Philippines - Fourth Small and Medium Industries Development Project

Document of The World Bank FOR OFFICIAL USE ONLY La/l 3023?XKoL Report No. 7531-PH STAFF APPRAISAL REPORT PHILIPPINES FOURTH SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT MARCH 15, 1989 Industry and Eneray Operations Division Country Department II 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 disclos;ed without World Bank authorization.  CURRENCY EQUIVALENTS (as of November J0, 1988) US$1.0 = P21.4 Pl.O0 - US$ 0.0467 Pi million - US$ 4',729 P1 billion = US$ 46.7 million ABBREVIATIONS ADB - Asian Development Bank AJDF - ASEAN Japan Development Fund BETP - Bureau of Export Trade Promotion (TTG/DTI) BOC - Bureau of Customs BOI - Board of Investments BSMBD - Bureau of Small and Medium Business Development (RDC/DTI) CB - Central Bank of the Philippines CITEM - Center for International Trade Expositions and Missions DBP - Development Bank of the Philippines DLC - Department of Loans and Credit (CB) DTI - Department of Trade and Industry GFSME - Guarantee Fund for Small and Medium Industries GTEB - Garments and Textiles Export Board ITDI - Industrial Technology and Development Institute ITG - International Trade Group (DTI) IGLF - Industrial Guarantee and Loan Fund JGF - Japan Grant Facility MEP - Market Encounter Program NACIDA - National Cottage Industries Development Authority NBFI - Nonbank Financial Intermediaries NEDA - National Economic and Development Authority NIST - National Institute of Science and Technology PCR - Project Completion Report PDB - Private Development Banks PDDCP - Product Development and Design Center of the Philippines (ITG/DTI) PFI - Participating Financial Institution PSP - Product Specialist Program PTTC - Philippines Trade Training Center PVO - Private Voluntary Organization RDG - Regional Development Group (DTI, SMI - Small and Medium Industry UiPISSI - University of the Philippines Institute for Small-Scale Industries FISCAL YEAR Government: January 1 to December 31 IGLF: January 1 to December 31  NS OFFCAL WI ONLY PHILIPPINES FOURTH SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT Loan and Project Summary Borrower: Republic of the Philippines Beneficiaries: Industrial Guarantee and Loan Fund (IGLF) and accredited financial institutions. Amount: US$60.0 million equivalent Terms: 20 years including 5 years of grace at the Bank's standard variable interest. Relen ing Terms: The Government of the Philippines would relend the proceeds of the loan to the IGLF on terms similar to the Bank loan. Government would bear the foreign exchange risk. IGLF would relend the proceeds to accredited participating financial institutions (PFIs) in domestic currency at rates based on the prevailing interest rate of time deposits in the Philippines. PFIs would be given a choice of five-year fixed rates or variable rates, adjusted according to market interest rate movements with a cap of 1? per semester. Maturities would conform to the maturity of subloans which would vary up to a maximum of 12 years depending on the purpose of the subloan. PFIs would on-lend the proceeds to their subborrowers at prevailing market interest rates. Cofinanciers: Asian Development Bank, Japan Grant Facility, ASEAN Japan Development Fund. Project Description: The Project's objectives are to help to ensure that: (a) long-term resources continue to be available for long-term financing needs of the SMI Aector; (b) the access of SMI firms to finance is improved b: strengthening the IGLF guarantee; (c) short-term pre-shipment export finance, along with a strong pre-shipment export finance guarantee, becomes more widely available to direct and indirect SMI exporters; (d) SMI exporters have improved access to inputs at world prices through streamlined and simplified duty drawback and exemption systems; (e) key technical assistance programs to SMI firms are continued and user cost-sharing is introduced; and (f) institutional and policy reforms related to SMI exporters are identified and appropriate measures designed. 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 Bark authorization.  - ii - The Project would have the following components: (a) a line of credit (comprising 992 of the total project cost) to IGLF to support SHI long-term investment and short-term export financing needs during 1989-1991; (b) an Export Component, which would provide equipment and related services, training and administrative costs, and consultancy assistance to improve the access of SHI exporters to duty drawback/exemption, export finance/guarantee and marketing assistance and trade information services; and (c) a DTI Support Component, which would provide training and equipment to strengthen DTI's regional offices and technical assistance for policy formulation and program design in the area of exporL and industry development. There are no unusual project ri-ks. Like any credit project, demand will be subject to the overall performance of the economy. However, the demand projections are reasonably conservative and well within the historical performance of the IGLF. The introduction of market-based interest rates will also help to ensure that credit demand is not subject to wide swings due to distortions in administered rates, as occurred in the past.  - iii - Estimated Costtal Local Foreign Total ------ (USS million) - Credit Component 195.0 160.0 355.0 Export Component 1.1 1.6 2.7 DTI Support Component 0.3 0.4 0.7 Total Baseline Cost 196.4 162.0 356.4 Price contingencies 0.2 0.1 0.3 Total Project Cost 196.6 162.1 358.7 Financing Plan: Subloan beneficiaries 80.0 - 80.0 T.A. beneficiaries 0.1 - 0.1 Participating Financial Institutions 28.0 - 28.0 IGLF 47.0 - 47.0 ADB - 100.0 100.0 ASEAN Japan Development Fund 40.0 - 40.0 Japan Grant Facility 1.5 2.1 3.6 IBRD - 60.0 60.0 Total 196.6 162.1 358.7 Estimated Disbursements IBRD FY 90 91 92 93 ------- (USS million) ------ Annual 12.3 19.0 23.3 5.4 Cumulative 12.3 31.3 54.6 60.0 Rate of Return: N.A. a/ Project costs includes a negligitle amount of taxes and duties  - iv - PHILIPPINES FOURTH SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT Table of Contents Paso No. Loan and Project Summary ...............................,......... i I. SECTORAL BACKGROUND.. 1 A. The Industsial Sector. 1 B. Thre Small and Medium (SMI) Industries Sector. 2 SMI Definition. 2 SMI Role in Manufactu-ing Sector. 2 Overall Incentive Framework for SI. 3 SMI Financing. 4 SMI as Exporters ...............,. 5 Technical Assistance for SI. 6 C. Bank Objectives and Role in the Sector. 7 II. THE PROJECT. 9 A. Project Objectives .................................. ..... 9 B. Project Description ....................................... 10 C. Credit Component (IGLF) ................................... 10 The IGLF Program ...................................... 10 Operating Policies and Procedures ..................... 11 Eligibility for IGLF Loans ............................ 12 Past Performance of IGLF .............................. 13 Interest Rates ........................................ 13 Preferential Rate for Selected Regions ................ 15 Demand for IGLF Funds ................................. 16 PFI Share of Term Loans ............................... 16 IGLF Guarantee ........................................ 16 Export Pre-Shipment Facility .......................... 17 IGLF Organization and Staff ........................... 18 IGLF Project Supervision .............................. 18 IGLF Financial Position and Performance ............... 