Sri Lanka - Third Small and Medium Industries Project (SMI III)

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 6823-CE STAFF APPRAISAL REPORT SRI LANKA THIRD SMALL AND MEDIUM INDUSTRIES PROJECT (SMI III) November 10, 1987 Tidustry and Energy Division Country Department 1 Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Currency Equivalent Currency Unit - Sri Lanka Rupee Sri Lanka has a floating exchange rate. For SMI I a rate of US$1 = Rs 17.5 has taen used and for SMI II a rate of US$1 = Rs 20.0 was used. For the proposed SMI III the following rates prevailing as of June 30, 1987 are used: US$1 = Rs 28.5 Rs 1 = US$0.035 Rs 1 million = US$35,000 FISCAL YEARS Government of Sri Lanka January 1 to December 31 Commercial Banks = January ' to December 31 DFCC April 1 to March 31 National Development Bank January 1 to December 31 FOR OFFICIAL USE ONLY Abbreviations and Principal Acronyms ADB - Asian Development Bank AWPR - Average Weighted Prime Rate BO - Bank of Ceylon BTT - Business Turnover Tax BMR - Balancing, Modernizing and Rehabilitation CB - Commercial Banks CBOC - Commercial Bank of Ceylon CBSL - Central Bank of Sri Lanka CDIC - Capital Development and Investment Corporation CDS - Committee of Development Secretaries DFCC - D olopment Finance Corporation of Ceylon DRC - Domestic Resource Cost DSI - Department of Small Industries DTI - Department of Textile Industries EDB - Export Development Board EPR - Effective Protection Rates ERR - Economic Rate of Return FCB - Foreign Commercial Banks FIAC - Foreign Investment Advisory Committee FTZ - Free Trade Zone GCEC - Greater Colombo Economic Commission GITI - Garment Industry Training Institute GOSL - Government of Sri Lanka HNB - Hatton National Bank IDB - Industrial Development Board IPS - Industrial Policy Statement ISC - Industrial Sector Credit LIAC - Local Investment Advisory Committee LOLC - Lanka Orient Leasing Company MISA - Ministry of Industry and Scientific Affairs MRID - Ministry for Rural Industries Development MTI - Ministry of Textile Industries NCB - Nationalized Commercial Banks NDB - National Development Bank of Sri Lanka NIBM - National Institute of Business Management NSB - Nationai Savings Bank PB - Peoples Bank PCI - Participating Credit Institutions PMEs - Public Manufacturing Enterprises RRDB - Regional Rural Development Banks SITC - Standard International Trade Classification SMI - Small and Medium Industries TBR - Treasury Bill Rate TIPR - Trade and Industrial Policy Reform TOR - Terms of Reference UNDP - United Nations Development Program This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. SRI LANKA THIRD SMALL AND MEDIUM INDUSTRIES (SMI III) PROJECT STAFF APPRAISAL REPORT TABLE OF CONTENTS Page Credit and Project Summary I. INTRODUCTION ............ ................. 1 II. SECTORAL BACKGROUND ...................... . .... 1 A. The Economic Setting ........................... 1 B. The Industrial Sector ........................... 2 C. The Financial Environment ................ 4 D. The SMI Sector .............................. 8 III. THE BANK GROUP'S INDUSTRIAL LENDING STRATEGY ....... 13 A. Lending and Industrial Strategy ................. 13 B. The Bank Group's SMI Operations ................. 16 IV. THE PROJECT ........................... ...**** 17 A. Objectives and Scope ............................ 17 B. Institutional Structure ................. 19 C. Project Costs and Financing Plan ................ 21 D. The Credit Component ............................ 22 E. The Technical Assistance Component .............. 24 V. THE CREDIT ...................... ... ..... . . . . 28 A. Terms and Conditions ........................... 28 B. Administration Procedures ....................... 30 0. Co-Financing ..o............... 0 00 90000 .... 3z r. Project Benefits and Risks ...................... 32 VI. AGREEMENTS REACHED AND RECOMMENDATIONS .......o.... 34 -2- ANNEXES 1. Outline COSL: SMI Development Policy 2. Interest Rate Structure 3. Subproject Profiles: SMI I and II 4. Performance of Participating Credit Institutions (PCIs) 5. Improving the Efficiency of the Financial Sector 6. Review of Duty Drawback/Export Credit Procedures 7. Export Marketing Fund 8. SMI Technical Assistance Facility 9. Disbursement Schedule 10. Supporting Documents Available: Project File This report was prepaied by Messrs. D.K. Groves, T. Maxwellt Q. Amed and C. Teng following an appraisal mission to Sri Lanka in May/Junet 1987. The mission combined with an ADB mission preparing the cofinancing component. A post appraisal mission was carried out as part of a review of the industrial sector in September 1987 to assess reconstruction needs following the recent peace accord. 10 SupotigDoumnt valaleIroec Fl Thsreotwa reae byMsss D..Goe, .Mxel Q he n SRI LANKA Third Small and Medium Industries Project (SMI III) Credit and Project Summary Borrower : Democratic Socialist Republic of S.-i Lanka. Beneficiaries : Eligible Participating Credit Institutions (PCIs) includ- ing public and private sector commercial banks and development financing institutions. As Under SMI I and II, these would include: Bank of Ceylon (BOC), Commer- cial Bank of Ceylon (CBOC), Development Finance Corpora- tion of Ceylon (DFCC), Hatton National Bank (HNB), and the Peoples Bank (PB). Technical assistance would be provided to the Export Development Board (EDB) and NDB to improve SMI operations, and to the BOC and PB to improve their overall operations. Amount : SDRs 15.7 million (US$ 20.0 million equivalent) Terms : Standard IDA terms with 40 years maturity. Co-Finanring : The Asian Development Bank (ADB) proposes to provide US$15.0 million through a parallel line of credit on terms and conditions similar to those of the proposed Project. Project Description : The objectives of the proposed project, which complement previous and ongoing industrial sector operations, are to (i) provide credit through the banking system to small and medium scale private manufacturing enterprises, and (ii) make a further contribution to policy reform and institutional strengthening in the areas of tariff admiaistration, export promotion and financial sector operations. Major components of the proposed IDA SMI Project would be a credit component for refinancing term subloans, through the SMI Fund, to private seclor SMIs; and a technial assistance component to help COSL and relevant agencies (i) improve the efficiency of the financial sector through continued training for the PCIs; and technical assistance to the BOC and PB to develop action programs to improve their overall operating and financial efficiency, (ii) improve the access of indirect exporters to duty drawback and export credit facilities, -2- (iii) improve the efficiency of public mantfacturing enterprises (PMEs) through the implementation of action programs developed under ongoing industrial development projects, and (iv) establish an SMI technical assistance facility. The benefits arising from the project would be more effective investment in the industrial sector; improved PCI performance; and increased employment opportunities. Direct benefits of the lending component would include US$35-US$40 million in incremental output per annum. Through the financing of about 3,650 subprojects, about 31,400 additional jobs are expected to be created at a job/cost ratio of US$1,750; in addition, productivity in existing units would be improved through BMR in'estment. Although a risk exists that an adequate number of eligible subprojects will not materialize, the project pipeline and projections indicate a credit demand well in excess of the amount to be provided by the proposed credit. Collection rates could also deteriorate, but the project provides for strengthening PCI appraisal and supervision capabilities, particularly of the two largest commercial banks, to help minimize this risk. The final r'sk is that the Government may not proceed with policy reform in the area of duty drawbacks and export financing as rapidly as expected; IDA will continue to monitor developments closely in its economic and sector work and project supervision. Relending Terms : GOSL would onlend the project proceeds to NDB for 18 years, including a five year grace period, at an initial rate equivalent to seven percentage points below the Average Weighted Prime Rate (AWPR) for the Commercial Banks for short term (i.e. 12 months or less) lending operations. In turn, NDB would refinance PCI operations at the AWPR, less six percentage points. The PCIs would relend the proceeds at a rate, fixed or variable, suffi- cient to cover their costs of operation and the project risk. Given the spread between the IDA and COSL onlend- ing rates, GOSL will bear the foreign exchange risk. On the basis of the present AWPR and spread requirements, the relending rate would be between 13%-16% which com- pares favourably with current Commercial Bank funding of 14%-22%. The mechanism for establishing interest rates and spreads would be reviewed semi annually and, if necessary, adjusted based on procedures agreed between COSL and IDA. The actual rate charged to NDB and sub- sequently to the PCIs shall be amended on January 1 and -3- July 1 to (i) reflect any significant movement in the market reference rate, and (ii) remain positive in real terms vis-a-vis inflation as reflected by the Colombo Price Index. The maximum subproject repayment period would be ten years including a two year grace period. Project Costs Foreign Local Foreign Total Local Foreign 'otal % of -----(Rs Million)---- ----(U$ Million)------ Total Subproject Investment 484.5 840.7 1,325.2 17.0 29.5 46.5 63.5 Technical Assistance: Financial Sector Efficiency 31.4 65.6 96.9 1.1 2.3 3.4 68 Export Promotion 14.3 17.1 31.4 0.5 0.6 1.1 55 SMI Technical Assistance Facility 11.3 14.3 25.5 0.4 0.5 0.9 56 Improving Industrial Efficiency 28.5 59.8 88.4 1.0 2.1 3.1 68 Total Project Cost 570.0 997.5 1,567.5 20.0 35.0 55.0 63.5 Financing Plan ADB 427.5 427.5 - 15.0 15.0 27.3 GOSL 57.0 57.0 2.0 - 2.0 PCIs 228.0 228.0 8.0 - 8.0 Sub-borrowers 285.0 285.0 10.0 - 10.0 IDA - 570.0 570.0 20.0 20.0 6.2 570.0 997.5 1,567.5 20.0 35.0 55.0 63.5 -4- Disbursements Bank Group Fiscal Year FY88 FY89 FY90 FY91 FY92 FY93 ---------------(US$ Million)---------------- Annual 3.0 3.0 4.0 5,0 4.0 1.0 Cumulative 3.0 6.0 10.0 15.0 19.0 20.0 % 15 30 50 75 95 100 Economic Rate of Return (ERR) : A minimum ERR of 15% would be required for all subprojects above the PCI review free limit or with nominal tariff protection of more than 40%. Staff Appraisal Report : No. 6823-CE Map : No. IBRD 17278 SRI LANKA STAFF APPRAISAL REPORT THIRD SMALL AND MEDIUM INDUSTRIES (SMI III) PROJECT I. INTRODUCTION 1.01 The Government of Sri Lanka's (GOSL) Statement on Industrial Policy (IPS) of February 1987, gives high priority to private industrial develop- ment, with particular emphasis upon the cole of small and medium industries (SMI). The Statement continued GOSL's support since 1977 for industrial development via the SMI sector. IDA has assisted GOSL's strategy by provid- ing credit, technical and marketing assistance to SMIs and by improving the institutional arrangements for credit delivery under two previous Small and Medium Industry (SMI) projects (paras. 3.07-3.09). With little or no experience of SMI financing in Sri Lanka, institutional performance under the first SMI was mixed. However, with the foundation of experience of SMI I, performance under SMI II has been satisfactory and GOSL has requested financing for a third SMI project to support the thrust of its IPS. This report recommends a Credit of SDRs 15.7 million (US$ 20.0 million) which would be supplemented by cofinancing of US$15.0 million from the Asian Development Bank (ADB). II. SECTORAL BACKGROUND A. The Economic Setting 1/ 2.01 Real CDP in Sri Lanka grew by only 2.7% p.a. during 1970-1976, due to a combination of a policy framework unconducive to growth or efficiency, poor weather conditions which affected agricultural growth adversely and the sharp rise in fuel costs. In late 1977, the newly elected Government initiated a liberalization strategy with the objective of increasing the growth rate of production and employment, savings and investment and exports. 2/ To achieve these objectives, GOSL introduced policies which included exchange rate unification and depreciation, import trade liberaliza- tion, interest rate increases to encourage savings, full cost pricing for 1/ For a comprehensive review of the current economic situation in Sri Lanka, see Report No. 6701-CE Sri Lanka--Issues in Macro-Economic and Industrial Development Policy, dated April 20, 1987. 2/ Thit reform program was introduced in agreement with the IMF in sup- port of a standby facility and, subsequently, in January 1979, an Extended Fund Facility. -2- most imported commodities and the establishment of a free trade zone to attract export-oriented foreign private investment. The economy initia'ly reacted vigorously to these changes, with real GDP growch accelerating to an average of 7.3% p.a. during 1977-1979, but it slowed down to 5.4% in 1978-1986. The main areas of growth have been agriculture, services, garment exports and construction, all of which benefitted from libe-alization, the increased level of investment and other incentives. With assistance from foreign donors, fixed investment has risen from about 15% of GVP in the early 1970s to 26% in 1986. 2.02 Some of the policies and achievements also led to serious financial imbalances. For example, as the public investment program gained momentum, it grew beyond the country's resource availabilities, thus contributing to unsustainable budgetary and balance of payments deficits and to undesirable levels of foreign commercial borrowing. More importantly, the imbalances in the budget and in the balance of payments were aggravated by an inadequate public sector resource mobilization effort and by the existence of an overall policy environment not conducive to exports due to a lack of adjustment in the exchange rate and high protection which created a bias toward import substitution. Although the budget deficit decreased significantly during the late 1970s with significant increases in public sector investment and a disappointing revenue effort, it remained in the 10%-14% range during the mid 1980s. Due to this budgetary deficit, external developments and an incentive structure biased against exports, the current account deficit increased to 19.8% of GDP in 1980, declining significantly to 4.8% in 1984, but increased to an estimated 9% in 1986. After a short lived increase in 1984-85 the prices of the key traditional exports (tea, rubber and coconut) have resumed their earlier decline and forced a deterioration of 18% in the terms of trade between 1985-86. This has impacted upon reserves, which now stand at about two months of imports, and the debt servicing ratio is 28% of export income. The sudden decline of tea, rubbet and coconut prices in 1985-86 and the increasing level of ethnic disturbances, with its consequent impact on budgetary resources and negative impact on the service sector (e.g. tourism), underscores the continued vulnerability of the Sri Lankan economy and the need for diversification. In these circumstances particular attention must be given to the stimulation of industrial growth and exports. B. The Industrial Sector 2.03 Structure and Performance. Although Sri Lanka has a limited industrial base, the manufacturing sector accounts for about 15% of GDP and 45% of exports. The sector's structure has remained relatively unchanged over the past decade. Large enterprises, mainly public sector corporations, are concentrated in cement, ceramics, chemicals, petroleum, textiles, steel and wood products. Currently, the manufacturing sector consists of 20 medium- to large-scale public manufacturing enterprises (PMEs) under the control of the Ministry of Industries and Scientific Affairs (MISA); about 50 corporations supervised by other line Ministries; about 400 large-scale registered private factories mainly in the Colombo area; b,000 smal. and medium registered private factories; 25,000 dispersed small and rottage inits concentrated in handicrafts and industrial services, and about 70,00) qmall informal agro-industrial units. At the time of the last industvial ensus Lin 1983 there weee 100,000 industrial establtshments. Over 86% of these employed fewer than five workers. Howevet, units with less than tive employees account for 30% of employment and contributed about 8% to value added and output. More dramatically, they achieve a value added per person of only Rs 7,900 (US$275), compared to Rs 40,000 (US$1,400) for the larger private sector units. Overall the private secto employs 90% of ind-istrial workers and accounts for about 60% of manufactured value added. 2.04 Government policy has had a significant impact on industrial perfor- mance. Liberalization of trade and industrial policies in 1977, the lifting of foreign exchange restrictions and growing commitment to the private sector as a basis for industrial development contributed to strong industrial growth of about 8% p.a. in 1978. However, after this initial improvement, the rate of real growth in industry slowed to an annual average real rate of 6% in 1978-1986. The appreciation of the exchange rate after 1978 adversely affected the production of traded goods. Furthermore, although import tariffs were maintained to provide significant levels of tariff protection for manufacturers vis-a-vis other sectors the growth opportunities created by the inward tooking policy were limited due to the small size of the local market. There have been wide variations in the performance of the public and private sector enterprises. While overall growth in industrial output from 1978 to 1986 was 6% p.a., output of the PMEs essentially stagnated with an average annual growth rate of only 1%. Private sector output is dominated by chemical, rubber and plastic products (34%); beverages and tobacco (27%); and textiles, garments and fabrics (25%). Garments exports, which increased from US$12 million in 1977 to US$325 million in 1986, now account for about 57% of total manufactured exports although the valued added content is only about 10%. Despite the private secto:'s growth, the PMEs remain important, accounting for about 50% of industrial investment and contributing abo.. 40% of value added in the non-petroleum manufacturing sector. The Industrial Policy Framework 2.05 Prior to 1977 the industrial sector policy framework constrained its devclvpment along the lines of its comparative advantage. High protection levels and subsidies to capital, and heavily tax,1 1 Ibor, led to a high concentrated and capital intensive industrial structure. Complex Government regulations and interventions led to heavy administrative and regulatoly structures, features accentuated by the emphasis given to PMEs. Moreover, Government encouraged the creation of industries contributing to the vertical integration of productive processes with a view to substituting for imports, a characteristic particularly visible in the textile sector, thus reducing even further gains of specialization. -4- 2.06 In recognizing the constraints caused by these policies, GOSL has made a number of major revisions to its policies since 1977. It has replaced most import quotas and licensing with tariffs and provided improved invest- ment and export incentives for foreign and local entrepreneurs. In 1986, with Technical Assistance (TA) funding from the First Industrial Development Project (IDP I--Cr. 1401-CE), GOSL prepared an IPS linking the present situa- tion and its medium term industrial objectives. Cabinet has accepted the IPS and COSL has established a small Council of Ministers and a Presidential Committee on Privatization (PCP) consisting of three civil servants and three private sector industrialists to develop a detailed implementation program, which would become the key element in any future dialogue between GOSL and IDA on proposed industrial sector lending to Sri Lanka. COSL's policies relating to SMI operations are set out in Annex 1. In the meantime, however, a great deal remains to be done to translate the proposals of the IPS into effect: (i) action is necessary to ensure that the Tariff Commission is appropriately staffed to carry out impact assessments of previous tariff reform and to implement agreed programs of further tariff reform. Adequate staffing would be a necessary conditions for negotiations; (ii) a further reduction is necessary in the bias toward import substitution in favor of export orientation, particularly in the provision of export financing and the extension of duty drawbacks to indirect exporters; (iii) significant commer- c:alization and rationalization of the PMEs, which are highly inefficient, is needed to improve their contribution to the Treasury; (iv) improvement is required in the allocation of financial resources through increased financial sector efficiency and the development of market determined interest rates; and (v) a reduction is necessary in the regulations affecting new and exist- ing business operations. The proposed project woula address a number of these issues which specifically constrain SMI development. C. The Financial Environment 1/ The Banking System 2.07 Prior to 1977, the institutional sources for industrial financing were four domestic commercial banks (CBs), DFCC and four foreign commercial banks (FCBs). Traditionally, private industry relied on self-financing for up to 80% of its fixed capital needs and on commercial bank credit to finance working capital, with some rollovers for long term investment. Overall, CB credit accounted for about 85% of all institutional finance to private industry. Although public sector industrial corporations obtained CB credit budgetary allocations accounted for 80% of their financial requirements. DFCC was the only source of long term equity and loans, with a monopoly in 1/ Annex 10.3 in the Project File--The Structure of the Finance System and the Provision of Industrial Finance--gives a more comprehensive review of the finance environment. -5- foreign exchange lending to private industry. Since 1977, a significant number of FCBs have entered the financial system, NDB was established, and leasing companies and a number of general financing institutions have set up ope:ations. The expanded system consists of The National Savings Bank (NSB), two public and two private domestic commercial banks, two industrial develop- ment banks, four regional rural development banks (RRDBs), 21 FCBs, 24 for- eign currency banking units, 50 finance companies providing leasing and hire purchase facilities, three major specialized leasing companies and several provident funds and insurance companies. There are six money brokers who operate in the interbank/secondary market. In addition to the institutions monitored by the Central Bank of Sri Lanka (CBSL), there is an active unoffi- cial market with deposit and lending rates higher than official rates. 