Dranint of The World Bank FOR OMCIAL USE ONLY XAJ D' rm- C4?? (LAQ /643- C/f Ripen No.P-4232-1 REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$75.0 MILLION AND A PROPOSED CREDIT OF SDR 22.8 MILLION TO THE PEOPLE'S REPUBLIC OF CHINA FOR A THIRD INDUSTRIAL CREDIT PROJECT February 11, 1986 This doimemt ha a resSited dIshiSim ad my be wmd by redplea emly ilath perfeae of I their idSl slt& lb cefo moy nt odherwise be disdaed witbhet WeM Bhu a.dcoi_ldeu. CURRENCY EQUIVALENTS Currency Unit = Yuan - Renminbi (Y) Calendar 1984 December 1985 US$1 = Y 2.32 Y 3.20 Y 1.0 = $0.43 $0.31 LIST OF ABREVIATIONS AND ACRONYMS BOC - Bank of China CIB - China Investment Bank CNTIC - China National Technical Import Corporation DFC - Development Finance Company EDI - Economic Development Institute ICB - International Competitive Bidding ICBC - Industrial and Commercial Bank of China PBC - People's Bank of China (Central Bank) PCBC - People's Construction Bank of China SEC - State Economic Commission SPC - State Planning Commission FOR OFICIAL USE ONLY CHINA THIRD INDUSTRIAL CREDIT PROJECT (CHINA INVESTMENT BANK III) Loan/Credit and Project Summary Borrower: People's Republic of China Beneficiary: China Investment Bank (CIB) Amount: $100 million equivalent, comprising $75 million equivalent IBRD and SDR 22.80 million ($25 million equivalent) IDA. Terms: Loan: 20 years, including 5 years grace; standard variable interest rate. Credit: Standard Relending Terms: The proceeds of the loan and credit would be onlent to CIB for 20 years, including 5 years grace at a fixed interest rate of 7.OZ p.a., plus commitment fees equal to those under the loan and credit; the Government would bear the interest rate risk on the Bank loan and the foreign exchange risk between the US dollar and (a) the currency pool for the Bank loan; and (b) the SDR for the IDA credit. Subborrowers would be charged a fixed interest rate of 8.5Z p.a. and would bear the foreign exchange risk between the US dollar and the Yuan. Project Description: The project, designed to support CIB's short-term financing plan, will further strengthen CIB, which provides investment loans for small- and medium-size industrial projects needing foreign exchange. The objective would be to continue Bank support for improved investment efficiency through import of technology and the introduction of improved project design and selection methodology. Subborrowers would be some 80 state and collective enterprises primarily in the 19 eastern provinces and municipalities. The investments are expected to have high financial and economic returns. The main project risk relates to the capacity of CIB, a young institution, to further improve its present standards, especially for project economic and marketing appraisals and for financial management and resource mobilization. This risk is, however, expected to be minimized with the start in 1986 of specialized training abroad for CIB staff. IThis document has a netried dtrnbution and my b used by nrepients only in the performance of their offic duties. Its contents may not otherwise be disclosed without World Bank authoization. - ii - Bank FY 86 87 88 89 90 - (US$-mln) - Estimated Disbursement Annual 5.0 18.0 40.0 20.0 17.0 Cumulative 5.0 23.0 63.0 83.0 100.0 Staff Appraisal Report: None I~~~~~~~~~~~~~~~~~~~~~~~~~ REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN AND CREDIT TO THE PEOPLE'S REPUBLIC OF CHINA FOR A THIRD INDUSTRIAL CREDIT PROJECT (CHINA INVESTMENT BANK III) 1. I submit the following report and recommendation on a proposed loan and credit to the People's Republic of China to help finance a third industrial credit project. The loan for $75.0 million equivalent, would have a term of 20 years, including 5 years of grace, with standard variable interest rate. The credit, for SDR 22.80 million ($25.0 million equivalent), would be on standard IDA terms. The proceeds of the loan and credit would be onlent to the China Investment Bank (CIB) with a 20-year term, including 5 years of grace, at an interest rate of 7.0% p.a., plus commitment fees equal to those under the loan and credit. PART I - THE ECONOMY 2. A country economic report entitled, "China: Long-Term Issues and Options" (No. 5206-CHA) 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 proceed- ed 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. -2- Growth and Stabilization 5. Reforms have helped stimulate rapid development of the whole economy. Real GDP growth averaged 5Z p.a. between 1978 and 1981 and 1OZ 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 commerce) rising at nearly 11% p.a. between 1981 and 1984 and grain output at 8Z 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 1OZ p.a. over the same period, with heavy industry growing somewhat faster than light industry (12X p.a. vs. 9Z 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 (4% p.a. between 1981 and 1984) and improvements in the efficiency of energy utilization (primary commercial energy consumption grew only 60Z 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 5% of GDP in 1979 to less than 1% in 1981, reduce inflation to around 2% 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 5.5% respectively in 1983) and China's foreign currency reserves (excluding gold) rose to $17 billion (over 7 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 effective indirect levers, there vas 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 20Z and domestic credit grew by 36Z. The retail price index rose by only 3% 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 Government has responded quickly by launching a strict - 3 - stabilization program that includes further increases in interest rates as well as a series of administrative 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. 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 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 fized capital 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 Iears. Gradually over time, and only partly as a result of conscious policy, a two-tier 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 10.8Z for 10-year loans. However, interest rates on budgetary capital construction loans (formerLy grants) rpmain 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 - 5 - difficulties in securing macroeconomic balance highlight the need to 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 (7Z p.a. for industry, 6Z for agriculture, a little over 7Z for GNP) are below rates of growth achieved with the Sixth Five Year Plan, invest- ment is to be restrained in 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 extsided and market networks strengthened. The scope of mandatory planning will be further reduced and markets for capital, technology, and i&bor 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 CDP growth of well over 6Z p.a.) will require significant improvements in efficiency as well as continued high saving and investment rates. The plan proposal recognizes there must be - 6 - major structural changes in the economy over the next two decades, including a reduction in the share o 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 emphasize 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 problemn 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 technolcgy 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 chrllenge as enterprise and ru-al 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, sistained growth the plan proposal calls for export growth of 40-50% over the next five years, greater efforts to attract foreign investment, and increased commercial borrowing. If exports grow at 8% p.a. between 1984 and 1990 and imports grow at 9Z 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 1X 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. The 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 8% p.a. and imports at 9Z 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 comercial 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 Group 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 1'.0s. 