Philippines - Second Rural Finance Project

Document of The World Bank Report No. 13116-PH STAFF APPRAISAL REPORT PHILIPPINES SECOND RURAL FINANCE PROJECT AUGUST 16, 1995 Agriculture and Environment Operations Division Country Department I East Asia and Pacific Region  CURRENCY EQUIVALENT Currency Unit - Peso (P) US$1 = P25.77 Pi = 0.0385 (as of June 1995) ACRONYMS ARF - Agrarian Reform Fund BSP - Bangko Sentral ng Pilipinas (the Central Bank) CARP - Comprehensive Agrarian Reform Program CPL - Currency Pool Loan CLF - Countryside Loan Fund DBP - Development Bank of the Philippines DENR - Department of Environment and Natural Resources DOF - Department of Finance FRSCL - Single Currency Loan at Fixed Rate EMB - Environmental Management Bureau GOP - Government of the Philippines ISAP - Institutional Strengthening Action Plan LBP - Land Bank of the Philippines NGOs - Non-Government Organizations PCIC - Philippine Crop Insurance Corporation PFIs - Participation Financial Institutions PNB - Philippine National Bank RBs - Rural Banks RCF - Retail Cofinancing Fund SDI - Subsidy Dependence Index VRSCL - Single Currency Loan at Libor-based floating rate FISCAL YEAR January 1 - December 31  PHILIPPINES SECOND RURAL FINANCE PROJECT STAFF APPRAISAL REPORT Table of Contents Loan and Project Summary ...................... iii I. THE ECONOMY ........................................... 1 Overview .............................................. 1 Agriculture in the Economy ............................ 2 II. THE RURAL FINANCIAL SECTOR ............................ 4 Structure ............................................. 4 Lending Structure ..................................... 5 Policy Reforms and Issues ............................. 6 Land Bank of the Philippines .......................... 7 Bank Sector Assistance Strategy .12 III. THE PROJECT .15 Project objectives and Description .15 Detailed Features .16 Project Cost and Financing .20 Procurement .21 Disbursement .22 Monitoring, Reporting and Audits .23 IV. PROJECT IMPLEMENTATION .24 General .24 Credit Operations .24 Institutional Strengthening Component .31 V. PROJECT IMPACT, BENEFITS AND RISKS .32 LBP .................................................. 32 Risks .34 VI. AGREEMENTS REACHED AND RECOMMENDATION .34 This report is based on findings of pre-appraisal and appraisal missions comprising Messrs. A. Chupak (mission leader), Y. Ziv (Bank), P. Harrison and J. Nogales (consultants) who visited the Philippines in January/February and May 1994. The report was updated in April 1995. Task Manager: A. Chupak; Financial Advisor: Mr. K. Siraj; Peer Reviewers: Messrs. I. Dalla and J. Yaron. Document clearance was provided by Mr. J. Gutman, Chief, EA1AE and Mr. C.E. Madavo, Director, EAl. Assistance in preparing the documents was given by Saraswathi Sundaram.  ANNEXES Annex 2.1 Land Bank of the Philippines Operation and Performance ........................................... 36 Annex 2.2 Nature of Sub-loans Supported Under the First CLF, 1991 - 1994 ................................ 56 Annex 3.1 CLF I & II Cash-flow Projections ...................... 61 Annex 3.2 Disbursement Schedule ................................. 67 Annex 3.3 Supervision Plan ...................................... 68 Annex 4.1 Environmental Technical Services ...................... 70 Annex 4.2 Institutional Strengthening Program ................... 78 Annex 4.3 Project Training and Technical Assistance Programs .... 85 Annex 5.1 LBP's Financial Projection ............................ 88 Annex 7.1 Documents in the Project File ......................... 92 Map: IBRD No. 24105R1  - iii - PHILIPPINES SECOND RURAL FINANCE PROJECT Loan and Project Summary Borrower : Land Bank of the Philippines (LBP) Guarantor : Republic of the Philippines Beneficiaries Investors in economic rural activities, and rural populations Poverty Category: Not applicable Amount : US$150 million equivalent consisting of three separate loans of US$50 million each: (a) Currency Pool Loan (CPL/Loan A); (b) US dollar Single Currency Loan at Libor- based floating rate (VRSCL/Loan B); and (c) US dollar Single Currency Loan at fixed rate (FRSCL/Loan C). Terms : The CPL and VRSCL, would be for 20 years, including 5 years of grace. The FRSCL would be payable in 15 years with 3 years of grace and 12 years maturity on each disbursed amount. Loan A, the CPL, would be lent at the Bank standard variable interest rate, Loan B, VRSCL, at the Bank standard LIBOR-based variable interest rate for US dollar, and Loan C, the FRSCL, at the Bank standard fixed interest rate term for US dollar for 12 year maturity. Commitment Fee : 0.75% on undisbursed loan balances, beginning 60 days after signing, less waiver. Relending Terms : The Land Bank of the Philippines (LBP) would relend the proceeds of the Bank loans: (i) to accredited participating financial institutions (PFIs) in domestic currency under the Currency Pool Loan (CPL) and in domestic currency or in US dollars under the Single Currency Loan (SCL) options; and (ii) to LBP's own clients jointly financed with other financial institutions in domestic currency under the CPL terms and in domestic currency or in US dollars under the SCL options. The foreign exchange risk for small and medium sized sub-borrowers (with total assets up to Peso 250 million) would be borne by the Government in exchange for a market related fee payable by LBP. In other cases the foreign exchange risk would be borne by the sub- borrowers. Interest rates charged by LBP to the PFIs would be freely negotiated on the basis of: (i) a market reference rate (the weighted average of Treasury Bills rates for 90 days) for domestic currency lending; and (ii) a LIBOR-based variable interest rate for US dollar lending under the SCL program. Sub-loans would be made at prevailing market interest rates. Sub-borrowers would be given a choice of a fixed rate (the prevailing variable rate plus a premium) for several years or a variable interest rate periodically adjusted. Maturity would conform to the maturities of sub-loans made by the PFIs and LBP to sub-borrowers, but would not exceed 15 years.  - iv - Financing Plan : See para. 3.10 Present Value : Not Applicable. Map : IBRD No. 24105R1 Project Identification No : PH-PA-4614  I. THE ECONOMY Overview 1.1 With a per capita GNP of US$970 (1994) and a population of over 68 million, the Philippine archipelago ranks among the lower middle-income countries. Following a decade of relatively strong economic growth in the 1970s (6% p.a.), the Philippine economy was severely affected by a recession during the early 1980s. Beginning in 1980, and with renewed vigor following the change of Government in 1986, the Philippine Government (GOP) embarked on an adjustment program aimed at correcting a wide range of structural problems. Reforms undertaken in agricultural pricing and marketing, the financial sector, investment incentives, direct and indirect taxation were accompanied by trade liberalization and privatization. 1.2 Although these structural reforms led to an initial economic recovery during the second half of the 1980s, the Philippines has largely failed to sustain its economic growth. While GDP grew at an average of 5.2% per annum during the late 1980s, growth dropped to below 1% in 1990-93 before rising to 4.3% in 1994. Among the factors responsible for the sluggish performance of the country's economy during these years were frequent macroeconomic policy slippage, such as delayed Government response to revenue shortfalls and higher oil prices, worries about future disruption of trade and capital flows due to high foreign debt and public deficits, numerous external shocks, including a string of major natural disasters during the early 1990s, political uncertainties and depressed private investments. Unlike in other countries which embarked on similar adjustment programs, private sector response to adjustment was slow because of deep-rooted oligopolies, low private savings and investment rates and continued severe shortages in the power sector. 1.3 In 1991 the Government initiated a new macroeconomic program, combining stabilization with renewed structural reform. Among the key reforms undertaken during this period were substantial liberalization of foreign investment, tariff reforms, deregulation of the foreign exchange market, decentralization of fiscal and administrative powers from central to local governments, and fiscal and monetary tightening to help improve macroeconomic imbalances. The reforms were accompanied by a comprehensive agreement to restructure medium and long term foreign debt held by commercial banks and a national action plan to address the crisis in the power sector. The successful implementation of stabilization policies during the last three years has begun to create an emerging track record of sound macro-economic management, while other structural reforms have substantially contributed to correct major policy- induced distortions, thus leaving the Philippines with a business environment which compares favorably with that in neighboring countries. To sustain these efforts in the years to come, further consolidation of reforms is required in such areas as revenue generation, energy, transport and capital markets. In view of the Government's limited capacity to finance development expenditures, increased private sector investments will be essential over the years to come. 1.4 The Government's medium term development plan therefore focusses on: (i) macroeconomic stability through continued tight management of financial policies--in 1994, the consolidated public sector deficit was practically  - 2 - eliminated, and inflation fell to 7%; (ii) enhancing the role of the private sector through extending the successful privatization program and encouraging private participation in infrastructure investments; (iii) an improved law and order situation (iv) poverty alleviation through sustained growth as well as targeted interventions; and (v) environmentally sustainable growth through stronger preservation of natural resources, better control on air and water pollution, reduced urban degradation and better protection of coastal waters and fisheries. Agriculture in the Economy 1.5 Sector Structure and Performance. Agriculture continues to play a significant role in the economy, both in terms of its direct contribution to production and employment and as a basis for activities in the manufacturing and service sectors. During the first four years of the 1990s, agriculture's direct contribution amounted to about 22% of GDP, agri-based industry accounted for another 13%, while as much as one-third of value added in the service sector was also linked to agriculture. Agriculture remains the most important source of employment directly providing income to 45% of the labor force. Although the sector's direct contribution to national output and employment has dropped continuously over the past two decades, the pace of change has been remarkably slow compared to other countries in the region. This slow structural shift is a reflection of industry's failure to become the main engine of growth and principal source of labor absorption over the last two decades. 1.6 Following a decline in output during the crisis years of the early eighties, the agriculture sector recovered to grow at an average annual rate of 3%, contributing about 16% to domestic growth between 1985 and 1990. The early 1990s were characterized by stagnation in both agricultural output and value added in agro-processing. The sectoral growth rate during the period of economic recovery was below both growth in the rest of the economy and the sector's comparatively strong performance during the 1970s. Sectoral value added, agricultural exports, and food production per capita have lagged far behind those in most other East and South Asian countries. Several factors account for this slowdown, including the fact that the fruits of the green revolution had largely been exploited by the end of the 1980s, an overall downward trend in international commodity prices for the Philippines' traditional export crops, natural calamities, and a series of macro-economic and sector specific impediments which have led to underinvestment in the sector. Among the latter two figure an exchange rate that became overvalued in the late 1970s, the absence of long term credit, deterioration of intersectoral terms of trade, weak rural infrastructure and an inefficient transport system, feeble support services and slow implementation of agrarian reform. 1.7 Rural Poverty. Persistent widespread rural poverty is the most disappointing aspect of past economic performance in the country. Over two- thirds of all poor households live in rural areas, where both the incidence and the severity of poverty remain high. The incomes of over half of all rural households fall below the rural poverty line (US$230 in 1992) and the number of rural poor households has increased by over 52% from 2.3 million to 3.5 million between the mid-1960s and the late 1980s. Several factors account for this, including falling real wages, a continuing high population growth rate, an increasing scarcity of land, inadequate growth of the agriculture sector and a  failure of the economy as a whole to provide sufficient employment opportunities outside agriculture. Sustained sectoral growth, combined with increased employment opportunities outside the agriculture sector in rural areas will be indispensable to reduce rural poverty in the years to come. The proposed project would assist in achieving these goals through the provision of needed term lending facilities for financing rural development activities. 1.8 Government Strategy and Outlook. Aware of the critical role that agriculture must play in economic recovery and in spearheading the attack on rural poverty, the Government has implemented a series of institutional reforms to stre-igthen sector management and policy reforms aimed at reducing government interventions in pricing and marketing and at eliminating discrimination against agriculture. It has also embarked on the Comprehensive Agrarian Reform Program to achieve better distribution of cultivable lands and aims at increasing allocation of public resources to agricultural development. The Government's sectoral objectives as stated in the Agricultural Development Plan (1990) are: (i) to increase the productivity and real incomes of small farming and fishing families; (ii) to attain self-sufficiency in rice and corn for food security; (iii) to help attain a favorable balance of trade for the country; and (iv) to help ensure productivity of the agricultural resource base over the longer term. The focus of this broad plan has been refined under the Medium Term Agricultural Development Plan 1993-98. During implementation of this, Government intends to concentrate its efforts on the development of Key Production Areas (KPAs) which it has defined for different crops. The KPA approach aims to achieve greater and more diverse aggregate production as a result of increased specialization and hence higher yields. It recognizes that (i) prospects in the international market for some of the Philippines' traditional exports (mainly sugar) appear bleak; and (ii) the gains of the green revolution have been substantially reaped, particularly for rice. Consequently, future sectoral growth will have to come from increased diversification, intensification, and linkages between production of raw materials and processing. This new approach, which will result in substantial changes in cropping pattern and increased commerce in agricultural products, will require substantial sectoral investments by the private sector, pointing up the need for adequate term financing. 1.9 With a planned agricultural growth rate of about 4%, and a similar or higher rate aimed for in other rural businesses, incremental rural output over the five year project disbursement period would amount to about P150 billion at 1994 prices. Assuming Incremental Capital to Output Ratios (ICORs) for the sector of 3-4, the investment required to support this growth would be around P450-600 billion or some US$20 billion. It is unlikely that more than 20% of this would be provided by Government. Consequently, the majority of investment would need to come from private investment of which a significant part would be funded by formal borrowing. Assuming private investment is funded 50% by retained profits, 25-% informal borrowing and 259% borrowing from banks, the incremental formal credit required over the five year project period would amount to about US$4 billion. The project would provide about 5% of this.  - 4 - II. THE RURAL FINANCE SECTOR Structure 2.1 The formal rural finance system in the Philippines is essentially comprised of four types of institutions: (i) a relatively small number of commercial banks with rural branches; (ii) thrift banks, including private development banks, savings and mortgage banks, and savings and loans associations; (iii) family-owned local rural banks and; (iv) specialized Government banks. The formal rural finance system is furthermore supported by several government sponsored non-bank financial institutions which provide guarantee and insurance services to agriculture. The two most important institutions are the Quedan and Rural Credit Guarantee Corporation, known as the QUEDANCOR, providing mainly warehouse guarantees, and the Philippine Crop Insurance Corporation (PCIC) focussing on insurance of grain production. 2.2 Commercial banks have accounted for almost 64% of total loans granted to agriculture between 1988-1994. However, their lending has essentially been limited to highly collateralized loans granted to large local and multinational agribusinesses. Although the bulk of their lending consists of short term loans, these are often rolled over on a regular basis to large long term customers. Commercial banks do not generally lend to small-scale rural borrowers, due to the high costs and higher perceived risk involved. 2.3 Thrift banks, including private development banks, savings and mortgage banks, and savings and loans associations accounted for only 7.5% of loans to agriculture in the last five years, with the bulk coming from private development banks which are heavily concentrated in Central Luzon and have generally relied on the funds of the Development Bank of the Philippines (DBP) for term lending to medium-scale agri-based industries. 2.4 Rural Banks (RBs). Unlike commercial and thrift banks which tend to mobilize more resources in rural areas than they invest there, RBs mostly mobilize and reinvest resources in rural areas and have thus played a significant role in the development of the rural economy. Their development throughout the country was, however, largely spurred by heavily subsidized Government funds (about P4.5 billion), which were made available through special deposits and Central Bank rediscounting facilities for onlending to agriculture during the 1970s and early 1980s. Under such programs, more attention was given to extending loans than to ensuring project viability, repayment capacity and collection. As a result, over 80% of loans granted under such programs as the Masagana-991 were never collected, leaving the majority of rural banks in financial distress. The elimination of Government subsidies to rural banks in 1985 resulted in widespread closure of rural banks and left most of the remaining institutions in a weak financial position. Less than half of the over 1,100 rural banks which operated in 1981 are currently deemed viable enough to operate or qualify for rehabilitation and only about 250 are still strong enough to 1/ Most RBs participated heavily in the Government-supported Masagana-99 (M- 99) agricultural credit program during 1973-81, which aimed to bring about self sufficiency in rice production.  - 5 - operate without external assistance. Although they still account for close to 30% of the banking sector's branch network, rural banks retain less than 3% of the sector's total assets and have accounted for about 13% of loans granted to agriculture over the last five years. 2.5 In 1987, the Government launched the second initiative to rehabilitate rural banks, with a focus on encouraging the infusion of fresh capital by rural bank owners against Central Bank support through a combination of arrears conversion into Government equity and rescheduling of the remaining arrears into a 15-year installment program. After five years of rehabilitation, the exposure and management capacity as well as financial strength of many of the RBs have been improved, however, about 230 (30%) of them remain weak, making them ineligible for intermediation of Government loans in the rural areas. 2.6 Specialized Government Banks. The role of specialized Government banks in lending to agriculture dropped quite significantly between 1982-85, but they have regained significant importance over the last five years, mainly due to Land Bank of the Philippines (LBP) aggressive expansion in agrarian lending. Between 1988-94, Government banks accounted for about 20% of lending to agriculture. Three specialized Government banks have traditionally extended credit to the rural sector: the Philippines National Bank (PNB), the Development Bank of the Philippines (DBP) and LBP. While PNB was partially privatized in 1992, DBP accounts for only a small share of lending to agriculture, leaving LBP as the main player. In 1993 it accounted for over 14.5% of loans granted to agriculture and was one of the only sources for sectoral term lending. While LBP services medium and large scale rural enterprises through its commercial banking operations, it has in the last seven years aggressively expanded its agrarian operations which provide loans to small borrowers and agrarian reform beneficiaries mainly through cooperatives. Lending Structure 2.7 As Table 2.1 indicates, formal lending for agricultural production has declined significantly over the past 10 years, in absolute terms, as a share of total value added and particularly also as a share of total loans granted by the banking sector. This decline is due essentially to two factors: the traditional better lending opportunities for private banks, associated with higher revenue (directly and indirectly) and lower credit risk, and a change in central bank rediscount policy toward more sectoral balanced lending. Since the second half of the 1980s, the composition of the agricultural loan portfolio has changed away from loans for tree crops and sugar toward more loans for cereals and livestock production; this change was brought about by high interest rates, an aversion to term-lending and the reluctance of large land owners and private banks to further invest in or lend against property which may be subject to agrarian reform.  -6- Table 2.1: Agricultural Production Loans Granted 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 Loans Granted 49.5 29.9 27.5 25.1 25.2 29.9 24.0 29.2 28.4 26.7 (in Billion 1985 Pesos) 1/ Agricultural 32.2% 19.3% 16.9% 15.4% 16.1% 18.6% 13.8% 16.1% 18% 17% Loans/AG.GDP Agric. Loans/ 8.0% 8.1% 9.9% 7.5% 7.3% 7.4% 6.6% 7.2% 5.3% 4.1% Total Loans Granted 1/ Nominal loan amounts deflated by Agricultural GDP Deflator Source: BAS Policy Reforms and Issues 2.8 Past Reforms. During the 1980s, Government efforts to strengthen the rural finance system and induce private banks to increase lending to agriculture have focussed on: (i) interest rate reforms resulting in deregulation of deposit and lending rates; (ii) greater reliance on market mechanisms to allocate financial resources; (iii) reduced rural credit subsidies and Government direct intervention; and (iv) institutional reforms in support of LBP as an apex institution for rural credit and the rural bank rehabilitation efforts. 