India - Electronics Industry Development Project

Document of The World Bank FOR OFFICIAL USE ONLY t-N 3e093-/'V 4.A/~~4 -3 o e S- /A Report No. 7704-IN STAFF APPRAISAL REPOI'T INDIA ELECTRONICS INDUSTRY DEVELOPMENT PROJECT MAY 24, 1989 Asia Country Department IV (India) Industry and Finance Operations Diviqion This document has a restricted distribution and may be used by ecipients only in the perfonmnace of their officral duties. Its contents may not otherwise be disclosed without Wodd BDnk author4oo. 0  29& =Y EOUIVALENTS Rs 1 - US$0.067 Rs 15 - US$1.00 FISCAL YEI= Government of India - April 1 - March 31 IDBI - April 1 - March 31 ICICI - April 1 - March 31 ABBREVIATIONS AND ACRONYMS ASIC - Application Specific Integrated Circuits CAD/CAM - Computer Aided Design and ManufacturIng CEDT - Center for Electronics Design and Technology DFI -Development Finanice Institution EPABX - Elect.onics Private Auxiliary Branch Exchange ERAS - Exchange Risk Administration Scheme Eximbank - Export-Import Bank of India FERA - Foreign Exchange Regulation I,t GOI - Government of India IC - Integrated Circuit ICICI - Industrial Credit and Investment Corporation of India IDBI - Industrial Development Bank of India IIT - Indian Institute of Technology JGF - Japan Grant Facility LSI - Large Scale Integration MES - Minimum Economic Scale MODVAT - Modified Value Added Tax MRTP - Monopolies and Restrictive Trade Practices Act OGL - Open General License PIU - Project Implementation Unit PMP - Phased Manufacturing Program PSE - Public Sector Enterprise RBI - Reserve Bank of India REP - Import Replenishment SCL - Semiconductor Complex Ltd. SDC - Swiss Development Cooperation SFC - State Financial Corporation SSI - Small Scale Industry VLSI - Very Large Scale Integrated Circuit  FOR OFCIAL USE ONLY ~PA ELECTRONlICS INDUSTRY DEVELOPMENT PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. IAN AND PROJECT SUMMARY ....................................T i I. INTRODUCTION ................................................. 1 II. SECTOR BACKGROUND ............................................ 2 A. Electronics Industry Structure and Performance ........... 2 B. Assessment of Competitiveness ........................... 4 C. Potential and Prospects for Development .................. 5 D. Policy Environment ....................................... 6 E. Policy Constraints ....................................... 10 F. Manpower Constraints ..................................... 11 G. The Financial Sector.. .......,... 12 III. THE BANK'S ROLE IN INDUSTRY .................................. 18 A. Previous Bank Lending to Industry ........................ 18 B. T"s Bank's Future Lending Strategy ....................... 19 C. Electronics in Bank's Lending ............................ 19 IV. THE PROPOSED PROJECT ......................................... 2. A. Project Objectives ....................................... 21 B. froject Description .. 21 C. Term Credit to Expand and Upgrade Electronics Capacity... 22 D. Manpower Development and Training . . 23 E. Technical Assistance .. 25 (i) Software Capability Devrelopment .................... 25 (ii) Seminar Program .................................... 26 (iii) Training and Technical Assistance for the DFIs ..... 26 F. Project Cost ......................... 27 G. Financing Arrangements .................... 28 This report is based on the findings of an appraisal mission to India in January 23 - 'larch 8, 1989. Mission members were Messrs. G. Gowen (Senior Economist), K. Arichandran (Senior Financial Analyst), J. Bredie (Technical Education Specialist), Arnold Miller (Consultant), B. Wadia (Consultant), A. Bhojwani (Consultant), P. Reymond (Consultant), J. Delisle (Consultant, Swiss Development Cooperation), and A. Pittet (Consultant, Swiss Development Cooperation). The report was prepared by Messrs G. Gowen, K. Arichandran, and J. Bredie. This document has a restricted distfibution and may be used by recipients only in the performance of their official duties Its contents may not otherwise be disclosed without World Bank authorization.  - ii- Pag-e No. V. THE PARTICIPATING FINANCIAL INSTITUTIONS ..................... 30 A. Industrial Development Bank of India (IDBI) .............. 30 B. The Industrial Credit and Investment Corporation of India Limited (ICICI) ............................... 31 VI. THE PROPOSED LOAN ........................................... 33 A. Terms and Conditions ..................................... 33 B. Administrative Procedures ................................ 34 C. Project Benefits and Risks ............................... 37 VII. AGREEMENTS AND RECOMMENDATIONS ............................... 39 A. Agreements ................................... 39 B. Recommendation ................................... 40 ANNEXES 1. Electronics Production 1980-87 2. Manpower Development 3. Technical Assistance 4. The Industrial Development Bank of India (IDBI) 5. The Industrial Credit and Investment Corporation of India Limited (ICICI) 6. Documents in Project File  INDIA ELET=RONICS INDUSTRY DEVELOPMENT PROJECT Loan and proiect Summary B kiorrowers (a) India, acting by its President. (b) Industrial Development Bank of India (IDBI); (c) Industrial Credit and Investment Corporation of India (ICICI). Guarantor of the Loans go IDBI and iCI i India, acting by its President Loan Amounvts : US$210 million equivalent to be lent as follows: (a) US$8 million equivalent to India; (b) US$101 million equivalent to IDBI; and (c) US$101 million equivalent to ICICI Terms Twenty years, including 5 years of grace, at the Bank's standard variable interest rate. Relending terms : Development Finance Institutions (DFI) Credit Component. The loans to IDBI and to ICICI for fixed assets and permanent working capital would be relent in foreign exchange at the Bank's standard variable interest rate plus 2% to provide a spread to the DFIs, or in rupees at the prevailing Exchange Risk Administration Scheme (ERAS) rate (presently 15% with a cap rate of 18%). This rate would be adjusted according to ERAS terms to cover the foreign exchange and interest rate risks. ProiectX Description : The project would include the following components: (a) private and joint sector investment (US$420 million) in fixed assets and permanent working capital with Bank financing through IDBI and ICICI (US$202 million) us a