Philippines - Small and Medium Industries Development Project

CIRCULATiNG COPY r tIE - -4 Y TO BE RETURNED TO REPORTS DSK DOCUMENT OF INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT Not For Public Use CIRCULATiNG COPY Report No. P-1633-PH TO BE RETURNED TO REPORTS DEVSK REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF THE PHILIPPINES FOR A SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT May 14, 1975 This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report.  CURRENCY EQUIVALENTS Currency Unit - Peso (P) US$1 = 7.00 p 1 - US$0.143 P 1,000 US$143 P 1,000,000 US$143,000 Fiscal Year July 1 to June 30  REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF THE PHILIPPINES FOR A SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of the Philippines for the equivalent of $30 million. The loan would be for a term of 16 years, including a grace period of 4 years and at an interest rate of 8-1/2% per annum. The proceeds of the loan except for $0.7 million would be relent on the same terms to the Develop- ment Bank of the Philippines (DBP), the Industrial Guarantee Loan Fund (IGLF) administered by the Central Bank (CB) and the National Electrifica- tion Administration (NEA) for onlending at an interest rate of 12% per annum with various terms to a wide variety of small and medium industry sub-projects. The balance of $0.7 million would finance technical as- sistance by government to small industry. PART I - THE ECONOMY 2. The most recent Economic Report - "Current Economic Position and Prospects of the Philippines" (No. 568-PH of November 7, 1974) was circu- lated to the Executive Directors on November 11, 1974. Annex I contains country data. Recent Developments 3. In the past two years there has been a sharp increase in the level of economic activity in the Philippines. The growth in real GNP, which had been about 5-6% a year for more than a decade, doubled to 10% in 1973. The strong recovery in 1973 was led by the international commodity boom and resultant increased export incomes in the Philippines, by a strong recovery in agricultural and industrial production for the domestic market, and by an expansion in public and private investment. The increased domestic out- put, and a 28% improvement in the external terms of trade, resulted in a 14% increase in gross national income in real terms in 1973 compared with about 1% in 1972. Underemployment and unemployment remain quite high, how- ever, and in common with most other countries, the rate of inflation in- creased appreciably in the past 18 months. The Government has pressed anead with a number of important and potentially far-reaching economic and social reforms in such areas as agrarian reform, taxation, customs administration and tariffs, banking and government organization. 4. The agricultural sector, whicn has suffered from adverse weather conditions during the previous three years, grew by 7% in 1973. Rice pro- duction in crop year 1973-74 increased by 23% over the level of the previous year when floods reduced production. This increase was mainly due to fa- vorable weather conditions, increased use of fertilizers, more supervised credit and increased investments in supporting rural services as part of a general drive for rice self-sufficiency. Tihe impact of typhoons and flooding  -2- in December 1974 appears to have been significant and as a result no in- crease in rice production is likely for the crop year 1974-75. The Govern- ment made rapid progress in implementation of the program of agrarian reform for the nation's one million rice and corn farm tenants in 1973 and issued certificates of land transfer covering about 144,000 tenants mostly associa- ted with the large holdings. But this was considerably slowed down in 1974 mainly due to the increased resistance of medium scale farm owners, ad- mvanistrative difficulties and land evaluation and compensation problems. As a result, only about 47,000 additional certificates were issued during 1974. Recently the Government indicated its intention through various decrees and memoranda to resolve these problems and move forward with the implementation of the program. 5. The boom in export incomes and increased activity in agriculture has provided the base for renewed expansion of the industrial sector which grew by about 11% in 1973. Non-traditional industrial exports, which have been increasing since 1970, are estimated to have doubled in 1973 to about $200 million. The growth of industrial production for export has also been stimulated by the Government's industrial export drive which includes a range of export incentives. However, industrial output and exports have been affected by the recent dampening of domestic demand and a slowdown in the economies of key trading partners, and industrial export earnings grew more slowly in 1974. 6. The growth in production was also assisted by increased public development outlays in 1973 made possible by a significant improvement in the financial position of the Government. The ratio of public investment to GNP is currently about 3% compared with 1.8% in FY72. The Government has implemented a series of long needed tax reforms and improvements in tax administration, such as customs and tariff reform, tax amnesties, re- forms in corporate and local taxation, continuation of the export tax, and increased taxation on luxury items and on gasoline. These reforms, aided by the increased economic activity, the boom in export incomes, and domestic inflation, resulted in a 36% increase in tax revenues in FY73, and an esti- mated 47% in FY74. As a result, the ratio of national and local Government tax revenues to GNP has increased from an average of 9% in recent years to an estimated 12.4% in FY74. 7. High prices for the Philippines chief exports, including coconut products, sugar, copper and wood products, were largely responsible for an increase in merchandise receipts of almost 70% in 1973. ,The merchandise trade account recorded a surplus of about $270 million, as compared with a $150 million deficit in the previous year. International reserves rose by about $600 million during the year and stood at $876 million, equivalent to about five months of imports, at the end of December 1973. However, since mid-1974, a large trade deficit has appeared, largely because the growth in export prices has moderated while import prices have continued to rise rapidly. As a result of this trade deficit, the overall balance of payments surplus is estimated to have fallen from about $700 million in 1973 to less than $100 million in 1974. By the end of 1974 international reserves were about $1.2 billion, equivalent to roughly four months imports.  