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 technol- 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. - 8 - 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 of 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 Government 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 the 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 coilective 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 in 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 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, industry, and technical cooperation. 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 suosectors, 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 for 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 broadened 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 ti 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 medium-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. In addition, we will be a cooperating agency for a second UNDP umbrella project in China. 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 - FART III - THE INDUSTRIAL AND FINANCIAL SECTORS The Industrial Sector 38. Characteristics and Accomplishments. China is one of the world's ten leading industrial producers, and has the largest full-time industrial employment (63 million). However, manufacturing output per capita is only about 25% of the average for middle income countries and about 4% of that for industrialized market economies. State enterprises comprise 22% of China's 392,000 industrial enterprises, the rest being urban or rural collective enterprises, but they account for 72% of output. Manufactured exports were only 5% of gross industrial output in 1984, but accounted for 55% of total merchandise exports. Light industrial products were 37% of total exports, and heavy industrial goods 18%. Manufactured exports grew by about 20% p.a. in real terms over 1977-81, and by 18% in 1982-1984 despite the world recession. A wide range of Chinese manufactures is internationally competitive in terms of production cost, but quality and variety often need upgrading. Three accomplishments of Chinese industry stand out. First, despite ieriodic disruptions, gross output has grown at nearly 10% p.a. during 1957-1983 and grew by a record 14% p.a. in 1984, due to a very high rate of fixed investment in industry, averaging 10-15% of GDP and reaching more than $28 billion in 1984. Second, the industrial base has been broadened to produce nearly the full range of machinery and industrial products manufactured in the world. Third, China has mobilized unskilled labor, rural savings, and low-grade raw materials to establish a large number of small- scale rural factories, bringing extra income and basic goods (albeit often of low quality) to rural areas, and contributing greatly to employment. 39. Weaknesses. Chinese industry also has numerous shortcomings: (a) Technology is outmoded in many sectors; while the use of older, labor- intensive equipment is generally sensible given Chinese factor proportions, a lot of Chinese equipment and processes produce substandard products and waste energy and raw materials. As a result, inputs are used very inefficiently, and total factor productivity has not significantly changed since the 1950s; incremental capital output ratios have risen, over staffing is widespread and energy use per unit of GDP is 2-1/2 times that of other developing countries. (b) Heavy industry, with its high demands on scarce capital and energy, still represents half of industrial output and two-thirds of total fixed industrial investment, and foreign trade has thus been relatively neglected. (c) Decisions are badly coordinated: supply and demand are often mismatched and investments made with insufficient attention to choice of location, scale, or product mix. Some of these weaknesses are the result of past policy errors, neglect of medium term sectoral planning, and two decades of international isolation. Others stem from deficiencies in the economic system: insufficient incentives to conserve inputs or improve output quality, distorted prices favoring consumer goods of light industry, restricted access to imports, and inadequate contacts and information flows between producers and users and among different ministries and regions. - 12 - 40. Constraints on Growth in the l980s. It is particularly important now to correct these weaknesses because the conditions which favored past industrial success have substantially altered. Energy production, especially electric power, raw materials, transport and high level manpower are likely to constrain growth. In addition, the Government is trying to reduce the resources allocated to industrial investment in view of past over-investment and in order to free more resources for the energy and transport sectors and for consumption. At the same time, industrial exports will have to expand, in the face of difficult world market conditions, to help offset reduced energy exports, and industry must remain a principal source of new jobs. It is possible for industry to grow at about 7% p.a., as called for in the Government's long-term plan objectives, provided that China reduces its unit energy and materials consumption, emphasizes light industry, and, in general, continues to foster modernization and to reform its economic system so as to make efficiency and productivity gains the main engine of growth. 41. Government Strategy. Since 1979, the Government has followed a strategy based on readjustment and system reform. Under the readjustment, the new priorities were: (a) technical "modernization" of existing enterprises, particularly through imported technology, rather than "capital construction" (of new facilities); (b) development of light industry and manufactured exports; and (c) energy and materials conservation, particularly in heavy industry. The adjustment has been successful, particularly in shifting emphasis towards light industry and technical modernization investments, which helped reduce energy consumption. These priorities were reiterated in the general orientations given for the preparation of the Seventh Five-Year Plan (1986-1990). A broad framework for the industrial reform was approved by the Government in October 1984; its main thrust is to decentralize economic decision-making and rely on the market to provide incentives and guide decisions, through the following measures: (a) industrial enterprises will be made independent units pursuing profits and responsible for losses; (b) the tax system will be improved, and enterprises allowed to retain their profits after income and other taxes; (c) a more rational price system will be introduced by reducing the scope of state-controlled prices and increasing the freedom of enterprises to adjust their prices to market conditions; (d) the scope of mandatory planning would be reduced in favor of indicative planning with focus on medium and long-term guidance; and (e) the investment finance and banking systems will be reformed, to generalize the use of loans and other capital charges for investment finance. 42. Recent Developments. Some of these measures have been partly implemented in 1985. Collective enterprises, the most dynamic segment of industry, were given greater freedom in their decision-making; collective enterprises, and a majority of state enterprises, now pay profit and adjustment taxes (instead of full profit remittance to the Government); a two- tier price system giving more autonomy to the enterprises in pricing their sales above a production quota was established for most industrial products; and the role and autonomy of the banking system in investment finance decisions was increased, with the share of loans in investment financing increased to 15-20% and that of budget appropriations reduced to about one- thi-d over 1979-1984. Industrial reform had raised the interest of enterprise management in increasing output and profits, but had not been accompanied by more extensive pricing changes to give better allocation signals, and there has been little discernible improvement in industrial efficiency as yet. - 13 - Furthermore, the imnediste effects of the first measures and of control loosening in 1985 were an upsurge of inflation and economic overheating; in response, the Government has tightened control over investment finance and stopped many low-priority projects. The Financial Sector 43. Role. As in most centrally planned economies, China's financial system is relatively underdeveloped because most fixed investment and even working capital used to be financed through the budget. The financial system has served mainly to channel budgetary funds for approved purposes and to help control state and collective enterprises. More recently, increased attention has been paid to using the banks to mobilize savings, increase investment efficiency, and provide a detailed review of Project proposals independent of the enterprises and their supervisory agencies. 