Dotmmt of The World Bank FOR OFrICIAL USE ONLY Report No. 6556-CHA STAFF APPRAISAL REPORT CHINA GANSLU PROVENCIAL DEVELOPMENT PROJECT THE [NDIUSTRIAL DIVERSIFICATION COMPONENT April 15, 1987 Prj cr s t ) P fPp.i tlE'Tr ;'.;t .Asii a P.icific Reginnal OEfice 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 Official Rate I Yuan (Y) = US$0.27 3.70 Yuan (Y) = US$1.00 (as of March 31, 1987) FISCAL YEAR January 1 - December 31 PRINCIPAL ABBREVIATIONS AND ACRONYMS USED ABC - Agricultural Bank of China BOC - Bank of China CIB - China Investment Bank CITIC - China International Trust and Investment Corporation DFC - Development Finance Company EDI - Economic Development Institute FTIO - Financial Trust and Investment Organization CDP - Gross Domestic Product CEC - GaLisu Economic Commission CEMI - Gansu Economic Management Institute GITC - Cansu Investment and Trust Company CPC - Gansu Planning Commission GPIO - Cansu Project Implementation Office ICBC - Industrial and Commercial Bank of China IDA - International DeveLopment Association IFC - International Finance Corporation ITC - Investment and Trust Company LIBOR - London Interbank Offer Rate PBC - People's Bank of China PCBC - People's Construction Bank of China PICC - People's insurance Company of China RCCs - Rural Credit Cooperatives SAA - State Audit Administration SEC - State Economic Commission SOE - Statement of Expenditure SPC - State Planning Commission TOR - Terms of Reference TTA - Training and Technical Assistance UNDP - United Nations Development Program FoR OMFCL Uu ONLY (1) CHINA GANSU PROVINCIAL DEVELOPMENT PROJECT THE INDUSTRIAL DIVERSIFICATION COMPONENT 1/ Loan/Credit and ProJect Suimary Borrower: People's Republic of China (PRC) Beneficiaries: Gansu Province and Gansu Investment and Trust Company (GITC) Amount: Loan: US$20.0 million equivalent Credit: SDR 410,000 (US$500,000 equivalent) Terms: Loan: 20 years, including 5 years grace, at standard variable Interest rate Credit: standard Relending Terms: The PRC would relend loan proceeds to Gansu Province on the same terms that apply to the loan. ioreign exchange subborroweis, whose subloans would be denominated In US dollars, would pay a `ixed interest rate of 8.5% and assume the US dollar exchange risk, while the Province would assume the exchange risk between the currency pool and the US dollar and the interest rate risk. Local currency subborrowers would pay a variable Interest rate fixed Initially at 10.08%. This rate would be adjusted from time to time to reflect changes in rates on loans of maturities of five years Issued by the Agricultural Bank of China and the Industrial and Commercial Bank of China, respectively, to rural and light Industrial enter- prises. Foreign exchange and Interest rate risks on local currency subloans would be carried by the Province. 1/ "Project" is used to describe this component In the text, ln conformity with standard Bank practice. This document has a rstricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. (ii) ProJect Medium- and long-term credit would be provided to light Objectives and and rural industrial enterprises for technological trans- Description: formation and capital construction, proooting higher out- put and labor productLvity, especLally In rural areas. Prospective subprojects would be generated by standard Provincial procedures, supplemanted by economic analysis by the Gansu Planning Couuission and financial analysis by GITC, which would be responsible for credit decisions. The project would also support t:aining and technical assistance for implementing agencies and enterprises on enterprise management, project appraisal and Implement- ation, and economic analysis and planning. A series of studies would be undertaken on economic topics and selected agroprocessin% industries. The project would generate employment, expand light and rural industry investment and output, upgrade appraisal procedures to select efficient investments, introduce subsector studies as a basis for strategy formulation, develop implementing agencies, and train individuals in management and technical skills. Risks consist of unfamiliarity with the economic and financial criteria to be used for subproject selection; uncertainties concerning input supply and markets for rural industrial products because these are outside the Provincial plan; and failure of subborroQJers to repay in full and on time because of cash flow problems, which could make interest rate spreads Insufficient to cover costs of intermediation. These risks are addressed through training and technical assistance in economic and financial analysis to assist subproject selection and improvement of planning priorities, and through particular attention to projected subborrower liquidity and debt service capacity as well as to rates of return in credit decision-making. Bank/IDA Fiscal Years Estimated FY88 FY89 FY90 FY91 FY92 Disbursements: (US$ millionT Annual 1.4 4.9 6.4 6.0 1.8 CumulTtive 1.4 6.3 12.7 18.7 20.5 Economic Rate of Return: n.a. CHINA GANsU rRoVINCIAL DEVELOPMENT PROJECT TEM INDUSTRIAL DIVERSIFICATION COMPONENT STAFF APPRAISAL REPORT Table of Contents Pate No. LOAN, CREDIT AND PROJECT SUMMARY ..................................... i Is INDUSTRIAL SECTOR ....... .......................... Si...... 1 A. Structure and ........................P...........o....... I B. Constraints on Performance and Growth................0.. 4 C. Government Policies and Objectives...................... 5 II, FINANCIAL SECTOR ................... 7 A. Institutional Frameworkrk....... o........ o.............. 7 B. Interest Rates .......................................... 8 C. Investment Planning and Financing......................... 9 D. Foreign Exchange Lending for Investmentoo.........e....oo. 10 E. Bank Strategy for Industry and Finance.......a n c e...... 11 III. THE PROJECT. ..................... .................. ......... 12 A. Background and Rationa ..... * ................. ..66....... 12 B. Project Description...4 .0o0000i0.o............... 0, 0 , 0. 13 Credit for Investment 14 Training and Technl al Assistance.............0...... 15 Project Administraition. ....... .e.....0o0000.... 18 This report is based on findings of an appraisal mission to China in October 1986. Mission members were J.D. Von Pischke (Mission Leader), Edgar C.H. Su and J. Chanmugam (AEPID), Henry Warren and Frederick T. Moore (Consultants). Project appraisal was preceded by a detailed review of industrial development issues in Gansu as part of the Gansu provincial study (Report No. 6064-CRA - Growth and Development in Gansu, China). IV. THE GANSU INVESTMENT AND TRUST COMPANY ..,........C..O...O..... 18 A. InstLtutional ........... .................. . 18 Scope of Operations ......................... 18 Organlzation and Staffing.............................,. 19 Policies. ........* e...... e.g... so..... *.. ....... *...... * 20 Interest Rates .. . * 21 Procedures and Standards.*.......0C0........... 21 Supervision of Relationships with Clients............... 22 GITC's Procurement and Disbursement Practices....e..oe. 22 B. Operatio ns CC C 22 C. Financial Aspects 23 Financial Position 23 Financial Performance 23 Portfolio Quality. C 24 Accounting Standards and Auditing..dt.n.".............. 25 Financial Projections C 26 V. THE PROPOSED BANK LOAN AND IDA CREDIT .C...C....C... 26 A. Benefits and Risks C C C C C 26 B. Features of the Proposed Loan 27 On-Lending and Relending Arrangements. 6040*46*.CC 27 Amortization SchedulesCChCCCCCe dCC uClCCCC CesCCCOCCCCC C 28 Women and MLnoritiesn o r i t l es.. .........CCCCC 29 Environmental Effects 29 C. Procurement and Loan DisbursementbursementCCCCCCCCCC.... 29 D. Features of the Proposed IDA Credite....t 30 E. Audits and Reporting. , C 31 VI. RECOMMENDATIONS AND AGREEMENTS REACHED AT NEGOTIATIONS.. ...... 1 Recommendation ......... C 32 ANNEXES 1. Selected Interest Rates In China, 1986 2. Gansu Investment and Trust Company Table 1 Lending Rates, Effective from December 1, 1986 Table 2.1 Statement of Operations, 1980-1986 Table 2.2 Projected Statement of Operations, 1987-1991, Assumptions Table 2.3 Projected Statement of Operations, 1987-1991 Table 3 Loan Approvals by Sector, 1980-85 and January- September 1986 Table 4 Loan Portfolio by Sector, 1985 and 1986 Table 5 Regional Distribution of Loan Portfolio Table 6 Size of Loans Committed, 1984, 1985 and January- September 1986 Table 7 Balance Sheets, 1980-1991 Table 8 Income Statements, 1980-1991 Table 9 Cash Flow Statements, 1980-1991 Table 10 Analysis of Loan Portfolio in Arrears, 1980 Through September 30, 1986 Table 11 Resource Position, as of December 31, 1986 Attachment 1 Articles of Association of the Gansu Investment and Trust Company 3. Studies Attachment 1 Analytical Studies Attachment 2 Agroprocessing Subsector Analysis - Terms of Reference (Revised) 4. Estimated Commitments and Disbursements of Proposed Loan/Credit 5. Selected Documents and Data Available in the Project File CHARTS 1. Gansu Investment and Trust Company Organization Chart CHINA CANSU PROVINCIAL DEVELOPMENT PROJECT THE INDUSTRIAL DIVERSIFICATION COMPONENT 1/ I. THE INDUSTRIAL SECTOR A. Structure and Performance 1.1 China is one of the world's ten leading industrial producers and the provj4 er of the largest full-time industrial employu nt. Its industrial sec- tor - is the most important productive sector and source of development and represents over one third of gross domestic 2;oduct (GDP). The sector comprises 437,200 enterprises, mostly small _!' (992), employing 63.4 million workers (13% of China's total labor force). State enterprises constitute the sector's core, with 64,000 enterprises employing 35.9 million, and producing 742 of total industrial output. Other industrial enterprises comprise mainly urban and rural "collective" enterprises; these 352,000 units, with an average employment of about 50 workers, are responsible for one-fourth of total indus- trial output. Small private enterprises and village industries have emerged in recent years as significant producers, wich a contribution of 7.52 to total industrial output. Gross industrial output value of Y 875.9 billion (US$296 billion equivalent) in 1985 was shared almost equally by light (472) and heavy (531) industry subsectors. Chinese industry produces nearly the full range of industrial products including machinery. Subsectoral structure is well balanced, with 122 of industrial output from food industries, 192 from textiles/clothing, 82 from chemicals, 182 from machine-building, 82 from metallurgy, and 11X from energy. 1.2 Industrial output per worker is low in China. It averaged Y 11,090 (US$3,960) in 1984, which was only ore fourth of the average for middle-income countries and about 42 of that for industrialized economies. Performance in terms of overall labor productivity and profit rate varies significantly between state and collective enterprises on one hand, and between light and heavy industries on the other, as illustrated below: 1/ "Project" is used to describe this component in the text, in conformity with standard Bank practice. 2/ In Chinese statistics. industry comprises manufacturing, energy (coal, petroleum, power) and mining. It is divided between heavy industry (energy, mining, metallurgy, buildinp aterials and most chemical and engineering industries) and light industry (textiles and clothing, food industries, light chemical and metal industries, and miscellaneous). 3/ In China, enterprises are classified as large, medium, or small but the size (defined in terms of plant capacity or value of fixed assets) varies from one industry to the other. -2- SELECTED PERFORMANCE INDICATORS OF CHINA INDUSTRY (1984) Output/ Capital/ Profit & tax Global produc- worker worker to capital tivity of factors (Y) ------ (X) (1981 - 10) /b Average for Industry 11,090 9,620 23.9 n.a. of which: State enterprises 14,395 13,460 24.2 109.7-112.5 Collectives 6,570 4,060 22.3 n.a. of which: Heavy industry 10,320 12,050 20.3/a 121.0-123.1 Light industry 12,210 6,610 32.1 89.0-94.2 /a 22.1% excluding coal industry which has a profit to capital ratio of 2.6Z. /b For state enterprises only. First figure based on respective weight of 0.6 for capital and 0.4 for labor, second figure based on reversed weights. Source: Statistical Yearbook of China, 1985. Light industry, which accounts for only 29% of total operating capital (net fixed assets and working capital) in the industrial sector, has shown the highest returns (profits and taxes) on capital. In terms of trendts, heavy industry in recent years (1981-84) has improved its efficiency in the use of production factors, with labor productivity increasing by 8.5% p.a.; on the other hand, light industry has had only a marginal increase of 2.1% p.a. in labor productivity despite large increases in operating capital, and its global productivity of factors has declined. This reflects the need for application of more modern and sophisticated technology and improvement of efficiency in the light industry. 1.3 Growth of industrial output has accelerated, from 8.7% in 1980 to 14.0% each in 1984 and 1985, averaging 11.6% p.a. (in real terms) over the 1981-85 period. The main fuel for growth has been a high rate of capital accumulation in industry supported by a highly diversified machine-building sector; in state enterprises alone, investment in industry (including energys) increased from Y 38.04 billion (US$22.3 billion) in 1981 to Y 65.35 billiun (US$28.2 billion) in 1984. Light industry has received, on an average, 22% of total industrial investment, and has grown at an average rate of 9.4% p.a. (in real terms) over 1981-84. Ii 1984, output of collective enterprises increased in real terms by 28%, compared with the growth of state-owned industry by 11%; growth in 1984 was evenly balanced between heavy and light industry, with the - 3 - fastest growth in machine-building (in particular power-generating machinery), consumer durables and construction materials. In 1985, light industry's growth was slightly faster than heavy industry. 