China - State Farms Commercialization Project (formerly known as Commercialization of State Farms Project)

Report No. PIC608 Project Name China-State Farms Commercialization Project Region East Asia and Pacific Sector Agriculture Project ID CNPA3591 Implementing Agency Project Office of State Farms Department Ministry of Agriculture (MOA) 11 Nan Zhanguan Nanli Beijing, China Telephone: 86-1-5003366, Ext. 2652 Fax: 86-1-500-2448 Contact: Mr. Lu Bai Rong Date Prepared May 1996 Appraisal Date May 1996 Projected Board Date November 1996 1. Country/Sector Background. The State Farms System (SFS) comprises a State Farms Bureau (SFB) in the Ministry of Agriculture (MOA), 29 provincial level bureaus (only five of which fall directly under the jurisdiction of the central Bureau), some 2,200 state farms encompassing diverse agriculture, industry, transportation, construction and trade activities, and about 1,400 enterprises operating as separate legal entities. Spread out over 38.3 million ha, the SFS occupies 4% of China's total land area and about 49 of the arable land, with a total population of about 12 million. The first farms were established in the late 1940s and early 1950s, primarily as resettlement centers to provide employment for demobilized military personnel after China's own civil war. Their effectiveness in reclaiming and developing marginal lands, and delivering security and social services to remote areas of the country led to their widespread adoption in the 1950's, and eventually farms were set up in all provinces. Under the centrally planned economy they served as reliable suppliers of such strategic commodities as rubber, grain, cotton, sugar and wool for government procurement and of milk, fish and meat for regional urban centers. 2. Starting in 1978, with the introduction of rural economic reforms which lessened their importance in supplying essential agricultural products, the central government encouraged state farms to integrate agricultural, industrial and trade activities and readjust their production mix to achieve better economic results. By 1993, agricultural sales accounted for less than 20% of total sales for the entire system. As a result, the State Farms occupy an important position across the spectrum of the rural economy, and reform demonstrations in their activities would serve as replicable models for achieving greater efficiency, across a number of sectors. 3. China has established that enterprise reform is high on its list of priorities as evidenced by the "Decisions on Issues Concerning the Establishment of a Socialist Market Economic Structure" issued in November 1993 by the 3rd Plenary Session of the 14th Party Congress.  This document outlined a 50-point agenda for economic reform to be attained by the end of the century across an unprecedented array of interrelated fronts, including (1) creating a "modern enterprise system" of corporate ownership and management, based on the principle of corporatization and providing for full separation of the state's exercise of ownership rights from the enterprise's exercise of legal person property rights, and (2) encouraging the development of mixed ownership forms of enterprises, including the "privately-owned, individually-owned and foreign-invested" sectors. In practice this has meant a reduction in privileged access to resources and markets, elimination of direct subsidies, and diversified business relationships to provide for the capital, services and markets once assured by the State. Since then a number of significant reforms have been announced, including the promulgation of a Company Law (effective in July 1994) which provides rules for the incorporation of all ownership mixes of enterprises into limited liability and limited liability shareholding companies; specifies governance structures (e.g. size and composition of boards of directors and boards of supervisors), provides rules regarding transfer and sales of shares; and outlines procedures for mergers and bankruptcy. 4. In this background of enterprise reform, the SFB has embarked on a new round of reforms which will: further increase the autonomy of farms and enterprises; diversify ownership to include individuals, collectives, and cooperatives; promote joint ventures with foreign partners; restructure the provincial and municipal bureaus to facilitate their transition from arms of government to commercial entities; and diversify their roles in agriculture, industry and trade. With the integration of its agricultural production capability with sideline production from household farms and renovation and rationalization of its processing facilities, the SFS has the potential to become a major force for competitive commercialization of agroindustry in the emerging socialist market economy. 