China - Regional Cement Industry Project

Document of The World Bank FOR OFFICIAL USE ONLY MICROFICHE COPY Report No. 8260-CRA Report No. 8260-CHA Type: (SAR) SONG, KYUN/ X72058 / A-8091/ AS3IE STAFF APPRAISAL REPORT CHINA REGIONAL CEMENT INDUSTRY PROJECT FEBRUARY 11, 1992 Industry and Energy Operations Division Country Department II East Asia & Pacific Regional Office IThs document ha a restidcted distbuton and may be used by redpienb ony In the performance of their officiW duties. Its contents may not otherwise be didosed without World Bank authorization.  CURRENCY EQUIVALENTS (As of September 1, 1991) Currency name Renminbi (RMB) Currency unit - Yuan (Y) 100 Fen Y 1.00 - $0.487 $1.00 - Y 5.36 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES I metric ton (ton) 1,000 kilograms (kg) 2,204 pounds 1 kilometer (kn) 1,000 meters (m) c 0.621 mile 1 meter (m) 3 1.0936 yards - 39.37 inches 1 cubic meter (m3) 35.31 cubic feet (CF) 264 US gallons 1 hectare (ha) 10,000 square meters (m2) - 11,960 square yards 1 megawatt (MW) 1,000 kilowatts (kW) 1 kilocalorie (kcal) 1,000 calories (cal) 0.2519 BTUe GLOSSARY AND ABBREVIATIONS APCIC - Anhui Provincial Credit and NCC - Ningbo Cement Company Investment Company NCIDI - Nanjing Cement Industry Design APG - Anhui Provincial Government Insitute ARSSC - Anhui River and Sea Shipping Company NIC - Ningbo investment Company ATCC - Anhui Tongling Cement Company NJMG - Nanjing Nunicipal Government BDIC - Beilun District investment Company NTMG - Nantong Municipal Government CAD - Computer-Assisted Design OPC - Ordinary Portland Cement CIB - China Investment Bank PBC - People's Bank of China CIF - Cost, Insurance and Freight RIC - Research Institute of Cement CPC - China Petrochemical Corporation SM - State Audit Administration CSC - Chanjiang Shipping Company SABMI - State Administration for Building dwt - Dead weight tonnage Materials Industry EIA - Environmental Impact Assessment SCSC - Shanghai Changjiang Shipping Company EPA Environmental Protection Agency SDARI - Shanghai Merchant Ship Design and ERR - Economic Rate of Return Research Institute FOB - Free on Board SER - Shanghai Economic Region FRR - Financial Rate of Return SOE - Statement of Expenditure GOP - Gross Domestic Product SPB - State Pricing Bureau GOC - Government of China SPC - State Planning Commission HCIDI - Hefei Cement Industry Design Institute SRC - System Reform Commission ICB - International Competitive Bidding SRMIC - State Raw Materials livestment ICBC - Industrial and Commercial Bank of Corporation China TCC - Technical Cooperation Credit IDC - Interest During Construction TCIC - Tongling City Investment Company IlC - International Finance Corporation TCIDI - Tianjin Cement Industry Design ITC - International Tendering Company Institute . JPG - Jisagsu Provincial Govermnent tpd - Tons per day JSC - Joint Stock Company tph - Tons per hour kWh - Kilowatt hours tpy - Tons per year NIS - Management Information System TVE - Township and Village Enterprise mt - metric ton WBMTC - Wenzhou Building Materials Trading HBMG - Ningbo Municipal Government Company IBH1 - Ningbo Building Materials Industry WCG - Wenzhou City Government Bureau ZCC - Zhongguo Cement Company NBUMTC - Nantong Building Materials Trading ZDIBM - Zhejiang Design Institute of Building Company Materials  FOR OMCIAL USE ONLY CHINA REGIONAL CEMENT INDUSTRY PROJECT Loan and Project Summary Bogrowert The People's Republic of China Beneficiaries: Anhui Tongling Cement Company (ATCC, Anhui Province); Ningbo Cement Company (NCC, Ningbo Municipality); Zhongguo Cement Company (ZCC, Nanjing Municipality); and State Administration of Building Materials Industry (SABMI). Amount: $82.7 million equivalent Terms: 20-year repayment, including five years of grace, at the standard variable interest rate Proiect Objectives: The project would help China achieve its goals for the cement sector, which are to: (i) expand cement produc- tion capacities based on economically viable technol- ogies and scales; (ii) improve product quality and pro- duction efficiency of existing cement plants in accor- dance with the country's increasing demand for high- grade cement; (iii) strengthen domestic capabilities for research and design in the cement industry; and (iv) address the issue of economic inefficiency and po'llution relating to a majority of the country's small cement plants. In addition, the project would help China develop and experiment with, for major govern- ment-sponsored investments, the "joint-stock" ownership system, a new ownership structure emerging in China under the ongoing economic reforms. Project Descrintion: Consistent with the above goals, the project would con- sist of three components: (i) Tongling cement produc- tion and distribution component; (ii) Zhongguo cement plant rehabilitation component; and (iii) the technical assistance component. The Tongling component would implement a regional cement production and distribution scheme, which involves installation of a cement plant at Tongling in Arnkui Province, with a capacity of 1.2 million tons per year (tpy) of clinker and with a grinding capacity to produce 690,000 tpy of high-grade cement, and construction