1.4 Industrial investments in China are divided into "capital construc- tion" (i.e., creation of new entities or major expansion of existing enter- prises) and "technical updating and transformation" (i.e., renewal, moderniza- tion, and limited expansion of existing facilities). Capital construction, generally under the supervision of the State Planning Commission (SPC) and financed largely by budget resources, has focused on heavy industry. Techni- cal transformation projects, financed principally by enterprises' own funds and bank loans, have been more evenly distributed between light and heavy industries; industrial collective enterprimes have represented on average 9% only of total sectoral investments as indicated below: INDUSTRIAL INVESTMENT TRENDS (Y billion) 1982 1983 1984 Heavy manufacturing 20.05 22.97 27.60 Light industries 12.65 13.03 13.90 Total Manufacturing 32.70 36.00 41.50 of which: Capital construction 15.92 15.57 17.56 Technical transformation 16.78 20.43 23.90 of which: Collective enterprises 3.23 3.08 4.07 Source: China, Statistics Survey, 1985. A105 Chinese industry has remained essentially inward-oriented, to meet the rapidly growing demand of the domestic market for consumer goods in par- ticular. The export/output ratio averages about 4.7% for manufacturing. How- ever, exports of manufactured products have grown rapidly in recent years and reached Y 31.6 billion (US$13.6 billion) in 1984 (+27%), with light industries showing more rapid growth (+34%). Imports of manufactured products, which until 1983 were maintained below manufacturing exports, increased by 64% in 1984 to reach Y 50.4 billion (US$21.7 billion), mainly as a result of the big increase (+114%) in imports of machinery and transport equipment generated by the ongoing program of industri.al modernization. 4 B. Constraints on Performance and Crowth 1.6 Notwithstanding its remarkable growth and product-coverage perfor- mance, the development of China's manufacturing sector has remained con- strained by industry-specific shortcomings and issues, which can be grouped in the following two broad categories: (a) the use of outmoded plants and technologies, resulting in high con- sumption of raw materials and energy; and (b) an uncoordinated system of centralized planning and decision-making, combined with a distorted structure of industrial prices. 1.7 About 80% of industrial fixed assets are of pre-1960 vintages,4/ and the bulk of these assets need to be replaced to ensure technical efficiency. At present, total consumption of raw materials and energy has represented on an average 85X of manufacturing production costs, equivalent to about 68% of gross output value; light industries with an input/output ratio of 70X have been more inefficient than heavy manufacturing (ratio of 65X). There has been also a lack of incentives for efficient use of inputs due to uneconomically low prices of energy supplies and basic industrial intermediates (para. 1.10). 1.8 Chinese industrial organization is characterized by planned produc- tion, decentralized control and poor communications, which create a highly complex and diversified system. All enterprises come under one of the subsec- toral ministries which supervise them through provincial- or county-level bureaus. Interministerial activities are coordinated by the SPC and the State Economic Commission (SEC) and their provincial bureaus. The primary instru- ment for economic consistency and coordination is the annual plan, which sets production targets and allocates quotas for key commodities through an iterative process between the enterprises and SPC. However, the availability and dissemination of relevant statistics and information through these vertical channels are often insufficient for effective detailed planning, and horizontal links between ministries and enterprises at the central and provincial levels are inadequate. As a result, supply and demand are often mismatched, and shortages of key inputs (e.g., energy supplies, raw materials, transport, qualified managers and engineers) constrain production. Moreove-, the overemphasis put on self-sufficiency at national and provincial levels during the past decades and the presence of administrative barriers to trade between regions have sacrificed the benefits of specialized production and -conomies of scale, and permitted the installation of costly plants with uneconomic size. Finally, the excessive focus of the plans on physical output and quantitative targets, compounded by inadequate links with users, have often led enterprises to neglect product quality and variety and to continue producing substandard or outdated goods. 4/ Keeping outdated assets in operation has been due partly to the use of unusually low and nondifferentiated rates of depreciation, and to China's past isolation from technological developments in the rest of the world. 1.9 As mny prices were set in the 1950s (by the central or provincial authorities) and have changed little since then, the structure of industrial prices is often at variance with today's production costs or market scarci- ties. In general, consumer goods of light industries are priced relatively high compared to basic, intermediate, and machinery products of heavy indus- try. Many enterprises have thus a strong incentive to favor the inclusion of more profitable and higher priced products in their projects, irrespective of their viability and production scale. 1.10 Continuing efforts and policy reforms are needed to remove the con- straints on further industrial development. Heavy industry growth is con- strained by the availability of domestic energy (likely to expand less quickly than in the past), and thet of light industry by raw material availability. The basis of industrial growth will therefore have to shift from capital accu- mulation to efficient use of available inputs, in order to free more resources for other sectors (e.g., transport) and consumption. At the same time, indus- try must remain a principal source of employment, and seek to expand exports in more competitive world markets to pay for imports of modern foreign tech- nology and machinery. Also, the sector must respond to rising living stan- dards and a more sophisticated consumers' demand through improved quality and variety of industrial products, as well as expanded production volume. The transition from extensive to intensive (productivity based) growth and from quantity to quality requires reforms if industry is to grow at above 7% p.a. as targeted by the current Seventh Five-Year Plan. 1.11 Efficient and rapid industrial development will largely depend on innovation, hence on reform progress and technology transfer. However, direct technology transfer through imports may be constrained in future by China's export gains in face of protectionist measures in industrialized countries against light industry goods. Thus, China will have to rely more on technol- ogy transfer through foreign borrowings and direct investment, on technology diffusion among domestic firms, and on further modernization of its capital goods industries. C. Government Policies and Objectives 1.12 The Chinese Government has been quite aware of the industrial sector's shortcomings, in particular its production inefficiencies and its technological backwardness. It has followed since 1979 an economic strategy based on two elements, i.e., readjustment and system reform, to correct some of the fundamental weaknesses and lay a sounder basis for sustained growth. The readjustment has emphasized the following priorities: (a) above all, technical updating of existing enterprises, particularly through importation of foreign technology; (b) development of more efficient light (consumer) industry and of manufactured exports; and (c) energy and materials conservation, particularly in heavy industry. - 6 - The adjustment has been rather successful, particularly in shifting emphasis towards light industry (which helped reduce energy consumption) and in shift- ing investments from new capital construction towards modernization projects (paras. 1.3-1.5). These priorities have been reiterated in the general orientations for the Seventh Plan for 1986-90. 1.13 The Government approved in October 1984 a broad framework for the industrial reform to be progressively implemented over the coming years. The main thrust of the reform is to decentralize economic decision-making and to separate it from administration and to rely more on the market to provide incentives and to guide decisions. In this context, the following main deci- sions have been taken: (a) state enterprises will be made independent units pursuing profits and responsible for losses. This is a difficult task snd will require, irter alia, clearer separation of economic activities from administrative functions and of enterprises from line agencies. Already, greater freedom has been given to collective enterprises, which have been the most dynamic segment of the sector in 1984 and 1985 (para. 1.3); (b) the tax system will be improved, finance and banking will be reformed, and a larger role will be given to indirect macroeconomic regulation. Already, nearly all state enterprises pay a profit and "adjustment" tax (instead of full profit remittance to the govern- ment), and have greater freedom in production, pricing and marketing of output above their mandatory plan targets. Moreover, the role and autonomy of the banking system has been increased, and capital construction investments have been largely shifted from grant to loan financing (para. 2.9); (c) a more rational price system will be introduced by reducing the role of state-controlled prices and increasing the role of free-market prices. A two-tier price system has been established. The supply of key products subject to mandatory plan allocation and to adminis- trative prices is shrinking, while a growing and substantial share is allocated by the market mechanism at flexible prices; and (d) the scope of mandatory planning will be reduced and replaced by indicative planning with focus on medium- and long-term guidance. There would be a cautious movement in this direction because the immediate effects of the first measures and of control loosening in 1985 were an upsurge of inflation and overheating of the economy, and China still has to develop the macroeconomic tools (credit, tax- ation, pricing) to manage and fine-tune its emerging market economy. -7- II. THE FINANCIAL SECTOR A. Institutional Framework 2.1 China's banking system consists of a small number of nationwide spe- cialized banks with extensive branch networks, under the supervision of the People's Bank of China (PBC) which serves as the country's central bank. PBC is responsible also for consolidating the credit plans of the specialized banks, implementing credit plans through redeposit requirements and loans to the specialized banks, proposing banking regulations and interest rates, supervising foreign financial dedlings and the use of foreign exchange, and chairing the Council of PBC, an advisory and coordinating body consisting of the leaders of all banks and other financial institutions. Because a separate central bank is a very recent development in China's financial system (formally established only at the beginning of 1984), both institutional articulation and development of instruments of monetary control are still incomplete. Certain policy changes in early 1985 appear to have strengthened the ability of PBC to monitor and restrict credit issuance by the various specialized banks. 2.2 The Industrial and Commercial Bank of China (ICBC) was established at the beginning of 1984 and took over the commercial banking functions origi- nally exercised by PBC. It serves as a savings bank for urban residents, as a commercial bank and source of working capital for most urban enterprises, and in a limited way as an investment bank financing expansion and modernization projects of urban state and collective enterprises. It also provides funding for the increasing number of individual enterprises in urban areas (mostly in commerce and other services). The Bank of China (BOC) also under the aegis of PBC, serves as a commercial bank for foreign trade units for most foreign- exchange transactions, and as an investment bank providing loans in foreign exchange and some financing of complementary domestic investment costs. The Agricultural Bank of China (ABC) performs functions similar to ICBC's but serves mainly China's rural areas. It also supervises the nationwide network of Rural Credit Cooperatives (RCCs), which handle the banking business of most of China's peasants and many rural enterprises as well. The People's Con- struction Bank of China (PCBC), under the aegis of the Ministry of Finance, is the nation's investment bank specialized in financin& capital construction projects with budget appropriations and loans; it also handles commercial banking business for China's construction industry. The China Investment Bank (CIB), created in 1981 under the aegis of the Ministry of Finance and PCBC, is the only industrial development finance institution in China which bases its investment decisions on generally accepted project appraisal criteria; it pro- vides foreign-exchange and local-currency long-term loans essentially to tech- nical transformation projects in urban light industries. While different banks are specialized in terms of activities and clientele, there is some overlap, particularly in financing of fixed investment in industry. This overlap is leading to increasing competition among different banks to finance attractive industrial projects. 