China - Second Technical Cooperation Project

Document of The World Bank FOR OMCuIL USE ONLY CA /_cy- CkP 1Rat Nt.P-4231 -CHA REPORT AND RECOMMENDATION OF PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION ON A PROPOSED CREDIT OF SDR 18.0 MILLION (US$20.0 MILLION EQUIVALENT) TO THE PEOPLE'S REPUBLIC OF CHINA FOR A SECOND TECHNICAL COOPERATION PROJECT February 11, 1986 IThE. dwosmnut hos a resnided d~ibsh. aud -y he mud by reciplefls ely In the prfsn.ace of their efusE ditls. Its couknts may met shmwlse be disclosed without Woeld hak uh sicthoude.I  CURRENCY EQUIVALENTS Currency Unit - Yuan (Y) Calendar 1984 December 1985 US$1 = Y 2.32 Y 3.20 Y 1.0 = $0.43 $0.31 FISCAL YEAR January 1 to December 31 ABBREVIATIONS AND ACRONYMS IDA - International Development Association MOF - Ministry of Finance MOFERT - Ministry of Foreign Economic Relations and Trade SPC - State Planning Commission TCC - Technical Cooperation Credit UNDP - United Nations Development Program  FOR OMCIAL USE ONLY CHINA SECOND TECHNICAL COOPERATION PROJECT Credit and Project Sumiary Borrower: People's Republic of China Amount SDR 18.0 million ($20.0 million equivalent) Terms: Standard Project Description: The purpose of the project is to assist the Government in preparing projects that are expected to be financed by the Bank or the Association and to help develop capacity for preparing and implementing investment projects and administering techni- cal assistance. The project will consist of technical assist- ance and training subprojects which will be selected by agreement between the Government and the Association. Most of the subprojects will support project preparation. A few subprojects will be aimed primarily at strengthening the core agencies and other institutions involved with Bank opera- tions. Others will provide for economic and policy studies to be carried out by research agencies. Experience under the first technical cooperation project has been satisfactory and the proposed project incorporates lessons of experience. Given the Bank's expanding lending program in China, demand for tech- nical assistance will remain high. Project risks are therefore minimal. Estimated Cost: Local Foreign Total (US$ million) -- Consultants 2.0 13.0 15.0 Training 1.9 5.1 7.0 Equipment /a 0.1 0.9 1.0 National Personnel, including Local Consultants 4.0 - 4-0 Total 8.0 19.0 27.0 Financing Plan: IDA 1.0 19.0 20.0 Government 7.0 - 7.0 Total 8.0 19.0 27.0 Estimated Disbursements: IDA FY 1987 1988 1989 1990 1991 Annual 2.0 5.0 6.0 5.0 2.0 Cumulative 2.0 7.0 13.0 18.0 20.0 /a Cost includes taxes and duties on equipment estimated at 15Z. No estimate of total taxes and duties is given because of the uncertainty of total amount of equipment to be financed. TIhis document hasastcddistibutuon and may be used by reipients only in dte perfonnnceof the oficd duts Its contens My othrwise be dicosed wihout World Bank authoiatono  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE PEOPLE'S REPUBLIC OF CHINA FOR A SECOND TECHNICAL COOPERATION PROJECT * 1. I submit the following report and recommendation on a proposed IDA credit to the People's Republic of China to help finance a second technical cooperation project. The credit, for SDR 18.0 million (equivalent to US$20.0 million), would be on standard IDA terms. PART I - THE ECONOMY 2. A country economic report entitled, "China: Long-Term Issues and Options" (No. 5206-CRA) was distributed to the Executive Directors on May 22, 1985. Basic data on the economy are given in Annex I. Background 3. Since 1978, China has initiated economic reforms in both rural and urban areas and in the external sector. Reforms have been greatest in rural areas. Following some experiments with the abolition of collective farming in impoverished areas, the Government implemented a comprehensive restructuring of rural institutions based on various forms of the "production responsibility system". By 1983 the farm household had become the fundamental unit of management and production in agriculture, within a framework of collective or state ownership of land and major fixed assets. Reforms have not yet proceeded as far in the urban economy, but there have been significant changes in enterprise management and finance. The scope for collective and individual economic activities has been enlarged and state enterprises have been allowed greater freedom in production, pricing and marketing above their mandatory plan targets. State enterprises have also been allowed to retain some profits and investment projects have increasingly been financed on a loan rather than a grant basis. 4. In international trade and investment, China has promoted opening up to the rest of the world in recent years. Between 1978 and 1984, the share of exports to GDP nearly doubled to about 10%, a ratio similar to other large economies such as the U.S. and Brazil. Foreign investment has been encour- aged, first through establishment of four Special Economic Zones and signing of joint venture contracts for off-shore oil exploration, and more recently through opening of several coastal cities to foreign investment. Growth and Stabilization 5. Reforms have helped stimulate rapid development of the whole economy. Real GDP growth averaged 5% p.a. between 1978 and 1981 and 10% p.a. between 1981 and 1984. During these six years, per capita incomes in real terms more than doubled in rural areas and increased by more than 50% in urban  areas. Agriculture has continued its remarkably strong performance, with gross agricultural output value (excluding rural industry and coomerce) rising at nearly 11% p.a. between 1981 and 1984 and grain output at 8 p.a. (reaching over 400 million tons in 1984). Cash crops and animal husbandry, stimulated by rising demand and attractive prices, have also grown rapidly. Gross indus- trial output value grew at over OZ p.a. over the same period, with heavy industry growing somewhat faster than light industry (12X p.a. vs. 9X p.a.). If rural industrial output is included, total industrial output value grew at close to 12Z p.a. in real terms between 1981 and 1984. The energy constraint on industrial growth was eased by rising coal output (8Z p.a. between 1981 and 1984), renewed increases in crude oil production (4Z p.a. between 1981 and 1984) and improvements in the efficiency of energy utilization (primary commercial energy consumption grew only 60X as fast as GDP between 1981 and 1984). Manufactured exports growth at 8Z p.a. between 1981 and 1984 was slower than during the 1978-81 period but it started from a much higher base and in the face of worsening world market conditions. 6. The Government continues to face difficulties in combining system reform and rapid overall growth with maintenance of economic stability. During 1979 and 1980, China experienced large budget and current account deficits combined with excessive investment and inflationary pressures. In response, a strict stabilization program was introduced in 1981 relying mainly on administrative controls on investment spending. The program slowed growth but also helped lower the budget deficit from about 5X of GDP in 1979 to less than 1Z in 1981, reduce inflation to around 2Z p.a., and change China's external position to one of current account surpluses averaging nearly $4 billion during 1982-84. As a result, foreign debt and debt service ratios remained at low levels ($6.4 billion and 5.5Z respectively in 1983) and China's foreign currency reserves (excluding gold) rose to $17 billion (over seven months' imports) by mid-1984. 