China - Shanghai Industrial Development Project

Document of The World Bank FOR OFFICIAL USE ONLY AJS 32 P-cws Report No. 7702-CHA STAFF APPRAISAL REPORT CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT JANUARY 9, 1991 Industry and Energy Operations Division China Department 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.  CV--j.RNCY EQUIVALENTS (As of November 1990) Currency utame = Renminbi (RMB) Currency urit = Yuan (Y) = 100 Fen Y 1.00 = $0.19 $1.00 = Y 5.22 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric system GLOSSARY OF ABBREVIATIONS AND ACRONYMS BOCOM - Bank of Communications CIB - China Investment Bank CRS - Contract Responsibility System ERR - Economic Rate of Return FRR - Financial Rate of Return GDP - Gross Domestic Product GNP - Gross National Product GOC - Government of China GVIO - Gross Value of Industrial Output ICB - International Competitive Bidding ICBC - Industrial and Commercial Bank of China IFS - International Finance Corporation MOF - Ministry of Finance MOFERT - Ministry of Foreign Economic Relations and Trade OEM - Original Equipment Manufacturer PBC - People's Bank of China PCBC - People's Construction Bank of China PCR - Project Completion Report PFIs - Participating Financial Institutions PMU - Project Monitoring Unit PPY - Per Person-Year PRC - People's Republic of China SFERTC - Shanghai Foreign Economic Relations and Trade Commission SEAC - Shanghai Electrical Apparatus Corporation SECC - Shanghai Electronic Components Corporation SEPB - Shanghai Environmental Protection Bureau SFIC - Shanghai Foreign Investment Commission SIDP - Shanghai Industrial Development Project SIEB - Shanghai Instrumentation and Electronic Industry Bureau SITCO - Shanghai Investment and Trust Corporation SMG - Shanghai Municipal Government SMEIA - Shanghai Mechanical and Electrical Industries Administration SOE - Statement of Expenditures SPERI - Shanghai Planning Economic Research Institute SPPMC - Shanghai Printing and Packaging Machinery Corporation SPSIC - Shanghai Precision and Scientific Instrument Corporation TORs - Terms of Reference  FOR OFFICIAL USE ONLY CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Loan and Project Summary Borrower: People's Republic of China. Beneficiaries: Shanghai Municipal Government (SMG) and the Partici- pating Financial Institutions (PFIs).l/ Amount: $150.0 million equivalent. Terms: Twenty years, including five years' grace; standard variable interest rate. Onlending Terms: The proceeds of the loan would be made available by the Borrower to the SMG on terms and conditions satisfactory to the Bank. S.4G would onlend the entire proceeds to the five PFIs for 20 years, including five years' grace, and at a variable interest rate equal to the Bank rate. The PFIs would in turn extend subloans to eligible enter- prises for a maximum period of 12 years including a maximum grace period of three years at a variable interest rate equal to the Bank rate plus at least 1.25 percent; subborrowers would carry the foreign exchange risks associated with the Bank's loan. Project Description: The project would support the development of four industrial subsectors in Shanghai (printing machin- ery, electrical apparatus, electronic components and precision and scientific instruments). It would aim to promote increased efficiency and competitiveness through: (a) technical assistance for organiza- tional restructuring in each of t1o subsectors and upgrading internal enterprise management systems; (b) financing through a credit component of techno- logical restructuring subprojects that are environ- mentally sound and based on rational product, mar- keting and organizational restructuring strategies, and sound financial and economic criteria; and (c) implementation of policy reforms at the subsec- tor level. The project will also include an insti- tutional development component consisting of policy studies on enterprise reform issues and the effects of recent and planned policy changes in the four 1/ The PFIs are: China Investment Bank, Industrial and Commercial Bank of China, People's Construction Bank of China, Bank of Communications Shanghai Branch, and Shanghai Investment and Trust Company. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - subsectors. In addition, there are preproiect training courses for the PFIs in subproject appraisal. Benefits and Risks: Subsector-wlde restructuring and implementation of subsector policy reforms would result in improvement of subsector efficiency, growth and exports. Sub- project eligibility criteria will ensure their eco- nomic and financial viability. The main project risks pertain to implementation of subsector policy and enterprise reforms, and to the timely implemen- tation of the project. However, SMG is strongly committed to the needed reforms, and has implemented several of the enterprise reforms since appraisal. During appraisal, the Bank and SK4G agreed on: the subsector policy and enterprise reforms that would be implemented in connection with the project and a framework for periodic reviews and studies in con- sultation with the Bank. In addition, legal restructuring of the subsector corporations would take place before subloans to them are approved. Arrargements for preproject training, implementation at the level of the subsector corporations, techni- cal assistance and overall project coordination should facilitate project implementation. Estimated Cost: /a Local Foreign Total ------------ ($ million) -----_ Technological restructuring 131.7 155.2 266.9 Training 2.6 11.7 14.3 Computers 0.8 3.7 4.5 Management assistance 4.1 9.7 13.8 Institutional development 0.1 - 0.1 Total 139.3 30.3 319.6 Financing Plan: la IBRD - 150.0 1'r.0 PFIs, other banks and enterprises 139.2 - l.:9.2 Shanghai Municipal Governme.t /b 0.1 30.3 30.4 Total 139.3 180.t 319.6 /a Tentative figures based on the initial pipeline of subprojects. Detailed final estimates will be prepared by thc PFIs for each subproject at the time they are appraised. Since these are preliminary estimates, no attempt has been made to separate contingencies. /b Includes $105,000 equivalent from the Japanese Grant Facility to finance the estimated foreign costs for the studies and some of the training.  - iii - Estimated Disbursement: Bank FY: 1991 1992 1993 1994 1995 1996 -----iiii---- ($ million) --__-_______ Annual 5.0 17.5 40.0 42.0 29.5 16.0 Cumulative 5.0 22.5 62.5 104.5 134.0 150.0 Economic Rate of Return: At least 12 percent for subprojects.  - iv - CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Table of Contents Page No. I. INTRODUCTION .1...................... . 1 II. THE INDUSTRIAL SECTOR IN CHINA . . . . . . . . . . . . . . . 3 A. Structure and Performance. 3 B. Industrial Development Issues and Strategy . . . . . . . 3 C. Bank Support for Industry. 7 III. THE INDUSTRIAL SECTOR IN SHANGHAI . . . . . . . . . . . . . . 11 A. Background .11 B. Shanghai Municipality and Its Industrial Structure . . . 11 C. Industrial Performance .13 D. Resources and Constraints .13 E. Development Strategy and Policies . . . . . . . . . . . . 15 F. The Four Subsectors .19 Enterprise and Subsector Policy Reforms . . . . . . 19 Subsector Restructuring . . . . . . . . . . . . . . 21 G. Bank Role and Strategy .24 IV. THE PROJECT........................ . 25 A. Project Objectives . . . . . . . . . . . . . . . . . . 25 B. Project Components . . . . . . . . . . I . . . . . . . . 25 Financial Assistance Component . . . . . . . . . . . 25 Technical Assistance Component . . . . . . . . . . 26 Institutional Development Component . . . . . . . . 27 C. Eligibility Criteria .27 D. Project Cost and Financing . . . . . . . . . . . . . . . 27 E. Project Implementation Arrangements . . . . . . . . . . . 29 Role of the Shanghai Municipal Government . . . . . 29 Role of the Subsector Corporations . . . . . . . . . 30 Role of the Participating Financial Institutions . . 31 F. Environmental Impact .33 This report is based on the appraisal by a Bank mission, composed of Darius Mans (Mission Leader), Harbaksh Sethi, Sally Zeijlon, Shanker Krishnan, Anupam Khanna, Natalie Lichtenstein, Mohan Pherwani and Edgar Su (Consultant), that visited China in February/March 1989 and the postappraisal by a Bank mission composed of Sally Zeijlon (Mission Leader), Ramaswami Venkateswaran, Swoon Weng Leong (Consultant) and Zhou Yuling that visited Shanghai in March 1990. Peer reviewers include Julio Gamba (AS5IE) and Emanuel Sharon (Consultaat).  Page No. V. THE LOAN ...................................................... 35 A. Lending Arrangements and Terms ..35 B. Procurement ............................................... 36 C. Disbursement ..37 D. Reporting and Auditing ..37 E. Benefits and Risks ..38 VI. AGREEMENTS AND RECOMMENDATIONS .39 ANNEXES 1. The Development Strategy and Policies for Shanghai's Industrial Sector . . . . . . . . . . . . . . . . . . . . 41 2. Statement of Shanghai Municipal Government on the Development Program and Strategy for SIDP Subsectors . . . . . . . . 50 3. Shanghai Electronic Components Subsector . . . . . . . . . . 55 4. Shanghai Precision and Scientific Instruments Subsector . . . 67 5. Shanghai Electrical Apparatus Subsector . . . . . . . . . . . 77 6. Shanghai Printing and Packaging Machinery Subsector . . . . . 88 7. Consulting Services Terms of Reference . . . . . . . . . . . 98 8. Scope of Subproject Feasibility Studies . . . . . . . . . . . 104 9. Implementation Schedule of Major Activities . . . . . . . . . 107 10. Key Monitoring Indicators .108 11. Shanghai Investment and Trust Corporation . . . . . . . . . . 109 12. The Industrial and Commercial Bank of China . . . . . . . . . 116 13. The People's Construction Bank of China . . . . . . . . . . . 122 14. Bank of Communications - Shanghai . . . . . . . . . . . . . . 128 15. China Investment Bank .136 16. Estimated Disbursements .142 17. Progress Reports for the Project . . . . . . . . . . . . . . 143 18. Documents Available in the Project File . . . . . . . . . . . 148 CHARTS 1. Organization Chart of Sharing Relationship of Subsector Corporation with Various Levels of Government . . . . . . 149 2. Organization Chart of Shanghai Mechanical and Electrical Industries Administration . . . . . . . . . . . . . . . . 150  CHINA SHANC,HAI INDUSTRIAL DEVELOPMENT PROJECT I. INTRODUCTION 1.1 The ongoing economic reforms in China have decentralized much of the investment responsibility from the Center to the provinces. In industry, this requires the provinces to play a more active role in the preparation and exe- cution of development programs and strategies for individual subsectors. The Government of China (GOC) has requested the Bank to assist some selected prov- inces in carrying out this task. The Tianjin Light Industry Project (Loan 3022-CHA, February 1989) was the first operation to assist the development of specific subsectors at the provincial level. The proposed Shanghai Industrial Development Project is the second such project. 1.2 Shanghai is the largest and economically preeminent city in China and has the status of a province. It has a strong industrial base which is facing increasing competition from other provinces and has been growing much slower than the rest of China's industry. The reasons for this include a squeeze on the availability of raw materials, comparatively outmoded manufac- turing technology in many enterprises in Shanghai, limited investible resources after meeting its tax obligations to the Central Government, and, until two years ago, slower implementation of the government's enterprise reform program in Shanghai than in other provinces. In a significant depar- ture from past policies, Shanghai has now been designated as a major focus for economic deveiopment and opening to the outside world. Reform initiatives are being implemented and, if successful and consistent with past practice, ire expected to be replicated elsewhere in China. While some pause in the imple- mentation of these initiatives was evident in 1989, the commitment of the national and municipal governments to the reform effLrts in the city has been reconfirmed and progress is again evident. Important elements of Shanghai's industrial strategy are to move into more technology-intensive, less pollut- ing, and less energy- and raw-material-intensive subsectors, which could be competitive within China and in export markets, and to implement enterprise and related economic reforms more extensively (Annex 1). The subsectors to be assisted in the proposed project are passive electronic components, precision and scientific instruments, electrical apparatus and printing machinery. Strengthening these types of industries is consistent with Shanghai's indus- trial strategy. 1.3 During project preparation, in-depth studies of the four subsectors in Shanghai were carried out by foreign consulting companies--Boston Consult- ing Group and Booz, Allen and Hamilton--with the assistance of local consult- ing firms. These studies and discussions between the Shanghai Municipal Gov- ernment (SMG) and the Bank have assisted the government in the preparation of development programs and strategies for the four subsectors (Annex 2) which are consistent with the conclusions and recommendations of the consultants' studies. They outline: (a) the subsector policy reforms needed in the sub- sectors; (b) viable product and market strategies for each subsector; (c) plans for restructuring the organization and production facilities of the subsectors; (d) investment programs; and, (e) implementation plans.  1.4 The main objective of the proposed project is to assist SMG in the implementation of the above-mentioned development program and strategy. The proposed Bank loan of $150 million would support the foreign exchange needs of the project. It would be onlent through five participating financial in,titu- tions (PFIs) in Shanghai for technological restructuring and technical assis- tance, including consultant services for organizational restructuring, manage- ment upgrading, training and computers in the four subsectors. The subproj- ects to be financed by the PFIs will be consistent with SMG's strategies for the four subsectors and will also meet the other eligibility criteria agreed upor. with the Bank.  - 3 - II. THE INDUSTRIAL SECTOR IN CHINA A. Structure and Performance 2.1 Industry is China's largest productive sector, accounting for 46 percent of its gross domestic product (GDP) in 1988 and employing nearly 18 percent of the country's total labor force. About 99,000 state-owned enterprises generate 57 percent of total industrial output; the remainder is produced by more than 1.5 million nonstate enterprises--primarily urban and rural collectives, township and village enterprises. The state enterprises concentrate on important raw materials, capital goods, and strategic commodi- ties such as fertilizers, although there are also state enterprises producing a wide range of light industrial and consumer goods. Nonstate enterprises mainly produce downstream consumer products. The gross value of industrial output (GVIO), which amounted to Y 1,811 billion ($486.7 billion) in 1988, is shared almost equally by light and heavy industry. GVIO increased rapidly between 1980 and 1988, at about 13.7 percent a year in real terms. During this period, light industry registered a much faster annual growth rate (14.9 percent) than did heavy industry (10.9 percent). Macroeconomic stabili- zation policies initiated in 1988 led to a reduction of the annual growth of total industrial output to 6.7 percent in 14.39 and an estimated 6 percent for 1990. 2.2 Between the mid-1950s and mid-1970s, Chinese industry was oriented mainly toward the rapidly growing domestic market. Since then manufactured exports have grown rapidly, especially during the 1980s. They rose from around $8 billion in 1980 to about $33 billion in 1988, and expanded further in 1989, in spite of the overall slowdown of the economy. The share of exports in industrial output was 6.8 percent in 1988. B. Industrial Development Issues and Strategy 2.3 Between 1949 and 1978, China's iriustrial development was guided by an inward-oriented, import substitution strategy, with emphasis on capital accumulation. This led to rapid growth of industrial output and employment, building up industrial skills, and development of a wide range of basic, intermediate and consumer goods industries. Nevertheless, it also resulted in deficiencies that have constrained industrial development in several respects. The most obvious deficiencies pertain to: outdated technologies (nearly 80 percent of the current stock of capital equipment is obsolete and needs replacement or technical renovation); institutional rigidities deriving in part from quota and price controls; a distorted structure of prices; inade- quate infrastructure; and an underdeveloped financial sector. These problems are reflected in the low productivity of labor and low efficiency of resource use in Chinese plants. 2.4 Emphasis on self-sufficiency at the regional level has led to a fragmented national market, reduced domestic competition, and the suboptimal use of scarce skills and resources. As a result, potential gains from econo- mies of scale are often missed. Subeconomic-sized enterprises proliferate, often in the same markets as large enterprises, and are usually financially profitable due to government price controls and other support. Institutional inflexibility, compounded by inadequate market integration, has provided  - 4 - little incentive for industrial enterprises to improve managerial efficiency and product quality. This incentive is further reduced by the weak budgetary constraint for large state-owned enterprises, which can normally expect their losses to be covered by the government. The low prices of energy and basic intermediates for industrial production also contribute to the inefficient use of inputs. Investments in infrastructure, particularly for transportation and telecommunications, have lagged behind those in industry. This disparity has in turn been a major constraint on industrial development. 2.5 Between 1979 and 1988, the Government of China (GOC) changed its industrial development strategy and gradually introduced reforms, after periods of local and regional experimentation, to strengthen market forces and improve the incentives to industrial efficiency. The new strategy emphasized modernizing existing equipment, developing manufactured exports and more effi- cient light industry, and conserving material and energy resources in indus- try. The introduction of these reforms has been a cautious process, though, involving experimentation and repeated fine-tuning. The reforms implemented since 1979 have focused mainly on five areas: (i) enterprises--strengthening management accountability; (ii) prices--expanding the role of market forces in price determination; (iii) trade--promotion of exports to earn foreign exchange, which in turn finances imports of modern technology and equipment; (iv) financial sector--developing financial institutions and markets; and (v) investment--decentralizing responsibility and shifting its pattern to address key bottlenecks. 2.6 Enterprises. Enterprises have been provided with various Incentives to enable them to operate with greater management autonomy in a more competi- tive business environment. Reforms adopted in 1984 aimed at decentralizing economic decision-making toward the provinces and enterprises based on greater use of market signals. The state enterprise reforms introduced, among other things, a system of contract management responsibility, introduction of greater uniformity in tax rates for enterprise income, wage incentives for workers, and higher profit retention. While these actions have demonstrably increased enterprise autonomy and resulted in improvements in enterprise per- formance, continued initiatives are needed to address the distortions that have become evident during the incremental reform process. GOC continues to actively study and experiment with modification of the management contracting system, alternative forms of enterprise ownership, and the introduction of company law and bankruptcy legislation. Of particular importance are current efforts to design a shareholding system ("joint-stock ownership") suitable for Chinese state-owned enterprises. Several versions of shareholding are being introduced experimentally in selected locations, among which Shanghai is prom- inent. These include clarification of ownership rights and exposure of enter- prises to increased competition, which are vital to further efficiency gains (para. 3.22). As part of this effort, the government has established the National Administrative Bureau of State-Owned Property. Not only is this seen as a first step in the separation of the ownership role from the policy and regulatory functions of government agencies, but the new body also has a man- date to devise policies for asset valuation and transfer. 2.7 Prices. In 1984, reforms were adopted to enhance the role of mar- kets in determining prices and industrial output by reducing the role of man- datory planning and initiating the correction of major price distortions. As a result of these price reforms, a two-tiered pricing system now exists: con-  trolled prices for production to meet planned output targets, and market- related prices for the growing portion of output above plan targets. The Government conside.ably raised the price of major industrial inputs including energy. The proportion of industrial output sold at market-related prices has increased significantly. For example, as early as 1985 a major enterprise survey showed that 53 percent of output was already being sold directly in the market, while only 20 percent of the output was determined by the state's mandatorv plan and 27 percent by the guidance plan; since then, the proportion under planning has continued to decline. The share of industrial materials and intermediate goods under state distribution has also fallen considerably. For example, even for steel and coal, less than 50 percent was under state distribution in 1988, and nearly three quarters of all metal-cutting tools were sold by state enterprises in the market. Virtually all consumer goods are now sold in the market and the gap between state and market prices for these categories has become quite small. The impact on enterprise behavior of these reforms has been significant. By late 1988, the majority of enterprises (state and nonstate) were making decisions with reference to market prices, indicating that allocative efficiency was increasing. Marginal choices are increasingly being made at market prices because virtually all enterprises sell a portion of their products in the market and depend on market transac- tions to purchase their marginal inputs. 2.8 In 1988, further price reforms were interrupted when the Government reacted to rapid inflation by initiating a macroeconomic stabilization pro- gram. In its initial stages, this three-year program involved strict control of the prices of the approximately one-fifth of commodities still within the price control system, but did not increase controls for commodities already outside that system. The Government has stated its intention of doing away with dual pricing in the medium term, and adjusting controlled raw material, energy and transport prices, to reduce remaining distortions. In early 1990, and following the government's success in reestablishing macroeconomic stabil- ity, new price adjustments for cotton, and for rail and water freight trans- port were announced. The two-tiered pricing system represents a significant improvement over the strict price control of the past. Nevertheless, remain- ing distortiors in relative prices and large gaps between controlled and mar- ket prices have a numiber of shortcomings; reduced allocative efficiency, discriminatiorn across producers and consumers, administrative complexity, and creation of opportunities for corrupt practices. It is thus important that the government continues with its stated intention to continue the process of price reform. 2.9 Trade. As a result of the decentralization of export respor.2ibili- ties in the 1980s, several thousand Chinese enterprises now have the right to trade directly with foreign firms, and many more use trading companies as agents rather than selling exportable goods to them. There is concern that this rapid granting of direct export rights, especially in 1988, without suf- ficient regulation and institutional support for enterprises to adhere to quality and delivery standards, may -ave created negative impressions in over- seas markets. GOC is studying ways of addressing such problems, and expanding direct trading more slowly, although its commitment to the "open-door" policy initiated in 1979 has not changed. The availability of foreign exchange to nonexporting enterprises has improved somewhat with the creation of the for- eign exchange adjustment centers, mainly in the coastal zone. Central manda- tory planning continues to be used to ensure imports of essential raw materi-  -6 als to fill the deficits left in the domestic economy, and lice:nsing (rather than tariffs) discourages some consumer goods imports. Export competitiveness has been maintained through periodic adjustments in the exchange rate, the most recent of which occurred in November 1990 (para. 3.27). 2.10 Financial Sector. Prior to 1979, China essentially had a monobank system which allocated resources according to fiscal directives. Reform of the system was initiated in the early 1980s with the formal establishment, in 1984, of the People's Bank of China (PBC) as the country's central bank, and divestiture of its banking functions to independent specialized banks. Since 1986, China's financial sector reforms have accelerated. Before then, the system was largely limited to four national banks, specialized along economic and sectoral lines, and financial assets mainly consisted of deposits and government bonds. As a result of the reforms, the range of financial institu- tions and instruments has markedly increased. Numerous nonbank financial institutions (NBFIs) have been established. Financial bonds, commercial paper, bankers acceptances, trade bills, and bond-like enterprise shares have been introduced. These reforms have resulted in considerable financial deep- ening, despite some setbacks in the recent period of high inflation: M2 as a proportion of C,DP increased from 37 percent in 1979 to 75 percent in 1987, before declining to 60 percent in the first half of 1989. The reforms have also succeeded in reducing the rcle played by the budget in investment finan- cing, while substantially increasing the role of bank finance. 2.11 Notwithstanding these advances, weaknesses remain. The system is dominated by the four specialized banks. Financial institutions still need substantiEl institutional upgrading to function as effective intermediaries. The recent trend of increasing portfolio arrears in the banking system needs to be arrested. Regulation and supervision of the financial system require considerable strengtiuening, as do the accounting and legal frameworks, and while recent reliance on administrative mechanisms has enabled the government to regain control of rapidly accelerating inflation, in the longer term, PBC should make greater use of indirect monetary credit policy tools. In this connection, PBC, assisted by the Bank (para. 2.15 and 2.18), is currently formulating plans designed to strengthen its clearing, supervisory and regula- tory functions. 2.12 Interest rates have been adjusted several times during the past decade. As of August 1990, interest rates on deposits generally range from 8.64 percent for one-year deposits to 13.68 percent for eight-year deposits, and from 2.16 percent for sight deposits to 6.48 percent for deposits of less than one year. The interest rate on individuals' time deposits of three years' or more duration are indexed to the rate of inflation. Lending rates are generally 9.36 percent for working capital loans, and between 9.36 percent and 11.16 percent for fixed asset loans, depending on their maturities. How- ever, further rationalization of the structure is necessary. There is an excessive number of different rates, and they are widely dispersed. For some categories of loans and deposits, there is an inadequate margin with a poten- tially negative impact on bank profitability. The general level of real rates In the recent past was negative, but recent and projected declines in the inflation rate, coupled with the above-mentioned adjustments, have served to mitigate this problem. Although the need for a more flexible interest rate mechanism remains, the general level of real rates is now positive and is projected to remain so.  - 7 - 2.13 Investment. The above reforms have also been accompanied by a pro- gressive reduction in the incidence of central planning and the raising of approval limits for provincial authorities, to three times the level they were at in 1984. Enterprises are now empowered to embark on small-scale, technical updating projects without following complicated approval processes if the project can be financed with the enterprise's own funds. Close to 30 percent of fixed investment is now financed from retained funds. The ongoing stabili- zation program has resulted in some retrenchment in this process. For exam- ple, in July 1990, the government published a list of 23 product groups for which central approval will be required for investment projects. This measure was taken partly in recognition that large scales of production, necessary for such products, were avoided as provinces tend to favor projects whose size is within provincial approval limits. By reducing the implied waste, the cpntral government also hopes to free up scarce resources for key debottlenecking investments in energy, infrastructure and raw materials. The recognition )f this problem is a positive move, but the longer-term solution lies in a fur- ther deepening of ongoing enterprise, price and financial system reforms. C. Bank Support for Industry 2.14 The Bank Group's industrial lending operations in China, which began in 1982, comprise the following: (a) five loan/credit operations totaling $945.6 million to the China Investment Bank (CIB) (Loan 2226-CHA/Credit 1313- CHA, December 1982; Loan 2434-CHA/Credit 1491-CrdA, June 1984; Loan 2659-CHA/ Credit 1663-CHA, March 1986; Loan 2783-CHA/Credit 1763-CHA, March 1987; and Loan 3075-0-CHA, May 1989); (b) four loans totaling $394 million (Loans 2541- CHA, May 1985; 2838-CHA, June 1986; 2958-CHA, June 1988; and 3066-CHA, May 1989) for a Fertilizer Rehabilitation and Energy Saving Project, a Fertilizer Rationalization Project, a Phosphate Development Project, and the Hubei Phos- phate Project; (c) a $100 million loan (Loan 2784-CHA, April 1987) for the Shanghai Machine Tool Project; (d) a $20 million industrial development compo- nent of the Gansu Province Project (Loan 2812-CHA and Credit 1793-CHA, April 1987); (e) a loan of $127 million (Loan 2943-CHA, May 1988) for the China Pharmaceutical Project; (f) a loan of $154 million (Loan 3022-^HA, February 1989) for the .ianjin Light Industry Project; and (g) a credit/loan of $114.3 for the Rural Industrial Technology (Spark) Project (Loan 3274-CHA/Credit 2186-CHA, December 1990). In addition, the Planning Support and Special Stu- dies Project (Credit 1835-CHA, June 1987) includes components for long-term planning and strategic studies in some industrial subsectors. International Finance Corporation (IFC) support, since the first operation in 1985, totals $25 million equivalent in the following projects: Guangzhou and Peugeot (Investment No. 813, FY85), China Investment Company (Investment No. 974, FY87), Shenzhen China Bicycles Co., Ltd. (Investment No. 1020, FY87), and Shenzhen Crown Electronics (Investment No. 37740, FY88). 2.15 Apart from some delays in the first China Investment Bank (CIB) operation, disbursement of the CIB loans and credits generally has proceeded satisfactorily. A PCR for the first CIB project has been prepared. The PCR concludes that the project's objectives have been fully achieved, in particu- lar, in laying a foundation for CIB, a new financial institution, to develop as an autonomous and efficient intermediary in industrial finance. With con- tinued Bank support, CIB's capacity in project design, selection and appraisal has improved significantly since its establishment. Lessons learned from the implementation of the first project were reflected in the design of subsequent  CIB projects supported by the Bank. Recently, the quality of CIB's portfolio has deteriorated, mainly due to the general economic downturn Chine has been experiencing. Strengthening of CIB's canabilities to monitor and supervise subprojects and cope with problem loans is a priority in providing further Bank assistance to CIB. Physical implementation of the first two fertilizer projects is proceeding satisfactorily. After some delays in project implemen- tation due to the Government's recent austerity program and the resulting shortage of local counterpart funds, the two phosphate projects are now pro- ceeding well. Procurement is well under way for the Pharmaceuticals Project, Phosphate Development Project, Shanghai Machine Tool Project, which involves rehabilitation and modernization of the machine tool subsector in Shanghai, and the industrial component of the Gansu Project, which involves diversifica- tion and modernization of rural industry. 2.16 The Bank Group's overall objectives in the industrial and financial sectors in China are to assist the Government to: (a) improve the policy framework for the sectors as a whole; (b) build sound institutions and prac- tices for financial intermediation, subsector planning, and project approval and implementation; (c) promote and implement technology upgrading, plant restructuring and rehabilitation, and energy and material conservation in selected subsectors at the provincial and national levels; and (d) promote enterprise reform in the state sector. In the industrial sector, the Bank Group would seek to underpin further enterprise, trade, and price reforms designed to give market forces a greater role in stimulating efficiency improvements. In the financial sector, emphasis would be placed in the near term on strengthening and enhancing the viability of the banking system, which must play an increasingly important role as other economic reforms proceed, through reforms designed tc. (i) safeguard banks' financial viability, through adequate interest rate spreads and accurate reflection of their port- folio quality; (ii) improve bank management; (iii) strengthen regulation and supervision of the financial system; and (iv) improve the bank accounting framework. Other reforms to be supported include strengthening the central bank's ability to implement effectively monetary and credit policy with greater use of indirect tools, developing more robust money and capital mar- kets, improving the overall level and structure of interest rates, and enhanc- ing competition in the banking system. 2.17 The Bank's pipeline and the program of economic and sector work agreed with the government reflect these objectives. Specific plans in the industrial sector include assistance to selected major subsectors, including chemicals, fertilizers, machinery manufacturing, electronics, and building materials, consistent with their comparative advantage and national economic priorities. The increasing devolution of responsibilities for planning and implementation from the center to the provinces has the potential for a sig- nificant impact on the industrial sector, provided the provincial authorities can effectively enunciate and carry out their new role. The anticipated pro- vincial operations, including the present project, involving subsector restructuring in the context of coherent provincial industrial development strategies, is designed to help selected provinces articulate and implement their new responsibilities for industrial planning and project implementation. The Bank is also assisting the rapidly growing nonstate industrial sector. Initial support for the latter is through the Spark program (para. 2.14), which is providing technical and financial support to rural enterprises.  - 9 - 2.18 In the financial sector, specific plans include further support for CIB as well as other intermediaries designed to foster their overall institu- tional developmnent in a more competitive banking enviromnent. While their large market share argues for upgrading the leading nationwide specialized banks, the possibility of strengthening some of the newer intermediaries will also be reviewed. Support is also planned for improving the regulatory and supervisory activities of the central bank and other core central agencies. Financial intermediaries would also continue to help support operations with principally real sector objectives. Under such operations, the intermediaries would be expected to satisfy minimum eligibility criteria, and would receive support for targeted institutional improvements, as is the case for the pres- ent project. 2.19 In recent years the Bank, through its economic and operational work, has sought to assist the government in defining and Implementing its program of enterprise reform. This effort has included two sector reports and opera- tions at the national and provincial level in the chemical, machine tool, textile, paper and packaging subsectors designed to promote corporate and physical restructuring. While considerable progress has been made in increas- ing enterprise autonomy (para. 2.6), it is now apparent that further clarifi- cation of the ownership function is essential to the next stage of enterprise reform. At a recent workshop jointly organized by the Bank and the System Reform Commission, participants agreed on the importance of several areas of reform: separating policy and regulatory functions from the state's ownership role; diversifying the ownership function between state agencies; relieving state enterprises of some of their social welfare obligations; and further steps to promote competition. The importance of consolidating enterprises operating below economic scales, which typify much of China's state sector, to enable them to compete effectively was also emphasized. Continued cooperation in the design and monitoring of the next phase of "joint-stock" experiments is anticipated, and a series of supporting operations is planned. Once the cor- porate restructuring and enterprise reform program under the proposed SIDP is fully implemented, the beneficiary enterprises would be suitable candidates for 'joint-stock" experiments; similarly planned operations in the cement, electronics and heavy engineering subsectors would promote the development of diversified ownership mechanisms at the national level. 2.20 The Bank Group's program of economic and sector work and technical assistance in industry, trade and finance provides the basis for an active policy dialogue with the Government on the issues described in Section B above. To date, studies have been completed on the state enterprise manage- ment system, enterprise reform, the electronics subsector, the financial sec- tor, external trade and capital, and industrial policies and structural change. Further studies and technical assistance are underway on enterprise reform and the automotive sector. Additional work is planned on other subsec- tors at the national and provincial level. This work is being carried out jointly with Chinese agencies. 2.21 In addition to the above, the Bank Group is the executing agency for UNDP technical assistance projects and has financed two technical cooperation credits, thereby encouraging the use of technical assistance, particularly for project preparation. EDI's large training program in China and the past lend- ing program have helped in raising investment efficiency in China by demon- strating how the Hank Group's appraisal methodology can be applied to improve  - 10 - project selection and efficiency of project design, and by strengthening institutions' project preparation and appraisal capacities.  - 11 - III. THE INDUSTRIAL SECTOR IN SHANGHAI A. Background 3.1 Shanghai is one of three municipalities in China with provincial status. The city proper is the largest in China. Shanghai led the country's industrial revolution in the mid-nineteenth century, and by the 1930s, the city was East Asia's largest port and leading manufacturing, commercial and financial center. Until the mid-1980s, the municipality led all other prov- inces in industrial production and exports. It has been the major supplier of manufactured goods to the rest of China, and the largest single source of fiscal revenues to the central government. In the reform decade (1979-88), however, Shanghai's economy stagnated compared to those of other coastal prov- inces. Jiangsu and Guangdong have displaced Shanghai as the top industrial producer and top exporter, respectively. In recent years the growth rate of output in Shanghai's industry, the municipality's most important sector, has lagged behind all but the poorest provinces. 3.2 One of the most important reasons for this relative stagnation is that Shanghai's industrial structure, technology, and management have not been able to handle the increasing competition in export markets and within China caused by national economic reforms introduced since 1979. The municipality's industrial sector is inefficient and inflexible. It includes many activities that are not well suited to the characteristics of the location: congested transport, lack of local raw materials, and, especially in the city, insuffi- cient space for efficient factory layouts. Investment in support services and infrastructure has been inadequate, and their underdevelopment is an addi- tional constraint to Shanghai's industry. 3.3 The central government aims to transform Shanghai into one of the largest industrial and trade centers on the west coast of the Pacific. Shanghai, with its strong economic and human resource base, is intended to lead China's integration into the world economy, and set an example for imple- menting industrial restructuring and policy reforms. To encourage greater competition among enterprises, SMG is gradually reforinr.g its economic manage- ment and has begun to shift to indirect market controls. SMG also is con- structing infrastructure within the city and in the surrounding suburbs and rural areas to facilitate industrial growth, restructuring and modernization, and encourage foreign investment. B. Shanghai Municipality and its Industr.al Structure 3.4 Shanghai is located on the eastern fringe of the Yangtze River Delta. Only 748 of its total 6,340 square kilometers are classified as urban. This area comprises 12 central districts, collectively referred to as the city, and two satellite towns. The rural and suburban areas are divided into nine counties that include 197 townships and more than 3,000 villages. The permanent population of Shanghai at the end of 1988 was estimated to be 12.62 million, of which 7.23 million (58 percent) was urban. Over six million people live in the city proper. 3.5 Shanghai is China's richest province in terms of per capita income. In 1988 its gross product amounted to Y 64.8 billion, or Y 5,145 ($1,379) per  - 12 - capita--over four times the national average. Computed through net material product, the per capita municipal income was Y 4,487 ($1,203), more than 50 percent higher than that of Beijing. Shanghai's GVIO, excluding village and rural enterprises, was Y 118.1 billion ($32 billion) in 1988, which repre- sented 8.1 percent of the national total. About 70 percent of GVIO originated in the urban districts of the municipality. Industry accounts for 67 percent of the municipality's net material product, while agriculture accounts for 4 percent and the growing service sector for 29 percent. The labor force num- bers 7.7 million, of which 12 percent is engaged in the primary sector, 60 percent in the secondary sector, and 28 percent in the tertiary sector. Most of the labor force is employed in industrial activities, even in suburban areas of the municipality. 3.6 Shanghai's industry is fragmented and highly diversified. There are 12,431 enterprises in the municipality (excluding about 20,000 village and township enterprises): 4,318 state enterprises, 7,069 collectives, and 1,024 others, including foreign joint ventures. Of the 749 independent accounting enterprises classified as large and medium in size, 11 employ more than 10,000 workers, 86 employ 3,000 to 10,000, 397 employ 1,000 to 3,000, and 255 employ fewer than 1,000. There are enterprises involved in virtually every indus- trial activity except mining. Light industry has the largest number of enter- prises--7,134,-representing 57 percent of the total--and a GVIO of Y 59.6 billion ($16 billion) or 55 percent of the total, in constant 1980 prices. Textiles and nonelectric machinery are the most important industrial subsec- tors, accounting for 13.9 percent and 14.5 percent of GVIO in 1987, respec- tively. These subsectors are followed by iron and steel (7.7 percent), elec- tronics (7.5 percent), chemicals (6.4 percent), and electric machinery (6.3 percent). In each of these subsectors, except textiles and chemicals, the city's share of gross national output was 10 percent or more in 1988. Shanghai also held large shares of the output of chemical fibers (21.2 per- cent), and instruments (15.4 percent), among others. 3.7 State-owned enterprises dominate the municipality's industrial sec- tor. Shanghai's state-owned enterprises contribute a higher proportion of GVIO than state-owned enterprises do in other provinces. In 1988, about 68 percent of Shanghai's industrial output was generated by state enterprises, compared to 43 percent in Jiangsu and 39 percent in Zhejiang. The state enterprises are poorly positioned to operate in competitive markets, as their flexibility is limited by the lack of separation of regulatory, ownership and management functions, overly bureaucratic systems of organization and manage- ment, and a long history of command planning. As in the rest of China, state- owned industry in Shanghai has grown more slowly than the municipality's col- lectives. 3.8 About one-quarter of Shanghai's industrial output is exported; the sales of the remainder are split evenly between Shanghai and the rest of China. In 1988, Shanghai exported $4.61 billion in merchandise. This repre- sented an increase of 10.8 percent over 1987. Light products and textiles are the major exports, accounting for 62 percent of the total in 1988.  - 13 - C. Industrial Performance 3.9 Shanghai's industrial performance has fallen off in recent years. This stagnation is evidenced by the municipality's low growth of GVIO, munici- pal zevenue collection, and productivity. Despite this stagnation, though, the efficiency of Shanghai's industry remains high compared to that of other provinces. 3.10 Since 1978, Shanghai's GVIO has grown at a much slower pace than that of its neighboring provinces. In Shanghai, growth has averaged 7.0 per- cent per annum on average, while Jiangsu, Zhejiang, Anhui and Fujian achieved growth rates in excess of 13 percent, the national average. The difference between growth rates was more marked between 1983 and 1987. During this period growth of GVIO in Shanghai was 9.0 percent per annum, while the national average was 16.5 percent (constant 1980 prices). As a result of relatively lagging growth, Shanghai's industrial output as a p.oportion of national industrial output decreased from 12.9 percent in 1978 to 7.1 percent in 1988. Similarly, exports dropped from 29.7 percent to 9.7 percent of national exports (measured in current US dollars). 3.11 Shanghai's municipal revenue, which is mainly collected from enter- prises, also declined as a share of the country's total between 1978 and 1988, from 17.0 percent to 10.1 percent. Except for a brief period in 1984 and 1985, municipal revenue collections have fallen steadily in absolute terms since 1980. Budget revenues were Y 18.2 billion in 1985, Y 17.6 billion in 1986, Y 16.5 billion in 1987, and Y 15.4 billion in 1988. 3.12 The average labor productivity of Shanghai's state-owned industry, Y 33,735 per person-year (PPY), is almost double the national average o_ Y 18,056 PPY, but its rate of improvement is below the national average in almost all subsectors. Shanghai's industry remains the most profitable among the provinces in China, with profit rates about 50 percent over the national average. Nevertheless, because of their booming light industry collectives, in 1988 Jiangsu and Zhejiang had output-to-capital ratios of 2.3 and 2.4, respectively, while that of Shanghai was 2.0. However, for state-owned enter- prises Shanghai has the same ratio (1.7) as the other two provinces (based on 1988 current prices). The national average for all independent accounting enterprises Js 1.4, and 1.1 for state enterprises. D. Resources and Constraints 3.13 Shanghai retains a lower percentage - its revenue collections than any other province--23.5 percent in 1986 and 1987, and as little as 10-15 per- cent in previous years. In 1988, its collections were 10 percent of the national total, but its budgetary expenditures were only 2.6 percent. The municipality's restricted budget has resulted in poor infrastructure for industrial development. It also has had negative consequences for enterprises in Shanghai, from which SMG collects much of its revenue. Despite Shanghai's lead position in gross profitability, the small proportion of profits retained by enterprises in Shanghai has constrained investment. Since the 1970s, few new sizable factories have been built other than the giant steel (Baoshan) and petrochemical (Jingshan) complexes managed by the central government. The limits on retained profits also have constrained enterprises from doing ade- quate research and development.  - 14 - 3.14 The effects of the low rates of investment in the past can be seen in the aging physical stock of capital in Shanghai. Buildings and machinery are ouatdated and ill-equipped to meet the challenges of increasing interna- tional and domestic competition. Factory sites are cramped and layouts exhi- bit histories of piecemeal additions resulting in inefficient workflow pat- terns. It is estimated that roughly two-thirds of machinery and equipment matches international technological levels of the 1960s or earlier. This partly explains the stagnation in productivity improvements (para. 3.12). 3.15 While the physical stock of capital needs improvement, Shanghai's human resource base is strong compared to the rest of China. The municipal- ity's relatively high labor productivity can be attributed to its unequalled base in skilled human resources, accumulated experience in running industrial enterprises, and educational, scientific and technical infrastructure, com- pared to the rest of China. Shanghai has a relatively high proportion of engineers and technicians on the staff of its industrial enterprises (6 per- cent compared to 4 percent nationally) and a large number of scientific and technical personnel in municipal research and design institutes. The 1982 census showed, for example, that Shangha' had 24 university graduates and 204 senior middle school (high school) graduates per 1,000 residents; in contrast, the corresponding figures for Sichuan, an interior province, were only 3 and 40, respectively. 3.16 Shanghai's industrial performance has suffered from another con- straint--a shortage of land. This shortage has several aspects. One is the overcrowding and lack of space within the city itself. Second is the absence of mechanisms to adjust land use patterns appropriately since there is no market for land or usufruct rights. Third is the lack of funds for building costly infrastructure needed to develop new industrial sites. Fourth is the related problem of urban transport which results in employees being unwilling to relocate to new factories outside the city. Finally, there is the problem of environmental pollution, which has surpassed acceptable limits; for exam- ple, 80 percent of the biological waste in the water originates in industrial effluents. 3.17 Recently, the cost of raw materials has risen and reduced the prof- itability of some Shanghai enterprises because their output prices have not been adjusted. This sharp increase in the effective cost of raw materials reflects the impact of the government's price reform program together with a decline in the share of plan allocations that are obtained at low, controlled prices and raw material shortages. Rising wage and energy costs have also led to a decline in the profitability of enterprises since, reflecting the high priotity attached by the goverimnent relating to the control of inflation, liberalization of output prices in Shanghai has proceeded slowly. Neverthe- less, output prices for the four subsectors that would be beneficiaries of the proposed operation (para. 3.34) have been largely liberalized.  - 15 - E. Development Strategy and Policies 3.18 In contrast to its role during the earlier 1980s, Shanghai has now been designated as a leading center of China's economic reform effort and, as a result, the Municipality has embsrked on a number of major initiatives. SMG's broad goal is to take full advantage of China's opening to foreign mar- kets, as well as the large and growing domestic market, by specializing in the fields of industrial production for which it is best suited. To these ends, the SMG has been gradually reforming industrial policy and providing incen- tives ior competitive behavior by industrial enterprises. In keeping with China's incremental reform process, successful experiments are expected to be replicated elsewhere in the country. While some pause in this process was evident during the austerity program in 1989, the central and municipal gov- ernments' commitment to these initiatives has been reconfirmed and progress is again evident. This section summarizes Shanghai's broad industrial develop- ment strategy and policies. SMG's detailed strategy and the related policy reforms are presented in Annex 1. 3.19 Shanghai is giving priority to those categories of industry that are most suitable for the municipality's resource endowments and shortages: the strong human skills and research base, and the lack of raw materials, energy and land. In consumer goods and light industry, the two goals are to increase exports and the range of goods produced for domestic consumption. The former will be achieved by improving product quality, modernizing techniques of pro- duction, and reorganizing enterprises to raise efficiency and lower costs. The latter will be achieved by producing more of the higher quality goods being demanded in China. In heavy industrial equipment and machinery, the goals are to increase research and development efforts, improve production efficiency and product quality in the electrical and mechanical industries through greater product standardization, Integrate electronic and mechanical products, and increase exports in these categories. For raw materials for heavy industry, the goals are to make better use of the existing complexes, develop downstream processing, and moderately increase the production of other material inputs required by the priority subsectors in Shanghai. 3.20 Shanghai is implementing a number of enterprise reforms. These reforms are intended to revitalize the state-owned sector by making it more responsive to market forces. This is to be achieved by granting enterprises greater managerial autonomy, separating ownership from management, making enterprises responsible for their profits and losses, reducing government interference in routine enterprise affairs, and promoting new forms of group company. Shanghai's experience in these reforms is serving as a national example. 2.21 During 1987 and 1988, Shanghai abolished the administrative corpora- tions that formed an intermediate level of bureaucratic control between the industrial bureaus and the enterprises. Instead, subsector corporations were created. These are not administrative units, but independent accounting enti- ties that are responsible for their own profits and losses. They have limited direct authority over the enterprises. They provide some services for the enterprises, such as sales and marketing, for fees that serve as their main source of income. SMG viewed the formation of these corporations as a first step in obtaining a clearer separation of government and enterprise roles, and carrying out a reorganization of the subsectors. The subsector restructuring  - 16 - to be carried out under the project is an important next step in this process (para. 3.37). 