5. Country Assistance Strategy. The Bank Group's objectives and assistance strategy (as presented to the Board on June 1, 1995, with an update on March 26, 1996) are to help China meet its two major challenges: (1) achieve macroeconomic stability while maintaining rapid (and more efficient) growth and (2) insure that this growth is sustained by shifting resources toward priority areas, including poverty reduction, human resource development, infrastructure and environmental protection. The ultimate objective is to assist the Government in developing the institutions and instruments necessary for sustaining rapid growth and broad-based development using a mix of economic and sector work, technical assistance, lending, investment and guarantee operations, in which the IFC and MIGA will play significant roles. To help the Government meet its first challenge, the Bank Group will assist efforts to restructure the enterprise incentive framework, implement market-oriented reforms, and increase reliance on indirect instruments for macroeconomic management. The principles underlying the Bank Group's support to SOE reform are (i) creation of autonomous corporate enterprises with clear lines of governance, a fully transparent set of modern financial accounts, and clearly defined management prerogatives and responsibilities; (ii) separation of the provision of social services (including housing, social security, education and health from -2 -  enterprises; (iii) subjecting enterprises to market discipline by eliminating subsidies and promoting competition; and (iv) promoting greater flexibility in ownership to facilitate enterprise restructuring through acquisition of new technologies, management expertise and financing sources. Closely linked will be reforms in the financial sector to encourage more efficient financial intermediation, better resource allocation, and higher returns to savers. Reforms in these two sectors lie at the core of the Government's reform agenda and are designed not only to increase the efficiency with which investment resources are used in the economy, but also to facilitate the management of aggregate demand. The proposed project is consistent with the CAS in that it addresses both enterprise and financial system reform elements as they relate to the rural economy in accordance with the principles outlined above. 6. Project Objectives. Under the umbrella of promoting the continuation of commercialization of the rural sector, the basic objectives of the project wold be to i) support, accelerate and catalyze enterprise reform with the State Farm System with a line of credit to be extended through an independent project financial intermediary (PFI) to state farms and their enterprises for technological modernization of existing production facilities or establishment of new commercial ventures, and (ii) to increase the capacity of the PFI to conduct long- term lending activities. It would help the State Farm system to fulfill its role in initiating and demonstrating economic development in rural areas and spreading these benefits to surrounding areas, supplemental to (and competitive with) both other large integrated processing, marketing and commercial networks (e.g. the Grain Bureau system), thousands of county-owned enterprises and tens of thousands of township and village enterprises (TVEs). In addition, it would strengthen yet another financial intermediary and help to build up a set of national institutions able to compete in the arena of rural lending. Performance monitoring indicators for the Project would be focussed at the level of subprojects (Bank loan funds disbursed, number of subloan proposals approved, number of subprojects under implementation, number of subprojects in operation, number of subprojects operating profitably, number of enterprises shifting social burden to government administrative entity) and the PFI (appointment of additional staff, person-months of technical assistance completed and tasks completed, interest and fee income, collection performance on non-entrusted portfolio, improvement in financial strength as measured by risk- weighted capital adequacy and reduction of non-profitable activities). 7. Project Description. The proposed project would consist primarily of a line of credit to the China Trust and Investment Corporation For Economic Development (CTICED), for subloans to eligible borrowers in the State Farm System (SFS), to fund investment activities that are consistent with the efficient use of resources in the emerging market environment of the beneficiaries. Financing would be predominantly used by small and medium scale light industries, of a scale sufficient to support appropriate environmental pollution control technology, and linked to defined steps in the continuum of enterprise reform in China--enterprise autonomy, ownership diversification, and removal of social services from enterprises. Through its support of a Project Management Unit within SFS, and technical assistance to CTICED, -3 -  the Project would also enhance the capacity of support agencies to ensure adequate direction on environmental, procurement and financial aspects of subproject implementation. The enterprises to be assisted by the project have common characteristics and constraints on which project management and objectives are based. However, they are at various stages in the progression of enterprise reform and they are engaged in a wide range of commodities and activities. The project needs to accommodate this diversity if it is to be effective. Investments under the project are likely to cover, inter alia, the following major production activities: dairy development, food processing, industrial products, pharmaceuticals and traditional Chinese medicine, textiles, and wood processing. 