China - Fourth Industrial Credit (Fourth China Investment Bank) Project

Document of The World- Bank FOR OFFICIAL USE ONLY Report No. 6412-CHA STAFF APPRAISAL REPORT CHINA FOURTH INDUSTRIAL CREDIT PROJECT (CHINA INVESTMENT BANK IV) January 29, 1987 IDF Division Projects Department East Asia and Pacific Regional Office This documnt 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 Dank mutborlzatior.  CURRENCY EQUIVALENTS (Currency Unit = Yuan Renminbi Y) 1981 1982 1983 1984 1985 1986 Y per $, year average 1.70 1.89 1.98 2.32 2.96 3.45 December 1985 Y 3.20 = $1.0 Y 1.00 = $0.31 December 1986 Y 3.69 = $1.0 Y 1.00 = $0.27 (In this report $ refers to US$) FISCAL YEAR January 1 to December 31 LIST OF ABBREVIATIONS AND ACRONYMS ABC - Agricultural Bank of China BOC - Bank of China CIB - China Investment Bank CITIC - China International Trust and Investment Corporation CNTIC - China National Technical Import Corporation DFC - Development Finance Company EDI - Economic Development Institute ICB - International Competitive Bidding ICBC - Industrial and Commercial Bank of China LIT - Limited International Tendering MOF - Ministry of Finance PBC - People's Bank of China (the Central Bank) PCBC - People's Construction Bank of China RCC - Rural Credit Cooperatives SEC - State Economic Commission SPC - State Planning Commission UNDP - United Nations Development Programme  FOR OMCIL USE ONLY CHINA FOURTH 1NDUSTRIAL CREDIT PROJECT (CIB IV) Table of Contents Page No. Loan/Credit and Project Summary .......................o.***.**..***00 iv I. THE INDUSTRIAL SECTOR ....................................... 1 A. Structure and Performance. .............. 0.00.00. 0000-0-.0- 1 B. Constraints on Performance and Growth.................... 3 C. Government Policies and Objectives ...................... 5 D. Bank Group Strategy for Industry ......................... 6 II. THE FINANCIAL SECTOR .............. ........................... A. Institutional Framework ..... 000000..0 ..0.0.000... .e000000 7 B. Interest Rates. 0000000000000 0000000.0.00...00...0..000.000 9 C. Investment Planning and Financing........................ 10 D. Foreign Exchange Landing for Investment.................. 11 III. THE PROPOSED PROJECT ................000000.... 12 A. Project Objectives and Components ........................ 12 B. CID's Institutional Aspects.............................** 13 C. CIB's Operational and Financial Position................. 19 IV. THE BANK LOAN AnD TDA CREDIT .............. ................ ... 23 A. Main Features of the Loan/Cred&t........................ 23 B. Procurement and Disbsursements.....* ......... .0 ..... ...*. 25 C. Reporting and Auditing Requirements ...................... 26 D. Benefits and Risks ..... .... **-0-0 .. ..... 26 V. AGREEMENTS AND RECOMMENDATIONS ..................... 27 This report is based on the findings of an appraisal mission, composed of Zafar Shah Khan (Mission Leader), Jayarajan Chanmugam, Edgar Su, and Victor Chang (consultant), which visited China in July 1986. 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.  - ii - Page No. ANNEXES CHART MAP IBRD-20187 China - Fourth Industrial Credit Project  - Mii - CHINA FOURTH INDUSTRIAL CREDIT PROJECT (CIB IV) Loan/Credit and Project Summary Borrower: People's Republic of China Beneficiary: China Investment Bank (CIB) Amount: $300.0 million equivalent, comprising $250.0 million equivalent IBRD and SDR 40.9 million ($50 million equivalent) IDA. Terms: Loan: 20 years, including 5 years grace; standard variable interest rate. Credit: Standard Relending Terms: The proceeds of the loan and credit would be onlent to CIB for 20-year term, including 5-year grace period at a fixed interest rate of 7.02 p.a.; CIB would pay commit- ment fees equal to those under the loan and credit. The government would bear the foreign exchange risk between the US dollar and (a) the currency pool for the Bank loan; and (b) the SDR for IDA credit. Subborrowers would pay a fixed interest rate of 8.52 p.a. and would bear the foreign exchange risk between the US dollar and the Yuan. Project Description: The project aims to assist in (a) upgrading productivity and efficiency of small- and medium-scale industries by importing modern technology, and (b) further institu- tional strengthening of CIB so that it can effectively perform as a model development finance institution and a catalyst in the ongoing reform of the investment design and selection system in China. The project would also enhance the capability of CIB to mobilize foreign currency resources from international capital market to provide financing for the industrial sector. It is estimated that about 175 state and collective enter- prises largely in the light industry sector would receive subloans for modernization and expansion. The project risks are minimal and mainly relate to CIB's continued and successful institution-building and its future development financing role. However, the commitment of CIB management to various measures agreed with the Bank and the close supervision by Bank staff would ensure satisfactory progress in this area.  - iv - Estimated Disbursementz Bank FY 1987 1988 1989 1990 1991 1992 ( l .llioiUY Annual 15.00 66.00 105.00 69.00 33.00 12.00 Cumulative 15.00 81.00 186.00 255.00 288.00 300.00  CHINA FOURTH INDWUSTRIAL CREDIT PROJECT (CIB Iv) I. THE INDUSTRIAL SECTOR A. Structure and Performance 1.01 China is one of the world's ten leading industrial preducers and the provideV of the largest full-time industrial employment. Its industrial sector - is the most important productive sector and source of development and represents over one thA;d of GDP. The sector comprises 437,200 enterprises, mostly small _' (99%), 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 74% 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, with a contribution of 7.5% to total industrial output. Gross industrial output value of Y875.9 billion ($296 billion equivalent) in 1985 was shared almost equally by light (47%) and heavy (53%) industry subsectors. Chinese industry produces nearly the full range of industrial products including machinery. Subsectoral structure is well balanced, with 12% of industrial output from food industries, 19% from textiles/clothing, 8% from chemicals, 18% from machine-building, 8% from metallurgy, and 11% from energy (Annex 1). 1.02 Manufacturing output per worker is low in China. It averaged Yll,O9O ($3,960) in 1984, which was only one fourth of the average for middle income countries and about 4% of that for industrialized economies. Perfor- mance in terms of overall labor productivity and profit rate varies signifi- cantly between state and collective enterprises on one hand, and between light and heavy industries on the other, as illustrated below (details in Annex 2): 1/ In Chinese statistics, industry comprises manufacturing, energy (coal, petroleum, power) and mining. It is divided between heavy industry (energy, mining, metallurgy, building materials and most chemical and engineering industries) and light industry t.extiles and clothing, food industries, light chemical and metal industries, and miscellaneous). 