7. This comfortable balance of payments position, achieved at the cost of drastic reductions in investment spending and some recentralization of investment decisionmaking, disappeared rapidly during the course of 1984 and early 1985. Partly as a result of decentralization of decisionmaking and the lack of effeccive indirect levers, there was a rapid acceleration of invest- ment and consumption during 1984 and the first half of 1985 causing the economy to overheat. Real GDP grew by 14% during 1984, while average wages in state-owned enterprises rose by 20% and domestic credit grew by 36Z. The retail price index rose by only 3Z in 1984, but preliminary figures show an inflation rate of 9% for 1985. Imports of capital goods increased from $4 billion in 1983 to over $7 billion in 1984, with most of the increase occurring in the second half of the year. There was also a rapid expansion in consumer goods imports. These trends continued during early 1985. As a result, foreign exchange reserves (excluding gold) had fallen to about $11 billion by June 1985 (equivalent to 3.5 months of imports), and the current account deficit for the year is likely to be in the range of $10 billion. The Govern- ment has responded quickly by launching a strict stabilization program that includes further increases in interest rates as well as a series of adminis- trative directives governing bank credit and project approval. As a result, aggregate credit and demand as well as new import orders have begun to slow, though total imports will continue to rise as past orders are filled.  -3- Recent Reforms 8. The Central Committee of the Chinese Communist Party issued a major document on "reform of the economic structure" in October 1984. Recent reform developments have been fully in accordance with the directions indicated in the October decision: (a) state enterprises should be made fully independent units which pursue profits and are responsible for losses; (b) the scope of mandatory planning should be reduced and replaced by indicative planning while the focus of planning should shift from annual to medium- and long-term guidance planning; (c) a more rational price system should be introduced by reducing the role of state-controlled prices and increasing the role of "floating" and free market prices; and (d) the tax system should be improved, finance and banking should be reformed and a larger role should be given to indirect macroeconomic regulation through instruments such as tax, credit and pricing policy. 9. Rural reforms have continued to progress more rapidly than reforms elsewhere in the economy. There has been a remarkable spread of nonagri- cuLtural activities like processing, transport, and commerce. "Specialized households" (which concentrate on cash crops, animal husbandry, or nonagri- cultural activities) and pooling of capital by small groups of households in various types of ventures are becoming increasingly common forms of economic organization in China's rural areas. Wholesale markets for some agricultural products have emerged. To encourage investment in land improvement and devel- opment, farming contracts between collective and peasant households for the use of land (which typically had been fixed for no more than 3-5 years) can now be extended to as long as 15-20 years. In early 1985, the system of agricultural procurement was changed. Previously the Government purchased quota output of grain and other crops at relatively low prices and stood ready to purchase all above-quota output at a higher price. Under the new system, procurement up to a certain amount (below former quota procurement) is based on contracts concluded voluntarily between peasants and procurement agencies. Prices for these purchases are based on the relatively high average price of past years. Output above the contracted amount must be sold by peasants directly on the free market, but the Government will intervene to purchase grain if the price falls to the original low quota procurement price. Thus a considerably larger portion of basic crop production will be produced for and traded on markets with flexible prices.. 10. The momentum of urban reforms has revived, with significant progress on several fronts. In enterprise management, the focus has been on broadening and delineating the decisionmaking authority of urban enterprises. Profit retention now extends to virtually all state-owned industrial enterprises and to nonindustrial sectors like transport, commerce, construction, and other services. Urban collectives and individual enterprises, as well as a variety of joint ventures between them and state enterprises, have grown rapidly (the number employed in urban individual enterprises rose from 150,000 in 1978 to 2.31 million in 1983). 11. In financial reforms, the most important new development has been the implementation of a profit tax system to replace profit remittances by state enterprises to the government budget. Though most enterprises have  - 4 - switched to this system, the benefits have been limited because of the application of a different effective tax rate for each enterprise, to offset the impact of distorted relative prices and other factors. Similar problems have resulted in the abandonment of an attempt to impose a fee or charge on the fixed capi-tal provided to state enterprises by the Government, and they have hindered the shift from grant to loan financing of new fixed investment. Financial discipline at the enterprise level remains weak, in spite of efforts to strengthen accounting and auditing systems and more strictly enforce existing financial regulations. 12. Some progress has been made with price reform. The majority of agriculture commodity prices were decontrolled even before the recent change in pricing and procurement of grain. Prices of many minor consumer goods are also set by negotiations between producers and commercial units. "Floating prices" (up to 20% above or below official prices) are now allowed for many industrial producer goods (either for all output or for output above the mandatory plan target). Price adjustments for key energy products and raw materials (which in many cases are severely underpriced) and for subsidized basic consumer goods like grain and edible oil have proven more difficult to implement, hindered by the potential impact of price changes on urban living standards and on the finances of energy-using enterprises. Nevertheless, some price rises have occurred (e.g., for coal and petroleum), and moreover the share of free market transactions, at largely uncontrolled prices, has increased in recent years. Gradually over time, and only partly as a result of conscious policy. _ t-n--Ler system is emerging; a large but shrinking share of the total supply of most important goods is subject to mandatory plan allocation and administratively set prices, while at the margin a substantial and growing share is allocated by the market mechanism, largely at flexible prices. This pattern may permit China to "grow out of the plan" in a rela- tively smooth transition, though there are obvious threats to this strategy arising from the strong incentive for arbitrage between planned and unplanned realms. 