8. The State Farms Bureau invited provincial and municipal bureaus and their farms to submit proposals for subprojects representing their best commercial opportunities--whether it was expansion of an already successful enterprise or a new endeavor which had been studied for its market potential, its financial result and its affordability. In order to be eligible, an enterprise or its sponsor, in the case of new endeavors, would have to be a legal entity registered with the local Commerce Bureau, have separate accounts and financial statements in the format prescribed by MOF for SOEs, show satisfactory financial performance for the past three years, not be in receipt of any direct subsidies, be current on credit obligations, and demonstrate commitment to the enterprise reform process with a stated program outlining specific steps and the time frame within which they would be accomplished. New enterprises (i.e. established after September 1995) would have no obligations for schools, clinics, housing or government- imposed burden and employees would be covered by established pension programs. Existing enterprises would have already made provision for joining an established pension program and have action plans for unloading housing and other social obligations and government burdens. Activities to receiving funding under the project would be presented as part of a business plan demonstrating a good understanding of the commercial, technical, financial and organizational aspect of the subprojects. Subproject fixed asset investment would be limited to three times the pre-project fixed assets of the sponsoring enterprise; post investment debt/equity ratio would not exceed 4:1; enterprises (or sponsors, in the case of new enterprises) would contribute at least 30t of the project cost as equity and have assurances of the availability of remaining funding requirements and adequate working capital. 9. After screening by the Bank during the preparation phase, about 50 subprojects were selected for site visits during the preappraisal mission with Bank staff, a team of international technical and financial consultants, and CTICED loan officers; the subprojects were evaluated for their technical and financial viability, state of preparation, and degree to which they met eligibility criteria. On the basis of the findings at that time, CTICED selected an initial tranche of ten subprojects and began detailed analysis and appraisal, which is still underway. CTICED has submitted the first drafts of seven subproject appraisal reports for Bank review, and comments to strengthen the appraisal process have been provided to CTICED and will be discussed further during appraisal. CTICED is committed to consider the remaining subprojects in the pipeline, but it is not obligated to select these -4 -  subprojects for financing under the project. Some subprojects may strengthen or adjust their proposals, advance their preparation work or meet the eligibility criteria and eventually materialize into subloans, and others will drop out or be rejected by CTICED. Sponsors of additional subprojects may submit their proposals directly to CTICED or through the State Farm Bureau. 10. Project Financing. The project is expected to cost about $400 million. The Bank is considering a loan of $200 million for this operation, and the balance would be funded by the Government. 11. Project Implementation. The main elements of project management will be a Project Management Office (PMO) within SFB and the World Bank On-Lending Department within CTICED. A Project Coordinating Committee, consisting of representatives of SFB, CTICED, the State Asset Management Commission, and the Director, Office of External Economic Relations, MOA will have strategic oversight responsibility for the project. In addition, an SFB/CTICED Task Force, comprising representatives of the PMO and CTICED's World Bank On-Lending Department has been established to facilitate cooperation on subproject selection and processing. As the PFI, CTICED would be responsible for making subloan decisions under the project, and then to oversee procurement, disbursement and collection, and supervise sub-borrowers' performance. The project would be implemented by farms and enterprises, under the guidance and general supervision of the provincial (or municipal) State Farm Bureaus or Agribusiness Corporations. 12. Lessons from Previous Operations. A recent study of the Bank's Operations Evaluation Department (Industrial Restructuring Study, draft, March 17, 1995, OED, Country Policy, Industry and Finance Division) summarizes experiences with industrial restructuring that are relevant to the present project. In a study of 44 completed projects, it was concluded that examples of China and Hungary suggest that effective and sustainable public sector restructuring requires that public enterprises be exposed to hard budget constraints and competition. In China and Hungary, enterprises to be remodeled and developed were distinguished from those that had to be phased out, and particularly in China, support institutions were established. With its continuous formal and informal Economic and Sector Work, the Bank helped China clarify the conditions needed for successful restructuring, including price increases, ownership changes and social impact mitigation. Of the 18 factors identified in the report as determinants of successful project outcome, seven were found to be statistically significant: macroeconomic stability, market liberalization, labor policies, ownership and management, Borrower performance, and Bank performance. In the case of China, the report identified good management, relative independence from government interference, and exposure to competition (especially export competition) as the major factors for successful outcome. For China, OED's report specifically recognized the importance of formal and informal ESW that helped China clarify the conditions necessary for successful restructuring, including price increases, ownership changes, and social impact