2.3 Other smaller or secondary financial institutions include most prom- inently the People's Insurance Company of China (PICC); and the China Interna- - 8 - tional Trust and Investment Corporation (CITIC), which provides capital and "imiddleman" services to joint ventures. Analogues of CITIC ezist in many provinces. Provincial branches of specialized banks have also set up domestic trust and investment departments or subsidiaries for investments which would be difficult for the parent banks to undertake, of which CITC is one. Most recently, many urban collective credit cooperatives have appeared, financed by small groups of people pooling capital. B. Interest Rates 2.4 Nearly all domestic interest rates in China are set by administra- tive decree, with some variation permitted within an allowed band. The pres- ent structure of interest rates for the main types of loans and deposits is preLmented in Annex 1. The changes made in 1985 are the most recent of a series of rate adjustments designed to make enterprises more conscious of the cost of capital and to make deposits a more attractive form of saving for individuals. One important effect of the recent change has been to generate a more normal term structure of domestic interest rates, with a rising yield curve; in particular, working capital loans now carry an interest rate not higher than loans for fixed investment projects. 2.5 Foreign exchange loans in China carry many different; interest rates, ranging from near zero to world market rates. These rates appear to be based largely on the cost of different sources of foreign capital. BOC provides some loans at an interest rate that fluctuates with LIBOR. Its present six- monthly adjustable interest rate (effective October 1986) is 7.43Z for five- year US dollar-denominated loans. BOC also lends substantial amounts at low subsidized rates out of special allocations made by the Government for specific high priority projects. Moreover, large amounts of capital goods imports are financed by domestic-currency loans converted into foreign exchange from central or local government resources; borrowers do not have to repay such loans in foreign exchange and bear no risk of exchange rate fluctu- ations. CIB, which makes medium-term loans at fixed interest rates, had maintained a foreign exchange lending rate of 81 p.a. since its establishment but it was increased to 8.5Z in 1986; this rate will also be applicable to the fourth industrial credit to CIB (CIB IV). Foreign capital from concessionary bilateral sources is generally passed on to Chinese project entities at the same interest rate that China pays to the foreign lender. 2.6 Efforts to unify the structure of interest rates across different banks have been relatively successful in the area of deposit rates and domes- tic currency loans for modernization projects. However, there has been very little progress in unifying rates for foreign exchange loans, and in narrowing the gap in interest rates between capital construction loans (2.4-4.2% p.a.) and bank loans for other investment projects (7.9-10.8Z). Finally, directed credit schemes carrying subsidized interest rates have proliferated since 1984, in particular in Shanghai and Tianjin, and the share of loans made at the posted rates has declined somewhat. For example, in Fujian Province, about 40% of total BOC foreign exchange lending in 1984 consisted of loans at a subsidized rate of 2% p.a.; in Jiangsu Province, similar foreign exchange loans by BOC (carrying a subsidized interest rate of 41 p.a.) were started in 1984 and are estimated at about 30% of total loan approvals in 1985. The Bank - 9 - study of the financial system and investment in China addresses, inter alia, the role and structure of interest rates, and will form the basis of further dialogue with Chinese authorities on this subject. C. Investment Plannin and Financing 2.7 Investment planning in China's state sector is centered around the project preparation and approval process. Although gradually changing, it is characterized by a short time horizon, incomplete coverage and neglect of sec- tor planning. Planning techniques are not very sophisticated and aim primar- ily at achieving consistency rather than optimization, though even consistency has been an elusive goal in an environment of excess investment demand. Investment proposals must go through a number of approval stages. Approval authority is vested in SPC for capital construction projects, and SEC for modernization projects; their provincial and local branches are allowed to approve projects within certain free limits (specified in terms of estimated total project investment cost). A crucial stage in the project approval process is the project's .nclusion in the plan (annual or pluriannual, aggregate or regional), which essentially sets investment ceilings within which projects must vie for a position. 2.8 Another crucial stage of the project approval process is the approval and commitment of project financing which is the main constraint on the enterprises' investments; once financing is arranged, approval of a proj- ect is relatively easy. The interaction between investment planning and financing is complex; patterns vary across subsectors and industries and between different provinces of China; in some provinces, banks play an impor- tant part at an early stage in project evaluation and even in their design, while in other regions banks are brought in just before project inclusion in the plan. 2.9 There have been major changes in the financing structure of fixed investment in China's state sector. The share of the budget appropriations fell sharply from 66% in 1978 to 35% in 1984. Correspondingly, the share of self-financing by enterprises, local authorities, and other agencies rose from 32% in 1978 to 43% in 1984. Domestic-currency bank loans, negligible in the late 1970s, have been financing an increasing share, reaching about 15% in recent years; foreign loans, also negligible in the late 1970s, accounted for 6-7% of the total in 1982-84. Enterprises' funds (retained profits and depre- ciation, and major funds) reprusented a major portion of self-financed invest- ment, and local governments, and government agencies provided a smaller pro- portion (about 34%). Patterns of financing have been different between capi- tal construction and modernization investment. Domestic loans have accounted for a larger share of modernization investment than of capital construction investment (22% versus 13% in 1982). The major difference relates to the relative shares of budgetary appropriations and self-financing; appropriations accounted for about half of total capital construction investment in 1982 but only 11% of modernization investment while self-financing comprised nearly two-thirds of total modernization investment but only one-third of capital construction investment. - 10 - 2.10 In the state-owned industrial sector, most enterprises have relied on internal sources to finance over half of their total fixed investments with greater reliance on accumulated depreciation than on re qined profits. The share of budget appropriations has been relAtively low._ Recourse to loans varies greatly across enterprises, industrial subsectors, and regions, with enterprise financial profitability appearing to be an important determinant. Working capital is financed differently from fixed investment. Though many industrial enterprises had large amounts of working capital financed by budge- tary grants, virtually no additional appropriations have been made in recent years to industry for this purpose and enterprises have relied on loans for their working capital needs. However, the norms determining the ceilings on such borrowing have been to a large extent historically based, and thus tend to provide a conside.able cushion above minimum needs. Furthermore, working capital loans cover whatever purchases an enterprise may make, including pur- chases of inferior goods which necessitate periodic write-offs of circulating assets. D. Foreign Exchange Lending for Investment 2.11 BOC is the primary source of foreign exchange loans for Chinese enterprises. Its foreign exchange loan approvals were US$3.25 billion in 1984 and US$3.36 billion in 1985; disbursements being US$2.1 billion and US$3.25 billion respectively in the two years. CIB's loan approvals were US$66.2 million in 1984 and US$295.3 million in 1985; a small fraction of BOC's approvals. Substantial financing of imported equipment is also made through conversion of domestic currency loans from PCBC and ICBC into foreign exchange using government resources. 2.12 The complex structure of interest rates for foreign exchange loans in China has been discussed in paras. 2.5 and 2.6. Other unusual features of the foreign exchange lending system, which are directly relevant to the Bank Grrcup's financial intermediation operations, include mainly the issue of loan repayment in foreign exchange and the foreign exchange retention system. Project entities borrowing from certain sources of foreign exchange must repay in foreign currency, from either their own export earnings or those of a parent or other related organization having f'reign exchange. This applies broadly to World Bank-financed projects in sec'ors like industry, transporta- tion and energy, financial intermediation loans, and the majority of BOC loans. However, other projects, financed under special or directed credit programs, often on concessional terms may be exempt from this requirement; this includes BOC special loans and to many of the domestic loans "converted" into foreign exchange to finance imports with government authorization. The requirement of repayment in foreign exchange is a heavy burden on investment projects with a large import component which do not generate foreign exchange directly through exports. Even if they have high economic and financial rates of return, such projects have greater difficulty in obtaining financing. 5/ This is because the bulk of budgetary appropriations for fixed investment go to large projects involving the creation of new enterprises rather than projects undertaken by existing enterprises. - 11 - Enterprises prefer to obtain foreign exchange loans that are exempt from the repayment requirement rather than to borrow from sources, such as CI8, which demand repayment in foreign exchange. 2.13 Compartmentalization of China's foreign exchange allocation system is exacerbated by the foreign exchange retention system. In order to promote exportst local governments and to a lesser extent enterprises were permitted to retain a portion of their foreign exchange export earnings to use primarily in importing capital and producer goods. Other domestic units were given "quotas" allowing them to draw foreign exchange from BOC to pay for their imports; however, these quotas cannot be freely traded, so that units without exports and foreign exchange retention authority cannot have foreign exchange (needed to repay foreign exchange loans, for example). The system has contri- buted to excessive compartmentalization and consequently to inefficiencies. Also, the buildup of huge unredeemed quotas in the hands of lower levels of government and enterprises may have contributed to the sharp deterioration in China's external position in 1984/85. These issues are being addressed in the context of the Bank's policy dialogue with the Government (para. 2.16). E. Bank Strategy for Industry and Finance 2.14 The Bank's primary objectives in its economic and lending work for industry in China, based on China's needs and the Bank's abilities, have been to assist the Gover:1"nent to: (a) build up sound institutions and practices for project appraisal, investment finance, and subsectoral planning; (b) promote and implement technology upgrading and energy/material- conservation throughout the sector; and (c) carry out reforms in the financial sector. The Bank has used various forms and channels for assistance to Chinese indus- try. It is the executing agency for the United Nations Development Programme (UNDP) technical assistance projects and has financed two technical coopera- tion credits, and has, thus, encouraged the use of technical assistance, particularly for project preparation. Economic Development Institute's (EDI's) large training program in China (in the period 1980-85, about 1,500 Chinese officials attended 35 EDI courses) and the past lending program have helped in improving investment efficiency in China by demonstrating how the Bank's appraisal methodology can be applied to improve project selection and efficiency of project design and by strengthening institutions' project prepa- ration and appraisal capacities. 2.15 As regards direct project assistance, a loan for plant rehabilita- tion and modernization (with particular emphasis on energy savings) for the chemical fertilizer industry was approved in FY85. A project to support the modernization of the machine tool subsector in Shanghai was approved in FY87. A project to assist in upgrading cement production technology is under consideration. DFC-type lending has been an effective means of assisting the modernization of small- and medium-scale industries based on a methodical - 12 - project appraisal. The Bank has assisted in the establishment and iuistitutional strengthening of CIB, a development finance company (DFC), and has provided four industrial credits for the above purpose. The utilization of theme credits is generally satisfactory and CIB has made considerable progress since its foundation. In future, the Bank plans to gradually diversify its assistance by increasing subsectoral focus and supporting additio al financial intermediaries. The proposad project provides one such opportunity. 