13. The Government recognizes the need to develop new tools of indirect macroeconomic management and has taken some steps to do so. The People's Bank of China was established as a separate central bank at the beginning of 1984, with its commercial banking functions taken on by the newly created Industrial and Commercial Bank of China. In 1985, new methods of credit planning and control were introduced and lower-level and specialized banks were given significant redeposit requirements. Interest rates (including deposit rates) were also raised in 1985, with some move toward unification of rates and development of a term structure resembling that in other countries. Technical transformation loans with a maturity less than one year and loans for working capital now carry the same 7.9Z interest rate while loans of longer maturity carry higher rates, up to 10.8% for 10-year loans. However, interest rates on budgetary capital construction loans (formerly grants) remain low and there are a variety of directed credit schemes. On the external side greater use is now being made of the exchange rate. The old internal settlement rate was abolished at the beginning of 1985 and between January and end-October 1985 the rate against the U.S. dollar declined by over 13%. Despite these changes progress in developing new indirect levers of control has been slow. Recent difficulties in securing macroeconomic balance highlight the need to  - 5 - strengthen institutions and macroeconomic management tools (including monetary, fiscal, and exchange rate instruments) for a decentralized and more market-oriented economy. Long-Term Issues and Prospects 14. In September 1985 a national party conference adopted a proposal which will be the basis for drafting a new Seventh Five Year Plan covering the period 1986-90. The proposal reaffirms a political commitment to economic reform and provides guidelines for future reform and development. One of the main objectives of the plan will be to create a favorable environment for reform which, in turn, will set the stage for future development. Target growth rates (72 p.a. for industry, 62 for agriculture, a little over 7% for CGP) are below rates of growth achieved with the Sixth Five Year Plan, invest- ment is to be restrained .n the next few years, and emphasis is to be placed upon quality rather than quantity of output. It is felt that slower growth will facilitate reform. 15. The plan proposal identifies three main areas of reform. First, enterprise management and incentives are to be improved by: giving enterprises greater autonomy in production, pricing, and employment decisions; lowering and equalizing taxes; increasing competition, increasing accountability for performance; and reforming personnel procedures. In addition, some small state enterprises will be turned over to collective or individual management through contract or lease. Second, the role of the market is to be extended and market networks strengthened. The scope of mandatory planning will be further reduced and markets for capital, technology, and labor will gradually be developed. Third, the emphasis of planning will shift from detailed admin- istrative control to indirect macroeconomic control through economic policy. To this end a series of mutually reinforcing reforms in the planning, pricing, fiscal, banking, and labor and wage systems will be introduced during the plan period. 16. Implementation of the plan proposal will help foster an environment in which fundamental reforms can be gradually implemented in a coordinated way. But specific policy measures will take time to design and then to imple- ment. Many of the reforms required will be difficult, particularly since reforms in different areas are closely interrelated, and thus appropriate sequencing and coordination are essential. For example, price reform in the absence of improvements in enterprise financial discipline will have limited benefits, yet the more profit-oriented behavior that would result from tighter financial discipline would exacerbate the adverse impact of distorted prices. Similarly, reform of the labor allocation system will be incomplete without eliminating many of the "social responsibilities" of enterprises (which now provide housing, medical care, and pensions for their workers and in many cases education and jobs for workers' children) and replacing them with Government-supported social service programs. The plan proposal suggests moving in this direction by commercializing housing. 17. China's objective of quadrupling the gross output value of industry and agriculture between 1980 and 2000 (which means GDP growth of well over 6% p.a.) will require significant improvements in efficiency as well as continued  -6- high saving and investment rates. The plan proposal recognizes there must be major structural changes in the economy over the nezt two decades, including a reduction in the share of agriculture, a rise in the share of industry and services (which at present is unusually low), and substantial urbanization. There will also be a shift within agriculture, away from grain and basic crops and into cash crops and animal husbandry. The new plan will emphasi-. development of the service sector, mainly through removing restrictions on collective and individual activity. Urban development will focus on small and medium sized cities and towns while restrictions on growth of large urban areas will continue. 18. Certain physical/technical constraints will hinder the attempt to achieve China's targets for the year 2000 and its longer-term goal of catching up with developed countries. Despite rapid growth and substantial improve- ments in efficiency in recent years, agriculture may again become a constraint on overall growth, since land in China is severely limited. In energy, short- ages of fuel (primarily coal) and electricity may continue to constrain growth in transport and commercial infrastructure. Without large new investments and improved efficiency, economic growth will lag. In mobilizing resources in all these areas, China could profitably make use of foreign borrowing. Finally, the rising share of the elderly in China's population (related to the slowdown in population growth) means that more resources will have to be devoted to maintaining their consumption levels, especially in the decades after 2000. 19. Poor motivation and inefficient utilization of labor in the state sector of the economy are major problems which can be solved only by coor- dinated reforms in labor allocation, the wage system, enterprise management, and social services, among other things. Reforms in the system of education and training to develop China's "human capital" potential also are crucial. Backward technology and inefficient use of existing technology must be addressed by a combination of reforms, appropriately directed investment, and transfer of advanced foreign technology. Irrational location of factories, suboptimal scale of many plants, and poor utilization of physical capital in general are related problems. 20. If reforms successfully transform the economic system, with a bene- ficial impact on growth and efficiency, a new set of issues will come to the fore, as the plan proposal recognizes. Management of a reformed economy with indirect fiscal, monetary, and other instruments is a major issue (see para. 13 above). In this context, maintaining an adequate saving rate (if the Government no longer accounts for the bulk of aggregate saving) and avoiding inflation (as well as deep cyclical downturns) will be major goals. Assuring an adequate minimum standard of living for the population and an appropriate level of social services will become a major challenge as enterprise and rural communal responsibilities in these areas are reduced. The problem of poor, backward rural areas in various parts of the country will continue to require attention. Redistributing financial resources to these areas through the fiscal system, easing restrictions on migration out of the poorest areas, and lowering nonagricultural wages to make investment in them more attractive are some options for alleviating poverty.  - 7 - 21. In order to mobilize the external resources needed for rapid, sustained growth the plan proposal calls for export growth of 40-50X over the next five years, greater efforts to attract foreign investment, and increased conmercial borrowing. If exports grow at 82 p.a. between 1984 and 1990 and imports grow at 9% p.a., China would have a relatively modest current account deficit of around $4-5 billion p.a. (except in 1985) during the remainder of this decade, equivalent to about 1% of GNP. This implies that the present debt service ratio would increase only moderateLy by 1990. If China's exports grow more slowly imports will probably have to be cut back because a higher borrowing target, though feasible in terms of debt service indicators, would probably run into supply constraints as China would become one of the largest developing country borrowers. This highlights the need for continued export growth in order to meet other plan objectives and service greater commercial borrowing. TLe plan proposal recognizes that greater use of exchange rate and pricing policies will be needed to encourage export growth. 22. Even with continued good export performance, China will have substantial external capital requirements during the remainder of the decade. Under the trade growth assumptions outlined above (exports growing at 8X p.a. and imports at 9% p.a. during 1984-90), the current account deficit would be over $5 billion in 1990 and the gross borrowing requirement would be about $6.5 billion. If export growth fell to 6% p.a. during this period and imports continued to grow at 9% p.a., the current account deficit would reach $14 billion by 1990. Although the plan proposal calls for increased borrowing at conmercial rates, access to concessionary capital will play an important role in sustaining China's growth. China also has a claim to concessionary lending because it is still one of the poorer countries of the world. But China's access to concessionary capital to finance development and moderniza- tion is limited; apart from Bank Croup funds, a significant amount of conces- sionary capital is likely to come only from Japan and a few other bilateral donors and will probably average no more than $500-600 million p.a. during the rest of the 1980s. PART II - BANK GROUP OPERATIONS 23. To achieve the target growth rates envisioned in proposals for the Seventh Five-Year Plan, to increase efficiency and innovation, and to maintain equity in distribution, China will need continuing and fundamental reforms. Large investment will be required and China will need to import more technoi- ogy and increase trade. In the next few years, therefore, the Bank can best assist China by increasing its access to foreign technology and practices and supporting the development and implementation of reforms that will help to increase the efficiency of resource use and reduce poverty. 24. To address China's objective to update technology, the Bank will play the role of intermediary. In transportation, energy, industry, agriculture and the social sectors, the Bank will contribute to technology transfer by bringing the Bank's experience to bear on project design and by helping China to seek appropriate technical solutions through international competitive bidding, training, and foreign technical assistance.  25. Bank assistance will be closely linked with the Government's reform efforts. There are five major elements common to both rural and urban reform in China that will be the focus of the Bank's involvement. First, institu- tional change, involving both the separation of economic and administrative functions and further decentralization of decisionmaking, will extend to every sector in which the Bank is involved as well as the overall process of plan- ning and management. Second, financial sector reform, primarily development of financial institutions that can serve as intermediaries between the suppliers and users ot resources, has become a focus of reform and is an area where Bank assistance can play a useful role. Third, improving planning and project analysis will be critical to reform in sectors such as agriculture and industry, where decisions are now being made by households and independent enterprises, as well as in infrastructure where direct government involvement will be required. The Bank will therefore continue its emphasis on introduc- ing appraisal methods and will include sector investment and financial planning as well as analysis of intersectoral issues. Fourth, the Bank will be involved in the Government's major program of price reform and development of indirect levers such as control via money, credit and fiscal policies. And finally, the Government will make institutional and policy changes to further improve the quality of social programs. The Bank will thus support reforms in health, education and other social services and measures in particular, to address the problems of poor regions. Economic and Sector Work 26. Our economic and sector work in China aims to develop the Bank's understanding of the structure and direction of the Chinese economy and to introduce to the Governmert new perspectives on economic management. This work builds a foundation for lending and for the dialogue with Government on issues of reform and development options and policies in the various sectors. Past work has included two major economic reports, studies on sectoral investment analysis and planning, and collaborative research with Chinese institutions. We have also organized seminars on macroeconomic and sector issues. 27. Over the next two years, the Bank will carry out a large program of studies to follow up on issues identified in the most recent economic report and analyze policy options. In this program, we will examine alternatives for developing tne financial system and foreign trade and investment. We will also analyze issues of intersectoral and interregional planning and develop- ment of resource-poor regions. One such study is already underway in Gansu province to review and formulate programs to increase interregional resource flows, improve the spatial efficiency of development and reduce poverty. Research on urban development and transport planning and finance at the provincial level will also be initiated, and we will undertake studies of regional industrial subsectors to form the basis for project preparation. Collaborative studies with Chinese research institutions will continue. An ongoing study of management and guidance of state-owned industrial enterprises will be followed by a study of collective enterprises, which are expected to become increasingly important industrial organizations in the reformed system.  -9- Lending Operations 28. Since China's change of representation in the Bank Group in May of 1980, 31 projects involving lending of $3,049.9 million to China have been approved. Of the projects, ten have been in the agriculture sector, seven in energy, four in transport, three in industry, three in education and one each ia health, water supply and technical cooperation. In FY85, IFC made its first investment in China of US$17.02 million in automobile manufacturing. Annex II contains a summary statement of these loans, credits and IFC invest- ment as of October 31, 1985. 