China - Fourth Rural Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 17038 IMPLEMENTATION COMPLETION REPORT CHINA FOURTH RURAL CREDIT PROJECT (LOAN 3265-CHA/CREDIT 2182-CHA) August 26, 1997 Rural Development and Natural Resources Sector Unit East Asia and Pacific Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Yuan (Y) 1990 $1=Y4.78 1991 $1 = Y 5.32 1992 $1 = Y 5.42 1993 $1 = Y 5.73 1994 $1 = Y 8.50 1995 $1=Y8.40 1996 $1 = Y 8.30 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES 1 meter (m) = 3.28 feet (ft) 1 kilometer (km) = 0.62 mile (mi) 1 hectare (ha) = 2.47 acres (ac) 15 mu 1 kilogram (kg) = 2.2 pounds (lb) ABBREVIATIONS AND ACRONYMS ABC - Agricultural Bank of China ADB - Asian Development Bank ADBC - Agricultural Development Bank of China BOC - Bank of China EDI - Economic Development Institute ERR - Economic Rate of Return FIL - Financial Intermediary Loan FRR - Financial Rate of Return FSTAP - Financial Sector Technical Assistance Project IBRD - International Bank for Reconstruction and Development ICB - International Competitive Bidding ICR - Implementation Completion Report IDA - International Development Association IFAD - International Fund for Agricultural Development LIB - Limited International Bidding MOA - Ministry of Agriculture MOF - Ministry of Finance NCB - National Competitive Bidding NGO - Nongovernmental Organization PBC - People's Bank of China RCC - Rural Credit Cooperative RC I - Rural Credit I Project (CR 1462-CHA) RC II - Rural Credit II Project (CR 1642-CHA) RC III - Rural Credit III Project (CR 1871-CHA) RC IV -. Rural Credit IV Project (LN 3265/CR 2182-CHA) SAR - Staff Appraisal Report TA - Technical Assistance TEG - Technical Expert Group Vice President Jean-Michel Severino, EAP Manager Geoffrey Fox, EASRD Staff Member Ramesh Deshpande, Principal Financial Operations Officer, ECSPF  FOR OFFICIAL USE ONLY CONTENTS PREFACE ....................................................................................... EVALUATION SUMMARY ........................................................v PART I: PROJECT IMPLEMENTATION ASSESSMENT .................................1 A. Project Background ......................................................... B. Achievement of Project Objectives ......................................................2 C. Implementation Record and Major Factors Affecting the Project ... 13 D. Project Sustainability ....................................................... 16 E. Bank Performance ................................................... 16 F. Borrower (MOF) and Beneficiary (ABC) Performance .. 16 G. Assessment of Outcome ....................................................... 17 H. Future Operation ....................................................... 18 I. Key Lessons Learned ....................................................... 19 PART II: STATISTICAL TABLES ....................................................... 21 Table 1: Summary of Assessments ....................................................... 21 Table 2: Related Bank Loans/Credits ....................................................... 22 Table 3: Project Timetable ....................................................... 22 Table 4: Loan/Credit Disbursement: Cumulative Estimate and Actual ......... 23 Table 5: Key Indicators for Project Implementation ...................................... 24 Table 6: Key Indicators For Project Operations ............................................. 25 Table 7: Studies Included in Project ....................................................... 25 Table 8a: Project Costs ....................................................... 26 Table 8b: Project Costs ....................................................... 26 Table 8c: Project Financing ....................................................... 27 Table 9: Economic Costs and BenefitsZa ....................................................... 27 Table 10: Status of Legal Covenants ....................................................... 28 Table 11: Compliance with Operational Manual Statements ......................... 32 Table 12: Bank Resources: Staff Inputs ....................................................... 32 Table 13: Bank Resources: Missions ....................................................... 33 ANNEX A: BORROWER'S CONTRIBUTION TO THE ICR ........................... 35 ANNEX B: ICR MISSION'S AIDE MEMOIRE ....................................... 45 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.   - iii - IMPLEMENTATION COMPLETION REPORT CHINA FOURTH RURAL CREDIT PROJECT (LOAN 3265-CHA/CREDIT 2182-CHA) PREFACE This is the Implementation Completion Report (ICR) for the Fourth Rural Credit Project in China, for which Loan 3265-CHA in the amount of $75 million equivalent and Credit 2182-CHA in the amount of SDR 143.7 million ($200 million equivalent) were approved on October 30, 1990 and made effective on March 22, 1991. The loan and credit were closed on December 31, 1996. These were fully disbursed; and the last disbursement took place on February 5, 1997. The ICR was prepared by Ramesh Deshpande, Principal Financial Operations Officer, Agriculture, Industry and Finance Division, Country Department III, Europe and Central Asia Region, with the assistance of Kay Hill and Weiguo Zhou (Consultants), and reviewed by Messrs. Joseph Goldberg, Chief, EA2RS and Yo Kimura, Project Advisor, EA2DR. The borrower provided comments that are included as an annex to the ICR. Preparation of this ICR, which began during the Bank's final supervision mission in May 1996, was completed by an ICR mission that visited ABC headquarters and selected provincial branches during March 1997. The ICR is based on materials in the project file. The borrower contributed to the preparation of the ICR by providing views reflected in the mission's aide-memoire, preparing its own evaluation of the project's execution and initial preparation, and commenting on the draft ICR.   - v - CHINA FOURTH RURAL CREDIT PROJECT (LOAN 3265-CHA/CREDIT 2182-CHA) EVALUATION SUMMARY Introduction 1. The Fourth Rural Credit Project (RCIV) was one of the first few operations, Bankwide, which the Bank processed using guidelines contained in Operational Directive 8.30. The project was designed in the context of the Bank's ongoing dialogue on financial sector issues, and on the understanding that the Chinese authorities would be prepared to implement various policy reforms and institutional changes supported by the project. At the time of RCIV's appraisal, there was considerable uncertainty over the pace and direction of China's financial sector reforms. The financial sector, as others, was caught in a problematic situation, where it was given substantial responsibility for allocation of China's investible resources but its decisions had continued to be subject to heavy intervention by government at all levels. The Bank Group's financial sector review,' which was then under discussion with the government, had recommended the introduction of a range of reforms to enable banks to become full financial intermediaries, including enactment of a comprehensive banking law; strengthening of bank management; competition among and a mix of financial intermediaries; and further rationalization of monetary, credit and interest rate policies. Project Objectives 2. Against this background, RCIV's main objectives were to: (a) stimulate growth and diversification of agriculture by financing profitable investments by farmers, collectives, state farms, and enterprises; and (b) promote efficiency of rural financial intermediation through introduction of sound, market-oriented, policies and development of main institutions concerned with rural savings mobilization and lending. 3. The Agricultural Bank of China (ABC) used the Bank Group funds along with its own funds to provide subloans to expand production and improve productivity of commercial agriculture including crops, livestock, fisheries, agroprocessing, and The World Bank, "China: Financial Sector Review: Financial Policy and Institutional Reforms," Report No. 8415-CHA dated June 29, 1990.  - vi - marketing facilities in seven regional clusters, including Inner Mongolia, five provinces of Shaanxi in the northwest; Jilin and Liaoning in the northeast, Jiangxi and Guangdong in central and south China, and Beijing municipality. ABC also used a part of the Bank Group assistance in Guangxi Zhuang Autonomous Region and three provinces of Fujian, Hunan and Hubei, which were covered by earlier IDA-assisted credit projects. Given the line-of-credit nature of the project, ABC had the flexibility of adjusting the lending program in response to a changing macroeconomic environment and subproject appraisals including market and credit risk analysis. Implementation Experience and Results 4. Achievement of Project Objectives. The project's first objective of stimulating growth and diversification of agriculture was substantially achieved through provision of credit (investment funds and incremental working capital) for commercially viable production and productivity improvements in agriculture and agroprocessing, with emphasis on environmental protection and poverty alleviation. Most of the subprojects are expected to achieve their production targets, but a small number (6 percent), accounting for 16 percent of subloans disbursed, are considered problem projects and have the potential to threaten the viability of the project, if not corrected. The project's second objective of promoting efficiency of rural financial intermediation was, however, only partially achieved because some of the core features of the project designed to accelerate ABC's commercialization were either not implemented or only partially implemented. These included elimination of subsidies on onlending of Bank/IDA funds from MOF to ABC and ensuring minimum interest spreads to ABC and the Rural Credit Cooperatives (RCC). In retrospect, the financial sector objective of the project may have been too ambitious, as it did not fit with the government's phased approach to sector reform and many of the proposed activities were outside the control of ABC. 5. Banking Reforms. During the course of RCIV's implementation, as part of broader financial sector reforms, the government took important steps toward the project's objective of promoting efficiency of rural financial intermediation and introduced important policy and institutional changes. In 1993, ABC was split into two institutions: (a) the existing ABC retaining its commercial banking functions; and (b) the newly established "policy" bank, the Agricultural Development Bank of China (ADBC) assuming government business including subsidized credits for grain procurement and poverty alleviation. Subsequently, in 1996, the government also separated the grassroots RCC system from ABC supervision, to function independently under a newly created organization which is currently under the State Council but is expected to become a RCC federation. These initiatives were indeed consistent with the Bank's recommendations for financial sector reform and RCIV's objective of promoting efficiency of rural financial intermediation.  - vii - Summary of Findings, Future Operations, and Key Lessons Learned 6. The project outcome is viewed as unsatisfactory on the basis that it at best only partially achieved its sector policy and institutional development objectives and its level of achievement of the financial objectives was negligible. One could ask how an institution that had satisfactorily implemented three previous projects could perform poorly on the fourth. Also, it is unusual to rate a project with an estimated ERR of 24 percent as unsatisfactory. But RCIV had higher aims than the earlier projects, extending into the overall operations of ABC and even into the government's financial sector development strategy. The same project in today's financial sector environment would have a much greater chance of achieving its objectives. 7. A study of rural investment and finance, which had been intended to support sector development, was reduced in scope and intended consultations with the Bank on a general interest rate structure were not carried out as a result of the split of ABC and the overlap with a subsequent Bank-assisted Financial Sector Technical Assistance Project (FSTAP), which focused on reforms applicable to all financial institutions. The financial objectives that the project had envisaged-elimination of subsidized credit, a more rational interest rate structure for the project and for ABC as a whole, and adjustment of the provision for bad debts to levels more realistic and in line with international practice-were not implemented within the time frame of project implementation. It is unclear why MOF provided subsidized credit to ABC, but the interest rate structure and provisioning are issues still unresolved for the sector and still being addressed by the Bank and government. 8. The main objectives of the institutional development programs were to upgrade ABC's financial management. A financial management symposium, intended for ABC and PBC participation, to discuss ABC's long-range business planning, credit plan formulation and lending policies was not held because both ABC and the Bank decided this could be better handled by the FSTAP. Some studies were carried out and reviewed by the Bank, but not pursued further in light of the impending hiving off of policy lending and RCC oversight. 9. The project's sustainability is uncertain; the real sector benefits are likely to be substantial, but ABC's sustainability and its continued profitability will be somewhat contingent on the financial reform process. The pace of commercialization of all the formerly specialized banks will to a large extent be influenced by state enterprise reforms, since the financial health of one affects the financial health of the other. 