2.16 The Bank has also initiated economic and sector work related to industry and finance. State enterprise management has been studied through the collaborative research program, and a similar study on collective enter- prises is under preparation. A major study of the financial system and investment has been completed recently and is being discussed with the Government. A study of foreign trade, including industrial exports, is under- way. The current dialogue on macro and sector issues will also be maintained and, in this context, price reform and the development and use of indirect control instruments will receive a major focus, in close consultation with the International Monetary Fund. III. THE PROJECT A. Background and Rationale 3.1 Background. Despite a substantial effort to develop industry in Gansu during the past 35 years, the Province remains overwhelmingLy rural, with agriculture the main source of livelihood for the population. In the past, the industrial strategy for the province gave near-exclusive emphasis to a buildup of heavy industry using Gansu's considerable natural resources in petroleum and metal ores (copper, nickel, etc.), coal and hydro power. Even as late as 1983, 93% of Gansu's industrial output was contributed by state enterprises, mostly in heavy industry. State enterprise capital assets in Gansu at Y 754 per capita far exceeded the China-wide average of Y 431. While there are also a few enclave enterprises sited at mine-mouth or by the hydropower source, the impact of industrial development has been largely confined to the city of Lanzhou. Lanzhou today is a modern industrial city with a structure of employment and income levels much like those of many similar cities in China but with weak links to its much poorer provincial hinterland. 3.2 Further development of heavy industry based on natural resources will no doubt continue to take the lion's share of investment capital in the province. But Gansu's planners have also begun to turn their attention to another major resource--the generally underemployed rural labor force whose earnings opportunities are currently restricted to low productivity agri- - 13 - culture work. The Bank's Gansu Provincial Study 6 also lends support to this line of thinking. The Study points out that continued near-exclusive emphasis on development of mineral-based heavy industry would do little to generate nonagriculture employment and, if accompanied by continued restrictions on labor mobility, would almost certainly result in a significant increase in the agricultural labor force by the year 2000. This would put still greater pressure on the Province's fragile natural resources base since even with major investments in irrigation, the population depending upon rainfed agriculture would remain above the carrying capacity of the land. Yields and output per worker in rainfed areas would probably stagnate or grow very slowly, and the Government would have to continue its grain, water and fuel relief programs. 3.3 The Study concludes that a concerted effort to develop labor-inten- sive industries and services, relying on relatively low economic costs of labor, could enable Gansu to increase its overall growth rate as well as ease its poverty problem. Such an approach would involve support and stimulus for rural and light industries. These generally require lower overall investment, are relatively more labor-intensive and could distribute the benefits of growth more broadly than an exclusive emphasis on heavy industry. These stra- tegic considerations underlie the industrial diversification scheme thiat forms the basis for the proposed project. In fact, there has been a significant shift in favor of light and rural industries in recent years, as markets have been stimulated by higher urban as well as rural incomes. 3.4 Rationale. Institutional and economic management innovations reflected in project objectives provide the rationale for Bank support. Greater use of economic criteria would permit more strategic, subsector approaches to resource allocation by planners, involving horizontal linkages rather than the prevalent vertical pattern of industrial planning and struc- ture. Emphasis on financial analysis permits better incorporation of risk in financing decisions, as a basis for development of a more robust capital structure for industry. The project is also the Bank's first opportunity to establish a relationship with a provincial investment and trust company, which could lead to broader Bank support for financial reform. B. Project Description 3.5 Support is proposed for Gansu Province's efforts to stimulate diversification--especially in rural areas--with the following components: (a) a fund of US$20 million equivalent for medium- and long-term sub- loans to support investments in light and rural industry enterprises (paras. 3.6-3.11); and (b) SDR 410,000 (US$500,000 equivalent) to finance related training and technical assistance (TTA). TTA will help to facilitate and secure 6/ Growth and Development in Cansu, China. Report No. 6064-CHA, November 20, 1986. - 14 - effective use of the investment funds through the strengthening of an intermediary, the Gansu Investment and Trust Company (GITC), to handle the credit fund and for broader purposes involving primarily the activities of The Gansu Planning Commission (GPC) in regard to its overall sector planning and its economic appraisal of industrial projects, which would increasingly involve the use of formal tech- niques. TTA would be available to all project implementing agen- cies, and would also support technical assistance offered by the Bureaus of Light and Rural Industry to enterprises for which they have responsibility (paras. 3.12-3.18). Credit for Investments 3.6 Current provincial procedures will be used to identify prospective subprojects in agroprocessing, pharmaceuticals, metallurgy, electronics, plastics, machinery, building materials and other sectors by Provincial autho- rities. The majority of these proposals are for expansion of existing enterprises, although several are for new enterprises, especially in rural areas. Several preliminary subproject proposals have been examined by Bank missions during project preparation and appraisal, and appear promising, making delays in commitment of project funds unlikely. The capacity of Provincial authorities to generate sufficient eligible subprojects is satisfactory. The Bank would review in detail the first 9 subproject proposals submitted for financing. Upon achievement of satisfactory subproject appraisal for these 9 subprojects, GITC could submit appraisal summaries for some of the remaining subprojects, for which the complete appraisal reports would be held by GITC for examination by Bank supervision missions (paras. 6.1, 6.4). This procedure would apply to subprojects for which subloans not exceeding US$500,000 equivalent are sought, up to an aggregate US$4.0 million equivalent limit. 3.7 Light industries, for which the Bureau of Light Industry is respon- sible, would account for not mo-a than US$8 million for at least four subproj- ects. Rural industries, within the responsibility of the Bureau of Rural Industry, would be supported by subloans totaling at least US$12 million to at least 18 subprojects. Bank funding of any single subproject would not exceed (IS$3 million equivalent. This limit applies to both light and rural indus- trial subprojects and is appropriate because many rural industries are medium scale in size, employing several hundred workers in activities requiring large amounts of capital per worker. Any funds unused in the light industry cate- gory could be devoted to rural industry subprojects. 3.8 The loan would cover the greater of 50% of agreed subproject cost or 100% of foreign exchange costs. For subprojects not utilizing foreign exchange subloans, the loan would cover an average of 50% of the agreed costs of these subprojects as a group, excluding the cost of land (para. 5.13). Subproject sponsors would provide adequate equity to conform to GITC's customary requirement that subborrowers finance at least 10% of the cost of investments supported by credit. These amounts would be supplemented, where appropriate, by additional loans from GITC's own resources. - 15 - 3.9 The project would expand the capacity for project preparation and evaluation in GPC through the application of modern economic criteria incorporating discounted cash flow methodology. All subproject proposals for which subloans of US$300,000 equivalent or more are requested would be subjected to economic analysis to ensure that they would have an economic rate of return exceeding 12%, an appropriate minimum threshold having regard to the opportunity cost of capital in Gansu and China generally. (Subprojects financed by subloans of less than US$300,000 equivalent would be required to have projected financial rates of return of at least 12%.) Economic analysis would be performed by GPC, which would give GPC the capacity to apply such analysis to all investment projects, financed by GITC as well as other institutions in the Prov.nce. In addition, economic analysis on a number of topics will be initiated to provide a better basis for planning decisions (paras. 3.13-3.16). Under existing Provincial procedures, there is a major risk of project selection being influenced by factors inconsistent with viable financial performance because of socio-economic considerations and commodity flow rationalization criteria within the administrative responsibility system. The nature of this risk often escapes evaluation because the effects of poor selection are difficult to interpret. When an enterprise fails to perform well, its weaknesses are often diagnosed as faulty management, technical problems or inadequate capitalization. However, the root cause for failure may be that the assumptions used in project selection were unrealistic. 3.10 In parallel with emphasis on economic tools, the project would expand the capacity of GITC to apply financial analysis in credit decisions for subproject proposals found acceptable on economic grounds by GPC. Finan- cial analysis would emphasize financial viability, subproject liquidity and debt service capacity as projected by sources and uses of funds statements, which are not widely used in Gansu. More rigorous use of financial analysis would contribute to GITC's development as a commercial lending institution. 3.11 CITC will be responsible for all subloan credit decisions and for subloan supervision. However, since GITC is not yet authorized to handle foreign exchange, disbursement of foreign-currency subloans would be handled by the Gansu Department of Finance. This somewhat cumbersome dual disburse- ment agreement is required by national regulations set by the PBC which are beyond the jurisdiction of provincial authorities. GITC has submitted a request to PBC to deal in foreign exchange, but no action has been taken by PBC pending a review of the experience of ITC foreign exchange operations in China. This issue will be pursued by the Bank in the dialogue on financial sector reform. Disbursement of local-currency subloans would be handled directly by GITC, as would any foreign-currency subloans approved after GITC is permitted to handle foreign exchange. Training and Technical Assistance 3.12 TTA will be provided to promote project objectives in the areas of enterprise management, project appraisal and implementation, and economic planning. TTA target groups consist of enterprise managers and cadre from agencies responsible for project implementation, including GITC and county investment and trust companies (ITCs). TTA includes: assistance to GPC and - 16 - the Cansu Economic Comission (CEC) to undertake agroindustrial studies and associated economic analysis; assistance to Gansu Province in implementing its various training programs; study tours abroad and within China for staff from implementing agencies; and purchase of office equipment for agencies involved in the industrial diversification project. The estimated cost of TTA is US$500,000. These costs were prepared on the basis of the actual requirements of implementing the designated tasks. They were reviewed with participating agencies during project appraisal and revised at negotiations. The cost estimates for advisors and consultants are based on the Bank Group's experience in similar projects. A total of 7.2 staff-years of consulting services are budgeted, including 1.5 staff-years allocated for expatriates. Details of TTA are available in the Project File. 3.13 Studies. Major studies of the agroprocessing subsectors and a series of studies on analytical topics of interest to planners, to be directed by GPC, would be undertaken. This agency has the greatest need to apply economic appraisal methodology, interpret conversion factors for policy formulation, and conduct subsector analysis for planning industrial develop- ment and diversification. GEC, which is responsible for production from existing enterprises, will collaborate with GPC in these studies. Most analysis of subsector issues currently conducted by Provincial agencies is focused in individual enterprises; the proposed studies would address issues that transcend individual enterprises, providing new planning perspectives. 