29. In addition to the already approved second rural credit project and the proposed project we expect to present projects to the Board this year for provincial higher education, power infrastructure, port and railway development, aquaculture, health and industry. For FY87 and beyond, we expect the China lending program to continue to grow from current levels. Infrastructure projects in energy and transport will remain priorities. Technical renovation of enterprises, particularly in industry, will be given greater attention and support as will the regional approach to project development, now being used to assess the needs of Gansu province. 30. In the energy sector, future Bank lending will be aimed at reducing energy consumption and expanding energy production. For example, in the coal subsector, we will assist in upgrading the facilities and operations of exist- ing mines and in transferring improved technology for mines under construction or in operation. In power, we will assist China in technology transfer, staff training and institution building. Through a power tariff study, we will seek to introduce a tariff system based on marginal cost and the need for a nation- wide power system development program. In the gas subsector, the rationale for project involvement will lie in the identification, packaging and transfer of specialized technologies as well as in the strengthening of investment planning and management capabilities. 31. Future transport projects will both upgrade technology and strengthen institutions. In roads, major changes in organization and financing will be required as a result of administrative decentralization and introduction of the production responsibility system in rural areas. In rail- ways, we will focus on technologies to improve domestic production of railway equipment and materials in addition to our work on line construction and electrification. We also intend to broaden our involvement in ports to include coastal shipping and inland water transport. For all transport subsectors, we will support efforts to improve financial analysis and investment planning. 32. Agriculture lending will focus on developing institutions to provide services to individual farmers and to monitor and stimulate change in the pace and pattern of agricultural development. The shift from grant to loan finance and the increased autonomy of the rural banking system will be major aspects of change that will be supported through rural credit projects. We will continue to assist with the training, research, extension, and other service activities of the ministries concerned with agriculture. In addition, we expect to finance programs for specialized agricultural development such as livestock and fisheries, and _or irrigation and area development.  - 10 - 33. Bank Lending in industry, as in agriculture, will focus on strength- ening of financial intermediaries which provide credit to state and collective enterprises. In addition, we expect that there will be large regional projects in fertilizer, cement and machine tools and other subsector projects concerned with upgrading technology and improving organization and management. 34. Bank Lending in education will gradually be broadeneu beyond the present concentration on higher education. For example, we will finance vocational and technical education which is now being given great emphasis in China. In view of the Government's recent decision to universalize access to primary and lower secondary education, another major aim of education lending will be to assist with basic education, particularly in poor rural areas. In this context, support for teacher education will be given priority. 35. Project preparation in the urban sector is currently concentrated in Shanghai on efforts to improve services, especially in environmental upgrading and housing, and development of municipal institutions. Future lending is expected to include support for development of mediumr-size and small urban areas in specific provinces. In addition, we expect to continue lending for rural water supply. Bank lending in health will provide access to new medical technologies for more efficient health care in both the lingering problems of communicable disease, primarily in poor rural areas, and the emerging problems of chronic disease. This will involve further support for medical training and planning and management of service delivery systems. Projects will also support the reform of systems for supplying and financing health services. 36. Cofinancing with multilateral and bilateral agencies has been arranged for projects in coal, power and rural water supply and will remain a feature of our assistance program. We will explore options for cofinancing with export credit agencies. Commercial bank cofinancing and the use of B-loans also appear viable, particularly as China increases the overall volume of its foreign borrowing. In technical assistance, we will continue to incor- porate into projects components for training, overseas study, and access to foreign expertise. EDI activities remain an important element of the Bank's program and in coming years will provide an extensive program of policy seminars for senior Chinese officials, and economic and financial management courses and sector-specific training for officials from core and line agencies. Implementation 37. Project implementation is generally proceeding well. Most project agencies, as well as the Ministry of Finance and the State Planning Commission, have established and staffed offices to handle Bank projects. Disbursement performance has also been satisfactory. Special accounts have been established for 22 of the 30 approved projects and have helped to speed disbursements. In October 1985, the Bank opened a resident office in Beijing to support further expansion of the lending program, accelerate project prepa- ration, improve project implementation and further economic and sector work.  - 11 - PART III - TECHNICAL ASSISTANCE Sectoral Context 38. Access to technical assistance for a broad range of economic sectors and activities will continue to be essential for achieving China's economic development objectives. China is itself working vigorously to improve access to co_mercially held technology through the promotion of joint ventures, licensing arrangements, service contracts and other means. However, the scope for technical assistance is vast. In recognition of these needs, bilateral and multilateral development agencies are expanding their support. Technical assistance agreements have been signed with the governments of Australia, Japan, the Federal Republic of Germany and Canada. A number of other governments are also providing technical assistance, and substantial assistance is made available through the United Nations Development Program (UNDP) as well as through the World Bank Group. IDA's Role and Strategy 39. A key element of the Bank's program in China has been to provide technical assistance to strengthen China's capacity to prepare and implement investment projects. Project preparation and implementation are carried out by the various sectoral ministries and other line agencies, and technical assistance is often required to introduce technology and other know-how not presently available in China. It