Philippines - Industrial Finance Project

Document of The World Bank FILE COPY FOR OFFICIAL USE ONLY Report No. 3331-PH PHILIPPINES STAFF APPRAISAL REPORT ON THE INDUSTRIAL FINANCE PROJECT April 7, 1981 Projects Department East Asia and Pacific Regional Office 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 EQUIVALENTS Currency Unit = Peso (P) US$1.00 = P 7.50 US$1 million = P 7.5 million P 1 = US$ 0.133 P 1 million = US$ 133,000 P 1 billion = US$ 133.0 million ABBREVIATIONS ADB = Asian Development Bank ADFU = Apex Development Finance Unit BOI = Board of Investment Central Bank = Central Bank of the Philippines CEO = Chief Executive Officer DBP = -Development Bank of the Philippines DFCs = Development Finance Companies EPZA = Export Processing Zone Authority ERR = Economic Rate of Return FCDUs = Foreign Currency Deposit Units FRR = Financial Rate of Return GSIS = Government Services Insurance System GNP = Gross National Product ICB = International Competitive Bidding IFC = International Finance Corporation IGLF = Industrial Guarantee and Loan Fund LBP = Land Bank of the Philippines MOI = Ministry of Industry OBUs = Off-Shore Banking Units PAB = Philippine Amanah Bank PDBs = Private Development Banks PDCP = Private Development Corporation of the Philippines PFIs = Participating Financial Institutions PICA = Private Investment Company for Asia, S.A. PISO = Private Investments Systems Organization PNB = Philippine National Bank SAL = Structural Adjustment Loan SEC = Securities and Exchange Commission SMI = Small and Medium Industries UNDP = United Nations Development Program USAID = United States Agency for International Development FISCAL YEARS January-December  FOR OFFICIAL USE ONLY PHILIPPINES STAFF APPRAISAL REPORT ON THE INDUSTRIAL FINANCE PROJECT Table of Contents Page No. 1. THE INDUSTRIAL SECTOR ....................................... 1 Critical Role of Industry in the Economy .................... 1 Policies and Incentives Contributing to Present Structure of Manufacturing Sector .... ............ 2 The Present Structure and Problems of the Manufacturing Sector ...................................... 3 Industrial Development Program .............................. 5 The Policy Reform Program ................................... 6 Anticipated Effects of Policy Reforms on the Manufacturing Sector ...................................... 11 2. THE FINANCIAL SECTOR ........................................ 12 Overview ......................... .......................... 12 Institutions in the Financial System .... ............ 14 The Financial Markets ................... ................... 16 The Financial Sector Reforms of 1980 ......... .. ............ 17 Future Evolution ...................... ...................... 23 3. BANK'S INDUSTRIAL LENDING STRATEGY AND PROJECT OBJECTIVES .... 25 The Bank-s Past Industrial Lending .......................... 25 The Rationale and Strategy for Future Bank Lending ... ...... 26 Project Objectives ......................................... 27 4. THE PROJECT ......................... ........................ 28 Project Description ...... .............. .................... 28 Institutional Arrangements for the Project ........ ......... 29 The Project Procedures ................. .. ................... 32 Resource Requirements and Allocations .......... .. ........... 35 5. PARTICIPATING FINANCIAL INSTITUTIONS (PFIs) ....... .. ........ 36 Private Development Corporation of the Philippines (PDCP) ... 36 Philippine Investments Systems Organization (PISO) .......... 39 The Development Bank of the Philippines (DBP) ............... 42 Commercial Banks .. 48 Investment Houses .. 48 This report was prepared by Messrs. Khalid Siraj, I. Ahmed, E.K. Hawkins, B. Cu Kok and J.B. Shim following a field appraisal of the project in August-September 1980. 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.  - ii - Page No. 6. CONCLUSIONS AND RECOMMENDATIONS ..... ........................ 49 Justification and Risks ....... .............................. 50 Features of the Loan ........................................ 51 Agreements and Understandings Reached at Negotiations ........ ................................... 52 Recommendation .............................................. 53 LIST OF ANNEXES 1. Philippine Government's Statement of Policy on the Future Evolution of the Financial Sector. 2. Operating Policy Guidelines of the Apex Development Finance Unit, Central Bank of the Philippines. 3. Outline of ADFU's Guidelines on Procurments. 4. Private Development Corporation of the Philippines: A Review of Institutional, Operational and Financial Aspects. 5. Philippine Investment Systems Organization: A Review of Institutional, Operational and Financial Aspects. 6. Development Bank of the Philippines: A Review of Institutional, Operational and Financial Aspects. 7. Supporting Tables. T-1 Composition of Gross Value Added in Manufacturing, 1970, 1975 and 1979. T-2 Projected Macroeconomic Performance: With and Without Structural Adjustment. T-3 Total Assets of the Philippine Financial System, 1974-80 (June 30). T-4 Status of the Bank's Industrial Lending to the Philippines, as of December 31, 1980. T-5A Characteristics of Subprojects Financed Under the Bank's DFC Loans by Sectors and Regions, as of September 30, 1980. T-5B Characteristics of Subprojects Financed under Bank's SMI Loans. T-6 Comparative Selected Data on Commercial Banks Identified as Potential PFIs. T-7 Comparative Selective Data on Investment Houses Identified as Potential PFIs. T-8 Estimated Quarterly Disbursement Schedule for the Proposed Bank Loan.  PHILIPPINES INDUSTRIAL FINANCE PROJECT STAFF APPRAISAL REPORT I. The Industrial Sector /1 Critical Role of Industry in the Economy 1.01 Historically, the rate and pattern of industrial growth have been unsatisfactory and continue to be a significant cause of the country s eco- nomic problems. The industrial sector has been a large net burden on the balance of payments, relying heavily on imported capital, equipment and intermediate goods, but exporting very little. Nontraditional manufactured exports have increased rapidly in recent years, but export expansion has been concentrated on a few items and backward linkages with the rest of the economy have been limited. The efficiency and labor intensity of industrial invest- ment have also been less than satisfactory. Expansion of the economy's real output has been low relative to the high level of capital formation in the 1970s, reflecting in part the low efficiency of industrial investment. Due to the slow expansion of industrial employment, an excessively high proportion (85%) of incremental labor has been absorbed by the agriculture and services sectors resulting in low, or even declining, value added per worker in some areas and sectors. A primary cause of the balance of payments problem, low investment efficiency and low labor intensity has been the distortive effect of past trade, industrial and financial policies on the allocation and use of capital by domestic market-oriented manufacturing and service industries. 1.02 Improvement in the performance of the industrial sector is crucial to attaining the Philippines- development objectives. Manufacturing is the key to accelerating macro-income, employment and export growth; it is also important for restraining growth in imports of capital and intermediate goods and for using capital and foreign exchange resources efficiently. During the past year, the Government has taken a number of important steps to deal with long-standing structural problems. This chapter briefly highlights past policies which have been responsible for the evolution of the current indus- trial sector and the present structure and problems of the industrial sector. A presentation of the country-s industrial strategy and planned development program follows, including a discussion of the comprehensive reforms in industry and trade policy which the Government is implementing to bring about fundamental structural adjustment. /1 The industrial sector is normally defined to include mining and quarry- ing, construction, public utilities and manufacturing. The last of these is the focus of this chapter.  - 2 - 1.03 Planned financial reforms will play an important complementary role in improving the performance of the industrial sector. The Government is in the process of restructuring the financial system to make it more flexible and responsive to the country's long-term development needs. A review of the Philippine financial system, relevant problems and the reforms is given in Chapter 2 of this report. Policies and Incentives Contributing to Present Structure of Manufacturing Sector 1.04 Postwar Industrialization and Trade Policies (1950-70). In the 1950s and 1960s, import substitution was the major objective of the Govern- ment's industrialization policy. Strict foreign exchange controls and restrictions on imports of nonessential goods, in response to balance of payments problems, resulted in the development of strongly protected domestic consumer goods industries and made imported raw materials, intermediate goods and capital goods available at artifically low prices due to the higher valuation of domestic currency that the controls permitted. Throughout the 1960s, trade policy continued to favor import substitution in consumer goods production with the result that by the end of the decade, the manufacturing sector was heavily dependent on imported inputs and there were virtually no manufactured exports other than traditional processed primary commodities. Moreover, the artifically low prices of capital goods, in combination with high protection, led to inadequate employment creation and allowed consider- able inefficiency of investment reflected in a high capital/output ratio. The Philippines has an incremental capital/output ratio about 35% higher than neighboring Asian countries which have roughly comparable patterns of investment. 1.05 Industrialization Policy in the 1970s. Faced with a rapid deterio- ration of the balance of payments, due in part to the structurally unsound pattern of manufacturing growth, the Government realized in the late 1960s that exports in general, and manufactured exports in particular, needed to be more actively encouraged. Steps were also needed to accelerate industrial output and employment growth and to encourage more efficient use of resources by domestic industries. Consequently, an Industrial Incentives Act was introduced in 1967, which provided fiscal incentives (e.g., tariff exemption for imported equipment, accelerated depreciation, reinvestment allowances) for industrial investment in preferred areas. The Act also created a Board of Investment (BOI) to determine the preferred areas eligible for investment incentives through an Investment Priorities Plan and to administer the grant- ing of incentives. Subsequently, an Export Incentives Act was introduced in 1970 which granted fiscal benefits (e.g., tax credit for import duties and domestic taxes paid on inputs) to export-oriented industries. 1.06 Additional related policy measures included floating and subsequent depreciation of the exchange rate in 1970, and the introduction of various export promotion measures designed to give selected exporters of nontradi- tional manufactures access to duty-free imports. Initial steps were taken in  - 3 - 1973 to reform the tariff system by simplifying the rate structure and redu- cing the rate spread. Various programs for the promotion of small- and medium-scale industries were also adopted. Although manufactured export performance has improved significantly as a result of these measures, the performance of home industries /1 has remained inadequate and overall sector employment and output growth have improved only marginally. 1.07 The Incentive System and its Effects. The key instrument of the import substitution strategy discussed above has been tariff and trade policy. High tariffs and import restrictions have led to an inefficient use and allocation of resources, particularly capital, and have generally imposed an effective penalty on export production. Resources were channelled into industries mainly producing consumer goods for the domestic market which enjoyed high levels of protection. Fiscal and financial incentives also promoted inefficient use and allocation of resources. Fiscal incentives granted to industries without adequate attention given to labor intensity of subsectors have had a significant capital-cheapening effect, encouraging both an industry mix and choice of technology within industries that are excessively capital intensive. The complicated and burdensome process of administering the fiscal incentives has also effectively favored relatively large capital-intensive firms with representatives in Manila that can absorb the additional overhead costs. The financial system has further reinforced the capital-intensive bias of investment incentives. Bank lending rates have been subject to administrative ceilings which have tended to reduce the user cost of capital for selected firms eligible to borrow. Due to the inability of the banks to align interest rates with risk, other rationing devices (such as excessive reliance on collateral and preferential treatment for selected customers) have been unduly utilized by the financial sector to the detriment of the smaller, less well-established firms. To the extent that the investment incentives and financial policies de facto discriminated against small- and medium-size enterprises and labor-intensive industry, they indirectly discouraged regional dispersal since these industries are ones that might be expected to locate outside Metro Manila. In addition, both the fiscal incentive and banking systems are centrally administered from Manila, making it more difficult for entrepreneurs in other regions to avail of the fiscal benefits. The Present Structure and Problems of the Manufacturing Sector 1.08 The manufacturing sector accounts for 25% of GDP (1979), 30% of fixed investment and 12% of total employment. Food processing is the largest industry, contributing one-quarter of total manufacturing value added. Other major industries are chemicals, petroleum and coal, basic metal industries, textiles, and tobacco processing (Annex 7, T-1). Instead of being a dynamic /1 Home industries are those industries producing for the domestic market.  -4- leading sector, manufacturing grew relatively slowly during the last decade at 6.5% p.a. The structure of Philippine manufacturing is highly dualistic. The "unorganized" sector, defined as manufacturing establishments with less than five workers, employs nearly two thirds of the manufacturing work force but produces less than 5% of total manufacturing value added. The "organized" or "factory" sector produces most of the value added but provides only liraited employment opportunities. Home industries account for more than 80% of total manufacturing output, of which consumer goods constitute over 50%. 1.09 Manufactured exports are dominated by traditional mineral and agro-processing industries. Considerable progress was made during the last decade in increasing the processing of primary products such as copra, logs, and copper and thereby achieving a higher percentage of domestic value added. Exports of traditional manufactured products account for about half of total Philippine exports. Primary export processing industries are mainly large scale and capital intensive. In response to the various export promotion measures introduced in the early 1970s (paras. 