3.14 Agroprocessing is one of the largest light industrial sectors in Gansu in terms of employment, fixed assets and output value. A series of studies of agroprocessing industries will be conducted tnder the project, for which US$60,000 equivalent has been allocated. These studies will be conducted in two phases to accommodate GPC staffing considerations and to permit reassessment of study formats and terms of reference for Phase II based on Phase I experience. Phase I studies will focus on vegetable oil processing, sugar and beet by-products, and paper made largely from wheat straw, and will be completed by September 30, 1988. Results of Phase I studies will be submitted to the Bank Group for review and comment by December 31, 1988 (para. 6.1). Phase II will consist of at least two studies selected by GPIO from a list including flour milling, soya bean derivatives, and fruit and vegetable bottling and canning. Phase II will be completed by September 30, 1989, and results will be submitted to the Bank Group for review and comment by December 31, 1989 (para. 6.1). These studies will be conducted under GPC auspices with the assistance of technical institutes in Cansu, supported by specialist consultants from elsewhere in China or from abroad, and national research institutes. Annex 3, Attachment 2, provides TOR formats for these studies. Specific TOR for each study are subject to agreement by the Bank Group (para. 6.3). 3.15 TTA would provide about US$32,000 to fund a series of studies of shadow prices, economies of scale, capacity utilization, employment creation andt labor use, efficiency of production, administered prices, subcontracting, and provincial balances of trade and payments (Annex 3, Attachment 1). The scope of work on each of the analytical studies has been agreed with GPC. Detailed guidelines will be developed for each study prior to its initiation, and will be subject to prior approval by the Association. Expertise for these - 17 - studies is available from consultants elsewhere in China and from abroad. TOR would be submitted to the Bank Group for review and comment by September 1, 1987. Each TOR would include a schedule of implementation and target completion dates of not later than December 31, 1988 (para. 6.3). 3.16 Training. Assistance would be provided to the Cansu Economic Man- agement Institute (CEMI) for improving and expanding its training programs in modern project appraisal methodology for managers of enterprises and project agencies in the Province. GEMI is a leadership training agency established in 1985 to provide management training to government and enterprise officials. GEMI would be encouraged to develop new courses in project cycle activities, modeled on those conducted by the Central Institute of Finance and Banking in Beijing and the Shanghai Institute for International Economic Management, which nave had assistance from the Bank Group's EDI. Six 60-day CEMI courses in project cycle management are planned from 1987 through 1989, accommodating 25 participants each from enterprises and project agencies, and two 60-day courses in business administration will enroll 81 rural and light industry enterprise managers and supervisors. The curricula of these courses will be subject to review and comuent by the Bank Group, and will be submitted for this purpose by September 30, 1987 (paras 6.1). Instructors have been selected from GEMI's faculty, and additional experienced lecturers will be recruited from other teaching institutions in Gansu. GEMI is making arrange- ments for key instructors to attend training-of-trainers courses given by the two institutes in Shanghai and Beijing (para. 6.3). TTA funds would finance foreign consulting services to assist CSZMI. The total cost of training assistance to GEMI is estimated at about US$94,000. 3.17 GPC, GEC and the Department of Finance provide training for related agencies and enterprises, which would be expanded by TTA funds for materials, improved equipment, and related expenses. CEC will use consultants to help enterprises investigate project alternatives or introduce new technology. GPC provides training in project preparation to project agencies and enterprises. The costs of an experienced adviser to assist and train GIIC management are included in the TTA program (para. 4.8). Also included are familiarization visits by selected managers to one or more lending institutions abroad. The purpose of these visits would be to obtain information on financial manage- ment, information systems and lending procedures and policies. The Bank Group has encouraged the Bureau of Rural Industry to organize a program under which its staff and leaders of small enterprises in Gansu could seek technical assistance from similar small enterprises in other parts of China that are successful and have reputations for good quality products. To enable Cansu cadres to become acquainted with recent developments in planning and administration of industry, short-term study tours with specific objectives or themes would be organized for key personnel from GPC, GEC, Department of Finance, GITC and the Gansu Project Implementation Office (GPIO). These training, study tours and consultancy services are estimated to cost about US$184,000 and will be carried out according to a schedule satisfactory to the Association (para. 6.1). 3.18 GPIO would use about US$31,000 of TTA funds to hire a foreign con- sultant to set up a project management information system and train staff in its use. Office equipment such as copiers and small computers, which would - 18 - assist project agencies to implement the project efficiently, is included in TTA, with an estimated cost of about US$126,000. Project Administration 3.19 Implementation of the Gansu Development Pro,ect would be coordinated by a Gansu Project Implementation Committee chaired by the Provincial Governor and composed of representatives of all agencies associated with the Project. Management of the industrial diversification project and related TTA would be the responsibility of the Committee's secretariat, the GPIO. GPIO is led by a GPC Deputy Director. This Office will also have responsibility for keeping project accounts. The Committee and GPIO have been established, and key personnel appointed. At negotiations the province agreed to maintain the committee and GPIO with staff, responsibilities and functions acceptable to the Bank Group. IV. THE GANSU INVESTMENT AND TRUST COMPANY A. Institutional Aspects Provincial Perspective 4.1 The financial sector in Gansu has the same type of structure as that of the nation as a whole (paras. 2.1-2.3). Data on the market share of indi- vidual financial institutions are not available, but the major intermediaries are ICBC, PCBC, SOC and ABC. CIB is not represented. The Province has an ITC called the Gansu Investment and Trust Company, and several smaller ITCs formed at county levels, none of which is affiliated financially with national institutions. 4.2 GITC was founded in 1980 by the Province of Gansu, with a registered share capital of Y 200 million. The establishment of this type of financial institution at the Provincial level was c,)nsistent with the Chinese Government's economic reforms that phased out government grants as the sole external source of permanent enterprise capital, and replaced these with loans (paras. 2.09-;.10). GITC is administratively responsible to the Department of Finance on a day-to-day basis for its policies and operations. Its credit plans, management of trust funds, bond issues, lending criteria and regulations including interest rates are also under the overall supervision of the Gansu branch of PBC. Scope of Operations 4.3 CITC's lending and investment operations consist primarily of local currency loans to support technical transformation and modernization of exist- ing state-owned or collective enterprises within Gansu. In exceptional cases, loans have been mads for capital construction, but no working capital finance is provided. All projects must meet criteria of quick economic retura and financial profitability. GITC lends for projects both within and o' ,side the Plan; the share of loans to projects outside the Plan has gradually increased from 4% in 1983 to 12% in 1986. Maturiti' of loans are up to fiv.. years. No - 19 - size limit is specified. The average size of loans issued through 1986 is about Y 500,000. GITC'i resoujrces consist primarily of equity contributed by the Provincial Government. However, GITC may borrow from domestic sources outside the Province, and lend freely within Gansu for projects outside the Provincial Plan up to the sum of its resources mobilized outside the Plan (e.g., in the form of bonds and deposits), its retained earnings, and 20% of the resources allocated to it ander the Provincial annual budget. 4.4 GITC also manages special budget funds provided by the Provincial Government for lending to specific categories of borrowers or programs, including small-scale industries, hdndicraft collectives, special mining projects, youth employment, and poor villages. In line with the Provincial Government's policy to develop rural industries, GITC launched a large lending program for collectives in towns and villages in 1985. GITC plays no decision-making role with respect to these loans (para. 4.25). Organization and Staffing 4.5 GITC has no Board of Directors in view of its relationship with the Department af Finance. However, GITC is a legal entity and has a degree of independence in credit decisions that justifies its project role (paras. 4.14- 4.20). A former senior officer of PBC is its Manager. As Chief Executive Officer, he formulates policy for review by the Department of Finance and runs the institution on a day-to-day basis, making credit and investment decihions following review and recommendation by GITC's Credit Division. 4.6 GITC has two Deputy Managers. One oversees the Finance Division, which is responsible for accounting, and the Administrative Division. The other is responsible for the Credit Division, which evaluates loan applica- tions and makes recommendations to the Manager regarding applicants' credit- worthiness and loan terms and conditions, and for the Economic P,velopment Division, which includes new business, research and special assxWnments (Chart 1). The Manager, Assistant Managers and Division Chiefs make up the management team, which meets regularly to discuss policy and review perfor- mance. 4.7 GITC's total staff numbered 28 at the end of October 1986. GITC has received tentative approval from the Provincial Government of a plan to expand its staff to 60 within three years. By the end of 1986, GITC had increased its staff to 15, and expects to expand to 50 by the date of loan effectiveness to cope with an increasing volume of business. A new Division handling World Bank-financed projects will soon be established. Some staff members, especially those rehired after retirement, have extensive banking experience but none is familiar with modern project appraisal methodology incorporating discounted cash flow and projection of financial statements. Lacking engineers, GITC has relied heavily on tne engineering appraisals of supervisory bureaus and design institutes. 4.8 GITC's staff recruitment plan for 1987/88 and a comprehensive training program (part of which would be supported by the project) were reviewed at negotiations and found to be satisfactory (para. 6.3). The Bank Group has propos.d that GITC engage a consultant for one year to assist - 20 - management and train staff on project appraisal and supervision (para. 3.17). CITC has recruited an engineer to review the technical viability of projects, and expects to have a second engineer during 1987. 4.9 GITC has no branches. 3owever, it has contracted out project inves- tigation and supervision work to ITCs in the counties. There are at present eight small, county ITCs, which are independent of CITC and Provincial authorities and operate only within the jurisdictions in which they were formed. Their combined oortfolio amount to less than one-fifth of GITC's. Since GITC's projects are scattered all over the Province, arrangements with county ITCs are very helpful. To upgrade their project appraisal and supervision capability, the training program for the component includes a provision for the project staff of county ITCs (para. 3.12). Policies 4.10 GITC's operations are guided by its Charter (Annex 2, Attachment 1), which is satisfactory to the Bank Group. GITC also follows regulations issued on April 26, 1986 by PBC titled "Temporary Provisions for the Management of Financial Trust and Investment Organizations" (FTIOs) (Project File). These provisions state that FTIOs shall implement national financial policies oriented toward econ3mic development, currency stability, and improved socio- economic results, avd that they should be staffed by qualified financial mana- gers. FTIOs may engage in a wide range of activities, including trust invest- ments and trust lending; leasing; serving as agents for safekeeping, collec- tion and payments, and the issue of negotiable securities; guaranteeing debts and issuing negotiable securities approved by PBC. FTIOs may issue working- capital loans only to enterprises they invest in, but they may issue interim turnover loans to other enterprises for up to three months. Fixed asset loans, investments and leasing handled by FTIOs must fall within the scope of the fixed asset plans formally approved by the State. FTIOs mt'st take respon- sibility for their own profit and loss, subject to PBC leadership, management, coordination, supervision and examination. FTIOs' interest rates are deter- mined according to PBC regulations. 4.11 PBC regulations effectively define and control the activities of GITC. They provide an adequate initial basis for a relationship with the Bank Group within the context of the project and the implementation of financial and economic reforms in China. As GITC develops it should further define its activities in a manner that increases its ability to manage risk. Particu- larly, its debt/equity ratio deserves careful attention from the perspective of its ability to bear risk and earn a suitable return on its equity (paras. 4.24-4.25). It should also define exposure limits to a single borrower and industry, which will become more important as its debt/equity ratio rises with enhanced resource mobilization efforts. 