2.9 Outstanding Issues. Despite the above measures to strengthen the rural financial system, institutional lending to agriculture remains affected by several factors, including (i) reluctance to lend to agriculture due to higher risks; (ii) the requirement of urban collateral or relatively liquid commodity assets; (iii) the lack of medium- and long-term financing particularly for rural development; (iv) the weak financial condition of many rural banks which could serve as financial intermediaries; (v) concentration of non-government bank lending on large borrowers; (vi) continued proliferation of government non- financial agencies supporting subsidized rural credit programs despite past efforts to consolidate various funds under the Comprehensive Agricultural Loan Fund, known as the CALF; and (vii) overemphasis on provision of credit, as opposed to rural savings mobilization. 2.10 Necessary Reforms. Besides measures at the macro level (further liberalization of prices and import) which would permit increased profitability of rural production, further efforts to strengthen the rural financial system and allow for increased participation in rural lending should focus on four main areas: (i) removing remaining credit subsidies and thereby encouraging the private sector to lend to agriculture on an equal footing with public institutions; (ii) further rehabilitation of rural banks through private sector initiative and indirect government support; (iii) strengthening rural cooperatives to permit them to serve as viable financial intermediaries; and (iv) increasing efforts to streamline and consolidate government sponsored credit programs, relying on banking institutions to carry them out. These would be supported by the proposed project through the institutional and policy reform component and the provision of term lending facilities (paras. 3.2 and 3.9).  -7- Land Bank of the Philippines 2.11 Mandate. Land Bank of the Philippines (LBP) was established in 1963 as the primary agency responsible for agrarian reform financing. Ten years later its scope was substantially broadened and LBP was accorded full banking powers, allowing it to receive deposits and engage in underwriting activities. At the same time its capital was raised to P3 billion, with P1.8 billion common shares that were finally paid up by Government in 1986, and P1.2 billion preferred shares which have never been issued. 2.12 Although legislation between 1963 and 1987 clearly established LBP's major role as financier of land reform, its activities until the late 1980s were mainly outside the small farm sector, partly because of slow land reform implementation. Since the enactment of the Comprehensive Agrarian Reform Program (CARP) in 1987, however, LBP has re-addressed itself to its legal priority of providing support to the agrarian sector, and substantially increased its agrarian activities. The legal framework supporting LBP has changed again in 1995. Under the new Land Bank Act (RA 7907, approved Feb 23, 1995), LBP's position has been substantially strengthened. Specifically, the new act (i) provides for LBP's capital to be increased to P9 billion (US$ 330 million), (ii) reconfirms governments intentions to underwrite and fund LBP's land reform lending, including specifically earmarking funds from the Asset Privatization Trust which are to be made available to LBP for this purpose, and (iii) removes LBP from the constraints of operating within government salary scales. 2.13 Organizational Structure. LBP's dual role as commercial bank and financial institution responsible for financing of agrarian reform activities is clearly reflected in its current organizational structure (see Appendix D (LBP's organizational charts), Annex 2.11. LBP's operations and staff are divided into two broad streams: "agrarian" and "banking". Agrarian sector staff based in 12 regional and 126 field offices make loans to small farmers through cooperatives or rural banks and deal with land valuation for land reform through the regional land reform offices. Banking sector staff deal with corporate clients through LBP's head office and its network of 161 branches. Within its banking sector, LBP engages in two main types of activities: (i) commercial banking; and (ii) investment banking mainly limited to investments in Government securities and newly privatized companies. LBP is controlled by a Board of Directors, which until recently has comprised seven members; four ex-officio positions - the Secretary of Finance, who is the Chairman; the President of LBP, who is the Vice- chairman; the Secretary of Agrarian Reform; and the Secretary of Labor, and three appointees of the President of the Philippines, representing (i) agrarian reform beneficiaries; (ii) the landowners; and (iii) the private sector. Under the new act, the board is increased to nine. The ex-officio members have been increased to five by the addition of the Secretary of Agriculture, the other four members represent land reform beneficiaries (2) , and the private sector (2) . Details on LBP's operation and performance are given in Annex 2.1. 2.14 Assets and Liabilities. LBP has substantially expanded its available resources over recent years to a total of P97.2 billion (US$3.6 billion) as of December 31, 1994. About 9% of these resources result from retained earnings, bringing LBP's total equity to P10 billion. The main source of funds at 1994 year end was government deposits of P47 billion or 48% of total resources. On the assets side, cash and investment in Government securities together also  - 8 - totalled P47 billion or 48% of its total assets, and net loans amounting to P37 billion, 38%. 2.15 Lending Operations. LBP also substantially expanded its lending portfolio during the last five years (1990 - 1994) at an annual nominal rate of 41% (Table 2.2). This has resulted in LBP's total gross loan portfolio increasing by a factor of about four, from P9.7 billion to P38.4 billion (US$1.4 billion) . As of December 1993, loans outstanding to the agrarian sector (mainly for short-term) accounted for about P11.5 billion or 30% of LBP's gross loan portfolio; commercial lending (including agriculture) P18.2 billion or 47%, and wholesale ALF and CLF term lending P3.3 billion or 9% of the loan portfolio. Table 2.2: Summary Evolution of LBP's Gross Loan Portfolio (P million) 1990 1991 1992 1993 ----1994 ----- Annualized Total % Change 90-94 Interbank Loans 532 770 1,470 2,877 1,363 3.5 27% Commercial Loans incl Commercial Agriculture 3,354 4,453 5,557 11,087 18.232 47.5 53% ALF/CLF Loans 1,783 3,304 3,334 8.7 na Agrarian Reform Mortgages (ARM) 2,013 2,054 2,090 2,119 2,065 5.4 1% Agrarian Reform Loans 2,165 5,108 7,366 9,131 9,489 24.7 45% Other Loans 1,622 1,257 2,614 5,684 3,934 10.2 25% Total Loan Portfolio 9,686 13,642 20,880 33,707 38,417 100.0 41% Loan Portfolio (Constant End '1994 P million) 13,604 17,117 24,223 35,935 38,417 30% 2.16 Initially LBP extended agrarian loans to individual farmers, but over the past five years it has increasingly changed its strategy and now channels credit to these borrowers on a wholesale basis through two main channels - agricultural cooperatives and rural banks. In 1994, rural banks accounted for 92.0 billion (339) of LBP resources disbursed for agrarian loans, while cooperatives lent 67% or P4.0 billion. The number of cooperatives serviced by LBP increased dramatically from just over 200 in 1988 to over 6,500 at the end of 1993, but fell to 3,734 in 1994. 2.17 Most of these cooperatives have only been formed recently, are small in terms of membership and asset size, and have very limited management and loan administration capacity. This requires that LBP deploy a substantial amount of field staff resources assisting cooperatives with sub-loan administration, general cooperative management and project development. Additionally, the limited experience and equity of many of the borrowing cooperatives tends to impact negatively on their repayment capacity. To assure that the cooperatives, served by LBP, will in due course develop into viable organizations and adequate retailinq institutions for LBP loans, several issues must be addressed: (i) LBP needs to make its accreditation criteria for cooperatives more stringent; (ii) cooperatives need to be provided with technical assistance aimed at institutional strengthening; and (iii) more emphasis needs to be placed on savings mobilization preceding or at least in tandem with agrarian lending. LBP is aware of these issues and has decided to consolidate and strengthen its current achievements in agrarian lending rather than substantially expand it over the next few years - this is reflected by both the reduction in numbers of cooperatives serviced and in loan disbursement to cooperatives from P6.3 billion in 1992 to P5.3 billion in 1993 and P4.0 in 1994. In addition, the proposed project through the institutional strengthening component would address these issues (para. 3.9).  - 9 - 2.18 Portfolio Quality. Analysis of LBP's balance sheet (Annex 2.1) indicates that the proportion of net loans either past due or in litigation improved from 7.0% in 1990 to 1.5% in December 1993 but declined to 5.2% in 1994. However, the overall satisfactory situation concerning past due loans has partially resulted from a rapid increase in restructured loans, particularly in the agrarian sector (LBP usually restructures agrarian loans as a result of natural calamity) . Overall 10.3% of all net loans are either past due or restructured - about the same as the 1990 figure, 9.8%, but a deterioration from 5.7% in 1991. In the banking sector, the situation has generally improved, and by December 1994 only 2.8% of net loans were either restructured or past due. However, there do appear to be problems with the agrarian portfolio. Although net non-performing loans and restructured loans as a share of net loans (net of mortgage loans) improved significantly between 1988 (42%) and 1990 (4.9%), the figure has significantly deteriorated since then to 28.6% in-December 1993 and 37.3% in December 1994. This deterioration was caused by: (i) too rapid lending expansion to newly established cooperatives; (ii) weak cooperative borrowers (para. 2.17); (iii) inadequate crop insurance arrangements; and (iv) an exceptionally high level of natural disasters which destroyed farmers' produce. The issue of the quality of the agrarian loan portfolio would be treated under the institutional action plan of the proposed project (para. 3.9). 2.19 Profitability, Liguidity and Solvency. LBP's net income has risen substantially over the last six years reaching P1.2 billion in 1993. Real returns to equity have averaged 5% between 1990 and 1994. LBP's earnings have come mainly from its commercial banking (60%) and investment operations (40%). Until the end of 1992, the Agrarian Reform Fund (ARF) substantially covered LBP's nominal net costs associated with agrarian lending. Therefore, agrarian lending did not have a significant impact on LBP's profit and loss account through 1992. As of January 1, 1993, however, ARF no longer covers LBP's operating costs associated with lending to small farmers. This affects LBP's profitability to the extent that interest rates do not fully cover these costs. Indeed the net accounting loss on the agrarian sector borne by LBP in 1993, after allowing for support of P461 million (US$16 million) from ARF was P974 million (US$36 million). This loss did not take into account the necessary provisioning adjustments or the opportunity cost of funds deployed. The fact that LBP's profit was not substantially reduced in 1993 as a result of ARF diminishing support was largely due to strong performance in both its foreign exchange and share owning operations. Profits of P222 million on foreign exchange revaluation, and P636 million on assets sales - mainly privatization issue shares - pretty well offset the net accounting loss on agrarian operations. In 1994, support from ARF increased again to P1,171 million (US$43 million) and the net loss on agrarian lending borne by LBP consequently fell to P777 million (US$29 million). 2.20 One means of evaluating LBP's operational performance and its self sustainability is to review its Subsidy Dependence Index (SDI)' over the past six years. The level of this index depends upon LBP's role - whether certain l/ The definition of the SDI is the percentage by which the average annual lending interest rate would need to be raisecl, over the interest rate actually collected, in order to fully cover the cost of both explicit and implicit subsidies.  - 10 - costs are considered as provision of services on behalf of the Government and, therefore, LBP should be reimbursed for them, or whether they are truly part of LBP's costs and therefore need to be covered by interest rate spreads or user fees. The most pragmatic approach is to consider the situation under which LBP is likely to be working in the future.1 2.21 The SDI worsened (Table 2.3) between 1988 and 1991 (from 4.1% to 30.81) as the volume of agrarian loans was increased, but improved in 1993 and 1994 as the size of the banking operations expanded relative to loans to small farmers and interest rate on ARLs has become positive in real terms as inflation went down. The SDI is now 6%, indicating that in 1994 LBP needed an effective subsidy of roughly 6% of its gross interest earnings in order to break even. In the past three years, the average effective subsidy LBP has had from 'free' provision of equity, would have covered its 'Adjusted Net Loss'. This indicates that this subsidy together with the profit which LBP made on its banking sector activities would have been sufficient to compensate for the net real costs of agrarian lending. Table 2.3: Summary of LBP's SDI Calculation (Million Pesos) 1988 1989 1990 1991 1992 1993 1994 Net Profit per accounts Excluding CapitaL Gains 384 429 855 967 859 900 1,220 ADJUSTED NET LOSS (after taking account of underprovisioning and use of interest -51 -240 -425 -1,049 -1,245 -504 -502 free capital) Interest Income 1,124 1,394 2,262 3,175 3,793 6,185 8,271 SDI - proportion by which overall 4.5% 17.2% 18.8% 33.0% 32.8% 8.1% 6.1% interest rate would need to increase to cover costs & eliminate subsidies 2.22 LBP's liquid assets to deposit ratio has somewhat declined from a high 1.4 in 1989 to 0.9 as of December 1993. This level remains satisfactory, and well above the average for the top five Philippine private banks, which was 0.5 at the 1993 year end. Although LBP's equity as a share of total assets has dropped from a peak of 31t in 1989 to 10.5% in December 1994 (mainly due to the rapid expansion of deposits), LBP remains highly solvent and its risk assets to equity ratio of about 4.4 compares favorably to that of the top five Philippine private banks (5.2 in 1993). 1/ For these estimates, it is assumed that LBP would be responsible for loans to small farmers [Agrarian Reform Loans (ARLs)], through their cooperatives, but its operations in land purchase and Agrarian Reform Mortgages (ARMs) would be as an agent of Government/ARF who would provide the necessary funding and fully cover LBP's related operating costs. In this instance, to be conservative, LBP's technical support for cooperative development is considered an integral part of LBP's small farmer lending operations, and therefore, its own responsibility.  - 11 - 2.23 Outstanding Issues. LBP will be facing four main issues over the years to come: (i) its relationship with ARF; (ii) financial responsibility for land reform; (iii) cost of agrarian lending; and (iv) resource mobilization. These issues would be addressed in LBP's Institutional Strengthening Action Plan (para. 3.9). 2.24 ARF. The Agrarian Reform Fund (ARF) was established under CARP to finance costs associated with agrarian reform. Between 1987 and 1990 about P2.85 million were transferred from ARF to LBP to cover operating costs in the agrarian sector and to fund land reform mortgage loans and agrarian production loans. In 1991, however, ARF failed to cover the full costs associated with lending to the agrarian sector plus financing of agrarian loans and land mortgages, leaving LBP to fund P1.6 billion worth of agrarian loans with its own resources. Beginning in January 1993, ARF intends only to cover operating costs associated with land acquisition and transfers (in 1993 it did not fully cover these costs, leaving part to be shouldered by LBP, but in 1994, resource flow from ARF to LBP was more than adequate for this purpose) . Since essentially all agrarian loans extended by LBP between 1987 and 1991 were covered by ARF, it should also be held responsible for loan losses (85% as agreed upon by LBP's Board) associated with these loans. This not only requires that LBP provision adequately for these loans, but that the share of ARF's provisioning be adequately reflected in its outstanding balance with LBP. The issue of adequate provisioning for expected loan losses would be addressed through the corporate action plan {para. 3.9(e)). 2.25 Land Reform. The current arrangements for land purchases under CARP have serious potential implications for LBP, as there is a mismatch between payments to landowners and receipts from small farmer mortgages which amounts to about P22,900 (US$820) per hectare in present value terms, before accounting for administrative costs. The present procedure requires LBP to pay landowners within 30 days, partly by cash (30%) and partly by LBP bonds (70%), funded through ARF. To date this has not created a problem as ARF has fully funded these costs. While adequate funds may continue to be available to cover the cash payments (30%) associated with new land acquisition, ARF no longer has the resources to ensure financial coverage of the ten years future liability associated with the remaining 70% of any land purchase. Should ARF fail to mobilize new resources, LBP would be left with a substantial amount of bonds to be serviced and retired, yet with only limited income from corresponding mortgages. These mortgages, as well as the land purchased but not yet distributed are currently included in LBP's "risk assets", and potentially limit the volume of LBP's other business, because of BSP's restrictions on "risk asset ratios" for banks. In order to safeguard the remainder of LBP's business against the possibility of not being reimbursed for its cost of servicing bonds, arrangements whereby CARP related mortgage financing operations be legally protected from the rest of LBP have been finalized (see para 3.9) . In parallel, the corresponding assets (land for distribution and mortgages) need to be excluded from LBP's risk assets. Under the agreed arrangements LBP would act solely as a collecting agent, manager and bookkeeper for CARP, while the financial obligations would be assumed by GOP. 2.26 Costs of Agrarian Lending. LBP's operating costs associated with agrarian lending have dropped markedly, from 34% of net outstanding loans in 1988, when it focussed mainly on retailing, to 7.2% in 1994, when it engaged exclusively in wholesaling. Together with an estimated annual loan loss of about  - 12 - 8%, however, the total costs amount to some 15%- of average net loans outstanding, which LBP's current interest rate spread of between 4% and 10% fails to fully cover. This issue should be addressed by: (i) further raising interest rates charged to small farmers as much as politically feasible; (ii) reducing unit operating costs; and (iii) identifying sources to cover costs associated with the provision of technical assistance to cooperatives, as it is estimated that up to 25% of agrarian operating costs are incurred by the latter. These can be regarded as development expenditures which interest rates charged to farmers should not necessarily cover as long as adequate alternative resources can be secured for this purpose. Cost reduction of agrarian lending operation would be part of institutional strengthening program {para. 3.9(d)). 2.27 Resource Mobilization. Currently, LBP is dependent on government agencies (public) deposits. Of total deposits held by LBP (P51.5 billion, as of December 31, 1993) public sector deposits were 90% (P46.6 billion) . Furthermore, besides its equity, LBP's own resources consist mainly of short term deposits, while it depends almost exclusively on external resources for term lending. To reduce dependence on public deposits and foreign financing in the long run, LBP is considering the development of new instruments, such as loan sales and medium term bonds, as well as setting annual targets for the increase of private sector deposits and savings. Resource mobilization efforts would be part of the institutional strengthening action plan under the proposed project (para. 3.9(c)). Bank Sector Assistance Strategy and Experience 2.28 The Bank has actively supported agricultural development in the Philippines, as a means to stimulate both economic growth and rural poverty reduction. Since 1964, the Bank has approved some 45 loans and credits (about US$1.8 billion) for investment in agriculture and rural development. Approximately one-third of these were for irrigation development, and another one-third for rural credit. The remainder have been for area-based rural development projects, rural infrastructure, processing and storage, land settlement, extension and research, smallholder forestry, watershed management and erosion control, agricultural inputs (under one policy-based loan) and small coconut farm development. Implementation of completed and ongoing Bank-financed projects has generally been satisfactory, although some operations have experienced delays because of local funding constraints, overly optimistic targets, design changes during project implementation, peace and order problems, weak or poorly coordinated multiple implementing agencies, and time-consuming procurement procedures. 2.29 Previous agricultural credit projects (including loans for crops, livestock, fisheries, and agro-processing) have been mainly for medium- and long- term credit. Investments financed have been generally productive, and completed projects have shown satisfactory results. Of the 16 previous credit operations, the Development Bank of the Philippines (DBP) received eight loans totaling US$130.4 million. Although these projects emphasized DBP's institutional development and financial viability, DBP experienced high loan arrears on its overall portfolio (most of them on loans not financed by Bank projects) which contributed to its financial difficulties in mid-1980s, and in turn had an adverse impact on agricultural credit operations in general. Some US$23 million uncommitted under the Third Livestock and Fisheries Project (Loan 1849-PH) and the Smallholder Tree Farming Project (Loan 1506-PH), both implemented by DBP,  - 13 - were cancelled due to DBP's financial problems. Some of the past credit projects (Loans 432-PH, 607-PH, 1010-PH, and 1399-PH) provided some US$76 million to the Central Bank for onlending through the rural banking system to finance farm mechanization, irrigation equipment and rural enterprises. Performance under these projects in terms of increased production and rural employment was satisfactory, but the projects were only moderately successful in promoting institutional development mainly due to financial problems of rural banks, arising particularly from sub-loan arrears under government-sponsored credit program (principally M-99, para.2.4) . Another project, the Small Farmer Development Project (Loan 1646-PH) implemented by LBP (December 1978 to June 1985), had experienced institutional problems including weak field office organization and sub-loan arrears. 