1.05-1.06), industries producing such nontraditional exports as garments, electronics, handicrafts and footwear expanded rapidly. Their exports rose from just under $200 million in 1972 to about $2.0 billion in 1980. In contrast with primary export product processing, nontraditional export industries are more varied in size and are relatively labor intensive. Employment in these industries increased tenfold during the decade from 20,000 to over 200,000 workers. However, due to the high cost and low quality of domestic inputs, nontraditional exports are largely dependent on imported inputs and, as a result, have remained enclaves with only few backward linkages with the domestic manufacturing sector. Consequently, value added is only 25% of output in these industries. 1.10 Employment creation and regional dispersion continue to be two major problems confronting the manufacturing sector. Labor absorption in manufacturing has been low because of the relatively low growth rate of the sector and the capital intensity of "organized" home industries and commodity export processing industries. Employment in manufacturing has remained virtually constant at 10-12% of total employment since the early 1950s. Recently, employment in manufacturing has expanded at an average annual rate of about 3%, creating a mere 40,000 jobs and absorbing less than one tenth of the annual increase in the labor force. Employment in the dominant "unorganized" sector has expanded by only 1.1% annually. The dependence of import-substituting consumer goods industries on imported inputs has created a strong incentive for these industries to locate near Manila, the country's major port and consumer market. Provision of better infrastructure, investment and financial incentives, and centralized government administra- tion have added to the attractiveness of Manila. Excluding the resource- based industries, nearly 90% of all manufacturing value added is produced in and around the capital city.  5 Industrial Development Program 1.11 Since the late 1960s, the necessity of modifying the import- substitution industrial and trade policies of the previous two decades has been increasingly recognized in the Philippines. A number of reforms in the early 1970s marked the start of a more outward-looking policy (para. 1.05 and 1.06). In 1977, the Government commissioned a study of its industrial policies by a University of the Philippines team which indicated that the chief causes of poor industrial performance were the highly protective trade regime and the capital-intensive bias of investment promotion policies./l Simultaneously, the Ministry of Industry (MOI) had studies carried out of several industries that were felt to need restructuring. The shared concern of the Bank and the Government about the performance of the industrial sector led to the subsequent undertaking of a Bank industrial sector mission in early 1979 followed by a joint IMF-Bank financial sector mission to look at interrelated questions of banking reform and industrial finance (para. 2.20). The reports of these two missions /2 confirmed the findings of the Govern- ment's own studies and helped to formulate strategies for industrial and financial development. 1.12 Industrialization Strategy. The Philippine national economic development strategy was set out in a Five-Year Development Plan for the period 1978-82. The Plan's major objectives include: (a) accelerating the rate of growth; (b) generating sufficient productive employment opportunities for the rapidly growing labor force; (c) providing for the basic needs of the population; and (d) reducing social, regional and economic disparities. The industrialization strategy in support of this plan aims at increased processing of domestic raw materials, continued increases in exports of nontraditional manufactures, accelerated employment generation by small- and medium-scale industries and the implementation of selected large-scale projects. Broadly, the Government seeks to develop an industrial structure which is based on the country's comparative advantage with respect to labor costs and raw material availability and which is efficient and competitive by international standards. To achieve these objectives, both continued export expansion and restructuring of home industries are necessary as neither, alone, is likely to be sufficient. /1 Romeo M. Bautista, John H. Power and Associates-, Industrial Promotion Policies in the Philippines (Manila, Philippines, The Philippine Insti- tute of Development Studies, 1979). This study was partly financed under the Bank Loan No. 1374-PH for the Third Education Project. /2 IBRD Reports No. 2513-PH (in 3 volumes) and 2546-PH, entitled Industrial Development Strategy and Policies in the Philippines, and The Philippines: Aspects of the Financial Sector, dated October 29, 1979, and October 1, 1979, respectively.  1.13 By strengthening export promotion measures, continued expansion of manufactured exports can be maintained with increased backward linkages and greater participation by industries, firms and regions. The Philippines is in a potentially strong competitive position to further expand its labor intensive exports as its wage rates and labor productivity levels compare favorably with those of its international competitors. Furthermore, marketing channels have been established and entrepreneurs have gained significant experience in exporting. 1.14 As home industries account for more than 80% of manufacturing investment, output and employment, an improvement in their performance is necessary if the manufacturing sector as a whole is to make more efficient use of capital and foreign exchange resources and create substantially more employment. Reorienting trade and investment incentives to improve capital efficiency and allocate investment to more labor-intensive lines of produc- tion will both save resources and generate more employment per peso of investment. The resources saved, in turn, can be devoted to either raising investment or expanding consumption and the domestic market more rapidly. Furthermnore, if home industries are encouraged to become more competitive by international standards and to develop in line with the country-s compara- tive advantage, they should also be able to export an increasing share of their output, either directly or indirectly. The Policy Reform Program 1.15 To help implement its industrial objectives, the Government recently outlined its industrialization strategy in combination with a policy reform program in a Statement of Industrial Policy for the 1980s. This statement provided the basis for the Bank's first Structural Adjustment Loan (SAL I) of $200 million which was approved in September 1980./l 1.16 The policy reform program includes staged reforms over a five-year period to correct the import substitution and capital-intensive biases of existing industrial and trade policies, and covers the following five major areas: (a) export incentives and promotion measures; (b) tariff reform, trade liberalization, and complementary measures; (c) investment incentives and their administration; (d) industrial restructuring; and (e) major industrial projects. Not all the elements of the industrial policy reform can be imple- mented simultaneously. Hence, the Government-s initial policy reforms have been focused primarily on trade policy (i.e., export incentives and tariff reform) since it has been chiefly responsible for the disappointing perfor- mance of the industrial sector. Although some progress has been made in the other three areas (investment incentives, industrial restructuring, and major industrial projects), major advances in these areas will take a number of /I Yor details of the structural adjustment program, refer to the President's Report No. P2872-PH, dated August 21, 1980.  years to achieve, and will form the basis of future dialogue between the Bank and the Government. Under the SAL I, a technical assistance component of $5 million has been established. The Government plans to draw on this component to help finance the various studies and training programs which will be necessary to support and implement the policy reform program. Highlights of the reform program are discussed below. 1.17 Export Incentives and Promotion Measures. Starting in 1979, the Government initiated steps to strengthen the export regime by: (a) streng- thening and broadening fiscal incentives for export production and trading; (b) simplifying import/export procedures; (c) liberalizing bonded manufac- turing warehouse arrangements for exporters; (d) improving export financing facilities; and (e) strengthening institutions that promote exports and international trade. With regard to fiscal incentives, in October 1979, the Government decided to make export industries eligible for all those fiscal incentives that were earlier available to only home industries and increased the coverage of fiscal incentives available to export traders and trading houses. In addition, to improve export/import procedures, the Government adopted appropriate administrative measures to simplify the hitherto time-consuming duty drawback system and burdensome export documentation requirements. The Government also plans, with the assistance of IMF, to introduce standard costings/allowances for the tax credit/duty drawback on imported inputs into export production. In order to make bonded manufacturing warehouses more generally available to both large and small exporters, the BOI has improved its control procedures and eased the eligibility requirements. A Bonded Export Marketing Board was also created in October 1979 to promote bonded manufacturing facilities and to widen the range of products and industries using such facilities. With regard to export financing, the availability of credit for working capital requirements of export industries has been limited in the past, particularly for smaller and nontraditional exporters. To correct this shortcoming, in April 1979 the Central Bank suitably modified its rediscount facility. In addition, the Government empowered the Philippine Export and Foreign Loan Guarantee Corporation to guarantee loans to the export sector. The Government is also studying possibilities of improving the availability of medium-term credit for export industries and improving the participation of the commercial banking sector in extending medium-term export financing, particularly to the smaller and newly established export industries. Finally, the Government, through various administrative measures adopted in 1979 and 1980, has made important institutional improvements to better serve the needs of export industries. These measures include: reorganization of the Ministry of Trade; supporting the establishment of export trading companies which would, inter alia, extend export finance to their small-scale suppliers; and broadening the charter of the Export Processing Zone Authority (EPZA) to enable it to plan, develop and manage 12 new industrial estates.  -8 - i.18 Tariff Reform and Complementary Measures. The objectives of the Government's tariff reform are to lower the overall level of protection in the economy and to even out the spread in tariff rates within and between industry sectors. The reform will establish a system of nominal tariff rates between 10% and 50% and should bring most effective rates of protection within a range of 10-80%. Since the continuation of import licensing would work against the aim of the tariff reform, liberalization of licensing will be undertaken simultaneously. Subsectoral restructuring programs will also be initiated to help existing industries adjust to the policy changes (para. 1.25). 1.19 In August 1980, the Government legislated a comprehensive tariff reform covering 75% of the line items in the Tariff Code. In respect of the remaining 25% of the line items, legislation is expected to be passed in the first half of 1981./l Starting in January 1981, tariff rates for 14 important industry subsectors will be realigned (over a four-year period to cushion their impact) to achieve greater uniformity in protection and the current peak tariff rates for all other industries will be reduced (in two steps on January 1, 1981 and January 1, 1982) from 100% and 70% to a ceiling rate of 50%. The reform will reduce overall effective rates of protection for the economy from 36% to 23% and for the manufacturing sector from 44% to 29%. The movement toward greater uniformity in effective rates will reduce allocative distortions and provide a more even incentive for import substitution. The reduction in the higher rates of protection afforded to some industries should, in the long-run, lead to increases in competitiveness and efficiency and help strengthen the linkages between home and export industries. 1.20 While import licensing was maintained for balance of payments reasons, it is in some cases a stronger protective device than the applicable tariff. Many of the products on which peak tariffs are being lowered, as well as the products of 13 out of 14 subsectors for which tariff revisions are being made, are subject to licensing. As continued import licensing would defeat the tariff reform's objectives of fostering greater competitiveness of domestic industry and encouraging stronger linkages with exports, in August 1980, the Government adopted a plan for removal of import licensing restrictions. The liberalization of licensing will proceed in stages in coordination with the tariff reform to allow local industries time to adjust and to spread the balance of payments effect over the four-year tariff reform period. 1.21 Although the revenue loss from the tariff reform is expected to be small, increases in indirect taxes are desirable to help constrain private consumption and the expansion of imports that could result from lowering tariffs and relaxing import licensing. The Government, however, will /1 The Government is in the process of reviewing the remaining 25% of line items so as to complete the realignments of nominal tariff rates within the 10-50% range in all subsectors.  consider revision in indirect taxes if they become necessary in the future as tariffs are lowered and import restrictions eased. 1.22 As tariffs are lowered, the exchange rate wili become increasingly important as an instrument for promoting efficient resource allocation. Furthermore, while the proposed tariff and trade policy reforms will ultimately have beneficial effects on the balarnce of payments, the time path of the adjustment process and the short-term effects on the balance of payments will depend greatly on exchange rate policy. The Government intends to maintain a flexible exchange rate policy conisistent with basic market prices, taking into consideration the need to keep the current account deficit at a sustainable level as well as the desire to prevent disorderly fluctuations in the exchange rate. The exchange rate issue will be a matter of close review by the Gov'ernment, IMF and the bank. 1.23 Investment Incentives and Promotion Policy. Analytical work on investment incentives and promotion policies was started after that on export promotion and tariff reform. Although some urogress has been made; major improvements in investment incentives and their adrministration will require sustained effort over time. Reforms in these areas are related to removing the capital bias of fiscal incentives, improving the allocation system, adopting appropriate policies towards regional dispersion of industry and streamlining of administrative procedures for granting of incentives. 