18 D. Export Component .......................................... 19 Pre-shipment Export Guarantee ......................... 19 Access to Inputs ...................................... 20 Trade Information Services ............................ 22 Marketing Development ................................. 23 This report was prepared by Mr. K. Young and Ms. M. Hanson (AS2IE), and Messrs. B. Nichols, E. Park, and M. Moran (consultants) following a field appraisal of the project in October/November 1988.  v Page No. E. DTI Support Component ..................................... 24 Support for Regional Operations ...................... 24 Policy/Program Design Assistance ...................... 25 Implementation ........................................ 25 F. Overall Project Cost. and Financing ....................... 25 III. THE PROPOSED BANK LOAN .................. ...................... 29 A. Features of the Loan ...................................... 29 Lending Arrangements .................................. 29 Procurement ........................................... 30 Disbursement .......................................... 30 Free Limit and Subproject Review ...................... 31 Reporting and Audit Requirements ...................... 31 B. Benefits and Risks ........................................ 32 IV. AGREEMENTS AND RECOMMENDATION ................................. 32 A. Agreements and Understandings ............................. 32 B. Condition of Effectiveness ................................ 34 C. Recommendation ............................................ 34  - vi - ANNEXES 1. SHI Activity by Industry 2. Industrial Guarantee and Loan Fund Table I IGLF Accredited Financial Institutiors as of 12/31/87 Table 2 IGLF Outstanding Loan Portfolio (including Sponsorship Scheme) as of 12/31/87 Table 3 TGLF Loans Compared to Other Categories of Credit In the Philippines, 1982-86 Table 4 Number of Branches of IGLF - Accredited Financial Institutions by Region Table 5 IGLF Summary of Operations, 1982-87 Table 6 Characteristics of STD Approvals by Size, Purpose and Maturity, 1982-87 Table 7 Regional Distribution of IGLF Loans Approved, 1982-87 Table 8 Sectoral Distribution of IGLF Loans Approved, 1982-87 Table 9 Analysis of Arrears of IGLF Portfolio as of 12/31/87 Table 10 Analysis of Arrears Between End-Users and PFIs UJnder the Accreditation Scheme as of 12/31/87 Table 11 Analysis of Arrears Between End-Users and PFIs as of 12/31/87 Table 12 Loan Collection Ratios of PFIs from End-Users, 1983-87 Table 13 Outstanding IGLF Loans With and Without Guarantees as of 12/31/87 Table 14 Summarized IGLF Balance Sheets, 1982-87 Table 15 Summcrized IGLF Income Statements, 1982-87 Chart 1 IGLF Otganization Chart 3. Detailed Cost Estimates for the Project 4. Disbursement Schedule 5. Project File Data and Documents  PHILIPPINES STAFF APPRAISAL REPORT FOURTH SMALL AND MEDIUM INDUSTRIES DEVELOPMENT PROJECT I. SECTORAL BACKGROUND A. The Industrial Sector 1.1 The development of industry during the 1970s occurred within a policy environment that provided high and variable levels of trade protection, a distorted exchange rate, handsome incentives for new investment, and cheap and readily available long-term finance from public financial institutions. In addition, the Government itself became a large direct investor in major industrial projects. Although industrial growth was rapid, it was costly. Capital and intermediate good inputs grew faster than output, and total factor productivity declined systematically. The benefits of growth were also unevenly distributed. The share of employment in manufacturing remained low (at only 112) and actually declined somewhat during the 1970s, as sizeable growth in medium and large firms was offset by an employment contraction in small-scale industry. Real wages in industry also declined, while the protection afforded the manufacturing sector caused an appreciation of the real exchange rate and a downward bias against rural incomes. 1.2 The structure of the industrial base that was created in the 1970s was brittle and largely uncompetitive. Non-traditional manufacturing export growth was narrowly concentrated in prcduct mix (semi-conductors and garments) and destination (the USA). The remainder of industry, where the bulk of value added was created, was highly susceptible to domestic demand. This was, however, artificially inflated by protection, by heavy foreign borrowing and by infusions of credit and transfers from the government. The momentum given to industrial growth by these measures began to taper off in the late 1970s, when the scope for further expansion of import substitution under heavy protection was exhausted, and technological weaknesses and other inefficiencies fostered by the lack of competition began to take their toll. In addition, the financing requirements of high domestic demand could not be indefinitely sustained. Rapid changes in the international environment since 1980, high interest rates and a foreign exchange crisis led to forced austerity measures which further propelled industry along its downward trend. Industrial output declined by 25Z during 1982 through 1986. tlany firms ceased operation and declared bankruptcy. Even firms in operation limped along at 50-60% capacity utilization. Since 1987, however. there has been a significant recovery in industry which grew at 8% in 1987 and is estimated to grow at 102 in 1988. This has largely resulted from the excellent performance of manufacturing. 1.3 The lessons of the past have not gone unheeded. Since 1980, Government has undertaken a process of gradually removing the major sources of distortions within the system. Although the reform process has been far from  2 smooth, or as yet complete, much has been accomplished as a result of cumulative actions over the past seven years. Paradoxically, the economic arid financial crisis which derailed the trade reforms during 1983-85, provided the momentw for drastically reducing some of the more intractable government interventions in the industLial sector. Following the change in government in February 1986, the pace of reiorm has quickened and, with the resumption of import liberalization in 1986, significant progress has now been achieved in all of the key areas of needed reform including tariff refom, incentives, financial policy, foreign exchange and exchange rate management and privatization of public industrial asse* s. Although policy-induced distortions still remain, the degree of transformation is striking and represents a major achievement of the policy reform process. B. The Small and Medium Indt'eries (SMI) Sector 1.4 SMI Definition. The SMI sector in the Philippines includes cottage, small-scale and medium-scale industries which m&y be defined either in terms of asset size or number of employees. The asset based definition is used by the banking sector in determining eligibility for finance; the Census of Manufacturers, however, categorizes industries based on number of employees. Thus, cottage industries may have total assets before financing ranging between P50,000-499,999 (about US$2,300-23,000), or less than 10 employees; small industries may have total assets ranging between P500,000-4,999,999 (about US$23,000-240,000), or 10-99 employees; and medium industries have total assets ranging between P5-20 million (about US$240,000-930,000), or 100-199 employees. Based on fixed asset data provided is the Census of Manufacturers, there appears to be strong correlation between the asset- and employment-based SMI