two tranches of US$500,000 each; as a condition of the first tranche, NG/NRB would be required to meet its US$500,000 contribution to the IEF; the second tranche would be disbursed upon satisfactory review and approval by IDA of the utilization of the first tranche in accordance with agreed eligibility criteria and operating procedures. MOI would prepare progress reports on the utilization and replenishment of the IEF for IDA's review and comments. During negotiations, agreement was reached that HMG/NRB will ensure that the funds are replenished to ensure availability of foreign exchange to exporters under the IEF. NRB would transfer foreign exchange funds to the IEF equivalent to US$100,000 each time there is a disbursement out of the IEF in the equivalent amount. IDAWs US$1.0 million contribution would be available to the IEF for the first two years of the total NIDC's commitment period of four years. At the beginning of the third year of NIDC's commitment period, the IDA contribu- tion to the IEF would become available for financing eligible NIDC subloans. By this time, it is expected that HMG/NRB would be in a position to substitute IDAWs contribution with its own funds. HMG through NRB will on-lend the US$1.0 million of IDA funds in the IEF to NIDC for its subloans to private enterprises; however, NIDC would emphasize on-lending to export-oriented industries. Actual NIDC utilization is expected over four years from the date funds are available to NIDC, which should provide sufficient time for HM/NRB to plan for the periodic XJ Based on the total merchandise exports in convertible foreign exchange for FY82, a fund of US$1.5 million would meet about 2-1/2 months of the foreign exchange requirements of exporters estimated at about an average of 15Z of the value of exports. VI These would meet part of the initial foreign exchange requirements only and HMG/NRB would fund any succeeding and recurring foreign exchange needs out of its ovu funds as is the normal procedure or out of the IEF for exporters. -11- replenishment of IDA's portion in the IEF with its own foreign exchange funds. For NIDC, this would mean a total commitment and disbursement period of four and six years respectively. During negotiations, agreement was reached on the objec- tives, policies, eligibility criteria and proposed operational procedures for the Import-Export Facility as well as HMG/NRB assurance that the IEF would be main- tained as a permanent revolving facility for exporters. 3.06 Leather Subproiects. In preparing this project, special attention was given to the leather subsector since it is export-oriented and labor intensive, uses local raw materials, and offers scope for expanding domestic processing and improving competitiveness in the export market. A leather subsector study was prepared by Tropical Products Institute (TPI) and financed by IDA which iden- tified two important subprojects. These would involve: (a) the upgrading and expansion of the hide collection system of Raw Hide Collection and Development Corporation (RHCDC); and (b) balancing and rehabilitation of the tannery section of Bansbari Leather and Shoe Factory (Bansbari) as well as expansion and modern- ization of its footwear section (paras. 5.05-5.09). RHCDC and Bausbari with the assistance of LICC, would finalize the feasibility reports for NIDC's appraisal and financing would be available under the proposed Credit through the NIDC subloan component. As in other subloans under the Credit, NIDC's decision would be subject to IDA's review and approval. Since RHCDC and Bansbari are public sector enterprises, whereas NIDC's financing is normally limited to private sector enterprises, agreement was reached during negotiations that NIDC's financ- ing of these subprojects would be arranged possibly as exceptions in view of EM's repayment guarantee. Standard NIDC terms and conditions would apply except for the following arrangements: (a) repayment of NIDC subloans to RHCDC and Bansbari would be guaranteed by HMG; and (b) upto 30% of eligible expenditures of the approved subprojects could be financed out of the IDA Credit in the form of H1Gfs equity in RHCDC and Bansbari. j/ Recent estimates indicate the following possible utilization out of the proposed credit: US$350,000 as subloan and US$150,000 as equity for RHCDC and US$950,000 as subloan and US$400,000 as equity for Bansbari. Financing of both projects would amount to Us$1.85 million or 29% of the proposed NIDC subloan component. C. Technical Assistance Component 3.07 Industrial and Export Incentives. Nepal's new Industrial Enterprises Act (IEA) and Foreign Investment and Technology Act (FITA), emphasize private industrial investment with the objectives of export promotion and efficient import substitution, particularly in labor-intensive enterprises with strong employment impact. Within the overall objectives of its current five-year development plan, HIr has also adopted a Special Program for Industry for FY83-FY85. Projects have been identified for establishment, where possible, with jj IDA and NIDC would disburse the proceeds of the Credit under the usual dis- bursement procedures, as adopted under IDA Credit 705-NEP. -12- private sector participation jj; HMG also, plans to achieve fuller capacity utilization in existing firms, and rehabilitate potentially viable industries which are operating at low levels due to management problems, inadequate infrastructure, or shortages of imported raw materials. HM is prepared to assist domestic industries with appropriate monetary and fiscal incentives par- ticularly those under the Special Program. While taking actions to achieve objectives under the Special Program, HMG remains concerned that the existing incentive measures have so far had little effect on private industrial investment and exports. There is a strong preference among investors for trade, real estate and construction which yield more rapid and attractive returns than industrial projects and especially export projects. Mission analysis indicates that the problems in the present industrial and export incentives include that: (a) many policy measures outlined in the Acts have either not been translated into opera- tional regulations, or have been interpretted conservatively, thus undermining confidence of present and potential entrepreneurs; (b) incentives for exporters are inferior to those provided under the previous dual e=change rate system, which provided exporters a highly attractive exchange rate for third country exports; and (c) multiple categories with differential incentives to industries of different sizes and locations were incorporated, which has made implementation of these policy measures cumbersome. To help address these issues, the IDP would finance a study to: review the existing package of industrial incentives and analyze its impact on industry; recommend more effective industrial incentives; and devise measures to improve institutional arrangements and procedures and provide necessary training for effective implementation. HME's Department of Industries will execute the study involving consultancy assistance and manpower training at a cost of about US$100,000. The terms-of-reference for this study, which have been discussed and agreed with HMG, were confirmed during nego- tiations. 3.08 The Light Engineering Subsector accounts for about 5X of industrial employment and 3% of value-added, which is low given the importance of the sub- sector for industrial development. Import substitution prospects are reasonable, as indicated by the findings of an IDA-financed study on electrical goods and accessories. .j Some simple equipment, including household stoves, agricultural implements, and consumer goods could be made by labor-intensive medium-scale 1/ In industries such as paper, sugar, food processing, textiles, shoes, dry cell batteries, cement, brick and tile, metal pipe, electrical goods, zinc, leather, gelatin and beer manufacturing. Sector studies have been prepared under IDA assistance in the leather and electrical accessories subsectors. 21 In November 1982, Kirloskar Consultants (India) and ISC completed the Elec- trical Goods and Accessories Subsector Study, financed under TA Credit 659; the study indicates that of 11 product groups, 9 could be manufactured in Nepal, viz. distribution transformers, light bulbs, electric fans and motors power capacitors, aluminum ACSR rods, energy meters, electrical components, radio receivers and wet cell batteries. Electric irons and LT insulators were found to be unfeasible. -13- enterprises. The subsector consists of: small unorganized units producing simple metal products such as handtools, utensils, construction hardwares, metal containers and crafts; general engineering workshops which fabricate agricultural implements, water turbines, suspension bridges, roof trusses and other metal products; engine repair workshops; and foundries. There are five training institutes and centers, but there is much underutilized capacity, inadequate raw materials, shortage of skilled manpower, lack of up-to-date equipment and poor product quality and design. The IDP would finance a study of the light engineer- ing subsector with the objective of formulating a development strategy. The study would: review the status of the industry and policies affecting the sec- tor, identifying major constraints; identify potentially viable product groups, and required ancillary services, and activities possibly assisted by foreign technical partners indicating the relative priorities of such products and serv- ices; assess which incentives would be needed to promote efficient import sub- stitution activities; and specify institutional support needs, including credit, manpower development, and technical services. ISC will execute the study, with external consultancy at a cost of about US$50,000. The terms-of-reference have been discussed and agreed with H)G and ISC, and confirmed during negotiations. 