1.24 With regard to the capital-intensive bias of the incentives, MOI/BO0 is studying the feasibility of introducing a labor-favoring package of incentives. The feasibility of eliminating the tariff exemption on imported equipment as an investment incentive for firms oriented towards the domestic market will be examined in the future. In 1979, 1401/BOI made significant changes in its processes of priority determination and project evaluation, thus improving the allocation system. Revised guidelines were adopted to reduce the number of industries on the "overcrowded industries" list. In March 1980, MOI/BOI formulated proposals for making greater use of economic analysis in priority determination and project evaluation. In order to improve the regional dispersal of industry, a law was enacted in May 1980 to provide additional incentives for investments in the underdeveloped areas of the country. In addition, all Government financial institutions are to give priority to projects in the less developed areas. The Government is studying the feasibility of introducing additional measures to encourage industries to locate outside the Metro Manila area. Improved infrastructure would be provided in the regions through the national export processing zone/industrial estate program. In order to better implement and administer the above changes, MOI/BOI has also streamlined some of the procedures for the administration of incentives, reducing the paperwork requirements for registration and cutting-down the processing time for the evaluation of projects. Further measures being considered by the Government are: (a) review of the staffing requirements necessary to complete the reorganization of MOI/BOI and implement improved procedu res; and (b) improvements in BOI-s  - 10 - management information systema for monitoring the performance of BOI-registered projects. 1.25 Industrial Restructuring. Subsectoral restructuring programs, which would set the course for the development of a particular industry over a five-year period, are to be implemented concomitantly with trade liberali- zations and improved investment promotion procedures. The programs would specify the direction of a subsector's development, government policies and the role of the private sector, and the instruments required to implement the program (e.g., incentives, level of protection, financial and technical assistance) and would be designed to help existing industries produce at lower costs, improve efficiency and otherwise increase their competitiveness. Sectoral restructuring would constitute "adjustment" assistance to industries affected by the tariff reform and would emphasize positive measures to increase competitiveness rather than the continuation of negative protective measures that retarded development. Programs for restructuring the cement and textile industries are now underway. Additional industries have been tentatively identified as needing restructuring programs, however, much remains to be done to give focus and content to these programs. The development of small- and medium-scale industries (SMI) can contribute to creating employment, generating exports, utilizing more domestically available resources and stimulating development outside of Metro M'lanila. Existing SMI development programs, however, suffer from a number of shortcomings. Although the overall availability of credit to SMI has improved, the various credit programs have remained highly concentrated in the Metro Manila/Southern Tagalog areas. Working and venture capital finance is not readily available to SMI and technological and skill development programs for SMI need to be strengthened. MOI is in the process of actively formulating programs which would broaden the scope of its assistance to SMI. 1.26 Major Industrial Projects. In September 1979, a program of 11 major industrial projects was announced by President Marcos. In October 1979, the National Development Company was reorganized and revitalized to act as the corporate arm of the Government in initiating priority industrial projects. The 11 projects are expected to contribute to technological deepening and import substitution in the production of intermediate goods. The Government is taking an active role in promoting the projects because they are typically large, involve new technology, have relatively long gestation periods, and hence are considered risky by private entrepreneurs. As there are multiple demands on the country-s limited capital resources, initiation of the projects would be phased over a five-year time period. To the extent possible, foreign capital and export credits would be utilized to finance the projects. 1.27 The 11 major industrial projects will have a significant effect on the outcome of the overall industrial development program. Much will depend on care and good judgment in preparing and carrying out the projects, and  - 11 - project design will need to emphasize foreign exchange earning or saving capacity. The Government intends to continue a prudent and flexible approach towards the implementation of the major projects, establishing them only after rigorous economic and financial analyses have convincingly demonstrated their viability. Anticipated Effects of Policy Reforms on the Manufacturing Sector 1.28 The policy reforms discussed in the preceding paragraphs have concentrated on the rationalization of trade policies. The reforms already completed represent a major step towards a freer and a more open trade regime. They will make possible the operation of home industry in a much more efficient and competitive environment and encourage productive resources to be allocated to areas of activity in which the Philippines has an existing or potential comparative advantage. The reforms will gradually remove the tools which enabled inefficient operations to survive and sometimes thrive, to the economic detriment of the country. Subsequent phases of the reform program will require large inputs of staff and management time and the continued full support of BOI/MOI at the highest levels. In view of the Government's strong commitment to the program and its performance to date, significant further progress is likely over the next few years. 1.29 The policy reform program should lead to a substantial restruc- turing of the industrial sector and an improvement in its performance. The combined effect of the policy reforms aimed at domestic and export industries would be to accelerate the growth of manufacturing value added (from 6.5% to over 9% in 1985-90) (Annex 7, T-2). Higher output growth, together with an increased employment elasticity, would double the annual rate of employment creation (from 3% to 6%), so that the manufacturing sector would generate 150,000 jobs per year and account for about one-fourth of the new jobs required in the economy as a whole. 1.30 Domestic market-oriented and nontraditional export industries would each generate about half of the projected increment in manufacturing output and employment growth. Nontraditional manufactures would play a central role in sustaining the country-s export drive, while home industry would contribute to reductions in the capital/output ratio and the import elasticity. The recent strengthening of export incentives and promotion measures should permit the nontraditional manufactured export drive to be continued with increased backward linkages and participation by more firms, industries and regions. Given the projected growth in overseas markets, the volume of nontraditional manufactured exports could potentially grow at an average rate of 16% p.a. over the next decade, with employment in these export industries growing at a slightly lower rate. In the absence of the measures being taken to strengthen export incentives, Philippines export performance would have been closer to the projected average growth for developing countries of 11% and employment creation would be correspondingly lower. The reforms affecting home industry would help raise its employment elasticity. Greater labor intensity in home industries, together with the projected growth in nontraditional manufactured exports, would also benefit small- and medium-scale industries because of  - 12 - their comparative advantage in labor-intensive sectors. This, in turn, would stimulate manufacturing activities in outlying regions where labor costs are lower, and reinforce the locational effects of planned infrastructure investment in these regions. 1.31 Without the policy reform program, manufacturing performance would have continued along the lines of the 1970s. The average annual growth of manufacturing value added would have fallen (from 6.5% to 5.4%) in the late 1980s primarily because of increasing constraints imposed by high cost and inefficient production for a limited domestic market. The number of jobs added in manufacturing each year would be 70,000 lower than would be created with the reforms, and although nontraditional manufactured exports would grow at a respectable average rate of about 13% p.a., they would have been nearly $2 billion lower in real terms at the end of the decade. 2. THE FINANCIAL SECTOR 2.01 The proposed project is closely associated with the development of the financial sector. This Chapter is divided into four main sections: a brief overview outlining the historical development and current problems in the financial sector, a description of the major financial institutions, a review of the recent reform measures and the need for and direction of future reforms. Overview 2.02 The financial sector in the Philippines is relatively well developed and, in many respects, the financial system has served the country well. The external creditworthiness of the Philippines has been firmly established, starting from a precarious and difficult balance of payments position in the early 1970s. The shock of the sharp and extended deterioration in the terms of trade (following the oil price increases in 1973-74) was weathered without disturbance to the monetary system. The banking system was strengthened by increases in capitalization mandated by the reforms of 1972,/l a sophisticated money market was developed and a basis was laid, through creation of Off-Shore Banking Units (OBUs) and Foreign Currency Deposit Units (FCDUs), for linkages with the international banking system. At the same time the banking system was strengthened through substantial improvements in the professional management of institutions, general upgrading of operational standards and by a tighter control on its operations and management by the Central Bank. /1 These reforms were formulated by a joint IMF-Central Bank Survey Commission and were aimed at strengthening of commercial banks through increase in their share capital, provision of enhanced regulatory and supervisory powers to the Central Bank and statutory separation of commercial banking from investment banking.  - 13 - 2.03 The rapid evolution of the financial system in the 1970s resulted in universal responsiveness of the system to the needs of the economy for mobili- zation of savings in financial form. Total gross assets of the financial sector grew by 11% (in real terms) between 1974 and 1979 (Annex 7, T-3) while real GNP grew at 7%. The range of financial assets increased and there was a clear response on the part of the savers to keep a larger proportion of their savings in financial form. 2.04 Gross domestic savings have been relatively high in the Philippines in the recent past, but Government's objective is to further increase it from 24% to 27% of GNP over the next ten years to reduce its reliance on foreign savings. While all sectors are expected to increase their rate of savings, the household sector share is expected to rise from 9% of GNP in 1978 to over 11% in the 1980s. This will imply a marked increase in the savings effort in a sector which is already shouldering the task of financing a large part of the country's investment requirements. Not only is there the need to increase the absolute rate of savings, there is also general agreement that it would be desirable that an increasing proportion of such savings should be available and intermediated on a longer-term basis. Long-term peso funds have been particularly scarce in the past and the main shortcoming of the financial system is that it has failed to provide adequate long-term finance. As the country continues to industrialize, the needs of industry for such longer-term finance will become particularly imperative, although other sectors, such as agriculture, mining, and housing will also require such financing. 2.05 As the economy has grown in size and complexity, the Government has become increasingly aware of the need to make adjustments in the financial system to enable it to respond better to present and future needs. Histori- cally, the financial system has grown in a rather ad hoc fashion and specialized institutions were set up in response to specifically identified needs. The Central Bank carefully guided and regulated the financial system and the functions and sources of funding of various classes of banking institutions were limited by administrative regulations. The tendency to specialization was reinforced by the implementation of the reforms of 1972, which reaffirmed and made more definitive the separation of regular banking activities - the normal task of commercial banks - from investment banking activities, notably merchandizing, distribution and underwriting of security issues. Commercial banks were prohibited from the acquisition of equities, other than in "allied undertakings." Specialization led to considerable fragmentation among institutions, limited competition by segmenting markets and reduced the responsiveness of the system to changing needs and demands. It also did little to lengthen maturities and promote longer-term lending and borrowing. 2.06 At the same time the incentive system has not been geared to mobilize sufficient savings, encourage longer maturities and allocate resources where they were most needed. Nominal interest rates have been closely regulated and during periods of relatively high inflation, as in 1979 and 1980, real interest rates have been essentially negative. Low real interest rates have been one of the major factors contributing to  14 - relatively inefficient and capital intensive investment. i4oreover, the absence of adequate differentials between short- and long-term rates inhibited longer-term savings and stood in the way of banks investing in longer term obligations. 2.07 The problems in interest rate structure were aggravated by Central Bank rediscounting policies. The Central Bank has maintained a complex series of rediscount windows at concessional rates to support what it considers to be "priority" areas of investment. This has frequently resulted in misallocation of resources, encouraging overinvestment in some areas while other sectors of the economy, such as smaller manufacturing enterprises and housing were starved for investment funds. At the same time, "lender-of-last-resort" discounting facilities have been practically non- existent which accentuated the liquidity preference of banking institutions and compelled them to match the maturities of their assets and liabilities. Institutions in the Financial System 2.08 Controlling the entire financial system is the Central Bank of the Philippines. It possesses extensive regulatory powers over the financial sector, formulates and operates the monetary policy of the Government, provides loans and discounts to financial institutions in accordance with the imperatives of monetary stabilization and development policy and exercises wide powers to supervise, inspect and discipline financial institutions. 