definitions; average fixed assets of the various SMI subsectors, defined in terms of omployment, fall well within the total asset cut-off points for SMI. 1.5 SMI Role in Manufacturing Sector. The latest data available from the 1983 Census of Manufacturing Establishments show that there were over 55,000 firms in the SMI sector, equivalent to over 98X of the total number of manufacturing establishments. While SMI account for 432 of the employment generated by the manufacturing sector, they hold only 23? of the fixed assets of manuft.cturing establishments, indicating their relative labor-intensity, and contribute 21Z of the total value-added of the mar.ufacturing sector (see Table 1.1 below). Of particular significance in interpreting this data is the highly dualistic structure of firm size. There are a very large number of cottage industries (less than. 10 employees) which constitute 90Z of the number firms in manufacturing and 21? of employment and yet contribute only 22 of value added in the sector. At the other extreme are a dominant group of large firms which constitute only 1Z of firms yet account for 57Z of employment and almost 80Z of value added. In the middle is a relatively small gro"'- (abo: t 5,000) of small and medium firrns which contributp about 22Z of mar.-Lacturing employment and 192 of value-added. It is this group of small and medium firms that is the focus of this Project.  3 Table 1.lt INDUSTRIAL STRUCTURE, 1983 Share of Share of Firm size Number of firms employees value added SMI 55,330 43.3 21.1 Cottage (<10 employees) 50,313 21.0 2.4 Small (10-99 employees) 4,512 14.4 10.4 Medium (100-199 employees) 505 7.9 8.2 Large (200+ employees) 717 56.7 78.9 Total 56,047 100.0 100.0 Source: NCSO, Census of Establishments, 1983. 1.6 SMI firms are important in a wide range of manufacturing subsectorL contributing ever 302 of value added in food processing, apparel, leather products, footwear, wood and furniture, printing, chemicals, rubber, plastics fabricated metals and machin.ery. The most prominent SMI subsector is food processing which accounts for over one quarter of all SMI value added (see Annex 1). 1.7 Overall Incentive Framework for SMI. The overall incentive framework has been biased against SMI firms. During the sixties and seventies, restrictive trade policies, noted above, worked against small firms by providing incentives for capital-intensive sectors where SKI are at a disadvantage, by discriminating against domestic suppliers of intermediate inputs for export products, and bv generally permitting inefficient production, irr2spective of firm size. The Go-ernment has recognized the costs of the highly protectionist trade policy, not only to SMI but to all industry, and since 1980 has been implementing far reaching trade reforms. 1.8 Fiscal incentives also have discriminated against SMI by favoring capital-intensive firms. Onercas registration procedures have also restricted SMI firms' access to sucnl incentives. In addition, misguided incentives to cottage industries, initiated in the 1970s through the National Cottage Industries Development Authority (NACIDA), made such industries dependent on subsidies, and had the effect of inhibiting the growth of potentially efficient firms and preventing the natural phasing out of non-productive firms. Government has also taken steps to try to reduce these biases. Cottage incentives have been abolished. Board of Investments (BOI) incentives have been revised with a view to making them more neutral among different types and sizes of industry. Rather than create new incentives and administrative systems for SMI firms, the emphasis has been on improving SMI access to incentives already available for industrial promotion. The Department of Trade and Industry (DTI) has been recently reorganized and has placed increased importance on effective delivery of its services, including BOI incentives to the regions. Simplified BOI registration procedures, administered through regional offices by staff capab.e of advising SMI firms of their eligi',;ility for incentives, are being pursued under the reorganized  4 DTI. A further simplication arises from the introduction, under the Omnibus Investment Code, of a restricted validation period (3 days) and assessment time (17 days) for application. Registration is deemed to have been granted by default uviless formally granted within that time period. While it is too early yet to assess the effectiveness of these measures, DTI has hired consultants to undertake a study to evaluate the impact on SM; registration. This study is scheduled for completion until 1989 and will be submitted to the Batik . 1.9 SMI Financing. SMI access to financing, especially term financing through conventional banking channels, nias been restricted. This has resulted because of the lack of interest by the banks in lending to SMIs with weak collateral and the higher cost and efforts of credit appraisal of small firms. In an effort to offset these biases, the Government established a number of credit programs for SKI firms. Two of the major institutional sources of long-term finance for the SMI sector have been the Industrial Guarsntee and Loan Fund (IGLF) and the Development Bank of the Philippines (DBP). DBP programs were discontinued between 1985 and 1987 due to a lack of counterpart funds and overall institutional weaknesbes (but under a rehabilitation program agreed by the Bank, DBP has now been restructured and is operational again). 1.10 IGLF is a rediscount and guaran.ee mechanism operated by the Central Bank (CB) under which accredited financial institutions (commercial banks, rural and thrift banks, private development banks and nonbank financial institutions) are reimbursed for term loans (fixed asset and permanent working capital) and, recently, short-term pre-shipment export credit to SMI, IGLF also offers guarantees to cover credit and collateral short risks taken by the participating financial institutions (PFIs) on IGLF rediscounted loans. IGLF has in the past sourced its funds primarily from funds transferred from the Government budget and from World Bank borrowings. 1.11 Overall, IGLF has become an important source of term finance for SMI firms. by the end of 1986, IGLF loans represented 5X of all loans outstanding to manufacturing firms in the Philippines. Moreover, it accour.ted for over 10? of all loans outstanding with maturities over 3 years. While this is still significantly less than the SMI share (21Z) of value edded in ifacturing, it is nonetheless substantial and clearly is the major source of term funds for SMI. Furthermore, repayment perforn.ance has been good with arrears from end-users to PFIs amounting to only 4Z of loans outstanding during 1982-86. In the context of the overall turmoil in financial markets in the Philippines in the mid-1980s, this is a very credible performance. 1.12 Nonetheless, there are a number of drawbacks and deficiencies in the IGLF program that need to be remedied in order to provide SMI better access to term finance. First, the interest rate arrangements under the IGLF program have lagged behind changes in the overall interest rate regime in the Philippines, which is largely market determined. The IGLF program as currently priced fails to cover adequately the Government's interest, credit and foreign exchange risks. Second, there is little evidence that significant domestic resources are being mobilized to complement IGLF term lending to SMI firms. Third, SMI access to credit is restricted by an ineffective guarantee program. These problems need to be remedied not only to preserve the gains  5 that have already been made by the IGLF orogram but to expand its scope and establish it as a continuous and increasingly self-reliant source of term finance for SMI. These issues are being addressed under the proposed Project (paras. 