China - Fifth Industrial Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY 14. Al C4 Repout No. 7659-CHA STAFF APPRAISAL REPORT CHINA FIFTH INDUSTRIAL CREDIT PROJECT APRIL 28, 1989 Industry, Trade and Finance Operations Division Country Department III 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 (Currency Unit - Yuan Renminbi Y) 1982 1983 1984 1985 1986 1987 1988 Y per $, year average 1.89 1.98 2.32 2.96 3.45 3.72 3.72 DecemL3r 1985 Y 3.20 - $1.0 Y 1.00 - $0.31 December 1986 Y 3.72 - $1.0 through December 1988 Y 1.00 - 0.27 (In this report $ refers to US$) FISCAL YEAR January 1 to December 31 LIST OF ABBREVIATIONS AND ACRONYMS ABC - Agricultural Bank of China ADB - Asian Development Bank BOC - Bank of China BOCOM - Bank of Communications CIB - China Investment Bank CITIC - China International Trust and Investment Corporation CMD - Credit Management Department CNTIC - China National Technical Import Corporation DFC - Development Finance Company EDI - Economic Deveiopment Institute EDPS - Electronic Data Processing System FTC - Foreign Trade Corporations FXAC - Foreign Exchange Adjustment Center GOC - Government of China ICB - International Competitive Bidding ICBC - Industrial and Commercial Bank of China KfW - Kreditanstalt fur Wiederaufbau MOF - Ministry of Finance PBC - People's Bank of China (the Central Bank) PCBC - People's Construction Bank of China RCC - Rural Credit Cooperative SAA - State Audit Administration SAEC - State Administration of Exchange Control SEC - State Economic Commission SPC - State Planning Commission TA - Technical Assistance TVE - Township and Village Enterprises UCC - Urban Credit Cooperative UNDP - United Nations Development Programme  FOR OFFICIUL USE ONLY Fifth Industrial Cred!t Proiect (Cis v) Staff Auraisal xeDort Table of Contents Paie LOAN AND PROJECT SUMMARY .iii I. INTRODUCTION. 1 II. THE INDUSTRIAL SECTOR. 2 A. Structure and Performance. 2 B. Main Sectoral Issues and the Government's Strategy. 3 C. Bank Support for Industry. 5 III. THE FINANCIAL SECTOR. 7 A. Institutional Framework. 7 B. Main Sectoral Issues and Reforms. 8 C. Bank Strategy .13 IV. THE PROPOSED PROJECT ..13 A. Project Objectives and Components .13 B. CIB's Institutional Aspects .15 C. CIB's Past and Planned Operations .22 D. CIB's Financial Performance. Position and Projections .27 V. THE BANK LOAN .30 A. Main Features of the Loan .30 B. Procurement and Disbursements .32 C. Reporting and Auditing Requirements .33 D. Benefits and Ri3ks .33 VI. AGREEMENTS AND RECOMMENDATION .34 This report is based on the findings of an appraisal mission composed of Messrs. Zafar Shah Khan (Mission Chief), Carlo Punsalan and Kyung Song, which visited China in January 1989. The report also reflects contributions made at pre-appraisal by Messrs. Hang Tuck Kun, Tan Aik Hong and Johannes Schoter (Consultants). This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Page ANNEXES 1. Interest Rate Changes .37 2. Development Strategy Statement .38 3. Statement of Operating and Financial Policies .41 4. Training Program .45 S. Actual and Planned Term Loan Operations .46 6. Loan Approvals by Sector and Branch . 47 7. Sectoral and Geographical Distribution of Subprojects under CIB I, II, III and IV .48 8. Project Implementation Schedule .50 9. Key Monitoring Indicators .51 10. Actual and Planned Lending, Investments and Fee-Generating Operations .52 11. Actual and Planned Resource Mobilization .53 12. Actual and Projected Income Statements .54 13. Actual and Projected Funds Flow Statements. 5 14. Actual and Projected Balance Sheets .56 15. Actual and Projected Key Financial Ratios .57 16. Projected Disbursement Schedule .58 17. Selected Documents and Data Available in the Project File .59 FIGURES CIB Organization .60 HAP IBRD - 21327 China - Fifth Industrial Credit Project  -iii CHINA FIFTH INDUSTRIAL CREDIT PROJECT (CIB V) Loan and Proiect Sunmary Borrower: People's Republic of China Beneficiary: China Investment Bank (CIB) Amount: $300.0 million equivalent Terms: Twenty years, including five years' grace, at the Bank's standard variable interest rate Onlending Terms: The proceeds of the loan would be onlent to CIB for a 20- year term, including a 5-year grace period, at a variable rate equal to the Bank rate; CIB would pay a commitment fee equal to that under the loan. Subborrowers would pay a variable interest rate equal to the Bank rate plus a minimum spread of 1.5Z and would carry the foreign exchange risk between the Bank's currency pool and the yuan. However, subborrowers with a loan of less than $1 million would have the option of only carrying the foreign exchange risk between the US dollar and the yuan, subject to payment of an appropriate fee to CIB for carrying the exchange risk between the currency pool and the US dollar. Project Description: The project includes the following components to be financed under the proposed Bank loan: (a) industrial credit of $299 million for the financing of small- and medium-sized restructuring projects in the light industry sector and the removal of the sector's operational bottlenecks; and (b) technical assistance of $1 million for CIB to train staff and introduce an electronic data processing system for accounting and financial management information system. Benefits and Risks: The project would further the institutional development of CIB, including the introduction of new products and services. This strengthening would help prepare CIB to face newly emerging competition effectively and would support the institutional deepening that is critical to the success of the reform effort. The project would also help upgrade the productivity and efficiency of about 200 small- and medium-scale industrial projects by importing modern technology and other inputs. The project risks relate mainly to CIB's sustained and successful institution-building. The assurances the Bank has  - iv - obtained from CIB management and the government's commitment to financial sector reform should ensure successful implementationi of the project and realization of its objectives. Estimated Disbursements: Bank FY 1990 1991 1992 1993 1994 1995 Annual 15.0 81.0 96.0 60.0 33.0 15.0 Cumulative 15.0 96.0 192.0 252.0 285.0 300.0  CHINA FIFTH INDUSTRIAL CREDIT PROJECT (CIB V) I. INTRODUCTION 1.1 The development of China's industry has been particularly hampered by a weak financial sector and the lack of suitable intermediaries for delivering medtum- and long-term finance. Indeed, until 1984 banks in China were little more than fiscal agents for the government. As one of the measures to remedy this weakness, in 1982 GOC established the China Investment Bank (CIB). Four IBRD/IDA operations (totalling $645.6 million) have assisted CIB in its rapid growth as a financial intermediary specializing in investment loans for small- and medium-sized restructuring projects, sponsored mainly by enterprises in the light industry sector. CIB is also the financial intermediary for the Tianjin Light Industry Project, the first Bank-assisted regional industrial project in China, approved by the Board in February 1989. During its relatively short existence, CIB has made rapid progress in developing its staff and operating systems and in adopting a more commercially oriented style. However, its institutional deepening has sometimes lagged behind the expansion of its organizational structure and operations. Thus, there is a need for continued and vigorous efforts to strengthen its staff and procedures. 1.2 CIB has prepared a new development strategy and operational and financial plans based thereon for 1989-92. Its main focus is on further institutional development and continued investment financing of its traditional clientele. i.e., state enterprises .la the light industry sector, where over the years, CIB has developed a special expertise. However, it plans some diversification through a modest increase in its assistance to collective enterprises, a change that is justified in view of their growing importance in China and the relative dynamism of the nonstate sector. CIB has also started to introduce, although on a limited scale in the beginr._ng, new products (mainly working capital financing and equity investments, including leasing operations) and services (guarantees, managed loans, letters of credits, etc.) for its clients and has made progress in diversifying its resource base. These are welcome moves, as Bank experience shows that the performance of financial intermediaries has generally been better when they have diversified their sources of funds by mobilizing savings from the marl -., have provided a variety of financial products and services and have o rated in a competitive environment. 1.3 The fourth industrial credit project (CIB IV) of $300 million became effective on June 22, 1987 and was almost fully committed by the end of 1988, much ahead of the or.ginal schedule. Although CIB has started borrowing from The Asian Development Bank (ADB) and international capital markets, it still needs continued Bank support for further institutional development and enhancement of financial resources. The proposed CIB V project would help implement CIB's new development strategy and operational plan. Particular emphasis would be given to its further institutional  - 2 - strengthening, including the development of new products. which will in turn strengthen its ability to compete and survive in the rapidly changing financial environment of China. During the project preparation stage, the Bank assisted CIB management and staff in planning new products and services. For example, key CIS staff visited merchant and commercial banks in other countries, aid senior staff of two such banks participated in the pre-appraisal of the project. 