2.08 The non-bank financial institutions involved in providing services to the industrial sector include finance companies, leasing companies and two merchant banks. The merchant banks have been inactive mainly due to the slow development of the securities markets. However, because of the tax advantages of leasing, finance and leasing companies have developed rapidly; presently more than 50 finance companies offer hire purchase finance. Six leasing companies, including Lanka Orient Leasing (LOLC) in which IFC has a shareholding, also provide term financing. These institutions have grown rapidly by offering high interest rates on deposits and lend for consumer goods and transport equipment. 2.09 The two Government-owned national commercial banks (NCBs), the Bank of Ceylon (BOC) and the People's Bank (PB), dominate the commercial banking system, accounting for approximately 75% of deposits. The commercial banks are involved primarily in short-term lending, witl about 50% of lending going to commerce and 25% to industry. Most commercial bank resources come from sort term deposits, with few deposits of a mattrity of 12 months or longer. Because of the need to meet Business Turnover Tax (BTT) charges, high CBSL reserve provisions, and to service the cost of large non performing asset portfolios, the NCBs' lending margins are relatively high (6%-8%). 2.10 GOSL and CBSL have continuously stressed the need for the NCBs to improve their efficiency while giving preference to agriculture and other priority (and high-risk) sectors. However, these entreaties have had little success, on the one hand, because of inadequate debt recovery regulations and, on the other the Banks' reluctance to accept risks involved in lending to some high priority sectors. Cabinet is presently considering changes to debt recovery rules and regulations including (i) simplification of the procedures for the issue and service of summons for debt recovery; (ii) the introduction of a "market rate of interest" related to the Treasury Bill Rate (TBR) which debtors would have to pay from the date of a court award to the date of payment; and (iii) establishment of one or more specially designated "Commercial" Courts with sole powers and exclusive jurisdiction to hear cases submitted by "approved credit institutions". Administrative proposals -6- include (i) the establishment of a Credit Insurance Fund; (ii) the estab- linhment of a Credit Information Bureau coordinated by the CBSL Banking Supervision Division; and (iii) the redistribution of work among the Colombo Courts to concentrate debt recovery actions in one court. Capital Market 2.11 The market for shares and other securities in Sri Lanka is undeveloped and stocks and debentures have not been significant sources of finance for industry. Although a small number of brokers make a market for shares and about 300 companies are listed, most are closely held or dormant, and tradin, volume is thin. Development of the market has been hampered on the supply side by the relatively small number of medium and large companies in Sri Lanka and the strong tradition of closely held ownership. On the demand side, interest in investing in shares is low due to relatively high returns available on fixed interest deposits and commercial activities. GOSL is taking steps to revitalize the market through (i) the formation of an equity fund, (ii) legislation to establish a Securities Council to monitor the operations of the capital market, and (iii) consolidation of the opera- tions of the country's two stock exchanges which have not operated effec- tively. 2.12 Once the procedures proposed under the Securities Council Act are in place, COSL could stimulate greater securities activity and the development of primary and secondary markets in Governmental instruments by increasing the tax incentive for companies to go public, reforming the system of under- writing, developing new investment and unit trusts by DFCC and the merchant banks and issuing shares in profitable public sector corporations. This would complement the establishment of the Sri Lanka Capital Development and Investment Company (CDIC) by GOSL, NDB ani other Sri Lankan financial institutions, including the state-owned commercial banks, to provide equity to new ventures, particularly joint ventures between public corporations and private parties. The measures proposed by GOSL to develop the capital market into a major source of industrial financing are a step in the right direc- tion, but more needs to be done. A joint IMF/Bank review of the Financial Sector in May 1986 considered the role of the capital market in the financial sector and proposed a general outline program for upgrading its activities. This is to be taken up under a proposed Financial Sector Credit in FY89/FY90. interest Rates 2.13 After 16% inflation in 1983, inflation declined to 1.5% in 1985, but rose to 8% in 1986. (Based upon the Colombo Consumer Price Index.) In response to a tighter monetary policy and proposed policy changes to support a SAF from the IMF, projections for 1987-1990, which assume reduced budget deficits, anticipate inflation to be 8%-10% over the next three years. Against this background of inflation movement, interest rates have remained positive in real terms for seme time. However, GOSL's interest rate and -7- refinancing pclicies have led to the present structure and level of interest rates are affected by a number of anomalies, including (i) an interest rate structure with wide ranges in lending and deposit rates, with some deposit rates exceeding lending rates; (ii) simultaneous inadequate and excessive liquidity in different financial institutions; (iii) high reserve require- ments for financial institutions side by side with an unreguiated capital market; and (iv) priority for Government resource mobilization over private sector financing. Although term deposit and loan interest rates have declined considerably during FY85-FY87, interest rates overall are still high. Currently, long-term deposit rates (i.e., 12 months) are about 10%-14% (Aanex 2). Term loans are presently 14% and working capital rates 14%-22%, partly due to the CBSL's restrictive monetary (i.e. reserve) policies and partly due to high spread requirements to meet GOSL tax requirements and to service the cost of funding non performing investments. 2.14 The constraining effect of high real interest rates on economic activity has been compounded by the perverse relationship of relative rates with medium- and long-term lending rates being less than time deposit and savings rates. Currently, under CBSL's refinance schemes and the lending policies for term financing of the state-owned commercial and development banks, lending rates for medium- and long-term loans are 8% below the rates for Commercial Bank overdrafts and equal to the Average Weighted Prime Rate (AWPR) of 14.5% for prime short term lending operations. Through this sub- sidy mechanism, GOSL has tried to insulate the non-traditional manufacturing and export sector from the high cost of capital, but given the fungibility of finance and complementarity of fixed and working capital, this policy has not been very effective. GOSL has also devised complex regulations to dis- criminate in its financial subsidy policy between agriculture, tourism, manufacturing, approved ministerial projects and others. The financial system, which is largely owned or controlled by the State has, until recently, also been used to subsidize PMEs, diverting funds from potentially viable private sector projects. Under the proposed Project, steps would be taken to increase the role of market forces in the determination of term lending rates; initially funds would be onlent from GOSL via NDB to the PCIs at an agreed spread below the AWPR, which is the -esent market reference for interest rate determination under ongoing IDA Projects. The AWPR is proposed as the initial interest rate reference point pending the maturity of the CBSL's Treasury Bill Market or the determination of some other appropriate market related reference. Using the AWPR as a reference, the PCIs would be free to charge sub-borrowers a variable or fixed term lending rate that reflected their cost of borrowing and project risk. In line with the recom- mendations of the June 1986 joint IMF/Bank Financial Sector Report the CBSL is developing a Treasury Bill Market through the weekly auction of Treasury Bills. In the short time since its creation in January 1987, the Treasury Bill market (which is a voluntary market) has developed into a sizable and relatively free market with about 30%-40% of total bills outstanding held outside the CBSL although the degree to which this growth is linked to the tax exempt status of TB income has not been quantified. With sustained -8- growth in the Treasury Bill Market the TBR could become a viable alternative for the AWPR as the market reference for determining onlending rates under the proposed project and at the time of the semi annual interest rate mechanism review agreed with GOSL consideration would be given to the use of the TBR as the market reference. D. The SMI Sector The Policy Environment 2.15 COSL defines small and medium industry (SMI) units as any industrial enterprise privately or cooperatively owned with total fixed assets (exclud- ing land and buildings) with a book value not exceeding Rs 4 million (US$140,000) prior to the granting of a subloan. Government policies for industrial development allow SMIs to set up and operate with little regula- tion, and market signals are the main determinants of SMI investments and their viability. Except for location permits in line with zoning regula- tions, licensing is not required to establish an SMI unit. GOSL's policy requires SMIs to be in the private sector. Subsectors with strong potential, high value added and limited economies of scale are promoted, but not reserved, for SMI production. There is a push to develop SMIs in more remote urban and rural areas (particularly in the Mahaweli) but this objective again is pursued by promotion and provision of services rather than with distor- tionary incentives. With the recent signing of the Indian-Sri Lankan peace accord COSL is giving particular emphasis to employment generated through SMI operations in the Northern and Eastern Provinces. 2.16 Technical assistance activities in support of SMI are at present mait.ly a government responsibility, carried out by technical agencies under the direct control of the Ministries of Industries and Scientific Affairs (MISA), Textile Industries (MTI) or Rural Industries Development (MRID). These include the Industrial Development Board (IDB), the Export Development Board (EDB) and the Textile and Garment Industries Training Centres. To a large extent these agencies have focused their assistance to the SMI sector on providing physical facilities, developing industrial estates, building and equipping service centres and establishing training and production centres for handicrafts. The First and Second SMI Projects supported these agencies in their programs for the promotion of new, viable enterprises and the provi- sion of extension services to existing firms. Components under the SMI projects encouraged them to increase their contact with the private sector by emphasizing activities which support local entrepreneurs, and providing direct services to the private sector in project preparation, export promo- tion and extension services. While some TA activities, especially those with a strong focus on direct relationship with local businessmen, have been quite effective in meeting SMI needs for technical and marketing support, deficien- cies still exist due to the quality of some of the services and the effec- tiveness of the delivery system itself. Considering the inherent limitations of these public sector organizations in staffing and funding, alternative channels in the private sector should be developed. Under the proposed project, this approach will be tried in the areas of export marketing and SMI technical assistance (paras. 4.21-4.26). -9- Characteristics and Role of SMI 2.17 Sectoral Share. 3MIs continue to dominate the private manufacturing sector, accounting for over 90% of private industrial units, over 70% of employment and over 55% of value added in private manufacturing. The only substantial increases in larger industrial investment and output have been among firms involving foreign capital, approved either by the GCEC or FIAC. During July 1977-June 1986 about 450 manufacturing firms were approved; if implemented, these approvals would represent Rs 8.1 billion (US$280 million) in total investments, and employment potential of 87,000. GCEC approved operations averaged Rs 12 million per investment and FIAC approved firms Rs 23 million. However, only about 20% of these firms are in commercial operation, and the number to be implemented is uncertain. The trends in CCEC/FIAC approvals have also been falling since 1983, with a steady decline in investment in all subsectors. Domestic investment has increased markedly, however, and combined local/foreign investments have shown a steady increase, with growth most noticeable in SMI operations. 2.18 Geographical Distribution. About 65% of registered SMIs are located in the urban areas of Colombo, Kalutara, Kandy, Matara, Jaffna, Galle and Kurunegala districts (Annex 3). Unregistered small and cottage industries are more widely dispersed among small towns and villages, the Colombo dis- trict representing only abcut 30% of the units. While unregistered small firms are characterized by wide dispersal, the major product lines are con- centrated in varying districts, depending upon location of raw materials or market access. In each of the ten major Standard International Trade Class- ification product Lines, which account for 60% of the 15,500 units in the 300 products lines defined by IDB, three districts contain over 50% of the units. 2.19 Subsectoral Distribution. The main SMI product groups, constituting about 90% of the employment and 85% of the invesUent in registered SMIs, are textiles and garments, light engineering, rubber and chemical goods, wood and paper products (Annex 3). Most LIAC approvals during 1980-86 have been in these groups, as well as building materials in response to growth in public and private construction. Product concentrations among unregistered SMI units are found in related lines: handlooms, pottery, jaggery, blacksmithing, sheet rubber, rice mills and bricks. However, several of these traditional products have been unsuccessful in competing with local or imported items manufactured by labor-intensive modern firms. 2.20 Growth Subsectors. Agro-industries, selected textile products and light engineering are expected to be growth areas in the medium term. In the recent past agro-industries (food processing, etc.) accounted for about 30% of SMI investments. This subsector's importance is likely to increase, as expansion in agricultural output in the Mah&weli area generates larger agricultural surpluses for processing. Substantial capacity expansion is expected in rice and flour milling, oil extraction and ice and cold storage for the fishing, poultry and cash crop sectors. Also, project opportunities in the handling, storage and processing of fruits and vegetables for domestic and export markets could be numerous. Growth in the tacilliary sectors -10- supporting the garment sector, which accounted for about 57% of manufactured exports, is projected to develop in response to continued investments in garment manufacturing for exports based on both local cotton and imported blend fabrics. In light engineering, the investment level of about 20% will probably continue, concentrating in engineering workshops, in response to maintenance requirement of agricultural equipment, faster urbanization and industrialization. Although not presently significant, the number of SMI units owned or operated by women, particularly in the garment, handicraft and food processing industries, is increasing and the general support given under SMI I and II would continue under the proposed project. 2.21 Export Market Prospects. In the past, SMI production for exports concentrated on products such as textiles, garments, handicrafts, etc. which were exported mainly to Europe and the United States. More recently, however, there has been increasing product and market diversification, demon- strated by exports of leather products, fashion garments and processed marine products, fruits and vegetables to newer markets including Europe and the Middle East. The outlook for further growth appears promising, provided that appropriate policy and institutional support are developed. A central deficiency in the present system is that only direct exporters are entitled to export incentives. This has restricted development in the export sector with companies of limited size trying to export directly despite lack of expertise. A related institutional problem is the lack of private sector marketing institutions with strong marketing skills which can assist small producers in export market development. These aspects will be addressed in the proposed project (para. 4.22). SMI Credit 2.22 Past Investment. Since 1977 credit has expanded in all sectors. 1/ From June 1980 to June 1986, institutional credit to the private sector increased by nearly 70% in nominal terms. 2/ However, a large portion of private sector credit went for trade, particularly imports. 3/ Industrial 1/ Of the 21 commercial banks operating in Sri Lankn, 18 have established Foreign Currency Banking Units; total assets/liabilities it creased from US$220 million at December 31, 1980 to US$400 million at December 31, 1986. Of the US$360 million in advances, 89% were for under six months, with less than 6% having maturities of over three years. 2/ Public development projects were funded largely through the budget, while public corporations, until recent curbs, relied largely on suppliers' credits. 3/ Advances for commercial purposes represented 50% of total advances at June 30, 1986. -11- credit represented about 25% of total commercial bnnk advances at June 1986; while short-term advances continued to dominate, medium- and long-term credit showed a modest increase in share, from 19.6% of industrial advances at June 1980 to 21.4% by June 1986. Loans to textile, food processi,,g, chemical and metal industries constitute over 90% of private industrial credit. 2.23 GOSL has initiated a number of measures to facilitate growth in industrial and export credit for both small and large scale industry. Through the u5e of a revolving fund, NDB has established sound direct lending and SMI refinance operations and now plays a key role in SMI refinancing. In 1980, the Sri Larka Export Credit Insurance Corporation provided facilities for pre- and post-shipment credit and the CBSL has continued to refinance term loans to small, medium and large scale enterprises which export at least 20% of their output value. Difficulties exist with this scheme as availability f refinance funds from the CBSL fluctuates. Overall, however, these measures have increased availability of short and long term finance, particularly for non-traditional SMI export enterprises. 2.24 Future Demand. Provision of NDB refinance, effective incentives and SMI project promotion training have resulted in substantial increases in the PCI term lending to SMIs with the demand by existing and new SMIs for term loans increasing. With sizable growth prospects in agro-industries, light engineering, and construction as well as in a range of export-related lines, demand for credit by SMIs is expected to remain strong. With the total commitment of available funds under SMI II, SDRs 7.5 million of subloan applications are presently held pending with the PCIs, and applications are being approved at the rate of SDRs 1.2 million per month. Implementation of the recent peace accord is also likely to generate renewed investment in SMI operations, particularly for balancing, modernizing and rehabilitation in the Northern and Eastern Provinces. Against this background projected demand for term credit by SMIs during 1988-90 is estimated at US$150 million. About US$75 million of this demand is expected to be met from institutional sour- ces; IDA and ADB cofinancing under the proposed project would contribute US$35 million for 4,250 subloans. Other institutional sources would include: SMI Fund refinance using repayments from SMI I and II, commercial bank credit, mainly for working capital, using internal resources; and CBSL refinance. The size of the SMI III lending component is geared to the SMI project lending capacities of the PCIs; the Project would involve substan- tial, continuous institution-building elements. Technical and Marketing Services 2.25 The Ministry of Rural Industry Development (MRID). The MRID, through the IDB (which was previously controlled by MISA) is responsible for provid- ing technical and extension services to all SMI subsectors except textiles and cottage industries. Under SMI I and II, IDB was responsible for implementing specific programs to establish service centres for developing -12- rubber products, building materials and light engineering, and for estab- lishing a subcontracting exchange to facilitate purchasing links between small and larger firms. To date the programs have had limited success. IDB has faced problems with the exodus of officers to private as well as other public institutions. However, under MRID, IDB plans to upgrade its perfor- mance by improving career paths for extension officers, strengthening its regional services through intensive coaching, and tapping private sector know-how in addressing the technical needs of its SMI clients. The Depart- ment of Small Industries (DSI), also under MRID, is responsible for services to cottage industries; while DSI has made some progress in developing the coconut fibre industr,, most of its programs deal with promotion of hand- icrafts for local sale. 2.26 The Ministry of Textile Industries (MTI) formulates policies and implemeuts programs for Lhe textile and garment subsectors; under SMI I, MTI established a very successful Garment Industry Training Institute (GITI) with outside collaboration and participation of the Garment Exporters' Associa- tion. The Department of Textile Industries, under MTI, has been successful in transferring most of its operations to the private sector, selling its powerlooms and organizing decentralized production and exports of handloom products. 