2.15 - 2.21, 2.24 and 2.25 - 2.27) 1.13 In addition, there are two other issues that have surfaced. First. the program has not been effective in covering cottage or micro enterprises. Only 12 of the value of loans outstanding are to cottage firms. The design of the program, which uses existing financial institutions, appears inappropriate to address the needs of this group. Experience elsewhere suggests that a spe- cialized and nontraditional form of financial intervention would be required to reach this group effectively. While IGLF has started an innovative program through private voluntary organizations, its usage has been small. In this context, the Bank is proposing to review alternative approaches, outside of the IGLF framework, for cottage firms and to support them with a possible project focussed on their unique needs. 1.14 Second, Government is concerned that not enough IGLF funds are going outside of Metro Manila. In 1987, only 27Z of IGLF loans went to the regions; this figure compared with the 42Z of SMI industrial value added which originated in the regions. IGLF loans made outside the three most active regions (in 9 out of a total of 12 regions) amounted to only 72 of the total program. While part of this relative shortfall in the regions may be due to political turmoil, higher intermediation costs may also be a factor. Accordingly, the Government proposes that IGLF offer schemes to stimulate investment in the depressed areas of the country. While improving the guarantee mechanism will be the primary long term change to achieve this end, shorter term solutions include offering PFIs IGLF loans at a discount for specified depressed areas. The Government has explicitly ruled out ot'-sr approaches, such as minimum credit targets for PFIs or fixing below market rates for sub-borrowers in the regions, realizing that such approaches are often counterproductive. 1.15 SMI as Exporters. Nontraditional exports accounted for about 642 of Philippine exports in 1987 and are expected to be a continued source of economic growth for the country. Eight groups of manufactured goods contributed nearly 802 of nontraditional exports: garments, electronic goods, chemicals, food products, handicrafts, furniture, footwear and wood products. With the exception of electronic goods, SMI are important manufacturers in each of these subsectors and may be assumed to be important direct or indirect exporters. While the specific export contribution of SMI manufacturers cannot be quantified, as data are not currently collected on this type of SMI performance, the importance of SMI production in the above nontraditional export groups, together with the fact that in 1984 nearly 65Z of the 4,409 exporting firms had shipments valued at US$100,000 or less, would indicate that SMI are active direct exporters. SMI are also known to be important subcontractors to direct exporters in the garments and handicraft industries. Since trading companies in the Philippines accounted for less than 42 cf total exports, SMI export contributions have generally been in the form of direct e::ports or as subcontracting for larger direct exporters.  6 1.16 The fact that so many small and medium direct exporters have been exporting without much help from trading companies and that the substantial potential for backward linkages from the major manufactured export products have not been exploited yet, clearly suggests that small and medium producers could make an important contribution to the acceleration of nontraditional exports. In this regard, the World Bank's recent Industrial Sector Report on the Philippines (No. 6706-PH, 7/30/87) stressed the importance of improving the access of small and indirect exporters to duty free imports and to working capital finance. While administrative arrangements exist in the Philippines to provide exporters with duty free access, there are many gaps, restrictions and inefficiencies in the existing systems that prevent small and indirect exporters from adequate coverage. This issue is addressed in the proposed Project (para. 2.42 - 2.48) 1.17 A second important constraint on SMI exporters is the lack of adequate access to pre-shipment export finance so that even confirmed orders cannot be fulfilled. Existing schemes have in practice covered only a very limited number of exporters and a limited export value. Moreover, most of the exporters excluded from access are small or indirect exporters. To try to remedy this situation, Government recently established a new window in IGLF to finance the pre-shipment needs of SMI exporters. lowever, usage to-date of this facility has been limited. This may be partly due to the banks' unfamiliarity with the scheme. However, the major constraint appears to be the lack of an effective pre-shipment export guarantee facility. The existing guarantee offered by Philguarantee is extremely limited in its coverage and as such is not an effective instrument to expand export finance. Proposals are included under the Project to establish an effective guarantee facility through selective institutional and operation changes in Philguarantee (para. 2.40). 1.18 Technical Assistance for SMI. Support for the SMI sector in the Philippines is offered through a wide range of programs addressing financial, technical, business advisory, training and marketing issues. These programs are delivered through government and private financial institutions, Government departments and their associated agencies and by state-owned corporations. The Department of Trade and Industry (DTI) itself has played the major role in designing and delivering technical assistance to the SMI sector. DTI's Bureau of Small and Medium Industry (BSMI), which has a strong regional representation, has historically providpd firm-level technical assistance (most often assisting SMI in preparing financing proposals) and industry-wide clinics through which private sector specialists help address specific design or production problems of St1I producers. DTI's Center for International Trade Exhibitions and Missions (CITEM) has achieved notable success in exposing SMI products to export markets and, together ;.ith the Design Center of the Philippines (PDDCP), has worked with SMI in various subsectors to upgrade the quality and design of their products to international standards. In addition, the Department's Bureau of Foreign Trade is responsible for helping industries of all sizes to overcome market information imperfections by providing up-to-date market data and information relating to new trading opportunities. However, effective dissemination of the data collected has been a problem. Important among existing programs for SMI are two firm-level assistance programs, the Product Specialist (PSP) and  7 Market Encounter Programs (MEP), which have proven track records of effectively helping SHIs in product design and marketing. 