2/ In China, enterprises are classified as large, medium, or small but the size (defined in terms of plant capacity or value of fixed assets) varies from one industry to the other.  -2- Table 1.1s SELECTED PERFORMANCE INDICATORS OF CHINA INDUSTRY (1984) Output/ Capital/ Profit & tax Global produc- worker worker to capital tivity of factors (Y) --- (X) (1981 = 100) /b Average for Industry 11,090 9,620 23.9 n.a. of which: State enterprises 14,395 13,460 24.2 109.7-112.5 Collectives 6,570 4,060 22.3 n.a. of which$ 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% excl.ding coal industry which has a profit to capital ratio of 2.6%. /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 291 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 trends, 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. 1.03 Growth of industrial output has accelerated, from 8.71 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 energy) increased from Y38.04 billion ($22.3 billion) in 1981 to Y65.35 billion ($28.2 billion) in 1984. Light indufitry has received, on an average, 22% of total industrial investment, and has grown at an average rate of 9.4Z p.a. (in real terms) over 1981-84. In 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 fastest growth in machine-building (in particular power-generating machinery),  - 3 - consumer durables and construction materials. In 1985, light industry's growth was slightly faster than heavy industry. 1.04 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 av.d bank loans, have been more evenly distributed between light and heavy industries; industrial collective enterprises have represented on average 9% only of total manufacturing investments as indicated below (details in Annex 3): Table 1.2: MANUFACTURING INVESTMENTS 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. 1.05 Chinese industry has remained essentially inward-oriented, to meet the rapidly growing demand of the domestic market for consumer goods in particular. The export/output ratio averages about 4.7% for manufacturing. However, exports of manufactured products have grown rapidly in recent years and reached Y31.6 billion ($13.6 billion) in 1984 (+27%), with light indus- tries showing more rapid growth (+34%). Imports of manufactured products, which until 1983 were maintained below manufacturing exports, increased by 64% in 1984 to reach Y50.4 billion ($21.7 billion), mainly as a result of the big increase (4114%) in imports of machinery and transport equipment generated by the ongoing program of industrial modernization. B. Constraints on Performance and Growth 1.06 Notwithstanding its remarkable growth and product-coverage perfor- mance, the development of China's manufacturing sector has remained  -4- constrained by industry-spec;fic shorccomings 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. 1.07 About 80% of industrial fixed assets are of pre-1960 vintages,3/ 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 85Z of manufacturing production costs, equivalent to about 68X of gross output value; light industries with an input/output ratio of 70% have been more inefficient than heavy manufacturing (ratio of 65%). 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). 1.08 Chinese indtstrial 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 State Planning Commission (SPC) and the State Economic Commission (SEC) and their provincial bureaus. The primary instrument 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 infor- mation 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 sup- plies, raw materials, transport, qualified managers and engineers) constraIri production. Moreover, the overemphasis put on self-sufficiency at national and provincial levels during the past decades and the presence of administra- tive barriers to trade betveen regions have sacrificed the benefits of spe- cialized production and economies 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. 1.09 As many prices were set in tkhe 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 scar- cities. In general, consumer goods of light industries are priced relatively 3/ 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 Western world.  - 5 - 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 that 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, industry must remain a principal source of employment, and seek to expand exports in more competitive world markets to pay for imports of modern foreign technology and machinery. Also, the sector must respond to rising living standards and a more sophisticated consumers' demand through improved quality and variety of industrial produccs, as well as expanded production volume. The trantition 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) iaidustry and of manufactured exports; and (c) energy and materials conservation, particularly in heavy industry. The adjustment has been rather successful, particularly in shifting emphasis towards light industry (which helped reduce energy consumption) and in shifting investments from new capital construction towards modernization projects (paris. 1.03 and 1.05). These priorities have been reiterated in the general orientations for the Seventh Plan for 1986-90.  -6- 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 deLiSions have been taken: (a) state enterprises will be made independent units pursuing profits and responsible for losses. This is a difficult task and will require, intee alia, clearer separation of economic activities from administrative functions and of enterprises from line agencies. Already, greater freedom has been given to collective enterprisee, which have been the most dynamic segment of the sector in 1984 and 1985 (para. 1.03); (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. 2.09); (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 han 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 wi'l 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. D. Bank Group Strategy for Industry 1.14 The Bank Group's primary objectives in its economic and lending work for industry in China, based on China's needs and the Bank Group's abilities, have beeu to assist the Government 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.  - 7 - The Bank Group has used various forms and channels for assistance to Chinese industry. It is the executing agencv for UNDP technical assistance projects and has financed two technical cooperation credits, and has, thus, encouraged the use of technical assistance, particularly for project preparation. EDI's large training program in China (in the period 1980-85, about 1,500 Chinese officials attended 35 EDI courses) and the p*st lending program have helped in improving investment efficiency in China by demonstrating how the Bank Group's appraisal methodology can be applied to improve project selection and effi- ciency of project design and by strengthening institutions' project prepa- ration and appraisal capacities. 1.15 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 'Y85. Other industrial projects under consideration would support the modernization of the machine tool subsector in Shanghai, and aasist in upgrading technology in cement produc- tion. DFC-type lending has been an effective means of assisting the moderni- zation of small- and medium-scale industries based on a methodical project appraisal. The Bank Group has assisted in the establishment and institutional strengthening of the China Investment Bank (CIB), a DFC, and has provided three industrial credits (para 3.05) for the above purpose. The utilization of these credits is generally satisfactory (paras. 3.23 and 3.24) and CIB has made considerable progress sLsLce its foundation (paras. 3.02, 3.22, 3.26 and 3.27). The proposed fourth industrial credit to CIB (CIB IV) would pursue the same objective. Another project is being developed to support the development of rural light industries in Gansu. one of the poorer provinces of China. This assistance would be provited through the provincial investment and trust company. In future, the Bank Group plans to gradually diversify its assistance by increasing subsectoral focus and supporting additional financial intermediaries. 1.16 The Bank Group 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 will be discussed shortly with the Government. A study of foreign trade, including industrial exports, is underway. In addition, the Bank Group and the Government have agreed to a study of the engineering industry in FY87. 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 IMF. II. THE FINANCIAL SECTOR A. Institutional Framework 2.01 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  x 8 - 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 dealings and the use of foreign exchange, and chairing the Council of the People's Bank of China, an advisory and coordina- ting body consisting of the leaders of all banks and other financial insti- tutions. 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. 2.02 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 banl 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 nQtwork 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 Construction Bank of China (PCBC), under the aegis of the Ministry of Finance, is the nation's investment bank specialized in financing 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 provides foreign exchange and local currency long-term loans essentially to technical transformation projects in urban light industries. While different banks are specialized in terms of activities and clientele, thkere 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. 2.03 Other smaller or secondary financial institutions include most pro- minently the People's Insurance Company of China (PICC); and the China Inter- national Trust and Investment Corporation (CITIC), which provides capital and "middleman" services to joint ventures. Analogues of CITIC exist 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. Most recently, many urban collective credit cooperatives have appeared, financed by small groups of people pooling capital.  -9- B. Interest Rates 2.04 Nearly all domestic interest rates in China are set by administra- tive decree, with some variation per'ditted within an allowed band. The pres- ent structure of interest rates for the main types of loans and deposits is presented in Annex 5. The changes made in 1985 are ttLe 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. 2.05 Foreign exchange loans in China carry many different interest rates, ranging !rom near zero to world market rates. These rates appear to be based largely ,n the cost of different sources of foreign capital. The Bank of China provides some loans at an interest rate that fluctuates with LIBOR. Its present six-monthly adjustable interest rate (effective October 1986) is 7.43% for 5-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. The China Investment Bank, which makes medium-term loans at fixed interest rates, had maintained a foreign exchange lending rate of 8% p.a. since its establishment but it was increased to 8.5% in 1986; this rate will also be applicable to CIB IV (paras. 4.01 and 4.02). Foreign capital from concessionary bi-lateral sources is generally passed on to Chinese project entities at the same interest rate that China pays to the foreign lender. 2.06 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 (7.9-10.8%). 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 Bank of China foreign exchange lending in 1984 consisted of loans at a subsidized rate of 2% p.a.; in Jiangsu Province, similar foreign exchange loans by the Bank of China (carrying a subsidized interest rate of 4% p.a.) were started in 1984 and are estimated at about 30% of total loan approvals in 1985. The Bank 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 (para. 1.16).  - 10 - C. Investment Planning and Financing 2.07 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 the State Planning Commission for capital construction projects, and the State Economic Commission 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 inclusion in the plan (annual or pluriannual, aggregate or regional), which essentially sets investment ceilings within which projects must vie for a position. 2.08 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. 2.09 There have been major changes in the financing structure of fixed investment izr China's state sector (Annex 6). The share of the budget appro- priations fell sharply from 66% in 1978 to 351 in 1984. Correspondingly, the share of self-financing by enterprises, local authorities, and other agencies rose from 32% in 1978 to 431 in 1984. Domestic-currency bank loans, negligi- ble in the late 1970s# have been financing an increasing share, reaching about 15% in recent years; foreign loans, also negligible in the late 1970st accoun- ted for 6-71 of the total in 1982-84. Enterprises' funds (retained profits and depreciation, and major funds) represented a major portion of self- financed investment, and local governments, and government agencies provided a smaller proportion (about 34%). Patterns of financing have been different between capital 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 invest- ment 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. 