China - Construction Bank Transformation Project

SAR3605.DOC/EA2CO/Malik/5/l/97/div./hth4/mjd3 CONFIDENTIAL Report No. 16317-CHA STAFF APPRAISAL REPORT CHINA CHINA CONSTRUCTION BANK TRANSFORMATION PROJECT May 1, 1997 CFILE COP Country Operations Division China and Mongolia Department East Asia and Pacific Regional Office SAR3605.DOC/EA2CO/Malik/5/1/97/div./hth4/mjd3 CURRENCY EQUIVALENTS (as of December 1996) Currency = Renminbi Currency Unit = Yuan(Y) Y 1.00 = 100 fen Y 1.00 = $0.12 $1.00 = Y 8.30 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System Vice President Jean-Michel Severino, EAP Director Nicholas C. Hope, EA2 Division Chief Klaus Rohland, EA2CO Staff Member Surinder Malik, Principal Financial Economist, EA2CO SAR3605.DOC/EA2CO/Malik/5/2/97/div./hth4/mjd3 ABBREVIATIONS AND ACRONYMS ABC Agricultural Bank of China ADB Asian Development Bank ADBC Agricultural Development Bank of China ALM Asset Liability Management BOC Bank of China BOCOM Bank of Communications CAS Country Assistance Strategy CCB China Construction Bank CICC China Investment Consulting Corporation CDs Certificate of Deposits CIB China Investment Bank CITIC China International Trust and Investment Corporation EA Environmental Assessment EAP Environmental Action Plan EDI Economic Development Institute EIA Environmental Impact Assessment EXIM Export-Import Bank of China FSTA Financial Sector Technical Assistance FYP Five-Year Plan GDP Gross Domestic Product HO Head Office ICBC Industrial and Commercial Bank of China IFC International Finance Corporation IT Information Technology LIBOR London Interbank Offered Rate MOF Ministry of Finance NBFIs Nonbank Financial Institutions NCCIB Northeast Capital Construction Investment Bank NPC National People's Congress PBC People's Bank of China PCBC People's Construction Bank of China PHRD Policy and Human Resource Development PICC People's Insurance Company of China PMO Project Management Office RAP Resettlement Action Plan RCCs Rural Credit Cooperatives SAR Staff Appraisal Report SDBC State Development Bank of China SOEs State-Owned Enterprises SPC State Planning Commission SWIFT Society for Worldwide Interbank Funds Transfer TICs Trust and Investment Corporations TVEs Town and Village Enterprises UCCs Urban Credit Cooperatives CHINA CHINA CONSTRUCTION BANK TRANSFORMATION PROJECT LOAN AND PROJECT SUMMARY Borrower: The People's Republic of China. Implementing Agency: China Construction Bank. Beneficiaries: China Construction Bank and state and nonstate enterprises. Poverty: Not applicable. Amount: $230 million. Terms: 20 years including 5 years of grace, at the standard interest rate for LIBOR-based US dollar single currency loans. Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days after signing, less any waiver. Financing Plan: See para. 4.43. Economic Rate of Return: Not Applicable. Map No.: IBRD 28734 Project ID Number: CN-PE-3605 CONTENTS 1. THE FINANCIAL SECTOR ........................................................................................1 A. Introduction......................................................................................................... B. Developments During 1979-93 ...........................................................................1 C. Reforms since November 1993 ...........................................................................2 D. Structure and Growth of Financial System .........................................................3 E. M ajor Sector Issues and Government Strategy ...................................................8 2. THE CHINA CONSTRUCTION BANK ..................................................................14 A. Background ....................................................................................................... I4 B. Business Scope ..................................................................................................16 C. Financial Performance.......................................................................................19 D. Internal Constraints to Commercialization .......................................................22 E. Diagnostic Studies.............................................................................................22 F. CCB's Commercialization Initiatives................................................................28 3. LESSONS OF EXPERIENCE AND BANK GROUP STRATEGY.......................31 A. Lessons of Experience.......................................................................................31 B. Bank Group Strategy .........................................................................................32 4. THE PROJE5CT ...........................................................................................................35 A. Project Rationale and Objectives ......................................................................35 B. Project Description............................................................................................36 C. Transformation Component ..............................................................................36 D. Delivery M echanism for Technical Assistance.................................................41 E. Credit Component .............................................................................................42 F. Onlending Arrangements...................................................................................43 G. Environmental and Social Aspects ...................................................................44 H. Project Organization and M anagement.............................................................46 I. Project Performance M onitoring Indicators .......................................................47 J. Project Cost and Financing.................................................................................48 The project was appraised by Surinder Malik (Financial Economist, Task Manager), Xiaofeng Hua (Institutional Specialist), Hoi-Chan Nguyen (Legal Expert), and Edgar Su (Credit Specialist, Consultant). Richard Roulier (Financial Specialist), Fernando Montes- Negret (Financial Economist), Robert Keppler (Information Technology Specialist) and Naiqin Lu of the Bank's Resident Mission in China contributed to the preparation of the project. The peer reviewers of the project were Khalid Siraj (Financial Institutions), Barbara Kafka (Financial Sector) and Rene-Marie Bakker (Technical Assistance Delivery). - 11 - K. Procurement and Disbursement ........................................................................49 L . A ccounting and A uditing ..................................................................................50 5. PROJECT RISKS ANDBENEFITS .........................................................................51 6. AGREEMENTS REACHED AND RECOMMENDATION...................................53 ANNEXES Annex 1: Selected Economic Indicators, 1991-96.........................................................55 Annex 2: Selected Interest Rates, 1985-96 ....................................................................56 Annex 3: Financial Sector Reforms Matrix ...................................................................57 Annex 4: China Construction Bank Organization Chart................................................62 Annex 5: China Construction Bank Financial Statements.............................................63 Annex 6: Terms of Reference for Institutional Development Program.........................70 Annex 7.1: Project Implementation Schedule...................................................................76 Annex 7.2: Implementation Plan for Institutional Development Program .......................77 Annex 8: Project Performance Monitoring Indicators...................................................78 Annex 9: Bank Supervision Input into Key Activities...................................................80 Annex 10: Proposed Procurement Arrangements ............................................................81 Annex 11: Estimated Disbursement Schedule .................................................................83 Annex 12: Resettlement and Rehabilitation Policy Framework ......................................84 Annex 13: Documents Available in Project File..............................................................96 TABLES IN TEXT Table 1.1: Structure and Growth of the Financial System, 1988-95...................................7 Table 2.1: CCB Loan Portfolio by Industry, 1993-96 ......................................................17 Table 2.2: CCB-Key Financial Indicators, 1992-96 ......................................................20 Table 4.1: Project C osts....................................................................................................48 Table 4.2: Project Financing Plan.....................................................................................48 FIGURES IN TEXT Figure 1.1: Structure of Net Financial Assets, 1996...........................................................4 Figure 1.2: Nominal and Real Interest Rates....................................................................10 Figure 4.1: Sequencing of CCB's Institutional Development Program ...........................42 Figure 4.2: Transformation Component Management......................................................47 MAP IBRD 28734 -1- 1. THE FINANCIAL SECTOR A. INTRODUCTION 1.1 Financial sector reforms have been an important component of the Government's overall reform effort since 1979 to gradually transform the Chinese economy from a centrally-planned economy to a socialist market economy. In a short period of 15 years, the sector has undergone a pronounced transformation, from the monobank structure of the centralized planning era to one with substantial deepening and widening as indicated by the diversity both of the institutions and the instruments. But the piecemeal nature of reforms and slow progress on fiscal and enterprise reforms often has accentuated macroeconomic instability and, in general, financial sector reforms lagged behind those in some of the other areas of the economy. China is now entering an important phase in its transformation to a market-based system, and the Government considers further policy reforms and institutional strengthening and modernization of the financial sector to be of paramount importance in sustaining rapid economic growth through enhancing the efficiency of resource mobilization and allocation. The pace of financial sector reforms has accelerated in the last two years. However, both macro and institutional hurdles to creating a safe and sound financial system are enormous, and given the linkages between the fiscal, enterprise and financial sectors, a weak sector infrastructure, and paucity of banking skills, development of an market-based financial system will of necessity be a gradual process. B. DEVELOPMENTS DURING 1979-93 1.2 For much of the period prior to 1979, China had a monobank system typical of socialist economies, with most financial transactions being handled by the People's Bank of China (PBC). Money and financial intermediation played a very limited role, as government and enterprise financial needs were fulfilled by the annual budget, investment, and credit plans, which directly allocated resources. The first stage of reforms focused on breaking up the monobank system. The Agricultural Bank of China (ABC) was rechartered in 1979 as a specialized bank to take over PBC's rural banking functions. In 1984, PBC's formal establishment as the country's central bank was completed with the divestiture of its urban commercial banking functions to the newly created Industrial and Commercial Bank of China (ICBC). The Bank of China (BOC) remained the principal vehicle for foreign exchange transactions, while the China Construction Bank (CCB)I, established in 1954 as part of the Ministry of Finance (MOF), Until early 1996, the China Construction Bank was known as the People's Construction Bank of China (PCBC). -2- continued to manage budgetary trust funds. Nonbank Financial Institutions (NBFIs) were established, along with the creation in 1981 of the China Investment Bank (CIB), to channel loans from multilateral institutions. An interim banking regulation was promulgated in January 1986.2 1.3 During the 1987-93 period, the Government allowed some diversification and limited competition. The Bank of Communications (BOCOM) was recreated as a universal bank, two savings banks were established along with two new commercial banks, five regional development banks, and a large number of urban credit cooperatives. The traditional barriers of specialization between the banks were gradually relaxed. NBFIs, especially Trust and Investment Corporations (TICs), proliferated in the light of heavy demand for investment (partly due to low and/or negative real interest rates) on the one hand, and credit rationing and regulatory distortions on the other. A number of foreign banks were allowed to open branches with limited business scope, mostly foreign trade-related operations. Two stock exchanges (Shenzhen and Shanghai) were established, new financial instruments emerged, and there was limited development of capital markets, driven by the development of secondary market trading in government securities. 