1.19 Successive Product Specialist Programs (PSP) have resulted in a strong design awareness in firms and a small professional design industry in the Philippines. The increased level of design awareness has led to a growth in the level of employment of in-house designers, who continue to benefit from their contact with the product specialists and with international buyers at the Market Weeks. The Market Encounter Program (MEP), through its organization of regional fairs, has served to introduce national and international buyers to regional producers of crafted goods. The program has promoted improved product design and sales by SMI manufacturers through a program of product adaptation and market promotion in the regions, with follow-up consultdncy and advisory services to participants. 1.20 Over the long term, the establishment of a specialized trade promotion organization, providing an integrated range of services tc exporters and foreign buyers and funded without recourse to budgetary allocations from the government would appear warranted. Such an organization could be based on models existing in some of the world's most successful exporting nations, including Japan, Hong Kong, Singapore, and South Korea. These provide an integrated set of relevant services to exporters and foreign buyers, enjoy the confidence of government and exporters, are represented in the principal export markets, employ qualified and competent staff, and are securely and adequatel- financed. Such a major overhaul of the export support system is, however, not achievable overnight, and intermediate steps will be taken under this Project to improve the responsiveness and relevance of existing programs and institutions. 1.21 With the exception of CITEM's trade fairs and some of the training courses ?rovided by DTI and funded in part by the Bank, the extension services offered by DTI are generally provided free of charge to SMI. As a result, it is difficult to judge the appropriateness as well as the value accorded DTI's services. In addition, DTI has been criticized as being too promotional, and overly concerned about increasing the absolute number of SMI. For future technical assistance programs, particularly those for which Bank financinig will be provided, the focus will be on improving the efficient growth and profitability of SMI, and on sharing cost_. with participating SMI (paras. 2.52 and 2.53 - 2.54) C. Bank Objectives and Role in the Sector 1.22 The Bank remains committed to assisting the Philippines to regain a reasonable rate of growth in the industrial sector which is sustainable for the medium to long term. Substantial industrial sector work has been undertaken in the recently completed Country Economic Memorandum and Industrial Sector Report. This work identifies a number of areas where further improvements are necessary if industrial sector growth is to be attained. These include: maintenance of a competitive exchange rate; continued policy and regulatory reforms to encourage greater competition and more efficient production; financial and physical restrLcturing of many large firms in the face of a changing policy environment which better recognizes the  8 Philippines' comparative advantage in labor; expanded availability of long- term finance; and measures to increase exports, particularly from the SMI sector. In supporting the industrial sector, therefore, Bank assistance would take the form of policy advice (related both to the industrial and financial sectors), institutional support, and the transfer of term resources. Discus- sion with the Government on broad policy issues will continue in the context of economic and sector work, and implementation of reform measures under the Economic Recovery Loan (Loan 2788 of 3/30/87). Proposed industrial projects would also address continuing export policy and administration issues as well as constraints on the development of micro-enterprises. 1.23 The proposed SMI IV Project is a follow-up to three previous projects (Loans 1120-PH, 1727-PH and 2169-PH) designed to promote the development of the SMI sector. All these loans have been fully disbursed, Project Completion Reports (dated June 17, 1981 and October 6, 1988, respectively), have been prepared for the first two loans and a Projeit Performance Audit Report for the first loan (PPARI 3696 dated June 16, 1982). Under these projects, the Bank approved US$187 million 1/ for assistance to the sector. All three loans concentrated on providing finance to SMI through IGLF and DBP, and also contained technical assistance components. Due to inherent institution-wide weaknesses and poor financial performance in the Development Bank of the Philippines, most of the US$48 million allocated to DBP under the SMI III project was cancelled. In addition, US$6.7 million of the funds allocated to IGLF from the Third SMI loan was cancelled due to rtduced demand for IGLF funds. This lower than expected demand was brought about by a combination of reduced borrowing by end-users due to political uncertainties and higher than market interest rates charged by IGLF to the PFIs (during the mid-1980s the average cost of deposits in the PFIs was lower than the cost of IGLF money). Apart from the reduced demand for IGLF funds in 1986 and 1987, the :redit components of the SMI projects have generally performed well and achieved their objectives in terms of channeling substantial credit to SMIs, increasing the number of financial institutions participating in the program and operating with low arrears and high collection ratios from both the PFI's and end-users. However the sub-loan pricing mechanism adopted under these projects has not been fully satisfactory. Under these projects, PFIs were charged fixed interest rates which were based on the cost of funds from the Bank and 3 predetermined spread. However with the liberalization of interest rates in the past few years, IGLF's interest rates quickly become out-of-line with market conditions, causing distortions which could not easily or quickly be alleviated. The proposed Project incorporates changes in interest rate policy to remedy past problems. The quantitative impact of the Bank's lending to the SMI sector is given in Table 1.2 below: 1/This amount is prior to cancellations and does not iiicluie an additional $56.9 million which was made available to DBP for SMI lending under Loans 1190-PH and 1572-PH.  9 Table 1.2: IMPACT OF SANK SMI LENDING Loan Numr of Total sub- Incremntal Cost per aount eubprojecte project cost employmnt job Loan (USS million) financed (USS million) geerated (US1) SMI I (Loan 1120-PH) 80.0 t01 60.1 17,968 8,850 SM! II (Loon 1727-PH) 26.0 264 56.0 10,497 5,886 SMI III (Loan 2169-PH)/a 152.0 2100 273.0 - - a/ The numbers shown here for SMI III are from the Staff Appraisal Report. Of the original loan amount, US$64.6 million was canceled. 1.24 The technical assistance components of the first two SKI projects were relatively small and restricted to helping defray some of the operating and capital costs of DTI's developing extension program for SHI. Under the SMI III project, the technical assistance component was substantially expanded both in scope and cost, and included training of DTI staff SMI industry group, provision of required vehicles, equipment, and reference libraries, pilot projects for common facilities and new technologies and SMI subsector-related studies. 