is the Bank's policy to use UNDP and other sources of grant financing for technical assistance whenever these are avail- able. The Bank was the executing agency for two UNDP-financed projects in China which were aimed specifically at preparing investment projects to be financed by the Bank. UNDP allocated $1.8 million for this purpose during its first China Country Program, 1982-86: $1.4 million under a Pre-investment Umbrella Project and $400,000 for preparation of the Bank's first coal pro- ject. Eighteen subprojects were financed from the Umbrella Project which provided financing for many of the early Bank Group projects in China. Among bilateral donors, Australia has provided more than $4 million for preparation of Bank Group projects in energy and urban development. Other donors providing technical assistance for project preparation include the Federal Republic of Germany, Canada, Japan, Norway and Sweden. While making a very useful contribution to project preparation technical assistance needs, these sources of funds have been insufficient to meet the requirements of what has been a rapidly expanding program. 40. The shortfall has in part been met by "piggybacking" in Bank loans and IDA credits, that is, including the funds in one project for the preparation of repeater projects in the same sector. The Chinese authorities, however, prefer the flexibility of a freestanding technical assistance credit, especially since "repeater" operations with the same project beneficiary are likely to be relatively uncommon. Accordingly, IDA approved the Technical Cooperation Credit (TCC) for $10 million in September 1983 with the principal objective of providing a ready source of financing for technical assistance to help prepare projects to be financed under the expanding Bank Group lending program in China. The Ministry of Finance assumed responsibility for the project and established an office to administer the TCC. The Bank provided  -12 - training to the TCC office staff and organized a study tour financed from the UNDP Umbrella Project to Pakistan and Bangladesh to enable the Chinese officials to learn first-hand how other countries manage technical assistance, and in particular how they administer freestanding technical assistance projects financed by IDA. Simple procedures were established and a one-page TCC subproject application form was issued to line ministries. The TCC became effective in December 1983, and the first subproject was approved in January 1984. Twenty-three subprojects have now been approved, comitting 90Z of the funds. A list of subprojects is attached as Annex IV. Twenty subprojects are underway, of which five have been completed. Four of the five completed sub- projects have resulted in investment projects supported by the Bank. Nearly 35Z of the funds have been disbursed, and the pace of disbursement is expected to accelerate. Several subprojects have been cofinanced with other donors. In general, the first TCC is judged by both the Government and the Bank as successful and effective in achieving its objectives. 41. While the main objective of the first TCC was to finance technical assistance for project preparation, the project was also designed to streng- then the Government's capacity to select, prepare and implement projects and to administer technical assistance. Subprojects have been designed to ensure transfer ox knowledge to strengthen various ministries' ability to select and prepare projects. The Chinese have worked with Bank staff and consultants provided under the TCC to design subprojects so that they can learn as much as possible from the expatriates. A key part of this process is professional study tours which provide government officials with exposure to technologies they lack and opportunities to visit potential suppliers and meet sources of consulting expertise. Provision was also made for institution-building assistance to agencies involved with Bank Group operations. 42. As stated in para. 39 above, it is the Bank's intention to continue to use grant funds for technical assistance whenever they are available and include technical assistance components in its loans and credits where appropriate. UNDP has included a second pre-investment Umbrella Project in its draft Second Country Program for China. Up to $5 million may be made available for this project for which the Bank would be a cooperating agency. However, these sources of financing of technical assistance are expected to be insufficient to meet the requirements of the expanding Bank Group operations in China. The second TCC will provide an assured and flexible means of financing technical assistance for project preparation and other identified technical assistance requirements, when other sources are unavailable. We also expect that more and more subprojects will have institution building objectives. Some subprojects may support policy studies in response to an increasing number of requests from the senior Government officials for advice on various policy issues, exceeding what the Bank can provide through its regular economic and sector work. A separate UNDP project of $1 million for policy studies to be executed in cooperation with the Bank is expected to cover some of the needs in this area. Administration of Technical Assistance 43. The three main organizations dealing with administration of technical assistance in China are the State Planning Commission (SPC), the  - 13 - Ministry of Finance (MOF) and the Ministry of Foreign Economic Relations and Trade (MOFERT). SPC is responsible for ensuring that proposals for technical assistance are in accordance with the national development plan. MOF must ensure that counterpart financing is available for each project and also act as the coordinating authority for Bank activities in China, including tech- nical assistance. MOFERT is the Government's coordinating authority for United Nations and most bilateral technical cooperation. The line ministries are responsible for initiating requests for technical assistance, providing counterpart support and technical supervision, and taking follow-up action on completed projects. PART IV - THE PROJECT Project Formulation and Preparation 44. The Bank has been discussing the possibility of a second TCC with the Government for the past 18 months. A project preparation mission was fielded in May 1985, and preliminary agreement was reached on processing a second TCC. This was confirmed during the programming mission which took place in July, and the project was included in the FY86 lending program. An assessment of the demand for funds from a second TCC was carried out with project divisions and with selected line ministries during the project preparation mission. An initial illustrative list of subprojects was prepared. An updated list is attached as Annex V. Discussions on the proposed second TCC were held with the Ministry of Finance in Washington in November 1985. Negotiations were held in Washington from February 3-6, 1986. The Government of China was represented by Mr. Ku Baogen, Controller Accountant, External Finance Department, Ministry of Finance. Supplementary project data are provided in Annexes III, IV and V. Project Objectives and Description 45. The project will: (a) provide an assured and flexible source of financing for technical assistance for the preparation of projects to be financed by the Bank Group; (b) strengthen the Government's capacity to select and prepare investment projects; (c) strengthen institutions involved with Bank Group operations including the core agencies; (d) support the carrying out of economic and policy studies and contribute to the professional development of research agencies responsible for such study programs; (e) strengthen the local consulting industry; and  - 14 - (f) in selected cases finance technical assistance for preparation of investment projects which may not be financed by the Bank Group. 