3.22 One of the obstacles to industrial restructuring in Shanghai has been the difficulty of transferring assets through mergers or acquisitions of enterprises or their parts. This difficulty has resulted from the unclear ownership of state assets. SMG has initiated some experiments to solve this problem, and is studying wider measures. Following the establishment of the National Administrative Bureau of State-Owned Propercy at the central-govern- ment level in 1988, Shanghai set up a parallel department under the Municipal Bureau of Finance, with a mandate to devise policies for asset valuation and transfer. The department is also playing a role in current efforts to define the state-ownership function. SMG is experimenting with enterprise groups: some involve full mergers of state-owned enterprises in the same line of busi- ness; others resemble holding companies. Integrated companies along the lines of those in the four SIDP subsectors are being established in several more subsectors. Finally, SMG is at the forefront of current national efforts to design and implement a shareholding system with diversified public ownership. Several important joint-stock experiments have been initiated in the city and others are contemplated. The corporations to be supported under the proposed project are potential long-term candidates for such experiments once the nec- essary corporate restructuring to be supported under the project has been achieved and the prerequisites for successful joint-stock companies estab- lished. 3.23 Since 1988, the primary instrument used to separate ownership from management in Shanghai's large- and medium-sized enterprises has been the contract responsibility system (CRS). Under the CRS, each enterprise negoti- ates and signs a contract, valid for three to five years, with the Municipal Bureau of Finance and the relevant industrial bureau. The contract always specifies how much money the enterprise should submit as revenue to the gov- ernment, and may also state goals for profit retention for investment or tech- nical development, volume of exports, and, especially for new products, the productioD volume and quality. Once the contract is signed, it is expected that the managers will decide how to fulfill the enterprise obligations. While the CRS has resulted in increased enterprise autonomy, it also has some drawbacks. For example, it allows much negotiation of eacht enterprise's obli- gations and benefits. This has resulted in lower effective profit taxes for poorly performing enterprises and constrained the production and investment strategies of other enterprises. 3.24 Authority over most investment decisions has been delegated from the central government to SMG and Shanghai industriai bureaus. The current rules for enterprises with no foreign ownership fall into two categories. First. all new capital construction projects with costs under Y 30 million ($8 mil- lion) require SMG approval. Second, technical renovation projects--those involving replacement of part of a factory--require the relevant industrial bureau's approval for amounts up to Y 3 million in the case of light industry and for amounts up to Y 5 million for heavy industry. Technical renovation projects between these amounts and Y 30 million require SMG approval. In either category, projects costing more than Y 30 million require central go7- ernment approval. It is expected that further steps to relax these limits will be initiated once the current national stabilization program is success- fully brought to its conclusion.  - 17 - 3.25 During 1987 and 1988, some flexibility in setting industrial prices in Shanghai was introduced. Jurisdiction over many prod -t prices, particu- larly for consumer goods, was transferred from central government to SMG. The Shanghai Price Bureau has in turn delegated the pricing of many goods to the enterprises. Nevertheless, it still monitors these prices regularly to ensure that they do not deviate from guideline prices by more than 20 percent, or by an amount necessary to match quality improvements over the guideline's product definition. Since the stabilization program began in 1989, only smaller devi- ations have been allowed; however, further liberalization can be expected in the medium term. 3.26 Foreign trade reform in Shanghai began in 1979 as part of the national policy of opening the economy to the outside world. Since then, the number of channels for foreign ti:ade has been increased. Hitherto Shanghai has been slow to grant direct export rights to enterprises, and this has been identified as a cause of poor export performance, particularly in markets where the international norm is custom production and contact between buyer and producer is important. However, in 1989, about half of Shanghai's export- ing enterprises switched to the agency system of exports instead of selling their goods outright to a trading company as under the previous purchasing system for exports. Under the new agency system, trading companies export the products of enterprises for a fee. Some subsectors are introducing training schemes to improve the enterprises' ability to export and are planning phased programs to acquire export rights from the trade companies and other agents. 3.27 Several additional export incentives have been introduced during the last few years. First, enterprises are now allowed to retain a share of their foreign exchange earnings, with the share varying from as low as 8 percent for below-plan exports, to as much as 93 percent for direct exporters.1/ They do not actually hold foreign exchange, but their foreign exchange receipts are converted into domestic currency by the Bank of China and given to the enter- prises. In addition, they receive that currency and a quota, or entitlement, to purchase a fixed amount of foreign exchange for approved imports. Second, enterprises receive rewards for exceeding their export targets, including bonuses, larger shares of retained foreign exchange for above-target earnings, and the freedom to sell that foreign exchange at the Foreign Exchange Adjust- ment Center, where market rates have until recently been higher than the offi- cial exchange rate. As a result of these efforts, Shanghai's enterprises now have access to the most active foreign exchange market in China. Thirdly, China has sought to maintain export competitiveness through regular adjust- ments in the official rate, the most recent of which occurred in November 1990; the official rate is now close to that prevailing in the adjustment centers. 3.28 At least four measures have been taken by the central and municipal governments to increase the number of financial instruments and institutions in Shanghai. First, the Bank of Communications was reestablished and its headquarters situated in Shanghai; this step increased competition among Shanghai's financial institutions and should help to improve financial ser- vices for industrial borrowers. Second, Shanghai now has a small primary 1/ For a discussion of the foreign exchange retention mechanism see: World Bank: China: External Trade and Capital, 1988, Chapter 2.  - 18 - securities market; a stock exchange was opened in December 1990. Third, an interbank money market was recently introduced. Fourth, two foreign exchange adjustment c,nters were established in 1987; since then they have grown rapidly in volume. 3.29 SMG has modified technology policy over the last three years to encourage technology development in Shanghai's enterprises. Firms may negoti- ate that 1 percent to 2 percent of sales be retained for research and develop- ment purposes. Enterprises can now hire personnel from university and research institutes as consultants, and may enter into contracts for joint reFearch with these organizations. Research institutes receive financial rewards if the technology they develop is used by an enterprise. Research institutes are now expected to generate their own funds. Strong client rela- tionships with enterprises are making research more relevant to enterprises' needs; however, SMG will need to monitor this closely to ensure proper diffu- sion of technology developed by research institutes to industrial enterprises and that basic research is not neglected. 3.30 SMG also is actively encouraging foreign investment as a way to bring in sophisticated technology, gain access to export markets, and develop local supplier industries. In June 1988, the Shanghai Foreign Investment Commission (SFIC) was established to provide "one-stop" approvals for foreign investments. Within Shanghai municipality, industrial parks also have been established to provide appropriate infrastructure for foreign factories. The redevelopment of the Pudong area of the municipality is being designed to attract foreign firms through provision of adequate modern infrastructure and support services for businesses and trade. 3.31 SMG also is altering industrial location and environmental protec- tion policy. The goals are to reduce congestion and pollution in the city proper, and to facilitate the movement of enterprises to locations with ade- quate space for economic scales of production. A zoning system for new enter- prises has been introduced for the city and surrounding counties and satel- lite. The new zoning system also designates restricted locations for heavily polluting firms. Relocation of existing factories is still difficult, how- ever, because there is no land market. 3.32 Several schemes have been introduced to facilitate labor mobility. Lifetime employment guarantees are being phased out. For example, employment contracts lasting one or several years have been introduced and must be used for all newly hired industrial workers. Some enterprises have established retraining programs to teach workers new techniques of production, and indus- trial bureaus are providing retraining for some senior and skilled workers. Under the Labor Bureau's guidance, enterprises are establishing job defini- tions and standards to encourage evaluation of employee performance and fairer competition for positions. 3.33 Enterprises in Shanghai have traditionally paid their workers' (unfunded) pensions upon retirement. This placed a cost burden on older enterprises, which typically have a lower ratio of active to retired workers than new competitors in other provinces. The pension system also made workers reluctant to move between enterprises, since this would result in lost bene- fits. To address these problems, a new municipal pension scheme was estab- lished in 1988. The new scheme is based on employer contributions and is  - 19 - administered by the newly formed Consolidated Retirement Pension Funds (CRPF) under tle Shanghai Labor Bureau. An unemployment mpensation scheme has also been established. Under that scheme, employees involuntarily released from industrial jobs receive payments until jobs are found for them, or for a maxi- mum of two years. F. The Four Subsectors 3.34 There are four subsectors included in the project: printing machin- ery, electrical apparatus, electronic components, and precision and scientific instruments. The printing macht.nery and electrical apparatus subsectors are under the Shanghai Mechanical and Electrical Industries Administration (SMEIA). SMEIA is the largest bureau in Shanghai and accounts for about 25 percen. of the municipality's industrial output. The electronic components and precision and scientific instruments subsectors are under the Shanghai Instrumentation and Electronic Industry Bureau (SIEB). Chart I shows the organizational relationships between the subsector corporation, bureau, SMG and Central Government. Chart 2 shows the internal structure of a bureau. 3.35 These subsectors are among the priority suDsectors in SMG's develop- ment strategy (para. 3.19). Each has historically been a leader in China and occupies a significant or dominant position in its domestic market now. Nev- ertheless, competition from new domestic producers has reduced profitability and, in some cases, also diminished market share. Exports also are low, despite China's potential competitiveness. 3.36 During preparation of the project, consultants (para. 1.3) carried out extensive market research and analysis of the weaknesses, capabilities and potential of each of the four subsectors. The consultants' reports are avail- able in the Project File. Based on this work, and that of Bank staff, enter- prise and subsector policy reforms cutting across th four subsectors have been agreed between the Bank and SMG. These reforms are described below first. Then the agreements with respect to the subsector specific product and market strategies and organizational restructuring that would be supported under the project are briefly described for each subsector. Therefore, this section provides a brief descriptior. of the intentions of SMG regarding the development program and strategy for the project subsectors. A translation of the full text of SMG's official statement on its intentions is attached as Annex 2. Details on the subsectors and their strategies can be found in Annexes 3 to 6. Enterprise anid Subsector Policy Reforms 3.37 Under the project, SMG is undertaking a common set of enterprise and subsector policy reforms across the four subsectors. These measures, which are under the control of SMG, are intended to provide an appropriate structure and policy framework for the managerial, organizational and technical improze- ments to be implemented under the project. These improvements are intended to raise efficiency, growth and competitiveness, consistent with the broad strat- egy of Shanghai's industrial development and to provide reform models which can be subsequently replicated in other subsectors. The measures include: (a) the legal establishment of integrated corporations (paras. 3.38-3.40); (b) phased introduction of direct export rights for the integrated corpora- tions (para. 3.41); and (c) improved access by the subsectors to foreign  - 20 - exchange (para. 3.42). Since appraisal, the four integrated corporations have been legally established. In addition, organizational changes within the cor- porations have begun. These changes are consistent with the introduction of direct export rights and the subsector restructuring, which would take place under the project. 3.38 Integrated Corporations. In 1988, each of the four subsectors com- prised essentially all of Shanghai's factories which manufacture products in the subsector's broad product group. However, these were independent, often suboptimally sized factories with many overlapping products and duplicate manufacturing processes. The subsector corporations had limited control over the factories under them (para. 3.21), and, therefore, were unable to carry out the needed product and manufacturing rationalization. To address this issue, in each of the four subsectors, an integrated corporation was legally established and a charter issued for it in May 1989. Each consists of some, but not all, of the factories that were in the subsector as of January 1989. Each integrated corporation consists only of priority factories that have an important role to play in implementation of viable product, market and manu- facturing strategies. (See Annexes 2 through 6 for details on the strategies, and the lists of factories included in each integrated corporation.) In the future, additional factories could be acquired by or merged with the inte- grated enterprise. Joint ventures with foreign firms could also be possible. The decision to acquire or merge would be based on consideration of the tech- nical and economic efficiency of the units to be merged and their impact on the larger integrated corporation that would result from the union. Further- more, in each subsector, there are some factories, such as foundries, that supply critical inputs to the manufacturing processes in the subsector. They were initially included in the integrated corporation, but may become indepen- dent of the corporation later. 3.39 For each integrated corporation, financial consolidation of the subsector corporation and constituent factories was carried out within nine months of charter issuance. The municipal government's completion of this process, despite the delays in the Bank's consideration of this project which occurred during this period, provides strong evidence of the SMG's commitment to the restructuring program. The integrated corporation assumes all debt and tax obligations, including those under the CRS, as a single unit. Related changes are being phased in over two years. At the end of that period, the integrated corporation would become the sole legal entity, responsible for all profits and losses. It would exercise certain rights, including export and foreign exchange retention, as a single unit. The integrated corporation would be empowered to reallocate all resources, including employees, materials and equipment, between factories and divisions as needed to rationalize pro- duction. After the transition period, the formerly separate factories and subsector corporation will lose their status as independent legal entities. At negotiations, understandings were reached on appropriate transition periods for the subsector corporations. These enterprise reforms are reflected in the charters, found acceptable to the Bank, and approved by SMG in May 1989. That approval was required before any subloan could be made to the corporation (para. 4.8). The charters define the structure, composition, rights and obli- gations of each integrated corporation, and the means by which these may be amended in the future (see Annex 2).  - 21 - 3.40 The integrated corporations are establishing corporate headquarters that would have the following responsibilities: setting company-wide policy; implementing the investment strategy; financial management; export develop- ment; purchase of bulk raw materials; and coordinating the divisions. Busi- ness divisions that would be profit centers, responsible for product develop- ment, production, sales and marketing, have also been defined, and staff reorganization is under way. Each diviqion involves one or more factories, which will operate as cost centers. Some of the corporations have research institutes and material processing centers that will also be cost centers. SMG recognizes that complex tasks will have to be carried out in the inte- grated corporations in terms of organizational restructuring, design and implementation of management systems, and financial and manufacturing consoli- dation. Therefore, it has been agreed that assistance of consultants to pro- vide the restructured corporations with expertise in these critical areas would be provided under the project (para. 4.16). 3.41 Trade Rights. Under the project the integrated corporations would use the agency system for exporting instead of the old purchasing system (para. 3.26). A joint office of corporate staff and foreign trade company staff will be established to handle exports. This arrangement would facili- tate both the training of corporate trade staff and direct contact between the corporation and overseas clients. Integrated corporations would be granted direct export rights once they have built up trained staff and demonstrated their ability to take responsibility for the risks associated with exporting. Annual reviews of each integrated corporation's progress in this area will be carried out to decide when-it would be appropriate to grant direct export rights (para. 4.14). 3.42 Access to Foreign Exchange. Each integrated corporation would also be allowed to retain as much of its foreign exchange earnings as needed to service the subloans received under the project and meet other operational needs. In addition, the corporations would be allowed to buy foreign exchange at the Foreign Exchange Adjustment Centers should their export earnings be inadequate to meet their needs. Subsector Restructuring 3.43 Electrical Apparatus. Before the commencement of the agreed restructuring (paras. 3.38-3.40), Shanghai's electrical apparatus subsector consisted of a subsector corporation (SEAC), 28 factories, a research insti- tute and four subsidiaries of the corporation. The subsidiaries provided ser- vices--material procurement, marketing and sales, systems engineering and technology development--to the factories. The subsector employs over 23,000 people. In 1989, its total sales were Y 703 million, and its profits were 19 percent of sales. The Shanghai subsector's domestic market share was about 10 percent in 1987. Exports were about $8 million in 1989. A significant share of these exports were contactors and relays sent to European firms under buyback agreements. 3.44 Shanghai's electrical apparatus subsector is growing more slowly than its domestic competitors. It has failed to expand output in line with market demand. Ma.y of its products are outdated. The subsector's operating efficiency is good compared to many other domestic producers, but very low by international standards. Compared to iniustrialized countries, manufacturing  - 22 - costs are high, delivery times are long, and technology is outdated. Many products are produced by several factories in the subsector, each operating below economic scale. Overseas marketing has been weak. 3.45 Since appraisal, 21 of the 28 factories in the electrical apparatus subsector have been reorganized into an integrated corporation with five divi- sions according to product groups. This will allow consolidation of fragmen- ted facilities, and permit efficiency gains. Export marketing would be han- dled at the corporate level and domestic sales at the divisional level. Three key strategies have been identified for the domestic market: (a) maintain and strengthen SEAC's lead position in components and systems products through efficiency gains and production of new-generation products; (b) build elec- tronics capabilities for applications in electrical apparatus; and, (c) strengthen marketing and sales capabilities by setting up nationwide sales and service centers and establishing a corporate brand. To increase exports, the corporation would focus on independent standard components and dependent standard subassemblies for original equipment manufacturers (OEMs), and build export channels for markets in Southeast Asia and the United States. 3.46 Electronic Components. In March 1989, Shanghai's passive electronic components subsector consisted of a subsector corporation, 24 factories, and one research and development institute. The subsector's share of the domestic market declined from 25 percent in 1983 to 7 percent in 1989 and profits as a share of sales declined from 40 percent to 18 percent in the same period. Restructuring was considered necessary to increase the subsector's competi- tiveness through increased product specialization, larger scales of produc- tion, quality improvement and lower unit costs. Exports were Y 34 million in 1989, one-quarter of China's exports of electronic components. However, export quality was low. 3.47 Following appraisal of the proposed SIDP, only eight of the 24 fac- tories and the research institute were joined to form the integrated corpora- tion. This arrangement allows the integrated corporation to focus on priority products that have a strong potential to be competitive in domestic and inter- national markets. The factories are being grouped into five business units. There are three aspects of the strategy: first, for existing products with strong market demand, technology will be upgraded and production efficiency improved to international standards; second, for new products such as chip components and hybrid circuits, foreign technology will be acquired and pro- duction for the domestic market geared up; and tlird, marketing will be improved and targeted on television manufacturers and foreign joint ventures in China as well as OEMs and distributors in foreign markets. In the long run, the objective is to improve technology to the level of the leaders in the industry. 3.48 Precision and Scientific Instruments. In March 1989, Shanghai's precision and scientific instruments subsector consisted of a subsector corpo- ration, 13 factories and a research institute. In 1989, it employed over 9,000 people and had sales of Y 169 million. All the factories are small by international standards. Output grew by 5 percent a year between 1983 and 1989--faster than the domestic average of 3 percent for this subsector. Nev- ertheless, its profitability has declined from 42 percent to less than 20 per- cent of sales over the same period and competition from domestic manufacturers has increased. The subsector earned $3.3 million from exports in 1989. The  - 23 - Shanghai subsector has a wider range of products than its competitors, and needs to focus on a smaller range of products and improve quality. Currently, its overhead costs and inventories are high, equipment utilization is low, and the production cycle is long. Marketing and financial accounting systems are poor. 3.49 The strategy to be adopted by Shanghai's precision and scientific instruments subsector under the project aims to reduce unit costs and raise quality to gain a greater share of domestic and foreign markets. Six of the 13 factories have now been regrouped to form a single integrated corporation. The new corporation will concentrate on seven products in three groups for the domestic market, and two products for export. The strategy for this subsector has five elements: (a) improve design and quality, and integrate new technol- ogies into priority products; (b) rationalize and consolidate priority facto- ries; (c) introduce modern management practices; (d) improve marketing chan- nels; and (e) train and redeploy staff. 3.50 Printing Machinery. In March 1989, Shanghai's printing machinery subsector consisted of a subsector corporation and 12 factories. Eight enter- prises manufactured printing and post-press machines and four manufactured components. In 1989, the subsector employed 7,000 people, and had total sales of Y 185 million. The Shanghai subsector's domestic market share was 13 per- cent in 1987. The Shanghai subsector's exports of $5.0 million in 1990 are almost three times the exports of 1983. 3.51 Although Shanghai has been the traditional leader in printing machinery in China, there are major challenges to Shanghai's position as a result of shifts in domestic market demand and initiatives taken by competi- tors. The domestic market is growing at an annual rate of 10 percent and there is excess demand for printing machines. There is also growing demand for new products to improve the speed and quality of printing. The Shanghai subsector has not fully kept up with this growth. In addition, the subsector is not able to exploit fully its export potential, despite its significant cost advantage in many products. The subsector needs to upgrade product qual- ity, develop new machines, and sell through new marketing channels. 3.52 Since appraisal, the printing machinery subsector in Shanghai has undertaken a program of reorganization, and is adopting a focused product and market strategy. The new integrated corporation includes a large number of existing factories because each has a critical role in implementing the agreed product, market and manufacturing strategies. However, under SIDP, there would be substantial rationalization of production to remedy the current prod- uct duplication and excessive vertical integration. The corporation is being organized into three divisions based on three key product groups: large presses, small and medium presses, and post-press equipment. For large presses, the approach will be to gear up production of web presses based on imported technology, and to develop multicolor sheet-fed offsets, beginning with low-speed models. In small and medium presses, the division will invest in equipment for the manufacture of letter presses with the flexibility to accommodate the anticipated shift of demand from letter presses to sheet-fed offsets, and increase production of duplicators, which are in great demand. For the post-press division, the priority will be on upgrading quality and increasing production. To increase export earnings, the integrated corpora- tion will seek joint production agreements with some of its curre.t technology  - 24 - partners for sales into Western markets, and for the Southeast Asian markets, it will appoint a sales and servicing agent. G. Bank Role and Strategy 3.53 To revitalize its economy Shanghai needs to adjust the structure and management of its industrial sector (para. 3.18). The Bank is well-placed to assist SMG in formulating, implementing and financing an integrated package of needed policy and enterprise reform measures based on its experience with industrial restructuring elsewhere in the world and previous economic and sector work and lending operations in China. This experience includes the industrial restructuring projects in Hungary, Mexico, and Indonesia, past sector work on enterprise reform in China, and the Shanghai Machine Tool Project. 