2.27 The Export Development Board (EDB) established in 1979 is the execu- tive arm of the Export Development Council of Ministers, headed by the Presi- dent. The EDB was established to: advise GOSL on formulation of export development policies and programs; do research and development on export products and markets; and act as the central agency for export and related supply development, coordinating the activities of key public and private agents. Several private associations and advisory committees of exporters and manufacturers in major product groups have been organized; EDB uses these private groups to implement subsector development schemes. However, with its strong management and financial position the EDB should have performed more dynamically. Although the EDB places strong emphasis on mobilizing the private sector to expand exports and to establish a supply base for light industrial products, progress has not been significant. 2.28 Private Technical and Marketing Services. The EDB, IDB and other SMI service institutions have useful roles to play in: providing effective investment and export incentives for industry; identifying and promoting promising product lines; and filling gaps in technical services to help improve productivity. However, due to problems attracting, retaining, and motivating suitable managerial and technical staff they have difficulty providing the effective consultancy and commercial services needed for SMI development. Higher salaries are available in the private and banking sec- tors, and civil service rules make it difficult for a government agency to offer attractive performance incentives. Also, political pressures often result in diversion of staff and funds from activities with high impact and prevent promotions based upon performance. In contrast, private commercial -13- agencies have a direct, concrete interest in maximizing efficiency. The comparative advantage of public institutions is in developing certain target groups for economic and social reasons, rather than focusing only on short term profitability. However, they are likely to continue losing their best talent to the private sector. The challenge is to have SMi tap the know-how available in both the public and private sector, making it profitable for efficient private organizations to meet development objectives. Some of this can be achieved by "getting the prices right" through export and investment incentives and tariff revisions. However, more direct managerial, marketing and technical services also are needed to address key constraints blocking growth in SMIs and other key export-oriented light industries. SMI III would assist SMI investors to tap private capabilities to meet these needs through technical assistance, quality improvements and export marketing assistance. III. THE BANK GROUP'S INDUSTRIAL STRATEGY A. Lending and Industrial Strategy 3.01 The promotion of Sri Lanka's industrial sector has long been an objective of the Bank Group (IDA/IBRD) policy. This has been considered necessary both to create an alternative stable source of growth and employ- ment and to strengthen the balance of payments through the growth of exports and import substitutes. To date, IDA has pursued its industrial sector objectives by means of a series of IDF operations which have channelled funds primarily through two specialized development finance institutions: DFCC and NDB for medium-sized industry and through these institutions and selected commercial banks for small and medium scale industry. Four loans were made to DFCC prior to 1977, aimed at supporting private firms' foreign exchange requirements. Credits for SMI development approved in 1979 and 1981 were channelled through DFCC, NDB and the commercial banks. An Industrial Development Project (IDP I--Cr.1401-CE) was approved in June 1983, followed by IDP II (Cr. 1692-CE) in October 1986 to DFCC and NDB for large scale industrial investment and important elements of policy reform. These eight operations represent a transfer of resources of about US$200 million at current prices. 3.02 The main thrust of IDA lending in support of the industrial sector (in addition to meeting long-term foreign exchange needs) has been two-fold: to strengthen institutional aspects of development finance and to establish a better policy framework for the industrial sector. As regards the former, results have been mixed. While DFCC and NDB are generally effective term lending institutions, they nave sofe problems. Because of heavy investment in tourism prior to the ethnic disturbances, both face potentially serious collection problems, although thig risk has been eased by CBSL refinancing/ rescheduling of the tourist loan portfolio. Both need to diversify their sources of funding and the range of their activities to compete more effec- tively in the financial system. More fundamentally, these institutions are -14- not fully integrated into the financial system, depending heavily on Govern- ment support and conducting their operations under interest rate structures that make it impossible for them to raise domestic resources on a commercial basis. These problems are being addressed at least in part with TA under IDP II. With the assistance of NDB, IDA has also developed a successful program of lending through the commercial banks for SMI operations. However, the commercial banks are still developing their capabilities to appraise large scale industrial projects, and IDA financing for such projects is presently confined to the two DFIs. The July 1986 IMF/Bank Financial Sector report which focused upon the operating efficiency of the NCBs, recommended strengthening of the capital market, introduction of a Treasury Bill Market (para. 2.14), changes in reserve requirements, and general measures for institutional reform now provides IDA with the much needed comprehensive view of the financial system needed to develop a strategy for reform and this is initiated under the proposed project. 3.03 With respect to the second objective--policy improvement--under IDP I and II a comprehensive phased program of trade and industrial policy reform program (TIPR) is being implemented by GOSL which focuses on tariff reform and import liberalization, rationalization of export incentives, a review of the industrial incentive structure, privatization of the PMEs through rationalization and development of performance evaluating and monitoring systems, and implementation of GOSL's recently prepared IPS. 3.04 Despite the work program which has been agreed, considerable dif- ficulties remain. Notwithstanding GOSL's stated commitment to the TIPR program, its political ability to take effective action in the light of the need to implement the requirements of the recent Indo-Sri Lankan peace accord and the forthcoming 1989 elections will dictate the pace of future reform. Tariff reforms have been proposed and action taken to implement many of the proposals which significantly reduced the levels of tariff protection on a wide range of products/industries. Subsequent modifications have diluted some of the real impact of the changes, and the protective structure still in place affords significant protection to PME industrial units or monopoly products. Export and industrial incentives need further rationalization and improvement, but there is not a clear consensus in the Government on how best to proceed with this. Progress on public enterprise reform has been very slow; while some action has been taken to privatize or close units and fur- ther divestments are under consideration, GOSL has not developed a clearly articulated policy with respect to the role of PMEs, nor fully committed itself to their operating autonomy. Finally, there is a need for a detailed program of actions to support the IPS to ensure consistency of industrial policy decisions. Recent discussions with COSL in the context of a proposed IMF Structural Adjustment Facility and future industrial sector lending hold out promise of such a program; however, the desire for concensus within Government portends slow progress in its development and actual implementa- tion. -15- Future Involvement 3.05 The objective of future IDA operations in the industrial sector is to formulate a program of action to achieve already agreed industrial objec- tives for Sri Lanka. The strategy's 'jasic objectives are to increase the efficiency and growth of industry by; increasing private activity, improving the environment for export industries, reducing the protection of the domes- tic market, adopting a more dynamic approach to public sector operations, improving the allocation of financial resources, and improving the efficiency of financial intermediaries. 3.06 The strategy objectives indicate clearly that the IDA views its involvement as a multi-faceted one. Individual actions need to be considered in the context of an integrated approach to address sector issues and priorities. Four operations are presently planned to achieve some of these objectives: (a) The proposed SMI III would focus on one or two areas of necessary TIPR, on policy issues affecting SMI operations and provide needed financial assistance to SMI through the financial system. SMI III would support the overall institutional development of the PCIs, upgrading their appraisal capability to enable them eventually to appraise larger projects. It would also initiate action to address some of the major issues identified in the 1986 joint IMF/IBRD Finan- cial Sector Report including the need to reduce the costs of Commer- cial Bank intermediation. The Project would provide the technical assistance necessary to (i) lay the foundations for financial sector reform, and would represent a key step in moving toward a Financial Sector lending operation in FY90, (ii) extend export credit and duty drawback facilities to indirect exporters, and (iii) further steps to improve the productivity performance of SMIs; (b) A third Industrial Development Project (IDP III) in FY88/FY89, providing funds for large scale industrial investment, would focus on further tariff and export incentive structure rationalization and would also expand the focus on debt recovery policies and procedures; (c) A Public Sector Enterprise Restructuring Credit in FY90 or a similar operation integrated closely with the SAF would focus on privatiza- tion of the PMEs and specifically upon the rationalization and improvement of operating efficiency in the telecommunications, cement and textile subsectors; and (d) A multi institutional Financial Sector Credit (FY90) based on the institutional reviews of the NCBs and operational diversification of the DFIs under IDP II and SMI III. -16- B. The Bank Grou 's SMI Ogerations 3.07 IDA's two SMI projects expanded the institutional coverage of lending operations by assisting COSL to establish new financing instituti,ns and for the first time, using public and private commercial banks as intermediaries for term financing in Sri Lanka. The projects also addressed technical and marketing constraints in major light industrial subsectors, supporting the promotion and extension services of EDB and the IDB; and assisted GOSL develop the technical fouindations for Lhe major reform of COSL's trade and industrial policies, particularly in the area of tariffs, by funding effec- tive protection and export incentive studies. More specifically, SMI I (CR.942-CE) contributed substantially to the establishment of NDB, providing technical and institutional assistance in support of its eirect and SMT re-financing activities. The Project also provided local and international training for some 950 loan officers and managers at regional and branch level. Under the Project, about 1,745 subloans averaging US$9,100 were approved, with fixed costs per job (excluding land) of about US$1,500. Ini- tially, commitment and disbursement of the credit component proceeded well ahead of schedule but political uncertainties resulted in a number of sub- project cancellations and extension of the closing date to December 31, 1985 when $900,000 of unutilized technical assistance funds were cancelled. Major subsectors financed were: agro-industries, construction and building materials, and light engineering. Random samples of subprojects indicate that most are operating without notable technical difficulties. Given the inexperience of the PCTs and NDB in SMI term lending operations overall colLection rates of 77% were very satisfactory. As of June 30, 1987 a hard core of arrears of principal and interest und,_r SMI I accounted for Rs 104 million (S$3.6 million) or 86% of the remaining portfolio balance of Rs 120 million (US$4.2 million). Efforts by the PCIs and IDA have contained the arrears and detailed recovery programs are gradually reducing the amounts involved. Progress under the technical and marketing service component was slower than anticipated due to delays in locat"ig suitatle consultants, constructing facilities and recruiting staff. 3.08 Given the rapid initial utilization of credit funds under SMI I the objectives of SMI II (Cr. 1182-CE), approved in June 1982, were to provide needed foreign exchange, accelerate growth and consolidate productivity improvements in SMIs, tapping the sector's scope for value added, low-cost employment generation and export earnings. The Project provided US$28 mil- lion equivalent, for refinance by NDB of 80% of the SMI term loans made by the PCIs (four commercial banks and DFCC). A US$2.0 million TA component provided funds for (i) PCI staff training; (ii) improvements in SMI extension services; (iii) establishing an SMI consultancy.fund to tap local private sector expertise in solving problems of SMIs; (iv) expansion of service facilities for light engineering SMis; and (v) export development including practical consultancy and training, sales trips, policy studies and pilot projects involving exporters and export-oriented manufacturers in key light industrial products. -17- 3.09 As of October 30, 1987, after a one year extension of the closing date, 85% of the credit had been disbursed and, at the current rate of dis- bursements of SDRs 1.0 million a month, should be fully disbursed by Decem- ber 31, 1987. The major reasons for the slow utilization were: (i) over optimistic assessment of demand at the ti..ie of appraisal due to the rapid commitment rate of SMI I; (ii) saturation of "easy" SMI subsectors in rice milling, construction materials and other subsectors; (iii' the political uncertainties re.ulting from the ongoing ethnic disturbances; (iv) initial high level of arrears under SMI I; (v) inadequate promotion of the project by the PCI branches; and (vi) high levels of rotation of trained SMI staff. However, since late 1985 an increase in the PCI spreads from 5% to 7% has made SMI II lending more competitive with PCI general industrial lending and improved collection performance resulting from increased project supervision on SMI II subprojects has boosted PCI confidence in the scheme. Extensive project promotion by NDB, increasing sponsor interest in the SMI scheme, simplification of appraisal formats, clarification of sectoral and expendi- ture eligibility have also improved the project pipeline considerably, and average monthly commitments are now about Rs 37 million (SDRs 1.0 million). SDRs 7.5 million of subprojects have been approved subject to cancellation of prior commitments. The SDRs 1.8 million TA component of SMI II is fully committed against firm contracts/consulting agreements. IV. THE PROJECT A. Objectives and Scope 4.01 Objectives. IDA's lending for industry since 1977 has been success- ful in supporting a program of broad policy teform, upgrading financial institutions, and improving Government institutions' systems and procedures supporting industrial development and financing of high priority investment projects. The proposed Project would continue this approach, focusing on these broad themes as they affect SMI. More specifically the project would: (i) provide needed foreign exchange for viable SMI projects, with an emphasis on export-oriented ventures; BMR for existing enterprises; reconstruction needs in the Northern and Eastern Provinces; and employment generated in the high unemployment districts in the South; (ii) continue the overall institutional development of the PCIs; (iii) deepen IDA's dialogue with GOSL on issues affecting the efficiency of the financial sector for industrial financing through an analysis of the operational and financial viability of the two predominant nationalized commercial banks (NCBs); this dialogue and the support- ing analysis should provide the basis for an agenda of actions that could be implemented in the context of a proposed Financial Sector Cre6it in FY90; -18- (iv) expand on programs to address trade and industrial policy issues, particularly the need to improve the operational capabilities of the Tariff Commission and to remove the constraints to export financing and duty drawbacks for indirect exporters in the SMI sector; and (v) continue the institutional development of SMI technical and marketing service agencies through the provision of technical and marketing assistance facilities to be accessed by the PCIs to assist SMIs upgrade their technology and product quality. 4.02 In discussions with GOSL, emphasis has been given to the importance of the ongoing program- of TIPR and financial reform as they relate to SMI operations, fucusing o. .1tne aLtio11S most feasible in an environment of political uncertainty and severe budgetary and balance of payments con- straints (e.g. establishing appropriate relative incentives between producing for exports and the domestic market and productivity improvements in the public sector). In the policy area, the Project's major focus would be on initiating the analysis necessary to develop proposals for financial sector reform with emphasis on measures to (i) increase the role of market forces in the determination of interest rates; (ii) reduce intermediation costs of the NCBs; and (iii) improve credit discipline and reduce the level of the finan- cial systems' non-performing assets. 4.03 To meet these objectives, the cofinanced project would have the following components: (a) a US$29.5 million credit component for term loans to SMIs from PCIs with subproject review and partial refinance by the SMI Fund. The component would include co-financing of US$14.5 million from ADB; and (b) A US$5.5 million technical assistance component, inclusive of US$500,000 from ADB, to provide: (i) training and consultancy assistance for NDB and the PCIs, to improve term lending operations; (ii) technical assistance to the NCBs to review their operations and develop a program of actions to improve their operating efficiency; (iii) support for SMI export promotion development programs, includ- ing consultancy and training, sales trips, policy studies, and pilot projects involving exporters and manufacturers in key light industrial groups; M. -19- (iv) establishment of a technical assistaze facility to make greater use of private sector know how and institutions in the expansion of productivity services; and (v) support for the implementation of ongoing programs to improve industrial efficiency, particularly of the PMEs. B. Institutional Structure The Apex Agency 4.04 Under SMI I, NDB, which was established in 1979, was selected as the apex institution to operate an SMI refinancing fund to recycle the repayments from subloans under SMI I and subsequent SMI operations. The Fund was main- tained by NDB's SMI department which also carried out the administration and reporting requirements. By August 31, 1987, Rs 1.07 billion (US$37.5 mil- lion) of refinancing has been approved for 3,680 projects and about Rs 580 million (US$20.4 million) disbursed. Under SMI III NDB would continue to administer the Fund as the apex agency for SMI operations and the signing of a subsidiary loan agreement, satisfactory to IDA, between COSL and NDB would be a condition of effectiveness of the IDA Credit. As under SMI I and II, separate accounts would be maintained by NDB for the Fund and a separate review of the Fund's utilization would be carried out annually by the Auditor General as part of his review of NDB's overall operations. 4.05 NDB/SMI Fund Organization and Staffing. NDB's SMI operations are organized into six main sections. The Analysis and Review Section reviews PCIs' appraisals and refinance applications. The Reporting and Liaison Section prepares periodic reports on the credit institutions' lending, super- vision and collection performance. The Finance and Disbursement Section disburses refinance, collects repayments, administers SMI project funds for the technical service components and maintains accounts. Three other sec- tions are responsible for monitoring and supervision, training, and subsector analysis. Professional staff consist of a manager, six section heads, six analysts and nine other officers. However, NDB has had some difficulty recruiting and retaining senior staff due to shortages of experienced staff in Sri Lanka. Despite staffing problems and higher than expected refinance activity, NDB's performance under SMI I and II has been good. As anticipated, the emphasis has been on developing procedures, reviewing refinance applications, and upgrading PCTs' appraisal standards through formalized training programs. NDB has also made subproject review more systematic by: establishing norms for key aspects of appraisal, including appropriate levels of permanent working capital, land, and buildings; prepar- ing subsector analyses to avoid overinvestment and to identify market oppor- tunities; and investigating sources of appropriate equipment. -20- 4.06 The Policy and Strategy Statement for the SMI Fund would be discussed and agreed during negotiations. The Statement would specify the Fund's objectives, function, organization and staffing, work program and reporting requirements under the proposed project. The revised Policy and Strategy Statement would be cleared by COSL prior to Board Presentation and any future modification would require prior GOSL/IDA/ADB approval. 4.07 Although NDB's overall performance has been satisfactory, analysis of its operations for FY84-FY86 and FY87 year to date indicates that it faces some potential problenD in four inter-related areas affecting profitability: operating costs, portfolio infection, cost of borrowing and staff produc- tivity. In the area of profitability, net profits as a return of capital have declined from 11% (FY84) to 9.3% (FY86), while net profits as a percent- age of average total assets have fallen from 7% (FY84) to 4.7% (FY86). Operating costs as a percentage of average loan portfolio are high at 1.9%. In the area of portfolio infection arrears of principal and interest have increased from 10.4% (FY84) to 12.4% (FY86). To address these weaknesses and to develop appropriate remedial measures, a review of NDB's strategies and operational plans is being undertaken by expatriate consultants funded under IDP II to develop new operating objectives for NDB. The terms of reference focus on analyzing NDB's present operations and determining its future in the financial system. A detailed analysis of NDB's overall operations is con- tained in the Project File. Participating Credit Institutions (PCIs) 4.08 The Participating Credit Institutions. The implementation of the first two SMI projects by the PCIs, with the assistance of NDB, has demon- strated PCI capability for selection of suitable project sponsors and for appraising and supervising SMI subprojects. Subject to fulfilling the condi- tions of participation (paras. 