46. Items to be financed include consultants, training - principally study tours - and equipment. The Government's contribution to individual subprojects would normally consist of counterpart staff, local consultants, office space, equipment, secretarial services and vehicle operation. The Government's contribution is expected to average about 26% of the costs of the individual subprojects. The majority of the credit will be used to finance feasibility studies and to assist with review of existing studies. A smaller proportion will be used to finance other project preparation work such as expert panels, individual specialists, study tours and some related equipment. 47. Subprojects to support project preparation would be principally for projects which are expected to be financed by the BaDk Group. However, in a few cases project preparation subprojects may finance technical assistance for preparation of investment projects to be financed by the private sector with support from the International Finance Corporation or from other sources. Technical assistance required during the implementation of projects already being financed by the Bank Group, such as advisory services (where these are not included in the project loan or credit) would also be eligible in exceptional cases, primarily where the need for such technical assistance was not foreseen at the outset. In addition to technical assistance for specific investment projects, other types of subprojects would be financed if they are of high priority. These would include subprojects to strengthen the Government"s capacity to select and prepare investment projects. For example under the First TCC training was provided in how to prepare master plans for development of China's ports. 48. A second category of subprojects is directed primarily towards institution-building technical assistance activities to strengthen insti- tutions involved with Bank operations. While many institution-building technical assistance activities are already financed under Bank and IDA project loans, there are other important activities which fall outside the scope of Bank Group supported projects. These may include sector and sub- sector studies. They may also include assistance to core agencies such as the recently established Audit Administration which was supported under the First TCC. 49. A third category of subprojects we expect to finance under the Second TCC are those which support the carrying out of economic and policy studies and contribute to the development of research agencies responsible for such study programs. The Bank has provided some assistance in this area in response to requests from the Government. However, the Government's policy reform program is gaining momentum and further assistance is needed, mainly in the form of short-term, highly specialized experts. Provision has been made for financing such expertise in the Second TCC. However, to the extent that UNDP financing is available, the UNDP financing would be used first (para. 42). 50. To strengthen China's ability to prepare projects, an effort would be made to ensure that consultants' terms of reference include appropriate  - 15 - provision for training of counterpart staff. If the line ministry agrees, additional man-months would be included in consultants' contracts for training. Also, in certain cases it may be desirable to have local and foreign consultants work in combination on specific assignments to facilitate the transfer of technology. Consultants would be contracted in accordance with following approval of their terms of reference by the Association. 51. The design of subprojects under the proposed project will incorpor- ate lessons of experience under the First TCC. For example, for large con- sulting contracts it has proven useful for a small team of Chinese experts to visit the home office of the consulting firm before the consultant finalizes his report. The Bank may also send the project officer to join in these dis- cussions. This allows for timely exchange of views on proposed recommenda- tions. This results in an improved final report which is more likely to be acceptable to all parties concerned. There are other advantages as well: it is less likely that the final report will have to be reviewed, which saves time and money; and it is less expensive for the Chinese experts to visit the consulting firm's home office than to have the consultants return to China at this stage. The Chinese may also combine this visit with other business abroad, such as visits to manufacturers of equipment to be purchased under the project or to visit other projects similar to the one they are undertaking. Organization and Implementation 52. The External Finance Department of MOF would be responsible for overall coordination and subproject processing. Prior to financing any sub- project for preinvestment studies from the TCC, MOP would first verify with SPC the priority status of the follow-up investment project and determine through consultation with MOFERT and UNDP that no UNDP or other bilateral funds are available for the purpose. Assurances were obtained at negotiations that MOF would ensure that there is effective coordination among the depart- ments and agencies involved in project implementation and that a suitably qualified project coordinator would serve until the Closing Date, with the assistance of other competent MOF staff as required. The MOF staff member assigned to coordinate implementation of the first Technical Cooperation Credit would continue to serve as project coordinator under the proposed project. State Council approval of the Development Credit Agreement would be a condition of effectiveness. 53. Line ministries would present requests for TCC financing to MOF. These requests will likely stem from discussions with line ministry staff during project missions. NOF would review proposals on a case-by-case basis; proposals supported by MOF would be forwarded to the Association for approval. The line ministry would handle all technical aspects of the sub- projects and would contract consultants, arrange study tours and other training and procure equipment. MOF would provide administrative assistance when needed and would maintain records on the status of each subproject, documenting the elapsed time between various steps in subproject processing and the contracting of consultants. Assurances were obtained at negotiations that the Government would maintain procedures satisfactory to the Association for supervising the work of consultants and reviewing their reports and recow- mendations. Assurances were also obtained that IDA could terminate with-  - 16 - drawals for a particular subproject in cases of delays exceeding six months in the effectiveness of contracts for consultants. Project Cost and Financing 54. The proposed project would cover a two-year commitment period (FY87- 88). The total project cost is estimated to be $27 million, including taxes and duties, with a foreign exchange cost of $19 million. The proposed IDA credit would be SDR 