2.09 The financial system comprises the banking sector, consisting of commercial banks, rural banks, thrift banks, private development banks and specialized Government-owned banks, and the nonbanking sector, comprised of investment houses and finance companies. In addition, there are the social security institutions consisting of private insurance companies, the Government Services Insurance System (GSIS) and the Social Security System (SSS). A brief review of the various types of institutions is given below. 2.10 Commercial Banks. At the center of the financial system are the commercial banks, both domestic and foreign, which command more than half the resources in the financial system. At the end of 1979 there were 26 private domestic commercial banks, two Government or semi-Government banks and four branches of foreign banks. The Government-owned Philippine National Bank (PNB) and the top ten private commercial banks together commanded nearly 70% of the total resources of the commercial banking system. In contrast, there were several banks which had a low capital base and which possessed small resources that were often expensively mobilized, evidencing need for either strengthening of their capital bases or consolidation through mergers. 2.11 At the end of 1979, the deposit structure of commercial banks comprised 20% demand deposits, 37% savings deposits and 42% time deposits. Although time deposits as a percentage of total deposits more than doubled between 1969 and 1979, the resources of commercial banks (as is normal with such institutions) remained essentially of a short-term character and maturities were rarely in excess of two years. Longer term deposits have in  - 15 - the past been inhibited by restrictions imposed by the Central Bank on interest rates, and statutory restrictions and disincentives. Commercial bank lending has been predominantly short-term (usually not exceeding one year). 2.12 Rural Banks have so far had a unitary structure and had for their main function extension of production credits to small farmers and loans to rural enterprises. by 1979 their number exceeded 1,000 and they covered a wide geographical area. Although they provided 16% of all institutional agricultural credit, their assets comprised only 2% of the total assets of the financial system. Besides, their powers were severely restricted as they could provide finance only to small farm families cultivating not more than 50 hectares of land, small merchants whose capital did not exceed P 50,000 and cooperatives. Their resource mobilization effect has been meager; they have been heavily dependent on funding from the Government and have little capacity for designing projects or undertaking project evaluation. Notwithstanding these deficiencies, the rural banks constitute an important element in the Government's rural development strategy and have in the past served as secondary channels for Bank agricultural lending. 2.13 Thrift Banks. There are three categories of thrift banks: stock savings and loan associations which extend credit for not more than 12 months, savings and mortgage banks which invest depositors' monies in bonds or loans for housing and private development banks (PDBs) which provide medium- and long-term loans to small- and medium-scale enterprises. The resources of PDBs are partly derived from time and savings deposits and substantially from loans from the Government-owned, Development Bank of the Philippines (DBP). The PDBs have essentially been undynamic institutions but in view of their geographical diffusion they possess potential for being reorganized into effective vehicles for SMI and rural industries financing. 2.14 Specialized Banks. These are Government-owned institutions. The major specialized institutions are the DBP, the Land Bank of the Philippines (LBP), both of which have received loans from the Bank and are capitalized at a high level, and the Philippine Amanah Bank (PAB). DBP performs a variety of functions and finances both industrial and agricultural enterprises as well as large and small enterprises in these sectors. The LBP was established mainly to finance the acquisition of landed estates by the Government as a part of the land reform program and PAB provides credit to Muslim communities in Mindanao. The DBP is an institution of particular importance as its resources constitute nearly 11% of the total resources of the Philippines financial sector and it is the principal source of long-term credit in the Philippines. Notwithstanding substantial improvement in its operational standards and staff quality resulting from the Bank's financial and technical assistance to it, much yet needs to be done to assist DBP's development into a competent professional institution. The size of its development financing and the reach and diversity of its operations make it a significant factor in the Philippine financial system. As a prospective participating financial institution in the proposed Bank loan, its organization and operations are more fully dealt with later in this report (Chapter 5).  - 16 - 2.15 Investment Houses. The "rationale" for the establishment of invest- ment houses was to underwrite corporate securities, but in retrospect this was an objective which they have not been able to fulfill adequately. They have instead been active in short-term money market operations and have derived resources through the issuance of "deposit substitutes" of short-term maturity. As such, they have been in direct competition with commercial banks in the mobilization of short-term resources and have almost exclusively used their resources for financing short-term needs, which also are catered to by commercial banks. The combined resources of investment houses at the end of 1979 constituted no more than 3% of the total resources of the financial system. In the context of investment houses, mention needs to be made of Private Development Copporation of the Philippines (PDCP) and the Philippine Investments Systems Organization (PISO). Although they are licensed investment houses, their major function is development banking. They provide long and medium term loans, principally in foreign currencies, participate in equity financing and in underwriting of shares and securities. Both the institutions are borrowers of the World Bank (para. 3.02)./l 2.16 Finance companies are stock corporations which extend credit to enterprises and directly to consumers, usually by discounting commercial papers or accounts receivables. They also engage in leasing. Their resources are relatively small and their main activity is centered around consumer finance. Almost 85% of the total resources of finance companies is accounted for by three companies which are joint ventures with Fidelity International Bank, Citibank and Chase Manhattan Bank. 2.17 The Insurance System. The total assets of the private insurance companies and the Government Service Insurance System (GSIS) and the Social Security System (SSS) comprise about 16% of the total assets of the financial system. The insurance sector funds have not been utilized towards any meaningful development of the long-term financial market. GSIS makes direct investments in stocks and bonds of both private and government institutions and in the process assumes substantial liquidity risks. The SSS operates on a more conservative basis. Notes receivables of PNB and DBP constitute 60% of its portfolio; the balance of its investments are housing loans and loans to policyholders. Private insurance companies invest mainly in bonds and undertake mortgage financing. About 15% of their portfolio is invested in equities; the relatively low participation in equities is the result of Government regulatory restrictions on their investment in this field. The Financial Markets 2.18 Capital Market. The capital market in the Philippines has not been a significant source of medium- and long-term finance. The limited extent to which the capital market serves as a source of long-term capital for the J1 Details of PDCP's and PISO's organization and operations are discussed in Chapter 5.  - 17 - private sector is illustrated by the small number of public offerings in the primary market. At present there are only 196 equity issues listed on the stock exchanges (representing 0.5% of all corporations registered with the Securities and Exchange Commission) and only one bond issue. Growth of the capital market, both in the number and size of issues, is however, desirable in the pursuit of objectives such as a wider distribution of equity ownership, mobilization of long-term capital for development and providing a secondary market outlet when financial institutions need to revolve their portfolios. But such growth cannot be expected to occur quickly, and it is, therefore, unlikely that the capital market will, in the near future, become a predominant intermediary for long-term flow of funds into private industry and trade. Nevertheless, policies, practices and institutional developments can be undertaken to encourage growth of an efficient capital market. The most important elements of an environment conducive to capital market development are the regulatory framework and the tax regime. The former is the responsi- bility of the Securities and Exchange Commission (SEC) whose activities have been recently expanded. Significantly, under the contemplated reform of the Corporate Law, the SEC will be given powers to require corporations to go public where the public interest so requires. However, the present definition of a "public offering" as a sale to a very small number of outside share- holders (15-20) is ineffective in broadening the base of ownership. In addition, the tax treatment of corporate income, interest and dividends needs to be reviewed to encourage a genuine public ownership base. 2.19 Money Market. In contrast with the marginal role of the long-term capital market, the short-term money market has played an important role in the Philippines. In the early 1970s, the money market grew very rapidly and its volume of business escalated at an annual rate of 50% during 1974-75; deposit substitutes increased to the equivalent of about 80% of the total savings and time deposits with commercial banks. This spectacular growth was made possible by an absence of control over money market interest rates and consequently the effective rate on deposit substitutes rose to over 30% p.a. in comparison with the time-deposit rates of 8 to 11%. The flurry of activity in the money market, however, brought about no noticeable change in extension of maturities in money market borrowings, at least not beyond the two-year limit. In 1976, the Government sought to reduce the wide disparity between effective yields on deposits and deposit substitutes by imposing a transaction tax of 35% on deposit substitutes and by limiting after tax yields on deposit substitutes to 16%. These measures slowed down the growth rate of deposit substitutes to only 5% per annum after 1975. The Financial Sector Reforms of 1980-81 2.20 The Joint IMF/World Bank Study. In the late 1970s, the Government became increasingly concerned about the future direction of the financial system and in 1979 commissioned a joint IMF/World Bank study on the financial sector in the Philippines. The mission's report concluded that the major problem besetting the financial system was that specialization of functions  - 18 - had led to excessive fragmentation and there were too many institutions, often too small, to function efficiently and effectively to meet the financing needs of a growing economy. What was needed was to reduce legislated specialization so that the financial sector as a whole could move away from its rigidly compartmentalized and specialized structure to a system in which institutions would be free to respond flexibly and competitively to the changing needs of an evolving economy. The report, therefore, recommended that measures should be adopted enabling commercial banks to provide medium and long-term credit and to participate in the underwriting and financing of equity. The report also recommended changes in interest rate, in discount and monetary policy and in fiscal policy to provide for greater responsiveness to market forces and greater incentive for long-term lending. Substantially based on the recom- mendations contained in the joint IMF/World Bank financial sector report,/l and a series of subsequent discussions held between the Government and the Bank staff, the Government prepared and implemented a comprehensive set of banking and financial reforms, briefly described in the following paragraphs. 2.21 Institutional Reforms. The first step was a series of amendments to the basic banking legislation which were approved by the National Assembly in March 1980. The following summarizes the major instituitional changes brought about by the new banking legislation: (a) A new class of financial institutions (banks with expanded commer- cial banking authority) will be licensed under the new legislation and will, in their operations, combine commercial banking functions with investment banking, including equity participations and under- writing of equities and securities. The authorization for "expanded banking authority" will be given by the Monetary Board, the regula- tory body of the Central Bank, and commercial banks and investment houses can apply to be licensed /2 provided they meet the minimum net worth requirement and other criteria prescribed from time to time by the Monetary Board. The net worth requirement has, to begin with, been set by the Monetary Board at P 500 million. The regu- lations guard against overconcentration of economic power in "expanded banks" as they are not permitted to hold more than 35% of the paid-in share capital of any enterprise in whose equity they invest. Further, their equity investments are kept within prudent limits by restricting their aggregate holdings in stocks to 50% of their net worth. Permission has already been given by the Monetary Board to PNB to function as an "expanded bank." /1 The World Bank, Philippines: Aspects of the Financial Sector, October 1979 (Report No. 2546-PH). /2 Thrift and rural banks must first become commercial banks before they can seek authorization to become "expanded banks."  - 19 - (b) Thrift banks have now been granted full domestic banking authority, including opening of checking accounts, but will not have authority to undertake foreign banking operations or perform investment bank- ing functions. Rural banks, which in the past operated as unit banks, have now been given power to establish branches and perform most domestic banking functions, except establishment of domestic letters of credit. The restrictions on the size of their operations have also been abolished. These expanded banking functions will enable thrift and rural banks to provide a broader scale of services to the housing, farm and SSE sectors and will provide them a wider field of operations and enhance their ability and incentives for higher resource mobilization. The wider functions which thrift and rural banks will now perform will make banking facilities more wide- spread in the Philippines and will bring about a healthy competition between these institutions and commercial banks. (c) Investment houses have been permitted to undertake trust and foreign exchange operations and given access to the Central Bank's dis- counting facilities. Considering that they will now have to compete with large "expanded banks," it is likely that they will specialize in merchant banking functions (in addition to direct investment financing) and provide investment advisory and resource packaging services to Philippine entrepreneurs. This service can be of considerable utility as the Philippines adopts more complex and sophisticated project financing techniques. PDCP and PISO, who are borrowers of the Bank, will continue, in addition, to perform their development banking functions and would be participating financial institutions in the proposed Bank loan. Although these amendments do not in themselves abolish the specialized nature of the banking system, they do enlarge institutional functions, make possible greater competition as between various categories of institutions and provide them greater flexibility in their operations. Subject to the consent of the Monetary Board, the reforms will also make possible the evolution of financial institutions from one category to another. 