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

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-4679-CE MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDRS 15.7 MILLION (USg20 MILLION EQUIVALENT) TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR THE THIRD SMALL AND MEDIUM INDUSTRIES PROJECT (SMI III) November 10, 1987 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 authoriddion.  Currency Equivalent Currency Unit - Sri Lanka Rupee Sri Lanka has a floating exchange rate. For the First Small and Medium Industries (SMI I) Project a rate of US$1 = Rs 17.5 has been used and for SMI II a rate of US$1 = Rs 20.0 was used. For the proposed SMI III the following rates as of June 30, 1987 are used: US$1 = Rs 28.5 Rs 1I= US$0.035 Rs 1 million = US$35,000  FOR OMCIAL USE ONLY Glossary and Principal Acronyms ADB - Asian r ;lopment Bank AWPR - Average Weighted Prime Rate BOG - Bank of Ceylon BMR - Balancing, Modernization and Rehabilitation CDS - Committee of Development Secretaries EDB - Export Development Board COSL - Government of Sri Lanka HNB - Hatton National Bank IDA - International Development Association ISC - Industrial Sector Credit NCB - Nationalized Commercial Banks NDB - National Development Bank of Sri Lanka PB - Peoples Bank PCIs - Participating Credit Institutions SMi - Small and Medium Industries FISCAL YEARS Government of Sri Lanka January 1 to December 31 Commercial Banks = January 1 to December 31 DFCC = April 1 to March 31 National Development Bank January 1 to December 31 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  SRI LANKA Third Small and Medium Industries Project (SMI III) Credit and Project Summary Borrower : Democratic Socialist Republic of Sri Lanka. Beneficiaries : Eligible Participating Credit Institutions (PCIs) includ- ing public and private sector commercial banks and development financing institutions. As Under SMI I and II, these would include: Bank of Ceylon (BOC), Commer- cial Bank of Ceylon (CBOC), Development Finance Corpora- tion of Ceylon (DPCC), Hatton National Bank (HNB), and the Peoples Bank (PB). Technical assistance would be provided to the Export Development Board (EDB) and NDB to improve SMI operations, and to the BOC and PB to improve their overall operations. Amount SDRs 15.7 million (US$ 20.0 million equivalent) Terms Standard IDA terms with 40 years maturity. Co-Financing : 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 po'icy reform and institutional strengthening in the areas of tariff administration, 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 sector SMIs; and a technical assistance component to help GOSL 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 manufacturing enterprises (PMEs) through the implementation of action programs developed under ongoiag 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 investment. 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 'he 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 risk 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 Tersis : 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 woulc 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 GOSL 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 13X-16X which com- pares favourably with current Commercial Bank funding of 14Z-22X. The mechanism for establishing interest rates and spreads would be reviewed semi annually and, if necessary, adjusted based on procedures agreed between GOSL 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. Financing Plan (US$ Mill) ADB 15.0 GOSL 2.0 PCIs 8.0 Sub-borrowers 10.0 IDA 20.0 ==== 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  MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR A THIRD SMALL AND MEDIUM INDUSTRIES PROJECT 1. I submit the following report and recommendation on a proposed development credit to the Democratic Socialist Republic of Sri Lanka for the equivalent of US$20.0 million on standard IDA terms with a maturity of 40 years to fund investment for a wide range of industries under the Third Small and Medium Industries Project (SM III). 2. Background. For a number of years IDA has worked closely with the Government of Sri Lanka (GOSI-) to develop and implement a program of trade and industrial policy reform which would create an environment conducive to industrial development. IDA has provided assistance on industrial policy reform and financing through the banking s-,stem for smal1, medium and large scale private sector investment. Since 1979 IDA has provided Sri Lanka with two SMI credits for US$46 million to fund enterprises with total fixed assets at book value (excluding land and buildings) of less than Rs 4.0 million (US$140,000), before loan approvals, which constitute the bulk of Sri Lanka's industrial units. Under SMI I and II about 3,700 subprojects have resulted in investment of about U$100 million and the creation of about 36,000 jobs at a job/cost ratio of US$1,600. The first SMI project is fully disbursed; full disbursement of the second project is expected by December 31, 1987. Analysis of a random sample of subprojects indicates that subproject perfor- mance is satisfactory, with most projects operating without notable technical difficulties. The cumulati7e collection performance of the Participating Credit Institutions (PCIs) at 70Z under both projects, has been satisfactory. In its recently published Industrial Policy Statement, the Government has attached high priority to the development of the SMI sector because of its role as an employment generator and ancilliary support for the development of non traditional export-oriented industrieb. The proposed Project would reinforce this priority through provision of investment support and technical assistance for programs focusing on technology transfer, productivity improvement and financial sectcr efficiency. 