18 million ($20 million equivalent) and would finance the entire foreign exchange costs. About $1 million of the local currency costs covering the cost of local consultants and some locally procured equipment would also be financed. The Government would finance the remaining $7 million of local costs principally for subproject counterpart personnel drawn from line ministries, local design institutes and local consulting firms. No allowance has been made for physical and price contingencies as the project is essentially a line of credit to help finance a program defined in financial terms and for which the specific requirements are not known precisely. Cost estimates for consultants, training, and equipment are based on experience under the first TCC. 55. The proposed credit amount is based on an estimate of the technical assistance requirements for project preparation during FY87-88. This would include any remaining technical assistance required to prepare the projects expected to be brought forward for Board consideration in FY86, technical assistance requirements of projects in the pipeline for FY87-88, and the initial requirements of projects programmed after FY88, i.e., technical assistance expected to be needed before the close of FY88 for such projects. Sufficient funds have also been included to finance high priority institution building subprojects and economic and policy studies. Assurances were obtained at negotiations that MOF would make credit funds available to line ministries as grants, except when an investment project resulted, in which case the funds would be repaid to MOF on terms and conditions satisfactory to the Association. Normally the repayment would take place in the first year after the grace period of any loan made for the investment project. 56. Based on experience with the first project, we estimate that 30-35 subprojects or activities would be financed from the second TCC. The method of implementation for each subproject and allocations from the credit would be agreed between the Government and the Association. The list of proposed sub- projects covering about 85% of the credit amount was reviewed with the Government during negotiations (see Annex V). Processing of some of the proposed subprojects is proceeding. IDA review and approval of initial sub- projects will be made subject to approval of the second TCC itself. Procurement and Disbursement 57. Consultant services to be financed from the proposed credit would be contracted in accordance with the Bank's Guidelines for the Use of Consul- tants. Equipment to be financed from the credit would be limited and the cost of most individual items is expected to be small. Procurement of items and groups of items estimated to cost $200,000 or more for each contract (if any) would be through international competitive bidding in accordance with Bank  - 17 - Procurement Guidelines. Domestic manufacturers would receive a preference of 15Z or the applicable customs duty, whichever is less, in bid evaluation. Items and groups of items estimated to cost less that $200,000 for each contract and not exceeding an aggregate amount of $1 million may be procured on the basis of quotations from at least three qualified suppliers. Prior review by the Association would be required for equipment contracts estimated to be $200,000 or more. 58. It is estimated that about 70% of the credit would finance consul- tant services and about 30% would finance study tours, other training and equipment. The Association would finance {i) 100% of expenditures for consul- tant services; (ii) 100% of expenditures for overseas study tours and other training; (iii) for equipment, 100% of foreign expenditures for direct imports, 100% of local ex-factory costs for locally manufactured items and 75% of local expenditures for other items procured locally. To facilitate dis- bursement, a Special Account to be maintained in US dollars with an authorized allocation of US$ equivalent to SDR 1.4 million would be established in a bank on terms and conditions satisfactory to the Association. Replenishment of the Special Account would be made quarterly or whenever amounts withdrawn are equal to 50% of the initial deposit. For expenditures relating to training, overseas study tours and contracts for goods and services each valued less than $100,000 equivalent, reimbursements would be made on the basis of Statement of Expenditures (SOEs). Documents supporting the SOEs would be retained at the Ministry of Finance and made available for review by IDA supervision missions. Monitoring and Evaluation 59. The Ministry of Finance would be responsible for monitorino the project and would collect, review and evaluate information regarding indivi- dual subprojects. Semi-annual progress reports would be forwarded to the Association. The line ministries would be responsible for monitoring the progress of individual subprojects. Project-related accounts would be audited by independent auditors acceptable to the Association and the audit report would be provided to the Association within six months of the end of each fiscal year. Assurances on reporting, accounts and audits were obtained at negotiations. The Government intends to request the Audit Administration of China to conduct the audits for this project. Benefits and Risks 60. The major benefit of the proposed project would be the development of a pipeline of projects intended and suitable for financing by the Bank or the Association. The project would also strengthen other institutions which support the development and implementation of investment projects. A longer- term benefit would be the strengthening of the Government's capability to pre- pare projects. We expect that the domestic consulting industry would also be strengthened through work with foreign consultants, thus reducing dependence on expatriate consultants and advisers for preparation of repeater projects. 61. There a-e no major risks in the implementation of the proposed project.  - 18 - PART V - RECOMNENDATION 62. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed credit. A. W. Clausen President February 11, 1986 Washington, D.C.  -19- ANNEX I Pqae 1 of 6 i9ioet 1L TNl9 N ASIA A PACIC ASA & PACIFIC au X sq. no TOM 95*1.0 9561.0 9561.0 CIOCILTURAL 3257.6 3632.0 3365.9 .w apin C) ..) .. 300.0 278.3 1011.l a, maurn a cw"va (U4Lea OF OI. mqoIMLvm) 202.0 259.0 S1.A 2354. s6.a vopuAnou.n-uAR (tTn Au) 651000.0 115160.0 1019102.0 ulIAS POPULATION Or TOrAL) 13.6 I .. 21.0 223 35.9 POIULATIIO Pmoc POMATYUI IN UE 2000 CHILL) 1242.3 ssau rauuCHI (K) 1571.0 POPUILATIOM iniNmum 1.6 POPMATOM Omsm PER SQ. Km. 6.1 35.3 106.2 173.1 386.9 PER SQ. a1. ACI. LaUD 199.8 210.0 260J. 353.3 15-t TPOIATIM ACE STUCTURE (Z) 0-14 US 36.9 37A 32.0 36.3 36.2 15-64 IRS 56.2 57.2 63.1 5.6 57.7 65 AND ARM 4.7 5.0 5.0 6.3 3.5 POMILATlOl GROWN RATE (S) TOTAL 1.1 2.2 1.7 2.0 2.3 SUSIA .. .. .. *.1 4.1 ant urns RATE (PER r36) 39.2 /d 35.7 13.6 27.5 30.1 CRUDE DA1 RATZ (PU TSUl) 23.5 71 3.8 7.1 10.2 9.4 GROSS EORODUCrIW AT 2.8 73 2.3 1.0 1.7 1.9 ACCTORS. AIAL (mul) .. DS0 CS OP HAUlED M) .. .. 71.0 69.6 56. uIND1 OF MM PuOD. PM CAPITA (t1971-100) .. 100.0 123.0 116.6 126.6 PER CAPI SUPPLY OF CaIzAS (C or iqU cm) ) 96.6 Id 101.6 119.8 106.3 115.7 oums (CaRAS n DU) 53.0 Id 56.2 69.7 60.1 60.3 OF WIIOI ANIML AM PULSE 12.5 d 13.3 15.9 14.4 14.1 cHILD (CACS 1-4) DATN Uam 13.5 3.5 2.0 7.3 7.2 glm LP EXPEC. AT siH (TAM) 61.0 /a 60.9 67.1 60.5 m0.6 INANT HOtT. RATE (PER 3005 165.0 73 H 9.0 35.0 H 9.2 64.9