Sri Lanka - Second Industrial Development Project

Docment of The World Bank FOR OFFICIAL USE ONLY Report No. 14700 PROJECT COMPLETION REPORT SRI LANKA SECOND INDUSTRIAL DEVELOPMENT PROJECT (CREDIT 1692-CE) JUNE 27, 1995 Country Operations and Industry and Finance Division Country Department III South Asia Region i This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EOUIJALENT Currency Unit - Sri Lanka Pupee (annual average) Rs. Per US$1.00 USS Per Rs.1.00 1986 28 .017 0.0355 1987 29.445 0.0339 1988 31.807 0.0314 '989 36.047 0.0277 1990 40.063 0.0249 1991 41.372 0.0241 1992 43.830 0.0228 1993 48.322 0.0206 1994 49.500 0.0200 A33REV-IATIONS ADB - Asian Develorment Bank AWPR - Average Weighted Prime Rate BOC - Bank of Ceylon CBSL - Central Bank of Sri Lanka DFIs - DeveloDment Finance Institutes DFCC - Development Finance Corporation of Ceylon GOSL - Government of Sri Lanka IPS - Industrial Policy Statement NDB - National Development Bank of Sri Lanka PB - Peoples Bank PCI - Participating Credit Institutions PFDP - Private Finance Development Project PMES - Public Manufacturing Enzerprises SMI - Small and Medium Industries TIPR - Trade and Industrial Policy Reform FISCAL YEARS GOSL = January 1 to December 31 Commercial Banks = January 1 to December 31 Development Finance Corporation of Ceylon (DFCC)= April 1 to March 31 National Development Bank of Sri Lanka (NDB) = January 1 to December 31  FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation June 27, 1995 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Sri Lanka - Second Industrial Development Project (IDP-II) (Credit 1692-CE) Attached is the Project Completion Report (PCR) for the Sri Lanka Second Industrial Development project (Credit 1692-CE, approved in FY86), prepared by the South Asia Regional Office, with Part II contributed by the Borrower. The Credit, totalling US$20.0 million, was approved on May 8, 1986, and closed on June 30, 1994, seven months behind schedule due to delays in completion of technical assistance (TA) programs. The project was the second of several credits extended to the Government of Sri Lanka for strengthening industrial and trade policy reforms and the development of the industrial sector. Its main objectives were to: (i) provide credit through the banking system to medium and large-scale industries; (ii) develop the institutional capabilities of Development Finance Institutions (DFIs); and (iii) strengthen reform programs in the areas of trade and industrial policy. The project broadly achieved its objectives of delivering credit efficiently and strengthening the institutional base for financial intermediation. The TA component helped improve the incentive framework for private sector development by: (i) simplification of the import tariff structure and elimination of export taxes; and (ii) streamlining personal and corporate tax structures. More than 70 percent of the sub-projects have performed satisfactorily in terms of profitability. The DFIs cash collection ratios were also higher than the IDA minimum requirement of 75 percent with returns on assets and on equity well above the covenanted ratios; their debt/equity ratios also were below the covenanted ratios. The outcome with respect to technical assistance was mixed: while operational capabilities of the DFIs improved, lesser progress was made in respect of support to policy reforms, due to a failure to effectively coordinate and monitor the program. The principal lessons that emerge from the implementation of the project are: (i) that successful project implementation depends crucially on initial conditions: well functioning and well managed development finance institutions are essential to channel credit efficiently and ensure good loan recovery; (ii) that concurrent efforts are needed to strengthen the institutional and resource base of financial markets to ensure a steady stream of loanable funds; and (iii) that technical assistance programs that accompany the credits should have clear objectives, spell out the means to achieve them, and establish mechanisms for coordination and monitoring implementation. Project outcome is rated as satisfactory and the institutional development impact is rated as substantial. Sustainability is rated as likely. The PCR is comprehensive in its coverage of the performance of the project and principal issues, and its overall quality is good. No audit is planned. Attachment This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed wiLhout World Bank authorization.  I  PROJECT COMPLETION REPORT FOROFFICIALUSEONLY SRI LANKA SECOND INDUSTRIAL DEVELOPMENT PROJECT (CREDIT 1692-CE) CONTENTS Page No. Preface . . . . . . . . . . . . . . . . . . . . . . . . Evaluation Summary. . . ............... iii PART I: PROJECT REVIEW FROM IDA'S PERSPECTIVE . . . . . . . . . . . . . . 1. Project Identity . . . . . . . . . . . . . . . . . . . . . . . . . 2. Background . IDA's Strategy and Involvement . . . . . . . . . . . . . . . .1 The Industrial Sector . . . . . . . . . . . . . . . . . . . . . 2 Policy Reforms. 2 3. Project Objectives and Description .3 Project Objectives . . . . . . . . . . . . . . . . . . . . . . 3 Project Description . . . . . . . . . . . . . . . . . . . . . . 3 4. Project Design and Organization. 4 5. Project Implementation and Results . . . . . . . . . . . . . . . . 5 Implementation and Results of Credit Component . . . . . . . . 5 Sub-Project Financed . . . . . . . . . . . . . . . . . . . . . 6 DFCC and NDB Performance in Project Implementation . . . . . . 7 Implementation and Results of Technical Assistance . . . . . . 7 GOSL's Performance in the Implementation of TA . . . . . . . . 9 6. Project Sustainability . . . . . . . . . . . . . . . . . . . . . . 10 Sub-Projects' Performance. . . . . . . . . . . . . . . . . . . 10 DFI's Performance . . . . . . . . . . . . . . . . . . . . . . . 10 7. IDA's Performance .11 8. Borrower's Performance . . . . . . . . . . . . . . . . . . . . . . 12 9. Project Relationships .12 10. Project Documentation and Data .13 11. Consulting Services. . . . . . . . . . . . . . . . . . . . . . . . 13 12. Conclusions and Lessons Learned .13 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  -2- Contents (cont'd) PART II: PROJECT REVIEW FROM BORROWER'S PERSPECTIVE . . . . . . . . . . . . 16 PART III:STATISTICAL INFORMATION . ..17 1. Related Bank Loans . . . . . . . . . . . . . . . . . . . . . . . . 17 2. Project Time Table . . . . . . . . . . . . . . . . . . . . . . . . 18 3. Credit Disbursement . . . . . . . . . . . . . . . . . . . . . . . 18 4. Project Implementation . . . . . . . . . . . . . . . . . . . . . . 18 5. Project Costs and Financing . . . . . . . . . . . . . . . . . . . 19 A. Project Costs . . . . . . . . . . . . . . . . . . . . . . . 19 B. Project Financing . . . . . . . . . . . . . . . . . . . . . 19 6. Project Results . . . . . . . . . . . . . . . . . . . . . . . . . 19 7. Status of Covenants . . . . . . . . . . . . . . . . . . . . . . . 19 8. Use of Bank Resources . . . . . . . . . . . . . . . . . . . . . . 20 A. Staff Inputs . . . . . . . . . . . . . . . . . . . . . . . 20 B. Missions . . . . . . . . . . . . . . . . . . . . . . . . . 20 ANNEXES I. Sub-Loan Financing - Under IDA Credit . . . . . . . . . . .21 II. Sectoral Distribution of Sub-Projects . . . . . . . . . . .22 III. Geographical Distribution of Sub-Projects . . . . . . . . .22 IV. Sub-Project Performance . . . . . . . . . . . . . . . . . .23 V. Financial Performance Indicators - DFCC . . . . . . . . . . . . . 24 VI. Financial Performance Indicators - NDB . . . . . . . . . . . . . . 25 VII. Technical Assistance - Allocation and Utilization . . . . .26 VIII. People's Bank and Bank of Ceylon Operational Review . . . .27 IX. ADB Line of Credit - DFLI (ADB 754 SRI) . . . . . . . . . . . . . 29  PROJECT COMPLETION REPORT SRI LANKA SECOND INDUSTRIAL DEVELOPMENT PROJECT (CREDIT 1692-CEI PREFACE This is the Project Completion Report (PCR) for the Second Industrial development Project (Credit 1692-CE) to the Government of Sri Lanka (GOSL) in the amount of SDR 17.4 million (USS 20.0 million equivalent inclusive of US$ 2.0 million technical assistance). The Credit was approved on May 8, 1986, signed on July 24, 1986, became effective on October 9, 1986 and closed on June 30, 1994. The project was originally scheduled to close on December 31, 1993; however, due to unexpected delays in the completion of some TA programs, the GOSL requested IDA to extend the credit closing for six months. The main objectives of the project were to complement the previous industrial sector operations through further reform in the areas of trade and industrial policy and provide credit through the Development Finance Institutions (DFIs) to medium- and large- scale private industrial enterprises for creation of new operations as well as for modernization, rehabilitation and expansion of existing private industries and selected public manufacturing enterprises. The project had two major components: (i) a credit component of US$ 18.0 million equivalent for sub-project financing; and (ii) a technical assistance component of US$ 2.0 million equivalent for implementation of the GOSL's policy reform programs and institutional development of DFIs. The Asian Development Bank (ADB) provided US$ 20.0 million through a parallel line of credit on terms and conditions similar to those of IDA's. The implementation of the project was, overall, satisfactory. The credit component was largely committed about a year and half ahead of appraisal schedule and the TA component was fully utilized. A small balance of funds remained unutilized at the time of project closing and was cancelled. The PCR (Preface, Evaluation Summary, Parts I and III) was prepared by the ITF Unit of the Country Operations and Industry and Finance Division, Country Department III, South Asia Region (SA3CI). Part II is to be prepared by the Ministry of Finance (MOF). The DFIs and MOF provided part of the statistical information required for Part III. This PCR is based on the Staff Appraisal Report (SAR); the Development Credit Agreement (DCA); supervision reports; internal Bank memoranda; correspondence between IDA and the borrower; and other documents and reports in the project file.  