1.4 The proposed CIB V project includes: (a) financial assistance in the form of an industrial credit of $299.0 million for the light industry sector; and (b) technical assistance (TA) of $1.0 million for CIB's further institutional strengthening, mainly through an expanded staff training program that meets its needs for new and improved skills and through the import or computer hardware and software. II. THE INDUSTRIAL SECTOR A. Structure and Performance 2.1 Industry makes up about half of China's GDP and employs 182 of the total labor force. About 97,600 state enterprises generate 62% of total industrial output with the remainder produced by more than a million enterprises, mainly urban and rural collectives. Gross industrial output, valued at Y 1,3S1 billion ($371 billion) in 1987, is shared almost equally by light and heavy industry. 2.2 The gross value of industrial production grew at 10.82 in real terms p.a. in 1978-87, a reflection in large part of the high rate of capital accumulation in industry. The gross output of light industry increased by an average of 12.8Z p.a. during the same period, w..ich was substantially faster than that of heavy industry (Table 2.1) and which came about mainly because of the economic reforms initiated in 1979. Table 2.1: CHINA--INDUSTRIAL GROWTH TRENDS (percent) Average Annual Growth Rate Share in Output 1952-78 1978-87 1978 a/ 1987 b/ Gross industrial output 11.3 10.8 100.0 100.0 Heavy industry 13.6 9.1 57.3 49.9 Light industry 9.1 12.8 42.7 50.1 Source: Statistical Yearbook of China, 1987, 1988 a/ At 1970 constant prices. b/ At 1980 constant prices.  - 3 - 2.3 Over the two decades from the mid-fifties to mid-seventies, Chinese industry was oriented mainly toward the rapidly growing domestic market. Since then, Chinese manufactured exports have grown rapidly from around $3 billion equivalent in 1975, to about $9 billion equiv4le-it in 1980 and $26 billion equivalent in 1987. This impressive performance was sustained by strong growth in exports from light industry, which doubled in nominal terms during 1984-87 (Table 2.2) and accounted for nearly two- thirds of the total exports of manufactured goods. The share of exports in industrial value added was 18.2? in 1987. Table 2.2: CHINA--STRUCTURE OF EXPORT COMMODITIES ($ billion) - --------- Exports -------- - Share (Z) - 1984 1985 1986 1987 1984 1987 Total va'ue of exports 25.0 27.3 31.4 39.5 100.0 100.0 Primary exports 11.4 13.9 11.4 13.3 45.6 33.7 Manufactured goods 13.6 13.4 20.0 26.2 54.4 66.3 Heavy industry a/ 4.6 3.6 6.4 8.6 18.4 21.6 Light industry 9.0 9.8 13.6 17.6 36.0 44.7 Source: China Customs Statistics, 1986/1, 1987/1, 1988/1. a/ Includes chemical products. B. Main Sectoral Issues and the Government's Strategy Pre-reform Policies and Their Impact 2.4 Traditionally, China's industrial development was guided by an inward-oriented and import-substitution strategy. This approach led to rapid growth in industrial output and employment, the acquisition of industrial skills and the development of a wide range of basic, intermediate and consumer goods industries. On the other hand, it also resulted in numerous problems, includirg inefficiencies in production, lack of technological development, poor product quality and inadequate knowledge of markets abroad. Evidence of these deficiencies is that manufacturing output per worker in China in 1985 was a low $3,350, about one-fourth the average productivity in newly industrialized countries (NICs) and much below the productivity in more industrialized countries. This low productivity can be explained in part by overmanning and outdated technologies and in part by a lack of incentives and plant level inefficiency. Nearly 80Z of the current stock of capital equipment is worn-out or obsolete, and most needs replacement.  2.5 Although the level of investment has been very high in China, the efficiency of resource use is low. Chinese enterprises are characterized by excessive utilization of raw materials and high consumption of energy per unit of output and by a slow response to changing price and quality signals in the product and factor markets. Mandatory planning, institutional rigidities and an environment of distorted and controlled prices have provided little incentive for efficient management at the factory level. Over-emphasis on self-sufficiency at the regional level has also resulted in fragmented markets and reduced domestic competition. As a result, potential gains from economies of scale, specialization and division of labor have often been missed. A lack of labor and capital mobility has led to subontimal use of scarce skills, talent and resources. 