3.09 Tourism Promotion. In FY83 the tourism sector generated about Rs 950 million (US$67 million) in foreign exchange receipts, increasing by IlZ from FY82 compared to a 28X increase in the previous year. The receipts in convertible currencies (i.e. net of receipts in Indian rupees) decreased from Rs 617 million in FY82 to Rs 494 million FY83. Since FY79, the total number of tourist arrivals has remained at about 160,000 while the proportion of non-Indian tourists declined from 77% in FY79 to 70% in FY81. Investments in tourism-related projects, notably hotels, increased in anticipation of growth in tourist arrivals, which did not materialize. As a consequence, occupancy rates have been very low, averaging about 36% in FY81, causing serious financial difficulties in many hotels; this is reflected in NIDC's increasing arrears from hotels/tourism projects. Given the underutilization of hotel capacity and relatively adequate state of infrastructure services for the sector, the immediate need is to increase the flow of visitors by a strengthened promotion and marketing program and by improving air access to Nepal. Recently, KMG has taken a number of measures to improve air access, including a more liberal aviation policy. j/ The IDP would finance a Tourism Promotion Study which would: analyze the major factors causing slow growth in tourist arrivals; review and assess the adequacy of air passenger services; recommend specific measures to promote an expanded tourist flow; and outline a program for tourism marketing, with estimated financ- ing requirements. Consultancy services would be provided at a cost of about US$50,000. The terms-of-reference for this study, which have been discussed and agreed with the Secretary of Tourism and Chairman of RNAC, were confirmed during negotiations. Id Rights have been granted to bi-weekly chartered flights to a European operator; Royal Nepalese Airlines Company (RNAC) has expanded its routes including most recently Karachi and Hong Kong and plans to service Singapore, Japan, and China. -14- 3.10 TA for the Leather Group. Since 1978, the leather industry has received some technical assistance support, mainly from UNIDO; one private Nepalese com- pany and Bansbari have received technical assistance from private foreign firms, mainly from Germany. Having screened the range of technical assistance com- ponents presented by the TPI/ISC study, the IDP vould provide a total of US$550,000 for consultancy and advisory services, training and logistical support to LICC, the implementing agency, and to the individual companies. The details of the technical assistance program for the leather sector under the IDP are discussed in Chapter V. 3.11 NIDC Technical Assistance. NIDC has entered into an agreement with the Industrial Credit and Investment Corporation of India (ICICI) to implement an institutional assistance program, which would be funded by KfW, one of NIDC's major creditors. Ihis program would involve: deputation of senior ICICI staff to NIDC to work closely with NIDC counterparts, focusing on management informa- tion, loan recovery, market analysis, systems for project evaluation and monitor- ing, problem project treatment and financial planning. A short-term training program on specific topics would also be organized as part of the program in Nepal; selected NIDC staff would be provided with on-the-job training at ICICI's offices in Bombay. 3.12 To complement ICICI's institutional assistance program, the IDP would provide US$50,000 for consultancy services to develop and assist in conducting a "projects course" and technical and entrepreneurial development workshops in NIDC; the projects course would initially be opened to NIDC's operating staff although for succeeding courses, plans include accommodating the staff of other financial institutions and other relevant ministries such as department of industries, ISC, and the Planning Commission. The course is expected to provide practical tools on project preparation, evaluation, and implementation using Nepalese case studies to be prepared by NIDC with the assistance of a consultant. The consultant will also assist to initiate a workshop for NIDC's clients in project financing, implementation, and management including specific NIDC proce- dures on loan disbursements. When implemented, the above training strategy should lead to improviug the quality of industrial projects undertaken in Nepal. 3.13 An amount of US$35,000 is allocated to fund the foreign exchange cost of "on the job" training of selected NIDC staff; this training would be undertaken with other development finance companies (DPCs) experienced in follow-up activities and rehabilitation of problem projects, (para. 4.11). This would be important support to NIDC's new Special Cell which handles the increasing numbers of problem projects. -15- D. Summary Components and Costs 3.14 An IDA Credit of US$7.5 million is proposed for an Industrial Development Project in Nepal with the following components: I. Credit Components (US$ 000) A. NIDC Subloans: 5,500 B. Import/Export Facility 1.000 Sub-Total 6.500 II. Technical Assistance A. Industrial Incentives Study 100 B. Light Engineering Study 50 C. Tourism Promotion Study 50 D. TA Program for Leather Sector 550 E. NIDC Technical Assistance 85 F. Contingencies 165 Sub-Total 1.000 Total Credit US$7,500 The total project cost is estimated at US$ 12.0 million equivalent broken-down into US$ 7.5 million from IDA Credit (68Z), US$ 2.8 million from subproject sponsors (27Z) and US$ 1.7 million from HMG/NRB (5Z). IV. NEPAL INDUSTRIAL DEVELOPMENT CORPORATION A. Institutional Aspects 4.01 The first IDA Credit line to NIDC was approved on May 3, 1977, became effective on February 17 1978, and was committed fully by March 31, 1982; as of October 31, 1984, disbursements amounted to US$3.4 million or 85x. The implemen- tation of this credit encountered some problems, including: inadequate domestic resources for NIDC to implement some of its subprojects; institutional weaknesses in NIDC's financial planning and reporting; frequent changes in top management; and inadequate subproject supervision in the early stages of implementation, causing slow utilization of the Credit. Principally due to the inadequate provi- sion of domestic resources by EB)INRB for NIDC's projects, Credit 705-NEP was informally suspended j/ for about 14 months (July 15, 1980, to September 9, 1981). With the assistance of HME and IDA, NIDC has improved operations sig- nificantly and has taken appropriate actions to upgrade its performance. NIDC has issued debentures in local currency and increased its equity; quarterly XJ It was agreed IDA would not authorize new subloan requests from NIDC. -16- management information reports jj are prepared; management is monitoring opera- tions closely, particularly disbursements and collections. Mr. R. N. Dhungel, NIDC's General Manager since 1981, has initiated important changes in NIDC's policies and organization. These include: diversifying its portfolio by promot- ing industries other than tourism/hotel projects and certain agro-based projects; amending NIDC's charter to strengthen its legal powers against defaulting clients; introducing intensive case by case follow-up of clients in arrears, and establishing a special cell for problem projects; and ensuring coordination and assistance from zonal and district administrators in NIDC's collection efforts. Also, NIDC recently has made an arrangement with ICICI, the strongest development bank in India, in which selected NIDC staff will receive on-the-job training at ICICI in project appraisal, supervision and accounting systems and ICICI staff will provide on-the-job training for NIDC staff in Kathmandu. These aspects have been incorporated in NIDC's draft Statement of Operational and Financial Policies and its Strategy Statement for FY85-FY88. The Statements and related institu- tional upgrading measures were confirmed during negotiations, and approval by NIDC's Board would be a condition of effectiveness (para. 8.02). 4.02 Board and Management. NIDC was established in 1959, under a special Act, to take over the functions of an Industrial Development Centre which had been established in 1957 under Nepal's First Five-Year Plan (FY56-FY61); about 95% of NIDC's shares are owned by the HMG and the remaining 5% by NRB. The Act provides for eight members on NIDC's Board of Directors, including a chairman and a general manager appointed by llMG, and two members representing private trade and industry. As of end FY84, three members, including the Chairman, are from the Ministries of Finance aud Industry; one member represents NRB; and two represent Nepal's chambers of commerce and industry and the private sector. NIDC's general manager is also the Board's Secretary and recently, NIDC's two deputy general managers have been invited to attend Board meetings; this move is extremely useful as it promotes communication between management and the Board. Also, the chairman of ISC was a permanent invitee to NIDC's Board, to provide policy advice and ensure coordination between ISC's project promotion and NIDC's lending. NIDC's Act also allows the nomination of up to four Board Advisors with the approval of HMG. Under the IDP, NIDC plans to invite an IDA representative to some of the meetings of its Board particularly when major institutional and policy matters are involved. 4.03 During the implementation of InA's first credit line to NIDC (Credit 705-NEP), one major concern has been the frequent changes of NIDC's General Manager. However, there has been an improvement in the tenure of the last two General Managers. NIDC's current General Manager, Mr. R.N. Dhungel, was appointed in November 1981 for an initial tenure of four years which is adequate; he is the first appointee from within the organization; he is experienced in development banking and knows the organization well. Mr. Dhungel continues to initiate changes in NIDC's organization, policies, and procedures which are appropriate and contribute to improvements in NIDC's operations. 1/ Progress reports are submitted to ID& which would continue under the proposed Credit. -17- 4.04 Organization and Staffins. NIDC s organization (Annex 5) is composed of ten basic divisions and four regional offices; two divisions (internal audit and research/planning) report directly to the General Manager; three divisions and regional offices report to a Deputy General Manager for Operations; another Deputy General Manager for Ac-inistration supervises four divisions. In the last five years, NIDC's organization has evolved in response to its growing level of operations and the need to address major issues. Divisions were split to recog- nize the growing importance of project development and promotion, project monitoring and follow-up, financial planning, and training. NIDC has been able to maintain a reasonably low turnover (less than 10X annually) of professional staff which numbered 100 as of the end of FY84. NIDC continues to emphasize training through in-house trainiL- courses and selected short-term orientation courses and few short-term foreign training courses. The IDP would provide technical assistance funds to develop a projects course and technical workshops in NIDC as well as to finance foreign training in supervision, particularly of problem projects (paras. 3.12, 3.13). B. Policies and Stratezies 4.05 Lending Policies. NIDC's Investment and Operational Policies are guided by its Act, with attention given to maintaining H1's industrial policies and priorities. A draft of NIDC's updated Statement of these policies is shown in Annex 3, which was discussed and confirmed during negotiations; approval by NIDC's Board would be a condition of effectiveness. This Statement provides a satisfactory framework for NIDC to extend financial assistance to industrial enterprises in Nepal; requirements of cottage and small industries are provided by the commercials banks, principally through IDA's Credit 1191-NEP (Cottage and Small Industry Project). NIDC's Policy Statement provides for a minimum finan- cial assistance of Rs 50,000 and a maximum amount equal to 25% of its networth (currently about Rs 53.0 million or US$3.1 million) or 70% of the total project cost whichever is lower. NIDC is also required to maintain a maximum debt:equity ratio of 5:1. For its first IDA credit line (Credit 705-NEP), the maximum sub- loan was US$1.0 million to ensure financing of a range of subprojects (para. 6.04). Under the IDP, the limit would be increased to US$1.5 million; this reflects the increasing costs of projects, but should still cover a reasonable range of medium and large subprojects; the new limit is 23Z of the subloan component compared to 25% in NIDC's first credit line. NIDC occasionally receives larger applications which normally are treated as special projects for which HMG or bilateral financing is available and relent through NIDC. Nonethe- less, the IDA Credit would be available for consortium financing arrangements, to reduce NIDC's financial exposure and risks, and to encourage equity involvement by foreign technical partners involved in these larger projects. 