Philippines - Industrial Investment Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 7823-PH STAFF APPRAISAL REPORT PHILIPPINES INDUSTRIAL INVESTMENT CREDIT PROJECT SEPTEMBER 5, 1989 Industry and Energy Operations Division Country Department II Asia Regional Office 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 EQUIVALENTS (as of November 30, 1988) Currency Unit - Peso (F) US$1.00 - P 21.4 P 1.00 - US$ 0.0467 ACRONYMS ADB - Asian Development Bank AJDF - ASEAN Japan Development Fund APT - Asset Privatization Trust BOI - Board of Investment CBP - Central Bank of the Philippines CALF - Comprehensive Agricultural Loan Fund DBP - Development Bank of the Philippines DOF - Department of Finance DTI - Department of Trade and Industry ERL - Economic Recovery Loan FSAL - Financial Sector Adjustment Loan FSS - Financial Sector Study FX - Foreign Exchange GATT - General Agreement on Tariffs and Trade GDP - Gross Domestic Product GFIs - Government Financial Institutions GNP - Gross National Product GSIS - Government Service Insurance System IACC - Inter Agency Coordinating Committee IDP - Institutional Development Plan IGLF - Industrial Guarantee and Loan Fund IMF - International Monetary Fund OPG - Operating Policy Guidelines PFI - Participating Financial Institutions PNB - Philippine National Bank QRs - Quantitative Import Restrictions SEC - Securities and Exchange Commission SME - Small and Medium Enterprises SSS - Social Security System TA - Technical Assistance Fiscal Year DBP: January 1 to December 31  PHILIPPINES INDUSTRIAL INVESTMENT CREDIT PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. Loan and Project Sumnmary .......................................... i I. THE INDUSTRIAL SECTOR ............................................ 1 A. The Economic Setting ................................1........l B. The Policy Framework ......................................... 2 C. Structure and Performance .................................... 3 D. Selected Subsectoral Issues .................................. 5 II. THE FINANCIAL SECTOR ............................................ 6 A. Introduction ................................................. 6 B. Evolution and Structure ...................................... 7 C. Major Financial Sector Policies .............................. 9 D. Financial Sector Reforms ..................................... 10 E. Institutional Arrangements for Providing Long-Term Credit .......................................... 11 F. Industrial Credit ............................................ 13 G. Bank Strategy in the Sector .................................. 15 III.THE BORROWER AND PARTICIPATING FINANCIAL INSTITUTIONS ........... 16 A. The Development Bank of the Philippines ...................... 16 Introduction ............................................. 16 Historical Perspective: 1958-1986 ........................ 17 DBP's Rehabilitation: 1986-1988 ......................... 17 DBP's New Role and Strategic Orientation ................. 19 Organization and Management .............................. 20 Personnel Policy and Training ............................ 21 Accounting and Management Information System ............. 21 Loan Activities and Asset Management ..................... 22 Liability Management ..................................... 23 Projected Financial Position and Performance ............. 24 Audit ........................... .......................... 25 B. The Participating Financial Institutions ..................... 25 This report is based on the findings of an appraisal mission consisting of Messrs. Vinod Busjeet (Task Manager), Christian Duvigneau and Joachim Iska (AS2IE), which visited the Philippines in February/March 1989, 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.  IV. THE PROPOSED LOAN ............................................... 26 A. Project Objectives ........................................... 26 B. Project Description .......................................... 26 C. Loan Amount .................................................. 27 D. Project Implementation ....................................... 28 E. Relending Mechanism, Terms and Conditions .................... 29 F. Disbursements ................................................ 34 G. Procurement .................................................. 35 H. Monitoring, Reporting and Auditing ........................... 35 I. Justification and Risks ...................................... 36 V. AGREEMENTS, UNDERSTANDINGS AND RECOMMENDATION .................... 36 A. Agreements and Understandings ................................ 36 B. Conditions of Effectiveness .................................. 37 C. Recommendation ............................................... 37 Annexes 1.01 Average Nominal Tariff Rates, 1982-88 1.02 Financial Performance of Manufacturing Corporations 1979-87 1.03 Subsectoral Issues 2.01 Total Assets of the Financial System, 1980-88 2.02 Outstanding Credit to Manufacturing, 1980-88 3.01 DBP - Financial Statements, 1984-88 3.02 DBP - Financial Projections 1988-94 3.03 DBP - Organization Chart 3.04 DBP - Policy Statement 3.05 Participating Financial Institutions 4.01 Supervision Plan 5.01 Documents in the Project File  - i - PHILIPPINES INDUSTRIAL INVESTMENT CREDIT PROJECT Loan and Project Summary Borrower: Development Bank of the Philippines (DBP) Guarantor: Republic of the Philippines Beneficiaries: Accredited participating financial institutions (PFIs) and private sector medium and large enterprises. Amount: US$65.0 million equivalent Terms: Repayable over 20 years, including five years of grace, at the standard variable interest rate. Relending Terms: DBP would relend the proceeds of the Bank loan to accredited PFIs in domestic currency at market rates. Maturities would conform to the maturity of subloans made by the PFIs to subborrowers, but would not exceed 13 years for equipment subloans and leasing. 7 years for working capital subloans, and 10 years for the financing of equity and quasi-equity investments. The grace period would not exceed 3 years for equipment and working capital subloans and 5 years for the financing of equity investments. Lease financing would have no grace period. The PFIs would on-lend the funds to their subborrowers at prevailing market interest rates. The Government would bear the foreign exchange risk in exchange for a market-related fee payable by DBP. Co-financier: The Japan Grant Facility will provide grant funds of US$3.5 million equivalent to finance industrial subsector restructuring studies.  - ii - Proiect Objectives: The proposed project aims to: fill the gap in the supply of term credit to medium and large industrial enterprises; improve credit delivery for industry by assisting DBP carry out its wholesale banking function of channeling term funds to retail financial institutions; broaden the financial services available to enterprises; help promote development of the capital market by introducing the financing of equity and quasi- equity investments by PFIs; support and develop, within DBP and the Department of Trade and Industry (DTI), capabilities to conduct analytical and policy-oriented studies on industrial subsectors; and assist the Government in identifying, in selected subsectors, the appropriate policy and institutional framework which could lead them to become internationally competitive and efficient. Project Description: The project would have the following components: (a) a line of credit for (i) equipment and working capital financing; (ii) lease financing; (iii) financing of equity and quasi-equity investments; and (b) studies, training, and technical assistance related to subsectoral industrial restructuring. Benefits: The project would (a) provide timely assistance to industrial development in the Philippines; (b) enable DBP to develop the institutional capabilities to embark on the wholesale banking role envisaged for it in the Financial Sertor Adjustment Program supported by the Bank and (c) through provision of technical assistance, help the Government in charting reforms that may be necessary for the efficient and competitive development of enterprises in specific subsectors. Risks: The major risk is that investment demand may not materialize as projected. Commitments could slow down because of slower than expected economic growth or reluctance by financial intermediaries to accept new financial instruments that would be introduced under the proposed project. Leasing is a relatively new industry in the Philippines. Moreover, the local market for equity is small and owners of privately held companies may remain reluctant to allow PFIs to hold shares in their companies, even for a limited period. Consequently, the loan size has been set in light of conservative demand projections, and the amounts allocated for lease contracts, equity and quasi-equity instruments are relatively small.  - iii - Estimated Costs: Local Foreign Total ------(US$ million)---- Credit Component 45.0 65.0 110.0 Studies,Training and Technical Assistance 1.0 3.5 4.5 Total 46.0 68.5 114.5 Financing Plan: Local Foreign Total ------(USS million)---- Subborrowers 30.0 - 30.0 PFIs 15.0 - 15.0 DBP/DTI (Technical Assistance 1.0 - 1.0 Beneficiaries) Japan Grant Facility - 3.5 3.5 IBRD - 65.0 65.0 Total 46.0 68.5 114.5 Estimated Disbursements: Bank Fiscal Year 1990 1991 1992 1993 1994 1995 Annual 2.6 15.6 22.1 14.3 7.8 2.6 Cumulative 2.6 18.2 40.3 54.6 62.4 65.0 Rate of Return: Not Applicable  PHILIPPINES STAFF APPRAISAL REPORT INDUSTRIAL INVESTMENT CREDIT PROJECT I. THE INDUSTRIAL SECTOR A. The Economic Setting 1.1 Recent Bank economic reportsl indicate that while economic growth in the Philippines was rapid during the 19709, distortions in the pattern of incentives resulted in inefficient investments, slow employment growth and low levels of domestic savings. Heavily dependent on imports and foreign capital, the economy did not adjust well to the severe exter- nal shocks of the post-1979 period with its high oil prices and interest rates, and declining export prices. The economy experienced declining growth rates, a deteriorating balance of payments, and the accumulation of a large external debt. A political crisis in 1983, combined with a world- wide debt crisis, led to a cessation of foreign credits, and forced the Government to embark on a major stabilization effort. The stabilization measures were supported by International M4onetary Fund (IMF) Standby Arrangements of December 1984 and October 1986. Overall, the objectives of the stabilization programs have been met or surpassed. Inflation has been brought under control, with the consumer price index registering an increase of 8.8Z in 1988 and 3.8% in 1987, compared to 50X in 1984 and 23% in 1985. The current accottnt swung from a deficit of 4.82 of GNP in 1984 to a surplus equal to 3.OZ of GNP in 1986, and showed only slight deficits in 1987 (1.3Z) and 1988 (1.0X). GDP growth was positive in 1986 after two years of decline and showed an impressive acceleration to 4.7% in 1987 and 6.6% in 1988. 