1.4 Between 1979 and 1993, the lack of separation between the fiscal and monetary functions of the government and the subordinate role of the central bank were combined with a drastic decline in the central government's share of budgetary revenues in gross domestic product to half the prereform level. This led to a rapid decline in the share of investments financed by budgetary funds, and bank lending began to replace budgetary financing at a time of rapid expansion of output. The rapid growth of output, together with extremely low interest rates and the absence of hard budget constraints on poorly capitalized state enterprises, fueled the enterprises' demand for credit. Rapid decentralization and autonomous expenditure decisions by economic agents in the absence of market-imposed discipline led to demand-driven and fairly lax credit and monetary policies and a break down of the control mechanism that aggravated the stop-go cycles experienced by the Chinese economy during the 1980s and early 1990s. All interest rates continued to be administered by the authorities, with the structure of interest rates reflecting government priorities on resource allocation across sectors and types of borrowers. Interest rates were more successfully used for resource mobilization than as an allocative tool, with government directives to the lending decisions of banks, priority lending, and financial subsidies to public enterprises remaining the more important allocative instruments. C. REFORMS SINCE NOVEMBER 1993 1.5 On the occasion of the Third Plenum of the Fourteenth Party Central Committee in November 1993, a more systematic long-term strategy was announced to stimulate a 2 The Provisional Regulations of the People's Republic of China on the Control of Banks. -3- rapid transformation of the Chinese financial system. Instead of earlier partial measures, an overall sector policy framework was developed, with the focus of the reform effort shifting toward providing a legal basis and a regulatory environment for the financial sector, enhancing the powers of the central bank to conduct monetary policy, and gradual transformation of the four specialized banks into commercial banks. Reform measures introduced since the announcement of the strategy are detailed in Section E (Major Sector Issues and Government Strategy), and have included: * the promulgation of important financial legislation, including the Central Bank Law and the Commercial Banking Law; * strengthening of the central bank's powers to conduct monetary policy and prudential supervision of the financial institutions, and prohibition on the central bank from extending overdrafts and direct lending to the government; * creation of three new policy banks to separate policy from commercial lending and increased autonomy to the specialized banks in their lending decisions; * separation of ownership links between banks and nonbanks to prevent risky financial activity by nonbanks from transmitting large systemic shocks to the banking system; * elimination of preferential sector lending rates, increasing the frequency of interest rate adjustment and abolishing indexed term deposits; * introduction of asset/liability ratio management for selected financial institutions to be extended to the large state banks at a future date; * increased competition by the licensing of China's first nonstate owned bank, ownership diversification of nationwide commercial banks, creation of a large number of City United Commercial Banks through the merger of urban credit cooperatives, and licensing of selected foreign banks to undertake limited local currency business on a pilot basis; * development of a modern payment and clearing system and a book-entry system for government securities trading; and * initiation of open market operations. D. STRUCTURE AND GROWTH OF FINANCIAL SYSTEM 1.6 The banking sector in China as at end-1995 comprised the central bank, 4 formerly specialized banks, 3 policy banks, 5 nationwide and 9 commercial banks, 12 insurance companies, 332 trust and investment corporations, 98 securities companies, 65 finance companies, 16 financial leasing companies, 50,000 rural credit cooperatives, and 5,100 urban credit cooperatives. In addition, there were 11 foreign-funded and joint- venture banks, 469 representative offices, 120 branches, 5 finance companies, 6 leasing companies and 1 joint-venture investment bank set up by foreign financial institutions from more than 30 countries and regions. The banking sector dominates the financial system, and within banking, the four formerly specialized banks continue to be the -4- mainstay. Gross assets of the banking sector increased over fivefold or at an annual average rate of over 25 percent. The ratio of M2/GDP increased from 90 percent in 1991 to 100 percent in 1995. 1.7 The Central Bank Law has confirmed PBC's main functions as that of monetary management, prudential supervision, lender of last resort, and banker to the government. Unlike in the past, when PBC's autonomy was limited and compliance with credit and monetary targets undermined by the traditionally strong provincial and local governments, the Law has been effective in the recentralization of control. 1.8 In spite of some diversification, the four wholly-owned state banks-ICBC, BOC, ABC and CCB-continue to constitute about 70 percent of both outstanding deposits and loans of all financial institutions. All four banks are ranked by asset size as among the top 100 banks in the world.' Traditionally, these banks have represented little more than convenient vehicles for the state in financing priority projects. Since the mid-1980s, these banks have widened the scope of their activities and now openly compete, especially for deposits. The authorities have mandated that these banks be gradually transformed from their role as state fiscal agencies into commercial banking organizations over the next decade or so, and under the new Commercial Banking Law, they have been reclassified as commercial banks. FIGURE 1.1: STRUCTURE OF NET FINANCIAL ASSETS, 1996 Otherl Credit Coops 8% State Banks 69% Other Banks 8% Lg including financial trust & investment companies, financial and leasing companies and policy banks Source: PBC 1.9 The three policy banks-State Development Bank of China (SDBC), Agricultural Development Bank of China (ADBC), and Export-Import Bank of China (EXIM)-have been in business only a short period. The main objective in establishing these banks is to gradually shift the burden of financing social and development projects of the government away from the formerly specialized banks, and to prevent such loans from interfering with the effectiveness of monetary policy. Resources of these banks, as 3 Institutional Investor, August 1995. -5- initially contemplated, are raised from the issue of government-guaranteed bonds largely placed among the formerly specialized banks, earmarked budgetary allocations, and foreign borrowings, including from bilateral and multilateral sources. 1.10 The nationwide commercial banks include BOCOM, which was originally established in 1908, nationalized in early-1950s, revived in 1986 and restructured in 1994; CITIC Industrial Bank, formerly the finance department of CITIC, the government's flagship investment organization; Everbright Bank, belonging to the Everbright Group and incorporated in Hong Kong; Hua Xia Bank, belonging to the Chinese conglomerate, Capital Iron and Steel Works; and CIB. The other commercial banks, including Minsheng Bank that started operations in early-1996, compete for deposits and clients, and while some started operations as regional development banks, they now operate outside their original region. With the exception of Minsheng Bank, which is the first nonstate-owned commercial bank in China, all other banks are owned by state enterprises, central government, local governments and/or municipal bureaus. The nationwide banks are more independent than the specialized banks and have a more diversified client base. The two main housing savings banks in Yantai and Bengbu, raise funds for home construction and provide mortgage finance for individuals in their respective cities. 1.11 As at end-1995, there were 50,000 rural credit cooperatives (RCCs) and over 5,100 urban credit cooperatives (UCCs). The RCCs are regulated through balance sheet ratios, and deposits from individuals and town and village enterprises (TVEs) are the main source of their funds. In line with the rapid growth of TVEs, more than half of their total loans are accounted for by TVEs, with agriculture loans accounting for another 20 percent. As part of rural financial system reform, the government separated the RCCs from ABC towards the end of 1996. Prudential supervision of RCCs now rests with PBC. The UCCs are located in large- and medium-size cities, and serve the growing nonstate-owned enterprise sector (collectives and private enterprises). Their main sources of funds are enterprise and household deposits. 1.12 The joint venture banks, owned jointly by local authorities and foreign investors, provide merchant and investment banking services and trade finance. The regulatory framework for foreign banks was introduced in 1994. China International Capital Corporation, a joint venture between CCB and Morgan Stanley established in 1995, is China's first international investment bank. The foreign banks are not allowed to engage in local currency business; more recently, a few foreign banks have been given the permission to engage in local currency business on a pilot basis. 1.13 The NBFIs, consisting of trust and investment corporations (TICs), securities companies, finance companies and financial leasing companies, have been one of the fastest-growing segments of the financial sector. The creation of TICs is a response to the new demand for financial intermediation outside the state banking system and a useful tool with which local governments can undertake their own investment projects outside the sphere of the central government influence. The two provisional regulations -6- issued in 1986 to provide the basic legal framework for TICs gave them a wide range of latitude for their business scope, and combined with lax supervision, boosted their expansion from 32 in 1986 to 745 in 1988. Alarmed by their rapid growth, PBC launched a rectification drive that lasted two years, over which their number was reduced through closure and mergers. As of end-1995, there were 332 TICs associated with specialized banks or local enterprises of provinces, cities and special economic zones. Most TICs are joint stock companies with agencies/departments of the state as their only shareholders. They are not allowed to take individual deposits, and interbank borrowings were until recently a significant source of their funds. TIC operations are very diversified. Concerned at the risky activities of TICs, the authorities decided to sever their ownership link with banks, and also to restrict their right to borrow from interbank markets. The number of TICs has since been reduced to about 200. That TIC operations are risky was borne out in early-1997, when PBC decided to close, rather than bail out, the second largest TIC that had run large losses as a result of risky investments and poor management. 1.14 Experimental establishment of finance companies, organized by conglomerate groups, began in 1987 and there were 65 finance companies as at end-1995. Business scope includes loans, deposits, trust, investments, leasing and interbank lending. Virtually all the customers of finance companies are their parent state-owned enterprises (SOEs). Leasing companies are rare in China and as of end-1995, there were only 16 leasing companies, most of them affiliated with the large commercial banks. The old insurance industry of China was reorganized in the early 1950s into one state-owned People's Insurance Company of China (PICC). Ten years later, its domestic business was suspended because casualty losses of SOEs could be covered with self-insurance by the State and the people's livelihood, health, housing and retirement were the responsibility of enterprises. Domestic insurance was therefore considered unnecessary, and PICC was reduced to carrying marine insurance. Market reforms reinstated the need for domestic insurance, and in 1996 there were 23 Chinese insurance institutions (3 national and 20 regional) and 6 subsidiaries of foreign insurance companies. In 1996, PICC was split into life insurance and property insurance. 