of a 600,000 tpy clinker grinding capacity at Ningbo in Zhejiang Province to process clinker to be shipped from Tongling. This com- ponent would be supported by a river and coastal bulk transport system, the first interprovincial bulk cement transportation and distribution network in the country, which would include a loading terminal at Tongling, bulk carriers, a clinker receiving terminal at Ningbo This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  (Zhejiang), and bulk cement receiving terminals at Nantong (Jiangsu) and Wenzhou (Zhejiang). The Zhongguo component involveq replac4ng wet-process cement produc- tion units (with a 150,000 tpy capacity) by a 640,000 tpy cement dry-process cement unit in order to improve production efficiency and product quality and to expand production capacity of an existing medium-scale cement plant. The technical assistance component provides financial and technical support to strengthen four cement industry research and design institutes and a study to improve the efficiency and emissions of small- scale cement plants. Pro1ect Benefit: The quantifiable benefits of the project come mainly from the expanded production of high-grade cement and improved production efficiency of an existing plant. In addition to quantifiable benefits, the investment components of the project would have a significant impact on future cement plants by providing models for optimization of such investments. Hitherto, the lack of interprovincial cooperation in China has contributed to the prevalence of suboptimal size plants based on segmented markets. The benefits from the technical assistance component, although unquantifiable, would be significant and sector-wide. Prolect Risks: Given the chronic deficit of high-grade cement in the Shanghai Economic Region and elsewhere in the country, shortfalls in the projected demand for the output of this project are not perceived as a risk. The sensi- tivity test of economic analysis indicates a satisfac- tory economic rate of return for the project even with the assumption that the entire output of the project will have to be exported. A major risk for the Tongling component is the need for cross-provincial coordination of plant operations and transport after start-up. This risk would be minimized by contractual arrangements to ensure the timely installation of related facilities, offtake and shipping of project output, market diversification of the receiving cities, and flexibility in terms of the bulk-handling capacity of the receiving terminals. Another technical risk for both the Tongling and Zhongguo components is the lack of Chinese experience with these plant designs. This risk has been reduced by the use of internationally experienced consultants in the basic design of the project facilities and the preparation of technical specifications for the procurement packages of major processes and equipment, and by placing single party responsibility for performance in the process areas.  Estimated Costs: * Local Foreian Total - $ million ------ Tongling (ATCC) 88.8 34.3 123.1 Tongling (NCC) 11.1 6.0 17.1 Zhongguo (ZCC) 37.7 17.8 55.5 Technical assistance 0.9 3.0 3.9 Incremental working capital 7.3 - 7.3 Base Cost (06/91) 145.8 61.1 206.9 Physical contingencies 13.0 6.1 19.1 Price contingencies 12.1 6.8 18.9 Total Proiect Cost 170.9 74.0 244.9 Interest during construction (IDC) Bank loan - 8.7 8.7 (Total project cost plus IDC on Bank loan) (170.9) (82.7) (253.6) IDC on other loans 11.5 - 11.5 Total Financing Required 182.4 82.7 265.1 Financin_ Plan: Eguity: APCIC 28.0 - 28.0 SRNIC 18.9 - 18.9 NIC 3.8 - 3.8 NJMG 13.2 - 13.2 CPC 7.5 - 7.5 TCIC 7.4 - 7.4 BDIC 1.7 - 1.7 Internal funds 13.7 - 13.7 Loans: IBRD - 82.7 82.7 APCIC 40.8 - 40.8 SRMIC 20.1 - 20.1 ICBC 27.3 - 27.3 Total 182.4 82.7 265.1 Estimated Disburse- IBRD FY 1992 1993 1994 1995 1996 ments: Annual 0.5 10.8 46.9 19.5 5.0 Cumulative 0.5 11.3 58.2 77.7 82.7 Economic Rate of Return: 18.1%  CHINA REGIONAL CEMENT INDUSTRY PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. I. INTRODUCTION . . . . . . . . . . . . . . I II. AN OVERVIEW OF INDUSTRY IN CHINA . . . . . . . . . . . . 2 A. Background . . . . . . . . . . . . . . 2 B. Industrial Development Strategy . . . . . . . . . 2 C. Bank Support to Industry . . . . . . . . ..... 5 III. THE CHINESE CEMENT INDUSTRY . . . . . . . . . . . . . . . 8 A. Status of the Cement Industry . . . . . . . . . . . . 8 B. Demand and Supply ............. . . 9 C. Structure and Performance of the Industry . . . . . . 11 D. Marketing and Distribution . . . . . . . . . . . . . 14 E. Pricing . .. . . . . . . . . . . . . . . , - 14 F. Government Strategy for the Cement Industry . . . . . 15 G. Bank Role and Project Justification . . . . . . . . . 16 IV. THE CEMENT INDUSTRY IN THE SHANGHAI ECONOMIC REGION . . . 17 A. The Shanghai Economic Region . . . . . . . . . . . . 17 B. The Regional Cement Market . . . . . . . . . . . . . 18 C. Structure and Performance of the Regional Cement Industry . . . . . . . . . . . . . . . . . . . . . . 19 D. Market Integration . . . . . . . . . . . . . . . . . 20 V. PROJECT INSTITUTIONS . . . . . . . . . . . . . . . . . . 20 A. Introduction . . . . . . . . . . . . . . . . . . . . 