80 In the latter part of 1973, inflation emerged as a major problem in the Philippines. Starting in mid-1973 consumer prices began to rise at an annual rate of more than 40%. This was caused caused by the large increase in liquidity since the export boom began in 1973, and by a number of factors, including the higher rate of world inflation, domestic food shortages and the increased cost of petroleum. Aided by monetary and fiscal policies aimed at absorbing the excessive liquidity expansion, the rate of inflation slowed to less than 20% by the end of 1974. Other factors that helped moderate the rate of inflation include the substantial reduction in the balance of payments surplus in 1974 and the considerable increase in rice production in crop year 1973/74. The inflation of the last two years has exacerbated the decline in real wages whiclh fell by a total of about 25% between 1969 and 1973. The urban wage earners have been most affected. Agricultural and entrepreneurial incomes have improved very substantially. oiney wages will have to be raised in the near future if further deteriora- tion in the living standards of wage earners is to be avoided. The Energy Crisis 9. Imported petroleum provides some 97% of the Philippines' total energy requirements. In 1973 the equivalent of 71 million barrels of petroleum crude and other petroleum products were imported at a cost of about $230 million cif. When the energy crisis developed in late 1973, it looked as though economic activity in the Philippines would be severely disrupted. There were temporary dislocations but the Government moved quickly with conservation measures to reduce non-essential consumption. By March 1974 these problems had been overcome and the Philippines is now obtaining sufficient petroleum for its needs. In 1974 the volume of imports of petroleum and products is estimated to be at about the same level as in 1973 (71 mi'llion barrels) but at a cost of about $780 million cif. 10. The Government has decided to accelerate the development of local energy sources, especially hydropower and geothermal energy. These will be supplemented witlh nuclear energy in the 1980's. The transport sector, which nowv accounts for 40% of total energy consumption, is likely to continue to be the major consumer of energy. The growth in demand for energy will therefore be influenced by the pattern of expansion in this sector. In any event, total demand for energy is expected to grow at about 10% a year, and even with more rapid development of natural power sources, petroleum would still account for more than 90% of total energy needs by 1980. The Philip- pines does not have any commercial oil fields, but the Government has taken steps to encourage more exploration. Growtih Prospects 1t. The abrupt deterioration in the external terms of trade since the middle of 1974, and the recession in the economies of key trading partners, together with umcertainty about how quickly they will recover,  now threatens some of the Philippines' recent economic gains even though the Government remains committed to maintaining the growth momentum which began in 1973 to provide for a continued increase in incomes and employment. The high priority accorded to expanding employment opportunities - in the short-term as well as the long-term - stems from the fact that unemployment and underemployment are still high and the labor force continues to grow at 3% a year. 12. Priority is also being given to expanding food production for the domestic market, to expanding export production and to accelerating develop- ment of local energy resources. The difficulties experienced during the last two years in importing sufficient quantities of food at reasonable prices, especially cereals, have increased the Government's resolve to achieve food self-sufficiency as soon as possible. The Government rightly recognizes that the increased cost of petroleum and other imports cannot be financed indefinitely by borrowing abroad and it is actively encouraging both local and foreign investors to expand the productive capacity of ex- port industries and to undertake major new import-replacing investments. Because it will take time for these investments to have an impact on the balance of payments, the Government is seeking increased support from the international financial community to help carry out its development program and to ease the adjustment to higher petroleum and other import prices. Be- cause of the substantial improvement in the external debt burden and inter- national reserve position in the last two years the Philippines now has the capacity to borrow externally larger amounts of capital in support of its development program, if capital is made available. 13. Maintaining a GNP growth rate of about 7 percent a year in real terms during the next few years will depend heavily on the buoyancy of the domestic market. The prospects are for continued expansion in agriculture with a 4-5 percent increase in production in the year ahead. With a few exceptions, industries are operating at relatively high levels of capacity utilization. Increased investments will be needed in a wide range of consumer and intermediate goods industries. A number of big projects are proposed in mining, wood processing, fertilizer, steel and shipbuilding which are likely to push up the private investment rate from recent levels of about 16% of GNP to perhaps 22 percent by the latter part of the decade. The public infrastructure program that was approved in 1973, which called for outlays of about P 12 billion at current prices in FY74-77, has become outdated because of the subsequent rapid inflation and changes in invest- ment priorities as a result of the energy crisis. A new program has not been finalized, but the Government is putting more emphasis on developing nuclear and indigenous power resources and on irrigation, feeder roads and other projects to support increased food and export production. The Gov- ernment has made considerable progress in recent years in building up its capacity to prepare and execute projects. However, there will be a need for continued efforts to strengthen this aspect of administration. The ratio of public investment to GNP is projected to rise from the present level of 3% to about 4% by 1977.  Balance of Payments 14.