Philippines - Second Industrial Investment Credit Project

Report No. 872a-PH Philippines FILE COPY Appraisal of a Second Loan FLCP to the Republic of the Philippines for Industrial Financing through the Development Bank of the Philippines November 5, 1975 Agricultural Credit and Development Finance Companies Division East Asia and Pacific Projects Department Not for Public Use Document of the World Bank 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 EQUXVALENTS US$1 -a79.5 P1 0USt.1333 P1 million - St3133O000 P1 billion T-S$133 million ABBREVIAX.!IsONTS ADB - Asian Development Bank BOI - Board of 1nvestments CB - Central Banik COI - Commission on Audit DBP - Development Bank of the Philippines DOI - Department of Industry GSIS - Government Services Insurance System IFC - International Finance Corporation IMF - International Monetary Fund IPD - Industrial Projects Department NEDA - National Economic Development Authority PDB - Private Development Bank PDCP - Private Development Corporation of the Philippines RFC - Rehabilitation Finance Corporation (DBP's predecessor) SEC - Securities and Exchange Commission SSS - Social Security System FISCAL YEAR July 1 JSale 30  PHILIPPINES APPRAISAL OF A SECOND LOAN FOR INDUSTRIAL FINANCING THROUGH THE DEVELOPMENT BANK OF THE PHILIPPINES TABLE OF CONTENTS Page No. SUMMARY AND RECOMMENDATIONS ............. ............. i - v I. INTRODUCTION .......................................... 1 II. THE PHILIPPINE ECONOMY ................................ 1 III. THE INDUSTRIAL AND FINANCIAL SECTORS ................. 2 A. The Industrial Sector . . 2 The Role of Industry in the Economy.. 2 Industrialization Stragegy . . 3 Policies and Incentives. 3 Industrial Investment . . 4 B. The Financial Sector . . 4 Overview. . 4 Financial Sector Development . . 5 Policy Measures . . 5 Interest Rates . . 6 IV. DBP - ROLE IN THE ECONOMY ............................ 7 Overall Operations ......................... 7 Economic Impact ............................ 7 Promotional Role ........................... 8 Other Activities ........................... 8 V. DBP - INSTITUTIONAL CHARACTERISTICS .................. 9 Charter and Ownership ...... ................ 9 Board of Governors ...... ................... 9 Organization ......... ...................... 9 The Industrial Group ...... ................. 9 Management .......... ....................... 9 Staffing ...... 10 Industrial Project Appraisal ..... .......... 10 This report was prepared following a field appraisal of DBP by Messrs. P. Mistry, A. Gros, J.B. Shim and R.C. Thorell (Consultant) in May 1975.  -2- Page No. Industrial Project Follow-up ............. .. 11 Operating Policies ....... .................. 11 Procurement and Disbursement ............... 12 Lending Operations ............... 12 Guarantee Operations ...................... 13 Investment Operations ...................... 13 Financial Position ......................... 13 Financial Performance ...................... 15 Portfolio Quality .......................... 16 Capital Structure ............... 18 Foreign Exchange Risk ......... .......18 Reserves Policy . ............. .. 19 Audit ...................................... 19 Internal Reporting ... .......... 20 Projected Operations and Resource Requirements ................. 21 Projected Financial Position and Performance 21 VI. OBJECTIVES, JUSTIFICATION AND MAIN FEATURES OF THE LOAN ................. 22 Objectives ........................ 22 Justification . . ........... 23 Main Features of the Loan ................ .. 23 VII. AGREEMENTS REACHED AT NEGOTIATIONS ................. .. 25 ANNEXES 1 The Philippine Economy 2 The Industrial Sector 3 The Philippine Financial Sector 4 DBP's Board of Governors 5 DBP's Staffing Position as of March 31, 1975 6 DBP's Financing Operations 7 DBP's Financial Position and Performance 8 DBP's Portfolio Quality and Arrearages 9 DBP - Reserves Policy Statement 10 DBP Audit 11 DBP's Projected Operations, Finances, Resource Position and Requirements 12 DBP's Interest Rates and Other Charges 13 DBP - Statement of Operating Policies and Procedures 14 Estimated Disbursement Schedule CHARTS No. 9981 - DBP - Organization Chart No. 9984 - IPD-I Organization Chart  PHILIPPINES APPRAISAL OF A SECOND LOAN FOR INDUSTRIAL FINANCING THROUGH THE DEVELOPMENT BANK OF THE PHILIPPINES SUMMARY AND RECOMMENDATIONS i. The Philippine Government has requested a second Bank loan for financing industrial investment through the Development Bank of the Philippines (DBP). This report recommends a Bank loan of US$75 million to cover a part of DBP's foreign exchange requirements for capital goods financed under the project for FY76-77. ii. Following a sharp improvement in 1973 when the economy registered an impressive 10% real growth rate, the successive shocks of