44. Institutional Background. China's financial system has included five specialized state banks grouped under two separate jurisdictions. Under the People's Bank of China (PBC) which had ministry-level status as a multi- purpose central and comercial bank, there have been the Bank of China (BOC), responsible for commercial transaction and loans in foreign exchange, and the Agricultural Bank of China (ABC), in charge of banking and financial administration in rural areas nationwide. The Ministry of Finance (MOF) has supervised two institutions: the People's Construction Bank of China (PCBC), which has the main financial responsibility for appraising and disbursing for capital construction in the productive and social sectors of the economy, through both grants and loans in local currency, and the China Investment Bank (CIB). The Government established CIB in December 1981 with an initial paid- in share capital of Y 400 million as its fifth bank and first development finance company. CIB lends for investments requiring both foreign exchange and local currency primarily to modernize or expand industrial enterprises. CIB is closely tied to PCBC for administrative services, access to enterprises and other agencies, and recruitment of staff and managers. 45. At the beginning of 1984, PBC was established as the central bank and given the mandate to supervise the banking operations of all other financial institutions. Institutional articulations and development of monetary control instruments for PBC are still incomplete; greater authority given to PBC in 1985 appears to have strengthened its ability to monitor and restrict credit supply by the other banks. PBC's comercial banking activities (taking deposits and providing short-term working capital loans and medium-term modernizations loans in local currency) were spun off to form the Industrial and Commercial Bank of China (ICBC). The extension of PBC's supervisory role over the entire financial system is a further step towards separating MOF's fiscal functions from the regular banking activities of the financial system, and provides an institutional framework within which other financial sector issues, such as interest rates and the roles of the various specialized banks, can be dealt with. It is also expected to reinforce the ongoing effort to increase the efficiency of investment by shifting from a grant system administered by MOF to a more autonomous credit system. In addition, a Financial Board of Governors representing MOF and the main banks was established, to improve coordination in policy making and implementation. - 14 - 46. Investment Finance. Fixed investment in China is financed from a variety of sources: state budget grants (from central and local governments), extra-budgetary funds of various government agencies, enterprises retained profits and depreciation allowances, domestic bank loans and foreign loans. The share financed by state budget grants has fallen steadily during the past 15 years, from 75% in 1970, to 31% in 1982 and 1983. Until 1979, tl offsetting increase was virtually all from enterprises and government agencies; bank loans financed less than 2% of fixed inv-stment. Since then, the role of credit has expanded dramatically: in 1982 and 1983, domestic bank loans financed 16% of fixed investment in the state-owned sector, and foreign loans a further 7%. Now PCBC passes on budget funds as loans to most enterprises that are profitable; the state budget grants go mainly for infrastructure, and capital construction projects in certain heavy industries (e.g., coal mining), which have high priority but low profits. Loans and self-financing have accounted respectively for 22% and 65% of modernization investments, compared to 13% and 35% respectively for capital construction. The domestic bank loans for capital construction are mostly from PCBC, using both state budget funds and enterprise and agency deposits; those for modernization are chiefly from ICBC and BOC. Under the new banking system, most of PCBC's modernization lending is to be transferred to ICBC. All lending is supposed to be in line with the annual national credit plan prepared by PBC and approved by the State Council; however, following the overheating fueled by excessive credit supply in late 1984 and early 1985, further efforts are required and being made to control this lending. 47. The shift from grants to loans gave enterprise managers some incentive to economize on investment costs, as higher amortization reduced profits, which have been one measure of enterprise performance. The introduction of limited profit retention increased this incentive, and the recent shift from profit remittance to an industrial income tax went further in this direction. However, given the existing distorted price structure, full reliance on credit would shift investment towards the more financially profitable industries, which may not be those with the highest economic returns. The success of the financial reforms will therefore remain incomplete without comprehensive price reform. 48. Foreign Exchange Finance. Enterprises whose investments include foreign exchange costs often look for overseas partners, usually for compensation trade, especially if overseas marketing is expected to be critical and difficult. Enterprises which do not need, or fail to obtain, such partners turn to BOC and CIB for foreign exchange investment loans. BOC, which concentrated on short-term finance until 1981, has become the primary source of foreign exchange loans to enterprises since 1982. It had been using China's balance-of-payments surplus for most of its investment lending for modernization projects, until early 1985. BOC's foreign exchange disbursements totalled about US$1.8 billion in 1983, and its approvals reached US$3.25 billion in 1984. Among the various types of foreign exchange loans provided by BOC, the attractive loans at "prime" rate and special B loans (disbursed in foreign exchange and repayable in domestic currency) have increased their share. BOC's loan criteria remain primarily commercial, with the ability to generate foreign exchange to repay the loan given greatest weight. In some provinces, CIB and BOC meet together with the core agencies to divide up the investment program; in most provinces, however, they actively compete for business. Competition is based in part on special terms and - 15 - exemptions accorded to one or the other bank by the Government; these anomalies reflect poorly coordinated decision-making in the financial sector. They do not lead to significant misallocation of resources, and coordination is expected to improve (para. 45). However, the simpler appraisal procedure of BOC and its B loans repayable in domestic currency have put significant pressure on the competitive position of CIB. 49. Interest Rates. Lending rates to industry, while low by international standards, have been positive in real terms and were increased substantially in 1985 to make enterprises more conscious of, and sensitive to, the cost of capital. Except for the low rates of 2.4Z to 4.2% p.a. charged for capital construction investments which are generally deemed to have marginal profitability, domestic interest rates have had since April 1985 a rational term structure with a rising yield curve. Deposit rates for enterprises and agencies are 1.8% p.a. for d%mand deposits and 4.3% to 5.76Z p.a. for time deposits, depending on maturity. Working capital loans carry a rate of 7.92% p.a., and loans for modernization have rates ranging from 7.92% p.a. (1-year