Philippines - Rural Finance Project

Document of The World Bank FOR OFFICIAL USE ONLY Repwt No. P-5563-PH MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIV'ALENT TO US$150 MILLION TO THE LAND BANK OF THE PHILIPPINES WITH THE GUARANTEE OF THE REPUBLIC OF THE PHILIPPINES FOR A RURAL FINANCE PROJECT MAY 30, 1991 This docment hs a restricted distribaton d may be ased by recisoly to the performance of teir offical duties. Its contents may not otherwise be disclosed without World Bank authorisation.  CURRENCY EOUIVALENTS (as of November 1, 1990) Currency Unit-Peso (P) US$1.00 P 28.00 P 1.00 US$0.0357 ACRONYMS ALF - Agricultural Loan Fund CBP - Central Bank of the Philippines GDP - Gross Domestic Product CLF - Countryside Loan Fund DENR - Department of Environment and Natural Resources LBP - Land Bank of the Philippines QGFB - Quedan Guarantee Fund Board PCIC - Philippine Crop Insurance Corporation PDIC - Philippine Deposit Insurance Corporation PFI - Participating Financial Institutions WAIR - Weighted Average Interest Rate (of time deposit up to 180 days) FISCAL YEAR January 1 to December 31  FOR OMCLAL USE ONLY ZPHILPZINES EaLU& EINAlCE PRQECT Loan and Project Summary BoxrYroe: Land Bank of the Philippines Guaranmtor: Republic of the Philippines Beneficiaries: Participating financial institutions amount: US$150 million equivalent Term,s: The Bank loan would be for 20 years, including five years of grace at the standard variable interest rate. Qnlendinz Terms: The Land Bank of the Philippines (LBP) would relend the proceeds of the Bank loan to accredited Participating Financial Institutions (PFIs) in domestic currency at the prevailing market rates. Maturity would conform to the maturities of sub- loans made by the PFIs to sub-borrowers, but would not exceed 15 years. The foreign exchange risk would be borne by the Government in exchange for a market related fee payable by LBP. PFIs would be given a choice of a fixed rate for several years or a variable interest rate periodically adjusted. PFIs would onlend the proceeds to their sub-borrowers at prevailing market interest rates. Financine Plan: Local Forei Total --------US$ million- Sub-borrowers 30.0 -- 30.0 Participating Financial Institutions 20.0 -- 20.0 Land Bank of the Philippines 2.5 0.9 3.4 Agricultural Credit Policy Council 0.1 -- 0.1 IBRD 0.0 80.0 150.0 TOTAL 122.6 80.9 203.5 ,Economic Rat- of Return: Not Applicable Staff A-ppraisal Regort: Report No.9563-PH Nu: IBRD No. 22431 This document has a restricted distribution and may be used by recipients only in the pen., nnance tirofficial duties. Its contents may not otherwise be disclosed without World ftnk aunorization.  MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE LAND BANK OF THE PHILIPPINES FOR A RURAL FINANCE PROJECT 1. I submit for your approval the following memorandum and recommendation on a proposed loan to the Land Bank of the Philippines (LBP) for US$150 million equivalent. The loan to LBP would be guaranteed by the Republic of the Philippines against a fee of one percent per annum. It would carry the Bank's standard variable interest rate and would have a fixed amortization schedule of 20 years including a grace period of five years. The proposed loan would help to finance viable private investments in the agriculture and rural sectors. LBP would relend the proceeds of the Bank loan to accredited Participating Financial Institutions (PFIs) in domestic currency at the prevailing market rates. 2. Country/Sector Background. Philippine rural financial sector activities from the mid-1960s to the early 1980s were influenced by macroeconomic policies that were biased against agriculture (an overvalued currency; a subsidized credit environment which was particularly prejudicial to small, poorly collateralized borrowers; and a heavily regulated financial market with high intermediation costs). Recognizing the negative impact of these policies on agriculture and rural financial sector development, the Government has since introduced substantial changes. Starting in 1981, there has been a gradual shift away from direct intervention and towards market-oriented interest rates. Savings and time deposit rates were deregulated in 1981, non-agricultural short-term rates in 1983, and agricultural short-term rates in 1984. Presently, about 93X of all agricultural credit is extended at market determined rates. The balance, mainly production loans to small farmers with less than five ha of land, is lent by LBP through cooperatives and Rural Banks (RBs); the small subsidy involved is enjoyed by the intermediary institutions, with the credit actually reaching final borrowers at 4X to 10 in real terms. This is clearly a much better situation than in most developing countries. The Government has also moved from using pricing mechanisms towards a greater reliance on the market to allocate financial resources. Direct lending by non-financial Government institutions ceased in 1986, and the Government's role is now seen primarily as one of providing infrastructure and a policy environment that will make private commercial lending for agriculture viable. 