- The economic report projects merchandise export receipts to in- crease by about 25% in 1975 and by another 5% in 1976, with only a small increase in the unit value of exports. Import payments are projected to in- crease by a total of almost 40% in the same period, including a 30% increase in prices. A cumulative decline in the external terms of trade of about 23 percent during this period would probably wipe out the gains made in the recent export price boom and return the terms of trade to the level prevailing in 1972. However, the outcome for the balance of payments is quite sensitive to assumptions about external prices and without the projected deterioration in the terms of trade, for example, the projected trade deficit of $1.2 bil- lion in 1976 would be reduced by about $1 billion. 15. On the assumptions in the economic report, the total foreign ex- change requirements for meeting the current account deficit and amortizing loans during 1975 and 1976 would be about $2.3 billion. About $700 million would be provided by direct investment and short-term trade finance and about $700 million would come from suppliers' credits and commercial commodity fi- nancing. Disbursements of project finance to the public sector, from the pres- ent pipeline, would amount to about $300 million. The balance of the remain- ing capital inflow of about $200 million in 1975 and $400 million in 1976 could be financed by the Central Bank through short and medium-term borrowing. Net reserves, however, would be negligible by 1976 and unless additional cap- ital were made available in the form of development aid, the Government would be forced to consider a reduction in its growth targets for the rest of the decade. 16. Recent important gains in reducing the external debt burden and in improving the external reserve position would be jeopardised if the banking system had excessive recourse to short and medium-term borrowing abroad. Fortunately, some assistance may be forthcoming from the IMF, In addition, foreign donors should consider extending quick-disbursing commedity loans with long maturities, which would make an important contribution to main- taining growth and a manageable balance of payments position in 1975. There is considerable scope for additional maedium and long-term loans from foreign donors to finance the much larger capital goods imports proiected for 1976. The Philippine Consultative Group reviewed the improved foreign exchange position at its meeting in December 1974 and accepted the need for some of- ficial commodity aid in addition to rising levels of commitments for rievelop- ment projects to support the Philippines' increased development program. If the projected inflows on the capital account are forthcoming and if the pres- ently identified shortfalls in foreign exchange availabilities are met with an appropriate combination of medium and long-term loan capital as suggested, management of the external debt would not present serious problems. Medium and long-term debt outstanding would rise from $2 billion this year to about $3 billion by 1976 but the ratio of debt service payments to exports would fall from 15 percent this year to about 13 percent in 1976. The Philippines would still be in a position to contract substantial amounts of external debt during the final years of the decade although this would lead to an  - 6 - increase in the debt service ratio to about 16-17 percent by 1980. The Philippines is already credit.worthy for substantial Bank lending. Moreover, at present, the Bank/IDA share in total debt outstanding is about 9 percent and its share in debt service is about 5 percent. Even with a substantially higher level of Bank lending, these shares would not be expected to increase significantly in the years ahead. 17. During the last two years, the Government has significantly im- proved its fiscal performance with taxes increasing by more than an average of 40 percent each year. Nevertheless, the Governments ambitious develop- ment program, which would increase public investment from the current level of 3 percent of GNP to about 5 percent by the end of the decade, will con- tinue to require resources in excess of the foreign capital which will be- come available for financing the import component of development projects. Some financing of local currency expenditures will be justified, especially for projects of economic and social importance which need only limited amounts of foreign exchange. PART II - BANK GROUP OPERATIONS IN THE PHILIPPINES 18. The Philippines has received 29 Bank loans and three IDA credits totalling $644 million, net of cancellations. About 50 percent of the Bank/ IDA lending, about $306 million, has been for infrastructure projects in power, transportation, water supply and for education whilst $25 million has been for population. The remainder has been divided about equally be- tween agriculture and industry. About $168 million of this has been for irrigation, livestock, rice processing, rural credit and rural development and about $145 million for industry in four loans for the Private Develop- ment Corporation of the Philippines and one loan for the Development Bank of the Philippines. There has been a marked improvement in the way Bank financed projects in the Philippines have been executed in the last two or three years compared with experience in the 1960's when shortages of peso counterpart funds combined with poor administration to cause serious prob- lems. All these projects are now going reasonably well. Annex II contains a summary statement of Bank loans, IDA credits and IFC investments as of March 31, 1975 and notes on the execution of on-going projects. 19. The Bank's lending program has been designed to continue to sup- port the increased Philippine development effort with its particular emphasis on agriculture and infrastructure. Shortages of domestic financial revenues led to low investment for these purposes in the past. The last two years have seen major changes which have helped to overcome these constraints and both the ambitious Philippine development program and the Bank's lending program have been designed to make good past neglect and to meet future needs. Commitments in FY74 amounted to $165.1 million, compared to an average of about $30 million a year in the previous five years.  -7 - 20. Six loans in the Philippines totalling $178 million - Population, Sixth Power, Inter-Island Shipping, Fourth Private Development Corporation, Tarlac Irrigation annd Rural Development have already been approved by the Executive Directors in FY75. Including the proposed loan total Bank lending in the Philippines in FY75 would be $208 million. Projects which may be ready for Board consideration in FY76 include irrigation, livestock, fisheries, grain storage, education, industrial investment, and urban development. 