4.06 Operating Strategy. NIDC's draft Strategy Statement for FY85-FY88 is shown as Annex 4. This Statement was discussed and agreed during negotiations and approval by NIDC's Board of Directors would be a condition of Credit effec- tiveness. This Statement has been formulated not only to achieve improvements in NIDC's operations and procedures but also to expand and improve its promotional and advisory assistance for clients and prospective entrepreneurs in Nepal. The main features include that: NIDC (a) would not financc new hotel projects in the -18- Kathmandu area in view of its high exposure (54X of total portfolio) in the hotel/tourism sector; (b) NIDC would emphasize financing of export-oriented projects; (c) would improve its standards and procedures for subproject appraisal and implementation, with increased attention to providing technical assistance to its clients; (d) NIDC would implement the institutional development program agreed with ICICI; and (e) NIDC would intensify its follow-up and collection efforts. Collection targets have been set so that NIDC's debt service coverage ratio is at least 1.1 times (paras. 4.11). 4.07 NIDC Act. Since NIDC's inception, its Act has been periodically amended; two major amendments were approved in 1984. The first amendment adds a specific provision which would enable NIDC to share the collaterals on its loans with other persons or institutions; this would help promote co-financing which has been possible only with NIDC's guarantees which increase rather than reduce NIDC's exposure to a given subproject and increase the cost to industrial bor- rowers (para. 3.02). The second amendment refers to Section 21 of its Act which empowers NIDC to take possession of and sell mortgaged assets upon defaults of its clients; this method of loans recovery is protracted. Consequently, the assets remain unmaintained, resulting in deterioration in condition and value, thus threatening the eventual sale and adequate recovery. NIDC's amendment would provide it the option to manage or have managed the foreclosed properties until the assets are sold. This amendment is important, since it would improve NIDC's collection, as well as encourage higher utilization of productive assets. As agreed during negotiations, changes in NIDC's Act, NIDC's Policy Statement and Strategy Statement would be subject to prior approval by IDA. C. Standards and Procedures 4.08 Promotion. Since 1974, when the Industrial Services Center (ISC) was established as a spin-off of NIDC's Industrial Planning and Feasibility Division, project identification and preparation has been the primary responsibility of ISC. NIDC and other organizations hire ISC to prepare feasibility studies on potential projects; such feasibility studies have served as the main source of subprojects financed by NIDC. This arrangement has worked reasonably well. Through its Project Development and Promotion Division (PDPD), NIDC regularly advertises potentially feasible projects; regional industrial tours in collabora- tion with the chambers of commerce and industry also are undertaken. Interested entrepreneurs are provided with more detailed project profiles. In view of the limited supply of experienced entrepreneurs in Nepal, NIDC needs to do more than match potential entrepreneurs with viable subprojects; NIDC needs to take active measures to capture and sustain an entrepreneur's interest and reinforce his capabilities. With initial assistance from ICICI, NIDC plans to conduct workshops for prospective entrepreneurs and for those for which financial assis- tance have been approved. 4.09 Appraisal. Project appraisal is undertaken by project teams which provide interaction among analysts of different disciplines. Under Credit 705-NEP, NIDC's appraisal standards were improved and are now of reasonable quality. For medium and large projects, NIDC calculates economic as well as financial rates of return; these will continue to be required under the IDP. The -19- problems in many of NIDC's subprojects are rooted in the difficult environment, and the inexperience and vasilating commitment of entrepreneurs. These difficul- ties have led to slow project implementation, with related cost overruns and financing squeezes. As part of its strategy to improve appraisal standards and quality of projects financed, NIDC will give greater attention to: (a) getting feedback on project implementation, particularly on past due accounts; (b) analyzing performance and problems in key subsectors as a basis for judging new investments; (c) ensuring clients' compliance to pre-establishment require- ments as formulated by NIDC during appraisal; and (d) arranging joint financing with commercial banks and higher equity contributions, to reduce NIDC's exposure. These steps should lead to more accurate estimates on project costs and implemen- tation schedules. ICICI will assist in implementing these steps. 4.10 Implementation/Disbursement. NIDC tends to be fairly cautious in its loan processing, partly due to the assistance clients need in the detailed preparation and planning their subprojects. To facilitate monitoring of project implementation, NIDC has initiated a system of formulating a time-bound list of activities agreed with each client after loan signing. The Project Implementa- tion Division (PID) reviews the status of projects and prepares monthly reports specifying next steps for NIDC including a project completion report. Loans are disbursed by reimbursing actual capital expenditures according to an agreed debt/equity ratio. This is appropriate since it ensures the sponsor's equity contribution and proper application of the loan proceeds. However, NIDC's experience shows that timely availability of equity funds is one major cause of delay, which is further exacerbated when these delays lead to cost overruns which can affect project viability. NIDC's loan conditions with regard to the equity aspects are reasonable, although problems with equity availability in later phases of implementation are difficult for NIDC to control. As a policy, if initial utilization of subloans is not made within three months from the date of approval letter, NIDC provides for the cancellation of the subloan. However, in practice, many subloans remain committed but unutilized for longer periods. This ties up large amounts of funds for projects which may not be implemented and need to be reappraised. For these subloans, NIDC should be prepared to exercise its remedial options firmly during the implementation stage. These include suspension or cancellation of loans and reappraisal of projects A1 which is costly and difficult but necessary to ensure viability and prevention of future problems. 4.11 Follow-up/Collections. NIDC would seek to improve its follow up and collection performance maintaining: an annual debt service coverage ratio g/ (DSCR) of at least 1.1; and total arrears in principal and interest not exceeding |j These should be referred back to the Project Analysis Division (PAD). 21 Defined as net profit after taxes plus total cash collection of principal Plus total interest expensed Plus non-cash charges less uncollected interest income divided by total interest expenses Dlus total principal payments on NIDC's debts. -20- the amount of unimpaired paid-in capital and reserves. These were agreed during negotiations as part of NIDC's Strategy Statement; in addition, a condition in the credit agreement has been made which would provide IDA the option to withhold approval and authorization of subloans under the Credit if NIDC does not comply with these criteria and if remedial measures which are satisfactory to IDA are not taken. As part of its semi annual progress report, NIDC would provide IDA its DSCR, and the amount of interest and principal in arrears, and NIDC's net- worth. jj NIDC expects to meet these criteria through the following actions: (a) setting quarterly collection targets based on a project-by-project review by the Project Monitoring and kvaluation Division (PMED); (b) undertaking analysis of problem projects by a special cell in PHED; (c) implementing a clearing arran- gement agreed with the commercial banks and HMG's licensing department on NIDC's defaulting clients; (d) coordinating and securing assistance from HMG's zonal and district offices in its collection efforts; and (e) charging a penalty rate of 7% for late payments. 21 Through its new special cell, NIDC has initiated a more comprehensive analysis of problem projects on the basis of which NIDC will provide assistance in helping clients improve their operations. The institu- tional assistance program with ICICI will help address these aspects. In addi- tion, to assist in developing NIDC's expertise in supervision and collections, the technical assistance component of the IDP will finance the foreign exchange cost of a two- to three-month "on the job" training of two or three selected staff of the special cell with other DFCs with substantial experience in handling problem projects. 4.12 Procurement. NIDC requires a minimum of three valid quotations from reputable suppliers; the sponsors indicate their choice and should provide satis- factory justification considering price, dependability of supply, availability of spare parts and after sales service, completeness of the offer, performance guarantee, and arrangements for installation and training where necessary. Out- side consultants are used for complex projects although NIDC staff are competent to advise clients on most projects, particularly in major subsectors financed by NIDC, e.g. oil, rice and flour mills. India remains the largest supplier of machinery and equipment; 21 this is due largely to the level of technology used in Nepal, price, transport cost advantage, and ease of obtaining spare parts. Since the validity of quotation is normally for up to six months, NIDC should focus on timely implementation to avoid price escalation, and avoid delays caused by the need for rebidding. NIDC's procurement procedures are satisfactory and conform to the Bank's standard practice for DFCs. i} This could be based on proforma figures to be confirmed by NIDC's audited financial statements (para. 4.26). 0 To encourage earlier settlement of overdues, the penalty rate is reduced to between 4' to 6.5% if payment is made within 3 months to 24 months after which the full 7% is applied. 