1.15 Discounting of commercial paper was begun by PBC in April 1986. Subsequently, banks started to underwrite treasury bonds and issued financial institution bonds and negotiable CDs. Secondary market for treasury bonds appeared in 1988. State bonds of successive shorter maturities have been issued since 1981. The volume of outstanding bonds, however, has remained very small. -7- TABLE 1.1: STRUCTURE AND GROWTH OF THE FINANCIAL SYSTEM, 1988-95 1988 Gross 1995 Gross Annual Ave Assets Assets Growth Financial System (Y billion) Financial System (Y billion) (%) Central Bank Central Bank People's Bank of China 462 76 People's Bank of China 2.062 43 24 Policy Banks Policy Banks State Development Bank of China 194 57 n a Agricultural Dev Bank of China 542 51 n a Import and Export Bank of China 10.25 n a Specialized Banks Wholly State-owned Banks Industrial & Commercial Bank of China 561 70 Industrial and Commercial Bank of China 3,107 50 28 Agricultural Bank of China 301 50 Agricultural Bank of China 1,23095 22 Bank of China 55970 Bank of China 1,995.13 20 People's Construction Bank of China 339.40 China Construction Bank 1,72267 26 Other State Banks Nationwide Banks Bank of Communications 111 56 Bank of Communications 361 96 18 CITIC Industrial Bank 8 76 CITIC Industrial Bank 86 49 39 China Investment Bank 6 70 China Investment Bank 52 73 34 Everbright Bank 33.69 n a Hua Xia Bank 12.26 n a Regional Banks Other Banks Guangdong Development Bank 1.00 Guangdong Development Bank 54.72 77 Shenzhen Development Bank 1.24 Shenzhen Development Bank 20.31 49 China Merchant Bank 241 China Merchant Bank 64.80 60 Fujian Industrial Bank 0 22 Fujian Industrial Bank 16 69 86 Yantai Housing Savings Bank 0 15 Yantai Housing Savings Bank 3 60 58 Bengbu Housing Savings Bank 0 07 Bengbu Housing Savings Bank 0 45 32 Pudong Development Bank 35.24 n.a Hainan Development Bank n a n.a. Shenzhen City United Bank 13 36 n.a Credit Cooperatives Credit Cooperatives Urban Credit Cooperatives 20 50 Urban Credit Cooperatives 454.50 56 Rural Credit Cooperatives 149.00 Rural Credit Cooperatives 1,065 36 32 Foreign Banks (5) n.a Foreign Banks (62) in 191.40 n.a. NBFIs (745) n.a. NBFIs (494) & 526.63 n.a. Li Net assets in 1995, number of institutions in parentheses for both years. A Excluding securities firms, number of institutions in parentheses for both years Source- PBC 1.16 The capital markets in China suffer from the same constraints and controls as the rest of the financial sector. The authorities still assign quotas on the amounts of equity and securitized debt that can be issued in any year. Share prices on both the Shanghai and Shenzhen stock exchanges have exhibited extreme volatility. This has resulted from inherent problems such as limited disclosure, bunching of public offerings, a lottery system of assignment, limited participation of wholesale and institutional purchasers of securities, and the circumscribed role of competitive underwriters or primary dealers. Government oversight of the market is still weak, as authorities find it difficult to enforce regulations. China is trying to increase the efficiency, stability and transparency of capital markets and reduce systemic risks by setting standards for credit rating agencies, encouraging competition among underwriters, and strengthening the regulatory regime and oversight. -8- E. MAJOR SECTOR ISSUES AND GOVERNMENT STRATEGY 1.17 Despite the acceleration of financial sector reforms in the last two years and progress made to date, further policy reforms and institutional strengthening and modernization of the sector are necessary in order to enhance the efficiency of resource mobilization and allocation. Development of an efficient financial system in China would require: (a) at the macro level, an effective monetary policy that relies on indirect control instruments; further strengthening of the legal and prudential framework for banks and nonbanks; successful transformation into commercial banks of the formerly specialized banks; further reforms in the SOE sector in order to deal with delinquent loans and increase their interest sensitivity without which indirect monetary policy cannot be effective; further reforms in the investment regime and public finances in order to provide banks with increased autonomy and for the government to finance its priority investment program as well as some of the public services now supplied by state enterprises; enhanced competition; new financial accounting standards, risk provisioning rules and reduced taxation, and further liberalization of interest rates to provide financial institutions with means to price risk; and (b) at the institutional level, increased autonomy and accountability of bank managers, new corporate governance and incentive mechanisms, significant reorganization (including reduction of their overblown staff) and adoption of new systems and procedures and above all, it would require converting human resource into human capital to enable banks to manage commercially their assets and liabilities. At present, neither the regulators nor the financial institutions are capable of identifying and controlling the multiple risks in an increasingly market economy. 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 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. 1.18 Monetary Management. The credit plan has been the centerpiece of the system for controlling and allocating credit in China. By setting limits on prices (interest rates) and quantities (credit ceilings on financial institutions), PBC tried, often unsuccessfully, to accomplish the dual objective of directing credit while maintaining macroeconomic stability. Despite the erosion of its effectiveness evidenced by actual credit often exceeding targeted levels and periodic episodes of rapid inflation, the credit plan remains binding for the state banks, thereby preventing PBC from using monetary control effectively and efficiently. Aware of the increasing inconsistency between China's highly decentralized and largely market-driven economy and centrally allocated credit, the authorities have been trying to reduce the scope of the credit plan, modifying the relationship between PBC and the specialized banks and between PBC and the government, and further developing China's financial infrastructure. The new Central Bank Law has improved the institutional framework for monetary policy; direct central bank lending to the government is prohibited, and, unlike in the past, when unauthorized lending by PBC branches tended to weaken central control over lending, PBC branches -9- are no longer allowed to extend credit to fund policy loans and local governments. The 1995 credit plan covered the policy banks and the specialized banks, with other financial institutions' lending now largely controlled through asset/liability management ratios. In addition, lending quotas that used to be fixed by each branch are now fixed by each bank, thereby allowing the formerly specialized banks to experiment with asset/liability management in selected branches. 1.19 Since the unification of the exchange rate in 1994, the direction, content and form of monetary policy and its implementation have undergone significant changes. The discontinuation of direct financing of the government, opening of a rediscount facility, centralization of lending at PBC's Head Office (HO), authority to recall loans extended to banks, and introduction of asset/liability management guidelines for banks have all helped in the increased use of indirect instruments to manage aggregate demand. The Government's stated position is to gradually phase out the credit plan, while pressing ahead with the development of indirect instruments. The working capital credit plan is expected to be abolished in 1998 as the large state-owned banks are brought under asset- liability ratio management. The fixed asset credit plan is expected to be phased out by the end of the Ninth FYP (1996-2000). An integrated interbank market was established in January 1996, allowing for flexibility in short-term money market rates, and PBC started open market-like operations based on Treasury securities in April 1996. Substantial reduction in the role of the credit plan, setting up a well-designed auction system, and further liberalization of interest rates will permit full-fledged open-market operations. It should be noted that the prevalence of large sectors of the economy operating with no commercial objectives (large number of loss-making SOEs) limits the effectiveness of indirect monetary policy, which relies on interest rate elasticity as the main transmission mechanism for monetary policy. 1.20 Interest Rates. The structure of interest rates reflects government priorities on resource allocation across sectors and types of borrowers and incorporates some recognition of a positive, although quite flat, yield curve. However, the structure is unduly complex, often obscuring real economic priorities. Margins between lending and deposit rates tend to fluctuate arbitrarily without reflecting an upward sloping yield curve, and on several occasions deposit rates have exceeded lending rates of similar maturity. Low and often negative real interest rates in recent years contributed significantly to the rapid increase in the demand for credit and investment expenditures, encouraging not only relatively capital-intensive production but also complicating the task of aggregate demand management. At the same time, however, the volume of bank deposits has grown enormously, reflecting China's high savings rate, strong public confidence in the banking system, and dearth of alternative financial and real assets for most institutional and household savers. The unusually rapid growth in bank deposits in the last few years also owes something to the reintroduction in 1993 of inflation-indexed deposits for households. 1.21 International experience has demonstrated that while interest rates can be deregulated quickly and seemingly easily, it can bring in its wake considerable financial disruption if it is not preceded by adequate institutional and policy preparation and the -10- deployment of skilled and experienced central bank staff. Thus, while deregulated interest rates are an important and desirable objective, they can best be fully attained only in the final stages of the financial reform process after a number of conditions, for example, macroeconomic stability, contestable financial markets, healthy financial institutions and real sector enterprises, trained bank staff and bank supervisors, and modem accounting and auditing systems, have been put in place. While some of these conditions are unlikely to be met soon in China, the government needs to phase in reforms that reduce the most egregious distortions first and subsequently extend greater freedom to market participants in stages. FIGURE 1.2: NOMINAL AND REAL INTEREST RATES 10 00 1986 19 q1988 198 Apr Aug 1991 199 May Jul 1994 145 May A, g 135 1985 , 1990 1990 993 1 3 ' 1996 196 -5 00' ... *. -10.0 1 ,*-+-- Nominal Spread -15.0A- 1-Year Deposit (Real) Year -*A**1-3 Year Lending (Real) Source PBC. 1.22 The Government plans to undertake a phased liberalization of administrative controls on interest rates, establishing initially a regulated interest rate system based on economic conditions. The level of interest rates, especially lending rates, is gradually becoming an important tool for managing aggregate demand. The effectiveness of interest rates should increase as SOEs become increasingly interest-rate sensitive in making their decisions. The Government has freed interest rates in the interbank market, and is now adjusting interest rates more frequently to reflect economic conditions. Indexed termed deposits, which served their purpose in the late-1980s through the early- 1990s in restoring depositors' confidence in the banks, were abolished in 1996 since they had proven very costly to the banks. Also, the Government was successful in controlling inflation. By reducing deposit rates by more than lending rates, the authorities are trying to provide the banks with higher margins to help them recover costs and build up their capital and reserves. Banks and nonbanks are permitted to vary their lending rates within a prescribed band (from -10 to +20 percent) of the base rate. Interest rates at present are positive in real terms. 1.23 Fiscal and Enterprise Reforms. Reforms in the financial sector are intricately linked to reforms in the fiscal and SOE sectors. State banks historically have acted as fiscal agents of the Government, and these banks, rather than the budget, have financed a large proportion of the investments and working capital needs of state enterprises. Similarly, enterprises, rather than the budget, have been responsible for the provision of a - 11 - large number of social services-education, health, pension, housing-for their workers. Government's reform measures and the resultant increased competition have had an adverse impact on the financial performance of SOEs. Initially, the SOEs were able to stay in business as a result of government subsidies and new credits from the banking system under a demand-driven and lax credit and monetary policy environment. Concerned at macroeconomic stability and high inflation, the authorities have been gradually reducing subsidies to state enterprises and tightening credit, reflecting both PBC's policy stance and enhanced powers and the banking system's increasingly commercial focus. This has further aggravated the financial position of SOEs and made their structural deficiencies more obvious. Weak SOE performance has led to a further weakening of the banks' portfolios, estimated by PBC at 20 percent of loan portfolios. If international norms are applied, nonperforming loans may constitute a much higher proportion of total loan portfolios. 1.24 Sector Infrastructure. The financial sector infrastructure-legal, informational, prudential and payments and clearance-is weak. Until 1994, financial sector reforms lacked a legal foundation. This gap was filled by the passage in 1995 of a number of important legislation, including the Central Bank Law, the Commercial Banking Law, the Negotiable Bills Law, the Insurance Law, and the Guarantee Law. Still more legislation, including a legal framework for securities and for trust and investment corporations, are under preparation. While 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 the Government. 1.25 The implementation of laws would depend upon how soon the operational guidelines based on detailed rules and regulations are formulated and enforced. Introducing a basic shift in the role of regulations from compliance with economic directives under the central planning system to setting of prudential norms and their compliance by financial institutions and the need to train personnel to monitor and enforce such compliance will take time. It also implies the existence of accounting standards and financial reporting, adoption of risk-based loan portfolio classification, and a focus on the overall risk borne by individual banks and nonbanks. 