1.2 The remarkable recovery of the Philippine economy has been largely led by the industrial sector which grew at 7.72 in 1987 and 8.9Z in 1988. Contributing 33% of GDP and 42Z of total merchandise exports and accounting for 152 of total employment in 1988, the industrial sector, which is mostly private, has benefitted from the comprehensive structural reforms introduced by the Government which aimed at increasing economic efficiency by stimulating private sector initiative and activity. Among the important reforms implemented since February 1986 are a significant devaluation of the Peso, a major tax reform, the removal or reduction of a host of import controls and import duties, a re-orientation of the public investment program to focus on essential infrastructure improvements, the restructuring of the two largest government financial institutions and the commencement of a privatization program. Since, despite the recent economic growth, GDP in 1988 was barely ahead of the pre-recession (1983) level and gross value added in manufacturing of P25.2 billion (expressed 1/ Philippines: An ABenda for Adjustment and Growth (Report No. 5268-PH, November 30, 1984); Philippines: A Framework for Economic Recovery (Report No. 6530-PH, November 5, 1986); Philippines: Toward Sustaining the Economic Recovery (Report No. 7438-PH, January 30, 1989).  - 2 - in 1972 prices) only slightly surpassed the pre-recession peak, there is substantial scope for expansion of the industrial sector. With the present policy framework being characterized by a substantial reduction of past distortions, the industrial sector is poised for growth. Term credit to finance the investment requirements of industry will consequently be required. B. The Policy Framework 1.3 Industrial policy in the Philippines from 1950 to 1980 can be divided into three distinct periods: a first phase of import substituting industrialization in the 1950s under rising protective barriers; a major shift towards a more open and liberal trade regime in the early 1960s which, however, was not sustained; and a reversal to more interventionist policies beginning in the late 1960s with increasing recourse to protec- tive barriers, large public-sector-led or-supported investments and generous incentives administered by the Board of Investment (BOI). The result was an incentive environment that led to suboptimal investments and an inefficient industry that was largely inward oriented and internation- ally uncompetitive. 1.4 In the eighties, momentum for reform was prov'ded by the onset of the second oil price shock, the world economic recession, the surge in interest rates and the weakening in primary commodity prices. The Govern- ment accordingly initiated a broad range of structural reforms with the support of two Bank-financed Structural Adjustment Loans (Loan Nos. 1903- PH, 1980; 2266-PH, 1983). Among the policy initiatives taken were: (a) a major trade liberalization program arnd (b) reform of BOI incentives. The trade reforms, which aimed at correcting in a comprehensive manner the adverse incentive effects of the trade regime by reducing the level and variability of protection, included actions in all key areas affecting the protection regime: tariff reform, phasing out of import restrictions, removal of the protective elements of the indirect tax system, and cur- tailment of exemptions to import-substituting industries. As for BOI incentives, they were rationalized in the Omnibus Investment Code which corrected two major weaknesses of past incentives: (a) the favoring of import substituting industries over exports and (b) the favoring of capital-intensive over labor-intensive technologies. 1.5 A cornerstone of the trade policy reform was the significant narrowing of the band of import tariffs: from a OX - lOOZ band before 1980 to I0Z-502 by 1985. This led to a major reduction in average nominal and effective protection rates and their variability. This reduction was initially accompanied by a relaxation of import restrictions, but as a response to severe balance of payment pressures in 1983 and 1984, the number of regulated import items increased again between 1983 and 1985. Since the end of 1985, however, 1,292 import restrictions have been liberalized including those on iron and steel, yarn and thread, tires, plastics and other important industrial inputs, and some consumer goods, including garments and textiles. While average nominal tariff protection has not changed in recent years (Annex 1.01), liberalization of import restrictions has been the focus of trade reform.  - 3 - 1.6 The trade liberalization has had a major impact on the structure of industrial protection, by significantly reducing the pro-import- substitution bias. In the absence of full trade liberalization even today, an effective system of export incentives and promotional measures in accordance with the General Agreement on Tariffs and Trade (GATT) is also necessary to counteract the anti-export bias of the past trade regime. Given the nascent stage of export development, it is important that small and new exporters, as well as indirect exporters, are covered by the export promotion system: to be able to obtain imported inputs efficiently and at world market prices, and to have access to working capital financing. Consequently, in addition to trade liberalization measures, the Government has been pursuing an export promotion policy, using duty drawback exemption schemes to ensure free access to inter- mediate imported inputs for exporters, and supporting exporters through an export finance facility. 1.7 As a result of cumulative policy adjustments since 1980, the Philippine economy is now more open and transparent in its regulatory and incentive structure than at any time since 1950. The average nominal tariff in the Philippines is now comparable to that of other countries that have also liberalized in recent years and effective protection may be even lower in some areas. 1.8 The Government remains committed to a policy of trade liberali- zation. A schedule for liberalization of products that remain under trade control has been provided by the Government as part of a program assoc- iated with an Extended Fund Facility approved by the IMF in May 1989. Some 104 items are scheduled to be liberalized in 1989 and 455 items will be reviewed for liberalization in the future. This will leave 114 items under continued import control, mostly for health and security reasons. 1.9 While it is important to maintain the momentum of trade reform, the industrial sector will need financial support to take advantage of the trade liberalization and incentive reforms already undertaken. Moreover, future trade reforms should be carried out in the context of subsector specific strategies that consider the entire impact of tariff, price and other government policies on each industry's costs of production and the level of effective protection. Many firms in protected industries will need time to restructure so as to be competitive at world prices. These subsectoral issues, which will be addressed through the technical assis- tance (TA) component of the proposed Industrial Investment Credit Project, are discussed in more detail in paras. 1.14 to 1.18 and in Annex 1.03. C. Structure and Performance 1.10 As a result of the policies pursued at the time, the structure of the industrial base created in the 1970s was brittle and largely uncompetitive. Non-traditional manufacturing export growth was narrowly concentrated in product mix (semi-conductors and garments) and destination (the United States). The remainder of industry, accounting for the bulk of value added, was highly dependent on domestic demand which, however,  -4- was artificially inflated by heavy foreign borrowings and infusions of subsidized credit and government transfers. The momentum given to industrial growth by these measures began to taper off in the late 1970s, when the scope for expancion of import substitution under heavy protection was exhausted, and technological weaknesses and other inefficiencies fostered by the lack of competition began to take their toll. Moreover, t-he financing requirements of high domestic demand could not be sustained indefinitely. 1.11 Rapid changes in the international environment since 1980, high interest rates and a foreign exchange crisis led to forced austerity measures which accelerated industry's downward trend. The situation was exacerbated by political instability. The decrease in investments and the suboptimal allocations, as well as high power costs and frequent labor disputes contributed to low productivity. Total factor productivity growth in the manufacturing sector, an indicator of efficiency perfor- mance, was negative whereas the Philippines' major competitors displayed a positive growth in that period. Poor performance, high domestic interest rates and devaluation losses for firms with foreign currency denominated loans left many firms in financial distress (Annex 1.02). with low profit- ability and high indebtedness. Many firms ceased operation and declared bankruptcy. Firms in operation limped along at 50-602 capacity utiliza- tion. After steady growth rates of gross value added in industry in the 1970s, the sector experienced a slowdown in 1980-83 followed by a sharp decline after two years of severe recession in 1984-85, during which industrial output fell by almost 202 in real terms. 1.12 The industrial sector began to recover at the end of 1986. The recovery was led by rapid expansion of private construction (17.2Z in 1987 and 12.82 in 1988), fueled by increased availability of housing loans. Spurred by rising private consumption, manufacturing output increased by an impressive 7.12 in 1987 and 8.7Z in 1988. The financial performance of manufacturing corporations improved, both in terms of profitability and adequate capitalization (Annex 1.02). The improved performance of indu- stry can be attributed to the increasingly stable political environment, growing domestic demand and the policy reforms which, by providing enterp- rises with access to competitively priced imported inputs, enhanced the competitIveness of Philippine exports. 1.13 The recent growth has been well diversified. Rapid recovery of the manufacturing sector has been fueled by growth in virtually all manufacturing subsectors, with only a few subsectors remaining in conti- nued depression or recovering slowly; among these are pulp and paper, wood processing, chemicals and some metal working/engineering industries. The most dramatic growth has been registered by three consumer goods sub- sectors: food, beverage industries and textiles. This primarily reflects strong consumer demand in the domestic market, but also increased exports of processed foods and textiles as a result of the improved incentive framework.  - 5 - D. Selected Subsectoral Issues 1.14 In the context of the more open economy that the Government is trying to foster, there is need for both financial and physical restruc- turing that would enable firms to improve efficiency and international competitiveness The more liberal policy environment has affected various subsectors differently, with some able to fashion the appropriate competi- tive response but others not equipped to do so. Given the diverse struc- ture of industry, a restructuring strategy needs to address specific constraints, problems and requirements of individual subsectors. This subsector approach to restructuring is warranted since at the policy level, certain trade and regulatory policies are often subsector-specific and, at the enterprise level, the technology, marketing and organization needed to compete effectively differ according to the subsector. 