I  - iii - PROJECT COMPLETION REPORT SRI LANKA SECOND INDUSTRIAL DEVELOPMENT PROJECT (IDP-II) (CREDIT 1692-CE) EVALUATION SUMMARY 1. Obiectives and Description. The main objective of the project was to support and complement IDA's previous industrial sector operations by providing credit through the banking system to medium and large scale manufacturing industries. The project also aimed at making further contribution to institutional strengthening of the participating Development Finance Institutions (DFIs) and to reform programs in the areas of trade and industrial policy, export promotion, and public enterprise efficiency. IDP-II took further steps to address issues in interest rate policies and induced the Government to move towards rationalization of financial markets, specifically acceptance of the principles that lending rates should reflect the cost of funds. At the time of project preparation, a Bank/IMF mission carried out a detailed analysis of the financial sector to determine measures needed to promote the capital markets and availability of development finance, improve the domestic money market, and rationalize the interest rates. To help ensure that the interest rates were appropriately adjusted during project implementation, the proceeds of the credit were divided into two tranches of US$ 10.0 million each, with the release of the second tranche to be made following an agreement between the Government and IDA on a mechanism for determining appropriate interest rates for term lending. 2. The project had two components: (i) a Credit component of SDR 15.7 million (US$ 18.0 million equivalent) for sub-project financing in the priority areas of agro-industries, chemicals, light engineering, garments, rubber products, and industrial services activities; and (ii) a SDR 1.7 million (US$ 2.0 million equivalent) Technical Assistance (TA) component for institutional development of DFIs, improvement the efficiency of selected public manufacturing enterprises (PMEs), and supporting the Government's reform policy in the areas of industrial and trade incentives. The Asian Development Bank (ADB) co-financed the project, through a parallel line of credit of US$ 20.0 million on terms and conditions similar to those of IDA's. 3. Project Implementation and Results. IDP-II was signed on July 24, 1986, became effective on October 9, 1986 and closed on June 30, 1994. The original closing date of the project, December 31, 1993, was extended for six months per Government's request owing to unexpected delays in the completion of some of the TA programs. Because of strong demand for investment financing by private manufacturing enterprises, the credit component was committed by October 1988, 17 months ahead of appraisal schedule. The credit component was 95 percent committed to 77 eligible industries. The unutilized balance of the  - iv - credit component was partly used for TA programs in line with the project's objectives. At project closing, about half a million dollars of the proceeds of the credit remained unutilized and were cancelled. 4. Despite continued political problems, the credit component was implemented satisfactorily and achieved, for the most part, its development objectives. IDP-II successfully provided needed investment financing to a large number of private manufacturing enterprises in the major areas of industrial activities and significantly contributed to employment generation. The project also succeeded in maintaining a dialogue with the GOSL on issues related to the privatization of the PMEs and on trade and industrial incentives, and paved the way for further IDA commitments in support of the industrial sector. Based on recommendations of the joint IMF/Bank mission in April 1986, and subsequent discussions with the Government, the mechanism for determining long term interest rates was agreed with the Government on April 15, 1987. Under the adopted formula, interest rates charged for sub-loans and those charged by the GOSL to the DFIs were based on Average Weighted Prime Rate (AWPR) for short-term lending operations of the commercial banks as established daily by the Central Bank of Sri Lanka (CBSL). The Legal Documents were amended accordingly and the second tranches were released by both Bank and ADB in June 1987. 5. The project correctly identified the risks related to the ethnic disturbances and their consequences on the sub-borrowers' performance and the DFIs' operations; therefore, steps were taken under the project to help the DFIs to strengthen their operations in order to carefully monitor the performance and viability of the sub-projects. The sectoral distribution of sub-loans was consistent with the major areas of activity expected to be financed at the time of appraisal. The project mainly financed enterprises in metals and chemicals (33%), food processing (30%), and textiles (12%). About 92 percent of the total sub-loans were used for expansion of existing industries. Sub-projects were largely concentrated in a few Districts in the Western Province mainly due to lack of sufficient infrastructures in other parts of the Island. There was no demand for sub-project financing in the Northern and Eastern Provinces due to continued ethnic disturbances in those two Provinces. 6. The lack of reasonably accurate follow-up data on sub-project performance has made it difficult to make an objective and in-depth assessment of the benefits of the project. However, based on some information provided by the DFIs, the performance of more than 70 percent of the sub-projects in terms of their profitability and output level was satisfactory (Annex IV). The performance of the DFIs was also satisfactory despite the continued civil disturbance in the Island. They met the minimum required cash collection ratio of 75 percent and kept their returns on assets and equity well above the covenanted ratios. 7. The TA component focused mainly on capacity building of the DFIs, improving efficiency of specific PMEs, and implementing trade and industrial policy reform programs. Funds allocated for improving the efficiency of PMEs and those for supporting industrial and trade policy reform programs were not fully utilized and the unutilized balance was allocated for capacity building  objectives beyond those identified at appraisal. These included training of the staff of DFIs and commercial banks, technology development for the Ministry of Finance, and operational review of the two state-owned commercial banks. 8. Although the TA programs for institutional development of the DFIs were implemented satisfactorily, the results of programs designed to support the policy reforms were mixed. The two DFIs fully and effectively utilized the TA funds and managed to improve their operations through intensive staff training and restructuring of their institutions. TA funds allocated for improving the efficiency of PMEs were utilized for three studies and some training programs. In order to evaluate the financial and economic viability of selected PMEs, a major sensitivity study of the PMEs was conducted by foreign consultants in 1989. The major recommendations made by the study were implemented and provided the background work for the IDA's Public Manufacturing Enterprise Adjustment Credit, approved in November 1990. During the period 1989-1994, 44 enterprises including Cements, Tyre, Leather, Mining and Mineral Development, Distilleries, Pugoda and Mattegama Mills, and Ceramic Corporations have been privatized. More enterprises are expected to be privatized during the course of 1994/1995. 9. Since 1986, IDA approved six (industrial and adjustment) operations with overlapping objectives on policy reforms. Therefore, it is not possible to evaluate precisely the impact of the IDP-II TA on the GOSL's trade and industrial policy reform programs. The IMF, too, was simultaneously active in financing and dialogue. IDP-II's Staff Appraisal Report (SAR) lacked a detailed terms of reference for the TA activities in this area. The TA funds for implementing the trade and industrial policy reforms were utilized for a few training and study tours and did not achieved its objectives. However, both the Bank and IMF have continued an active dialogue with the GOSL under other IDA projects approved since 1986. The implementation of the GOSL's medium-term Policy Framework Paper (PFP), presented in 1986, was significantly constrained by spreading civil disturbances in the South and later by the 1989 Parliamentary and Presidential elections. The macro economic environment sharply deteriorated during 1987- 1988. In 1989, the new government adopted a stabilization program which was supported by the IMF's Structural Adjustment Facility and subsequently by the IDA's Economic Restructuring Credit (approved in 1990). Since 1989, the GOSL has made considerable efforts to implement the major elements of these reform programs. The import tariff structure was substantially simplified, stamp duties on letters of credit were reduced, and export taxes were eliminated. The incentive structure consisting of duty rebates and tax holidays was maintained to promote exports. To further promote the private sector, income taxes were substantially simplified and personal and corporate income taxes were reduced. 10. The TA funds, for the most part, were not managed and utilized efficiently by some of the TA beneficiaries mainly because of their inefficient organizational capabilities and lack of regular follow-up and proper recording system. In the absence of a central unit to coordinate the TA activities under IDP-II, project reporting on TA was of poor quality. This weakness was recognized by the Third Industrial Development Project (IDP-III,  - vi - approved in July 1988) which proposed the establishment of an IDP Monitoring Unit (IMU) in the MOF to closely monitor the TA activities under both IDP-II & III. Despite IDA's efforts in strengthening the IMU through consultants, computers, and training, this Unit did not succeed in proper and effective monitoring of the TA activities. It was not adequately staffed and lacked an effective recording system. While both DFIs complied with the audit and reporting requirements, the Government did not provide IDA with timely audit of the project accounts. The 1992 and 1993 project accounts have not yet been submitted to the Association. 