3.54 Through the work already done on the proposed project, the Bank has established a broad dialogue with SMG on overall industrial development strat- egy and policy in Shanghai. At the subsector level, the proposed project would assist in the design and implementation of specific strategies and restructuring programs for four priority subsectors in Shanghai. These efforts would assist SMG in developing relevant approaches to, and experience in, the kind of industrial restructuring that is required elsewhere in the industrial sector, and provide models for subsequent replication in Shanghai and the rest of China. In addition, the operation would contribute to insti- tution building in Shanghai through technical assistance to strengthen the capability of SMG to do industrial sector planning and policy analysis in two ways: first, it would improve local consulting capability in the area of industrial restructuring because three major consulting firms in Shanghai have worked closely with the foreign firms that have helped develop the subsector development programs, and local consulting firms would work on the implementa- tion of the programs also; and second, two policy studies to be done in con- junction with the project would contribute to building policy-making institu- tions in Shanghai. One of these studies, which is looking at enterprise reforms and the supporting mechanisms to be developed, such as boards of directors and asset transfers, is already under way. The other study would monitor the impact of policy changes on the four subsectors and suggest modi- fications if needed. 3.55 The consulting firms, with the assistance of the subsector corpora- tions and SMG (para. 1.3), have carried out in-depth studies of the four sub- sectors, which are satisfactory to the Bank and available in the Project File. These studies were financed under the Japan Grant Facility. They focus on: subsector competitiveness in domestic and foreign markets, technology and manufacturing capabilities and trends, product and market strategies, organi- zational development strategies, investment plans and overall program imple- mentation. Annexes 3 to 6 summarize the main findings and recommendations of the consultants' reports. The Bank has played an active role in guiding and providing inputs to the studies. These studies have helped form the basis for a constructive dialogue with SMG, the subsector corporations and their indus- trial bureaus, and agreement with the Bank on development strategies and pro- grams for the four subsectors, including subsector policy reforms, organiza- tional and technological restructuring, and technical assistance. The initial organizational restructuring is underway.  - 25 - IV. THE PROJECT A. Project Objectives 4.1 The proposed project forms part of the Bank's overall effort to support the implementation of GOC's program of industrial reform. The project will focus on four subsectors in Shanghai which have been given priority in the municipal government's development strategy: electronic components, pre- cision instruments, electrical apparatus and printing machinery. The project would assist the implementation of the Shanighai government's development strategies and programs for the above subsectors. Specifically it would pro- mote increased efficiency, and greater domestic and international competitive- ness in the four subsectors through: (a) rationalization, modernization and expansion of plants in the four subsectors based on sound product and market strategies, upgraded technological and manufacturing capabilities, and clear financial and economic performance criteria; (b) organizational restructuring and upgrading of internal enterprise management systems; and, (cl subsector policy reforms. B. Project Components 4.2 The project will have three main components: (a) financial assistance for technological restructuring of enterprises in the four subsectors; (b) technical assistance to support organizational restructuring, man- agement upgrades and project implementation, including training, computer hardware and software, and management consultancy services; and, (c) institutional development assistanr-e for economic policy making and the PFIs in Shanghai. The description of the three components is as follows. Financial Assistance Component 4.3 The project will provide financial assistance of $133.8 million out of the proposed Bank loan toward meeting the foreign currency requirements for technological restructuring in the four subsectors, including the costs of production equipment and technology transfer. The funds would be onlent through the PFIs (para. 4.17). Altogether for the four subsectors, about 40 subprojects for technological restructuring have been proposed for financing under the project. In tne electronic components subsector, the investments would include improvements in product design and quality, capacity expansions and manufacturing improvements for existing products such as capacitors, resistors, connectors and switches, transformers, relays and future growth  - 26 - products such as chip components and hybrid circuits. In the precision instruments subsector, the investments would include improvements in product design and quality, capacity expansions and manufacturing improvements in three key areas: analytical instruments--spectrophotometers and chromato- graphs; general purpose and environmental control instruments; and optical system products, particularly microscopes and optical elements. 4.4 Financial assistance for technological restructuring would also be provided to the electrical apparatus subsector. The specific areas to be sup- ported include: gearing up for volume production of new generation products already being manufactured under existing technology transfer agreements from industrialized countries (e.g., contactors): developing new systems products based on technology for which licensing arrangements have already been negoti- ated (e.g., AC drive converters); developing a few key new generation stand- alone products (e.g., voltage control units and leakage switches); and devel- oping some electronics products for application in electrical apparatus (e.g., uninterruptible power supply). In the printing machinery subsector, financial assistance would be provided for increasing production of large web-presses, as well as labor-intensive subassemblies of these presses for export, and of the large, medium performance, multicolor sheet-fed offset machines, introduc- tion of small and medium multicolor sheet-fed offset machines and duplicators, replacing the old generation of letterpresses, mainly for the Chinese market. In addition, support would be provided for upgrading product quality and increased output of post-press machines (e.g., cutting and binding machines). Technical Assistance Component 4.5 The project will provide technical assistance to finance computer equipment and software, training, and consulting services. Broad outlines of programs in each of these areas have been established by the corriorations with the assistance of consultants. Each corporation will submit its requests for such financing in the form of subloan proposals to the PFIs; these are expec- ted to total $16.2 million. The category of training includes courses for management and technology development, and travel abroad for acquisition of foreign technology. About $8.5 million of the loan will be used for this purpose. During negotiations it was agreed that the Bank and SMG would review annually, by September 30 each year, a 12-month program for overseas training financed under the project. The requiremenits of computer equipment including software have already been specified for each corporation at an estimated total cost of $2.7 million. 4.6 During appraisal, agreement was reached on the nature of consultant services needed during project implementation. They cover services in the areas of: project management, organizational restructuring, production con- solidation, preparation of feasibility reports, management information sys- tems, financial and cost accounting, and industrial engineering and opera- tional effectiveness. About $5 million of the loan will be used to finance the necessary consultant services. Generic terms of reference (TORs) for these services are included at Annex 7. Each of the four corporations has tailored these generic TORs to their own specific requirements and the revised TORs have been agreed with the Bank. Local and foreign consultants will be engaged to help carry out the scope of work in the TORs. The Bank has approved the corporations' request to negotiate directly with the consultants who helped develop the subsector strategies and development programs to assist  - 27 - in carrying out the above scope of work. Appointment of all the consultants needed to carry out the full scope of work outlined in the TORs is a condition of loan effectiveness. Institutional Development Component 4.7 The project will asssist institutional development in the areas of economic policy-making, project appraisal, and subsectoral restructuring. During project implementation, two interinstitutional studies will be coordi- nated by the Shanghai Planning Economic Research Institute (SPERI). These studies involve monitoring the impact of policy changes on the four subsec- tors, and assessing the implementation of enterprise reforms in those subsec- tors as well as their wider applicability in Shanghai's industrial sector. Terms of reference for these two studies have been agreed with the Bank. Since March 1989, managers and project staff from the five PFIs have attended courses on project appraisal. In April 1991, a seminar on industrial restruc- turing will be given by the Economic Development Institute in collaboration with the Shanghai Planning Commission, and educational institutiopq in Shanghai. This course will assist industrial managers in Shanghai to analyze the need for industrial restructuring and appropriate restructuring methods. The institutional development component is being financed by SMG; this finan- cing includes $105,000 equivalent from the Japanese Grant Facility to finance the estimated foreign costs of the studies and courses. C. Eligibility Criteria 4.8 The Bank has reviewed subprojects in the pipeline for their appro- priateness with respect to the agreed subsector strategies (para. 3.37). The enterprises would submit the feasibility studies of subprojects according to the format agreed with the Bank (Annex 8). The PFIs would appraise each sub- project proposed for financing to ensure that: (a) it is sponsored by a cor- poration that has been established as an integrated enterprise, as reflected in a charter acceptable to the Bank and approved by SMG (para. 3.38); (b) it is consistent with the subsector strategies agreed between SMG and the Bank (Annex 2); (c) the subproject and the sponsoring factory are in compliance with environmental control guidelines (para 4.31); and, (d) the subproject would nermit the sponsoring corporation to maintain a satisfactory financial position. Furthermore, all subprojects except for those for training, compu- ter equipment (including software) and consultant services, would have to have minimum financial rates of return of 12 percent in constant prices. Subproj- ects above the free limit would also have to have an economic rate of return greater than 12 percent in constant prices. Assurances on the above eligibil- ity criteria were obtained at negotiPtions. D. Project Cost and Financing 4.9 The total cost of the pipeline of subprojects, including incremental working capital, is estimated at $320 million (based on November 1990 prices), of which $180 million (56 percent) would be in foreign exchange. Table 4.1 summarizes the estimated project costs including contingencies. The estimates are of a tentative nature as the project components are based on preliminary cost estimates of the subprojects in the pipeline. Consequently, no attempt has been made to separate contingencies. Final cost estimates for the actual  - 28 - subprojects financed could be different since these would be prepared by the enterprises for subproject appraisal by the PFIs. Table 4.1: ESTIMATED PROJECT COST /a Local Foreign Total 2 of Total ------ ($ million) ------ FINANCIAL tS.SISTANCE COMPONENT Technological Restructuring Capital Costs: Instrumentation 8.0 27.9 35.9 11.2 Electronic components 16.9 64.6 81.5 25.5 Printing machinery 11.1 22.3 33.4 10.5 Electrical apparatus 14.2 40.4 54.6 17.1 Subtotal 50.2 155.2 205.4 64.3 Incremental working capital /b 81.5 - 81.5 25.5 Subtotal for Technological Restructuring 131.7 155.2 286.9 89.8 TECHNICAL ASSISTANCE COMPONENT Training 2.6 11.7 14.3 4.5 Computer Hardware and Software 0.8 3.7 4.5 1.4 Consultant Services 4.1 9.7 13.8 4.3 Subtotal for Technical Assistance Component 7.5 25.1 32.6 10.2 INSTITUTIONAL DEVELOPMENT COMPONENT 0.1 - 0.1 - Total Financing Required 139.3 180.3 319.6 100.0 /a Final estimates to depend on individual subproject cost estimates that will be prepared by the PFIs at the time of subproject appraisal. Since these are preliminary estimates, no attempt has been made to separate contingencies. Project cost estimates include taxes on local costs and customs duties on imports. Local taxes are about 15 percent of local costs. Foreign costs financed by the Bank would be exempt from customs duties. /b Imports of raw materials and parts will be financed through foreign exchange earnings, for which the working capital is included in the local cost.  - 29 - 4.10 Furthermore, the pipeline may change if the PFIs' detailed analysis shows that some of the subprojects in the current pipeline are not viable and therefore no longer eligible for financing, or if other suitable subprojects are developed. Moreover, although the project is intended to assist the four subsectors, the PFIs would be alluwed to use the proceeds of the loan for this project to finance subprojects in other industrial subsectors as agreed between the Bank and SMG on the basis of agreed development strategies to be prepared by the municipality; assurances to this effect were obtained at nego- tiations. 4.11 The proposed Bank loan will provide $150 million. Based on the initial pipeline of subprojects, this would leave a foreign exchange financing gap of $30.4 million. If there is such a gap after all subprojects are appraised and firm foreign exchange estimates are known, SMG would finance it. Local currency requirements would be financed by the PFIs, other Chinese banks and the enterprises' own resources. Table 4.2 summarizes the financing plan for the project. During negotiations, assurances were obtained that SMG will make available all funds needed for implementation of the project. Table 4.2: ESTIMATED FINANCING PLAN (S million) Local Foreign Total FINANCING PLAN IBRD - 150.0 150.0 PFIs, other banks and enterprises 139.2 - 139.2 Shanghai Municipal Government /a 0.1 30.3 30.4 Total Financing Plan 139.3 180.3 319.6 /a The Japanese Grant Facility will finance the estimated $35,000 equivalent in foreign costs for the studies, and $70,000 equivalent of the foreign costs for training seminars. E. Project Implementation Arrangements 4.12 Project implementation will be carried out by SMG, the subsector corporations and the participating financial institutions. During negotia- tions, agreement was reached on the formats and frequencies of reports to be used by each of these parties to monitor project implementation (para. 5.9). Role of the Shanghai Municipal Government 4.13 SMG will carry out the enterprise and subsector policy reforms as outlined in the agreed development program and strategy (Annex 2), and coordi- nate and monitor all project-related activities. For the latter, SMG has established a project monitoring unit (PMU) comprised of staff from the Shanghai Planning Commission, the Shanghai Bureau of Finance and the Shanghai Foreign Economic Relations ar1d Trade Commission. The unit's responsibilities  - 30 - include: (a) monitoring technical assistance and training under the project; (b) providing advice to the subsector corporations and PFIs on Bank procedures including matters related to procurement and disbursement; and (c) monitoring project implementation and forwarding to the Bank regular reports on progress of the project. During 1989, staff of the PMU participated In seminars orga- rized by SMG and MOF covering Bank disbursement and procurement procedures and reporting requirem!nts. During negotiations, assurances were obtained from SMG that it will maintain the PMU throughout project implementation, with competent staff in adequate numbers, and given functions and responsibilities acceptable to the Bank- 4.14 During negotiations, assurances- were obtained that SMG also would maintain a Steering Committee of high-level officials to guide the work of the PMU with composition, functions and responsibilities acceptable to the Bank. In addition, this Steering Committee would annually review the progress of the project. Moreover, the Shanghai Planning Economic Research Institute will be monitoring the impact of the subsector policy and enterprise reforms under- taken in connection with the project and identifying any adjustments or new reforms needed. During negotiations, assurances were obtained that SMG will each year: (a) prepare and furnish to the Bank, by April ;5 of each year, an assessment of policy and enterprise reforms in the project subsectors and (b) exchange views on these assessments with the Bank. Role of the Subsector Corporations 4.15 Restructuring programs in each subsector will be carried out by project implementation units (PIU) set up in each corporation. These units will come under the responsibility of the general manager of the corporation and be headed by a project manager. The project manager will divide the PIU into specific task groups in ctitical restructuring areas such as organization structure and development, product development, management systems, and opera- tional effectiveness programs. The role of the task groups will be the devel- opment of detailed plans and execution of appropriate implementation activi- ties. Project managers will regularly report to the corporate management on progress and any problems in project implementation. The project implementa- tion schedule is at Annex 9. Annex 10 gives the key performance indicators for project implementation. One of the first tasks will be to consolidate the financial accounts of the new integrated corporations. During negotiations assurance. were obtained from SMG that this would be done within nine months of charter issuance for each corporation. Draft consolidated statements were completed at that time, and were revised following discussion with the Bank. 4.16 Because of the complex nature of the subsector restructuring pro- grams, consultants will be hired to assist the PIUs in overall project manage- ment and development and implementation of plans in each functional area (para. 5.5). Terms of reference for these services have been agreed with each corporation (para. 4.6).  - 31 - Role of the Participating Financial Institutions 4.17 The proceeds of the proposed loan will be onlent through five PFIs, consisting of four banks and one nonbank financial institution. The four banks are the Bank of Communications (BOCOM) Shanghai, China Investment Bank (CIB), Industrial and Commercial Bank of China (ICBC), and People's Construc- tion Bank of China (PCBC). The nonbank PFI is the Shanghai Investment and Trust Corporation (SITCO), a Shanghai-based financial institution. The PFIs would be responsible for the normal functions performed by financial interme- diaries. These include independent appraisal and supervision of the subproj- ects, evaluation of the borrowers' creditworthiness, coordination of procure- ment and other project implementation arrangements, disbursement of loan proceeds, and recovery of debt service obligations. In addition to onlending Bank funds in foreign exchange, the PFIs would also provide local currency loans to finance capital costs denominated in local currency and incremental working capital requirements of the borrowing corporations. 4.18 Bank loans for industry in China using financial intermediaries have so far been onlent primarily through CIB (para. 2.15). An important step for the Bank in the financial sector in China is to esthblish relationships with other key financial institutions. This would ailow the Bank to understand better and assist in the evolution of financial institutions in China. The proposed project would further this process by including BOCOM, ICBC, PCBC and SITCO as financial intermediaries for the first time under a Bank project. This project also would strengthen the capability of these PFIs to appraise and manage medium and long-term loans. It would support moves to increase the number of qualified financial institutions in the area of long-term lending, a field hitherto dominated by PCBC and CIB (which is closely affiliated with PCBC). 4.19 Responsibility for project implementation would rest with the Shanghai branches of the four banks and SITCO. which is based in Shanghai. The bank branches would be able to approve subprojects independently under the proposed Bank project, without having to seek further approval from their head offices. Each of these five institutions is considered to be capable of car- rying out the project appraisal, implementation, and supervision tasks required under the proposed project. However, to strengthen their skills further, staff from the PFIs are attending preproject training courses. These courses cover project appraisal methodology as recommended by the Bank, and acquaint the PFIs with Bank procedures on procurement, disbursement, and reporting. Each institution would lend to a specific subsector, and would therefore be able to develop expertise on the issues and risks faced by that sector during the restructuring process. The financial condition and perfor- mance of these institutions have been assessed by Bank staff, and judged to be satisfactory. A summary description of each PFI, its operations, financial condition, and performance is provided in the following paragraphs. More detail on each PFI's operations Ss presented in Annexes 11 through 15. 4.20 Bank of Communications. BOCOM is a universal bank with its head- quarters in Shanghai. Established in 1908 in Beijing, the bank was reconsti- tuted in 1986, at which time its headquarters were moved from Beijing to Shanghai. As of December 1988, BOCOM had 8 branches and 24 subbranches in China employing about 5,000 staff, plus a large Hong Kong branch. BOCOM's  - 32 - total assets, including the Fong Kong branch, were Y 42 billion at the end of 1987. 4.21 The Shanghai branch of BOCOM, an independent legal entity, has grown rapidly since it commenced its operations in 1986. A. the end of 1988, total assets of the branch were Y 4.1 billion, with Y 1.0 billion in medium-term loans. The branch has aggressively recruited qualified staff from other institutions, and its medium-term lending operations are handled by about 20 staff members. The branch's pretax return on average assets in 1988 was high at 4.0 percent. Capitalization was strong as of end-1988, with net worth being 19 percent of assets. Arrears on principal payments were about 3.5 per- cent of outstanding loans as of September 1988, and all the arrears were less than 60 days overdue. 4.22 China Investment Bank. CIB commenced its operations in 1981 as a development finance institution. While CIB is administratively under the leadership and supervision of MOF, it remains closely tied with PCBC. Its primary focus is financing the technical transformation needs (i.e., fixed asset investments involving modernization or rehabilitation) of small- and medium-sized projects, particularly in the light industry sector. CIB had total assets of Y 6.7 billion as of end-1988, with 56 branches and subbranches employing about 1,000 staff. The Bank Group's involvement with CIB has been extensive (see para. 2.15). 4.23 Between 1985 and 1989, CIB's Shanghai branch approved 63 loans totaling about Y 370 million equivalent, mainly in foreign exchange. Of the loans made, only two have been rescheduled during the last five years of oper- ation, and the branch reported no arrears a, of December 1989. The branch showed a pretax return on average assets of 3.8 percent for 1989. It has 14 professionals in charge of appraisal and supervision activities, and these staff are well trained in project appraisal methodology satisfactory to the Bank. 4.24 Industrial and Commercial Bank of China. ICBC accounts for about half of the deposits and loans of the entire banking system in China. It was established in 1984 as a spin-off from the People's Bank of China (the central bank). Today, 1CBC provides most of the short-term loans received by indus- trial and commercial enterprises in urban areas, and has a large share of urban savings deposits as well. The bank had total assets of Y 562 billion at the end of 1988. and a network of about 24,000 branches and subbranches employing 440,000 staff. 4.25 At the end of 1989, ICBC's Shanghai branch had total assets of Y 38 billion and a staff of about 14,000. The branch's financial performance has been good, with a pretax return on average assets of 2.3 percent in 1989. Although most of its loans are for short maturities, the branch has a large portfolio of medium-term loaas for technical transformation purposes. Between 1985 and 1989, the branch financed 1,788 of these projects, with cumulative commitments of over Y 6.7 billion. The branch has a special credit unit responsible for technical transformation loans. This unit has a staff of 17, most of whom are financial analysts and economists. The unit handling techni- cal transformation loans reported arrears of less than 1 percent of the port- folio as of December 1989; loans affected by arrears were estimated to be 2.6 percent of the portfolio.  - 33 - 4.26 People's Construction Bank of China. PCBC was established in 1953 and is the primary bank in China for the financing of medium- and large-sized fixed investment projects. At the end of 1988 the bank was responsible for total assets of Y 342 billion, consisting of Y 165 billion of its own assets and Y 177 billion of projects managed for the government's fixed investment budget. The bank has a nationwide network of more than 3,000 branches, sub- branches and savings deposit offices, with a total staff of approximately 100,000. PCBC's primary business lines remain project financing and lending to constructicn enterprises, but the bank is expanding its range of operations considerably. The Bank is currently preparing a Financial Institutions Devel- opment Project, a component of which is expected to assist PCBC to achieve its institutional development objectives. 4.27 At the end of 1989, PCBC's Shanghai branch employed 3,000 staff, had total assets of Y 14.4 billion, and managed government investments of Y 14.8 billion. Between 1985 and September 1989, the branch approved Y 6.9 billion in loans. About three-quarters of its lending is devoted to medium- and long- term project finance; the remainder comprises working capital loans. Its staff already is familiar with Bank project analysis procedures, since about half the management staff in Shanghai have attended courses sponsored by the Bank. The financial performance of the branch has been good, with a pretax return on average assets of 2.3 percent in 1989. The branch's overdue princi- pal amounted to 0.7 percent of its outstanding loan portfolio as of December 1989. 