the oil crisis, rapid inflation and a recession in principal export markets caused the eco- nomy to drop back to the underlying long-term growth rate of 6% in 1974. Declining prices for its major commodity exports notwithstanding, the Philippines continued to maintain a sound international reserves position. iii. The Philippines is placing heavy reliance on further industria- lization to achieve its growth and employment objectives. The industrial sector (mainly manufacturing) is the third largest in the economy. It accounts for 30% of NDP, absorbs over 35% of total fixed investment but employs only 15% of the labor force. The pattern of industrialization until the early 1970's, was almost entirely import-substitution oriented; its evolution having been encouraged by a restrictive set of protective policies coupled with an incentives system aimed at directing investments. in desirable directions. Philippine industrialization has also been capital intensive and has made little contribution to increasing employment for a rapidly growing labor force. Recent analyses suggest that the extant policy regime may, in some respects, be dysfunctional for future industrial development along soundly based lines. Government has, as a result, insti- tuted a review of its industrialization policies to examine the need for change. Investment in industry is expected to require about P52 billion between 1976-80; the proposed loan represents about 1% of this amount. iv. The financial sector in the Philippines, although relatively sophisticated, has not as yet developed adequate mechanisms for meeting the demand for long-term investment funds. Its development in this direction has been constrained by policies influencing the credit system and interest rates. Following the Central Bank-International Monetary Fund (CB-IMF) Joint Commission review of the banking system, the Government has taken several actions to strengthen the financial sector. It has, since this survey, requested follow-up studies to be carried out by the Bank, the International Finance Corporation (IFC) and the IMF to provide further guidance on policy measures required to assist the development and functioning of institutions and markets for long-term funds mobilization.  - ii - These studies would also examine the role played by the present interest rate structure in influencing such development. With inflation under control, effective interest rates on loans on-lent to sub-borrowers who bear the exchange risk are estimated to be a real 8-10% over the maturity period of the loan. v. DBP is the single largest institutional source of long-term funds in the Philippines. It has, since its inception, approved financial assist- ance totalling nearly US$3 billion, mostly to the industrial sector. The sheer volume and diversity of its operations cause it to play a prominent and unique role as the Government's arm for financing economic development. The same reasons make it difficult to quantify precisely DBP's contribution to development. However ex ante and ex post evaluations carried out on spe- cific samples of industrial projects financed by DBP suggest that these projects yield economic returns of around 15%. DBP has recently been instrumental in promoting a "countryside development program" aimed at channelling a greater proportion of its resources into rural areas, and in assisting the development of local private development banking institutions. vi. DBP is a wholly government owned institution whose overall direction is entrusted to a 9-member Board of Governors which is chaired by its chief executive and which includes four other full-time DBP executives. Since its re-organization in 1973, DBP has entered a consolidation phase, con- centrating its efforts on strengthening management and improving internal co- ordination. It employs 2,800 staff, of whom 55% are located in its 35 bran- ches and 24 agencies. The proposed loan would be handled by Industrial Pro- jects Department I (IPD I). vii. Systematic project appraisal was introduced in DBP about four years ago. Following an initial period of radical improvement, the pace of progress in further refining and upgrading the quality of appraisal has slowed in the last year, largely because of the loss of experienced personnel in IPD-I who were transferred to strengthen other parts of the organization. Follow-up practices are gradually being improved although again the pace has been slower than expected earlier. DBP's management has committed itself to ensuring that progress in appraisal and follow-up are given high priority and will be improved to the satisfaction of the Bank. At negotiations DBP outlined a program of staffing, training and control which was aimed at achieving significant improvements in IPD-I's project appraisal and supervision. The program