Philippines - Industrial Restructuring Project

Document of The World Bank FOR OFFICIAL USE ONLY goA-.AJR f 7 ^ Pv Report No. 8989-PH STAFF APPRAISAL REPORT PHILIPPINES INDUSTRIAL RESTRUCTURING PROJECT NOVEMBER 15, 1990 Industry and Energy Operations Division Country Department II Asia Regional Office This doeument has a reskicted dbtibudon and may be used by reripents on a the perfoance of their officid dufies. Its contents may io oewise be didosed whout Wodd Bank autwiaton.  CURRENCY EQUIVALENTS (as u.C August 31, 1990) Currency Unit - Peso (9; US$1.00 - i 24 P 1.00 - US$0.0417 ACRONYMS ADB - Asian Development Bank AJDF - ASEAN Japan Development Fund AP - Action Program APT - Asset Privatization Trust BOI - Board of Investment CBP - Central Bank of the Philippines DBP - Development Bank of the Philippines DENR - Department of Environment and Natural Resources DOF - Department of Finance DTI - Department of Trade and Industry ECAs - Export Credit Agencies EIA - Environmental Impact Assessment EMB - Environmental Management Bureau ERL - Economic Recovery Loan EXCEL - Export Credit Enhanced Leverage Program 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 IIC - Industrial Investment Credit Project IDP - Institutional Development Plan IGLF - Industrial Guarantee and Loan Fund IMF - International Monetary Fund IRP - Industrial Restructuring Project IRU - Industrial Restructuring Unit NDF - Nordic Development Fund OPG - Operating Policy Guidelines PDCP - Private Development Corporation of the Philippines PDIC - Philippines Deposit Insurance Corporation PFI - Participating Financia'l Institution PNB - Philippine National Bank PTRI - Philippines Textile Research Institute PSCC - Philippines Standard Customs Code (PSCC) QRs - Quantitative Import Restrictions SEC - Securities and Exchange Commission SME - Small and Medium Enterprises SSS - Social Security System TTA - Training and Technical Assistance TMAP - Textile Manufacturers Association of the Philippines Fiscal Year DBP: January 1 to December 31  FOR OmCAL USE ONLY PHILIPPINES STAFF APPRAISAL REPORT INDUSTRIAL RESTRUCTURING PROJtCT Table of Contents Page No. Loan and Project Sunmry . . . . . . . . . . . . . . . . .i I. THE INDUSTRIAL SECTOR . . . . . . . . .. . . . . . . . . .1 A. The Economic Setting ........... .. ... ..1 B. The Existing Policy Framework . . . . . . . . . . . . . 2 C. Agenda for Further Reform . . . . . . . . . . . . . . . 4 D. Structure and Performance . . . . . . . . . . . . . . . 5 E. Environmental Issues . . . . . . . . . . . . . . . . . . 6 P. Selected Subsectorss Issues and Action Program . .. . 7 II. THEFII ANCL SECTOR .. . .-.-..-. 10 A. Introduction . . . . ........... .... .- 10 B. Evolution and Structure . . . . . . . . . . . . . . . . 10 C. Financial Sector Reforms ............... . 12 D. Institutional Arrangements for Providing Long-Term Credit ................. . . 14 E. Industrial Credit . . . . . . . . . . . . . . . . . . . 16 F. Bank Strategy in the Sector . . . . . . . . . . . . . . 17 III. THE BORROWER AND PARTICIPATING PINANCIAL INSTITUTIONS . . . 20 A. The Development Bank of the Philippines . . . . . . . . 20 Introduction . . . . . . . . . . . . . . . . . . . . 20 Historical Perspective: 1958-1986 . . . . . . . . 20 DBP's Rehabilitations 1986-1989 . . . . . . . . . . 21 DBP's New Role and Strategic Orientation . . . . . . 23 Organization and Management . . . . . . . . . . . . 24 Personnel Policy and Training . . . . . . . . . . . 24 Accounting and Management Information System . . . . 25 Loan Activities and Asset Management . . . . . . . . 26 Liability Management ........ .. . 27 Projected Financial Position and Performance . . . . 28 B. The Participating Financial Institutions . . . . . . . . 29 This report vas written by Mr. Vinod Busjeet with contributions from Mr. Zderek Drabek (Chapter I). It is based on the findings of (i) an appraisal mission consisting of Messrs. Vinod Busjeet, Christian Duvigneau, Zdenek Drabek (Bank), and Aldo Baietti, Peter Dinsdale, Jan Rennel and J.H. Tomlinson (consultants), vho visited the Philippines in June 1990, and (ii) a September 1990 post-appraisal mission consisting of Messrs. Vinod Busjeet, I_mail Dalla, John Chang, and Waman Tambe (Bank). I Thb document has a resticted distribution and may be used by reipAents only in the peformamce of their offcial duties. Its contents may not otherwise be disclosed without World Bank authorization.  Pa-t No. IV. THE PROPOSED PROJECT . . . . . . . . . . . . . . . . . . . . 31 A. Project Objectives . . . . . . . . . . . . . . . . . . . 31 B. Project Description . . . . . . . . . . . . . . . . . . 31 C. Loan Amount .... . . . . . . . . . . . . . . . . . . 33 D. Project Implementation-Credit Component . . . . . . . . 34 E. Project Implementation - TTA Component . . . . . . . . . 35 F. Relending Mechanism, Terms and Conditions . . . . . . . 38 G. Disbursements . . . . . . . . . . . . . . . . . . . . . 42 H. Procurement . . . . . . . . . . . . . . . . . . . . . . 42 I. MoniL ring, Reporting and Auditing . . . . . . . . . . . 43 J. Benefits and Risks . . . . . . . . . . . . . . . . . . . 43 V. AGREEMENTS. UNDERSTANDINGS AND RECOMMENDATION . . . . . . .44 A. Agreements and Understandings . . . . . . . . . . . . . 44 B. Condition of Effectiveness . . . . . . . . . . . . . . . 45 C. Recommendation . . . . . . . . . . . . . . . . . . . . 45 ANNEXES 1.01 Number of Items Regulated, Liberalized and Newly Regulated, 1977 to 1988 1.02 Trends in Tariff Protection 1.03 Comparative Trade Regimes 1.04 Financial Performance of Manufacturing Corporations 1.05 Total Factor Productivity in Selected Manufacturing Industries 1.06 Cement Subsector 1.07 Pulp and Paper Subsector 1.08 Textile Subsector 1.09 Ship Repair Subsector 1.10 Inter-island Shipping Subsector 1.11 Action Program: Cement Subsector 1.12 Action Program: Pulp and Paper Subsector 1.13 Action Program: Textile Subsector 1.14 Action Program: Inter-island Shipping Subsector 1.15 Action Program: Ship Repair Subsector 2.01 Total Assets of the Financial System 3.01 Development Bank of the Philippines, Financial Statements, 1984-1988 3.02 Development Bank of the Philippines, Actual and Projected Financial Statements, 1989-95 3.03 Development Bank of the Philippines, Organization Chart 3.04 Development Bank of the Philippines, Policy Statement 4.01 Industrial Subsectors Not Eligible for Financing 4.02 Technical Assistance Funds 4.03 Training and Technical Assistance in the Cement Subsector 4.04 Training and Technical Assistance in the Pulp and Paper Subsector 4.05 Training and Technical Assistance in the Textile Subsector 4.06 Training and Technical Assistance in the Inter-island Shipping Subsector 4.07 Training and Technical Assistance in the Ship Repair Subsector 4.08 Technical Assistance to DBP and ENB on Environmental Control 4.09 Supervision Plan 5.01 Documents in Project File  PHILIPPiNES INDUSTRIAL RESTRUCTURING PROJECT Loan and ProAect Summarv Borrowers Development Bank of the Philippines (DBP). Guarantort Republic of the Philippines. Beneficiatiess Accredited participating financial institutions (PFIs); private sector medium and large enterprises. Amounts US$175 million equivalent. Termes Repayable over 20 years, including five years of grace, at the standard variable interest rate. Onlendings DBP would relend the proceeds of the Bank loan to accredited PFIs in foreign or domestic currency at market rates. Maturities would conform to the maturities of subloans made by the PFus to subborrowers, but would not exceed 15 years for physical restructuring investments and leasing, and 7 years for working capital. The maximum grace period would be three years, except for lease financing which would have no grace period. The PFIs would onlend the funds to their subborrowers at prevailing market interest rates. In the case of onlending by DBP in domestic currency, the Government would bear the foreign exchange risk in exchange for a market- related fee payable by DBP. CofinancinE: Export credits from a number of countries vould be sought to finance a part of the proposed Project under the EXCEL Program. An amount of US$75 million is expected to be provided in this form. Bilateral grants and low cost funding for training and technical assistance (TTA) would be provided by Scandinavian (NDF, BITS, and NORAD) and other sources. Protect Obiectivess The proposed Project aims to: (a) Support the revival and the strengthening of the industrial sector; (b) Support sound industrial investment in subsectors free from major distortions resulting from inappropriate trade and regu.1atory policies; (c) Help make the cement, pulp and paper, textiles, shipping and ship repair subsectors more competitive through reforms of subsector-specific policies, and institutional strengthening;  - 11 - (d) Strengthen the institutional framework for environmental protection; and (e) Strengthen DBP's capabilities to play a more active role in developing the capital market and to act as a wholesale bank channeling ternm funds to retail financial institutions. Proiect Descriltions The Project would comprise the following components: (a) A credit line and export credits to be mobilized under the EXCEL Program to DBP to be passed on to PPIs for on-lending to enterprises in eligible industrial subsectors for modernization, expansion and new facilities, including investments in energy conservation and pollution control devices. (b) Lease financing. (c) Training and technical assistance for (i) selected subsectors and (ii) environmental protection. Benef its: The main benefits of the proposed Project are related to increased efficiency of existing industrial capacities, establishment of new facilities and reduction in industrial pollution, particularly in the Manila area. The moderniza- tion of the shipping and ship repair sectors would contri- bute to the more efficient functioning of the island-based economy through improved transportation facilities. The Project would thus increase international competitiveness and support Government efforts to revive industrial growth. The Project would also help strengthen the credit delivery system. Riskst The main risk is that there could be an unanticipated slowdown in loan demand because there could be: (a) an unforeseen downturn in the economy and (b) delays in implementation of the subsector action progran which could delay the eligibility of some subsectors for Bank funds. These risks have been minimized by keeping the loan size in the lower range of estimated credit demand. The risk of delays in subsector policy actions has been reduced through extensive discussion of the action programs with key agencies. The commitment of the Government to major reforms in trade and tariff regime evidenced in its announcement of a specific plan will also help. Another risk relates to the capacity of the agencies to absorb the extensive technical assistance provided under the project. The involvement of the industry associations and government agencies in the design and implementation of this TA is expected to minimize this risk.  - Aii- Estimated Costs Local ?oregin Total ------ (us$ Million)------ Credit Component 275.0 250.0 525.0 Technical Assistance Project implementation support 0.3 1.5 1.8 Capacity building 0.5 12.6 13.1 Policy development 0.2 0.9 1. Subtotal 1.0 15.0 16.0 Total 276.0 265.0 541.0 Financina Plan: Local Foreian Total --- - (US$ Million)----- Participating Financial Institutions 55.0 0.0 55.0 Subborrowers 220.0 0.0 220.0 Eport Credits 0.0 75.0 75.0 Proposed Loan 0.0 175.0 175.0 Total Funds for Subprojects 275.0 250.0 525.0 Bilateral Funds for TTA 0.0 15.0 15.0 Local Contribution (DBP, Beneficiaries) 1.0 0.0 1.0 Total Funds for TTA 1.0 15.0 16.0 Total 276.0 265.0 541.0 Estimated Disbursements: Bank Fiscal Years 1991 1992 1993 1994 1995 1996 Annual 7 42 60 33 27 6 Cumulative 7 49 109 142 169 175 Rate of Return: Not applicable.  PHILIPPINES INDUSTRIAL RESTRUCTURING PROJECT STAFF APPRAISAL REPORT I. THE INDUSTRIAL SECTOR A. The Economic Setting 1.1 The Philippines has gone through a period of major economic restructuring and reorientation.ll Since the political and economic crisis of 1983, and particularly since the change in Government in 1986, the authorities have made concerted efforts to correct distortions that had led to an inefficient pattern of investment, low savings and high dependence of imports and foreign capital. The Government initiated a major stabilization and structural reform effort, supported by several Bank adjustment operations (para. 1.7) and by the IMF Standby Arrangements of 1984 and 1986. 1.2 Overall, the objectives of the stabilization programs were met or surpassed. During 1986-89, the economy recovered across a broad front. GDP and its principal sectoral components grew steadily if not spectacularly. Consumption and investment grew strongly and inflation was kept at single- digit levels. Both the current account deficit and external debt were reduced. Fiscal accounts improved and a sizeable primary surplus was achieved. Among highly-indebted countries, the adjustment performance of the Philippines rmnks near the top. Its growth has been relatively high and stable compared to that of such countries as Argentina, Mexico and Brazil which have experienced multiple episodes of negative growth in the last ten years and at least one in the last three. 1.3 Sound economic management was accompanied by a series of bold reforms to reduce distortions in commodity and factor markets, to rationalize the role of the public sector and to maintain market orientation in general. Distortions were reduced through the abolition of monopolistic marketing arrangements for sugar and coconut products, the removal of price controls and export taxes on several agricultural products, and the reduction of trade restrictions on a wide variety of inputs important for local industry. The role of the public sector was rationalized through the restructuring and downsizing of the two largest Government financial institutions, the reorientation of the public investment program to focus on essential infrastructure, and the establisbment of a program to improve the performance of public corporations and to privatize a selected set. Market orientation was maintained in the setting of interest rates, credit allocation, exchange rates and the prices of most commodities. /1 Philippiness An A&enda for Adiustment and Growth (Report No. 5268-PH, November 30, 1984); Philippines: A Framework for Economic Recovery (Report No. 6530-PH, November 5, 1986); Philippines: Country Economic Memorandum: Issues in Adiustment and Comnetitiveness (Report No. 8933- PH, October 31, 1990).  - 2 - 1.4 Despite substantial recovery from the crises of the mid-1980s, the econamy has not yet firmly stabilized. After three years of relatively rapid growth, the economy appears to be slowing down. A series of severe exogenous shocks has contributed to the worsening of the economic outlook for 1990. A drought in early 1990 severely disrupted agricultural production, and an earthquake in July 1990 caused an estimated US$600 million in damages to public infrastructure alone. In addition, the Gulf crisis dislocated about 50,000 Filipino workers from Kuwait and Iraq, and is expected to increase the oil import bill by approximately US$500 million. As a consequence, GDP growth, which averaged 6S during 1988 and 1989, is expected to reach only 3.5Z in 1990. Investment growth, strong in 1988 and 1989 (averaging 16S), Is expected to slow down to around 7? this year. Export growth is also tapering off from the rates experienced recently. Indeed, a revealing index of the decline of external competitiveness is provided by the country's share of exports in key world markets: it has been declining in most export products in most developed country markets. 1.5 The analysis of the economic slowdown in the latest CE4 points out, among other things, that the substantial structural adjustment effort undertaken since 1986 has proved insufficient in improving the country"s relative competitiveness. This has occurred, not because of lack of commitment on the part of the Government, but because the world has not stood still while the Philippines has adjusted. Its competitors (e.g. some ASEAN countries) have also adjusted and grown at varying speeds, some much faster than the Philippines, thereby presenting the country with something of a moving target as far as competitiveness is concerned. The challenge for the future is not only to continue with structural reforms to improve economic efficiency but to do so at a speed and with a thoroughness that will enable the country to lessen the economic distance between it and its competitors. Continued reduction of policy-induced distortions in the industrial sector will form a significant part of the Government's response to that challenge: contributing 25.2? of GNP and 67t of merchandise exports and accounting for 10.5? of total employment in 1989, the Industrial sector, which is mostly pri7ate, plays an important role in the economy. Term credit to finance the resulting investment and restructuring requirements will consequently be required. B. The Existing Policy Framework 1.6 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 1950 under rising protective barriers; a major shift towards a more open and liberal trade regime in the early 19608 which, however, was not sustained; and a reversal to more interventionist policies beginning in the late 19609 with increasing recourse to protective barriers, large public-sector-led or-supported investments and generous incentives administered by the Board of Investment (OI). The result was an incentive environment that led to suboptimal investments and an inefficient industry that was largely inward oriented and internationally uncompetitive.  - 3 " 1.7 In the eighties, momentum for reform was provided 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 Government accordingly initiated a broad range of structural reforms wdth the support of two Bank-financed Structural Adjustment Loans (Loan Nos. 1903-PH, 198't. 2266- PR, 1983). Among the policy initiatives taken were: (a) a major trade liberalization program and (b) reform of BOI incentives. The trade reforms, .which aimed ^t 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 regimes tariff reform, phasing out of import restrictions, removal of the protective elements of the indirect tax system, and curtailment 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. 1.8 A cornerstone of the trade policy reform was the significant narrowing of the band of import tariffs: from a OZ - 1002 band before 1980 to 10X-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. In the 1986- 1988 period, however, 1,345 import restrictions were 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. Annex 1.01 presents the trends in import liberalization which has been the focus of trade reform since 1986. As a share in the total numter of items classified in the Philippines Standard Customs Code (PSCC), regulated imports declined from 34.1Z in 1985 to 10.22 in December 1988. Vhile average nominal tariff protection has not changed significantly in recent years, effective rates of protection have declined (Annex 1.02) mainly because of the liberalization of import restrictions. 1.9 The trade liberalization has had a major impact on the structure of protection, by significantly reducing the pro-import-substitution bias. In the absence of full trade liberalization, however, 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 systems to be able to obtain imporsed 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 ptursuing an export promotion policy, using duty drawback exemption schemes to ensure free access to intermediate imported inputs for exporters, and supporting exporters through an export finance facility.  - 4 - C. Aaenda for Further Reform 1.10 As a result of the cumulative policy adjustments since 1980, described earlier, the Philippine economy is now more open and transparent in its regulatory and incentive structure than at any time since 1980. However, its competitive position in world markets has not improved, largely because its principal competitors generally have more open economies, as evident in Annex 1.03. For example, while the Philippines has moved to reduce quantitative restrictions to the extent that almost 902 of importable items are not subject to restrictions at present, Malaysia and Thailand have had liberalization ratios of over 952 for many years. Similarly, average nominal tariffs in the Philippines, despite having declined since 1980, remain above those of Indonesia and Malaysia, though lower than those of Thailand. Further trade refarm measures would be desirable not only because they would raise absolute efficiency in the economy but also because they would promote its relative competitiveness. 1.11 A major issue is the continued presence of quantitative restrictions (QRs) which, still affecting more than 101 of the PSCC lines, encourage inefficient investments and production activities, and has contributed to low productivity in certain segments of the maniufacturing and agriculture sectors. QRs also represent a highly inefficient instrument of trade policy, since they deprive the Government of a significant source of revenue. This is particularly important under the present severe budgetary constraints. Moreover, QRs are not transparent instruments of protection as they do not allow an effective assessment of relative support provided by the Government policies. 1.12 Removal of QRs would, therefore, be highly desirable. It is recognized, however, that some industries could be severely affected by such a step and may require temporary assistance to allow adjustment to the reformed trade regime. Such support would best be provided in the form of tariff surcharges which would be progressively reduced and time-bound. 1.13 Another remaining issue is the continued high protection of industry in genetal and of manufacturing in particular. Even though effective protection of industry has recently declined, the existing effective protection of about 502 for the industry as a whole is excessive. It implies effective rates of protection for some industries well over 1OOZ, and in exceptional cases, even close to 2001. With this level of protection, the benefiting industries have little incentive to increase efficiency. 