0 In FY81/82, India accounted for about 43% of total imports of machinery and transport equipment. -21- 4.13 Manazement InformationlAccounting. With the assistance of an advisor and IDM, NIDC has improved its management information and accounting systems. It prepares regular operational data in a satisfactory form; its accounts are adequately audited. An annual long-form audit report on NIDC's operations and financial accounts would continue to be submitted to IDA not later than five months after the end of its fiscal year. D. Operational Performance 4.14 L2ndini Operations. A summary of NIDC's operations for FY79-FY84 is provided in Annex 6. NIDC's operations suffered a set-back in FY80 when its disbursements declined by 43% due to shortages in local currency resources (para. 4.01). Since FY79, NIDC-s level of business has grown, averaging about Rs 60-70 million per year from Rs 40-50 million p.a. in the preceding five years. Commitments and disbursements have accelerated since FY82 after the informal suspension of the First IDA Credit was lifted in September 1981 (para. 4.01); there is a strong indication that project sponsors are now more active in moving projects into implementation. This trend and level of operations are expected to continue based on NIDC's relatively large uncommitted approvals and pipeline of projects (para. 4.28). 4.15 Portfolio Characteristics. Since its inception until the end of FY83, NIDC has approved total 'inancial assistance amounting to Rs 584.6 million; .j this is broken down into Rs 496.6 million in loans, to industrial ente2prises, Rs 54.2 million in equity investments, and Rs 33.8 million in guarantees. Tourism accounted for Rs 226.9 million (78 projects) or 39% while manufacturing (including power and transportation) accounted for Rs 232.02 million (321 projects) or 61%; of the latter category, the major subsectors included food (27Z), forest-based products (10%), mining and minerals (8.7%). Most of the projects are new enterprises and concentrated in the central region (Katbmandu Valley, Bagmati, Narayani, and Javiakpur areas). Tourism is a major sector in Nepal and accounted for 54% of NIDC's outstanding portfolio with 40% in the manufacturing sector of which 28Z was in the food industry (Annex 7). The IDP will assist the tourism sector not through financing of additional facilities since these are presently adequate, but through appropriate tourism promotion (para. 3.08) to increase tourist arrivals as a means to boast foreign exchange earnings and improve the performance of NIDC's clients in the sector. 4.16 The average loan of NIDC is Rs 1.5 million (US$95,000 equivalent). Excluding a few very large projects, this average is much lower mostly covering small- and medium-sized projects (upto Rs 10.0 million in fixed assets invest- ments). Loan maturities range from 5 to 15 years, although over 50% have repay- ment periods o' 10 years and longer. In FY81, exports of NIDC's projects are estimated at about Rs 250 million equal to about 15% of total exports; these /J Rs 8.74 million was disbursed to 414 cottage and village industries; NIDC discontinued this operation from 1976 as responsibility for CSI lending has shifted to commercial banks. -22- projects account for about 20Z of industrial value added. NIDC's assisted projects have an estimated Rs 2.0 billion in assets and have directly generated about 22,000 jobs i/ at a cost of about Rs 90,000 per job or US$5,700 per job. 4.17 Equity Investment. As of July 15, 1984 NIDC's equity portfolio stood at Rs 80.2 million (38% of its networth) invested in 24 companies. Ten companies are known to be operating profitably while only four have paid dividends equiv- alent to only 3Z of NIDC's investment; seven are operating at a loss and five are still under construction. Rs 4.9 million are in preference shares of two com- panies on which Rs 0.4 million in dividends have accumulated but have not yet been received. Together with NRB, NIDC has invested Rs 1.7 million in the Security Marketing Centre, Ltd. NIDC has controlling interests in six companies, of which two companies 21 account for 58Z of total equity portfolio. In these cases, NIDC is also a major creditor; although it is NIDC's policy to gradually divest its shareholding, this would be extremely difficult, given the absence of a securities market and poor profits of some of the projects. It is, thus, imperative for NIDC to be extremely cautious in undertaking these dual and often conflicting roles. In 1984, NIDC made an investment of Rs 3.0 million in common shares and Rs 5.2 million in preferred shares of Nepal Arab Bank, Ltd. which is a private commercial bank organized as a joint venture with Dubai Bank; NIDC is represented in its Board which should facilitate co-financing of NIDC's sub- projects. 4.18 Local Currency Resources. NIDC's sources of local currency funds are HMG in equity subscriptions, and NRB in loans debentures and some equity. As of July 15, 1984 NIDC had a networth of Rs 213.4 million 21 equal to 41% of total assets; loans from and debentures held by NRB were Rs 81.5 million and Rs 100.0 million respectively. These local currency resources account for 75% of NIDC's total assets. Beginning in FY82, NIDC issued its debentures at rates of 8.5% and 9.5%; these debentures are tax-free, guaranteed by HEN and repayable on the fifteenth year fron date of issue. To date, the only buyer is NRB; at the cur- rent cost of 9.5%, NIDC has a gross spread of 2.5% and a net spread of less than 1.5% after deducting HMG's guarantee fee and NIDC's interest rebate. 4.19 Foreign Currency Resources. At the end of FY84, NIDCrs outstanding foreign currency resources stood a Rs 93.1 million equivalent or 19% of total resources. IDA accounted for Rs 43.7 million (47%) representing disbursed amounts of Credit 705-NEP. Outstanding KfW loans in local currency were Rs 21.8 million with an undisbursed balance of about Rs 26.0 million (US$1.5 million). jj NIDC estimates about 110,000 more in indirect job created mainly from hotel-related services. 3/ Nepal Livestock, Ltd. and Himal Cement in which NIDC's share is 97% and 84% respectively. jI Rs 190.3 million in paid-in capital and Rs 23.1 million in reserves; NIDC's paid-in capital was increased by Rs 20.0 in FY83 and by Rs 18.5 in FY77. -23- The balance of Rs 27.6 million represented loans from USAID, and governments of Denmark and India, all of which has been disbursed. KfW and IDA credit lines are untied funds. NRB absorbs the foreign exchange risks on all NIDC foreign cur- rency borrowings through the reimbursement of exchange losses and does not charge a fee to NIDC or its subborrowers. The bulk of the subprojects under the proposed Credit are expected to be small- and medium-sized projects and exchange risk should continue to be absorbed by HMG/NRB without a fee in line with its policy to promote private industrial investment. In addition it is proposed that HMG directly absorb the exchange risk to avoid the cumbersome accounting in collecting exchange losses. Agreement was reached on this modification during negotiation and would also be reflected in the subsidiary loan agreement between NIDC and HM. 4.20 NIDC Terms. Annex 2 shows the deposit and lending rates of commercial banks and financial institution in Nepal. NIDC follows these rates, which are determined in consultation with NRB. Since 1976, NIDC discontinued lending to cottage and village industries. NIDC's lending rates are in line with those of the commercial banks and were increased by one percent to 121 for fixed capital and 151 for working capital effective from June 15, 1982; jj for industries producing luxury or semi-luxury items, a uniform rate of 17% is applied. During the commitment period of the proposed credit, inflation is projected to range between 6% and 91 per annum and NIDC's lending rates would remain substantially positive in real terms (para. 2.22). The IDA funds will be onrlent to NIDC at a rate of 7% for fixed capital and 10X for working capital, providing a spread of 4% after deducting the one percent rebate. This spread should be adequate to cover NIDC's overhead costs and required debt provisions, as well as providing a reasonable profit margin. The loan would be repayable in a fixed amortization period over 18 years including a grace period of 5 years. These lending terms were discussed and agreed during negotiations. The on-lending rates would be reviewed annually and adjusted when necessary, to maintain a positive real lend- ing rate and consistency with commercial bank lending rates. 4.21 Credit 705-NEP was relent to 25 subprojects, with an average loan size of US$134,000. Ten subloans were above the free-limit of US$80,000 of which two subloans were for US$1.0 million, the maximum amount allowed under the Credit. IDA reviewed 40% of the subloans by number and 85% by amount. The subprojects reviewed showed ex-ante financial rates of return of 15% and above and economic rates of return of over 17Z. NIDC's experience on these projects has shown some weaknesses such as slow project implementation, cost overruns, inadequate working capital, lags in entrepreneurial interest and lack of competent management. NIDC has adopted appropriate policies and a strategy (paras. 4.05-4.06) to address these weaknesses. Implementatiou of these measures would be assisted under the IDP, particularly through the technical assistance components. 3/ The increase was based upon IDA recommendations under the Nepal CSI project. Prior to this date, NIDC rates were one percent lower for undeveloped areas and one percent higher for specified developed areas such as Kathmandu, Biratnagar, and Birganj. -24- E. Financial Performance 4.22 Profitability. Annex 8 shows NIDCs summarized income statements for the years ending July 15, 1980 to 1984. NIDC showed reasonable profits although it only managed an average of 3.0% return on equity, due to a large equity base which averaged 42% of total resources. As a result, NIDC had an accounting gross spread on total resources of about 4.5% while its marginal gross spread on bor- rowed funds was only 3%. Administrative and general expenses have been main- tained at a reasonable level of 1.6% of total assets while the cost of borrowings has increased from an average of 5.4% in FY79 to 9.0% in FY84. Under the IDP a net spread of 4% is proposed which is reasonable and adequate to cover overhead costs of about 1.5%, provision for bad debts of 1.0%, plus 1.5% in profit margin before taxes. 