11. Sustainability. The key factors to the short-term success and long-term sustainability of development finance investment operations can be summarized as: (i) the performance of the sub-borrowers with respect to the financial viability and profitability of their operations, and the rate of return of their investment; (ii) the financial performance of the credit institutions and sustainability of their long-term lending; (iii) efficient use of the supporting TA funds for capacity building of the institutions involved in the project; and (iv) the Government's timely compliance with needed reform in the areas of trade and industrial policy as well as financial sector operations. 12. Because of inadequate information on ex-post sub-project rates of return, it is difficult to assess the sustainability of benefits of the sub- projects. However, based on the information provided by the DFIs on the success of the financed sub-projects in terms of profitability, output level, and satisfactory employment generation, the expected net benefit of the sub- projects is likely to be sustainable. The two DFIs are, in general, well managed and financially viable institutions. They utilized the TA funds effectively for their institution capacity building objectives. Their loan collection performance, which reflects their internal efficiency, and is an important indicator for sustainability of project finance, has been satisfactory under the IDP-II operation and for other IDA financial intermediation operations (Four SMIs and IDP-III). 13. Long-term sustainability of DFIs' lending is also dependent on the policy and regulatory environment in which these institutions operate. Sri Lanka has had eight successive industrial investment credits, with overlapping objectives, financed by IDA in a period of 14 years starting 1979. The evidence is that the financial institutions still remain dependent on the GOSL and multilateral donors for funding their long-term development lending. Insufficient access to term savings and lack of secondary markets in debt instruments have made it difficult for private entrepreneurs to obtain domestically funded term loans. Thus, funds provided through multilateral agencies have been the major source of term lending through the financial system. 14. In Sri Lanka, financial institutions with access to primary term savings are publicly controlled and invest their funds on either a short-term basis or on longer dated public securities issued at managed rates. Therefore, other credit institutions (DFIs and commercial banks), which are capable of reaching the private borrowers, are unable to mobilize long-term  - vii - domestic resources for term lending. The Private Finance Development Project (PFDP), approved by the Board in 1993, addressed these issues and attempted to help the GOSL change and strengthen the role of financial institutions that have access to term savings and strengthen the local bond market in order to mobilize domestic resources for long-term investment. GOSL's effort to implement the elements of the financial sector reform program is the key to the sustainability of the IDP-II and other financial intermediation operations. GOSL needs to improve efficiency of the financial sector and strengthen the institutional framework within which financial institutions operate. 15. Lessons Learned. There are three important lessons learned from the design and implementation experience of the IDP-II project. First, one of the key factors that affects the sustainability of an intermediation operation is the financial viability and sustainability of the credit institutions which, in turn, is affected by their internal operational efficiency as well as the policy and regulatory framework in which they operate. Satisfactory loan collection performance reflects internal operational efficiency of the DFIs and is a major indicator of program sustainability. Successful implementation of the IDP-II credit was partly because of the DFIs' satisfactory performance. However, for an intermediation operation to have its prolonged impact on the economy, the financial sectors at the macro level should be strengthened. 16. Second, effective monitoring and supervision of the project by both IDA and the Government is integral to the success of the project. The major weakness in the design of the IDP-II was the absence of a central agency to coordinate and routinely follow-up the TA activities. For an effective and timely monitoring and reporting system, the project should adequately provide resources to the Government and ensure the set up at the outset. An APEX system (set up in the Government or by private sector), commonly used in other IDA's operations, has proved to be able to address this issue. 17. Third, the design of the TA is critical to effective implementation of the project. In order to improve the design and implementation of the TA, responsibilities for implementation of TA activities and structure should be agreed and put into place at an early stage of the project; goals should be set realistically so that they can be reasonably achieved; tasks should also be set so that the recipients feel capable of implementing the program and achieving the TA's objectives; IDA should spend enough time with all the parties during the project implementation and ensure that the TA beneficiaries maintain their commitments for implementation; terms of reference of the TA and the time table for its implementation should be precise and clear; and finally the design and implementation experience of preceding IDA projects should be clearly evaluated before defining the elements of the TA for new projects. June 7. 1995  I  1 PROJECT COMPLETION REPORT SRI LANKA SECOND INDUSTRIAL DEVELOPMENT PROJECT (IDP-II) (CREDIT 1692-CE) PART I: PROJECT REVIEW FROM IDA'S PERSPECTIVE 1. Project Identity Name : Second Industrial Development Project Credit Number : Credit 1692-CE RVP Unit : South Asia Region Country : Sri Lanka Sectors : Finance and Industry 2. Background 1.01 In late 1977, the Government of Sri Lanka (GOSL) reversed its long-standing policy of control and extensive intervention and began to encourage market forces to play an increasing role in the allocation of resources. The Government introduced measures to implement a phased reform program focusing on liberalization of trade and industrial policies which included exchange rate unification and depreciation, trade liberalization, interest rate increases to encourage savings, relaxation of regulations on private domestic investment, improving the efficiency of the Public Manufacturing Enterprises (PMEs), and the establishment of a Free Trade Zone to attract export-oriented foreign private investment. 1.02 IDA's Strategy and Involvement. To assist the GOSL in its commitment to implement the 1977 liberalization of trade and industrial policies and further promote private industrial sector, IDA sent an industrial sector mission to Colombo in 1978 with the objective of identifying weaknesses in Sri Lanka's institutional and policy framework, analyzing the performance of the public industrial enterprises and assessing the potential of small and medium scale industries (SMIs). After the review, IDA initiated a series of industrial sector projects starting 1979. 1.03 The Board approved two credits for SMI development in 1979 and 1981 followed by the first credit for large scale industrial development in 1983. These credits, in addition to meeting the long-term investment financing for small, medium, and large scale industries, were used as vehicles to develop the basis for intensive discussion with GOSL to implement elements of a comprehensive phased trade and industrial policy reform program covering tariff reform, industrial and export incentives and public sector efficiency. In early 1986, with Technical Assistance (TA) funding from the first  2 industrial development project (IDP-I), GOSL prepared an Industrial Policy Statement (IPS) which gave high priority to private industrial development, with particular emphasis on the role of SMIs. IDA continued its support by approving five more industrial and financial sector intermediation operations (table 1, page 13) with the objective of making a further contribution to policy reform and providing credit through the banking system for long-term, capital investment in eligible productive enterprises. 1.04 The first IDP which became effective in January 1984, provided a total of USS 25.0 million equivalent in IDA financing to assist the GOSL in introducing a comprehensive medium-term (1983-1988) program of trade and industrial policy reform while funding medium and large scale industrial sub- projects. The credit component of US$ 23.0 million was fully committed as of July 31, 1985 and the progress on the implementation of key policy components was satisfactory. However, both the Government and IDA recognized, at the time, the need for further policy adjustment. Furthermore, with GOSL's support for the private sector investment and healthy demand by the private sector for industrial finance, the necessity for accelerated processing of Second Industrial Development project was recognized in late 1984. In January 1985, the GOSL formally requested IDA for the early processing of IDP-II particularly since full commitment of IDP-I credit component was expected by mid-1985. In response to the Government's urgent need for the second line of credit for medium and large scale industries, IDA sent its preparation and appraisal missions in April and June of 1985 and had the project approved by the Board in May of 1986. 