term) to 10.80Z p.a. (for terms over 10 years). Lending rates on foreign currency loans are set partly by reference to international costs. But the bulk of BOC's US$ loans for modernization are charged BOC's prime rate, which was increased from 7.5-8.5X p.a. to 8.5-9.5% p.a. in September 1985. However, the Government has also made special allocations, currently US$500 million p.a., for urgent modernization projects in Shanghai and Tianjin, to be lent by BOC at the subsidized rate of 2.52Z p.a. Moreover, large amounts of capital goods imports are financed by domestic currency loans converted into foreign exchange from central or local government reserves and carrying the domestic interest rates without foreign exchange risks. Despite the progress made in rationalizing and unifying the structure of interest rates for deposits and domestic currency loans, China still needs to further develop a more consistent interest rate policy, in particular for foreign exchange loans, as part of its financial, banking and other economic reforms. Bank Objectives and Role in the Industrial and Financial Sectors 50. The Bank's principal objective in industry and finance is to support the program of adjustment and reform focussing on areas where prior experience and expertise gives it a comparative advantage. The focus is on improving policies and institutions, upgrading technology, conserving energy and materials, and promoting exports. So far, the Bank's industrial lending operations have included two Industrial Credit Projects (CIB I and II, Credit 1313/Loan 2226-CHA and Credit 1491/Loan 2434-CRA) approved by the Executive Directors in December 1982 and June 1984. Most recently, a loan for plant rehabilitation and modernization (with particular emphasis on energy savings) for the chemical fertilizer industry was approved in May 1985, (Loan 2541-CHA). Other industrial projects under consideration would support the modernization of the machine tools subsector in Shanghai, and assist in upgrading technology in cement production. Most recently, in discussions held in October 1985, the Government has indicated its interest in further expanding Bank financing for projects in industry during the Seventh Five-Year Plan period (1986-90). The industry program is being supported through both sector studies and collaborative research. In particular, the Bank will undertake in 1986, with the Government's cooperation, a review of the financial system and of investment finance issues, including the structure of interest rates. - 16 - PART IV - THE PROJECT Background 51. The need for a financial intermediary for industrial lending involving import of equipment and technology was identified by the Bank's first economic mission to China in October-December 1980. Specific proposals for the first Industrial Credit Project (CIB I) were developed in the course of 1981 and 1982, and implementation began in 1983. The second Project (CIB II) was appraised in October 1983, negotiated in Washington in April 1984 and approved by the Board of Directors in June 1984. At that time, it was anticipated that CIB would commit the new loan/credit over an 18-24 month period, i.e. by mid 1986. In fact for reasons described in para 52 below, the funds were almost fully committed within 12 months, by October 1985. The Bank was aware of the acceleration and had included a larger third loan/credit for lending in FY86; however, a number of institutional changes involving CIB's organization, training programs and recruitment are still under discussion, as well as issues relating to CIB's longer-term financing plans. Some of these matters in turn reflect uncertainties arising from the rapid evolution of the financial and credit policy in China (paras. 43 - 49 above) and broader patterns of institutional change relating thereto. In the light of CIB's now urgent need for new resources (CIB branches have been instructed to suspend pipeline development and appraisal of new loans), and pending further discussion and agreement on various measures of institutional strengthening and long term plans for CIB, the Government has requested an interim opera- tion, which is designed to assist CIB to implement its short-term financing plan for carrying commitments through 1986. The proposed $100 million loan/credit arises from this request. A fourth and full-fledged loan to CIB is planned for FY87. Since no new appraisal is yet completed, except for updated information provided throughout the report, the loan/credit would be implemented under the arrangements agreed for CIB II. The proposed loan/credit to CIB was negotiated in January 1986. The Coverrnment and CIB were represented by a delegation headed by Mr. Xu Baogen, of the Ministry of Finance. Supplementary project data are in Annexes III and IV. 52. CIB I was signed in December 1982 and became effective in April 1983. By the end of 1984 the proceeds of the Bank loan of $40.6 million and IDA credit of SDR 28 million (equivalent to $40 million) were fully committed for 56 subprojects. Disbursements amounted to $41.5 million as of January 31, 1986, compared with the revised forecast of $32.5 million up to December 31, 1985. The second CIB project, consisting of a loan of $105 million and credit of SDR 65.8 million (equivalent to $70 million), was signed in June 1984. With all the conditions of effectiveness satisfactorily met by CIB and Government on schedule, it became effective in October 1984. The loan/credit was practically fully committed (for 153 subprojects) within 12 months, instead of 18-24 months as originally projected. The fast pace at which CIB II was committed is attributable to the following developments: (a) in anticipation of CIB II, the State Council issued a Circular in April 1984 to all provinces, regions and municipalities emphasizing the role of CIB, as a new channel for the utilization of foreign funds, with great advantages for developing the national economy and accelerating the technical transformation of industry; (b) the State Council designated 14 coastal cities in 1984 to join the four Special Economic Zones as special centers opening their doors to - 17 - foreign investors and enjoying more autonomy in investment decision making; (c) given the encouragement of the Central Government and the increasing need for financing technical transformation projects, the provincial authorities provided full support in setting up CIB branches. As a result, the number of CIB branches increased sharply from 7 in early 1984 to 19 by early 1985; moreover, BOC's foreign exchange lending in 1985 was sharply curtailed and consequently a number of project sponsors shifted to CIB for financing. Disbursement under CIB II has been faster than under CIB I. As of January 31, 1986, cumulative disbursements under CIB II amounted to $33.8 million, compared to $15 million projected up to December 31, 1985. 53. CIB has achieved a great deal in its institutional development since its founding in 1981. It has adopted effective procedures, modern project appraisal techniques and comprehensive project supervision guidelines, and is presently recognized in China as the only financial institution capable of appraising industrial projects thoroughly and according to well founded methodologies. However, the rapid expansion of its branch network and lending operations has strained its existing organization. The recent restructuring of the Head Office (para. 56) although desirable, will not make an immediate contribution to the streamlining of the organization because the existing staff transferred between departments need to be trained, and additional staff need to be recruited. The monitoring and coordinating capabilities of the Bead Office and the Project supervision capabilities of the branches in particular should be upgraded so that CIB is further strengthened to perform the important role it was assigned by the Government for the modernization of China's industry. Regular supervision missions of the Bank have shown that overall, CIB has continued to perform satisfactorily. 