4.12 GITC has no formal Policy Statement because it is relatively new and because its close relation with the Department of Finance has effectively set its policies. However, GITC's scope and functions will broaden under the project and as it seeks to diversify its sources of funds. To assist its development, GITC has agreed to prepare a Policy Statement listing its operational and financial policy guidelines covering its objectives, - 21 - operations, finances, and organization. GITC will submit this statemnt to the Bank Group for comment not later than March 31, 1988. A Policy Statement satisfactory to the Bank Group would be adopted by June 30, 1988 (para. 6.1). Any subsequent changes in this statement that could materially affect project objectives or implementation would be subject to approval by the Bank Group. Interest Rates 4.13 GITC's lending rate structure and levels are consistent with domes- tic rates elsewhere in China, and are expected to evolve as the impact of financial reformr becomes more widespread. CITC charges interest rates ranging from 6.04% to 7.92% p.a. on loans financed from its capital obtained through Government allocations. These rates are determined by the Department 6f Finance in conformity with PBC regulations. Penalty rates are charged on these loans: a borrower who alters the objective of a loan or uses loan funds for working capital purposas is charged interest at 7.2% p.a. retroactive from the date of loan signing. Interest on the delinquent portion of a loan which is not rescheduled is 8.64% p.a. starting from the due date. On loans financed by its bond issue, which is outside the National Credit Plan, GITC charges 7.92-9.60% pea* (para* 4.27). However, subsidies by the Department of Finance to borrowers of these funds harmonize the net interest cost on all lending by GITC (Annex 2, Table 1). (Interest rates on project subloans are described in para. 5.7). GITC's rates are consistent with rates elsewhere in China (Annex 1). Gansu Province has assured the Bank that GITC would exchange views with the Bank prior to making any reduction in its lending rates on loans with maturity of at least three years; and that at the request of any party the Covernment and GITC would exchange views with the Bank on GITC's lending rates in light of GITC's cost *of funds and profitability and of movements in interest and inflation rates in China and internationally (para. 6.1). Procedures and Standards 4.14 Investment proposals in the Provincial annual plan are submitted to banks and to GITC for their consideration. Each proposal received by these financial institutions includes a feasibility study, which GITC uses as a pre- appraisal report. GITC is under no obligation to finance projects presented to it by the authorities. 4.15 The criteria currently applied by CITC in its credit decision-making are (a) adequacy of feasibility study and technical design documentation; (b) evidence of enterprise legal standing and verification of assets; (c) evidence of a prescribed level (usually 30%) of own funds to finance the proposed investment; (d) satisfactory prospects for product demand, raw mate- rial and other input supply, satisfactory location and access to transport, access to technology and compliance with environmental protection require- ments; (e) assured supply and quality of labor and construction materials; (f) satisfactory enterprise performance, debt service record and repayment capability as demonstrated by financial statements; (g) adequate management capability; and (h) a guarantor for the loan amount and interest (usually a profitable legal entity owned by a prefecture or higher jurisdiction or by a supervising agency). While these criteria are comprehensive, GITC's small - 22 - appraisal staff is not able to apply them rigorously to the large number of projects processed each year. 4.16 GITC, as the financial intermediary with approval authority for sub- loans under the project, would continue to apply the criteria listed above, but would develop the capacity to apply modern appraisal methods (para. 3.12) to supplement its review of documentation, in particular through more syste- matic use of financial plans. These methods would facilitate analysis and refinement of financial plans for subprojects and for enterprises undertaking subprojects. The financial plan for each prospective subproject would be analyzed to establish projected debt service ability, suitably adjusted for adversity. Debt service ability will be determined by residual funds flow, before financing, as shown by subborrowers' funds flow statements, projected with the balance sheets and income statements presented in accordance with principles generally accepted in industrialized countries. Adjustment for adversity would consist of projections revised downward to reflect factors most likely to go wrong in each subproject. Supervision of Relationships with Clients 4.17 CITC's project supervision during and after construction is minimal and should be upgraded. Accordingly, GITC would establish a system, satisfac- tory to the Bank for monitoring the progress of each subproject during the period for which GITC has an exposure (para. 6.1). This system should include periodic follow up through reporting requirements and subproject visits. CITC's Procurement and Disbursement Practices 4.18 CITC's borrowers follow procurement procedures laid down by Provin- cial regulations. These are generally adequate, but not fully in line with Bank requirements. For example, loan disbursement is currently made in full once the project sponsor has made the required equity contributions and is not linked to progress in construction. However, for subloans under the project, procurement and disbursement procedures satisfactory to the Bank will be followed (paras. 5.12-5.13). B. Operations 4.19 Lending constitutes virtually all of GITC's operations, as it has made less than Y 1 million of equity investments and has issued no guarantees. From 1980 through September 30, 1986, GITC received 1,747 loan applications for Y 630.4 million and approved 1,373 loans for Y 520.5 million (Annex 2, Table 2). Before 1985, GITC's level of operations fluctuated from year to year, with no clear trend, primarily contingent upon annual Provincial Govern- ment allocations. In 1985, GITC's lending activity increased sharply with total approvals of Y 161 million, compared with Y 48 million in 1984. This was attributable to a new Provincial Government policy to provide more assis- tance to township and village indus'ries (para. 4.4), and to the bond issue proceeds (para. 4.27). In the first nine months of 1986, GITC was not able to maintain the level of operations achieved in 1985. Its approvals declined 30Z, mainly because of funding constraints. - 23 - 4.20 Projects financed by CITC cover a wide range of sectors (Annex 2, Table 3); light industry is the most prominent with a share of 37% in amounts commited, followed by services and others (331), metallurgy (141), construc- tion materials (3%), machinery (5%), chemical and pharmaceuticals (6%), and electrical and electronics (4%). This pattern is reflected in the sectoral distribution of CITC's portfolio as of December 31, 1986 (Annex 2, Table 4). About half of CITC's projects are located in Lanzhou, 13% in Jiayuguan in the western part of the Province, 11% in Longnan in the south, and 7X in Tianshui in the east, with the other counties each accounting for less than 5% of the portfolio (Annex 2, Table 5). While about two-thirds of CITC's loans approved are for amounts of less than Y 250,000, more than half of its loan volume consists of loans of more than Y 1 million (Annex 2, Table 6). 4.21 Loans financed from funds provided through provincial budget alloca- tions carry a maximum maturity of 5 years. Loans funded from proceeds of the 1985 bond issue are likewise limited to five year maturities under the policy of matching funding and lending terms. Loans issued under special trust funding arrangements show a wider maturity spectrum. A comprehensive term profile of GITC's loan portfolio has not been available. Management estimates that 60% of the principal amount of loans outstanding in 1986 carried original maturities of three years or less, 30% had maturities of three to five years and 10% had maturities extending beyond 5 years. Approximately 20% of all loans had grace periods varying from 6 to 12 months. The average effective portfolio maturity is roughly three years. C. Financial Aspects Financial Position 4.22 GITC's balance sheets for 1980-86 and 1987-91 projections are included in Annex 2, Table 7. During the first seven years (1980-86), GITC's total assets more than tripled (from Y 100.3 million at end-1980 to Y 373.2 million at end-1986). GITC's loan and equity portfolio as of Decemb- er 31, 1986 accounted for 92% of its total assets compared with 71% and 82% at the end of 1984 and 1985, respectively. GITC had reduced its cash and bank deposits to the lowest level in four years while sharply increasing its lend- ing. Its managed funds declined in 1986 after transferring most youth employ- ment loans to the newly established Provincial Youth Employment Bureau, and incorporating viable lead and zinc mining trust loans into its own loan port- folio. On the liability side, government contributions treated as CITC's share capital increased iLom the initial level of Y 86.7 million in 1980 to Y 323.4 million at the end of December 1986, exceeding the authorized capital by 62%. CITC's debt/equity ratio was 0.12:1. Financial Performance 4.23 GITC's gross revenue grew from Y 175,000 in 1980 to Y 10.6 million in 1986 and its income before tax itncreased from Y 142,000 to Y 7.9 million (Annex 2, Table 8). However, net income declined from Y 2.1 million in 1984 to Y 1.4 million in 1985, due mainly to the expiration of a five-year tax holiday. Cross revenue increased 83% in 1986 and net income increased 193%, due to the interest income (around Y 3.6 million) on bonds issued in 1985. - 24 - The return on average equity was 1.32 in 1984, 0.iX in 1985 and 1.42 in 1986. These low rates reflect the fact that 892 of GITC's assets are financed by equity and the fact that its lending rates are low. CITC's equity consists of Government allocations, own funds, appropriated surplus and retained earnings. Its equity-heavy capital structure gives CITC a large risk-bearing capacity and considerable scope for growth through borrowing, which contributes to its suitability as a vehicle for the proposed project. To fortify CITC's financial condition, it was agreed that GITC's debt/equity ratio will not exceed 1.5:1 (para. 6.1). Portfolio Quality 4.24 As of December 31, 1985, loan amounts in arrears reached Y 32.7 mil- lion, corresponding to 132 of CITC's loan portfolio. During the first nine months of 1986, loan portfolio quality deteriorated: amounts in arrears rose to Y 50.2 million, and the percentage increased to 15X. About one third of the arrears have been overdue for more than 12 months (Annex 2, Table 10). There are many contributing factors. One is that repayment schedules proposed in appraisals and included in loan agreements are generally unrealistic because they assume that all annual surplus will be used for loan repayment until repayment in full is achieved. Another factor is that GITC's low penalty interest rate encouraged borrowers to delay repayments and use the funds payable to GITC for working capital purposes (para. 4.13). GITC has not made any bad debt provision, and bad loans have never been written off, although it is becoming clear to GITC management that some of its assets are worthless, and that financial reforms may increase its lending risk. 4.25 In view of these developments, it is desirable that GITC thoroughly review its portfolio and reassess defaulting borrowers' ability to repay in light of realistic cash flow projections (para. 4.16). At negotiations, an assurance was obtained from Gansu Province that GITC will complete a review of its loan portfolio by December 31, 1987, and that GITC would decide, on the basis of this review and in consultation with the Bank, actions to be taken by June 30, 1988, regarding provisions for bad debts, rescheduling, write-offs, and penalty interest rates (para. 6.1). After such review and reassessment, GITC should: (i) write off unrecoverable loans; (ii) make adequate provisions for possible loan losses; (iii) reschedule loans overdue for more than 12 months, in light of the borrowers' ability to service debt; and (iv) increase its penalty interest rate on overdue loans to a level above ICBC's lending rate on working capital loans. Accounting adjustments required to make GITC's financial statements closer representations of its true status should not impose any constraints on CITC because of its low debt/equity ratio (para. 4.22). GITC has no decision-making authority over managed funds (para. 4.4), which fund loans made at the behest of the Provincial Government. As an independent enterprise it should not be accountable for these loans in the same manner it is responsible for loans made independently. GITC desires that the behest portions of its assets and equity be segregated in its financial statements, which should be accomplished in 1987, and this convention will be followed in its reporting to the Bank (paras. 5.18, 6.3). 