2.22 Monetary Policy Reforms. As a further step towards implementation of the reforms, particularly to facilitate term-lending, the Central Bank adopted, in August 1980, a number of monetary policies. Four of these are of particular significance: (a) The Central Bank has established a "lender-of-last-resort" facility to provide liquidity to the banking system in times of cash strin- gency. Although discounting facilities were available in the past, they were highly discretionary, very limited and were often suspended, creating serious problems for banks at times when liquidity needs were most urgent and pressing. Under the new regulations, "lender-of-last-resort" discounting would be more or less automatic. These assured arrangements for overcoming temporary liquidity shortages will broaden the planning horizon of  - 20 - banks and encourage them to undertake term-transformation with greater confidence. (b) For the first time, long-term bills will be eligible for Central Bank discounting. All such bills when discounted by the Central Bank will be at 6% p.a. below the interest rate at which the financial transaction reflected in bill was provided. The dis- counting facility itself and the substantial discount of 6% will act as important incentive to term lending. (c) "Expanded banks" and commercial banks would be further encouraged to lend long- and medium-term by two measures: (i) the Monetary Board has been given discretionary powers to reduce the risk assets to net worth ratio from 10% to 6% to provide additional leverage to banks to undertake term financing; and (ii) the previous statutory limit which permitted a maximum of 20% of deposit resources to be used for term-financing, has been abolished and discretionary powers have now been given to the Monetary Board to prescribe from time to time ceilings for term lending in accordance with the needs of the economy and consistent, of course, with sound liquidity management. (d) To encourage longer-term deposits, reserve requirements have been fixed at a nominal rate of 5% for all deposits whose original maturity exceeds 730 days. This change will become effective on January 1, 1982. 2.23 Fiscal Incentives. The third element in the reforms package is fiscal incentives. The most significant incentive involves a reduction of gross receipts tax on interest income on loans of longer maturity. The measure envisages that no tax will be levied on maturities exceeding 7 years, 1% on maturities between 4 and 7 years, 3% on maturities between 2 and 4 years and 5% on shorter maturities. A second incentive exempts "expanded banks" from tax on dividends earned by them on their equity investments. Both these measures are meant to encourage term lending and equity investments. Another significant fiscal measure that has been adopted exempts share transactions, that have for their objective the merger of financial institutions, from capital gain tax. 2.24 Interest Rate Policy. Until 1976, interest rates that could be charged by the banking system were restricted to a maximum nominal rate of 12% p.a. for loans secured by real estate mortgage and 14% p.a. for loans not so secured. The banks, however, discounted interest at the time of disbursement and this practice gave them an effective yield of 13.6% and 16.3%, depending upon the security offered. In addition, banks were allowed to charge service fees ranging from 0.75% to 2% p.a. OnA the deposit side, savings rate was 6% p.a. and time deposit rate a maximum of 11.5%, p.a.  - 21 - 2.25 Between 1976 and 1981 the Central Bank made substantial changes in the interest rate structure as outlined in the summary below: (a) a distinction is now made between long-term and short-term interest rates and financial institutions are permitted to charge 21% (inclusive of service charge) p.a. on loans of two years maturity or more and 16% to 18% (inclusive of service charge) on loans of shorter maturity. However, effective July 1, 1981 there will be no interest rate ceiling for loans of two years maturity or more; (b) the interest rate ceiling on deposits of 730 days maturity or more has been abolished. At present, short-term time deposits (less than 730 days maturity) are subject to a 14% ceiling while lower rates apply to savings deposits (9%) and NOW accounts (7%). However, effective July 1, 1981, the Government has decided to abolish interest rate ceilings on all types of deposits. Demand deposits, as is normal, will continue to bear no interest; (c) in August 1980 the Government gave financial institutions the option to charge variable interest rates for loans having a maturity of four years or more. This arrangement permits banks to vary the interest rate every six months and charge a mark-up of 3% over a reference rate based on time deposits of 730 days' maturity. This rate is computed and announced every month by the Central Bank. From July 1, 1981 the maturity of loans permitted variable interest rates will be reduced from a minimum of four years to two years and there will be no ceiling on the spread allowed. The introduction of variable interest rates will encourage term transformation as periodic adjustments in the interest rate will protect "spreads" on term-lending in situations where subsequent increase in deposit rates raise the cost of funds and threaten to erode margins on term loans. Although interest rates were sometimes positive in relation to inflation, variations in inflation rate notably in 1973 and 1974 and again in 1979 and 1980 combined with tight control on interest rates brought about a situation where real interest rates became essentially negative. 2.26 Evaluation of Reforms and Issues. The objective of greater availability of equity and long-term finance for the industrial sector is expected to be substantially facilitated through the adoption of the reforms which constitute an adequate basis for the proposed loan. However, there are some refinements which if made, would further improve the policy framework and give greater consistency to the reforms package: (a) "Expanded Banks." The net worth qualification limit of P 500 mil- lion reflects the Government's cautious approach in the matter, but as more experience is gained and as the process of institutional  - 22 - consolidation goes forward, there would be a need to license more expanded banks through lowering of the net worth qualification limit. Large banks essentially service large clients particularly in the metropolitan area and unless some of the relatively smaller banks are given expanded powers, the eventual beneficiaries of the reform may only be the established enterprises and the large industrial sector. A phased lowering of the net worth limit would, therefore, be consistent with the principle of greater competition and easier accessibility of equity and term finance, particularly to the relatively new and smaller enterprises. In its statement of policy on the future evolution of the financial sector presented during loan negotiations, the Government declared its intention to make "expanded" banking more broad-based by encouraging accelera- tion in the process of institutional mergers and consolidation and by lowering the net worth qualification limit (Annex 1). However, definitive action will only be taken by the Government after it had sufficient opportunity to monitor and evaluate the performance of "expanded banks" that are now being licensed. (b) Interest Rate. Notwithstanding forward movements in the deregu- lation of interest rates, there still remains some element of control which as in the past, might distort the pricing of money and inhibit rapid adjustments to reflect positive rates in relation to inflation. However, the Government has affirmed its adherence to positive interest rates as an instrument of policy and believes that the deregulation and flexibility already introduced and in the process of introduction will give interest rates greater market orientation. It nonetheless feels that complete deregulation of short-term lending rates may be detrimental to the interest of the small businesses, newcomers to industry and regional industries and, as a result of the oligopolistic character of the Philippine banking system, lead to undue concentration of economic power by diversion of funds to the large scale sector. This, the Government contends would be socially and politically undesirable. While the Govern- ment affirmed at negotiations that it will seek to maintain positive real lending rates, it believes that the basis for such revisions should be long-term underlying trends. The Government fears that too frequent changes based on short-term variations in inflation rates could be destabilizing. In addition, it is necessary that lending rates of Government financial institutions, particularly DBP, should not be subsidized and should reflect market rates. This will be consistent with the Government's current interest policy and with the objective of developing a competitive long-term lending market by private financial institutions. Agreements concerning periodic interest rate review, the lending rates of the government financial institutions and establishment of suitable criteria and an  - 23 - appropriate mechanism for conducting such reviews of interest rates on a regular basis, reached with the Government at negotiations are recorded in the Government's statement of policy (Annex 1). Future Evolution 2.27 The financial sector reforms of 1980-81 though constituting an adequate basis for the proposed loan, should be considered an episode, albeit an important episode, in the continuing process of industrial and financial sector evolution. The creation of "expanded banks," the forward movement towards a more flexible and market-oriented interest rate policy, the introduction of variable interest rates and the adoption of a more flexible and incentive-oriented monetary and Central Bank rediscount policy are important milestones and should assist in mobilizing and channeling resources to meet the financial needs of the Government's new and ambitious industrial policy and improve the efficiency of industrial investment. 2.28 The Government intends to monitor closely the performance of the financial sector, and to ensure that the sector fully and adequately supports and assists in the realization of the objectives of its industrial policies. At negotiations, the Government issued a statement of policy contained in a letter signed by the Mfinister of Finance affirming its objectives of future financial sector reforms (Annex 1). The following are some important specific long-run objectives of the Government: (a) The Government has already adopted measures under its industrial policy to encourage the expansion of export industries. These include fiscal incentives and special Central Bank discounting facilities for export finance. The institutional structure has also been strengthened including: (i) establishment of a guarantee facility by the Philippine Export and Foreign Loan Guarantee Cor- poration to assist exporters in obtaining loans from commercial banks; (ii) establishment of a Cottage Industry Guarantee Fund to support cottage industry which is mainly oriented towards exports; and (iii) creation of an Export Credit Corporation to provide medium term finance to export industries. (b) Although the 1980 financial sector reforms will strengthen the rural banking system, the Government has stated that it is one of its important objectives to further examine the working of rural banks to make them less dependent on Government funds, more business- like in their approach and more self-sustaining and profit-oriented in their operations. The Government also recog- nizes that the crucial area of agricultural credit, as a whole, needs to be examined including the changes that may be required in the respective roles of the various government financial insti- tutions such as LBP and DBP and the Central Bank. While creating an agricultural credit structure best suited to take into account the susceptibility of this sector to adverse factors beyond the  - 24 - control of the farmers, the Government has already taken the important step in this direction by establishing the Philippine Crop Insurance Corporation. The Corporation will initially insure rice crops and will gradually expand its coverage to other crops as more experience is gained. (c) The provision of housing finance remains one of the Government's major concerns. The greater resource mobilization capacity given to thrift banks by the banking reforms is expected to increase the provision of housing finance, and this will be supplemented in a meaningful measure by the operations of the recently created Home Mortgage Finance Corporation and the Home Development Mutual Fund. The Government will monitor and review the developments and will encourage private investment in the financing and supply of housing. (d) The Government has decided to embark upon a policy that would make more efficient use of insurance and social security funds possible. These funds are essentially long-term in nature but, considering their social security character, it is necessary to protect them from excessive risk exposure. In the past social security and insurance funds have been used for direct investment in projects which may have carried excessive risk. The Government has affirmed that insurance and social security funds would, in the future, be used as important components in the development of a long-term financial market and for this purpose it would devise policies which, without exposing such funds to undue risk, will ensure their flow to the most economically desirable sectors. To limit the risk, without interfering with the direction of ultimate flow of funds, the Government will encourage such funds to be invested in high grade bonds and securities. (e) The Government has been using the Central Bank's discounting facilities to channel credit on a preferential basis to what it considered desirable sectors of economic activity. The Government, however, is aware that subsidized allocative discounting can result in misallocation of resources and has decided to keep the Central Bank's preferential rediscounting policy continuously under review so that only those sectors receive preferential treatment which are justified by rigorous economic analysis. The recent simplification in the structure and complexity of the Central Bank's rediscounting is a first step in this direction. (f) In the final analysis, a growing part of the long-term credit needs for development will have to be met by the capital market. The  - 25 - development of a capital market has become all the more urgent because "expanded banks" would need an active secondary market to be able to revolve their portfolio and generate liquidity for further investment in equities. While several steps have been taken in the past to develop the capital market--including the licensing of stock exchanges, establishment of the Securities and Exchange Commission, and revision of the commercial code to provide a legal framework for its growth--these measures have not resulted in the desired structure, with stock market activities dominated by highly specu- lative transactions. The Government, therefore, has expressed its intention to prepare a plan of action to develop, strengthen and streamline the network of institutions and regulatory authorities constituting the capital market. (g) The specialized Government banks were created to cater to particular needs. While these institutions will, in their operations, continue to stress the purposes for which they were created, they will, on the other hand, align themselves more closely with the objective of the Government's current development policy and will be given greater autonomy and freedom in portfolio selection. The Government intends to review the regulations governing the interest rates charged by these institutions to ensure that their rates are compatible with both Governxment's current interest rate policy and with the objective of development of long-term lending by private financial institutions. 