20 B. Background . . . . . . . . . . . . . . . . . . . . . 21 C. The Anhui Tongling Cement Company (ATCC) . . . . . . 21 D. The Ningbo Cement Company (NCC) . . . . . . . . . . . 22 E. The Zhongguo Cement Company (ZCC) . . . . . . . . F. The Four Cement Industry Research and Design Iastitutes . . . . . . . . . . . . . . . . . . . . . 24 This report was prepared by Messrs. K. Song (Task Manager), C. Punsalan, R. Hur, M. Fog, and A. Fateen. Mr. S. Leong contributed to the cement industry chapter, and Ms. E. Sun contributed to the financial analysis chapter, and Ms. N. Lichtenstein provided assistance on legal aspects. The peer reviewers for this project were Messrs. D. Brown and A. Ody. Ms. D. Christmas provided secretarial support. This report is based on the findings of an appraisal mission which visited China in October 1989, a post-appraisal mission in February 1991, and follow-up discussions by the appraisal team on several occasions. The Acting Division Chief is Ms. B. Kafka and the Department Director is Mr. S. J. Burki.  - ii - Page No. VI. THE PROJECT . . . . . . . . . . . . . . . . . . . 25 A- Objectives . . . . . . . . . . . . . . . 25 B. The Tongling Cement Production and Distrlbution Component . . . . . . . . . . . . . . . . . , . . . . 26 C. The Zhongguo Plant Rehabilitation Component . . . . . 28 D. The Technical Assistance Component . . . . . . . . . 28 VII. PROJECT MANAGEMENT AND ENVIRONMENTAL PROTECTION . . . . . 29 A. Engineering Arrangements . . . . . . . . . . . . . 29 B. Project Management . . . . . . . . . . . . . .. . . 29 C. Implementation Schedule . . . . . . . . . . . . . . . 30 D. Environmental Aspects . . . . . . . . . . . . . . . 30 VIII. CAPITAL COSTS. FINANCING PLAN, PROCUREMENT AND DISBURSEMENT 31 A. Capital Cost Estimates . . .. . . . . 31 B. Financing Plan . . .......... .. . . . . 32 C. Procurement . . .. . . . . . . . 35 D. Allocation and Disbursement of the Bank Loan . . . . 36 IX. FINANCIAL_ANALYSIS . . . . . . . . . . . . . . . . . . . 37 A. Financial Management Practices in China . . . . . . . 37 B. Financial Performance and Projections . . . . . . . . 38 C. Financial Rate of Return and Sensitivity Analysis . . 40 D. Financial Covenants and Reporting Requirements . . . 40 X. ECONOMIC ANALYSIS . . . . . . . . . . . . . . . . . . . . 41 A. Economic Costs and Benefits . . . . . . . . . . . . 41 B. Economic Rate of Return and Sensitivity Analysis . . 42 C. Other Benefits . . . . . . . . . . . . . . . . . . 42 D. Project Risks . . . . . . . . . . . . . . . . . . . . 42 XT. AGREEMENTS REACHED AND RECOMMENDATIONS . . . . . . . . . 4 TABLES IN TEXT 3.1 China - Cement Consumption, Production, and Imports . . . . 9 3.2 China - Output of Cement by Plant Categories . . . . . . . 12 4.1 SER--Summary of Cement Consumption and Production, 1982-2000 . . . . . . ... . . . . . . . . . . 18 4.2 Limestone Deposits in the Region, 1988 . . . . . . . . . . 20 5.1 Summary of Organizations and Staffing for the Four Design Institutes.. . . . . . . . 25 6.1 Cement Production and Consumption in Ningbo, Nantong, and Wenzhou Cities . . . . . . . . . . . . . . . . . . 27  - iii - TABLES IN TEXT (cont'd) 8.1 Summary of Estimated Project Costs . . . . . . . . . . . 32 8.2 Financing Plan . . . . . . . . . . . . . . . . . 33 8.3 Procurement Arrangements . . . . . . . . . . . . . . 35 8.4 Allocation of the Bank Loan .. .. . . . . 36 9.1 ATCC, NCC and ZCC - Summary of Selected Financial Data . . 39 9.2 Financial Rates of Return Sensitivity Analysis . . . . . 40 10.1 Economic Rate of Return Sensitivity Analysis . . . . . . 43 ANNEXES 1.1 Enterprise Ownership and Management Reforms in China 3.1 The World Cement Industry 3.2 China - Historical Cement Production, Consumption, Imports and Exports, 1950-90 3.3 China - Investment Program During the Seventh and Eighth Five-Year Plans 3.4 Comparison of Domestic and International Prices of Cement and Main Inputs, June 1991 4.l Major Economic Indicators of the Shanghai Economic Region, 1989 4.2 Cement Production and Consumption in the Shanghai Economic Region, 1982-2000 4.3 Large and Medium-Size Cement Plants in the Shanghai Economic Region, June 1990 5.1 Main (Expeririental) Features of "'Joint Stock Company" Experimentation under the Project 5.2 ATCC - Organization After Project Completion 5.3 NCC - Organization Chart After Project Completion 5.4 ZCC - Organization Chart Aftar Project Completion 5.5 The Four Cement Industry Research and Design Institutions - Organization Chart 6.1 Summary of the Tongling Cement Production and Distribution Component 6.2 Cement and Clinker Inland Water Transport System for the Tongling Output 6.3 Summary of the Institutional and Contractual Arrangements for the Sale and Distribution of the Tongling Output 6.4 Summary of the Zhongguo Cement Plant Rehabilitation Component 6.5 Outline of Work Programs for the Four Cement Industry Research and Design Institutes under the Technical Assistance Component 6.6 A Study on the Efficiency and Environmental Assessment of Small Cement Plants - Terms of Reference 7.1 SABMI - Organization of the Project Coordination Group 7.2 ATCC, NCC, and ZCC - Organization of Project Management Teams 