1.14 A related issue is the scope of distortions arising from the existing structure of protection. Even though the bias has been considerably reduced, existing interventions continue to discriminate against exports and agriculture. Moreover, the level of protection within the manufacturing sector is highly uneven. These distortions arise because the present band of tariffs, ranging from 0? to 50?, results in a situation where some sectors receive the excessively high level of protection noted above, whereas others are protected considerably less, and some even negatively. This pattern of protection encourages investments in relatively less efficient (high cost) activities, while discouraging activities in which the country may have a comparative advantage. The high dispersion of tariff rates also increases the  administrative costs of tariff collection and, together with high tariffs, encourages smuggling and misdeclaration on tariff documents (technical smuggling). This adversely affects budgetary revenues and leads to unfair competition between domestic production and imports. 1.15 These problems can be remedied through a revision of the tariff schedule to reduce significantly the level and dispersion of tariff rates. Recently, the Government has proposed the introduction of a four band system with tariffs ricing in steps as followes 32 for all goods that previously had a tariff rate of SZ or less; 102 tariff on raw materials; 20? on intermediate goods and 302 on final goods. If implemented as proposed, this would be a highly beneficial move. The revenue loss resulting from the reduction in top tariff rates would be offset by increased revenues from (a) replacement of qRs by tariffs and/or tariff surcharges, and (b) stricter compliance with simplified customs declarations, as well as by lower costs of customs administration. 1.16 While it is important to maintain the momentum of trade reform, the industrial sector will need financial support to take advantage of the trade libera'"tation reforms envisaged. Moreover, many firms in heretofore protected industries will need funds as well as technical assistance to restructure so as to be competitive at world prices. These needs will be addressed through the proposed Industrial Restructuring Project (IRP). D. Structure and Performance 1.17 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. These policies encouraged capital-intensive industries and discouraged structural changes within the manufacturing sector, establishment of optimal size plants, backward linkages and adoption of modern technology. 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, 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 expansion 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, the financing requirements of high domestic demand could not be sustained indefinitely. 1.18 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 performance, was negative whereas the Philippines' major competitors displayed a positive growth in that period. Poor performance, high domestic interest rates and devaluation losses  - 6 - for firms with foreign currency denominated loans left many firms in financial distress (Annex 1.04), with low profitability and high indebtedness. Many firms ceased operation and declared bankruptcy. Firms in operation limped along at 50-602 capacity utilization. After steady growth rates of gross value added in industry in the 19709, 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. 1.19 The industrial sector began to recover at the end of 1986 and registered the first significant positive growth in 1987 (6.7X) which further accelerated in 1988 (9.6?). The growth continued to be fairly strong in 1989 (6.9?). This growth led to a rapid increase in manufacturing employments the number of persons employed in manufacturing increased by 20.42 between 1986 and 1989. Initially, the recovery was strong particularly in industries oriented towards the domestic market, which experienced a rapid expansion of consumption. The consumption-led domestic recovery induced, therefore, rapid growth of production in consumer goods industries such as food processing, beverages, tobacco and footwear, which spilled over into producer goods industries. The growth of domestic consumption and demand for manufactured goods began to slow down at the end of 1988 as the capacity constraints were rapidly reached in the industry. At the same time, the growth of manufacturing output began to be increasingly more dependent on the growth of domestic investments and exports. Investments picked up considerably in 1988 and 1989 when gross capital formation increased by 17.32 and 14.8? respectively. The financial performance of manufacturing corporations has improved, both in terms of profitability and adequate capitalization (Annex 1.04). The manufacturing sector has also made efficiency gains as measured by the total factor productivity index (Annex 1*05). The improved performance of industry indicates that the industrial sector has benefitted from the structural and policy reforms introduced by the Government which aimed at increasing economic efficiency by stimulating private sector initiative and activity. E. Environmental Issues 1.20 The Philippines has a comprehensive set of environmental legislation and institutions responsible for protecting the country's ecosystems and ensuring sustainable and environmentally sound development. At the Cabinet level is the Department of Environment and Natural Resources (DEMR). The functional arms of DENR dealing with industry are the Environment Management Bureau (EDM) and the thirteen regional offices. EMB is responsible for: recommending policies for environmental management; developing standards for ambient air quality and emission, and water quality and effluent standards; developing solid waste and hazardous substances information; evaluating proposed industrial and municipal projects that have environmental impact; recommending issuance of Environmental Compliance Certificates for proposed projects that meet the Bureau's requirements; monitoring and enforcing environmental standards; and assisting the regional offices of the DENR in disseminating environmental inform%tion to the general public. 1.21 The country's pollution control regulations are generally based on technically sound principles. Unfortunately, DEMR and EMB do not have the  -7- staff, equipment and financial resources to evaluate satisfactorily the adequacy of pollution control mechanism, in manufacturing enterprises, or monitor and enforce the country's environmental standards. Basic analytical equipment such as pH meters, dissolved oxygen meters, turbidimeters and spectrophotometers as well as the expertise to use such equipment properly is lacking. As a result, DIN1 and EMB suffer from institutional weaknesses and the application of the law is inconsistent. The extent of pollution abatement facilities vary considerably, from full compliance with applicable standards to virtually total neglect, even among recent investment projects. The technical assistance component of the proposed IRP would help towards the institutional strengthening of EMB. F. Selected Subsectorss Issues and Action Proaram 1.22 In the context of the more #,pen economy that the Government is trying to foster, there is need for both financial and physical restructuring 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 competitive response but others not equipped to do so. Given the diverse structure of industry, a restructuring strategy must take into account 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. 1.23 In the past, the articulation and implementation of a sound restructuring strategy was hampered by insufficient know-how and Government reluctance to introduce further policy reforms in some subsectors, 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 was 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. These subsectoral issues are being studied under the technical assistance component of the Industrial Investment Credit (IIC) Project (Loan 3123-PH, 1989]. The studies already completed cover the following subsectorst cement, pulp and paper, textiles, inter-island shipping and ship repair. Their findings are summarized in Annexes 1.06 to 1.10. 1.24 The studies show that the low productivity and high operating costs that characterize these sectors result from high energy intensity of production, high wastage rates of raw materials, high maintenance costs, low labor productivity, suboptimal scale of production, inadequate labor ard  -8- technical skills and lack of preventive maintenance systems. Another issue is the procurement and use of inefficient and obsolete technology. For example, second-hand plants using pre-1975 technology are being installed in the cement and pulp and paper industries, and old vessels are being purchased by shipping companies. The studies have also identified pollution problems. Underlying the problems identified have been deficient sectoral policies. Though most if not all of these problems will necessitate new investments, the sine qua non for such investments should be elimination of the remaining policy distortions. 1.25 In the cement industry (Annex 1.06), the major distortion is the existing price control by which the Government hopes to protect consumers. However, since demand for cement has recently been growing very rapidly, it has become necessary for the Government to liberalize cement imports and permit free pricing of imported cement. This has led to a major increase of domestic prices and very slow supply response of the domestic cement industry to satisfy demand. Price controls have also limited the incentive to expand and modernize the industry. In view of these adverse effects, it would be advisable to remove price controls in the cement industry. 1.26 The Du1p & naner industry (Annex 1.07) suffers primarily from an irregular structure of import tariffs. Imported inputs are subject to high tariffs, which will need to be lowered to reduce production costs. In addition, the tariff rates are highly dispersed, thus providing uneven protection to domestic producers and encouraging technical smuggling. The tariff rates on output of the industry are also too high and non-uniform. These issues need to be addressed but, to ensure consistency with changes of other tariffs, the solution lies in a general tariff reform rather than a piece-meal approach. 1.27 In the textile sector (Annex 1.08), there are no major policy issues except that (a) the quotas for garment exports favor established mills and are not fully utilized; and (b) there is high effective protection on some products and high nominal tariffs on the cascade of yarn, cloth and garments because of high tariffs on polyester fiber. There is, therefore, need to review the Quota Allocation System and reduce the tariff on polyester fiber and reduce the cascade on downstream products accordingly. 