Sri Lanka - Third Industrial Development Project (IDP III)

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 7230-CE STAFF APPRAISAL REPORT SRI LANKA THIRD INDUSTRIAL DEVELOPMENT PROJECT (IDP-III) June 28, 1988 Industry and Energy Division Country Department 1 Asia Region 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 EQUIVALENT Currency Unit - Sri Lanka Rupee Sii Lanka has a flexible exchange rate system. For the proposed IDP-III the following rates prevailing during appraisal in December 31, 1987 have been used: US$1 = SLRs 30 SLRs 1 = US$0.03 FISCAL YEARS GOSL = January 1 to December 31 Commercial Banks = January 1 to December 31 Development Finance Corporation of Ceylon (DFCC) = April 1 to March 31 National Development Bank of Sri Lanka (NDB) January 1 to December 31  ABBREVIATIONS ADB - Asian Development Bank AWPR - Average Weighted Prime Rate BOC - Bank of Ceylon BTT - Business Turnover Tax BMR - Balancing, Modernizing and Rehabilitation CB - Commercial Banks CBOC - Commercial Bank of Ceylon CBSL - Central Bank of Sri Lanka CDIC - Capital Development and Investment Corporation CISIR - Ceylon Institute of Scientific & Indestrial Re:earch DFCC - Development Finance Corporation of Ceylon EDB - Export Development Board EPR - Effective Protection Rates ERR - Economic Rate of Return ETF - Employees Trust Fund FCB - Foreign Commercial Banks FIAC - Foreign Investment Advisory Committee CCEC - Greater Colombo Economic Commission COSL - Government of Sri Lanka HNB - Hatton National Bank IDB - Industrial Development Board IPS - Industrial Policy Statement LIAC - Local Investment Advisory Committee MISA - Ministry of Industry and Scientific Affairs NCB - Nationalized Commercial Banks NDB - National De-elopment Bank of Sri Lanka NERDC - National Engineering & Research Development Centre NSB - National Savings Bank NTC - National Telecommunications Commission PB - Peoples Bank PCI - Participating Credit Institutions PMEs - Public Manufacturing Enterprises SB - Sampath Bank SLSI - Sri Lanka Standardization Institute SMI - Small and Medium Industries TBR - Treasury Bill Rate TIPR - Trade and Industrial Policy Reform TOR - Terms of Reference This document has a restricted distribution and may be used by recipients only in the performance of their offcial dutles. Its contents may not otherwise be disclosed without World Bankt authorization.  SRI LANKA THIRD INDUSTRIAL DEVELOPMENT PROJECT STAFF APPRAISAL REPORT TABLE OF CONTENTS Page Credit and Project Summary ... ............................... iii-v I. INTRODUCTION ..o......... oo.oo... oo.o.. oo..o............. 1 II. THE INDUSTRIAL SECTOR ... o ..............................oooo 2 A. Economic Setting .o.o...o.o.o... *........... * ................. 2 B. Structure and Performance ....*oo...o.......*..*...**.*. 3 C. GOSL'S Program for Industrial Development .......*o.*.oo 4 - Objectives and Strategy for Industrial Development .. 4 - Overall Assessment of Intentions and Progress ....... 5 - The IMF Structural Adjustment Facility (SAF) ........ 8 III. INDUSTRIAL FINANCING so ..... .........o ... ...*...o........... 8 A. The Financial System *......, .......................... 8 B. Investment Demand .......... .. . .. . . .. . .. . . * * * * * * * * * .... 12 IV. THE BANK GROUP'S INDUSTRIAL AND FINANCIAL SECTOR STRATEGY .. 13 A. Lending and Industrial Strategy ........0................ 13 B. Impact of Previous Industrial Sector Operations ........ 14 - Trade and Industrial Pclicy Reforms * ................. 14 - Financial Sector ......... . ........................ 14 - Effectiveness - Resource Transter..................... 15 C. Future Involvement .......... . . .. . . .. . . .. . . .. . . .. . . .. . . . 16 V. THE PROJECT .......... o ............................... 17 A. Project Objectives and Description ..................... 17 B. Institutional Arrangements 5...................... 19 C. Costs and Financing Plan ............................... 23 D. The Project Component............* . .................. . . . .. 24 VI. THE CREDIT .......... o.o ...... o*oo....oo... oo....... o..... 28 A. Terms and Conditions ................................... 28 B. Administration Procedures 31 C. Benefits and Risks 34 VII. AGREEMENTS AND RECOMMENDATION ............................. 35  -ii- Annexes 1. Interest Rate Structure 1983-1987 2. Technical Assistance: Debt Recovery Reform 3. The Capital and Securities Market 4. Performance of Proposed Participating Credit Institutions (PCIs) 5. Technical Assistance: DFCC IS Technical Assistance: NDB 7. Technical Assistance: Tariff commission 8. Technical Assistance: The Export Development Board 9. Technical Assistance: Industrial Technology Development 10. TOR: Telccommunications Component for NTC 11. Strengthening of Environmental Review Capabilities 12. Disbursement Schedule 13. Project File This report was prepared by Messrs. G. Segerlund, D. K. Groves, B. Cu Kok, S. Wu, T. Maxwell, and B. Sheahan (IFC) following an appraisal mission to Sri Lanka in March 1988. Th' mission combined with an ADB mission preparing the cofinancing component.  -i ii- SRI LANKA Third Industrial Development Project (IDP-III) Credit and Project Sumary Borrower S Democratic Social.st Republic of Sri Lanka. Beneficiaries : Eligible Participating Credit Institutions (PCIs) includ- ing public and private sector comiercial banks and development financing institutions. These would include: Bank of Ceylon (BOC), Commercial Bank of Ceylon (CBOC), Development Finance Corporation of Ceylon (DFCC), Hatton National Bank (HNB), National Development Bank (NDB), the Peoples Bank (PB), and Sampath Bank (S8). Technical assistance would be provided to the PCIs, the Presiden- tial Tariff Commission (PTC), Export Development Board (EDB), the Ministry of Industries and Scientific Affairs (MISA), and the National Telecommunications Commission (NTC). Total Project Amount SDRe 89.8 million (US$124.3 million equivalent) Credit Amount s SDRs 31.7 million (US$43.8 million equivalent) Terms s Standard, with 40 years maturity. Co-Financing : The Asian Devel. tent Bank (ADB) proposes to provide US$40.5 million, inclusive of technical assistance of US$1.0 million for project financing through a parallel line of credit on terms and conditions similar to those of the proposed Project. Onlending Terms The Government would relend the project proceeds to eligible PCIs for 18 years including a three year grace period, at a variable rate aligned with the average of the AWPR 1/ for overdraft facilities prevailing over the previous six month period, less a spread of 4S. Given the absence of facilities ir Sri Lanka for hedging long-term foreign exchange risk, COSL would bear the foreign exchange risk on repayments to IDA. The implicit compensation to vhe COSL for taking the foreign exchange risk would be variable and set by the market as the difference between the GOSL's onlending rate to the PCIs and the international cost of foreign loan funds to Sri Lanka. The use of a market determined variable AWPR as a reference point for determining GOSL's onlending rate, together with GOSL's flexibible exchange rate management, will ensure that borrowing costs reflect foreign exchange risk on a continuous basis. Based on current interest rates present GOSL compensation would be 31. The PCIs would onlend the proceeds to sub-borrowers at market determined rates. On the basis 1/ The AWPR is a weighted aver-ge of the interest rates applied to all new or rolled over advances above Rs 1.0 million extended to prime customers of the commercial banks in Sri Lanka. This information is provided weekly to the CBSL which compiles and publishes the AWPB as an official index.  -iv- of the present AWPR and spread requirements, the relend- ing rate would be between 13x-16% p.a. Interest rates, foreign exchange compensation rates, and spreads would be reviewed semi annually on or about January 1 and July 1 with appropriate adjustments of interest rates and spreads as necessary to (i) reflect movements in the market reference rate, and (ii) remain positive in real terms vis-a-vis inflation as reflectzd by the Colombo Price Index. Project Description : The objectives of the proposed project, which complement previous and ongoing industrial sector operations, are to (i) provide credit through the banking system to medium and large scale private industrial enterprises for the creation of new operations and the balancing, modernizing and rehabilitation (BMR) of existing facilities as well as the BMR of a limited number of public manufacturing enterprises with private shareholdings or operating under private sector management service contracts, and (ii) support implementation of GSOL's policy reforms and institutional strengthening in the areas of tariff administration, export promotion, technology development and financial sector/capital market operetions. These objectives would be achieved by mobilizing (i) about US$110.0 million equivalent to finance new investment and BNR of economically viable enterprises, (ii) US$7.0 million equivalent to support technical assistance and training in the areas of industry, trade and finance relating to the private sector; and (iii) US$3.8 million (including a Project Preparation Facility (PPF) of US$750,000) equivalent to finance technical assistance for the NTC to establish a regulatory framework for operations of a commercially run communications utility and private telecommunication companies. Benefits and Risks : The main benefits of the proposed Credit are: (i) increased production of efficient import substitutes and products for exports; (ii) increased efficiency in the industrial sector as a result of policy changes; (iii) strengthening of the financing/capital market and technology development institutions which service private sector industry; and (iv) a rapid increase in private sector industrial capacity utilization and production which would add momentum and credibility to the ongoing programs of trade and industrial policy reform. Although a risk exists that an adequate number of subprojects might not materialize due to the continuing ethnic con- flict, the project pipeline and our projections indicate a credit demand well in excess of the amounts to be provided by the proposed credit. Another risk is related to timely implementation of the proposed technical assis- tance program for policy reform support. This risk is limited by the COSL's commitment and determination to go ahead with the policy reforms and would be monitored closely by the Association through its ongoing economic and sector work and project supervision.  - v^ Project Costs toreign Local Foreign Total Local Foreign Total S of ---(Ui NIllionFKillion)