2.30 Recent Financial IntermediarV Loans. The Bank's strategy to help develop the Philippine financial sector has the following main objectives: (i) to phase out subsidies through interest rates or other lending variables; (ii) to support the privatization of the public commercial bank - the Philippine National Bank (PNB) - and to strengthen the second tier operations of DBP and LBP while ensuring that they maintain an adequate creditworthiness upon solid financial conditions consistent with international prudential criteria; (iii) to support Government's policies, based upon market mechanisms, to price lending interest rates and fees of complementary services such as crop insurance and small- and medium-lending guarantee schemes; and (iv) to encourage private financial intermediaries to lend directly to small and medium sized borrowers, including those in the countryside, charging market fees to fully cover operating costs and the risks involved. Also, financial intermediaries, including those in the rural areas, would be induced to enhance their domestic resource mobilization. 2.31 Under the first Rural Finance Project (Loan 3356-PH) and the Industrial Restructuring Project (Loan 3287-PH) the above strategy was successfully initiated. During implementation of the two projects substantial progress was achieved in meeting the stated objectives. First, lending rates to financial intermediaries have been set at levels that are deemed competitive with those of domestically mobilized resources. Given the substantial reduction in interest rates during the implementation life of the two projects, a recent modification of onlending rates has been put into effect so as to redefine the formulae and select the most reliable indicator as the proxy for market rates. The rate of Treasury bills, the most traded paper in the market, has been selected as the proxy, which seems more than adequate for the proposed loan. Second, PNB has already started its privatization process in a successful way. DBP and LBP have strengthened their second-tier lending operations and have maintained an adequate solid condition. Under the proposed operation, LBP would be required to: (i) establish adequate solutions with the Government on how to further strengthen its institutional and financial condition, particularly with regard to its agrarian reform activities; (ii) increase its efficiency with special emphasis on its agrarian lending, by increasing its spread and reducing unit operating costs through operational streamlining and efforts to support grouping and a more efficient organization of eligible cooperatives; and (iii) enhance its procedures for the accreditation of eligible cooperatives (paras. 3.9 and 4.21) . Third, adequate accreditation procedures of financial intermediaries have been established under the first two projects. With regard to LBP, the accreditation criteria have proven to be satisfactory and in line with interna-  - 14 - tionally accepted prudential standards. Fourth, under the first Rural Finance Project (Loan 3356-PH) a component was included to strengthen the private rural banks1. The component aimed at enhancing their financial condition as well as their prospects of mobilizing domestic resources in the rural areas. The component was successful by helping to increase the paid-in capital of rural banks by P1583.9 million. As a result, there are currently over 250 rural banks with a sound financial condition (out of a total of 787 rural banks) . These sound rural banks are now an important factor to provide financial services in the countryside. 2.32 From the standpoint of the proposed project, the most important earlier Bank credit operations were the Agricultural Credit Project (Loan 2570-PH of US$100 million) and the first Rural Finance Project (Loan 3356-PH of US$150 million). Under these projects, the Agricultural Loan Fund (ALF) and the Countryside Loan Fund (CLF) were established in 1985 and 1991, respectively. ALF and CLF (the FUNDS) are wholesale lines of credit available to banks for onlending to agricultural and rural investments. Both of the FUNDS are the responsibility of LBP. The FUNDS are now fully committed and the present rate of disbursements is controlled by the rate of repayment of outstanding loans and provision for fund amortization. 2.33 ALF and CLF performance in terms of their financial positions, disbursement and loan collection, the number of PFIs, the range of sub-borrowers and sub-sector coverage, is satisfactory, but the FUNDS are short of free lending resources to meet the country's growing demand for rural investment financing. The proposed project has been prepared for the purpose of continuing and strengthening the FUNDS operation with particular emphasis on providing additional resources for term credit and strengthening LBP as a wholesale financial institution serving the rural areas. An analysis of loans made and sub-projects supported under the CLF is provided in Annex 2.2. Lessons Learned 2.34 The broad lessons that emerge from the review of the previous agricultural and rural credit projects are: (i) directed credit by crop or type of investments, at subsidized interest rates, did not sustain economic growth, improve credit delivery system in the rural areas, or increase access of rural borrowers to formal credit facilities; (ii) heavy arrears and poor financial conditions of the apex institutions and/or the selected PFIs severely constrained projects' sustainability; (iii) private financial resource mobilization is extremely important for institutional sustainability; and (iv) strong financial institutions along with qualified and experienced management and staff, at headquarter, branches and field offices, are crucial to projects' success. Whenever interest rates either fell significantly below or moved well above prevailing market rates, serious implementation problems emerged: above-market rates resulted in slow disbursement, while below-market rates led to concentration of credit to relatively wealthier and large clients. These lessons have been incorporated in the design of the proposed project, by applying a 1/ The program was launched on August 30, 1991 and managed by the Philippines Deposit Insurance Corporation (PDIC).  - 15 - market determined interest rate policy (paras. 4.7 to 4.9), and through policy actions to be taken under the institutional strengthening program (para. 3.9). Rationale for Bank Lending 2.35 The proposed project is consistent with the Country Assistance Strategy (CAS) which was presented to the Board on February 3, 1994. Bank assistance strategy in the Philippines focuses on supporting the maintenance of an adequate macroeconomic framework; improving and expanding infrastructure; strengthening the private business climate; and enhancing poverty alleviation, sustainable development and improved governance. The proposed project would contribute to these objectives. In particular, it will assist private sector investments which are now constrained by inadequate availability of medium and long term loan funds, and it will also help poverty reduction through expanding investments opportunities in the rural areas where most of the poor live. The project will further advance the process already started under the first Rural Finance Project (Loan 3356-PH), in (i) strengthening LBP as the major wholesale financial institution serving the rural areas; (ii) strengthening rural cooperatives through technical assistance and training to upgrade their operation to become viable financial intermediaries serving their members; (iii) strengthening the rural banking system through the provision and mobilization of term lending resources and technical assistance; and (iv) encouraging more private banks to operate and provide financial services in the rural areas, particularly to finance medium and long term investments. Therefore, the proposed project should be seen as a temporary intervention, providing needed financial resources, support institutional strengthening activities, and allowing more time for the rural financial sector to address its limitations. Bank involvement in the project is justified in view of the need to provide resources to private economic rural activities and thus contribute to rural growth, employment and poverty alleviation. This would be achieved by improving financial intermediation channels to the rural economy and by providing credit resources for private rural investments. This project and the institutional and policy reforms it supports are expected to play a major role in fostering rural development. III. THE PROJECT A. Project Obiectives and Description 3.1 Building on the achievements of the first Rural Finance Project (Loan 3356-PH), the proposed project would help to expand the volume of medium and long term commercial credit to agriculture and rural development in the Philippines and to enhance the policy framework of the rural financial sector by: (a) supporting the development of LBP's two funds: the Countryside Loan Fund (CLF) and the Retail Cofinancing Fund (RCF) to finance private sector investments in the rural areas; (b) strengthening LBP as the main wholesale financial institution serving the rural areas; and (c) upgrading the operational capacity of rural cooperatives, Participating Financial Institutions (PFIs), particularly Thrift Banks (TBs) and Rural Banks (RBs), to provide financial services in the rural areas.  - 16 - 3.2 The project would be implemented over five years, and would comprise the following components: (a) Credit: medium and long term loans to finance private investments in agricultural and other viable rural operations, (both fixed assets and incremental working capital) for a broad spectrum of agricultural and non-farm rural investment, (e.g. production, processing, marketing, transport services, storage facilities, custom service or leasing operations, and import of critical inputs). The credit operation would be determined by market forces, with no earmarked allocations by crop or type of investment and would bear a market determined interest rate. This component would include two programs. (i) CLF II: a wholesale operation to be carried out by LBP. CLF II resources would be channelled through accredited financial institutions for onlending to private investors; (ii) RCF: a cofinancing lending program for medium and long term rural investments, implemented by LBP to finance, together with other financial institutions, eligible sub-projects initiated by LBP's own customers; (b) Institutional Strengthening Program. Strengthening LBP financially and organizationally to ensure its sustainability in providing financial services to the rural population. This component would support LBP's long-term development program with concentration on private saving mobilization, agrarian lending policy, and organizational streamlining. The component would consist of implementation of an Institutional Strengthening Action Plan (ISAP) aimed at strengthening LBP's financial and institutional capabilities as wholesale financial institution serving the rural areas. An important element of this would be training and technical assistance with special attention on the management and members/staff of the cooperative, TBs, and RBs. B. Detailed Features The Credit Component 3.3 The credit component, under the project, would provide sub-loans totalling US$220 million which would finance private rural investments of at least US$260 million. Two programs would be offered: (a) a wholesale operation to be carried out through the second phase of the Countryside Loan Fund (CLF II) with total investment of about US$120 million; and (b) LBP's medium- and long- term lending facility to be implemented through the Retail Cofinancing Fund (RCF) with total sub-projects cost of about US$140 million. Each of the two sub- components would provide two types of loans: a Peso or US Dollar sub-loans to accommodate the sub-borrowers' needs. The foreign exchange risk would be borne by the government for small and medium sized sub-borrowers (up to total assets of Peso 250 million) and by the sub-borrowers in all other cases.  - 17 - 3.4 CLF II. The project would provide US$90 million equivalent of additional funds for the existing CLF lending facility. LBP, which is already managing the ongoing CLF, would be the apex institution for channelling the CLF sub-component through the Participating Financial Institutions (PFIs), for eligible incremental investments in agricultural and non-farm rural economic activities (paras. 4.5 to 4.6). LBP would perform this wholesale function on a commercial basis, and would exclude itself from direct lending to sub-borrowers under CLF. Assurances to these effects were obtained at negotiations {para. 6.1 (a)}. 3.5 RCF. The Retail Cofinancing Fund (RCF) of about US$120 million would finance medium and long term rural investments to be carried out by LBP's retail customers. The RCF would be funded partially by the Bank (US$60 million) and jointly with at least US$60 million by LBP and any financial institutions; the latter's participation would be at least 75% of the cofinancing package (LBP and private financial institution) or about 32% of the sub-project cost. The RCF would enable LBP to finance directly together with any financial institution viable medium- and long-term rural investments of its own clients, on terms competitive with those of the PFIs and in accordance with the Policy Manual to be agreed upon with the Bank. The main reasons for having this cofinancing component are: (i) it would allow LBP to develop further its activities in cofinancing and syndication operations which is an important feature in the development of its wholesale operation; (ii) LBP, as the administrator of the CLF has not been able to offer CLF medium- and long-term loans to its own customers on a retail basis, placing it at a disadvantage vis-a-vis CLF-accredited banks; and (iii) existing rural commercial clients of LBP, especially those that have pledged their collateral to LBP, have been deprived from using CLF loans. The cofinancing lending program not only meets LBP's need for additional term resources, but would also enable LBP to improve earning opportunities on the counterpart requirements funded with internally generated resources, contributing to its financial viability. 3.6 Single Currency and Peso Sub-Loans. Under the project, sub-borrowers would be able to select sub-loans denominated in US dollars or Pesos under the new SCL expanded program offered by the Bank. A survey of potential and existing sub-borrowers under the first CLF operation has shown that a number of them are well situated to bear the foreign exchange risks of a single currency loan because they generate foreign exchange revenue through direct and indirect export of their products. The survey further indicated that the US dollar would be the most appropriate currency for serving the needs of potential sub-borrowers. LBP has selected the two main borrowing options under the SCL program: the SCL at fixed rate (FRSCL) and the SCL at Libor-based floating rate (VRSCL) . This selection would allow LBP to offer a wider variety of loan term choices, including both currency and interest rate basis, to match the needs of sub- borrowers while minimizing the attendant risk. This should enable LBP to reduce the overall cost of intermediating such risk. 3.7 The demand for medium and long term funds is currently running at a level substantially above their availability. Future needs for term lending resources, and hence the rate of drawdown of the loan, would be dependent on the overall performance of the economy, interest rate relative to other rediscounting sources, and the level of investment and reinvestment in the rural sector. It is estimated that the total investment requirement to maintain existing  - 18 - agricultural facilities and provide for planned sectoral economic growth of about 4% per annum over five years (as proposed in the Philippine Agricultural Medium- Term Development Plan 1993 - 1998) would be about US$20 billion in 1994 prices (para. 1.9) . On this basis, LBP's available medium and long term resources would provide about 2% of total agricultural investment. Under a more modest scenario of lower 1% annual growth, investment needs would be reduced to about P150 billion over five years, mostly for reinvestment. In this case the combined CLF funds would provide about 8% of total agricultural investment. As CLF combined resources would be used not only for agriculture, but also for other rural endeavors, the percentage of total rural investment which CLF would cover, assuming full disbursement in five years, would likely be below 5%. This should be readily attainable, provided the fund is well administered and its cost is in line with wholesale market interest rates. 3.8 The records of CLF I and II and RCF (the FUNDS) operations would be kept separately within LBP's accounts. Detailed estimates of the FUNDS cash-flow are given in Annex 3.1. As LBP would operate the FUNDS on a commercial basis, it should make profits. Such net profits would be reflected in LBP's Profit and Loss Account, and would remain within the FUNDs as LBP's contribution. Agreement to this effect was reached at negotiations {para. 6.1 (b)}. Institutional and Policy Reform Component 3.9 To guarantee LBP's continued strong performance in the rural areas and to allow for sustainable expansion, LBP has prepared an Institutional Strengthening Action Plan (ISAP) agreed with the Bank and which would be implemented as part of the proposed project. The approval of the agreed ISAP by LBP's Board would be a condition of loan effectiveness {para 6.2 (i)}. The ISAP would include specific measures to address the following institutional issues: (a) Safeguarding LBP's Financial Strength. Arrangements have been made or would be made between LBP and Government to safeguard LBP in three main areas: (i) Land Reform Bonds. The issuance of National Government Bonds to compensate landowners for newly purchased land under CARP has been approved for implementation under an Executive Order 267 dated July 25, 1995; (ii) Land Reform Risk Assets. As a corollary to the changed status of land reform bonds, arrangements would be made with GOP/LBP to exclude land acquired for redistribution and land reform mortgages from LBP's risk assets; and (iii) Dividend Policy. Arrangements would be made with GOP/LBP that dividends would only be paid by LBP from its real profit after (1) allowing adequate provisioning for loan losses, (2) adjusting for the impact of within year inflation, and (3) when profits allowed, retaining earnings at a level equal to at least one seventh of the growth in LBP's net agrarian loan portfolio. During negotiations agreement was reached that (ii) above would  - 19 - take effect before December 31, 1995 and (iii) would be carried out annually {para 6.1 (c) and (d)). (b) Lending Objectives. LBP would define a detailed and realistic lending program for the next five years, based on sectoral needs, resource availability--both for lending and covering support service costs--and still maintaining profitability in real terms. (c) Resource Mobilization. While LBP's resources consist chiefly of public short-term deposits, it depends mainly on external resources for term-lending. To reduce dependence in the medium/ long run, on public sector deposits and on foreign financing, LBP would aim at increasing private savings, including short-term rural deposits. Issuing medium- or long-term Peso bonds or similar debt instruments would be phased in. Such an operation would be initiated on a pilot basis. (d) Costs of agrarian lending and related lending interest rates. Currently LBP's spread does not fully cover agrarian lending costs. LBP has successfully mobilized substantial government agencies' deposits which have yielded a high net income for LBP, which may be sufficient to cover the agrarian lending costs (including adequate provisions for probable losses) . However, to sustain its operations over the long term, LBP would not only rely on this source of additional income, but would also strive to increase its lending spread and reduce unit operating costs. These reductions can be obtained through organizational streamlining and introduction of mechanisms (such as grouping or merging cooperatives). Furthermore, LBP would monitor its costs associated with the provision of "non-banking" services (i.e. technical assistance and training to cooperatives), as well as those associated with CARP related activities, with the aim of securing adequate funding for them. (e) Provisioning for loan losses. Three areas would be revised: (i) LBP's loan classification system for agrarian loans (including restructuring) ; (ii) corresponding provisioning ratios; and (iii) timeliness of provisioning. (f) Strengthening LBP's cooperative intermediaries. An important element in improving LBP's loan quality will be the strengthening of its cooperative borrowers. A program to achieve this will be carried out by LBP as follows: Ci) Improved cooperative accreditation criteria: LBP would review its cooperative accreditation criteria, so as to assure adequate repayments and a gradual reduction of technical assistance needs. As stricter accreditation criteria would disqualify a significant number of cooperatives, application of the new criteria would be pha- sed in gradually. This process would be accompanied by a technical assistance program to help cooperatives achieve the above mentioned criteria within a predetermined time  - 20 - period. In the meantime, LBP would limit its exposure to cooperatives that fail to meet the new criteria and have questionable performance records; (ii) Enhanced cooperatives and agrarian database: Statistics of agrarian loans need to include information on the amounts collected and rescheduled. For this purpose LBP will develop a cooperatives' and agrarian collections data base and monitoring system; (iii) Enhanced savings and cross guarantees among cooDerative members. LBP will design a pilot program to include some 100 selected cooperatives to start savings and cross guarantee programs. (g) LBP's Staff Training and Technical Assistance Program. Continued training of LBP staff is an important element in the enhancement of LBP's ability to deal with the growing challenges related to its operations. To enhance and upgrade its training system, LBP will carry out a Technical Assistance (TA) program aiming at strengthening the following aspects associated with rural credit: (i) LBP's agrarian sector operations, by: (1) fortifying LBP's Field Offices and their operations; and (2) enhancing the cooperatives' financial intermediation capacity. (ii) CLF related staff in LBP and the PFIs would be trained in the following areas: (1) upgrading the knowledge and skills of LBP's CLF unit's staff for reviewing and appraising sub- project feasibility studies and supervising the PFIs and their sub-projects; (2) developing the PFI skills--especially RFIs--in the preparation and presentation of sub-project financing requests; and (3) enhancing the ability of LBP's CLF unit and PFIs staff to review and monitor environmental aspects of sub-projects and strengthening the enforcement process of the environmental clearance system; and (iii) LEP's accounting and management information system, focusing on: (1) the development of an improved cost allocation methodology and procedures, mainly between agrarian and commercial banking operations; (2) the development of integral accounting and reporting require- ments of the CLF and other foreign funded lending programs; and (3) the development of an adequate data base on LBP's cooperative system. 