7.3 Project Implementation Schedule and Key Milestones 7.4 Environmental Protection and Standards  - iv - ANNXES (cont'd) 8.1 Project Capital Cost Estimates 8.2 Summary of Major International Competitive Bidding Packages 8.3 Estimated Disbursement Schedule for the Bank Loan 9.1 Key Assumptions Underlying the Financial Analysis 9.2 ATCC - A Summary of Projected Financial Statements 9.3 NCC - A Summary of Projected Financial Statements 9.4 ZCC - A Summary of Actual and Projected Financial Statements 9.5 Financial Rate of Return Calculations 10.1 Assumptions Underlying the Economic Analysis 10.2 Economic Rate of Return Calculations MAPS IBRD 21752R China: Major Cement Plants and National Design and Research Institutes IBRD 21753 Tongling Cement Production and Distribution Component (Tongling Plant) IBRD 22058 Tongling Cement Production and Distribution Component (Ningbo Plant) IBRD 21754 Zhongguo Cement Plant Rehabilitation Component DOCUMENTS AVAILABLE IN THE PROJECT FILES References: 1. China - Regional Cement Subsector Review, February 15, 1985 2. Feasibility Studies for the Tongling Cement Plant 3. Feasibility Studies for the Zhongguo Cement Plant Rehabilitation 4. Comparison of Bulk and Bag Distribution of Cement 5. Registered Charters of Project Entities 6. Joint Venture Agreements between Investors for ATCC and NCC 7. Draft Contracts for the Sale and Shipping of ATCC's Output 8. Work Programs for the Four Cement Industry Research and Design Institutions 9. Environmental Impact Assessments for the Three Project Plants  - 1 - CHINA REGIONAL CEMENT INDUSTRY PROJECT I. INTRODUCTION 1.1 The Government of the People's Republic of China (the Government, GOC) has requested a Bank loan of $82.7 million equivalent to finance a Regional Cement Industry Project. The project is the first Bank operation in the Chinese cement sector, a sector characterized by low quality products, low production efficiency, and suboptimal production facilities. The project aims to help China implement its strategy for the cement sector by providing sup- port for: (i) the definition of an optimal model for the large-scale produc- tion of high-g.--de cement J1 based on an economically viable technology and scale, a related bulk transportation system on the Yangtze River, and success- ful u.egotiations among the various jurisdictions in the Shanghai Economic Region (SER) for pooling the currently segmented cement markets; (ii) rehabil- itation of a medium-sized cement plant; (iii) strengthening of local capabili- ties for research, technology development, and the design of plant and eq.ip- ment at four of the country's cement industry research and design institutes; and (iv) the investigation of measures to improve production efficiency, prod- uct quality and pollutant emissions in small-scale cement plants. In addi- tion, the project would help China experiment with the "joint-stock" ownership system for major Government-sponsored large investments. Two experimental shareholding companies would be established to implement the major (Tongling) component of the project. 1.2 The Tongling component represents a major innovation in interprovin- cial cooperation for large-scale investments. In the past, provincially-spon- sored projects have often resulted in suboptimal scale investments, the result of an excessive preoccupation with self-sufficiency and local funding con- straints. The GOC, with assistance from the Bank, designed this project com- ponent to include the cooperation of several provincial and municipal juris- dictions: the Anhui Provincial Government (APG); the Ningbo Municipal Govern- ment (NBMG); the Nantong Municipal Government (NTMG); and the Wenzhou City Government (WCG). Their agreements on the provision of investment funds, sharing and pricing of output, transportation of products, and other related issues have resulted in an economically and institutionally viable project component that should be a model which can be replicated in the cement and other industrial subsectors. 1.3 The project was first identified as a result of the Bank's sector work on the cement and cement manufacturing industries in 1985. The appraisal was completed in October 1989. The project was postappraised in February 1991. 1/ By normal international convention, high-grade cement refers to cement having an average 28-day compressive strength of 525 kg/cm2 and above, and suitable for structural construction uses.  - 2 - 1.4 This report recommends a Bank loan of $82.7 million equivalentg which would cover 31 percent of the total financing required and 100 percent of the total foreifn exchange financing required. II. AN OVERVIEW OF INDUSTRY IN CHINA A. Background 2.1 Industry is China's largest productive sector, accounting for nearly 46 percent of its gross domestic product (GDP) in 1989 and employing 17 per- cent of the country's total labor force. About 99,000 state-owned enterprises generate 56 percent of total industrial cutput; the remainder is produced by more than 1.7 million nonstate enterprises--primarily urban and rural collec- tives, and township and village enterprises (TVEs). the state enterprises concentrate mainly on important raw materials, capital goods, and strategic commodities such as fertilizers, while nonstate enterprises mainly produce downstream consumer products. Gross industrial output, which amounted to Y 2,201.7 billion ($584.8 billion) in 1989, is shared almost equally by light and heavy industries. The gross value of industrial production increased rapidly between 1978 and 1989, at about 12.5 percent a year in real terms. During this period, light industry registered a much faster average annual growth rate (14.5 percent) than did heavy industry (10.9 percent). Chinese manufactured exports have also grown rapidly from around $8 billion in 1980 to about $37.5 billion in 1989. 