1.05 The Industrial Sector. Although Sri Lanka has a limited industrial base, the manufacturing sector accounts for about 19 percent of the GDP and 73 percent of the value of exports of which 68 percent is attributed to the exports of textiles and garments. The structure of the sector, except for relatively recent and rapid growth in garment manufacturing, has remained generally unchanged. However, emerging industrial sub-sectors such as Jewelry, Machinery and Equipment, Ceramics, Rubber and Leather are potentially capable of a higher value added, unlike the textile and Garment sector. There are about 400 large-scale private manufacturing enterprises concentrated mostly in the Colombo District, 6,000 small and medium industries, and 95,000 small informal agro-industrial units. The private sector employs about 98 percent of the workers in the industrial sector and accounts for about 89 percent of the manufactured value added. 1.06 Policy Reforms. In 1986, GOSL presented a medium-term Policy Framework Paper (PFP) with policy objectives that included trade and industrial sector reforms. Achievement of first year objectives of the PFP was, however, significantly constrained by civil disturbances spreading to the South and later by the Parliamentary and Presidential elections in September/November 1989. As a result, the macro-economic environment deteriorated sharply during 1987-88 period. In 1989, the new Government, initiated an adjustment program with the support of the IMF and IDA in the context of the second year PFP aimed at reducing macro-economic imbalances and improving the incentive structure for the private sector through privatization, trade reforms and fiscal adjustment (para 1.25). The 1989 adjustment program was supported by an IMF's Structural Adjustment Facility  3 (SAF) and subsequently complemented by the IDA's Economic Restructuring Credit (ERC; Credit 2128-CE). Since 1989, there have been considerable efforts to implement policy reforms in the areas mentioned above. On trade policy reform, the import tariff structure was substantially simplified, stamp duties on letter of credit were reduced, and export taxes were eliminated. The incentive structure consisting of duty rebates and tax holidays were maintained to promote exports. In order to offer further incentives to the private sector, income taxes were substantially simplified and both personal and corporate income taxes were reduced. With the introduction of excise taxes, the Government reduced custom tariffs and simplified the turnover tax structure. 3. Proiect Obiectives and Description 1.07 Project Objectives. The objectives of the project were to complement and expand the focus of the IDP-I (Cr. 1401-CE) through further reform in the areas of trade policy, industrial incentives, export promotion, public enterprise efficiency and industrial finance and financial policy while simultaneously supporting project investment in high priority industrial sub- sectors. More specifically, IDP-II was designed to: * meet industrial term lending requirements to increase output, employment, efficiency and exports of viable medium and large scale private industrial firms, and a selected number of public sector manufacturing enterprises; * strengthen the operations of the country's two development finance institutions (DFIs), namely Development Finance Corporation of Ceylon (DFCC) and National Development Bank (NDB); * further support the progressive reform of tariffs; reinforce the process of utilizing effective protection analysis, and address industrial and export incentive issues to provide a better basis for fostering the expansion of manufactured exports in line with Sri Lanka's comparative advantage; and * complement the programs to improve efficiency of selected PMEs, initiated under IDP-I. 1.08 Proiect Description. The two major components of the project were: (i) a credit component of SDR 15.7 million (US$ 18.0 million equivalent) for sub-project financing in the priority areas of agro-industries, light engineering, chemicals, garments, rubber products, construction related activities, and industrial service activities; and (ii) a TA component of SDR 1.7 million (USs 2.0 million equivalent). The TA element of the project focused on: (a) expanding and strengthening the DFIs' operational capacity; (b) improving the efficiency of selected PMEs; (c) institutionalizing the tariff reform process, and (d) implementing findings of the policy studies in the areas of trade and industrial incentives.  4 1.09 The IDA funds for term lending were complemented by a parallel line of credit of US$ 20.0 million from the Asian Development Bank (ADB) on terms and conditions similar to those of IDA's. ADB provided full support for the policy conditionality of the IDA project and supplemented IDA's TA component by USS 400,000 for staff training and consulting services in DFCC and NDB. 4. Project Design and Organization 1.10 IDP-II was similar in design to the IDP-I project (para. 1.04) with emphasis on sectoral policy reforms. The project, however, took further steps to address issues in interest rate policies, and recommended that the project should be used as an instrument to induce the Government to move towards a rationalization of financial markets, specifically acceptance of the principle that the lending rate should reflect the cost of funds. The Staff Appraisal Report (SAR) noted that the constraining effects of high interest rates on economic development in Sri Lanka were compounded by the perverse relationship of relative rates with medium- and long- term rates being less than time deposit rates and considerably less than the rates for short term commercial banks' working capital loans. In April/May 1986, a joint Bank/IMF financial sector review mission, which focused on the issue, made several recommendations on the functioning of Sri Lanka's financial markets and the development of an appropriate interest rate policy. To help ensure that interest rates were appropriately adjusted during project implementation, the proceeds of the ADB and IDA projects were divided into two tranches equivalent to US$ 10.0 million each, with release of second tranche to be made following agreement between GOSL and IDA on a mechanism for determining appropriate interest rates for term lending. 1.11 The size of the IDP-II lending was geared to the term lending capacities of the DFIs, demand by the private sector for industrial finance, and the total project cost. Based on the 120 medium- and large- scale private sector sub-projects in the pipelines of the DFIs in mid-1986, total project cost was estimated at about USS 90.0 million. IDP-II contributed about 21 percent of the project cost; together with the ADB co-financing facility, met about 40 percent of the needed capital investment by the private sector. The balance was provided by the DFIs, suppliers' credits and sub-borrowers. The Government relent the project proceeds to DFCC and NDB for 18 years including a five-year grace period at an initial rate of 9 percent and 10 percent per annum, respectively, with the relending rate subject to annual review and adjustment. The higher rate to NDB was justified as its income was free of taxes until end of 1989. Effective January 1, 1990 the lending rate to NDB was reduced to 9 percent. The DFIs, in turn, onlent the proceeds at an initial rate of 14 percent per annum, with maximum repayment period of 15 years, including a three-year grace period. The initial onlending rate was to be reviewed annually and revised as necessary to ensure that this remained positive in relation to medium-term inflation projections and allow an appropriate spread to the term financing institutions. The foreign exchange risk was borne by GOSL.  5 1.12 The maximum subloan size was Rs 41.5 million (US$ 1.5 million equivalent), with a free limit of US$ 300,000 and US$ 400,000 for DFCC and NDB, respectively. The credit component financed 100 percent of foreign expenditures and 70 percent of local expenditures/civil works of the sub- projects. The cut-off level for acceptance of sub-projects was an Economic Rate of Return (ERR) of at least 15 percent. 5. Proiect Implementation and Results 1.13 IDP-II for SDR 17.4 million (USS 20.0 million equivalent) was approved on May 8, 1986, signed on July 24, 1986, became effective on October 9, 1986 and closed on June 30, 1994. The project was originally scheduled to close on December 31, 1993; however, because of unexpected delays in the completion of some TA programs, funded under this credit, the GOSL requested IDA to extend the credit closing for six months. A noticeable feature of the project implementation was that the credit component was committed well ahead of schedule while the supporting TA for the Government policy reform program lagged behind the schedule and was not fully utilized. 1.14 The credit component was 95 percent committed to 77 medium and large scale industries. Appraisal estimated that the project funds would be committed within four years of Board approval which allowed the DFIs to submit sub-projects' finance applications for IDA approval until March 1990. However, because of strong demand for term lending by the private manufacturing enterprises, the credit component was utilized by October 1988, 17 months ahead of schedule. Due to partial/full cancellation of some of the sub-loans through the life of the project, 5 percent (about US$ 1.0 million) of the credit funds remained unutilized of which about 70 percent was transferred to the TA component per GOSL's request in September 1992. The TA component (including the transferred funds) was 90 percent utilized. At the time of project closing, 2 percent (about half a million dollars) of the total funds remained unutilized and were cancelled. Actual disbursements were well ahead of the SAR estimates, with an acceleration during the initial period, 1987-1989. 