10. The Bank's performance was satisfactory, with the exception that it overestimated the scope for certain elements of the financial sector reform program during project preparation, ABC believes that the Bank did not effectively listen to its concerns during appraisal and negotiations about the difficulty of implementing the financial sector reform program, and the Bank did not give enough attention to the institutional development and financial sector objectives during supervision. The Borrower (the Ministry of Finance, MOF) and the Beneficiary (ABC) did not comply with one of  - viii - RCIV's core covenants, namely, the elimination of subsidized interest rates on Bank Group funds to ABC. Also, despite considerable technical assistance provided by the Bank Group (RCI to IV) and other donors, ABC's loan portfolio management performance remained at a relatively low level. ABC, as a rule, should not administer foreign-funded project-type lending such as RCIV through international or other noncredit departments but integrate such lending with its mainstream credit departments to improve the project's institutional development impact, efficiency of resource planning, portfolio management, and quality of financial services provided to clients. The Borrower (MOF) should have placed greater emphasis on introducing sustainable banking practices in agricultural lending by allowing ABC to (a) retain minimum interest spreads on subloans assisted by the project, and (b) make adequate provisions for nonperforming subloans. These issues must be addressed by the government and the People's Bank of China (PBC) through ongoing banking reforms and possible future Bank-assisted operations with ABC and other financial institutions. 11. The major lessons learned are (1) there is a fairly narrow limit as to how far an FIL for one banking institution can go in achieving reform objectives for the whole financial sector; (2) when financial sector objectives are introduced into an FIL, all stakeholders must be explicitly involved and exhibit ownership of and commitment to the project objectives; (3) the Bank and Borrower should only develop projects for which there is a strong consensus and common understanding about the main objective of the project, particularly in a complex and sensitive policy area such as financial sector reform; and (4) projects must be kept simple enough that both Bank and implementing agency resources are not stretched beyond capacity to supervise implementation.  - 1 - CHINA FOURTH RURAL CREDIT PROJECT (LOAN 3265-CHA/CREDIT 2182-CHA) PART I: PROJECT IMPLEMENTATION ASSESSMENT A. PROJECT BACKGROUND 1. The Agricultural Bank of China (ABC) was reestablished in 1979 to take over rural banking functions of the People's Bank of China (PBC). This was the first major initiative the government took to begin restructuring of the country's monobank system, which was established in 1950 to serve specific needs of a centrally planned economy. Tlhe Bank Group started working with ABC in 1981. In 1990, when the Fourth Rural Credit Project (RCIV) was approved for Bank Group assistance, ABC had successfully implemented two IDA-assisted rural credit projects in three provinces (RCI, FY84, $50 million; and RCII, FY86, $90 million), while the third project (RCIII, FY88, $170 million) was under implementation. RCI to III were generally well implemented with partial or substantial achievement of development objectives, satisfactory borrower performance, likely sustainability and satisfactory outcomes. However, they had focused narrowly on strengthening ABC's capacity for investment appraisal and, considering the overall pace of financial sector development, did not address its broader institutional requirements. 2. RCIV was one of the first few operations Bankwide, which the Bank processed using guidelines contained in Operational Directive 8.30. The project was designed in the context of the Bank's ongoing dialogue on financial sector issues, and on the understanding that the Chinese authorities would be prepared to implement various policy reforms and institutional changes supported by the project. At the time of RCIV's appraisal, there was considerable uncertainty over the pace and direction of China's financial sector reforms. The financial sector, as others, was caught in a problematic situation, where it was given substantial responsibility for allocation of China's investible resources but its decisions had continued to be subject to heavy intervention by government at all levels. The Bank Group's financial sector review,' which was then under discussion with the government, had recommended the introduction of a range of reforms to enable banks to become full financial intermediaries, including enactment of a comprehensive banking law; strengthening of bank management; competition among and 1 The World Bank, "China: Financial Sector Review: Financial Policy and Institutional Reforms," Report No. 8415-CHA dated June 29, 1990.  -2 - a mix of financial intermediaries; and further rationalization of monetary, credit and interest rate policies. 3. The Bank processed RCIV on the basis that there must be an understanding with the government on the financial sector development strategy, and that it (RCIV) should not only address interest rate issues related to the project per se, but also to the reform of the overall interest rate structure (administered by PBC), which should, inter alia, provide for more automatic interest rate adjustment mechanisms. 4. In support of this approach, the Bank kept RCIV negotiations on hold for over six months until after it received a positive response from the government to the recommendations of the Bank's financial sector review.2 During RCIV negotiations, the government agreed to carry out RCIV's mid-terrn review, to enable the Bank to discuss with Chinese authorities the progress in implementing not only the project and ABC's institutional development objective, but also overall financial sector reform. Specifically, RCIV required the government to take measures to: 3 eliminate subsidies on Bank Group funds onlent by the Ministry of Finance (MOF) to ABC; * provide minimum interest rate spreads to ABC; * establish an appropriate recapitalization plan for ABC; and * strengthen ABC's financial management and credit policies. B. ACHIEVEMENT OF PROJECT OBJECTIVES Overview 5. The project's first objective of stimulating growth and diversification of agriculture was substantially achieved through the provision of credit (investment funds and incremental working capital) for commercially viable production and productivity improvements in crops, livestock, aquaculture, and agroprocessing with emphasis on environmental protection, poverty alleviation, and market development. Most of the subprojects are expected to achieve their production targets, but a small number (6 percent), accounting for 16 percent of subloans disbursed, are considered problem projects and have the potential to threaten the viability of the project, if not corrected. The project's second objective of promoting efficiency of rural financial intermediation was, however, only partially achieved. In retrospect, the financial sector objective of the project may have been too ambitious, as it did not fit with the government's phased approach to sector reform and many of the proposed activities were outside the control of ABC. 2 Ibid.  6. RCIV's performance with reference to key elements of the above two main objectives was as follows. Agricultural Growth and Diversification 7. Subloans. During the project period (1991-96),3 ABC financed 1,780 subprojects involving a total investment of about Y 4 billion ($648 million equivalent) and a lending program of about Y 2.5 billion ($386.8 million equivalent), which in local currency was higher by about 53 percent than the appraisal estimate of Y 1.8 billion. The increase in the lending program was mainly due to the cost escalation contributed by high rates of inflation during 1993-96 and the devaluation of the yuan.4 Subborrowers' contribution turned out to be much higher than 30 percent of the project cost, at about $261 million compared to the appraisal estimate of $164 million. ABC provided about 17 percent of the total project cost from its own funds. The project supported term transformation of ABC's predominantly short-term resources. ABC could also roll over subloan repayments to improve its profitability. 8. In most of the project provinces, RCIV-assisted loan portfolio was largely in line with the appraisal estimates (Part II, Tables 8A and 8B.); however, overall, the proportion of agroprocessing investments was larger at 53 percent compared to 31 percent expected at appraisal. ABC also financed construction and upgrading of 23 primary and wholesale markets, which activity was added to the project after the Bank Group appraisal. Given the line-of-credit nature of the project, such adjustments in the lending program were expected; in fact, ABC branches which did not adequately respond to the changing economic environment had a greater incidence of failed or problem subprojects. By ownership, about 42 percent of subloans went to state farms and state-owned enterprises (Y 1,057 million); 40 percent to collectives (Y 1,007 million); and 18 percent to specialized households, individuals and joint ventures (Y 480 million). Lending in poverty counties amounted to about 22 percent of total. 9. Realizing the problems with project implementation at the grassroots, within about a year from RCIV commencement (March 1991), ABC developed an action plan and guidelines for subproject management and appraisal, including types of subloans eligible for financing, determination of loan repayment terms and interest rates, and outlining corrective measures that must be taken for subloans that did not comply with the project's procurement and environmental guidelines. 3 The project's closing date was extended by one year from December 31, 1995 to December 31, 1996 to enable ABC subborrowers to complete outstanding procurement actions under approved subloans, and prepare pilot business plans in two provinces as part of the preparation of the proposed ABC Commercialization project. 4 The exchange rate at appraisal was at $1: Y 4.7, which changed as follows: 1991, Y 5.7; 1994, Y 8.7; and 1996, Y 8.3.  - 4 - 10. RCIV introduced new initiatives to improve ABC's subloan approval processes by establishing a nongovernmental Technical Expert Group (TEG) at ABC headquarters, and private consultant rosters at provincial branches to advise subborrowers; and to assist ABC in supervising compliance with technical aspects of the subprojects; developing technical guidelines for investment appraisal in major subsectors; and introducing enterprise appraisal as a criterion for subloan approval. These aspects have become an important part of ABC's credit appraisal process, both in project and nonproject lending, and are being extended to provinces that did not have an opportunity to participate in Bank Group-assisted projects. ABC recognizes this as one of RCIV's most important elements in contributing to its ongoing commercialization. 11. Subproject Performance. The ICR mission briefly assessed virtually all subprojects of which about 100 were reviewed in detail. This review indicates that with the improvement in ABC's portfolio management capabilities through RCI to III, the majority of RCIV-assisted subprojects, about 94 percent, are performing satisfactorily and are expected to reach their production and productivity improvement goals anticipated at appraisal. These investments were of a commercial nature based on recognized local competitive advantage, and were broadly consistent with sector strategies pursued by the government and assisted by the Bank Group. 12. Subloan Repayments. As per ABC calculations, as of December 31, 1996, subloans amounting to Y 217 million ($26 million equivalent) or 11 percent of the total outstanding subloans at Y 2.1 billion ($247.8 million) were overdue (or nonperforming), while interest due but remaining uncollected amounted to Y 54 million ($6.4 million equivalent). Subloans amounting to Y 17.3 million ($2.1 million) were classified as "bad." The overdue subloans at the regional level range from 3 percent in Hubei to 21 percent of outstanding subloans in Guangdong. Besides Guangdong, the other branches which had high levels of overdues included Beijing (15 percent); Liaoning, Jiangxi (11 percent) and Shaanxi (10 percent), reflecting the relatively high incidence of problem subprojects in these regions. Repayment periods for subloans set by ABC branches generally tended to be shorter than warranted by subprojects' cash flows, possibly because the branches hoped to accelerate the rollover of Bank Group funds, to enhance development impact of foreign funds and improve profitability on project operations. In reality, however, ABC branches had to often extend grace periods for repayment of principal, originally set at about one to two years, by a further two to three years due to subborrowers' inability to repay their obligations on due dates. The branches also routinely extended subloan grace periods to subborrowers even though they had the capacity to repay, collecting only interest due for the year. 13. This implicit rescheduling of subloans seemed to have encouraged subborrowers to (a) possibly hide their financial problems for extended periods; and/or (b) use repayments due to ABC as working capital or investment funds to expand their businesses, without necessarily subjecting themselves to ABC's reappraisal of their continued credit eligibility. For most of these subloans, ABC would be eventually required to extend originally-set subloan maturities. The branches' prevailing practice of  - 5 - extending subloan grace periods, besides significantly weakening portfolio management, has indeed exposed ABC to increased credit risks and potential problems with its repayment obligations to MOF under the project. 14. ABC's classification of subprojects by their likely outcome shows that the proportion of subloans involved in failed or problem subprojects in RCIV was significant, at about 16 percent of the total subloans disbursed or Y 380 million ($45 million equivalent). This could have serious implications for ABC's future profitability on project lending, as well as its total operations if their problems are not addressed.5 15. About 5.6 percent of the total investments (Y 221 million) in 27 subprojects (including a group of several small subloans for citrus development in Guangdong) have failed mainly because of natural disasters such as widespread floods and diseases affecting shrimp, scallop and eel culture in Liaoning and Guangdong, and citrus planting in Guangdong and Guangxi. A few (four) agroprocessing subprojects (Guangxi, Hunan and Jilin) have failed due to lack of markets, use of low or inappropriate technology, and poor financial management. ABC has started developing financial workouts with subborrowers, and enforcing guarantees for subloans against failed investments. 