2.2 China's industrial development has been constrained by several structural deficiencies that stemmed mainly from rigid economic planning and past industrial strategies oriented towards self-sufficiency at the national and regional levels. The most obvious deficiencies pertain to outdated tech- nologies, institutional rigidities deriving in part from quota and price con- trols, a distorted structure of prices, inadequate infrastructure, and an underdeveloped financial sector. These problems are reflected in the low productivity of labor and low efficiency of resource use in Chinese plants. The structure of industry also is skewed toward basic, heavy industry. The emphasis on self-sufficiency at the regional level has led to a fragmented national market, reduced domestic competition, and the suboptimal use of scarce skills and resources. As a result, potential gains from economies of scale are often missed. Institutional inflexibility, compounded by inadequate market integration, has provided little incentive for industrial enterprises to improve managerial efficiency and product quality. The low prices of energy and basic intermediates for industrial production also contribute to the inefficient use of inputs. Investments in infrastructure, particularly for transportation and telecommunications, have lagged behind those in indus- try. This disparity has in turn been a major constraint on industrial devel- opment. The financial markets are still in their infancy and until recently only provided limited intermediation services for enterprises. B. Industrial Development Strategv 2.3 Since 1979, the Chinese Government has shifted the focus of indus- trial development toward light industry and, as part of the ongoing economic  - 3 - reforms, has introduced incentives and market forces to impreve economic effi- ciency. The development strategy has emphasized modernizing existing equip- ment, developing manufactured exports and more efficient light industry, and conserving material and energy resources in industry. The reforms have focused mainly on four areas: (i) prices--expansion of the role of market forces in price determination; (ii) enterprises--strengthening of enterprise autonomy and management accountability; (iii) trade--promotion of exports to earn foreign exchange to finance the importation of modern technology and equipment; and (iv) financial sector--enhancement of the scope and efficiency of financial intermediation. However, given little international precedent or experience in successful transition from centralized planning to an effective integration of plan and market, these reforms will continue to be a difficult and cautious process, involving experimentation and repeated fine-tuning. 2.4 The price reforms are designed to reduce gradually the distortions that cause allocative economic inefficiency, particularly by reducing the scope for allocation of resources under mandatory planning and by allowing market forces to play a greater role in price determination. At present, a two-tier pricing system exists as a result of differences between the con- trolled prices for quota production under the state allocation plan and mar- ket-related prices for output above plan targets. Since the start of the economic reforms, the Government has allowed a growing portion of industrial products to be sold at market prices outside the plan, and it has considerably raised the price of major industrial inputs, including energy. While the current transitory system is a significant tmprovement over the strict price control of the past, significant distortions in relative prices and large gaps between cortrolled and market prices have a number of shortcomings: reduced allocative efficiency, discrimination across producers and consumers. adminis- trative complexity, and creation of opportunities for corrupt practice and other distortions. The Government's strategy is to continue reducing its administrative control over pricing in parallel with gradual dismantling of annual production planning and allocation. 