4.23 Portfolio Quality. Annex 9 provides NIDC's collection performance and arrears position. Its collections were lowest in FY81 with a collection ratio of only 29% (49% in M80) which resulted in a debt service coverage ratio (DSCR) of slightly below unity and a significant increase in arrears from Rs 39.8 million to Rs 69.1 million. With the assistance of HMc and NIDC's concerted efforts, its collection in FY82 and FY83 improved to Rs 48.9 million and Rs 56.7 million respectively (twice the level of FY81), which enabled NIDC to attain a satisfac- tory DSCR of more than 1.3 times and a higher collection ratio of 35%. However, the amount of arrears continued to rise reaching Rs 113 million in FY84; these arrears have been contained to less than 30Z of NIDC-s portfolio, but the per- centage of its portfolio affected by arrears was about 75%. Although NIDC managed to maintain a satisfactory DSCR due mainly to a substantial equity base which was equivalent to almost double the amount of arrears at the end of FY84, NIDC will continue to intensify its collection efforts (para. 4.11); and it has also adopted collection targets to achieve a minimum DSCR of 1.1 times. Con- ditionality have been provided under the IDP for NIDC to meet minimum financial standards on its collection performance; in the event that these are not met and remedial measures satisfactory to IDA are not taken by NIDC within a period of two months after having been advised by IDA, IDA would have the right to withhold approvals and authorizations of subloans under the Credit. 4.24 Financial Position. Annex 10 shows NIDC's summarized balance sheets for FY80-FY84. Due to its substantial equity base, NIDC has a strong financial position. Given the nature and stage of industry in Nepal (para. 2.07), NIDC's capital structure is appropriate to handle its development financing activities which are focused on smaller and new projects, and relatively inexperienced entrepreneurs. During the five year period (FY80 to FY84), NIDC's total assets have grown at 10% per year to Rs 525 million; its borrowings grew at a faster rate (15.0%) than its equity (6.5%) resulting in a higher contractual debtlequity ratio of 1.4 in FY84 compared to 1.13 in FY80. NIDC plans to raise a proportion of debts through foreign exchange borrowings from KfW and IDA. and NIDC's local currency debentures; however, total borrowings are expected to increase to less than twice its equity (para. 4.29) by FY88 which is still low and well within the -25- maximum debt/equity ratio of 5:1 proposed under this Credit. 1/ Maintenance of this ratio was confirmed during negotiations. 4.25 On the average about one-third of profits before taxes are appropriated to cover potential bad debts; NIDC's accumulated provisions 2 were equivalent to 5% of loan portfolio or 15% of its total arrears; these provisions are reasonable, particularly considering NIDC's equity base, relatively low dividend payout, ZJ improving collection performance and adequate collateral coverage. 4.26 Audit. Under its first credit line, NIDC has been preparing a comprehen- sive long-form audit of its financial and portfolio accounts. It has been the practice for the auditor-general to subcontract NIDC's annual audit to an inde- pendent external audit for a term of three years. NIDC's current auditor is Sunder and Company which is reasonably well qualified. The annual audit reports have been reviewed by IDA and found to be satisfactory, although completion of the audit has been longer than five months from the end of fiscal year (i.e. by December 15 of each year) as required under Credit 705-NEP. This deadline is provides about three months from the date 41 of the General Meeting of Stock- holders wherein the auditor's report of NIDC's annual balance sheet and accounts is to be presented. F. Proiected Operations 4.27 Lending Activity. NIDC's loans grew at an average of 15% per year during FY80 to FY84. This rate is expected to continue and its total approvals 51 are projected to be about Rs 575 million during FY85 to FY88 (Annex 11); about 45% of total loans are estimated to be in foreign currency based on NIDC's actual experience. Based on NIDC's experience, commitments and disbursements would amount to Rs 487 million and Rs 340 million respectively during the same four 11 Credit 705-NEP required the same maximum debt/equity ratio. 2/ NIDC's auditors have also certitied that its provisions for bad debts are reasonable after a status review of each account and relevant collateral values; NIDC properly allocates its provisions according to the status of projects, for example, provisions for subloans under legal action are high at 40% of the outstanding arrears. SJ This has been equivalent to less than 1% of paid-in capital; dividends in the last five years averaged about 30% of unappropriated net profit. Ol First Monday after September 15 (month of Aswin) as provided in Section 26 of NIDC's Act; this short-form audit should also be submitted to IDA no later than October 15 each year as the basis of determining NIDC's compliance of DSCR and collection/arrears level (para. 4.23). 5/ Including possibly two leather subprojects identified under the IDP (paras. 3.04). -26- year period. These estimates are reasonable considering HMG's emphasis on private industry and NIDC's current large pipeline of projects (para. 4.28). 4.28 Pipeline. NIDC's pipeline of projects as of the end of FY84 consists of (a) uncommitted approvals jj of Rs 161.1 million of which Rs 99.8 million are in foreign currency loans (US$5.8 million); and (b) projects under appraisal requir- ing an estimated Rs 99.0 million in loans including Rs 76 million in foreign currency (US$4.4 million). These projects are in areas such as marble/aggregate mining, oil extraction, canvass shoes, pencil, wires/pipe manufacturing, pulp and paper, textile spinning, sugar, brick/tile factory, engineering workshops, and trekking lodges. NIDC's existing sources of foreign currency plus the proposed IDA Credit would meet about two-thirds of potential requirements (para. 4.29). 4.29 Resources. For FY84 NIDC's foreign currency resources available for commitment amounted to about US$2.0 million representing its fourth credit line from KfW; however, this would cover only its projected commitment in small and medium industrial firms Z/ with fixed assets of upto Rs 10.0 million. Projected requirements for FY85 to FY88 are estimated at US$12.0 million; the IDA Credit component of US$6.5 million for NIDC would cover about 55% projected commitments. However, a four year commitment period is proposed to take account of large projects with some tied financing, and the funds to be available from the IEF (para. 3.03) beginning in the third year of project implementation. NIDC would need to plan for additional foreign currency resources by the end of 1986. 4.30 Projected operations show a need of about Rs 60 million in local currency for the four years starting FY85. Existing local currency resources of NIDC are estimated at about Rs 39 million in cash balances. During negotiations, agree- ment was reached that HMG/NRB would make adequate funds available to NIDC for the implementation of the Project; as provided in its Strategy Statement, NIDC will ensure that sufficient funds are available before commitments are made. For subloan requests under the proposed Credit, NIDC will be required to provide information showing availability of local currency resources. This arrangement would not only ensure that NIDC is not over-committed but would also provide a mechanism to promote timely implementation and disbursements of subloans, and cancellation of slow moving projects. 4.31 Financial Projections. Annexes 12, 13, 14 show NIDC's projected income, cashflow, and balance sheet statements for FY85 to FY88. Despite NIDC's larger volume of business, its net income is expected to remain at about Rs 3.5 million level representing an average of 1.6% of equity, due to an increasing proportion of borrowings and projected higher overhead, but with an assumed fixed profit spread. However, its DSCR would be comfortably over the minimum of 1.1 (para. 4.23) assuming NIDC meets its collection targets of Rs 80 million in FY85, jj These are approvals awaiting signing of a loan agreement. 2.1 For a few larger projects, NIDC would either provide its guarantee as in a pulp and paper project (Rs 50.0 million) or secure foreign exchange from HNG which is limited and reserved for high priority projects as in a joint ven- ture for a dry-cell battery project. -27- increasing to Rs 140 million in FY88. Also, NIDC's cash balances are adequate to absorb possible shortfalls in collection and prepayment of deferred income taxes and some dividend payments. It also would allow NIDC to establish a sinking fund for the repayment of debentures, which is recommended once NIDC's collections improve and actual cash balances are more than about Rs 20.0 million. NIDC is expected to remain liquid, with its current ratio at more than 3.0 times. NIDC's contractual debt:equity ratio is projected to reach 1.8 by FY88 which is still low; equity would be used to finance over 502 of the total loan portfolio, and provisions for bad debts would average about 7% of loans which is adequate. V. LEATHER DEVELOPMENT PROGRAM A. Subsector Focus 5.01 Subsector Focus. In recent years, IDA has intensified its subsector work in Nepal, to help identify and address problems blocking growth in promising export-oriented and import-substituting product groups. j/ The proposed IDP would continue this subsector theme by focusing on the leather industry, vhich in peak years has constituted nearly half of Nepal's manufactured exports (para. 2.10). The IDP draws upon an Integrated Leather and Leather Goods Development Program, which was formulated by the Tropical Products Institute (U.K.) in association with Nepal's Industrial Services 6enter (ISC), as part of a subsector study financed under IDA's First Technical Assistance Credit 659-NEP. Z/ Key features of the industry are discussed in Chapter 2, Annex 1, and the Leather Sector Working Paper (Project File). 5.02 The leather program has been designed to address major constraints in the sector: (a) for cattle and buffalo leather, inadequate collection systems of raw materials and poor flaying and curing techniques; (b) for the poatskin leather, difficulties in export market penetration and a limited domestic market for processed skins; (c) for all leather producers, low quality of leather and leather goods, due to outdated and worn-out equipment in tanning and finishing and poor design techniques, limited market information and distribution channels. 5.03 The specific components of the proposed program embody the strategy of focusing on hide processing, since goatskin processing has adequate installed capacity and is not in need of investment credit; furthermore, there is already V Preparation for the Cottage and Small Industries Project, financed under IDA's first TA Credit (659-NEP) included detailed subsector studies in: woolen carpets and garments; metal crafts; cotton handloom products; forestry products; and selected agroindustries. Other subsector and feasibility studies have covered building materials and electrical equipment. Z/ Leather and Leather Products Subsector Study: Nepal, in two phases, Reports dated September 1980 and March 1981, by TPI/ISC. -28- in operation a reasonably efficient collection system to exploit the potential supply of goatskins. An integrated technical assistance program to various segments of the industry should help to reduce the vulnerability of Nepalese hide and goatskin producers to large shifts in external demand. This would be achieved through improving the quality of leather and leather goods for both the export and domestic markets, and through an active export promotion component, which should help Nepal regain market share in leather exports. Specifically, the project provides possible financing under the NIDC subloan component (para. 3.07) for: the expansion of the hide collection capacity of RHCDC; and modernization of Bansbari's tannery and footwear departments. Technical assis- tance in key aspects of leather collection, processing, and footwear manufacture, and export promotion also would be provided. 