4.26 Resources. From its founding in 1980, GITC's operations have relied primarily on the Provincial Government's annual budget allocations to its - 25 - equity capital, on which no dividends have been required. Other, minor sources include: the 1985 bond issue, deposits from enterprises, managed funds provided by the Provincial Government for earmarked lending, and retained earnings, as shown below: Table 4.1: GITC RESOURCES AS OF DECEMBER 31, 1986 Amount (Y'000) Z Government allocations 323,393 91.2 Bond issues 18,368 5.2 Deposits 953 0.3 Retained earnings 9,919 2.8 Interest subsidy, depreciation and bad debt reserves 2,174 0.6 Total 3549807 100.0 4.27 A bond issue of Y 70 million was authorized by the Provincial Gov- ernment in 1985, with GIT?;s subsidiary, Gansu Economic Development Corpora- tion, handling the issue., When Y 38 million of the issue had been sold in September 1985 the State Council ordered a suspension, which remains in effect, in order to review credit allocation by ITCs in China and its impact on monetary policy and macroeconomic objectives. The coupon rates are 5.04% for one-year, 8.28Z for two-year and 9.36% for five-year issues. Y 3.9 mil- lion of the issue matured and was repaid in July 1986. Lending rates for bond-financed loans are 7.92% p.a. for maturities up to three years and 9.6% p.a. for maturities exceeding three years (para. 4.13 and Annex 2, Table 1). 4.28 CITC is expected to continue to rely solely on Government alloca- tions for new resources until Bank funds under the proposed project are avail- able. GITC's resources were almost fully committed as of December 31, 1986 (Annex 2, Table 11). Accounting Standards and Auditing 4.29 GITC keeps its accounts on a cash basis. Distortion in its annual accounts is minimized by the use of semiannual due dates, one of which is November 30, relatively close to its December 31 year-end. GITC's small Finance Division has no internal audit procedures. External audits that meet Chinese requirements are routinely conducted by the Tax Bureau of the Provin- 7/ This subsidiary has no other activities. - 26 - cial Government and by PBC. Due to lack of qualified staff, the Gansu Branch of the State Audit Administration (SAA) has not conducted regular audits of the accounts of financial institutions. 4.30 Although its accounting system generally meets local standards, GITC is planning improvements in order to manage its finances more effectively. GITC hopes to base its accounting system on the Uniform Accounting System for ITCs in China being drafted by PBC, and GITC is currently upgrading its management information system. These changes should ensure that GITC's accounting system would be properly set up and operated in accordance with generally accepted accounting principles. Financial Projections 4.31 Provincial Government allocations to GITC have varied greatly and are decided only one year in advance (para. 4.26). At times the full alloca- tion has not been received. With funding not confirmed, GITC has not projected its operations beyond one year and consequently lacks experience in preparing projections. With access to Bank funds and as economic reforms create opportunities for GITC to diversify its sources of funding, financial projections will be more useful to management. Its first five-year projec- tions were constructed for project negotiations (Annex 2). These show rela- tively rapid growth, high liquidity, and continued low leverage with asso- ciated low returns on equity. Under the project, GITC will prepare, in a form satisfactory to the Bank, five-year projections of its operations, resource requirements, financial results and position, for submission to the Bank annually with its audited financial statements (paras. 5.18, 6.3). V. THE PROPOSED BANK LOAN AND IDA CREDIT A. Benefits and Risks 5.1 Benefits. The project is expected to create employment and to enhance the productivity of labor, especially in rural areas in Gansu Province, where incomes are much lower than in urban areas. Therefore, the project is expected to have a positive impact on poverty alleviation. The Bank loan will fund a selected portion of the Province's investment program between 1987 and 1989, which responds to "investment hunger" occasioned by economic reforms and inefficiencies in the investment allocation system. The project provides the first opportunity for systematic application of modern appraisal procedures on a Province-wide basis, using financial and economic analysis. This will ensure that project funds would be allocated to sub- projects with acceptable expected economic and financial rates of return, con- tributing to investmeni efficiency. Sixty percent of loan proceeds will be directed at rural enterprises, which are dispersed. These enterprises often have had difficulty attracting finance because of their outside-the-plan status, but they face greatly enhanced commercial prospects because of eco- nomic reforms that have widened the markets to which they access. 5.2 Institutions that are expected to benefit from training and techni- cal assistance include GEMI, GPC, GEC, Department of Finance, the Bureaus of - 27 - Light and Rural Industries, GITC, GPIO and rural and light industrial enter- prises, especially those receiving project funds. Benefits include the capa- city to use economic analysis in investment allocation and subsector planning, more effective management of enterprises and of investment projects, and sus- tainable local training capacity. The project is expected to maintain the net worth of GITC through profitable subloans, and to introduce credit decision criteria based on analyses of subborrower sources and uses of funds state- ments, balance sheets and income statements (para. 4.16). 5.3 Risks. Risks arising from subproject selection criteria are being managed under the project through Bank review of all subprojects and through intensive efforts to communicate appraisal criteria to implementing agencies in Gansu. In addition, upgrading CITC's loan administration under the project should reduce risks (paras. 4.17-4.18). Risks peculiar to rural industries include information problems in the determination of feasibility, enterprise management, and difficulties in obtaining raw materials, access to lucrative markets and financing. These risks are to some extent contained by the fact that rural industries are not necessarily characterized by small size. These risks would decline with enlargement of markets through the dismantling of administrative responsibility with the implementation of economic reform. Reform would tend to diminish the monopoly power of enterprises arising from their affiliation with State and Provincial agencies, requiring more enterprises to behave competitively in markets. The risks facing rural industries with the implementation of reform will become more commercial in nature, and the avenues to address them will widen. In response to implemen- tation risks a large TTA component is included in the project (paras. 3.12- 3.18). 5.4 The impact of subproject selection risks will be felt most keenly by GITC. While other implementing agencies will have their areas of responsibil- ity and power enlarged by the use of project funds, GITC's growt' inder the project will be concentrated in the most risky segment of its po .folio, which is rural industries. These risks are being addressed by careful evaluation of credit risk in decision-making and in specifying a spread that is expected to protect CITC from losses from its participation in the project (paras. 4.16, 5.8). CITC has a conservative financial structure, suggested by a capital-to- assets ratio of 89% in September 1986, and the entire proposed loan amounts to less than one-quarter of GITC's equity. B. Features of the Proposed Bank Loan Onlending and Relending Arrangements 5.5 The proposed Bank loan of US$20 million equivalent for the indus- trial subloans would be made to the People's Republic of China at the Bank's standard variable interest rate. The Government would relend the entire amount to Gansu Province on terms and conditions acceptable to the Bank. Gansu Province would use these funds in accordance with a Project Agreement with the Bank. State Council approval of the Loan Agreement would be a condi- tion of effectiveness of the proposed loan (para. 6.2). - 28 - 5.6 GITC's participation in the project would be governed by a Project Implementation Agreement between GITC and the Province, satisfactory to the Bank, the signing of which would be a condition of effectiveness (para. 6.2). At negotiations a draft of the Project Implementation Agreement was reviewed by the Bank. 5.7 Relending Terms. The exchange risk on foreign exchange subloans would be carried by subborrowers. Fcr bookkeeping and valuation convenience, subborrowers' obligations would be denominated in US dollars. The foreign exchange risk between the US dollar and the Bank's currency pool would be carried by the Province. The interest rate on US dollar subloans would be fixed at 8.5%, consistent with those on similar dollar loans elsewhere in China issued by institutions such as CIB. No foreign exchange risk would be borne by recipients of local currency subloans, which are funded from the con- version of the foreign exchange provided by the Bank. The foreign exchange risk or the portion of the Bank loan converted for this purpose would remain witn the Province. Domestic currency subloans would carry a variable rate that would be consiscent with those charged on five-year fixed-asset loans issued to light and rural industrial enterprises by ICBC and ABC, respective- ly. The current rate on these ICBC and ABC loans is 10.08% (Annex 1), which would be the initial rate charged by GITC. GITC's rate on these subloans would be changed from time to time to reflect changes in the ICBC and ABC reference rates. This variable rate is expected to remain above the rates of inflation thar have been reported in China (3% p.a. in 1981-84, 9% in 1985, and about 6% in 1986) and above those projected by the Bank through 1995. Rate changes would apply to outstanding subloan balances as well as to new loans. Penalty rates equal to 20% and 50% of CITC subloan base rates would apply respectively to amounts in arrears from the date of arrears and to amounts diverted by subborrowers from the date of the first disbursement. 5.8 A spread of at least 4% would be deducted from the relending rate to determine the rate at which project funds provided by the Bank would be loaned to CITC by the Province. This spread is expected to cover GITC's administra- tive costs and risk on these subloans. This pricing objective would be included in the Project Implementation Agreement between the Province and GITC (para. 5.6). Amortization Schedules 5.9 For the Industrial Diversification Project, the loan amortization schedules between the Bank and the Government, between the Government and Gansu Province, and between Gansu Province and GITC would all be identical with respect to timing of payments of interest and repayment of principal. Back-to-back repayment of subloans and the Bank loan would not be appropriate because subloan maturities in China are usually short, averaging less than six years. Therefore, as for other Bank credit operations in China, CITC would receive proceeds of the Bank loan on country terms for China: 20 years, includinx five years' grace. Subborrowers' subloan amortization schedules aouid refiect -he expected repayment capacity of individual subprojects or of tne Knerprist2s implementing them, and would be structured so that enterprises r) lld re a'lowed a cushion for adversity (para. 4.16). The positive float r -e1 ed lr t-he Department of Finance and GITC by the difference between sub- - 29 - loan and the loan's amortization schedules would reside with and be controlled by the Department of Finance with respect Lo foreign currency subloans it disburses, and with and by GITC with respect to other subloans. Women and Minorities 5.10 Investments funded by the Bank are expected to be neutral with respect to opportunities available in Gansu to women or ethnic or religious minorities. Environmental Effects 5.11 Atmospheric, water pollution and hazardous waste controls specified by the Province for all industrial investments will be applied in subproject design and selection of industrial processes. The standards and regulations conform to the national code. The appraisal of each subproject would include a description of specific action to safeguard the environment; this would be reviewed by the Bank in accordance with Bank environmental guidelines. C. Procurement and Loan Disbursement 5.12 Procurement. Individual contracts for goods and services would not exceed US$3 million equivalent. All contracts would be awarded after compari- son and evaluation of quotations elicited from at least three qualified sup- pliers. Civil works contracts would be awarded on the basis of local competi- tive bidding procedures satisfactory to the Bank. All subproject appraisal reports would contain a description of procurement and selection procedures, and contract documentation would he available for review by the Bank. Local procurement procedures which require each subborrower to obtain quotations or bids from three suppliers, from which the selecticn of award would be made, have been reviewed by and are acceptable to the Bank Group. 5.13 Disbursements. GITC would follow procedures under the project that will ensure proper disbursement for equipment and services against valid docu- mentation. For civil works, disbursements would be based on progress in construction and for perrnanent working capital, disbursements would be based on increases in capacity utilization. All subloan disbursements would follow equity contribution by subproject sponsors in accordance with GITC guidelines (para. 4.15). Disbursements from the Bank loan would be made for the full amount of subloans not exceeding the greater of: (a) 100% of the foreign expenditures for imported equipment and services; or (b) 50% of the agreed cost of subprojects including equipment and services, civil works and perr.anent working capital but excluding the cost of using or acquiring use of Land. For subprojects receiving subloans in domestic currency only, the 50% financing limit would apply to the average financing for these subprojects as a group, permitting variations for specific subprojects at the discretion of CITC (para. 3.8). For contracts covering costs of equipment and services of US$200,000 or more, disbursement would be made by the Bank against full documentation. For contracts of less than US$200,000, disbursement will be made against statements of expenditures (SOEs). Supporting documentation for SOE disbursement would be retained by CITC on behalf of the Department of Finance and made available to Bank staff for review during supervision - 30 - missions. To accommodate the seasonality of construction activities in Gansu and to assist early implementation, retroactive financing is provided for expenditures made for agreed project costs after January 1, 1987, using procurement procedures satisfactory to the Bank. Subproject expenditures of up to US$2,350,000 equivalent are eligible for retroactive and refinancing. Civil works expenditures are expected to account for the bulk of eligible subproject costs. 