2.5 Rapid increases in free market prices and costs of urban living in 1989 slowed the pace of price reforms in recent years. After the announcement of major price reforms in May 1988, urban consumer prices, having risen by 15 percent in the first two quarters of that year, soared at an annual rate of over 60 percent in the third quarter. These developments forced the GOC to rescind the proposed price reforms and initiate a major stabilization (auster- ity) program. Despite the ongoing three-year austerity program, which could have implied a significant retreat to strong price controls over some strate- gic commodities, however, price reform has been a firm part of the Govern- ment's reform agenda. Major adjustments of controlled prices for agricultural commodities (soybean, grain, cotton, edible oils, energy inputs, coal, crude oil and power) and transport (freight and passenger transport) were made dur- ing 1990/91. Further price adjustments are planned for 1992. These adjust- ments are expected to create a more favorable environment for further price reform, including a gradual decontrol of prices and continued enlargement of the share of total output allocated by markets. 2.6 Reforms have been introduced in the management arrangements and ownership structure of enterprises with a view to improving the efficiency of enterprises. The central theme of these reforms has been the decentralization  - 4 - of economic decision-making, from the government to enterprises and from higher government tiers to lower ones. Enterprises, whose main function had been to carry out production mandates from the government before the reforms, have thus been provided various incentives to operate with greater autonomy in a more competitive business environment. As a consequence of these reforms, Chinese enterprises have now become diverse in terms of ownership, size, and organizational and management arrangements. Many small state enterprises have been converted to collective enterprises, and new rural collective enter- prises, operated by TVEs, have proliterated in areas close to major cities. The scope for privately-owned enterprises was expanded greatly by new regula- tions in 1988, which eliminated ceilings on the number of employees, and expanded the lines of business they can enter. New hybrid forms of enter- prises based on domestic joint ventures among different bureaucratic jurisdic- tions have also emerged, as a means of dealing with inter-regional trade and investment barriers. As for the management arrangements of state enterprises, significant changes have also been made in the degree of enterprise control over their assets and profits. The state enterprise reforms introduced, among other things, a system of contract management responsibility, a uniform tax rate (55 percent) for many large enterprises, wage incentives for workers, and higher profit retention by enterprises. 2.7 The economic environment over the next several years is expected to be conducive to continued experiments with enterprise reforms. Such refotms, however, will continue to be gradual and cautious; the step-by-step process which has characterized China's successful reform efforts to date is likely to continue. Main topics on the agenda include modification (in some cases, phasing out) of the management contracting system for state enterprises, introduction of a system of uniform taxation- alternative forms of enterprise ownership, separation of social (security) functions from commercial enter- prises, and the introduction and application of compary and bankruptcy legis- lation. In particular, the Chinese government has in recent years been actively investigating theoretical and practical issues related to adapting a shareholding system to Chinese state enterprises, and is launching controlled "Joint stock" experiments at selected locations. In this connection, an important change in the state investment system was initiated in early 1989 through the creation of state and local investment companies, which can pro- vide equity-type funding for state enterprises. Uitil the recent past, all state-sponsored investments for state enterprises had been wholly debt- financed.2/ 2.8 Against this background, the Government has designated two of the project companies as pilot enterprises for experimenting with the main fea- tures of the "joint stock" system. This experiment will include, inter alia: ownership sharing by state and local investment companies, establishuent of board of directors for major corporate decisions, and sharing of profits in the form of dividends among investors (paras. 2.15, 5.5 and 5.8). The Govern- ment intends to allow these companies to experiment with additional features 2/ This practice was an improvement over the preceding one of total grant financing. However, total debt financing of newly formed companies fur- ther complicated the ambiguity of enterprise ownership, and was also in conflict with a norm of prudent financial management.  - 5 - of the "Joint stock" system such as divestiture of ownership by institutional and individual investors in the organized stock exchange when such experimen- tation becomes feasible. 