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 retained profits. The  - 11 - share of budget appropriations has been relatively low.41 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 considerable cushion above minimum needs. Furthermore, working capital loans cover whatever purchases an enterprise may mak1,i, including purchases of inferior goods which necessitate periodic write-offs of circulating assets. D. Foreign Exchange Lending for Investment 2.11 The Bank of China is the primary source of foreign exchange loans for Chinese enterprises. Its foreign exchange loan approvals were $3.25 bil- lion in 1984 and $3.36 billion in 1985; disbursements being $2.1 billion and $3.25 billion respectively in the two years. CIB's loan approvals were $66.2 million in 1984 and $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 sing government resources. 2.12 The complex structure of interest rates for foreign exchange loans in China has been discussed in paras. 2.05 and 2.06. Other unusual features of the foreign exchange lending system, which are directly relevant to CIB operations, include mainly the issue of loan repayment in foreign exchange and the foreign exchange retention system. Project entities borrowing from cer- tain 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 foreign exchange. This applies broadly to World Bank-financed projects in sectors like industry, transportation and energy, CIB 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 authori- zation. 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 proje_ts have greater difficulty in obtaining financing. Enterprises prefer to obtain foreign exchange loans that are exempt from the repayment requirement rather than to borrow from sources, such as CIB, which demand repayment in foreign exchange. 4/ 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.  - 12 - 2.13 Compartmentalization of China's foreign exchange allocation system is exacerbated by the foreign exchange retention system. In order to promote exports, local governments and to a lesser extent enterprises were permitted to retain a portion of their foreign exchange export earnings, to use prima- rily 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 Group's policy dialogue with the Government; the financial sector report and the study of foreign trade of China will offer a further opportunity to discuss them (para. 1.16). III. THE PROPOSED PROJECT A. Project Objectives and Components 3.01 The basic purpose of the proposed project is to assist the Govern- ment to promote and implement technology upgrading and modernization in indus- try, to build up sound institutions and procedures for project appraisal and investment financing, and to improve financial intermediation practices. The project would also further strengthen the role and influence of CIB in the decision-making process of concerned Government agencies and industrial enter- prises relating to industrial investments. More specifically, the project objectives would be to: (a) guide and assist CIB in its further institutional development and, thus, to enable it to efficiently carry out its operations and to effectively perform its role of a model development finance institution and catalyst in the ongoing reform of the investment design and selection system in China; and (b) continue financing high priority industrial investments through a general line of credit, and providing CIB with assistance and guid- ance in its project selection and appraisal work. 3.02 CIB has received so far three loans/credits from the Bank in an aggregate amount of $345.6 million equivalent. The last project (CIB III) approved by the Executive Directors in March 1986, was an interim operation to meet urgent short-term foreign exchange needs of CIB (para. 3.25). This fourth loan to CIB was planned in the context of discussions on a number of institutional changes and issues relating to long-term financial planning. CIB has now taken several measures for its institutional strengthening and improved financial planning including the reorganization of the head office in late 1985, resulting in the establishment of separate departments for economic, financial and market evaluation, technical appraisal, and supervision of projects; appointment of a new Vice President in January 1986  - 13 - to have overall responsibility for lending operations; appointment of a full time President in August 1986; filling of some of the managerial vacancies; increase in staff both at head office and branches; training of staff in financial institutions in other countries; preparation of a new financial management system; introduction of medium-term financial planning, etc. Additional measures being planned by CIB, in consultation with the Bank, for its further institutional strenghtening and improvement in financial planning are included in its operational plan (Annex 7) and described in paras. 3.06, 3.08, 3.16-3.21, and 3.30). During negotiations, appropriate assurances were obtained from CIB for the implementation of its operational plan. 3.03 The proposed project would comprise of a loan/credit of $300 million to be made to the People's Republic of China. State Council approval of the Development Credit Agreement and the Loan Agreement would be a condition of loan/credit effectiveness. The loan/credit would finance the foreign exchange costs of the following components: (a) Line of Credit - $299.3 million to CIB for onlending to small- and medium-sized projects mainly in the light industry; and (b) Technical Assistance - A technical assistance of $700,000 to support the implementation of a medium-term program of training abroad for CIB's staff (para. 3.21). 