21. IFC has made conmitments in the Philippines totalling $76.1 million for investments in thirteen companies in the fields of development banking, power, telecommunications, ceramic tiles, paper, petroleum products, nickel mining and refining, chemicals and synthetic fibers. Of these investments, as of March 31, 1975, $18.5 million have been sold, $0.4 million cancelled and $2.3 million repaid, leaving a net portfolio of $55.0 million. On the same date $8.8 million was undisbursed. Preliminary proposals have been received for an aluminum smelter and other projects in the pulp and paper, dinnerware, metal alloys and shipbuilding fields. PART III - TUE INDUSTRIAL SECTOR AND THE ROLE OF SMALL AND MEDIUM INDUSTRY A. Industrial Sector 22. Background: The Tndustrial Sector is the third largest in the Philippine economy (after agriculture and services) accounting for 28% of net domestic product in 1974, absorbing over one-third of total fixed investment and providing employment for 15% of the total labor force. Since the early 1970s Government has placed increasing emphasis on in- dustrial growth to expand and diversify exports, meet growing domestic demand, and provide increased employment opportunities. Reliance on the industrial sector as a maior vehicle for enhancing export earnings has resulted in a rapid increase in non-traditional industrial exports from US$49 mJiiion in 1969 Lo US$200 million in 1973. The pattern of industri- alization until now, however, has resulted in an industrial structure dominated by capital intensive large scale firmswhich have done little to expand employment. Consequently, the Government is relying heavily on the rapid development of labor intensive small and medium industry to achieve its employment and investment dispersal objectives. 23. Institutional Framework: Until 1974 the principal regulatory agency which guided private industrial investment was the Board of Invest- ments (BOI) which was set up to administer the Investment Incentives Act of 1969 and later the Export Incentives and Foreign Investment Regulation Acts. In addition to its regulatory functions, BOI is also an active pro- motional agency. About one-half of new industrial investment in the Phil- ippines goes into BOI registered projects. Between June, 1968 and June, 1974, B5I approved projects requiring a total investment of $1.1 billion.  -8- In July 1974, a new Department of Industry was created to play a more active role in industrial policy formulation and implementation. Apart From assuming research, evaluation and planning functions previously carried out by BOI, the new Department has also been charged with responsibility for co-ordinating the efforts of all agencies in promoting the growth of SMI through its Commission on Small and Medium Industries. 24. Industrial Investment and Finance: The National Economic and Development Authority's Four-Year plan for FY74-77 estimates total industrial investment requirements in the period to be in excess of $ 3.5 billion. In- vestment in manufacturing is expected to account for about two-thirds of the total. This level of investment will require a large increase in domestic resource mobilization, as well as a sustained inflow of foreign capital on reasonable terms. Two institutions, the Development Bank of the Philippines (DBP), the government's principal development financing institution, and the Private Development Corporation of the Philippines (PDCP), are the main pro- viders of long term industrial finance. In addition, several commercial banking and other financial institutions also provide a limited amount of term finance to industry. Working capital needs are covered mainly by com- mercial banks. The remaining financing is provided by direct and indirect foreign investment, internally-generated funds and by equity financing through the capital market. B. Small and Medium Industries 25. Definition: Small and medium industries (SMI) firms in the Phil- ippines are defined as those with total fixed assets of between P 100,000 and P 4 million. Small firms are those with total fixed assets of between P 100,000 and P 1 million, while medium firms are those with total fixed assets of between P 1 million and P 4 million. Of the 10,248 firms covered in the 1971 ASM 1/, 8,203 are cottage industry type units. Small and medi- um industries accounted for 1,654 (16.1%). Excluding cottage industry type units (i.e. firms with less than 20 workers), SMI accounted for 81% of all manufacturing establishments in the "modern" manufacturing sector, but employed only 27% of the manufacturiag labor force and contributed 21% of the gross value added. 26. Characteristics: Between 1962 and 1968, the growth of SMI- greatly exceeded the growth of large firms. Between 1968 and 1971, this pattern was reversed as small industries showed an absolute decline, and medium sized firms grew very slowly. This decline appears to have been encouraged by the introduction of investment and export incentives (see para 23) which by their nature have been more beneficial to large, capital intensive industry. In 1971 by industry branch, the share of SMI in employment and production 1/ Annual Survey of Manufacturers covers all establishments with 5 or more workers.  - 9 - was greatest in manufacture and sub-assembly for capital goods industries (transport equipment, electrical, and non-electrical machinery) and signifi- cant in intermediate goods (rubber, wood and paper products, chemicals and chemical products and basic metals) and consumer goods (food, textiles, furniture, and printing and allied industries). These product groups offer scope for import substitution and enjoy effective rates of protection higher than the average for all manufacturing making it easier for SMI to enter these segments. Geographically, 65% of SMI firms are concentrated in the Southern Luzon area, close to principal sources of supply and major consump- tion markets and where infrastructure and other services are more developed. The Greater Manila area alone accounts for 52.5 percent of all SMI estab- lishments with another 6.9 percent located in or around Cebu City in the Visayas. The Government's industrial policy is now emphasizing the regional dispersal of industry, including SMI, away from urban areas, including the Greater Manila area. SMI firms produce mainly for domestic markets with direct sales to local markets and reaching regional markets through middle- men. Exports of SMI in furniture, textiles and garments, handicrafts and small electrical machinery and appliances have increased in the last two years after amounting to about 14% of total SMI output in 1969. But SMI firms still face production problems especially with product design and quality; they are generally considered unreliable for supplying large batch orders especially for export. 