was considered entirely satisfactory. Procurement and disbursement procedures are sound and ensure that purchases from sub-loans are made with due regard for economy and efficiency. viii. With the increased availability of funds from the Bank, the Central Bank, Treasury and other sources, DBP's lending operations reached the unprecedented level of P2.4 billion in FY75, compared to P293 million in FY74 and P234 million in FY73. In addition to a major and unusual increase in its hotel financing operations, lending increased in every other sector, especially industry. The increase in lending took place at the expense of DBP's guarantee operations which declined from P2.8 billion in FY74 to P0.9  - iii - billion in FY75. Equity investment approvals, mainly in government enter- prises, totalled P212 million, a much higher level than in the previous two years. ix. As of June 30, 1975, DBP's total assets were just over P7.8 billion, and it had outstanding contingent liabilities of P3.5 billion. Its finan- cial position was basically sound as was its liquidity position. However, DBP has recently been financing long-term assets with short-term liabilities, a situation which if uncorrected could weaken its financial position and jeopardize its future ability to service debts. During negotiations assur- ances were obtained that Government would bolster DBP's long-term resource base. Agreement was also reached on a total debt/equity ratio limit of 10:1 for DBP. FY75 saw a decline in DBP's net income attributable mainly to a decline in the level of collections (DBP records its income on a cash basis) and a major depreciation charge on assets acquired through foreclosure. To arrest further deterioration of its earnings performance DBP will need to increase the level of collections and its rates and charges on loans and guarantees. Agreement on these increases was reached at negotiations. x. A low level of collections and the magnitude of its arrearages continue to pose the main financial problem for DBP. Over the past year, however, DBP has achieved a measure of success in reducing its arrears. As of June 30, 1975, 60% of the number of accounts were in arrears with overdue principal and interest amounting to 15.5% of the outstanding port- folio. Steps are now being taken toward reducing arrears by rescheduling those major accounts on which such action is warranted and overdue. Follow- up and collection practices are also gradually being improved. To bring this persistent and serious problem under control, agreement was reached at negotiations that DBP would inter alia: reschedule all accounts in need of such action by March 31, 1976; increase penalty charges; and intensify follow-up and collection efforts. The Government also agreed that it would protect DBP against the risk of default or loss on all accounts which DBP finances at the Government's request. Furthermore, in view of information available about the quality of its portfolio, agreement was reached on DBP's making adequate provisions for reserves against losses on doubtful accounts. xi. At present, DBP carries the full foreign exchange risk on a substantial part of its direct borrowings. Adequate provision has not been made for possible losses arising from currency fluctuations. At negotiations, agreement was reached on creating a special reserve account to provide for such losses. xii. An evaluation of DBP's audit was undertaken in conjunction with the appraisal of the proposed loan. TLe audit, carried out by the Commission on Audit (COA), was found to be thorougl- as far as the testing of detailed transactions went. However, it was found to be lacking in analytical content and did not include an analysis of DBP's portfolio. Nor was it sufficiently supported by adequate documentation. Moreover, audit reports and the auditor's certificate in DBP's published annual reports provided unqualified opinions and did not point out: (i) that DBP's financial reporting differed in  - iv - material respects from "generally accepted accounting principles" as applied in the Philippines; and (ii) the audit was not conducted fully in accordance with "generally accepted auditing standards". These findings were fully dis- cussed in the field with DBP's management and COA staff who expressed a willingness to incorporate necessary changes in present auditing practices and appropriate qualifications in audit reports to meet the Bank's require- ments. At negotiations, agreement was reached on the following: (i) sub- mission to the Bank of an annual audit report on DBP prepared in accordance with the Bank's "Illustrative Form of Audit Report for Development Finance Companies"; (ii) inclusion of a thorough portfolio analysis in COA audit reports; and (iii) submission to the Bank of a separate audit of DBP's portfolio carried out by the Central Bank, within four months of the end of each fiscal year. xiii. In meeting 50% of DBP's foreign currency resource requirements over the next two years the proposed loan would address two priority objectives: (i) the transfer of needed resources to assist in developing the Philippine industrial sector; and (ii) continuing the process of institution building begun with Loan No. 998-PH. Under that loan, DBP has, as of July 31, 1975, financed 15 projects with economic rates of return varying from 11% to 80% and with internal financial rates of return of between 14% and 50%. 