4.28 Shanghai Investment and Trust Company. SITCO was established by the Shanghai Municipal Government as a nonbank financial institution in 1981. Today SITCO and its subsidiaries offer a wide range of corporate financial services, including loan and equity financing. Between 1984 and 1988 SITCO approved over 200 loans totaling $1.5 billion equivalent in foreign currency and Y 1.1 billion in local currency. Almost all of this lending has financed technical transformation projects. SITCO has 30 staff members responsible for project appraisal and supervision. Its total staff of 408 is well qualified, as both in-house and overseas training are emphasized. SITCO's pretax return on average assets was 2.3 percent in 1989. SITCO is strongly capitalized, with a capital-to-assets ratio of 18 percent at the end of 1989. Apart from rescheduling three loans totaling $25 million, SITCO reports no overdue prin- cipal or interest payments since it started its lending operations in 1986. F. Environmental Impact 4.29 While Shanghai has major problems of environmental pollution, the project subsectors are not major contributors to Shanghai's environmental problems. It should be noted, in particular, that the electronic components subsector included in the project consists only of the manufacture of passive components; it does not include semiconductor manufacturing plants which are known to be the major contributors to fluorocarbon pollution within the elec- tronics industry. However, there are some environmental issues in the project subsectors, such as the use of electroplating and disposal of acids and wastes. These would be addressed in the project through the arrangements summarized below. 4.30 The Shanghai Environmental Protection Bureau (SEPB) has confirmed that all the subsector enterprises involved in the project must comply with  - 34 - its guidelines. SEPB would approve their renovation and expansion plans and would periodically monitor their compliance. Moreover, as part of the invest- ment approval process in Shanghai, SEPB would routinely be involved in approv- ing all feasibility reports for subprojects under the loan, i.e., clearance by SEPB is required before any subproject can be financed by the PFIs. In par- ticular, SEPB would require that all subprojects in the subsectors to be financed under the Bank operation include adequate expenditure for controlling environmental pollution. For each feasibility report, SEPB would review the environmental provisions to ensure that they meet China's environmental stan- dards, which are adequate for the project subsectors. It would also ensure that the subproject's sponsoring factory is in compliance with those stan- dards. 4.31 Bank staff have determined that SEPB has the capability and staffing to monitor the environmental aspects of the project effectively. During nego- tiations, assurances were obtained that the PFIs will not approve any subproj- ect for financing until: (a) the subproject is approved by SEPB and meets prevailing environmental guidelines; and (b) the existing operations of the subproject's sponsor are in compliance with SEPB's environmental standards. The approach to addressing the environmental issues in the project will be complemented by the Bank's Shanghai Sewerage Project (Loan 2794-CHA and Credit 1779-CHA) which addresses industry-wide environmental issues in Shanghai. The focus in that project has been to install sewer interceptor and collection systems to reduce organic pollution loads into the most heavily polluted sec- tion of the city draining into Suzhou Creek.  - 35 - V. THE LOAN A. Lending Arrangements and Terms 5.1 The People's Republic of China (PRC) will borrow the proposed Bank loan of $150 million, and pass it on to SMG on terms and conditions satisfac- tory to the Bank. SMG will make available the loan proceeds to the PFIs under Subsidiary Loan Agreements with each. The initial allocation of the loan proceeds among the PFIs is based on a proration of the estimated foreign cur- rency costs of the project. This allocation is presented in Table 5.1 below. This initial allocation is subject to change during project implementation. Funds may be reallocated from one PFI to another subject to Bank approval, depending on the progress made by each PFI in committing its allocated share of the loan proceeds. Table 5.1: INITIAL ALLOCATION OF LOAN PROCEEDS AMONG THE PFIs (S million) PFI Amount BOCOM 22.0 CIB 27.8 ICBC 42.0 SITCO 27.0 PCBC 31.2 Total 150.0 5.2 The PFIs will onlend the Bank's funds to finance eligible subproj- ects in the four subsectors (para. 4.8). The Bank will sign a Loan Agreement with the PRC, a Project Agreement with SMG, and a Financial Intermediaries Project Agreement with the PFIs. Approval of the Loan Agreement by the PRC's State Council and signing of the Subsidiary Loan Agreements satisfactory to the Bank will be conditions of effectiveness of the loan. 5.3 SMG will lend the funds to the PFIs on the same terms as the Bank's loan to the PRC. These terms include a 20-year maturity, with five years' grace, at the Bank's standard variable interest rate. For loans made by PFIs, the maximum maturity would be 12 years, including a grace period of up to three years. The PFIs would charge their borrowers an interest rate equal to the Bank's standard variable interest rate plus at least 1.25 percent. The PFIs' spread is considered adequate to cover their administrative costs, risks and a reasonable profit margin. The PFIs would handle the foreign exchange risk of the Bank's currency pool in one of two ways: (a) they would pass on to their borrowers the entire foreign exchange risk of the Bank's currency pool, or (b) the PFIs would pass on most of the foreign exchange risk through a scheme where they would lend in a three-currency basket (US Dollar, Japanese Yen and German Deutsche Mark), in order to improve the transparency and pre-  - 36 - dictability of the final borrower's nominal debt service payments. This bas- ket would very closely track the Bank's new targeted currency pool; hence the residual foreign exchange risk to the PFIs under this scheme would be small and could be covered by charging their borrowers an appropriate premium. The PFIs intend to consider this second option only for subloans made with roll- over funds (i.e., funds arising from repayments on the initial set of subloans made by the PFIs). 5.4 The PFIs would lend Bank funds for either "investment' subloans or "technical assistance" subloans. Investment subloans would fund goods, related services and technology transfer for subprojects to be appraised by the PFIs. The free limit for investment subloans will be $3 million. In addition, each PFI's first two investment subloans below the free limit would be submitted to the Bank for approval. The maximum subloan size will be $20 million. Any subloan above this amount will be subject to approval by the Bank on an exceptional basis only, and Bank staff may directly participate in appraisal of the subproject, together with PFI staff. Based on the current investment pipeline, however, no subloans above $20 million are expected. Technical assistance subloans will finance all consultants' services, computer equipment and training that are not tied to specific investment subprojects (para. 4.5). All technical assistance subloans will be presented to the Bank for approval. The last date for submission o.' all subloan applications will be December 31, 1993. The expected project completion date is December 31, 1995, and the closing date of the loan will be June 30, 1996. During negotia- tions, assurances were obtained from PRC, SMG and the PFIs on the above lend- ing arrangements and terms. B. Procurement 5.5 For goods and related services, individual contracts over $1 million will be awarded after international competitive bidding (ICB) is carried out according to Bank procurement guidelines. Only two or chree contracts are expected to exceed $1 million. Local bidders would be granted the standard margin of preference, equal to customs duties and other import taxes, or 15 percent of c.i.f. cost, whichever is lower. Contracts below $1 million would be awarded after a comparison is made of quotations solicited from at least three qualified suppliers from different countries. Items of a prop::i- etary nature or spare parts may be procured through direct contracting. Since only a few contracts are likely to go out for ICB, no procurement table is given. Consultants' services during project implementation would be obtained in accordance with the Bank's Consultants Guidelines and financed out of loan proceeds. The Bank has approved SMG's request for direct negotiations between the subsector corporations and the consultants used in developing the subsec- tor strategies and development programs because the consultants have helped design the strategies to be implemented during execution of the project and are competent to undertake the task. In addition, local consultants may be contracted separately for some of the tasks covered in the TORs. During nego- tiations, assurances were obtained that each corporation would engage all the necessary consultants to carry out the work described in the terms of refer- ence (Annex 7) prior to loan effectiveness. Technology transfer, overseas training, and study tours would be subject to approval by the Bank. The Bank's standard prior review and approval procedures (from bidding documents through contract award) will be applied to all ICB contracts. All other con- tracts may be subject to post-review by the Bank, and the PFIs are to maintain  - 37 - all the relevant documents for this review. The PFIs will be responsible for supervising procurement by subborrowers. C. Disbursement 5.6 Disbursement of the loan proceeds will be allowed as follows: (a) for investment subloans, 100 percent of amounts disbursed by a PFI for foreign expenditures and for local ex-factory expenditures; (b) for goods under technical assistance subloans, 100 percent of foreign expenditures, 100 percent of local expenditures (ex-factory cost) for goods bought directly from the manufacturer and 75 percent of local expenditures for other items procured locally; and (c) for consultants' services and training under techni- cal assistance subloans, 100 percent of expenditures. Disbursements for training and study tours and for contracts of less than $200,000 each will be made against Statements of Expenditure (SOE). In the latter case, full docu- mentation will be held by the PFIs for rev.ew by Bank supervision missions. Each PFI will provide a monthly SOE to the Bank, with a copy to be kept by the PMU. 5.7 To facilitate disbursement of project funds, Special Accounts will be established on terms and conditions satisfactory to the Bank. A separate Special Account will be established for each PFI. The Bank will make a maxi- mum initial deposit in each PFI's Special Account as follows: $1.2 million for BOCOM, $1.5 million for CIB, $1.7 million for PCBC, $2.3 million for ICBC, and $1.5 million for SITCO. These amounts represent the estimated four-month average of project expenditures to be withdrawn by each PFI from the Special Account. Applications for replenishment will be submitted monthly, or when the amounts withdrawn are equal to 50 percent of the initial deposit, which- ever occurs first. Disbursements under the project are expected to be com- pleted by June 30, 1996. The estimated schedule of disbursements is given in Annex 16. It is based on the disbursement profiles of loans through financial intermediaries and other industrial loans in China, as well as the Bank's experience with industrial restructuring projects in other countries. 5.8 Eligible expenditures incurred after March 15, 1989, up to a maximum of $5 million will be eligible for financing on a retroactive basis. The majority of such expenditures will be for financing initial payments for transfer of technology, the consultants' services that are immediately needed to prepare for project implementation and for travel abroad to acquire foreign technology. D. Reporting and Auditing 5.9 Shanghai Municipal Government. SMG established a PMU, which will become fully operational under the project (see para. 4.13). One of the responsibilities of the PMU will be to monitor project implementation and forward to the Bank regular progress reports on the project and audited proj- ect accounts. The format and frequency of these progress reports were agreed at negotiations (Annex 17). The PMU, with the assistance of the PFIs, will also prepare a project completion report within six months after disbursement of the loan proceeds is completed. 5.10 Participating Financial Institutions. Each year the PFIs will pro- vide the following reports to the Bank, through the PMU: (a) statements of  - 38 - loan collection ratios on Bank subloans; (b) audit reports of the accounts of the Shanghai branches of the four banks and of SITCO; and (c) audit reports of project accounts, including Special Accounts and SOEs. The accounts of SITCO and the Shanghai branches of the four banks would include an Income Statement and a Balance Sheet, with these financial statements accompanied by appropri- ate supporting schedules and explanatory notes. In particular, (a) the Income Statement would incorporate, or be accompanied by, a Statement of Allocation of Profits that would record the distribution of profits, and (b) the Balance Sheet would be accompanied by a Statement of Changes in Net Worth that would detail the reasons for the changes in net worth (capital and retained earn- ings) from one period to the next. The audit reports of the accounts of the PFIs would be carried out by auditors acceptable to the Bank. All audited accounts and statements will be provided to the Bank within six months after the end of each institution's financial ye-.r beginning with the financial year ending 1990. The PFIs will also provide the Bank, through the PMU, quarterly reports on commitment, disbursement and procurement under each subloan. E. Benefits and Risks 5.11 Organizational and technological restructuring and policy reforms will result in greater efficiency and competitiveness in the four subsectors under the project. The strategies that have been agreed with SMG are designed to improve product quality and exports. The subproject selection criteria will ensure that investments under the project are financially and economic- ally viable and are consistent with SMG's strategy for each subsector. 5.12 The main project risks pertain to: (a) the implementation of the enterprise and policy reforms that are to be carried out at the subsector level, and (b) the timely implementation of the project. However, SMG is strongly committed to the needed reforms (para. 3.37), as reflected in the statement of their intentions (Annex 2). In addition, agreement has been reached on a framework for periodic reviews, and consultations with the Bank, on the subsector policy environment (para. 4.14). Regarding the second risk, specific agreements have been reached on arrangements for project implementa- tion, including training prior to the project, establishment of the PMU, implementation arrangements at the subsector corporations, and engaging con- sultants to provide management assistance to support project implementation.  - 39 - VI. AGREEMENTS AND RECOMMENDATION 6.1 During negotiations, assurances were received on the following con- ditions of loan effectiveness: (a) State Council to approve the Loan Agreement (para. 5.2); (b) The Shanghai Municipal Government (SMG) and the PFIs to sign Sub- sidiary Loan Agreements satisfactory to the Bank (para. 5.2); and (c) All subsector corporations to engage the necessary consultants (para. 5.5). 6.2 Assurances also were received from the PRC, SMG, and PFIs on the following: (a) PRC to: make loan proceeds available to SMG on terms and conditions satisfactory to the Bank (para. 5.1); (b) SMG to: (i) maintain a Project Monitoring Unit throughout project implemen- tation with functions and responsibilities acceptable to the Bank and with competent staff in adequate numbers to coordinate and monitor overall implementation of the project (para. 4.13); (ii) maintain a Steering Committee that would guide the work of the PMU, and annually: prepare and furnish to the Bank by April 15 of each year an assessment of policy and enterprise reforms in the project subsectors and exchange views on these assessments with the Bank (para. 4.14); (iii) ensure that financial consolidation of the new integrated cor- porations is carried out within 9 months of charter issuance (para. 4.15); (iv) ensure the availability of funds for the implementation of the project (para. 4.11); (v) ensure that overseas training under technical assistance sub- projects shall be carried out in accordance with annual pro- grams acceptable to the Bank and provide to the Bank for con- currence, by September 30 in each year, the proposed training program for the following year (para. 4.5); and, (vi) meet reporting and auditing requirements (paras. 5.9 and 5.10). (c) Each PFI to: (i) onlend to subborrowers on terms and conditions acceptable to the Bank (para. 5.3);  - 40 - (ii) ensure that all subprojects to be financed under project meet the agreed eligibility criteria (para. 4.8); (iii) seek Bank approval of the first two investment subloans below the free limit and all technical assistance subloans (para. 5.4). (iv) meet reporting and auditing requirements (paras. 5.9 and 5.10); and (v) be allowed to use the proceeds of the loan for this project to finance subprojects in other industrial subsectors as agreed betwee,. the Bank and SMG on the basis of agreed development strategies to be prepared by the municipality (para. 4.10). 6.3 During negotiations, understandings were reached on appropriate transition periods for the subsector corporations (para. 3.39). In addition, SMG's official statement of its develupment program and strategy for the project subsectors was received during negoti&- ions and found acceptable to the Bank (para. 3.36). 6.4 With the above conditions and assurances, the proposed project is suitable for a Bank loan of $150 million, repayable over 20 years including five years' grace at the Bank's standard variable interest rate, to be made to the People's Republic of China.  ANNEX 1 - 4.1 - Page 1 CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT The Development Strategy and Policies for Shanghai's Industrial Sector 1/ Strategy for Structural Change 1. The central government aims to transform Shanghai into one of the largest economic centers on the west coast of the Pacific over the long term. Shanghai intends to specialize in the fields of industrial production for which it is best suited, in the context of an industrial sector that is trade- oriented and based on advanced science and technology. Shanghai's industrial development priorities are to: take advantage of China's opening to foreign markets by developing manufactured exports and increasing the value-added of those exports; phase out manufacturing activities that require large amounts of energy, raw materials, and land, and those that cause excessive environmen- tal damage, in favor of industries and services more suitable to Shanghai's resource endowments; improve the technological level of Shanghai's industry; build appropriate supporting infrastructu:e for modern industry; and strengthen support services for industry. Shanghai's industry will have to introduce, update and adapt technology, accelerate product innovation, restructure and rehabilitate some enterprises, introduce new activities, and reach international standards in more product groups. This strategy for structural change is consistent with the priorities adopted by the central government at the outset of the stabilization program, and therefore has not been altered as a result of that program. 2. SMG is giving priority to three categories of industry. The first of these is consumer goods and light industry. Here there are two aims: to increase exports, it will be necessary to improve product quality, modernize techniques of production, and reorganize enterprises and subsectors to raise efficiency and lower costs; and for the domestic market, it is intended to enlarge the range cf goods produced, and develop the higher quality goods being demanded in China. The second priority category is heavy industrial equipment and machinery. The aims for this area are to increase research and development efforts, standardize the electrical and mechanical industries, integrate electronic and mechanical products, and increase exports in these categories. The third category is raw materials for heavy industry where the aims are to make better use of the output of existing complexes, develop down- stream processing and moderately increase the prod4ction of some other mate- rial inputs required for the priority subsectors. 3. In addition, efforts will be made to acquire, produce or adapt advanced technology in such areas as microelectronics, optical fiber communi- 1/ The document was prepared by Bank staff based on extensive discussions of Shanghai's industrial strategy and policies, with all key agencies involved.  - 42 - ANNEX 1 Page 2 cations, bioengineering and new materials. The first goal would be to learn how to apply techniques from these areas to traditional subsectors. For exam- ple, the combination of electronics and machinery technologies could improve production efficiency and product design capability in many existing enter- prises throughout the industrial sector. 4. In conjunction with these industrial priorities, expansion of related services and infrastructure is important. Shanghai has a large popu- lation concentrated in and around the city and an intensive industrial base, as well as being an important commercial center. It needs pre- and post- production services, domestic and foreign trade services, tourism, finance, insurance, consulting and information services, postal services, telecommuni- cations, most types of transport, and real estate. The shortage of adequate infrastructure and support services for industry has been a significant con- straint on Shanghai's industrial development, but the SMG has begun to address this problem. Shanghai has emerging opportunities to provide such services for industry in other parts of China. Industrial Policies 5. Prior to the introduction of the national stabilization program in 1989, Shanghai had become a major site for the experimental introduction of reformed industrial policies, particularly in the areas of enterprise autonomy and foreign investment. The goal of these reforms was to gradually strengthen incentives for competitive behavior by industrial enterprises and shift to indirect market controls. While some caution was evident during the initial stages of the austerity program introduced in 1989, major policy changes introduced earlier have not been reversed, and in some areas that are impor- tant for the improvement of enterprise efficiency, further measures have been taken. In particular, the implementation of policies rblated to the restruc- turing, and improved competitiveness in international markets, of the four SIDP subsectors, remain a commitment of SMG and the industrial bureaus for the subsectors. These measures are setving as examples for the municipality's industrial sector. Enterprise Reform 6. Consistent with national reform priorities and progress, enterprise refo-m has become a major area of system reform in Shanghai. The aim of this refo. has been to revitalize the state-owned sector by granting enterprises greater managerial autonomy, separating ownership (of the whole people) from management, making enterprises responsible for their profits and losses, improving the business environment (especially by reducing government inter- ference in routine enterprise affairs), promoting "horizontal cooperation" among enterprises, and introducing the notion of sector management. These efforts have been buttressed by a variety of other reform measures such as those effective in the area of labor, investment, planning and the material allocation system. 7. Amon, the specific enterprise reform measures in Shanghai between 1986 and 1988 was the abolition of the administrative corporations that formed an intermediate level of control between the industrial bureaus and the enter- prises. Although many such "companies" resurfaced as subsector corporations,  - 43 - ANNEX 1 Page 3 the reformed legal entities are independent accounting units without, in prin- ciple, administrative means for controlling the enterprises. Instead they provide a variety of corporate services, such as sales and marketing, the payments for which are their primary source of income. In addition, many corporations are responsible for coordinating subsector production, but their authority over the individual enterprises, which are also independent legal accounting entities, has been limited. The resulting ambiguity meant that it has been difficult to comprehensively rationalize production processes and product lines within subsectors. This weakness is being addressed in SIDP through the formation of integrated enterprises, which is already underway. The integrated enterprises are now financially consolidated single legal enti- ties within which resources are becoming mobile. 8. An important instrument now being used in Shanghai to separate own- ership and management is the contract rebponsibility system (CRS). Since mid- 1987, 98 percent of the roughly 1,700 large- and medium-scale industrial enterprises under the jurisdiction of the Municipal Economic Commission have come under CRS, as have an additional 700 commercial er.terprises. Leasing, which is increasingly being used in other parts of China, has not been wide- spread in Shanghai. Only a few industrial enterprises, and less than 10 per- cent of commercial enterprises, have been leased. 9. The unclear ownership of state enterprises in China is arguably the most pressing problem facing the enterprise reform program. As an attempt to address this issue, the central government established the National Adminis- trative Bureau of State-Owned Property (NABSOP) in July 1988. Shanghai has established a parallel Department under the Municipal Finance Bureau for the same purpose. The Department is studying asset valuation and asset transfer, as well as the definition of the ownership function for state-owned enter- prises, and will issue policies in these fields. 10. One of the diffictulties exacerbated by unclear ownership of state assets conrerns the transfer of assets and property rights such as through mergers and acquisitions of enterprises or their parts. Such adjustment mech- anisms are necessary for the reorganization and rationalization of industrial structure. Prior to 1990, there had been a few cases of mergers in Shanghai, but these mainly involved collective enterprises or were structured as manage- ment contracts. In recognition of the importance of further improvement in this area, SMG is initiating an experiment with enterprise groups. This involves the merging of state-owned enterprises producing similar or r4lated products, or using the same sort of equipment, in order to facilitate their reaching an economic scale of production. In addition, to bring integrated financial strength into play, the larger company resulting from the merger would be allowed to own portions of other related companies to form an enter- prise group. In that case, the portion not owned by the state-owned enter- prise could be owned by collectives or other enterprises. Plans to apply this experiment in about 20 subsectors are being formulated, with four or five groups to be established late in 1990. In addition, integrated enterprises along the lines of those in the four SIDP subsectors are being established in several more subsectors, in particular in the electrical and mechanical indus- tries.  - 44 - ANNEX 1 Page 4 11. The Shanghai Office of Economic System Reform is also studying the possible wider application of the joint-stock system. So far, Shanghai has proceeded cautiously with experiments with joint stock companies. Presently there are only 11 enterprises that have issued stock. However, most of the shares are owned by the state, other enterprises and workers in the enter- prise, and are not widely traded. 