54. CIB III would extend the objectives and achievements of CIB II further in time and would remain practically identical to CIB II in objectives and design. CIB III would pursue the Bank Group's institution-building efforts with CIB. CIB should begin to move upstream more into project design, to further improve the appraisal work especially of its recently established branches, and to appraise larger and more complicated projects, including those involving sectoral issues. Towards these objectives, the focus would be on improving further CIB's overall appraisal capability, especially in economic and marketing issues, through overseas training (para. 59), and on building CIB's capacity for resource mobilization and cash management (para. 57). The Bank, for its part, would continue to pay particular attention to Project appraisal and implementation. This institutional strengthening is particularly important because CIB has just completed a period of rapid expansion and these early years are crucial for consolidating CIB's credibility with other agencies. At the same time, the development of a DFC like CIB is a long-term process which will need to continue well beyond the proposed loan/credit. The China Investment Bank (CIB) 55. Headquarters. CIB consists of a Head Office situated in Beijing and 19 branches, 1 for each of a corresponding number of municipalities and provinces that together account for some 76% of China's population and 87% of its industrial output. CIB's 32-member Board of Directors, consisting of senior officials of PCBC and other ministries and agencies of the central and local governments, meets once a year to review and decide on CIB's annual - 18 - plan, major policies, etc. A Managing Committee consisting of the Board Chairman, three Deputy Chairmen and seven Managing Directors deal with all other major matters including loan approvals of Y 10 million or more and borrowings below $50 million. Loans below Y 10 million are approved by the President, who is a Deputy Chairman of the CIB Board and the First Vice President of PCBC. Day-to-day management is largely in the hands of CIB's first full-time Vice President. The Head Office has six departments - Project Lending, Technical and Engineering, Supervision and Implementation, Finance and Accounting, Coordination and Planning, and the General Administration Office -- each headed by a Manager or Deputy Manager. An internal auditor is directly responsible to the Managing Committee. The CIB Head Office management has extensive experience, primarily within PCBC. Although some of the concepts involved in DFC financial operations and economic appraisal of projects were new to them, CIB staff have been willing to adopt them once clearance was given from above. 56. The Head Office has 65 staff and the branches have a total of 463. Except for engineers, virtually all came from PCBC or are new graduates, as interagency transfers are rare i.n the Chinese system. As CIB's operations have been expanding rapidly, and CIB's branches have been given most responsibility for Project selection and appraisal, staff recruitment by the branches has generally caught up with the workload. In anticipation of more project supervision work and increasing need for specialization in reviewing appraisal reports submitted by branches, CIB Head Office was restructured in September, 1985, by setting up two new departments (Project Supervision Department and Technical Department). The former Economic Research Departmfnt was absorbed by the Project Lending Department. The Head Office staff was increased from 38 in mid 1984 to 65 in November 1985 by recruiting new graduates, but some experienced staff have left CIB in the course of 1985 finding jobs with better compensation. A second full-time Vice-President was appointed in January 1986 to supervise and coordinate the three operational departments (Project Lending, Technical and Project Supervision Departments) now dealing with the Project appraisal and supervision work of the branches. CIB urgently needs financial expertise to undertake planning of its resource needs, raising funds overseas in the international capital markets, and overall funds management. Staff of CIB Head Office needs to be strengthened and, in order to recruit and retain qualified staff, CIB's staff compensation should be made more competitive. CIB management is considering action for improving this situation and would implement a long-term training program under the project (para. 59). 57. As agreed with the Bank under CIB II, CIB has been employing since end of 1984 a number of external Senior Advisors comprising: (a) a part-time senior engineer to supervise the work of the Head Office and branch engineers; and (b) a team of professors of economics at Beijing University, working part- time at CIB's Head Office to guide the branches in their economic analysis, review economic aspects of appraisal reports, and coordinate with other agencies on economic issues related to CIB's work. For the provision of information and analysis on world markets as needed to review proposed loans, CIB has signed a satisfactory contract with China Trade Consultants and Technical Service Corporation under the Ministry of Foreign Economic Relations and Trade. CIB will continue to employ these Advisers as agreed under CIB II. In addition, in order to meet the urgent needs of CIB's Finance and Accounting Department, CIB will continue its best efforts to recruit - 19 - experienced financial experts for planning CIB's resource needs, mobilizing resources abroad, and managing CIB's cash and funds. 58. Branches. CIB has branches in Shanghai, Beijing and Tianjin Municipalities and Jiangsu, Hebei, Fujian, Hubei, Liaoning, Anhui, Zhejiang, Shandong, Heilongjiang, Guangdong, Guangxi, Sichuan, Jilin, Shanxui, Hunan and Inner Mongolia Provinces. Branches were opened at a much faster pace than originally planned, because many provincial governments and PCBC branches were eager for CIB to operate in their areas. However, such a high rate of expansion placed a great strain on CIB's Head Office, and therefore CIB has decided to pause in its further branch network expansion in order to consolidate and complete the organization of its existing network. The existing network has strengthened its staffing and improved its capacity and capability for project selection, appraisal and implementation. 59. Training. As most CIB staff were not previously familiar with development banking, training has been a major and critical activity. The Economic Development Institute (EDI) has given four five-week development banking courses, primarily for CIB and PCBC staff, and a further one is planned for 1987. CIB has also sent staff to short-term banking seminars overseas and to long-term domestic training in finance and English language, and has conducted a dozen in-house seminars focused on project appraisal techniques. CIB has appointed a training officer to coordinate its training program, and has selected staff from CIB and from MOF's institutes of finance and banking to work as a part-time team of trainers to raise the quality of CIB's in-house training, especially at the branch level. CIB's in-house training program for 1986 and 1987 will include several seminars per year on Project appraisal, supervision, Accounting, etc., some to be given at the Head Office and others for and at specific branches. CIB also needs to provide specialized training to its more experienced staff. To this effect, assurances were obtained during negotiations that CIB would send selected staff for long-term academic and operational training overseas according to a long-term training program acceptable to the Bank; an understanding was reached that some 30 CIB staff would receive such training during the period 1986-1990. However, because CIB cannot at present release a large number of its more 'txperienced staff due to their relative scarcity and heavy workload, CIB would start this training program gradually in 1986 by sending 4 of its staff for long-term training overseas; the foreign exchange costs would be financed from the $300,000 training component under CIB I. Operating Policies 60. In accordance with previously agreed Policy and DeveLopment Strategy Statements, CIB continues to focus on relatively small- and medium-sized modernization projects of existing state or collective enterprises. In view of the tighter foreign exchange situation currently experienced by China, CIB has recently begun to give preference to export-oriented projects, in particular in provinces with small foreign exchange earnings. Sectoral emphasis remains on light industries, but CIB has been expanding its scope to include chemicals, machinery, electronics, building materials, metallurgy, etc., in accordance with the demand for loans. CIB lends local currency only in conjunction with foreign exchange, and only for fixed investment; its borrowers obtain the necessary complementary working capital loans from ICBC. An assurance obtained under CIB II was repeated under the proposed - 20 - project that CIB would exchange views with the Bank/Association on any proposed changes in its Charter, Supplementary Regulations, Policy Statement, Development Strategy Statement or Lending Procedures. 