1.28 In the Ship BuildinR and Repair subsector (Annex 1.09), the major policy issue is the general high tariff on inputs. The industry also suffers from worn out/obsolete equipment due to the lack of local and foreign investors to participate in financing new and upgraded shipyards. Given its geographical location, the Philippines has great potentials to attract international contracts for shipbuilding and repairs. However, due to inadequate facilities and marketing efforts, these potentials have not yet been fully developed. In the shipping sector (Annex 1.10), the major policy issues include franchising, price control and statutory rate of return requirements. In comparison with the cement industry, the price control in shipping is more complex. The price control has been introduced to accompany franchising of routes, which in turn was justified on the grounds of protecting consumers and ensuring safety standards. However, neither of the latter objectives has been met satisfactorily over the years. The statutory requirement for rate of return on investments is a tool borrowed from public  utility regulation, but is inappropriate for a potentially competitive industry and a ptincipal reason for the poor profitability of shipping operations in the last few years. The price control should be removed, and the removal should be accompanied by measures to facilitate entry into the industry. There is also need for improvements in (a) the institutional set up for monitoring and regulating the sector, which at present is characterized by a great number of agencies, overlapping responsibilities and cumbersome rules; and (b) safety regulations which are outdated and inconsistent. 1.29 The analysis in the subsector studies provided the basis for the formulation of an Action Program (AP) for restructuring the subsectors. The various components of the AP, detailed in Annexes 1.11 to 1.15, aim at improving the policy environment of the subsectors and strengthening the institutional support structure. The policy improvements include measures to promote competition and efficiency through deregulation of prices, removal of barriers to entry and streamlining of tariffs for inputs and outputs. The institutional strengthening measures include training and technical assistance to industry to plan investments in modernization and restructuring, studies for the removal of specific bottlenecks in the availability of key inputs, and assistance to industry, DBP and EMB for environmental upgrading. The AP has been discussed and agreed in principle with DBP, industry associations and key agencies of the Government. During negotiations, an agreement was reached with the Government that it will undertake in a timely manner measures to implement the AP and review the status of implementation with the Bank annually. The key policy actions included in the AP are those which are required before a subsector would be eligible for financing from this Loan (para. 4.4). 1.30 Implementation of the AP requires actions by various agencies of the Government, DBP and industry associations. Many components of the AP would require coordination and consultation among the various parts of the Government and with the private sector. DBP's Industrial Restructuring Unit (IRU) will have the responsibility fcr monitoring the implementation of the AP, ensuring coordination among the various parties, identifying issues and initiating follow-up actions. It will also coordinate formal annual reviews of the AP. IRU's role and responsibilities in this regard were confirmed during negotiations (para. 4.21). 1.31 Policy and institutional improvements need to be effected if the industries reviewed, as well as others, are to realize their full potential. If these shortcomings are not corrected, resources will continue to be mis- directed to sub-optimal facilities at the expense of the consumer and the economy. Adjustment of these policy- and institutional shortcomings alone, however, will not guarantee a rapid and rational development of these industries: long-term funding, technical assistance and training need to be provided as well.  - 10 - TI. THE FINANCIAL SECTOR A. Introduction 2.1 The industrial policy reforms of the 1980s, presented in Chapter I, yere accompanied by financial sector reforms. In 1980, the Government initiated policies that led to deregulation of interest rates and liberali- zation of exchange controls, with the result that the financial system is now characterized by market-determined Interest rates and an essentially open capital account. Following the dislocations in the real sectors during 1983- 85 and the concomitant disarray of the financial sector, the Government undertook measures for rehabilitating government-owned financial institutions, notably the Philippine National Bank (PNB) and the Development Bank of the Philippines (DBP), in the context of the Economic Recovery Loan (ERL; Loan No. 2787-PH, 1987). With the restructuring of these two financial institutions largely accomplished and the banking sector having regained its health, what remains to be done is to put the financial sector on a firm enough footing to support the significant shifts in resource allocation which the economy must undertake in response 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 intermediate funds at reasonable cost to new productive activities. Conse- quently, the Government has embarked on a series of financial sector reforms supported by the Bank through a Financial Sector Adjustment Program Loan (PSAL), 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 institutions. By providing funds to DBP to help it carry out its wholesale functions, the proposed Project fits into the overall strategy for development of the country's financial sector. B. Evolution and Structure 2.2 As of December 31, 1989, assets of the financisl system totalled 3 1015.8 billion, representing an increase from 1980 of 224 percent in nominal terms. The major components of the system, their nominal size and percentage distribution in 1980 versus 1989 are presented in Annex 2.01. 2.3 Commercial Banks. The comercial banks account for the largest share (41 percent) 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 countrys total assets contracted by 44 percent in real terms; loans to the private sector contracted even more sharply, by 63 percent. 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 commercial bank,  - 11 - 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 1986-89. As an additional indication, the banks' capital adequacy ratios have improved in recent years. 2.4 Privately-owned banks form, by far, the largest part of the banking system. There are now 29 banks, of which four are foreign and one (PNB, still the biggest) is 70 percent government-owned; in 1989, PNB successfully underwent a partial privatization when a public issue of 30 percent of its shares was oversubscribed. Eleven banks are licensed as universal banks, a classification that allows them to engage in activities such as those under- taken by investment banks, leasing companies and finance companies in addition to traditional commercial banking activities. 2.5 Non-bank Institutions. The next largest component of the financial system comprises the non-banks, which include insurance companies, pension funds, investment institutions, trust operations and others. Their assets amount to i 151 billion, or 15 percent of the system's financial assets. The most important are insurance companies and investment institutions, i.e., finance and investment companies. 2.6 The Securities Market. While the Philippines has long had stock exchanges, the capital market has not really developed into a significant alternative source of funds to banks. Public participation remains narrow and it is generally felt that investors are not adequately protected from loss from irregular activities. The market is dominated by a few big issues and trading is subject to large swings in volume and price. The top ten stocks contribute almost 80 percent of market capitalization, a much higher level of concentration than in the stock markets of other ASEAN countries. 2.7 It should be noted, however, that though the equities market in the Philippines is se:. l undeveloped, it has witnessed remarkable growth in the last four years despite episodes of political instability. Renewed confidence brought about by a new Government, the higher earnings prospects of companies and listing of new issues has led to substantial growtht the market capitalization of the 145 listed companies at the end of 1989 stood at P 260.4 billion, representing 27 percent of GNP compared to the total market capitalization of P 12.74 billion in 1985 representing a mere 1.35 percent of GNP. Moreover, in 1989 six companies listed new shares whose par value totalled P 2.17 billion (US$98 million equivalent); this was supplemented stock dividends and pre-emptive rights offerings totalling i 4.09 billion par value. As for the secondary market in equities, it has been active, with the market breaking all previous records in 1986, 1987 and 1989. The 1986 turnover of P 11.47 billion represented an increase of 555 percent over the preceding year's turnover of P 2.07 billion while that of 1987, 3 31.35 billion, was a 273 percent increase over 1986. In 1988, turnover dropped to P 23.90 billion, but increased by 125 percent in 1989 to P 53.8 billion. The growth in the total volume and value of stocks traded in 1989 could have been higher had it not been for the aborted coup attempt in early December 1989 which adversely affected stock trading during the last weeks of the year.  - 12 - 2.8 Foreign portfolio Investments in Philippine securities totalled US$433.2 million in 1989, about seven times the 1988 level of $60.4 million. Hong Kong-based dealers accounted for the biggest block of foreign investors in Philippine securities with a share of 70.7 percent of the total volume. The foreign portfolio investments were primarily in commerciallindustrial sector securities (46.7 percent) and financial sector securities (33.9 percent). 2.9 As for corporate debt securities, both the primary and secondary markets remain small, with very few long term issues being offered in the public market. In 1989, the volume of transactions in the commercial paper market rose by 23.6 percent to amount to P 20.9 billion. There have been no new corporate bond issues. The government securities market is far more active. The largest issued and actively traded government securities are T-bills2 total transactions in 1989 amounted to P 361.1 billion. National government bond issues total approximately P 34.0 billion and those of government-controlled corporations and the Central Bank of the Philippines (CBP) are about P 4.0 billion and P 7.4 billion, respectively. 2.10 Leasing. Introduced in the Philippines in 1957, the leasing industry consists of financing companies which act as lessors. Supervision 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 percent; industrial machinery, 10.4 percent; business and office machines, 10 percent; heavy equipment, 9.1 percent and others, 34 percent. 