1.15 Implementation and Results of Credit Component. Implementation of the Credit component proceeded as planned in the SAR and was satisfactory. Based on the work of the joint Bank/IMF mission and subsequent discussions with GOSL, the mechanism/formula for determining long-term interest rates was agreed with the Government in April 15, 1987. According to the adopted mechanism, the final onlending rates for long-term loans was linked to the Average Weighted Prime Rate (AWPR) for the short-term lending operations of the commercial banks as established daily by the Central Bank of Sri Lanka (CBSL) with GOSL onlending the proceeds of IDA credit to the two DFIs at the AWPR less spread of 5 percent for DFCC and 4 percent for NDB until December 31, 1989, and 5 percent for NDB thereafter (para 1.11). In turn the DFIs would be free to lend the funds at any rate they deem appropriate to cover their costs of borrowing and the operating costs and risks inherent in sub- loans. The DFIs could provide the option for the sub-borrower to borrow at a fixed rate for the life of the loan or at a variable rate with periodic adjustment corresponding to the changes in the AWPR. The onlending rate was  6 to be reviewed and adjusted if necessary on July 1 and January 1 of each year. The Development Credit Agreement (DCA) was amended accordingly and the second tranches were released by the Bank and ADB in June 1987. 1.16 The project provided the basis for continuing discussions with GOSL on major policy issues and paved the way for further IDA commitments in support of industrial sector operations. The SAR correctly identified that due to the possible risks that might arise from ethnic disturbances, adequate number of eligible sub-projects might not materialize and that the sub- projects already approved by the DFIs might not be able to continue operations and service their debts. Therefore, steps were taken to carefully monitor the DFI's operations and performance and viability of existing sub-projects, while the pipelines and projections of DFIs indicated credit demand well in excess of amount provided by IDA credit and ADB loan. Despite the continued political problems, the project was implemented satisfactorily with commitments and disbursements well ahead of the rate anticipated at the time of appraisal. 1.17 Sub-Proiects Financed. The IDA Credit component of the project generated significant employment by creating about 1,850 jobs with incremental fixed investment per job of about US$ 25,300. The average size of the sub- loans was about US$ 243,600 for NDB and US$ 372,500 for DFCC. The ADB loan of US$ 20.0 million was committed to 186 smaller industries, with average sub- loan size of about USS 143,300, and created about 4,500 additional jobs (Annex IX}. For DFCC, the number of large sub-projects requiring prior IDA approval was 70 percent by amount and 30 percent by number as anticipated in the SAR. It was envisaged at appraisal that in the case of NDB sub-loans, approximately 70 percent by amount and 40 percent by number would be above the NDB's free limit and, therefore, require prior IDA approval. Only 8 loans, accounting for 55 percent by amount, were actually above the free limit (Annex I}. This happened in part because of sluggish demand for investment in large sub- projects as a result of the continued ethnic disturbances in the North and East, spread of civil unrest to the South, and Parliamentary elections (see para 1.06). One of the positive features of the IDP-II lending was the relatively low incidence of problem loans. 1.18 The lack of reasonably accurate follow-up data on sub-project performance has made it difficult to carry out an objective and in-depth analysis of the benefits of the project. No systematic data are available on the ex-post ERR to allow an assessment of the actual performance of the sub- projects. In the absence of such information, IDA requested DFIs to collect data on the sales, output level, and profitability of sub-projects financed under the IDA credit component. In terms of financial performance, as reported by the DFIs, 19 out of 23 sub-projects financed by DFCC and 39 out of 54 of those financed by NDB are performing satisfactorily with profit and sales higher than expected (Annex IV). The poor performance of some of the sub-projects seems to have been affected by factors such as lack of entrepreneurial development and experience/managerial skills on the part of private investors, political instability, and changes in the world market conditions that affected the performance of export-oriented projects.  7 1.19 About 26 percent of the sub-loans were made to export-oriented industries; 92 percent of total sub-loans were used for expansion of existing industries (Annex I). The sectoral distribution of sub-loans was consistent with the major areas of activity expected to be financed at the time of appraisal. The project mainly financed enterprises in metals and chemicals (33%), food processing (30%), and textiles (12%) (Annex II). About 93 percent of sub-projects by amount and 70 percent of those by number were concentrated in a few Districts in the Western Province (Annex III). Demand for sub- project financing in other parts of the Island was low mainly due to lack of sufficient infrastructure. Due to continued ethnic disturbances in Northern and Eastern Provinces no sub-project lending has taken place in these two Provinces. 1.20 DFCC and NDB Performance in Project Implementation. Based on a review of DFCC and NDB operations vis-a-vis other financial institutions and their satisfactory lending of the IDP-I credit proceeds, these two DFIs were selected to participate in IDP-II. The overall performance of the DFIs was satisfactory despite the difficult political and social environments. Both institutions maintained the financial performance covenants during the life of the project (Annexes V and VI). The DFI's cash collection ratios were higher than the IDA's minimum required of 75 percent and their profitability was satisfactory with returns on assets and on equity well above the covenanted ratios. Their debt/equity ratios were below the covenanted ratios. 1.21 Implementation and Results of Technical Assistance. The technical assistance aimed at: (i) strengthening and expanding the DFIs' operational capacity (US$ 500,000 to each DFI)1; (ii) improving efficiency of specific PMEs (US$ 550,000); (iii) institutionalizing the tariff reform process and implementing trade and industrial policy reform (USS 250,000); and (iv) developing an integrated Industrial Strategy (US$ 200,000). The actual utilization during the project implementation, however, was different from that set out in the SAR (Annex VII). Funds allocated for improving the efficiency of the PMEs (studies and consultancies) were 70 percent utilized and those allocated for supporting industrial and trade policy reform programs (iii and iv) were only 22 percent utilized. Since the TA funds were not used according to the original allocation, in early 1991, IDA reallocated the unutilized amounts and made them available for other eligible TA activities. The DCA was amended accordingly at that time. In the last three years of the life of the project, the TA funds were mainly used for training programs for the staff of DFIs and commercial banks, technology development for the Ministry of Finance (MOF), and supporting the restructuring of the two state- owned commercial banks (such as financing their operational review and their international financial audits for 1993). The latter program was approved in the context of the IDA's support for GOSL's financial sector reform program (para. 1.26). 1.22 The IDP-II TA programs for institutional development were implemented satisfactorily and made significant contribution to improving institutional capabilities of the beneficiaries. The TA for policy reforms, 1/ Figures in parenthesis represent allocation in the Staff Appraisal Report.  8 however, were implemented with mixed results. The SAR lacked clear terms of reference for implementation of the TA in this area. As the policy reform programs were also supported under six other IDA (industrial and adjustment) projects during late 1980s and early 1990s, it is not possible to evaluate precisely the impact of the IDP-II TA on the policy reforms. The IMF was simultaneously active in financing and dialogue. As a result, the success of reform programs addressed by IDP-II and macroeconomic developments during the life of the project may not all be attributed to this project (para. 1.06 and 1.25). 1.23 DFCC and NDB fully and effectively utilized their TA allocations. The TA to these two DFIs (under this project and other IDA industrial sector projects) for their institutional upgrading proved to be very useful. Both DFCC and NDB have successfully managed to improve the efficiency of their operations through intensive staff training and restructuring of the institutions. IDP-II financed two studies to examine the DFIs operations, business activities, human resources development, and their role in the financial system. Studies were completed by foreign consultants and recommendations were implemented based on which the DFIs prepared new strategies for their business activities. TA for training of the staff of the CBSL and other commercial banks also helped these institutions to develop capabilities of their staff in the areas of financial management and sub- project appraisal and supervision. 1.24 TA funds allocated for improving PMEs efficiency was about 70 percent utilized for three studies and some training programs. In 1987, two studies were conducted on the Ceramic and Ceylon Plywood Corporations to review their financial viability and to recommend short-term measures for improving their operations. However, in 1989, before any major action took place on these corporations, IDP-II funded a major "Sensitivity Study of the PMEs" in order to evaluate the financial and economic viability of selected PMEs. The objective of the study, which covered a sample of about 17 major public enterprises, was to prepare accounts of these PMEs on a standardized basis and carry out a sensitivity analysis under various restructuring scenarios. The study also identified specific trade reforms to improve efficiency of the manufacturing sector and recommended a time-bound plan for the privatization of PMEs. The major recommendations of the study were: (i) to close about 4 public corporations; and (ii) to restructure and privatize a number of the PMEs. These recommendations provided the background work for the IDA's Public Manufacturing Enterprises Adjustment Credit (approved in November 1990) and almost all the recommendations have been implemented. 