1.15 The articulation and implementation of a sound restructuring strategy has been hampered by insufficient know-how and Government reluc- tance to introduce, at this stage, further policy ref3rms in some subsec- tors, out of fear that they would collapse if these reforms were embarked upon hastily and without proper sequencing. In addition to inter-island shipping, a service subsector with substantial linkages to industry, these subsectors are the capital-intensive processing industries with large, sunk investments and include cement, pulp and paper, chemicals, and certain metal working/engineering industries. These as well as some other subsectors (textiles, certain agro-food processing industries) also face the reluctance of banks to extend credit given the subsectors' poor performance in past years and the banks' inability to assess their growth potential. Thus, there is need to assist the Government, the banking sector and industrialists to analyze these subsectors and identify public policy measures as well as business strategies that would together form part of a coherent subsectoral strategy. 1.16 Two of the majorl/ ar,d promising industrial subsectors --- cement, pulp and paper -- and the inter-island shipping subsector are described in Annex 1.03. All three are hampered by physical, financial and policy constraints. Many of the existing plants in the cement and pulp and paper subsectors lack economies of scale and are overmanned and technologically obsolete. The last decade has seen no fundamental rehabi- litation of existing capacity or major additional investments. As for inter-island shipping, the fleets have deteriorated substantially, with the average age of the more than 4,000 inter-island vessels exceeding 20 years. Firms in these subsectors also face financial distress resulting from declining profitability in the pre-1986 years and foreign exchange losses incurred on their foreign currency loans following the Peso devalu- ations in the mid-eighties. 2/ in 1987, the largest enterprises in the cement (10 firms) and pulp and paper (19 firms) subsectors accounted for 9.3Z of total assets and 4.7Z of total sales of the top 1,000 corpor- ations in the Philippines.  -6- 1.17 The physical and financial problems of these subsectors are compounded by policies that inhibit competitive efficiency. Inter-island shipping is regulated by as many as fifteen different agencies, with the setting of passenger and freight rates being the most constraining regula- tion. The pulp and paper industry suffers from distorted policies and regulations in the forestry sector which contribute to raw material costs which compare unfavorably with those of competing countries; furthermore, there is need for improved incentives to promote waste paper collection, classification and processing and for reduced duties on inputs and outputs to foster industry competitiveness. As for the cement industry, it is characterized by a tightly controlled distribution system that perpetuates de facto import control and price ceilings. 1.18 These subsectoral problems call for an examination of the physical and financial restructuring needs of the subsectors as well as of the policy and institutional changes required to foster competitiveness and efficiency. More specifically, the following issues need to be delved into more fully: (a) the impact of trade policy on the structure of the subsector and recommendations for policy improvements; (b) the role of regulatory policy, in particular policies governing distribution and pricing, in shaping the industry, and how the policy might be improved; (c) cost structures in the Philippines, now and potentially after rehabil- itation, and proposals for physical restructuring of the industry; (d) investments necessary to increase efficiency of distribution and produc- tion and (e) financial distress in the subsector and options for financial restructuring. Issues specific to the pulp and paper subsector that need further examination are: the efficiency of raw material production and processing; desirable changes in policies governing tree farming and tree plantations for pulp production. Specific issues facing the inter-island shipping subsector which need study are: the feasibility and scope of fleet restructuring, repair yard modernization and privatization of government owned companies. These subsectoral issues will be addressed in the studies forming part of the TA component of the proposed Project. II. THE FINANCIAL SECTOR A. Introduction 2.1 The industrial policy reforms designed to improve the environ- ment for efficient private production and investment, presented in Chapter I, were accompanied by financial sector reforms. In 1980, the Government initiated policies that led to deregulation of interest rates and libera- lization of exchange controls, with the result that the financial system is now characterized by market-determined interest rates and an open capital account. Following the dislocations in the real sectors during 1983-85 and the concomitant disarray of the financial sector, the Govern- ment undertook measures for rehabilitating government-owned financial institutions, notably the Philippine National Bank (PNB) and the Develop- ment Bank of the Philippines (DBP), in the context of the Economic Reco- very Loan (ERL; Loan No. 2787-PH, 1987). With the restructuring of these two financial institutions largely accomplished and the banking sector  - 7 - having regained its health, what remains to be done is to put the finan- cial sector on a firm enough footing to support the significant shifts in resource allocation which the economy must undertake in respense to the new array of incentives put in place with the stabilization and reform programs of recent years. In addition, the financial sector must be relied on to mobilize a large quantity of private savings, and to inter- mediate funds at reasonable cost to new productive activities. Conse- quently, the Government has embarked on a series of financial sector reforms which would be supported by the Bank through a Financial Sector Adjustment Program Loan (FSAL), approved on May 3, 1989. The aim is to make the banking sector more competitive and responsive to the needs of the real sectors. An important component of the reform program is to improve the institutional arrangements for the provision of long-term credit; this involves the transformation of DBP into a wholesale bank channeling funds to the private sector through retail financial institu- tions. By providing funds to DBP to help it carry out its wholesale functions, the proposed Project fits into the overall strategy for develo- pment of the country's financial sector. B. Evolution and Structure 2.2 As of December 31, 1988, assets of the financial system totalled 3 879 billion, representing an increase from 1980 of 1802 in nominal terms but a decline of 23X in real terms. The major components of the system, their nominal size and percentage distribution in 1980 versus 1988 are presented in Annex 2.01. 2.3 Commercial Banks. The commercial banks account for the largest share of total assets of the financial system. During 1980-86, the banking sector underwent substantial contraction in real terms as a result of the political turmoil and economic shocks experienced by the country: total assets contracted by 44Z in real terms; loans to the private sector contracted even more sharply, by 632. Between 1980 and mid-1987, three commercial banks, 147 rural banks and 32 thrift institutions, involving total assets of P 14 billion (US$700 million equivalent), failed. These failures were compounded by the de facto insolvency of the largest commer- cial bank, PNB. With increasing stability and improvement in the real sectors starting in 1986, the health of the banking sector has steadily improved as evidenced by good profit margins in 1986-88. As an additional indication, the banks' capital adequacy ratios have improved in recent years: loan volumes contracted sharply in 1984-86 while the bank margins improved substantially, resulting in improved capital-to-assets and capital-to-loans ratios in 1986 and 1987. There are now 29 banks, of which four are foreign and one (PNB, still the biggest) is government- owned. Privately-owned banks form, by far, the largest part of the banking system. Seven banks are licensed as universal banks, a clas- sification that allows them to engage in many near-banking activities such as those undertaken by investment banks, leasing companies and finance companies. 2.4 Non-bank Institutions. The next largest component of the financial system comprises the non-banks, which include insurarce comp-  -8- anies, pension funds, investment institutions, trust operations and others. Their assets amount to P 138 billion, or 162 of the system's financial assets. The most important are insurance companies (with assets of P 75 billion) and investment institutions, i.e., finance and investment companies (with assets of P 24 billion). 2.5 The Securities Market. Though there are two operating stock exchanges, the Manila Stock Exchange and the Makati Stock Exchange, the equities market in the Philippines is still small relative to the totality of the financial system. In 1985, market capitalization of the 138 listed securities was P 12.74 billion, representing 32 of systemwide assets, compared with 4Z in Korea, 52 in Thailand, 92 in Taiwan, 122 in India, and 242 in Malaysia, in the same year. Renewed confidence brought about by a new Government and the higher earnings prospects of companies has led to growth of the market capitalization in the last three years, with the 141 companies listed in 1988 valued at F 88.6 billion. Nonetheless, the securities market has yet to function as an important source of investment capital; the primary market for equity remains small: except for addition- al issues through stock dividends and pre-emptive rights offerings, new issues are rare. As for the secondary market in equities, it has been active, with the market turning around and breaking all previous records in 1986 and 1987. The 1986 turnover of P 11.47 billion represented an increase of 5552 over the preceding year's turnover of P 2.07 billion while that of 1987, F 31.35 billion, was a 2732 increase over 1986. In 1988, turnover was P 23.90 billion. 2.6 Foreign investments in Philippine securities totalled US$ 61.8 million in 1988. Hong Kong-based dealers accounted for the biggest block of foreign investors in Philippine securities with a share of 64.1Z of the total volume of portfolio investments, followed by the United States (23.6Z) and the United Kingdom (5.0Z). These portfolio investments were primarily in commercial sector securities (68.22), with the rest invested in mining sector issues (16.8Z), financial sector securities (11.12) and oil and manufacturing (3.42). 2.7 As for corporate debt securities, both the primary and secondary markets are small, with very few issues being offered in the public market. As of year-end 1987 there were F 3.36 billion registered commer- cial paper issues, but only P 1.16 billion were sold in the market. There have been no new corporate bond issues. The government securities market is far more active, with national government bond issues totalling approximately F 34.0 billion and those of government-controlled corpora- tions and the Central Bank of the Philippines (CBP) being about F 4.0 billion and P 7.4 billion, respectively. Government bonds are not widely traded because they carry fixed interest rates which are far below market rates. They are consequently issued with "sweeteners" such as eligibility for bank reserves and as substitutes for mandated agricultural lending. The largest issued and actively traded government securities are T-bills, which had a total of P 107.5 billion outstanding as of end-1987.  - 9 - 2.8 Leasing. Introduced in the Philippines in 1957, the leasing industry consists of financing companies which act as lessors. Super- vision is carried out by the Securities and Exchange Commission (SEC) in consultation with CBP. The industry's growth was stunted by the political and economic crises in the earlier part of this decade. In view of the country's substantial investment needs in durable equipment, the use of leasing as a financing instrument has been quite limited. As of September 30, 1988, the nine leading lessors had an outstanding lease portfolio of P 1.4 billion distributed thus: motor vehicles, 31.5?; industrial machinery, 10.4?; business and office machines, lOZ; heavy equipment, 9.1X and others, 34Z. C. Major Financial Sector Policies 2.9 Interest Rate Policy. There has been a gradual move away from a regime of close control over interest rates combined with restrictions on international payments, current as well as capital, to a system which in practice is open to international flows and charac~terized by market- determined interest rates. Starting in 1980, ceilings on various categories of bank lending and deposit rates were eased and then progres- sively removed. The last deposit rate ceiling (on deposits with maturity of two years or less) was removed in mid-1981, and the last lending rate ceiling (on short-term loans) on January 1, 1983. Before the deregulation of interest rates, the banks had been circumventing the ceiling through a proliferation of additional charges and fees. The change thus brought greater transparency to the system. Real interest rates in the Philip- pines have remained substantially positive for deposits as well as lend- ing, except in 1983, when inflation suddenly flared up. 2.10 Foreign Exchange Pricing and Allocation. From the system of foreign exchange rationing introduced in October 1983, there has been a progressive liberalization of exchange controls. Banks are no longer subject to control on their holdings of foreign exchange. Despite remain- ing controls on capital movements, wholesale funds are relatively free to move in and out of the Philippines. The relatively small gap between the official and open market exchange rates in recent times illustrates this openness and the small practical relevance of controls. 2.11 CBP/Government Role in Credit Allocation. Until recently, the Government/CBP played a direct role in credit allocation in sectors considered by it to have priority: it did so by designing credit programs and subsequently assuming responsibility for obtaining funding for them and their implementation. It is estimated that these programs, which cover both agriculture and industry, accounted for about 52 to 7? of total banking sector loans outstanding at the end of 1986. Most of the agricul- tural programs involved subsidies. The subsidy provided to the end users of funds under 13 major agricultural sector credit programs for which data are available amounted to at least P 3.4 billion during 1981-86 in the form of lower than market interest rates and uncollected loans. As a percentage of the annual budget deficit during this period, subsidies on  - 10 - these 13 programs ranged from a low of 2Z in 1986 to a high of 82 in 1983. The cost to the Government was substantially higher than the amount of P 3.4 billion stated above if the following additional items were con- sidered: interest rate subsidies and uncollected loans for the smaller programs for which data are not available; administrative expenses of the implemenfing agencies including CBP; and government equity in failed rural banks and the tax exemptions granted to them. 2.12 The policy in government-sponsored credit programs in recent years, however, has been to move towards elimination of subsidies; for all major programs, the on-lending rates are now market oriented. Moreover, the basic nature of many of the programs is changing so that while they still reflect broad government objectives, decisions on lending to individual borrowers and the credit risks involved are now left to the banking system. D. Financial Sector Reforms 2.13 As pointed out in para. 2.3, the sharp contraction of the economy during the first half of the eighties had its inevitable impact on the banking system and highlighted its weaknesses and fragility. In the wake of this distress and pressure on the banking system, there has also been a spate of legal suits against CBP and its personnel, hampering CBP's role as the supervisor and regulator of the financial system. The present institutional arrangement for safeguarding the interests of insured depositors has also proved inadequate. In addition, the expected increase in the demand for investment credit has prompted concern about the absence of an institutional framework for the mobilization and provision of long- term funds for investment purposes. 2.14 The first financial sector reforms undertaken by the Government to address the problems and concerns stated above were in the context of the ERL in 1986-87. As its main focus was on adjustment and stabilization of the whole economy, ERL dealt with only the most pressing of the finan- cial sector problems: the rehabilitation of the government financial institutions (GFIs). The GFIs had suffered from outside interference in lending decisions, the undertaking of costly government credit programs without reimbursement, lack of internal controls and auditing, poor management practices in terms of lending decisions and portfolio manage- ment, and excessive size and diversity of functions. At the same time, their special position allowed them unlimited use of government deposits, exemptions from taxes and access to government-guaranteed borrowings. In the context of ERL, the Government undertook a reform program centering on the rehabilitation of PNB and DBP, the two largest GFIs. During 1986, the Government, recognizing the de facto insolvency of these two institutions, arranged a transfer of all their non-performing assets of P 10 million or more each to the Asset Privatization Trust (APT) for workout, and relieved them of the corresponding liabilities. Institutional strengthening plans were also adopted at the same time. PNB's financial restructuring plan involved a reduction of its assets from P 79 billion to P 26 billion. The restructuring of DBP is described in detail in Chapter III.  - 11 - 2.15 The GFI reform program also laid the groundwork for future reform of the Social Security System (SSS), the Government Service In- surance System (GSIS), Philguarantee and the Land Bank of the Philippines based on detailed policy studies of these institutions. Furthermore, under the ERL, the Government undertook to privatize the six commercial banks taken over by the Government because of their weak financial condi- tion. Thus far, two banks have been fully and two partially privatized; privatization of the remaining two banks is envisaged in the near future after the litigation involving them is resolved. 2.16 With the rehabilitation and financial restructuring of PNB and DBP substantially completed, the stage was set for a comprehensive review of the financial system, carried out by the Bank and supported by the Government. The resulting Financial Sector Study (FSS) 3 identified the following as four critical problem areas: (a) supervision and regulation of commercial banks, including the governing legal framework; (b) institu- tional arrangements for the protection of insured depositors; (c) high intermediation costs and lack of effective competition; and (d) institu- tional arrangements for the mobilization and provision of long-term capital. 2.17 Based on the FSS findings, a Financial Sector Adjustment Program to be supported by a US$300 million Bank loan (FSAL; Loan No. 3049-PH, 1989) has been designed for implementation in the next two years. The program involves specific actions in the problem areas listed in paragraph 2.16. Bank supervision and regulation would be improved by (a) strengthe- ning the legal and supervisory framework so as to empower CBP to take corrective actions in a timely fashion with respect to problem banks and, if necessary, to effect bank closures; (b) improving the supervisory and regulatory procedures; and (c) separating the supervisory and regulatory function from receivership-liquidation. Arrangements for depositor protection would be strengthened by enlarging the role of the Philippines Deposit Insurance Corporation to empower it to act as receiver-liquidator of failing banks and strengthening it financially and institutionally to enable it to play that role effectively. Intermediation costs would be reduced through promotion of more effective competition, reduction and elimination of certain fiscal impositions as well as improvement of laws governing debt recovery and insolvencies. Fund mobilization and medium- and long-term credit delivery would be enhanced through actions involving a revamping of DBP to enable it to act essentially as a wholesaler of long-term funds, and the elimination of CBP's role in credit allocation. E. Institutional Arrangements for Providing Long-Term Credit 2.18 Under the FSAL, CBP has agreed to continue to reduce sharply, and ultimately eliminate, its direct involvement in the management of government-sponsored credit allocation programs. Since mid-1986, the 3/ Philippines: Financial Sector Study (Report No. 7177-PH, August 23, 1988).  - 12 - responsibility for making policy decisions regarding a number of agricul- tural programs has shifted to the Comprehensive Agricultural Loan Fund (CALF). The reduction of CBP's role in administering credit programs will be pursued further by transferring the administrative responsibility for remaining agriculture sector credit programs to CALF; the sole exception is the Agricultural Loan Fund which will likely be transferred to the Land Bank of the Philippines. The administrative responsibility for industrial sector programs will be assigned to a revamped DBP (see para. 3.9). When these measures have been completed, CBP will have completely withdrawn from the management of credit allocation programs, and its role would be confined to liquidity management through discount window operations. 2.19 While the banking system has been able to meet most short-term credit needs, the provision of long-term credit has been inadequate. Indeed, the most significant gap in the current financing system is in the provision of long-term credit. With the shrinking of lending activity by DBP and PNB concurrent with their rehabilitation programs, the specialized government institutions have not made a substantial contribution to the supply of term credit in the last three years. Their share in the total credit made available to the manufacturing sector, for example, declined sharply from a high of 43Z in 1984 to only about 22 in 1986. As for the commercial banking system, the short-term nature of their lending and their caution became even more pronounced in recent years with the turmoil the financial system went through. The limited amount of term lending made by the commercial banks is usually through "roll-over, of short-term loans. The short-term horizon of lenders and investors is not surprising in view of the interest rate and exchange rate volatility during the last decade. Term transformation has not been accomplished to any significant degree because the banks have been unwilling to assume the liquidity risk. This has resulted in a situation wherein the main sources of medium - and long-term funding in the Philippines have been the government-directed credit programs described earlier. Instead of lending from resources raised from the market, the banks merely acted as lending conduits for funds borrowed by the Government from foreign sources or to a lesser extent, provided from the budget. 