2.11 The volume of new leases written in the last two years indicate the market potential: leases booked by the leading five lessors alone amounted to P 870 million in 1988 and P 1.4 billion in 1989. Projections of total leasing demand made by these firms for the period 1990 to 1994 range from P 13.2 billion to P 14.4 billion. In anticipation of improved market conditions and demand for big-ticket equipment leases, two of the industry leaders increased their capitalization substantially in 1989. Indeed, the growing size of lease contracts has led to an increase in lease syndications, with the participation of several leasing companies and funding banks. C. Financial Sector Reforms 2.12 Financial sector reforms in the Philippines have been undertaken in three distinct phases. The first phase undertaken in the early 1980. focussed on two issues: institutional fragmentation in the system and interest rate policy. Institutional fragmentation was reduced by introducing the concept of universal banking which allowed commercial banks to undertake practically all kinds of financial activities. As far as the interest rate policy is concerned, 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  - 13 - internaticnal flows and characterized by market- determined interest rates. All rates, deposit as well as lending, are now market determined. 2.13 During most of the 1980s, nominal interest rates have been rising because they were following rising inflation; real interest rates did not show an upward pattern, though they stayed at a high level. Since late 1989, however, interest rates have risen dramatically (they are now 25 percent in nominal terms equivalent to 10 percent real). Three factors explain this rise. First is the increase in domestic debt. In order to place larger stocks of domestic debt, the Government had to offer more attractive rates of return. Second, inflationary expectations have risen in the wake of economic and political difficulties since 1988. This puts upward pressure on nominal interest rates as people try to hedge for the future. Third, the increasing current account deficits (reaching 3.5 percent of GDP in 1989) are creating an expectation of a weakening currency, thus widening the exchange rate risk premium built into the domestic interest rate structure. The solution to these problems lies in better control over the fiscal situation of the country. This is being addressed by the Bank and Zn? in the context of over- all stabilization measures. 2.14 The second phase of financial sector reforms was initiated during 1986-87 in the context of the Bank's ERL. It concentrated on reforming and rehabilitating government financial institutions (GFIs), specifically PNB and DBP. These institutions 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 management, 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. 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. 2.15 The reforms under the third phase, the most recent and still continuing, were developed as a result of the Financial Sector Study (PSS).21 It concentrated on commercial and central banking sectors and identified the following as four critical problem areast (a) supervision and regulation of commercial banks, including the governing legal framework; (b) institutional arrangements for the protection of insured depositors; (c) high intermediation costs and lack of effective competition; and (d) direct involvement of the central bank in credit allocation because of the absence of satisfactory institutional arrangements for the mobilization and provision of long-term capital. Based on the FSS findings, a Financial Sector Adjustment Program svpported by a US$300 million Bank loan (FSAL; Loan No. 3049-PH, 1989) was designed. The program involves specific actions in the listed problem areas. 2/ Philinnines: Financial Sector Study (Report No. 7177-PH, August 23, 1988).  - 14 - 2.16 Since the approval of PSAL in May 1989, satisfactory progress has been made in the implementation of the agreed program. Four studies related to the legal and supervisory framework--on bank reporting requirements, asset valuation and loan lose provisioning, trust account treatment, and accounting principles governing preparation and reporting of financial statements of banks--have been completed, with the recommendations of the first two already acted upon. As regards PDIC's institutional strengthening, excellent progress has been made in instituting revised policies and procedures, management information system and in recruitment of new staff and training. Measures have also been taken to increase effective competition in the banking system: lifting of the moratorium on establishment of new banks, with one new commercial banking licence already issued; conversion of two commercial banks into universal banks; two mergers involving five thrift banks and three rural banks, and removal of all restrictions on the opening of new branches in Tpriority' rural areas. Indeed, during the May to December 1989 period, 54 new bank branches were allowed to be established compared to 2 in 1988 and none in 1987. Moreover, satisfactory drafts of bills to amend insolvency, reorganization, and chattel and real estate mortgage laws have already been prepared. The progress in reducing the central bank's involvement in credit allocation has also been very satisfactory (para. 2.17). 2.17 Major actions that remain for implementation before disbursement of the second FSAL tranche are: initiation of the phase-out of the Gross Receipts Tax; enactment of the amendments to the Central Bank Act to strengthen CBP's supervisory powers and amendments to the PDIC Act to appoint PDIC as a receiver in cases of bank failure and to increase its authorized capital. Second tranche disbursement is event-bound, not time-bound; completion of the remaining required actions is expected by mid-1991. D. Institutional Arrangements for Providing Long-Term Credit 2.18 Under the PSAL, CBP agreed to continue to reduce sharply, and ultimately eliminate, its direct involvement in the management of government- sponsored credit allocation programs. The administrative responsibility for industrial sector programs has been assigned to a revamped DBP (para. 3.9), and the Agricultural Loan Fund has been transferred to the Land Bank of the Philippines. There are still a few small agricultural credit programs (but on which no new disbursements are being made) that remain with CBP, but in practice its role is now confined to liquidity management through discount window operations. 2.19 While the banking system has concentrated on providing 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. 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  - 15 - 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 liability 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 3 5.8 billion and P 5.7 billion for private and public insurance 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 & 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 arrangement to bring the providers and users of long-term funds together. 2.22 Given the domestic long-term funds available 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. These domestic term funds would supplement the foreign borrowings which, in the foreseeable future, would likely remain the main source of term funds for the industrial sector. According to agreed FSAL measures, a revamped DBP will fulfill the wholesale role for domestic and foreign funds 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 individual subloans. Chapter III provides a detailed description of the strategic reorientation of DBP.  - 16 - E. Industrial Credit 2.23 The Bank's growth projections, based on an assumption of continued good policy performance and a favorable external environment, suggest an average growth rate of 4.5Z for both overall GDP and industry in the Philippines during the 1990-92 period. Financing this growth 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. Small and medium enterprises (SMEa) 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. 2.25 Demand for Industrial Term Credit. The business community, financial institutions and government officials feel strongly that demand for term credit will continue to be strong. As the experience with the IIC Project (paras. 3.21 - 3.23) demonstrates, there is a substantial need for financing modernization and expansion in industry as existing production facilities have reached their full capacity. 2.26 A review of the project pipelines of financial institutions active in the provision of term credit to industry suggests that for the creditworthy medium-and large-scale enterprises, concrete demand as evidenced by actual loan applications would amount to around P 8 billion for 1990-91. Demand for term credit by SMEs in the formal industrial sector is expected to be around 4 billion for the same period. Thus, term credit demand of approximately a 12 billion by the formal private industrial sector for 1990-91 appears to be a reasonable estimate. A conservative assumption of an annual growth rate of 4? in demand for term credit over the next three years, in line with prevail- ing estimates of GNP growth, would lead to a projection of about P 25 billion (US$1.04 billion equivalent) for the term credit needs of the formal private sector in industry during the 1991-93 period. 2.27 An evaluation of demand for finance by the private sector should also include the substantial financing needs arising from the restructuring and rehabilitation of industrial enterprises. In the subsectors discussed in Chapter 1 and Annexes 1.06 to 1.10, 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. Estimates by the consultants looking into industrial restructuring needs suggest that for the cement, textile and garment, and pulp and paper subsectors alone, at least US$700 million would be needed for physical restructuring over the next three years. 2.28 SguWlv of Industrial Term Credit. Credit availability is a source of concern for the manufacturing sector. As Table 2.1 shows, loans provided by commercial banks to the private sector have not yet recovered in real terms to pre-crisis levelss indeed, real credit availability in 1989 was only half that of 1984.  - 17 - Table 2. 1t LOANS GRANTED BY COMMERCIL BANRS TO MANUFACTURING SECTOR (Peso Billions) 1984 1985 1986 1987 1988 1989 al Nominal 115.6 87.2 82.2 94.2 123.9 151.7 Real b/ 115.6 70.9 65.9 66.9 72.6 67.5 a/ Data as of end-September 1989 annualized. bI Adjusted by GDP deflator using 1984 constant prices. 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 unsatisfied. It is in this context of paucity of term credit that the proposed Project for financing private medium-scale and large enterprises was developed; it would also address the financing needs of the larger investments characteristic of the more capital-intensive industries, such as cement, chemicals, metals, pulp and paper and textiles. 