27. Constraints on Growth: SMI firms presently face a number of problems. They lack expertise in management, organization and choice of technology and generally do not have ready access to the skilled part of the labor force. They also suffer a lack of know-how in marketing arrange- ments, particularly for export marketing and financing, and face difficul- ties in executing project feasibility studies and in presenting project ideas and expansion plans in a form acceptable to financing institutions. For these reasons and because financing institutions have tended to rely heavily on collateral and co-makers' guarantees, SMI lack access to ex- ternal sources of medium and long-term and working capital. With an excess demand for funds and little opportunity for preferential yields on higher risk clients because of statutory interest rate ceilings, fi- nancing institutions have tended to lend to larger, well known, low-risk clients. So SMI have been forced to rely heavily on insufficient internal resources or short-term borrowing from non-institutional sources at 5-10 percent per month (depending on the amount). This has made it difficult for existing firms to expand and for new firms to get established. 28. Reasons for promoting SMI Development: The government's devel- opment strategy for industry has several objectives, namely, employment creation, better regional distribution of investment and income, reduced dependence on industrial goods imports and the generation of a wider base of manufactured exports. Industrial investment is to be divided among: (i) a few large investments in some sectors (e.g. mineral and wood proc- essing, shipbuilding, fertilizer, etc.), (ii) modern large to medium  - 10 - sized firms in export oriented sectors (e.g. textiles and garments, elec- tronics, etc.) 1/ and (iii) in small labor intensive units. Up to now the bulk of investment has been directed toward the first two types and invest- ment in small industries has been largely neglected. SMI have generally been unwittingly discriminated against by the monetary and fiscal incentive framework and have been denied access to credit, and other types of assist- ance on an equal basis. To correct this bias the government now aims to promote SMI development. The proposed project is part of that program, and aims at correcting these biases by increasing the supply of available credit for SMI, making access to such credit easier for small firms and by expanding upon the government's framework for extending technical assistance. With such encouragement SMI are expected to play a greater role in the industrial sector and to contribute more effectively toward productive and efficient employment creation and toward better regional income and investment distribution. 29. The Government's Program: The government, recognizing the potential of SMI in employment creation, in the development of entrepreneur- ial and managerial skills and in assisting a more equitable income and in- vestment distribution, adopted a program in early 1974 to promote the de- velopment of SMI. The Government's program emphasises the promotion of rural and labor-intensive SMI, while still recognising the legitimate needs of established SMI in the urban areas. The main components are substantial increases in SMI lending through the Development Bank of the Philippines (DBP) and the Industrial Guarantee Loan Fund (IGLF), and the provision of technical assistance through the Department of Industry (DOI). Within DOI, a Commission on Small and Mledium Industries (CSMI) is responsible for implementing and coordinating the program. It operates 50 field teams in provinces and towns outside the Greater Manila area, which are responsible for assisting entrepreneurs with project feasibility studies, loan appli- cations and the many other time consuming steps which are the greatest bottlenecks in realizing a project. The field teams are supported by a central unit in DOI. Although the direct assistance approach has been very successful so far, it has also suggested the need for small technical as- sistance centers at the regional level to provide a link between field support and central services. Amongst other Government initiatives to promote SMI development, the most promising is a program run by the National Electrification Administration (NEA) which establishes industrial producer cooperatives in rural areas to provide employment opportunities for rural unemployed and underemployed and promote an economic level of power use in rural areas which are being electrified. 1/ These are the types of firms which have recently been the prihcipal beneficiaries of our DFC loans through DBP and PDCP. Such loans have proven beneficial and effective and will continue to feature in our future lending programs for the Philippines.  - 11 - PART IV - THE PROJECT The Loan 30. Background: The proposed loan is the seventh in a series of Bank Group loans for financiug industrial investment in the Philippines, but the first targeted specifically at small and medium scale industry. The most recent industrial loan was a $30.0 million Bank loan to the Pri- vate Development Corporation of the Philippines (PDCP) approved in November, 1974. The proposed project was appraised in October-November 1974 and negotiations were held in April, 1975. The leader of the Philippine negotiating team was Ambassador Eduardo Z. Romualdez, assisted by 'iss Fe Villafuerte and Mr. Anselmo Sevilla of DBP, Mr. Antonio Locsin of NEDA, Mr. Florentino Policarpio of NEA, Mr. Joseph Pernia of DOI and .'Ir. Ramon Teodoro of the Department of Justice. The Appraisal Report (No. 667a-PH) on the project is being distributed to the Executive Directors separately. Annex III provides a loan and project summary. 