2.20 The situation is expected to worsen as the demand for investment credit increases with the growth of the economy. The current constraint on the availability of long-term credit reflects a lack of adequate arrangements regarding credit, interest rate and liquidity risks. The credit risk in long-term lending in itself is substantial, and commercial banks will be willing to assume such risk only if arrangements are made to relieve them of another accompanying risk, i.e., the liquidity risk. Given the liquidity crises of the past, banks are unwilling to assume the liquidity risk inherent in term transformation, and their present liabi- lity maturities are not, nor are they expected in the foreseeable future to be, long enough to enable the banks to lend long-term. 2.21 However, some domestic long-term resources are available in the system from institutional savers like insurance companies, SSS and GSIS and pension funds. It is estimated that gross premium receipts in 1986 amounted to P 5.8 billion and P 5.7 billion for private and public in-  - 13 - surance companies, respectively. Also, it is generally believed, and confirmed by the institutions, that the annual increments to investible funds are quite large. For pension funds, the estimate for incremental funds mobilized in 1986 was at least P 600 million. These institutions are also willing to invest long-term in the private sector if suitable opportunities are identified, i.e. they are willing to assume the maturity risk. As for the interest rate risk, the end users have already shown their willingness to assume it by borrowing on a variable rate basis. What is needed is to develop a financially viable institutional arrange- ment to bring the providers and users of long-term funds together. 2.22 Given the availability of domestic long-term funds through GSIS, SSS, pension funds and insurance companies on the one hand, and the lack of long-term credit on the other hand, the FSS identified the need for a financial institution to assume the role of a wholesaler by mobilizing long-term funds and channelling them to other financial institutions (retail) for onlending to individual enterprises. According to agreed FSAL measures, a revamped DBP will fulfill this role in line with an Institutional Development Plan which spells out its new role. As a wholesale institution, DBP will not assume the credit risk on the in- dividual subloans. Chapter III provides a detailed descr 'ption of the strategic reorientation of DBP. F. Industrial Credit 2.23 The Bank's growth projections, based on an assumption of con- tinued good policy performance and a favorable external environment, suggest an average overall GDP growth in the Philippines of about 62, with a rate of 8Z for industry, during the 1989-92 period. Achieving this target will necessitate a gradual increase in the rate of investment, from the 1988 level of 18Z of GNP to at least 22Z. Financing this investment will be a major challenge to the financial system in the next few years. 2.24 Short-term Working Capital Credit. The larger creditworthy enterprises obtain the working capital finance they need from the banking system. Smail and medium enterprises (SMEs) have generally relied on trade credits, internal cash generation, loans from informal credit sources (usually family and friends), and, to a limited extent, loans from commercial banks. Recently, due largely to their excess liquidity and lack of alternative investment opportunities, commercial banks have begun to lend to well-collateralized SMEs with whom they have established relationships, usually through the Industrial Guarantee Loan Fund (IGLF) program. The expectation is that since the banks' relationships with these SMEs have now been established, they will continue to have their working capital needs met unless the economic recovery attains such strength that there is a general liquidity squeeze. 2.25 Demand for Industrial Term Credit. The business community, financial institutions and government officials feel strongly that demand for term credit will increase substantially as political stability in the country is sustained and macroeconomic conditions improve. Credit demand has thus far been mostly for working capital and, to an extent, for l  - 14 - investment capital to enable firms to reach full capacity utilization. There is, however, now a substantial need for financing expansion and new projects in industry as existing production facilities have reached their full capacity. 2.26 A reviev of the project pipelines of financial institutions active in the provision of term credit to industry suggests that for the creditworthy large-scale enterprises, concrete demand as evidenced by actual loan applications would amount to around P 8.5 billion for 1989-90. Demand for term credit by SMEs in the formal industrial sector is expected to be around P 4 billion for the same period. Thus, term credit demand of approximately P 12.5 billion by the formal private industrial sector for 1989-90 appears to be a reasonable estimate. A conservative assumption of an annual growth rate of 5% in demand for term credit over the next three years, in line with prevailing estimates of GNP growth, would lead to a projection of about P 20 billion (US $950 million equivalent) for the term credit needs of the formal private sector in industry during the 1989-91 period. 2.27 An evaluation of demand for finance by the private sector should also include the financing needs arising from the restructuring and rehabilitation of industrial enterprises. In the subsectors discussed in paras. 1.16-1.16 and Annex 1.03, many firms are finding it difficult to maintain adequate levels of working capital finance and service their debt. For such firms, the need is for extensive financial restructuring, converting their short-term borrowings into long-term debt to conserve cash flow and remove uncertainty, in addition to physical restructuring. Preliminary estimates by a recent World Bank mission looking into indus- trial restructuring needs suggest that for the cement, textile and gar- ment, and pulp and paper subsectors alone, at least US$500 million (P 10.5 billion) would be needed over the next three years. 2.28 Supply of Industrial Term Credit. Credit by the banking system to manufacturing increased substantially between 1980 and 1984, but then declined sharply in line with falling growth rates of value added in the sector, as Annex 2.02 shows. Reflecting the continued acceleration in economic activity, outstanding loans of the commercial banks to the manufacturing sector grew substantially in 1937 and 1988. If past trends continue, the commercial banks, which do not have long-term resources to on-lend, will continue to concentrate on the provision of credit on a short-term basis, using the short-term 'revolving" bank loan as the primary debt instrument and leaving the demand for term credit unsatis- fied. It is in this context of paucity of term credit, that the proposed Project for financing private medium-scale and large enterprises was developed. 2.29 Given the estimated demand for industrial term credit of US$950 million (US$1.45 billion if industrial restructuring needs are included) for 1989-91, the term finance available to the sector is inadequate: the IGLF program would make US$275 million available for SME term financing (including US$60 million from the Bank, US$100 million from the Asian Development Bank (ADB) and US$28 million from local financial institu-  - 15 - tions) whereas the Asean Japan Development Fund (AJDF) would provide US$300-350 million to all sectors, including agriculture. This would leave a gap of at least US$325 million (US$825 million if restructuring requirements are also considered), after taking into account the funds supplied by the various sources, including AJDF and ADB. The proposed Bank loan of US$65 million for financing medium-scale and large industrial enterprises is therefore a conservative amount, compared to expected total needs. As for the substantial financing requirements for industrial restructuring, they could be addressed by a subsequent Bank operation, depending on the findings of the subsectoral studies to be undertaken under the proposed Project. G. Bank Strategy In the Sector 2.30 Bank support for the proposed Project would be consistent with its country assistance strategy of helping to sustain economic recovery and bring about a structural transformation of the economy. The Bank remains committed to assisting the Government maintain a reasonable and sustainable rate of growth in the industrial sector over the medium to long term. The recently completed Country Economic Memorandum and In- dustrial Sector Reports4i identify areas where further improvements would promote industrial sector growth. These include: continued policy and regulatory reforms to encourage greater competition and more efficient production; financial and physical restructuring of many large firms in the face of a changing policy environment which better recognizes the Philippinies' comparative advantage in labor; expanded availability of long-term finance; and measures to boost exports. To support the in- dustrial sector, therefore, Bank assistance would take the form of policy advice (related both to the industrial and financial sectors), institu- tional support, and the transfer of term resources. The dialogue with Government on broad policy issues will continue in the context of economic and sector work, and implementation of reform measures under the ERL Program and the FSAL. 2.31 The proposed Project is a follow-up to the Industrial Finance (Apex) Loan (Loan 1984-PH, 1981) designed to provide term funds to medium and large industrial projects. Under the Apex Loan, the Apex Development Finance Unit was established as a separate unit in the Central Bank to on- lend the proceeds of a US$150 million Bank loan and a commercial loan of US$100 million to private sector enterprises through participating finan- cial institutions (PFIs). In the face of deteriorating economic condi- tions, disbursement of Apex loan funds, however, was disappointing. What discouraged loan utilization was the effective cost of funds to subbor- rowers because of their assumption of the foreign exchange risk. Given the significant Peso depreciations since the Apex program was initiated, potential subborrowers grew extremely averse to borrowing foreign currency 4/ Philippines: Toward Sustaining the Economic Recovery (Report No. 7438-PH, January 30, 1989); The Philippines: Issues and Policies in the Industrial Sector (Report No. 6706-PH, July 30, 1987).  - 16 - loans. To increase the utilization of Apex funds, CBP decided in July 1984 to bear the foreign exchange risk on loans to export-oriented or Import-substituting projects. Even this did not help because the adverse economic and political developments that subsequently occurred depressed demand for medium - and long-term credit. Total disbursement of Bank funds amounted to only US$44.7 million while commercial loan funds dis- bursed totalled US$32.2 million. While approval and disbursement targets were not met, the Apex program has been successful in achieving its institution building objectives: it has made possible the establishment of a semi-autonomous, professional Apex Unit within CBP and the development of organizational units in each PFI that have the capability of handling long-term, project based lending. The proposed Project was designed in the light of the experience of the Apex loan and incorporates changes in the denomination of the subloan currency and assumption of the foreign exchange risk to remedy past problems. 2.32 The Bank's continuing participation in the term financing of industry at this time is a logical step since the proposed Project will (a) assist the industrial sector exploit the opportunities provided by the improved economic and socio-political environment; and (b) build upon the successful institution-building experience of the Apex project as well as on the restructuring of DBP undertaken in the context of the ERL Program (Chapter III). Given the size of the financing gap and the modest amount of the Bank loan, the Bank funds will be complementary to, rather than crompeting with, other suppliers of funds. The TA component dealing with industrial subsectors would facilitate and enhance the Bank's dialogue with the Government on industrial restructuring and lay the groundwork for a program of reforms that may be supported by future subsector lending operations. III. THE BORROWER AND PARTICIPATING FINANCIAL INSTITUTIONS A. The Development Bank of the Philippines Introduction 3.1 DBP would be the borrower of the proposed Bank loan, the proceeds of which it would relend to participating financial institutions (PFIs) for on-lending to medium-scale and large enterprises. The proposed operation is designed in the context of a long-term Institutional Develop- ment Plan for DBP that, as made clear in Chapter II, is linked to a coherent vision of the evolution of the overall financial sector. As a result of its rehabilitation under ERL, DBP is already moving towards integration into the market-based financial system that characterizes the Philippines: precluded from reliance on government resources, notably deposits, it is now self-sustaining; its lending policies are market- oriented; and its role in the system will be defined as being that of a predominantly wholesale bank for onlending funds to retail financial institutions rather than to end-users. The proposed Project would rein- force the expected evolution of DBP by strengthening its wholesale lending function through provision of term funds for relending to PFIs and by monitoring its progress in achieving its wholesale lending targets.  - 17 - Historical Perspective: 1958-1986 3.2 Established in 1958 as a Government-owned development bank, DBP's financing operations until 1986 encompassed almost all segments of the economy, and both large and small-scale enterprises. In addition to its industrial, agricultural, real estate and transportation lending, DBP engaged heavily in lending to social sectors such as education and health care. Starting in the seventies, under the guise of its developmental mission, DBP financed high-risk and low-return government development programs ("directed" or "behest* lending), and the takeover of financially distressed firms at Government's direction. 3.3 This lack of financial discipline in its lending, compounded by serious weaknesses in internal organization and procedures (notably credit appraisal and supervision), led to serious financial problems. In the early 1970s, the total debt to equity ratio rose to over 10:1; the current ratio fell to 0.2:1; and arrears in the loan portfolio and defaults in the guarantee portfolio were high. With its resource mobilization capacity undermined, DBP had to rely mainly on government deposits for funding its activities. 3.4 Several capital increases between 1972 and 1980, substantial government deposits to support its liquidity position, and various meas- ures to strengthen its organization and procedures all failed to stop DBP's deterioration in the early eighties. Serious portfolio arrears and poor collection rates persisted, as did the more intractable issue of high-risk and low-rate behest loans. As part of the Industrial Finance Loan, the Government and DBP were asked to implement an "Action Program", which included further organizational changes, measures to reduce DBP's dependence on government deposits, and actions to improve the collection performance. The financial effects of 'behest" lending were to be made transparent, and Government was to provide financial assistance if DBP's financial viability would be impaired as a result of "behest' lending. However, continuation of DBP's problems, exacerbated by the economic and political crises of the period, led to DBP losing its accreditation as a participating financial institution in the project. Consequently, Bank loans to DBP were suspended. As evident in Annex 3.01 and in Table 3.1 below, DBP's financial situation in 1985 remained poor, with a net loss of P 6.9 billion (US$370 million equivalent) and a high debt/equity ratio of 15:1. DBP's Rehabilitation: 1986-88 3.5 Following the advent of a new Government in 1986, the severity of DBP's problems and its technical bankruptcy were addressed by a com- prehensive rehabilitation and financial restructuring program developed in conjunction with -the Bank-financed ERL. Major components included: (a) a new charter and policy statement, (b) installation of a new management team and Board of Directors, (c) transfer of P 74 billion of non-perform- ing accounts to the Asset Privatization Trust (APT), created by the Government to sell those assets; (d) implementation of a drastic cost  - 18 - reduction program through staff reduction and sale of branches; (e) an internal reorganization and strengthening program focussing on credit policies, legal procedures, financial controls, accounting and internal controls, and personnel management; and (f) phasing out of subsidized Government deposits. 3.6 DBP's financial restructuring and the major elements of its internal strengthening program under the ERL have essentially been com- pleted, witth DBP being solvent during the last two years (Annex 3.01). Its recent performance, summarized in Table 3.1, shows that DBP has met and, in some areas, bettered the ERL targets set jointly by the Bank, the Government and DBP. Its indicators of capital adequacy, liquidity and earnings performance are sound. DBP's debt/equity ratio is now a very conservative 1.2:1, compared to the ceiling of 5:1 set under the ERL. Earnings indicators look impressive: return on assets is 14.4X; return on average net worth, 38.42. DBP's performance also compares favorably with that of leading private financial institutions in the Philippines (paras. 3.27-3.28 and Table 3.3), except for its relativelv higher administrative expenses; these, however, are expected to decline as a percentage of average total assets over the coming years as its loan volume increases and its activities shift from retail to primarily wholesale banking which is less personnel-intensive. Table 3.1: SUMMARY OF DBP'S FINANCIAL PERFORMANCE, 1985-88 (Peso billion) ERL 1985 1986 1987 1988 Targets Total Loans Outstanding 27.5 5.27 4.39 5.01 n.a. Total Debt 67.6 6.82 7.G7 6.32 n.a. Total Equity 4.5 2.68 3.46 5.11 n.a. Net Income 6.9 5.6 0.8 1.6 n.a. Ratios: Debt/Equity 15.0 2.5 2.0 1.2 5.0 Net Worth/Risk Assets (2) 11.3 35.9 37.4 52.8 10 Liquid Assets/Deposits and Short 0.57 35.5 26.8 57.6 n.a. Term Borrowings (Z) Liquid Assets/Deposits (Z) 63.1 208.4 161.3 64.5 80 Provisions for Doubtful Accounts/ 0 47.3 34.9 28.6 25-39 Total Loans (2) Net Interest Margin/Total Assets (2) (8.6) (29.5) 9.7 9.2 4.5 Return on Average Net Worth (X) (182.2) (157.7) 25.5 38.4 10.0 Ldministrative Expenses/ 1.1 6.1 5.7 6.0 n.a Average Total Assets (2) Personnel Costs/Total Assets (2) 0.4 3.7 2.5 2.6 2.5-3.5  - 19 - 3.7 It should, however, be pointed out that DBP's 1988 earnings performance is not fully indicative of DBP's long-term earning capability on a going concern basis. Of the total operating revenues of P 2.6 billion, only 31Z is interest from loans, whereas 18S comes from invest- ment in securities, primarily Governmenit issues, and SO from the sale of assets acquired through foreclosure on loans made prior to the 1986 rehabilitation. This reflects the cautious investment approach taken in the first two years after the financial restructuring. As for interest expense, P 1.4 billion of interest-free Government funds or 12? of total funds, were on DBP's books in 1988; as these free deposits are gradually being repaid (the rehabilitation schedule calls for full repayment by the end of 1989), these funds will have to be replaced with higher-cost funds, which would decrease the spread DBP is realizing. This combination of factors which reduce revenues and increase expenses will lead to lower, though still positive, net returns in the future. DBP's New Role and Strategic Orientation 3.8 As described in paras 2.18-2.22, the recent FSS identified the lack of institutional arrangements for mobilizing and channeling long-term funds as a major constraint to investment and recommended that a revamped DBP could be developed to fill this institutional gap. This involves mandating DBP to act as a predominantly wholesale financial institution, catering to financial intermediaries rather than directly to business enterprises. Under the FASL, agreement with Government has been reached on this new orientation. 3.9 The wholesale DBP would mobilize and channel term funds to the private sector through retail financial institutions. Given the availa- bility of domestic long-term funds from SSS, GSIS, insurance companies and pension funds, DBP is expected to play a major role in domestic resource mobilization. However, DBP's increased reliance on domestic resource mobilization can only be gradual: in the near future, the lack of a developed capital market and the Government's continuing need to tap domestic savings through high-yield Treasury bills would impede DBP's raising significant long-term peso funds. In such an environment, DBP will have to fund itself to a significant degree through foreign sources in the coming years. In this context, DBP has been designated as a principal conduit for official foreign borrowings, the proceeds of which are to be channeled through retail financial institutions for financing private enterprises. In line with this, the Government has agreed to the transfer from the Central Bank to DBP of the existing credit programs with foreign funding -- the Apex Development Finance Program (APEX) and the Industrial Guarantee and Loan Fund (IGLF). Moreover, DBP is expected to be the main wholesale conduit for the AJDF. 3.10 As part of the FSAL, the Bank helped DBP formulate an Institu- tional Development Plan (IDP) that defines and makes operational DBP's wholesale banking strategy, including an action plan for mobilizing domestic term funds. DBP's transformation to a primarily wholesale bank will be accomplished through a gradual reduction of its retail loan approvals and outstanding retail loans to enterprises, relative to the  - 20 _ wholesale loan approvals and outstanding wholesale loans to financial institutions. Agreement has been reached under the FSAL that by the end of 1993, DBP's portfolio is to be primarily wholesale. Subject to the availability of expected bilateral and multilateral funds, DBP projects that 642 of its outstanding loan portfolio will consist of wholesale loans by then. Annex 3.02 provides details of the gradual reduction, in rela- tive terms, of retail lending and the concomitant growth of wholesale loans, as set out in the IDP. During negotiations, DBP agreed to the implementation of the IDP. 3.11 The transition will also entail gradual disinvestment from DBP's branch network. With the exception of 15 regional and metropolitan branches, all branches will be pooled into five regional development banks, which are to be privatized according to a schedule agreed under the ERL as well as the FSAL. By 1993, DBP's equity stake in these regional development banks would have been reduced to 30X. Organization and Management 3.12 Before 1987, the Board of Directors held day-to-day operational responsibilities. Under the revised charter, the Board is a policy making body distinct from management; only the Chairman and the Vire-Chairman of the Board are also bank managers. Composed of nine member 2ppointed by the President of the Republic of the Philippines, the Boar, now includes five members from the private sector. 