3. The agrieultural/rural sector is critical to the Philippine economy. In 1989, it generated about one-fourth of both GDP and exports, and employed about half of the country's labor force. Nonetheless, in the same year agricultural credit accounted for only 6.5X of total lerding by the banking system and, of this, an insignificant share (less than 46) was directed towards medium- and long-term investments. The informal sector, although an important source of seasonal credit, does not traditionally provide medium and long-term financing for agricultural/rural investments. The inadequate volume and short-term nature of institutional lending, and the conservatism of the commercial banking system, have been highly accentuated in recent years because of the financial crisis of the mid-1980s. A systematic roll-over of short-term loans has in practice provided some long-term resources to the rural sector, but most term lending by commercial banks has been supported by long-term foreign funds channeled to the productive sector through a second- tier rediscounting mechanism, the Agricultural  - 2 - Loan Fund (ALF). Established and financed by the Bank under the now completed Agricultural Credit Project (Loan 2570-PH), ALF has recently been transferred from the Central Bank to she Land Bank of the Philippines (LBP) in compliance with one of the requirements of the Bank's Financial Sector Adjustment Loan (Ln. 3049-PH), and renamed the Countryside Loan Fund (CLF). ALF/CLF's present resources are now fully committed, with reflows adequate to support only US$18.0 million of medium and long-term rural credit, the demand for which is conservatively estimated at about US$200 million annually for the next five years. The proposed project would provide continued support and strengthening of CLF's operations. 4. In parallel with the commercial banking system, the Philippines has a private rural banking system that is quite unique among developing countries. Some 803 Rural Banks (RBs) cover 66% of the total number of municipalities and cities in the country. RBs are small in asset size, but their resources have mostly been mobilized and invested back in the countryside, in contrast with the rest of Philippine banks that tend to invest outside the rural areas (only 71 of commercial bank resources were allocated in the countryside as of year-end 1989, compared with 70X for RBs). However, most RBs participated heavily in government supported agricultural credit programs during the late 1970s/early 1980s, which were plagued by political interference and resulted in heavy financial losses for the RBs and the Central Bank of the Philippines (CBP). As a result, RBs today are financially weak and cannot serve effectively to mobilize and lend resources for rural productive and commercial activities. Moreover, the weakest RBs are bankrupt, with the Philippine Deposit Insurance Corporation (PDIC) having to pay insured deposits financed mainly through currency emissions by CBP. A program to strengthen t.'e rural banking system by inducing financial institutions in good standing to re-capitalize RBs would be supported by the project, along with further liberalization of rural banking policies. 5. Presently, many viable agricultural and agro-industrial projects are no,t financed by lending institutions because of lack of bankable collateral. As the Government has systematically withdrawn from direct lending, it has developed several rural guarantee programs to reduce the perceived risks of such lending, most notably the Quedan Guarantee Fund Board (QGFB) and the Philippines Crop Insurance Corporation (PCIC). QFBl's primary tasks are to enable the private marketing sector to absorb more agricultural produce and to encourage the banking system to channel more funds into the food marketing industry. QGFB guarantees the integrity of warehouse receipts and insures the banks against default for 80X of the loan values, for which it charges the banks a fee. In 1990, QGFB incurred low claims of only about 3% of its guarantee volume. For the future, in order to sustain and eventually increase its operational impact, QGFB needs to provide credit guarantee services for a w'ler range of economic activities; mobilize additional equity through privatizi con; gradually increase its fee structure to cover operating costs and expected losses; and focus more on the needs of small farmer groups. PCI is mandated to insure small farmers against natural calamities and pest and disease damage. At the end of 1990, about 151 of total cultivated land under annual crops "rice and corn) and 255,000 farmers were insured. To broaden PCIC's impact on rural credit, it needs to increase the insured area for rice and corn, expand its coverage to other crops, and modify its premium structure to improve its financial position. These actions would be supported by the proposed project.  - 3 - 6. Lessons Learned. The broad lessons that emerge from the review of the previous agricultural and rural credit projects are that: (a) directed credit by crop or type of investments, at subsidized interest rates, did not sustain economic growth, improve the credit delivery system in the rural areas, or increase the access of rural borrowers to formal credit facilities; and (b) heavy arrears and poor finarLcial conditions of the apex institution and/or the selected Participating Financial Institutions (PFIs) severely constrained project success. Whenever interest rates either fell significantly below or moved well above prevailing market rates, serious implementation problems emerged: above-market rates, resulted in slow disbursement of Bank loan funds, while below-market rates led to concentration of credit to relatively wealthier and larger clients. These lessons have been incorporated in the proposed project. 7. Project Objectives. The proposed project would help to expand the volume of credit for agriculture and rural development and to enhance the policy and institutional framework of the Philippines' rural financial sector by: (a) supporting the development of the CLF rediscounting facility, now administered by LBP, as the Government's primary mechanism for resource mobilization to finance increased private investment in the agriculture and rural sectors; and (b) providing for the institutional and financial strengthening of the rural banking (RB) system, PCIC, QGFB, and LBP, to facilitate better access to formal credit and banking services in rural areas. 8. Project Descrintion. The project would be implemented over five years and would comprise the following components: (a) Credit to finance investment in fixed assets and incremental working capital, and seasonal production, for a broad spectrum of agricultural and other viable rural investments. This component would also include a pilot scheme under which funds would be channeled through selected agricultural cooperatives as financial intermediaries to finance long term investments by their members; (b) Policy and Institutional Development through: (i) further liberalization of banking policies concerning the opening of new branches in rural areas, merging of banks in rural areas, adjusting the current limit on the maximum shareholding that a single investor can have in a distressed rural bank to enable the mobilization of the additional required capital, and inducing financial institutions in good standing to invest in rural banks with equity deficiencies; and (ii) strengthening of the existing rural insurance and guarantee funds, bringing these up to a sustainable and sound position to provide farmers and banks with adequate services at market prices; and (c) Studies and Training, including comprehensive studies on the informal rural credit sector and the rural tarm lending market, taking into account the respective efficiency and the magnitude of the formal and informal rural financial sectors. The training program would include training for ALF/CLF and Participating Financial Institution (PPI) project related staff mainly in sub- projects appraisal, supervision and inflation implications on sub-borrowers cash- flow and sub-loan repayment, and environmental screening, monitoring, and compliance with environmental laws and regulations. Also, members of cooperatives, and their management would be trained to enhance their ability to handle credit operations.  - 4 - 9. The total project cost is estimated at US$203.5 million equivalent, with a foreign exchange component of US$81 million (about 40%). The proposed Bank loan of US$150 million equivalent would finance about 74% of total project costs, 99% of the foreign exchange requirements and 57% of local costs. Sub-loans will be granted exclusively in domestic currency and the entire foreign exchange would be made available to GOP through the conversion process. Therefore, the foreign exchange risk would be borne by the Government in exchange for a market related fee payable by LBP. A breakdown of costs and the financing plan are shown in Schedule A. All goods and works contracts costing US$5 million or more would be awarded after International Competitive Bidding. Limited international bidding and direct contracting would be allowed when justified on technical or economic grounds. Other goods, services, and works under US$5 million would be procured through established commercial chennels. A disbursement schedule is presented in Schedule B. Retroactive financing of up to US$15 million equivalent is proposed for the credit component, to fund ALF/CLF loans made after November 1, 1990. A timetable of key project processing events and the status of Bank Group operations in the Philippines are given in Schedules C and D, respectively. The Staff Appraisal Report No. 9563-PH, dated May 24, 1991, is being distributed separately. 10. Environmer.tal Impact. To reduce the risk that sub-projects with potential adverse environmental impact would be financed by the project, the following measures would be taken: (a) LBP in collaboration with the Department of the Environment and Natural Resources would work out adequate procedures and guidelines for environmental screening and monitoring in conformity with the existing comprehensive environmental laws, procedures and regulations; and (b) the project training program for LBP and PFIs' staff would include courses on environmental planning and management of sub-projects. 