4.09-4.10), the five PCIs participating under SMI II 1/ would continue to be the PCIs responsible for appraisal, supervi- sion and collection of subloans under the proposed project, although any financial institution meeting the conditions of participation could apply to participate. A summary of PCI performance under SMI I and II is given in Annex 4, and detailed reviews are contained on the Project File. 4.09 Eligibiligy Criteria. As a condition for participation in the Project each PCI is required to have an appropriate level of SMI operational staff. These levels were agreed during negotiation. Based upon a review of present staffing, the number of SMI Fund/PCI staff to receive foreign and local training under SMI III were also agreed during negotiations. Funding for foreign training is available under SMI II. SMI III's technical assis- tance component includes provisions for local and overseas training of SMI Fund/PCI utaff, on-the-job training of Fund/PCI staff in project review and supervision (para. 4.19). 1/ These are the Bank of Ceylon, Commercial Bank of Ceylon, Development Finance Corporation of Ceylon, Hatton National Bank and the People' Bank. -21- 4.10 During negotiations it was agreed with GOSL and NDB that each PCI would be required to achieve and maintain, within an agreed timetable, a minimum annual and cumulative collection level under SMI II And any sub- sequent IDA financed projects of at least 70% of principal amounts due on loans. The maximum portfolio infection level should not exceed 20%. Achievement of targets would be reviewed semi-annually by ADB and IDA. Sub- loan authorizations under the project would be suspended until a PCI has taken specific steps to address its collection and arrears problem satisfac- tory to the Association. As of October 30, 1987 only the CBOC had not met the collection and portfolio infection criteria. As a condition of effec- tiveness at least two PCIs should have established their eligibility to participate in the project by meeting the conditions noted above and by signing participation agreements with NDB. 4.11 Associated Participating Institutions. Under SMI II, the Regional Rural Development Banks (RRDBs) participated in the training programs run by NCB; it is proposed that this association should continue. In the area of project lending, the RRDBs could participate in the Project subject to meet- ing the conditions of participation and project eligibility noted in paras. 4.09-4.10. However, given the nature of the RRDBs' operations in both type and size, it is unlikely that they would participate to any significant extent. More appropriately their financing requirements, which are predominantly for local currency working capital, would be provided by the CBSL's Rural Credit Department. The recently established Investment and Credit Bank would also be eligible to participate in the project as an associated institution. After a year of operations its performance would be reviewed and if satisfactory it would be graduated to full participation status. C. Project Costs and Financing Plan 4.12 The costs of the proposed project are estimated at US$61 million, of which IDA would finance US$20 million, or about 32.5%. IDA financing would be used for the subloan component for SMI subprojects and for TA. On average, sponsors would contribute about 25% of subproject costs; PCIs 37.5%, and IDA/ADB 37.5%. The estimated costs and detailed financing plan are shown below: -22- Estimated Costs Foreign Local Foreign Total Local Foreign Total % of ----- (Ra Million)---- ----(U$ Million)----- Total Subproject Investment 484.5 840.7 1,325.2 17.0 29.5 46.5 63.5 Technical Assistance: Financial Sector Efficiency 31.4 65.6 96.9 1.1 2.3 3.4 68 Export Promotion 14.3 17.1 31.4 0.5 0.6 1.1 55 SMI Technical Assistance Facility 11.3 14.3 25.5 0.4 0.5 0.9 56 Improving Industrial Efficiency 28.5 59.8 88.4 1.0 2.1 3.1 68 Total Project Cost 570.0 997.5 1,567.5 20.0 35.0 55.0 63.5 Financing Plan ADB 427.5 427.5 - 15.0 15.0 2.35 GOSL 57.0 57.0 2.0 - 2.0 PCIs 228.0 228.0 8.0 - 8.0 Sub borrowers 285.0 285.0 10.0 - 10.0 IDA - 570.0 570.0 20.0 20.0 36.5 570.0 997.5 1,567.5 20.0 35.0 55.0 63.5 D. The Credit Component Funding 4.13 An estimate of potential demand for financing by SMIs has been made based on conservative assumptions regarding the rate of growth of the sector (5% p.a.), the incremental capital/output ratio and permanent working capital requirements. Taking these into account and anticipating levels of interna- tional and domestic inflation, total investment requirements by SMIs for FY88-FY90 is estimated at US$150 million. However, based on past SMI I and II operations, the PCIs will only provide about 50% of these needs from their own resources and will need to mobilize the balance from multilateral agen- cies and from the project sponsors. The proposed IDA project is part of the mobilized funds with US$15.0 million for subproject financing and US$5.0 million for technical assistance. An additional US$14.5 million for sub- project financing, and US$500,000 for technical assistance would be provided by ADB through co-financing. ~J il -23- Project Eligibility 4.14 Subprojects eligible for refinance, as under SMI II, would involve BMR, or expansion of private or cooperative enterprises engaged in manufac- turing, mining, construction, agro-industry, fish processing, handicraft production or industrial services e.g. transport and other services which are part of an industrial enterprise; repair workshops and other industrial services which add value to a product; and export enterprises with direct involvement in organizing the decentralized production base. All subprojects would need to be financially viable, and PCIs would continue to assess whether a subproject would improve quality, price competitiveness, or produc- tion of goods for which demand has been established. PCIs will calculate ERRs on an agreed sample of all subprojects with subloans between Rs 2-Rs 4 million or producing products with a nominal tariff protection level of 40% or more. The eligible ERR threshold would be 15%. The PCIs will also incor- porate simple indicators of economic impact in their subproject appraisals, including expected fixed costs per job and percentage of raw materials of local origin. For more common subprojects the PCIs will use standard project profiles for reference. SMI Fund staff would carry out subsector analysis on product group economic viability. Credit Guarantee Scheme 4.15 The CBSL's SMI Credit Guarantee Scheme established under SMI I would continue to provide partial coverage of eligible SMI subloans. To encourage the PCIs to reduce collateral requirements coverage would be restricted to subloans refinanced under the SMI Projects with preference given to those subloans without acceptable alternative collateral. Guarantee premiums, which would come from the PCIs' spreads, would be 1% of the amount guaran- teed. !/ To give a high degree of coverage for high risk, small loans it is proposed that, subject to a review of the Scheme's present operation and cash flows to be completed by June 30, 1988, coverage up to a maximum of Rs 1.6 million, would be provided as follows: (i) 80% of subloans for subloans below Rs 2.0 million; (ii) 60% of subloans for subloans between Rs 2.0 million and Rs 3.0 mil- lion; and (iii) 40% of subloans for subloans between Rs 3.0 million and Rs 4.0 mil- lion. 1/ The premium would be adjusted, if needed, to reflect default perfor- mance. -24- 4.16 Under SMI I and II granting of CBSL Credit Guarantee coverage was automatic upon subproject approval by NDB. This removed the right of rejec- tion by the CBSL which was liable for a percentage of project losses. An element of CBSL participation in the approval process should exist, and under SMI III, CBSL will carry out an ex post review of credit guarantee proposals on a random sample basis. Where appraisal standards have not been met the PCIs will be advised accordingly. If, after three cautions, the weakness is not rectified the PCI would be declared ineligible for coverage. On exhaus- tion of reasonable legal action by PCIs to recover overdue payments, claims for losses would be finalized by the CBSL within 90 days of submission by the PCIs. E. The Technical Assistance Coopoent Technical Assistance 4.17 The technical assistance component of SMI II provides funding for SMI service facilities, process and product development, training, a sub- contracting exchange, and general promotion and extension services. The programs have now become operational and the combined TA of US$5.5 million under the proposed project would build on this foundation to focus on finan- cial sector efficiency, SMI marketing assistance, and SMI technology. Specifically the Project would provide: (i) US$500,000 for SMI systems improvements and the training of NDB and PCI SMI staff; (ii) US$1.5 million for the review and implementation of agreed recommen- dations relating to the operating system and procedures of the BOC and PB; (iii) US$250,000 for assistance to the CBSL to upgrade its Banking supervi- sion capabilities, particularly in the area of computerized monitor- ing; (iv) US$650,000 (inclusive of US$500,000 from ADB) for export promotion programs including extension of export credit and duty drawback facilities to indirect exporters, and a review of the possible use of transferable tax credits; (v) US$500,000 for short term technical and productivity improvement assistance to SMI units; and (vi) US$2.1 million to assist with the improvement of the efficiency of the industrial sector (particularly the PMEs), through further trade and industrial policy reform. -25- 4.18 TOR and implementation timetables for the various studies were agreed with GOSL/PCIs during negotiations and the selection of consultants would follow the Guidelines for the Use of Consultants by World Bank Borrowers. Execution of the various studies would be monitored by IDA/AD8 during the course of supervision missions and all programs would be subject to an annual operational review. Improving Financial Sector Efficiency 4.19 Under SMI I and II, funds were provided to the SMI Fund/PCIs to assist them in building their capability for project financing through staff training, systems improvement and subsector analysis This assistance would continue; approximately US$500,000 would be provided to extend technical assistance to the SMI Fund/PCIs for training of regional and branch office staff and to the CBSL for training of staff in the Development Finance Department associated with the credit guarantee scheme. During negotiations agreement was reached with GOSL, NDB and CBSL on the detailed training programs for FY88-FY90 consisting of basic programs for staff new to project financing, an advanced program for more senior staff and overseas training for key management personnel. 4.20 Despite substantial improvements in recent years, there are a number of areas where structural and operational shortcomings within the financial sector need to be addressed. The joint IMF/IBRD Financial Sector Mission of June 1986 identified weakness in the adequacy and effectiveness of CBSL supervision and unacceptable high NCB operating costs expressed as a percent- age of total assets. The NCB's asset portfolios are also suspect due to the high level of non performing investments. The impact of BTT, reserve requirements, high operational costs and high levels of non performing assets is reflected in the high spreads (6%-8%) charged on NCB transactions. Thus their inefficiences become a cost to the economy as a whole. A detailed review of the NCB's operations, particularly the level of portfolio infection and collections is now mandatory, and under the proposed project technical assistance would be made available to carry out the reviews necessary. The Terms of Reference (TOR)--Annex 5--for these were agreed with GOSL and the NCBs prior to negotiations and US$1.5 million would be provided to cover the cost of the assistance. In addition, to evaluate and monitor the performance improvement prograi in the NCBs, technical assistance is proposed for the CBSL Banking Supervision Department to improve its capabilities by upgrading its performance monitoring and evaluation systems. The estimated cost of this assistance is US$250,000. Given their close involvement with the Bank- ing Supervision Department and the need for special technical skills to implement the performance and evaluation systems, it was agreed with GOSL/CBSL that the IMF would supervise the implementation of this component on behalf of IDA. -26- Export Promotion 4.21 Policy and Procedural Reform. As noted in para. 2.05, GOSL has made considerable efforts to provide incentives for export oriented industries. However, these measures' effectiveness since 1977 has been offset by appreciation of the real value of the rupee and cumbersome procedural arran- gements to access the incentives. For large exporters the procedural bot- tlenecks are not insurmountable, but for small enterprises access is not cost effective. The benefits of the incentive structure, particularly export credit and duty drawbacks, are also limited, applying only to direct exporters. This stifles the growth of many ancilliary industries which should be developing to support key direct exporters (e.g. the garment industry). GOSL has recognized the need to remove these constraints and, in parallel with implementation of the recommendatioas of the Committee on Export Incentives, proposes to utilize technical assistance to address these issues. TOR (Annex 6) for consultants to be appointed within six months of credit effectiveness to provide technical assistance to appropriate govern- ment agencies and the PCIs to extend export credit and duty drawback facilities to indirect exporters were agreed prior to negotiations. A total of US$150,000 would be provided for the 12-15 consultant months of assistance anticipated and IDA would review the findings/progress of the assistance during project supervision and the annual project review. 4.22 Export Marketing. In addition to reviewing the access of direct and indirect exports to credit and duty drawback facilities, GOSL would also provide technical assistance to support direct and indirect export marketing moves (Annex 7). Detailed policies and procedures for this assistance would be agreed during negotiations. The TA which would be managed by EDB will concentrate on the following enterprise level marketing activities: (a) desk market research; (b) overseas field market research, to formulate a firm's export marketing strategy for target markets; (c) minor product adaptation, when indicated as required by market research; (d) overseas travel by company executives, limited to purposes directly related to a properly researched marketing strategy; (e) product inspection services, to reinforce a company's claims of reliable product quality; and (f) training related to export marketing. In addition to company-level measures, support will be given to the back-up activities such as: (a) strengthening service supply from management consultants and other groups in Sri Lanka; (b) provision of trade information in small product-specific libraries, mainly run by subsector industry associations; (c) group marketing activities, either when SMIs undertake eligible activities as a group, or when new marketing information is collected on behalf of a subsector and published, to lead to cost-effective firm-level market research. Support will be for costs of technical and advisory services and travel expenses; US$500,000 would be made available to the EDB from the ADB, to meet 50% of the cost of eligible expen- ditures. This support for market development would represent a very small percentage of the total costs of an exported product and would not run counter to Article 14 of the GATT Code on Subsidies and Countervailing Duties. -27- SMI Technical Assistance Facility (TAF) 4.23 During the supervision of ongoing SMI Projects and preparation for the proposed project, a correlation was found between successful project implementation and the provision of technical assistance to SMI units. If the agreements are properly structured, firms benefit from access to proprietary design, changing process improvements, modern management methods, and market access through brand image and direLt marketing efforts. 4.24 To develop sources of technical services in the private sector and to generate demand-oriented technology and productivity upgrading proposals, a SMI technical assistance facility (TAF) of US$500,000 would be established. The general scope and procedures for the use of the facility were agreed with GOSL during negotiations (Annex 8). The TAF would provide pcrtial grants through the PCIs to existing or potential SMI entrepreneurs to finance eligible and viable "technology subprojects" such as consulting services, training programs, collaboration packaging or small R&D projects which either introduce new or improved existing technology in private industry. The TAF would provide part of subproject costs. with the balance paid by the sponsor- ing SMI. It is estimated that TA requ :;s from individual SMI sponsors woul.d involve about 50-100 foreign consultant-months at US$10,000 p.m. and 100 local consultant-months at US$1,000 p.m. inclusive of salary, costs, fees, travel and subsistence. Initially, cost sharing would be assessed on a case by case basis and be reviewed after some experience has been gained; however, it is anticipated that the cost sharing basis will be 50:50. The TAF would be administered by NDB which would be responsible for developing detailed policies and procedures, which would be agreed during negotiations, promoting SMI operations, soliciting proposals from private industry, appraising the eligibility and viability of each subproject, submitting approved proposals for IDA approval, disbursing the funds and supervising the subprojects. Policy Coordination 4.25 On effectiveness of the Project, the role of the SMI Coordinating Committee established under SMI II would change from that of subproject coordination to policy review. To achieve this vital role the Committee would be restructured to include the Secretary, MISA (Chairman), the Secretaries, MTI and MRID (or their designated representatives), repre- sentatives from NDB and CBSL and representatives from the SMI Chamber of Commerce. The Committee would receive the quarterly reports prepared by the SMI A?Und, examine operational or coordination problems, and make recommenda- tions to COSL on improving efficiency in policy implementation. However, implementing agencies would channel authorization requests and reimbursement claims for expenditures directly through NDB for reimbursement/disbursement from a Special Account (para. 5.08) or to IDA; in exceptional circumstances NDB could provide bridge financing from the SMI Fund for expenditures under the Technical Assistance Components. As under SMI II, the implementing agencies would be expected to carry out their specific activities and respon- sibilities autonomously, within the framework and objectives, guidelines and procedures agreed between GOSL and IDA under the Credit and Subsidiary Loan agreements. -28- V. THE CREDIT A. Terms and Conditions 5.01 Lending Arrangements. The proposed credit of SDRs 15.7 million (about US$20 million equivalent), including the lending component of US$15.0 million equivalent and a technical assistance component of US$5.0 million equivalent, would be made to COSL on standard IDA terms and conditions, with 40 years maturity. Based on past experience with similar projects as reflected in the relevant standard disbursement profile, the Credit is expected to be fully disbursed in about six years (Annex 9). GOSL would onlend the proceeds of the credit component to NDB, to refinance eligible SMI subloans made by the PCIs on terms and conditions outlined in the Subsidiary Loan Agreements, a draft of which was agreed in substance during nego- tiations. GOSL would onlend to NDB in Rupees. Given the unsophisticated nature of the sub-borrowers, the small size of many of the sub-loans, the controlled foreign exchange market and the margin between the cost of funds and the onlending rate to NDB, GOSL will bear the foreign exchange risks on repayments to IDA. NDB would pay interest to COSL on the Rupee amounts of the credit component disbursed and outstanding; repayment to GOSL for the lending component would be on the basis of a composite amortization schedule reflecting the actual mix of fixed and variable subproject amortization. NDB also would be responsible for administering disbursements for the technical assistance component, the bulk of which would be preallocated. The proceeds of the technical assistance component would not be repayable to GOSL, since these are development expenditures geared to increasing sectoral efficiency, productivity, output and exports. 5.02 Lending Terms. The initial onlending rate from GOSL to NDB would be the AWPR at the time of credit effectiveness less an initial spread of 7% which is reasonable in view of medium-term inflation projection of 8%-10% for the next three years (para. 2.12) and rates being charged by the commercial banks (14%-24%). The onlending rate from NDB to the PCIs would be 6% below the AWPR at the time of effectiveness which would give NDB a spread of one percent to meet the cost of SMI operations. These presently equate to 1.6% which is borne by NDB. At the time the AWPR mechanism was established to set the market reference rate there was no viable alternative rate. However, the Treasary Bill Market initiated in January 1987 is reaching a level when the Treasury Bill Rate (TBR) could become a viable and more acceptable alterna- tive. Accordingly, during negotiations it was agreed with COSL that the mechanism for establishing interest rates and spreads would be reviewed on January 1 and July 1, with appropriate adjustment as necessary. The actual interest rate to be charged to NDB and the PCIs respectively would be amended on January 1 and July 1 to (i) reflect any significant movement in the market reference rate, and (ii) remain positive in real terms vis-a-vis inflation rates as reflected by the Colombo Price Index. The PCIs would charge SMI sub-borrowers a negotiated interest rate on subloans refinanced by NDB, with rates either fixed or variable based upon agreement between the PCI and the -29- sub-borrower. Subloans on which no disbursements have been made for 12 months would be reviewed and, when appropriate, cancelled to facilitate project completion and to promote full utilization of the project funds. To encourage the PCIs to become more independent in SMI financing, refinancing of subloans would be decreased from the current 80% to 75%. This will be subject to an ongoing review. 