61. Interest Rates. CIB will increase its interest rate for foreign exchange loans from 8% to 8.5% p.a. An assurance was obtained during negotiations that CIS will onlend proceeds of the loan/credit at an interest rate of 8.5% p.a. This new interest rate would enable CIB to maintain its competitiveness with BOC (para. 48). As world interest and inflation rates have fallen over the past two years, CIB's rate is now less out of line with international rates, and should be positive in real terms over the life of CIB's loans, given projected world and domestic inflation rates. In 1985, CIB adjusted its lending rates for local currency loans from 3.6% to the new structure of domestic interest rates for modernization loans which range from 7.92% to 10.8% p.a., depending on maturity (para. 49). With an average of about 91 p.a.; these rates are also expected to remain positive in real terms. China's inflation rate was about 3Z p.a. in 1981-1984, about 9% in 1985, and is projected to range between 7.0 and 7.7% p.a. in the coming 5 years. Assurances obtained under CIB II were reconfirmed that: (a) CIB would afford the Bank/Association an opportunity to exchange views with it prior to making any change in its interest rates; (b) CIB would inform the Bank/Association promptly after changes in the foreign exchange lending rates of other Chinese banks; (c) the Government would take into account the impact on CIB's operations in determining the foreign exchange lending rates of other Chinese banks; and (d) from time to time at the request of any party, the Government and CIB would exchange views with the Bank/Association on such impact and on the interest rates to be charged by CIB in its lending opera- tions in light of CIB's cost of funds and profitability and of movements in interest and inflation rates in China and internationally. 62. ?-.iject Selection, Appraisal, and Supervision. With the help of Chinese experts and the Bank, CIB prepared an Industrial Projects Appraisal Manual which has been used by its branches. This manual has been well received by various government agencies in China and is being used in some of China's other banks. The manual and the instructions for its use were revised, based on CIB's experience to date, and reissued in November 1984. CIB's staff h-vve been conscientiously applying the manual in their appraisal work and are using it to screen out projects that appear unsuitable -- some 20-30% of :he applications. On the basis of extensive factory visits, Bank missions have concluded that most projects selected by CIB have been good. The quality of appraisal reports from the more experienced branches has been improving, but is still uneven in the newer CIB branches. The Head Office has sent about half of the reports it received back to the branches for revision, and strives to impose consistent quality controls. With the staff strengthe- ning achieved in 1984 and 1985, the proposed further training and continued close Bank supervision, further improvements are expected. CIB will supervise these and future subprojects on the basis of its Project Supervision Manual, which was issued in 1983. CIB is giving priority to supervision work, which is done by the branches but overseen by the Head Office's Supervision Department. 63. Subloan Repayments. The maturity of CIB's loans does not exceed twelve years, and is normally seven years or less, including a grace period of two to three years. Shorter loan periods are often used by CIB because of the - 21 - high financial profitability of most industries to which CIB lends. The grace and repayment periods are based on the incremental profits and depreciation allowances which will be used to service the loans. If any enterprise does not have sufficient retained foreign exchange for interest and principal payments on its foreign exchange loan from CIB, the supervisory agencies and local government will provide the balance, or the enterprise will have to purchase it. An assurance obtained under CIB II was reconfirmed that the Government would enable enterprises to obtain the foreign exchange needed for payments to CIB. 64. Accounting System and Audit. CIB's accounting manual, incorporating the Bank's comments and based on Western accounting principles, was issued in January 1983. China's accounting and audit profession is not well developed, and the Bonk is helping to provide technical assistance to build up the capability of the newly established State Audit Administration. CIB's accounts will continue to be audited annually by independent auditors acceptable to the Bank/Association, and the audit report will be submitted to the Bank/Association within six months after the end of each fiscal year. CIB's 1983 and 1984 accounts were audited by the China Consultants of Accounting and Financial Management, an independent firm of professional auditors and accountants. These audits were performed satisfactorily and on schedule. The auditors' opinion on CIB's accounts for both 1983 and 1984 was unqualified. Operations, Finances, and Outlook. 65. Operations. In 1983 and 1984, CIB approved a total of $116 million foreign exchange loans and Y 305 million local currency loans. CIB's activity more than doubled in 1985, with total approvals of about $217 million in foreign exchange and Y 346 million in local currency. Approvals under CIB I and II totalled $238.4 million for 211 subprojects, of which 131 were subpro- jects below the free limit established for each CIB branch. Disbursements, after a slow start in 1983 and 1984, accelerated markedly in 1985 and reached a cumuLative total of $75.3 million by January 31, 1986. CIB has also used its own resources to approve 52 projects for a total of $31 million and Y 39 million (para. 66). The approved subprojects cover a wide range of manu- facturing subsectors of light industry; textiles and clothing were the predom- inart subsector with a share of 29Z in number and 25Z in amount, followed by metal products and light machinery (17% and 20% respectively), chemicals and pharmaceuticals (9% and 16%) and consumer electronics (12% and 92). Of the 8 provincial branches active under CIB I and the 19 active under CIB II, the Jiangsu branch has been the most active, with an overall share of 27% of total commitments, followed by Tianjin (18%), iebei (12%), and Shanghai (9%); the subprojects from the well-established.branches and industrial centers such as Tianjin, Shanghai and Hebei have been significantly larger than in other provinces. Most sub-borrowers were state enterprises, with a few urban collectives. The projected economic rates of return range from 12% to 67% p.a., and the financial rates of return to the enterprise from 13% to 53Z p.a. Most of the subprojects have a high marginal capital-labor ratio, largely due to the pervasive overstaffing of existing enterprises (so that little additional labor is needed) and also due to concerns with the quality of output on the part of exporting enterprises, which they feel can best be ensured by more automated processes. Most CIB subprojects introduced advanced technology, and a number of them have promoted exports, conserved energy and reduced pollution as well. - 22 - 66. Resources and Financial Position (see Annex IV, Table 1). Of its Y 400 million paid-in share capital, CIB