3. Project Objectives. The proposed project would complement previous industrial sector operations, particularly the ongoing SMI II project, by providing credit through the banking system to small and medium scale private manufacturing enterprises. It would also contribute to policy reform and institutional strengthening in tariff administration, export promotion and financial sector operations. The Project objectives are to: (i) provide needed foreign exchange for viable SMI projects, with increased emphasis on export-oriented ventures and balancing, modernization and rehabilitation (BMR) of existing enterprises; (ii) continue the PCIs' overall institutional development and deepen IDA's dialogue with GOSL on issues affecting the efficiency of the financial sector for industrial financing through an in  -2- depth analysis of the operational and financial viability of the two predominant state owned commercial banks; this dialogue and the supporting analysis should provide the basis for an agenda if actions that couLd be supported by future IDA financial sector operations; (iii) address trade and industrial policy issues, particularly the need to improve the Tariff Commis- sion's oDerational capabilities and to remove constraints on export financing and duty drawbacks for indirect exporters in the SMI sector; (iv) assist SMIs upgrade their technology and product quality; and (v) improve industrial efficiency, particularly of the Public Manufacturing Enterprises, 4. Project Description. The project, wh:ch is expected to be fully implemented within six years, would include: (a) a US$15.0 million credit component for term loans to SMIs from PCIs with subproject review and partial refinance by the SMI Fund, and (b) a US$5.0 million technical assistance component for PCI staff training, the review of NCB operations to develop programs to improve their operating efficiency, support for SMI export promo- tion and supply development programs, the establishment of an SMI technical assistance facility to make greater use of private sector knowhow and institutions in the expansion of productivity service facilities, and con- tinued assistance irh trade and industrial policy reform. A US$15.0 million parallel line of credit from the ADB will be used to cofinance the proposed project; U$500,000 of the credit would be for technical assistance sup- plementing IDA's US45.0 million technical assistan, ? component. The ADB loan would be processed on similar terms and conditions Lo the IDA project. The total costs involved in the project are about US$55 milliun, with a foreign exchange component of about 63.5% (US$35.0 million). A breakdown of the costs and financing plan is shown in Schedule A. Amounts and methods of disbursement are shown in Schedule B. A timetable of key processing events is shown in Schedule C and the status of Bank Group operations in Sri Lanka is shown in Schedule D. The Staff Appraisal Report is No. 6823-CE dated November 2, 1987. 5. Rationale for IDA Involvement. The proposed project would a sow IDA to continue to play a significant role in strengthening further the ongoing SMI programs in the area of institutional development and the provision of technical assistance. In the area of policy dialogue, the Project would expand the role of IDA in the financial sector through support for interest rate reform, implementation of recommendations of the Committee on the Law and Practice relating to Debt Recovery and technical assistance to the Bank of Ceylon (BOC) and the People's Bank (PB) to implement action programs to improve their overall operating/financ.ial efficiency. It would assist COSL to (i) continue tariff reform, (ii) provide support for indirect exporters through duty drawbacks and export credit, and (iii) create a technical assis- tance facility (TAF) to assist SMI operations. The project thus supports the longer term objectives of developing more ambitious trade, industrial and financial sector reform programs which would be taken up under future industrial lending operations.  -3- 6. Agreed Actions. During negotiations, agreement was reached between IDA, GOSL and NDB on: (i) conditions of PCI participation including collec- tion ratios for FY88-FY90, portfolio infection levels, and staffing; (ii) timing and substance of action programs and the annual review of the technical service components; (iii) detailed policies and procedures of the proposed Export Marketing and SMI technical assistance facilities; (iv) the initial use of the AWPR as the market reference rate for setting term lending rates; (v) semi-annual review on January 1 and July 1 of the mechanism for determining interest rates and spreads and appropriate adjustment ad neces- sary to (a) reflect any significant movement in the market reference rate, and (b) remain positive in real terms vis-a-vis inflation rates as reflected by the Colombo Price Index; (vi) onlending terms and conditions, margins, subproject eligibility criteria; (vii) GOSL's budgetary allocations for the project, and NDB's commitment to provide additional finance for operating costs of the SMI Fund, if needed; and (viii) procedures for procurement, disbursement, subproject review, periodic reporting, accounting and auditing. 