2.6 Distortions in the trade regime have contributed to the relative isolation of Chinese industry from the rest of the world. Enterprises generally have had to go through foreign trade corporations (FTCs), which have virtual monopolies in their subsectors, for imports and exports. Enterprises do not normally participate in trade negotiations, nor do they receive information on sale prices. As a result, enterprises have often been unaware of the latest developments in foreign markets, including changes in patterns of demand, new products, emerging competition and price movements. A related constraint is that the access of enterprises to foreign exchange has generally been tied to their ability to export. It has been extremely difficult for non-exporting enterprises to service their foreign exchange loans and to import raw materials and spare parts (para. 3.18). 2.7 Industrial development has also been held back by inadequate physical infrastructure (transport?tion, telecommunications and energy), in which investment has lagged. In add.tion, institutional infrastructure- -research and development organiz,ations and vocational training schools- -has been lacking modern technology and know-how for the most part and often has weak links to its industrial clients. Post-reform Era 2.8. Since 1979, GOC has attempted systematically to tackle these fundamental weaknesses. The development strategy for the industrial sector has emphasized modernization of equipment, development of more efficient light industry, promotion of manufactured exports, and conservation of materials and energy. There have been two main thrusts to the reforms adopted in 1984, which were designed to give greater impetus to this effort. The first is a series of measures designed to reduce the role of mandatory planning, correct the major price distortions and enhance the role of markets in setting prices and determining industrial output. A growing number of industrial products can now be sold 'in the market," though planned allocation of inputs and outpu,. coupled with a regulated, albeit morc flexible, price system still apply to the bulk of industrial output. This situation has led to a three-cier pricing regime under which the prices for small number of key commodities are still centrally fixed, the bulk of indus.rial goods are subject to a broad band of negotiated but still regulated prices (which can be adjusted up to about 15Z in either direction of the fixed prices), and the prices for non-essential foodstuffs  - 5 - and some light consumer goods are largely market determined. Price reform remains a critical item on GOC's reform agenda. However, recent worries relating to the inflatior.ary implications of these reforms have resulted in a cautious approach, and the prccess has slowea temporarily. 2.9 The second thrust is another set of reforms aimed at changing the incentive structure and expanding managerial autonomy at the enterprise level. These enterprise reforms include initiatives to: (a) devolve the control over decisions relating to investments, payment of bonuses to workers and expenditures on social services for employees through higher profit retention; and (b) change the structure of production and contraLtual linkages among enterprises, clarify the relationiship and responsibilities of management and their supervisory governmental agencies, and make managers more responsive to changing price, market and profit considerations by allowing them to change the level and mix of production, through the contract responsibility system. 2.10 In trade, the main changes have involved the partial break-up of the export and import monopolies. This break-up has been done mainly through limited decentralization of the export trade and the granting of direct trading rights to some 100 large production enterprises all over China. Progress has also been made in increasing the availability of foreign exc:iange to non-exporting enterprises (para. 3.18). 2.11 The reforns are being implemented in China at a different pace across regions and subsectors. Nevertheless, their impact on the light industry sector has, as indicated by its recent performance (para. 2.3), been particularly significant. Most enterprises (85Z-90Z of all medium- and large-sized state enterprises) now operate under the contract responsibility system, and managers have greater autonon,y over investment decisions and are increasingly subject to compptitive pressures. Some progress has also been made in breaking down the current rigidities of the labor market. However, the central and provincial authorities recognize that the reforms require continued deepening. Priorities for action include: clarification of enterprise ownership issues, a step that will, inter alia, help to promote mergers of the suboptimal plants that characterize China's fragmented industrial structure; continued, progressive relinquishing by government authorities of their preoccupation with control of subservient enterprises and adoption of a supporting and enabling role; and promotion of national market integration and an end to the imposition of additional barriers to inter-provincial trade. C. Bank Group Support for Industry 2.