3.04 All subprojects will use the loan/credit proceeds to finance the cost of fixed assets, interest during constructioni on subloans and associated working capital and will meet the following eligibility criteria: (a) subprojects will pertain to the manufacturing subsectors; (b) subprojects in heavy industry will be only for modernization and energy/material saving; (c) the beneficiary enterprises will have a satisfactory projected financial situation; and (d) the subprojects will have a minimum FRR and ERR of 12%. Satisfactory assurances were obtained during negotiations on the above eligibility criteria. B. CIB's Institutional Aspects 3.05 Establishment. The Government, with advice and assistance from the Bank, established the China Investment Bank (CIB) in December 1981, primarily for financing small- and medium-sized projects for industrial modernization. It is administratively under the leadership and supervisory responsibility of MOF. Although there is no apparent parent-subsidiary relationship, CIB remains closely tied with PCBC at headquarters as well as at provincial branch levels for assignment of key personnel, administrative services, dealings with industrial enterprises, joint financing and access to the planning authorities and technical bureaus. A capital contribution of Y900 million ($243 million  - 14 - equivalent), representing 22.5X of its authorized share capital, has been paid in by the Government and the Bank/Association have made three loans/credits, 2226/1313-CHA for $70.6 million equivalent in FY82, 2434/1491-CHA for $175 million equivalent in FY84, and 2659/1663-CHA for $100 million equivalent in FY86. CIB has also obtained local currency loans from PCBC. 3.06 Organization. CIB's head office performs an administrative and supervisory role for its entire operations. It has six departments--Project Lending, Technical and Engineering, Supervision and Implementation, Finance and Accounting, Coordination and Planning, and the General Administration Office--each headed by a Manager or Deputy Manager (Chart 1). Provincial branch offices, which have direct responsibility for screening, appraisal and supervision of projects, have expanded from 3 in 1982 to 19 at present. Some branches have also established subbranches in the more active areas in a province. Each branch office carries out its business in accordance with the guidelines and policies set by the head office. The organizational structure of provincial branches follows broadly the same pattern as at the head office. In accordance with CIB's lending procedures approved by the Ministry of Finance in April 1983, the project proposals have to receive approval of CIB and enter its official pipeline before authority is granted by the provincial authorities for the detailed feasibility studies to be under- taken. The above approval is given by the head office after the review of preliminary evaluation of the enterprise and the project done by the branch office. Subsequently, full appraisal of the project is undertaken by the branch office. Appraisal reports on all projects are then submitted by the branch office to the head office for approval. The concerned staff and the advisers in the head office assist branches in project appraisal as necessary and also provide comments and advice on draft appraisal reports. After loan approval, branches undertake project supervision following established guidelines and submit periodical reports to the head office. The organization of CIB is generally satisfactory though there is a need to grant limited authority to branches, based on their individual capability, for decisions on individual subloans. The delegation of authority to branches for subloan approval is included in CIB's operational plan (para. 3.02). During negotiations, CIB confirmed that this authority normally would not be less than 50% of the free limit to be provided for various branches under CIB IV (para. 4.04). CIB also needs to establish a separate organizational unit at the head office for carrying out research and studies relating to the industrial sector which would have a direct bearing on CIB's operations (para. 3.19). 3.07 Board, Management and Staff. CIB's 33-member Board of Directors has remained structurally the same since 1983; it is chaired by the President of PCBC and is represented by concerned Government departments and banks. The Board meets once a year to review and decide on CIB's major policies, annual plan, financial and operational performance, and foreign borrowings. A Managing Committee consisting of the Board Chairman, the three Deputy Chairmen and eight Managing Directors meets from time to time to deal with all other major matters including loan approvals of Y10 million ($2.7 million equivalent) or more, foreign borrowings below $50 million and appointment of senior officials. Loans below Y10 million are approved by the President and borrowings of above $50 million are approved by the Board..  - 15 - 3.08 Until recently, day-to-day management of CIB head office was the responsibility of the two Vice Presidents who are also CIB Managing Directors; the second of these Vice Presidents was appointed in January 1986. They worked in close coordination under the general guidance of the President who was also a Vice President of PCBC. In August 1986, CIB appointed a full-time President as the chief executive officer (CEO). The two Vice Presidents continue to have the responsibility of supervising specific departments (Chart 1). Each branch office of CIB is headed by a President (also a Vice President of the local branch of PCBC) but in general the day-to-day management rests with a Vice President (exceptions are two branches where presidents are full time CEOs). For the future, while CIB should maintain close operational cooperation with PCBP, as it continues to develop, it should also become more and more administratively independent at the branch level by having full-time top management which focuses exclusively on CIB affairs. CIB's operational plan (para. 3.02) therefore, provides for the appointment of full time presidents at branches in future; this would be accomplished during 1987-88. 3.09 The total number of staff at the head oifice has increased from 33 in 1984 to 66 in mid-1986. Similarly, the staff at the branches has also increased from 84 to 490 during the period. The staff includes 77 engineers and 266 economists/financial analysts, who are directly involved in project appraisal and supervision work. Middle level managers and professional staff generally lack advanced financial skills and experience and thus need intensive training (para. 3.21). 3.10 Activities. CIB's policy statement allows it to mobilize medium- and long-term foreign currency resources, to provide investment loans, to develop consulting services, and to undertake other financial operations (i.e. equity investments, guarantees, loan syndications, etc.) So far CIB's main activity has been to borrow in foreign exchange from the Bank Group and to onlend, together with its local currency funds, to industrial projects. It has recently borrowed from the international capital market and would be increasing its reliance on this source (paras. 3.25 and 3.30). CIB's unique role in China is the evaluation of projects' viability following well founded methodology, including economic cost-benefit analysis. Consequently, its gradual upstream involvement in project preparation has begun to contribute to modifications in project design and scope resulting in optimal utilization of investments or dropping of economically non-viable projects at an early stage of preparation, thus saving related costs. Similarly, CIB's increasing participation in investment deliberations at the provincial level has started to make an impact on the decisions with wider implications. Although the above developmental role of CIB is still very limited, it is expected that with further development of middle management and professional staff, CIB would be able to have a much greater impact on this important area of industrial planning and investment at sectoral, regional, and project levels. 