new "single window" mechanism for financing of both term and working capital requirements of sub-borrowers; (b) improvement of skilled man-power development and training capacity of selected education and training institutions (US$26.8 million) through grants from DOE (financed by US$8.0 million from the Bank, $16.2 million grant funds expected from the Swiss Development Cooperation and US$2.6 million from GOI) for equipment, training and other assistance; and (c) technical assistance (US$3.0 million) for: (i) development of the computer software industry studies, seminar, and project identification; (ii) support of electronics policy  .11- development through seminars and studies; and (iii) upgrading the capability of financial institutions to screen and appraise electronics projects (financing of US$2.7 million expected from Japan Grant Facility, $0.2 million from GOI and US$0.1 million from the DFIs. The total cost of the project would be US$450 million. Risks : The credit component would provide longterm finance to about 30 subprojects, resulting in total investment of about US$420 million and employment of about 12,000 people. It would initiate reform in the system for financing industrial investments in the direction of increased institutional flexibility. The manpower and training component would result in an upgraded capability to produce 4000 middle and higher level technical and professional staff annually in the fields of electronics and computer software. The major risk of this project is that the Government will implement further needed reforms too slowly. This would commensurately reduce the pace at which the industry achieves lower costs and increased efficiency, which in turn would lead to less than expected efficiency of subsequent users throughout the economy. Recent policy reforms provide a sufficient basis for the project, and the Bank and Government will continue to discuss further reforms both in the context of macro-economic and sector work and the proposed project. ERAS scheme is new and will require close monitoring to ensure that relending rate adjusts properly to market conditions, and the needs of financial institutions and sub-borrowers for some predictability in their financial planning. Finally, with respect to the manpower component there is a potential risk of delays in implementation because the organizational set up is new, and the institutions are not familiar with Bank procedures. Additional supervision at start up will help reduce this risk.  -lii- Estimated CGosts: Local Ensign Total ------- (US$ million) ------ Credit Line for Expansion Fixed Assets 144.1 150.0 294.1 Working Capital 74.1 52. 1261. Sub-total 218.2 202.0 420.2 Manpower Development 19.3 7.5 26.8 Technical Assistance & Stvt.ies 0.6 ,2.4 3,0 Total 238.1 211.9 450.0 Financing Pla: Bank 0.5 209.5 210.0 GOI 2.8 -- 2.8 Development Finance Institutions 50.7 -- 50.7 Subproject Sponsors & others 167.6 167.6 Swiss Development Cooperation 16.2 16.2 Japan Grant Facility 0.3 2.4 2.7 Total 238.1 211.9 450.0 Estimated -Lsbursements: Bank FY 91 22 i3 2& 95 96 -----------------(US$ million)-------------- Annual 19.6 60.5 71.2 41.4 14.7 2.2 0.3 Cumulative 19.6 80.2 151.4 192.8 207.5 209.7 210.0 Economic Rate of Return: Subprojects financed by the Financial Intermediaries would have a minimum economic rate of return of 12%.  INDIA ELECTRONICS INUSTRY DEVLPNE PROJE STAFF APPRAISAL REPORT I. INTRDUCION 1.01 India has the potential to develop a competitive electronics industry of international stature based on its large pool of high level scientific and technical manpower, its growing and potentially vast domestic markets, and the significant existing industrial base with its large pool of capable managers and entrepreneurs, including Indians now resident abroad. After several decades of following restrictive regulatory policies and an inward looking trade regime, the Government, in recent years, has enacted a far-reaching program of policy reform, which for electronics goes further than for almost any other industry. It provides a sound initial basis to try to realize this industry's immense potential for increased production and employment and as a source of productivity improvements throughout the economy. 1.02 The proposed Electronics Industry Development Project would assist the Government in its further efforts to foster this industry's sound development with the objective of eventually reaching a level of international competitiveness. First, it would provide technical and financial support to the two largest development finance institutions to improve their capability to identify, appraise and finance economically sound projects in this sector. Second, it would help to improve the quality of medium and high level technical and professional manpower needed for the industry's rapid and efficient growth. Third, it would lay the basis for expanding capacity in the most promising area, computer sofhrare, by identifying projects and measures to provide needed infrastructure. Finally, the project would provide an important basis for on-going discussions between the Government and the Bank on policies for the electronics sector and for industry as a whole.  -2- II. SECTOR ACKGRO A. Electronics Industry Structure and Performance 2.01 The world electronics industry reached an estimated worldvidk production of nearly US$500 billion in 1987, its rapid growth spurred by technological advances that have lowered the cost of information processing by more than 20S per year for more than four decades. It now accounts for about 108 of worldwide manufacturing and its impact, through communications, broadcasting, and information technology reaches to every corner of the world economy. The Indian electronics industry, established almost 25 yearz ago, accounts for only about 0.6% of international electronics production. Relatively stagnant during the 1970s with an annual growth rate of 10% in real terms, it has begun to catch up, its growth rate accelerating to 18% per annum in the first half of the eighties and to nearly 25% per annum in 1985-87. Gross output reached a level of Rs 47.2 billion (US$3.6 billion) in 19e7. The industry now comprises more than 5% of manufacturing value added in India and is expected to continue its rapid rate of expansion. 