3.10 Estimated Project Costs and Financing. Total project costs are estimated at US$262.7 million, of which US$91.9 million (35%) would be the foreign exchange component and about US$15 million would be taxes and duties. The foreign exchange cost component was estimated based on the assumption underlying the indicative lending program and would vary depending on the eventual composition of the lending program in response to market forces. The  - 21 - proposed Bank loans of US$150 million would finance up to 57.1% of total project costs--about 99% (US$91 million equivalent) of the foreign exchange costs and about 35% (US$59 million equivalent) of the local currency costs. Local cost financing is justified because of the Philippines' current economic situation and the poverty alleviation objectives of the project. The remaining project costs would be financed as follows: (i) sub-loan beneficiaries, at least 14.9% (US$39.2 million equivalent); (ii) participating banks at least 21.7% (US$57 million equivalent; and (iii) and LBP, at least 6.3t (US$16.5 million, including US$1.5 million contribution to the TA and Training program). The Bank loans for an aggregate amount of US$150 million would be made available to LBP with the guarantee of the Government of the Philippines. The three loans of US$50 million each include a currency pool loan (CPL/Loan A), a US dollar Libor-based single currency loan (VRSCL/Loan B), and a US dollar fixed rate single currency loan (FRSCL/Loan C). The CPL and the VRSCL would have a term of 20 years with 5 years of grace and would carry the Bank's standard variable interest rate for the targeted currency pool loans and for a US$ Libor-based single currency loans, respectively. The FRSCL would be payable in 15 years with 3 years of grace and would carry the Bank's standard US dollar fixed rate for 12 years maturity. Table: 3.1 Second Rural Finance Project PROJECT COSTS AND FINANCING (US$ million) Subloan PFIs LBP IBRD TOTAL Benefic. CREDIT COMPONENT: CLF II 18.0 12.0 - 90.0 120.0 RCF 21.2 45.0 15.0 60.0 141.2 Sub-total 39.2 57.0 15.0 150.0 261.2 TA & Training - - 1.5 - 1.5 Total Project Cost 39.2 57.0 16.5 150.0 262.7 Percentage 14.9 21.7 6.3 57.1 100.0 3.11 Procurement of goods and work financed with loans funds would be on the basis of procedures which are customary for a development finance operation. They would apply both to situations where CLF/RCF funds are disbursed directly against any sub-project and also when disbursement is used to repay an interim loan for an eligible sub-project. Contracts above US$5 million equivalent will normally be procured by International Competitive Bidding (ICB) in accordance with Bank procurement guidelines, including the use of Bank's standard bidding documents. In evaluating ICB tenders, a margin of 15% of the c.i.f. bid price or actual custom duties, whichever is less, would be allowed for preference for domestic manufacturers. All ICB packages will be subject to Bank prior approval. Other procurement would follow established commercial practices which are satisfactory to the Bank. Limited International Bidding (LIB) and direct contracting would be allowed for contracts costing more than US$5 million equivalent in the following cases: (a) in the case of modernization or expansion projects, for standardized equipment or proprietary parts needed for compatibility with existing equipment; (b) for machinery which is available from  - 22 - only limited number of suppliers worldwide; and (c) where procedures are otherwise justified for technical reasons. These cases would be subject to Bank prior approval. LBP would review the compliance of participating banks with procurement procedures during its periodic supervision of project assisted sub- loans. Disbursement 3.12 The proposed Bank loans of US$150 million would be disbursed over a period of five years, during Bank FY96-2001 (for the CPL and VRSCL; the FRSCL is scheduled to be fully disbursed by December 1998. The disbursement estimates are based on experience under the last two projects of this type, the Agricultural Credit and the Rural Finance Projects Loans 2570-PH and 3356-PH, respectively. The disbursement schedule is given in Annex 3.2. The project would be completed by September 30, 2001 and the expected Loan Closing Date for the CPL and VRSCL would be June 30, 2002, the closing date for the FRSCL would be December 15, 1998. Disbursement of the loan proceeds would finance medium and long-term rural investments in fixed assets, excluding land, and incremental working capital including expansion of existing rural enterprises. The Bank would finance 100% of PFIs and LBP's eligible sub-loans or 75% and 42.5% of sub-projects' costs in the case of CLF II and RCF, respectively. Disbursements for all expenditures would be based on full documentation except for sub-loans below the free limit of US$3 million for which disbursements may be made under statement of expenditures (SOEs) . Supporting documents for disbursements based on SOEs would be retained by LBP for review by external auditors and Bank supervision missions. Retroactive financing of up to US$15 million equivalent is also proposed for eligible credit sub-loans made by CLF after January 1, 1995. These sub-loans were made under the pressure of the heavy demand for CLF resources which lead LBP and PFIs, in anticipation of additional financing, to use short-term and/or unrelated resources to support eligible rural sub-projects. Table 3.2: Summary Disbursement Schedule Amount of Loan % of Expenditures Allocated to be Financed (US$ million) Loan A: Currency Pool Loan Category 1. CLF II 40.0 100% of sub-loans 2. RCF 10.0 100% of sub-loans Sub-total 50.0 Loan B: VRSCL Category 1. CLF II 25.0 100t of sub-loans 2. RCF 25.0 100% of sub-loans Sub-total 50.0 Loan C: FRSCL Category 1. CLF II 25.0 100t of sub-loans 2. RCF 25.0 100% of sub-loans 50.0  - 23 - 3.13 LBP would establish three Special Accounts (one for Currency Pool Loan-Loan A, one for the VRSCL-Loan B, and one for the FRSCL-Loan C) in accordance with Bank guidelines to facilitate rapid disbursement of the Bank loan. For each loan, the borrower will open and maintain in US Dollars a Special account in a commercial bank specifically authorized for this purpose by the Bangko Sentral ng pilipinas (BSP) and approved by the Bank. Initial deposits of US$5 million for each of the Special Accounts would be made by the Bank into the Special Accounts, representing about 37.5t of the expected first year disbursements. However, the authorized allocation for each Special Account, shall be limited to an amount equivalent to US$3.5 million until disbursements and outstanding commitments against the respective loan shall be equal to or exceed the equivalent of US$10 million. Applications for replenishment of the Accounts, supported by appropriate documentation, would be submitted regularly (preferably monthly, but not less than quarterly) or when the amounts withdrawn equal 50t of the initial deposit. Monitoring, Reporting and Audits 3.14 A project supervision plan is presented in Annex 3.3. LBP would submit to the Bank, on the basis of agreed format, periodic progress reports on project implementation (quarterly progress report on the Credit component and semi annual progress report on the Institutional Strengthening component) . These reports would include an assessment of carrying out the credit, and the institutional strengthening, including the technical assistance and training components. LBP and the PFIs would maintain separate accounts for project funds. The accounts of LBP, CLF, and RCF, the project Special Accounts and the Statement of Expenditures (SOEs) related to project activities, would be audited annually by independent auditors acceptable to the Bank. The audit reports, including an opinion regarding the supporting documentation for disbursements based on SOEs, would be submitted to the Bank within six months after the end of LBP's fiscal year. Also, LBP would be responsible for the preparation of the Borrowers' inputs to the project Implementation Completion Report. Agreement to this effect was obtained during negotiations {para. 6.1 (e)}. LBP would also require PFIs, as necessary, to provide auditors' opinion on whether sub-loans, under the project, are in agreement with the terms and conditions of project lending. In addition LBP would selectively review project sub-loans and would provide a brief report on the quality of sub-loans and the adequacy of PFIs' supervision and record. 3.15 LBP would maintain a monitoring and evaluation system for the project components. The objectives would be to identify constraints, initiate corrective measures and upgrade project performance. The main elements of the monitoring and evaluation system would comprise: (a) regular reporting on the financial and physical progress within both LBP and the PFIs; and (b) annual evaluation during project implementation to assess performance of (i) the institutional strengthening and the training programs, (ii) typical sub-projects, and (iii) the project financial impact on PFIs.  - 24 - IV. PROJECT IMPLEMENTATION A. General 4.1 As the Borrower of the Bank loans, LBP would assume overall responsibility for project implementation. LBP is a universal bank, owned by the Government, with considerable experience and exposure in the rural sector. LBP is virtually the only financial institution in the Philippines which provides agricultural and rural credit through rural financial institutions and cooperatives to small farmers, fishermen, and non-farm investments. Since July 1990, it has managed successfully two Bank-financed credit funds: the Agricultural Loan Fund (Loan 2570-PH) and the first Countryside Loan Fund, CLF I, (Loan 3356-PH) . LBP is currently refining the monitoring tools which will be put in place for the new project. Also, LBP is continuing to upgrade, through a regular and continuous training program, its own staff, those of the PFIs, and cooperatives. Overall, LBP is a strong bank, with 161 branches and 126 field offices scattered throughout the country, with sound systems and a well qualified staff of about 7,300. Over the recent years (1986-1994), LBP has been profitable, in both current and constant terms, with average net current earning of about P900 million (about US$35 million) annually. In all these years, except 1989, LBP's net income was sufficient to more than maintain the real value of its equity, the real rate of return averaged at 5%. At 1994 year-end LBP had a substantial capital base, totaling over RIO billion (over US$385 million) , or 10o of its total assets. LBP has maintained a cautious exposure policy, and its total risk assets to capital ratio at 1994 year-end amounted to 4.4:1. To ensure LBP's financial strength, it would maintain, during project implementation, the following financial indicators: (i) Risk Assets to Net Equity Ratio of not more than 8:1; (ii) Liquid Assets to Short-term Deposits of not less than 45%; (iii) profitability in real terms during any consecutive three year period; and (iv) ARF arrears associated with LBP's land compensation bonds and cash payments would not exceed 10% of LBP's equity or P1 billion, whichever is lower. Agreement to these effects was obtained at negotiations (para. 6.1(f)}. A detailed description of LBP's operation and performance is provided in Annex 2.1. Specific implementation arrangements are discussed below. B. Credit Operations 4.2 Credit operations would be carried out by the Wholesale Lending Department for the Countryside Loan Fund (CLF) and the Retail Lending Department for the Retail Cofinancing Fund (RCF). The CLF and the RCF units would handle day-to-day implementation of the CLF II and the RCF operations. While overall responsibility of the credit component would rest with LBP, the responsibility to implement the CLF II and the RCF would rest with LBP's Program Lending Department and the Branch Banking Group, respectively. 4.3 The CLF unit would onlend wholesale project funds to the PFIs and provide them, as necessary, with technical assistance on CLF operation. It would process sub-loan applications from PFIs; provide guidelines to PFIs on sub- project selection and appraisal; carry out selective end-use verification of sub- projects funded by the CLF; monitor sub-project performance; conduct training with PFIs; manage the overall CLF relationship with the PFIs; and liaise closely with the RCF unit to ensure proper implementation of its lending program.  - 25 - 4.4 Credit Operating Policies and Procedures. Under the proposed project LBP would continue to enhance its capabilities as a second tier bank. The credit operation (CLF II and RCF) would be carried out on the basis of policies and procedures established in Policy Manuals (PMs) for CLF II and RCF, to be approved by LBP's Board, and satisfactory to the Bank. The PMs would be periodically updated to reflect necessary policy changes. Policies to be incorporated under this loan are outlined below (paras. 4.5 to 4.20) and will be incorporated in the respective PM. The adoption and implementation of the PMs, satisfactory to the Bank would be conditions of loan effectiveness {para. 6.2(ii)}. Key policy issues discussed below include: eligibility criteria for CLF and RCF resources (paras. 4.5 and 4.6); interest rate structure and foreign exchange coverage fee (paras. 4.7 to 4.9); PFIs accreditation criteria (paras. 4.10 and 4.11); sub- projects appraisal (paras. 4.12) sub-project review and disbursements (para. 4.13); sub-loan rescheduling (para. 4.14); sub-loan maturities (para. 4.15); environmental protection (para. 4.16); and supervision of CLF and RCF sub-loans (paras. 4.17 to 4.19); accounting and audit arrangements (para. 4.20). During negotiations, agreement was reached on (i) the inclusion of the above features, when applicable, in the PMs; and (ii) that the PMs would not be revised without prior consultation with and approval of the Bank (para. 6.1(g)). Eligibility Criteria 4.5 Sub-borrowers under CLF II and RCF will be limited to private sector individuals or enterprises, provided that CLF's and RCF's total exposure under sub-loans to any single borrower does not exceed 5% of LBP's equity. Eligible investment would be medium and long term private investment financed for the establishment of new enterprises, expansion of existing enterprises or reinvestment in existing enterprises. All agricultural and rural industries based projects would be eligible, including fisheries, agro-industries, and agricultural service enterprises. To qualify, proposed sub-projects would have to be appraised by the PFIs or LBP (for RCF's sub-projects) as technically feasible, financially viable, environmentally sound, and in the case of larger investment sub-projects exceeding US$1 million equivalent, economically justified. 4.6 Project medium and long term investment financing is extended to basically support private small and medium-sized firms in the rural sector, which do not presently have easy access to funds over one year's duration for real new investments. Project funds would finance investments in fixed assets such as new buildings and machinery and incremental working capital (measured in real terms, excluding the inflation element of stocks). Land, existing buildings, or other assets previously used within the rural sector (except breeding livestock) would be ineligible. Under CLF II the PFIs would be required to provide, for each sub- project, at least 10% of the financing package from their own funds. The minimum equity contribution by the sub-borrower would be determined by the PFIs and LBP (for RCF sub-borrowers) on the basis of its sub-project appraisal, but should not be less than 15%. Bank financing of any single sub-project, under CLF II, would not exceed, in any case, 75% of sub-project costs. Sub-projects, under the RCF credit program, would be financed jointly by LBP and private financial institution and the Bank. Bank financing of any single sub-project, under RCF, would not exceed 42.5% of sub-project cost. LBP and private financial institution share in financing a RCF sub-project wculd be at least 42.5% of the respective sub-project costs. Cofinancing of private financial institution would be at least 75% of the cofinancing package or 32% of sub-project costs.  - 26 - Interest Rates 4.7 GOP has made important improvements over the past several years to eliminate distortions and ensure that resource allocation and mobilization would be driven by market forces. Consequently, there has been a departure from the previous mechanism which set interest rates through administrative procedures. Financial institutions are now allowed to set competitive interest rates freely, both for deposits and for loans. Under the proposed project, interest rates would: (a) be in line with market rates, as required by GOP policy; (b) in line with interest rate arrangements under the latest and on going Bank credit loans to LBP and DBP; and (c) cover the Bank's interest rates and the foreign exchange risk related costs. It is not likely that the smaller borrowers who are not direct or indirect exporters would be in a position to bear the foreign exchange risks and therefore, would be offered loans in domestic currency. The attendant foreign exchange risk of Peso lending to these sub-borrowers would be borne by the Government in exchange for market related fee payable by LBP. Foreign exchange risk of US dollar onlending would be borne by the sub-borrowers. In both cases (US dollar and Peso sub-loans) the system would allow free negotiations between LBP and PFIs, on the one hand, and between PFIs, including LBP with regard to sub-loans under the RCF, and the final borrowers on the other, to set rates which reflect market forces and risks involved. 4.8 The onlending interest rates charged by LBP to the PFIs for the peso sub-loan operation would be variable and adjustable every quarter. It would be based on the 91 day Treasury Bill (T-Bill) rate (as applied under latest and on going Bank credit loans to LBP and DBP). The Philippine financial market does not have any benchmarks for the medium to long-term end of the yield curve. At the short-term end of the yield curve, the 91 day T-Bill is the most actively traded security in the market; close to P400 billion as of the end of 1992. The 91-day T-Bill rate is considered a better benchmark than the 60-91 day weighted average deposit rate, because it reflects better the opportunity costs to a financial intermediary. Sub-borrowers would be given a choice of a fixed rate (the prevailing variable rate plus a premium) for several years or a variable interest rate periodically adjusted. The fixed onlending rate, for those borrowers who select this option, would be equal to either (i) the rates resulting from the current formula1; or (ii) the equivalent long-term market rates (i.e., term lending fixed rates of insurance or other financial companies, or domestic bond market rates). Interest rates charged by LBP to the PFIs for US Dollar subsidiary loans would be market rate and as such could offer variable or fixed rates. Market rate would be based on the cost of funds to LBP (Bank charges) plus an adequate spread to cover cost of GOP guarantee , operating costs, and associated risk of LBP and PFIs. These arrangements would be subject to periodic review as necessary but at least once a year. 4.9 Fee for Coverage of Foreign Exchange Risks. When onlending in Peso under the CLF II operation, the difference between the 91 day T-Bill rate and the World Bank loan costs, minus LBP's spread of 2% (to cover LBP's wholesale 1/ The fixed rate under the current formula is the variable rate at the time of the fixing plus a charge of 2%, 3% or 3,5% per annum, depending on the sub-loan maturity left (1-3 years, more than 3-5 years, and more than 5-8 years, respectively).  - 27 - operating costs) would be passed on to DOF. This amount is intended to cover the foreign exchange risks and the guarantee fee. It should be noted, however, that given that the T-Bill rate is market-determined, there cannot be a guarantee that the fees passed on to the DOF would always be sufficient to cover the foreign exchange risks involved, especially in times when there is excess liquidity. Nevertheless, given that the T-Bill rate reflects an active market and there do not seem to be major distortions, it is expected that over longer periods of time--provided that monetary policy is balanced--this formula would provide an adequate fee to the Government for undertaking the foreign exchange risks. PFI Accreditation Criteria 4.10 Accreditation criteria of Participating Financial Institutions (PFIs) should ensure that three fundamental aspects are complied with: solvency, profitability, and quality of ownership and management. Criteria need to be credible, transparent, unequivocal, and compatible with sound and generally accepted financial principles and with the Bangko Sentral ng Pilipinas (BSP) regulations. While accessory factors could be taken into account for fine tuning purposes (e.g. reviewing LBP's credit ceiling limits), care would be exercised to avoid deviation from the main criteria. The following types of Financial Institutions (FIs) would be allowed to participate in the CLF II operation, provided that they meet the financial and administrative criteria: Universal, Commercial, Rural, Thrift, and Cooperative Rural banks, including non-bank financial institutions such as Investment and Trust Corporations, Stock Savings and Loan Associations, and Rural Credit Unions. (a) BSP Banking Regulations. Eligible FIs would comply with all BSP regulations, particularly those related to the review of loan portfolio and other risk assets, definition of past due loan accounts, loan classifications, and adequate provision for expected loan losses. (b) Solvency Requirements. Eligible FIs would comply with a minimum net equity base of at least 10% of their risk assets. The net equity base would be computed applying the criteria established by BSP, at the time of accreditation. (c) Profitability Requirements. Eligible FIs would demonstrate their profitability in real terms during the life of the sub-loans. To calculate it the following method should be used: the Nominal Profits (NP) should be adjusted, using the procedure indicated by the International Accounting Standard No. 29. If the adjusted profit obtained is positive, then it would be considered that the real profitability criteria have been met. The adjustments proposed to the nominal profits would simply be two: (i) the initial equity multiplied by the annual inflation would be deducted from the nominal profits; and (ii) the initial fixed assets multiplied by the annual inflation would be added to the nominal profits. If the resulting number is positive then it would be accepted that the real profitability has been positive. A financial intermediary complying with all other requirements except real profitability would be qualified provided that concurrence would be obtained in advance from the Bank. While  - 28 - such an exception may be required, it would need to be qualified for exceptional cases such as when a PFI has taken write-offs accruing to several past years or when the negative real profitability has been an exception and financial projections clearly demonstrate that in the future the PFI would make real profits. (d) Ownership and Management Ouality Requirement. Ownership and management quality should be satisfactory to LBP. This would include qualified management team of good reputation, presence of adequate and qualified staff, sound operation policies and procedures, compliance with all relevant laws, decrees and regulations. (e) Banks Underqoing Financial Rehabilitation. Banks undergoing financial rehabilitation should not become eligible until actual rehabilitation has taken place, permitting them to fully comply with the three main criteria under (a), (b), and (c) above. 