2.29 Given the estimated demand for industrial term credit of US$1.75 billion (including industrial restructuring needs) for 1991-93, the term finance available to the formal industrial sector is inadequate: the IGLP program provides US$275 million 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 institutions); ADB is expected to provide a US$100 million industrial credit line and the Asean Japan Development Fund (AJDF) would provide US$300-350 million to all sectors, including agriculture. This would leave a potential gap of at least US$l billion after taking into account the funds supplied by the various sources, including AJDF and ADB. The proposed Bank loan of US$175 million for financing medium-scale and large industrial enterprises is therefore a conservative amount, compared to expected total needs. F. Bank Strategy In the Sector 2.30 Past Lending. Bank experience in lending to the Philippines industry sector has recently been reviewed by OED.31 The review covers six loans over the period 1975 to 1989: Loans 1052-PH and 1514-PH to the Private Development Corporation of the Philippines (PDCP IV and V); Loan 1572-PH to the Development Bank of the Philippinews (DBP III); Loans 1727-PH and 2169-PU for Small and Medium Scale Industry (SMI II and III); and Loan 1984-PH for lending to industry (Apex). The loans are essentially loans to SHIs (SMI II and III 31 Project Performance Audit Report On the Philippines - Six DPC and SMI Loans (Report No. 8781-PH, June 21, 1990).  - 18 - and part of DBP IIT) and loans to larger industry (PDCP IV and V. part of DBP III and the Apex Loan). The loans were made to institutions (PDCP and DBP) for lending directly through enterprises as well as indirectl" through apex arrangements (SMI II and III; Apex). Some loans also had strong technical assistance components, intended to support the small industry promotion activities within the Government, to set up pilot plants and, through UNDP funds with the Bank acting as Executing Agency, to build up technical expertise. 2.31 The SMI loans performed well. The funds were disbursed to a large number of SHI units through financial intermediaries, and the repayment record on them was good. The subloans generated substantial employment and were distributed broadly in regional terms. A large amount of funds was cancelled under SMI III partly because of stoppage of operations by DBP in 1984 but mainly because of the 1983-86 economic recession. The main factor in the success of the SM! loans was the bearing of all foreign exchange risk by the Government and the broad distribution channels used, particularly commercial banks which had other loan and business relationships with the SM! sub- borrowers. 2.32 The performance under the larger industry loans was mixed, partly due to the difficult economic environment in the country but mainly because of the requirement that the DFCs pass on the foreign exchange risk to the subbor- rowers. PDCP IV and V and the larger industry component of DBP III were fully utilized, but a large part of the Apex Loan was cancelled because of the poor economic environment and the unwillingness of subborrowers, in the context of a rapidly depreciating peso, to bear the foreign exchange risk on subloans. The incapacity of the subborrowers to repay subloans on which they had agreed to bear the foreign exchange risk affected adversely their lenders, mainly PDCP, whose business was mainly in foreign currency lending. 2.33 The broad lessons that emerge from the review of these loans are: (a) the Bank policy on the foreign exchange risk has created repayment problems in an environment of exchange rate instability and affected the sustainability of those development finance institutions whose business was primarily in foreign currency loans. Moreover, it has also led to a drying up of demand for such funds from entrepreneurs; (b) the Bank's traditional DFC model was flawed to the extent that it led to specialization in foreign exchange lending; as the case of PDCP shows, it is necessary for such DFCs to divercify into local currency operations. The Apex lending model offers the advantage of using comercial banks which have such local currency activities. Both these lessons have been incorporated in the subsequent industrial sector loans, namely SMI IV (Loan 3038-PH, 1989) and the Industrial Investment Credit Project (Loan 3123-PH, 1989), as well as in the proposed Project. 2.34 Lending Strategy. 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 Industrial  - 19 - Sector Reports A/ identify areas where further improvements would promote industrial sector growth. These includes 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 Philippines' comparative advantage in labor; expanded availability of long-term finance; and measures to boost exports. To support the industrial sector, therefore, Bank assistance would take the form of policy advice (related both to the industrial and financial sec%ors), institutional 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 PSAL. 2.35 The proposed Project is a follow-up to the IIG project designed to provide term funds to medium and large industrial projects. This project involved a loan of USS65 million to DBP for onlending to private sector enterprises through participating financial institutions. The project has proceeded successfully, with approval and disbursement targets being exceeded (paras. 3.21-3.22). The proposed Project was designed in the light of the experience of the IIC loan. 2.36 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 institu- tion-building experience of the IIC project as well as on the restructuring of DBP undertaken in the context of the ERL Program (Chapter II). Given the size of the financing gap and the amount of the Bank loan, the Bank funds will be complementary to, rather than competing with, other suppliers of funds. The TA component dealing with industrial subsectors would facilitate the industrial restructuring process by providing necessary skills to both the public and private sectors, and supporting environmental pollution control efforts. 41 PhiliDRines: Toward Sustaining the Economic Recovers (Report No. 7438-PH, January 30, 1989); The Philippines: Issues and Policies in the Indulstrial Sector (Report No. 6706-PH, July 30, 1987).  - 20 - III. THE BORROVER MID PARTICIPATING FINANCIAL INSTITUTIONS A. The Development Bank of the Philippines Introduction 3.1 DIP would be the borrower of the proposed Bank loan. DIP would relend the Bank funds to participating financial institutions (PFIs) for on- lending to private medium-scale and large enterprises. The proposed operation is designed in the context of a long-term Institutional Development Plan (IDP) for DIP 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 rehabilita- tion under EEL and the policies initiated as part of the PSAL, DIP is already moving towards integration into the market-based financial system that charac- terizes 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 institu- tions rather than to end-users. The proposed Project would reinforce the expected evolution of DIP 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. Historical Perspective: 1958-1986 3.2 Established in 1958 as a Government-owned development bank, DIP'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, DIP engaged heavily in lending to social sectors such as education and health care. Starting in the seventies, under the guise of its developmental mission, DIP 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 19708, 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, DIP had to rely mainly on government deposits for funding its activities. 3.4 Several capital increases between 1972 and 1980, substantial government deposits to 4upport its liquidity position, and various measures to strengthen its organization and procedures all failed to stop DIP'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 Apex Industrial Finance Loan (Loan 1984-PH), administered by the Central Bank and in which DIP was one of several participating financial institutions, the Government and DIP were asked to  _ 21 - implement an "Action Program': this 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 Rehabilitations 1986-89 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 comprehensive 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-performing accounts to the Asset Privatization Trust (APT), created by the Government to sell those assets; (d) implementation of a drastic cost 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 been completed, with DBP being solvent and profitable during the last three 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 0.85:l, compared to the ceiling of 5sl set under the ERL. Earnings indicators look goods return on average assets is 9.52; return on average net worth, 17.52. 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).  - 22 - Table 3.1s SUMMARY OF DBP'S FINANCIAL PERFORMANCE, 1985-89 (Peso billion) m~~~~~~~~~~~~~~ 1985 1986 1987 1988 1989 Targets Total Loans Outstanding 27.5 5.27 4.39 5.01 5.70 n.a. Total Debt 67.6 6.82 7.07 6.32 5.30 n.a. Total Equity 4.5 2.68 3.46 5.11 6.27 n.a. Net Income 6.9 5.6 0.8 1.6 1.10 n.a. Ratios: Debt/Equity 15.0 2.5 2.0 1.2 0.85 5.0 Net Worth/Risk Assets (Z) 11.3 35.9 37.4 52.8 172.5 10 Liquid Assets/Deposits (Z) 63.1 208.4 161.3 64.5 165.3 80 Provisions for Doubtful Accounts/Total Loans (Z) 0 47.3 34.9 28.6 31.81a 25-39 Net Interest Marginl Total Assets (Z) (8.6) (29.5) 9.7 9.2 11.0 4.5 Return on Average Net Worth (X) (182.2)(157.7) 25.5 38.4 17.5 10.0 Administrative Expenses/ Average Total Assets (Z) 1.1 6.1 5.7 6.0 4.5 n.a. Personnel Costs/ Total Assets (Z) 0.4 3.7 2.5 2.6 2.6 2.5-3.5 la The figure for pre-rehabilitation (pre 1986) non-performing accounts (NPAs) is 108?; the provisions exceed the NPA a'tual account because they were not yet reversed for accounts already collected and sold. The provisions for post-rehabilitation (post 1986) accounts equal 2.8S. 3.7 It should, however, be pointed out that DBP's 1989 earnings performance is not fully indicative of DBP's long-term earning capability on a going concern basis. Of the total operating revenues of 1 1.9 billion, only 52? is interest from loans; 25Z comes from investment in securities, primarily Government issues, 5Z from the sale of assets, and the remainder from trust funds and other miscellaneous sources. This reflects the cautious investment approach taken in the first three years after the financial restructuring. As for interest expense, until December 19, 1989, 1 1.4 billion of interest-free Government funds or 12S of total funds, were on DBP's books. On December 20, 1989, these funds were converted into a special time deposit costing DBP 15.752. As DBP mobilizes higher cost funds, its spread would decrease. This combination of factors which reduce revenues and increase expenses will lead to lower, though still positive, net returns in the future.  - 23 - DBP's New Role and Strategic Orientation 3.8 As described in paras 2.19 - 2.22, the 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 be developed to fill this institutional gap. This involved mandating DBP to act as a predominantly wholesale financial institution, catering to financial intermediaries rather than directly to business enterprises. Under the PSAL, agreement with Government was 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 availability 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 Apex Development Finance Program (APEX) and Industrial Guarantee and Loan Fund (IGLF) have been transferred from the Central Bank to DBP. DBP is also expected to be the main wholesale conduit for the AJDF. 3.10 As part of the FSAL, the Bank helped DBP formulate an Institutional Development Plan 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 wholesale loan approvals and outstanding wholesale loans to financial institutions. Agreement was reached under the PSAL 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 65Z 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. The implementation of DBP's wholesale banking strategy, considered essential for its future, will continue to have top priority. During negotiations agreement was reached with DBP for continued implementation of the IDP. 3.11 Because of circumstances beyond its control, DBP did not meet its 1989 wholesale lending targets: the bilateral and multilateral funds envisaged did not materialize in time. However, since late 1989, DBP has made a good start with the IIC Project (paras. 3.21-3.22). The following programs are expected to increase its wholesale lending activities substantially during 1990-1991 the Industrial Guarantee Loan Fund (IGLF), the AJDF, an Asian Development Bank line of credit similar to the IIC Project, and the proposed Project.  - 24 - 3.12 As part of its reorientation towards wholesale lending, the Government and DBP have also agreed that, over time, DBP should divest itself from its retail operations. A study is currently being undertaken by consultants to determine the best approach to divestiture. As a first step, DBP is working on a complete separation of wholesale and retail operations. This is expected to be completed by end November 1990, to be followed by preparatory work that will enable privatization of at least 302 of the equity base of the retail operations by June 1991. By 1993, DBP's equity stake in retail operations would have been reduced by 70X. During negotiations agreement was reached with DBP and the Government that all steps necessary to get in vendible form will be taken by June 1991. Oraanization and Management 3.13 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 Vice-Chairman of the Board are also bank mnnagers. Composed of nine members appointed by the President of the Republic of the Philippines, the Board now includes five members from the private sector. 3.14 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 mobilization, which has to be carried out in the financial markets by an individual 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 oversees the Financial Institutions Group that manages wholesale lending. The Industrial 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 Ad- ministrative 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. Personnel Policy and Training 3.15 Under the ERL, DBP reduced its staff from about 3500 to 2000, mainly through an early retirement scheme. 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 competitive 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 senior officers from leading private sector banks to head its departments.  - 25 - 3.16 DBP has engaged in extensive training of its staff in corporate finance, loan packaging, financial analysis and legal issues. A training program in industrial restructuring has been implemented as part of the TA component of the IIC Project. DBP is developing detailed terms of reference for a training program that will cover two areas critical to its successful evolution as a wholesale banks (a) its capital markets and resource mobilization staff and (b) wholesale lending. The capital markets component will consist largely of on-the-job training in connection with the proposed bond issue and DBP's merchant banking activities. The wholesale lending component will focus on the criteria, systems and procedures required for dealing with PFIs as clients. The training program would be funded under the Japan Grant Facility associated with FSAL. The details of the training program were reviewed and confirmed with DBP during negotiations. Accounting and Management Information System 3.17 The flow of accounting data has improved substantially over the last three years. Revised Branch and Head Office Accounting and Procedures Manuals have been completed. Liquidity and reserve summaries are generated 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 centralized in the Transactions Processing Department. A central mainframe computerized information system, acquired from Citibank, is expected to be operational by end 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 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 computerized by the end of 1990. In the meantime, the branches operate with stand-alone microcomputer 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. 3.18 Each major department or unit of DBP is responsible for establishing its respective goals and targets and consolidating these into an integrated business or action plan. Overall, the systems for identifying problem areas are working, as are the systems for monitoring progress and evaluating performance. Internal management communication and cooperation among the departments are appropriate, especially in the formation of special-function mmangement committees, to rationalize certain problem areas and to develop inter-departmental solutions. There is a functioning planning and budgeting process and the accounting systems and internal controls are adequate.  - 26 - Loan Activities and Asset Management 3.19 The DBP loan window was reopened in mid-1986 after a hiatus of four years during which no new loans were disbursed. In 1987-1988, as management cautiously focussed on rehabilitation rather than on expansion, DBP's investment policy was conservative, with lending being primarily short-term and excess liqaidity being invested in securities, mostly Government issues: in 1987, DBP realized no positive new net lending, while its securities portfolio grew by P 2.7 billion; in 1988, outstanding loans increased by P 610 million, while investments in securities were reduced by P 192 million. With its rehabilitation completed, DBP engaged more fully in lending activities in 1989: outstanding loans grew by P 854 million and investments in securities decreased by P 1.7 billion. 3.20 Industrial Investment Credit Proiect. DBP's wholesale lending activities commenced in late 1989 with the effectiveness of the Bank-financed IIC Project. DBP's handling of it has thus far been outstanding. It engaged in an aggressive marketing effort, with senior management playing an active role in developing and enhancing relationships with financial institutions. This resulted in 23 financial institutions being accredited, including ten commercial banks, two merchant banking institutions, five private development banks and one finance company. 3.21 Commitments and disbursements of IBRD loan funds have far exceeded appraisal estimates. To date, 29 subprojects have been approved with IBRD funds committed amounting to P 1.4 billion (around US$ 63.8 million equivalent out of a total loan of US$65 million). Most of the subprojects (24) are for expansion or modernization of production facilities. Of the IBRD funds committed, P 1,298.3 million or 92.5% are for loan financing and P 105.6 million or 7.5% are for leasing. At an aggregated level, IBRD financing represents 35.72 of the total project cost of P 3.9 billion; at the subproject level, IBRD funds account for 15.2X to 70.3Z of total (sub) project cost. DBP expects disbursements to be completed by December 1991. In line with its wholesale banking role, DBP has encouraged loan syndication by the PFI1: 9 of the approved subprojects involve syndicates of PF11. 3.22 With the transfer of the ongoing IGLF program from the Central Bank to DBP in 1990 and the additional foreign funds anticipated to be channelled through DBP (AJDF, ADS and Bank funds), wholesale loans outstanding are projected to grow substantially, from P 5.6 billion in 1990 to P 34.3 billion in 1995. The bulk of these loans will be for the industrial sector. Retail lending is projected to grow at a more modest pace, from P 6.5 billion in 1990 to P 12.8 billion in 1995. 3.23 DBP uses resources from its *Regional Development Fund' to extend loans that do not completely satisfy traditional conmmercial 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 environmental pollution. The Regional Development Fund comprises, and is limited to, 30a of each year's net income  - 27 - after taxes and repayments of loans sourced from the Fund. As of December 31, 1989, these loans amounted to 3 73.8 million. By 1995 these loans are projected at P 1.4 billion or 3S of total loans outstanding. The IDP provides that (a) the risk exposure of these loans and compliance with the 30? net income ceiling will be monitored closely; and (b) appropriate provisions will be made to take into account the potentially higher risk. These provisions will be at least 10? above the average provisioning on conventional performing loans. 3.24 DBP's record in recovery of pre-rehabilitation non-performing loans has been better than anticipated under the rehabilitation plan. Out of non- performing accounts representing 1 4 billion that remained on DBP's books after the transfer of the bigger accounts to APT, 1 1.8 billion were collected. In addition to standard loan collection and foreclosure acti- vities, an "incentive scheme for pretermination- was 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 more than 10O of the pre-rehabilitation portfolio since the allowance for bad debts has not yet been reversed to reflect recent collection or sale of accounts; actual arrears on this portfolio amounted to 64? as of December 31, 1989. DBP intends to write off all the past due accounts of this portfolio by end-1992. As for loans made after the rehabilitation (1986), actual arrears equalled 5.9X as of December 31, 1989; the loan loss reserves of 2.8Z underestimate the reserves available to cover these actual arrears as the substantial excess reserves currently for the pre-rehabilitation portfolio will be available for the post-rehabilitation loans. Transfer of half of these excess reserves to the latter will raise loan loss reserves to 11; transfer of the whole excess will result in a 15.8? loan loss reserve. Given DBP's past history, its conservative provisioning policy is appropriate. Liability Management 3.25 DBP's balance sheet is now exceptionally liquid, with cash and due from banks representing 165.3? of deposits. In the coming years, liquidity will decrease as lending activities grow. There is some maturity transformation risk, with an average maturity of funding liabilities of 4.3 years, compared to an average loan maturity of 6 years. 