3.13 DBP has developed a revised organizational structure (Annex 3.03) that is appropriate for implementing its wholesale banking strategy. The guiding principles behind the new organization structure are: (a) clear separation of funding and lending operations; and (b) upgrading of the resource mobilization function by creating a Capital Markets Department. Given the increased importance of resource mobiliza- tion, which has to be carried out in the financial markets by an indiv- idual of high standing, the Capital Markets Department is headed by an officer holding the rank of Vice President, reporting to the Executive Vice-President in charge of the Treasury Group. On the lending side, an Executive Vice President for Marketing will oversee the Wholesale Loans Department that will manage wholesale lending; the Entrepreneurial Banking Department will be in charge of the Metro Manila Branch, and the Corporate Banking Department will be in charge of project management. The In- dustrial Restructuring Unit (IRU), which forms part of the Strategic Planning Center, reports directly to the Chairman. The two Executive Vice-Presidents and the Senior Vice-President in charge of Accounting and Administrative Services also report to the Vice-Chairman, who in turn reports to the Chairman. An Internal Audit Department reports directly to the Board of Directors. The revised organizational structure and the arrangements regarding the head of the Capital Markets Department and staffing of the IRU were confirmed during negotiations.  - 21 - Personnel Policy and Training 3.14 Under the ERL, DBP has reduced its staff from about 3500 to 2000, mainly through an early retirement scheme. The new wholesale orientation of DBP is expected to lead to a further net staff decrease of about 250: selective recruitment of a small numbe' of qualified indiv- iduals to handle the new wholesale banking functions will be offset by reductions in staff resulting from DBP's disinvestment from the branch network and reassignment of existing staff from retail banking to whole- sale banking. 3.15 A job and performance evaluation system as well as a merit oriented financial reward system are in place, with the integration of the two systems planned for end-1989. The Chairman and senior management are aware that the reorganized DBP must be able to offer compensation competi- tive with the private financial sector, if it is to attract and retain the high caliber staff necessary for it to perform its functions effectively. Consequently, DBP now supplements its salaries with productivity bonuses. In the last two years, DBP has been able to attract nine seniot officers from leading private sector banks to head its departments. 3.16 DBP has engaged in extensive training of its staff in corporate finance, loan packaging, financial analysis and legal issues. Aware that the training efforts will have to be reoriented towards DBP's new ac- tivities in wholesale banking, DBP's management is reviewing its training needs for the period 1989-92. This assessment will take into account: (a) the incorporation of the APEX and IGLF units currently in the Central Bank; (b) the increased importance of resource mobilization efforts; and (c) DBP's role in conducting iidustrial restructuring studies and acting as a wholesale channel for loans. As a first step, a training program in industrial restructuring will be implemented as part of the TA component of the IIC Project. During negotiations, an understanding was recorded in the Minutes of Negotiations for Bank review of DBP's institution-wide training program to follow the one on industrial restructuring. Accounting and Management Information System 3.17 The flow of accounting data has improved substantially over the last two years. Revised Branch and Head Office Accounting and Procedures Manuals have been completed. Liquidity and reserve summaries are gene- rated daily; financial statements of branches and the head office are consolidated monthly. The general ledger is computerized and closed daily. Subsidiary ledgers for loans, which had been booked separately by lending groups and industries before the reorganization, have been centra- lized in the Transactions Processing Department. A central mainframe computerized information system, acquired from Citibank, is expected to be operational by 1990. This state-of-the-art system will provide an integrated management information system that allows immediate access to all transaction information which is stored in a centralized data base. The system will also integrate on-line authorization and printing of customer advices, and contract administration for loans, placements, bonds, deposits, commitments, receivables and sundries until final  - 22 - maturity. The system will also incorporate an automated accounting service. Internal communications within the head office and between branches and head office are expected to be comptterized by the end of 1989. In the meantime, the branches operate with stand-alone microcom- puter systems for the general ledger, loans and liabilities and the savings and current accounts. The ongoing computerization and a system of account profitability analysis are expected to improve the management information system considerably. Loan Activities and Asset Management 3.18 The DBP loRn window was reopened in mid-1986 after a hiatus of four years during which no new loans were disbursed. Since then, DBP's investment policy has been conservative, with lending being primarily short-term and excess liquidity being invested in securities, primarily Government issues. In 1987, DBP realized no positive new net lending, while its securities portfolio grew by P 2.7 billion. In 19,88, outstand- ing loans increased by P 610 million, while investments in securities were reduced by P 192 million. 3.19 DBP's lending in the coming years will consist of (a) wholesale loans to PFIs, (b) retail loans to enterprises in areas where the commer- cial banking system may still be hesitant to enter fully and (c) syndi- cated loans wherein it will play a catalytic role in mobilizing the participation of private sector banks. Given its predominantly wholesale orientation, the transfer of the IGLF program to DBP and its expected role as the main AJDF wholesale conduit, wholesale loans outstanding are projected to grow substantially, from P 3.8 billion in 1989 to P 31.1 billion in 1993. The bulk of these loans will be for the industrial sector. Retail lending is projected to grow at a more modest pace, from P 7.9 billion in 1989 to P 15.2 billion in 1993. 3.20 DBP uses resources from its "Regional Development Fund" to extend loans that do not completely satisfy traditional commercial banking risk or collateral criteria. Considered essential from a developmental point of view, these loans involve concessions in one or more of the following parameters -- interest rates, repayment terms, or collateral requirements. They are intended to finance mostly projects outside the Metro Manila area which would introduce new technologies or manufacturing processes, or projects enabling enterprises to reduce or minimize environ- mental pollution. The Regional Development Fund comprises, and is limited to, 30Z of each year's net income after taxes and repayments of loans sourced from the Fund. As of December 1988, these loans amounted to P 74 million. By 1993 these loans are projected at P 1.9 billion or 3.92 of total loans outstanding. The IDP provides that (a) the risk exposure of these loans and compliance with the 30Z net income ceiling will be monit- ored closely; and (b) appropriate provisions will be made to take into account the potentially higher risk. These provisions will be at least 1OZ above the average provisioning on conventional performing loans.  - 23 - 3.21 Recovery of pre-rehabilitation non-performing loans has met with some success. Out of 6,000 non-performing accounts, representing P 4 billion, that remained on DBP's books after the transfer of the bigger accounts to APT, P 1.2 billion were collected on 3,800 accounts. In addition to standard loan collection and foreclosure activities, an "incentive scheme for pretermination' has been devised. By offering the debtors a roll-back of interest to 1984 (retroactive computing of interest due on the basis of 1984 rates) and condonation of penalties in exchange for a 20% downpayment and an agreed schedule of repayment of the recomputed past due, DBP collected on about 300 formerly doubtful accounts. Loan loss reserves cover 98Z of the pre-rehabilitation port- folio; actual arrears on this portfolio amounted to 65.9Z as of March 31, 1989. DBP intends to write off the past due accounts of this portfolio by end-1989. As for loans made after the rehabilitation (1986), loan loss reserves are more than adequate: they amount to 112 though actual arrears equalled only 1.98Z as of March 30, 1989. This low arrears ratio compares favorably with the 4.0 average arrears ratio of the ten largest private commercial banks. Given DBP's past history, its conservative provisioning policy is appropriate. Liability Management 3.22 The current average maturity of funding liabilities is about 1.8 years, against an average loan maturity of 3.8 years. DBP's balance sheet is now exceptionally liquid, with cash and due from banks represent- ing 65Z of deposits. In the coming years, liquidity will decrease some- what as (a) interest-free Government deposits are reduced and (b) wholesa- le lending activities grow. 3.23 To fund its projected lending, DBP intends to supplement its foreign currency sources by actively tapping the domestic capital market. As a wholesale institution, DBP aims at playing a major role in domestic resource mobilization. In addition to promoting an active secondary market and lobbying for appropriate regulatory changes designed to open up the primary market, DBP will enter the market for its own account by Issuing a variety of instruments, specially designed to tap different categories of institutional investors. Through recruitment of a few experts in its Treasury Group, DBP would acquire the required capabilities for designing, packaging, timing, pricing and placing its debt instru- ments. Given investors' current preference for short-term paper, DBP envisages that it would initially launch a P 300 million, 3-year, bond issue in 1990 to establish its presence in the market. Favorable recep- tion in the market would then be followed up by a P 500 million issue in 1991 and further issues with longer maturities and lower coupons, to the extent allowed by market conditions and crowding-out effects resulting from government funding requirements. DBP's efforts at domestic resource mobilization will be closely monitored during the supervision of the Project by the Bank.  _ 24 - Proiected Financial Position and Performance 3.24 Though DBP's performance still has room for improvement, its results for the last two years show that DBP is now endowed with features that enable real optimism regarding its future prospects. It has a new management that has demonstrated a willingness and an ability to make hard decisions; it has developed a focused strategy and has restructured its organization to implement that strategy; it has developed and is im- plementing improved controls and procedures. Of equal importance, its operations are to be governed by a set of policies designed to ensure that it avoids the mistakes of the past. On April 5, 1989, DBP's Board ap- proved a new Policy Statement (Annex 3.04) which reflects its wholesale lending orientation and which deals with, among other things, DBP's investment policies, financial prudence limits and capital structure. Salient features of the Policy Statement provide for: (a) private sector orientation with autonomy in decision-making; (b) an interest rate and fees policy that is consistent with prevalent market rates and ihat ensures full recovery of all its direct and indirect costs, including provisions as required, plus an adequate profit margin; (c) prudent interest rate and maturity match between its assets and liabilities; and (d) a debt-equity ratio not exceeding 5:1. These market-oriented poli- cies, implemented by its now more streamlined organization under new management, should enhance and speed up the integration of DBP into the market-based financial system of the Philippines. DBP has agreed to carry out the Project in accordance with its Policy Statement. Barring an unex- pected deterioration in the macroeconomic environment, DBP is now poised for growth. 3.25 Detailed projections of DBP's future financial performance are presented in Annex 3.02 and summarized in Table 3.2. These projections are of an indicative nature, as the assumptions underlying them are dependent on general macroeconomic conditions, the development of the local capital market, and the availability of bilateral and multilateral funds. Table 3.2: SUlMHARY OF DBP'S PROJECTED FINANCIAL PERFORMANCE, 1989-1993 (Peso Billion ) Year 1989 1990 1991 1992 1993 Wholesale Loans Outstanding 3.85 13.23 18.03 23.90 31.13 Retail Loans Outstanding 7.88 9.00 11.34 13.31 15.17 Total Debt 10.24 19.21 25.45 32.39 40.09 Total Equity 5.16 6.11 6.99 8.17 9.67 Net Income 0.84 0.96 0.88 1.18 1.41 Ratios: Debt/Equity 1.9 3.1 3.6 3.9 4.3. Liquid Assets/Deposits and Short Term Borrowings (Z) 20.7 27.4 31.5 34.4 28. Liquid Assets/Deposits (Z) 26.2 32.9 33.9 34.4 28.3 Provisions for Doubtful Accounts/ Total Loans (2) 8.1 3.9 4.0 3.7 3.8 Net Interest Margin/Total Assets(Z) 6.6 6.7 6.6 6.4 6.3 Return on Average Net Worth (2) 17.7 17.0 13.4 15.6 15.8 Administrative Expenses/ Average Total Assets (2) 4.6 2.6 1.9 1.6 1.4  - 25 - Audit 3.26 In addition to the audit performed by the Government Commission on Audit, a private independent firm audits DBP's annual financial state- ments. Continued use of independent external auditors, agreed under the FSAL, will help enhance DBP's ongoing efforts to build a positive market reputation and image in the financial community. B. The Participating Financial Institutions 3.27 The seven PFIs identified by DBP for possible participation in the proposed Project are privately-owned and comprise six commercial banks and one investment house. As of December 31, 1988, they accounted for 222 of total assets of the financial system excluding the Central Bank. In terms of assets, four of the PFIs are among the five largest commercial banks in the country. Key financial data and ratios on the PFIs are presented in Annex 3.05 and summarized in Table 3.3 below. Table 3.3 PFIs - FINANCIAL DATA AND RATIOS (December 81, 1988) Return on Total Average Debt/ Risk Assets/ Liquid Aaata/ Adm. Expenase/ Aaeto Net ;r.fh Equity Net Worth Deposita Avg. Totel Assets PFI (P Ei lion) (1) (T.1is) (Tiese) (I) (S) For East Bank 28.09 24.9 11.6 6.3 57.6 4.1 Bank of Philippine Islands 26.28 22.5 12.8 6.1 62.7 4.1 Hetropolitan Bank 26.05 27.1 16.8 8.6 57.0 3.4 PCIB 19.68 21.2 8.0 4.4 54.6 4.9 Citytrust 8 09 16 9 7 9 3.8 95.8 a.0 International Corporate Bank 7.27 15.4 5.6 380 116.1 4.9 Anscor Capital and Investment Corp. 0.29 13.5 0.8 1.0 n.a. 6.6 3.28 All the seven PFIs being considered have good profitability, with annual return on average net worth ranging from 13.5Z to 27.1? and averaging 20.2?. This compares with an average of 20.0? for the ten largest private commercial banks. Although their debt/equity ratios ranged from a low of 0.8:1 to a high of 16.3:1 and averaged 9:1, they all are in compliance with CBP's maximum risk assets to capital ratio require- ment of 10:1. Moreover, they have all maintained a satisfactory liquidity position. 3.29 The identified PFIs have both the past record and the potential to operate effectively as term-lenders if provided with term funds. Having participated in the Apex project, six of the seven PFIs have experience in term-lending and have organizational units with the skills to undertake project financing. They all have good management and well- trained staff.  - 26 - IV. THE PROPOSED LOAN A. Project Objectives 4.1. The proposed Project would help fill the gap in the supply of term credit to medium and large industrial enterprises with healthy operations and good business prospects; improve credit delivery for industry by assisting DBP to carry out its wholesale banking function of channeling term funds to retail financial institutions; broaden the scope of financial services available to enterprises; help promote development of the capital market by introducing, on a pilot basis, the financing of equity and quasi-equity investments by participating financial institu- tions (PFIs); support and develop, within DBP and the Department of Trade and Industry (DTI), capabilities to conduct analytical and policy-oriented studies on industrial subsectors; and assist the Government in identify- ing, in selected subsectors, the policy and institutional framework which would provide the correct signals and support for these subsectors to become internationally competitive and efficient. B. Project Description 4.2 To achieve the above objectives, the Project would include the following components: (a) Line of Credit for Equipment and Working Capital. This would be the project's largest component, estimated at US$40 million and accounting for about 62Z of the Bank loan. It would provide long-term financing to viable industrial enterprises, covering plant improvements or construction and acquisition of equipment as well as the working capital requirements associated with investment in plant and equipment. Incremen- tal marketing and worker training and relocation expenses may also be financed. (b) Lease Financing. As medium-term financial instruments, leasing contracts can be part of a financing package offered to industrial enterprises. The project would provide an estimated $15 million (about 23? of the loan) to finance PFIs for the purchase of equipment which they would lease to subborrowers. (c) Equity and Quasi-Equity Investments. A pilot component, estimated at US$10 million (some 15? of the loan amount) would provide financing for equity and quasi-equity investments by the PFIs against their financing subborrowers' purchase of equipment, goods, services and works. Such investments would include common or preferred stock, conver- tible debentures or subordinated debt, which could be used either alone or packaged in combination with debt. Through this pilot component, the project would be able to offer comprehensive financing packages designed to meet the long-term needs of companies that are operationally healthy but need additional capital for expansion. The equity component is also designed to assist enterprises which, as SMEs, formerly benefitted from  - Z7 - the IGLF loan program but which have since graduated from the program and are now poised for growth. (d) Studies, Training and Technical Assistance (TA). This component would be financed through a US$3.5 million grant from the Japan Grant Facility. It would complement the provision of finance through improvements in the technical capabilities of DBP and DTI to conduct subsectoral studies which would (i) provide subsector data, analyses, and strategies that would help financial institutions assess individual projects, and (ii) develop proposals for subsectoral restructuring, including measures to improve the policy and institutional framework for the selected subsectors. The first set of studies would cover the following subsectorss cement; pulp and paper; inter-island shipping and textiles. These subsectors were selected because they need substantial restructuring, operate under regulatory policies requiring major improvement and, under present circumstances, are unable to obtain financing from the banking system. These studies, under terms of reference finalized with the Bank's concurrence, have already started. Following their completion, it is envisaged that studies covering chemical industries, metal working/engineering and agro-industri- es/food processing would be undertaken. The final version of the studies would be published to ensure a wide dissemination of the information collected and analyzed by the consultants. Bank supervision missions will review the findings of these studies and discuss their implementation. Consultant services as well as training and technical assistance requirements identified by the studies would be financed through this component. All the studies are expected to be completed by October 1990. 4.3 The allocation of the Bank loan among the various components (equipment financing, leasing and equity investments) are indicative estimates based on expected use. During project implementation, the Bank loan funds would be allocated among the various financing instruments depending on actual demand. The project would cater to medium and large industrial enterprises that, by virtue of their size, would not normally be eligible for financing under the Bank-financed Fourth Small and Medium Industries Development Project (SMI IV; Loan No. 3038-PH, 1989). The minimum size for assets of eligible firms would be P 20 million (before the financing provided under the project). The line of credit provided under the Project would not be subsector-specific. C. Loan Amount 4.4 The proposed loan of US$65 million equivalent would be made to DBP at the Bank's standard variable interest rate and would have a term of 20 years including 5 years of grace. The Government of the Philippines would guarantee the Bank loan to DBP. It is expected that the Bank loan will be fully committed within two years after effectiveness. 4.5 The proposed Bank loan would cover 572 of a total financing package of US$114.5 million. The balance would be provided by the project sponsors, PFIs and the Japan Grant Facility as shown in Table 4.1.  - 28 - Table 4.1 PROJECT COSTS AND FINANCING PLAN Estimated Costs Local Foreign Total -