3. BANK'S INDUSTRIAL LENDING STRATEGY AND PROJECT OBJECTIVES The Bank's Past Industrial Lending 3.01 The Bank's past industrial lending strategy in the Philippines has largely aimed at the promotion and strengthening of development finance companies (DFCs) acting as vehicles for efficient intermediation of financial resources including those provided by the Bank. Another major objective of the Bank-s DFC lending was resource transfer to provide foreign exchange needed for industrial development in futherance of the Government's industrialization programs, particularly, with a view to promoting balanced growth through regional development, employment generation and growth of exports. 3.02 Since 1962, when it made its first DFC-type loan to the Philippines, the Bank has provided nine loans aggregating $343.4 million to three DFCs viz: PDCP (five loans for a total of $123.4 million), DBP (three loans for a total of $205.0 million) and PISO (one loan of $15.0 million). In addition, the  - 26 - Bank has made two loans aggregating $55 million for the development of small and medium scale industries (SMI) through DBP and the Industrial Guarantee and Loan Fund (IGLF), a compensatory financing and guarantee fund of the Government (Annex 7, T-4). The Bank has also assisted the rural industries through the CB-IBRD Rural Credit Program and the Bank-assisted Urban Projects contain credit components for cottage industries. 3.03 The Bank achieved a reasonable degree of success in institution building. The standards achieved by the institutions vary, with the two private sector institutions (PDCP and PISO) showing greater sophistication. DBP's operations, on the other hand, although much improved, still reflect some weaknesses largely on account of some Government directed lending to priority areas and problems in its loan collections. 3.04 In all, 261 subprojects in medium/large industry and about 2,500 SMI subprojects, covering a broad spectrum of industries, have been assisted under the Bank's financing. These subprojects involve a total investment of P 8.9 billion and are estimated to generate net additional exports of $480 million annually, and about 91,000 new jobs. The DFC financed sub- projects in medium/large industry generally had strong financial and economic viability; their ex-ante average financial rate of return (FRR) was 28% and average economic rate of return (ERR) 33%./1 Some salient characteristics of subprojects financed under Bank loans are tabulated in Annex 7, T-5. Although, on the whole, there was a substantial beneficial economic impact in the use of Bank funds by the DFCs, the financing was substantially for capital intensive projects which were overly dependent on protection and largely concentrated in the Metro Manila area. This was the result of Government policies which favored capital intensity and import substitution and laid little emphasis on employment impact and export orientation based on comparative advantage. The Rationale and Strategy for Future Bank Lending 3.05 In 1978, the Bank reviewed its operational program in the industrial sector in the Philippines and concluded that while the Bank-s past lending to individual DFCs had achieved significant institution-building objectives, there were serious deficiencies and distortions in the Government-s industrial and financial policies which inhibited appropriate industrial growth. It was decided, therefore, that industrial and financial sector policy improvements should, in addition to institution building, be made an essential objective /1 Based on a representative sample of 130 subprojects for FRR and 103 subprojects for ERR. While FRR ranged between 12% and 86%, ERR ranged between 10% and 112%.  - 27 - of future Bank lending to the industrial sector. As stated in Chapter 1 of this report, an Industrial Sector Report was completed in early 1979. The findings and recommendations of this report provided the basis for major changes in industrial and trade policies in the context of SAL I /1 approved by the Executive Directors in September 1980. The Financial Sector Report produced jointly by the IMF and the Bank in September 1979 recommended fundamental reforms in the financial system; these reforms were directed at providing the legal basis and encouragement and incentives to financial insti- tutions to make investments in equity and long-term loans. After extensive discussions with the Bank, the Government formulated and implemented in 1980-81 a package of financial reforms (paras. 2.20 to 2.25). These reforms, which are fundamental and comprehensive, constitute the underlying basis for the proposed loan. The primary objectives of the project are to focus on financial sector issues and to gradually transfer to the Central Bank the responsibility for administering and supervising the Bank loan. Inasmuch as the project will address financial sector issues, the proposed loan will constitute the Bank's first financial sector loan to the Philippines for industrial financing. 3.06 In addition to SALs and Financial Sector loans, the Bank hopes to lend for specific subsectors of industries and to continue its SMI lending. A loan to support the rehabilitation and rationalization of the textile subsector is planned for FY82 and in addition the scope of SMI lending would be broadened to include assistance to specific subsectors with development potential. In addition, nonfinancial assistance including training and manpower development will be provided. The next SMI Bank loan is also scheduled for FY82. Project Objectives 3.07 The project serves a number of objectives. First, it would enable the Bank to shift the focus of its involvement from institutional issues to broader sector related issues as described in para. 3.05. Secondly, through t'he proposed cofinancing arrangements, the project would assist in raising additional resources from the international market for financial institu- tions relending operations. Thirdly, the project would provide for the establishment within the Central Bank of an organizational set-up with the capacity to relend the proceeds of the Bank loan to participating financial institutions (PFIs) and for gradually assuming the responsibility for guiding and supervising the operations of the PFIs. This should improve the Central Bank's institutional capacity as an onlender of funds for development purposes. Finally, the proposed arrangements would gradually expand the number of financial intermediaries having access to Bank funds, thereby /1 President Report No.P 2872-PH, dated August 21, 1980.  - 28 - allowing the Bank and the Central Bank to help develop institutional capacity for long-term lending in a larger number of financial institutions. The recent financial sector reforms encourage long-term lending by commercial banks particularly through term transformation of their peso deposit resources and the participation of these institutions in the proposed loan would have a crucial impact in developing their professional capacity and know-how to evaluate long-term investments. 4. THE PROJECT Project Description 4.01 The propos"d project reflects the Bank's new approach to industrial lending in the Philippines, and supports the Government's financial and industrial sector reforms described earlier in this report. Instead of lending separately for individual DFCs, as in the past, the Bank would use a two-tier approach under which the Central Bank would be the borrower and would relend the proceeds of the loan to accredited participating financial insti- tutions (PFIs). The proceeds of the Bank loan would be used for financing economically and financially viable industrial projects in accordance with the objectives of the industrial policy of the Government. The Central Bank would be responsible for identifying and accrediting PFIs and evaluating and monitoring their performance. The institutional and administrative arrangements are described in paras. 4.04-4.23. 4.02 Although sectors such as agroprocessing, construction, mining, shipping and utilities are eligible, the bulk of the loan is expected to go to the manufacturing sector. The project is intended to finance mainly medium- and larger-scale enterprises. The asset size of beneficiary enterprises under the project is estimated to range from P 4.0 million ($53,000) to P 100.0 million ($13.3 million) with a majority of projects in the P 15.0 million ($2.0 million) - P 50.0 million ($6.7 million) range. About 170 sub- projects are expected to receive assistance under the project. To ensure a reasonably wide distribution of project funds, a ceiling of $6.0 million on subloans has ben agreed with the Central Bank. There are a number of ongoing programs aimed specifically at meeting the long-term credit needs of cottage and small-scale industries and the Bank will continue to support the more important of these programs separately through its SMI lending (para. 3.06). 4.03 The project is a part of the Philippine Government's program for further developing the industrial sector and introducing complementary reforms in the financial sector so as to ensure efficient intermediation, and to attain a balanced and efficient growth of industry./l The industrial sector reform will help create an investment environment that will be conducive to growth of those subsectors of industry which have inherent economic compara- /1 Details are discussed under chapter on "Industrial Sector."  - 29 - tive advantage, need minimnum protection, can compete effectively in the export market and make optimal use of local resources. The project incor- porates features that would facilitate growth of industry in the aforemen- tioned directions and the subproject selection criteria would emphasize conformity with the objectives of the Governnent's industrial policy. Moreover, the Central Bank would closely monitor the financing policies of each PFI to ensure compliance with national priorities and wherever necessary would suggest and assist PFIs in the identifying specific areas of investment that are likely to yield maximum benefits to the economy. To this end, the Central Bank's organizational unit in charge of the project would maintain a close working relationship with the relevant Government ministries, particularly the National Economic and Development Authority, MOI and BOI. If necessary, ADFU may itself undertake studies to explore new and desirable fields of investment. An understanding has been reached between the Bank and the Central Bank that in respect of all subloans over $500,000, the ERR will be calculated and that normally no subloan which has an ERR below 12% will be financed under this project. Institutional Arrangements for the Project 4.04 The Apex Development Finance Unit (ADFU). Presidential Decree No. 1309, issued in 1978, authorized the Central Bank "to borrow from foreign banks and other foreign or international agencies both public and private, for the purpose of financing the special credit operations" such as the proposed project. In addition, the Central Banking Act was amended in April 1980, allowing the Central Bank to lend to non-bank financial intermediaries. These steps give the Central Bank full legal authority to undertake the proposed project. 4.05 On the strength of this legal authority the Central Bank created in August 1980 a separate unit named the Apex Development Finance Unit (ADFU) with the specific responsibility for administering the project. The primary objective of this unit as defined by the lIonetary Board /1 is "to assist in promoting and financing sound industrial development in the Philippines, in line with Governmnent policy and in coordination with other Central Bank offices and other Government institutions and entities." ADFU is mandated to achieve this objective by "channelling funds through suitable financial institutions capable of evaluating sound investment proposals and able to undertake efficient intermediation of medium- and long-term financial resources." The project-s size, its importance in the context of industrial and financial policy reforms, and its expected long-term expansion justify full-time attention of a separate organizational unit. 4.06 ADFU-s Operating Policies. The Monetary Board has approved operating policy guidelines for ADFU which would serve as its charter. These guidelines cover all major aspects of ADFU's organization and activities. Some salient features are summarized below: /1 This objective is spelled out in the operating policy guidelines for ADFU approved by the Monetary Board, in August 1980 (see para. 4.06).  - 30 - (a) Functions. ADFU's functions are to: (i) administer and relend to PFIs, the Central Bank's borrowings from the Bank and the Asian Development Bank (ADB) relating to the industrial sector; (ii) help build up the institutional capabilities of PFIs and (iii) expand, subject to necessary safeguards, the institutional participation in ADFU's financing program. (b) Eligibility of PFIs. To be eligible for ADFU's financing, PFIs should meet the accreditation criteria described in detail in para. 4.15. (c) ADFU's financing will be restricted to viable and development- oriented industrial projects. (d) Project Selection and Monitoring. The responsibility for select- ing, appraising and supervising subprojects to be financed under the project, would rest with PFIs who would thus have adequate decision-making autonomy. However, ADFU through its monitoring of PFIs, would ensure that they apply satisfactory standards of project evaluation and supervision. (f) Decision-Making Authority. All policy matters and decisions concerning the accreditation of new PFIs would be taken by the Monetary Board. The authority for approving subprojects submitted by PFIs or recommending approval to the creditors would, however, rest with ADFU. 4.07 The guidelines approved by the Monetary Board were generally satisfactory but some modifications were necessary to bring them in line with the basic philosophy of the proposed Bank financing, as are some additions, to make them more comprehensive. First, instead of being restricted to administering foreign exchange funds obtained from the Bank and ADB, ADFU should have the capability of mobilizing and administering funds raised from other sources including foreign commercial banks. This is needed not only for raising the overall resources required for the project (para. 4.24), but also for the long-term development of ADFU. Moreover, some amendments to the guidelines are also needed with regard the accreditation criteria (para. 4.17) and procurements (para. 4.22). The Central Bank agreed to incorporate the necessary amendments in the operating policy guidelines and has since obtained Monetary Board's approval to the revised guidelines (Annex 2). 