1.26 During the last three years, PBC and MOF have with the assistance of international experts financed under the Financial Sector Technical Assistance (FSTA) project, initiated steps toward overhauling the financial and enterprise accounting systems, and prudential banking framework. A modem payment and clearing system has been designed and the pilot phase has been initiated. To date, drafts of about 30 accounting standards have been prepared. The draft basic banking accounting standards include, among others, definition of past due loans and a loan classification system, accrual of interest and loan loss reserve. Similarly, PBC has identified deficiencies in asset quality of banks through reviews of selected branches of specialized and nationwide banks. It has prepared a draft comprehensive examination procedure manual, studied various international models of supervision, organized training courses for its supervisory - 12 - staff, and reorganized its supervisory functions. Enforcement of regulations however would pose a major challenge for PBC as implementation would require substantial further training of supervisory staff, -and development of an off-site surveillance system. The difficulties involved in enforcing prudential control over the various NBFIs is even more formidable, since supervision of NBFIs is qualitatively different from that of banks. PBC plans to set up a complete supervisory system for NBFIs in the next five years. 1.27 Institutional Development of Financial Institutions. The four specialized banks, with over $1 trillion in total assets, a workforce exceeding 1.6 million, and with almost 150,000 branches and outlets, face important external and internal constraints to commercialization. The external constraints include constraints in the present macroeconomic and policy framework as well as in the broad institutional framework that have a negative impact on the banks in their effort to enhance efficiency. Like other SOEs, these banks have to also shoulder heavy social welfare responsibilities for their staff. The internal constraints are also formidable in view of the specialized banks' past role as fiscal agents of the Government. The specialized banks lack appropriate governance and legal framework, inadequate financial policies, weak and fragmented business infrastructure, and insufficient knowledge base needed to support commercial banking operations. Accounting standards that do not follow international norms on classified assets and a loan loss provisioning policy that is independent of the banks' actual risk profiles, exaggerate bank profits. Very high income and other taxes on overstated profits further weaken the financial position of the large state banks and reduce their net worth. The issue of shielding the specialized banks from losses on directed credits to SOEs and providing them with an environment to maintain a positive net worth assumes paramount importance in the prevailing monetary and financial conditions in China. 1.28 Equally important for banks to operate profitably in a deregulated environment is the existence of human and managerial capital in the banking system. In a market-based competitive system, banks should be able to assess the degree of riskiness of assets, rank them according to the size of risks involved, appraise the creditworthiness of borrowers and the economic and financial viability of projects, and to comprehend the significance of changing economic environment domestically and internationally for banks' operations. Such skills are conspicuous by their absence in China, where all decisions about credit allocation, and pricing of loans have been centralized until recently in the government. However, the banking system will not remain sound unless there are borrowers with a positive net worth. Reform of SOEs, including the provision of a social safety net, is critical to the full commercialization of the specialized banks. It is only after the specialized banks are placed on strong commercial footing, and the prudential regulatory framework is in place, further substantial deregulation of the financial sector, including full liberalization of the interest rate policy and increased competition from domestic and foreign banks, can be undertaken. 1.29 With the establishment of the policy banks in 1994, the Government has given the formerly specialized banks increased autonomy in their lending decisions and they are no longer required to make policy loans at their own risk. The banks now can turn down - 13- funding requests for government-approved projects, considered risky and/or financially nonviable. The Commercial Banking Law has clarified commercial banking principles, and specialized banks are required to draft new corporate charters. Like other banks, the large state banks have also been made responsible for their profits and losses, and under the single legal person concept, lending control has been centralized in the HO in order to avoid problems associated with branch lending under pressure from local governments. The banks have been given the liberty to experiment with different systems and processes, for example, closure/merger of unprofitable branches, management by asset/liability ratios, and new incentive systems that link bonus to performance. All specialized banks are following a zero growth employment policy, and giving priority to upgrading the skills of staff and management. 1.30 The main objective in establishing the three new policy banks is to gradually shift the burden of financing social and development projects of the government away from specialized banks. The authorities define policy lending as loans for long gestation, low profitability, or high-risk projects considered essential for national economic development that would otherwise not be financed through the commercial banking system. The mandate of policy banks needs to be further clarified, especially their relationship with the rest of the financial system. The Government needs to issue detailed regulations on how policy banks will be expected to meet their charters, and how the banks are going to finance their operations, who will bear the burden of any losses against nonpayment of interest or principal, and how those losses are going to be covered by the budget. 1.31 Competition. Greater competition is a sine qua non of financial reform. In order to increase competition in the banking sector, the authorities have decided to diversify ownership of nationwide commercial banks, license nonstate-owned banks, merge and convert the UCCs into city united commercial banks, and permit selected foreign banks to conduct local currency business on pilot basis. The objective for now is to retain the four specialized banks as 100 percent state-owned commercial banks. Two nationwide bank, Hua Xia Bank and Everbright Bank, have already been converted into joint stock companies and new shareholders now account for between 50 and 80 percent of the equity of the banks.' China also licensed its first nonstate-owned bank, Minsheng Bank, which went into operation in early 1996. The provincial capital-level UCCs are being merged and converted into city united commercial banks with new shareholders, including IFC as a potential shareholder in the Shanghai City United Bank. Such mergers and conversion have already taken place in a number of other major cities, and the plan is to have a large number of such banks in the coming 10 to 15 years. 4 While foreign financial institutions are not permitted to take equity positions, ADB has been given special exemption to take a small shareholding in Everbright Bank. - 14 - 2. THE CHINA CONSTRUCTION BANK A. BACKGROUND 2.1 Introduction. The China Construction Bank (CCB) has total assets, including agency services5 in excess of $200 billion, about 357,000 employees, 13,954 branches and subbranches and 28,245 deposit-taking offices. No matter how measured, CCB is an immense institution. For much of the history of the People's Republic of China, CCB has played a key role channeling funds for construction of infrastructure and basic industries in the framework of a planned economy. CCB's administrative orientation and structure, the deficiencies identified in the diagnostic studies of selected branches (Section D), and the challenges associated with the bank's transformation into a market- oriented commercial bank are best appreciated in light of the institution's conflicting mandates, absence of governance mechanisms, evolving regulatory environment, and its geographic scope and size. 2.2 Historical Setting. During the early 1950s, specific treasury functions were managed and budgetary allocations were processed by BOCOM and Northeast Capital Construction Investment Bank (NCCIB). BOCOM received monthly allocations for capital construction from MOF, distributed these funds to designated parties and projects, and managed the nationwide funds transfer capability for construction projects. On September 9, 1954, the Government Administrative Council (predecessor to the State Council) established the People's Construction Bank of China under the administration of MOF. CCB originally received annual budgetary allocations for capital construction from MOF and disbursed and administered the funds as designated by the State Planning Commission (SPC) in accordance with the State's plans for key construction projects. NCCIB was merged into CCB and CCB's initial staff was drawn from BOCOM. By 1958, CCB had a staff of 17,000 and branches in provincial capitals, major industrial centers and at large project sites. 2.3 During the Great Leap Forward (1958), CCB underwent its first restructuring. The HO of CCB became the Department of Capital Construction Finance in MOF, and CCB branches were transformed into divisions of local finance bureaus and the number s Agency services appear on CCB's balance sheet as "Channeling Government Investment" (if funded by MOF or SDBC) or as "Channeling Loans" (if funded by provincial or local governments or state enterprises). The agency services theoretically do not constitute credit risk to CCB, which charges fee with respect to its administration. However, documentary deficiencies, inconsistencies in categorization, lack of balance between agency assets and liabilities, as well as responsibilities to fulfill contractual obligations as an "agent," all suggest that these activities may not be risk-free, and may require efforts in the future to assure a more accurate separation of "managed funds' from CCB's own assets and liabilities. - 15 - of employees dropped to 7,000. In 1962, following three difficult years of the Great Leap Forward, the State Council reestablished CCB in order to improve control of the budget and of capital investments. In 1970, during the peak of the Cultural Revolution, CCB was again restructured and was merged into PBC. The HO became a 12-person Unit for Capital Construction within MOF. In 1972, the bank was again reestablished but remained under MOF until 1979. In 1979, as part of China's reform program, the State's system of capital investment was transformed from a centralized system to one in which CCB allocated policy loans for the accounts of the State and various State instrumentalities. CCB was also formally removed from MOF's internal organization and system and placed directly under the State Council. The opening of subbranches at the administrative county level was accelerated, and CCB commenced commercial banking activities, including mobilizing commercial and retail deposits and lending for its own account. Lending was originally limited to fixed assets and working capital for state construction firms. In 1984, however, lending scope was extended to real estate development and commercial housing projects and, in 1986, individuals were allowed to open special savings accounts that formed the basis for housing loans. The bank was granted a foreign exchange license in 1986 and, in the subsequent 10 years, diversified its products and its target markets. However, CCB's predominant focus continued to be on its fiscal functions and on processing policy loans on behalf of the Government. Although the focus remained on long-term lending for infrastructure projects and basic industries, the bank also developed the capacity to mobilize retail/household deposits. 2.4 In 1994, with the decision to separate policy from commercial lending and to establish SDBC, CCB was reclassified as a state commercial bank, and was no longer required to make policy loans at its own risk. CCB was also relieved of specific fiscal functions as MOF assumed responsibility for preparation, readjustment and allocation of budgetary targets for fixed asset investment; drafting and publishing financial policies and procedures for project units and construction firms; and review and clearing of annual final accounts of project units and construction firms. On March 26, 1996, the bank officially changed its name from the People's Construction Bank of China to China Construction Bank. 2.5 Management. The overall administration and operation of CCB is the responsibility of the President's Council, composed of the President and five Executive Vice Presidents, all appointed by the State Council. As required by the Central Bank Law of 1995, the qualifications of senior management are reviewed by PBC before such appointments are made. The CCB HO has the last say in the appointment of senior management at the branch level, even though such nominations are made in consultations with provincial/local governments and reviewed by PBC branch offices. CCB's annual budget, business plan (i.e., lending and deposit-taking plans) and the President's draft performance and policy report outlining the current situation, annual plan and future goals, prepared by the President's Office and the Policy Research Department in consultations with other operational departments, is presented to the Assembly of General Managers and branch Presidents, which convenes twice a year. After open discussions, the President's Report is issued in its final version for implementation by the HO and -16- branches. CCB's current President, Wang Qishan was appointed in March 1994. Prior to this appointment, President Wang was a Deputy Governor of the People's Bank of China. 