China - Second Industrial Credit (Second China Investment Bank) Project

Document of The World Bank FOR OFFICIAL USE ONLY Co?. /y P/- $k1-' Report No. 4897-CHA STAFF APPRAISAL REPORT CHINA SECOND INDUSTRIAL CREDI I rI PROJECT (CHINA INVES9MENT BINK I1, May 15, 1984 Projects Departmient 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 diselosed without World Bank authorization.  CURRENCY EQUIVALENT Official Rate 1 Yuan (Y) = US$0.49 2.06 Yuan (Y) = US$1.00 (as of February, 1984) Internal Settlement Rate 1 Yuan (Y) = US$0.36 2.8 Yuan (Y) = US$1.o0 FISCAL YEAR January I to December 31 PRINCIPAL ABBREVIATIONS AND ACRONYMS USED BOC - Bank of China CCAFM - China Consultants of Accounting and Financial Management CIB - China Investment Bank CIECC - China International Engineering Consulting Corporation CNTIC - China National Technical Import Corporation DFC - Development Finance Company EDI - Economic Development Institute GDP - Gross Domestic Product ICB - International Competitive Bidding ICBC - Indtistrial and Commercial Bank of China MOF - Ministry of Finance PBC - People's Bank of China PCBC - People's CQ_nstruction Bank of China SDR - Special Drawing Right UNDP - United Nations Development Program  FOR OFFICIAL USE ONLY CHINA INDUSTRIAL CREDIT II PROJECT (CEINA INVESTMENT BANK II) STAFF APPRAISAL REPORT Table of Contents Page No. I. THE INDUSTRIAL SECTOR ................ * . I .. ..... ... . a * 1 Characteristics and Accimpllshments 1 Weaknesses ............... I. .......... . 1 Con-traints on Growth in the 1980s .......................... 2 Government Strategys........... *.... .. 2 Recent Developments .................... , 2 II. THE FINANCIAL SECTOR........ 3 Role ..... ........ 3 Tnstitutional Background... . ...-. .-.. ... .- . ..- . . .- 3 Investment FinanceR ...................... ...... 3 Interest Rae-n.........*-*.-*..-.... ***.-@vv*..........5 Bank O0jectives and Role in Industrial and Financial Secos ector.s .. .....*.~**a*~...,.. . 5 III. THE CHINA INVESTMENT BANK (CIB).................. . 6 Establishment.... .. .0 ...... . ... .... 6 Performance under CIB I .... ...... ..... . ....... . ..... . 6 CIB II Objectives and Strategy ... 7 Management, Organization, Staffing and Traing .g 7 Policies and Strategy. . -.. ......... o ......... . -. 12 Procedures........ .......... ....................... 13 Opertins....i o.... 16 Resources and Financial Position.o..-i o .......17 Accounting System, Audit and Project Completion Report... 18 Prospects and Projections........ ......... ....... 18 * IV. THE PROPOSED LOA N/CR E D I T 19 Amount and Maturity. ............................. . , f 19 Onlending Terms . . . . . . . . . a. . 20 Free Limit, Maximum Subloan Size and Debt/Equity Ratio..... 20 Procurement and Disbursement , ...... .... 21 Environmental Safeguards..e.g., ... 22 Benefits and Risks ....... *o ....... * 22 This report is based on the findings of an appraisal 'mission to China in October 1983. Mission members were Stephen EttLnger (Mission Leader), Edgar Su, and Alain Soulard. I This document has a restricted distribution and tnay be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Page No. V. AGREEMENTS REACHED AND RECOM4ENDATIONS........... .........., 23 ANNEXES 1. Policy Statement of the China Investment Bank 2. Development Strategy Statement for 1984-19B6 of the China Investment Bank 3. CIB Five-Year Financial and Operational Projections 4. Sectoral Distribution of CIB I Subprojects 5. Estimated Cumulative Disbursements of the Proposed Loan/Credit 6. Selected Dccuments and Data Available in the Proj,et File CHART China Investment Bank Organization Chart MAP IBRD 17773R - China Industrial Credit II Project  CHINA SECOND INDUSTRIAL CREDIT PROJECT (CHINA INViESTMENT BANK II) Loan/Credit and Project Summary Borrower; People's Republic of China Beneficiary: China Investmert Bank (CIB) Amount: $175.0 million equivalent, comprising $105.0 million equivalent IBRD and SER 65.8 million ($70.0 million equivalent) IDA_ Terms: Loan: 20 years, including 5 years grace; standard variable interest rate. Credit: Standard Relending Terms: Loan and Credit: 20 years, including 5 years of grace; fixed interest rate of 7.0% p.a., plus commitment fees equal to those under the loan and credit; the Government would bear the interest rate risk on the Bank loan and the foreign exchange risk between the US dollar and (a) the currency pool for the Bank loan and (b) the SDR for the IDA credit. Subborrowers would bear the foreign exchange risk between the US dollar and the Yuan. Project Description: The project furthers the development of CIB, which pro- vides investment loans for small- and medium-size indus- trial projects needing foreign exchange. The objective would be to help raise investment efficiency through import of technology and the introduction of improved project design and selection methodology. Subborrowers would be some 60-80 state and collective enterprises primarily in coastal provinces and municipalities. Based on the experience under CIB I, the investments are expected to have high financial and economic returns. The main project risks relate to the capacity of CIB, which is a young institution, to strengthen its appraisal standards, especially in the technical, economic and marketing areas, and to the need for continued government commitment to CIB within the process of economic reform. However, the project provides for recruitment of additional technical and economic staff, plus training and marketing consultancy for CIB. This will further strengthen CIB's ability to identify and evaluate projects. Furthermore, the Government's commitment to economic reforms and to CIB remains firm.  - i~i - Bank FY 1985 1986 1987 1988 1989 ------- $ millions --------------- Estimated Disbursement: Annual 3.0 37.0 70.0 35.,j 30.0 Cumulative 3.0 40.0 110.0 145.0 175.0 Staff Appraisal Report: No. 4897-CHA, dated May 15, 1984 i  CHINA INDUSTRIAL CRED!, II PROJECT (CHINA INVESTMENT BANK II) I. THE INDUSTRIAL SECTOR Characteristics and Accomplishments 1.01 China is ore of the world's ten leading industrial producers, and has the largest full-time industrial employment (56 million). However, manufacturirg output per capita is only about 25% of the average for middle income countries and about 4% of that for industrialized market economies. State enterprises comprise only 22% of China's 389,000 industrial enterprises, the rest being urban or rural collectives, but account for 78% of output. Manufactured exports were only 4.1% of gross industrial output in 1982, but accounted for 55% of total merchandise exports. Textiles were 21% of total exports, other light industrial products 14%, and heavy industrial goods 20%. Industrial exports grew by about 20% p.a. in real terms over 1977-81, and by 10% in 1982 despite the world recession. A wide range of Chinese manufactures are internationally competitive in terms of production cost, but quality and variety often need more emphasis. Three accomplishments of Chinese industry stand ,out. First, despite periodic disruptions, gross output has grown at nearly 10% p.a. since 1957, due to a very high rate of fixed investment in industry, averaging 10-15% of GDP. Second, the industrial base was broadened to produce nearly a full range of machinery and industrial raw materials. Third, China has mobilized unskilled labor, rural savings, and low-grade raw materials to establish a large number of small-scale rural factories, bringing extra income and basic goods (albeit often of low quality) to rural areas, and contributing greatly to employment. Weaknesses 1.02 Chinese industry also has numerous shortcomings. (a) Inputs are used very inefficiently, and total factor productivity has not changed since the 1950s; incremental capital/output ratios have risen, overmanning is wide- spread and energy use per unit of GDP is 2-1/2 times that of other developing countries. (b) The structure of production is unbalanced: heavy industry, with its high demands on scarce capital and energy, has received 80% of total fixed industrial investment; foreign trade has been relatively neglected. (c) Technology is outmoded in many sectors; while the use of older, labor- intensive equipment is generally sensible given Chinese factor proportions, a lot of Chinese equipment and processes produce substandard products or waste energy and raw materials. (d) Decisions are badly coordinated: supply and demand are often mismatched and investments made with insufficient attention to choice of location, scale, or product mix. Some of these weaknesses are the result of past policy errors, neglect of medium term economic planning, and two decades of international isolation. Others stem from deficiencies in the economic system: insufficient incentives to conserve inputs or improve output quality, distorted prices, restricted access to imports, and inadequate contacts between producers and users and among different ministries and regions.  -2- Constraints on Growth in the 1980s 1.03 It is particularl) important now to correct these weaknesses because the conditions which favoredl past industrial success have substantially altered. Most importantly, domestic energy output is likely to expand at no more than 2% p.a. during the remainder of the 1980s. Raw materials, transport and high level manpower will also be constraints. In addition, in view of past industrial over-investment and in order to free more resources for the energy and transport sectors and for consumption, Government is trying to reduce the resources allocated to industrial investment. But at the same time, industrial exports will have to expand, in the face of difficult world market conditions, to help offset reduced energy exports, and industry must remain a principal source of new jobs. It is possible for industry to grow at about 8% p.a., as called for in Government's long-term prospectus, provided that China reduces its unit energy and materials consumption, emphasizes light industry, and, in general, continues to reform its economic system so as to make efficiency the main engine of growth. Government Strategy 1.04 In 1979, Government introduced a policy of adjustment and reform. The adjustment has increased the emphasis on: (a) light industry; (b) maru- factured exports; (c) "modernization" of existing workshops, rather than "capital construction" (which involves building new facilities); and (d) energy conservation. The main thrust of reform has been to decentralize decision-making and to rely more on incentives and markets to guide decisions. The changes affecting industry include: (a) profit and foreign exchange retention; (b) wider