mitigation. Of importance to China also is the report's finding that separating the production and social service functions of public firms is essential, but presents a major challenge. In addition, and not China-specific, governments need to institute hard - 5 -  budget constraints, new oversight committees, managerial autonomy, and performance and regulatory agreements. The report concluded that a complementarity of Bank services is key to industrial restructuring: lending and non-lending services, economic analysis, policy advice, and provision of specialized support services--projects alone are not sufficient. It also concluded that in terms of individual lending instruments, more stringent conditions need to be applied to financial intermediation loans (including return on equity, capital adequacy ratio, debt service capacity, degree of portfolio rescheduling, and collection rate). The findings of the OED report have been taken into account in the design of the proposed project, both in relation to the performance expected of the PFI and the selection criteria for participating enterprises. 13. Environmental Aspects. The types of enterprises now being considered are generally of small to medium scale with pollution control requirements which can generally be met through application of widely available and relatively simple control technologies. Consequently, the Bank has designated an environmental impact B-rating to the project. Initial environmental documentation would consist of an Environmental Review, which would define the administrative processes by which environmental clearances are to be secured during the subloan appraisal process and outline the supervision procedures to be implemented by SFB, with the support of technical consultants, to check that the procedures are being followed and that the necessary pollution control facilities have been installed and are operating satisfactorily. The Environmental Review would be reviewed during appraisal, and assurances would be obtained that SFB would appoint consultants under terms of reference agreed with the Bank who would carry out the supervision process and provide their reports to the Bank. In addition, a recent directive of the PBC called for lending institutions to incorporate natural resource conservation and pollution control into their criteria for loan approval and to link compliance with national guidelines with disbursement of funds. An assurance would be obtained that CTICED would require the local EPB's approval of the subproject's environmental assessment as part of its loan approval process. 14. Resettlement. Of the 50 subproject proposals reviewed during preappraisal, none would involve land acquisition which would impact on the sideline or main incomes of people using this land, and no one would lose housing. Most subprojects are expected to utilize vacant land within the confines of the sponsoring state farm or, in a few cases, within existing industrial zones developed by city or county governments. If displacement occurs or land acquisition impacts on the incomes of people, it would be necessary to provide a resettlement plan. Assurances would be obtained that in such cases, a resettlement plan meeting principles and procedures satisfactory to the Bank would be required as a condition of subloan approval by CTICED, and where more than 200 persons are affected, the Bank's prior approval of such plans would be required. The principles and procedures would be agreed during appraisal. 15. Program Objective Categories. The project represents the opportunity to expand enterprise reform concepts through the major remaining state-owned sector of agriculture and industry in China and - 6 -  promotes the concepts of corporatization and commercialization in fields with great impact on the entire rural sector. 16. Project Benefits. The project would promote the development of enterprises through improved efficiency and market competitiveness by emphasizing corporate planning, business management and marketing, upgrading technology, and expanding and diversifying production. It would serve to reinforce reform measures in the financial sector, particularly with respect to financial condition, accounting and control with FIs, and lending criteria for capital allocation. It would enhance the efficiency of a relatively new PFI and contribute to greater competition in the rural banking sector. In consideration of the delegation of appraisal and investment decisions to CTICED, the Bank has not carried out FRR and ERR analysis of the entire project. It would, however, as part of appraisal, carry out reviews of a typical range of subprojects which can be expected to be financed under the project. The review would focus on both historical performance of the sponsor or existing enterprise to confirm credit worthiness and projected operations of the subproject to confirm financial/economic viability. Financial projections would be made for each subproject for a 10-year period; these would include income statements, cash flow statements, financing plans, debt service analysis and from these, financial and economic rates or return. CTICED would be expected to carry out this type of analysis for each subproject as part of its appraisal process. Contact Point: Public Information Center The World Bank 1818 H Street N.W. Washington D.C. 20433 Telephone No.: (202)458-5454 Fax No.: (202)522-1500 Note: This is information on an evolving project. Certain components may not necessarily be included in the final project. - 7 -