2 .25 IFC has supported the SMI sector by financing four projects: a leasing company aimed at assisting SMI; a venture capital fund which invests largely in light manufacturing firms, including SMI; a debt-equity swap fund which invests in Philippine businesses, including SMI; and an agricultural development bank subsidiary of a commercial bank which invests in agribusinese opportunities. II. THE PROJECT A. Project Objectives 2.1 The basic objective of the proposed Project is to provide employment opportunities, improve income distribution and regional development, and provide a catalyst for promoting general economic growth and exports. The proposed Project specificall" would help to ensure that: (a) long-term resources continue to be available for long-term financing needs of the SMI sector; (b) the access of SMI firms to finance is improved by strengthening the IGLF guarantee; (c) short-term pre-shipment export finance, along with a strong pre-shipment export finance guarantee, becomes more widely available to direct and indirect SMI exporters; (d) SMI exporters have improved access to inputs at world prices chrough streamlined and simplified duty drawback and exemption systems and he;:er access to common bonded warehouses; (e) the effectiveness of technical assistance delivered by DTI is improved by better focusing it on the needs of growth and export-oriented firms; and (f) institutional and policy reforms related to SMI exporters are identified and designed.  10 B. Project Description 2.2 The proposed Project would have the following components: (a) a line of credit (comprising 99Z of total project cost) to IGLF to support SMI long- term investment and short-term export financing needs during 1989-1991; (b) an Export Component, which would provide equipment and related services, training and administrative costs, credit and consultancy assistance to improve the access of SMI exporters to duty drawback/exemption, export finance/guarantee and marketing assistance and trade information sezvices; and (c) a DTI Support Component, which would provide training and equipment to strengthen DTI's regional offices and technical assistance for policy formulation and program design in export and industrial development. C. Credit Component The IGLF Program 2.3 The IGLF Program, established in 1952, is owned by the National Economic Development Authority (NEDA) and administered by the Department of Loans and Credit (DLC) of the Central Bank of the Philippines (CB). IGLF operates as an apex unit with the basic objective of providing resources to financial institutions for on-lending to SMI. This rediscount mechanism enables the IGLF program to have a wide geographical reach, since many of the institutions have an extensive regional branch network. Decisions on policy issues affecting IGLF's operations are made by a ministerial and deputy ministerial interagency Review Committee (RC), which is chaired by NEDA and includes representatives from CB, DTI, Department of Finat.ce and UP-ISSI. 2.4 Under the IGLF accreditation scheme, IGLF approves participation in the program of specific financial institutions and then delegates all subloan appraisal and supervision responsibilities to those accredited financial institutions. Before granting accreditation status, IGLF undertakes a thorough review of the institution to determine its overall financial viability and the adequacy of its staff to implement an SMI lending program. The performance of each accredited institution is reviewed annually by IGLF and the Bank is informed of the findings of these reviews. At year end 1987, the IGLF program included 31 accredited financial institutions, of which 14 were commercial banks, 3 were savings/mortgage banks and 14 wl?re private development banks (PDBs), nonbank financial intermediaries (NEFI), or specialized government banks. The accredited institutions operate a total of 1,074 branches throughout every region of the Philippines. Of the 31 accredited institutions, 10 were particularly active and accounted for 72Z (by amount) of IGLF loans outstanding as of December 31, 1987. Commercial banks accounted for 32Z of IGLF's total 1987 loan approvals, while nonbank financial intermediaries accounted for 23Z. private development banks for 42Z, and other financial institutions--such as savings and mortgage banks--for 3Z of approvals (Annex 2). 2.5 Because IGLF's emphasis is on accrediting and monitoring financial institutions, rather than approving individual subloans, it has well-defined approaches for both accreditation and supervision of PFIs. Both processes  start with Central Bank review information, which then is supplemented with extensive additional information on PFI organization, staff, financial strength, collection ratios and SMI lending experience. IGLF offers a course and detailed guidebook for examiners conducting both pre-accreditation appraisals and annual performance reviews of the participating financial institutions. rhe guidebook, together with a representative performance review report, is included in the Project File, I-C). The examinations themselves focus on the institutions': (a) overall performance and financial position; (b) managerial and organizational structure; and (c) operational polices and procedures. The guidebook, together with a representative performance review report is included in the Project File, I-C. If the examiner recommends that accreditation be suspended or if, apart from the annual supervision, it becomes apparent that the PFI has an unacceptable arrears position with IGLF, IGLF rescinds the accreditation and stops re- discounting loans to the institution. In the event of unacceptable arrears, after giving notice to the PFI, IGLF moves directly to obtain payment on its loans by debiting the PFI's deposits with the Central Bank. 2.6 IGLF also has a small sponsorship program for rural banks, under which it becomes more actively involved in the credit evaluation of the end- user. While the PFIs under the sponsorship scheme still take the credit risk, their inadequate analytical capabilities necessitate a detailed review of the subloans by IGLF staff prior to rediscounting. Since the rural banks would not otherwise qualify for the IGLF program, the sponsorship scheme enables IGLF to promote industrial growth outside Metro-Manila and to contribute to development in rural areas. The sponsorship scheme, which acccunted for only 1Z of the total IGLF portfolio in 1987, is not financed under the proposed Project. 2.7 The parJicipating financial institutions (PFIs) are free to select their own projects for financing, with IGLF financing assured if the project meets broad eligibility criteria (appropriate asset size, acceptable financial position and credit-rating, etc). Full repayment rests with the PFI unless the loan also carries an IGLF guarantee. Accordingly, the risk to IGLF is limited to insolvency or inability to repay of the PFI; it does not include default by the end-user, which would mean a loss to the PFI but not to IGLF. Operating Policies and Procedures 2.8 IGLF's basic policies concerning its operations and relationship with accredited institutions. as well as the administrative details on its lending policies, are incorporated into a Policy Manual, which is approved by the Review Committee and periodically up-dated to reflect policy change. Policy alterations to be incorporated under this loan are outlined below (pazagraphs 2.9 to 2.30), and will be published in a revised Policy Manual as a condition of loan effectiveness. Kev policy covenants, discussed below, include arrangements regarding maximum size of firms eligible for IGLF funding and maximum subloan amount (para. 2.9); compliance with environmental laws and regulations (para. 2.12); interest rates from IGLF to the participating financial institutions (paras. 