5.14 To facilitate disbursements, a Special Account would be established for the Gansu Provincial Development Project. This account would be main- tained in US dollars in a bank on terms and conditions satisfacLory to the Bank. The account would be in the name of the Department of Finance of the Gansu Provincial Government and in an amount representing about four months of average expected disbursements during implementation period. The amount of the initial deposit will be the US dollar equivalent of SDR 8 million, of which a nominal SDR 1.0 million is intended to support the industrial diver.1fication project. 5.15 The commitment pariod for the loan is expected to close on June 30, 1990, about two and one-half years following project effectiveness. Disbursements are expected to be conpleted by June 30, 1992 for the Industrial Diversification project, while the closing date for the entire project is expected to be June 30, 1994. Disbursement projections (Annex 4) are based on the disbursement profile of DFC lending in the East Asia and Pacific Region. D. Features of the Proposed IDA Credit 5.16 The proposed IDA Credit of SDR 410,000 (US$500,000 equivalent) for financing training and technical assistance would be made to the Government on standard IDA terms, and the Government will pass on these funds to Gansu Prov- ince under terms and conditions satisfactory to the Association. Gansu Province would use these funds as specified in a Project Agreement with the Bank. State Council approval of the Development Credit Agreement would be a condition of effectiveness of the credit (para. 6.2). Disbursements would be mace by the Province to its constituent implementing agencies as administra- tive allocations, and to GEMI and GITC as grants. TTA funding would cover 100% of local anu foreign costs of agreed TTA activities. Up to US$150,000 equivalen: of agxeed TTA costs are eligible for retroactive financing, largely to accommodate expenditures on equipment. Expatriate consultants would be selected in accordance with the "Guidelines for the Use of Consultants by the World Bank and by the World Bank as Executing Agency." Local consultants will be obtained directly under terms of reference satisfactory to the Association. Office equipment and vehicles for which $166,000 has been allocated, will be purchased directly from suppliers in accordance with procedures acceptable to the Association. 5.17 Responsibility for administration of these funds and for TTA imple- mentation and supervision would be vested in the GPIO. The Special Account established for the provincial project would be available to fund TTA disbursement (para. 5.14). SOEs would be prepared to obtain withdrawals from the Credit, for amounts conforming to agreed costs. Documentation supporting disbursements would be held by CPIO for inspection by the Association, and - 31 - project accounts in the Department of Finance would be audited according to procedures specified in para. 5.18. E. Audits and Reporting 5.18 World Bank audit requirements would be applied to GITC, SOEs and Special Accounts by the SAA beginning in 1987 (paras. 5.13, 5.14, 5.16, 5.17). The SAA would also apply audit standards acceptable to the BankC Group to the Department's accounts pertaining to the project. Statements carrying the auditor's opinion would be submitted to the Bank Group within six months of the close of each fiscal year. GITC should submit to the Bank Group quarterly operations and financial reporto in a form satisfactory to the Bank Group following loan effectiveness. Its accounts would be audited annually by independent auditors acceptable to the Bank Group. The audited financial statements of GITC, the audit report and five-year financial projections would be submitted to the Bank Group within six months after the end of each fiscal year. A project completion report would be prepared by GPIO and submitted to the Bank Group within six months following completion of disbursements. GITC and GPIO would provide progress reports in a format satisfactory to the Bank Group. VI. RECOMMENDATIONS AND AGREEMENTS REACHED AT NEGOTIATIONS 6.1 During negotiations, the following assurances were obtained from the Cansu Provincial authorities: (a) subprojects will be selected, appraised and monitored in accordance with criteria and methodology agreed with the Bank (paras. 3.6, 3.7, 4.17, 5.13); (b) completion of studies of agroprocessing industries, in two phases, by September 30, 1987, and September 30, 1989, respectively, and their submission to the Bank Group by December 31, 1988 and December 31, 1989, respectively (para. 3.14); (c) curricula funded from the credit would be prepared and submitted by GEMI to the Bank Group for review and comment by September 30, 1987 (para. 3.16); (d) the training program will be implemented according to a schedule satisfactory to the Bank Group (para. 3.17); (e) GITC will prepare and furnisn to the Bank a Policy Statement by March 31, 1988, to be adopted not later than June 30, 1988 (para. 4.12); (f) the Bank Group, the province and GITC may initiate exchanges of views on appropriate interest rate policies for CITC (para. 4.13); (g) GITC's debt/equity ratio shall not exceed 1.5:1 (para. 4.23); - 32 - (h) CITC will review its loan portfolio and delinquent borrowers by December 31, 1987 (paras. 4.24-4.25); (i) CITC will take certain actions regarding unrecoverable loan amounts, bad debt provisions, rescheduling, write-offs, and penalty interest rates by June 30, 1988 (para. 4.24-4.25); and (j) GITC's accounting, audits and reporting under the project (para. 5.18). 6.2 The following are conditions of effectiveness: (a) State Council approval of the Loan Agreement and Development Credit Agreement for the project (paras. 5.5, 5.16); and (b) signature of a Project Implementation Agreement between the Province and CITC (pare. 5.6). 6.3 Understandings with Gansu Province wert reached on: (a) terms of reference and schedules of implementation and completion of a series of economic studies to be done under the TTA part of the project (pare. 3.15); (b) GITC's staffing plan and training programs with implementation schedules (para. 4.8); (c) segregation of behest loans in CITC's financial reporting (pare. 4.24); (d) preparation of GITC's five-year financial projections (para. 4.31); and (e) GEMI arrangements for training of its instructors (para. 3.16). 6.4 All subprojects would have to be approved by the Bank before dis- bursement would be authorized. Subproject appraisal results will be communicated to the Bank under two procedures; one requiring submission of full reports, the other utilizing appraisal summaries (para. 36). Recommendation 6.5 Subject to the above conditions and the conditions outlined in the Staff Appraisal Report for the Agriculture Component and Education Component, the Provincial Development Project would constitute a suitable basis for an IDA Credit of SDR 119.1 million (US$150.5 million equivalent) on standard IDA terms, and a Bank loan of US$20 million equivalent, with a maturity of 20 years including five yr,ars of grace, both to the People's Republic of China. 6.6 Out of the proceeds of the Credit, SDR 410,000 (US$500,000 equivalent) and out of the proceeds of the Loan US$20 million equivalent will be allocated to the Industrial Diversification component dealt with in this Report. >- H 0,4 -34- ANNEX 1 CHINA GANSU PROVINCIAL DEVELOPMENT PROJECT The Industrial Diversification Component Selected Interest Rates in China, 1986 (I p.a.) Item Old rates /a Current (1986) rates /b Individual.,' Deposits Demand deposits 2.88 2.88 Time deposits 6 months 4.32 6.12 1 year 5.76 7.20 3 years 6.84 8.28 5 years 7.92 9.36 8 years 9.00 10.44 Enterprise Deposits Demand deposits 1.80 1.80 Time deposits 1 year 3.60 4.32 2 years 4.32 5.04 3 years 5.04 5.76 Loans - rculating capital 7.20 7.92 Modernization loans: Under 1 year 5.04 7.92 1-3 years 5.76 8.64 3-5 years 6.48 9.36 5-10 years (7.20) 10.08 Over 10 years (7.92) 10.80 Foreign exchange loans: Bank of China /c 8.0-9.5 8.5-9.5 China InvestmeiaF Bank Id 8.0 8.0 Capital construction 2.4-3.6 2.4-4.2 Loans to urban and rural individual enterprises 8.64 9.36-11.52 /a Effective after the 1984 increases. 75 Ef.5fective since 1985. 7F Bank of China rates are linked to its foreign exchange borrowing cost and declined in 1986. /d Increased to 8.5% in 1986. Source: People's Bank of China. .EPID December 1986 -35- .Cx2 Table 1 m6 P1IEIIII KKLOM P66CC _. _.......__.. ..... IK I"IRII. OiuKiSi7iTiU CUIU 61U I UCSThCIN D TNT W Ltnding bitns, etftftJve fro hcs,bev 1, 1916 : It. Lean Interet Rte Internt lte Interet Rte Period CDwpd Paid bV hrrwig Subidized by 611C Cat sniu Prooincial 6werrnment (yevs) (I per mm) (I per ) ( I rW an) Technical Iranafornation Loans Loans financed by 6ansu Provincial 1 6.48 6.4N 0 6owerrment Rllocaiions 1-3 7.20 7.20 0 above 3 7.9t 7.92 0 Loans financed by 6IIC's Bond Issues 1-3 7.9t 5.64 2.SS 3-5 9.60 S.04 4.56 Other Loans Handicraft Loans 1-3 0 0 0 Snall Business Loans 1-3 0 0 0 Metallurgy Trust Loins 7 0 0 0 Employment Creation Irust Loans 1-5 0 0 0 REPIG Rpril 1997 J muLU PP:CITft EELOPP4T PJICT THE I1 TI3 DIOZSaFICRTION C 3E mm, ,MsruM.r _ TE,T _MOV STMiEuur O w -Tu . ism - 1m c v mlo ) ism lies isaim an iM ISM Me. _ wt _ . _mtp Us Usint no _lmn up. _sinm Us _ m no. _ . _ LAint p MIieeLian 40ftlo P1an 7 w6Mls m Iui 4m 0 *I7c4 i P4S0?1 W. U9 as..6 VWm Iwo a.6 T"LAmL" 0paw asios , 10 S 46w.mS * nm aa. Mc 2 m waa tmhtp Plan Zwl m0.in aW mm S w.mw 26.4 6? M i49 m '.9a i Out-ide Pi t a. w,i S a.m a ee.- we aa.ine as eam rTOAS LA.. VINp..a. ama sm,inD ISM .e.s ci Iw.mW .w mm0f Ts mm ia8.6as m. LAMM& Caaw-u.m" LOAiND.c S4 * Anasma.a .ste aa m 6 I0 *r m em"Aw o*_ss run_ o .o s *6 2 *._ s _ mma3dPin te a.wm masa az em m. g.m _ as e_"l aimburomments sw oiwnI mw uw s * ae.m am.i Loa"e CugreaWm Lamno 55610 . .' _an _m _.m __ Sqml4bq Iriowtaaint. Sold00 a 0 votes _ _A.s .e..6e. _ r 96. U Laa.a ~~~wuwin~~ lam.. mm aaw.in a67 aa.q 1 MAW mum aenaw Ma. a mqui~ a.Lm4.a mm u.in ?. awe MWO. rnma aa.4ft -Uuq,aWien Cro.tdm trr.mt Liarvir S .m .i L.Pam w _ Sea..- FaWd Ots LAMMI0M * e..s~ Catii ,a.n ,re .m, _ , _ No94*i*o Va law aMiafi5 an dwrvl e *mm tm *iparbw @__~~~utfawfn f_laam eV e e* ** -'go i.-a a _ eW eZe__^" , -~~~~~~~~~~~~- - z* te2_ .e*2l.X,l_ rso ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~ ~ ~ ~ ~ ~~~~~~~~~~~~~~~~~~~~~~~~~~c -37- 002 Table 2.2 CHINI 6RNSU PROUNCIRL OCUELOfIIEHT RWECT THE IlOI!SIRIRL OIUERSIfICRTION CWONENT 6RNSU INUESTHENT RNO TRUST COORNY PROJECTED STATEMENT Of OPERRTIINS, 1987 1991 ............. ....................... .... ..... ... ... .. .... ASSIIMPTONS ...... ......... .................. ................................ ........... ............................ .. ... .... . . ................. .. ... INO Loan and other foreign currency loans ...... ......... .......... ......... ........ 30X of the US$ 20 nillion IND loan would be approved In the first year, 701 of the sae 190 lon wuld be approved in the seco,d yw. * Rsswue to obtain a US1 30 nillion foreign exchnge loan in 1989 501 of which to be approved in the first year (1989), 277 of which to be approved in the second year, 232 of uhich to be approved in the third year. - 702 of apprwovals would be disbursed in the first year. 301 of approvals would be disbursed in the second year, - 251 of the disbursed loans would be collected each in the 2nd, 3rd, 4th and 5th years of disbursenent. Local Currency Loans .. ........ . ... 1002 of approvals would be disbursed in the first year, 251 of the disbursed loans would be collected each in the 2nd, 3rd, 1th and 5th years of disbursenent. Equity Investments ..... ..... .. . . 1001 of equity investnent should be disbursed in the first year. No sale back of equity investments is projected, Exchange Rate I USa 3.7 Y REPID Opril 1987 -38- Table 2.3 CHI.. SANSII PROUIIICIIL KUELINT PIOJECI TC I[IIUSTIIIL OTUORSriCATIII CVOICNT 6Nu IKSTKNT U RIUSi CWIN ,............................... POWECTED STREllENI Of TlOERAoIS, 1907 - 19 (V'OO0) 1986 1967 1988 199 19% 1M9 ...... ................. .. .... .. .................................................................................. Approvals 1810 Loan 22,t00 51,800 USS (qUaulent ('000) (6,000) (14,000) Other roreign Currency Loans 0 0 5S,S00 29,600 25,90 UA (qivalent ('000) (15,000) (8,000) (7,000) Local Currency Lons 80,000 93,500 112,500 112,000 117,0 Equity lInestnts 0 1 ,;m 7,500 3,50 3,000 Total Loan Aprouuls 120,113 102.200 145,300 168,000 141,600 142,900 Oishursmients 18RO Loin 15,540 42,920 15,540 0 0 US$ Eqiualent ('000) (4,200) (11,600) (4.200) Other foreign Currency tans 0 0 38,850 37,370 27,010 US$
Groupe de la Banque mondiale · Staff Appraisal Report
China - Gansu Provincial Development Project : the Industrial Diversification Component
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Groupe de la Banque mondiale
Type de document
Staff Appraisal Report
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Chine
Source
Banque mondiale