5.04 The objectives of the leather technical assistance components are to: assist the Government in promoting growth and upgrading the product quality in the leather group, by improving collection, flaying, tanning and manufacturing methods, strengthening measures to identify buyers and suitable foreign col- laborators. The two investment projects would increase the supply and improve the quality of hide leather and footwear products. However, with the continued recession in the world leather market, specific allocations are not being made for these two potential subprojects. Rather, during the early period of project implementation, technical assistance would be provided to RHCDC and Bansbari in finalizing the design and appropriate timing of the subprojects, determining the required financial restructuring, and improving performance on the basis of existing investments (paras. 5.11-5.13). B. Leather Sector Subprojects 5.05 Bansbari Modernization Subproiect. The Bansbari Leather and Shoe Fac- tory, Ltd. (Bansbari), established as a public sector enterprise with Chinese aid in 1961, has an installed capacity for processing about 300 hides a day, but is processing about 100 hides daily due to suboptimal plant layout, some obsolete machinery and equipment and weak demand for the relatively low quality output. As a result, output is well below Bansbari's breakeven level. Bansbari's finan- cial statements (Working Paper 2) show accumulated losses of Rs 9.3 million as of July 15, 1983 against an authorized share capital of Rs 25 million, of which Rs 24 million was paid up. The company's share capital has been diluted and new equity infusion may be required. The Tannery Department showed a profit in FY81 as a result of a strong market for leather, as well as the dual exchange rate system which increased the profitability of leather exports (para. 2.05). The elimination of bonus entitlements and the unification of the exchange rate reduced incentives to export. Recently, most of the output from the tannery section was consumed by Bansbari's footwear and small leather goods section. Bansbari has had some success in selling the higher quality leather originating from grade 1 raw hides to importers in China and India, although some sales were made at distressed prices in order to move a large backlog of accumulated inven- tory. Bansbari's management plans to expand exports by implementing its modern- ization programs and increasing technical and marketing collaboration tie-ups. -29- 5.06 Bansbari's proposed modernization project jj consists of balancing, mod- ernization and replacement investments in its tannery, and the purchase of appropriate equipment for its footwear division. The fixed investment costs of machinery and equipment required by Bansbari's tanning and footwear divisions are estimated at US$850,000 (Rs 14.7 million), consisting of a soaking drum, spraying machine, toggle dryer, staking and splitting machines, shaving machine, as well as footwear machinery and equipment and spare parts. Working capital require- ments are estimated at US$500,000 (Rs 8.6 million). The project would more than double Bansbari's shoe production from 80,000 to about 180,000 pairs per annum, 2J and would enable Bansbari to produce a wider range of footwear designs. Currently, the company manufactures about a half dozen traditional styles of leather shoes and children's footwear. In addition, Bansbari produces army boots, which generate more consistent earnings, as volume orders for standard products enable longer production runs than for custom shoes. For its tannery department, the project would result in an effective capacity of 300 hides per day of which about 120 hides equivalent in finished leather would be required by the footwear division 3/ and finished leather from about 180 hides per day would be available both for exports and for local cobblers. 5.07 Hide Collection Expansion and UpRrading. The Raw Hide Collection and Development Corporation, Ltd. (RHCDC) was established in 1982 as a trading company to purchase and sell raw hides collected from various locations throughout Nepal. The company operates from Hetauda. At the moment, RICDC markets its hides to two customers -- Bansbari and Hetauda Leather Industry (HLI) - which are also the principal shareholders of RECDC. RHCDC's authorized share capital is Rs 10 million as of July 15, 1983; Bansbari had 52X and BLI had 48Z of the paid-up capital of Rs 1.1 million. A/ RHCDC's first two years of operations have been difficult, with losses of Rs 500,000 and Rs 1 million incurred in FY82 and FY83 respectively, which has resulted in a negative equity base. During the 12 months ended July 15, 1983, RHCDC collected about 80,000 hides which almost met Bansbari's and ELI's raw material requirements. Factors causing the 1088 situation were the small scale of RICDC's operations and its inability to raise sufficient working capital to enable it to make cash purchases of the best hides. Also, inadequate collection and curing methods, inputs and facilities led to ij Details on the proposed subproject are contained in Working Paper Number 2 (Project File). 2{ Estimated to be about 38% of current domestic demand for leather footwear. 2/ Estimated at an average of 4 sq. ft of hide per shoe. jI The company's management plans to issue additional share to interested inves- tors. Nepal Tanning Industries (Pvt.) Ltd. in Biratnagar has indicated an interest in purchasing about Rs 200,000 of shares, or about 15% of RHCDC's share capital. -30- significant deterioration in hide quality. jJ Under the proposed subproject for RHCDC, these inefficiencies would be addressed. 5.08 The subproject under consideration involves the upgrading and expansion of the hide collection system which would increase RHCDC's capacity from its present 80,000 hides p.a. to about 240,000 hides p.a. The build-up vould be gradual, taking into account RHCDC's administrative capacity and market demand from Bansbari, ELI and other producers who are moving into hide leather process- ing, such as Nepal Tanning Industries in Biratnagar. The collection system would be augmented to include two regional collection centers (at Butwal in the mid-Terai and Lahan in the south-east), 8 district centers, and 15 collection depots (Map 1). The subproject also would provide for site preparation, con- struction or rental of buildings at headquarters and regional centers; at the district centers, godowns with asbestos roofing would be used to protect against su mer temperatures. The subproject would provide for procurement of two trucks, two vans, one jeep and two motorcycles as necessary transport for moving the hides from the collection points to HLI's and Bansbari's factories, or to various depots to await pick-up by Bansbari's or ULI's trucks. The estimated fixed investment costs are US$350,000 (Rs 6.0 million) and the working capital require- ments are estimated at US$150,000 million (Rs 2.6 million). The economic benefits from the project would arise mainly from the use of hides which other- wise would be wasted, and the improved quality of inputs to leather producers. 5.09 Financial Restructurin2. Both Bansbari and RHCDC are in need of recapitalization since their net equity has been diluted and their debt is all short-term. During the preparation of the IDP, HMG has been advised of the need for such financial restructuring through equity infusion and long-term debt financing. VZ Although H11 expressed preference for the companies to have a high equity proportion to decrease the debt-service requirements, it would find it difficult to fund the equity from its budget. During negotiations, funding arrangements for RHCDC and Bansbari was discussed including the eligible expendi- tures under the Credit, i.e. allowing HMG to finance part of its equity contribu- tion from the IDA credit proceeds, on the conditions that: (a) H1G equity investments, which might be financed from the IDA credit, are utilized only for eligible productive expenditures; S/ (b) the equity does not exceed 30Z of total subproject costs. In addition, RHCDC and Bansbari, with the assistance of LICC and consultants funded under the IDP, would review and if necessary, redesign the jj Primarily in godowns handed over to RECDC by Bansbari. Formerly, Bansbari had its own hide collection department and storage facilities. However, most of the godowns leak water and have corrugated metal roofs which raises the inside temperatures in excess of industry norms for curing and preserving salted hides. V) NIDC usually requires a maximum debt:equity of 70:30 for its subprojects. ]) In contrast to financing equity investment for refinancing of existing debts and losses. -31- projects and formulate appropriate financing plans and project implementation time-tables. Accordingly, the companies could apply to NIDC for financial assis- tance under the proposed Credit. Agreement was reached during negotiations that: (a) RHCDC and Bausbari would be eligible for financing under the NIDC credit line on an exception and priority basis, provided that the subprojects meet NIDC's financial and economic appraisal criteria; (b) normal terms and conditions would be applied, except that HMG would guarantee repayment of RHCDC and Banabari subloans to NIDC (para. 3.07). C. Technical Assistance Components 5.10 The leather development program includes technical assistance components, most of which should proceed whether or not the two investment projects are undertaken. The total cost of these components are estimated at US$550,000 including US$100,000 for export promotion and US$450,000 in advisory service. Phase I of the technical assistance, would be for five segments of the industry including consultancy to Bansbari and RHCDC in finalizing their projects and upgrading methods with existing equipment. Phase II would be for RHCDC and Bansbari when the two investment projects are undertaken. 5.11 Hide Collection Advisor. A specialist experienced in collection and distribution of agricultural commodities and knowledgeable about curing and preservation of hides and skins would assist RHCDC in improving the efficiency of its operations and in formulating RHCDC's proposed expansion project. The ini- tial assignment would be about three months, to examine alternative means to improve existing operations. At the time that RHCDC's proposed expansion project is financed, six months of additional advisory assistance would be made avail- able, principally to assist RHCDC in implementing the project, particularly in the areas of collection systems and procedures for new regional and district collection centers. 