3.11 Policies. CIB's major operational and financial policies are outlined in its Policy Statement (Annex 8), and specific areas of emphasis for the 1986-1988 period are given in its Development Strategy Statement (Annex 9). The two statements are considered satisfactory and any changes therein, in future, would be after prior consultation with the Bank. CIB will  - 16 - continue to focus on small- and medium-sized projects aimed at expansion, modernization and technical transformation of existing enterprises, particu- larly in the light industry sector. Its total foreign currency lending to any one project would not exceed $15 million, and total local currency lending would not exceed Y30 million ($8.1 million equivalent). For larger projects, CIB would seek cofinancing with other lending institutions in China or abroad. CIB lends local currency only in conjunction with foreign exchange, and only for fixed investment. 3.12 Project Appraisal. CIB's project appraisal is undertaken in accord- ance with the Industrial Projects Appraisal Manual whizh was prepared in 1983 with Bank assistance and revised in 1985 mainly to reflect the lessons learnt in the meantime. The Manual, which has been widely distributed to agencies outside CIB, is comprehensive and provides detailed guidelines for the evalua- tion of projects. While considerable progress has been achieved by CIB in the short time since its inception in evaluating and appraising investment projects, the quality of appraisal reports continues to be uneven. The weaknesses are in three main areas. First, there has been a tendency, particularly by new staff and newer branches, to apply the appraisal manual guidelines and carry out the appraisal in a mechanical fashion, rather than in a thoughtful and reflective manner. Judgment still needs to be exercised in identifying the important issues relative to the subsector, the enterprise and the project, and then focusing attention on them. Second, in those instances where directives from the central authorities have dictated the proposed sizes for projects and markets to be served, appraisal reports have often provided little or no background as to the rationale for the project design. In such cases, a substantial amount of investigation and studies have been undertaken by the central authorities and provide a basis for their decisions; neverthe- less, CIB has been reluctant to discuss in its appraisal reports the matter beyond a perfunctory reference. Third, although detailed financial and economic benefit analyses are provided in CIB's appraisal reports along the lines prescribed in the appraisal manual, more effort is still needed in eval- uating the projects' strengths and critical features, and their risks and effects on the enterprises and on the economy in all cases. Moreover, financial analysis in project appraisal has in general focused on the project itself, and the financial situation of the sponsoring enterprise as a whole is often dealt with inadequately. The above weaknesses in the quality of appraisal reports reflect not only the inexperience of staff and the rapid growth of branch offices but also inadequate supervision by some of the branch managers and insufficient exercise of quality control by the head office. CIB management is aware of these deficiencies and is taking measures for their alleviation (paras. 3.15 to 3.21). 3.13 Supervision. CIB issued in 1983 a comprehensive and satisfactory Project Supervision Manual for its staff. The Manual covers the full cycle from loan agreement to project completion report. Supervision work is the responsibility of branches and their staff makes frequent visits to projects to assess the progress on their implementation and to review their performance and operating results after completion. The Supervision and Implementation Department at the head office monitors the supervision work of branches and its staff also visits selected subprojects.  - 17 - 3.14 Procurement and Disbursement. In keeping with national policy, all procurement financed by CIB can only be undertaken by one of the central or provincial agencies entrusted with procurement responsibility. CIB's proce- dures require a reasonable degree of competition, involving a comparison of at least three quotations from potential suppliers; most of the goods and equip- ment financed by CIB are procured in this manner. In a few projects involving relatively straightforward expansion, the specifications and technology of existing equipment have compelled the procurement of new equipment from the same supplier. Under Bank Group Credit Lines, CIB requires international competitive bidding for larger contracts (para. 4.07). Disbursements are authorized by CIB against submission of appropriate documentation and progress reports on project implementation and the procedures are satisfactory. 3.15 Institutional Strengthening. Since its establishment in 1981, CIB has made considerable progress in its institutional development. It has adopted effective lending procedures, modern project appraisal techniques and comprehensive project implementation and supervision guidelines. However, the large expansion of CIB's branch network and lending operations within a short period of time have worked against a balanced institutional growth and mainte- nance of consistent quality standards in operations. CIB has to alleviate these problems through further institutional development. It has already taken several measures in this regard (para. 3.02) and additional measures are described in paras. 3.16-3.21 below. 3.16 As a result of the reorganization of CIB in late 1985 and retirement of some of the senior managers, the positions of heads of Planning, Supervision and Technical Departments at CIB's head office are presently vacant. Although these departments are being managed by senior deputies, appointment of permanent heads is essential for an effective control and better guidance to staff. CIB's operational plan (para. 3.02) provides for the appointment of suitably qualified and experienced persons for the above vacancies in accordance with a satisfactory timetable. During negotiations, CIB confirmed that all appointments would be made by June 30, 1987. 