5.03 Repayment Terms. NDB would repay COSL on a fixed amortization schedule of 18 years with a five year grace period. The maturity for sub- loans refinanced by NDB would be from three to ten years, with grace periods ranging from six months to two years. As the subloan commitment period would be about three years, repayments by the PCIs could stretch over 13 years. However, as the average maturities of subloans would be seven years, about US$15 million would be accumulated in the SMI Fund by 1990, the estimated date of full commitments of the subloan component; NDB would be encouraged to use these funds to augment SMI refinancing operations, and to cover refinanc- ing requirements if there is a need for additiinal resources after full commitment under SMI III. 5.04 Subloan Sizes and IDA Review. Subproject eligibility would be limited to enterprises with total fixed assets at book value, excluding owned or leased land and buildings, valued at less than Rs 4 million prior to the granting of a subloan (this is the current SMI definition) and which comply with COSL's/IDA's environmental guidelines. The maximum subloan size would be Rs 4 million (US$140,000,, although subloans above this level would be considered by IDA on a case by case basis. Working capital financing would be allowed only as part of a fixed investment subloan and for permanent working capital needs since seasonal working capital financing is available from the CBs. A minimum of 25% of subproject costs should normally be provided by the sponsor in the form of equity to encourage sound capital structuring, although the actual equity requirement should be determined on a case by case basis. 5.05 About 3,650 subprojects with subloan sizes averaging about Rs 450,000 (US$15,000) would be financed. In view of the large number and relatively small sizes of subloans, simplified review and approval procedures would be used to limit administrative costs and processing times. The implementation of SMI I and II by the PCIs, with the assistance of the NDB, has demonstrated their increasing capability to select suitable project sponsors and for appraising and supervising SMI subprojects. Thus, under the proposed project, the PCIs will be given delegated authority of Rs 2.0 million for subloan sanctioning (DFCC would be given full delegate authority for RS 4.0 million which is consistent with the RS 8.0 million limit approved under Cr.1692-CE). NDB's staff would check the eligibility of subprojects, finan- cial viability, and the adequacy of proposed subloan terms, and would perform sample analyses to ensure that appropriate appraisal standards are being maintained on these smaller subprojects. NDB would be given delegated authority to approve subproject applications up to Rs 4.0 million. A sample -30- ex-post review of subprojects over Rs 2 million would be carried out by IDA. It is expected that subloans of over Rs 2 million would constitute about 8% of total subloans by number and 3G% by amount. About 80% of subprojects, by number, are expected to be for amounts below Ra 100,000. 5.06 NDB's Contribution to the SMI Fund. Under SMI I NDB made a capital contribution of Rs 20 million to the SMI Fund to cover the lag between refinance disbursements and withdrawals from IDA. As of August 31, 1987, Rs 384 million (US$13.3 million) was available in the SMI Fund for bridge financing purposes. Based on projected SMI commitments in FY88-FY90, no additional capital contributions should be needed by the Fund to cover operating requirements during the disbursement of SMI III, but NDB (has agreed) to make additional resources available to the SMI Fund, if required. B. Administration Procedures 1/ 5.07 Procurement. The PCIs would be responsible for ensuring that the machinery, equipment, spare parts and initial raw material procured for SMI subprojects are purchased at reasonable and competitive prices, due account being taken also of other relevant factors such as time of delivery, quality and reliability of the goods and availability of spare parts. Imported items costing over US$20,000 would be procured through international shopping on the basis of at least three price quotations, while procurement under con- tracts of less than US$20,000 could be by direct purchase. Individual con- tracts for the purchase of machinery, equipment or spare parts costing more than US$100,000 would be procured through limit international bidding proce- dures with approval of contract subject to prior review by IDA. PCIs would be required to maintain records of the procurement methods and documents, and to monitor the utilization of subloan funds through regular supervision visits. For subloans of over Rs 2.0 million, or 30% of subloans by amount, the SMI Fund would carry out a detailed review of the PCI's procurement procedures. Based upon experience under SMI II, these procurement procedures are considered satisfactory; NDB staff and IDA field supervision missions would continue to review implementation of these procedures. Procurement of goods and services under the credit and technical assistance components, as noted below, would be in accordance with IDA procurement guidelines. 1/ Annex 10 details the contents of the Project File which includes copies of PCI operating policies and procedures. ~ *...J -31- Procurement Method (US$ Million) LCB IS Other 1/ Total Subproject Invesi:ment 1.5 1.5 12.0 15.0 Technical Assistance 5.0 5.0 1.5 1.5 17.0 20.0 5.08 Disbursement Procedures. IDA would initially reimburse 75% of eligible SMI ubloan expenditure. With the large number and small amounts involved in the subloan operations, normal procedures of disbursing against documented expenditures on individual subproject accounts would be inap- propriate for most subprojects. To facilitate disbursements IDA would dis- burse on the basis of certified statements of refinancing for expenditures incurred up to 120 days prior to the refinance application, except during the bridge financing period (para. 5.10). The documentation would be retained by NDB for inspection during IDA's periodic supervision missions. All state- ments of expenditure, together with supporting documentation, would be audited annually. Prior authorization by IDA for goods and services under the technical assistance components would be required, and IDA would dis- burse: (a) 100% of expenditures for foreign and local consultants and train- ing; (b) 100% of foreign expenditures for equipment imported directly and of the ex factory cost of locally manufactured equipment; and (c) 80% of expen- ditures for other equipment procured locally. Requests for IDA disbursement would be fully documented. Withdrawal applications would be channelled through NDB. To facilitate disbursement of TA charges and payment applica- tions of less than US$250,000, GOSL/IDA would establish a Special Account equivalent to four months of expenditure (i.e. about SDRs 1.0 million) available to the PCIs and implementing agencies on a first come first served basis. As noted above, IDA would reimburse expenditures incurred up to 120 days prior to receipt of the application by NDB. 5.09 Reporting, Accounts and Auditing. NDB would submit quarterly reports to GOSL/MOFP and IDA on the SMI Fund's lending activities, as well as progress under the technical assistance components. The main report would be an aggregation of the PCIs' quarterly reports which would cover SMI staffing, training, lending, supervision, collection and arrears performance, and portfolio data. TA reports would summarize: implementation progress on 1/ Given the small size of SMI procurement, most of which are between US$1,000-US$2,000, international shopping or LCB is not an appropriate requirement. Procurement is made from local suppliers on the basis of three quotations. -32- aspects outlined in agreed action programs; steps to be taken during the next quarter; and estimates of impact of activities on employment, proiuctivity and exports. In addition, NDB would submit a quarterly report on: SMI Fund refinancing and relative activities; SKI staffing; and evaluation of charac- teristics of SMI sub-borrowers and impact of subprojects. Reports would have a form and content satisfactory to IDA and be accompanied by an overall review of the SMI sector in Sri Lanka. Quarterly reports would be submitted within 45 days of quarter end. A separate statement of account for the SMI Fund would be audited annually by the Auditor General of Sri Lanka or a designated private auditing firm, which would submit a report in a form satisfactory to IDA not later than four months after the close of each fiscal year; project accounts of each implementing agency would also be audited. If the Auditor General designates a private auditing firm, the firm would need to be satisfactory LO IDA and would be selected for at least the duration of the project to ensure continuity. Within six months of completion of the Project GOSL/NDB shall prepare a draft Project Completion Report conforming to IDA guidelines. 5.10 Bridge Financing. Closure of the subloan component of Credit 1182-CE is scheduled for December 31, 1987 at which time NDB, through the SMI Fund, would provide bridge funding to cover SMI refinancing requirements until the expected credit effectiveness in February/March 1988. Specific arrangements for IDA retroactive financing are not necessary as eligible disbursements made by the implementing agencies after Credit signing are automatically eligible for IDA disbursements once the Credit is made effective. C. Co-Financing 1/ 5.11 Preparation of the proposed project has been coordinated closely with ADB which has proposed a parallel loan of US$15.0 million inclusive of a technical assistance component of US$500,000. Preparation, appraisal and negotiations were carried out jointly with ADB, and ADB has provided full support for the conditionality of the IDA project and indeed in the broader areas of trade and industrial and financial sector reform. Both projects feature cross-conditionality. Disbursement would be funded proportionately from the ADB/IDA credit component. D. Project Benefits and Risks 5.12 Benefits. The proposed project would further support GOSL's efforts to carry out its far-reaching program of TIPR through through incremental, but significant, action in the areas of tariff administration, export promo- tion, and science and technology transfer. The project would also support COSL's/CBSL'S efforts to improve the efficiency of the financial sector and 1/ A copy of the ADB project document is held on the Project File. -33- address key constraints to more rapid development of SMIs. Term loans would be provided to about 3,650 new and existing enterprises meeting a portion of this sector's financing gap and further strengthening PCIs' SMI term lending operations. The subprojects financed are expected to result in about 31,400 new jobs, with incremental fixed investments (including buildings and equip- ment but excluding land) per job of about US$1,750. 1/ The average subloan si-e is expected to be about Rs 450,000 (US$15,000). About 60% of the credit is expected to be channelled to subloans of below Rs 1 million (US$34,000); about 20% for subloans of Rs 1-2 million to (US$34,000-US$70,000); and 20% for subloans from Rs 2-4 million (US$70,000-US$140,000). Major SMI subsec- tors are expected to be: agro-industries; metal products; building materials and construction contractors. Promotional and technical services provided under SMT I and II and su?plemented under the proposed project also should result in increased financing of: export-oriented SMIs in rubber products, handloom textiles, gem cutting and polishing; and engineering subcontractors linked to larger public and private industries. Subprojects above the free limit or with more than a 40% nominal tariff protection level would be sub- ject to economic analysis with a minimum 15% ERR eligibility threshold. 5.13 Benefits from the technical assistance components are more difficult to quantify. Extension of export credit and duty drawback facilities to indirect exports should provide an impetus to the development of ancilliary export related industries. The Export Marketing component would build on the programs of the EDB financed under SMI II and is expected to result in increased, diversified exports and value-added among key light industrial products. Action to adapt products, upgrade skills, increase quality con- trol, and promote exports should result in short- and medium-term increases in exports, employment and earnings. With the TAF local private sector know how would be tapped in addressing the technical problems of 400 to 500 SMIs, in areas which require specialized skills. Also, the TAF would further encourage establishment of private sector firms specializing in consultancy to SMI; increase appreciation by small entrepreneurs of the benefit of tech- nology transfer; and enable the SMIs to tap needed skills not readily avail- able within their own operations. 5.14 Risks. The success of the lending component would depend on the continued effective operation by NDB of the SMI Fund. Satisfactory policies, procedures and standards for the operation of the Fund have been established on the basis of experience; the key will be NDB's ability to retain qualified staff and provide training to enable expanded refinance operations, while increasing attention to monitoring and supervision of PCIs' SMI operations. 1/ This fixed cost per job figure is somewhat higher than the US$1,500 for subprojects approved under the SMI I and II, since the larger average subproject size and capital goods inflation are expected to result in somewhat higher fixed investments per job. L? - , - . -34- A further risk is that individual PCIs, particularly the BOC and PB, may be unable to meet their staffing commitments and, therefore, be incapable of improving appraisal standards in processing the lar-e volume of applications expected and devoting sufficient attention to subproject supervision. Under the proposed Project, minimum trained staff would be a condition of par- ticipation in the project; also, each PCIs Board would be required to reaf- firm its commitment to allocate additional SMI staff as required. With strong senior management commitment, adequa staffing can be provided through active deployment and training. Another risk associated with the demand for SMI credit is that PCIs may continue to impose high collateral requirements, thereby excluding some borrowers with viable SMI projects. This problem should be addressed by the increased Credit Guarantee coverage and by requiring a clear statement of collateral policy by each PCI, with close monitoring by NDB. 5.15 SMI III would build on organizational arrangements and capabilities developed under SMI I and II. However, che credit, technical and marketing component would require continued improvements in the services of the PCIs, and frequent IDA supervision visits would continue to be important. VI. AGREEMENTS REACHED AND RECOMMENDATIONS 6.01 During negotiations, agreement was reached between IDA, GOSL and NDB on: (i) conditions of PCI participation, including collection ratios for FY88-FY90, portfolio infection levels, and staffing (paras. 4.09-4.10). (ii) TOR and implementation timetables for various studies and on the annual review of the technical assistance components (para. 4.18): (iii) detailed policies of the Export Marketing fund (para. 4.22) and the SMI Technical Assistance Facility (para. 4.24); (iv) the initial use of the AWPR as the market reference rate for project operations and to the semi annual review of the mechanism for estab- lishing interest rates and spreads (para. 5.02); (v) the semi. annual adjustment on January 1 and July 1 of interest rates and spreads based on the mechanism for interest rate determination to: (a) reflect any significant movement in the market reference rate; and VY _'KI 1 -35- (b) remain positive in real terms vis-a-vis inflation as reflected by the Colombo Price Index (para. 5.02). (vi) onlending terms, conditions, margins, subproject eligibility criteria, and refinance arrangements (paras. 5.02-5.04); (vii) NDB's commitment to provide additional finance for the operating costs of the SMI Fund, if needed (para. 5.06); and (viii) procedures for procurement, disbursement, subproject review, periodic reporting, accounting and auditing (paras. 5.07-5.09). 6.02 During negotiations, drafts of the following documents were agreed: (i) PCI staff training programs for FY88-FY90 (para. 4.10). (ii) subsidi&.y loan agreement between GOSL and NDB (para. 5.01); and (iii) participation agreements between NDB and the PCIs (para. 5.01). 6.03 The following conditions should be met prior to credit effectiveness: (i) signing of a subsidiary loan agreement, satisfactory to IDA, between GOSL and NDB (para. 4.04); and (ii) signing of participation agreements, satisfactory to IDA, between NDB/SMI Fund and at least two eligible PCIs (para. 4.10). 6.04 With the above agreements and assurances, the proposed Project con- stitutes a suitable basis for a development Credit of SDRs 15.7 million (US$20 million equivalent) on standard IDA terms with a maturity of 40 years to the Democratic Socialist Republic of Sri Lanka. -36- ANNEX 1 SRI LANKA THE THIRD SMALL AND MEDIUM INDUSTRIES (SMI III) PROJECT OUTLINE--GOSL SMI DEVELOPMENT POLICY Background 1. Manufacturing industries consist of public sector corporations, registered private factories comprised mostly of small and medium enterprises whose plant and equipment is under Rs 1 million in value, !/ and a large number of unregistered small and cottage industries. In what follows the Rs I million cut-off point is used to define "small" industries. While issues discussed below may be common to all industrial enterprises,they are of particular importance in constraining the performance of small industries. Within this small industry group, however, other classifications based on problems peculiar to or strongly affecting various sub-groups, could be made. Thus it is possible to distinguish between medium and small enterprises in the organized sector and small and cottage level units, either self-owned or with less than five employees, in the informal, unorganized industrial sec- tor. 2. Problems of particular importance to small scale industries (SSIs) are: inadequate access to and the often high cost of credit; poor managerial skills in corporate management, finance, project preparation, marketing and production; associated inadequate technology and inefficient use of machinery; in some instances, a regulatory or policy environment which unin- tentionally favors larger enterprise units; and the lack of economies of scale in purchasing inputs. The result is generally low productivity, revealed in lower average value added and output level per employee and less capital per worker. 1/ Under IDA's SMI Projects small and medium industries are defined as those having a total investment (including land) of not more than Rs 8.0 million (US$280,000). -37- ANNEX 1 3. Recognizing the importance of SSIs in contributing to value added and employment and their potential for generating foreign exchange, the strategic objective of the Government should be not to discriminate in favor of such enterprises compared with other manufacturing establishments, but to remove impediments to their successful functioning, to improve their prospects by encouraging the development of skill acquisition and knowledge of technology and, particularly in the case of establishments in the informal unorganized sector, to bring them into the mainstream of modern industrial development. 4. In discussing the issues below and in developing a strategy and policies to deal with them, in many instances it is the entire manufacturing sector not only SSIs which would benefit. In the case of the SSIs, however, an integrated approach to the underlying problems is strongly advocated because the reforms are mutually reinforcing. To be successful, reform measures should have well defined objectives consistent with the overall industrial development strategy, there should be a sound institutional base for implementation with adequate physical manpower and financial resources, and an effective coordinating structure to harmonize the inputs of implement- ing organizations. Financial Requirements 5. One major issue concerns the onerous collateral requirements of the commercial banks. There are a number of reasons for this which have to do with genuine risk apprehensions of bankers, given their existing information base, the conservative attitude of bankers to industrial finance which has to do with their lack of expertize and training in the latter, and legal con- straints which affect the type of collateral which may be used, and the process of debt recovery. 6. A number of measures are contemplated to improve this financial situation. First, a credit information office should be established, owned and supported by the banking system, to furnish credit reports on request to financial institutions. Participation by commercial banks should be man- datory. Information to be systematically collected and processed should include details about ownership, capitalization, banker's estimate of credit availability, business record including sales, costs, profits, exports, etc., balance sheet information concerning assets and liabilities, information about related companies, business associates and other data relevant to credit standing. The credit office should also compile a data base on defaulters. While initially only commercial banks might be involved, the facility could be expanded subsequently to include other financial institu- tions. The primary beneficiaries of such a development might be credit users who, with banks not currently sharing credit information, are penalized because of those who have defaulted on past loans. It should be noted that such credit information is readily available in developed industrial societies. A by-product would be to increase the credit consciousness of Sri Lankan businessmen. -38- ANNEX 1 7, Secondly, there are a number of legal constraints inhibiting access to finance by SSIs in particular. A freehold title to land is required to mortgage not only the land, but the buildings, plant and equipment situated on the land. Consideration should be given to establishing a title insurance scheme whereby land with disputed title, leased land with disputed title, and encroached crown land where occupation has been prolonged, could have the title insured and become eligible for collateral. 