2.02 The subsector is domestically oriented. Total exports in 1987 (including free zones) reached only Rs 3.1 billion (US$240 million) and averaged less than 7; of output, of which 42% originate from the oldest and most active export processing zone on the outskirts of Bombay. Except for Chigia, this share is low for developing countries that have significant electronics subsectors. Imports meet only 25% to 30% of the demand for final products. However, except for such traditional consumer goods as radio receivers and black-and-white television sets (B&W TVs), whose inputs are mostly produced locally, the subsector imports about half of the required materials and components. 2.03 Public sector enterprises (PSEs) account for about 40% on average of the subsector's output, ranging from 104 in consumer goods to nearly 100% in communications and aerospece and defense. Most of the 3,000 or so electronics firms are small-scale industries (SSIs), which produce about 25% of total output and are especially important in consumer electronics. Medium and large private enterprises account for about 35% of total output; many of the large private firms have had long-standing associations with multinationals.  -3- 2.04 Electronics production in 1987 was as follows: USS billiU * Consumer electronics 1.42 38.6 Industrial electronics .54 14.5 Data processing & office supplies .30 7.9 Communications .56 15.0 Aerospace and defense -24 6.4 Sub total 3.04 Components .55 14.8 Export processing zones .10 2.8 Grand total 3.69 100.0 Source: Depa-tment of Electronics Expansion in consumer electronics, particularly color television production, has helped to accelerate the subsector's recent growth. This segment now accounts for nearly 40% of total electronics output. Although the production of data processing equipment has grown rapidly because of Government-sponsored modernization programs in industry and in banking, output in this segment only reached about 46,000 units in 1987 (mostly microcomputers), representing 8% of India's electronics subsector compared with a 20% share ir. other countries. The industrial, telecommunications and components segments each command about 15% of the subsector's total output. In telecommunications, two large PSEs dominate: Indian Telephone Industries and Hindustan Cables Limited. Industrial electronics, which includes several large PSEs, is concentrated in industrial process controls and power electronics. In this segment, several firms with international ties have been able to export worldwide. A breakdown of electronics production, 1980-87 is given in Annex 1. 2.05 The structure of the components segment is highly fragmented, with a few very large firms at one end and many small producers at the other. Production is largely for use in radio and television sets. Semiconductors (mostly discrete devices) account for only 12% of India?s components output compared with 30% to 50% in industrialized countries. Small- and medium- scale integrated circuits (ICs) are produced by a single PSE, Bharat Electronics Ltd. A second PSE, Semiconductor Complex Ltd., was producing large-scale integration (LSI) ICs partly from imported wafers until its plant was destroyed by fire in early 1989 (para 2.15). Very large-scaie integration (VLSI) ICs are still imported. In total, locally produced ICs meet less than 10% of demand and account for only 3% component production compared with a much larger share worldwide.  .4- B. Assessment of Competitiveness 2.06 India's electronics subsector has developed in an environment protecting it from both domestic and international competition and insulating it from technological progress. As a result, process technologies are generally outmoded (8 to 20 years behind); product technologies are 5 or 6 years behind; and Indian electronic goods generally have very high production costs and prices. For example, for 10 major electronics products, India's factory prices in 1986 exceeded world prices by 20% to 170% and many were of inferior quality. Products with prices near or below world prices, such as in printed circuit boards (PCBs) and computer software, are rare. 2.07 Several important factors account jor the high production costs and prices. Production scales are substantially smaller than international minimum economic scales (MES) of leading multinationals by factors of 20 to 100 in some product lines, which affects raw material prices, capacity utilization and other costs. Indian electronics industries also bear high customs duties on imported components inputs and several other indirect taxes so that total indirect taxes comprise 20% to 40% of the sales price. As scales are small most firms pay 15% to 40% above world prices obtainable through bulk purchase of materials and components. Profit margins for well operated Indian firms are high by international standards for electronics industries (from 18% to 40% of factory prices), reflecting lower competitive pressures and short term profit horizons. Other factors which hurt competitiveness include the following: India's relative isolation from world markets, which limits exposure to product trends and changing technologies; the related problem of supply uncertainties stemming from reliance on imported raw materials, components and other needs as well as delays due to customs administration (all of which result in costly inventories); the lack of suppliers, precision services, ii-id other industrial and service "infrastructure" of adequate technological capability and re'liability; limited and unreliable communications services; and Government regulation and controls. In addition, Indian electronics firms face shortages and interruptions of power, communications, and input supply (which contribute to costly inventories), and labor regulations that lead to inflexibility and encourage overstaffing. 