16. Besides failed investments, a number of subprojects (96) involving outstanding subloans of about Y 246 million (a sizable 10 percent of the subloan disbursements), have one or more problems-technical, financial, marketing and managerial-with potential to delay or reduce financial returns on related investments and possibly turn some of the problem subloans into bad debts. In terms of outstanding subloans, the problem subprojects relate predominantly to agroprocessing (54 percent), followed by livestock (27 percent), crops (8 percent), wholesale markets (6 percent) and aquaculture (5 percent). It is possible that the number and the amount of problem subloans could increase as ABC branches' current reporting on problem subprojects is not comprehensive and cover only those subprojects where the subborrowers have defaulted in payment of interest and principal. 17. Some of the subloans were clearly wrong decisions in terms of choice of technology, market prospects, and subborrowers' management capabilities. Additionally, some of the subprojects (mainly in the agroprocessing category) could not sustain anticipated profitability in a difficult macroeconomic environment that prevailed during the project period (1991-96), characterized by high rates of inflation and reduced access to credit. Among factors that contributed to the subprojects' poor performance were, in varying degrees, the following: (a) low profitability due to changes in relative prices of 5 At appraisal, annual write-offs of bad loans under the project were expected at about 1 percent of the outstanding loans; this may turn out to be a reality over the remaining life of the portfolio. The project had provided that ABC must receive a spread of at least 2.5 percent (after tax) so that it could build up necessary provisions for bad debts (up to I percent of interest spread on project lending). ABC, however, received a spread of less than 2.5 percent (subject to tax) and its bad debts provisioning continued to be regulated by MOF as part of a sectorwide policy based on fiscal considerations rather than the viability of the banking system.  -6 - inputs and outputs; (b) low capacity utilization; (c) lack of markets and marketing strategies; and (d) inadequate crop extension services, especially in remote/poverty areas. While these problems fall mainly within the purview of subborrowers, ABC branches and local governments' technical bureaus (which had sponsored the subprojects) should have assisted subborrowers to address these problems systematically, through effective extension services, supervision and monitoring and greater use of the TEG. 18. Problems faced by subprojects undertaken by state-owned enterprises are more acute as they lacked flexibility, resilience, and incentives for efficient management of related investments. As reform of the state-owned enterprises has become China's national priority for 1997 and beyond, ABC (especially at the provincial level) must use its financial leverage to accelerate the reform of the state-owned enterprises that are its clients, focusing first on those enterprises that have defaulted on the project-assisted subloans. These enterprises have various options such as reorganization; mergers; corporatization (shareholding arrangements); leasing; contract operations; sell-offs; and bankruptcy. This process is critical if ABC is to reduce RCIV's potential subloan losses. 19. Lending Through Rural Credit Cooperatives (RCC)s. Traditionally, ABC provided credit to state farms, collectives and specialized households. Individual households (peasant farms), which generally dealt with local RCCs for securing short- term production and farm improvement credit had practically no access to ABC. RCIV, therefore, extended the pilot started by RCIII of providing Bank Group funds (up to $10 million) to eligible RCCs in six new project provinces to enable local branches to develop operational strategies for RCCs' institutional development for microcredit operations. After a slow start, ABC and participating RCCs successfully implemented this component and gained valuable experience, even though RCC credit went largely to specialized households. With the separation of RCCs from ABC, follow-up on the pilot is expected to be continued by the new State Council organization for the RCC system. 20. Financial and Economic Rates of Return. A review of financial and economic analysis of some 40 representative subprojects indicated that rates of return on investments in crops and aquaculture continue to be strong. Financial rates of return (FRRs) and economic rates of return (ERRs) for livestock and agroprocessing would be lower due to changes in cost-benefit parameters and market prospects caused mainly by high rates of inflation during 1993-96 including adjustments introduced by the government in basic construction material, energy and transportation prices. For the project as whole, FRRs and ERRs would, however, be satisfactory at 22 and 24 percent, 2-3 percentage points lower compared to the appraisal estimates of 24 and 27 percent,  -7 - respectively. It is assumed that there would be no returns on failed investments.6 The net present value of the incremental production in crops, livestock and fisheries, together with value added by agroprocessing and marketing services, amounted to approximately $3.0 billion, as against the appraisal estimate of about $1.9 billion. The FRRs projected at completion for livestock and agroprocessing investments are estimated to be lower by 8 and 9 percentage points relative to the appraisal estimate but still are at satisfactory levels of 19 and 23 percent. The project benefits could, however, be enhanced if ABC and subborrowers rehabilitate and restructure the problem subprojects. Efficiency of Rural Financial Intermediation 21. Financial Sector Development. As part of a broader financial sector reform,7 the government took steps toward the project's objective to promote efficiency of rural financial intermediation and introduced important policy and institutional changes with regard to the rural financial system. ABC was split into two institutions: (a) the existing ABC retaining its commercial banking functions; and (b) the newly established "policy" bank, the Agricultural Development Bank of China (ADBC) assuming government business including subsidized credits for grain procurement and poverty alleviation. In 1996, the government also separated the RCC system, which was then operating under ABC's supervision, to function under a newly constituted organization under the State Council, operating directly under the general supervision of PBC (the central bank). Government initiatives to separate policy lending from ABC's commercial banking activity and RCCs from ABC's oversight were indeed consistent with the Bank's recommendations for financial sector reform, and RCIV's objective of promoting efficiency of rural financial intermediation. 22. As a result of these government decisions and the overlap with the Bank's subsequent Financial Sector Technical Assistance Project (FSTAP, Cr. 2423-CHA) some of the RCIV activities intended to support rural financial market development and broader financial sector development were considerably reduced in scope. For example, RCIV's mid-term review, which was intended to assess project implementation and the 6 The project's financial and economic rates of return at completion are based on recalculation of 40 representative investment models for principal subcomponents of crops, livestock, acquaculture, agroprocessing, and markets. The weighted average of the relative rates of return, by category of investments, were applied to the total investment cost of the project (including the cost of failed investments at 6 percent of the total on which no benefits have been assumed). The project FRR and ERR were lower compared to the appraisal estimate due to: (a) higher real prices of inputs and lower real prices of some of the outputs; (b) reduced yields on some investments; (c) changes in the relative shares of subcomponents in the investment program; and (d) increase in the standard conversion factor from 0.86 to I following the adjustment of the exchange rate. 7 Significant legislation was passed in 1995-the Central Bank Law, the Commercial Banking Law, the Negotiable Bills Law, the Insurance Law, and the Guarantee Law. The Central Bank Law provides PBC with the powers to regulate and supervise the banking system; the Commercial Banking Law stipulates capital adequacy, legal lending limits and insider trading, asset/liability management, and provides for compensation to financial institutions for losses that may result from loans to special projects at the behest of Government.  -8 - progress in financial sector development, was confined to only those aspects specifically affecting ABC and the financial sector review was left to be covered by the Bank Group's general financial sector dialogue with the government in the context of the FSTAP. Similarly, RCIV had proposed, a rural investment and finance study, under the leadership of MOF, focusing on further market orientation of credit and interest rate policies and introducing a competitive institutional base for rural finance, but the scope of this study was necessarily reduced to focus mainly on ABC's difficulties in raising longer-term resources for rural lending. Broad-based policy work in rural finance contemplated by RCIV was not carried out pending emergence of a new institutional set up contemplated for the financial sector. ABC, the newly established ADBC, and the State Council's Coordinating Group for Rural Reform (which is now responsible for RCC development) consider that the rationale for a broader rural financial sector review is now stronger than before, and that the Bank and government should find ways to continue their support for this activity. 23. ABC's Financial Management. While RCIV was being prepared, the Bank's financial sector operations including agricultural credit, had come under criticism: one objection was that traditional credit projects provided credit for production objectives rather than encouraging intermediation between savers and investors as an objective in its own right. The other objections included the traditional credit project's indifference to deposit mobilization, widespread use of subsidies, targeting without effect, and the use of specialized and protected agencies. The use of low interest rates in many such projects was seen as ineffective in reaching production and equity objectives and destructive in its impact on financial systems. The situation in China was not different, exacerbated by considerable uncertainty within China and within the Bank over the pace and direction of the financial sector reforms. The Bank was, therefore, exploring what kind of process credit operations in China should be trying to assist. 24. RCIV attempted to address the objective of upgrading ABC's financial management. However, some of the core features of the project that were explicitly designed to accelerate ABC's commercialization were either not implemented or only partially implemented. These included elimination of subsidies on onlending of IDA/Bank funds from MOF to ABC; ensuring minimum interest spreads to ABC and RCCs; and establishment of a recapitalization plan for ABC. However, the progress in this regard suffered a great deal as some of the core covenants under RCIV were either not implemented or the pace of implementation has been rather slow to have any significant impact. The Bank's Financial Sector Review8 had noted that it was then not feasible for China to replace the prevailing system of controlled interest rates by a system based on market forces mainly because the government still continued to use credit plans as a tool to influence the banking system's resource allocation across sectors and by types of subborrowers, including the level and pattern of investments in the economy. Interest 8 The World Bank, "China: Financial Sector Review: Financial Policy and Institutional Reforms," Report No. 8415-CHA dated June 29, 1990.  - 9 - rate liberalization per se would not have made much sense at the time unless the government was prepared to rapidly reduce its role in credit planning and increase the use of the interest rate as a tool in managing aggregate demand. This was expected to happen gradually as financial reforms were adopted. 