7. The following would be conditions for credit effectiveness: (i) signing of a subsidiary loan agreement, satisfactory to IDA, between GOSL and NDB; and (ii) signing of participation agreements, satisfactory to IDA, between NDB and two eligible PCIs. 8. Justification. The proposed project would address key constraints to more rapid development of SMIs. Term loans would be provided to about 3.650 new and exisLirg enterprises meeting a portion of the financing gap for this sector and further strengthening the 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 equipment but exclud- ing land) per job of about US$1,75J. The average subloan size 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 20X for subloans of Rs 1-2 million (US$34,000-US$70,000); and 20X for subloans from Rs 2-4 million (US$70,000-US$140,000). Major areas of SMI investment are expected to be: agro-industries; metal products; building materials and construction contractors. Promotional and technical services provided under SMI I and II 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. 9. Benefits from the technical assistance (TA) components are more difficult to quantify. The project would provide support for ongoing finan- cial sector reform through the improvement of the procedures and practices in the country's two largest Commercial Banks. The project would help strengthen the institutional support for trade reform and export promotion through imp.-oved staffing of the Tariff Commission and extension of export credit and duty drawback facilities to indirect exporters. An Export Market- ing component, funded oy ADB, would build on the SMI II export development programs and is expected to result in increased, diversified exports and  -4- value-added among key light industrial products. Action to adapt products, upgrade skills, increase quality control, and promote exports should result in short- and medium-term increases in exports, employment and earnings. With the creation of the SMI technical assistance facility (TAF), local private sector know how would be tapped in addressing the technical problems of 400 to 5o0 SmIs, in areas which require specialized skills. Also, th? TAF would further encourage establishment of private sector firms specializing in SMI consultancy; increase appreciation by SMI entrepreneurs of the benefit of technology transfer; and enable the SMIs to tap needed skills not readily available within their own operations. 10. Risks. The main risks to the success of the project are associated with the overall climate for investment in Sri Lanka. However, notwithstand- ing the drawn out etbnic disturbances which have afflicted Sri Lanka, commit- ment rates and subproject performance under existing projects are satisfac- tory. With the implementation of the recent Indian-Sri Lankan peace accord, the level of investment needs is expected to increase significantly par- ticularly in the construction relate. industries. While the rate of reform of industrial policy remains slow, the distortions affecting the private sector are only moderate and past experience, plus the subproject financial and economic rate of return requirements, indicate that the project will have an overall satisfactory rate of rettirn. At the project level the success of the lending component would depend on the continued effective administration of SMI operations by NDB. Satisfactory policies, procedures and standards have been established on the basis of past 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 supervi- sion of PCIs' SMI operations. A further risk is that individual PCIs, par- ticularly the BOC and PB, may be unable to meet their staffing commitments, reducing their capabilities to process the large volume of applications expected and to devote sufficient attention to subproject supervision. Under the proposed Project, the presence of minimum trained staff at the branch level would be a condition of participation in the pro4ect; also, PCIs' Board would be required to reaffirm its commitment to allocate additional trained SMI staff as required. With strong senior management commitment, adequate staffing can be pro ided through active deployment and training. Another risk associated wit., 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 proposed increase in Credit Guarantee coverage and by requiring a clear statement of collateral policy by each PCI, with close monitoring by NDB.  -5- 11. Recommendation. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed credit. Barber B. Conable President Washington, D.C. November 10, 1987 Attechments  -6- SCHEDULE A SRI LANKA THIRD SMALL AND MEDIUM INDUSTRIES PROJECT ESTIMATED COSTS AND FINANCING PLAN (LVS$ Million) Estimated Costs Local Foreign Total