2.08 Although the subsector is generally inefficient by world standards, a few firms in India now produce competitively with domestic prices that, if adjusted for indirect taxes and international profit norms, would approach world prices. These firms are typically found in product areas (such as B&W TVs) characterized by relatively simple and mature technologies that have been fully assimilated, and by domestic markets large enough to allow economies of scale. In addition, product areas that require a significant level of skilled labor such as PCBs, individual electronics products with a high design content, and above all, computer software, perform well. In most product areas, however, even the most efficient firms are uneconomic, exhibiting one or more of the following characteristics: production is highly capital Intensive; technology is difficult and has not been mastered because of inadequate technology transfer arrangements; the market is too small to allow adequate scale, or else the technology appropriate for the size of the market is obsolete; and  high protection allows "kit assembly" from foreign sole-source sippliers with resultant very high raw material costs. C. Potential and Prospects foX Development 2.09 India has the potential to develop a competitive electronics industry. Its main advantageo are its unusually large pool of high level scientific and technical manpower whose average wages are a tenth those of the U.S. and Western Europe- its growing and potentially vast domestic markets; and the significant industrial base -- including a long-standing electronics industry -- that has already developed with its pool of capable and experienced managers and entrepreneurs. Also, a large number of non- resident Indians with technical and managerial experience are a source of entrepreneurship and of assistance in developing collaborative arrangements with foreign sources of technology and finance. 2.10 These advantages need qualification, however. Skilled manpower lacks training and exper'.ence -- constraints which this project will help to address (paras. 4.07-4.13). Markets are not as large as India's vast population would suggest because low incomes coupled with high prices exclude much of India's population from them; in absolute size they are comparable to Turkey or the Philippines. The industrial base and its management evolved under a highly protected environment that until recently tended to stifle competition, allowed survival (indeed, prevented exit), despite outmoded or obsolete technical practices and limited scales of operations, and fostered inefficient managerial practices. As discussed below (paras. 2.17-2.23), there have been major improvements in this policy framework. 2.11 The Bank prepared a study of this sector,J/ submitted to the Government in July, 1987, which indicates that overall demand for electronics equipment is expected to expand In real terms at 18-20% over the medium term. Exports will grow even faster but will remain at less than 10% of total production. The study identified a number of product groups which are already competitive or can become so. The most promising exhibit many of the following characteristics: high need for engineering and skilled manpower in design, production, sales and installation, and servicing; a domestic market large enough to allow production at sufficient scale; the technology required for production can be assimilated, effectively used, and kept up to date given the present levels of technology and supporting infrastructure in India; relatively low intensity in use of capital and materials; high transport costs relative to product value; and local availability of critical inputs and experience at reasonable costs. 2.12 The most promising product groups for the domestic industry, which will be the primary focus of the industry's development in the next decade, are in the professional electronics segments of industrial electronics, computers and data processing including software, and te3ecommunications equipment. These segments include many product groups with prospects of 1/ India - Development of the Electronics Industryl A Sector ReRort, No. 6781-IN, (June 26, 1987), (Project File, No. 1).  -6- becoming competitive (e.g. in instruments, process controls, EPABXs) because they are skill intensive, have relatively low capital and raw materials needs and do not require high volumes and large scales. Attempting products which are technically very difficult, such as state-of- the-art mainframe computers and integrated circuit testers, may be very costly because their technologies are closely held, fast changing and require a hlgh level of R&r to assimilate as well as strong supporting technical and industrial service infrastructure. 2.13 Computer software, though still a tiny industry (estimated value of production in 1987 was about US$160 million), is particularly promising because of its high degree of skill intensity. Exports reached US$57 million in 1987 and are estimated to have grown to US$70 million in 1988. Though the industry is dominated by two firms, which account for about 60% of total exports, there are dozens of smaller firms whose potential contribution to both domestic production and exports is constrained by lack of access to marketing expertise, software productivity tools and hardware needed for software development, and risk capital to finance costs of product development and marketing. A technical assistance component of the project addresses these issues (paras. 4.15-4.16). There is a more generalized constraint from lack of specially trained manpower as discussed below (paras. 2.27-2.28) which the project will also address (paras. 4.07-4.13). 2.14 With regard to consumer electronics, domestic demand can support production at reasonable scale of some major *onsumer items (radios, black- and-white and color TVs) as well as major inputs for these products such as color picture tubes and glass shells that are used in color picture tubes. Export of some consumer items to other developing countries has begun and can be expanded to many consumer products, such as black and white TV, which are at the lower end of the technology scale and whose production is being relinquished by producers in more developed countries where the demand has stagnated or declined. 