2.16, 2.19 and 2.22); interest rates to be charged to end-users (para. 2.20); foreign exchange reserve account (para. 2.21); credit risk assumed by the PFIs (para. 2.20); operating policies  12 relating to the IGLF export pre-shipment window (para. 2.29 and 2.30); and financial analysis of subloans (para. 3.11). Eligibility for IGLF Loans 2.9 Cottage, small and medium scale industries in manufacturing and related service sectors are eligible for IGLF loans. Companies with total assets (before financing) of between 950,000 and P20 million may qualify for the loans, so long as they are manufacturing concerns or service industries supportive of manufacturing actizities (such as warehousing, machine shops, and mining enterprises), and are financially viable institutions with debt/equity ratios not exceeding 80/20. (The list of eligible industries is included in the Project File, I-M.) Maximum loans under the accreditation scheme are 90.4 million for cottage industry (with assets of 950,000 to P500,000), 94.0 million for small industry (with assets of P500,000 to P5.0 million), and P20.0 million for medium industry (with assets of P5.0 to P20.0 million). Loans are made for fixed assets (for a maximum of 12 years inclusive of 3 years grace), permanent working capital (for a maximum of 7 years inclusive of 2 years grace), and export packing credit (for a maximum of 180 days). Past Performance of IGLF 2.10 Lending through IGLF accredited in-titutions has been relatively successful in terms of the level of disbursements and repayments achieved. IGLF loan approvals increased steadily from 929 million in 1976 to 9188 million in 1982 to an estimated P1500 million in 1988, for an annual average growth of 162 (in real terms) over the 1976 to 1988 period. Arrears between sub-borrowers and PFIs under the accreditation scheme averaged 4.2Z from 1982-86. Loans affected by arrears were 23Z by number and 16Z by amount. Although in 1987 the arrearage rate jumped substantially to 9.4Z, the increase can be almost entirely explained by the large decrease in IGLF's outstanding portfolio resulting from high levels of prepayments and reduced amounts of new loans in 1986 and 1987 caused by higher-than-market IGLF interest rates. Of the arrears at year end 1988, 372 were less than one year past due, while 562 were over two years past due. With regard to payments by the PFIS to IGLF, as of December 31, 1987 arrears amounted to 6.5Z of loans outstanding (Annex 2). As a result of the subsequent expansion of the pcnrtfoio, arrears fell to less than 2% by year end 1988. 2.11 IGLF lending in 1987 was largely (about 762) to .uedium-sized industries; cottage industries accounted for less than 1Z of approvals and small-scale industries for 232. This distribution. while not in keeping with the size structure of the SMI sector (para. 1.5). indicates that the PFIs are directing their efforts to the larger end of the SMI spectrum: those businesses that generally have a track record, some collateral and the ability to present a business plan to the banks. Given that cottage and smaller SMI would very often require greater information gathering and supervision efforts on the part of the PFI, generally lack collateral, management abilities and financial statements, and historically have suffered generally higher rates of default, PFIs are less eager to lend to these borrowers.  13 2.12 IGLF-furded projects have tended to be in labor-intensive manufacturing industries, although some construction, tourism and service industries have also been financed. In 1987, the manufacturing sector accounted for 98t of approvals, with the more important subsectors being apparel/ footwear/ garments, food and food products and metal products (Annex 2). In light of potential environmental effects by some of the industries funded by IGLF loans, IGLF will specify that sub-borrowcers shall comply with all laws and regulations of the Philippines related to environmental protection, and specifically that they shall comply with P.D. 1067 Water Code 1976, and P.D. 1152 Environmental Code 1977. 2.13 Whereas before 1984, IGLF loans were largely for financing fixed assets, more recently the" have been focused on permanent working capital. In 1983, 75Z of the loans were for fixed assets and 25Z for permanent working capita;, while in 1987 the numbers changed to 372 for fixed assets and 63Z for permanent working capital. The mix changed when high interest rates and political turmoil discouraged businesses from assuming long-term obligations for new capital investment. Prepayments in 1986 and 1987 encouraged the trend, since the businesses were able to re-finance working capital loans but not fixed asset loans (IGLF prohibits re-financing and can monitor this most effectively when specific long-term assets are designated for financing). 2.14 In terms of regional distribution, IGLF has funded loans in all regions of the Philippines. It is represented throughout the provinces by its PFIs, which collectively have at least 15 branches in each region of the country. Fifty-onte percent of the PFI branches are located outside Metro- Manila. In 1987, IGLF loans were extended in every region except Cagayan Valley and Western Mindanao, with the greatest number and amount of loans going to Metro-Manila, Central Luzon, Northern Mindanao, Central Visayas and Southern Tagalog. Total amounts of IGLF lending in the regions remain limited however, inspite of the PFI distribution system. As noted below (para. 2.22), loans outside the three most industrial regions totalled only 7Z of the IGLF portfolio in 1987. Interest Rates 2.15 Under the SMI III loan, interest rates charged by IGLF to the PFIs were set at lZ for cottage and small industry and 16? for medium industry loans. Pre-determined spreads of 7Z and 5? for small and medium industry loans, respectively, brought the final end-user rates to 18Z and 21?. Although it was agreed under the Bank loan that the rates and spreads would be reviewed by the Government periodically to ensure that they reflected market conditions, in practice the rates were adjusted too slowly. When the average interest rate for all loans made by commercial banks was 21Z in early 1985, the 18Z IGLF loans were understandably popular. However, with market rates falling to 142 in late 1986 and early 1987, IGLF funds were over-priced and unused. No' only did IGLF releases fall by 642 in 1986, but extensive pre- payments of outstanding loans reduced the overall portfolio by 28Z (from P1,462 million to P1,057 million). Although releases increased in the second half of 1987, continuing prepayments in the first six months were enough to reduce the outstanding portfolio by another 272 (to P770.9 million).  14 2.16 It was agreed in March 1987 that IGLF interest rates should be more market-determined. PFI lending rates were deregulated, with the PFIs being allowed to set their own interest charges to subborrowers. The IGLF interest rate to the PFIs wes reduced to 10.2Z, E.ccording to a newly-adopted formula that set the price of funds as the higher of (a) the weighted average cost of all deposits in the Philippine banking system or (b) IGLF's total costs, including its administrative costs and its total cost of money (sourced from the Bank and from interest free budgetary transfers from the Government), with a 3-7Z p.a. foreign exchange premium added on funds borrowed from the Bank. In practice, there has been considerable ambiguity over exactly how to measure IGLF costs of funds and a wide range of estimates have been prepared. Interest rates on IGLF funds to the PFIs are determined by the IGLF Review Committee on a semi-annual basis. 