12. On several of these enterprise reform issues, a study will be done in conjunction with SIDP. The study will be managed by the Shanghai Planning Economic Research Institute (SPERI) and carried out by an interagency team headed by SPERI and the Research Association of the Shanghai Office of Eco- nomic System Reform. Investment Regulation 13. Authority on many investment decisions has been delegated from the central goverrnment to SMG and Shanghai industrial bureaus. The current rules fall into three categories: (a) for foreign joint venture investments, up to $5 million requires only district or county government approval, and larger amounts require SMG approval; (b) for domestic enterprises, all new capital construction projects, regardless of size, Liust have SMG approval; and (c) technical renovation projects (those involving some demolition ard replacement of production facilities, but not a whole new plant) or Liachinery imports must have the approval of the relevant industrial bureau for amounts up to Y 3 million for light industry and up to Y 5 million for heavy industry, and SMG approval up to Y 30 million. For all types of domestic enterprise investments, amounts over Y 30 million require central government approval. Enterprises can spend on technical renovation up to Y 50,000 (or Y 100,000 in some cases) without external approval provided they have sufficient retained earnings to cover the outlay and require little or no new bank credit for the project. For larger technical renovation projects, even if the enterprise has adequate retained funds to cover the full cost, industrial bureau approval must be sought. In all cases, approval is more difficult to obt&in for investment spending not anticipated in previcusly agreed long-term plans or contracts. 14. In concert with the general tightening of investment controls in China under the stabilization program, some retrenchment in the liberalization of investment controls occurred; however, these and other limits have not been changed in the past year and further relaxation is expected now that macrosta- bilization has been largely achieved. New central government regulations do restrict the expansion of industrial activities that create large amounts of pollution, or are judged excessively intensive in energy and raw material use, and require review of proposals in these fields by several government agencies at the level of government with approval authority for the investment pro- posed. In addition, project proposals for new small factories, in product groups for which economies of scale are important, are being reviewed by sev- eral levels of government, including the central government. Price Policies 15. Although general guidelines for pricing policies in China are set by the central government, few specific product prices are set centrally. These  - 45 - ANNEX 1 Page 5 are typically the prices of standard products and commodities used throughout the country. Products with a smaller market range have prices or instructions for pricing issued by the municipal government. The Shanghai Price Bureau has delegated pricing for many products to the enterprises, but retained the prac- tice of monitoring them regularly. Often the Price Bureau sets a guideline price for a basic product, and allows enterprises to set their price for simi- lar products within a prescribed range of guideline price. For example, for heavy industrial products, prices must be wlthin 20 percent of the guideline, and for electrical and mechanical intermediate goods, the range is typically 15-20 percent. For output beyond planned production targets, enterprises set their prices, subject to review by the Shanghai Price Bureau (or a central government bureau if the product is under central jurisdiction). 16. Regardless of the authority required, prices usually are set to cover costs, which is a disincentive to greater efficiency and cost savings. SMG has stated that it intends in the medium run to continue gradually freeing prices within its jurisdiction from administrative control as competition strengthens; however, in 1989 this process was temporarily slowed as a conse- quence of the continuing efforts to reduce inflation. Price increases have been recently authorized for some enterprises suffering financial losses as a result of input prices having risen more steeply than output prices during 1989 and early 1990. Most products within plan targets for output volume continue to be free to fluctuate within prescribed ranges. Enterprises still have the freedom to set market prices for new products involving technologi- cal, quality or design improvements, although these prices are reviewed by the Shanghai Price Bureau (or a central government bureau if the product is under central jurisdiction). Trade Policy 17. Foreign trade reform began in Shanghai in 1979, as part of China's policy of opening to the outside world. A general thrust of this reform has been the separation of the functions of government and enterprises and greater delegation of autfority to the enterprises. A single municipal trade depart- ment, the Shanghai Foreign Economic Relations and Trade Commission (SFERTC) was consolidated in 1984. It administers foreign trade through macroeconomic policies, coordination of import and export plans, approval of import and export licenses on behalf of the .Ainistry of Foreign Economic Relations and Trade (NOFERT), and approval and allocation of import quotas. 18. The number of channels for foreign trade has been increased. The first foreign trade corporations (FTCs) were established in 1980 for groups of industrial enterprises. Some national trading companies established special- ized local branches. Several forms of foreign trade organization have been established, to encourage integration between industry, technology development and trade, as well as direct contact between foreign buyers and industrial enterprises. There are now 20 branches of national FTCs in Shanghai, and 115 other entities with foreign trade rights. The latter group includes FTCs run by Shanghai's industrial or science and technology departments, eight large enterprises with direct trading rights, joint ventures between FTCs and enter- prises, and two trading companies. Shanghai has established 20 export agency offices in major overseas markets to promote sales there. In addition, various  - 46 - ANNEX 1 Page 6 specialized companies were established for advertising, export inspection, insurance, freight, transport, and other services. 19. The agency system, which is used for almost all imports, is being applied to exports as well. Until mid-1988, most industrial exports from Shanghai were handled by trading companies purchasing goods from the enter- prises and then selling them abroad on their own account. Under the agency system, the trading company handles the settlement and may facilitate the sale for a fee, but the enterprise is allowed contact with final customers and export market conditions. By the end of 1989, approximately one-third of Shanghai's industrial exporters had been shifted to the agency system. This number includes most textile- and garment-export enterprises, as well as some enterprises that export mechanical and other products. The results of this change have been encouraging, and the wider application of the agency system was undertaken in 1990. In addition, the number of firms with direct import and export rights was targeted to double from 50 to 100 during 1990. 20. During the last few years, several export incentives have been introduced: allowing enterprises greater retention of foreign exchange earn- ings; rewarding enterprises that fulfill their export quotas; and inst.tuting incentive payments of Y 0.02 per dollar of exports under the mandatory plan and Y 0.30 for above-plan exports. The directors of FTCs have been given greater responsibility, and their staffs and management receive bonuses related to export earnings. The devaluations of 1989 and November 1990 have also helped in this regard. 21. Shanghai is considering making further trade policy changes in at least three areas: (a) granting greater direct import rights for exporting enterprises within the municipality to ensure the availability of suitable materials and semifinished products; (b) approving direct export rights for more large- and medium-sizvd firms; and (c) improving export incentives and their administration. Two important incentives are allowing firms the use of larger portion of their foreign exchange earnings, and enabling them to buy and sell foreign exchange at market rates. _4nancial Intermediation 22. Central and municipal government measures have increased the range of financial instruments and number of financial institutions in Shanghai. The Bank of Communications was reestablished with its headquarters in Shanghai. This has increased the competition between Shanghai's financial institutions, which could contribute to better services for industrial borrow- ers. Shanghai now has a small primary securities market. An interbank money market was recently introduced. Two foreign exchange adjustment centers on which certain enterprises may trade at free market rates were established in 1987. Consideratio- is being given to expanding the scope and depth of these markets; improved means of supervising and regulating them are being studied. Foreign Investment 23. The Shanghai Municipal Government is actively encouraging foreign investment as a means of bringing in sophisticated technology, gaining access to export niarkets, and developing local supplier industries. In June 1988,  ANNFX 1 Page 7 the Shanghai Foreign Investment Commission (SFIC) was established to serve as the single municipal government office that a foreign company needs to contact in order to set up and run a business in Shanghai. In 1990, SFIC was brought into SFERTC to strengthen SFIC's authority of other parts of the municipal government. The SFIC approves foreign investment projects with total invest- ment of between $5 million and $30 million, as well as projects in the "restricted" category under $5 million, Most projects under that limit are now approved by district and county-level government. The SFIC provides for- eign investors with administrative services and advice about the industrial policies, laws and regulations affecting them in Shanghai, and helps them during project preparation and implementation. Within Shanghai Municipality, some industrial parks have already been established to provide foreign inves- tors with appropriate infrastructure for their factories. In such parks, SMG has initiated the long-term leasing of land to foreign firms on a trial basis. A large new industrial zone is under development in the Pudong district. Infrastructure and services are being designed to attract foreign investment, and SMG has begun active promotion abroad for the scheme. Technology Policy 24. Shanghai has drawn up a Science and Technology Development Plan for industry. This plan sets objectives for the renovation of traditional indus- try and new industrial development. According to this plan, projects funded by the Science and Technology Commission will ie divided into two categories: basic theoretical study and development of applied technology. The latter projects are now decided by the Economic and Science and Technology Commis- sions jointly according to their likely industrial usefulness and economic benefits. Research institutes receive rewards once technology they have developed is used by an enterprise, and may sell technology. They may also receive development funds from enterprises. For certain key projects, the government will give low interest loans to support research in both the insti- tutes and enterprises. Funds availab'e for science and technology with indus- trial applications are being concentrated in priority subsectors. The Science and Technology Commission recently established a department of new technology diffusion to help transfer technology from research institutes to enterprises, by setting up meetings and exhibitions, and providing specialized library, data bank and information exchange services. 25. With the exception of some large units, enterprises have not been able to do adequate research and development themselves dup to shortages of funds and personnel. To address these problems, under the contract system, firms may now negotiate that 1 percent to 2 percent of sales be retained for research and development purposes. Enterprises may hire some university and research institute personnel as consultants, or make contractual arrangements for joint research. The SMG will expand these arrangements to encourage prod- uct and technology development in Shanghai's enterprises. Location Policy 26. Many enterprises in Shanghai are crowfded in old buildings in con- gested parts of the city. This has several disadvantages. It makes it diffi- cult for raw materials to be transported to the factories, and for the finished goods to be shipped out. Expanding or modernizing manufacturing  - 48- ANNEX 1 Page 8 facilities, to include long assembly lines and a continuous flow of goods in progress, is difficult, since several floors of the same building or even several small buildings may house different stages of a production line. It is also difficult to keep some buildings clean, due to their open construc- tion, the air pollution from surrounding industry and traffic, or the large number of industrial plants relying on the same source of water for production needs or as a waste repository. Cleanliness is important for meeting interna- tional quality standards in many modern industries, such as pharmaceuticals and electronics. The densely industrialized parts of the city are unpleasant and sometimes unhealthy for nearby residents. 27. In recognition of these problems, the SMG is planning the location of factories taking into account the restructuring and expansion of the physi- cal facilities necessary for producing good quality products at competitive prices, as well as the costs of providing appropriate space, transport access, waste treatment, and other infrastructure in different locations. A zoning system has been introduced for the city proper as well as surrounding counties and satellite towns. Under this system, new enterprises will be authorized to set up factories and other facilities only in zones designated for their type of industrial activity. The movement of existing enterprises presents diffi- culties, though, because the land market is limited and experimental, and factories and workshops usually are moved in accordance with SMG's assignment of new space. Also, employees cannot easily move to new locations. While the employee of the relocating enterprise would be given a residence permit for the new area, other working members of the family would not. 28. The zoning system also designates areas where heavily polluting firms may locate, but in tandem with this, SMG has a system of fines charged to violators of the municipality's environmental code. However, the fines do not appear to be high enough to enforce compliance. Moving polluting firms may not resolve all the pollution problems if the new locations outside the city are no better equipped to clean air and water or dispose of waste than is the city. Labor Mobility and Incentives 29. The Shanghai government recognizes that restructuring the industrial sector will involve redefining some jobs, teaching workers new skills, hiring staff with different skills than those of current employees, moving employees from firm to firm, and reducing the number of employees in some enterprises or production lines. Several schemes have been introduced to facilitate this adjustment. Employment contracts have been introduced and must be used for all newly hired workers. The contracts last for one or several years and when they expire neither the enterprise nor the worker is obliged to renew the arrangement. Retraining programs have been established in some enterprises, to teach workers how to use new techniques of production. For some senior and skilled workers, industrial bureaus are organizing retreining. Since most enterprises have gained responsibility for selling their output, they are training some of their employees for sales jobs. Under the Labor Bureau's guidance, enterprises are establishing job definitions and standards to encourage evaluation of employees' performance and fairer competition for positions.  - 49 - ANNEX 1 Page 9 30. Until recently, the enterprises in Shanghai paid pensions to their own workers upon their retirement. This placed a cost burden on older enter- prises, which have a lower ratio of active to retired workers than new compe- titors. In addition, workers were reluctant to move between firms since this would result in loss of pension benefits. To address these problems, the Shanghai Labor Bureau has established the Consolidated Retirement Pension Funds (CRPF), which will pay the pensions of all retired industrial workers in Shanghai. All enterprises are required to contribute an amount equal to 25.5 percent of employee salaries to the pension fund, and employee pensions will be paid by the CRPF from 1989 onward. 31. Another recently established organization under the Labor Bureau is the Labor Services Company (LSC). The LSC pf lorms several functions that contribute to labor mobility. It finds jobs for contract workers when their contracts expire and helps recent graduates search for jobs. It also keeps a registry of unemployed people seeking jobs, and pays some compensation to those people who were released involuntarily from their enterprises until jobs are found for them (or a maximum of two years). For peop._ who have worked more than five years, unemployment compensation is 60-75 percent of the previ- ous salary for the first year, and 50 percent for the second. For people with less than five years work experience, unemployment compensation is 50 percent of the previous salary for one year.  - 50 - ANNEX 2 Page 1 CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Statement of Shanghai Municipal Government on the Development Program and Strategy for SIDP Subsectors _/ Introduction 1. Shanghai Municipality, which has provincial status, is the spcond largest province in China measured by industrial output value. However, in spite of its strong industrial base, Shanghai is facing increasing competition domestically while also being squeezed on the availability of raw materials and energy and saddled with outmoded manufacturing technology, deteriorating infrastructure and a scarcity of land for expansion. Even though it has lim- ited raw materials, energy and land, Shanghai has a strong base of hurnan resources and research and development compared with the rest of China. 2. Important elements of Shanghai's industrial strategy are to: (a) improve the organization and management of its industrial sector; and (b) move into higher value-added activities and subsectors which are more technology-intensive, and less polluting, and energy and raw material inten- sive. One of the areas within Shanghai's industrial sector that is being given priority under this strategy is industrial machinery and equipment. In this field, the goals are to upgrade technology, improve production efficiency and product quality in the electrical and mechanical industries through greater product standardization, integrate electronic and mechanical products, and increase exports. Four important subsectors in the field of industrial machinery and equipment are electrical apparatus, electronic components, pre- cision and scientific instruments, and printing machinery. These four subsec- tors would be assisted by the proposed Shanghai Industrial Development Project (SIDP). 3. In connection with the SIDP, SMG is undertaking new initiatives for enterprise reform, policy adjustments and industrial restructuring in the four subsectors. These measures are intended to provide an appropriate industrial structure and policy framework for the organizational, managerial and techni- cal improvements to be implemented under SIDP. TIe goal of these improvements is to raise e.ficiency, growth and competitivenes., consistent with Shanghai's industrial development strategy. The measures and achievements in these four subsectors will serve as examples for reforms elsewhere in the industrial sector. This statement sets out SMG's intentions with respect to the enter- prise reforms, policy changes, and strategies to be implemented under SIDP. 1/ This a translation of an official statement that was issued/adopted by the Shanghai Municipal Planning Commission on May 16, 1989.  - 51 - ANNEX 2 Page 2 Enterprise Reforms 4. Enterprise reforms are needed in the four subsectors to adjust their structure and management mechanisms to the increasing competition they now face. Each of the four subsectors is comprised of independent but subopti- mally sized factories with many overlapping products and duplicate manufactur- ing processes. The subsector corporations have limited control over the enterprises in the subsector and are unable to rationalize product lines and manufacturing processes. This rationalization is necessary to improve effi- ciency, produce higher quality goods that match the demands of domestic and foreign markets, and control the costs of production. 5. To facilitate industrial restructuring and factory rationalization, SMG will implement enterprise reforms in all four subsectots. An integrated corporation will be legally established in each of the four subsectors. This will be reflected in a legal charter for the integrated corporation that will define its structure, composition, rights and obligations, and the means by which these may be amended in the future. 6. The integrated corporation. will be legal entities, responsible for their own profits and losses. They will be financially consolidated, and assume debt and tax obligations as single units. They will exercise certain rights, including export and foreign exchange retention, as single units. Within the corporation, all resources, including employees, materials and equipment, may be reallocated between factories and divisions by the corpora- tion's management to facilitate the needed rationalization of product lines and manufacturing processes. 7. Each integrated corporation will consist of some, but not all, of the factories in the subsector as of January 1989, as well as the subsector corporation of that date. Each integrated corporation will ini-ially include only those factories and support services necessary for the efficient manufac- ture of the priority product groups. Those formerly separate factories will lose their status as independent legal entities after a transition period during which the consolidation of the integrated corporations would be com- pleted. The financial consolidation, and consolidation of contract responsi- bility system agreements currently outstanding, will be implemented as soon as possible. 8. Although some factories within each subsector will not initially be included in the integrated corporation, they will continue to operate indepen- dently within the same bureau, and the integrated corporation would maintain supply contracts with them. In each subsector, there are some factories, such as foundries, which supply critical components to manufacturing processes in the subsector. They will be included in the integrated corporation at this stage, but may become independent of corporation later. Other factories may be acquired by or merged with the integrated corporation in the future. The decision to acquire or merge will be based on consideration of the technical and economic efficiency of the factories to be merged and their impact on the integrated corporation. 9. The internal organization of each integrated corporation will include a corporate headquarters, business divisions, and factories, as well  -52 - ANNEX 2 Page 3 as research institutes. The divisions and factories in each integrated corpo- ration are listed in their charters. Each integrated corporation's headquar- ters will be responsible for setting company-wide policy, implementing the investment strategy, managing finances, developing exports, purchasing bulk raw materials, managing research and development, and coordinating the busi- ness divisions under it. Each integrated corporation will have several busi- ness depending on need. The business divisions are based on product groups with common technology and markets. Each business division will operate as a profit center, responsible for product development, production, marketing and sales. Each division will include one or more factories, which will be cost centers as will the research institutes belonging to the integrated corpora- tion. Policy Adiustments 10. Exports by the four subsectors should gradually move from the pur- chase to the agency system, then to direct exports, following relevant state rules. The integrated corporations will initially use the agency system for exporting. Under the agency system, joint office of corporate staff and for- eign trade company staff will be established. This arrangement will facili- tate both the training of corporate trade staff and direct contact between the corporation and overseas clients. For example, corporation staff would par- ticipate directly in export transactions such as negotiations, quoting prices, etc. The goal is to allow the integrated coroorations direct export rights once they have built up trained staff and demonstrated their ability to take responsibility for financial risks associated with exporting. Annual reviews of each integrated corporation's progress will be carried out to review their ability for direct export. 11. Each integrated corporation will be allowed to use retained foreign exchange earnings to service its foreign debt and import critical raw materi- als for its operation. In addition, the corporations will be allowed to buy foreign exchange, as available at the Foreign Exchange Adjustment Centers should their export earnings be inadequate to cover their debt service obliga- tions and meet other needs. If they earn more foreign exchange than they need, they should be able to decide on their own whether or not to make advance repayments of subloans under the SIDP. 12. The enterprise reforms and policy changes presented above will be monitored closely during project implementation. SMG has established a project monitoring unit (PMU) that will coordinate and monitor all SIDP- related activities. The work of the PMU will be guided by a Steering Commit- tee to be appointed by SMG. A study under the management of the Shanghai Planning Economic Research Institute (SPERI) will monitor the impact of policy change on the perforimance of the subsectors, in coordination with the Bank's supervision of the project. These organizations will review regularly with the Bank the implementation of enterprise reforms and policy changes. Owner- ship and management functions should be separated. The industrial bureaus and other SMG agencies would play a strategic role in the corporations, but would not participate in their day-to-day management and operations. One such mechanism is the board of directors, which could include representatives of the government and have the responsibility to define corporate strategy.  - 53- ANNEX 2 Page 4 Product and Market Strategies 13. Each integrated corporX 'on has adopted a focused product and market strategy based on priority products, i.e., those with the greatest potential to compete successfully in domestic and foreign markets. The product and market strategies for each subsector are presented ir. the following para- graphs. 14. Electrical Apparatus. The product and market strategy to be adopted by the integrated corporation is aimed at maintaining and strengthening the leader hip position in component and systems products, building up electronics capability for application in the electrical apparatus business and strength- ening its marketing and sales capabilities by unifying the marketing function, setting up nation-wide sales and service centers and establishing a corporate brand. The export market strategy is to focus on promising independent stan- dard components and dependent standard subcomponents. These are product groups where low labor and overhead costs give Shanghai's products a competi- tive advantage in overseas markets. 