2.15 In the critical area of integrated circuit production, particularly at very high levels of technical difficulty such as VLSI chips, Indian producers face much the same difficulties as for "high tech" professional electronics products: closely held, fast-changing technologies, and a requirement for a high level of R&D capability which in turn requires the availability of high-tech supporting services, and increasingly costly investment due to rising scales and capital intensiveness. India has been trying to develop a microelectronics capability, particularly for large scale integrated circuits through Semiconductor Complex, Ltd. (SCL), the DOE-administered wafer fabrication plant in Chandigarh that was completely destroyed by fire in February, 1989. Though in production for more than four years and capable of exporting simpler ICs such as clock chips, it had not begun to achieve competitive efficiency. The Government is now assessing how best to replace this loss. D. Policy Environment 2.16 Past Policy Framework. The very high prices and variable quality of electronic products have largely been the result of the industrial and  -7- trade policies followed until recently. These policies, which were an integral part of the industrial policy framework that emerged in the late sixties and early seventies, emphasized self-sufficiency, indigenous technological development with minimal recourse to foreign technology, reservation of key products to the public sector, concessions to small- scale producers and pressure for the regional dispersion of production. These policies in electronics, resulted in a capability to produce a large number of products in each of the electronics segments. However, they imposed major constraints on the development of an efficient electronics subsector: - The industrial licensing system severely regulated entry and restrained growth of the most efficient producers. Larger firms, especially those subject to the Monopolicies and Restrictive Trade Practices Act (MRTP) and Foreign Exchange Restrictions Act (FERA) were inhibited from expanding. Some 24 product areas including some that needed scale for efficiency (especially in consumer electronics and components) were reserved to SSIs. Exit of inefficient firms was discouraged by a combination of labor regulations, restrictions on asset transfer and bank lending practices. These policies and procedures, together with those limiting total domestic production capacity to the perceived size of the market, restrained domestic competition in important product areas. - The reservation of some segments to the public sector (telecommunications and defense) eliminated private-sector competition and allowed inefficient monopolies to develop; - The emphasis on technological self-sufficiency led to backwardness in processes and products. The policy climate did not encourage foreign collaborations and many joint ventures involved technology sufficient to enter production but not to update thereafter. Restrictions on royalty payments and other limitations did not provide sufficient incentives to encourage foreign firms to enter intc joint ventures especially those firms with proprietary technology in the more sophisticated areas; - The trade and protection policies, which resulted in extremely high levels of effective protection (d&te to high tariffs and the banning of competing imports), prevented alternative sources of potential competition from developing and discouraged exports, which could have exposed the industry to international trends and competition; - The high level of indirect taxes contributed to higher production costs, and the complicated structure of these taxes hampered the development of exports because it was difficult to identify the indirect taxes to be rebated or otherwise offset; and - By encouraging geographic dispersal, the Government policies hindered concentration of the industry, which was vital to developing a strong supporting infrastructure.  -8- 2.17 Recent Pollcy Reforms. The Government has recognized the importance of electronics--not only for its direct contribution to industrial output and employment but also as a source of productivity lmprovements in manufacturing and other sectors--and has singled out this subsector for policy changes to achieve efficient growth. A series of major policy changes dealing with different electronics segments commenced with the Policy on Electronics Components in 1981, and led up to the Integrated Policy Measures in Elee.tronics (March, 1985), which consolidated previous pronouncements and made additional fiscal and licensing reforms. A major reform in computer software followed with adoption in December, 1986, of the Policy on Computer Software Export, Software Development and Training. Incremental improvements have continued to be made since then. Electronics has also benefitted from the series of discrete policy actions initiated since 1985 applylng to all industries which cumulatively have significantly improved the policy environment for all industries. These reforms have been complemented by some liberalization of the financial sector, especially in capital markets (paras. 2.31-2.33). 2.18 Of the policy reforms affecting electronics, most important for electronics has been the gradual liberalization of the regulatory system to lift restrictions on entry and enterprise growth. Components and consumer electronics have been specifically delicensed, which has meant that they could undertake new investments without having to go through complex and time consuming Government procedures to obtain an investment license. Other electronics segments benefit from the recent increase in the general licensing minima from Rs. 50 million (US$3.3 million) to Rs. 150 million (US$10 million). For industrial projects generally, delicensing was extended to units importing up to 30% of input needs, up from 15% in the past. In areas still subject to licensing, more flexibility has been glven to adjust both output mix and capacity. Licensing procedures have been simplified. DOE introduced "single point" scrutlny of project applications in computers and industrial products in 1984, and computer software in 1986. Access to imported capital goods for electronics has been assured by placement of much of the specialized equipment used by electronics firms on open general license (OGL), which has meant these items can be im.ported without prior clearance from the Government. Reservation of products reserved for small scale industry, which included many types of components, has been virtually eliminated. 2.19 The product areas open for investment to electronics firms subject to the MRTP Act (which subjects them to different types of anti-monopoly regulation) has expanded from components to include all segments except consumer electronics. Electronics has benefited from the general increase in the threshold level for a firm to be classified as monopolistic. 