4.11 In the event that a PFI loses its accreditation status (having failed to meet one or more of the accreditation criteria), then LBP would: (i) cancel the uncommitted portion of the line of credit granted to the PFI; (ii) take the necessary actions to safeguard the committed portion extended to the said PFI; and (iii) notify the Bank on actions taken. 4.12 Sub-project Appraisals. Sub-loan appraisals would be the responsibility of the PFIs and LBP for the RCF sub-loans, whose capability would be determined by LBP according to CLF qualifying criteria. Appraisals of medium- and long-term sub-loans would be based upon the technical and financial features of the sub-projects. For each medium- and long-term sub-loan, the PFI and LBP (for RCF sub-loans) would prepare a financial plan including the sub-project's cash flow. The PFI, and LBP for RCF, shall estimate a financial rate of return (FRR) for all sub-projects with sub-loans of more than P5 million (US$200,000) equivalent. For the sub-projects to be acceptable, the real FRR shall be greater than the real interest rate of the sub-loan. LBP would ensure that an estimation of an economic rate of return (ERR) would also be carr,ied out for all sub- projects with sub-loans of more than US$1 million equivalent. These sub-projects should yield an ERR of not less than 12% in real terms or any other rate established from time to time by NEDA. To reduce the credit risk and minimize the sub-borrowers' foreign exchange risk, the appraisals of sub-projects under the SCL program would have to ensure that US dollar sub-loans be offered only to those sub-borrowers, regardless of their size, who: (a) are direct and indirect exporters and have a need for a single currency loan to match revenues earned in or tied to foreign exchange; and (b) have the capability to manage the risks associated with the foreign currency compositions of their assets and liabilities. When onlending in either Pesos or US dollars, the sub-project appraisals also would include an analysis of the appropriateness of the interest rate basis, whether fixed or variable, for the needs of the respective sub- project. 4.13 Sub-proiect's Review and Disbursements. As under the first operation, LBP would receive the sub-project credit evaluation carried out by the PFI in all cases. On an ex-ante basis--before disbursing--LBP would review a summary of the  - 29 - appraisal work prepared by the PFI, so as to ascertain that the sub-projects are consistent with CLF II guidelines, in which case it would authorize the respective disbursements. LBP would grant up to 45 days to PFIs to submit sub- loan documentation and evidence of payments and procurement. LBP would declare the sub-loans due and demandable and charge a penalty fee if PFIs do not submit the required documentation within the 45 day period after LBP's disbursements or if the submitted documentation does not satisfactorily support sub-projects that are eligible under CLF II. In any case, LBP would maintain rights to visit sub- projects after the sub-loan disbursements have been made. Bank concurrence would be required for all sub-loans above US$3 million equivalent. Disbursements to the PFIs would be subject to compliance with both pre-release and post-release documentation required. Proceeds would be credited to an account opened with LBP for this purpose. If a PFI advances a sub-loan release to a sub-borrower, the PFI can apply for rediscounting from CLF II within 90 days after the date of advance. On the other hand, the PFIs must release the full proceeds to the sub- borrowers within 15 working days of the receipt from LBP. 4.14 Sub-loan Rescheduling. The PFIs would be required to repay the sub- loans to LBP whether or not corresponding repayments have been received from the sub-borrowers. Thus, sub-loan rescheduling would not be allowed under CLF II. However, in case that there have been losses or damages caused from fortuitous events or 'force majeure' (e.g., typhoons, earthquakes) LBP may consider restructuring the PFIs consolidated debt to LBP, so as to accommodate the PFI's debt servicing capacity. Rescheduling of sub-loans under the RCF would be allowed only in cases where rescheduling would substantially improve the ability of the sub-borrower to service his debts. 4.15 Sub-loan Maturities. The repayment period for CLF II's and RCF's medium- and long-term sub-loans will be based upon the sub-project's cash flow and the sub-borrower's overall repayment capability. Repayment of most sub-loans would be within five to ten years, but would not exceed fifteen years or the pay- back period of the sub-project, whichever is shorter. Reasonable grace periods may be granted by LBP for the repayment of the principal based upon the sub- project's cash flow projections and the sub-borrower's repayment capability. Maturity of PFI and the cofinancing (LBP and private financial institution) participation under CLF II and RCF, respectively, would conform to the maturity of the related sub-loan. Environment 4.16 LBP will specify that sub-borrowers for CLF II and RCF funded projects should comply with all laws and regulations of the Philippines related to environmental protection, consistent with environmental guidelines of the Bank. LBP would be in charge of supervising compliance. To reduce the risk that sub- projects with undesirable environmental or social impacts would be financed by CLF II or RCF, the following measures would be taken. All sub-projects would comply with the Presidential Decree 1586 and its 1992 regulations which describes the Philippine environmental legal requirements for new investments, or the latest prevailing environmental laws and regulations which would be in force during sub-project processing. An Environmental Unit (EU) has been established within LBP to provide LBP, PFIs, and related sub-projects with environmental technical assistance and coordination services. The EU would be staffed by a core of professional and administrative assistants, supported by qualified  - 30 - consultants which would be providing periodic short term services. In addition, the EU would be responsible for the implementation of the training program for the project related staff in LBP and the PFIs. This program would include courses on environmental issues to increase CLF related staff capacity to review and monitor environmental aspects of sub-projects. Also, and in light of EMB's and DENR's manpower difficulties, the EU with the support of the Bank, would accredit consultancy firms to review and provide EIS and recommendations with regard to sub-projects. These consultants would extend the following services: (i) provide environmental scoping; (ii) review project descriptions and EIS prepared by sub borrowers; (iii) prepare descriptions and EISs for sub-borrowers which do not posses the technical capability to undertake them; and (iv) follow up and accelerate processing of applications within the clearing and permitting system of DENR and EMB. The list of accredited consultants was submitted for Bank review on August 19, 1994 and would be updated and reviewed annually. Assurances to these effects were obtained during negotiations {para. 6.1(h)}. Detailed description of the EU activities is provided in Annex 4.1. Proiect Supervision 4.17 Supervision of Sub-projects. The supervision of the sub-loans would be the responsibility of the PFIs and LBP for RCF sub-loans, with the requirements that specific officers would be designated for this purpose. PFIs and LBP would ensure through supervision that sub-borrowers use CLF II and RCF funds (the FUNDS) only for the approved purposes. This would be achieved through direct payments to suppliers of inputs and materials--as practicable--and through a careful follow up of funds application. In fact, as LBP would receive documentation and evidence of procurement after disbursements, LBP would have an adequate basis for determining whether or not the FUNDS have been used for approved purposes. Furthermore, sub-project visits would be a normal part of the supervision process. PFIs and LBP would also obtain periodic operating and financial reports from sub-borrowers and LBP would conduct selective end-use verification of funded sub-projects. In this manner, LBP would issue an annual assessment of the overall financial condition of the PFIs and shall use such findings in the annual renewal of PFI accreditation under CLF II. Thus, the PFIs would be required to submit and LBP to obtain (with regard to RCF) such reports--as prescribed by LBP (CLF Unit) from time to time--that allow LBP to properly monitor the PFI's (including AMG unit within LBP), sub-loan appraisal, disbursement and supervision processes and capabilities. 4.18 LBP Supervision of PFIs would be a permanent effort. A monitoring system to enable LBP to take corrective measures as soon as possible has been established under the first CLF. This system would be used to monitor PFIs' performance under the proposed project. LBP's supervision will focus on sub-loan promotion, appraisal, disbursements, and recovery, as well as sub-project supervision by the PFIs. The overall financial conditions of PFIs would be assessed and findings and recommendations included in comprehensive annual supervision reports to be prepared by LBP on each of the PFIs. Also, LBP would prepare an annual report on PFIs, summarizing their overall conditions and main issues affecting the principal categories of PFIs (KBs, TBs, and RBs) . This annual report would also include technical assistance as well as remedial action recommendations to enhance the financial, technical, administrative and developmental conditions of PFIs.  - 31 - 4.19 Supervision of LBP's operations would be carried out through analysis of its periodic reports to the Bank, concerning: (a) CLF's and RCF's sub-loans amounts outstanding and their main features, including their recovery status; (b) sub-loan applications pending LBP's appraisal results, approval, disbursements, and recoveries; (c) LBP's financial condition as reflected in its financial statements, review by independent external auditors satisfactory to the Bank; (d) PFIs' financial conditions as reflected in by LBP's analysis of the quality of their loan portfolio, their loan collection capabilities and their compliance with BSP's regulations on portfolio classification and loan provisioning; and (e) the project's accounts (CLF II and RCF), including audited Statement of Expenditures (SOEs) and Special Account. Bank supervision missions will complement LBP's analysis and enable a more through assessment of LBP's financial condition, operations, and fulfillment of reporting requirements (Annex 3.3). LBP would be required to maintain separate accounts for ALF, CLF I, CLF II, and RCF. LBP would also prepare an annual assessment of CLF II and RCF operations and financial conditions, plus its recommendations, if appropriate, on how to further enhance the project's efficiency and developmental role. Accounting and Audit Arrangements for Project-Related Disbursements 4.20 The PFIs and LBP (for RCF) would be required to maintain adequate records and accounting of CLF II sub-loans that are satisfactory to CLF Unit within LBP, especially to accurately reflect balances and movements in the CLF II and RCF sub-loans. PFIs would also be required to furnish their audited financial statements, at least annually. The external auditors should be acceptable to LBP and the format of the report should be satisfactory to LBP. LBP would communicate its requirements on external audits of PFIs in a timely manner, so as to allow the external auditors to know in advance about LBP needs, especially those related to PFI eligibility accreditation requirements under CLF II. C. Institutional Strengthening Component 4.21 LBP would be responsible for implementing the agreed Institutional Strengthening Action Plan (ISAP). The action plan would be annually reviewed and if warranted, adjustments to the respective strategy, actions, and targets would be made. In addition a semi-annual report on the outstanding issues and implementation of the ISAP would be prepared by LBP and would include its various departments involved in implementing the ISAP. Agreement to these effects was obtained at negotiations (para. 6.1(e)}. Details on the principles, targets, and timetable regarding the implementation of the ISAP are provided in the Working Paper and in Annex 4.2. 4.22 Training and Technical Assistance Program. LBP would be responsible for the preparation and implementation of the project training and Technical Assistance (TA) programs. The preparation work would be completed and carried out by December 15, 1995 (see Annex 4.3 for details). The programs would be updated annually. During negotiations agreement was obtained that: (i) the training program would be sent to the Bank for review by December 31, 1995, and thereafter the updated one for each fiscal year by November 30, of each year; and (ii) LBP will employ consultants whose qualifications, experience, and terms and conditions are satisfactory to the Bank {para. 6.1(i) and (j)}.  - 32 - V. PROJECT IMPACT, BENEFITS AND RISKS Impact and Benefits 5.1 LBP. Under its present operating arrangements LBP has the motivation, financial and institutional strength to absorb the proposed incremental funding to be provided under the project. The total incremental funding to be made available to LBP is equivalent to about 5% of its total assets as of year end 1993. However, this funding would have an important impact on LBP's long-term capital in that it would increase total equity and long-term borrowing by about 25% (excluding funds specifically supporting land reform), thereby helping to reduce LBP's heavy dependence on short-term government deposits. The RCF would benefit LBP in enabling it to offer medium and long term loans to its own retail clients. It would also help in developing LBP's cofinancing skills. Detailed projections of LBP's future financial statements are set out in Annex 5.1. The spread which LBP is able to make from onlending of project funds would have a modest positive impact on LBP's profit and loss account, equivalent to perhaps 5% of its present net profit. 5.2 Implementation of the comprehensive Institutional Strengthening Action Plan (ISAP) would enhance LBP's resources, further strengthen its operational effectiveness and cause it to be more transparent and realistic in accounting for its operations including the level of provisioning to cover possible losses in its agrarian loan portfolio. The technical assistance and training programs within LBP would both assist in improving operational effectiveness and reduce costs, particularly in LBP's agrarian sector operations within which field office staff would be upgraded. Furthermore, as a result of the focus on cooperative training, the level of inputs required of LBP to support its cooperative clients, would be reduced. Increased mobilization of long-term funds in the domestic market, either through issuing bonds or through wholesaling packages of its guaranteed loans, would complement direct borrowing under the project, and help to match resources to loans better. 5.3 Agreements achieved during final project preparation concerning LBP's land compensation responsibility would reduce uncertainties with regard to its future financial strength. Of particular benefit to LBP would be the finalization of measures to formally transfer ultimate responsibility for agrarian reform financing to government, thereby shielding LBP from risk that land reform operations may not be fully funded. Secondly, implementation of the dividend policy in the manner agreed during appraisal would remove the risk that LBP might otherwise be required to pay dividends resulting in capital reduction in real terms. 5.4 Financial Intermediaries. PFIs and particularly RFIs would benefit from the increased availability of funds under the CLF operation as well as from the TA which would help train their staff in project identification, formulation, and appraisal. The availability of long-term funds to the PFIs would allow them to have an improved balance with regard to their assets and liabilities. Borrowed funds would be more evenly matched with respect to loan maturity period than would be the case without the project. The-known availability of additional CLF funds would encourage participation of a wider range of qualified PFIs. Those participating would actively seek to promote investments needing long-term financing rather than to restrict their focus and efforts on providing short-term financing for trading. As a result of CLF II funding coming onstream, growing  - 33 - numbers of cooperating institutions would be able to expand their long-term lending activities rather than contracting, or seeking other sources of finance as would have been necessary if no second CLF tranche were available. The RCF would provide the FIs with the opportunity to participate in term financing with minimal credit risk, and therefore would be of particular benefit to FIs with high liquidity seeking alternative investments to Treasury Bills. 5.5 End-borrowers in rural areas would benefit significantly from the project through the increase of long-term capital availability at market rates. It is clear that the present volume of medium and long term loan capital available in the Philippines rural areas is very small compared with the level of investments and borrowing needed (para 1.9). This has tended to result in borrowers taking short-term loans and rolling them over rather than having firm longer term commitments from the financial institutions with whom they deal. The need for annual roll-over of loans places the borrowers in a weaker position vis- a-vis the financial intermediary than in the case when the term and the amount of the loan can be determined at the outset of the project. Consequently, the availability of long-term financing will encourage more investments than would have otherwise been the case. The selection of US dollars for the single currency portion of the loan would benefit the sub-borrowers of this portion by providing them with the currency of their expected revenues. This would enable the sub-borrowers to reduce their foreign exchange risk by providing a better match between their US dollar revenue and expenses. 5.6 Rural Poverty and Overall Economic Impact. On the basis of past experience, CLF and RCF resources (the FUNDS) are likely to be used for a wide range of rural sector investments including agriculture, livestock, agro- processing, rural manufacturing, as well as service industries in the rural areas such as transport and shipping. Sustained sectoral growth, combined with increased employment opportunities outside the agriculture sector in rural areas will be indispensable to reduce rural poverty in the years to come. The project would assist in achieving these goals through the provision of needed term lending facilities for financing private rural development activities. The project would help to finance about 2,000 investment sub-projects at a minimum total cost of about US$260 million, including sub-borrowers' equity contribution.' These sub-projects are expected to generate an incremental US$55 million annually in gross value added and create about 20,000 new jobs. Incremental employment would mostly be for low skilled rural workers, many of whom would be women, which would be an important factor in reducing rural poverty. Since the precise mix of the sub-project lending would depend on market demand, the quantification of an aggregate economic impact is not possible ex- ante. The free market ecoifomy in the Philippines and the system of effective taxes on financial intermediaries, together with aggressive borrowing by Government, has resulted in financial interest rates which are substantially positive in real terms at the sub-borrower level. Because of this, private investors would normally invest in projects from which they expect to generate a high real financial rate of return. This coupled with the relative and decreasing distortion between financial and economic prices suggests that investments supported by the FUNDS would also show attractive economic rates of l/ If sub-borrowers contribute 30% of project costs, and PFIs 12% as in CLF I, project costs would total US$293 million with CLF II increasing to US$207 million, and RCF to US$86 million.  - 34 - return. Estimated economic rates of return on those sub projects for which ERRs were calculated in the project completion report of the first Rural Finance Project/CLF I (Loan 3356-PH) averaged about 35' compared with FRRs for the same sub-projects of 30%. Similar results could be anticipated under CLF II, but with a smaller difference between ERRs and FRRs. 5.7 Risks. The main risks associated with this type of program relate to possible delays and/or inadequate implementation. The principal concern on the implementation side is that the introduction of agreed policy measures could be thwarted or postponed by political considerations, thereby weakening LBP as a financial institution and reducing its capacity to effectively implement both the lending programs under the project and its own institutional strengthening action plan. These risks would be mitigated through a gradual implementation process agreed upon and formalized through dated covenants in the legal documents. With respect to the credit component, the demand will be subject to overall performance of the economy. The demand for CLF and RCF resources, during the project period, is projected conservatively and is well within the historical growth performance of the first CLF. The LIBOR basis rate on the SCL program will add some volatility to the debt service of the respective sub-borrowers. Care would be taken to ensure that sub-borrowers are capable to bear this risk. VI. AGREEMENTS AND RECOMMENDATION 6.1 During negotiations agreement was reached with Government and LBP on the following: (a) LBP would exclude itself from retailing CLF II resources (para. 3.4); (b) LBP would operate CLF II and RCF (the FUNDS) on a commercial basis and the latter's net profit would remain within the FUNDS as LBP's investment (para. 3.8); (c) Land acquired for redistribution and land reform mortgages would be satisfactorily excluded from LBP's risk assets by December 31, 1995 {para. 3.9 (a) (ii)}; (d) LBP's dividend payments would be formulated in line with para. 3.9 (a) (iii); (e) LBP would submit to the Bank: (i) quarterly progress report with regard to the credit component; (ii) semi annual progress report with regard to the institutional strengthening component; audited accounts along with auditors' report on LBP, CLF II, RCF, the project's Special Account, and the Statement of Expenditures related to project activities within six months after the end of LBP's fiscal year; and (iii) part two of the project Implementation Completion Report within six months after the loan closing date (paras. 