2.6 Subsidiaries and Associated Companies. CCB has three wholly-owned subsidiaries: China Investment Bank (CIB), established in 1981; Trust and Investment Corporation of China Construction Bank, established in 1987; and China Investment Consulting Corporation (CICC), established in 1986, to provide investment and financial consulting services to both domestic and foreign investors. In addition to its wholly- owned subsidiaries, CCB holds a 42.5 percent interest in China International Capital Corporation, China's first full service international investment bank. This venture was established in 1995 and is managed by Morgan Stanley, which owns a 35 percent share. CCB also has a 40 percent stake in Jian Sin Bank (formerly the Hong Kong Industrial and Commercial Bank) and holds 10 percent of the issued share capital of the Hong Kong listed Ka Wah Bank. In addition, CCB has a full service branch in Hong Kong and representative offices in London, Frankfurt, New York, Tokyo, Seoul and Singapore. As of end-1995, the bank had established 338 correspondent banking relationships. CCB branches and subbranches also own many financial and nonfinancial enterprises. As part of the government policy of separating ownership links between banks and nonbanks, the TICs belonging to CCB branches and subbranches have been converted into branches and/or divested. However, subsidiaries in China, even when wholly-owned, are often not consolidated into a parent's financial statements. B. BUSINESS SCOPE 2.7 Lending Activities. As CCB strives to transform itself into a commercial bank, it has increasingly differentiated its own lending from agency services and has placed greater focus on its own-risk portfolio. In 1991, own-risk loans and agency services were about equal at Y 260 billion; by end-1995, own-risk loans had increased to Y 778 billion, about two-thirds higher than outstanding under agency services. Historically, CCB's loans were predominantly for fixed assets and/or technological renovation. CCB's own- risk loans were largely funded by a combination of deposits and PBC funds. The maturity profile of these funding sources is weighted towards short-term funding sources whereas the maturity profile of CCB loans is weighted toward long-term maturities. In order to improve asset-liability management, CCB has been focusing on raising more medium- and longer-term funding. It is also increasing the proportion of working capital financing. In 1991, working capital loans represented less than 23 percent of the portfolio; by 1995, their share had grown to 44 percent. 2.8 CCB's outstanding loan portfolio reflect its traditional focus on supporting key state projects and centrally-planned goals. Borrowers are primarily large SOEs engaged in specific infrastructure and manufacturing industries. While state enterprises have been the traditional clients of CCB, individual household enterprises, TVEs, and joint ventures are gradually becoming more important. CCB's loans appear to be well diversified by borrower; top 10 and top 20 borrowers constitute 4.5 and 6.6 percent of total loan portfolio, respectively. Only one borrower has loans outstanding that exceed 10 percent - 17- of the bank's capital, and loans outstanding to the top 20 borrowers constitute less than 90 percent of the bank's capital. TABLE 2.1: CCB LOAN PORTFOLIO BY INDUSTRY (percent) Sector 1993 1994 1995 1996 Power 18.0 15.4 13.2 12.7 Transport & Telecom 11.9 10.4 9.8 11.2 Metallurgy 8.5 6.9 5.8 6.0 Chemical 6.9 7.0 6.3 5.9 Urban Construction 6.7 6.4 7.5 7.6 Petroleum & Petrochemical 6.3 5.2 3.8 3.9 Equipment Installation, Survey & Design 5.8 5.2 4.9 4.8 Coal Mining 4.4 4.4 3.3 3.1 Machinery 4.0 3.8 3.5 4.3 Construction Materials 3.7 3.6 3.5 3.9 Others 23.9 31.7 38.4 36.6 Total Loans 100.0 100.0 100.0 100.0 2.9 Housing Finance. CCB is a major player in the housing finance in China with a dominant market share in all aspects of national housing reform projects. At December 31, 1995, CCB's housing-related (including managed funds) real estate deposits totaled Y 123.7 billion and housing loans outstanding amounted to Y 119.5 billion. CCB has been entrusted by over 1,500 provincial and local governments to participate in their programs for commercialization and reform of residential housing. CCB is the major supplier of financing for the construction and renovation of commercialized residential units, and loans to enterprises and institutions for the purchase of such residential housing. 2.10 Credit Cards and Electronic Funds Transfer. CCB's credit card services have grown rapidly since the bank began providing credit cards to its customers in 1990.6 Such services are available at 44 provincial level branches and by December 31, 1995, 4.5 million "Dragon Cards" had been issued (up 233 percent from the previous year). By the end of 1995, accepting merchants totaled 38,000, the cashing network expanded to 18,000 points and 1,500 ATMs were installed. Deposit balances related to the card services grew to Y 7.1 billion (an increase of 109 percent from 1994). CCB is a member of SWIFT, the international funds transmission system. The bank has recently introduced an intra-bank settlement system that connects HO with the more important branches. 6 Credit cards in China are debit cards. - 18- 2.11 Bond Market Participation. CCB is a major player in the domestic bond market, underwriting and acting as selling agent for about one-fifth of all Renminbi bonds issued in China since 1987. The proceeds from the issuance of the bonds by governmental agencies, major enterprises and key projects must be deposited in an account with CCB. CCB has also acted as debtor in the issuance of state investment bonds, the proceeds for which are onlent to key projects designated in the State Plan. 2.12 Resource Mobilization. Because of its traditional role as a specialized bank for capital construction projects, CCB has in the past received substantial Agency Funds from the central and local governments and has relied on the central bank for funds to finance priority projects. CCB is, however, also authorized to receive demand, short- and long-term deposits from enterprises and individuals. The bank has attempted to provide more efficient and diversified services and, thereby, to capitalize on the rapid growth in the pool of consumer savings in China. As a result, CCB has in the last several years achieved a dramatic shift in funding sources. The composition of deposits (individual versus enterprise), the relationship of deposits to agency funds, and the reliance on PBC borrowings all have been affected. After increasing on an average of 35.6 percent per year from 1990 to 1993, deposits (enterprise and individual) increased 55 percent in 1994 and another 37.5 percent in 1995 to reach Y 804 billion. Individual deposits, which represented only 1 percent of deposits in 1986, constituted 45.7 percent of total deposits by 1995. In 1991 deposits, agency funds, and borrowings from PBC constituted 31.6, 39.3, and 10.9 percent of total funding, respectively. By the end of 1995, the relative shares stood at 46.7, 28.4, and 8.5 percent, respectively. 2.13 There appear to be two implications in CCB's success in mobilizing deposits. First, the differential in deposit and loan growth rates is positive from a prudential perspective as deposit growth has outpaced loan growth (an annual average of 39.6 percent versus 31.3 percent during 1991-95), leading to a steady decline in loan-to- deposit ratio to below 85 percent in 1994 and 1995. Second, an increased reliance on the individual/household sectors to fund lending activities reinforces the need for a better quality loan portfolio. 2.14 Foreign Currency Lending and Funding Sources. Although CCB's focus has been predominantly domestic, it has had success in recent years in mobilizing foreign exchange deposits, issuing foreign exchange bonds, and arranging overseas financing for projects in China. As at end-1995, foreign exchange assets amounted to $14 billion representing 8 percent of CCB's total assets (including managed funds). Loans outstanding amounted to $8 billion, or 7 percent of total loans. Deposit constituted 7 percent of the bank's total deposits. About 50 percent of foreign currency loans were funded by long-term overseas borrowing. CCB has been a major arranger of overseas financing for projects in China. During 1994, the bank signed 64 syndicated and bilateral loan agreements with overseas banks and export credit institutions for a contractual value of $1.83 billion. In 1995, 78 such agreements were signed with a contractual value of $714 million. Total agreements in force at the end of 1995 totaled 280 with a value of $6.46 billion and outstanding of $4.2 billion. Interest rates on foreign currency loans - 19 - which are funded by external borrowings are set by CCB at a margin over its funding cost in the overseas market whereas if funding is from CCB's domestic sources, the applicable rates are established by PBC. In recent years foreign currency international note issuance by CCB has included: in 1992, a $150 million five-year note at LIBOR plus 0.55 percent; in 1993, a $50 million five-year note at LIBOR plus 0.50 percent, a $70 million seven- year note at LIBOR plus 0.60 percent, and a $120 million 10-year note at a fixed rate of 6.875 percent; in 1994, a V 15 billion seven-year note at LIBOR plus 0.45 percent; in 1995, a HK$1.2 billion seven-year note at HIBOR plus 0.75 percent; and in April 1997, a Euro Dollar $200 million five-year note at LIBOR plus 0.30 percent. C. FINANCIAL PERFORMANCE7 2.15 Table 2.2 provides an estimate of the size of CCB's operations. More detailed information is contained in Annex 5. CCB has a paid-in capital of Y 35 billion and total equity of Y 45.5 billion. The table suggests that while total profits have increased in recent years, the levels of profitability are low in comparison to international benchmarks. In addition, CCB not only has inadequate capital but a declining trend in capital ratio. While the proportion of profits derived from nonoperating sources have increased, the operating profit fell sharply in recent years, primarily due to increased operating expenses, increased level of provisioning for bad loans and the cost to CCB of complying with PBC's requirement to pay an inflation-linked interest subsidy in respect of term deposits of longer than three-year maturity.' Investment income increased significantly from Y 0.2 billion in 1991 to Y 8.4 billion in 1996, primarily due to CCB's holding of securities issued by SDBC and the Government. On the positive side, the numbers suggest improvements in loan to deposit ratios and in the CCB's efforts to focus on nonpolicy lending. 2.16 Overview of Financial Statements. The financial accounting systems were originally designed to assure banks' compliance with government's economic regulations rather than to monitor their financial health. The loan loss provisioning policy of MOF, inconsistent application of accrual accounting, absence of consolidation, and deficiencies in internal controls and internal audits contribute to misreporting of banks' financial performance and position. Among the more serious differences between Chinese and market-economy practices are: (a) the financial accounting system, especially loan classification; (b) interest accrual; (c) the treatment of provisions for loss; and (d) the treatment of taxes. In addition, there are inadequacies in banks' capacity to collect and verify the integrity of basic data. The lack of integrity of financial records is exacerbated by the absence of independent external audits performed in accordance with 7 Given existing financial accounting standards and uncertainties surrounding data integrity, the financial statements of Chinese banks can be misleading, and do not lend themselves to analyzing the banks. Reported profits, equity, and loan quality are particularly suspect. Nonoperating revenues as a percentage of total profit grew from 10.3 percent in 1993 to 44.0 percent in 1994 and 48.7 percent in 1995. - 20 - internationally accepted methodologies. Recent improvements in accounting practices (e.g., partial adoption of accrual accounting) preclude valid comparisons from one year to the next. Historically, the branches operated under the strong influence of local governments and information provided to the HO was not subjected to independent verification or analysis. Rather it was often constructed and filtered at multiple lower levels to demonstrate compliance with various directives from higher authorities. TABLE 2.2: CCB-KEY FINANCIAL INDICATORS, 1992-96 (Y billion) 1992 1993 1994 1995 1996 ASSETS Net Loans 344.82 458.93 553.34 772.82 989.65 Total Assets 524.41 741.50 982.19 1,251.76 1,573.54 Managed Funds 291.45 324.18 415.35 470.91 551.77 LIABILITIES Total Deposit 323.58 404.31 584.63 803.61 1,166.47 Total Liabilities 489.66 703.24 933.23 1,194.30 1,515.51 Managed Funds 289.51 328.23 425.02 488.36 564.30 Total Equity 37.22 34.20 39.29 40.01 45.51 OPERATING RESULTS Net Interest Income 10.60 14.03 19.45 24.33 29.22 Gross Revenues 31.49 52.18 81.85 104.43 118.87 Provision for Possible Losses 1.23 1.98 2.92 1.55 2.15 Operating Profits (OP) 3.99 2.24 0.44 1.33 -3.41 Earnings Before Tax (EBT) 4.03 2.56 3.00 6.17 4.77 Net Profit 1.57 1.15 1.35 1.52 1.22 INDICATIVE RATIOS (%) Equity/Total Assets 7.00 4.61 4.00 3.20 2.89 Loans/Deposits 106.56 113.51 94.65 96.17 84.84 Net Profit/Equity 4.22 3.37 3.43 3.79 2.67 EBT/Total Assets 0.77 0.34 0.31 0.49 0.30 EBT/Gross Revenues 0.13 0.05 0.04 0.06 0.04 OP/EBT 99.18 87.45 14.51 21.52 -71.44 Source: CCB. 2.17 Loan Classification. Loans in China are as yet not classified according to risk, borrower cash flow adequacy to service a loan, or to probability of repayment. Rather, the existing classification system is based on the number of days a loan is past due. All banks, under MOF regulations, are required to classify outstanding principal or interest as (a) "overdue" if payment has been overdue for more than six months but less than three years, (b) as a "collection loan"(or stale loan) if overdue for more than three years, and (c) as a "bad loan" if it satisfies published MOF criteria. The amounts "classified" represent only the portion actually past due and not the underlying principal of the specific loan or the total exposure to a troubled borrower. Also, while CCB has internal procedures for loan classification, different branches interpret and implement it differently. For the loan either to be "written off" or "forgiven," it requires the approval of MOF, approvals that can be extremely slow in being granted. At the end of 1996, - 21 - CCB's loan loss reserves amounted to 0.6 percent of its own-risk portfolio. While the level of loan loss reserves has been established pursuant to regulatory guidelines, it appears to be far inadequate in light of the reported level of classified loans. 