use of loans and other capital charges; (c) increased use of bonuses; (d) encouragement of foreign partnerships, urban collectives and very small private enterprises; and (e) limited price changes and more flexible pricing and marketing arrangements. In the Sixth Five-Year Plan (1981-85), about one-third of total industrial investment is to be for modernization, two-thirds for capital construction. To help implement this program, Government is expanding imports of technology, through joint ventures, compensation trade (where the equipment supplier accepts Chinese exports: as; payment), licensing agreements, and import of equipment, increas- ingly with technical assistance and/or training attached. Recent Developments 1.05 The adjustment program was initially fairly successful in control- ling investment and shifting emphasis toward light industry, which also helped reduce energy consumption. But actual capital construction in 1982 exceeded the plan by 25%, using mainly extra-budgetary finance (para. 2.04), primarily for industry and housing. This strained the supply of energy, building materials and transport capacity, and drained resources from light industry and from high priority energy and transport projects, while output of heavy industry, in supplying the producer goods demanded, greatly exceeded the plan. Industrial reform had raised the enthusiasm of enterprises for increas- ing output and profits, but had not been accompanied by more extensive pricing changes to give better allocation signals. Furthermore, there was no measur- able improvement in industrial efficiency. In response, Government has tightened control over investment finance and stopped many low-priority projects.  -3- II. THE FINANCIAI. SECTOR Ro1e 2.01 As in most centrally-planned economies, China's financial system is relatively underdeveloped because most fixed Investment and even worklng capital has been financed through the budget. The financial system has served m2inly to channel budgetary funds for approved purposes and to help control state and collective enterprises. More recently, increased attention has been paid to using the banks to mobilize savings, increase investment efficiency, and provide a detailed review of project proposals independeit of the enter- prises and their supervisory agencies. Institutional Background 2.02 China's financial system has included five specialized state banks grouped under two separate jurisdictions. The People's Bank of China (PBC) has had ministry-level status as a multi-purpose central and commercial bank. Under PBC have been the Bank of China (BOC), responsible for commercial transactions and loans in foreign exchange, and the Agricultural Bank of China, in charge of banking and financial administration in rural areas nationwide. The Ministry of Finance (MOF) has supervised two institutions: the People's Construction Bank of China (PCBC), which has the main financial responsibility for appraising and disbursing for capital construction in the productive and social sectors of the economy, through both grants and loans in local currency, and the recently-established China Investment Bank (CIB), which lends for investments requiring foreign exchange to modernize or expand industrial enterprises. 2.03 In September 1983, the State Council reformed the financial system by formally establishing PBC as the central bank, mandated to supervise the banking operations of all other financial institutions. The practical impli- cations of this -'ange are still being spelled out. PBC's commercial banking activities (taking deposits and providing short-term working capital loans and medium-term modernization loans) were spun off to form the Industrial and Commercial Bank of China (ICBC). The extension of PBC's supervisory role over the entire financial system is a further step towards separating MOF's fiscal functions from the regular banking activities of the financial system, and provides an institutional framework within which other financial sector issues, such as interest rates and the roles of the various specialized banks, can be dealt with. It is also expected to reinforce the ongoing effort to increase the efficiency of investment by shifting from a grant system administered by MOF to a more autonomous credit system. In addition, a Financial Board of Governors representing MOF and the main banks was established, to improve coordination in policy making and implementation. Investment Finance 2.04 Fixed investment in China is financed from a variety of sources: state budget grants (from central and local governments), extra-budgetary funds of various government agencies, enterprises' retained profits and depreciation allowances, domestic bank loans and foreign loans. The share financed by state budget grants has fallen steadily, from an average of 85% over 1962-66, to 31% in 1982. Until 1979, the offsetting increase was  - 4 - virtually all from enterprises and government agencies; bank loans financed less than 2% of fixed investment. Since then, the role of credit has expanded dramatically: in 1982, domestic bank loans financed 16% of fixed investment in the state-owned sector, and foreign loans a further 7%, as showi, in Table 2.1: Table 2.1: FINANCING OF FIXED INVESTMENT IN 1982 (STATE SECTOR) Capital construction Modernization Total