3.26 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, with the support of the Philippine authorities. 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. Organizational changes have been made in DBP to consolidate and give more prominence at senior levels to those activities that are closely identified with resource mobilization: designing, packaging, timing, pricing and placing its debt instruments. Thus far, DBP's resource mobilization efforts have consisted of designing securities to be issued by its clients and finding potential investors for  _ 28 - them. It has not issued its own debt securities on account of the high level of interest rates. Given investors' current preference for short-term paper, DBP envisages that it would initially launch a P 250 million, 3-year, bond issue in 1991 and 1992 to establish its presence in the market, to the extent allowed by market conditions and crowding-out effects resulting from government funding requirements. Favorable reception in the market would then be followed up by a P 500 million issue in 1993 and further issues with longer maturities and lower coupons. Proiected Financial Position and Performance 3.27 DBP's results for the last three years show that DBP is now endowed with features that enable optimism regarding its future prospects. Its management 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 is implementing improved controls and procedures. On April 5, 1989, DBP's Board approved 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 fort (a) private sector orientation with autonomy in decision-making; (b) an interest rate and fees policy that is consistent with prevalent market rates and that 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 5sl. These market-oriented policies, implemented by its now more streamlined organization, should enhance and speed up the integration of DBP into the market-based financial system of the Philippines. DIP's operations should continue to be governed by these policies to avoid the mistakes of the past. DBP's continued adherence to its Policy Statement during the project implementation period will be a condition of the Bank loan. Barring an unexpected deterioration in the macroeconomic environment, DBP is now ready to undertake more substantial lending activities. 3.28 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.  - 29 - Table 3.2: SUMMARY OF DBP'S PROJECTED FINANCIAL PERFORMANCE, 1990-1995 (Peso Billion) Year 1990 1991 1992 1993 1994 1995 Iholesale Loans Outstanding 5.58 11.48 16.74 22.99 28.84 34.16 Retail Loans Outstanding 6.51 7.87 9.19 10.47 11.69 12.83 Total Debt 11.16 18.10 23.05 29.53 34.98 40.25 Total Equity 7.01 7.82 9.09 10.52 12.11 13.74 Net Income .86 .90 1.27 1.56 1.59 1.78 Ratioss Debt/Equity 1.59 2.31 2.54 2.81 2.89 2.93 Liquid Assets/Deposits (Z) 135.1 139.1 11.9.2 119.7 110.8 113.6 Provisions for Doubtful Accounts/ 2.7 2.7 2.4 2.1 2.0 2.0 Total Loans (C) - Return on Average Net Worth (Z) 13.0 12.1 15.0 15.9 14.0 13.8 Administrative Expenses/ Average Total Assets (Z) 4.7 3.2 2.6 2.2 1.9 1.7 B. The Participatina Financial Institutions 3.29 The twelve PFTs identified by DBP for possible participation in the proposed Project are privately-owned and comprise eight commercial banks, two leasing companies and two investment houses. As of December 31, 1989, they accounted for 47Z of total assets of the financial system. Key financial data and ratios on the PFIs are presented in Table 3.3 below.  - 30 - Tablo 8.8: PFPI - F2NANCIAL DATA AND RATIOS (December 81, 1989) Return on Total Average Oebt/ Risk Asavts/ Liquid Assote/ Adm. Expense/ As tn Net worth Equity Net Worth Deposits Avg. Total Assets PFI (a el II In) (%) (rTim") (TIM" ) (X) mX Commercial Banks. For East Bank 85.46 29.8 11.1 9.6 55.8 4.8 PCI Bank 24.14 a0.0 7.4 7.4 5S.0 0S2 CocoBank 21.08 21.1 4.8 5.6 70.8 4.2 Equitable 11.96 2B.7 10.2 9.5 78.0 4.6 CltyTrust 11.09 26.4 6.8 6.4 122.2 n.e. Intorbank 10.67 16.4 7.7 7.9 182.2 7.9 Chlna Bank 9.50 81.8 8.8 8.1 69.6 8.8 Union Bank 4.12 27.0 4.5 4.4 106.2 4.8 Lesina Comwanies All Asia Capital 0.67 20.0 8.6 4.0 n.e. 8.4 BPI LesIng 0.02 20.9 5.1 4.5 n.a. 2.9 Investmont House Anscor Capital A Investment Corp. 0.497 27.1 1.2 1.8 n.a. 2.0 Private Developmnt Corporation of the Philippineo (PDCP) 7.87 8.9 16.2 C.9 n.e. 4.26 3.30 All the PFIs being considered, except PDCP, have high profitability, with annual return on average net worth ranging from 16.4Z to 31.82 and averaging 20.2?. This compares with an average of 20.3? for the ten largest private coummercial banks. Although their debt/equity ratios ranged from a low of 1.2:1 to a high of 16.2sl, they all are in compliance with CBP's maximum risk assets to capital ratio requirement of lOl. Moreover, they have all maintained a satisfactory liquidity position. 3.31 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 and IICP projects, nine of the twelve 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. The accreditation criteria for the PPIs are discussed in para. 4.9.  - 31 _ IV. THE PROPOSED PROJECT A. Proiect Obiectives 4.1 The objectives of the proposed Project are tot (a) Support the revival and the strengthening of the industrial sector; (b) Support sound industrial investment in subsectors free from major distortions resulting from inappropriate trade and regulatory policies; (c) Help make the cement, pulp & paper, textiles, shipping and ship repair subsectors more competitive through reforms of subsector- specific policies, TTA, and institutional strengthening; (d) Strengthen the institutional framework for environmental protection; and (e) Strengthen DBP's capabilities to play a more active role in the development of the capital market and to act as a wholesale bank channeling term funds to retail financial institutions. B. Proiect DescriPtion 4.2 To achieve the foregoing objectives, the Project would include the following componentss (a) Line of Credit for Equipment and Working Capital. This would be the project's largest component, estimated at US$150 million and accounting for about 86Z of the Bank loan. This would be supplemented by export credits of about US$75.0 million to be mobilized under the Export Credit Enhanced Leverage (EXCEL) Program; the objective of this program is to facilitate the access of private sector enterprises to export credits in countries where ECAs would otherwise be reluctant to provide such financing, notably in highly indebted countries. The Bank Loan and EXCEL credits would provide long-term financing to viable industrial enterprises, covering plant improvements or construction and acquisition of equipment as well as the working capital requiremuents associated with investment in plant and equipment; investments in energy conservation and pollution control devices would be included. Incremental marketing and worker training and relocation expenses may also be financed. (b) Lease Pinancing. As medium-term financial instruments, leasing contracts can be part of a financing package offered to industrial enterprises. The project would provide an estimated US$25 million (about 14? of the loan) to finance PuTs for the purchase of equipment which they would lease to subborrowers.  - 32 - (c) Training and technical Assistance (TTA) for (i) selected subsectors and (ii) environmental protection. TTA to the selected subsectors will involve strengthening existing institutions and training facilities that serve them and assisting enterprises in the identification, analysis and appraisal of restructuring investments. TTA for environmental protection will comprise a two-pronged approacht on the one hand, assistance, through D8P's Industrial Restructuring Unit (IRU), to industrial enterprises on the design of least- cost pollution control components compatible with prevailing standards, as part of their subprojects; on the other hand, support to the Environmental Management Bureau (EMB) in building up its capabilities to carry out industrial environmental audits and develop generic Environmental Impact Assessments (EIAs) for subsectors classified as environmentally critical. The Project would provide an estimated US$16 million for the TTA component, which is described in more detail in paras. 4.12 to 4.21. 4.3 The allocation of the Bank loan among the credit components (equipment financing and leasing) 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). 4.4 Subsector Eligibility. The line of credit provided under the Project would not be subsector-specific. To achieve the objective of supporting efficient and sound investment, however, no funding would be provided for projects in subsectors which are (a) protected by quantitative restrictions or excessive effective tariff protection--So or above; (b) subject to price control, and/or (c) subject to legal or administrative barriers to entry impeding competition. Annex 4.01 provides a list of subsectors which would be at present ineligible for financing by virtue of these criteria; this list would be updated periodically by DBP as warranted, in agreement with the Bank. However, DBP under certain exceptional circumstances may consider lending to investment projects in the ineligible subsectors provided that they meet agreed eligibility criteria (para. 4.28). Agreement was reached with DBP and the Government during negotiations that DiP amend its Policy Statement and its Operating Policy Guidelines to reflect that objective and the above eligibility criteria. 4.5 Action Proaram. Implementation of the proposed Project involves execution of the Action Program described in Chapter I and detailed in Annexes 1.11 to 1.15. The Action Program comprises (a) policy reforms to create a favorable enabling environment for private investment; (b) establishment of a support structure including institutional improvements and TTA to allow the subsectors to overcome identified constraints. 4.6 As pointed out in para. 1.15, the Government is finalizing a major reform of its trade, fiscal and regulatory policy framework to provide the right signals for making the industrial sector more competitive and efficient. This reform would remove most QRs, substantially lower and simplify the tariff band, and remove the distorting regulatory policies in cement (pricing) and  - 33 - the transport subsector (regulation of rates and routes; barriers to entry). As a result, the policy issues listed in the Action Program would be satisfactorily addressed, thus making the subsectors which would now be excluded from Bank loans eligible for funding, C. Loan Amount 4.7 The proposed loan of US$175 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 Republic of the Philippines would guarantee the Bank loan to DBP. It is expected that the Baunk loan will be fully committed within four years after effectiveness. 4.8 The proposed Bank loan would cover 322 of a total financing package of US$541 million. The balance would be provided by the project sponsors, PuIs, the EXCEL program and bilateral agencies as shown in Table 4.1. Table 4.1s PROJECT COSTS AND FINANCING PLAN Estimated Costs Local Foreian Total -