used Y 28 million to purchase $10 million from the Government as a revolving fund for its foreign currency lending. In 1983, CIB borrowed also Y 140 million from PCBC, and with it bought a further $50 million in foreign exchange, of which $10 million was added to its revolving fund. It borrowed again in 1984 from PCBC Y "84.5 mil- lion (at 1.8Z p.a. and a term of 15 years with one final balloon payment) with which it bought $100 million in foreign exchange from BOC. Because 100Z cash deposits are required by BOC in many provinces to open CIB's Letters of Credit for foreign suppliers, CIB has a need to establish revolving funds in several branches for the purpose of facilitating subproject disbursements. As a result, about $80 million of the purchased $150 million have been tied up in advance payments for subprojects and in provincial revolving funds; the other $70 million have been committed for non-Bank financed projects and for anticipated special investments. Moreover, in order zo avoid total disruption of its operations after exhaustion of CIB II funds, CIB had to continue its approvals at a reduced scale during the last months of 1985. By end of 1985, CIB had thus uncommitted approvals in foreign exchange totalling about $31.3 million against available secured resources of $17.6 million, leaving a resource gap of $13.7 million at the approval level. The proposed loan will contribute to cover this gap. CIB has also by end of 1985 a resource gap of Y 238.4 million in loca'l currency on an approval basis. On the other hand, since most of the approved subprojects are still in an early phase of imple- mentation and disbursement, CIB's loan portfolio represents only about 56% of its total assets which are in majority in liquid form as cash or bank deposits earning most of CIB's income. The net income after taxes of CIB reached Y 5.7 million in 1984 and Y 17.4 million in 1985, representing respectively 1.4% and 4.3% of equity. CIB's long-term debt to equity ratio was 1.2:1 by end of 1984 and 1.5:1 by end of 1985, well within the 5:1 limit convenanted under CIB I and II. Assurances were obtained that CIB would continue to maintain a long-term debt to equity ratio of no greater than 5:1. CIB has no debt service obligations until 1987. The overall financial position of CIB is robust. 67. Prospects and Projections (see Annex IV, Table 2). CIB has built up a large pipeline of 118 projects totalling $294 million, of which approxi- matelv 21% are for textiles, 20% for consumer goods light industries, 18% for steel industry, 11% for electronic industries, 7% for machinery industry, 7Z for chemicai. industries and 16Z for other subsectors. In the light of the present subproject pipeline, the demand for CIB financing expressed in the 19 provinces and municipalities covered by its branch network, and CIB's absorptive capacity, CIB and the Bank estimate that its foreign exchange loan approvals would be close to $200 million in 1986 and increase afterwards by an average 11.5% p.a. over 1987-1990 to reach $310 million in 1990; its local currency loan approvals would increase by an average 10.7% p.a. from Y 400 million in 1986 to Y 600 million in 1990. 68. Taking into account the present resource gap of about $14 million (para. 66) and its anticipated operations for 1986, CIB needs to secure about $215 million for its foreign exchange approvals during 1986. CIB received from MOF and other concerned authorities the authorization to borrow up to $50 million on the international capital market; a first borrowing of $30 million is being arranged with a Japanese bank, and CIB has contacted a number of foreign commercial banks to borrow the balance of $20 million in the first -23- half of 1986. This resource mobilization operation, the first one to be undertaken by CIB outside the Bank Group, the proposed CIB III credit/loan, expected loan repayments of $10 million, the reallocation to lending purposes of about $20 million from CIB's revolving funds, and if necessary additional borrowing abroad in the second half of 1986, constitute CIB's short-term financing plan to fund its operations during the year 1986. 69. In the longer term, CIB plans to make foreign exchange approvals totaLling $455 million during the 2-year period mid 1986-mid 1988 and $715 million from mid-1988 to end 1990. Collection of sub loan repayments would amount to $72 million and $355 million respectively during these two periods; by improving the management of its cash resources, CIB could also make available for project lending after mid-1986 some $20 million of its own resources presently tied up as working capital and revolving funds. The balance of foreign exchange resources would have to be borrowed on the basis of a sound long-term financial plan. With respect to local currency resources, CIB's current resource position is also tight but can be more easily managed by raising local resources when needed for disbursements. To meet these disbursement needs until mid-1988, CIB will have to raise some Y 600 million, in the form of loans (most likely from PCBC) and mainly paid-in capital from the Government. 70. CIB's financial position is projected to remain exceptionally strong, due to its large equity base and low loan default risk (Annex IV, Tables 3 to 6). Its total assets would increase from Y 1.26 billion by end of 1985 to Y 3.5 billion by end of 1988 and Y 4.9 billion by end of 1990; the share of loan portfolio would increase from 56% in 1985 to 81% in 1990. Due to the increase of its lending rates (para. 61), gross revenue would increase from 4% of total assets in 1985 to 1.SX in 1989 and 1990, and financial expenses from 1.65Z in 1985 to 4.5Z in 1989 and 1990, yielding a wider spread of 2.8-3.0% in 1986-1990 sufficient to cover administrative expenses, constitute provisions and generate a reasonable profit margin. On this basis, net income would increase from Y 17.4 million in 1985 to a peak of Y 43.1 mil- lion in i987, and then decline to Y 29.5 million in 1988 and Y 39.5 million in 1990 after the expiration in 1988 of CIB's five year income tax ho'iday. The return on equity would peak at 7.3Z in 1987 and decline to about 3.9% after- wards. CIB's long-term debt would increase from Y 635 million by end 1985 to Y 2.65 billion by end 1988 and Y 3.85 billion by end 1990. Due to the fore- seen addition of paid-in capital, the long term debt to equity ratio would peak at 3.7:1 in 1990 and remain well within the covenanted 5:1 limit. CIB's debt service coverage ratio will remain very comfortable, declining from 12.4 in 1987 to 10.1 in 1990. 71. An understanding was reached during negotiations that CIB will borrow $50 million from non-Bank Group sources in the first half of 1986. CIB has also been requested to prepare an adequate long-term financing plan designed to cover CIB's foreign exchange needs over the period mid 1986-mid 1988 so that a recurrence of negative resource positions and the interruption of its lending operations can be avoided in the future. The Proposed Bank Loan and IDA Credit 72. Amount and Maturity. The proposed interim loan/credit would be for $100 million, based on CIB's short-term needs and absorptive capacity for the - 24 - first half of 1986, with a plan for other foreign exchange to be raised by CIB. The Bank loan wouLd be $75 million equivalent and the IDA credit SDR 22.80 million ($25 million equivalent). State Council approval of the Development Credit Agreement and Loan Agreement would be a condition of loan/credit effectiveness. The CIB III funds are expected to be committed to some 80 subprojects representing 6 months of CIB's operations; the credit would be committed first. The terminal date for submitting subprojects would be June 30, 1987. Back-to-back repayment of the subloans and the Bank loan would not be appropriate because the subloans would have usually short maturities averaging about 5 years. Therefore, as for CIB I and CIB II, the Bank loan would be of fixed amortization, on the standard country terms for China, which are 20 years including five years' grace on principal. All of the loan/credit would be for subprojects; CIB's technical assistance and training needs over the period would be financed from CIB I (para. 59). 