15. Electronic Components. For electronic components, the product strategy will focus initially on a group of priority products currently pro- duced, and facing healthy market demand with opportunity for growth and gains through technological improvement. These products include capacitors, resis- tors, connectors, transformers and relays. The intention is to develop the capability to produce these products at lower cost by enlarging the scale of production and reaching international quality standards. This way both domes- tic and export sales are expected to increase. In addition to this strategy for currently manufactured products, the integrated corporation will develop new products in the areas of chip components and hybrid circuits. To develop these products, the corporation will acquire foreign technology. It is intended to first meet the demands of the domestic market in these fields, then export later when experience has been gained. In order to ensure the domestic market success of these products, the corporation will establislh customer support marketing programs focussed primarily on TV manufacturers and foreign joint ventures in China. To promote exports, the integrated corpora- tion will redesign some products to customer specifications in the switches and connectors, and capacitors product groups. A new organization will be established in the corporate headquarters for direct sales to OEMS, and sales through distributors in foreign markets, particularly the United States. The corporation will also seek contractual relationships with foreign producers to build up future export markets. 16. Precision and Scientific Instruments. The strategy that will be adopted by this subsector's integrated corporation is to reduce unit costs and raise quality to gain a greater share of domestic and foreign markets. The corporation will concentrate on seven products in three groups: (i) chromato- graphs and spectrophotometers in analytical instruments; (ii) microscopes, optical elements and optical meteorological equipment in optical systems; and (iii) balances and related items in physical and general purpose environmental instruments. The strategy for this subsector has five elements: (i) improve design and quality, and integrate new technologies into priority products; (ii) rationalize and consolidate priority factories; (iii) introduce modern management practices; (iv) improve marketing channels; and (v) train and rede-  -54 ANNEX 2 Page 5 ploy staff. The domestic market strategy will focus on major local distribu- tors, key customers, and joint ventures companies in China. The export strat- egy will focus mainly on using OEMs for components of spectrophotoineters and optical systems and using distributors for microscopes and general purpose instruments. 17. Printing Machinery. The subsector falls into three product groups: large presses, small- and medium-sized presses, and post-press equipment. For the large presses, the strategy adopted is to increase production of web presses and high and low-speed models of multicolor sheet-fed offsets. For multicolor sheet-fed offsets, the first phase will be adapting advanced tech- nology from abroad to suit domestic needs. For small- and medium-sized presses, there will be a gradual shift in demand away from letter presses to sheet-fed offsets. For this reason, equipment purchased for letter press production to meet increasing demand in the short run will be reoriented for offset production later. Also within the small- and mediumr-sized press group, duplicators will continue to be a priority product due to their continued strong demand. For the post-press equipment, where Shanghai already has a strong national market position and there are good prospects for continued demand growth, emphasis will be on increasing output and upgrading quality, enhancing capacity for developing new products, and forming economies of scale. For promoting exports, the strategy involves different approaches to Asian and Western (European and North American) markets. For Southeast Asian markets, the integrated corporation will seek reputed sales and service agents. For Western markets, it will seek joint production agreements with those foreign companies that already have technology transfer arrangements with the enterprises to be included in the integrated corporation. Conclusion 18. This above statement outlines the reforms, policies and product and market strategies being implemented by SMG for four subsectors--electrical apparatus, electronic components, precision and scientific instruments, and printing machinery. SMG is seeking World Bank support under the proposed SIDP to implement these measures.  55 ANNEX 3 Page 1 CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Shanghai E'ectronic Components Subsector 1/ Background and Organization 1. China's electronic components industry originated in Shanghai in 1924. At that time, the first electronic company (Ya Mei Ltd.) was set up to produce simple communication components. Up until 1949, the industry consis- ted of 70-80 small companies employing about 1,000 people. After 1949, the industry u,nt through three transitions in the 1950s, 1960s and late 1970s. In the 1950s, the small-scale passive components manufacturers, which by then had grown to about 300, were reorganized into several manufacturing factories. In 1960, these were again reorganized as eleven factories specializing in components for the radio industry, and later for the TV industry. In late 1970s and early 1980s, collectively-owned components manufacturing factories were integrated into the subsector, creating a diversified structure of small, medium, and large companies. During this period the technological foundation of the subsector was strengthened with imported product and manufacturing technologles. In 1985, an Electronic Component Research Institute was estab- lished to serve as the center of technical development, application engineer- ing, and quality assurance for the subsector. 2. In March 1989, the electronic components subsector consisted of 24 factories, of which half were state-owned, and half were collectives. The factories employ more than 27,000 people. Attachment 1 shows the main fea- tures of the factories. The aggregate value of the net fixed assets in 1988 was Y 180 million ($49 million) and the value of sales in the same year was Y 535 million ($145 million). The subsector produces a wide variety of pas- sive components: passive devices (capacitors, resistc. s/potentiometers); elec- tromechanical (connectors, switches) and electromagnetic (inductors, trans- formers, relays) products; and acoustic assemblies (speakers, microphones). In 1989, the industry met 8 percent of the nation's demand for electronic components; the domestic television industry was the dominant user. Exports of the subsector in 1990 were approximately Y 34 million ($6.4 million), rep- resenting 8 percent of the value of component production in Shanghai. 3. The organization of the subsector at appraisal is presented in Attachment 2. Within the Shanghai Municipal Government (SMG), the Shanghai Instrumentation and Electronics Bureau (SIEB) is responsible for overall development of the electronic components subsector. Since the mid-1980s, a program of enterprise reforms has been implemented gradually to separate the functions of regulation, ownership, and management. During 1987 and 1988, old administrative corporations were abolished in Shanghai. The remaining corpo- rations took on a coordination and support role without having clear .esponsi- bilities or financial authority. In line with this change, the role of the 1/ The subsector includes only passive components.  - 56 - ANNEX 3 Page 2 Shanghai Electronic Component Corporation (SECC) became support to SIEB in coordinating the subsector. The factories under SIEB became self-sufficient and operated quite independently. By the end of 1988, each of the 24 facto- ries in the subsector was a single profit center, responsible for its own business functions, planning, marketing, production and finance. The facto- ries varied widely in size and capability. None was of economic size by international industry standards and there was a great deal of overlap in products and production capabilities. Furthermore, the marketing function was seriously underdeveloped in all the factories; none had a credible export market capability. There were still multiple layers of external control, unclear roles and responsibilities, and less defined accountability for the corporation and factories vis-a-vis one another. Given these organizational constraints, the industry needed to be restructured to attain greater competi- tiveness. Performance of the Subsector 4. Between 1983 and 1989, the sector in Shanghai achieved a growth of only 5 percert per year compared to the national output growth of 22 percent per year. The following table shows the development of major product groups over this period. SHANGHAI: ELECTRONIC COMPONENTS SU8SECTOR PRODUCTION (Y MliliIon) Average annual growth rate Product group 1983 1984 1986 1988 1987 1988 1989 1983-87 (X) Resistors and Potentiometers 81.8 40.0 44.5 46.6 52.6 68.8 S0.1 8 Capacitors 70.7 89.8 90.7 89.8 89.2 77.S 78.2 6 Switches/ Connector* 41.6 42.8 40.6 41.8 68.8 45.2 88.6 -1 Acoustic Assemblies 48.1 44.3 40.6 41.8 62.9 65.0 66.0 4 Inductors/ Transformers 8.6 4.1 4.9 26.2 19.4 18.2 18.9 26 Relays 18.4 28.4 44.0 3a.6 44.0 48.6 60.6 18 Others 116.6 78.0 77.4 81.4 10.2 189.7 108.6 -1 SECS Production 825.7 307.0 348.8 86e.7 437.1 483.8 435.0 6 Nationwide Production 1,761.2 2,297.6 2,790.3 3,031.9 4,366.7 5,661.4 6,903.6 22 Percentage of SECS Production 18.6 13.4 12.6 12.1 10.0 8.6 7.4  - 57 - ANNEX 3 Page 3 Although the growth rate of most of the individual product groups in the table appears to be reasonable over the period, each one lags behind national growth for the group. No individual product within each product group dominates the production of output. The share of the subsector in the nation's output has declined continuously from 19 percent in 1983 to 7 percent in 1989. The sub- sector's profitability also has declined, from 40 percent of sales in 1983 to 18 percent in 1989. The subsector has not kept pace with the market growth. To increase the subsector's competitiveness, product specialization needs to be increased, quality to be improved, and a better quality/price ratio to be attained. These changes are addressed as part of the subsector restructuring. Market Development 5. The market for electronic components in China is very large and has grown over 20 percent per year since 1983. All the major product groups shared in this overall high growth, except for relays. Domestic manufacturers are the major suppliers of the domestic market. Within the domestic market passive components are sold directly to end-users. The market is dominated by constmer electronics, particularly the television industry which grew by about 52 percent per year between 1983 and 1987, before slowing at the end of the decade. The rest of the market is shared by telecommunications, computers, and other products. Imports and exports both have been low. Imports are tightly controlled by the government: only high-technology electronic compo- nents designated for specified user industries are permitted and very few electronic components that might compete with domestic production are allowed. Maximum imports ($113 million) during rhe last five years occurred in 1986 (12 percent of the total consumption). Exports amounted to only Y 105 million ($28 million) in 1987, 2 percent of domestic production. Continued rapid growth in all major product groups is projected for the future. In addition to products employing existing technologies, some new higher-technology prod- ucts such as chip components and hybrid circuits will enter the market. A temporary slowdown in growth during 1989 and 1990 resulted from government reEcraints on consumer electronics. Nevertheless, annual growth of over 25 percent is estimated during 1987-93. 6. Although Government regulations do not allow much import competi- tion, there is strong competition among domestic manufacturers. The Shanghai industry lost its market leadership to Jiangsu province in the 1980s, as shown in the following table. Shanghai now does not lead in any major product group.  58 - ANNEX 3 Page 4 CHINA: MARKET SHARE OF DOMESTIC COMPETITORS (X) 1983 1984 1985 1986 1987 1988 1989 Shanghai 25 22 20 17 10 9 8 Jiangsu 20 20 20 22 30 25 23 Guangdong - 3 5 8 10 14 19 Beijing 15 15 10 7 4 6 6 Others 40 40 45 46 46 45 45 In almost all product groups, Jiangsu manufacturers have competed aggres- sively, outgrowing the market on selected products such as capacitors, resis- tors, transformers, and developing new products. Guangdong is another compe- titor whose market share has grown rapidly. It is following an approach simi- lar to that of Jiangsu and now has matched Shanghai in the second place. Jiangsu and Guangdong have succeeded because of their greater degree of prod- uct specialization. This is reflected in their high share of top three prod- uct groups in the total output--70 percent for Jiangsu and 90 percent for Guangdong compared to 50 percent for Shanghai. Domestic users attribute the success of Jiangsu and Guangdong succest to high quality, better service, flexible technical adaptation, and competitive prices. The Shanghai subsector must reorient itself to respond to these needs of the domestic electronics industry. It needs to improve product quality, focus resources on selected products, develop new products and features, improve the qualitylprice ratio, and reorganize for faster growth. 7. Globally, the market for electronic components is very large but has grown rather slowly over the past few years. Industrialized countries consume about $30 billion of electronic components, and United States accounts for 50 percent of this market. US consumption also leads in almost all product groups. The large markets have a very high import propensity. Of the total $4 billion of components imported in these countries, the United States alone imports over 50 percent. Capacitors, relays, connectors and acoustic assem- blies account for 80 percent of US imports. Developing countries have managed to penetrate the import market in these countries, especially in the United States, even with high technology products. For example, one third of US imports of electronic components comes from less developed countries (LDCs). Even the share of imports into Japan and the EEC from LDCs is increasing. So far, neither China nor the Shanghai subsector has any significant role in export markets largely because of their variable quality of goods and poor service levels. In 1987 China's exports were Y 105 million; of this Shanghai contributed Y 26 million (25 percent). A large portion of these exports are at the very low end, for example to the toy industry. Although Shanghai's exports rose to Y 34 million in 1990, they remained concentrated among low-end products. In order for the Shanghai subsector to penetrate foreign markets, it must adopt flexible market channels, supply user-oriented products, reduce product size, and meet required specification standards. Distributors play a key role in the export of components. Their share continues to grow rapidly  - 59 - ANNEX 3 Page 5 as distributors take over service requirements from suppliers. For example, in the US the top five distributors control 50 percent of the market. Dis- tributors and end users are skeptical of China's ability to deliver products in this competitive market. For Shanghai to penetrate export markets, it must reorganize to become competitive in terms of quality, price, reliability, and customer accessibility. Subsector Capabilities and Competitiveness 8. The Shanghai electronic components subsector manufactures a wide variety of products which can be grouped into eleven major product groups.2/ The subsector is capable of supplying the full range of passive components except for the more modern chip-sized components. Although the subsector possesses a good market share in some major product groups, these shares have declined significantly as shown in the table below: SHANGHAI: DOMESTIC MARKET SHARE OF MAJOR PRODUCT GROUPS (Z) 1983 1987 1989 Capacitors 10.5 6.0 5.5 Acoustic Devices 14.8 6.8 7.3 Resistors 17.8 11.3 8.9 Connectors 25.3 14.4 8.2 Others 39.0 14.0 12.0 The subsector's loss of competitive leadership and profitability is attributed to its high degree of product diversification, outmoded technologies and poor quality products. Furthermore, the subsector has not been able to develop high-technology products such as chip components, hybrid circuits, sensors, and transducers, all of which are in great demand now. Therefore, there is an urgent need to upgrade and redesign potential products, rationalize product lines to achieve better concentration, and develop products with new technolo- gies. In export markets, the subsector's product technologies at the low end of the market are comparable to those of other manufacturers and its marginal success in exports has been primarily the result of price competition. This situation will remain so for years to come, as SECC will not be able to develop technological changes. However, in order to improve exports, SECC should work on improving the quality of its products and making them consis- tent with international standards. 2/ These product groups consist of: capacitors, resistors/potentiometers, connectors, relays, magnetic devices, acoustic assemblies, photoelectric devices, micro devices, electronic ceramics, crystal products, and trans- formers.  - 60- ANNEX 3 Page 6 9. The subsector also suffers from a number of shortfalls in production structure, manufacturing technologies, production organization and management systems. Manufacturing problems in the 24 factories include subscale opera- tions, excessive overhead, poor facilities and layout, inefficient product/ production development. Product and process overlaps occur with capacitors, connectors, switches, relays and magnetic materials. Manufacturing also is hampered by poorly maintained and outdated process equipment, a major portion of which is more than 10 years old. A new operational strategy is needed to establish a structure conducive to high quality and low-cost production. 10. Low quality, irregular and unreliable deliveries of some critical raw materials (such as ceramics, aluminum foil, plastics, resistant paste) is another key issue facing subsector. An effective supply chain needs to be established to improve this situation. Manufacturing systems are another area of concern. Problems in this area include inefficient production scheduling levels, long production cycles, large buffer inventories, and poor utilization of machines. Poor-quality control systems also contribute to higher costs. A weak management information system does not permit accurate strategic decision-making by the management. Training and incentive systems also need to be improved to promote better quality and stronger operating skills. Restructuring Needs 11. Despite the constraints under which the subsector has been operating --regulatory, organizational, technological, managerial, and financial--it has made a number of accomplishments. It is an important part of the Chinese elec- tronic components industry, employs good technical skills, has developed a small export capability, and is profitable. However, the subsector still faces many obstacles: (a) lagging growth with respect to the domestic elec- tronic components industry; (b) declining market share; (c) poor product tech- nology and quality; (d) absence of modern management systems; (e) inefficient production organization; (f) declining profits, a situation that restricts funds for future investments; and (g) low export capability. An intensive restructuring of the subsector is needed to introduce a modern structure and systems, upgraded and higher technology products, and modern manufacturing techniques. These changes will allow the subsector to regain its domestic market share, build up sustainable exports and foreign exchange, and achieve high levels of profitability for future investments. A comprehensive restruc- turing plan therefore has been developed for the subsector by the SIEB and the corporation with the assistance of a reputed international consulting firm. The plan consists of changes in organizational structure, product and market strategy, and operational strategy. 12. Organizational Structure. Under the new organizational structure, SECC will become a fully integrated company of eight factories, which manufac- ture priority products that have strong potential to become competitive in domestic and export markets. The research and development institute also will be integrated into the corporation. SECC was established as an integrated company following issuance of its charter in May 1989. Financial consolida- tion of the former subsector corporation, the eight factories, and the insti- tute was done during the nine months after that. The consolidated statements for 1989 are shown in Attachment 3. By June 1991, the remaining independent legal status of the constituent factories will be phased out, so that SECC  - 61 - ANNEX 3 Page 7 will be the sole legal entity, responsible for profits and losses. The former corporation will be reorganized to manage planning, finance, personnel, and service (particularly marketing) activities. SECC will assume all debt and tax obligations as a single unit. As part of the restructuring, some opera- tional functions currently performed by the Bureau will be transferred to SECC. A Board of Directors will be established to monitor the corporation's performance and set long-term objectives and policies. Within the corporation five business profit centers will be created. These units will manufacture: capacitors/hybrid circuits; resistors/potentiometers; connectors/switches; transformers/inductors; and relays. Each business unit will have the author- ity and respoasibility to run the unit as a modern business focusing on prod- uct development, production, and marketing of products at economic scales. The remaining 16 factories will continue to operate independently under the Bureau. 13. Product/Market Strategy. The product/market strategy focuses on selected products that have clear potential to be competitive in the rapidly growing electronic components market. A two-pronged approach is adopted: (i) product quality upgrading, capacity and manufacturing enhancement, and installation of new marketing mechanisms for five existing products; and (ii) development of two product groups with new technologies. The five exist- ing products have a large potential for immediate growth, both domestically and in exports. This determination is based on a detailed analysis of the products' rmarket attractiveness, competitive position, and the ability to improve operational performance of related factories. The five products are capacitors; resistors; connectors/switches; transformers/inductors; a.ad relays. The two products to be developed are hybrid circuits and chip compo- - nts. For the domestic market, the corporation will establish strong market- ing and sales capabilities for the seven product groups. This will be done through customer support programs focused primarily on TV manufacturers and by establishing links with foreign joint ventures in China. On the export mar- ket, the corporation will design customer-specific products for switches/con- nectors and capacitors and market them for direct sales and through local and regional distributors. It will also seek to build alliances with foreign producers to bu'ld up future export markets. The subsector's product/market strategy will form the basis of investment programs in each of the five busi- ness units. 14. Operational Strategy. The success of the restructured factories is closely related to their ability to develop and manufacture products effi- ciently, at economic scale, and at internationai standards of quality, their ability to develop a strong marketing organization, and their ability to introduce effective manufacturing systems. To achieve these objectives, the following measures will be implemented under the strategy: (a) short-term programs to improve product designs and quality, includ- ing acquisition of new product technologies in close coordination with the R&D institute; (b) reorganization of production layout including installation of equip- ment for rehabilitation, replacement and expansion purposes; (c) training of staff in production and management systems;  - 62 - ANNEX 3 Page 8 (d) implementation of a basic .nanagement information system covering production, quality control, personnel, financial and marketing functions; (e) installation of new marketing channels in domestic and export mar- kets; and (f) technical assistance to help the corporation and the factories plan and implement the strategies. 15. Investment Plans. The investment program to support the restructur- ing of SECC is estimated as follows: SECC: RESTRUCTURING INVESTMENT PLAN Local Foreign Total (Y million) ($ million) ($ million) Civil Works & Facilities 32.0 1.6 7.7 Equipment 40.3 42.9 50.6 Product Development & Tech. Transfer 3.8 9.3 10.0 Training 5.9 4.6 5.7 Technical & Management Assist. & Tools 10.8 3.5 5.6 Subtotal 92.8 61.9 79.7 Contingencies 27.9 12.3 17.6 Incremental Working Capital 125.1 - 24.0 Total 245.8 74.2 121.3 The cost estimate is based on an analysis of different programs recommended under the subsector strategy. These programs include product development, improvement in facilities, equipment for modernization and capacity expansion, training and technical assistance. As shown in the table, about 73 percernt of the installed cost is for 'hardware" (equipment and facilities), and 27 per- cent is for "software" (product development, training and management systems). The high cost of 'software' indicates the changes required in current business practices in order for SECC to succeed in domestic and export markets. Investments in equipment and facilities alone would not be sufficient to correct the problems of the subsector. 16. Implementation Plans. The subsectoral restructuring plan will take about five years to implement, as it involves complex tasks in major areas-- the policy environment, organizational structure, product and production oper- ation, and management organization and systems. Detailed implementation schedules for these tasks have been established, and are summarized in Annex 9.  - 63 - ANNEX 3 Page 9 17. Impact Analysis. As a result of the restructuring strategy, the capacity of the major product groups is expected to double by 1995. The pro- gram will substantially increase labor productivity, reduce overheads, and increase material efficiency. It will almost quadruple the volume of sales of priority products; domestic sales of these products will increase by over 15 percent per year and exports will contribute 22 percent of the total sales. Passive devices such as capacitors axid resistors will make a major contribu- tion to these sales. SECC: IMPACT ANALYSIS OF RESTRUCTURING PROGRAM L995 as Z 1989 1995 of 1989 Total Sales (S Million) 69.2 287.9 416 Domestic Sales ($ Million) 66.6 223.4 335 Export Sales (S Million) 2.6 64.4 2,500 Gross Margin (Z) 17.5 30.5 175 Net Profit Margin (Z) 6.9 14.3 207 Labor Productivity (Index, 1987=100) 98 450 459  CHINA SHANCHAI INOUSTRIAL DEVELOPMENT PROJECT Shanahai Electronic Comoonents Subscetor Malor Features of Factories in tho Subsector (1988) Year of Not fixed Salos establish- Nature of assets revenuo Employmnt Name of company went company ---- (Y million) ---- (no.) Major products Radio Factory No. 1 1960 State-owned 18.6 38.3 2,147 Resistors, capacitors, sensors Radio Factory No. 6 1960 State-owned 12.0 42.0 2,002 Capacitors Radio Factory No. 8 1960 State-owned 6.6 62.6 1,620 Relays Radio Factory No. 9 1960 State-owned 8.0 66.1 2,117 Switches, connectors Radio Factory No. 12 1960 State-owned 15.3 44.8 2,137 Potentiometers Radio Foatory No. 16 1968 State-ownod 4.6 20.6 1,033 Switches, sockots Radio Factory No. 28 1965 State-owned 10.7 24.6 B89 Inductors Tian He Capacitors Factory 1946 State-owned 8.1 37.4 2,201 Capacitors Fu Dan Capacitors Factory 1947 State-owned 13.8 40.3 1,778 Capacitors dagnotic Material* Factory 1964 Stote-owned 8.7 19.5 1,438 Magnetic materials Foi iJ Corporation 1960 State-owned 19.1 64.8 2,721 Acoustic assemblies Zong Ye Factory 1969 Colloective 13.1 11.6 816 Capacitors Lian Yi Radio Factory 1967 Collective 2.4 9.7 983 Capacitors agenetic Materials Factory No. 2 1968 Collective 2.4 6.6 442 Magnetic materials Electronic Compononts Factory No. 2 1969 Collective 0.9 6. 