4.08 ADFU-s Management and Requirements of Advisory Services. Under the overall guidance of the Governor of the Central Bank, ADFU's management rests with a Chief Executive Officer (CEO), who has a rank equivalent to a Deputy Governor. The CEO will be assisted by a deputy of Director rank who  - 31 - would supervise the day-to-day affairs of the unit. ADFU's Chief Executive Officer, prior to his appointment in June 1980, was a senior partner in a local firm of public accountants of international repute. He is well known and respected in financial and business circles in the country. His professional experience and standing should enable him to obtain the PFI's cooperation and to provide ADFU with effective leadership and management. The Central Bank is in the process of recruiting a suitable candidate for the position of Deputy CEO. Since ADFU's operations are expected to be on full stream in the fourth quarter of 1981, the Deputy CEO would be appointed, in consultation with the Bank, by September 30, 1981. An understanding to this effect was reached with the Central Bank at negotiations. 4.09 Given that ADFU is the first organization of its kind in the Philippines and the Central Bank's relative unfamiliarity with development banking, a senior adviser conversant with industrial finance has been appointed to assist ADFU in the formulation of policies and in the conduct of day-to-day operations. The services of the adviser are being financed by UNDP for which the Project Agreement between the Government and UNDP has been signed; the Bank is acting as the executing agency of the UNDP assistance. 4.10 ADFU in Central Bank Organization. The Central Bank is organized into five major "sectors" or groups of departments. Each "sector" is headed by a Deputy Governor who reports to the Governor through the Senior Deputy Governor. ADFU, however, reports directly to the Governor as it is a part of his office. This organizational arrangement is intended to give ADFU maximum operational autonomy, through direct access to the Governor and through him to the Monetary Board. 4.11 ADFU is to be organized into two main operating groups, each headed by a senior officer. The Operations Group will be responsible, inter alia, for the identification, evaluation and monitoring of PFIs and review and processing of subprojects submitted for financing by PFIs. The Finance and Administration Group will provide support to the Operations Group and handle loan disbursements, accounting, management information and staff training in addition to routine administrative matters. In addition, ADFU will have a unit in charge of economic work. ADFU-s internal organization would be in place by September 30, 1981 and a firm understanding to this effect was reached with the Central Bank at loan negotiations. 4.12 Staff. The total staff strength of ADFU approved by the Monetary Board is 28 including 20 professionals. Including the CEO, a total of 10 professionals have so far been appointed to the unit; four of these were recruited from the private sector. The present staff has adequate academic qualifications and is mostly experienced in the supervision of banks. For the initial operations which mainly consist of the evaluation of PFIs the present staff is adequate. Additional staff (including some economists) of suitable caliber, will, however, be needed to cope with ADFU's future workload as it expands. At negotiations, the Central Bank undertook to  - 32 - complete the recruitment of suitable additional staff needed for ADFU's operations, by September 30, 1981. 4.13 Staff Training. The Central Bank recognizes the need to develop ADFU-s staff skills through training programs, both on-the-job and formal. A beginning has been made in this direction. ADFU's present staff has benefitted from the evaluation of the first three PFIs viz. DBP, PDCP and PIS0 during which Bank staff collaborated closely with ADFU-s staff. In addition, three staff members attended a six-week project evaluation course organized by a local institution and a senior staff member attended, in the fall of 1980, an agro-industrial project evaluation course conducted by the Economic Development Institute of the Bank. 4.14 In the future, ADFU will develop systematic and comprehensive training programs not only for its own staff but also for the staff of accredited as well as potential PFIs. It should be possible to organize training locally, but foreign assistance may be needed to provide instructions in certain areas of expertise. UNDP financing, totalling $150,000, will be available for this purpose. Details of the training programs will be finalized in consultation with the adviser, on or before September 30, 1981. The Project Procedures 4.15 The Accreditation System. The accreditation process subjects an applicant institution to a comprehensive evaluation by ADFU, with a view to assessing the present and prospective suitability of the institution to act as an efficient intermediary for industrial financing. For this purpose, the Central Bank has set out in the ADFU-s operating policy guidelines the following criteria for the "accreditation" of PFIs: (a) sound financial position and performance and a healthy portfolio; (b) sound operating policies and procedures, and a development- oriented strategy for future operations; (c) an organization, management and staff with the requisite expertise to undertake term lending operations including the technical, economic and financial appraisal of projects and their supervision; and (d) compliance with all relevant laws, decrees and regulations to the satisfaction of all regulatory authorities. 4.16 The above mentioned criteria are generally satisfactory. The management of ADFU and the advisor, are expected to develop more detailed processing procedures for accreditation. In reviewing applications for accreditation, the ADFU will work closely with each PFI to help it develop  - 33 - its institutional capability for long-term lending. In addition, the Bank would review ADFU's evaluation reports on PFIs recommended for accreditation and draft subsdiary loan agreements between the Central Bank and PFIs, and would reserve for itself the right to be satisfied on both these scores prior to accreditation becoming effective. Agreement on this subject has been reached with the Central Bank. 4.17 Both privately-owned and Government-owned financial institutions meeting the accreditation criteria mentioned in para. 4.15 are eligible for accreditation. However, priority is given to private sector institutions in accordance with the Government-s policy of promoting more active partici- pation of the commercial banks and other private institutions in term financing. The Government-owned financial institutions have been used by the Government as the implementing arm for its special financing programs. Consequently, some of these institutions have had to carry a portfolio of doubtful quality which does not necessarily reflect the quality of their management. In accrediting Government institutions, agreements will be sought by ADFU from the Government to safeguard such institutions against losses incurred on projects financed at Government behest. In addition, the Government-owned PFIs would be required to lend on terms (and in particular, interest rates) consistent with the current interest rate policy of the Government and with the objective of development of a competitive long-term lending market by private financial institutions. These two additional criteria have been incorporated in the revised operating policy guidelines of ADFU (para. 4.07). 4.18 A number of financial institutions have expressed interest in applying for accreditation with ADFU. ADFU has already evaluated three major term lending institutions viz., DBP, PDCP and PISO with which the Bank has established a long-standing relationship under past Bank DFC loans. These three institutions will be accredited formally after loan negotiations. As a first step towards accreditation of additional PFIs the Central Bank has identified eight commercial banks and four investment houses which have the potential for serving as effective intermediaries for ADFU's resources. The characteristics of these prospective PFIs are discussed in the next chapter. However, for most of these commercial banks and investment houses develop- ment-oriented term lending is a new and unfamiliar activity. Consequently, they would require ADFU's technical assistance for establishing appropriate policies and procedures, organization and staffing prior to undertaking term-financing. At present and for the immediate future, ADFU's capacity for providing this technical assistance and its financial resources are limited. Therefore, it is ADFU-s intention to evaluate and initially accredit only two or three of the more promising institutions. After ADFU has established a satisfactory working relationship with five or six PFIs and as its own organization, operational capacity and resources develop, more PFIs would be accredited. An understanding to this effect was reached with the Central Bank at negotiations.  - 34 - 4.19 Monitoring of PFIs. In line with a basic objective of the project, the Bank would ordinarily rely on ADFu to carry out the institution building responsibility vis-a-vis the PFIs. To this end, ADFU would monitor the performance of each PFI to ensure general compliance with the accreditation criteria and its further progress. However, until such time as ADFU's staff has acquired the necessary expertise and capacity, the Bank would closely monitor the adequacy of ADFU-s supervision of the PFIs. The Bank would continue to pay particular attention to the supervision of DBP in view of the magnitude of the problems DBP is facing (para. 5.28-5.35). The Bank's monitoring of ADFU's work with PFIs would consist of: (a) requiring that each PFI be supervised in depth at least once a year and progress reports on PFIs be periodically reviewed; (b) reviewing with the management and staff of ADFU the supervision reports on PFIs. This would provide the opportunity for an exchange of views between the Bank and ADFU; and (c) participating with ADFU in its field work relating to supervision of PFIs, as necessary. Finally, the Bank would reserve for itself the right to undertake direct supervision of PFIs in cases where it considers performance to be unsatisfactory or in the event such supervision was considered helpful in improving the institutional capacity of a particular PFI. A firm understanding on these arrangements has been reached with the Central Bank. 4.20 Subproject Processing. ADFU will set an appropriate "free limit" for each PFI in regard to review and approval of subloans, in consultation with the Bank. After a PFI has appraised a subloan and taken a formal investment decision, it would submit its appraisal report to ADFU. Subloans above the "free limit" for a PFI will require a detailed review and approval by ADFU. In addition to the first-tier "free limit" described above, there will be a second-tier "free limit" of $4.0 million above which subloans would be submitted by ADFU to the Bank for the Bank's own review prior to approval (para. 6.05). Subloans within the scope of ADFU-s "free limit" would be authorized by ADFU for credit to the loan account subject only to the Bank's acknowledgement of notification from ADFU. This would give ADFU adequate authority to commit the loan proceeds, but would still leave a reasonable number of subprojects (about 15%) that would require Bank-s prior approval. However, before the ADFU's "free limit" becomes effective the Bank will scrutinize a reasonable number of subloan reviews done by ADFU to satisfy itself that ADFU has developed acceptable subproject review standards. 4.21 Supervision of Subprojects. The PFIs will be responsible for monitoring and supervising the implementation and operation of subprojects financed by them. ADFU, through its monitoring of PFIs, will ensure that this supervision of subprojects is being effectively carried out. For this purpose ADFU would: (a) require the PFIs to submit periodic reports on their supervision of subprojects; (b) periodically scrutinize the PFI's financial, operational and project supervision records; and (c) provide guidance to PFIs as appropriate on project supervision, in general, and supervision of problem projects in particular.  - 35 - 4.22 Procurement and Disbursements. As with DFC lines of credit, pro- curement under the project would be made by the end users of funds and supervised by PFIs. As a condition of its financing, ADFU would require all PFIs to formulate and adopt appropriate procurement policies and practices that would ensure that the goods and services to be purchased under its financing are suitable and reasonably priced. Three of the prospective PFIs (DBP, PDCP and PISO) are familiar with the Bank-s procurement requirements and are in compliance with them; procurement is generally made on the basis of competitive shopping. As for the new PFIs not conversant with the Bank-s procurement requirements, ADFU would assist them in formulating and implement- ing procurement policies. As with other DFC loans, clients of PFIs would be required to canvass and submit competitive quotations from at least three sources for major pieces of equipment/plant. ADFU would encourage PFIs to apply international competitive bidding (ICB) procedures wherever warranted by the size and nature of the purchase to benefit from the economies accruing from this method of procurement. At negotiations the Bank and the Central Bank reached an understanding on the outline of the guidelines on procure- ments to be followed by ADFU as well as PFI (Annex 3). Moreover, ADFU's policy on procurement quoted below, has been spelled out in its revised operating policy guidelines (para. 4.07): "ADFU will also review, for all projects, whether above or below the free limit, the appropriateness of the procedures followed or proposed to be followed by PFIs for procurement of goods and services necessary to carry out the project, and may propose modifications if these procedures do not conform to criteria or guidelines set out in the loan agreements with PFIs." 4.23 ADFU would require PFIs to adopt disbursement procedures that would ensure that disbursements are made for their intended purposes and in accordance with the terms of the supply contract. Withdrawal applications from the PFIs would be reviewed by ADFU prior to their submission to the Bank, in accordance with procedures agreed during negotiations. Disburse- ments would cover the direct and indirect foreign exchange cost of goods and services (para. 6.03), and would be made against normal documentation except for small local expenditures of less than $10,000 equivalent; documentation for such expenditures would be retained by ADFU for a post disbursement inspection by the Bank, and the annual audit of project accounts would include a separate opinion covering disbursements made from the loan account on the basis of statements of expenditure. Resource Requirements and Allocations 4.24 Resource Requirements. The Central Bank (ADFU) has already evaluated the lending programs of the three initial PFIs (DBP, PDCP, and PISO). Based on their resource requirements, ADFU proposes to allocate out of its total foreign exchange resources, including the borrowings from the international commercial sources, $60.0 million for DBP, $50.0 million for PDCP and $40.0 million for PISO; these allocations are considered  - 36 - appropriate. As regards the two or three additional PFIs that are expected to be accredited during the project implementation period their resource requirements are expected to aggregate $100 million. On these assumptions the total foreign exchange resource requirements of AFDU for covering the subloan commitments of PFIs in the two-year period from mid-1981 to mid-1983 are estimated at $250 million. The proposed Bank loan would provide $150 million while the balance $100 million will be secured by the Central Bank from borrowings from international commercial sources. The Central Bank has agreed to arrange, by July 31, 1981, the additional $100 million for the project by borrowing from international commercial sources. 