31. Uses of the Loan: The proposed Bank loan would be used to finance fixed assets and permanent working capital for a wide range of SMI sub- projects in manufacturing, agro industries, transportation services, small engineering facilities and small construction industries. The loan would also help the Department of Industry (DOI) to assist small entrepreneurs solve the problems of production, marketing and accounting that most of them confront. Although sub-loans under the proposed loan would be in local currency the projects financed are estimated to have a direct and indirect foreign exchange cost component of about 64% of total sub-project cost. Proceeds from the Bank loan would finance 60% of total sub-project costs. 2. yendin Arrangements: The proposed loan of $30.0 million would be made to the Government of the Philippines, which would relend in local currency the equivalent of $15.0 million to the Development Bank of the Philippines (DBP), $12.0 million to the Industrial Guarantee Loan Fund (IGLF), arxi1 $2.3 million to the National Electrification Administration (NEA) on the same terms as those of the Bank loan. The balance of $0.7 million would be used by the Government to linance the establishment of 7 Regional Technical Assistance Centers (RTACs) which would provide direct assistance to small entrepreneurs located outside the Greater Manila area. 33. Terms: The loan would be for a term of 16 years, including a grace period of 4 years and at an interest rate of 8-1/2%. The relending rate charged to ultimate sub-borrowers would be 12% per annum, the legal maximum rate for secured loans in the Philippines. In the event that Government decides to raise interest rate ceilings for medium and long-term loans, the relending agencies would consult with the Bank about raising the relending rate to ultimate borrowers. Sub-loans would be comitted over 2 years anid disbursed over 4 years and would have a maximum term of i2 years including a grace period of up to 2 years. The Government would  - 12 bear the full foreign exchange risk. A ceiling of $360,000 would be set for sub-loans to ultimate borrowers by DBP, which lends to medium as well as small-scale enterprises, and $115,000 for sub-loans through IGLF, which lends only to small scale industry, and NEA. 34. Procurement: The goods and services to be financed by the pro- posed loan would be procured in accordance with the established procedures of DBP, IGLF, and NEA respectively, The procedures of these agencies are satisfactory and should ensure that procurement from their sub-loans is carried out with due regard for economy and efficiency. Buildings, office equipment and vehicles to be procured for the RTACs would be in accordance with the DOI's procurement procedures which are satisfactory (Section 3.11 of the Loan Agreement). 35. Project Financing and Disbursement: For sub-projects to be fi- nanced by DBP and IGLF and NEA the Bank would finance 60% of total project costs, the financial institution 20% and the entrepreneur (or cooperative) 20%. For administrative simplicity, disbursements would be made against 75% of the value of DBP's and NEA's loans or IGLF's Special Time Deposits (STDs) against supporting evidence of disbursements by DBP, IGLF and NEA on a quarterly basis. Disbursements for the RTACs would be made against expendi- ture. 36. Project l4onitoring and Supervision: In view of the pioneering nature of this project monitoring and evaluation arrangements for each component of the project have been incorporated to ensure that the ex- perience gained from this project is distilled and applied to the design of similar future projects in the Philippines and elsewhere. Furthermore, arrangements for supervision of this project have been designed to ensure that sound resource allocation occurs without sacrificing the requirements for efficiency in the commitment and disbursement of funds. As a result, project supervision, at least in the initial stages of project implementa- tion, will require a heavy commitment of Bank staff time. Development Bank of the Philippines (DBP) 37. Background: DBP was established in 1958 as a wholly Government- owned development bank. It operates in all the important sectors of the economy, although industrial financing including guarantee operations in the past accounted for the bulk (79%) of its total financing followed by agricultural financing (9%), with the balance of 12% going for community development lending, lending to private development banks and for real estate. The Bank has previously made 3 loans through DBP for agriculture totalling $33 million, and 2 loans for industry and shipping totalling $70 million. DBP's financing over the past 4 years has accounted for 28% of total capital formation in the Philippine economy. DBP's financial position and perform- ance improved significantly in FY74. Its capital structure is sound and it is sufficiently liquid, largely as a result of a much higher level of collections in FY74. Administrative costs in FY74 declined substantially compared to FY73. DBP's arrears situation although still serious, is  - 13 - improving. As of June 30, 1974, total principal outstanding for loans in arrears more than one year amounted to about $96 million or 49% of the portfolio, compared with 54% as of June 30, 1973. 38. SMI Operations: DBP is the single largest source of term finance to the SMI sector and its volume of lending has been growing. SMI loan approvals totalled nearly $6.0 million in FY74, and approvals exceeded $5.5 million in the first half of FY75. SMI operations accounted for about 7.6% of total loans outstanding as of June 30, 1974, and for 13.6% of loan approvals in that year. DBP expects to commit a total of over $11 million in FY75 and nearly $30.0 million between FY76 and FY77. This together with DBP's other long-term peso requirements is expected to total between $220 and 280 million over the next two years, of which DBP expects to raise only 25-30% from the private capital market on a long term basis. The $15.0 million portion of the proposed loan to be channelled through DBP would meet about 50% of DBP's resource requirements for SMI lending over the next two years. DBP has approved SMI loans to a wide range of industries, although food processing and apparel and footwear accounted for over 38% of approvals between FY72 and FY74. The share of SMI loans made in the Greater Manila area has dropped from 84% in FY72 to 48% in FY74. The average size of DBP's SMI loans in FY74 was about $45,000. DBP's interest rate on SMI loans is 12% per annum, the maximum rate for secured loans in the Philippines. 