3.17 Many of the newly recruited middle level managers and staff are recent university graduates for whom training is essential. As one of the measures to cope with this situation, CIB's head office has engaged two part- time senior advisors, a senior engineer and a professor of economics, to train staff, to comment on project proposals ara.d to review appraisal reports submit- ted by branch offices. The senior engineer:. participation in training programs and advice to the Technical Department's engineers, and through them to the branches, have been most valuable snd effective. In future, as indicated in the operational plan (para. 3.02), CIB would have him review (a) all projects with above $2 million subloans and (b) any project which is in respect of a sector or technology in which CIB has had limited experience. In the past, the advisor has reviewed normally projects with subloans of above $3 million. The senior economic adviser has not, unfortu- nately, been able to devote the time he was expected to spend with CIB due to his other professional comnitments. His two assistants, who spend one day per week at CIB, have made very limited contribution to upgrade the CIB staff capabilities in the evaluation of economic aspects of projects, particularly cost-benefit analysis. In order to improve the professional ability of the  - 18 - rapidly increasing staff of CIB in the important area of economic analysis and evaluation, the present arrangements need to be reconsidered. As the economic advisor would be out of the country for one year, he is being temporarily substituted by another advisor and based on his performance, CIB would consider possible new arrangements. The Bank staff would follow up on this matter during project supervision. 3.18 As CIB's financial operations increase in scope and complexity, it is essential that the functions and responsibilities of the head office's Finance and Accounting Department should be enhanced and strengthened to pro- vide prompt accounting and disbursement services, and efficient fund manage- ment. Also, the activities of the Coordination and Planning Department in resource planning and mobilization need to be integrated more closely with lending operations. CIB plans to of set up a more appropriate financial management information system. A draft of the proposed system has been already prepared by CIB staff. It covers detailed procedures and guidelines for the preparation and consolidation of various periodical plans and reports at the head office and branches concerning resource mobilization, loan approvals, commitments and disbursements, income and expenditure, and loan recoveries. Bank staff has reviewed the proposed system and provided comments and suggestions to CIB for incorporation in the final version. Additional experienced staff are considered necessary to ensure that the financial information system can become fully operational as soon as possible. CIB has already appointed five additional staff for this purpose and has confirmed during negotiations that it will appoint one more well experienced staff for the financial information system and a full time internal auditor by June 30, 1987. The adoption of a financial management information system acceptable to the Bank would be a condition of loan effectiveness. 3.19 CIB had a Survey and Research Department which was mainly respon- sible for sectoral surveys, compilation of economic data and statistics and market analysis of projects. As the department was not fully integratred in normal operations, it was abolished in 1985 and its staff were merged in the Projects Department. Given the im13rtant role that a Survey and Research Departmewat plays in a development bank, a better alternative would have been to maintain its identity, to improve the professional capability of its staff, and to assign it a more prominent and active role. CIB has now agreed, as indicated in its operational plan, to establish a separate unit for economic and research work with a clearly defined role and adequate staff. CIB confirmed during negotiations that the necessary staff would be appointed by June 30, 1987. 3.20 In order to cope with the growing level of operations, CIB plans to increase its staff at the head office by 32 in 1987 and 1988 each to a total of 130. The staff at the branch offices is also planned to be increased by 132 in 1987 and by 148 in 1988 reaching to a total of 770. This staff size should be adequate to support CIB's projected operations. The increase in staff is included in CIB's operational plan (para. 3.02). 3.21 From the start of its operations, CIB has been conscious of the vital importance of training, in view of the new approaches being introduced in China for industrial project appraisal and supervision, and the lack of  - 19 - this kind of experience among CIB and PCBC staff. A start was made under the auspices of the Bank in 1982 with study tours to DFCs in Pakistan and the Philippines and several development banking courses given by the Bank's Eco- nomic Development Institute (EDI). Furthermore, CIB has been organizing in- house seminars and providing on-the-job training to new staff. In 1985 alone, 237 staff (including middle level managers) attended training seminars mostly on project appraisal; other topics included accounting principles and foreign resource mobilization. In addition, 12 staff went to the US (EDI coulse for development banking trainers), Japan (international finance) and India (resource mobilization). CIB needs to send more if its experienced staff for foreign training to deepen their expertise and upgrade its operations by observing comparable institutions. Besides, one or two years' advanced academic and practical training abroad for a few staff members (engineers, economists/financial analysts) would be of immense benefit to the whole organization, and, in addition, would provide a unique incentive to profes- sional staff. A program for training abroad in academic or operational institutions has been prepared by CIB for suitable candidates from the head office and branches; special training in English has been or is being arranged for selected staff. During 1986-90, the program foresees sending 38 staff for practical training for up to six months at selected foreign institutions including development banks and commercial banks, and 30 staff for advanced academic training ranging from six months to two years. The total foreign exchange cost of the training program, including a contingency provision of $120,000, is estimated at $1.0 million (Annex 7, para. 6). CIB will finance the training program by using $300,000 provided under CIB I for this purpose and the balance out of the technical assistance of $700,000 provided in the proposed project. The content and timetable of the training program is included in the operational