5.12 Tanning and Leather FinishinR Specialist. The IDP would provide assis- tance to the Bansbari company in improving the quality and range of tanned leather and in formulating a modernization and balancing program (BMR), to place Bansbari in a stronger position to compete in the export market. An initial four man-months would be needed to provide advice in tanning practices and to assess BMR alternatives. When BMIR is undertaken, eight man-months of additional techni- cal assistance would be provided, with a focus on making the most of the balanced capacity to improve the quality and efficiency on Bansbari's tanning operations. 5.13 Footwear Design and Production Advisors. The IDP would finance technical assistance to improve design and production of Bansbari's range of adult and children's footwear and boots. Two specialists in design and production would be hired for six man-months each. The footwear design advisor would be needed early to provide an input into the optimum product mix and recommend methods and equip- ment needed to produce the desired products. The shoe design advisor would also be a candidate for the cobbler upgrading program, if background and experience matched task requirements. The consultant on shoe production would be provided in conjunction with the equipment upgrading and expansion program of Bansbari. The advisors, if possible, would be from a major international footwear company which would be positioned to provide ongoing technical collaboration, marketing assistance, and subcontracting support to Bansbari. -32- 5.14 Cobbler Assistance. Based on an ISC survey, there are about 3,300 small cobbler units in the urban and rural areas and five (including Banusbari) shoe factories in Nepal. Urban cobblers in the informal sector produce leather shoes of passable quality for the domestic market using mostly imported leather from India. With technical assistance in design and production techniques, these units could improve their competitive position vis-a-vis imported shoes. The IDP would provide technical assistance in shoe design and production techniques, through an advisor operating with support from the Cottage Industries Development Board (CIDB). Emphasis would be on skills training, with courses to be mounted in Kathmandu and other urban areas such as in Hetauda and Biratnagar. The cour- ses would be opened to rural cobblers within access to the urban centers to enable them to adopt upgraded methods. The IDP would finance advisory services, materials, tools/equipment, and local costs for provision of training courses. 5.15 Export Market Promotion. Nepalese producers need to diversify their market outlets and strengthen their customer contacts. The IDP would include a component for export promotion to assist goatskin and hide leather producers and hide leather producing companies to attend the main international leather fair (Paris) held in September of each year, and co visit major leather producers, from whom Nepalese companies can learn design, production and market- ing techniques, and seek collaboration arrangements. An amount of US$100,000 is allocated to cover: (i) about 8 trips to the leather Fairs over the project period; estimated to cost US$25,000; and (ii) three industry-specific tours costing a total of about US$75,000 for about 25 manufacturers and exporters. The trips are intended for private manufacturers, and up to one officer of LICC per trip. The LICC officer attending the fairs or industry tours will be responsible for disseminating information to other producers in Nepal. LICC, with the assis- tance of the leather advisor, will prepare an annual specific program of export promotion activities for IDA's review and approval. 5.16 Effluent Control. The discharge of chrome pollutants into open streams or pcols located near producing companies (e.g., Bansbari, Hetauda Leather, Nepal Leather Industries in Bhairawa) represents a potential danger to nearby crops and to human health. The IDP would include technical assistance for a chemical recovery expert, experienced in control of pollution arising from wet-blue chrome tanning, to review existing production and control systems in the major tanning companies. The advisor, who will be attached to LICC, would analyze potential for introducing cost-effective equipment for effluent control. 5.17 Leather Industry Advisor. Continued advice, particularly in planning for the leather group and in formulating policy measures, is needed. The IDP would finance an advisor to LICC to provide support and consultancy services to various segments of the industry, including coordinating the work of consultants and devising improved training/marketing programs and policy measures in the leather and leather goods subsector. The leather advisor's assignment would be for 12 months. As part of its assistance to the industry, LICC plans to organize courses in leather goods design and manufacture, the costs of which would be borne by H1G; the advisor would assist in the design and initial implementation of the courses. -33- 5.18 Terms of reference for the consulting positions have been agreed by LICC, which would coordinate and monitor the progrsm, providing regular reports to IDA. Annual work programs will be prepared for each element and provided to IDA, for concurrence. During negotiations, these arrangements and the terms-of-reference were confirmed. HMG would continue to provide the funds to cover LICC's operat- ing budget. VI. THE PROPOSED CREDIT A. Credit Arrangements 6.01 The proposed IDA Credit of US$7.5 million equivalent would be made to KMG Nepal on standard IDA terms and conditions. The Credit provides for a commitment period of four years and a disbursement period of six years. The initial subloan component would be US$5.5 million, which HMG would onlend to NIDC through a subsidiary loan agreement. NIDC would draw down these funds for on-lending mainly to private enterprises for the financing of specific development projects. Eligible activities would be the establishment or balancing, modern- ization/rehabilitation, expansion (BORE) investments in manufacturing, agrobased enterprises, mining, and industrial services (e.g. engineering repair workshops); retail and other commercial enterprises would not be made eligible. New tourism/hotel projects in the Kathmandu Valley also would not be eligible in accordance with NIDC's strategy of diversifying its portfolio. Two public sector companies, Bausbari and RHCDC would be eligible under the NIDC subloan components on an exception and priority basis for their expansion and modernization projects identified under the development program for the leather subsector (Chapter 5); however, NIDC subloans to these companies would be guaranteed by HMG and HMG would have the option to utilize a portion of this component as its equity investment upto 30Z of eligible expenditures. KME would pass the proceeds of the Credit to NIDC in Rupees with IHM bearing the foreign exchange risk (para. 6.05). Repayments to HMG would be on interest rates resulting in a minimum fixed spread of 4Z to NIDC. 6.02 During the first two years of project implementation, HMG would utilize US$1.0 million of the Credit as its contribution to the establisiment of an Import/Export Facility to be handled by tle Nepal Rastra Bank; beginning the third year, HMG through NRB would on-lend this amount to NIDC under the same terms and conditions of its subsidiary loan agreement under the Credit with emphasis on NIDC subloans to export-oriented industries. 6.03 The technical assistance funds of US$1.0 million would be utilized for studies, consultancy and training for the Ministry of Industry, Ministry of Tourism, Industrial Services Center, Leather Industries Coordination Cell, Nepal Industrial Development Corporation, and leather/leather goods enterprises. The costs of the technical assistance components which are outlined in Chapter 3 would not be repayable to HMG as they constitute development expenditures; these are expected to result in improved industrial productivity and exports and help achieve enployment objectives. During negotiations, the terms of reference for these studies and consultancy were confirmed which are expected to be initiated around June, 1985. -3'- B. Maior Terms and Conditions 6.04 Interest Rates. MG would on-lend to NIDC at the minimum rate of 7% for fixed investment subloans and 10% for working capital subloans. In accordance with the existing interest rate structure in Nepal, NIDC's interest charges would be 12X for fixed investment subloans and 15% for working capital subloans and a commitment fee of 0.75% per annum; NIDC's lending rates are positive in rela- tion to medium term inflation projections (para. 2.17). NIDC's on-lending rates to industrial borrowers would be reviewed aunually, and would be revised if necessary to ensure that the rates remain positive in relation to medium-term inflation projection and consistent with the commercial bank rates for industry. NIDC would pay 1MG a commitment fee of 0.5% per annum of the undisbursed balance payable from the date of commitment to the date of disbursement of each subloan. 6.05 ExchanLe Risk. Under Credit 705-NEP, the Nepal Rastra Bank has carried the exchange risk through a procedure of foreign exchange loss reimbursement; under the proposed Credit, RNG would directly absorb the exchange risk, with arrangements similar to those under the CSI Project (Credit 1191-NEP). No exchange risk fee vould be charged since most of expected borrowers would be small enterprises; this is also in line with HMG's interest rate policy to promote industrial investments (para. 4.19). 6.06 Free Limit and Subloan Size. NIDC's subloan free-limit under the Credit would be US$150,000 equivalent. As in the Credit 705-NEP, this should allow IDA to reviev about 25% of the subprojects by number and about 70Z by amount. The minimum subloan size is expected to be US$20,000 as in Credit 705-NEP, wbich would avoid redundancy of coverage by commercial banks under the CSI Project. The maximum subloan size would be US$1.5 million vhich would still provide a reasonably broad range of subprojects and encourage financing from bilateral sources and joint venture partners (para 4.28). 6.07 Amortization Schedule. Repayments from NIDC to HMG would be based on a fixed amortization schedule of 18 years including a grace period of 5 years. The maturity and grace period of NIDC loans for fixed investment would not exceed 15 years and 3 years respectively; maturity of subvoans for working capital would not exceed 7 years. 6.08 Procurement. Given the expected size of contracts and maximum sualoan under the Credit, international competitive bidding would not be required. Under the Credit, NIDC would implement its existing procurement procedures which con- form to the Bank's standard practices for development banks; procurement deci- sions would continue to be based on a minimum of three valid quotations from established sources (para. 4.12). 