1.25 The privatization program has made significant progress in divesting a number of the PMEs since 1989. During the period 1989-1994, the Government privatized 44 public enterprises including Cement, Tyre, Leather, Mining and Mineral Development, Hardware, Distilleries, Pugoda and Mattegama Textile Mills, and Ceramics Corporations. The Sugar, Steel, Paper, and Salt Corporations are expected to be privatized during the course of 1994/1995. All the major corporations (except for Petroleum) have been converted to public companies (under Companies Act) except for few located in the North and East where there are ethnic disturbances. The TA for implementing the trade and industrial policy reforms was minimally utilized for training and study  9 tours and did not achieve its objectives. However, both the Bank and the IMF have continued to keep an active dialogue with the GOSL in this area under other IDA projects and IMF programs approved since 1986 (see para. 1.06 for implementation of some of the GOSL's reform programs since 1986). 1.26 Although the TA provided for the two state bank's operational review was not within the original objectives of the project, the program was in line with the overall objectives of the IDA Third Small and Medium Industries Project (SMI-III; Credit 1860-CE) which was approved in 1988. SMI- III initiated measures to improve the financial sector operations including TA to the two state owned commercial banks, People's Bank (PB) and Bank of Ceylon (BOC). The operational review of the banks (Annex VIII) that started in 1988 under SMI-III and IDP-II was undertaken by two international consultancy firms. These studies were continued and further funded under other IDA industrial sector operations (SMI-IV and IDP-III) and completed in 1992. 1.27 Although the use of TA funds by BOC has been relatively satisfactory, the impact of TA for PB has been low. BOC has taken appropriate actions to implement the recommendations of the studies to improve the credit policies and procedures. It, however, failed to implement the recommendations in the area of technology (disregarding the consultants' recommendations on suitable computer software) and human resources (because of possible adverse reactions from staff unions). BOC has reorganized the head office and some of the regional offices and is in the process of reorganizing the branches. BOC's Management Information System (MIS) has also been improved. As for the PB consultancy, the result was not satisfactory with respect to both the consultants performance and the project implementation by the bank. Despite IDA's continuous support, no progress has been made on the project implementation in the areas of the organization structure, human resource management, and MIS. Recommendations in the area of credit policy have been partially implemented and branch reorganization is proceeding slowly. Although SCBs implemented some of the recommendations of the studies, improved the functions of some units, and automated a limited number of their branches, they failed to implement a major restructuring which was the principal objective of the consultancies. The result was not as good as it was expected because of the slippage in the implementation of the financial sector reform program. 1.28 GOSL's Performance in the Implementation of TA. As the TA programs, under the IDA industrial policy operations, became more directed towards policy reforms in the areas of industrial and trade policy reforms and improving the performance of the PMEs, the need for a unit to coordinate processing and monitoring the TA programs was recognized by both GOSL and IDA. Therefore, the Third Industrial Development Project which was approved in July 1988 proposed the establishment of an IDP Monitoring Unit (IMU) in the National Planning Department (NPD) of the Ministry of Finance (MOF) (formerly the Ministry of Finance and Planning). The NPD was the focal point of formulation of industrial development during 1980s and actively participated in the preparation of the IPS of 1986. In 1989, because of political changes (see para 1.06), the functions of the NPD were changed and the IMU was transferred to the External Resource Department of the MOF. The Unit was also required to coordinate and monitor the IDP-II TA programs. IMU was not  10 effective in monitoring the TA programs mainly because of staff shortage and lack of the necessary follow-up and a proper recording system. Despite IDA's efforts in supporting the unit through funding the consultants, computers, training, and recommendations during supervision missions, IMU did not properly and effectively monitor the TA activities. 6. Project Sustainabilitv 1.29 The sustainability of development finance investment operations depend, to a large extent, on factors such as: (i) the success of the sub- borrowers with respect to their profitability and rate of return; (ii) financial viability and sustainability of the credit institutions; (iii) efficient use of the supporting TA funds in building and strengthening institutions involved in project implementation; and (iv) Government's compliance with project conditionality and macroeconomic management, in particular in the areas of trade and industrial policy as well as financial sector reform. 1.30 Sub-Projects' Performance. The sustainability of benefits of sub- projects is difficult to assess due to inadequate information on ex-post economic rate of return. However, based on the information provided by the two DFIs on the success of the financed sub-projects in terms of profitability, output level and their overall satisfactory employment generation, expected net benefit of the projects is likely to be sustainable. The strong demand for this type of financing by the private manufacturing industries in Sri Lanka has been supported by subsequent IDA credits (IDP-III and PFDP). The long-term sustainability of the sub-projects is partly dependent on their sound capital structure which can be achieved through encouraging a higher share of equity participation by the industries. Consequently, IDP-II required 30 percent equity participation for local expenditures and civil works. This ratio increased to 40 percent for total expenditures in the recent IDA financial intermediation operation, PFDP. 1.31 DFIs' Performance. A large amount of TA funds under all IDA industrial sector operations was allocated for the institutional development of the DFIs. These TA programs (training, consultancies, etc.) proved to be very useful and have had significant impacts on the DFIs operations. The two DFIs are, in general, financially viable and well managed institutions. Their loan collection performance, which is an important indicator for sustainability of the project financed, has been satisfactory for IDP-II operation and IDA other industrial sector projects (four SMIs and IDP-III). 1.32 Another factor that affects project finance is the external environment in which the credit institutions operate. Sri Lanka has had eight successive industrial investment credits, with overlapping objectives, financed by IDA in a period of 14 years starting 1979. The evidence is that the financial institutions remain dependent on the GOSL and multilateral donors for funding their long-term development lending. Virtually all financial institutions in Sri Lanka with access to primary term savings (such as: Employees' Trust Fund, Employees' Provident Funds, Sri Lanka Insurance Corporations, etc.) are publicly controlled and invest their funds on either a  I1 short-term basis or on longer dated public securities issued at managed rates. Insufficient access to term savings and lack of secondary markets in debt instruments have made it difficult for private entrepreneurs to obtain domestically funded term loans. Thus, funds provided through the multilateral agencies have been the major source of term lending through commercial channel. 1.33 Although the project was, in general, implemented satisfactorily, the positive impact of this project and other financial intermediation operations may not be sustainable in the long-term without improving the efficiency in the financial sector and strengthening the institutional framework within which financial institutions operate. Sri Lanka's financial institutions are relatively diverse and sophisticated and are capable of assisting private borrowers with at least short-term working capital lending. Yet, there are a number of problems -- inability to mobilize long-term domestic resources for term-lending; weakness in debt recovery legislation and banking supervision, etc. The recently approved PFDP addressed these issues. Through this project, IDA is attempting to help the GOSL in changing and strengthening the role of financial institutions that have access to term savings, and strengthening the local bond market in order to mobilize domestic resources for long-term investment. GOSL's success in implementing the elements of the financial sector reform program is the key to the long-term sustainability of the intermediation operations that have been designed to support the industrial sector projects. Unless the commercial banks and the DFIs can channel the domestically funded term savings to the private manufacturing sector, it is unlikely that they would be able to keep their current level of long-term development lending. 