39. Organization for SMI Lending: DBP's SMI lending is conducted principally through its Industrial Projects Department II (IPDII) and through its network of 32 branches and 24 agencies. Both IPDII and the branches have the capability to undertake satisfactory project appraisal but follow- up work in SMI lending is still weak. DBP has taken satisfactory steps to ensure that all projects are followed up on a regular basis. DBP's pre- sent loan processing procedures are complicated and time-consuming but it is taking steps to improve its performance. DBP has also agreed to make its best efforts to improve its arrears situation (Section 3.08 of the Loan Agreement), and a specific target date by which to achieve this was con- firmed during negotiations. It intends to limit to $5 million equivalent the proceeds of the loan which would be lent to medium scale industry. DBP would not make sub-loans under this project in those sub-sectors for which the Bank has already made previous loans through DBP (i.e. grain processing and storage, fisheries and livestock). Industrial Guarantee Loan Fund (IGLF) 40. Background: IGLF, established in 1952, is a long term compen- satory financing and guarantee fund for S2II owned by the National Economic Development Authority (NEDA) and administered by the Central Bank (CB). IGLF lending is directed through a network of eligible participating banks. Against their loans to SMI at an interest rate of 10%, participating banks now receive a Special Time Deposit (STD) on which they must pay interest of 5% to IGLF. A guarantee of up to 80% of the STD is also available for a fee of 2% of the amount guaranteed, and encourages participating banks to lend to collateral deficient entrepreneurs with sound projects. IGLF  - 14 - financing reflects Government investment priorities, with emphasis on projects which are labor-intensive, export oriented or located outside the major urban areas. Although a wide range of financial institutions are qualified to become participating banks under IGLF, only a few did so until recently. This was principally because of the cumbersome and time consuming procedures and requirements that existed prior to the restructuring of IGLF in 1974. Since then a large number of banks have begun to use IGLF. Under the proposed loan, IGLF has agreed with the Bank to set up an accreditation scheme which would be designed to ensure that participating banks either had or could develop within a short time, the ability to finance SMI on a sustained basis. 41. Operation: Since 1957, IGLF has approved financial assistance totalling nearly $28.0 million for 375 projects. Most of these approvals were made between 1955-65 after which approvals fell to very low levels. Following a restructuring of its procedures, IGLF approvals rose to nearly $1.0 million for 31 projects in FY74 and for the first four months of FY75 went to $1.7 million for 97 projects. No guarantees were provided independ- ently of STDs but the demand for guarantees combined with STDs has grown rapidly. IGLF has assisted a wide range of industries, but five (food processing, textiles, wood products, metal products and non-metallic minerals) accounted for nearly 60% of the total. The share of IGLF assistance going to the Greater Manila areas has dropped from 76% before FY74 to about 50% since then. IGLF's portfolio is of very high quality because participating banks are required to repay STDs whether or not their own clients default. As a result very little is known about default rates for IGLF financed projects. IGLF has agreed that in future it will collect and compile arrears data on all IGLF financed projects on a quarterly basis (Section 3.06 of the Loan Agreement). IGLF resources requirements for the two years FY76-77 are expected to be about $17.0 million. As of January 1975 IGLF had committed all its available resources. Its requirements for the second half of FY75 are being covered by a special Government contribution. The $12.0 million portion of the proposed Bank loan to be channelled through IGLF would meet about 70% of its requirements for the next two years. The Government has agreed to provide the balance of IGLF requirements. 42. On-Lending Rates: The Government has agreed that the interest rate charged to ultimate borrowers by the participating bank should be raised from 10% to 12% and that the interest paid on special time deposits should be raised from 5% to 7% (Section 4.03 of the Loan Agreement). This would give them a spread of 5% which should provide an adequate incentive to participate. In addition, the guarantee would be reduced from 80% to 60% of the amount of sub-loans made by participating banks; this would increase their risks and help to ensure sound project appraisal and folloui-up. Bank funds would be made available to IGLF at 8.5%. A Government contribution of P 30 million to IGLF's capital, which would be made before the loan became effective (Section 6.01 of the Loan Agreement), would allow IGLF to accept a rate of 7% on STD's.  - 15 - 43. Project Appraisal and Follow-Up: At present, project appraisals are carried out by the CB, and although judgements made are inclined to be rigid because of a iack of knowledge about local conditions they are basic- ally satisfactory. Follow-up work is carried out mainly by the participat- ing bank and varies in quality. Under the accreditation scheme (see para 40) participating banks would carry out appraisal and follow-up in accordance with standards set by CB, leaving CB staff free to concentrate on monitoring and reviewing the performance of each participating bank. CB has agreed with the Bank that SMI portfolios of participating banks would be subject to a CB audit over and above any existing audits if CB was not satisfied wqith the normal audits to which these institutions were subjected (Section 3.07 of the Loan Agreement). National Electrification Administration (NEA) 44. In 1972 NEA was charged with carrying out a program of rural electrification to provide area coverage throughout the Philippines by 1994. Concomitant to this program, NEA is also engaged in two power use programs in rural areas (irrigation and industrial producer cooperatives (ICs)), to provide employment opportunities for rural unemployed and underemployed and to promote an economic level of power use in rural areas which are being electrified. NEA established 5 pilot ICs during 1974 which have shown promise of being both economically and financially viable and of generating employment at a low capital cost. NEA has subsidized these ICs through low cost loans (6%) and management assistance on a cost free basis. In order to reduce the subsidies and to encourage efficiency and prompt ex- posure to normal business conditions, NEA has agreed to raise its interest rate on loans to ICs to 12% (Section 4.03 of the Loan Agreement) and to provide free management assistance for a brief fixed initial period, after which norral fees for this type of work would be charged. Of the 5 pilot ICs, two are in textiles, two in wood products and one in fibercraft. NEA plans to establish 24 new ICs, dispersed throughout the Philippines in rural areas during the two years '75-77. Its estimated resource requirements for this programr. are about $4.0 millions Over the same period NEA's resource re- quiremLents for its electric cooperatives program will be about $65.0 million. 