2.18 Interest Accrual. In most market economies, prudentially mandated policies require that interest not be accrued on a loan once interest or principal is more than ninety days past due. In China interest continues to accrue until a loan is 36 months past due. Taxes are based on accrued income and not on cash collected so CCB and other banks realize a negative cash flow associated with their nonpaying borrowers. It is likely that funds collected from other sources are diverted to service tax obligations calculated based on accrued income. 2.19 Provisioning Methodologies and Treatment. In accordance with the requirements of the MOF applicable to all banks in China, CCB is allowed each year to make a provision for loan losses equal to a specified percentage (0.7 percent in 1994 and 0.8 percent in 1995 increasing to 1.0 percent in 1997) of loans outstanding at the beginning of the year. The provision for loss is linked neither to true risk-levels (i.e., the statistical probability of loan repayment) nor even to the actual level of loans "classified" pursuant to the regulatory guidelines. 2.20 Tax Levels, Effective Tax-Rates and Disclosure. It is difficult for the formerly specialized banks to retain capital when subjected to an income tax rate of 55 percent (versus 33 percent for other local banks and 15 percent for foreign banks). The effective tax rate experienced by the banks, however, appears to be far in excess of 55 percent. In addition to routine property and stamp taxes calculated on original property values or on transaction values, banks are also subjected to a series of taxes and surcharges, for example, business, urban development, education, etc. based not on profits but on accrued interest income (whether or not received) and on gross fees. The sum of these taxes and surcharges totals approximately 6 percent of gross income. In March 1997, the Government reduced the income tax rate from 55 to 33 percent, but increased the business tax from 5 to 8 percent. 2.21 Impact of the Flawed Accounting Environment. The effects of the above government policies on CCB's financial statements are: (a) to show a level of "classified" exposure that is dramatically lower than would be disclosed by a bank in a market economy operating with a similar risk profile; (b) to provide a provision for loss well below statistically probable estimates of loss; (c) to substantially overstate real income and real equity levels; (d) to subject the bank to taxation levels in excess of real earnings, thereby diminishing cash flow and liquidity; and (e) to impair existing capital and fail to retain earnings that will be needed if banks have to have necessary resources to serve the real sectors. Obviously, these defects produce misleading financial statements and can result in unsound banks creating an unsafe financial environment. Even without adjustments to CCB numbers, a lack of profitability and capital inadequacy is apparent. If internationally accepted accounting methodologies were used to reflect CCB's financial reality, the picture would be significantly worse. The most serious impact of all - 22 - these defects, however, is that the bank's statements provide bank managers, regulators, and owners with a flawed understanding of reality on which they may base strategic, business, lending, and regulatory decisions. D. INTERNAL CONSTRAINTS TO COMMERCIALIZATION 2.22 Both in the Third Plenum of the Fourteenth Party Central Committee (November 1993) and in the Commercial Banking Law (adopted on May 10, 1995 and made effective as of July 1, 1995), a mandate for the commercialization of the "specialized banks" was announced. The Commercial Banking Law tasks banks with responsibility for their own profits and losses and requires that they focus on "efficiency, safety, and liquidity." Although CCB's priority, in common with the other formerly "specialized banks," is to comply with the regulatory mandate for transformation, this goal cannot be achieved in the near term. Transformation implies a complete redesign of the organizational structure, including CCB's governance system. The organizational structure designed to implement directives of government agencies must be replaced by a flexible structure designed to comply with laws and regulations while serving changing market needs. The information systems designed to report compliance with credit plans and administratively determined interest rates must be replaced with systems which help management understand the risks they are assuming and the profits (or losses) they are generating. Systems designed to serve the needs of centrally planned economy must be adapted to identifying and serving the needs of bank customers. Finally, to achieve new goals in a new environment, CCB will need highly skilled, trained and motivated workers. Diagnostic Studies 2.23 In consultation with the CCB President and its senior team for transformation, a series of diagnostic studies-organization and management, financial and management accounting, human resource development and information technology-were conducted to identify the constraints to commercialization and the priority and phasing of next steps. The studies were financed under a PHRD grant, conducted by an international consulting firm, and focused on two provincial branches (Shandong and Hubei) and the HO. The main findings of these studies are summarized below. 2.24 Organization and Management. CCB's organizational structure, reporting channels, and information flows were created for the convenience of governmental agencies and to assure implementation of the central plan. As a result, the organization mirrors the administrative levels and functions found in the government and, theoretically, facilitates direct reporting to and responsiveness to, and control by, government units. Decisions were typically made at higher government levels and, therefore, information systems within CCB were designed to monitor the flow of funds and verify compliance with directives rather than to support analysis or management decisions. Neither the number of levels, the location of offices, nor the functional departments are based on market needs, operational efficiency, or management control. - 23 - Vertical layers (e.g., HO, provincial branches, prefecture/municipal branches, and county sub-branches), continue today to mirror the organizational structure of the government. Functional units within each vertical level replicate the organizational structure at superior levels. These units report directly upward, without significant interaction horizontally or diagonally with other departments. While year-end aggregated balance sheet is prepared by branch, such segmentation has resulted in relatively isolated compartments, limitations in data quality, inefficient flows of information, confused lines of authority, and an inability of managers to supervise activities theoretically within their geographic scope of responsibilities or to establish accountability for good or bad performance. 2.25 CCB has no formal operating charter and no formal, transparent governance mechanism; it does not have a Board of Directors or a functioning Supervisory Board. The benefits and risks of CCB to the owner are masked by the diffused relationship between the bank and the government. CCB's transformation will require a formal charter to establish its legal identity and to define the roles, rights and responsibilities of the owner and of the management. In defining the rights and responsibilities of the owner and how these ownership rights will be exercised through a governing body, there will be an opportunity to separate the government's roles as owner, regulator, tax authority, and primary borrower in order to minimize the potential conflicts of interest inherent in these various roles. The main issues to be addressed in the Charter will include a system of governance, operational autonomy and accountability. Article 17 of the Commercial Banking Law in conjunction with the provisions of the Company Law suggests that CCB's legal structure will be a "wholly state-owned company." Under this legal structure, CCB will establish governing bodies such as a Board of Directors and Supervisory Board which will be vested with certain powers. In addition to establishing and assuring compliance with bank policies and procedures, the governing bodies would presumably also have responsibility to assure that the bank complies with all laws and regulations. The Board or primary governing body, however, would be the instrument of exercising ownership governance and not a direct arm of the government in assuring approval of loans to specific projects or of exercising the government's other roles as tax authority, regulator, etc. 2.26 It will also be necessary to establish internal policies and procedures and an organizational structure designed to manage risk, enhance efficiency, and to maximize profitability and customer satisfaction. The baseline business plan under the proposed project will identify the bank's markets, products, and processes necessary to achieve strategic goals and the steps necessary to become a financially viable institution in compliance with prudential laws and regulations. The plan will establish the process and standards for developing strategic business plans, investment plans and annual budgets. It will identify a number of departments which would need to be merged and/or restructured to facilitate CCB's functioning in an efficient commercial manner. For example, the various credit departments could be merged; training and personnel departments could be merged; the funding administration activities of the Planning Department could be integrated into a Treasury function; accounting activities could be - 24 - expanded and controller responsibilities, policies and procedures and controls required; the scope of internal control functions could be expanded (internal audit, loan review, legal and regulatory compliance, fraud identification, etc.) and a number of committees (ALM Committee, Market Risk Committee, Audit Committee, Credit Committee, etc.) could be established. The focus of the HO could shift from that appropriate for a government bureaucracy to aspects critical in a commercial bank, e.g., to improve the quality of information as the basis for decisions; to improve control systems; to identify and realize strategic benefits associated with CCB's competitive advantages; to design and advance a coherent strategy in which organizational synergy, market and profit goals are realized; to assure compliance with prudential regulations; and finally to maximize the value of the institution's human resources. Given the size and scope of CCB, it is unrealistic that the HO could exercise central control of all decisions. It will be necessary, however, that the HO establish directions, policies, and procedures and that it be able to identify those branches which are complying with policies and are achieving assigned goals. 2.27 As information flows improve, the responsibility and accountability within CCB must be defined along functional lines. As the organization transforms to meet the needs of the market, there will be a need for a "process-driven" structure. Whereas new rules and policies may be written quickly, the more important aspects of actually establishing new systems and new ways of monitoring compliance will be a resource and time consuming activity. 