6.09 Disbursement. Annex 15 shows the estimated disbursement schedule, which reflects experience under Credit 705-NEP and the profile of actual disbursements under development banking projects involving IDA credits. IDA's disbursements for eligible subloans vould be against 100% of the foreign exchange cost of imported goods and services, 70% of goods locally procured and initial permanent -35- working capital in the form of imported materials inputs provided this is part of a fixed investment subloan. For technical assistance components, ID& would finance 100% of exDenditures for consultancy/advisory services, overseas train- ing, and foreign exchange cost of imported goods. 6.10 Disbursements for the Import/Export Facility would be made in two tranches of US$500,000 each; disbursement of the first tranche would be made after HHG/1RB have established the IEF by contributing its minimum share of US$500,000 and adopting eligibility criteria and procedures satisfactory to IDA; disbursement of the second tranche would be made after IDA's satisfactory review of the utilization of the first tranche (para. 3.04); during negotiations, agree- ment was reached that upto US$1.0 million equivalent to IDnA's contribution to the IEF would be made available for eligible NIDC subloans beginning the third year after the Credit becomes effective (para. 3.05). 6.11 Reporting, Accounts, and Auditixg. MDI, NRB, LICC, and ISC/DOI, would be required to submit quarterly progress reports on the implementation of components under their jurisdiction. NIDC will continue to submit audit reports in a form satisfactory to IDA no later than 5 montbs after the end of its fiscal year, i.e. by December 15; it will also continue to submit quarterly progress reports on its operations and institutional developments. VII. PROJECT BENEFITS AND RISKS 7.01 Benefits. The IDP is expected to result in additional investments and improved efficiency in industrial enterprises in Nepal. Direct benefits of the lending components are expected to result in about Rs 160 million in incremental productive investments in about 40 enterprises; roughly 2,300 additional jobs would be created at a fixed cost per job averaging US$4,000. The TmportlExport Facility expects to generate exports in convertible foreign exchange of about US$10.0 million annually equivalent to about 30% of total merchandise exports in FY82. In addition, productivity and exports of the leather group would be increased through key investments and technical services at various stages of leather collection, processing, and footwear manufacture. New projects would be promoted particularly in light engineering and selected agroprocessing groups, which could result in new technology and foreign investments. The technical assistance components of the project are expected to assist HEG in implementing selected industrial policies and export promotion efforts. NIDC would be assisted to improve its operations which should result in an improved quality of industrial projects in Nepal. 7.02 Risks. A risk in the subloan component is that an adequate number of identified and eligible subprojects may not materialize due to inadequate entrepreneurial interest, the multiple constraints to industrialization and difficulties in incentives and their administration. The proposed IDP has been designed to help address these constraints by providing a conservative subloan amount; entrepreneurial training courses in preparing and promoting viable industrial projects; assistance in the development and implementation of appropriate incentives for industry and exports through training and technical -36- assistance; and incorporation of subsector development components in key product groups. Success of the leather development program would depend primarily on the recovery of the leather market, the actual structuring of the investment projects, and the ability of consultants to influence the upgrading of methods and designs. VIII. RECOMMENDATIONS 8.01 During negotiations, the following matters were discussed, and agreed: (a) project components and lending arrangements, particularly for the Import/Export Facility and for the technical assistance and investment projects in the leather group (paras. 3.02 - 3.15, 6.01 - 6.11); (b) terms and conditions of the proposed Credit, including relending interest rates, free-limit and subloan sizes, exchange risk, amortization schedule, and reporting requirements (6.02 to 6.11); (c) consultants' terms of reference for the technical assistance components (paras. 3.06 to 3.10); (d) NIDC's draft policy and strategy statements (paras. 4.05 - 4.06); (e) NIDC standards on debt service coverage and arrears and related action program (paras. 4.11, 4.23); and (f) Em's assurance to make available local currency resources to NIDC (para. 4.30). 8.02 The following would be conditions of effectiveness of the proposed Credit: (a) approval by NIDC's Board of Directors of its amended Policy and Strategy Statements (para. 4.04, 4.05); and (b) signing of a subsidiary loan agreement between HMG and NIDC reflecting the lending arrangements and major terms and conditions (para. 6.01). 8.03 As agreed during negotiatiorn, the signing of an agreement between HMG and NRB reflecting the lending arrangements for the import/export facility, would be a condition for disbursement of US$1.0 million allocated for the IEF com- ponent. MUl 1 -37- Page 1 of 5 NEPAL INDUSTRIAL DEVELOPMENT PROJECT NEPAL: THE LEATHER AND LEATHER GOODS SUBSECTOR Structure and Composition 1. In Nepal, leather processing and the manufacture of leather goods con- sists of the following five stages of production. 2. Staxe 1: Recovery of Hides and Skins. jj Nepal has fairly large sup- plies of livestock, estimated at about 13.4 million head; consisting of cattle (49%), goats (28Z), buffalo (20%), and sheep (3%). Collection and extraction rates take into account the difficult topography and religious practices which limit availability of cattle hides; the annual available supply is estimated at about 1.5 million goatszins, 0.3 million buffalo hides, and 0.2 million cattle hides. Over 70% of the buffalo and goats and over 60% of cattle are located in the mountain and hill areas. However, the low lying Terai in the southern por- tion of Nepal provides the greatest source of raw materials due to closer access to markets and better transportation links than in the hills. Buffalo hides and goatskins are of good quality, while cattle hides are of low quality, coming from fallen stock due to religious customs. Poor quality and collection difficulties Clack of transportation and, until recently, an effective organization), has meant that no more than 10Z of Nepal's hide resources is utilized by the leather industry. However, for goatskins, extraction rates are much higher and tanners feel that the supply of raw material is sufficient to meet their needs. .j In the long run, however, the main constraint to expanding production is the low collection rates, particularly in the hide sector. Improvements in collection, curing and flaying methods could more than double the amount of raw hides avail- able for collection, while the maximum number of goatskins are collected in years of peak leather demand (FY80). 3. Stage 2:- Tanning. O Prior to 1978, Nepal also exported raw hides and skins, mainly to India. However, a ban on such exports in April 1978 created the A} Collection and Recovery of raw hides and skins which are flayed, cured, and salted for preservation; in rural and village areas, hide and skins are hung on open stalls and sun-dried for preservation. 21 The TPI/ISC study estimated that about 40% of the potential supply is collected and extracted annually by small individual collectors who market their skins directly to the tanners in the Terai. ]| Tanning of hides and skins either through a 'wet blue" chrome-tanning process or through vegetable tanning, using large rotating drums; in rural areas a more traditional tanning method of open pits and vegetable extracts is used. ANNEX 1 -38- Page 2 of 5 impetus to expand tanning and processing capacity. In the last few years, Nepal has achieved impressive growth in production and exports of vet-blue, and more recently, finished goatskin leather. Nine private firms in the organized sector, all located in the Terai region, YJ have capacity to process about 6 million goatskins annually. In addition, about 600 rural tanners in the informal sector produce vegetable-tanned leather, mainly for the domestic market. Five of the goatskin tanneries have capacity t. process about 50,000 pieces each or about 150,000 sq. ft. per month. In addition, two companies (Bansbari Leather and Shoe Factory and Hetauda Leather Industries) concentrate exclusively on process- ing of buffalo and cattle hides. Buffalo leathers has good export prospects, while cattle hides are mainly used as sole leather and shoe uppers for the domes- tic market. 4. Stare 3: Semi-Processing to Crust Stage. 2/ Only NLI (Bhairava) has adequate finishing capacity and is able to produce good quality crust and finished goatskin leather. It is therefore able to change its product mix to meet fluctuating demand and is in the best position to meet cyclical swings in external demand. 2f Under the marketing tie-up agreement, the German company assists NLI in quality control and plant supervision. NLI's plant is however imbalanced: it has capacity to produce 50,000 vet-blue pieces, 70,000 crust, and 20,000 finished pieces per month, all on a single-shift basis. NLI and Nepal Tanning Industries (Biratnagar) also have capacity to process about 200 hides per day, in addition to their goatskin processing operations. 5. StaRe 4: Leather Finishing. A/ The manufacture of finished goatskin leather is a recent development in Nepal with the installation in 1979 of finish- ing machinery at NLI and in Hetauda Leather Industries in 1982. iJ Most of the other companies intend to install finishing equipment when market conditions improve. The finishing stage tends to be the most capital intensive with greatest opportunity for mark-up. However, it is also the most difficult and unless done correctly, producers will have less prospects to export the leather, than in wet-blue form. Thus, most producers have been cautious before moving into leather finishing. 6. Stage 5: Manufacture of Leather Goods. Once the local leather industry is able to produce sufficient quantity and quality of finished leather, it can A}J Nepal Leather Industries (P) Limited in Bhairawa (NLI), five units in Birgunj, and one each in Biratnagar, Lahan and Bara. Z/ Manufacture of crust leather through re-tanning, fat liquoring, and drying. O Most of NLI's crust output is exported to a German company which acts as as agent for selling the leather to leather goods manufacturers in Europe. 1
Groupe de la Banque mondiale · Staff Appraisal Report
Nepal - Industrial Development Project
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Groupe de la Banque mondiale
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Staff Appraisal Report
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Népal
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Banque mondiale