11. Rationale for Bank Involvement. The Bank has played a pivotal role among external donors in assisting the Philippine Government in the process of financial sector reform through a variety of inter-related operations, the most significant of which has been the ongoing Financial Sector Adjustment Loan (Ln. 3049-PH). In the agricultural sector, the Bank has also been instrumental in supporting Government efforts to withdraw from earlier subsidized directed credit programs, foster the move towards market determined interest rates, and establish the ALF rediscounting facility. The Bank is, therefore, particularly well- positioned to assist also with the next stage of rural credit policy reforms and institutional strengthening of the rural financial system. 12. Agreed Actions. During negotiations, the main actions on which commitments were obtained from the Government and LBP are the following: (a) use of ALF/CLF resources in accordance with market demand, with no pre-determined allocations by economic activity or type of investment, and no targeted borrowers; (b) LBP would manage the ALF/CLF on a commercial basis and would exclude itself from retailing these resources except for the Cooperative Experimental Pilot Plan; (c) re-lending terms and conditions from LBP to the PFIs; (d) on-lending terms and conditions from the PFIs and the sub-borrowers; (e) the mechanism for assumption of the foreign exchange risk by the Government; (f) strengthening of the main insurance and guarantee institutions; and (g) introduction of liberalized criteria so that banks could open new branches in small municipalities; investors  . 5 - could establish new banks for servicing rural areas; and financial institutions would be induced to provide a wider range of services in the rural areas. 13. Benefits and Risks. The proposed project would facilitate medium and long-term private investment in the agricultural/rural sector. It would help to finance about 2,200 investment eub-projects, at an estimated total cost, Including sub-borrowers' equity, of about US$200 million. These sub-projects are expected to generate incremental direct employment for 25,000 people, and an increase in gross value added of about US$40 million annually. Since the precise mix of the project lending program would depend on market demand, the quantification of aggregate economic impact is not possible. The main risk associated with this type of program is that implementation of agreed policy measures could be thwarted or delayed because of budgetary constraints or political considerations, particularly during the coming election period. However, a gradual and realistic implementation process has been agreed upon and would be formalized through dated covenants in the project legal documents. With respect to the credit component, the volume of demand for CLF resources would depend on the overall macroeconomic performance, but this is not considered a major risk as such demand during the project period has been projected conservatively and is well within the historical performance record of ALF. 14. Recommendation. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. Attachments Barber B.Conable President Washington, D.C. May 30, 1991  -6- SghgdutleA Regublic of the Philipnines Rural Finance Proglec Estimated Costs and Financint Estimated Costs: Local Fgreig Total ----(US$ Million)---- A. Credit Comgonent Short-Term 40.0 26.7 66.7 Medium- and Long-Term 80.0 1I33. Sub-total 120.0 80.0 200.0 B. Training and Studies Training 2.5 - 2.5 Studies P .2 1.O Sub-total 2.6 0.9 3.5 VTOAL PROJECT COST 122.6 80.9 20.3. Financing Plan: A. Credit Comoonent Sub-borrowers 30.0 30.0 Participating Financial Institutions 20.0 - 20.0 Proposed IBRD Loan 7.ZQ0 80, 15Q.0 SUB-TOTAL 120.0 80.0 200.0 B. Training and Studies Land Bank of the Philippines 2.5 0.9 3.4 Agricultural Credit Policy Council Q0.1 PA SUB-TOTAL 2.6 0.9 3.5 TOTAL FINANCING 122.i 80.9 203.5  -7 Schedule B Renublic of the lhillpines Rural Finance Pro gt Allocation of Loan Proceeds Categ2rx Amount Xt,Be FnWaced (US$ million) (1) Short term 50 1001 of sub-loans financing until 30 have been disbursed and 55X thereafter. (2) Medium & Long term financing lQp 751 of sub-loans disbursed. TOT. 150 Estimated Aank Disbursements IBRD Fiscal Year 92 93 94 9 6 97 (US$ million) Annual 36 27 27 27 18 15 Cumulative 36 63 90 117 135 150  - 8 - Republic of the Philippines Rural Finance Project Timetable of Key Proiect Processing Events (a) Time taken to prepare: 18 months (b) Prepared by: LBP with Bank assistance (c) First Bank Mission: November 1989 (d) Appreisal Mission Departure: February 1991 (e) Negotiations: May 22 to 24, 1991 (f) Planned date of Effectiveness: October 1, 1991 (g) List of Relevant PCRs and PPARs: Second Rural Credit Project (Loan 607-PH) PPAR: August 1976 Third Rural Credit Project (Loan 1010-PH) PPAR: December 1979 Fourth Rural Credit Project (Loan 1399-PH) PPAR: December 1985 Smallholder Tree Farming and Forestry Credit Project (Loan 1506) PPAR: December 1988 Third Livestock and Fisheries Credit Project (Loan 1894-PH) PCR: June 1989  t828 1 I II ! Y{l~ I I 1aa 5~ ~~~II R 0R U88888880888888