8. An associated problem is that the procedures to be followed under the Crown Land Ordinance are excessively time consuming, particularly for the hypothecation or mortgage of leased crown land to another party. An amend- ment to the Crown Land Ordinance should be made to give the Commissioner of Lands discretionary power to authorize hypothecation or mortgaging to suitable parties. 9. The non interest cost of borrowing funds is considerable. A stamp duty of 1% is payable on mortgages; stamp duty is payable on a pledge loan and is paid again if the pledge loan, after a maximum of six months, is converted to a trust receipt loan. It is suggested these stamp duties be reduced to amounts consistent with the transaction coats involved. 10. There are difficulties in disposing of assets in the event of default. While the Bank of Ceylon, the People's Bank and the NDB have power to dispose of collateral under sections 46 and 47 of the Mortgage Act, only land mortgaged can be sold to recover debt* In law, while land mortgage includes equipment bolted to the floor and walls of a building, if the equip- ment is disconnected, even after the execution of a mortgage bond, it ceases to form part of the land. An appropriate amendment to the relevant sections of the Mortgage Act appears to be urgently required. A further problem is that under the law a maximum interest rate of 12% applies during jurisdic- tion. This could induce default to obtain the lower legal rate of interest. 11. Finally, borrowers have access to a Debt Reconciliation Board. In practice, highly concessionary conditions have resulted from the borrower's viewpoint. Again changes should be made in the Mortgage Act to reduce the bias in favor of borrowers and, by requiring compliance with the terms of a mortgage, make financiers less risk conscious. 12. Many SSIs have to give trade credit to retailers whose collection time could be three to four months. The latter make payment by post-dated cheques which have no validity in law in the event of default. To protect suppliers and facilitate their access to credit an internal bill of exchange or legally binding promissory note should be introduced which should be negotiable or discountable with a commercial bank prior to maturity. 13. Another major step to increase the quantity and improve the quality of information at the disposal of the suppliers of credit would be to improve project identification and formulation. The decision of the Department of Census and Statistics to conduct ten-yearly censuses and annual surveys of manufacturing activity and the greatly improved coverage, quality and range of information, and the intended timely processing of data will provide -39- ANNEX 1 urgently needed planning information. To fully ensure its usefulness, it is important that user requirements are kept fully in mind. To support project preparation and evaluation by enterprises, private consultants, institutions such as the IDB and SLBDC, the commercial banks, FIAC, GCEC and LIAC, detailed information concerning trends in output, exports and imports, and excess capacity should be readily available at the lower level of aggregation consistent with the confidentiality requirements of the Census and Statistics Act. Speedy retrieval of d.ta by institutions and banks should be assisted by establishing computer terminal links. The IDB's ability to collect, codify and disseminate information about enterprise level production techni- ques and processes, and the availability of alternatives is also in urgent need of being strengthened. 14. A greater flow of reliable processed information on which to develop sound project proposals is one thing. Also required is an expanded supply of people qualified to undertake such analysis and an attitudinal change on the part of the commercial banking fraternity to the value of it. The reluctance of the banks to finance industrial investment has to do with their perception of risk, which is in substantial part due to past high defaults and to an inadequate supply of credit information. It is also a result of inexperience in dealing with loans to industry. At issue is the need to base loans also on the credit standing of the applicant and especially the likely profitability of the project as well as upon the collateral offered. To achieve this attitudinal change, in addition to better credit information, it is urged that commercial banks establish specialized industrial finance sections, staffed by personnel trained in the techniques of project evalua- tion. To facilitate their task, it is also desirable that institutions such as the IDB, SLBDC, MDB and private consultants, should greatly increase the quality of the feasibility studies which they do on behalf of the private sector. The reluctance of the commercial banks to rely upon their evalua- tions seems based upon unreliable and, hence, costly past appraisals. It is also important that a common core format be developed by the various institu- tions involved in project appraisal, whether this be for the purpose of obtaining a licence to manufacture or finance. 15. There are other measures to improve the ability of the commercial banks to service the requirements of industry. Given the legal reforms advocated above, the banks should be encouraged to take a first or second mortgage on land, buildings (and equipment) to cover the value of the loan. Should this not be adequate, a lien over materials in use or personal guaran- tees should be sought. In the case of the latter, guarantors should be apprised early of any signs of default in order that they might bring moral pressure to bear on the debtor. As a final resort, consideration should be given to establishing a government-backed loan guarantee system which would be called upon in the event of default and the above security being inade- quate. Access to such Last resort guarantee would require the banks to conform to minimum loan conditions. The guarantee might be financed, at least in part, by participating banks. ANNEX 1 16. In their industrial finance sections, the commercial banks might adopt the practice of making loan officers responsible for the performance of specified loans, and to ensure that their monitoring and implementation of the loan was as effective as possible, a commission paid the to officers provided the loan performance was satisfactory. 17. The Government is urged as quickly as feasible to continue to reduce interest rates by easing the pressures brought about by budget deficits and by allowing deposit and loan rates (with the possible exception of export credit) to be freely determined by what is now a competitive commercial banking system. The corollary of this freeing of the interest rate system, of course, would be the discontinuing of the special refinancing facilities which add to the cost of financial intermediation. In other words, the thrust of the above measures, taken in conjunction with interest rate reform, would be to greatly improve the access of manufacturers, and of small and medium manufacturers in particular, to industrial finance at normal interest rates (which, given the special guarantee provisions, might be lower than the average structure of rates). This recommendation is fully consistent with the objective of delivering an intended level of incentives to manufacturing via the tariff and export tax credit, and not unintentionally providing additional assistance in a discriminatory manner. It is also consistent with the policy objective of removing constraints to the development of small and medium scale industry but not discriminating in their favor. 18. The range of banking activities undertaken by the development banks needs to be expanded to make their services more effective. Other countries have successfully involved their development finance institutions in a range of conventional banking functions that both increase the liquidity of the bank and enable it to provide a balanced array of services to its clients, including accepting deposits, maintenance of current accounts, the issuing of letters of credit, and especially the provision of working capital. This will facilitate the provision of a package of services, including par- ticularly working capital, required for successful project implementation. It will also ensure comprehensive monitoring by the bank of the project. 19. This development, which would require the NDB to open branches, would in particular encourage greater NDB direct participation in small and medium industry development. At the moment, it participates indirectly by facilitating loans by five participating banks under the World Bank SMI Projects. 20. Steps should also be taken to expand the role of the Development Finance Corporation of Ceylon (DFCC) by increasing its authorized and paid-up capital to make it approximately of the same size as the NDB. The practice of requiring commercial banks to subscribe to DFCC debentures should then be discontinued. The additional capital should be subscribed by the Government, the Central Bank, the state owned commercial banks, and other commercial banks if they wished to participate. As in the case of the NDB, the DFCC should undertake a wider range of banking activities and the recommended freeing of interest rates should permit a sufficient spread between deposit and loan rates to restore profits to more normal levels. -41- ANNEX I 21. In the financing of small and medium scale manufacturing, priority could be given to certain products in the case of loans to modernize equip- ment and machinery. This would be in addition to general measures recom- mended elsewhere to provide working capital and post-export credit to direct and indirect exporters. Criteria for the selection of products should include low comparative costs, good existing export perfor,ance and prospects, and high domestic value added. Regardless of export prospects, such priority loans should also be made available to promote subcontracting between small and large enterprises. It should be the responsibility of the EDB and the IDB to identify such products and recommend them to MISA for priority treatment by the commercial and development banks. 22. Financial facilities should also be made available to promote cooperatives or mergers among small scale industries. Cooperative programs should assist small scale entei,prises (SSIs) operating in the same or related product areas to strengthen their competitive position, to improve environ- mental controls, to relocate plants, to make joint purchases of inputs and sales of outputs, and to share technological and management information. The IDB should be the lead agency in stimulating such a development to reduce prime costs, improve technology and raise productivity. The IDB should likewise promote, and priority banking accommodation be provided, attempts by SSIs to merge into larger units to achieve economies of scale and to reduce excessive competition among one another. Other Considerations 23. An integrated approach to the problems of SSIs has been recommended because, while the amelioration of financial constraints is of primary impor- tance in successful SSI development, it will not suffice if unaccompanied by the upgrading of management and technical capabilities. In this regard, the activities of the IDB particularly, and of the SLBDC and SLCSB, require strengthening by increasing the number and competence of staff concerned with entrepreneurial development and technical assistance. Whether provided by in-house extension services or institutional courses, these need to be under- taken by staff who have had relevant, problem solving management experience. In providing technical assistance the IDB should, in particular, assist in facilitating information flows about improvements in design, product specification, performance characteristics as well as about alternative technologies and production processes. 24. The subcontracting exchange of the IDB could assist marketing efforts by better identifying parts/components and products required by other producers, public procurement agencies and domestic and foreign consumers of final products, and matching these requirements with potential small scale producers. They could also assist in negotiating contracts and in providing appropriate advice and assistance to ensure satisfactory fulfilment of con- tracts. AftNEX 2 SRI LANKA ThIRD SMALL AND MEDIUM INDUSTRIES (6M1 III) INTEREST RATE $TRUCTUE. 10"l-1M (in per gent per annum) 3t December 89 8902 983 1804 3885 490 Central Bank Rote g1 14.0 14.0 13.0 33.0 51.0 10.0 Government Treasury Sittl - Primary market 13.0 13.0 12.0 44.0 32.0 12.0 - Secondary market 15.25 33.25 42.5 14.2 52.5 02.0 Commercial Banks Loan Rates: Inter Bank Call Loans 10.0-14.0 10.0-84.5 t0.0-55.0 10.0-15.0 82.0 10.0-52.0 Socured Loans and Overdrafts 95.0-30.0 16.0-30.0 18.0-Z0.O 57.0-30.0 87.0-20.0 04.0-88.0. Deposit Rates: Soving& Deposita 50.0-14.0 10.0-14.5 10.0-15.0 50.0-15.0 80.0-34.0 t0.0-32.0 Time Deposits - 6 months 15.0-21.5 13.0-18.2 t3.0-25.0 33.0-19.0 12.0-33.0 30.0-92.0 - 32 months 20.0-22.0 85.0-22.0 16.0-25.0 14.0-22.0 13.0-04.0 12.0-83.0 National Savings Bank Deposit Rates - Savings Deposits 12.0 .82.0 12.0 52.0 92.0 32.0 - 12-month fixed deposits 15.0-22.0 95.0-22.0 04.0-80.0 84.0-18.0 15.0 52.0 - 10-year Savings Certificates 55.0 9.0 11.0 55.0 11.0 53.0 Lending Rates of Credit Institution* State Mortgage and Investment Bank 32.0-24.0 12.0-24.0 52.0-24.0 12.0-24.0 10.0-17.0 30.0-94.0 - OFCC 37.0 17.0 84.0 34.0 14.0 14.0 - "o 37.0 97.0 34.0 34.0 34.0 34.0 a/ The rate charged by the Central bank an advances to commerclal banks for thoe temporary ltquidity purposes. -43- ANNEX 3 Page 1 SRI LANKA THIRD SKALL AND MEDIUM INDUSTRIES (SHI III) PROJECT SUBPROJECT PROFILES: SMI I AND II 1. Sub-loan Size SMI (I) SMI (II) TOTAL Amount Amount Amount RS '000 No. Amount As a % No. Amount As a % No. Amount As a % 0 - 50 1,101 32.2 14.0 262 7.0 0.8 1,363 39.2 3.7 50 - 500 504 110.4 48.1 1,107 209.3 25.5 1,611 319.7 30.4 500 - IN 136 86.9 37.9 326 209.8 25.5 462 296.7 28.2 IN - 2M 182 241.3 29.4 182 241.3 23.0 2M - 4M 61 153.9 18.8 61 153.9 14.7 TOTAL 1,741 229.5 100.0 1,938 821.3 100.0 3,679 1,050.8 100.0 -44- ANNEX 3 2. Classification of sub-project by type No. No. Ns No. No. a No. No. as Nov 881 51 752 39 1633 44 aaWIE 860 49 1186. 61 2046 56 Total 1741 100 1938 100 3679 100 3. Employment Generation 1741 1938 3679 J;1oyen 17526 18780 36306 -45- ANNEX 3 4. Sectoral Breakdown No. 'Åmout Amt, Woo. t. Nåo &A8<4. m a Coas Cotre 11 5.0 2.1 14 12,0 1.5 23 1.0 1.6 coas. gaterial 272 42,9 18.7 136 66.0 8.0 o8.9 10.4 pod pmo«@sla 474 56,6 24.7 516 226.2 27.9 9 282.8 26.9 omas89 9.5 4.1 108 37.8 4.6 197 47.3 4.5 Kopel Produts 215 22.4 9.8 170 63.6 7.8 383 86.0 8.2 Other &an ld, 120 10.1 4.4 44 12.6 1, 164 22,7 2.2 RepMir twtakop 51 4.1 1.8 93 23.9 2.9 144 28.0 2.7 Rabber Prod~cts 29 6.8 3.0 62 37.4 4.6 91 44.2 4.2 Te5iloc 52 7.7 3.4 42 21.8 3.1 94 33.5 3.2 doo Priodnotg 176 20.4 8.8 143 37.9 4.6 319 58.3 5.5 141s<allaneous Ameal Räb~ 118 42.3 5.2 118 42.5 4.0 & Ho>rticulture Chem. Producte 08 2.3 0.3 08 2.3 0.2 Com. Tr&npor% 144 41.3 5.0 144 41.3 3.9 - ..eher a al22 9,4 1.2 22 9.4 0.9 - Plas~i. Preducts 33 32.9 4.0 33 32.9 3.1 109 61,0 7.4 109 61.0 5.8 - Qther 252 44.0 19.2 176 88.7 10.8 428 132.7 12.7 1741 229.3 100.0 1938 821.3 10060 3679 1050.8 100.0 -46- ANNEX 3 5. Districeise Apovals 0~. n A6n 3 u~.Co san e No. ~s t mte. ag a a a e a 19 1.9 0.8 01 0,1 0.1 20 2.0 0.2 46 3.4 1.6 89 2309 3-0 131 27.6 .G sejulla 68 4.8 2,1 47 8.9 1.0 115 13.7 1.3 Satt:iealo 22 3.7 1.6 04 1.6 0.2 26 3.3 0.3 Colombo 400 83.8 34.5 554 306.0 37.3 954 389.8 37.1 * G 73 7,6 3.3 177 57.7 7.0 252 65.3 6.2· omak& 218 30.1 13.1 247 113.0 13.7 335 143.1 13.6 * Ismbu10,4 37 4.5 '2.0 43 13.1 1.6 80 17.6 1.6- Jafräa 51 12.4 5.4 07 3.4 0.4 58 15.8 1.5 * Kelaut&r 67 7.3 3.3 64 36.7 4.7 131 46.2 4.4 Kandy 152 9.4 4.1 80 23.3 2.8 232 32.7 3.1 * Uealle 29 4.5 2.0 98 3.9 4.5 127 41.4 3.9 K.luacecht ..-. - .. . . • Kanmoga 177 12.5 5.4 113 31.6 6.3 290 64,1 6.1 * Ial&M 92 11.6 5.0 97 37.9 4.6 189 49.5 4.7 * nämar 03 1,3 0.6 de . . 03 1.3 0.1 Haale 53. 4.7 2.0 26 5.9 0.7 79 10.6 1.0 Meffoesla 03- 0.2 0.1 24 4.8 0.5 27 5.0 0.5 wlAllgm 03 0.4 0.1 da G5 03 0.4 C.3 N¶ 11ra El3a 09 07 0.3 19 6.9 0.8 28 7.6 0.7 Polonaaru&a 33 3.6 1.6 48 11.2 1.3 83 14.8 1.4 pulIala 146 15.5 6.7 123 46.5 5.6 251 62.0 !.9 Rat&Pum 22 2.1 1.0 74 29.5 3.5 96 31,6 3.0 Traaeae c8 2.1 1.0 02 0.1 0.1 10 2.2 Z.2 C6 0.9 0.4 01 0.3 0.3 07 1.2 X. TOU 1741 229,5 100.0 1938 821.3 100.0 3679 1050.8 1c0.0 F-K, -- -~ g=~ -~r ~ aa 11 l C~ oc~a ±ar *%Mjor Region Conurbacions -47- ANNEX 4 SRI LANKA THIRD SMALL AND MEDIUM INDUSTRIES (SMI III) PROJECT PERFORMANCE OF PARTICIPATING CREDIT INSTITUTIONS : SMI I AND II Bank of Ceylon (BOC) 1. BOC is one of the two NCBs operating in Sri Lanka and is the largest commercial bank in the country, with total assets of Rs 42.8 billion, 702 branches and staffing of 10,530 (excluding recently employed security staff). As of December 31, 1985, its total deposits were Rs 19.0 billion, about 43% of all deposits of the banking system. In 1985 BOC earned gross income of Rs 1.1 billion and an operational profit before taxes of Rs 134 million, down significantly from the Rs 235 million in 1984. Although 8OC has been operat- ing profitably for the past decade, its return on equity (3.1%) and average total assets (0.3%) is low. This low return results from the significant number of unprofitable social functions carried out for the Government, and from GOSL's policies which have contributed to higher administrative costs (i.e. extensive branch network, overstaffing due to politically motivated personnel policy, etc.). 8OC's industrial lending amounted to 27% of its total lending in 1986, while term loans to SMI accounted for under 3% of total lending; but this is expected to grow as has been the case over the life of the two previous SMI projects. 2. Under SMI I and II, 1,568 loans for Rs 500 million (US$17.5 million) have been approved as of December 1986, making BOC the largest participant in the SMI program both in terms of numbers of projects and amounts. Collection performance of 75% and 84% for SMI I and -I respectively is satisfactory. In the past, BOC SMI operations (in line with their social functions objective) have concentrated mainly on the smaller new projects dispersed widely over the country, however, this has been changing somewhat as BOC's original borrowers have prospered and are coming back for expansion funding. 8OC's SMI unit is headed by an AGM Industry with daily operations under the charge of a credit manager. There are 19 SMI officers at headquarters and 44 at the district level who work full time on SMI operations. In addition, a large number of branch staff have had training in SMI lending. Based on its cur- rent and proposed staffing levels, branch networks, improved appraisal/end use capability, collections and experience in SMI operations, BOC qualifies for participation in SMI III. They anticipate their participation to be about 60% of the proposed SMI III credit of US$30 million compared to their SMI II share of slightly above 50%. Eggiligag~~~~~~~~ agglum9aam namemrua Me- --,- 1-- , -48- ANNEX 4 Commercial Bank of Ceylon (CBOC) 3. CBOC is the largest local privately owned bank in Sri Lanka and has 15 branches located predominantly in Colombo, Kandy and the Southern Region, with total staffing of about 1,150. As of December 31, 1986 its assets totalled Rs 3.3 billion, which was about 13% higher than in 1985. Total deposits of Rs 23 billion constitute 70% of the total assets. CBOC has been operating profitably for the past five years, its return on equity has averaged about 14%, return on assets 2.1%, and dividend to stockholders 22%. Industrial advances are about 10% of total lending, of which 2% is for SMI advances. As of December 31, 1986, 165 loans for about Rs 80.0 million have been approved under SMI I and II. CBOC has been cautious in its SMI lending, concentrating mainly on large and medium-sized expansion projects. However, their collection ratio at 60% for both SMI I and II is low and will have to improve to 70% for CBOC to be eligible for SMI III. The CBOC SMI unit is headed by a Senior Credit Controller (SCC) who reports directly to the AGM for International Operations and Credit. The SCC has two officers at head- quarters and 14 full time SMI officers at branches. With its sound client ba e, enthusiastic SMI operational staff, and branch network, CBOC could be more active in SMI operations and should be able to improve on its current level of utilization of SMI funds. The Development Finance Corporation of Ceylon (DFCC) 4. DFCC was established by an Act of Parliament in 1955 to provide financial assistance to the private sector. DFCC's initial authorized capi- tal was Rs 8 million which has been increased to Rs 100 million. At present 44% of DFCC's shares are held by the BOC and PB and other public sector institutions, 37% is held by foreign investors (including IFC) and 21% by private corporations or individ-jals. DFCC's eleven member Board includes two representatives appointed by BOC/PB, two by GOSL and six by the shareholders. The Chairman is appointed by GOSL. The General Manager is ex officio a director. As of March 31, 1987, DFCC had 134 staff including 59 profession- als. 5. DFCC's Statement of Operational and Finance Strategy provides a sound framework for its present operations. However, with the liberaliza.ion of the financial system DFCC recognizes that the focus of its operations requires some redirection, and it has appointed Morgan Grenfell to assist it in the process of formulating a new operational strategy. DFCC's operational policies and procedures are satisfactory and its internal controls over procurement, accounting and auditing are sound. -49- ANNEX 4 6. Notwithstanding external difficulties over the past few years and a change in accounting policy restricting interest treated as income, DFCC has recorded sound if unspectacular profitability. Net after tax profits have increased from Rs 6.4 million (FY80) to Rs 42.7 million (FY87) giving a ROA of 2.6%. In line with project approvals total assets have increased from Rs 300 million (FY80) to Rs 1.9 billion (FY87). With added equity infusion DFCC's debt/equity ratio is now 6:3:1; debt service coverage is 1:3:1 and the ROE is 19.6%. As part of the overall asset increase DFCC's portfolio increased from Rs 400 nillion (FY81) to Rs 1.6 billion (FY87) or by 26% p.a. Initially investments in the hotel sector constituted a major part of the portfolio, but through a conscious plan of diversification the portfolio is now relatively well balanced. As of March 31, 1987 arrears were Rs 81 mil- lion or 5% of the portfolio with four sectors--garments, textiles, rubber products and construction materials--accounting for 70% of the arrears. With the rescheduling of the hotel portfolio