25. Still within the bounds set by the Government's financial sector policy, RCIV attempted to introduce a comprehensive framework for interest rates and interest spreads that would have no element of subsidy and would help to ensure that ABC would remain a profitable and viable institution. However, the impact of various financial covenants, as they related to ABC, turned out to be far less than that expected at appraisal. (a) MOF Onlending to ABC. RCIV provided that (a) the MOF interest rate on Bank Group funds onlent to ABC in local currency should not be lower than the rate charged by PBC on ordinary long-term loans to other specialized banks, so that no subsidies were provided to ABC in relation to other specialized banks or sectors; and (b) the MOF rate on both IDA and IBRD funds onlent to ABC in foreign currency should not be lower than the rates charged by the Bank to the government on IBRD loans. This covenant, which was intended to eliminate subsidies to ABC and accelerate its commercialization, however, was not complied with. MOF onlent Bank Group funds entirely in foreign exchange at 5.4 percent, the weighted average cost of the IBRD/IDA blend. These funds should have carried an interest rate equivalent to that charged on IBRD loans (in the range of 7.2 to 7.5 percent); instead, ABC received an unintended subsidy of about 2 percent on the amount of $275 million disbursed over a period of six years. Surprisingly, the Government and ABC never sought Bank concurrence to use lower-than-market rates for project-assisted subloans. (b) Interest Spread on Project Lending: RCIV provided that ABC's interest spread on project lending should not be less than 2.5 percent (after payment of income and adjustment taxes to MOF) or such higher spread as may be agreed between the government and the Bank in order to enable ABC to fully cover its transaction costs and provide for possible bad debts annually up to 1 percent of the outstanding subloans under the project. ABC could have approached PBC to permit it to use flexible interest rates, which was possible both under PBC's policy for foreign-funded loans and project covenants; however, ABC did not do so as it feared that it would face client resistance to charging interest rates higher than those prescribed by PBC. Throughout project implementation, as ABC applied PBC-prescribed rates to project subloans, it was generally unable to earn the minimum spread of 2.5 percent (after tax). According to present calculations, ABC received a spread of less than 2.5 percent (before tax) during 1991-94 and 1996; in  - 10- 1995, however the spread was higher at about 3.23 percent.9 On subloans expressed in US dollars, which accounted for a very small part of the RCIV's loan portfolio, ABC received a spread of about 2.2 percent (before tax). ABC's view was that as it borrowed Bank Group funds entirely in foreign exchange (US dollars) and used these funds to expand its foreign exchange business, it earned profits that were sufficient to make good the shortfall in interest spreads on local currency subloans under the project. Perhaps, overall, ABC did earn additional margins that were sufficient to make good the shortfall in interest spreads on project subloans. However, if ABC had paid market rates on Bank Group funds borrowed in foreign exchange, the potential for cross-subsidization of local currency subloans would have been negligible. Moreover, RCIV had not contemplated cross-subsidization of local currency subloans, given that ABC's foreign exchange business had its own costs and risks, and that such cross- subsidization would not have been helpful to establish a sustainable lending program in the rural sector. (c) Positive Interest Rates on Project Lending. RCIV provided that ABC should onlend project funds to subborrowers at least at the same interest rates that it charges on subloans for similar purposes with similar maturities outside the project; and that taking into account inflation in the economy, interest rates paid by final beneficiaries on project subloans would remain positive in real terms. However, during 1993-95, interest rates especially on subloans with maturities up to five years prescribed by PBC were generally negative. Since ABC was using PBC-prescribed interest rates, the needed adjustment in interest rates was not made. (d) Interest Spread on ABC's Total Banking Business. RCIV had stipulated that ABC's interest spread on total banking business (including commercial and policy-based lending), should be adequate (after payment of taxes) to maintain its overall financial viability and profitability, and to enable ABC to make provisions for bad debts on the basis of criteria acceptable to the Bank Group. During the project period, PBC continued to administer interest rates that regulated ABC's interest spreads. ABC remained profitable (according to its income statement based on Chinese auditing principles) during the project period; however, its profits continued to be subject to tax, and its bad debt provisioning was still regulated by MOF guidelines. (e) ABC's Recapitalization. For ensuring ABC's overall financial viability, RCIV included the following covenants: (a) ABC's equity should not be 9 The interest spreads were as follows: 1.35 percent in 1991; 2.19 percent in 1992; 1.75 percent in 1993; 2.36 percent in 1994; 3.23 percent in 1995; and 1.88 percent in 1996.  initially less than 5 percent of the risk assets; and (b) MOF and ABC should develop a recapitalization plan for ABC, indicating the likely mechanisms of equity replenishment. The goal was to raise in phases ABC's risk-weighted capital adequacy ratio to 8 percent as per international standards (Basle Committee recommendations). As ABC was in the process of being split up and PBC began to pursue this aspect for the banking system as a whole, ABC did not prepare the recapitalization plan under RCIV. However, since July 1994, all commercial banks including ABC are required to provide to PBC for review the information on capital adequacy ratio. Furthermore, both the IMF and the Bank are of the view that recapitalization without first addressing more fundamental issues is not a good strategy. (f) Portfolio Review. As part of RCIV preparation, ABC carried out a comprehensive internal loan portfolio review and had agreed to update this information annually for ABC as a whole and for the project provinces for purposes of assessing ABC's overall subloan collection performance and adequacy of interest spreads, bad debt provisions and capital. ABC's initial proposals were that the responsibility for writing-off of accumulated bad debts arising in respect of loans disbursed prior to the end of 1988 should be undertaken by the government, and for bad debts against loans disbursed after that date by ABC. This approach was not pursued. Instead, ABC continued to follow prevailing MOF rules by which ABC anmually made incremental provisions for bad debts at the prescribed rate of 0.08 percent of the outstanding loan amount. Clearly, this amount is very low relative to the large volume of ABC's (or any other bank's) nonperforming loans. MOF's bad debt provisioning rules are not consistent with international standards and are primarily governed by fiscal considerations. (g) General Interest Rate Structure. While the level of interest rates, especially of the lending rates, is gradually becoming an important tool for managing aggregate demand, in recent years low and often negative rates of interests have, inter alia, affected the efficiency of financial intermediation, and encouraged relatively capital-intensive production in enterprises that have access to credit. During RCIV negotiations, the Bank had reached an understanding with the government (which also represented PBC) and ABC that while the loan/credit agreements should aim to rationalize onlending terms and conditions for the project, the government, ABC and the Bank Group should seek ways to rationalize the general interest rate structure for rural households, collectives, state farms and township and village enterprises (TVEs) by purpose and subloan maturities. This was proposed to be done during the course of project supervision, while related policy issues were to be considered by the proposed study of rural finance and investment and the project's mid-term  - 12- review. However, since the latter activity was moved to another Bank Group-assisted operation, namely the FSTAP, the issue of rationalizing the general interest rate structure was not effectively pursued during project supervision. 26. In retrospect, the project agenda seems to have been too ambitious, considering China's record of gradualism in the area of financial reform. The Minutes of Negotiation recorded that while the Chinese delegation agreed with the onlending terms proposed on the project, they "noted that, in order to achieve these onlending rates, considerable difficulties had to be overcome." This is not to say that ABC languished in the controls and constraints imposed on a financial sector that was emerging from its role as state fiscal agent into conmmercial banking organizations. ABC is ranked by asset size as among the top 100 banks in the world (Institutional Investor, August 1995). Probably the most significant event affecting ABC (and the other specialized banks) was the Third Plenum of the Fourteenth Party Central Committee in November 1993 which issued its "Decision on Issues concerning the Establishment of a Socialist Market Economic Structure." This document outlined a 50-point agenda for economic reform, including a long-term strategy to stimulate rapid transformation of the Chinese financial system and to gradually transform the specialized banks into commercial banks. Only then could ABC truly embark on a route toward commercialization, and its progress is outlined in Box 1. Human Resource Development 27. RCIV focused on core activities in ABC's very large training program that is funded from its own resources including: (a) training of trainers at three national training colleges (Tianjin, Wuhan and Changchun) and 147 regional/vocational training schools; (b) conduct of special courses for project/credit staff in project appraisal, supervision and monitoring; and (c) purchase of equipment for ABC headquarters, project provinces and the three national training colleges. Overall, during 1991-96, some 24,750 officials (including 500 trainers) received training under the project-assisted programs. About 350 officials (including 20 trainers from three national training colleges) were trained abroad, focusing on financial management, risk analysis, internal audit, foreign exchange business; foreign languages; and information technology. Domestic and overseas training for a large number of managerial staff has significantly enhanced ABC's institutional capabilities for rapid commercialization. ABC's three national training colleges have, over the years, developed comprehensive training material in collaboration with the Bank's Economic Development Institute (EDI). By investing about $650 million equivalent from its own resources since its reestablishment in 1979, ABC has developed infrastructure that is capable of training annually about 200,000 staff in different programs. With its ongoing commercialization, ABC is in the process of reorienting some of its trainers and training programs, and twinning with universities and banking institutes abroad, in Europe and the United States, to effectively address skill requirements of its new mandate.  - 13 - C. IMPLEMENTATION RECORD AND MAJOR FACTORS AFFECTING THE PROJECT 28. The main factors that had affected the achievement of RCIV's objectives as envisaged at appraisal were the following: Factors Subject to Government Control 29. Macroeconomic Environment. RCIV started in a relatively stable macroeconomic environment (with inflation rates ranging between 3 percent in 1991 and 5.4 percent in 1992) but faced high rates of inflation in the following two years, at 13 percent in 1993 and 21.4 percent in 1994. Though later years saw the inflation decelerating as a result of the government's successful implementation of stabilization policies, the inflation rates were still high at 15 percent in 1995 and about 10 percent in 1996. The inflation was driven mostly by increases in administrative prices for food, petroleum, coal and steel (and accommodated by excessive monetary expansion generated in part from sharp increases in foreign exchange reserves). On the one hand, this slowed down the completion of several subprojects, as ABC and subborrowers faced the constraint of raising counterpart funds; and on the other, subprojects that were completed during 1991-93 faced a severe shortage of working capital in the wake of PBC's tightened controls on bank credit. 30. The changes in relative prices of inputs and outputs reduced the profitability of some investments. The fallout was that several of ABC's subborrowers defaulted in subloan repayments, affecting the quality of RCIV's loan portfolio. As ABC had made the bulk (close to 80 percent) of the total subloan commitments proposed under the project by the end of 1992, the project could not effectively respond to economic stabilization measures by reducing the level of new lending and making subproject appraisal more rigorous, so that the project-financed portfolio would still be viable in an inflationary environment. Demand for project funds was also exacerbated by the fact that during the periods of high inflation (1993 and 1994), PBC-administered rates were negative in real terms. 31. Financial Sector Policy. During the early years of project implementation, the credit plan was the centerpiece of monetary management and guided the bulk of all lending activity. By setting limits on prices (interest rates) and quantities (credit ceilings), PBC tried, often unsuccessfully, to accomplish the dual objectives of directing credit while maintaining macroeconomic stability. Aware of the increasing inconsistency between China's highly decentralized and largely market-driven economy and a centrally plamned credit allocation, the authorities began to reduce the scope of the credit plan until by 1995, it was only applied to the four specialized banks and the policy banks, with other banks' lending controlled through asset/liability management ratios. The specialized banks are allowed to extend additional credit only if deposits exceed targets. The government's stated position is to continue to gradually phase out the credit plan, while pressing ahead with the development of indirect instruments.  - 14- Box 1: ABC's PROGRESS IN COMMERCIALIZATION * Establishment of ADBC Completed. The separation of ABC's "policy" business into ADBC, which started in 1994, was completed in 1996. ADBC, which used ABC's agency services for the past two years, now operates through its own branch network. * Separation of RCCs Completed. By end-1996, ABC had fully entrusted the administration of the RCC system to the Rural Finance Reform Office, set up under the jurisdiction of the State Council. * New Charter Prepared. Following the requirements of the new Law on Commercial Banks (1995), ABC has introduced a new charter and important initiatives in following key areas: Assets and Liability Ratios Management; Accounting and Audit; Personnel Management; Branch Network Assessment; Resource Planning and Adjustment; Capital Operations; Deposit Mobilization; Loan Portfolio Management; Noncredit Business; and Financial Management. * Pilot Programs Introduced. Several provincial and lower-level branches have piloted new management practices and improved credit risk management; profitability norms, organizational efficiency and quality of services provided to clients. * Large-Scale Readjustment and Relocation of Grassroots Offices Under Way. Over the past years, about 7 percent of the total number of offices (about 50,000) have been closed and/or relocated, using business potential and efficiency criteria. This process will continue over the next several years, with emphasis on closing down of unprofitable branches in rural areas and opening of new branches in urban areas. * Business Development. Much progress has been made in improving the quality of banking and financial services to clients. Besides traditional banking, ABC has introduced international banking services; credit card business; trade bills settlement; and other kinds of agency and noncredit services. Over 90 percent of the branches in large- and medium-size cities have computerized their operations and electronic banking including ATM stations. Some 6,000 offices are connected to electronic payments/ remittance systems. * Review of Financial Management Practices. In conjunction with RCIV and using the Asian Development Bank's technical assistance, ABC completed four major reviews as follows: Project Lending Review; Risk Management Policies and Procedures; Accounting Systems Review; and Accounting Systems Improvement. While the Financial Management symposium planned under RCIV for March 1991 was not held (as the Bank and ABC thought that this activity could be better handled by the Bank-assisted FSTAP), ABC carried out other activities provided by RCIV including the reviews of its medium- and long-term lending strategies and lending policies concerning its major client groups including TVEs, state farms, and the beneficiaries of poverty alleviation programs. The Bank reviews noted that the content of these studies were not analytical enough; moreover, in view of the change in ABC's business mandate, these studies would have to be redone or updated involving ADBC and RCCs. * Development of Business Plans. ABC carried out an activity that was not contemplated by RCIV appraisal, namely the development of business plans, on a pilot basis, for two provincial branches (Henan and Fujian) in conjunction with the preparation of the proposed ABC Commercialization Project for possible Bank assistance. These business plans focused on issues such as strategic analysis, financial analysis, portfolio analysis, and development of action plans that would accelerate ABC's commercialization. ABC proposes to field-test a suitable methodology and framework for the preparation of business plans, for purposes of replication in other provinces. . ABC's Management Information System. Based on the studies carried out as part of appraisal, RCIV had provided for a review of ABC's management information system (MIS) and related computerization programs. Using a long-tenn consultant to study this topic, ABC's management reviewed a medium- to long-term strategic plan for ABC's computerization and the development of an MIS. Some of the key elements of this work have been included in ABC's Ninth Five-Year Plan. ABC's MIS is still in a formative stage and needs much strengthening.  - 15 - Factors Subject to ABC Control 32. Project Implementation. Generally, RCIV relied excessively on government agencies for technical support, which are becoming increasingly out-of-date on broader technology and subsector issues. The use of TEG and local consultants helped to improve subproject designs and layouts to some extent, but as demonstrated by the incidence of problem projects, these arrangements were not adequately used by ABC branches, with a possible consequence that technical experience gained in one province has not benefited other areas. At the provincial level, ABC's supervision over subprojects, despite considerable improvement over RCI to III, was still less than optimal, especially in terms of ensuring compliance with technical standards, addressing subproject performance problems, and ensuring timely repayment of subloans. 33. Subprojects financed by RCIV generally followed local environmental regulations; however, for a good number of agroprocessing subloans, the Bank supervision missions pointed out deficient wastewater treatments. ABC promptly asked subborrowers to rectify environmental problems, stopping subloan disbursements where needed. ABC has now established a joint agreement with the National Environment Protection Agency for technical collaboration. 34. During the initial years of the project (1991-92), ABC's compliance with Bank Group procurement guidelines was a problem area as the provincial branches used local guidelines for national competitive bidding (NCB) and limited international bidding (LIB) procurement and shopping (both domestic and international) seemed to be the most frequently used procurement method. However, during project implementation, ABC revised local guidelines; provided necessary orientation and training to project staff and subborrowers; and brought about significant efficiency in procurement of goods and services. Factors Subject to Subborrower Control 35. Problems faced by several subprojects could be attributed to the lack of market orientation and management capabilities at the level of subborrowers. In several subprojects, subborrowers have not scrupulously followed technical standards recommended by the project; used traditional (and costly) designs and layouts, did not adequately explore marketing strategies, and ignored efficient financial management. Examples include: (a) failure to follow breeding and nursery guidelines to produce virus- free planting material for oranges which resulted in substantial losses in Guangdong and Guangxi; (b) financing investments in cotton and silk processing in Hunan, without adequate profitability and market analysis; and (c) poor technical and financial management of poultry breeding in Beijing and shrimp and eel production in Liaoning and Guangdong. Clearly, ABC and the governments' technical bureaus should have assisted clients more systematically to address these problems through necessary orientation programs and effective subloan supervision.  -16- D. PROJECT SUSTAINABILITY 36. The project's sustainability is uncertain. The real sector benefits are likely to be substantial, including increased production and productivity in a regime of diversified agriculture, incremental employment, enlarged product markets, enterprise efficiency, substantial use of improved technologies and environmental awareness. ABC's sustainability and its continued profitability will be somewhat contingent on the financial reform process. The existence of strong linkages between the fiscal, banking and enterprise sectors, and organizational changes needed to transform the existing institutions with different mindsets, culture and traditions into market-based institutions will take time. The pace of commercialization of ABC and the other formerly specialized banks will to a large extent be influenced by state enterprise reforms, since the financial health of one affects the financial health of the other. E. BANK PERFORMANCE 37. The Bank's approach, during project identification, preparation and appraisal, to achieve broader financial sector objectives (such as sectorwide interest rate reforms) through a single FIL such as RCIV, seems in retrospect too ambitious. The project had four different task managers over the six-year implementation period. Because of this and the fact that substantial organizational changes (split off of policy lending and then RCCs) were either impending or occurring during the course of implementation, supervision missions concentrated on tracking progress of the subprojects, and the eleven provincial branches' performances in subloan administration, instead of the overall institutional development of ABC and the financial sector objectives of RCIV. In retrospect, supervision did not place adequate emphasis on the institutional and sectoral objectives of the project and, therefore, is rated as deficient. F. BORROWER (MOF) AND BENEFICIARY (ABC) PERFORMANCE 38. The borrower (MOF) was not expected to have a direct role in RCIV implementation except for two sectoral activities, namely, the project's mid-term review and the rural finance and investment study. However, since the scope of these activities was reduced in the wake of ongoing financial sector reforms, ABC was asked to complete these studies focusing on its operations. It is unclear why MOF did not use market-based rates (or IBRD rates) for onlending Bank Group funds to ABC as required under the Loan/Credit agreements and why it did not seek the Bank's prior concurrence to use lower-than-market/IBRD rates. This left one important objective of the project, namely elimination of subsidies to ABC lending, unachieved. The ICR mission was informed that all future Bank Group loans/credits to financial intermediaries will carry market- based interest rates. 39. ABC on its part made best efforts to implement the project efficiently in spite of various systemic problems and the lack of adequate skilled manpower. In implementing RCIV, after initial difficulties concerning compliance with the Bank's procurement and environment guidelines (largely discovered through Bank supervisions), ABC made  - 17- major strides in rectifying the problems, improving subproject appraisal and supervision, and enforcing Bank procurement and environment protection guidelines. ABC did not, however, integrate project lending with its mainstream credit departments to improve the project's institutional development impact, efficiency of resource planning, portfolio management, and quality of financial services provided to clients. Because of this lack of integration, RCIV could make only a limited impact on improving the quality of ABC's lending and portfolio management. G. ASSESSMENT OF OUTCOME 40. The project outcome is viewed as unsatisfactory on the basis that it at best only partially achieved its sector policy and institutional development objectives and its level of achievement of the financial objectives was negligible. One could ask how an institution that had satisfactorily implemented three previous projects could perform poorly on the fourth. Also, it is unusual to rate a project with an estimated final ERR of 24 percent as unsatisfactory. But RCIV had higher aims than the earlier projects, extending into the overall operations of ABC and even into the government's financial sector development strategy. The same project in today's financial sector environment would have a much greater chance of achieving its objectives. 41. Sector Policies (Partial Achievement). The financial sector policies that had the greatest effect on ABC during project implementation-separation of policy lending (including grain procurement and poverty alleviation) from ABC into a newly established financial intermediary and separation of the rural credit cooperative system from ABC's oversight-were not the result of the project, but were definitely within the overall objectives of the financial sector reform recommended by the Bank and intended to be supported by the project. The RCIV activities intended to support rural financial market development and broader financial sector development-a study of rural investment and finance and ongoing consultations with the Bank on a general interest rate structure (this was an understanding reached at negotiations, but not covenanted)-were, in the case of the forrner, reduced in scope as a result of the split of ABC and by the overlap with a subsequent FSTAP, which focused on reforms applicable to all financial institutions and for the latter, not pursued. 42. Financial Objectives (Negligible). The financial objectives that the project had envisaged-elimination of subsidized credit, a more rational interest rate structure for the project and for ABC as a whole, and adjustment of the provision for bad debts to levels more realistic and in line with international practice-were not implemented within the time frame of project implementation. It is unclear why MOF provided subsidized credit to ABC, but the interest rate structure and provisioning are issues still unresolved for the sector and still being addressed by the Bank on a project-by-project basis. The Bank is now of the view that deregulated interest rates are an important objective, which can best be fully attained only in the final stages of the financial reform process after a number of conditions, such as macroeconomic stability, contestable financial markets, healthy financial  - 18 - institutions and real sector enterprises, trained bank staff and bank supervisors, and modem accounting and auditing systems, have been put into place. 43. Institutional Development (Partial Achievement). The main objectives of the institutional development programs were to upgrade ABC's financial management (with a symposium in Beijing, which ABC and the Bank decided could be better handled by the FSTAP). Some studies were carried out and reviewed by the Bank, but not pursued further in light of the impending split of policy lending and RCC oversight. ABC's recapitalization plan was not prepared, but there is a view in the Bank that this recapitalization without first addressing the more fundamental issues is not a good strategy. ABC did not provide the updated portfolio review annually to the Bank. 44. Physical Objectives (Substantial Achievement). About 94 percent of the subprojects are performing satisfactorily and are expected to reach their production and productivity improvement goals. The remaining 6 percent of the subprojects, accounting for 16 percent of the subloan amounts disbursed, are rated as failed or problem projects with the potential to further increase the proportion of overdue/nonperforming loans, the estimated FRR and ERR are 22 percent and 24 percent, respectively. 45. Poverty Reduction (Partial Achievement). Lending in poverty counties amounts to about 22 percent of the total subloan amount. H. FUTURE OPERATION 46. ABC would take steps, in conjunction with its clients, to improve performance of problem subprojects; spearhead the reform of state-owned enterprises that have borrowed project funds; and improve portfolio management to reduce overdue subloans. ABC should also continue various institutional development activities started by RCIV, including trainers' training and staff training programs in investment appraisal, project monitoring, and financial management. ABC should use its three national training colleges and several regional training institutes to disseminate skills and experience in project lending gained through RCI to RCIV. 47. Competitive Banking Model. When RCIV was processed, it was ABC's primary mandate to support rural financial intermediation and real sector development (including poverty alleviation). However, since ABC is now in a transition to becoming a full-fledged commercial bank, the Chinese authorities should focus on using a range of institutions including all commercial banks (not just ABC), the RCC system, policy banks, and nonbank financial intermediaries in order to promote competition and efficiency in the provision of financial services to the rural sector. The government and PBC should launch a broad-based program to develop institutional capabilities within the RCC system, ADBC, as well as ABC to enhance achievement of objectives of RCIV and the three earlier Bank-assisted rural credit projects. 