3.14 and 4.21); (f) during project implementation LBP will maintain the financial indicators as stated in para 4.1;  - 35 - (g) Policy Manuals (PMs) for CLF II and RCF would be issued, incorporating agreement with the Bank as noted below. Further changes in the PMs for project lending would not be made without the Bank's prior concurrence (para. 4.4); (i) eligibility criteria for CLF II and RCF loans, including minimum funding requirements and equity contribution of PFIs, LBP, and sub-borrowers, respectively (paras. 4.5 and 4.6); (ii) interest rate structure (paras. 4.7 to 4.9); (iii) PFIs accreditation criteria (paras. 4.10 and 4.11); (iv) sub-project appraisal and computation of ERR and FRR (para. 4.12); (v) sub-project review and disbursement (para. 4.13); (vi) sub-loan maturities (para. 4.15); (vii) conformity with environmental laws (para. 4.16); (viii) sub-projects', CLF II's, and RCF's supervision (paras. 4.17 to 4.19); (h) LBP will carry out existing guidelines and procedures for environmental protection and would take the necessary actions as detailed in para. 4.16; (i) the project training program for 1996 would be submitted for Bank review by December 15, 1995 and thereafter the updated program for each fiscal year by November 30, of each year (para. 4.22); and (j) LBP will employ consultants whose qualifications, experience, and terms and conditions are satisfactory to the Bank (para. 4.22) 6.2 Condition of Loan Effectiveness would be the approval by LBP's Board of: (i) the Institutional Strengthening Action Plan; and (ii) the Policy Manuals for CLF II and RCF (paras. 3.9 and 4.4). 6.3 Recommendation. With the above agreement and assurances, the proposed project is suitable for Bank loans totalling US$150 million equivalent to the Land Bank of the Philippines with the guarantee of the Republic of the Philippines. The Currency Pool Loan and the US dollar Single Currency Loan at variable rate would have a term of 20 years including five years of grace on repayment of principal, and carry the prevailing Bank's standard variable interest rates for the basket currencies loan and the Bank's standard LIBOR-based interest rate for US$ single currency loan. The fixed rate US dollar single currency loan would have a term of 15 years including three years of grace on repayment of principal, and carry the prevailing Bank's standard fixed interest rate for US dollar for 12 year maturity.  - 36 - Annex 2.1 Page 1 of 20 PHILIPPINES SECOND RURAL FINANCE PROJECT Land Bank of the Philippines (LBP) Operation and Performance Organization and Management 1. The Land Bank of the Philippines (LBP) was established in 1963 under the 1963 Land Reform Code Act (RA3844) as the agency responsible for financing agrarian reform. Its ordinary share capital of P1.8 billion' has been fully subscribed by the Government, but it has P1.2 billion of preference share capital which is authorized, but not issued. Since 1973, LBP has had full banking powers, allowing it to receive demand, savings and time deposits without limitation, and to engage in underwriting activities. 2. In line with normal commercial bank practice, LBP is controlled by a Board of Directors, which comprises seven members. These are the Secretary of Finance, who is Chairman; the President of the Bank, who is Vice-Chairman; the Secretary of Agrarian Reform; and the Secretary of Labor, all of whom are ex- officio members. In addition, there are three Board members appointed by the President of the Philippines to represent the agrarian reform beneficiaries, the landowners and the private sector. The new Land Bank charter (Republic Act 7909) now provided for LBP Board to be expanded to nine members. The Secretary of Agriculture is added to the ex-officio representation and the other members are increased to four of whom two are to represent land reform beneficiaries and two the private sector. Details of the organizational structure of the Bank are shown in Appendix E, figures 1 - 4. 3. Below the level of President, the operation of the Bank is divided into three sectors: the Banking Sector, the Agrarian Sector, and the Operations and Executive Sector. The organizational structure of LBP reflects its dual role. Its main operational divisions, Commercial Banking on the one hand, and Agrarian on the other, are entirely separate, with separate staffing and separate budgets. Furthermore, the outreach of the two sectors is through different channels. Agrarian reaches out to farmers through its Regional and Field Offices (of which there are 12 and 126 respectively), while the Banking Division does most (over 80%) of its lending business through Head Office. Its 161 branches are largely for collecting deposits and normally act only as conduits for loans, decision making being largely centralized. The only overlap between the two sectors, at an operational level, is that the branches provide checking and normal commercial banking facilities to the field offices, that is, advances made by the field offices are paid out through LBP branches and collections of loans are paid into LBP branches. 4. LBP has grown rapidly in the past seven years, and now has about 7,800 staff. In the period December 1987 to the end of 1990, the main change was 1/ LBP's authorized ordinary share capital has recently been increased by Peso 6 billion to Peso 7.8 billion under the new Republic Act (RA)7909.  - 37 - Annex 2.1 Page 2 of 20 in the agrarian sector where the number of field offices established rose from 29 to 91 and agrarian staff numbers increased by 135%. Little happened over this period within the banking sector - branches increased only from 26 to 32, and total staffing by 30%. The next three years, however, saw a reversal in the roles. There was a rapid expansion in the banking sector, with the number of branches opened increasing to 161 (by 403%) and branch steff by 297%. In the agrarian sector though, the number of field offices increased more modestly from 91 to the present level of 126 (by 38%). Field staff increased by 73% mainly to bring existing offices up to their staff full complemeni. Table 1. Build-up of Land Bank Staff Numbers and Branches Dec. Dec. Dec. Dec. 1992 Dec. 1993 Dec. Changes 1967 1990 1991 1994 87-90 90-94 Rxecutive Sector 491 636 735 773 930 n.a. 30% n.a. Operations Sector Agrarian Sector - Head Office 199 280 312 313 307 767 41% n.a. - Field 629 1,670 2,441 2,721 2,797 2,887 165't 73% Sub-total 828 1,950 2,753 3,034 3,104 3,654 135t n.a. Banking Sector - Head Office 355 414 485 545 672 1,185 17% n.a. - Branch 532 743 1,254 2,160 2,586 2.946 40t 297t Sub-total 887 1,157 1,739 2,705 3, 258 4,131 30% n.a. TOTAL STAFF 2,206 3,743 5,227 6,522 7,292 7,7895 70t 107t Ratio Ag: Banking 48:52 63:37 61:39 53:47 49:51 47:53 No. of Land Valuation - - 12 12 12 12 Offices Ho. of Field Offices 29 91 108 120 126 126 Ho. of Branches 26 32 66 107 128 161 Operations 5. Agrarian Sector. Until 1990, the most important part of LBP's operation in the Agrarian Sector was the provision of Agrarian Reform Mortgage Loans (ARMs) to individual farmers who have bought their land under the various land reform programs. Currently LBP has outstanding ARMs of about P2 billion (US$74 million). In addition it has land assets on its balance sheets, which are intended to be transferred to beneficiaries and so turned into mortgage loan assets of about P5.4 billion (US$200 million) . Official plans are for an expansion of land reform activities. Initial estimates were that between 1987 and 1997, P80 billion would be needed for the cost of land acquisition and distribution. Given the long maturity of the associated loans to mortgagees, this would have implied an expansion in mortgage lending on LBP's balance sheet to a portfolio figure of well in excess of P70 billion at the end of 1997. A reassessment of these figures, made in 1994, using LBP's own projections for land acquisition, which are below those of the DAR, suggested an end 1998 level of mortgages outstanding (or land for redistribution held by LBP) of P50 billion.  - 38 - Annex 2.1 Page 3 of 20 In either case, the level of agrarian reform mortgage operations would be large compared with LBP's commercial operations, and would only be sustainable with continued strong support from ARF (or other Government sources). 6. LBP's contribution to the Land Reform Program is (on behalf of Government), to carry out surveys and valuations, arrange for payment of landowners, operate a secondary market in Land Reform Bonds, and to administer mortgages of land reform beneficiaries, including the collection of payments. Because land reform financing is uneconomic, costing in discounted real terms about US$820 per ha (paid for by ARF/Government), it is strongly recommended that LBP continue to operate in this area only as an agent of Government and consequently that the associated assets and liabilities are taken off LBP's balance sheet. 7. Since 1987, LBP has been operating a Countryside Development Program, under which it provides loans for small farmers. It treats all farmers under 5 hectares (rice and corn farmers under seven hectares) as being agrarian reform beneficiaries and until well into 1992 allocated the cost of loans to such farmers to ARF. Initially LBP had extended loans to individual farmers whom it dealt with in groups, but with whom it maintained individual accounts. Over the past seven years however, LBP has changed its strategy, and now channels credit to these borrowers on a wholesale basis through two main channels - agricultural cooperatives and Rural Financial Institutions (RFIs) - mainly Rural Banks (RBs). The importance of LBP's Countryside Development Program increased substantially over the five years 1988-1992, but decreased slightly in 1993 and more significantly in 1994. The level of disbursements in 1994 was P6 billion (US$222 million), down from a peak of P7.5 billion (US$277 million) in 1992. The main reason for this drop was the reduction in lending to cooperatives (a 37% fall from 1992-1994) largely as a result of applying a more prudent accreditation criteria. Table 2. Countryside Lending By Channel - Amounts Disbursed (P billion) 1988 1989 1990 1991 1992 1993 1994 Individual Farmers 0.20 0.41 0.41 0.15 0.00 0.00 0.00 Cooperatives 0.08 0.41 1.80 4.96 6.35 5.33 3.99 Rural Financial 0.06 0.30 0.62 1.02 1.16 1.62 2.04 Institutions TOTAL 0.34 1.12 2.83 6.13 7.51 6.95 6.03 8. Loans to cooperatives which up to 1991 were made using ARF funds include Agricultural Production Loans, Commodity Loans, Operating Capital Loans, Agricultural Facility (fixed asset) Loans, and Agro-Industrial Loans. Short term loans carry an interest rate', which is currently positive in real terms, of 12% 1/ LBP interest rates are "simple interest rates" calculated on the basis of the amount outstanding and the number of days. For short term loans to farmers, interest is payable at the same time as loan repayment is due.  - 39 - Annex 2.1 Page 4 of 20 per annum (plus a 2% service charge) and have maturity periods designed to coincide with the crop cycle. In the case of fixed asset financing, the rate is 14% + 2% with maturity designed to match a reasonable pay-back period for the asset, e.g. 3-7 years. In the case of crop loans, which account for about 70% of all loans to cooperatives, LBP requires that the crops are insured by the Philippine Crop Insurance Corporation (PCIC). Onlending rate from cooperatives to members are determined by the coop itself. 9. LBP also operates a small farmer re-discounting program for Rural Banks (RBs), which must be accredited by LBP. Inter alia, they must have capital of at least 10% of their risk assets, and a past due ratio of not more than 50% (an easier requirement than that for Central Bank discounting which requires a past due ratio of not more than 25%). About half of the 750 RBs fulfill these criteria and are eligible for this LBP support. Under this program, LBP establishes a line of credit with the RB, on the condition that the RB re-lends the funds to small farmers or cooperatives who fulfil "agrarian criteria". These lines of credit are issued to the banks on a one year basis, and may be re-lent to beneficiaries on terms and conditions determined by the RB with a maximum re- discount rate of 85%. The main constraint to the RB program's growth is that the policies of the RBs are conservative. RBs typically only lend on a fully collateralized basis, generally using real estate as security. The normal requirement is for farmers to pledge real estate collateral worth at least double the loan size. This tends to exclude much of the rural community and is particularly difficult for new agrarian reform beneficiaries, who cannot offer land as security for loans from RBs because it is already mortgaged to LBP. 10. In addition to operating its own programs using its own funds (or ARF funds), LBP acts as an implementer of programs for other agencies including the Philippine Coconut Authority (PCA) and the Department of Agriculture (DA). The total supervised credit funds administered by LBP are fairly small compared with LBP's total agrarian funding (less than 10%), and in December 1993 amounted to 90.63 billion. 11. Banking Sector Like other commercial banks, LBP lends to the commercial sector on a range of terms and conditions, normally geared to a minimum spread of about 4% over its marginal cost of money. However, it also provides funds to clients from special sources, such as the Social Security Fund and targeted lines from DBP. Under the Social Security Fund, funds are onlent with a spread of 4% at a fixed interest of 16% for loans up to 5 years, and 17% for loans over 5 years. These funds are earmarked for small and medium sized businesses with an annual turnover in excess of P5 million and are limited to P20 million per borrower. Total resources available to LBP from SSS are about P0.5 billion. DBP funding, which is mainly funds of Japanese origin for industrial or export lending, amounted to P0.3 billion at the end of 1993. 12. Since 1990, LBP has been responsible for administering the Agricultural Loan Fund (ALF) and re-lending ALF recycled funds on a wholesale basis. Initially, LBP managed over P2 billion under this program. Now, however, most of these funds have been returned to the Central Bank. As at December 31st 1994, the outstanding balance of ALF funds in LBP amounted to R0.43 billion, (P88 million of which was lent out and the remainder held in short term instruments). Repayments of outstanding CBP originated loans which are being collected by LBP  - 40 - Annex 2.1 Page 5 of 20 should give rise to a further P0.19 billion. With the support of the Rural Finance Project (Loan 3356-PH), LBP has also been operating the Countryside Loan Fund (CLF) to wholesale resources for lending in rural areas using borrowings from the World Bank. By December 31st 1994, this loan had been fully drawn down. These US$150 million of funds are wholesaled both to Commercial Banks and Rural Banks with the pass on rate being determined by a market-linked formula. LBP earns a spread of 21 for administering the program. Total volume of outstanding LBP loans supported by CLF at December 31st 1994 amounted P3.2 billion. Loan Portfolio. 13. Between December 1990 and December 1994, LBP increased its non- interbank portfolio by about a factor of more than 4 in nominal terms (see Table 3). This is also a substantial increase in real terms, representing average real growth of some 301 p.a. over the past four years. Table 3. Evolution of LBP's Gross Loan Portfolio - Excluding Interbank Loans (P Million) Annualized 1990 1991 1992 1993 1994 a/ -change- Agrarian Reform Mortgages (ARMs) 2,013 2,054 2,090 2.119 2,065 1% Loans to Small Farmers 2,165 5,108 7,366 9,131 9,489 45% Commercial Agribusiness Loans 2,034 2,196 2,737 5,607 5,058 26% Sub Total - Agriculture 6,212 9,358 12,193 16,857 16,612 28% Livelihood Projects 778 43 492 631 600 -6% Government 844 826 2,122 5,017 3,334 41% Private - Non Agric 1,320 2,257 7,603 8,784 16,508 88% Total Gross Portfolio (Current P) 9,154 12,872 19,410 30.830 37,054 42% CPI (Dec '94/Jan '95 = 100) 71.2 79.7 86.2 93.8 100.0 Total Gross Portfolio (1994 Prices) 12,856 16.151 22,517 32,902 37,054 30% -------(% of total gross portfolio)--------- ARMs 22% 16% 11% 7S 6% Loans to Small farmers 24% 40% 38% 30% 25% Commercial Agribusiness Loans 22% 17% 14% 18% 14% Sub Total - Agriculture 68% 73% 63% 55% 45S Livelihood Projects (Mainly KKK) 9% 3% 2% 2% 2% Government 9% 6% lit 16% 9% Private - Non Agric 14% 18% 24% 27% 44% a/ LBP '94 figures not broken down in this way - allocation based on mission estimates. Lending to private non-agricultural businesses grew by the equivalent of 88% p.a. throughout this period and its relative importance increased from 24% of LBP's portfolio in 1990, to 441 in 1994. Agriculture (including ARMs, small farmer production loans and loans to agribusiness) is still an important sector funded by LBP, with P16.6 billion outstanding (45% of portfolio) in December 1994. The total amount of loans to agriculture grew by an average of 28% p.a. between December 1990 and December 1994, somewhat less than the average of all loans. A 45t p.a. increase in loans outstanding to small farmers was tempered by growth in the commercial agriculture portfolio of 26% and virtually no growth in ARMs. Lending to government entities grew by the equivalent of 51% p.a. overall in this period. In December 1994, the total outstanding to government of P3.3 billion, absorbed 16% of total portfolio. Finally, LBP remains a financier of livelihood projects. Its portfolio of these, (government subsidized directed credit to fund livelihood projects) , increased by a modest 1% p.a. between 1990 and 1994 and is  - 41 - Annex 2.1 Page 6 of 20 now only 2% of LBP's portfolio. Many of these loans, which are underwritten by Government, are now past due. 14. Loan data from LBP's balance sheet (Appendix A), detailed in Appendix B shows that overall, LBP's loan portfolio, including interbank loans, has increased from a gross figure of P9.7 billion as at December 1990 to P38.4 billion in December 1994. After taking account of provisions for probable losses, which have increased from P613 million to P1.8 billion but reduced as a percentage of gross loans from 6.3% to 4.6t, net loans amounted to P9.1 billion in December 1990, and P36.6 billion in December 1994. Overall, the proportion of net loans either past due or in litigation improved, from 7.0% in 1990 to 1.5% in December 1993, before deteriorating to 5.2% in December 1994. It should be noted that following an agreement with BSP it is LBP's policy not to classify ARMs as past due, even though payments on over half of these are behind schedule. If these mortgage loans are excluded from the calculation, (both from the numerator, and the denominator) , then net non-performing loins as percentages of net total loans were 9.0% in 1988 improving to 1.9% in 1993 but deteriorating to 5.6% in 1994 (Appendix C). The satisfactory situation with regard to the reduction of net past dues up to 1993 was partly offset by a substantial increase in loan restructuring in the agrarian sector, mainly as a result of natural disasters. This has resulted in the percentage of the net portfolio represented by net past dues plus restructured loans increasing overall from 5.7% in 1991 to 8.7% in 1992, 8.5% in 1993 and 10.5% in 1994. To cover its potential losses from loans not repaid (as well as other potential losses), LBP has made substantially increased provisions of P411 million in 1992, P814 million in 1993 and P872 million in 1994. BSP reports have indicated that LBP's total provisions for losses have generally been adequate, although this may reflect the pre-1992 situation, whereby potential losses on agrarian reform loans were mostly (at least 85%) chargeable to ARF. Loan Repayments 15. Agrarian Sector Mortqages. Repayments of ARMs which are passed directly to ARF, have been poor, but have improved. They are now about 60% of amounts currently due, up from 171 in 1986, and 37% in 1988, the first year following the CARL. 16. Loans to Small Farmers. LBP had collection problems on loans to the agrarian sector in the past. At the end of 1988, loans which were past due or in litigation made up 50% of the gross outstanding loans of P479 million. This unsatisfactory state of affairs appears to have resulted from LBP's previous role as a conduit for Government programs. Most of the past dues prior to 1987 are old and are unlikely to be cleared up. However, under the new Countryside Development Program initiated by LBP in 1987, the rate of repayment of loans, has been much better. Current collection rates to date under this program are reported to have varied between 90% and 93% over the six years up to 1993, with those of RBs being between 98% and 100%, while cooperatives, which over this period had had a slight downward trend in performance were between 88% and 93%. 1994 figures are markedly different. Overall current collection fell to 77%. The continued sound performance of RBs (99%) was offset by a significant deterioration in collection - to only 68% - from cooperatives.  - 42 - Annex 2.1 Page 7 of 20 17. Given the increase in the level of net non-performing loans plus restructured loans, from 4.9% in 1990 to 37.3% in 1994, it is clear that the level of provisioning has been inadequate. The calculations show that if it had been LBP's intentions to make provisions at a level which would cover 70% of past dues plus 30% of restructured loans, additional provisions of about P1.2 billion would need to be made. Even at this level of provisioning, the percentage of net past dues and restructured loans to total net loans for the agrarian sector would have been 26.4% at the end of 1994 compared with 2.8% for the banking sector. 18. An important element of LBP's corporate plan would be to collect adequate data and come to terms with the issue of adequate provisioning for agrarian loans. On the basis of historic 'current collection' data up to 1993 and anecdotal evidence on collection of past dues which suggests that about 35% are collected in the first year after loans become past due, provisions ought to have been made at a rate of about 7% on disbursements or 8-10% of the net outstanding portfolio. In 1994, however, collection performance deteriorated sharply, indicating higher provisioning may be necessary. On average, over the past six years provisions of 8.32t on disbursements would have been required to achieve provisioning equal to 70t of past dues plus 30% of restructurings. 