DFCC's collections have improved and are presently 93% of principal and interest due. Overall DFCC's performance is satisfactory. Under SMI I and II DFCC has been a major participant with cumulative appr>vals of Rs 214 million or 20% of the total. Disbursements followed this pattern and as of March 31, 1987 DFCC had disbursed Rs 121 million or 17% of total disbursements. Of the 167 subloans under supervi- sion, 43 are in arrears with total arrears of Rs 3.0 million or 2% of total outstanding. Currently, DFCC's collection rate on SMI operations is 85%. Hatton National Bank (HNB) 7. HNB is a privately held company with total assets of Rs 3.2 billion as of December 31, 1986, up from Rs 3.0 biliion in 1985. Total deposits accounted for Rs 2.3 billion or 74% of assets. Gross income for the year was Rs 320 million, while net income after taxes was Rs 27.6 million up from Rs 25.9 million in 1986. Return on equity was 13.2% and on assets 1.4%, and it paid a 25% dividend to its shareholders. Overall, HNB is a well run and profitable institution with management and staff who are highly capable and motivated. They are willing to make changes to keep abreast of recent developments in banking, as well as to meet the challenge of increased com- petition from a growing number of financial intermediaries. In its opera- tions, advances to industry accounted for 16% of total advances, of which approximately 2% was for SMI operations. Under SMI I and II, 136 loans for Rs 100 million have been approved as of end 1986 (includes term loan financ- ing and related financing). As a private bank, HNB's management is answerable to its shareholders and with profit maximization as its main objective, has been very careful in its selection and financing of SMI projects. Most of its lending has been to existing clients for medium-sized projects, which has resulted in most of the financing being successful. HNB has the highest collection ratio under SMI I and III and the lowest level of arrears among the PCI's. Based on present overall SMI performance, hNB easily meets the minimum requirements for SMI III participation. It is estimated that it will increase its involvement by at least 50% over SMI II's performance levels. -50- ANNEX 4 The National Development Bank (NDB) 8. NDB was established in January 1979 with an authorized share capital of Rs 2.0 billion (US$70 million) to finance agriculture, commercial and industrial enterprises through direct loans, equity and refinance. NDB issued Rs 600 million in initial share capital: 67% to GOSL, 17% to the CBSL and 8% each to the two state-owned commercial banks. Of the issued share capital of Rs 600 million, Rs 450 million has been paid in, leaving on call Rs 150 million, or 75% of the contributions of the CBSL and the commercial banks. The MOFP, the CBSL, the BOC and PB are represented on NDB's Board. The organization has six departments,: two for direct lending; one for refinance; and three for support functions. Department heads report to the general manager, who is responsible through the chairman to the Board. NDB's management has been assisted by consultants financed under the SMI Projects. An advisor to the SMI Fund assisted in establishing SMI refinance operations and procedures. These consultants contributed substantially to the initial development of NDB and the SMI Fund. 9. As of March 31, 1987, NDB had a staff of 175 including 90 profession- als. To continue the upgrading of new and existing staff NDB has sent a number of staff for training on local and overseas courses. For its day to day operations, NDB has a clearly defined statement of operating guidelines supplemented by an operational strategy for 1986-1988. Against the back- ground of sound policies and procedures and a cadre of well qualified staff, NDB's appraisals are sound, providing an adequate cover of technical, market- ing and financial aspects of their lending operations. End use operations are also satisfactory, although external influences upon project implementa- tion require the need for close attention to project implementation and rehabilitation. NDB's procurement standards are satisfactory with all for- eign exchange related procurement or major projects made through interna- tional competitive bidding and international shopping for limited supply or spare part procurement. NDB's accounting procedures are also sound and are subject to an annual audit by the Auditor General or an independent auditor acting on his behalf. 10. Since its establishment in 1979, NDB has supplemented its initial equity base of Rs 600 million with retained earnings of Rs 700 million to give it a total capital and reserves of Rs 1.3 billion as of December 31, 1986. In turn these resources and borrowings of Rs 1.2 billion have funded fixed asset investments and term lending operations of Rs 2.5 billion (US$88 million). As indicated by the accumulation of reserves NDB's profitability has grown consistently with net profits increasing from Rs 80 million in 1980 to Rs 108 million in 1986 or at an annual average rate of about 8%. ROA is presently 6%, debt/equity ratio 0:7:1 and the debt service coverage ratio is 4:5:1, all highly satisfactory. -51- ANNEX 4 People's Bank (PB) 11. PB is also a NCB with total assets of Rs 32.1 million as of end 1985, and is the second largest commercial bank in Sri Lanka It has 309 branches, and staffing of about 10,000. Total deposits reached Rs 19.3 billion, repre- senting a growth of 18% over 1984, and 40% of all deposits in the banking system. Total income was Rs 2.1 billion, although net profit declined from Rs 78 million to Rs 67 million. Although PB has operated profitably over the years, its return on capital (2%) and assets (4%) are low, as it has in the past handled a significant volume of unprofitable social functions at the request of GOSL, although its objectives are now to operate on purely commer- cial principles. These activities, (i.e. extensive branch networks, over- staffing, etc.) have resulted in high administrative costs and a portfolio heavily infected with a high percentage of non-performing loans (made for social reasons or to semi-government corporations). Advances to industry accounted for 25% of total advances; term loans to SMI amount to Rs 66 mil- lion or 3% of the industrial lending portfolio. Under SMI I and II, 1,385 loans for Rs 350 million have been approved as of end 1986, making PB the second largest participant in the SMI programs. In line with one of its stated objectives of promoting growth and development in all parts of the country PB, like BOC, has concentrated mainly on smaller new projects dis- persed all over the country. PB's management is fully committed to the SMI operations and visualizes considerable growth in this area and has been recruiting and training staff to carry out this work. Currently SMI opera- tions come under the DGM Domestic Finance and are the direct responsibility of the AGM Domestic Credit, who has 10 officers working for him at head- quarters, and another 24 assigned to the 16 regional offices. These officers work full time on SMI operations and are trained in appraisal, supervision, end use, etc. In addition, almost all branches have SMI trained officers who, depending on the volume of SMI activity, either work full or part time on SMI operations. Based on PB's current branch network, staffing levels, improved appraisal/end use capability, collection performance and experience, they are qualified for participation in SMI III. Conservative estimates by PB's SMI management suggest their participation in SMI III to be at least 25% over their SMI II involvement. -52- ANNEX 4 OPERATING PERFORMANCE 1. Cumulative Approvals (Rs Million as of March 31, 1987) SMI (I) SMI (II) TOTAL Amount No. Amount No. Amount No. Amount As a % Bank of Ceylon 658 86.0 1,006 338.4 1,664 424.4 40.4 People's Bank 896 91.5 569 201.7 1,465 293.2 28.0 Commercial Bank of Ceylon Ltd. 115 29.5 66 34.0 181 63.5 6.0 Hatton National Bank Ltd. 65 21.7 73 34.0 138 55.7 5.2 Development Finance Corporation of Ceylon 7 0.8 224 213.2 231 214.0 20.4 TOTAL 1,741 229.5 1,938 821.3 3,679 1,050.8 100.0 -53- ANNEX 4 2. Commitments and Disbursements (Rs million as of March 31, 1987) SMI (I) SMI (II) TOTAL Commit Disb. Commit Disb. Commit Disb. Amount Amount Amount Amount Amount Amount Bank of Ceylon 86.0 85.9 338.4 193.8 424.4 279.7 People's Bank 91.5 91.4 201.7 131.7 293.2 223.1 Commercial Bank of Ceylon Ltd. 29.5 29.5 34.0 24.2 63.5 53.7 Hatton National Bank Ltd. 21.7 21.7 34.0 31.4 55.7 53.1 Development Finance Corporation of Ceylon 0.8 0.8 213.2 119.8 214.0 120.6 TOTAL 229.5 229.3 821.3 500.9 1,050.8 730.2 SR R EANNA ToeIR SMALL AND MEDIUM INDUSTRIES (SMi III) PMOJECT SUBPROJECT PROFILES 9. Collection Performance of SNI (1) and SMI (II) subloans s at Dsceber 31, 1986: all PCIs W (2) () (4T()W6 (7)() G~blesna Seens Pi plmn Principal CoIiectica Rrg od taae 4 appoedauemefptaeela relomre pinolo olämtio Ruto ma et is) - "»r,ro ~ to .12.^6 . am . . 100 (___o.)_. a___n_ (_o_____t (_.)____ (co.) s~Mat im a 1 i. 2 4 m () (655) 107,194.7 <655 16,194.7 20 3 51,116.3 76,076.4 <265) 25,700.7 75 7 72 69 67 03 <'~~~') (2t2>... ~ ~ ~ ~ ~ 1% 2%~lI 53j643. -99j ~~!2. 401k3k54 12PA J&TO98 8 7 7 OM IML 1568) 485,346.2 (1478) 414,149.9 1e11) 297.440.1 116,709.0 (547) 53,421.6 78 74 1.5 - - 19 36e 316 9 5 07 e 11s,2n1.3 (c79) 130525. ( 56,94.5 75.560.9 247 29,492.5 72 6s 60 59 6o 77 24 4 ?! , . 2 (699) 1 9 2 .2 m 4s4! A 61 - - - . em0 TMaL 1400) 340,761.7 (1523) 290,9 .1 (699) 199,424.0 91,555.1 (420) 32,9.0 74 66 61 - 17 XKOCIeAL e=s gu () (115) 56,871.0 (ts) 36,01.0 63 19,830.2 ID,O40.9 ( 57) 11,50.5 60 as 69 72 71 63 U (I ) 56) 57,5 . 0( 50) 32,115.3 1 2,628.1 9,485.2 1 a1 2,332.9 de 43 532 - - 8 M¶0AL (171) 74,0.0 (165) 68,94.5 (115) 47.4583. 2,526.0 ( 70) 14,191.0 60 65 - - - 30 1.0.4. au ) ( 65) n,20s.2 65) 27,20.2 50) *,120.6 19,0«4.6 (> 5,442.5 1e 81 4 0 67 as I) (1) - %325.O [ gig .Sg,¾5O.O .6') .0,3.6 .902l.4, 1 .4 3 . Ji 4. 49 .. -.---.--.---.--_-- ma mral (156) 68,56o.2 (32) 66,555.2 ( 95) 38,419.2 28,116.0 ( 54) 6,914.9 se et 4 9 - 1e Ma i) (7) 1,001.1 07) 1,001.1 ( 04 652.2 440.9 ( 0 9.4 n 4 1 4 S II) 19). -18&4004 160) , i1641 6 - 9 - S orAL (204) 259,401.5 (167) 155,069.5 (162) 158,508.8 16,760.5 ( 43) 2,994.7 05 85 42 4 -2 S (I) 1756) 2f1,545.5 (1721) 282,797.2 (660) 95,6r.6 187,111.6 (596 72,145.4 72 70 67 66 66 75 u (11) 11745) 926,915.5 1544 712,918.6 1460) 62%,564.6 67,555.6 (526 18,257.5 85 76 68 74 - 5 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -- - - - --------------------------------------- -55- ANNEX 4 4. Staff Training under the SMI Project up to 1986 Local Training Overseas Training No. of No. of Officers No. of No. of Officers Programs Trained Progr4ms Trained Up to 1983 26 366* 04 54 During 1984 04 83 04 18 During 1985 07 183 05 14 During 1986 07 202 01 20 TOTAL 44 834 14 106 2nd Quarter 1987 (Planned) 04 75 * Excluding 291 officers from various categories who participated in 8 one-day seminars on SMI II. -56- ANNEX 5 SRI LANKA THIRD SMALL AND MEDIUM-SIZED INDUSTRIES (SMI III) PROJECT Improving the Efficiency of the Financial Sector Proposed Terms Of Reference For A Review Of The Lending And Other Operations Of The Bank Of Ceylon (BOC) And The People's Bank (PB) Background 1. The financial system of Sri Lanka has benefitted considerably from the new economic policy that has been pursued since 1977. Institution build- ing in particular has been very impressive as new domestic and foreign banks, development finance companies, leasing companies, finance companies and closed-end investment companies have been established. Institution building is likely to continue further with the creation of new domestic banks as well as insurance companies and open-ended investment companies (unit trusts) that are currently under active consideration by a number of groups. 2. The establishment of these institutions and in particular the arrival of a number of foreign banks have led to increased competition and enhanced efficiency especially in the areas of trade finance and corporate banking services. To meet the challenge of the new competitors, the nationalized commercial banks (NCBs), 1/ which still hold a dominant share of total finan- cial assets in the country, havi taken various measures to streamline their operations and improve their efFiciency, especially in the corporate banking area. However, despite their efforts to respond effectively to this chal- lenge, some concern is expressed at the high operating costs and high level of non-performing loans of the NCBs which are reflected in their intermedia- tion margins. 3. High operating costs may be caused by overstaffing and by inefficient operating procedures whilst the high level of non-performing loans may reflect inadequate loan appraisal, approval and monitoring systems as well as limitations on the effectiveness of debt recovery and collection. On the 1/ The NCB are the Bank of Ceylon (BOC) and the People's Bank (PB). -57- ANNEX 5 other hand, bad loan performance may be due to extraneous factors such as the adverse impact of the security situation on the hotel sector. In addition, deficient debt recovery may be caused by inefficiencies and impediments in legal procedures. 4. GOSL attaches high priority to the strengthening of the financial and operating performance of the NCBs and intends to provide every assistance to them to streamline their operations and enhance their efficiency. In this respect, it proposes to support a special review of the lending and operating procedures of the BOC and PB with a view to enhancing the efficiency of their lending operations and the effectiveness of inspection procedures. The study will be assigned to a firm(s) of specialist consultants with an international reputation, professionalism and experience in the review of commercial bank operations. 5. The review will aim to provide an assessment of the quality of exist- ing procedures, systems and facilities and will make specific and detailed recommendations for substantial improvements in the efficiency of lending and other operations. It is understood that the proposed review will not include a detailed analysis of the existing loan portfolios or of loan class- ification, provisioning and recovery policies as these have been subject to periodic review by the CBSL Department of Banking Supervision, although the findings of the CBSL will be taken into account in formulating recommenda- tions 6. Because of the possible sensitivity of the findings of the review, the review will be conducted on a confidential basis and will not be dis- tributed to or discussed with any parties other than those identified by COSL and the respective institution. The consulting assistance for these reviews would be funded from the TA component of SMI III. TA assistance for implementing agreed recommendations could be necessary and could be mobilized from UNDP, or the umbrella IDA TA project presently under preparation. Fri -58- ANNEX 5 BANK OF CEYLON Background 1. The Bank of Ceylon has expressed strong interest in undertaking a review of its overall operations as this would build on the improvements achieved over the past five years following a comprehensive review of the organization 7y the International Finance Corporation and successful implementation of the recommendations of the IFC study. Moreover, the proposed review will build on the findings and recommendations of the recent reporti on the cost effectiveness of the NCBs prepared by Mr. Dinneen, an adviser to the International Monetary Fund (IMF). Scope of Work 2. The proposed review will cover the analysis and evaluation of the following: (a) the structure and evolution over the fast five years of the financial position of the BOC based on the balance sheet and'other financial statements (profit and loss, sources and uses of funds, operating costs); (b) the operating performance over the past five years with particular emphasis on the level of profitability, loan losses, operating costs and costs of intermediation; (c) the distribution of loans by sector of economic activity, geographi- cal region, size of borrower and type of loan; (d) the distribution of non-performing loans by the same range of attributes; (e) the impact of the non-accrual of interest on non-performing loans and of loan loss provisions and write-offs on the overall profitability of lending operations; (M) the written loan policy guidelines for the terms and conditions of different types of loans and the loan appraisal, approval and monitoring procedures; (g) the policies and procedures on internal review and credit inspection systems; (h) the training programs and facilities on credit appraisal and credit inspection; (i) the operating systems and procedures at branch and head office level, both with regard to lending operations and other activities, e.g. deposit collection, cash handling, payment services, etc. -59- ANNEX 5 Assistance Required 3. It is estimated that about 12-15 consultant months of assistance would be required from three/four consultants, supplemented by the use of local consultants, working as a close coordinated team. The costs of this assistance would be funded in part by a foreign exchange allocation of US$250,000 from IDA's SMI III supplemented by local currency support from the BOC. Counterpart Support 4. In order for the consultants to obtain a proper understanding of how the different departments of the Bank interact with each other, a senior officer of the Bank would be assigned to work with the consultants. Addi- tionally, there would be frequent meetings between the consultants and senior management during the proposed review. Reporting 5. During the course of the review the consultants will provide the Bank's management with (i) an interim report setting out the major issues identified to date and proposed courses of action to analyse the issue and develop appropriate action programs for further work, (ii) a draft final report setting out the findings of the review and proposed remedial actions. This report would be supported by an outline action program indicating the time frame for implementing agreed recommendations and a training program focusing on the areas of weakness identified during the review. -60- ANNEX 5 PEOPLE'S BANK Background 1. The People's Bank (PB) was set up by the Government in 1961 and was expected to provide banking facilities to support government's development efforts in the fields, particularly of agriculture, cooperative and rural development. It was also hoped that it would as far as possible operate through cooperative societies. It was given all the powers of a commercial bank. Its growth during the period was rapid and it quickly became a major banking institution, both as a commercial bank and as a development bank. Although PB's designated role was to develop the cooperative movement, promote rural banking and PTant agricultural credit it deviated from these objectives and involved itself in commercial banking in order to obtain funds to finance development in the rural economy. 2. The People's Bank now has the largest number of branches in the financial system and also the largest number of employees (9,900) in any financial institution in Sri Lanka. However, even with this structure, profits have remained stable and business has continued to grow despite the fact that ethnic disturbances in the North and the East has resulted in a drop in Levenue from these areas and also the keen competition from foreign banks. The management of PB is, however, acutely aware of the need to improve efficiency and productivity to meet the challenges of the future and have taken a number of steps to achieve this objective, including full com- ..t2rization of the larger branches of the Bank, computerization of the *>erations of the International Division, the introduction of a more com- p:ehensive automated system which will include a management information system linked to the Central System, improvement of the manual systems in the branches not fully automated, strengthening Internal Audit and Management Audit, and organization changes to improve recovery of non-performing loans. Scope of Work 3. In an organization as large and complex as PB changes and improve- ments will inevitably have to be introduced slowly and cautiously, more so as the in-house capability of the Bank is somewhat limited and there are organizational constraints which cannot be eliminated easily. PB therefore proposes a programatic strategy which it feels is appropriate to the circum- stances and has not opted for formulating an overall Master Plan for improv- ing the Bank's operating efficiencies. In this regard the Board is of the view that the outside technical assistance would be useful in the following areas to support on-going efforts to improve productivity and efficiency. -61- ANNEX 5 (a) An in depth study of the existing operating systems at branch, regional and Head Office level in order to ascertain whether the system provides sufficient checks and balances to prevent fraud, embezzlement, etc., and also whether the audit system is adequate and effective; (b) An examination of the existing systems and procedures for credit evaluation and monitoring at Head Office and the branches with a view to: (i) making recommended changes, if necessary for i-mprovement; (ii) provide assistance for the setting up of a project evaluation department for large scale advances; (c) A study of present pricing policy on advances and overdrafts; (d) A study of the need for greater decentralization in operations to ensure quicker customer service; (e) Support for the full computerization program for the International Division; (f) Introduction of a comprehensive computer audit system; (g) Assistance in identification of new business opportunities for the Bank or through the People's Merchant Bank; (h) Development of a broad corporate strategy and plan for the next five years; (i) Planning a training program for key personnel and trainers; and (j) Improvement of manual systems in non-automated branches. Assistance Required 4. It is estimated that about 12-15 consultant months of assistance would be required from three/four consultants, supplemented by the use of local consultants, working as a close coordinated team. The costs of this assistance would be funded in part by a foreign exchange allocation of US$250,000 from IDA's SMI III supplemented by local currency support from the BOC. -62- ANNEX 5 Counterpart Support 5. In order for the consultants to obtain a proper understanding of how the different departments of the Bank interact with each other, a senior officer of the Bank would be assigned to work with the consultants. Addi- tionally, there would be frequent meetings between the consultants and senior management during the proposed review. Reporting 6. During the course of the review the consultants will provide the Bank's management with (i) an