2./ Telecommunications equipment formerly the exclusive preserve of the public sector, was opened in 1984 to the private and joint sector for manufacture of equipment at subscribers premises (i.e. telephone handsets, EPABXs) and in 1988 was broadened further to include some of the remainder, including rural exchange and transmission equipment (for public sector firms with State Government ownership greater than 50%). 2/ The level of a firms total assets at which it is considered to be a monopollstic for the purpose of Indlan regulatory laws was lncreased ln 1985 from Rs. 200 million (US$13.3 million) to Rs.l billion (US$66.7 million).  -9- 2.20 Domestic deregulation has had a major impact in increasing domestic competition in electronics as evident from the ex-factory price drops in some of the major products. Color TV set prices have fallen by 60% since 1984 when large scale production began. Microcomputers prices have dropped by nearly 50% in just the last two years. In telecommunications equipment the large public sector firms have improved marginally and partly due to competition from newly established private sector firms. Pressure on domestic profits as a result of competition has also helped to increase the incentive to export (see para. 2.22). In parallel with deregulation has come improved access to foreign technology, critical to electronics which now accounts for 20% of foreign collaborations. Restrictions have been lifted entirely on foreign ownership if equity is less than 40%, and greatly reduced on the types of technology firms are U.llowed to import. These measures have dramatically increased foreign co'laborations, which reached 173 in 1985 and grew to 260 in 1987 compared with an average of 10-15 a year in the mid-1970s. Foreign collaborations have become more attracti -t ioreign partners because of the 1987 increase of the royalty ceiling From 5% to 8%. 2.21 In the area of trade policies, quantitative restrictions (QRs) have been greatly reduced for components, which are now mostly on OGL to actual users and have been eliminated entirely in the case of software. The July, 1988, action to allow all industrial items on "limited permissible" to be purchased under Import Replenishment (REP) license has essentially eliminated this category as a quantitative restriction to users willing to pay the additional premium, currently around 20%, which accrues to REP license sales. The import duty structure has been largely rationalized, with raw materials generally at 45%, processed parts at 60%, components and peripherals at 80% and final products ranging from 90% to 150,. 2.22 The incentive to export has recently grown as a result of three factors: overcapacity in a number of products, especially in passive components (carbon film resistors, for example) following deregulation; improvement of export policies and administration which began in 1986; i/ and the adoption of a more flexible and realistic exchange rate policy leading to a real effective exchange rate that has depreciated more than 30% since the end of 1985. In response exports of electronics products from the domestic tariff area (i.e. excluding free zones), which had stagnated by 1984 have more than tripled in value since then, growing from 2.7% of total production in 1984 to 3.9% in 1987. With regard to the tax system, GOI has reduced and simplified corporate taxes; implemented a modified value added tax (MODVAT) that eliminates the cascading effect of indirect central government taxes for most products and facilitates indirect tax deduction for exports, and rationalization of tax incentives for small scale industries. 2/ A detailed review of recent changes in export policies and administration are given in India: Export Development Proiect Staff Anoraisal Report. Report No. 7603-IN, paras. 2.09-2.19.  -10- 2.23 As a result of the pioneering improvements in electronics policy framework which began in 1981 and the more recent general policy improvements that date mostly from 1985 onwards, production and investment have greatly increased, especially from the private and joint sectors. Electronics production, which had grown in real terms at nearly 13% between 1975-80 increased to more than 18% from 1980-85, and to 25% from 1985-1987. Electronics investment, as measured by the commitments of the two major all-India financial institutions, the Industrial Development Bank of India (IDBI) and the Industrial Credit and Investment Corporation of India (ICICI), which provide about 80% of project term financing for medium and large firms in this segment, had increased in the period 1983-85 to more than six times the level of a 1977-79, and in 1986/87 to more than double the rate of 1983-85. Noreover, the composition of electronics financing has changed: private and joint sector investment, which was less than half the total commitments of these institutions in 1977-79 is now more than 80%. E. Policy Constraints 2.24 The policy improvements to date are encouraging a more efficient industry that has promise in many areas of becoming internationally competitive. Despite the improvements discussed above, however, additional reforms will be needed to ensure that cost competitiveness and quality of Indian electronics products will approach international standards. The June, 1987, Electronics Sector Report (Project File, No. 1) provided an agenda for further change to achieve these objectives. The recommendations included: progressively eliminating quantitative restriction on imports and at the same time gradually reducing customs duties to compel dormestic firms to upgrade their products, improve efficiency and lower price:3 to meet world price and quality standards; simplifying and eventually eliminating domestic content requirements under phased manufacturing programs (PNPs); eliminating the remaining disincentives that restrict access to foreign technology leaving firms free to choose technologies appropriate for production and market conditions, with minimum Government involvement; extending capacity delicensing to industrial electronics, computers and telecommunications; and removing remaining HRTP clearance requirements for product groups where scale is needed for efficiency. 