plan of CIB (para. 3.02). C. CIB's Operations and Financial Position 3.22 Overall. CIB commenced its operations in 1983 and in the first two years (1983 and 1984) it approved a total of $116 million in foreign exchange loans and Y304.2 million in local currency loans (Annex 10). CIB's activity increased sharply in 1985, with total approvals of $215.3 million in foreign exchange and Y334 million in local currency. However, total approvals decreased to $95.5 million and Y109.6 million respectively in the first half of 1986 due to resource constraint (para. 3.25). The projeg s financed by CIB cover a wide range of manufacturing sectors; light industry- was the predominant subsector with a share of 30% in amount, followed by textiles (28%), consumer electronics (9X), chemicals (6%), services (5%), machinery (4%), metallurgical (3%) food processing (3%), and others (12%) (Annex 11, Table 1). Of the provincial branches, the Jiangsu branch has been the most active, with an overall share of 24% of total commitments, followed by Tianjin (14%), Hebei (11%), Henan (8X), Lioaning (7%), Shanghai (7%) and Hubei (6%), (Annex 11, Table 2). 5/ It includes leather products, footwear, wood products, pulp and paper, and light engineering goods.  - 20 - 3.23 Utilization of Earlier Loans/Credits. As of June 30, 1986, approvals under CIB I and CIB II totaled $238.7 million for 209 subprojects, of which 131 were subprojects below the free limit established for each CIB branch (Annex 12). The subprojects from the well-established branches and industrial centers such as Tianjin, Shanghai, Beijing and Jiangsu have been significantly larger than in other provinces (Annex 13). The average size of all the Bank-financed subloans is $1.2 million. The subloans are for 3-10 years, including grace periods from 1 to 3 years. Most subborrowers are state enterprises, with a few urban collectives. The projected economic rates of return range from a ninimum of 12% to 45% and the financial rates of eeturn from 13% to 35%. Subprojects have not contributed to significant employment creation, because of their focus on more advanced technology, increased compe- titiveness of the products in the international market, energy conservation and pollution reduction, while utilizing the existing labor fogce. CIB III became effective on July 3, 1986 (para. 3.25) and commitments - and disburse- ments amounted to $28.7 million (for 40 subprojects) and $7.4 million respectively as of September 30, 1986. 3.24 Subproject Implementation and Disbursements. Implementation of subprojects under CIB I has been slower than estimated at the time of appraisal. Procurement contracts were signed many months after Bank approvals (an average of nine months for some earlier approved subprojects), due primarily to long technical discussions and negotiations with foreign suppliers. Foreign exchange for study tours abroad for technical investiga- tions with potential equipment suppliers could be secured only after Bank approvals (unless financed by other sources), which delayed decisions on procurement and therefore final design. Detailed engineering work was also not initiated until after Bank approval. Civil works were often delayed due to shortages and problems in allocations of building materials and civil works designs and the bill of quantities were not finalized until the specifications of the equipment to be imported had been received by the enterprise. As a result, the first disbursements on the subprojects approved in 1983 were made on average 14 months after Bank approvals and full disbursements required another 16 months. Thus, even though CIB I was fully committed as scheduled in March 1985, disbursements have been lagging behind, and amounted to 69% of the credit/loan amount as of June 30, 1986. They are now projected to accelerate and complete before the end of 1987, the closing date of CIB I. The Bank drew CIB's attention to and helped to identify the causes of the slow pace of disbursement. As a result, the implementation of subprojects under CIB II is faster. As of June 30, 1986, commitments and disbursements accounted for about 97Z and 45% respectively of credit/loan amount. CIB now insists that its borrowers obtain special loans for project preparation or utilize other sources of foreign exchange to go abroad for technical investi- gation and to complete as much of the engineering wortn as possible before subprojects are submitted to the Bank for approval. Nonetheless, the procedures in China require that detailed designs be undertaken only after the full foreign currency resources are secured, and efforts are being made by CIB with the concerned authorities to minimize the procedural dela7s. 6/ This represents the total amount of subloans approved b1y IDA/Bank.  - 21 - 3.25 Roaurce Position. As of the end of 1985, CIB had received share capital of "0r million from the Government, of which Y28 million was con- verted into foreign exchange ($10 million), and borrowed Y420 million from PCBC, whichl,6as'been fully converted into foreign exchange ($150 million). In addi'tion, jhu Ciovernment has onlent to CIB $245 million received from IBRD/IDA under CIB ' ond'Cia II. Since CIB has been using the direct reimbursement method in disbursing Bank funds, it had to maintain a sizeable amount of foreign exc4ange funds as working capital. Therefore, most of its foreign exchange res>irces obtained within China have been used for that purpose and the balance used for financing its normal lending operations remained small. Dv4 to sharp iUcrease in loan demand in 1985, CIB II was virtually fully committed by mid-1985. At the same time, CIB's local currency resources were exhausted. As a result, CIB's operations in the second half of 1985 were cirtgiled considerably. By the end of 1985, CIB's foreign exchange commitment had exceeded {ts toreign exchange resources by $29 million and its local currency commitments had exceeded its local currency resources by Y219 million (Atuiev-14)* The',Bank was aware of the acceleration and had included a larger loankredit for lending in FY86. However, a number of institutional changes and issues relating to CIB's longer term financing plans were still under disc,4ssion. In order to avoid disruption of CIB's operations and to allow suff4c,ent time to have the changes made and issues satisfactorily resolved, the Bank Group, at the request of the Government, approved in March 1986 a 6lidging loan (CIB III) of $100 million ($75 million from IBRD and SDR 22.8 mi-I$ion, equivalent to, $25 million, from IDA). The Government also agreed to ^iake additional local currency funds available to CIB. The Sank has been ? 'ncouraging CIB to divirsify its foreign exchange resources and during the 'Iain negotiations f