interim report setting out the major issues identified to dcte and proposed courses of action to analyse the issue and develop appropriate action programs for further work, (ii) a draft final report setting out the findings of the review and proposed remedial actions. This report would be supported by an outline action program indicating the time frame for implementing agreed recommendations and a training program focusing on the areas of weakness identified during the review. R MMw m! wm -63- ANNEX 6 SRI LANKA THIRD SMALL AND MEDIUM INDUSTRIES (SMI III) PROJECT Review Of Duty Drawback/Transferable Tax Credit/Export Credit Procedures Background 1. Sri Lankan exports have long been characterized by a reliance on traditional products, namely, tea, rubber and coconuts. In the fifties and early sixties, it would have been difficult to identify export growth as a major policy concern. Indeed, the heavy dependence on export taxes as a source of government revenue resulted in a policy environment which was biased against exports. However, from 1977 on, under the Government's reform programs, a large number of policy measures were rapidly announced and imple- mented. An Export Development Council of Ministers, chaired by the Presi- dent, was established in 1979 with the Export Development Bureau (EDB) as its executive agency. The EDB introduced new export promotion schemes and sub- stantially revamped others. In 1980, the then existing duty drawback scheme was significantly revised and placed under EDB management. The number of products receiving drawbacks expanded rapidly and by 1984 the scheme had been extended to cover almost all non-traditional products using imported materials as well as sales to the Free Trade Zone (FTZ). A "manufac- ture-in-bond" scheme was introduced in 1982 and a system of export grants was set up in 1981. A preshipment refinancing scheme for non-traditional exports became operational in 1978 and the Sri Lanka Export Credit Insurance Corpora- tion (SLECIC) was formed in 1979. A new Industrial Policy was formulated and accepted in principle by the Government in March 1987. One of the main features of this policy is to replace the existing tax holidays and the Export Development and Investment Support Scheme (EDISS) payments made to exporters by the EDB with the Transferable Tax Credit (TTC). -64- ANNEX 6 2. The objectives of the current export promotion schemes are to: (i) provide exporters with duty-free access to imported inputs; (ii) provide inducements to exporting activities designed to increase their profitability; by compensating for the disadvantages the exporting industries suffer vis-a-vis import competing activities through tariff; and (iii) provide exporters access to credit on concessionary terms until distortions in market forces which determine interest rates can be removed. Duty/Tax Rebates 3. There are a number of schemes in place to ensure that exporting firms gain access to inputs at world prices. Firstly, the FTZ operated by the Greater Colombo Economic Commission (GCEC) enables exporters in the zone to obtain imported inputs as well as machinery and equipment free of customs duty and BTT. Secondly, the Manufacture-in-Bond Scheme permits duty free imports meant for re-export directly into the factory premises owned by the exporters. This scheme is now mandatory for all garments exporters. Thirdly, the Custom Duty Rebate Scheme (CDRS) is a system of general rebates granted on the raw materials and packaging materials for the processing of non-traditional exports. Lastly, firms that export (or are capable of exTorting) more than 50% of their production can qualify for exemption from custom duties and BTT on imported machinery and equipment otner than spares and motor vehicles. 4. Thus, schemes exist for the exemption of customs duties and fiscal levies on all inputs for the production of non-traditional exports with the exception of a few such as fuel and electricity. However, these schemes are biased towards direct exporters and restricted to non-traditional exports. GOSL proposes a revision to the duty rebate scheme that would extend its scope to include (i) inputs used in traditional exports; if not accommodated in the fixation cf export taxes; (ii) consumables used not unidentifiable or unincorporated in the finished product; and (iii) inputs used by indirect exporters. The TTC scheme is the obverse of the Customs Duty Rebate Scheme in that it is based on net foreign exchange earned. The operational details of the TTC scheme have yet to be worked out.. The reformulation of the CDRS has been undertaken by the Customs Duty Rebate Committee, functioning under the auspices of the EDB. The formulation of the TTC scheme is to be under- taken by an inter-agency committee headed by a representative of the Treasury. To support the two committees, GOSL has requested technical assis- tance as indicated below: -65- ANNEX 6 Scope of Assistance 5. Assistance would be provided to carry out an overall analysis of the current system of duty drawbacks for direct exporters paying particular attention to the following aspects: (a) CDRS (i) the method utilized by the Customs Duty Rebate Committee (CRDC) in calculating the rates; (ii) the procedure followed in revising drawback rates for existing products as well as that in obtaining rebate rates for a new product; (iii) the documentation and procedures followed by exporters in using the system; (iv) the procedures followed in reimbursing the exporter; and (v) investigating the feasibility of extending the rebate system to indirect exporters via a system of linked letters of credit, and identifying the major steps necessary for its implementa- tion. (b) Transferable Tax Credit (TTC) Scheme (i) the manner in which the TTC scheme has been operated by any other country/countries which have adopted a similar scheme; (ii) the quantum of assistance that should be extended to exporters to compensate for disadvantages the exporting industries suffer vis-a-vis import competing activities through tariffs; (iii) the method of calculation of value added by exporters as well as of TTCs; (iv) the feasibility of extending the scheme to traditional and non-traditiona agricultural exports and to indirect exports; (v) the mechanics of the grant of TTCs and the encashment thereof; and (vi) the administrative structure of the unit which will be entrusted with the operation of the TTC scheme. -66- ANNEX 6 The above will involve giving technical support to the two committees men- tioned above as well as visits to the plants of exporters using the system. It would be supported by a number of in depth case studies covering points (a)(i)-(iv) above. 6. The consultants would assist the two committees mentioned above to produce concise written reports on their findings covering the following areas: (a) CDRS (i) the coverage of the system with respect to products and exporters; (ii) the adequacy of the rebate for those covered; (iii) the timeliness of the rebate; (iv) the cost of the delay in the rebate to the exporter; (v) the main deficiencies of the present system; and (vi) a phased program for correcting the deficiencies. (b) TTC Scheme (i) the method of calculation of value added as well as of TTCs; (ii) the mechanics of grant of TTCs and the encashment thereof; (iii) the administrative structure of the unit responsible for the operation of the TTC scheme; and (iv) phased program of operation of the TTC scheme. Export Credit 7. The CBSL operates both medium-to-long and short-term concessionary refinancing facilities for exporters. The medium-to-long term credit takes the form of concessionary refinancing of up to 70% of the amount advanced by the commercial bank (with a margin of 2% for the commercial banks). The maximum loan allowable under the scheme is Rs 30 million. The duration of the loans range from three to fifteen years with a grace period of up to three years. Projects approved under GCEC and the cultivation and processing of tea, rubber and coconut in their traditional form are ineligible. Under the short term preshipment credit scheme, 100% concessionary refinance is granted to commercial banks for preshipment advances made by them to -M k 7 -67- ANNEX 6 exporters who have received an irrevocable Letter of Credit or a firm export order. For the purpose of the facility, exports are divided into two categories, viz., Category I consisting of tea, rubber, coconut and their derivatives, as well as garments, gems, marine products and petroleum products, and Category II consisting of all the rest. The amount available to any one bank for refinance of Category I goods is limited to the amount lent by the bank in the previous year. The amount available for refinancing Category II loans is open-ended in theory, though in practice an informal quota appears to be in effect. 8. Immediate access to both preshipment credit for exporters is one of the cornerstones of a successful export promotion drive in a number of countries. Much remains to be done to strengthen the existing schemes in Sri Lanka. In most countries, as it is in Sri Lanka, improving access to preshipment credit is more critical than that to postshipment credit because financial institutions are usually prepared to discount export bills. It is a general consensus among the banks, the EDB and the exporters that the country's financial system as a whole is efficient. The exact causes of the problem have not been analyzed fully, though some contributory factors have been identified. In the case of medium to long term lending, the allowed margin of 2% is not sufficient in relation to the operational costs and risks that the bank carry, the insistence on collateral especially where new as well as small and medium scale exporters are concerned, and the delays that are consequent upon the different procedures adopted by the EDB, commercial banks and the Central Bank are also mentioned as major constraints. With respect to the short-term preshipment credit, the banks are not always prepared to consider a firm export order or a letter of credit as sufficient collatoral to warrant a loan to purchase inputs. Moreover, there appears to be an unwillingness to make short term credit available liberally on the grounds that it would be inflationary. The Export Incentive Study carried out by the EDB and the Industrial Policy Committee have recognized that the lack of an adequate supply of short term credit for working capital is a major bottleneck in the development of exports and that the resolution of this financing problem should be one of the top concerns of the export policies. Scope of Assistance 9. Assistance would be provided to carry out an indepth review of the current systems of export financing and refinancing with particular emphasis upon: (i) the basis for determining financing/credit for exporters; (ii) the procedure for allocating credit to individual exporters; and -68- ANNEX 6 (iii) the procedure followed by exporters to access export credit i.e., the opening of Letters cf Credit, Bills of Lading, negotiation, etc. To obtain the necessary information on the above the consultants should have indepth discussions with officials of the CBSL, Commercial Banks, Exporting Houses, EDB, Ministry of Finance and Planning, and the Ministry of Industries and Scientific Affairs. The system and procedure analysis would include on site visits to a sample of direct exporters. 10. Based on the analysis above the consultants would investigate the feasibility of extending the export credit refinancing schemes to indirect exporters via a system of domestic letters of credit, linked with the letter of credit for direct exporters. 11. The consultants would produce a brief written report on their find- ings covering the following area: (i) the constraints to the effective implementation of the existing systems and the solutions thereto; (ii) modification necessary to extend the present/modified system to indirect exporters; and (iii) phased program for implementing system and procedural changes. -69- ANNEX 7 SRI LANKA THIRD SMALL AND MEDIUM-SIZED INDUSTIRES (SMI III) PROJECT Export Marketing Fund Background 1. Under SMI II, a grant of about US$540,000 was allocated to EDB to promote the country's exports through its various promotion and financial assistance programs. While the indepth assessment of the impact of these programs is yet to be completed, preliminary findings suggest that the impact has not been as substantial as was expected, except in a, few selected areas, including semiprecious stones, diamond cutting, prawn culturing, handicrafts and garment manufacture. However, the following weaknesses inherent in the TA under SMI II have been identified: (i) assistance was extended over a diverse category of products and activities of low strategic importance, thus diluting its overall impact, (ii) technological obsolescence, limited produc- tion capacity and low product quality were not specifically addressed, and (iii) serious weaknesses in the country's overall export marketing capability were left in place. Taking these findings into account, the TA under SMI III would focus on assistance (i) to EDB's developments efforts in selected areas of high export potential, and (ii) to strengthen the country's overall export marketing capability. In view of the limited resources and staff capacities of EDB, more emphasis would be placed on mobilizing private sector resources and on supporting the catalytic role of EDB as an information and coordina- tion centre. Scope 2. A US$500,000 Export Marketing Fund will be established under SMI III with funding from the ADB to be administered by EDB to finance the following activities and services of EDB and the private sector. 3. Export Development in Selected Subsectors. US$150,000 will be allo- cated to finance EDB's activities to introduce, develop and promote priority export industries, including e.g. leather products, shrimp and prawn cultur- ing. The Fund would finance the costs of (i) information and data collec- tion, (ii) consulting services, (iii) domestic and overseas training for EDB -70- ANNEX 7 staff and exporters, and (iv) laboratory and training machinery and equipment required by EDB. EDB would be required to select the industries/product categories of high promotional priority and promising prospects for this component of the TA. 4. Promotion of Export Marketing. US$350,000 would be allocated to financially support the direct and indirect export marketing efforts of EDS and SMIs and their associations. Activities eligible for assistance would include: (a) the establishment of trade centres in major overseas markets which would operate as information and coordination centres for the country's foreign trade, technological collaboration and joint ven- ture undertakings with foreign companies. To assess the scope for setting up such trade centres, a task force involving EDB and other government and private sector bodies concerned should be established. The Fund would provide US$50,000 for the task force to carry out a feasibility study on the trade centre scheme. The Fund would also provide US$50,000 to finance the cost of a market survey in a major overseas market. After evaluating the usefulness of such a survey, the number of surveys could be increased subsequently in consultation with IDA. (b) US$250,000 would be allocated to finance the cost of direct and indirect marketing activities of SMIs and their associations. At an individual SMI level, the following activities would be eligible for assistance: (i) establishment of new trading houses and opening of oversea3 branch offices; (ii) general market research; (iii) overseas field market research; (iv) participation in trade fairs; (v) minor product adaptation and product inspection services for enhancing product marketability; and (vi) domestic and overseas training for marketing management staff. (c) At a business association level, the following activities would be eligible for financing from the Fund: (i) establishment of small product-specific libraries; -71- ANNEX 7 (ii) group marketing activities; and (iii) organization of and participation in domestic and overseas trade fairs. 5. The support would be for the costs of data and information collection from overseas, technical and advisory services by consultants and travel expenses. The Fund would be utilized primarily for a 50% support for eligible expenditures. The beneficiaries of the assistance would not be limited to those directly connected with export trade, but would also include those indirectly contributing to exports such as the manufacturers of parts and components of exported items and packaging supplies. EDB would be required to formulate detailed operational policies, rules and procedures for the effective implementation of the scheme. A. - -72- ANNEX 8 SRI LANKA THIRD SMALL AND MEDIUM-SIZED INDUSTRIES (SMI III) PROJECT Technical Assistance Facility (TAF) Background 1. Technology development and the improvement of industrial efficiency are essential for accelerated and sound industrial growth. However, the access of small and medium industries (SMIs) to industrial information, including, in particular, on modern technologies, and the availability of such technologies are very limited. Studies and researches carried out in the past by government organizations on the industrial sector, subsectors and specific technologies are very often partial in scope, outdated and do not adequately meet the requirements of SMIs. While there could be valuable industrial/technological information collected, there has been no adequate system established to disseminate such information among SMIs. There is a need to improve the accessibility of SMIs to industrial information, par- ticularly on modern technologies, through building up such information and establishing an effective system of disseminating It to SMIs as well as financial institutions and other private and public sector organizations concerned with SMI development. 2. There are a number of public sector institutions which provide industry with assistance to improve their technology and productivity. However, the quality of such services is suspect since they have had little contact with private industry, have become largely "academic" and supply-oriented, and have a poor image among private industrialists. Moreover, due to permanent constraints in staffing and funding, many of them have little to offer to private industry in terms of technology updating. It is, therefore, considered necessary to develop alternative sources of techni- cal servi-es in the private sector and to enhance the availability of modern technologies to SMIs. -73- ANNEX 8 Sco2e 3. Under SMI III US$500,000 would be allocated to develop a technology transfer information system, prepare subsectoral studies and establish a Technical Assistance Facility (TAF) with a view to (i) disseminating practi- cal industrial/technological information to the private industry sector and other parties concerned with SMI development, and (ii) increasing the availability to SMIs of modern technologies. The TAF will be administered by NDB. Information Service 4. The TAF would provide NDB with US$25,000 to assess the scope of and to formulate plans for an effective industrial/technological information system for SMIs. The study should be carried out by foreign/local consult- ants and should produce action-oriented proposals for establishing such a system. The TAF would also finance in depth studies on about 20 priority subsectors or product groups covering the various aspects of the subsectors or product groups with particular emphasis on production technologies. The findings of the studies should be of high relevance to the operations of SMIs as well as to subproject appraisal by the PCIs under SMI III, and should be available to SMIs and all other parties concerned free or at a minimum charge. An amount of US$100,000 would be allocated for financing local consulting services for the studies. NDB, in consulation with the PCIs and other organizations concerned, would be required to select appropriate sub- sectors for the study. Technology Transfer 5. The TAF would also finance various activities of SMIs for their technological development, improvement in productivity and efficiency, and research and development (R & D). Partial grants would be given to SMIs for the financing of eligible and viable "technology subprojects" such as techni- cal consulting, services technical training programs, technical collaboration packaging or small R & D projects which either introduce new technology or improve existing technologies and techniques in SMIs. The grants would cover 50% of the cost of consulting services training , materials and small equip- ments; the other 50% will be contributed by the applicant enterprise. A sum of US$375,000 would be allocated for financing 50% of the total cost of US$750,000, which would comprise the total cost of about 200 man months of foreign and local consulting services, 50 man months of training as woll as the purchase of materials and small equipment. Windows for SMIs to apply for such assistance would be the PCIs. NDB and PCIs would be required, in con- sulation with other organizations concerned, to formulate detailed opera- tional policies rules and procedures for the effective implementation of the scheme. -74- ANNEX 9 SRI LANKA THIRD SMALL AND MEDIUM INDUSTRIES (SMI III) PROJECT DISBURSEMENT SCHEDULE (US$ million) Estimated Disbursements Association FY USA % FY88 December 31 1.4 7 June 30 3.0 15 FY89 December 31 4.6 23 June 30 6.0 30 FY 90 December 31 8.0 40 June 30 10.0 50 FY91 December 31 12.4 62 June 30 15.0 75 FY92 December 31 17.0 85 June 30 19.0 95 FY93 December 31 20.0 100 20.0 -75- ANNEX 10 SRI LANKA THIRD SNALL AND MEDIUM INDUSTRIES (SMI III) PROJECT PROJECT FILE The Industrial Sector 1. Industrial Policy Statement: GOSL The Financial Environment 2. Joint IMF/84nk Financial Sector Report: July 1986. 3. The Structure of the Financial Systems May 1987. 4. Joint IMF/Sank Detailed Review-ank of Ceylon. 5. Joint IMP/Bank Detailed Reviev-People's Bank. The SWI Sector 6. Sub Loan Analysis SMI I and II. 7. Progress Report: Technical Assistance SMI I and II. The Project-Institutional Structure 8. Anaual Report: National Development Bank. 9. The Participating Credit Institutions: - Bank of Ceylon - Commercial Bank of Ceylon - Development Finance Corporation of Ceylon SHatton National Bank - People's Bank The Project-Credit Component 10. Policies on Procedures: CBSL Credit Guarantee Scheme. 11. Draft Participation Agreements: NDB/SMI Fund and PCIs. The Project-Technical Assistance Component 12. Draft Statement of Policies and Procedurts for Export Marketing Fund. 13. Draft Statement on Policies and Procedures for SMI Technology Transfer Fund. The Project--Reporting Requirements 14. Draft Periodic Reports. 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