2.9 Trade reform measures have been limiled, and larger scale reforL to break up the state export and import monopolies and improve the foreign exchange allocation system have yet to take place. As a result of the limited decentralization of export responsibilities in the 19809, several thousand Chinese enterprises now have the right to trade directly with foreign firms. There has been a concern that this rapid granting of export rights, without sufficient regulation and institutional support for enterprises to adhere to quality and delivery standards, may have crested negative impressions in over- seas markets. GOC is fully aware of these problems, and has slowed the authorizations of direct trading, although its commitment to the "open-door" policy initiated in 1979 has not changed. The availability of foreign exchange to non-exporting enterprises has improved somewhat with the creation of the foreign exchange adjustment centers. While the operations of these centers are still limited in size, they have been growing rapidly, particu- larly in the recent past. 2.10 The major financial sector reforms include: (i) formal establish- ment of the People's Bank of China (PBC) as the country's central bank; (ii) divestiture of PBC's c omercial banking functions to independent special- ized banks; (iii) creation of a few new banks and nonbank financial institu- tions for various financial services; (iv) introduction of new financial instruments and establishment of related financial markets; and (v) a gradual rise in interest rates to stimulate economic use of capital and to promote domestic resource mobilization. These reforms have led to considerable finan- cial deepening despite some setbacks in the recent period of high inflation: the ratiL of the size of monetary assets (M2) to gross national product increased from 37 percent in 1979 to 75 percent in 1987, and the figure for 1990 was 88 percent. Notwithstanding these advances, weaknesses remain. The system remains overwhelmingly dominated by banks, in particular, the four specialized banks. Financial institutions have still to undergo substantial institutional upgrading to function as effective intermediaries. There has been a trend in the banking system of increasing portfolio arrears which needs to be arrested. Regulation and supervision of the financial system needs considerable strengthening as do the accounting and legal frameworks. Recent government efforts to finance investment in priority sectors through directed credit and selective interest rates need to be reviewed. While recent reli- ance on administrative mechanisms has enabled the government to regain control of inflation, in the longer term, PEC needs to develop its indirect monetary policy tools. C. Bank SuDport to Industrv 2.11 The Bank's objectives in supporting China's industrial development are to assist the Government in: (i) improving the policy framework for the industrial sector as a whole; (ii) building sound institutions and practices for subsector planning, project approval and implementation, and financial intermediation; (iii) promoting and implementing technology upgrading, plant restructuring and rehabilitation, and energy and material resource conserva- tion in selected sectors at the national and provincial levels; and  -6- (iv) carrying out various reforms, particularly in the enterprise and finan- cial systems. As the Bank's relationship with China has deepened, lending and sector work has increasingly concentrated on the articulation and design of the specific policies, institutions and procedures, which are integral parts of the reform effort. 2.12 The Bank Group's lending to the industrial sector in China, which began in December 1982, comprises the following: (i) five loans/credits totalling $945.6 million to the China Investment Bank (CIB) 3/ to develop it as a premier financial intermediary providing term financing for small- and medium-sized enterprises in a wide range of industrial subsectors; (ii) four loans/credits totalling $394.3 million to the fertilizer industry 4; to sup- port the b4ilding of new fertilizer plants, development of new phosphate mines, revamping of plants, and strengthening of the institutional infrastruc- ture; (iii) a loan of $100 million for the Shanghai Machine Tool project (Ln. 2784-CHA) in FY87, involving rehabilitation and modernization of the machine tool subsector in Shanghai; (iv) a loan of $128 million for the Pharmaceuti- cals Project (Ln. 2934-CHA) in FY88 to support the expansion of pharmaceutical production using modern technologies and proper manufacturing practices; (v) a loan of $154 million for the Tianjin Light Industry Project (Ln. 3022-CHA) in | FY89 to support the restructuring of textile dyeing and finishing, pulp and paper manufacturing, and packaging subsectors; (vi) a $20 million industry component of the Gansu Provincial Project (Ln/Cr. 2812/1793-CHA) in FY87 to be used for modernization of the rural industry base; (vii) a loan of $50.0 mil- lion and a credit of SDR45.1 million ($64.3 million equivalent) for the Rural Industrial Technology (Spark) Project (Ln/Cr. 3274/2186-CHA) to support the upgrading of standards and technology for the dynamic TVEs, China's rapidly growing nonstate enterprises; and (viii) a loan of $150 million for the Shanghai Industrial Development Project (Ln. 3288-CHA) in FY91 to support restructuring and development programs in four industrial subsectors--elec- trical apparatus, printing machinery, scientific precision instruments, and electronic components. In addition, the Planning, Support and Special Studies Project (Cr. 1835-CHA), approved in FY87, includes components for long-term planning and strategic studies in several industrial subsectors. 