48. Interest Rates and Recapitalization. In future, financial sector policies pursued by PBC and the government should ensure that ABC and similar financial institutions  - 19 - receive adequate interest spreads on foreign-funded (as well as domestic) lending to enable them to (a) fully meet transaction costs (including realistic provisioning for bad debts) and (b) earn a reasonable profit (after tax) so that they could increase their equity and/or pay a reasonable dividend on equity. Over a period, allowing commercial banks to raise private capital is an issue that must be addressed by a broader financial sector dialogue between the Bank and the government, if the processes started by RCIV and other similar Bank-assisted financial sector operations are to be sustained. Meanwhile, subject to continuing review of ABC's capital adequacy ratio, MOF guidelines on bad debt provisioning need to be revised, as well as ABC's ability to increase its capital base enhanced so that it could efficiently cope with problem loans, without jeopardizing its status as a viable universal bank. 49. Greater Donor Coordination. Future financial sector and financial intermediary operations in China should ensure greater donor coordination (among the Bank, the Asian Development Bank and the International Fund for Agricultural Development) to avoid wasteful overlap and duplication in technical assistance. 50. Technical Assistance: Design and Scope. RCIV relied for technical support excessively on government agencies that are becoming increasingly out-of-date on broader technology and subsector issues. China's future rural finance programs should facilitate subborrowers to engage technical experts competitively and irrespective of whether they work for the government or in the private sector. Future Bank Group and other donor-assisted credit operations should provide increased focus on strengthening ABC's portfolio management, institutional mechanisms for transferring new technologies to subborrowers, and stricter compliance with environment protection regulations. The project design should also place increased emphasis on the quality of subproject appraisals, which must adequately address product marketing issues and strategies for accessing domestic and/or export markets. 51. At the grassroots level (especially in poverty areas), many ABC and RCC clients still regard bank credit as a grant from the government. If new rural credit programs are to be launched, this perception must be changed through client education, involvement of self-help groups, accelerated introduction of new types of micro savings and credit programs, and institutional development of grassroots-level financial institutions including numerous types of rural credit cooperatives. The government should carry out a comprehensive rural finance and investment study that was contemplated by RCIV to address the above issues. I. KEY LESSONS LEARNED 52. The key lessons learned from the project include the following:  - 20 - (a) Limit to Reform. There is a fairly narrow limit as to how far an FIL for one banking institution can go in achieving reform objectives for the whole financial sector. (b) Ownership. When financial sector objectives are introduced into an FIL, all stakeholders (in this case, specifically PBC) must be explicitly involved and exhibit ownership of and commitment to the project objectives. (c) Consensus. The Bank and Borrower should only develop projects for which there is a strong consensus and common understanding about the main objective of the project, particularly in a complex and sensitive policy area such as financial sector reform. (d) Simplicity. Projects must be kept simple enough that both Bank and implementing agency resources are not stretched beyond capacity to supervise implementation.  - 21 - PART II: STATISTICAL TABLES TABLE 1: SUMMARY OF ASSESSMENTS Achievement of Objectives Substantial Partial Negligible Not Applicable Macroeconomic policies x Sector policies X Financial objectives X Institutional development X Physical objectives X Poverty reduction X Gender issues x Other social objectives X Environmental objectives X Public sector management X Private sector development X Project Sustainability Likely Unlikely Uncertain x Rank Performance Highly Satisfactory Satisfactory Deficient Identification X Preparation assistance X Appraisal X Supervision X Borrower Performance Highly Satisfactory Satisfactory Deficient Preparation X Implementation X Covenant compliance X Operation (if applicable) X Assessment of Outcome Highly Satisfactory Unsatisfactory Highly Satisfactory Unsatisfactory x  - 22 - TABLE 2: RELATED BANK LOANS/CREDITS Year of Loan/Credit Title Purpose Approval Status Rural Credit I (Cr. 1462-CHA) Provision of medium- and long-term loans in FY84 Completed Guangxi for investment in aquaculture, orchards, agroprocessing, livestock and TA. Rural Credit II (Cr. 1 642-CHA) Provision of medium- and long-term loans in FY86 Completed Fujian and Hunan for investment in aquacul- ture, orchards, agroprocessing, livestock and TA. Rural Credit III (Cr. 1871 -CHA) Provision of medium- and long-term loans in FY88 Completed Anhui, Henan and Hubei to stimulate growth and diversification of agriculture and increase the operational efficiency of ABC. Financial Sector Technical Support to govemment for continued FY93 Ongoing Assistance Project financial sector refonn (Cr. 2423-CHA) Agricultural Bank of China ABC's capacity building as a commercial Under preparation Commercialization Project bank. TABLE 3: PROJECT TIMETABLE Steps in project cycle Date planned Date actual Identification 04/88 10/03/88 Preappraisal - 08/08/89 Appraisal 11/89 12/11/89 Negotiations 04/90 09/10/90 Board presentation - 10/30/90 Signing - 12/10/90 Effectiveness 12/90 03/22/91 Project completion 06/30/95 12/31/96 Loan closing 12/31/95 12/31/96  - 23 - TABLE 4: LoAN/CREDIT DISBURSEMENT: CUMULATIVE ESTIMATE AND ACTUAL ($ million) FY91 FY92 FY93 FY94 FY95 FY96 FY97 Appraisal estimate 30.0 80.0 150.0 220.0 275.0 Actual 31.4 112.3 172.5 220.8 259.2 268.8 274.6 Actual as % of adjusted estimate 104.8 140.4 115.0 100.4 94.3 Date of final disbursement February 5, 1997  - 24 - TABLE 5: KEY INDICATORS FOR PROJECT IMPLEMENTATION Key implementation indicators in SAR Unit Estimated Actual La Incremental Production at Full Development: Crops Fruit ton 360,000 490,280 Vegetable and other specialty crops ton 170,000 163,420 Bamboo ton 1,000,000 117,500 Tea ton 40,000 12,280 Mulberry and cocoon ton 180,000 13,210 Livestock Cattle head 200,000 110,840 Sheep/Goat head 450,000 65,600 Poultry bird 21,000,000 13,304,000 Pig head - 165450 Fishery Freshwater fish ton 13,000 28,670 Shrimp ton 1,800 84 Scallop ton 6,000 2,490 Fingerling n/a adequate adequate Agroprocessing Fruit processing ton - 11,870 Fruit storage ton - 24,470 Livestock product ton - 12,610 Animal feed ton - 223,560 Tea processing ton - 5,600 Chinese medicine ton - 20,340 Cold storage ton - 97,620 Market each - 20 Incremental production value $ million 600 826 Incremental employment generation person/year 108,000 655,900 Training person - 24,750 La Figures are rounded.  - 25 - TABLE 6: KEY INDICATORS FOR PROJECT OPERATIONS (Not Applicable) TABLE 7: STUDIES INCLUDED IN PROJECT Study Purpose as defined at Status Impact of Study Appraisal/Redefined Study of rural invest- Review of rural financial Partially done focusing on Limited as ABC now in transi- ment and fnance institutions and credit ABC's constraints to raising tion to become a universal bank; and interest rate policies long-term funds for rural rural lending being moved to lending ADBC and RCCs Development of ABC's Review of status of lend- Completed Conclusions incorporated in lending policies for ing to TVEs, state farms ABC's lending policies major client groups and poverty groups  - 26 - TABLE 8A: PROJECT COSTS (Y million) Appraisal Estimate Actual/Latest Estimate La Local Foreign Total Local Foreign Total Crops 614.5 153.9 768.4 724.1 181.0 905.1 Livestock 535.2 134.0 669.3 448.0 112.0 560.0 Aquaculture 301.1 26.0 327.1 359.3 31.3 390.6 Agroprocessing & Marketing 572.1 245.0 817.0 1,509.4 621.3 2,130.7 Technical Assistance 5.7 8.5 14.2 6.3 8.6 14.9 Total 2,028.7 567.3 2,596.0 3,047.1 954.2 4,001.3 /a Source: ABC provincial branches. TABLE 8B: PROJECT COSTS ($ million) Appraisal estimate Actual/latest estimate /a Item Local Foreign Total Local Foreign Total Crops 130.2 32.6 162.8 125.3 31.3 156.6 Livestock 113.4 28.4 141.8 73.0 18.2 91.2 Aquaculture 63.8 5.5 69.3 60.3 5.3 65.6 Agroprocessing & Marketing 121.2 51.9 173.1 235.2 97.1 332.3 Technical Assistance 1.2 1.8 3.0 1.0 1.3 2.3 Total 429.8 120.2 550.0 494.8 153.2 648.0 /a Source: ABC provincial branches.  -27 - TABLE 8c: PROJECT FINANCING ($ million) Appraisal Estimate Actual/Latest Estimate /a Source Local Foreign Total Local Foreign Total IBRD 42.2 32.8 75.0 57.4 17.6 75.0 IDA 112.6 87.4 200.0 152.3 47.3 199.6 ABC/RCCs 110.9 0.0 110.9 85.4 26.8 112.2 Subborrowers 164.1 0.0 164.1 199.7 61.5 261.2 Total 429.8 120.2 550.0 494.8 153.2 648.0 /a Increases in investment costs were financed mainly by the subborrowers. TABLE 9: ECONOMIC COSTS AND BENEFITS /a Appraisal Estimate Actual/Latest Estimate Activity FRR ERR NPV FRR ERR NPV (N) (%) (Y million) (%) (%/0) (Y million) Crops 31 36 837 30 34 1,334 Livestock 27 28 386 19 27 260 Aquaculture 27 26 198 25 28 223 Agroprocessing 32 43 421 23 23 1,379 Marketing /b - - - 14 14 46 Total Project 24 27 1,944 22 24 3,044 /a FRR and ERR represent weighted averages, based on 40 representative models for the five subcomponents and their relative shares in the total project-assisted lending program. lb Marketing component was not separately listed at appraisal.  - 28 - TABLE 10: STATUS OF LEGAL COVENANTS Cove- Original Revised Agree- nant Present fulfillment fulfillment ment Section type Status date date Description of covenant Comments DCA Art. 1, 3 C Project entities defined as Section 1.02(a) Fujian, Guangdong, Hubei, Hunan, Jiangxi, Jilin, Liaoning, Shaanxi, Inner Mongolia, Guangxi, Beijing DCA Art, 3 3 NC MOF to onlend proceeds to MOF applied rate applicable to Section 3.01 (b) ABC at IBRD rate blend of IBRD and IDA funds DCA Art. 3, 3 NC MOF to take measures to insure ABC continued to be bound by Section 3.02 that ABC has authority to PBC rates for subloans, which increase subloan interest rates in some years were negative in to achieve minimum spread of real terms. 2.5% or such other rate agreed with Bank/IDA and that subloan interest rates are positive in real terms DCA Art. 3, 12 CP 06/30/92 Govt/ABC to carny out studies The studies were partially Section 3.07(a) under Part C (rural investment completed, partly due to simi- and finance, rural financial lar work under the later FSTAP institutions, and credit and project and the implementation interest rate policies) of new financial sector reforms. DCA Art. 3, 5 CP 12/31/92 Midterm review of financial The mid-term review was Section. 3.09 sector reform, Project and restricted to project-related ABC's institutional develop- matters. However, a general ment, including risk-assets ratio review of financial sector and recapitalization reform program was held as part of FSTAP project supervi- sion. Review of project imple- mentation issues conducted as part of project supervision. No recapitalization plan was pre- pared and reviewed. DCA Sched. 4 5 NA Annual Calculation of interest rate from No onlending in yuan; all in MOF to ABC for onlending in foreign exchange. However, yuan MOF did not comply with covenant, which required onlending at IBRD rate. PA Art. 3, 3 NC Spread between cost of funds Interest rate spread on local Section. 3.02(a) and subloans to be 2.5% after currency subloans was general- taxes ly less than 2.5 % (before tax) during 1991-94 and 1996. Interest spread was also less than 2.5% (before tax) on for- eign currency subloans. How- ever, ABC reported that spreads on incremental foreign exchange business generated by RCIV helped to make good the shortfall but details are not available. ABC did not approach PBC to allow flexibility in interest rates admissible on foreign-funded subloans.  - 29 - Cove- Original Revised Agree- nant Present fulfillment fulfillment ment Section type Status date date Description of covenant Comments PA Art. 3, 3 CP ABC to maintain financial ABC maintained its Section 3.02(b) viability and profitability, profitability, but kept the bad including provisioning for bad debt provision at the low rate debts on the basis of criteria set by PBC. acceptable to IBRD/IDA PA Art. 3, 3 CD ABC to maintain equity at level Recent audit indicated ABC's Section 3.03 not less than 5% of its risk capital adequacy ratio at about assets 8%. Art. 3, 5 CD 12/31/91 ABC to provide recapitalization Section 3.04 plan to Bank; discuss plan with Bank; modify plan to ensure that ABC's risk-weighted capi- tal adequacy ratio to be at least 8%; carry out plan PA Section 4.01 9 C 06/30 Auditing of Provincial Project Separate reports prepared for annually accounts; provide to Bank/IDA each province include project certified copies of accounts and accounts and provincial branch financial statements, auditor's financial statements published report, and financial statements in Annual Report. ABC's of ABC's provincial and county global accounts audited by the branches in project provinces State Audit Agency. and ABC's total operations. PA Part A 5 C Procedures for appraisal and Para. I approval, including enterprise appraisal for state farms and intermediary enterprises PA Part A 3 C Free limit subloans defined as Para 2 subloang in an amount to be financed out of loan/credit proceeds not to exceed $3 million equivalent PA Part A 3 C Request by ABC for authoriza- Para 3 tion to withdraw from Loan/ Credit account for a free-limit subloan shall contain a sum- mary description of subborrow- er, subproject and terms and conditions of subloan; first two irrigation subprojects to be submitted to IDA for review. PA Part B 3 CD Subborrower contribution to be After some initial problems Para I at least 300/h of total invest- with subborrower contri- ment; interest rate for subbor- butions and interest rates, rowers to be not lower than compliance was satisfactory. ABC's or RCC's prevailing Interests rates turned positive rate, positive in real terms and in real terms during 1995 and in compliance with interest rate after with the decline in spread covenant; amortization inflation. to be based on cash flow and not to exceed 15 years; subloans to be withdrawn and repaid in yuan or foreign exchange, with subborrower to bear foreign exchange risk.  - 30 - Cove- Original Revised Agree- nant Present fulfillment fulfillment ment Section type Status date date Description of covenant Comments PA Part C 3 C RCC eligibility: satisfactory Para 2 financial condition; equity reserves not less than 15% of total loan portfolio, total amount of past due loans not to exceed 20% of loans outstand- ing and past due loans in arrears more than 3 years not to exceed 5% of total loans outstanding. PA Part C 3 CD For RCC subloans, ABC to Several ABC subloans Para 3 onlend not more than 50% of exceeded 50% of subproject subproject cost; require repay- cost, but these were adjusted. ment by RCC within same amortization period as subloan and with same grace period; interest at ABC's prevailing rate for similar loans to RCCs. PA Sched. 2 10 CD LIB procurement procedures to After considerable problems Section 1, be used for items or groups of initially, usually in compli- Part C I items of machinery and equip- ance. ment estimated to cost $50,000 or more if used for producing export products and $ 100,000 for producing for domestic market. PA Sched. 2 10 C NCB procurement procedures Section 1, to be used for items/groups Part C 3 estimated to cost between $50,000 and $ 100,000 (except for export production) and for civil works under Part A. PA Sched. 2 10 C Price quotations to be obtained Section 1, for items/groups estimated to Part C 4 cost less than $50,000 PA Sched. 3 5 C Each project entity shall estab- Part A I lish and maintain a project management committee, including a representative of the environmental protection agency (EPA) PA Sched. 3 5 C 12/31/91 ABC to maintain and strength- TEG and consultant rosters Part A 3 en its Technical Expert Group established at various levels (TEG) at headquarters and by Dec. 31, 1991, review progress of strengthening PA Sched.3 5 CP Dec. 31 ABC to conduct assessment of Area livestock components Part B annually use of Area Management Plan- reduced due to lower profita- ning techniques and review bility; AMP techniques satis- with Bank/IDA factorily implemented. ABC will continue use of AMP techniques in future lending. Covenant Class: Status: I = Accounts/audits 8 = Indigenous people C = covenant complied with 2 = Financial performance/revenue 9 = Monitoring, review, and reporting CD = complied with after delay generation from beneficiaries 10 = Project implementation not CP = complied with partially  - 31 - 3 = Flow and utilization of project covered by categories 1-9 NA = not applicable funds 11 = Sectoral or cross-sectoral NC = not complied 4 = Counterpart funding budgetary or other resources 5 = Management aspects of the allocation project or executing agency 12 = Sectoral or cross-sectoral policy/ 6 = Environmental covenants regulatory/institutional action 7 = Involuntary resettlement 13 = Other  - 32 - TABLE 11: COMPLIANCE WITH OPERATIONAL MANUAL STATEMENTS Operational Manual Statements were complied with. TABLE 12: BANK RESOURCES: STAFF INPUTS Planned Revised Actual Stage of Project Cycle Weeks $'000 Weeks $'000 Weeks $'000 Preparation to Appraisal - - - - 175.5 488.3 Appraisal-Board - - - - 70.8 209.4 Negotiations through Board Approval - - - - 14.4 47.3 Supervision - - - - 130.0 446.3 Completion - - - - 22.5 75.0 TOTAL 413.2 1,271.3  - 33 - TABLE 13: BANK RESOURCES: MISSIONS Performance rating Number Imple- Devel- Stage of Month/ of Days Specialized staff skills represented L/ mentation opment Type of project cycle year persons in field status Lb objectives problems Identification 10/88 7 26 CS/EC/AQSILS/AGS/APSIFA Preparation 04/89 4 32 CS/EC/APS/FA Preappraisal 09/89 10 35 CS/FAIEC/APS/AQS/AGSIMS/HS/LS Appraisal 12/89 8 30 CS/HS/FA/EC/APS/AGS/LS/IDS Negotiation 09/90 4 CSIEC/LW/DS Board approval 10190 Signing 12/90 Effective 03/91 Supervision 1 05/91 5 21 CSIEN/GD/APS/LS I I LC/PP Supervision 2 04/92 4 17 EC/CS/APS/AQS 2 1 OS/LC/PP/SP Supervision 3 09/92 9 23 EC/CS/APS/AQS/GS/LSIMSIIE/AGS 2 I OS/LC/PP/SP Supervision 4 11/93 4 24 APS/CS/AQS/OO I 1 OS/LC/CF/SP Supervision 5 06/94 4 22 CS/APS/OO S S CF/SP/EI Supervision 6 05/95 4 13 CS/APS/AQS/OO S S SP Supervision 7 05/96 1 3 EC S S LC Completion 03/97 4 20 CS/EC/APS/AQS /a AGS: Agricultural Specialist; APS: Agroprocessing Specialist; AQS: Aquacultural Specialist; CS: Credit Specialist; DS: Disbursement Specialist; EC: Economist; EN: Engineer; FA: Financial Analyst; GS: Grassland (Rangeland) Specialist; HS: Horticulture Specialist; IDS: Institutional Development Specialist; IE: Irrigation Engineer; LS: Livestock Specialist; LW: Lawyer; MS: Marketing Specialist; 00: Operation Officer. /b 1: Highly satisfactory; 2: Satisfactory; S: Satisfactory. /c CF: Counterpart Funds; El: Environmental Issues; LC: Legal Covenant; OS: Overall Status; PP: Procurement Progress; SP: Studies Progress.   - 35 - ANNEX A ANNEX A: BORROWER'S CONTRIBUTION TO THE ICR IMPLEMENTATION COMPLETION REPORT PREPARED BY ABC FOURTH RURAL CREDIT PROJECT (CREDIT 2182-CHA; LOAN 3265-CHA 1. The Project 1.01 Name of project: Fourth Rural Credit Project Credit No.: CREDIT 2182-CHA/LOAN 3265-CHA Region: East Asia and Pacific region Country: China Sector: Agriculture Subsector: Rural Credit Loan Amount: CR 2182: SDR 143.7 Million/LN 3265: USD 75 Million 2. Project Background 2.01 Following the introduction of economic reforms since 1979, China's agriculture has achieved a remarkable progress, with a rapid growth in the output of grain, poultry and animal husbandry. The outstanding feature of the buoyant farn sector performance in 1996 was a record grain harvest of 490 million tons, about 25 million tons above the previous record in 1995, enabling the country, for the first time, to reach the level of per capita grain consumption close to the world average. However, it is premature to suppose that China's grain production has hit a new, consistently upward trend considering the factors such as relatively small size of cultivated land per capita, increasing reduction in farm land due to diversion to non-agricultural uses, relatively backward methods of production, and production losses caused by natural disasters such as floods and drought. Also, with growing population and per capita incomes, demand pressures on agricultural production are increasing. It is, therefore, imperative for China to continue to improve agricultural efficiency through increased production, productivity, product diversification and quality improvement, accompanied by more efficient agro-processing and marketing systems. 2.02 Since its re-establishment in 1979, the Agricultural Bank of China (ABC) was mandated to support rural development and poverty alleviation programs. In 1994, the government launched major financial sector reforms, with ABC and other state-owned specialized banks beginning their transition to genuine commercial banks. Following the  - 36 - ANNEX A promulgation of the Commercial Banking Law, the ABC was split and its policy lending (for government-sponsored programs) was transferred to the newly established Agricultural Development Bank of China (ADBC). Subsequently, the government also separated the network of Rural Credit Cooperatives (RCCs) from ABC's supervision in 1996 to PBC, in order to accelerate ABC's transition to a genuine commercial bank. 2.03 At the time launching of the Fourth Rural Credit Project (RCIV) in 1991, ABC had successfully implemented the first two IDA-assisted rural credit projects, while the third one was under implementation. These projects played an important role by supplementing ABC's longer term resources for rural development, and ABC's institutional development. Name of Project Project No. Total Loan Completion Date Rural Credit I 1462-CHA 47.2m. SDR June 1988 Rural Credit II 1642-CHA 84.0m. SDR September 1991 Rural Credit III 1871-CHA 123 .8m. SDR June 1994 3. Project Objectives and Design 3.01 The main objectives (as followings) of the Fourth Rural Credit Project were as follows: (a) to stimulate growth and diversification of agriculture by financing investments by farmers, collectives and enterprises; and (b) to promote efficiency of rural financial intermediation through introduction of sound, market-oriented policies and development of the main rural financial institutions. 3.02 Objective (1) was achieved through the provision of credit for commercially viable production and productivity improvements in crops, livestock and fisheries, agro- processing, and agro-products market development with a special emphasis on environmental protection and poverty alleviation. 3.03 Objective (2) was achieved mainly through the provision of technical assistance to ABC for its and RCCs' institutional development, in conjunction with major rural financial sector reforms that were introduced by the govenment in 1993. 3.04 The RCIV was processed as per the following schedule: Preparation: 1988 Pre-appraisal: August 1989 Appraisal: January 1990 Negotiations: September 1990 Effectiveness: March 1991 Completion: December 1996  - 37 - ANNEX A 3.05 The Project covers following eleven provincial branches: Beijing, Inner Mongolia, Liaoning, Jilin, Jiangxi, Fujian, Hubei, Hunan, Guangdong, Guangxi and Shaanxi. 3.06 The project was implemented according to the Credit, Loan and Project Agreements consistent with the government's macro-economic policies and sectoral development strategies. The project made use of available natural resources and competitive advantages to develop local economies. The project generated about 656,000 incremental full time jobs especially for women and assisted in poverty alleviation. 4. Project Organization 4.01 ABC headquarters had set up a Project Office which was responsible mainly for external liaison and correspondence, and developing project implementation strategies and management including guidelines for subproject appraisal, monitoring, procurement, staff training and study tours. The project office also conducted project supervision, monitoring and evaluation. ABC's provincial branches were responsible for subproject appraisal except for subloans in excess of their approval powers; monitoring subproject performance; resource mobilization; and subloan collection. ABC headquarters undertook regular supervisions with focus on assessing subborrowers' financial status, subprojects' market analysis, environmental protection and portfolio management. 4.02 Subproject approvals were made generally in compliance with the covenants and guidelines outlined in the Loan/Credit and Project Agreements. Subloans exceeding USD 3 million equivalent were to be approved by the Bank Group, USD 2-3 million equivalent by ABC headquarters and others by provincial branches. The project implementation indicated that the free limit for provincial branches and ABC headquarters were rather low to ensure the achievement of institutional development objectives. 5. Project Implementation 5.01 A total of 1,780 subprojects were implemented under the Project. Detailed information are as following: Category No. of Projects Total Investment IBRD/IDA Funds (000 RMB) (000 RMB) Crops 1,135 905,100 393,281 Livestock 142 559,954 282,514 Fishery 141 390,670 146,780 Agro-processing 339 1,773,538 750,212 Wholesale market 23 357,180 150,460 Total 1,780 3,986,442 1,723,247  - 38 - ANNEX A 5.02 By the end of 1996, the project had financed planting of over 320,840 mu of fruits trees, 69,660 mu of tea, 889,520 mu of other crops; construction of 137,280 mu of fishery (including freshwater and sea water); raising of 110,840 cattle, 65,600 sheep and goat, 165,500 pigs, 13.3 million poultry; building or improving of about 340 agricultural product and by-products processing plants and supporting of 23 markets. The combined output value reached 6.9 billion RMB yuan. 5.03 At the beginning of the project implementation, ABC Headquarters had established a Technical Expert Group (TEG) at the national level. The TEG's main functions were to provide advice to subborrowers on technical designs and layouts; review subproject feasibility studies and ABC subloan approvals; and supervise subproject compliance with technical aspects. The Group carried out its responsibilities satisfactorily. ABC headquarters and provincial branches used the project cycle approach in implementing the project, by carrying out individual subprojects' feasibility studies, appraisal and monitoring, with necessary attention to procurement of goods and services and environmental requirements as per the Bank Group guidelines. These approaches have now been extended to ABC's non-project lending undertaken by mainstream credit departments. In fact, many subprojects' good performance could be attributed to the introduction of systematic appraisal procedures through a series of Bank/IDA-assisted projects. 5.04 The project period was extended by one year mainly due to: (a) a substantial increase in the lending program resulting from the depreciation of the yuan relative to US dollar (from 1:4.7 in 1991 to 1:8.7 in 1994) and (b) high rates of inflation during 1992- 1994, which caused a remarkable increase in the project investment cost, which inevitably created problems for ABC to find increased amount of counterpart resources, and financially sound sub-projects in subsectors and areas included in the project. 5.05 Most of the subprojects financed by RCIV are performing satisfactorily. However, some 123 subprojects (including a group of small citrus subloans in Guangdong), about 7% of the total, approved during the project's first two years, 1991-93 have problems with achieving expected rates of return and subloan collections. The problem subloans amount to 632 million yuan or 15.9% of the total investment. Most of the problem subprojects are predominantly in tree crops followed by livestock, fisheries and agro-processing. These subprojects are relatively small and located in remote and/or poverty areas where there is an acute shortage of trained manpower making it difficult for subborrowers to secure satisfactory technical and marketing services. Performance problems are more acute for subprojects undertaken by state-owned enterprises which often lack flexibility, resilience and incentives required for effective management. 5.06 In support of the project's poverty alleviation objective, the RCIV approved subprojects in as many as 90 counties in eleven project provinces, which are classified as poverty counties, with total loans of RMB 476 million, financing investments in sub- sectors such as crops and livestock.  -39- ANNEX A 5.07 Unlike RCI to III, the Ministry of Finance (MOF) wanted ABC to bear the foreign exchange risk on Bank Group funds and, therefore, passed on the entire amount of about USD 275 million to ABC in US dollars. ABC headquarters used part of the dollar funds for expanding its own foreign exchange business (by providing corresponding local resources to provincial branches) and passed on the rest to provincial branches also in US dollars. The provincial branches used dollar funds for financing their respective foreign exchange business and issued subloans in local currencies using their domestic funds. Except for a few subloans which financed export-oriented activities, all other subloans were expressed in the local currency. Subborrowers operating in the domestic market were generally unwilling to undertake foreign exchange risk. The People's Bank of China continued regulation of interest rates and the limited ability of the subprojects to bear market rates of interest, it was difficult for ABC to use the flexible interest rate policy proposed by the RCIV. ABC therefore could not comply with the project covenant that required it to ensure a minimum interest spread of at least 2.5%. ABC received an average interest spread of about 2.16%. 6. Adjustment of the Project 6.01 In a changing macroeconomic environment characterized by high rates of inflation and responding to the problems faced in implementing numerous subprojects spread over a vast area, ABC made some adjustments in the project's lending program and included some investments in agricultural wholesale markets most of which have proved to be successful. 7. Onlending to RCCs 7.01 By the end of 1996, ABC had onlent SDR 8.62 million of Bank Group funds to RCCs. The objective was to orient, on a pilot basis, a few RCCs to undertake project- type lending. The subloans under this component were provided mainly to individual farmers which helped improve their living standards, and in some measure contributed to poverty alleviation in remote areas. 8. Implementation of Part B 8.01 By December 31, 1996, ABC used SDR 1.597 million (under Part B of the project): SDR 925,000 for staff training and SDR 0.672 million for procurement of office equipment. A total of 24,750 persons(including 500 trainers from ABC's three colleges and training school) received training through various programs, and 354 persons (including 20 trainers from three colleges) participated in overseas training and study tours. Training courses focused on project appraisal, management, monitoring and evaluation; benefit-cost analysis; financial management; risk management; and market analysis. In addition, some 10 foreign experts were invited to undertake grassland regional planning and training and provide technical assistance on flax textile industry loans. Through these training activities, ABC's credit management level has been substantially upgraded and staff quality improved.  -40- ANNEX A 8.02 ABC carried out a study to review its lending policies for three major types of client groups under the project's TA program, including state farms; poverty alleviation; and township and village industries. Besides, ABC has reviewed its middle and long- term lending strategies, information technology, portfolio status, and business planing procedures. In conjunction with RCIV, ABC used ADB-provided TA to review its Risk Management Policy and Procedures, Project Lending Review, and Accounting System Improvement. All these initiatives have contributed to ABC's commercialization process. 8.03 As part of RCIV preparation, ABC had carried out a comprehensive loan portfolio audit and agreed to update this information annually for ABC as a whole, and for the project provinces for purposes of assessing ABC's overall subloan collection performance; and adequacy of interest spreads, provisions and capital. Because the decisions on loan provisioning and write-offs rest with the government, ABC could not effectively follow up on the measures proposed by the project. 8.04 Overall, ABC actively pursued RCIV's institutional development objectives and prepared itself for a rapid transition from a specialized bank to a commercial bank. With the promulgation of the Commercial Banking Law in 1995, ABC has improved its asset quality by introducing asset/liability ratio management and risk management, commenced rationalizing the organizational structure by closing down unprofitable banking office and laying off credit agencies and setting up new banking offices in developed suburb areas; and begun reform of its internal management. (ABC's additional comments on the Bank's assessment of the institutional development objective are included as Appendix 1.) 9. Execution of Legal Documents 9.01 In general, ABC followed the project implementation requirements stipulated by the legal documents. 9.02 Compared with the previous projects, ABC made remarkable progress in complying with project covenants concerning procurement of goods and services; subloan approvals; monitoring; and environmental regulations. 10. Project Sustainability 10.01 RCIV's contribution to ABC's institutional capacity building, especially the spheres of financial management, project appraisal and portfolio management, would continue to remain relevant to its new role as a commercial bank. ABC expects further Bank project support to upgrade its internal management including development of management procedures, human resource development and information technology to accelerated commercialization within the country's broader framework for financial sector development.  -41- ANNEX A 10.02 Following its on-going transition from a specialized bank for rural development to a commercial bank, ABC is in the process of adjusting its internal organization and branch network to enable it perform as a universal bank, in a competitive environment, and going to develop its market-oriented lending business. 11. Bank and ABC Performance 11.01 The Bank Group supervision missions made important contributions for smooth and successful implementation of the project. The missions' comments on key issues were promptly reviewed, and effectively followed up by ABC. The missions included experts in agricultural marketing; project monitoring, financing and supervision; and procurement. 11.03 ABC, as a project beneficiary and implementing agency made necessary efforts to ensure timely and successful implementation of the project, with a focus on improved portfolio management and institutional capacity building. 11.04 During the project period, ABC worked out a series of loan portfolio management rules and procedures; held diverse training courses for managers and trainers; reviewed its loan portfolio performance; studied lending policies for its major client groups; and assisted in improving subproject management. All these initiatives made were critical for successful implementation of the project. 11.05 ABC and the World Bank have, over the years, established a collegial relationship which was fundamental to the successful implementation of the project. 12. Lessons Learned 12.01 Because real sectors assisted by the project were limited to crop planting, animal husbandry, aquaculture and agro-processing, ABC's lending choices were limited to rural and poverty areas where there was considerable lack of trained manpower for technical assistance to subborrowers and project management. Consequently, several subprojects may not realize their expected financial rates of return which has partially affected the efficiency of the project. 12.02 Future financial sector and financial intermediary operations should ensure greater coordination (among the Bank, ADB and IFAD) to avoid wasteful overlap and duplication in technical assistance provided for financial sector development including rural finance. 12.03 While ABC's institutional capacity for project appraisal, implementation and supervision has significantly increased through the implementation of the RCIV and earlier projects, it needs to be further strengthened and broad-based, especially in context of ABC's new mandate for commercial banking. ABC should aim to integrate project- type lending with its mainstream credit departments and not run it as a parallel activity. This will help to achieve greater impact on institutional development and bring to bear  -42 - ANNEX A professionalism and quality in project lending; and ensure better performance of loan portfolio and financial management. 12.04 The new ABC commercialization project proposed for World Bank assistance should not restrict its line of credit to specific real sectors but allow ABC to lend to any activity that is commercially viable based on market conditions. Subprojects should not be widely dispersed making it difficult for the branches to exercise effective supervision.  - 43 - ANNEX A APPENDIX 1: ADDITIONAL BORROWER COMMENTS ON WORLD BANK ASSESSMENT RATINGS Agriculurar Bank of China Iaternadonal Department SiF,Yulong Hota 40Fuch=gRoad- Beijing 100036, Th Pcop1c'sRepublicofChina FAX COVER SHEET Dare: Augusr 4,1997 No. of Pages: 2 (including this page) To: Mr. Rick Scobev, Senior Ecoxlomist Rural Development and Naurral Resource Uait East Asia ar.d PaciJlc Region, The World Bank Fax Na.: 1-202-5-7 "1561 From: Min Wei, Deputy General Manager International Deoar=eat, ABC Fax No.: 86-10-68416011 Sabjecr: Revised ICR-RCIV Message: Dear-2r. Rick Scobey, Thank you very much fr your fax dated July l0, 1997 which clearly addressed the details of :he Bankk's views and the internal raings on RCIV project Regarding to the issues mentioned in your x we would lile to have fbllowing co=enzs: Based on the imnlementation of the forth rural credit project, we view the project was successfil and we caa get tie same conclusion from the Banies revised ICR. However, the project's objecrive design for its sector refoxm i light of the nare of nural credit project was too ambitious. RCIW was a Un of credit, not a projec for systm taasftrm, so its desiged fnancial sector reform objectives could not be achieved by this project itself From the Borrower side, issues regarding adecuate provisioning for bad debts, preparation of a re-capitalizaion plan and rationalizaton of the general interest rate siaucture which were ptoposed by the Bank could not be imiemented completely tbroum the implementaticn of RCIV project in few years under the governernt's time-based policy framework. We believe that it could be more effective and efcient for the project implementatian if the Bank could have take into consideration of this Government's approach. In fact, the Chinese financial sector reforms in the past; especiaEly in recent three yeats, have  - 44 - ANNEX A made remarkable progress arnd some of them even exceeded whar the Bank requeird during the project anpraisal. Three policy banks had beea established in 1994. In 1996, Rural Credit Cooperatives de-hooked from ABC's supervision, which gave ABC another chance to concentre its efforcs on the commzeriTi7-qron tmder Central Bank Law and Commercial Bank Law. ABC has strengthened rt inernal corrrl tbrough establishment of asset-Liability management committee, loan approval committee and inz=mal auditing committee; gradually improving accotmting system; establishing management infoblion system, and enhancing human resource management. We understand the financial system in China has a long way to go, but both the Govemment and ABC is moving at rizt direction. The process will defi3itely lead o solve die issues like re capicaizaion plan, provision for bad debts and inrerest rare liberation. Based on above e=1-n-ion, I hove the Bank would take into account of ABC's comments, arnd reconsider the project rating. in view of their intresTs on this matter, I am sending ccpies to Mr. Li Yong, executive director at the Worid Bank and Mr. Zhu Xan, acdog direcnor of World Bank Desarr-ent, MOF. I am loolnrl forward to hearing from youL IMy best regards, Sincerey Yours Mi Wei cc: Mr. Li Yong Executive Director for China at the World Banlk Fax: 1-202-5221579 M r. Zhu Xian Acting Direcror World Bank Deparrment The Ministry ofFinc: Fax: 68511062  - 45 - ANNEXB ANNEX B: ICR MISSION'S AIDE MEMOIRE A World Bank mission' visited China from March 3 to 24, 1997 to review the implementation of the Fourth Rural Credit Project (RCIV), with a focus on assessing primarily the degree of achievement of project objectives; prospects of the project's sustainability; Bank and the borrower performance; project outcome; plan for the project's future operation; and lessons learned. The mission visited ABC's Beijing; Liaoning; Jiangxi; Hubei; and Guangdong branches to review their experience with project implementation. At these centers, the mission also met with ABC's project staff from other provincial branches which participated in the project, including Inner Mongolia; Jilin; Fujian, Guangxi; Hunan and Shaanxi, and visited a few representative subprojects to assess client perspective. At ABC headquarters in Beijing, the mission reviewed ABC's own project completion report and offered suggestions to improve its analytical content and conclusions. The mission's conclusions were reviewed and agreed with ABC officials.2 It was agreed that subject to further review of the ABC's revised ICR, government comments on the ICR, and the discussions with the Bank management, the ICR mission's aide memoire be kept on project file and the main conclusions and lessons learned be incorporated in the final ICR. 1 The mission comprised of Ramesh Deshpande (Bank), Christopher Cronberg, Andrew Kaelin and Zhou Weiguo (Consultants). 2 ABC headquarters officials included: Mss. Min Wei, Deputy General Manager; Hua Ruoming, Division Chief; Li Shiqin, Liu Pei and Mr. Zhang Jun, Project Officers.   MAP SECTION  I  1 20' ~1 25' 130 |.(-.A:oo r 120 ~ ~ ~ ~ 0 -- j . : ) oMohe f' t > <~~~~~~~~~~~~~~~~~~~~(-- C'~~~~~~~~~~~~~~~~~115D '' . . . {~~~~/ ~ ~ oBishui -T- ME LS.ETSE ' R EP MEMEOEA ! ='~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~~~~~~~~~~~~I' 4L Sl.AGA SNNIMiANfQN IM.EJPAN / MNOT,~M,CrO JM.L j ER6UN < -r- 6 s _ ~~~~~~~~~~~~~~~~~~~~~~~~~~A.MNU 5HANGHAISH, .'ERHUN M MANA JAN0 _ ' - ' ~~ X ~ z ~ S'/ Hei he0 o -. 50U M'EOhAM MLGUAMNGI 'ANMN (TAIWAN (C-' 0N 'AK - . . . r -TNjAM I HONG KOW3 E ' j A' ., ;*,_'_ KLAMO ( \ f AACMO, PORT P J .- -- - ! - - -j~~~~~~~~~~~~~~~~~~~~~PDE,P, ,HAUNAN.' SG..S:_,,,HUPIE M<h Tw \./ ' 5- i A 0: / tY jAKTf SHI -'' " S \ I' z -' p Longzhen"E , -, . . / : i3 - EXE aK~~~IZ N' ' Y ' .' \ TE PTITIL. :T yli N 'CLSNSARAOIrh a Lunguhun (. / --@,.> ...... MonzhouIi9~ AM' l A 0LOW Nnin M~~~~~~~O