7. IDA's Performance 1.34 The project was designed based on an assessment of potential demand for funds for medium- and large- scale industrial investment and on the satisfactory experience of IDP-I. IDA was diligent in recognizing the need for further policy reforms in the areas of trade, industrial incentives, and financial sector issues and moved expeditiously to respond to the GOSL's urgent need for the preparation of second line of credit for industrial term lending. By focusing on interest rate policy reform and collaborating with the IMF and Government to accomplish this goal, IDA contributed effectively to the success of policy reforms. The design of the project was adequate except in providing a detailed and clear terms of reference and implementation plan for the TA component, in particular in the areas of policy reforms. Preparation of the SAR was also timely. 1.35 IDA played a significant role in DFIs institutional development over the last 14 years starting initially with the first two SMI projects and later through a series of IDPs/SMI projects. This made the implementation of the credit component smooth and successful. IDA, however, did not adequately address the need for a centralized unit/agency for monitoring, supervision and reporting of the TA component. Given the continual delays in GOSL's compliance with the audit requirement for the project accounts, IDA should  12 have taken some actions to remedy the problem at the early stages of the project. 1.36 IDA sent twelve supervision missions beginning with project effectiveness (October 1986), with the last mission in April 1994 prior to project closing (June 1994). Most of the supervision missions were combined with those of IDA's other industrial projects. The ambitious objectives and broad scope of the TA programs under these projects, various policy related issues, large number of beneficiaries, and lack of clear and detailed terms of reference and implementation time table of the TA programs had made supervision of the TA more difficult and less effective. IDA needs to strengthen the emphasis of its supervision effort for the TA activities and improve upon the design of the TA programs. Clear and specific objectives of the TA programs, their link to the project objective, right allocation of funds, and potential benefit of the TA are the key factors to the effectiveness of TA programs and should be identified at early stages of the project. Goals under TAs should be set up so that they can reasonably be achieved. Similarly, tasks under TAs should be set up at a level of difficulty that the recipient feels capable and confident of meeting. With this in mind, IDA should ensure that all parties appreciate the time that may be required to achieve the objectives, and take steps to maintain the TA recipients' commitment to implement the elements of the TA programs on a par with the utilization of the credit component. 8. Borrower's Performance 1.37 Project reporting for the credit component was, overall, satisfactory; that for the TA component was sporadic and of poor quality mainly as a result of the weaknesses of the Project Monitoring Unit in the Ministry of Finance. Despite continuous efforts by IDA supervision missions to strengthen the reporting system of the MOF, the Unit still remains ineffective. Another factor that affected the poor implementation of the TA programs in the policy reform areas was that the commitment made by the relevant ministries to effectively utilize the TA funds for the implementation of the elements of these programs did not fully materialize during the project implementation. GOSL's performance on providing timely Audits of the Project Accounts was unsatisfactory. The 1992 and 1993 project accounts have not yet been submitted to the Association. 1.38 The DFIs were timely on submission of their financial accounts and managed to maintain the eligibility criteria under the project and effectively channeled the credit proceeds to viable and eligible private manufacturing enterprises. They utilized the TA funds effectively and improved their financial and administrative operations. 9. Project Relationships 1.39 The overall relationship between IDA and the DFIs in the implementation of the project was good. Regular reporting of the status of the credit component by the DFIs and their close working relationship with  13 IDA, during the supervision missions, were instrumental to satisfactory implementation of the credit component. The collaboration between the ministries/institutions received TA and IDA, however, was not as strong. IDA supervision missions should have spent more time with the TA beneficiaries with regard to their utilization of TA funds and should have identified weaknesses in this area from the beginning of project implementation. 10. Proiect Documentation and Data 1.40 In general, the DCA and SAR were adequate and used by the DFIs for guidance in project implementation. However, reported data on IDP-II project has, in general, been inadequate both for the credit and TA components. For the preparation of the PCR, some data related to the credit component was available from the DFIs. Data for the TA, however, was collected with considerable difficulty. During the last three supervision missions, IDA worked closely with the IMU staff to reconcile information on disbursements and commitments. The IMU, in turn, tried to coordinate with the relevant ministries to obtain additional information on the implementation of the TA programs. Upon the request from IDA, a short-term local consultant was hired by the IMU to prepare the actual utilization of the TA component and computerize the information. 11. Consulting Services 1.41 The quality of the work and the benefits stemming from the consultancies for the TA programs varied. The DFIs fully benefited from the services of foreign consultants for their operational review and implemented most of the recommendations derived from the studies. The consultancies for the restructuring of the BOC and PB were completed as scheduled. Although the quality of work performed by the consultants selected by BOC was, in general, adequate and satisfactory, the consultants for PB did not perform to the satisfaction of the bank. Lack of continuity in their teams, recommending practices of the USA without any consideration to local needs and culture, and overlapping the terms of reference for different stages of the studies were the main factors for their poor performance. 12. Conclusions and Lessons Learned 1.42 Overall, the project was implemented satisfactorily and achieved, for the most part, its main objectives. IDP-II was committed quickly because of the initial strong demand for financing from the private industrial sector and disbursements were ahead of the SAR schedule. The employment impact of thie sub-projects was significant. About two-thirds of the sub-projects performed satisfactorily with profit and sales higher than expected. Both DFIs were successful in managing the IDP-II loan portfolio with a high loan recovery rate. The TA for institutional development of the DFIs and other financial institutions had significant impact on improving the capabilities of their staff in sub-project appraisal and supervision.  14 1.43 Due to slow utilization of TA funds in the areas of trade and industrial policy reforms, the TA funds were made available for some activities of the financial sector reform programs. 1.44 The implementation experience of the IDP-II provides a number of important lessons, pertaining to the design, implementation, supervision of both the credit and TA components. (i) Sustainability of project finance is, in general, affected by the internal operational efficiency of the credit institutions as well as by the policy and regulatory environment in which they operate. Satisfactory loan collection performance reflects internal operational efficiency of the DFIs (e.g. effective appraisal and supervision) and is, inter alia, an important indicator of program sustainability. Successful implementation of the credit component of the IDP-II project was partly due to the efficient internal operations of the DFIs. However, a prerequisite for the sustainability of long-term finance is the need for an efficient financial sector within which financial institutions are to operate. For a satisfactory implementation of the financial intermediation operations, which are the vehicles for channeling term resources to the private industrial sector, financial policies at should be strengthened. (ii) Effective monitoring and supervision of the project by both IDA and the borrower including a proper reporting system in the Government is integral to the success of the project. The GOSL was not successful in monitoring the utilization of the TA funds and follow-up activities of the TA programs. A major weakness in the design of the IDP-II was the absence of a clear responsibility for coordinating and supervising the implementation of the TA. The quality of supervision and administration could be improved by either developing a strong and up-to-date monitoring and reporting system. The APEX system (Government agencies or Private sector), commonly used in other IDA's operations, could, if properly designed, help minimize such weaknesses. (iii) TA design is critical to effective implementation of the project and to achieving the level of success that is needed to promote the assisted entity's self-reliance and should have the following characteristics. Responsibilities for monitoring and reporting on TA activities and structure should be agreed and put into place at an early stage of the project; Goals should be set realistically so that they can be reasonably achieved; * Tasks under TA for policy reform programs and institutional development should be set so that the recipients feel capable of implementing the program and achieving the TA's objectives;  15 * IDA should spend enough time with all the parties to ensure that the TA recipients maintain their commitments throughout the life of the project; * SAR should precisely define the terms of reference of the TA programs and set a realistic time table for their implementation, taking into account the capabilities of the TA recipients as well as prevailing political constraints; * To ensure effectiveness of the TA programs, both IDA and Government should identify specific objectives of TA program, their link to the project objective, right allocation of funds, and potential benefits of the TA at early stages of the project and monitor these criteria during the implementation phase; and * IDA should effectively supervise and evaluate the TA programs of preceding projects and learn from the implementation experience of the past projects before defining the elements of the TA for a new project. June 7. 