45. NEA is competently managed with a sound organization. Responsibil- ity for the IC program lies with the Power Use Directorate (PUD), a small but rapidly growing department which is well managed and staffed. NEA has agreed to strengthen PUD's staff and to establish a Planning and Evaluation Division in PUD to evaluate the impact of the program (Section 3.10 of the Loan Agree- ment). PUD is also upgrading the quality of its project feasibility studies, and is designing the technical assistance it provides in a way which will expose infant ICs to normal business conditions as quickly as possible. To avoid unnecessary delays in the establishment of ICs, the Government has agreed with the Bank that the Department of Local Government and Community Development (DLGCD) will register ICs sponsored by NEA within 30 days after NEA Board approval for any IC (Section 3.09 of the Loan Agreement).  - 16 - Regional Technical Assistance Centers (RTAC) 46. The DOI is establishing 7 Regional Technical Assistance Centers (RTACs) between July 1, 1975 and June 20, 1977 to provide support for its field teams (see para 30) and to provide direct technical assistance in production, marketing and accounting for reasonable fees to SMII project proponents. The total cost for the 7RTACs will be about $1.5 million of which the proposed loan would provide $0.7 million to finance about 45% of construction costs and about 50% of pre-operating and operating expenses and all capital expenditures during the first two years of operation. Thereafter, RTACs will be fully funded out of the DOI budget. 47. Economic Justification: Over 900 sub-projects and 24 industrial co-operatives would be financed under the proposed loan. Prior calculation of individual economic rates of return for this number of sub-projects is not possible. The aggregate internal financial rate of return for the sub-projects is estimated to be over 38 percent and for the 24 ICs to be nearly 32 percent. This is based on incremental gross output from the pro- posed project as the principal benefit against investment and production costs. When these sub-projects and cooperatives are in full operation they are expected to result in additional investment in SMI of about $43 million (in 1975 price equivalents) and in the generation of about 12,300 additional jobs, mostly in rural areas. The project is expected to result in additional annual gross value-added of about $22 million and additional annual returns to labor of about $7 million. These effects are expected to increase annual SIll employment growth rates from 0.5% to 3.0%; output growth rates from 4% to 7.0% in real terms; and wage-bill growth from 0.1% to 2.9% in real terms annually over the 4-year disbursement period. At full production, output growth is expected to increase to 6.6% and the wage bill to 4.5%, annually. As the funds would be directed primarily to less developed regions in conformity with established Government policy, the increased growth in SMI employment, investment and output will effect a more equitable regional distribution of jobs and income, in terms of returns to labor as well as to small investors and consumers. Apart from substantially increasing the flow of resources to SMI, providing them with greater access to institutional credit and contributing to a greater regional dispersal of investment, the project would also achieve important institution building objectives in strengthening the capability of DBP, CB and the sponsoring banks, and NEA to service the needs of the SMI sector. PART V - LEGAL INSTRUMENTS AND AUTHORITY 48. The draft Loan Agreement between the Republic of the Philippines and the Bank, the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement of the Bank and the text of a draft resolution approving the proposed loan are being distributed sep- arately to the Executive Directors. The Loan would not become effective  - 17 - until the Government had made a capital contribution of P 30 million to the IGLF. 49. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOITIENDATION 50. I recommend that the Executive Directors approve the proposed loan. Robert S. McNarmara President Attachments May 14, 1975  WU~~xim (odd..1712) Ir .mbl lmd --SMIkn rats (;ea thanosd) . -5a /a 143 /c io2 Ufea" sortallsy vets (pe taom..O 11w bfra) OD 8 8D40 120-150 LIt. sawuoy at. birth (Years) 5 0 58 59 55 6 W.m r N.mctiw,rts. 3.3 3.2 2.9 2.5 ?z1.ettae pseth rats Lo. 3.0 3.0 ft 3.1 If 2.5 /f 2.2 /f FGPSQ &t1Vft (s5x} > 20h r2.t 370 h 3.0 Jb up.1athe gra rate -r 2* . 46 s7 4 Z 6 ACeSL1taft (pe(lros) 15-66 51 k 3 5 8 s 6 65 d or 3 4 4 Duoelo rtio A 1.5 / 1.3 & -. 1.0 A 1.b /1 Vrbso pulation - perornt Of rtta 30 /h 32 / b 25 /i 39 4 1 / lily Plangt I& of 205e5opor lt (tUa.) 409 490 282 So. of w_rs (U of married ) 6 10 4 MST~Mbor forw (thousads) 9S,I 13,200 h' 1A, 900 /A 16,000 10,2W0 1af Pgreent"P emqoyed in eicullsre 61 56 k 77 66 ;7 NF ftarcotDme opyd 6 7 I 5 Pecosot of 0etto..-1 tao, raeosd b7 hbat k% 29 AO. 25 /af,o 17 L,2 33 /t.r 16 Zul Percent of zntiwas iOum, r.eId bY bight, 2% 56 o A 46 /o 61 So r 36 Paroast of tatial laces. recived b7 lo_at 204 5 4 7' 7 A,i 3 7 8 yeroent of ationlJ lJcos ruclsed by lo.-b 4% 13 12 0 17 0 9 14 24, S os ~ top itl oi sours . .o 28 w owd by smllest 10% of oame ., , , . 2 IbBilfio per 96fstso . 9,00 / 7,970 2,220 2,210 ft Popalatcom P rd asng perrct 5,3% 6,650 1,88 1,760 2 po5setiin per hoptl bed 1,180 Li 80 ,a 850 8490 1I920 P.r oCpte calorie epp]y sa S of reqairemoth 87 96 no 110 t, Per upite prtic so ,-tOtsj (grms per 53 751. ; 78 7r 7 2 2 a f Which, eadmsl cd pulse 19 22 T6 17 e 22 19 Ddh et 1-4 years 7 5 is a m /S prinary vd, OOl Oroll t ratio 91 Z 12 Sd s /a Ad3sted A seady oboo,]l nronxOlleat ratio 26 45 13 28 41 TrWaof Q:'oOli proSided, MY" and _eod l1va 10 10 12 13 12 Tocatt-u .rmolment a S of . ol orUt 10 ,12 /ac 14 1 &I%t Ilbarac7 rato S 72 M70 S L al7b *g o Of DtrF