2.13 Physical implementation of most of the investment projects had pro- ceeded generally on schedule until the initiation of the economic austerity program in late 1989, when related local funding shortages began resulting in delays in the implementation of several Bank-financed projects. In recent months, however, the implementing agencies have been taking steps to expedite project implementation to catch up with the original schedule. GOC has given assurances that the necessary funds would be made available for Bank-financed projects. Disbursements of the above loans/credits, after some delays during 3/ The five CIB loans/credits are: Ln/Cr. 2226/1313-CHA in FY83; Ln/Cr. 2434/1491-CHA in FY84; Ln/Cr. 2659/1663-CHA in FY86; Ln/Cr. 2783/1763-CHA in FY87; and Ln. 3075-CHA in FY89. 4/ The four fertilizer loans are: Fertilizer Rehabilitation and Energy Saving Project (Ln. 2541-CHA) in FY85; Fertilizer Rationalization Project (Ln. 2838-CHA) in FY87; Phosphate Development Project (Ln. 2958-CHA) in FY88; and Hubei Phosphate Project (Ln. 3066-CHA) in FY89.  the past two years, have returned to a satisfactory level. Project Completion Reports (PCRs) have been prepared for the first three CIB loan/credits, and a PCR is currently being prepared for the Fertilizer Rehabilitation and Energy Saving Project. 2.14 The Bank's proposed future lending program in industry and finance includes: (i) support for selected major industrial subsectors--chemicals, fertilizers, manufacturing, electronics, building materials, etc.--at the national and provincial levels, within the framework of a defined sectoral strategies including broad-based restructuring; (ii) assistance to enterprises in undertaking key investment projetts in important industrial subsectors; and (iii) support for developing the infrastructure for sound financial sector development, and for consolidating the central banking function of PBC, and further support for CIB and other financial intermediaries in the context of the overall financial sector reform. The increasing devolution of responsi- bility for planning and implementation from the center to the provinces has expanded the role of provincial authorities in industrial development. While the central government rightly recentralized control of monetary policy as part of the austerity program, there is little practical evidence of a rever- sal in the overall trend. These developments in turn call for formulating a coherent national strategy for key industrial subsectors and a consistent set of investment priorities to be used as guides for provincial policies. The anticipated series of provincial and subsector operations is designed to help the central authorities and selected provinces articulate and implement their new responsibilities. 2.15 The reform measures introduced in recent years have created new opportunities for the Bank to help China in identifying and discussing reform- related issues and experimenting with new systems. For example, the Bank has produced several economic and sector studies on key reform issues; workshops and symposiums on enterprise and related reform issues have been jointly spon- sored by the Bank and the Government. Importantly, this project would create two companies based on experimental joint stock ownership, the first such arrangement for new state-sponsored investments designated officially by the System Reform Commission (SRC), who would provide a model for future invest- ments for medium- and large-scale state-owned enterprises (paras. 2.8, 5.5 and 5.8). The historical background, contents, and key issues of enterprise reforms, together with related Bank role and contributions, are detailed in Annex 1.1. 2.16 The International Finance Corporation's (IFC's) support for the industrial sector has been limited mainly because, with only a few exceptions, joint ventures have to earn their own foreign exchange to service foreign exchange obligations. This provision has made it difficult for IPC to support import-substituting joint ventures even though most potential partners in China are interested in the domestic market. Since its first operation in 1985, IFC has provided a total of $43.0 million to China, all of it to the industrial sector (equity participation of $3.0 million and loans of $40.0 million). Its five investments include: (i) Guangzhou and Peugeot Automobile Co., Ltd. (Investment No. 813, FY85); (ii) China Investment Co., Ltd. (Investment No. 974, FY87); (iii) Shenzhen China Bicycles Co., Ltd. (In- vestment No. 1020, FY87); (iv) Shenzhen Crown Electronics Co., Ltd. (Invest-  - 8 - ment No. 1066, FY88); and (v) Shenzhen Chronar Solar Energy Co., Ltd. (Invest- ment No. 119, FY89). 2.17 Related to the above, the Bank Group has engaged in a dialogue with the Government on the need to change the foreign exchange allocation and man- agement system. The current system distorts investments and discourages important import-substitution projects. The foreign exchange adjustment cen- ters, established in recent years in select trade cities and provinces and playing an increasingly important role (see para. 2.9), have the potential for alleviating th