2.25 The study also emphasized the need for an easement of industrial exit restrictions to complement the measures taken to improve entry. While recognizing that the changes for this purpose are needed in banking, labor regulations, and bankruptcy procedures that go well beyond the electronics industry the study suggested that the electronics industry might be selected for priority treatment. The study underlined the importance in the longer run of extending MODVAT to a more comprehensive value-added tax system; the need to persuade the states to harmonize state level taxes with the VAT system and to eliminate discrimination between local and out-of- state production which have become an important source of distortion that is fragmenting capacity in this industry. The study also pointed out the need to lift or reduce restrictions on location to allow economies of agglomeration to be realized.  -11- 2.26 Though this is a large agenda for change, there has been steady. though incremental progress in implementing it, even since the Sector Report was issued. It has taken the form both of broad industrial measures that affect electronics, and specific measures concerning only electronics. These include: reiucing further the licensing restrictions on MRTP firms; raising the threshold on the imported materials percentage that subjects a firm to licensing; extending delicensing to microcomputers, peripherals, and monitors; rationalization of the tariff structure for computers and computer peripherals; reduction of the indigenization objectives of the phased manufacturing program for all industries from 90% to 708; and elimination of QRs on a broad range of products for firms willing to pay an additional premium. As a result of the sector study and project preparation, dialogue has been established with DOE and other Government agencies on policies for this sector that is contributing to the change that is taking place. A Bank loan to support this industry's further development is well justified on the basis of improvements made before and during the project preparation period. The project will provide a context for a continuing dialogue with DOE and other Government agencies on a number of fronts as the results of project financed technical assistance and studies are discussed. These concern the key areas of software and manpower development as well as a range of specific issues (paras. 4.19-4.20) involving import tariff levels, indigenization, standardization, dissemination of information technology, etc. F. Manpower Constraints 2.27 Skill requirements for electronics are far higher than for industry as a whole. Nearly 30% of the electronics work force possess technical degrees at bachelor level or higher; in the case of computer software, about 90% of the work force are engineers. The most important basis for Indian competitiveness is the potential availability of higher level skilled, technically trained manpower at low cost. Indian electronics experts have proved their competence abroad, and in India their costs are less than most other developing countries with significant electronics industries. However, except for a few top-level institutions such as the five Indian Institutes of Technology and the Indian Institute of Science, which export about 30% of their graduates, and the DOE managed Center for Electronics Design and Technology (CEDT), Bangalore, the quality of training that is being provided for middle and higher level professionals is seriously deficient in practical application, iwith the result that extensive training, often of a year or more, must be provided by individual firms before higher level technical staff can be used productively. The lack of quality of instruction is rooted in a number of different factors: theoretical bias of curricula, shortage of teachers with practical experience, lack of opportunity to receive industry experience during the formal training period, lack of funds for well- equipped laboratories and workshops, and the lack of linkage with existing industry. 2.28 In the computer software industry, where India's potential competitive advantage may be greatest, the industry faces an absolute shortage of staff as well as an upgrading problem which is clearly evident from discussions with firms in the industry. DOE estimates that the  -12- programmers. systems analysts, computer engineers, and similar types of specialties needed by the end of the Seventh Flve year plan period will have reached more than 33,000 compared with an output from formal training institutions during that period estimated at little more than 9,000. The Government's software export policy (para. 2.17) recognizes this constraint and has recommended not only an expansion of public educational institutions and establishment of three new CEDTs, but also new incentives to upgrade the private-sector training and educational institutions. The project includes a component to support the Government's objective of improving the quality of the output of middle and higher level manpower, focused primarily on upgrading the electronics and computer science programs at a carefully selected group of engineering colleges (the principal source of higher level technical engineering manpower) and polytechnic institutes (the main source of middle-level technicians such as programmers, factory technicians, and repairmen). See paras 4.06-4.12. G. The Financial Sector _/ 2.29 Historically, India has followed relatively conservative monetary and financial policies. The main objectives have been to mobilize domestic savings on a large scale, contain inflationary pressures and achieve a pattern of investment conforming to the Government's economic and social priorities. These oLjectives have been pursued through several mechanisms. First, interest rates have been administered through the Reserve Bank and the interest rates paid on commercial bank deposits and other savings instruments as well as the lending rates have been kept positive in real terms. Second, the commercial banking system's scope for credit creation has been tightly circumscribed. Third, a system of quite rigid credit allocation guidelines has been used to direct funds to earmarked industries and social sectors. Within this policy framework, the financial system has grown rapidly over several decades and the nation's traditionally high savings rates have been accompanied by significant financial deepening. Savings rates have risen steadily from about 168 of GDP in the late sixties to an average of 23% since 1980. However, this success on the resource mobilization side contrasts with the more mixed results in resource allocation both in terms of their impact on economic efficiency and the financial condition of lending .,.nstitutions. The evidence suggests that in conjunction with restrictive industr4al policies, the credit allocation and interest rate policies encouraged inefficient patterns of investment in industry. 