2.28 Financial and Management Accounting. CCB's origin as an arm of MOF responsible for funding key state projects is reflected in the bank's key processes, and in particular its lending activities. In addition, the loan portfolio and lending processes at the provincial and lower levels have historically been influenced by local government officials. Without clear authority over (or responsibility for) lending decisions and with little focus on a borrower's capacity to repay, CCB did not develop a financial management system to track, monitor, or control financial risks. Perhaps the most immediate issue facing CCB is the need to develop a system of financial controls that (a) accurately records and tracks financial transactions, (b) precludes disappearance of assets due to fraud, (c) precludes violations of laws and regulations, (d) allows the bank to control expenses, (e) identifies and measures the quality of assets and of earnings, and (f) otherwise provides management and regulators with the basic data to evaluate management decisions and strategies. Specifically, if the bank is to be responsible for its own profits and losses, management will need the ability to weigh risks and rewards and to make lending and management decisions based on accurate information and meaningful analyses. In addition, management will need systems that allow it to issue and enforce directives on expense controls, risk tolerance, etc. 2.29 In the absence of a system to assure that transactions are properly recorded, senior managers have little ability to verify the authenticity or consistency of numbers that they receive from lower levels. There is a significant risk that senior managers are not aware of all assets and liabilities of the bank and that income and expenses may be misstated. - 25 - To correct the deficiencies, CCB needs to (a) introduce a new chart of accounts, (b) implement accounting policies and procedures, (c) improve data capture at lower levels by establishing a system of checks and balances in the initial recording of transactions, (d) establish a system for independent verification of transaction authenticity, and (e) institute a process by which data submitted by lower levels is analyzed and variances with prior periods are identified and explained. Essentially, CCB's challenge will be to design and implement a new financial and management accounting and reporting system to assure that financial data is relevant, timely and accurate. As part of the development of a new financial and management system, the bank will need to restructure the internal audit function and provide for it to report directly to the President (or to a newly established Board of Directors), rather than having all information filtered through all lower levels in the bank. 2.30 The organization of the credit function reflects the bank's history. Numerous departments process credit transactions based on the type of lending (e.g., fixed assets versus working capital) rather than based on market criteria, borrower convenience, bank control, or risk characteristics. No single department at HO or at provincial branches has overall responsibility for making or monitoring lending decisions. As a result policies can be implemented inconsistently. In addition, it is often difficult, perhaps impossible, to aggregate total exposure to a single borrower since loans may be distributed (even unknowingly) among several departments within several different levels of the bank. 2.31 The credit functions within CCB need to be reorganized by merging departments; establishing new standard loan approval procedures; and developing a risk-based monitoring system. Greater emphasis needs to be placed on formal and commercial- oriented credit assessments, independent and accurate loan reporting, and on compliance with prudential regulations and with the bank's own policies. Internal control functions need to be strengthened in order to detect irregularities in lending, deposit-taking, and processing of cash, expenses, foreign exchange, and electronic transfers. 2.32 The present CCB treasury function is restricted to trading in capital markets, such as foreign exchange, bonds and money markets with the objective of making a profit for the bank. It does not at present have responsibility for day-to-day management of short- and long-term funding, cash management, payments and currency balances. This does not ensure that CCB achieves an optimal balance sheet composition nor does it ensure the bank has the right currency at the right place at the right time, in accordance with agreed risk-return criteria. 2.33 Neither CCB HO nor its branches have significant experience in managing balance sheet composition or risks associated with interest rates, liquidity, or foreign currency positions. As the financial markets are further deregulated, CCB will need to strengthen its ability to control exposures and to make risk-reward decisions on balance sheet composition and on contingent assets and liabilities. CCB needs to establish an ALM function at HO with responsibility for the bank's overall balance sheet structure, - 26 - focusing on profitability and the liquidity aspects of interest rate risk, maturity mismatches, and open currency positions. 2.34 While MOF regulations preclude tax deductibility of adequate risk-based loss provisions, CCB needs to prepare internal estimates appropriate for management, owners, and regulators to be able to understand the bank's risk profile and the profitability of its operations. In addition to reporting "classified" loans pursuant to the MOF guidelines, CCB should improve monitoring, management and reporting of troubled borrowers by establishing separate classification criteria based on estimates of loan collectibility. A comprehensive program involving objective and independent review of the loan portfolio, and provisioning for poor quality loans needs to be joined with the establishment of an internal work out unit to maximize value to the bank for all problem loans. Such internal reports will give management, owners and regulators a measure of the extent to which regulatory required classifications and provisions are increasingly impairing banks' capital. 2.35 Human Resource Development. Like other specialized banks, CCB's goal in the area of human resources has been to comply with various State directives and thereby to maximize employment levels. Management has little autonomy over recruitment, retention, discipline, rewards, rotation, etc. Human resources have simply not been viewed as a strategic tool in achieving business objectives. Ministry of Personnel and Ministry of Labor dictated the number and sources of recruits, including mandatory targets for absorption of retired armed forces staff, as well as base salary and salary grading. Banks' lack of autonomy in personnel development has created high cost-low return training initiatives. Banks lack the alignment between their business strategies and the planning, acquisition, development and deployment of personnel. Performance evaluations are overly subjective and are heavily driven by time in position. There are no established career development practices, and formal practice of employee/manager goal setting, objective performance measurement, and regular performance feedback are not practiced. Given rigidities in Chinese housing patterns, traditional social practices, the system of Work Units, and other political impediments, management is extremely constrained in its ability to shift or rotate personnel geographically whether to provide career growth, to assure HO control of local operations, or to maximize productivity. In addition to being large, geographically dispersed, and perhaps inadequately motivated, the workforce has a very limited understanding of commercial banking. Attitudes, habits and perceptions are deeply ingrained such that Chinese banks face human resource challenges previously not encountered by financial institutions elsewhere in the world. 2.36 CCB's commercialization requires that its workers have new skills and different incentives. CCB's strategy, product and service offerings and technology can all be reengineered, but the success of their execution rests with the employees. In preparing itself and the workforce for the impending change to a market-driven environment, CCB must have a strategy to develop its current managers, mobilize and allocate its human resources, and train and motivate its employees. Currently CCB's training and personnel functions are strategically and operationally disconnected and there is little coordination - 27 - between the two functions. The resulting redundancies and inefficiencies lead to missed opportunities for financial and market improvements in CCB's position. 2.37 In order to succeed in a competitive environment, CCB must take a performance- based approach to managing individuals and organizational units, and establishing new training mechanisms. Training and personnel functions need to be combined into one human resources department. The current human resource planning, including training process will need to be much more closely aligned with the business planning process of the organization. Performance measurement criteria will need to be linked to the achievement of business objectives. For this, CCB will need to create position descriptions and a new performance appraisal process and format, train managers in performance measurement and management, link remuneration to performance, and formalize disciplinary and dismissal policies. CCB will need: (a) a more effective recruitment and placement policy to reduce the number of unqualified and increase the number of qualified people hired within CCB; (b) to reduce training expenses and optimize training resources; (c) to increase the efficiency with which it deploys people when and where their skills are most needed; and (d) to strengthen human resource information management. A new human resource planning process would need to be established within CCB to assess the implications of business initiatives in terms of future skill needs; identify critical human resource practices needed for execution of business plans; and analyze and assess the cost implications of human resource strategy. 2.38 As in the case of other large Chinese banks, CCB also has a large number of training institutes and working relationships with state-run universities, and a variety of training and education programs for employees. The main emphasis, however, was on formal education and the training approach was thus unfocused. As a result, there is no curriculum or design strategy that could be clearly and concisely articulated. Training is uncoordinated across the organization and is not focused on developing important banking or management skills. As early stages in the transformation provide management with an understanding of the bank's financial position, and as priority products, services, and target markets are selected, CCB will need to recruit, retain, train, and deploy personnel in a cost-effective fashion. 2.39 Information Technology. CCB HO is responsible for overall information technology (IT) strategy, planning, and priorities. While IT initiatives already taken by CCB have resulted in significant automation of core business activities such as deposit- taking, communications and coordination is minimal. As a result, IT resources are highly dispersed and fail to provide needed information across departments. There is no explicit alignment between the bank's business strategy and its IT planning and there are few standards and methods that are accepted and followed across the organization. Standards for technical architectures for the development and operation of banking applications have not been established thereby resulting in major systems' incompatibilities and high development and maintenance costs. The focus has been on networking and not on transaction processing or management information systems. Current stand-alone applications produce data integrity and consistency problems. Data design and - 28 - administration are done independently at the branches with no standards or procedures enforced, making data consolidation difficult. Security and disaster recovery do not exist in any form sufficient to protect CCB from operational risk. CCB is vulnerable to natural disasters, computer hardware and software failures, human error, and sabotage. 2.40 An effective IT strategy should be business-driven and should be developed jointly by line business units and the IT department. The strategy should provide clear guidance and direction for the development of IT implementation plans, and should be reviewed and updated periodically to address changes in market needs and technology. CCB's business needs should drive corresponding IT initiatives. For example, the business need for accurate management accounting and operational data dictates the need for systems to capture and deliver financial and operational information. CCB needs to develop an IT vision that gives overall guidance on how IT should be exploited for maximum business gains. Overall objectives of IT should be to use technology to improve the bank's core functional and operational processes. The long term IT goals are to provide computing and network infrastructure, and organizational capacity to satisfy management's needs for information and to offer technology based products and services to meet market demand. E. CCB's COMMERCIALIZATION INITIATIVES 2.41 Since enactment of the Commercial Banking Law in 1995 and the government decision to separate policy and commercial lending, CCB has taken a number of steps to transform itself. It is attempting to position itself to serve the market in anticipation of both further sector deregulation and increased competition. Whereas it considers the other three formerly specialized banks and nationwide commercial banks as its main competitors in the near term, senior management recognize the potential challenge posed in the longer term by new market entrants, foreign banks, and NBFIs. CCB was the first of the specialized banks officially to: (a) free itself from policy lending, (b) take steps to establish an asset liability management committee and a credit committee, (c) merge foreign currency operations with Renminbi lending, and (d) participate in a diagnostic study by an international consulting firm. 2.42 A number of initiatives have been taken to improve HO control and branch operations to facilitate the bank's meeting customer needs. Treasury functions have been centralized in the Fund and Planning Department, followed by adjustments in the structure of the department, whereby four regional divisions at HO have been made responsible for direct supervision of the 44 provincial branches. This has already improved the efficiency of funds allocation and minimized risks resulting from dispersed treasury operations. Credit management has been streamlined with four regional divisions at HQ responsible for the 44 provincial branches. Foreign currency and Renminbi lending operations have been consolidated at HO, and the plan is to consolidate such operations at provincial level. Branches have been given specified credit approval authority varying according to the strength of branch management and financial performance, and approval of loans over Y 100 million has been vested in the HO. - 29 - During 1996-97, the lending authority of about 90 percent of the county-level branches has been withdrawn. These actions were driven at least in part by the need to minimize problems associated with local government influence over branch lending decisions. The bank has also moved to merge various credit departments into one department and to impose unified management of all Renminbi loans. All project appraisal work is now undertaken by the project appraisal department. Credit approval authority has been vested in the credit management department, while the banking department is responsible for loan processing, disbursements, supervision and collections. In March 1996, CCB established a Credit Management Committee as the decision-making body for domestic and foreign currency lending operations. CCB also adopted a credit authorization system for the primary (provincial) branches, and established the Asset Safeguard Department to manage and monitor high-risk loans and to safeguard such assets. CCB also established an Asset Liability Management Committee and is experimenting with ALM ratio management in selected branches. This is in anticipation of gradual reduction and subsequent elimination of credit quotas during the Ninth FYP. Internal controls have been strengthened and, unlike in the past, subbranches within medium and large cities have been denied the rights to audit themselves. County-level branches that served as independent accounting units are being placed on a budgetary system. These changes are intended to streamline HO functions, maximize control, improve efficiency and asset quality, and to improve customer service. 