1995  16 PART II: PROJECT REVIEW FROM BORROWER'S PERSPECTIVE 2.01 The Government agrees with the Bank's comments that the credit component of the project was implemented satisfactorily well ahead of appraisal estimates. High demand for investment financing by manufacturing enterprises and successful implementation of credit component by the two DFIs mainly contributed to the satisfactory implementation of credit component. 2.02 Implementation of the technical assistance component other than the TA programs for institutional development of DFIs suffered due to non- availability of a proper coordination mechanism for TA. This was later identified both by the Bank and the Government and the Industrial Project Monitoring Unit (IMU) was established at the National Planning Department (NPD) of the then Ministry of Finance and Planning. However, IMU was not able to function effectively due to staff shortages and change of location from time to time. The IMU was transferred to the External Resources Department (ERD) in April 1989 but relocated again in the NPD in 1991. It was transferred back to ERD in 1993. 2.03 The Government has however been able to derive benefits from the TA activities funded under the project. Particularly important to mention is the PME Sensitivity Study which provided background work for the privatization of PMEs under IDA Public Manufacturing Enterprises Adjustment Credit. Apart from that TA funds made available as a result of transferring of unutilized credit funds to the TA component have been utilized for useful purposes. 2.04 As pointed out by the Bank it is not possible to evaluate impact of the TA component of IDP-II on the Government Trade and Industrial policy reform program because there were other projects financed by IDA and ADB with overlapping objectives and policy reforms in operation during the same period. The Government efforts in the reform trade and industrial policy continued throughout the period and led to the establishment of simplified import tariff and income tax structures among other reforms in import taxes, incentive schemes to promote exports and foreign investment and formulation of a new industrial strategy. 2.05 The project reporting, particularly on the technical assistance component was weak at the early stage of the project due to non-availability of staff at the IMU. This position was corrected at the latter part of the project and all transactions under the TA component were reconciled by end of 1993. 2.06 The Government agrees with the Bank's comments that due to insufficient access to primary term savings the DFIs continue to depend on funds provided through multilateral agencies to sustain the momentum of their lending operations. The Government has already initiated steps to address the issues and evolve a satisfactory, sustainable long-term solution.  17 PROJECT COMPLETION REPORT SRI LANKA SECOND INDUSTRIAL DEVELOPMENT PROJECT (CREDIT 1692 PART III: STATISTICAL INFORMATION 1. Related Bank Loans Credit Title/Amount Purpose Year of Status Approval Small and Medium Industries, Promote private industrial deveLopment focusing on 1979 Closed on $ 16 m (SMI I) SMI's assistance through addressing constraints 6/30/85 Credit 942-CE hindering their rapid growth in order to increase their contribution to employment generation, export expansion, and economic growth. Second Small and Medium To support and expand on the SMI I objectives. 1981 Closed on Industries Proj., S 28 m (SMI II) 12/31/87 Credit 1182-CE Industrial Development Project Provide term credit through DFIs to assist in 1983 Closed on (IDP-I), S 25 m strengthening the system of industrial financing, 9/30/88 Credit 1401-CE assist in trade and industrial reforms, and provide technical assistance to improve selected PMEs. Third Small and Medium Complement and expand previous industrial sector 1988 Closed on Industries Project operations by: (i) providing credit to the SMI 6/30/93 S 20 m private manufacturing enterprises; and (ii) make a (SMI-III) Credit 1860-CE further contribution to policy reform and institutional strengthening in the areas of tariff administration, export promotion and financial sector operations. Third Industrial Development Complement previous and on-going industrial sector 1989 On-going Project operations to provide credit through banking system Closing S 43.8 to medium- and large-scale private industrial 6/30/95 (IDP-III) Credit 1948-CE enterprises, support implementation of GOSL's policy reforms and institutional strengthening. Fourth Smalt and Medium Complement previous and on-going industrial and 1991 On-going Industries Project financial sector intermediation; to provide credit Closing S 45 m for SMI development and to make further 10/31/96 (SMI-IV) Credit 2250-CE contributions to policy reform and institutional strengthening in the area of trade policy administration and financial sector operations. Private Finance Development Provide investment finance to the private sector; 1993 On-going Project; USS 60 m assist in domestic resource mobilization for long- Closing (PFDP) Credit 2484-CE term investment by stimulating the development of 6/30/99 local bond market; further assist the GOSL in improving the financial sector operations through strengthening the financial intermediation including the key players such as contractual savings institutions.  18 2. Project Time Table Item Date Planned Actual Date Identification/EPS 3/1985 3/1985 Appraisal Mission 7/1985 7/1985 Credit Negotiations 4/1986 4/1986 Board Approval 5/1986 5/1986 Credit Signature 7/1986 7/1986 Credit Effectiveness 10/1986 10/1986 Credit Closing 12/1993 6/1994 Credit Account Closing 4/1994 10/1994 3. Credit Disbursement Cumulative Estimated and Actual Disbursements (US$ Millions' FY87 FY88 FY89 FY90 FY91 FY92 FY93 FY94 Appraisal Estimate 3.0 6.0 10.0 15.0 17.0 18.5 19.5 20.0 Actual 1/ 6.3 13.2 16.7 19.3 19.7 21.3 21.6 22.3 Actual as % of 210.0 220.0 167.0 128.6 115.8 115.1 110.7 111.5 estimate 1/ The actual amount in US$ is higher than the original US$ amount equivalent of SDR 17.4 million due to exchange rate differences between SDR and US$ during the life of the project. 4. Project ImDlementation Indicator Appraisal Estimate Actual Number of sub-projects financed -- 77 Average Size of sub-loans -- USS 282,074  19 5. Project Costs and Financing A. Project Costs, IDA Component USS Millions Item SAR Estimate Actual Utilization a. Term loan for Sub-Projects 18.0 17.1 b. Technical Assistance 2.0 2.6 Component Total 20.0 19.7 B. Project Financing (US$. million) Source Planned SAR Approximate Actual Util.l/ IDA 20.0 28.0 1/ ADB 20.0 26.7 2/ DFIs 20.5 Government 2.0 NA Sub-borrowers 20.5 14.8 Suppliers Credits 12.0 3.4 3/ Total 94.0 72.9 4/ 1/ Approximation is due to using the conversion factor to calculate the actual commitments made in Rupees (during the life of project) in terms of US$. 2/ IDA + DFIs; 3/ ADB + DFIs; 4/ For IDA component only; 5/ Actual Utilization was likely to be higher. 6. Project Results Indicator Appraisal Estimate Actual a. Employment Generated 2,500 1,875 b. Incremental Cost/Job -- US$ 25,372 c. Economic/Financial NA NA Rates of Return 7. Status of Covenants The GOSL and executing agencies were generally in compliance with covenants except for the audits of the project accounts which were continuously delayed. The 1992 and 1993 audits of the projects accounts are still overdue. DFIs were in general in compliance with all the covenants.  20 8. UBe of Bank Resources A. Staff Inputs (Staff Week) FY85 FY86 FY87 FY88 FY89 FY90 FY91 FY92 FY93 FY94 Preparation 17.9 11.7 Appraisal 10.3 21.9 Negotiation 1.0 Supervision 14.6 8.5 12.8 8.0 5.9 8.9 8.3 7.8 Other 8.0 Total 1/ 29.2 34.6 14.6 8.5 12.8 8.0 5.9 8.9 8.3 15.8 1/ The total staff weeks were 146.6 B. Missions Stage of Month/ Date Rating Project Year of Cycle Return Preparation Appraisal Supervision I 11/1986 11/21/1986 1 Supervision II 10/1987 10/08/1987 2 Supervision III 12/1987 12/11/1987 2 Supervision IV 7/1988 7/28/1988 2 Supervision V 11/1988 11/20/1988 2 Supervision VI 5/1989 5/11/1989 2 Supervision VII 12/1989 12/22/1989 2 Supervision VIII 12/1990 12/15/1990 2 Supervision IX 9/1991 9/05/1991 2 Supervision X 7/1992 7/10/1992 2 Supervision XI 6/1993 6/18/1993 2 Supervision XII 4/1994 4/24/1994 2  PROJECT COMPLETION REPORT SECOND INDUSTRIAL DEVELOPMENT PROJECT SUB-LOAN FINANCING - UNDER IDA CREDIT NDB DFCC Total NDB + DFCC Amounl/No. % of Total Sub-projects costs (Rs. Million) 881 513 1,394 100% O which: IDA 385 251 636 46% Client 283 151 434 31% DFI 190 24 214 150/o Other 23 87 110 8 0D/ % ol Sub-Projects Above Free Limit Amount (Net of Cancellations) 55% 75% Number 15% 30% Number of Sub-Projects 54 23 77 Of Which: Export-Oriented Sub-Projects 1 2 B 20 26% Expansion Sub-Projects 53 18 71 92% Number of Jobs Created 1,380 495 1,875 Average Cost / Jobs (Rs.) 638,651 1,035,374 743,386 Average Cost / Jobs (US Dollar) 11 21,797 35.337 25,372 Average Size of Sub-Loans (US Dollars) 11 21 243,577 372,459 282,074 1/ Conversion factor is the average exchange rates for 1986-1988. 21 IDA Credit Component divided by the number of sub-projects.  PROJECT COMPLETION REPORT SECOND INDUSTRIAL DEVELOPMENT PROJECT SECTORAL DISTRIBUTION OF SUB-PROJECTS NDB DFCC TOTAL No. ol Amount Approved Amouni No. ol Amount Approved Amount No. of Amount Approved Amount Sub-Proj. (Rs. Million)