2.17 Under the proposed Project, the price of IGLF loans to the PFIs will be pegged to prevailing domestic interest rates and not at IGLF's cost of funds. Since SMI loans ate in domestic currency (reflecting the typical financing requirements of the SMI sector) and interest rates in the Philippines are not regulated (since 1980, when they were deregulated, they have been positive except for a few short periods of high inflation in late 1984 and early 1985), linking the on-lending rates to local market conditions is appropriate. Tying tle IGLF interest rate to prevailing domestic interest rates will reduce fluctuations in demand stemming from misalignment of IGLF and other domestic market rates. .t will also ensure that IGLF money does not substitute for domestic resource mobilization by the PFIs. Such a formulation would further provide reasonable protection to IGLF for foreign exchange risk since domestic interest rates in the Philippines, being market determined, incorporate much of the exchange risk emanating from differential international and domesti. inflation. 2.18 In the past, the IGLF interest rate to both PFIs and end-users has been a fixed rate throughout the period of the loan. For the proposed loan, IGLF will provide an option to PFI's and end-users between an interest rate fixed for five years and a floating interest rate to be adjusted every six months according to market movements. Limiting the term for which the rate is fixed and introducing a variable rate alternative would eliminate the distortions and volatility that can occur under a long-term fixed rate system- -prepayments when fixed rates are higher than current marke~t rates and subsidies when fixed rates are lower. It would also provide IGLFIGovernment with much greater protection from the foreign exchange and interest rate risks which are assumed under World Bank, Asian Development Bank (ADB), and ASEAN Japan Development Fund (AJDF) loans. Since the PFIs indicate that SMI borrowers might be reluctant to borrow pure floating rate loans, an interest rate cap would also be introduced to limit the extent to which the interest rates float. IGLF portfolio managers in the PFIs indicate that a I% per semester cap on interest rate movements would make a floating rate more acceptable to end-users, and that such limited interest rate movements cou1 be budgeted and planned for by SMI borrowers. Under the floating rate scheme, new loans would be initiated at the rates effective at loan signing and then could be adjusted upwards by no more than 1% per semester. If interest rates increase dramatically or become highly volatile during the project period, the appropriateness of the cap would be reJieded.  15 2.19 Under either the fixed rate or variable rate options, the rates of the IGLF loans would approx4.mate the cost to the YFI's of borrowing funds of a similar maturity in the market. Under the fixed rate option, the rate to the PFI's would be set equal to the weighted average interest rate on all time deposits of over two year maturities. The rate would be fixed for five years after which the borrower could renew at fixed or variable rates for the remainder of the loan. Under the variable rate option, the rate would be set at the weighted average interest rate of all time deposits with maturities of six months or less. It would be adjusted every six months subject to a cap of 12 per adjustment. The initial rate offered under both approaches would be determined each six months according to rates prevailing during the previous semester. Applying these formulas for the second half of 1988 would have generated a five year fixed rate for that period of 13.0%, and an initial variable rate of 10.7Z. 2.20 Under the Proiect the policy of allowing the PFTs to set their own lending rates and hence their spreads will be conti,LLled. This approach ensures that IGLF lending is market oriented, and also is in keeping with the current policy for the Agricultural Loan Fund, which specifies that final lending rates to subborrowers and, hence, spreads to the PFIb, would be determined by the PFI rather than established by the Review Committee. This encourages the PFIs to lend more actively to cottage, small scale and regional SMI by allowing them to charge rates reflective of the higher processing costs and higher perceived risk of lending to thic SMI segment. As is currently the situation, the PFIs will continue to take the credit risk on their IGLF-funded loans to end users. 2.21 Although the foreigr exchange risk on the World Bank, ADB, and AJDF loans would be borne by the Government (or IGLF), the interest rate at which IGLF would relend to the PFIs would compensate for this foreign exchange risk to a significant extent, given the Philippines' liberalized interest rate policy and relatively open capital market. Over the long run, much of the gain and loss related to foreigxL exchange risk should balance out. To reflect the foreign exchange risk incurred, it was agreed during negotiations that IGLF will establish an equity reserve account in which the differential between IGLF lending and borrowing rates for foreign currency financed subloans, less proportionate administrative fees, will be accumulated. 2.22 Preferential Rate for Selected Regions. Demand for IGLF funds outside of Metro-Manila, Central Luzon and Central Visayas has been limited due to general economic conditions in the regions. Total IGLF lending outside the three major provinces in 1987 amounted to only 7% of total IGLF loan releases, as compared with a 22% average over the preceding five-year period. While political turmoil in the regions seems to be an important reason for the decline in IGLF lending, higher processing costs of regional financial intermediaries also make lending to those areas less attractive. Accordingly, the Government proposed that for loans made outside of Regions III, IV and VII (excluding a few specific depressed provinces within those regions), a rate reduction of up to 22 on average or up to 3Z for specific regions may be offered. This rate reduction is intended to remain in effect only until a more effective IGLF credit guarantee mechanism is establishedi ro encourage greater regional lending through risk sharing. The preferentLal rate will be  16 limited to the designated regions and amounts. During negotiations, it was agreed that the scheme will be reviewed by IGLF after one year (not later than June 30, 1990) and a plan will be adopted to phase out the subsidy once proposals to strengthen the guarantee are implemented (but not later than June 30, 1991). 2.23 Demand for IGLF Funds. Demand for IGLF loans declined significantly in 1986 and early 1987, reflecting the political instability of that period and above-market IGLF interest rates. However, during 1987 there was a nmajor recovery with releases climbing from an average of P7 million per month dtvring the first half of the year to P100 million in December. Releases were sustained at this level during 1988 and are estimated to have reached P1500 million for the year as a whole. Based on this performance and on bankers' expectations of continued strong demand for business loans, IGLF releases are forecast to remain at about this level through 1989 and to increase in nominal terms by 13Z (4Z real) per year from 1989 through 1992. This projected 42 real growth is conservative in comparison with the past growth of IGLF which averaged 6.5% since 1980. 2.24 PFI Share of Term Loans. Under the first three SMI projects, the IGLF program provided 10OZ rediscount to PFIs, as a means of demonstrating to the