1/ Ex- perience with the proposed loan is expected to be similar. As before, and in accordance with the Government's wishes, the proposed loan would be made to the Government and re-lent to DBP on essentially the same terms. A fixed amortization schedule of 18 years, including four years grace is re- commended. Sub-borrowers would be charged the maximum nominal interest rates presently allowed 2/ (resulting in estimated effective rates of 18-20% allowing for administrative charges and foreign exchange risk). The foreign exchange risk on currencies of procurement would be assumed by sub-borrowers, with the residual risk between currencies of procurement and of obligation being borne by the Government for a fee of 0.75%. To ensure the dispersal' of loan proceeds over a reasonably large number of industrial sub-projects, a ceiling of US$5 million would apply to any sub-loan under the proposed loan. The free limit of US$1 million set under Loan No. 998-PH would be maintained for the present. xiv. At negotiations, agreement between the Bank, DBP and the Government was reached on the following measures: (a) within the 5-year rollover period (1975-80) of the present securities repurchase agreement between the Central Bank and DBP, Government would ensure that long-term financing on suitable terms was made available to DBP for its hotel projects (paragraph 5.14); 1/ Both economic and financial rates of return cited here were those calculated at the time of sub-project appraisal. 2/ 12% on loans or parts of loans secured by land and 14% for loans or parts of loans secured by chattels and other securities.  v - (b) The risk on all accounts financed by DBP at the behest of the Government would be covered by the Government (paragraph 5.18); (c) Government would bolster DBP's long-term resource position through additions to equity or through the provision of long-term loans with maturities equivalent to DBP's own sub-loans (paragraph 5.14); (d) Government would convert P400 million in present short-term holdings in DBP into long-term debt with a maturity of at least 5 years (paragraph 5.14); (e) DBP would increase its interest rates (within ceilings presently allowed by the Monetary Board for loans not covered by specific statutes), guarantee fees, and penalty charges in accordance with an agreed upon schedule (paragraph 5.15); (f) DBP would review, and where justifiable, take action to restructure all industrial accounts by March 31, 1976 (paragraph 5.18); (g) DBP would exert its best efforts to reduce arrearages; it would also submit arrears data to the Bank on a quarterly basis (paragraph 5.18); (h) DBP's total borrowings and outstanding contingent liabilities would not exceed ten times its equity base (paragraph 5.19); (i) DBP would make provisions for possible foreign exchange losses (paragraph 5.20); (j) DBP would adopt a reserves policy statement mutually agreed with the Bank (paragraph 5.21); and (k) an annual audit report on DBP prepared in accordance with the Bank's "Illustrative Form" would be submitted to the Bank (paragraph 5.22); COA's own audits would include a thorough portfolio analysis; CB's-audits would be submitted to the Bank; and in the event that COA's audit reports for FY76 or beyond were found un- satisfactory, the Government would take such steps (including if necessary the appointment of outside independent auditors) as to ensure that the Bank could form a firm judgement on DBP's financial condition.   PHILIPPINES APPRAISAL OF A SECOND LOAN FOR FINANCING INDUSTRIAL INVESTMENT THROUGH THE DEVELOPMENT BANK OF THE PHILIPPINES 1. INTRODUCTION 1.01 The Government of the Philippines (GOP) has requested further Bank assistance for financing capital goods imports to expand the productive capacity of the industrial sector. This report recommends a Bank loan of US$75 million to the Government. The loan will be on-lent to ultimate Dorrowers through the Development Bank of the Philippines. 1.02 The Bank has so far approved six loans totalling US$118.4 million for on-lending through DBP for a wide variety of projects including grain processing, livestock, fisheries, tree-farming, shipping and industrial davelopment (including specifically small and medium scale industries).