7 449 Transformers Electronic Components Factory No. 13 1968 Collective 0.6 3.9 403 Sockets Electronic Components Factory No. 14 1974 Collective 0.3 2.1 249 Switches, Sockets Electronic Components Factory No. 16 1958 Collective 0.9 2.8 324 Fuses, sockets Eloectronic Components Factory No. 21 1968 Collectivo 22.8 6.7 660 Capacitors Xiang Yang Factory 1968 Collective 2.8 11.4 818 Resistors Yu Zhou Factory 1968 Collective 2.3 9.3 538 Potentiometers Huang Pu Factory 1961 Collective 0.8 8.0 613 Capacitors Chang Zhong Faectory 1965 Collective 1.7 12.9 667 Transformors Fong Lei Factory 1969 Collective 2.1 16.9 900 Acoustic assemblies Total 180.3 636.0 27.641 ox  - 65 - ANNEX 3 Attachment 2 CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Shanghai Electronic Components Subsector Subsector Organization, January 1989 Central Government Issue policy guidelines based State on state economic considerations Council Shanghai Municipal Issues policy guidelines for Government Shanghai Municipality Shanghai Bureaus act as Instrumentation and regulatory bodies Electronic Industrial Bureau |Corporatin iShanghai ICorporation| Subsector corpora- Electonic tions (8) coordi- Components nate companies' Corporation activities Companies 24 Companies| ompanies Companies (over 200) are production entities  ANNEX 3 - 66 - Attachment 3 CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Shanghai Electronic Components Corporation Consolidated Financial Statements, December 31, 1989 A. Consolidated Income Statement Y'OO0 Sales income 252,632 Less cost of goods sold 209,753 Gross income 42,879 Less administrative and selling expenses 12,645 Operating income 30,234 Other income 3,852 Interest and other expenses 13,926 Net income 20,160 Taxes 11,714 Net income after taxes 8,446 B. Consolidated Balance Sheet Y'OOO Y'000 Current Assets Current Liabilities Cash and bank balance 1,756 Accounts payable 80,664 Accounts receivable 68,582 Short-term borrowings 69,510 Inventories 148,056 Others 339 Total Current Assets 218,394 Total Current Liab. 150,513 Fixed Assets Long-Term Liabilities Land, buildings, machin- Long-term debt 83,748 ery and equipment 152,164 Others - Accumulated depreciation 70,629 Total Liabilities 234,261 Net Fixed Assets 81,535 Equity Other Assets 92,639 State funds 104,296 Special funds 49,483 TOTAL ASSETS 392,568 Enterprise funds 4,528 Total Equity/Funds 158,307 TOTAL LIABILITIES AND EQUITY 392,568  - 67 - ANNEX 4 Page 1 CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Shanghai Precision and Scientific Instruments Subsector Size and Organization 1. The Shanghai Precision and Scientific Instruments Subsector (SSIS) is a very small and young subsector. Most of the factories in the subsector were established in the 1950s. The subsector includes 13 factories and a research institute which together had net fixed assets of only Y 49.7 million ($13.4 million) at the end of 1988. Sales in that year were Y 155.8 ($42 million) and the subsector employed 9,500 people. The factories vary widely in size, but all are small compared to worldwide industry standards. The largest factory had sales of Y 30.2 million ($8.1 million) with net fixed assets of Y 13.2 million ($3.6 million) in 1988. The subsector's major prod- uct groups include analytical, optical and general purpose Instruments.li Attachment 1 summarizes the major features of each factory in this subsector. 2. The current structure of SSIS has organizational, operational and marketing strategic constraints which result in a lack of accountability, overlapping of products and processes and inability to meet changing marketing conditions. These constraints make it imperative to change the structure of the subsector to attain greater efficiency and competitiveness. Structurally, at the time of appraisal, SSIS was organized in a manner similar to the Shanghai Electronic Components Subsector (Attachment 2 of Annex 3). The SSIS is subjected to controls from various levels--the central government, the Shanghai Municipal Government, the Shanghai Instrumentation & Electronic Industrial Bureau (SIEB), and the Shanghai Precision Scientific Instrument Corporation (SPSIC). Reforms in 1987 and 1988 abolished the administrative level of SPSIC and put the factories under the direct control of SIEB. SIEB performed a regulatory and controlling role, making sure that the factories abided by policy guidelines and performance targets established by the central and state governments. This change gave SIEB more functions with respect to the factories, yet SIEB was not suitably equipped to carry out some of them. To make up for this, SPSIC was given a coordinating role, although it no longer had any direct responsibilities over the factories. Each of the 13 factories functioned as an "individual entity" responsible for its own plan- ning, marketing, production and finances. Performance of the Subsector 3. The subsector's output over the past few years is shown in the fol- lowing table: 1/ These include: analytical instruments- spectrophotometers, chromato- graphs; optical instruments--microscopes, optical elements, optical mete- orological products; and general purpose instruments--balances, pollution control instruments, etc.  - 68 - ANNEX 4 Page 2 SHANGHAI: SCIENTIFIC INSTRUMENTS SUBSECTOR PRODUCTION, 1983-89 (Y Million) Average Annual Growth (2) 1983 1984 1985 1986 1987 1988 1989 1983-89 Analytical Instruments 34 54 66 58 60 64 66 12 Optical Instruments 10 10 22 10 12 33 31 21 Balances 17 16 20 22 17 15 14 -3 Others 49 40 22 30 41 32 33 -6 SSIS Production 110 120 130 120 130 144 144 5 Nationwide Production 440 475 500 485 480 NA 540 3 Between 1983 and 1989, production in Shanghai grew faster than in the country overall--5 percent per year, compared to 3 percent per year. However, Shanghai's profitability during this period has declined from 42 percent to 20 percent. The growth of the subsector is based on its strong position in spectrophotometers, chromatographs, and general purpose instruments. These three products contribute 50 percent of the subsector's output and 65 percent of its profit. Microscopes and balances, two important products, have 14 per- cent of the subsector's output. However, these products contribute only 7 percent of the subsector's profits at present. Except for microscopes, the subsector has a sound and reputable position in the domestic market. The sub- sector has been able to increase its market share over recent years, but it faces continuous competition from other emerging manufacturers at the national level. A well defined developmental approach is required to increase its competitiveness. Also, its performance in export markets must be improved. The subsector's exports are very small, accounting for 4 percent of produc- tion. In 1987, it exported instruments with a total value of Y 6.0 million ($1.6 million). This represented over 40 percent of the nation's exports of these products. The products exported included primarily optical instruments and elements. CHINA: MARKET SHARE OF DOMESTIC COMPETITORS (Z) 1983 1987 1989 Shanghai 17 22 26 Jiangsu 13 15 17 Beijing 9 13 16 Others 61 50 41  - 69 - ANNEX 4 Page 3 Market Development 4. The market for scientific instruments in China is relatively small. In 1987, domestic consumption was Y 590 million ($160 million) and growth averaged only 2 percent per year between 1983 and 1987. Due to capacity limi- tations, local manufacturers have not been able to meet the national demand. Imports therefore have played an important part in meeting domestic demand for scientific instruments, particularly at the very high end of precision and technology. Imports have provided over 20 percent of the market, but over the last few years, the authorities have restricted imports. Domestic production of scientific instruments is dominated by analytical instruments (spectropho- tometers and chromatographs) and optical instruments (microscopes and optical elements), but the strongest growth has occurred in balances. CHINA: DOMESTIC PRODUCTION AND CONSUMPTION OF SCIENTIFIC INSTRUMENTS (Y Million) Production Consumption Average annual Average annual growth (X) growth (Z) 1983 1989 1983-89 1983 1989 1983-89 Analytical Instruments 180 200 2 260 270 1 Optical Instruments 180 282 8 280 280 0 Balances 40 58 6 30 62 13 Others 45 NA NA NA NA NA Total 445 540 3 570 612 1 Scientific instruments are sold to many industries, but the leading consumer is the chemical industry, with 16 percent of market consumption. Because of customer diversity, domestic sales are marketed through four national distri- butors. These distributors cover about three-fourths of the market. SSIS is the leading competitor in the industry and has increased its market share over recent years. In 1989, SSIS had more than 70 percent of the domestic market in four product groups (abey refractometers, universal tool microscopes, spectrum-photometers, and conductometers) and between 50 percent and 70 per- cent in three others (gas chromatographs, pH meters, and mechanical balances). However, its main competitors, Jiangsu and Beijing, also have strengthened their position in the domestic market in the 1980s, reaching 15 percent and 13 percent, respectively, of the national scientific instruments market in 1987 (when Shanghai's overall share was 22 percent). SSIS is specialized in analytical instrument and balances, but is largely diversified in other prod- ucts. In contrast, its major competitors are concentrated in a few product categories and have pursued new strategies in the market with improved prod- ucts. Over the coming years the market is expected to show slow growth of 3-4 percent per year. However, a shift is expected to occur from mechanical  - 70 - ANNEX 4 Page 4 to electronic balances, and towards environmental analysis instruments and optical meteorological products. Domestically, SSIS should develop a targeted distribution and marketing system for priority instruments. This requires effective technical support service to selected larger user companies, foreign joint ventures in China, and key national distributors. 5. The global market for scientific instruments in 1987 was about $5.0 billion. Of this market, analytical instruments, especially chromatographs and spectrophotometers, account for nearly 50 percent. Industrialized coun- tries consume nearly 70 percent of the world's scientific instruments. The United States leads, consuming 40 percent of world production. Analytical instruments, mainly chromatographs and spectrophotometers, constitute nearly one-fourth of the global scientific instruments market. The manufacturing of scientific instruments is highly concentrated in industrialized countries. For example, the top five US manufacturers control 50 percent of the domestic market. In Japan, the top three producers control 70 percent of the market. The European industry also is moving toward consolidation. Therefore, the ability to export scientific instruments depends largely upon the accessibil- ity of these Lhree markets--US, Japan, and EEC. Imports of scientific instru- ments in these countries account for 20 percent of global market and the United States accounts for half of this. Imports from developing countries in these countries are low, only 10 percent of world imports. They consist pri- marily of microscopes and optical measuring instruments, as well as elements in the US and Japan, and analytical instruments in the EEC. In this large global market, China's exports of scientific instruments are extremely low, amounting to Y 14 million ($3.8 million) in 1987. Optical instruments, including those of SSIS, are the major contributors to China's exports of scientific instruments. Distributors and end-users in import markets are skeptical of China's ability to deliver instruments of world-class standards. In order to build up exports in these markets, SSIS must be able to meet prod- uct requirements for international design and standards, reliability, and customer accessibility. SSIS also must build up appropriate marketing chan- nels, using OEMs for spectrophotometers and optical elements, and using dis- tributors for microscopes and general physical instruments. In 1989, the Shanghai subsector exported $3.3 million, a considerable increase over past years. Subsector Capabilities and Competitiveness 6. Within the three major product categories, the Shanghai instruments subsector manufactures a wide range of products. For a small domestic market this product mix is inappropriately wide and varied. The product range needs to be concentrated and other improvements implemented such as new designs for microscopes, better detector design and control systems for analytical instru- ments, the introduction of electronics in products, and microprocessor control for laboratory instruments. Competition also is affected by manufacturing organization, processes and systems. There are numerous overlapping products and duplication of manufacturing processes among the factories. This has led to a low scale of production, low utilization of equipment, high capital investment, excessive overhead costs, and so on. The workshops in the facto- ries are physically isolated from each other, and unsuited for modern manufac- turing. Manufacturing equipment is too outdated to adapt to changing market specifications; this leads to excessive downtime, high maintenance costs and  - 71 - ANNEX 4 Page 5 poor product quality. Also, the management organization and systems need improvement. Poor management of production has led to long production cycles, high inventories, and low productivity. Low-quality raw materials and parts, and their unsuitability for machining and assembly, hampers the production of precision instruments. Under this project, organizational steps will be introduced for improved procurement and specification procedures. Also, the corporation will work with suppliers to develop the latter's capability to provide timely deliveries. Improved access to foreign exchange under the project will allow the corporation to import critical raw materials and compo- nents, such as microprocessors and special optical glass and gratings. Also, rigorous inspection and acceptance programs for incoming materials will be established. Finally, the organization lacks marketing and financial account- ing systems to develop market strategies. As a result of these deficiencies, the subsecto,. faces serious cost constraints, both in domestic and interna- tional markets. The proposed development plan for the subsector addresses these constraints. Restructuring Need 7. The many problems facing the subsector in the area of organizational structure, product quality and technology, manufacturing process, and manage- ment structure and systems call for restructuring and renewal in a slowly growing market. The objective is to create an appropriate business environ- ment supported by appropriate policy which will make the subsector more com- petitive in domestic and export markets. The major elements of the restruc- turing strategy, the first step of which has been implemented, are summarized below. 8. Organizational Structure. Under the new structure, one financial entity has been formed by uniting the subsector administrative corporation and the factories manufacturing priority products as an integrated company, SPSIC. The integrated company was established by issuance of its charter in May 1989. Financial consolidation of the former subsector corporation and the factories was completed by March 1990. The consolidated statements for 1989 are shown in Attachment 2. By June 1991, the remaining independent legal status of the constituent factories will be phased out, so that SPSIC will be a single legal entity. SIEB will evolve into a regulatory entity and become less involved in the planning, financial, and operational activities of the corporation. Some functions currently performed by the Bureau will be transferred to the corpo- ration. As with the electronics subsector, the Bureau will concentrate on policy making. The former subsector corporation is being reorganized as a company headquarters and will be responsible for planning, financial, person- nel, and market development functions. SPSIC will assume all debt and tax obligations as a single unit. Under the corporation three business units will be established. These units will focus on priority products: analytical instruments; optical instruments and systems; physical instruments, and envi- ronmental control instruments. Existing factories associated with these busi- nesses will be consolidated under the relevant new units. This restructuring will eliminate product/production duplication, reduce manufacturing costs, improve product quality, and strengthen marketing and sales capabilities. The business units will be responsible for product development, production, and marketing functions. The factories grouped under the business units will operate as cost centers. Under the plan, six out of the existing 13 factories  - 72- ANNEX 4 Page 6 will be regrouped. The reorganization was agreed with the relevant authori- ties, and began in June 1989. Implementation is expected to be completed in 1992. 9. Product Market Strategy. A product/market strategy for the subsec- tor has been developed based on an analysis of products currently manufactured in the subsector, their market access, product technology, customer service, market growth and profitability. The basic principles governing this strategy are: improve quality, introduce new technology and designs, and establish appropriate marketing networks domestically and in export markets. Domesti- cally, the subsector will concentrate on seven products in three major product groups: (a) chromatographs and spectrophotometers in analytical instruments; (b) microscopes, optical elements, and optical meteorological in optical sys- tems; and (c) balances and related items in physical instruments and general purpose environmental instruments. Potential products for export are optical systems and components of spectrophotometers. Initially these would be sold at the low end of market. However, after technical improvements, the export market for complete sets of spectrophotometers, chromatographs and optical systems coul.d be large. The domestic marketing strategy for priority products will focus on major local distributors, key customers, and joint venture com- panies in China. This will be achieved by developing an adequate sales/tech- nical marketing staff and reorganizing the marketing function to facilitate market feedback on product performance. The export marketing strategy will focus mainly on using OEMs for spectrophotometers and optical elements and using distributors for microscopes and general purpose instruments. This strategy will establish an appropriate marketing infrastructure, initially tor the United States market, where there is a large potential for exports. The product/market strategy for the subsector will govern the strategic planning of the corporation relating to its future development and resource allocation. 10. Operational Strategy. The operational strategy involves product development, production rationalization, and improvements in management prac- tices, marketing and training systems. Strategic plans have been developed in each of these areas to promote efficient production and marketing of priority products. These plans consist of: (i) implementing product development plans for priority products to improve design and quality, and to integrate new technologies; (ii) rationalizing and consolidating priority production facto- ries to manufacture products at lower cost; (iii) introducing modern practices and systems for management information, strategic planning, financial and cost accounting, production management, and marketing; (iv) setting up improved marketing channels in domestic and export markets; (v) training and redeploy- ing staff; and (vi) providing technical assistance to implement the subsec- tor's strategy and the proposed project. 11. Investment Plans. The total cost of implementing the restructuring plans is estimated to be $58 million. The estimate for major cost categories is as follows:  - 73 ANNEX 4 Page 7 SPSIC: RESTRUCTURING INVESTMENT PLAN Local Foreign Total (Y Million) (S million) ($ million) Civil works and facilities 15.6 - 3.0 Equipment 16.5 15.9 19.1 Product and technology development 4.0 7.5 8.3 Training 2.7 2.2 2.7 Technical & management assistance 4.9 3.0 4.0 Subtotal 43.7 28.6 37.0 Contingencies 13.1 5.7 8.2 Incremental working capital 68.2 - 13.1 Total 125.0 34.3 58.2 A significant part of the investment is allocated to software activities for product development, training, and technical and management assistance. In order to use the hardware equipment to best advantage, software must be strengthened to allow for modern management practices, the development of quality products with new technology, and marketing in an extremely competi- tive environment. 12. Implementation Plans. Detailed implementation plans have been worked out for the major task areas: the policy environment, organizational structure, product and production rationalization, organizational moderniza- tion, and management systems. These plans are developed as a framework with the flexibility to accommodate changes during the implementation process as the need arises. Implementation is expected to take five years. Details are provided in Annex 9. 13. Impact Analysis. Restructuring of the corporation is expected to increase domestic and export sales, improve the corporation's profit margin, and increase labor productivity, as shown in the table below.  - 74 - ANNEX 4 Page 8 SPSIC: IMPACT ANALYSIS OF RESTRUCTURING PROGRAM 1995 as 2 1987 1995 of 1987 Total Sales ($ million) 34.1 63.2 185 Domestic Sales (million) 32.9 51.4 156 Export Sales ($ million) 1.2 11.8 983 Gross Margin (2 of Total Sales) 24.2 29.6 122 Net Profit Margin (2 of Total Sales) 9.8 11.8 120 Labor Productivity Index (1987=100) 100 400 ;00  CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Shanghai Precislon Scientific Instrument Subsector Us;or Features of -actories Jn the Subsector (1989) Year ov Not fixed Sales establish- Nature of assets revenue Employment Name of company m*nt company ---- (Y million) ---- (no.) Major products Optical Instrument Factory 1963 State-owned 12.6 32.6 2,850 Uicroscopes, optical element, measuring and analytical instruments Optical Instrument Factory No.2 1943 State-owned 6.1 6.7 711 Measuring instruments Optical Instrum_nt Fectory No.3 1958 State-owned 1.2 1.3 271 Surveying instruments Physical Optical Instrument Factory 1966 State-owned 4.6 4.3 309 Measuring instruments Optical Lens Factory 1958 State-owned 1.1 2.1 308 Optical lenses and *l em nts Analytical Instrument Factory 1952 State-owned 8.4 43.5 S,203 Analytical instruments Rex Instrument Factory 1953 State-owned 3.1 17.7 488 Electrochemical, analytical and environmental protection monitoring instruments Analytical Instrument Factory No.3 1968 State-owned 4.1 19.8 590 Analytical instruments Electro-Optical Devices Works 1958 State-owned 3.1 12.4 407 Light sources, electrodes Balance Manufacturing Factory 1948 State-owned 6.2 17.3 769 Precisian balances Balance Instruments Works No.2 1953 State-owned 1.9 7.5 4SO Precision balances Qin Fen Instrument Factory 1980 Collective 0.8 2.1 305 Microscopes Hongyu Equipment Factory 1968 Collective 0.7 2.8 33 Environmental protection and monitoring instruments Optical Instrument Research Institute 1984 State-owned 2.1 - 361 Product development Total 64.0 189.0 9.333 :D. rt  ANNEX 4 - 76 - Attachment 2 CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Shanghai Precision and Scientific Instruments Corporation Consolidated Financial Statements, December 31, 1989 A. Consolidated Income Statement Y'000 Sales income 131,774 Less cost of goods sold 100,281 Gross income 31,493 Less administrative and selling expenses 9,107 Operating income 22,386 Other income - Interest and other expenses 442 Net income 21,944 Taxes 9,568 Net income after taxes 12,376 B. Consolidated Balance Sheet Y'OOO Y'OOO Current Assets Current Liabilities Cash and bank balance 3,930 Accounts payable 26,282 Accounts receivable 15,391 Short-term borrowings 41,780 Inventories 76,431 Others 469 Total Current Assets 95,752 Total Current Liab. 68,531 Fixed Assets Long-Term Liabilities Land, buildings, machin- Long-term debt 14,620 ery and equipment 73,722 Others - Accumulated depreciation 35,046 Total Liabilities 83,151 Net Fixed Assets 38,676 Equity Other Assets 22,467 State funds 56,531 Special funds 14,370 TOTAL ASSETS 156,895 Enterprise funds 2,843 Total Equity/Funds 73,744 TOTAL LIABILITIES AND EQUITY 156,895  77 ANNEX 5 Page 1 CHINA SHANGHAI INDUSTRIAL DEVELOPMENT PROJECT Shanghai Electrical Apparat - Subsector Background and Organization 1. The Shanghai electrical apparatus industry emerged in 1919. Since then it has gone through many stages of development. From 1919 to 1956, the industry included hundreds of small electrical apparatus manufacturers. In 1956, the Shanghai Electric Power Facility Manufacturer Corporation was set up which included manufacturers of electrical apparatus as well As power genera- tion. In 1960, the Shanghai Electrical Arparatus Co. (SEAC) was set up as a separate company specializing in the manufacture of electrical apparatus. Until 1986, this company exerted considerable influence over the production, product planning, personnel, and marketing decisions of its factories. In 1987, the central government promoted the concept of each factory as an inde- pendent enterprise, and SEAC became purely a coordination entity. Despite recent changes, strong traditional ties have been built up between the coLpo- ration and factories over the last 30 years and these ties persist even now. 2. At the beginning of 1989, SEAC was coordinating 28 factories which operated as independent legal entities responsible for their own performance quota, technology and product development, production schedules, marketing and sales. This subsector is the largest manufacturer of low-voltage electrical apparatus products in China, with sales of Y 703 million and 23,100 employees in 1989. Its products have the broadest coverage of all domestic competitors in the electrical apparatus industry and include 800 series and 3,000 varie- ties. The products can be broken down into two basic categories: (a) compo- nents: contactors, relays, circuit breakers, transformers, voltage regula- tors; and (b) systems: switchboards, drive controls, and rectification sys- tems. The Shanghai subsector maintains a 15-20 percent domestic market share for its key products and has enjoyed real growth of about 5 percent a year over the last seven years. In 1989, it exported $8 million worth of electri- cal products. Attachment 1 shows the main features of the factories in the subsector. 3. In addition to the 28 independent factories, the subsector corpora- tion oversees the Shanghai Electrical Apparatus Technology Research Institute and four subsidiaries. The subsidiaries have been set up to facilitate mate- rial procurement, marketing and sales, systems engineering and technology development in the subsector. The SEAC headquarters corporation and its sub- sidiaries together employ about 350 people. Following its formation in 1987, the corporation provided some corporate functions, but horizontal integration among the factories was very limited. For enhancing the competitiveness and efficiency of the electrical apparatus subsector, changes in the current orga- nization structure were considered necessary in 1989, and the first steps in a restructuring program agreed with the Bank have been undertaken since then.  - 78- ANNEX 5 Page 2 Performance of the Subsector 4. The total size of the domestic market was estimated to be Y 6 bil- lion in 1987. It had been growing by about 8 percent a year between 1980 and