4.25 Allocations to PFIs. The proportion of Bank funds and commercial resources allocated by ADFU will be identical for all PFIs. This will ensure that each PFI will have the same mix of funds, at least in the initial phase of the project. Although ADFU would make specific allocations at the time of the accreditation of each PFI, these allocations will be subject to periodical review and reallocations may be made based on the performance of PFIs. The Bank would be consulted on both the original allocations and any eventual reallocation. 5. PARTICIPATING FINANCIAL INSTITUTIONS (PFI) 5.01 This chapter summarizes ADFU's evaluation of PDCP, PISO and DBP, all of which have applied to the Central Bank for accreditation as PFIs. In addition, the chapter also contains a review of the salient characteristics and features of the eight commercial banks and four investment houses identi- fied by ADFU as potential PFIs. A more detailed review of the institutional, operational and financial aspects of PDCP, PISO and DBP are given in Annexes 4, 5 and 6 respectively. Private Development Corporation of the Philippines (PDCP) 5.02 Background, Objectives and Functions. The privately-owned PDCP, a leading DFC in the Philippines, was established in 1963 with the active assistance of the Bank and IFC. Its objectives are to assist in the development of privately-owned industries, promote and facilitate participation of private capital from local and foreign sources; widen the ownership base of Filipino enterprises; and help promote industrial development and managerial expertise in the country. According to its Articles of Incorporation, PDCP may extend loans, invest in equity, issue guarantees, underwrite public offerings and syndicate loans. 5.03 Institutional Set-up and Capabilities. PDCP's ownership is held 70.3% by Filipino and 29.7% by foreign stockholders; ownership is widely distributed among nearly 1,300 stockholders. The Board of Directors has provided PDCP with excellent guidance and management. PDCP has an active and innovative management group. PDCP's staff represent a broad spectrum of  37 - diversified professional skills, which enables PDCP to effectively meet the varied needs of its clients. PDCP is also noted for its training institute which provides well-organized, professional and issues oriented programs for upgrading the quality of PDCP-s staff as well as staff from other Filipino and overseas development finance institutions. 5.04 PDCP-s project appraisals are comprehensive and satisfactory. Financial and economic rates of return are routinely calculated. Internal processing procedures are well established. PDCP-s supervision policies and procedures are basically sound with project supervision (planned project visits, appropriate reporting on the project status and prospects) starting at the time of loan signing and ending when the loan is fully repaid. Due to the recent expansion of PDCP-s portfolio and staff constraints, however, PDCP's supervision efforts have largely been restricted to projects experiencing difficulties. Consequently, problems are not spotted early on when they could perhaps be more easily dealt with. PDCP recognizes this shortcoming and has initiated a number of measures including assignment of more staff to supervision work, to improve its project monitoring capability. 5.05 Resource Allocation. PDCP provides assistance in the form of loans, equity investments, guarantees, syndication and underwriting. Loan operations, however, represent the most important form of assistance. Since its inception, PDCP has approved 715 projects and provided P 1,843 million ($246 million equivalent) in term loans; over 40% of these approvals were made after 1977. PDCP offers three types of loans: loans to medium- and large-scale industries mostly in foreign exchange; small business loans generally in local currency; and agribusiness loans also mostly in local currency. Although small loans have grown rapidly since 1975, loans to medium and large industries still constitute the bulk (over 85%) of PDCP's loans. As of year-end 1979, about 66% of total loan approvals went to the manufacturing sector; the balance was for power, transportation, communications, construc- tion, agriculture and mining projects. The regional distribution of PDCP's loans is satisfactory with more than 76% of loans made since 1975 going to projects located outside the Metro-Manila area. 5.06 Financial Aspects. After experiencing slow growth in 1976 and 1977, PDCP-s total assets recorded much faster growth rates of 10.6%, 22% and 15% (annualized) over the period 1978-March 31, 1980, at the end of which total assets stood at P 1,274.2 million. Both the short-term debt/equity ratio and the long-term debt/equity ratio have been well within the contrac- tual limits agreed with the Bank of 2:1 and 8:1, respectively. PDCP's liquidity has been strained since 1976 as a result of declining loan collec- tions and the general shortage of long-term peso funds. PDCP is taking steps to improve loan collections and raise larger amounts of medium- and long-term peso funds which should be facilitated by the recent financial sector reforms. Before its accreditation, the Central Bank will require PDCP to prepare and adopt specific satisfactory plans/programs to improve its liquidity position.  - 38 - 5.07 PDCP's major source of income is interest income from loans which accounts for 80-85% of total gross income. Net income increased from P 16.5 million in 1975 to P 24.5 million in 1979, with a satisfactory 16% return on average net worth, and is expected to exhibit a faster growth rate in the next few years when the full impact of the 1978-79 growth in PDCP's lending operations is reflected. 5.08 During the past few years, the quality of PDCP's loan portfolio has shown some sign of deterioration with total arrears increasing from 4.3% of total portfolio in 1975 to 7.2% in 1978. The major factors contributing to this increase in arrears include a general business recession in 1975 and 1976, the overall unsatisfactory performance of the Philippine industrial sector (Chapter 1), and a slackening in PDCP's supervision of projects (para. 5.04). In 1979, PDCP's management formulated a comprehensive program to reduce arrears which included improving internal supervision procedures, increasing supervision staff strength, and detailed reviews of past due accounts to determine which to reschedule and which to foreclose. These remedial actions have produced some results as indicated by the reduction in loan arrears to 6.7% of outstanding portfolio in 1979 and 6.4% in 1980 (October) but much of this reduction is due to loan rescheduling. PDCP has consistently made adequate provisions for possible losses on loans and equity investments; as of March 31, 1980, these provisions amounted to P 22.9 million, or 2.4% of the outstanding portfolio which is adequate. 5.09 Prospects and Resource Requirements. Although PDCP's peso lending for small industries is expected to increase, the major thrust of operations is expected to continue to be lending in foreign currency for medium- to large-scale industries. Including approvals of other assistance (equity investments, underwriting/private placements, guarantees and loan syndications), PDCP's annual approvals are expected to reach P 1.0 billion in 1980 and thereafter steadily increase to P 2.0 billion in 1984. 5.10 To achieve the projected growth in foreign currency loans up to mid- 1983, PDCP would require net additional foreign currency resources amounting to $180 million. Of this amount, PDCP has applied for a $50 million allocation under the proposed Bank loan and plans to raise the remaining $130 million from other sources such as IFC, ADB, Commonwealth Development Corporation and international commercial banks. PDCP expects to finance new peso loans largely through the IGLF program and from internal cash generation. However, the recent financial sector reforms should make it possible for PDCP to mobilize its peso resources from the domestic market. An understanding was reached with the Central Bank that it would require accredited institutions, particularly PDCP and PISO, to make their best efforts to raise long-term peso resources from the market and to appropriately increase their domestic currency lending. 5.11 Projected Financial Position and Performance. Based on its business forecasts, PDCP expects its total assets to grow from P 1,229 million in  - 39 - 1979 to P 3,830 million in 1984. Additional cash contributions of P 25-30 million to paid-in capital are projected to be made annually starting in 1981 to enable PDCP to remain within the contractual long-term debt/equity ratio of 8:1 contained in its Loan Agreement with the Bank. ADFU, in terms of the understanding with the Bank, would require PDCP to furnish it, as a condition of accreditation, with a program for its future capital increases. 5.12 PDCP's net earnings are projected to increase from P 24.5 million in 1979 to P 65.5 million in 1984, with an average annual increase of P 8.2 million. Projected loan operations will continue to contribute the largest share in earnings. Projected net income ranges between 1.8-2.1% of average assets and 16.7-19.1% of net worth, which is satisfactory. Philippine Investments Systems Organization (PISO) 5.13 Background, Objectives and Functions. PISO, a privately-owned DFC set up in 1974, is authorized by its Articles of Incorporation to undertake all the functions of a development bank/investment house including development oriented long-term financing, underwriting and merchandising of securities, and syndication. During its initial years, PISO concentrated on short-term money market operations and some loan syndications, but starting 1978 it directed a substantial portion of its business towards term lending which was facilitated by a $15 million loan from the Bank./l PISO is now one of the three institutions in the country specializing in medium- and long-term financing of industry. 5.14 Institutional Set-up and Capabilities. PISO's existing paid-in capital of P 33.8 million /2 is subscribed 30% by its only foreign stock- holder, the Private Investment Company for Asia, S.A. (PICA), an interna- tionally-owned private institution, and 70% by 16 local stockholders. PISO and ADFU have reached an understanding that PISO would raise its paid-in capital by a further P 10 million by the end of 1981, and would seek to broaden the base of its shareholders. 5.15 PISO is a competently managed institution. Broad policy guidelines are set by its Board of Directors comprising eleven members including three representing its foreign stockholder (PICA), seven representing the Filipino stockholders /3 and one nominee of PNB./4 The Chairman of the Board is also /1 Loan No. 1555-PH. /2 PISO-s paid-in capital was increased in 1978 by P 10 million, which was a condition of the Bank loan. PISO net worth as of March 31, 1980 stood at P 45.0 million. /3 One of them is a Deputy Minister of Finance. /4 PNB is the conduit for the Bank and ADB loans as the Government can not guarantee borrowings of a private institution like PISO.  - 40 - the President of PISO. PISO's staff have expertise in varied disciplines including engineering, finance, economics, law and banking. PISO has agreed with ADFU to recruit additional staff as needed by its expanding operations and to hire the services of a manpower resource development specialist to assist it in meeting its staff needs and to organize staff training on a systematic basis. 5.16 PISO-s appraisal procedures are well thought out and standards are satisfactory. PISO's appraisal reports generally cover all major aspects of the project; due attention is paid to the project-s economic viability (value added, exports, net foreign exchange savings and earnings, employment generation and regional development) and to the technical considerations (suitability of the technology, scale of operations and the environmental impact). Economic and financial rates of return are calculated for all loans above $750,000. As a condition of accreditation, ADFU would require PISO to calculate ERR for all subloans above $500,000 using ADFU financing. 5.17 Because of its relatively small project portfolio, PISO-s orga- nization, policies and procedures for project supervision are not yet fully developed. ADFU has therefore suggested and PIS0 has agreed to: (a) strengthen the supervision organization; (b) prepare and adopt a comprehensive project supervision plan; and (c) prepare a Project Supervision Manual to spell out PISO-s supervision policy and procedures for the guidance of the staff. Progress made in this regard reviewed with the Central Bank at loan negotiations was satisfactory. 5.18 Resource Allocation. Since the start of its operations in early 1975 through March 31, 1980, PISO approved various forms of term financial assistance totalling P 995.6 million. Medium- and long-term loans and loan syndications account for approximately 90% of PISO-s operations, while the remaining 10% of total operations comprises direct equity investment, guarantees, underwritings and private placements. PISO-s loans, which on an approval basis, grew rapidly from F 3.0 million in 1975 to P 105.1 mil- lion in 1979, fall into two broad categories: regular loans (loan in excess of P 2.5 million) and small business loans (loan up to P 2.5 million). The regular loans account for 48% of the total number and 89% of the total amount of loan approvals so far. The small business loans are made to small- and medium-scale industries and are almost entirely financed under the IGLF program. The average loan size is about P 7 million for regular loans and P 0.8 million for small loans. 5.19 By amount, about 56% of PISO-s loans have gone to the manufacturing sector, with the remainder going to the telecommunications (19.9%), transport (10.4%), mining (9.2%), and service (4.4%) sectors. While balanced regional dispersal of industrial investment and broadening of industrial ownership are major development objectives set out in its Policy Statement, PISO has achieved only limited success in these respects. Over 50% of its assistance has gone to projects located in Metro Manila and about 90% for well estab- lished clients. To improve the geographical distribution of its assistance  - 41 - without incurring the significant expenses of establishing its own branch network, PISO is entering into technical and financial collaboration with selected private development banks outside the Metro-Manila area. Further- more, PISO-s management has expressed its intention of allocating a much larger proportion of its loans to new projects/enterpreneurs in the future. ADFU, though its supervision of PIS0, would closely monitor PISOs progress in this regard and, if necessary, would provide appropriated guidance. 5.20 Financial Aspects. PIS0 has a sound financial position and a satisfactory earnings performance. PIS0's total assets maintained a 35% p.a. growth rate between 1977 and 1979, and amounted to P 231.3 million as of December 31, 1979. As of year-end 1979, both PISO's total debt/equity ratio (4.2:1) and long-term debt/equity ratio (2.2:1) were within the limits set in the Bank Loan Agreement. Between 1977 and 1979, PIS0