19. Banking Sector. According to the loan portfolio analysis, the quantity and the quality of the Commercial Loans and Discounts Portfolio has substantially increased and quality improved significantly since 1990. Performing regular commercial loans (excluding "livelihood loans" handled by LBP on behalf of government and ALF/CLF loans to PFIs) increased substantially from P2.3 billion to P17.6 billion between December 1990 and December 1994, (a factor of about 8 in nominal terms, or more than 5 in real terms). Table 4. Summary of Commercial Lending Handled by Banking Sector' (Million Pesos in Portfolio at Year End) 1990 1991 1992 1993 1994 A. Interbank Loans - Gross 532 770 1,470 2,877 1,363 B. Performing Regular Commercial Loans - Gross 2,264 3,377 4,B36 12,102 17,651 C. Regular Commercial Loans Restructured, 547 475 414 640 1,039 Past Due or in Litigation - Gross Restructured, PD or Loans in litigation as % 19.5S% 12.3% 7.9% 5.0% 5.6% total commercial loans (C as % of B + C) D. Performing Bills/Drafts etc. - Gross 642 511 1,320 1,799 1,725 E. Past Due Bills/Drafts etc. - Gross 80 73 21 76 33 % PD Bills/Drafts as % of all bills and drafts II.lt 12.5% 1.6% 4.1% 1.8% (E as % of D + E) Total PDs & Loans in Litigation as a % of Total 15.4% 10.5% 5.4% 4.1% 4.9% Gross Loans and Bills/Drafts (C+D as % of A+B+C+D+E) Total Net PDs & Loans in Litigation as a 12.4% 4.4% 1.7% 0.7% 0.9% percentage of Net Loans, Bills/Drafts I/ Gross figures. Provisions for bad debts have not been deducted. 2/ LBP's total regular lending portfolio i.e. total commercial loan portfolio, as classified in the balance sheet excluding (a) KKK Loans; and (b) ALF/CLF loans to PFIs in 1992 and 1993.  - 43 - Annex 2.1 Page 8 of 20 20. Between 1990 and 1994, past due commercial loans, restructured loans and items in litigation have increased from P0.55 billion to P1.04 billion. In proportional terms, however, the gross percentage of restructured and non- performing loans fell from 20% of the gross portfolio in 1990 to 5.0% in 1993, and 5.6% in 1994. Lending to other banks and for trade bills, etc., has also increased over the period. Interbank Loans, all of which are performing, have increased from P532 million in 1990 to P1.4 billion in 1994 while net lending for Other Bills, etc. has gone up from P642 million to P1.7 billion between 1990 and 1994. As a result of increased activity and improved collection, the percentage of the Other Bills portfolio which is past due has fallen from a gross figure of 11% in 1990 to 2% in 1994. 21. Overall, loan collection performance has improved impressively for regular banking sector operations. Gross non performing loans which fell from 35% in 1988 to 15.4% in 1990 continued their decline to 4.9% in 1994. Net non performing loans, which is a better measure of portfolio quality fell from 12.4% in 1990 to 0.7% in 1993 but increased slightly to 0.9% in 1994. within the 1994 total, the figure for ALF/CLF loans which are essentially wholesale, is satisfactorily low at less than 0.1%. Profitability 22. Overall Situation. LBP's Profit and Loss Account for the past five years is shown as Appendix C and summarized in constant currency terms in table 5. Between 1990 and 1994 LBP's activities expanded substantially both in nominal and in real terms. By 1994 total gross earnings were P8.6 billion (US$319 million) and net income, in current terms, after contributing P777 million to ARF, was R1.22 billion (US$45 million) . Nominal return to equity after tax has averaged 18% over the five year period (14% excluding gains from property sales) in nominal terms, and 5.1% in real terms. These calculations are based on the audited accounts, and therefore do not make any adjustment for underprovisioning of agrarian loans. If account were taken of this (para 17), LBP would still have earned a real net profit, on average, over the period reviewed of about 2%. Table 5. Summary Profit and Loss Account 1990-1994 (1994 Constant Million Pesos) -Change '90-'94- 1990 1991 1992 1993 1994 Total Annualized Interest Income 2,941 3,652 4,167 6,663 7,177 144% 25% Other Income 821 624 756 1,998 1,441 76% 15% Total Income 3,762 4,276 4,923 8,661 8,618 129% 23% Interest Payments 876 1,2S3 1,641 3,652 3,870 342% 45% Compensation and Benefits 261 298 332 1,079 534 105% 20% Other Admin Costs 244 377 558 1,079 820 2361 35% Taxes & Licenses 577 684 701 983 1,122 95% 18% Provision for Probable Losses 170 179 482 888 275 62% 13% Total Expenses 2,127 2,792 3,714 7,679 6,621 211% 33% Operating Income 1,634 1,485 1,209 981 1,997 22% 5% Less Payments to CARP -182 -248 -201 0 -777 Real Cost of Equity Maintenance -1,073 -879 -624 -681 -512 Real Income excl Gains on Property 380 358 384 301 708 87% 17% Real Return on Equity 5.4t 4.5% 4.5% 3.4t 7.7t  - 44 - Annex 2.1 Page 9 of 20 23. Total real income (of which typically more than 80% is interest income) has increased by 129% over the past five years, while expenses have increased by 211%, the most important item of these being the 342% increase in interest payments. The main reason for the larger increase in interest payments than in interest income, on a proportional basis, is that LBP has expanded very rapidly, particularly between 1992 and 1993, without significantly increasing its real equity capital. Consequently a far greater proportion of LBP's total resources are now borrowed funds than was the case in 1990. The apparant relatively large increase in total administrative and operating costs (168%) compared with the increase in income (129%) results in part from the increase in LBP's branching network, although the very high 1993 figure reflects the fact that LBP had to cover a greater proportion of 'agrarian costs' in its own profit and loss account than previously (or than in 1994). 24. Agrarian Sector. Table 6 below sets out the total net costs of (subsidy for) supporting the agrarian sector. After taking account of actual expenditure, cost of capital and estimated provisions needed and then netting back interest received, the total cost of supporting this sector has increased in nominal terms from P528 million in 1988 to P2,426 million in 1994. In real terms, the cost increased rapidly from 1988-1990 - by 101%, then by 27% between 1991 and 1992, but has declined slightly since. Table 6. Total Real Costs of Supporting the Agrarian Sector (Million Pesos) 1988 1990 1991 1992 1993 1994 Mortgages & Land Acquisition Operating Costs 67 165 291 283 330 321 Implicit Interest a/ Supporting Land for Resale & Fixed Assets 27 51 130 266 392 572 Implicit Interest a/ Supporting Mortgages 293 473 437 337 276 254 - less Mortgage interest Received -29 -54 -67 -63 -75 -96 Net Financing Cost 292 470 500 540 593 730 TOTAL NET MORTGAGE/LAND ACQUISITION COSTS 359 636 791 823 923 1,051 Agrarian Lending/COOP Development Operating Costs net of Provisions 125 325 453 421 598 497 Estimated Provisions Needed for Doubtful Debts b/ 29 236 510 625 579 502 Implicit Interest a/ Supporting Adj Net Loans c/ 56 341 694 848 873 875 - less Total Loan Interest Received -36 -167 -383 -615 -639 -499 Net Financing Cost 20 174 311 233 234 376 TOTAL NET AGRARIAN LOAN/COOP DEVT COSTS 174 734 1,274 1,280 1,411 1,375 TOTAL AGRARIAN SECTOR COSTS 532 1,370 2,065 2,103 2,334 2,426 TOTAL AGRARIAN SECTOR COSTS (Constant 1994 Pesos) 1,033 2,079 2,641 2,648 2,545 2,426 a/ At the T-Bill rate for the relevant year. b/ Estimated at 8.321 of disbursements - the average figure which over the past six years would have maintained total loan losses provided for equal to 70% of past due loans plus 30% of rescheduled loans, this implies that at the end of 1994, provisioning in the balance sheet was about P1.0 billion too low. c/ Based on net loan balance after adjusting for necessary increased provisions. 25. The importance of ARF participations in the cost of agrarian lending, the provision of technical assistance to the cooperatives, and the training of their managements and members, are not immediately apparent from LBP's published accounts. This is because ARF's participation towards administrative costs and payments of bond interest have been netted out of LBP's profit and loss account, as too has income collected for ARF from agrarian mortgages and, in some years, agrarian loans. ARF's net participation in the cost of LBP's agrarian operations is presented in Table 7 below.  - 45 - Annex 2.1 Page 10 of 20 Table 7. ARF effective net contribution to LBP - 1988-1994 (Million Pesos) 198B 1990 1991 1992 1993 1994 A. Gross Admin Support (incl. some provisions) 195 525 752 721 290 63B B. Bond and Other Interest Paid 161 202 200 312 291 917 C. Less Interest and other items Paid by LBP to ARF -65 -189 -193 -153 -120 -596 D. Net Payment Reported in LBP Accounts (A+B-C) 291 538 759 880 461 959 E. Less payment by LBP to ARF a/ -120 -120 -194 -171 -0 -0 F. Implicit Subsidies Due to ARF's Int. Free Balance in LBP 69 29B 577 573 538 617 G. Total ARF Subsidy in Current Pesos (D-E+F) 240 716 1,142 1,282 999 1,576 H. Implicit Cost of Mortgages/Land Purchase 359 636 791 823 923 1,051 I. ARF Effective Net Subsidy on ARLs (G-H) -119 80 351 459 76 525 J. Net Implicit Cost to LBP of Agrarian Lending 293 654 923 821 1,335 850 a/ The P777 million shown in the P & L account for 1994 is netted out of "Gross Admin Support". 26. In addition to the explicit costs absorbed by ARF (D in the table), ARF has also provided funds, free of interest, for onlending to Agrarian Reform Beneficiaries (ARBs). Valuing these at the gross T-Bill rate (the opportunity cost of acquiring such funds in the market), the effective participation provided in this way (line F in the table) has increased from P69 million in 1988 (about US$3 million) to P573 million in 1992 and P617 million in 1994 (about US$23 million). As a result of the increase number of ARBs, ARF's overall financing, between 1988 and 1991, of LBP's agrarian operation increased substantially in real terms (by 212%). In 1992, it increased slightly over 1991 (by 3%), but in 1993, it fell back sharply (by 28%), before increasing to its highest level ever in 1994. It should be noted, however, that LBP's costs associated with the provision of technical assistance to cooperatives is estimated at about 25% of total LBP's agrarian operating costs. The effective nominal loss to LBP on agrarian operations increased from P293 million in 1988 to R1.3 billion in 1993 (line J in the table) but fell to P850 million in 1994. The loss in real terms (in 1994 constant peso) increased from P569 million in 1988 to P1.46 billion in 1993 (P569 million in 1988 to P1.46 billion in 1993 in 1994 constant peso terms). Line I indicates the level of net support ARF can be considered to have provided, after accounting for pure land reform operations. In 1988, ARF did not even fully cover Agrarian Reform Mortgages (ARMs) and Land Purchase costs, however, by 1991 & '92 it was effectively providing P400 million p.a. towards Agrarian Reform Loans (ARLs) compared with LBP's effective contribution of about P800 million in those years. ARF's contribution to ARLs fell sharply in 1993 to only P76 million, but in 1994 increased again to P525 million (Line J). 27. At present interest rates, which for ARMs are fixed by the CARL, the real net present (discounted) cost of land redistribution amounts to about P22,900 (US$820) per hectare for the pure financial costs. Including the associated costs of surveying, landowner support and mortgage amortization collection, the present per ha cost would be about P29,200, or over US$1,000/ha'. 28. It is clear from Table 8 that at the interest rates and spreads of the past five years, provision of production loans to farmers is also a loss- 1/ The implication of this is that under the present arrangements, the faster the rate of Agrarian Reform, the greater Land Bank's potential losses.  - 46 - Annex 2.1 Page 11 of 20 making activity, even using resources which have zero financial cost. If resources had to be acquired in the market place, then losses would be significantly higher. Table S. Agrarian Loan Operating Costs (Million Pesos) 1988 1990 1991 1992 1993 1994 A. Average Gross Agrarian Loan Balance 440 1,683 3,191 6,233 8,245 9,214 D. Average Net Adjusted a/ Loan Balance 363 1,381 3,082 4,990 6,374 6,891 C. Operating Costs attributable to Agrarian Loans (including co-op support) 125 325 453 421 598 497 D. Provisions b/ Needed 29 236 510 625 579 502 E. Total Operating Cost and Provisions 154 560 963 1,047 1,176 999 F. Interest Collected 36 167 383 615 639 499 Figures as % of Average Net Adjusted Loan Balance Operating Costs (C/B) 34.5% 23.5% 14.7% 8.4% 9.4% 7.2% Provisions Needed (D/B) 7.9% 17.1% 16.6% 12.5% 9.1% 7.3% Total Operating Cost and Provisions (E/B) 42.4% 40.6% 31.3% 21.0% 18.5% 14.5% Average Interest Rate (Collected) (F/B) 9.9% 12.1% 12.4% 12.3% 10.0% 7.2% a/ Net balance per accounts, adjusted for necessary increased provisioning. b/ Provisioning at 8.32% of disbursements would allow 70% of past dues and 30% of rescheduled loans to be provided against on average. The cost of delivering agrarian loans (including costs associated with assisting with cooperative development) has clearly declined as the volume has increased and LBP has moved away from reLail to cooperative lending. However, if the market interest rates (gross T-Bill rates) are added to these figures, break even nominal interest rates collected on the adjusted volume of net loans outstanding would have needed to have been as follows (Table 9) for agrarian lending to have broken even. Table 9. Break Even Agrarian Interest Rates 1988 1990 1991 1992 1993 1994 T-Bill rate 15.5% 24.7% 22.5% 17.0% 13.7% 12.7% Cost of Operations & Provisioning 42.4% 40.6% 31.3% 21.0% 18.5% 14.5% Break Even Interest Rate Needed 57.9% 65.3% 53.8% 38.0% 32.2% 27.2% Break Even Interest Rate Needed (excl Coop Support) 46.6% 58.7% 49.8% 35.7% 29.7% 25.2% These 1994 figures can be compared with actual interest collected of about 7.2% of adjusted net portfolio. 29. The bankinq sector is a major element in LBP's operation. It now accounts for about 80% of LBP's assets and 60% of LBP's outstanding loans. Furthermore, it has contributed to covering the cost of the agrarian sector through direct contributions to ARF and the provision of funds for agrarian loans, mortgages and land purchase. Indeed, with the withdrawal of ARF support to agrarian loans in 1993, the proportion of total agrarian costs supported by LBP's banking sector was forced to increase sharply from 39% in 1992 to 57% in 1993 or an increase from p821 million to P1,335 million, but fell in 1994 to 35%, P850 million.  - 47 - Annex 2.1 Page 12 of 20 30. Within its banking sector, LBP undertakes two main types of activity (i) normal commercial banking, including commercial loans, foreign exchange dealing, etc.; and (ii) investments both in government instruments and in shares, particularly privatization issues. Most of LBP's banking sector profits appear to have come from investments. The salient points on the profitability of LBP's banking sector as a whole are that (i) income as a percentage of total net loan portfolio plus investments has been relatively modest, 17.4% in 1991, 13.7% in 1992, 13.9% in 1993 and 11.8% in 1994; (ii) interest expense has been low - 4.6% of financial capital (loans + investments + cash) in 1991, 4.5% in 1992, 5.8% in 1993 and 5.3% in 1994; and (iii) administrative costs have fallen from 3% of financial capital in 1991 to 2.2% in 1993 and 1.8t in 1994. The sound level of profitability achieved results partly from LBP's overall low cost of money. This is because (i) LBP has a substantial (but decreasing) proportion of its capital in the form of equity, and (ii) average deposit interest paid as a percentage of deposits is relatively low, averaging 7.2% in 1991, 5.2% in 1992, 6.4% in 1993 and 6.5% in 1994. While each of these rates is below the wholesale cost of borrowing, the differential has narrowed substantially. Average spreads from reinvesting deposits in T-Bills over the past four years are indicated as follows: Table 10. Average Spread on T-Bills 1991 1992 1993 1994 Nominal T-Bill Rate 22.5% 17.0% 13.7% 12.7% 20% BSP Reserve Requirement @ 4% .8% .896 .8% .8% Investment in T-Bills (80%) 18.0% 13.6% 11.0% 10.2% Less Final Tax - 20% T-Bill Interest -3.6% -2.7% -2.2% -2.0% Net Income 15.2% 11.7% 9.6% 9.0% Cost of Deposits 7.2% 5.2% 6.9% 6.5% Average Spread (Net Income to Deposits) 8.0% 6.5% 2.5% 2.5% LBP's favorable deposits mix, and hence low average cost of money is partly due to its position as one of the three receivers of government agency funds. An analysis of LBP's average deposit cost for savings and time deposits indicates rates paid to Government were 1-21 below the national average 1990 - 1992 but the differential appears to be narrowing, and was about 1% in 1993 and 1994. 31. Subsidy Dependency Index (SDI). One means of evaluating LBP's overall operational performance is to review its subsidy dependency. To do this, the SDI' for LBP is calculated using the methodology set out in World Bank Discussion Paper No. 1742. Clearly, the level of this index depends upon LBP's role - whether certain costs are considered as provisions of services to Government, which therefore should be reimbursed by them, or whether they are truly part of LBP's costs and need to be covered by interest rates or user fees. 32. The most pragmatic approach is to consider the situation under which LBP is likely to be working in future. That is LBP would be financially responsible for loans to small farmers [agrarian reform loans (ARLs)] but its 1/ The definition of the Subsidy Dependency Index (SDI) is the percentage by which the average annual interest rate would need to be raised in order to fully eliminate the cost of both explicit and implicit subsidies. 2/ Assessing Development Finance Institutions - A Public Interst Analysis: Jacob Yaron  - 48 - Annex 2.1 Page 13 of 20 operations in land purchase and agrarian reform mortgages (ARMs) would be as an agent of Government/ARF who would provide the necessary funding and cover LBP's operating costs. In this instance, to be conservative, LBP's technical support for cooperative development is considered part of LBP's small farmer lending operations, and so its own responsibility. Defined in this way, LBP's SDI over the past seven years is estimated as follows. Table 11. Summary of SDI Calculations (Million Pesos) 1988 1990 1991 1992 1993 1994 Net Profit per accounts Excl Cap Gains 384 855 967 859 900 1,220 Adj for LBP Support for ARMs etc. - - - - 85 - Adj for ARF Net Support to Agr Loans -5 -205 -259 -250 0 -317 Adj for ARF Bond and Interest Payments -161 -202 -200 -312 -291 -917 Profit Excl ARF, ARMs & Land Purch. 218 448 508 297 694 -14 Adj Due to Under Provisioning of ARLs -26 -114 -412 -533 -146 +96 Real Cost of Equity -475 -1,051 -1,147 -928 -805 -851 Subsidy on Govt Deposits -56 -70 -113 -203 -377 -448 Subsidy due to ARF Funding of ARLs -45 -258 -511 -335 -151 -132 - less interest on ARLs paid to ARF 36 135 126 90 0 499 Tax due to LBP Funding of Land/ARMs 296 485 501 365 281 349 ADJUSTED NET LOSS -51 -425 -1,049 -1,245 -504 -502 Interest Income (Net of ARM Interest) 1,124 2,262 3,175 3,793 6,185 8,271 SDI - Proportion by Which Overall 4.5% 18.8% 33.0% 32.8% 8.1% 6.1% Interest Rate Would Need to Increase to Cover Costs & Eliminate Subsidies 33. Under this scenario the SDI situation worsened between 1988 and 1991 (from 4.5% to 33.0%) as the volume of agrarian loans increased, but improved in 1993 and 1994 as the size of banking operations expanded relative to loans to small farmers. The SDI in 1994 was 6.1%, indicating that LBP needed an effective subsidy of roughly 6% of its gross interest earnings in order to break even. In the past four years, on average, the effective subsidy LBP has had from 'free' provision of equity, has more than covered its 'Adjusted Net Loss' . This indicates that this 'support', together with the profits which LBP makes on its 'banking sector operations' has been sufficient to compensate for the net real cost of agrarian lending. Licruidity & Solvency 34. LBP' s liquid assets to deposit ratio has somewhat declined from a high 1.4 in 1989 to 0.9 in December 1994, but remains satisfactory, and substantially above the 0.5 average of the top 5 private Philippine banks. Although LBP's equity as a share of total assets has dropped from a peak 31% in 1989 to 10.5% in 1993 (mainly due to the rapid expansion of deposits), LBP remains adequately solvent and its risk assets to equity ratio of about 4.4 (4.8 if equity were adjusted downwards as a result of underprovisioning) compares favorably to international standards and to average levels in the Philippines (average of the top 5 private banks is 5.2) . LBP also has the benefit of substantial unrealized gains on property and shares in privatized companies. These more than compensate for the possible overvaluation of agrarian loans (resulting from underprovisioning).  Annex 2.1, ApPendix A. LBP - Balance Sheets (Million Pesos) ----1990---- ----1991---- ----1992---- ----1993---- ----1994---- Total % Total % Total % Total % Total % ASSETS Cash & Due From Banks 4,400 19.3% 3,404 11.0% 8,169 16.5% 18,344 20.5% 13,687 14.1% Investments - Mainly T Bills 6,980 30.6% 9,692 31.4% 14,901 30.1% 31.448 35.1% 37,382 38.5% Loans & Discounts Land Amortization (ARR) 2,013 8.8% 2,054 6.7% 2,090 4.2% 2,118 2.4% 2,065 2.1% Inter Bank Loans 532 2.3% 770 2.5% 1,470 3.0% 2,877 3.2% 1,363 1.4% Commercial Loans 3,301 14.5% 4,250 13.8% 6,413 12.9% 12,819 14.3% 18,753 19.3% ALF/CLF Loans 1,873 3.8% 3,304 3.7% 3,334 3.4% Ag Reform/Other Agric Loans 3,119 13.7% 5,985 19.4% 7,694 15.5% 10,713 12.0% 11,142 11.5% Bills Purchased Etc. 721 3.2% 583 1.9% 1,341 2.7% 1,875 2.1% 1,758 1.8% Allowance for Probable Losses (613) -2.7% (792) -2.6% (854) -1.7% (1,417) -1.6% (1,790) -1.8% Sub Total Loans & Discounts 9,073 39.8% 12,850 41.7% 20,027 40.4% 32,289 36.1% 36,625 37.7% Bond Sinking Fund 160 0.7% 190 0.6% 220 0.4% 259 0.3% 298 0.3% Land for Resale 131 0.6% 856 2.8% 2,077 4.2% 3,461 3.9% 5,383 5.5% Bank Premises, Other Real Property, Furn & Equipt 518 2.3% 774 2.5t 973 2.0O 1,135 1.3% 1,261 1.3% Other Assets 1,561 6.8% 3,071 10.0% 3,179 6.4% 2,572 2.9% 2,571 2.6% TOTAL ASSETS 22,823 100.0% 30,837 100.0% 49,546 100.0% 89,508 100.0% 97,207 100.0% LIABILITIES & CAPITAL Deposits (Pesos) 7,899 34.6% 11,282 36.6% 23,737 47.9% 54,401 60.8% 52,404 53.9% Deposits - Foreign Currency 361 1.6% 632 2.0% 946 1.9% 3,366 3.8% 2,609 2.7% Special Time Deposits/Financing 528 2.3% 101 0.3% 112 0.2% 144 0.2% 131 0.1% Bills Payable 1,653 7.2% 2,503 8.1% 5,341 10.8% 8,045 9.0% 12,694 13.1% I Bonds Payable 1,412 6.2% 1,491 4.8% 1,725 3.5% 2,016 2.3% 2,497 2.6% Agrarian Reform Fund 1,919 8.4% 3,230 10.5% 3,507 7.1% 4,348 4.9% 5,367 5.5% Other Liabilities 2.776 12.2% 4,347 14.1% 6,066 12.2% 8,179 9.1% 11,284 11.6% TOTAL LIABILITIES 16,548 72.5% 23,586 76.5% 41,434 83.6% 80,499 0.0% 86,986 0.0% Paid in Capital - Common 1,800 7.9% 1,800 5.8% 1,800 3.6% 1,800 2.0% 1,800 1.9% Paid in Surplus 57 0.2% 57 0.2% 57 0.1% 57 0.1% 57 0.1% Reserves - Allocated 1,833 8.0% 1,828 5.9% 3,262 6.6% 3,261 3.6% 3,854 4.0% Undivided Profits & Free Surplus 2,585 11.2% 3,566 11.6% 2,991 6.0% 3,891 4.3% 4,510 4.6% TOTAL CAPITAL 6,275 27.5% 7,251 23.5% 8,110 16.4% 9,009 10.1% 10,221 10.5% TOTAL LIABILITIES & CAPITAL 22,823 100.0% 30,837 100.0% 49,544 100.0% 89,508 100.0% 97,207 100.0% Infl. Within Period 17.0% 11.9% 8.2% 8.7% 6.7% Year End Index (Dec 1994/Jan 1995 = 100) 71.2 79.7 86.2 93.8 100.0 Av Real Annual Summary Balance Sheet At Constant End 1994 Prices Growth '90-'94 Financial Assets (including land for resale) 31,327 37,720 56,349 94,214 95,946 32.3% Physical Assets 728 971 1,129 1,210 1,261 14.7% 1 Total Assets 32,055 38,691 57,478 95,424 97,207 32.0% 3 3 Financial Liabilities 23,242 29,593 48,067 85,820 86,986 39.1% X Net Capital (Before Physical Asset Revaluation) 8,813 9,098 9,411 9,604 10,221 3.8% . . 