2.30 As of December 1986, commercial bank credits of Rs 49 billion were officially classified as being extended to "sick industries" which have negative net worth. Outstanding credit to sick industries alone are about 15.7% of commercial banks' credit to industry and 8.1% of their total outstanding credit. The situation in the DFIs is similar; in 1985 IDBI's outstanding loans to sick industries were about 11% of its portfolio. In addition to the sick industry problem, the collection ratios on other A/ World Bank, India: Credit and Capital Markets Study, Report No. 6661-IN (February 27, 1987), provides a comprehensive analysis of the Indian financial sector.  -13- industrial and agricultural lending have been decreasing. The problems are being further exacerbated by increased competition faced by many industries resulting from the ongoing industrial liberalization. Together with deteriorating portfolio quality, the operating spreads of financial institutions have narrowed as recent interest rate adjustments have resulted in lower average lending rates and higher funding costs. Thus there is a need to rationalize the system of financial sector controls and improve the institutions' operational flexibility and profitability. In recognition of these problems the Government has since 1985 set up several committees to study the various financial markets and recommend ways of improving the working of the financial sector and their reports are providing a basis for an ongoing process of reform. 5/ 2.31 In the last few years, the Government has encouraged the development of new and more appropriate funding instruments and markets to finance industry; thus, it has encouraged a shift away from bank loans to more capital market funding of both private and public sector industrial firms. First, restrictions on the purposes for which companies could issue securities were progressively relaxed to allow flotation of debentures to fund new companies, mergers/acquisitions and working capital. Second, the quantitative limit for issues exempt from capital issues controls was doubled to Rs 10 million and listing requirements were eased. Third, smaller firms were given improved access to the non-convertible debenture market by the raising of the interest rate ceiling on their issues to 15% from 13.58. Fourth, in an effort to encourage public sector firms to raise funds on the capital markets, these firms were given the freedom to undertake public debenture issues even though their shares may not be listed. 2.32 Measures to diversify the markets and improve the attractiveness of issues by start-up firms have included the introduction of new instruments such as Cumulative Convertible Preference Shares (CCPS). These securities count as equity, carry a 10% dividend and are convertible into straight equity after three to five years. Also liquidity has increased--particularly in the debt markets--with the major public sector investment institutions playing an important role in maintaining secondary markets. Finally, the Government has introduced legislation to protect investors and boost confidence in the markets, and new institutions such as a stock holding corporation have been set up to simplify the purchase of securities. The introduction of further capital market reforms is expected soon. 2.33 In response to the various changes in regulations and fiscal incentives the capital markets have grown rapidly in the 1980s, and particularly since 1985. The equity market took off in 1980/81 when the amount issued rose 242% to Rs 2 billion as a result of FERA legislation which indigenized ownership of foreign firms. Since then the primary 1/ These are the Chakravarty Committee to Review the Working of the Monetary System (1986); the Patel Committee on the Operations of the Stock Exchange (198_; the Vaghul Working Group on the Money Mark-cs (1987) and the Hussain Committee on the Carital Markets (1988).  -14- market has grown fat. The volume of equity issued (including rights and preference shares) quintupled to Rs 8.8 billion in 1986 from Rs 1.77 billion in 1982. The debenture market also grew significantly over the sme period when the amount isaued more than doubled to Rs 5.9 billion from Ru 2.4 blllon. In general, the relaxation of guidelines controlling debenture issues brought down financing costs to companies, especially the cost of working capital, in comparison to bank loans. At the same time the yields to investors on these securities were higher than those paid on comparable bank deposits. These capital market developments have encouraged financiai. institutions to expand their activities to leasing, mutual funds, credit cards and other higher income earning activlties to compensate for the declining marglns on their basic lending activities. 2.34 Th Baking Syste. The Indian financial system is highly segmented with different roles clearly earmarked for the various institutions. The Reserve Bank of India (RBI) has a wide-reaching role in t!,e system. In addition to traditional central banking functlons, it has broad regulatory and policy implementatlon functions. The financial system is overwhelmingly in the public sector. There are currently about 30 private sector Indian banks and about 20 foreign banks which together comprise the private banking system. However, these banks are dwarfed by the huge public sector ones, both in terms of size and geographic spread. The private sector banks and foreign banks account for only about 4.3% and 4.5% respectively of total commercial bank assets. The remaining 91.2% is accounted for by 28 public sector commercial banks. 2.35 In spite of the increased role of the capital markets, the financial sector is still dominated by the banking system. Commercial banks have the lead role in resource mobilization and together with the Development Banks, they are the biggest source of funding for industrial investments. As of June 1987, the Scheduled Commercial Banks