73. Onlending Terms. The Government would onLend both the loan and the credit to CIB under a Subsidiary Loan Agreement, satisfactory to the Bank/Association, the signing of which would be a condition of loan/credit effectiveness. As under CIB I and II, both IDA and Bank funds would be onlent for 20 years including five years of grace, with CIB allowed to roll-over the funds. The Government would charge CIB a fixed interest rate of 7.0% p.a., plus the Bank and IDA commitment charges. The Government would thus bear the risk from the variable Bank interest rate, as under CIB I and II. Including the commitment fees, the total cost of these funds to CIB would be about 7.2% p.a., compared to its onlending rate of 8.5% p.a., leaving a net spread of about 1.32 p.a.. By onlending to CIB proceeds of the loan/credit denominated in US$ valued at the date of withdrawal, the Government would also bear the foreign exchange risk between the US$ and (a) the currency pool index (for the Bank loan portion) and (b) the SDR (for the IDA credit portion). These arrangements have been maintained because it would be too complicated and burdensome for CIB to pass these interest rate and foreign exchange risks on to its subborrowers. As subloans would also be denominated in US$, valued at the date of withdrawal, subborrowers would be taking any foreign exchange risk between the US$ and the Yuan. This risk will be small, as most new subborrowers are expected to undertake export-oriented projects (para. 60) and to earn foreign exchange which they will use for repayment. 74. Free Limit. As under CIB II, two free limits would be set: $2.0 million for branches agreed between CIB and the Bank/Association and $1.0 million for the other branches. Understanding was reached at negotiations that branches receiving the higher limit would be those adequately staffed and trained and which had consistently met reasonable appraisal standards, and that the Shanghai and Tianjin branches which meet these criteria would have the higher free limit. An estimated 40% of the subprojects by number and 70% by amount would be above the free limits. The first three subprojects from each new branch, regardless of size, would be subject to Bank/Association approval. The aggregate free limit would be $30 million. 75. Maximum Subloan Size. CIB may onlend for individual subprojects up to $15 million in foreign exchange, as per CIB's Development Strategy Statement. This high limit reflects the fact that in general it is for the larger of the medium-sized projects that CIB's appraisal is most valuable, because these projects are more likely to involve major technology import, serve nationwide or international markets which must be studied, and have many - 25 - linkages to other industries. However, the average subloan size is still expected to be about $1.5 million. 76. Procurement and Disbursement. As under CIB I and II, individual contracts of at least $3 million equivalent would be awarded after interna- tional competitive bidding (ICB), including prior Bank/Association review of bid documents, unless CIB auid the Bank/Association agree otherwise. A preference equal to 15Z of the c.i.f. cost or the customs duty, whichever is lower, would be extended to local manufacturers in the evaluation of bids. Contracts below $3 million would be awarded after evaluation and comparison of quotations solicited from at least three qualified suppliers. The existence of adequate competition to help ensure reasonable prices would continue to be examined as part of the review of all subprojects above the free limit. Only 3-5 contracts are expected to exceed $3 million. Disbursements would be made for 100% of: (a) foreign expenditures on goods and services for subprojects, and (b) the ex-factory price of locally-manufactured equipment for subprojects under contracts procured through ICB. Disbursements for contracts at or above $200,000 will be made against full documentation. Disbursements for contracts less than $200,000 will be made against Statements of Expenditures, with the full documentation held by CIB for review by Bank supervision missions. Disbursements are expected to be completed by June 30, 1990. The disbursement projections are at a slower rate for the initial two years than the disburse- ment profile of DFC lending in the East Asia and Pacific Region, in view of the general pattern of disbursement in China (para. 52), but the final years of the profile are telescoped because the loan/credit is expected to be fully committed in 1986, and disbursements would not extend for more than three years beyond. In order to allow CIB to use more of its own working capital in foreign exchange for lending purposes, and to facilitate project disburse- ments, a Special Account to be maintained in US dollars with an authorized allocation of US dollars equivalent of SDR 4.6 million would be established under the loan/credit in a bank on terms and conditions satisfactory to the Association. Applications for replenishment will be submitted quarterly or when the amounts withdrawn are equal to 50% of the initial deposit, whichever comes sooner. This small amount is justified in view of CIB's large cash resources in foreign exchange (para. 66). The Special Account and the Statements of Expenditures will be audited separately from CIB's accounts. 77. Benefits and Risks. CIB is already having a positive impact on China's industrial investmenL by selecting generally good projects and using an improved project appraisal methodology. As CIB becomes involved in project identification at an earlier stage, its contribution to project design will also increase. Although some projects that CIB rejects may obtain finance elsewhere, the general shortage of foreign exchange for investment, plus Government efforts to hold down total investment, and the influence that CIB's decision will have on other agencies, ensure that CIB's project selection will help determine which projects should be undertaken. There also remain long- term prospects for major spillover effects, especially through improving the project appraisal work of Chinese planning agencies and other banks. By demonstrating that locally controlled projects can be designed and evaluated from the national perspective, CIB could also give further impetus to decentralization. 78. In a narrow sense, the Project risk is low, because CIB has been financing generally good subprojects, and the Bank will continue to review - 26 - carefully the bulk of CIB's sublending (paras. 62 and 74). However, the project's success in its broader objective of introducing new project appraisal methodology and resource-allocation approaches to China depends largely on CIB overcoming its weaknesses in the critical areas of market estimation and economic analysis of subprojects, and financial management and resource mobilization. Continued Bank Group support is essentially for building up CIB in these areas. Less tractable are longer-term risks related to Government commitment to the economic reform framework within which CIB operates, and to CIB itself. The path of reform in China, as elsewhere, has not been without some difficulties, but the Government remains committed to the process. Furthermore, the Government's commitment to CIB remains strong, as indicated by the 1984 State Council circular to ministries and local governments supporting an enhanced role for CIB. PART V - RECOMMENDATION 79. I am satisfied that the proposed and loan and credit would comply with the Articles of Agreement of the Bank and the Association and recommend that the Executive Directors approve the proposed loan and credit. A. W. Clausen President February 11, 1986 Washington, D.C. -27- ANN-X I Pgse I of 6 __E~~~~~~~~~W __ st_ au (Uhma I. we otal. 954.0 951.0 951.0 AMCOL701PAL 325A sma.o 3005.9 M aM (as) *- . * 00.0 an.3 ioa.: CSiLOfa'F OI ot. hia) M.2.0 25. 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Groupe de la Banque mondiale · President's Report
China - Third Industrial Credit (Investment Bank) Project
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Groupe de la Banque mondiale
Type de document
President's Report
Pays
Chine
Source
Banque mondiale