0  Annex 2.1, Appendix B. Land Bank's Loan Portfolio (Current Prices) 1990 (Dec) 1991 (Dec) 1992 (Dec) 1993 (Dec) 1994 (Dec) P Mill Per- P Mill Per- P Mill Per- P Mill Per- P Mill Per- cent cent cent cent cent Inter Bank Loans & Call Loans 532 5.9% 770 6.0% 1,470 7.3% 2,877 8.9% 1,363 3.7% Sub Total Commercial Loans & Discounts 3,301 36.4% 3,938 30.6% 7,208 36.0% 16,108 49.9% 22,088 60.3% - Less Allowance for Probable Losses -169 -1.9% -239 -1.9% -267 -1.3% -386 -1.2% -422 -1.2% Sub Total Net Commercial Loans & Discounts 3,132 34.5% 3,699 28.8% 6,941 34.7% 15,722 48.7% 21,666 59.2% Agrarian Reform Mortgage Loans 2,013 22.2% 2,054 16.0% 2,090 10.4% 2,119 6.6% 2,065 5.6% - Less Allowance for Probable Losses -93 -1.0% -93 -0.7% -87 -0.4% -90 -0.3% -90 -0.2% Sub Total Net Agrarian Reform Mortgage Loans 1,920 21.2% 1,961 15.3% 2,003 10.0% 2,029 6.3% 1,975 5.4% Sub Total Agrarian Sector Loans 3,118 34.4% 6,297 49.0% 8,772 43.8% 10,728 33.2% 11,144 30.4% - Less Allowance for Probable Losses -295 -3.2% -401 -3.1% -497 -2.5% -934 -2.9% -1,273 -3.5% Sub Total Net Agrarian Sector Loans 2,823 31.1% 5,896 45.9% 8,275 41.3% 9,793 30.3% 9,871 27.0% I U, Bills Purchased 72 0.8% 95 0.7% 353 1.8% 593 1.8% 885 2.4% Customer Liability on Drafts - LCs etc. 570 6.3% 416 3.2% 967 4.8% 1,206 3.7% 840 2.3%I Past Due Bills 3 0.0% 13 0.1% 5 0.0% 5 0.0% 7 0.0% Past Due Import Bills etc 77 0.8% 60 0.5% 16 0.1% 71 0.2% 26 0.1% Sub Total - Other Bills etc. 721 8.0% 584 4.5% 1,341 6.7% 1,875 5.8% 1,758 4.8% - Less Allowance for Probable Losses -57 -0.6% -60 -0.5% -3 -0.0% -7 -0.0% -8 -0.0% Sub Total - Net Other Bills etc. 665 7.3% 524 4.1% 1,338 6.7% 1,868 5.8% 1,750 4.8% ===== __.. = .==___===.... =.... =- ---. = ... - _____ ----____- ..... TOTAL NET LOAN & DISCOUNT PORTFOLIO 9,073 100.0% 12,850 100.0% 20,027 100.0% 32,289 100.0% 36,625 100.0% ===== ~ .. .. ...... .....s ---- ------ =_= _S__ __ws _ - =e= ...... m m x LnM o 0  Annex 2.1. Appendix C. LBP Profit & Loss Accounts (Million Current Pesos) 1990 1991 1992 1993 1994 EARNINGS Interest on Loans & Discounts 710 1,232 1,528 2,480 2,843 Interest on Investments 915 1,220 1,406 1,656 2,026 Other Interest 313 404 616 1,974 2,308 Trading Gain & Equity Dividends 143 268 334 412 582 Commissions, Fees, & Trust Dept 32 46 85 111 142 Other Income 198 145 149 822 639 Foreign Exchange Profit 168 29 76 487 78 TOTAL EARNINGS 2,479 3,344 4,194 7,942 8,618 EXPENSES Interest on Deposits 445 731 953 2,718 3,244 Interest on Borrowings/Finance Cgs 132 249 445 631 626 Interest Payable on Bonds 0 0 0 0 0 Compensation & Benefits 172 233 283 989 534 Fees - Management, Spn, Legal etc 13 22 19 39 41 Insurance 11 18 56 129 129 Depreciation/Amortization 19 42 92 168 169 Other Expenses 118 213 308 653 481 Taxes & Licenses 380 535 597 901 1,122 Provision for Probable Losses 112 140 411 814 275 TOTAL EXPENSES 1,402 2,183 3,164 7,042 6,621 NET INCOME 1,077 1,161 1,030 900 1,997 1 Plus: Extraordinary Item 818 (n Less: CARP Expa Absorbed by LBP -120 -194 -171 0 -777 H Less: Provision for Income Tax -102 NET INCOME AFTER ADJUSTMENT 1,673 967 859 900 1,220 Nominal Return on Opening Equity 36.2% a/ 15.4% 11.8% 11.1% 13.5% IMPACT OF INFLATION ON INCOME (in current terms for each year) Within Year Inflation 17.0% 11.9% 8.2% 8.7% 6.7% Profit Before Capital Sales & associated income tax 957 967 859 900 1,220 TOTAL EQUITY 4,620 6,275 7,251 8,110 9,009 - less Physical Assets -456 -518 -771 -973 -1,135 Equity to be Maintained 4,164 5,757 6,480 7,137 7,874 Equity Maintenance Charge b/ 707 687 531 624 528 Adjusted Net Income (Excl Cap Gains net of income tax) 250 280 328 276 692 Withdrawals 0 0 0 0 0 Extraordinary Profit (Capital Gains net of inc tax) 716 (D Real Change in Equity 966 280 328 276 692 Real Rate of return on Opening Equity 5.4% 4.5% 4.5% 3.4% 7 7% a/ Would have been 20.7% without capital gain and associated tax. b/ Opening Equity to be maintained multiplied by the inflation between the opening and closing balance sheet dates (i.e. within Yr Inflation).  LAND BANK OF PHILIPPINES (As of July 2. 1993) Overall Structure | BOARD OF DIRECTORS AUDTO TRUST DEPT. PRESIDENT ---------- STANDING COMMITTEES | EXECUTIVE AND OPERATIONS SUPPORT SECTOR AGRARIAN SECTOR HCredit Supervision Group l |Landowners' Compensation & Assistance Group] Account Management Group HManpower b Scecial Services Group J |Field Operations Group Un Facilities & Special Assets Group T Farmers' Livelihood & Assistance Group Treasury Group HLegal Services Groupl fPormLnigDptetl HControllership Group| Countryside Financial Institutions Group| Cooperatives' Development Assistance Group rtI, :1 x x o OH  LAND BANK OF PHILIPPINES (As of July 1993) Agrarian Sector PRESIDENT l AGRARIAN SECTOR |LANDOWNERS' COMPENSATION&| FIELD OPERATIONS GR AUP|_ FARMERS' LIVELIHOOD & LANDOWNERS' COMPENSATION DEPARTMENT PROGRAM MANAGEMEN T DEPARTMENT I DEPARTMENT T FIELD SERVICES w BOANDOSNERS' COMPENSATION DEPARTMENT PROGRAM MANAGEMENT DPRMENT 11 DEPARTMENT 11 REGIO:NAL OFFICES l-XII l FIELD OFFICES I DEPARTMENT III LNONERS' ASSISTANCE I(D (D (D rtN X x 0  LAND BANK OF PHILIPPINES IAs of July 2. 1993\ Banking Sector |PRESIDENT B ANKING SECTOR| ACCOUNT MANAGEMENT GROUP BANKING OPERATIONS GROUP TREASURY GROUP BRANCH BANKING GROUP CREDIT & CENTRAL LIABILITY I TREASURYBRANCH ADMINISTRATION PROGRAM LENDING AFCCOUNT MA~NAGEMENT DEPT. I 4D E PT. j J PT OFIEDEPT. LOANS &TRADE I TREASURY SERVICE BRANCH OPERATIONS & ACCOUNT MANAGEMENT DEPT. II TRANSACTIONS DEPT. T FOREIGN IREMITTANCES BRNHATMTO& 4ACCOUNT MANAGEMENT DEPT. III LOGISTICS OMFEMINCES &ION OFIC OVERSEAS REMITTANCE & 1CUSTOMER DEVELOPMENT 1 +ACCOUNT MANAGEMENT DEPT. IV I 4MAIRKETING OFFICE OFFI& I U AFCCOUNT MANAGEM ~~~~~~~~~~~~~~~~~~~~~BRANCH AREA OFFICE VII ACCOUNT MANAGEMENT DEPT. Vl PROOF & TRANSIT DEPARTMENT| _REMITTANCE, INTER-OFFICE &I MOS MONITORING DEPT. I ATM CENTER BRANCH AREA OFFICES I - XIV D3' 1G 0 I ~~~rtD ~l x BRANCHES/GSUs 1X xo 0  LAND BANK OF PHILIPPINE (As of July 2. 1993) Executive and OPeration Support Sector PRESIDENT EXECUTIVE & OPERATIONS SUPPORT SECTOR MNPOER&COUNTRYSIDE CPREDIT SPEIA FCILTISULGAL SERVIE CONTROLLERSHIP FINANCIAL GROUP ASSETS ASSETS GROUP ~~~~~~~~~~GROUP GROUP INSTITUTIONS GRG R GROUP BRANCH HUMAN JUDICIAL CASES _ CREDIT _ RESOURCES _ GENERAL _ GOPERATIONS INVESTIGATION & ACCOUNTING OPERATIONS MANAGEMENT DEVELOPMENT SERVICES DEPT. AUDIT DEPT. LEGAL RESEARCH DEPT. SUPPORT DEPT. DEPT. DEPT. ADTEP.OFFICE FINSTCITUTO PERSONNEL SPECIAL CRDTAGRARIAN LEGAL INTR-OFFICE REGIONAL INSTITUTIONS ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~RASCTIONS OFFICS I-VIl DEPT. ~~~DEPARTMENT ASSETS GROUP RVEDPTOFIE CONTROCDEPT SECURITY &COUNTRYSIDE MEDICAL STRANSPORT FINANCIAL FIELD LEGAL BUDGET OFFICE OFFICE INSTITUTION OFFICE DEPT. AUDIT DEPT. PROJ ECT SSES&COOPERATIVES PROVIDENT MNGT. & BANKING LEGAL CSYSTEMS & DEVELOPMENT FUND OFFICE ENGINEERING OFFICE DEPT. R& ASSISTANCE DP.DEPT. GROUP PROPERTY OFFICE OF THE PUBLIC MAINTENANCE CORPORATE AFFAIRS DEPT. SECRETARY GROUP CORPORATE PLANNING DEPT. C. la 0 Lo I- lCD (D (D rt10 N TECHNOLOGY CLt DEPT. .FI. 0 t'J X 0  - 56 - Annex 2.2 Page 1 of 5 PHILIPPINES SECOND RURAL FINANCE PROJECT NATURE OF SUB-LOANS SUPPORTED UNDER THE COUNTRYSIDE LOAN FUND (CLF) 1992-94 1. Evolution of CLF Lending. By March 31, 1994, 687 sub-loans had been supported under CLF. CLF loans to PFIs totalled Peso 4.043 billion or about US$155 million' at the weighted average exchange rate for the period of US$1 - Peso 26. Total sub-loans made by PFIs amounted to Peso 4.889 billion (US$185 million) by the same date, and investments supported Pesos 7,006 billion (US$269 million) . Average projects were financed 30% by the sub-borrower, 12% by the PFI and 58% by CLF. Table A summarizes the development of the program over the period. Despite relatively high real interest rates, averaging 5.8% from LBP to PFIs and, with the addition of the average spread of 4.0%, almost 10t to sub- borrowers, funds were drawn down rapidly. Clearly, because CLF's rates are set three monthly, but the market is constantly readjusting, the CLF interest rate is sometimes higher, and sometimes lower than the T-Bill rate. The volumes of lending confirm the market's sensitivity to this. In the three quarters when the CLF rate was above the T-Bill rate, volume averaged Peso 200 million at peso 5 million per loan while in the six periods when the CLF rate was below the T-Bill rate, an average of Peso 573 million at Peso 6 million per loan were disbursed. Table A: CLF: Interest Rates. Inflation and Disbursements 1992 1992 1992 1992 1993 1993 1993 1993 1994 Q1 Q2 03 Q4 01 02 03 Q4 01 Overall Interest (CLF Pass on) 17.6% 15.4% 13.7% 13.8% 12.9% 10.7% 11.0% 11.2% 15.5% 13.5% T-Bill Rate 18.6% 15.1% 15.6% 14.8% 13.3% 10.9% 10.9% 14.7% 15 .1% 14.3% Variance (CLF:T-BillJ -5.5% 2.2% -12.2% -6.5% -3.2% -1.6% 0.9% -23.8% 2.8% -5.5% Quarterly Inflation 7.9% 12.0% 9.1% 3.9% 5.4% 9.2% 1.3% 7.9% 9.3% 7.3% Real Interest Rate 9.0% 3.0% 4.2% 9.5% 7.1% 1.4% 9.6% 3.1% 5.7% 5.8% Volume (million peso) 477 44 603 838 404 575 340 543 219 4,043 Number of Loans 216 31 90 65 51 64 49 81 40 687 Av Rediscount Amt (mil. peso)2.2 1.4 6.7 12.9 7.9 9.0 6.9 6.7 5.5 5.9 2. Distribution of New and Expansion Sub-projects. The available data indicate that banks preferred to finance established projects with proven records of profitability, although the proportion of new projects (19% by number, and 15% by value) was greater than under ALF (13% by number, 5% by value) . Of the total sub-loans, 556 were for the expansion of existing projects. The remainder went to finance start up projects, many of which were in the service sector - typically for transportation. 1/ This figure is higher than the US$150 loan amount, because there had been some use of second generation funds prior to final loan drawdown.  - 57 - Annex 2.2 Page 2 of 5 Table B: CLF: Sub-loan Support for New and ExDansion Prolects Loans Amount Number d M Peso 9 New Loans 131 19 729 15 Expansions 556 81 4,160 85 Total 687 100 4,889 100 3. Size of Sub-Borrowers. Of the 687 project loans, 568, or 83% were for small-sized businesses projects with assets that totalled less than Peso 20.0 million before financing. These businesses accounted for a significant proportion (22%) of CLF financing. Nevertheless, the bulk of the funds went to larger scale businesses - 30% to 96 projects for businesses with assets between Peso 20 and 200 million (US$ 0.8 - 7.6 million) and 48% to 23 firms with assets of Peso 200 million and above (US$ 7.6 million and over). Table C: CLF: Size of Borrowing Firms Loans Amount Number e M Peso % Small Firms 1/ 568 83 1,061 22 Medium Firms 2/ 96 14 1,495 30 Large Firms 3/ 23 3 2,332 48 Total 687 100 4,889 100 1/ Assets under Peso 20 million 2/ Assets Peso 20 - 200 million 3/ Assets over Peso 200 million 4. Sub-sector Distribution of Sub-loans. CLF loans were extended to a broad spectrum of rural based investments (Table D) : food and agro-processing constituted the largest share (41%) of total CLF availments by amount; agriculture and aquaculture represented 31%, manufacturing 15% and services, 13%. The main types of investment in primary production were for livestock, particularly poultry and pigs and sugar, among the processing loans, grain millers and associated businesses were major borrowers, with beer, a.cohol and sugar also important. Manufacturing covered a wide range of products, from aluminum foil to textiles and construction materials, while 80% of services projects in were transportation.  - 58 - Annex 2.2 Page 3 of 5 Table D: CLF: Sub-loans by Sub-sector Loans Amount Number % M Peso % Agriculture/Aquaculture 363 53 1,506 31 Food/Agro Processing 138 20 2,023 41 Manufacture 62 9 740 15 Service Industries 124 18 620 13 Total 687 100 4,889 100 5. Sub-loans Distribution by Purpose. With regard to the purposes for which the CLF loans were utilized, 54% went to fixed assets, 28% went to working capital, and 18* to a combination of working capital and acquisition of fixed assets. All in all, about two thirds of the total sub-loans were for fixed assets and one third for working capital. Table E: CLF: Sub-loans by Type of Investment Loans Amount Number % M Peso % Fixed Assets 266 10 2,658 54 Fixed Assets/Working Capital 141 14 868 18 Working Capital 280 31 1,362 28 Total 687 100 4,889 100 6. Sub-loan Size and Spreads. The average sub-loan size under the CLF program was Peso 7.1 million (US$ 270,000), or more than three times larger than the average loan under the previous ALF program, while the average spread was 4.06. The rural banks had the smallest average loan size, rediscounting an average of 483,000 Pesos (US$18,500) per loan with CLF. As would be expected, they had the largest interest rate spread, averaging 8.0% on a volume weighted basis. Average rediscount figures per loan and spreads for other types of institution were: commercial banks, Peso 15.1 million (US$580,000) at a spread of 3.7%; thrift banks Peso 3.2 million (US$120,000), with a 4.4% spread, Government banks Peso 5.2 million (US$200,000) with a 4.4% spread; and other financial institutions, Peso 28 million (US$1.1 million) with a 3.0% spread. Total sub-loan size was about 12% larger in each case (see Table G below).  - 59 - Annex 2.2 Page 4 of 5 Table F: CLF: Sub-loans by Loan Amount Loans Amount Number % M Peso Small 0-5 Million 583 85 951 19 Medium 5-50 Million 94 14 1,973 41 Large Over 50 Million 10 1 1,964 40 Total 687 100 4,889 100 Average Sub-loan Size: Peso 7.12 million 7. Institutional Participation. As of March 1994, 97 financial institutions were accredited for CLF funding as follow: commercial banks 25, government banks 2, thrift banks 16, rural banks 49, and non-bank financial institutions (NBFIs) 5. Of these, 20 commercial banks, 1 government bank, 12 thrifts, 16 rural banks and 2 NBFIs were making use of the program at that date. Among the participating financial institutions, the commercial banks had the highest total availment at 72%, followed by the thrift banks at 17%, government banks at 4% and both NBFIs and rural banks at 3% each. Compared with ALF, the share of thrifts fell, but that of all other institutional types increased. Table G: CLF: Sub-loans by Type of Institutions Loans Amount Avq Loan Number % M Peso % M Peso Commercial Banks 193 28 3,537 72 18.3 Government Banks 33 5 216 4 6.5 Thrift Banks 214 31 837 17 3.9 NBFIs 5 1 161 3 32.2 Rural Banks. 242 35 138 3 0.6 Total 687 100 4,889 100 7.1 8. Regional Distribution of Sub-projects. Region IV (Southern Tagalog) was the area with both the greatest number of sub-loans (40%) and amount disbursed (28%). This was followed by Region III (Central Luzon) - 20% of loans and 13% of amount disbursed, Region VII (12% and 14%) and Region VI (8% and 18%). Very little investment was made in Regions I (Ilocos), V (Bicol), VIII (Eastern Visayas), XII (Central Mindinao) and Cordillera (in total, 9% of loans, and 5% of amounts). 9. Loan Maturities. The payment of short-term sub-loans was normally set at 12 months, except for sugar and banana production, which were granted a six-month roll-over, for a total of 18 months. Medium- and long-term loans had maturity periods up to 10 years, including a grace period on capital repayment.  - 60 - Annex 2.2 Page 5 of 5 The overall average maturity of CLF loans was about 4 years. Rural banks and some thrift banks tended to make use of the maximum terms allowable for the different sub-projects. The commercial banks were more conservative in extending longer term credits. 10. Impact on Sub-Borrowers. Because the project is only two and a half years old, there has been no ex post evaluation of sub-project profitability. As a guide however, ex ante financial rates of return have been reviewed on a sample of those loans for which FRR calculations were made.' The results were as follows. Table H: CLF: Ex Ante FRRs from A Sample of 37 Sub-Proiects Sub-loans Sub-Loans Total between P5-50 M P50 M and above Range of FRR Results No. % No. % No. % Under 20t 6 22% 1 10% 7 19% 20 - 30% 11 41% 5 50% 16 43% 30 - 40% 4 15% 1 10% 5 14% 40% + 6 22% 3 20% 9 24% Total 27 100% 10 100% 37 100% Clearly, investors had expectations of returns well above the cost of money to them, which averaged about 10% in real terms. 11. Economic Impact. Economic analysis was only undertaken by banks for projects to which sub-loans exceeded US$1 million. In these cases, the ERRs were estimated by adjusting financial flows, using conversion factors provided to the PFIs and LBP by NEDA. Reported ex-ante ERRs averaged 35% on the projects in the sample reviewed (in total, loans to these projects amounted to about 45% of total loans) . On average ERRs were estimated to be some five percentage points higher than FRRs. Analysis of the sample also indicated that the sub-loans were projected to support total investment per job averaging Peso 2.5 million (US$95,000) for rediscounting amounts of over Peso 50 million; Peso 850,000 (US$33,000) for rediscounting amounts Pesos 5-50 Million; and Peso 340,000 (US$13,000) for rediscounting amounts below Pesos 5 million. Overall, an estimated 9,000 new jobs were anticipated to result from CLF funded projects. This number excludes both (i) the jobs created as part of the investment process, e.g. in the construction industry; and (ii) indirect employment, e.g in industries supplying project investments, such as feed milling in the case of livestock investments. 1/ The sample comprised all sub-loans of over Peso 50 million, and 33% of sub-loans Peso 5-50 million. For sub-loans below Peso 5 million, from which a 10% sample was taken FRRs were not estimated during sub-loan processing.  - 61 - Annex 3.1 Page 1 of 6 PHILIPPINES SECOND RURAL FINANCE PROJECT CLF & RLF Cash Flow Proiections 1. CLF projections are detailed in Table 1, with supporting schedules on subloan repayments given as Table 2. The basic assumption is for a US$ 120 million World Bank loan being drawn down from the beginning of 1995. Inflation assumptions are for international inflation to be at 3% per year and peso inflation to be at rates, indicated by NEDA, which fall from 10% in 1994 to 5% in 1997. Exchange rates reflect purchasing power being maintained at the 1993 peso:dollar exchange rate of 27.5. 2. The assumptions on the draw down of the World Bank CLF-2 loan, subloan composition and inflation rates are detailed in the first section of Table 1. These indicate a five year draw down period for the loan. Other sources of funds flowing into LBP for relending under the CLF programme are (i) the ALF-1 funds collected from CBP sub-borrowers, (ii) repayments existing of ALF and CLF-1 subloans back to LBP from PFIs, (iii) final draw down of CLF-1, (iv) LBP's cash contribution to new CLF supported loans 10% out of 75% i.e. 13.33% of new loan amounts, (v) new LBP-CLF bonds or securitized debt instruments to tap the domestic long term market, (vi) repayment of new loans, (vii) retained net profit from CLF operations. Outflows from the LBP-controlled CLF comprise (i) capital repayments to CBP of ALF-1 funds, (ii) capital repayments of the CLF-1 loan to World Bank', (iii) capital repayments of the CLF-2 loan to World Bank, and (iv) new subloans made (interest received from subloans is assumed to be equal to interest payable plus operating costs and so is netted out of the cash flow). 3. The flow of funds within years shown in Table 1 is from the standpoint of LBP. Inflows from CBP are on the basis of the amortisation schedule already submitted to LBP while the draw down of CLF-2 assumes US$40 million being drawn down in 1995, US$50 million in 1996, US$20 million in 1997 and US$7 and US$3 millions in the final two years of the project disbursement period. Repayments by PFIs of LBP subloans are based on the amortisation schedules shown in Table 2. These are based on typical lending profiles under CLF-1. The estimated LBP net profit contribution is based on the assumption that LBP makes a net profit of 0.5% per annum on the cash balance and loan balance of 1/ Capital repayments of both the existing CLF loan (3356-PH) and the proposed second World Bank CLF loan are assumed to be in 15 equal installments starting in the sixth year after first drawdown. Because the foreign exchange risk on the first loan would be borne by the Department of Finance the repayment schedule is based on the nominal sum of pesos borrowed. The same approach is taken in the case of the proposed new loan, i.e. it is assumed that the foreign exchange risk premiums which would be collected as part of the interest charged are not retained in the fund but are placed elsewhere and drawn on when loan repayment takes place.  - 62 - Annex 3.1 Page 2 of 6 the CLF fund. On this basis total inflows would be about P 2.7 billion in the first year of the project (1985), increasing to over P 3 billion thereafter. Assuming that LBP's policy is to retain about 159 of their CLF resources as cash, the funds available for new subloans would increase from about R 1.6 billion in 1994 to P 2.5 billion in 1996 and thereafter grows in line with projected inflation. By 1997, financing of CLF from bonds etc. would be introduced to allow this level of lending to be sustained in parallel with the repayment of the CLF-1 loan. 4. The third part of the Table 1 shows the position of CLF resources at the year end. It includes the cash balance built up and held within LBP and the outstanding balance of subloans made by LBP. These are financed by the ALF-1 loan from the Central Bank to LBP, the CLF-1 loan from the World Bank to LBP, the new CLF-2 loan from World Bank to LBP, LBP's cash contributions which have built up over time, LBP-CLF bonds outstanding and the build up of LBP's retained profit from operating the fund. In addition to LBP loans, there is a declining portfolio of old CBP loans which were made under the ALF and which continue to be administered by LBP. In current terms the total portfolio of ALF/CLF loans is estimated to build up from P 3.8 billion in December 1993 to P 9.2 billion in December 1999 (to P 6.4 billion in constant end 1993 currency values) . Over the period 1995 to 1999 an average of about P 2.0 billion new loans per year (in end 1993 currency values) would be made. 5. Table 3 shows the 'without project" situation, that is the flow of funds without any CLF-2. From this it can be seen that CLF lending would fall from its estimated 1994 level of about P 1.6 billion to an average of about P 0.6 billion per year in constant 1993 currency terms for the period 1995 to 1999. It can be seen from this that over the five year period (1995 - 1999) lending with the project would be approximately P 1.4 billion per year higher in constant terms than without the proiect. 6. Projections for lending from the parallel Retail Loan Fund (RLF) are given in Table 4. Under this program, World Bank would provide funds for LBP retail lending to rural sector borrowers. Cash inflows to the fund are the draw down of the World Bank loan and LBP's cash contribution, which would be disbursed to the fund at the rate of 20% of project cost, or a minimum of 23.5% of loans made and repayments of the loans themselves. It is assumed that net profits from the fund are withdrawn by LBP as they are made, so there is no fund build up from retained profits. Outflows comprise the loans made and, from the year 2000, repayments to the World Bank. 7. The lending under the LBP Retail Fund is projected at about P 250 million annually (in 1993 constant prices). The resultant portfolio of loans built up under this program is consequently estimated to be about P 950 million (P 820 million in 1993 prices) by the end of 1998. By that date, total assets in the fund, including the 15% held as cash would be about P1.12 billion in current terms, of which 75% would be funded by the World Bank loan and 25% by the build up of LBP cash contributions.  Table 1. CLF CASH FLOW PROJECTIONS (Million Pesos) e- 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 NEW LOAN LOAN SIZE (Million US$) 120.0 40.0