2.43 As CCB realizes greater independence in its credit approval procedures, the project appraisal department is being strengthened. One of CCB's principal advantages over its competitors is its expertise in evaluating, arranging and providing medium and long-term funding for construction and other infrastructure projects. Its analysts are well- qualified in various industrial fields. In addition to conducting an analysis of the feasibility of the project, the project appraisal department has begun to focus on the project's ability to generate income, the borrower's ability to repay and any credit support provided by collateral or guarantees. The decision to approve or reject a loan is now taken in light of this analysis. During 1995-96, over 1,000 projects were rejected even though these projects had the prior approval of the planning authorities. 2.44 As discussed in para. 2.24, the present four-tier branch structure is a product of the planned economy and based on the administrative divisions of the country. Some banking units are located in remote areas with limited business and are not profitable. CCB has undertaken a review of its branch and subbranch network with the objective of closing and/or merging unprofitable branches. About 85 lower-level branches were closed and/or merged in 1995-96, and this restructuring effort is expected to continue. In addition, CCB selected Hainan Province as a pilot for branch consolidation. The two administrative branches (the provincial branch and the municipal branch) in Haikou were consolidated into one CCB Hainan branch. This initiative has not only reduced the administrative layers, but also reduced direct interference in the branch operations by the local government. Remaining restrictions on CCB's ability to release and redeploy employees will restrain the speed with which noticeable branch efficiencies can be - 30 - achieved but it is encouraging to see the actions taken and results achieved to date in the branch consolidation efforts. 2.45 The bank has also instituted a "zero" growth employment policy and transfer of staff to regions of need has now been made part of staff career development. Earlier it was not possible to transfer staff from one branch to another due to the concept of work unit and associated benefits that are common in China. A new staff contract system has been introduced under which new staff would be hired on a fixed-term basis and could be released for unsatisfactory performance. Such contract hires would not be given the full range of traditional benefits. In a similar initiative, CCB is exploring ways to parcel out in selected cities its social obligations, for example, health, insurance, education and housing. The present remuneration system imposed by the government is based on control over the total wage bill. Performance is determined on the basis of position and seniority and has little to do with CCB's operational performance. CCB is experimenting with a new incentive system with the Shanghai branch on a pilot basis. Under this system a number of operational and financial targets are agreed between the HO and the Shanghai branch. A proportion of annual incremental profit is set aside for staff bonus, to be distributed to staff according to criteria established by the Shanghai branch if targets are met. The system was first tested in 1995 with good results as deposits and profits increased and the amount of past due loans declined. 2.46 In order to increase the size of individual savings deposits in the face of increased competition, CCB has expanded its deposit-taking operations, primarily by targeting customers to attract longer term deposits and improving client services. In this CCB has been quite successful; total deposits have increased at a very rapid pace. CCB has overtaken other banks in deposit mobilization and now trails only ICBC, the largest Chinese bank. With deposit mobilization growth exceeding the growth in its commercial loan portfolio, CCB's loan deposit ratio has improved substantially in the last few years. CCB intends to issue more bonds in the future in order to enhance its funding for medium- and long-term lending. 2.47 CCB is diversifying financial services and moving well beyond its traditional focus on loans for fixed assets and working capital. It now provides services for settlement, foreign exchange and other comprehensive banking services. CCB is also planning to diversify its operations to provide a wide range of banking and financial services either directly or through its subsidiaries. CCB's target is to diversify its revenue base to increase the contribution of fee-based activities such as investment banking, real estate, credit card and consultancy services. 2.48 CCB expects to further improve its operational efficiency through more targeted staff training and installation of modem operation facilities, including upgrading one training center to provide comprehensive training courses to staff and management. CCB also intends to computerize its branch network and to further enlarge its computerized settlement and clearance system. -31 - 3. LESSONS OF EXPERIENCE AND BANK GROUP STRATEGY A. LESSONS OF EXPERIENCE 3.1 The proposed project is the first of its kind in China. Previous financial intermediary lending took place at a point in China's financial reform where commercial banks could not (and were not permitted to) function effectively. This Project incorporates lessons of experience from similar projects elsewhere, especially projects in the transition economies of Central and Eastern Europe. There are, however, major differences in banks, in the financial system and in the expected roles of the State and private sector in China compared to banks, financial systems and economic organizations in other transition economies. The main banks in China are very large in terms of assets, branch network and workforce, even by international standards. More important, the Chinese authorities have adopted, as befits the political system, a policy of gradualism in its deregulation and reform program and large-scale privatization is now not in the cards. 3.2 The delivery mechanism (technical cooperation arrangements with international commercial banks or "twinning") used for the provision of banking expertise for commercialization and modernization of banks in some of the transition economies (Poland, Russia, Ukraine, Lithuania) is likely to be used in the context of the proposed project. Some of the recommendations of a recent Bank audit of experience with twinning in Poland' include: (a) a better-targeted and more intense supervision by the Bank in the early phases of the program is useful in speeding up the process as well as in assisting the preparation of the foreign banks to the country "realities"; (b) preparatory work and "education" must be taken in advance or prior to the actual undertaking of the twinning arrangements in order to avoid unrealistic expectations, and unnecessary delays, additional costs and possible friction among the partners; (c) more emphasis should be placed on direct dealing between foreign and domestic banks rather than with MOF and/or other government agencies; (d) communications problems (language and concepts) should be taken into account in order not to slow down implementation; and (e) there should be flexibility in specification of deliverables to take account of subsequent changes in priorities as work modules progress. 3.3 Given the size of CCB and the fact that some of the Western banks involved in twinning arrangements are overstretched, CCB proposes to adopt a consortia approach for its institutional development program. The consortia is likely to consist of some combination of reputable international commercial banks, international consulting firms, 9 Poland: Country Assistance Review (CAR)--Enterprise and Financial Sector Adjustment, June 1996. -32- information technology specialists and training specialists. Selection of wrong partners, lack of preconsultations with interested parties on what technical cooperation will mean, and poor choices of people for key roles in running the twinning program are among the pitfalls that would be avoided. During 1996, CCB, with the assistance of the Bank, initiated preliminary discussions with international commercial banks partly to understand more about the concept of twinning and partly to solicit foreign banks' interest in providing assistance for CCB's institutional development program. Once the list of foreign service providers is firmed up, they will be provided with copies of the diagnostic studies, and, if necessary, CCB/Bank will hold briefings on the financial sector environment in China for the selected firms. Foreign service provider(s) will hold on-site discussions with CCB management in order to finalize an institutional development program tailored to the needs and absorptive capacity of CCB. A joint management structure, involving an overall project manager in CCB working with a coordinator from the service provider, and similar roles for each work module in the twinning program, will be established to run the technical assistance program. The institutional development program will be structured in a number of separate modules detailed in Chapter 4, which will be implemented successively or, in some cases, in parallel depending on their urgency and the presence of interdependencies. 3.4 In the Bank's experience, financial intermediation loans and credits have often had limited success in the past due to the pursuit of real sector objectives under subsidized directed credit programs with little consideration to their impact on financial sector development. The Bank therefore emphasizes that all bank operations and policy advice related to the financial sector should be consistent with, and supportive of, a coherent country strategy for financial sector development, and FILs should be made part of a well-articulated and time-bound program for financial policy and institutional reforms, including minimizing distortions in economic incentives and promoting macroeconomic stability, conducive financial sector policies, effective accounting and auditing systems and acceptable prudential regulations and competent supervision and enforcement, and satisfactory management of financial intermediaries. The Bank has a well-articulated sector strategy that has been discussed with and agreed by the Chinese authorities, and the main objective of the ongoing Financial Sector Technical Assistance (FSTA) project and the proposed FSTA-II is to strengthen China's financial infrastructure. While financial sector reforms in the eighties generally lagged reforms in some of the other areas of the economy, the nine FILs to date involving the China Investment Bank (CIB) and the Agricultural Bank of China (ABC), however, have performed well in meeting real sector objectives and in limited institution building, with satisfactory collection rates, sustainable subprojects, and without causing additional distortions in the system. B. BANK GROUP STRATEGY 3.5 Macroeconomic and structural reforms continue to be central to the Bank's assistance strategy in China as laid out in the Country Assistance Strategy (CAS) presented to the Board on March 18, 1997. Incomplete reform of the financial sector, - 33 - state-owned enterprises and public finances constrains development of strong macroeconomic management tools and threatens sustained rapid growth. The Bank Group's program has been designed to support the timely implementation of key elements of structural reforms in these critical areas. The ultimate objective is to assist the Government in developing the institutions and instruments necessary for sustaining rapid and more stable growth and broad-based development using a mix of economic and sector work, technical assistance, lending, investment and guarantee operations, in which the IFC and MIGA will play significant roles. 3.6 The Bank is closely associated with the overall reform effort in China. Since the preparation and implementation of FSTA, the policy dialogue has intensified through a number of workshops/seminars, strategy/policy notes, sector updates, a capital markets study and studies on China's investment regime, pension system and state enterprises, a paper on interest rate liberalization, various CEMs, including the 1996 CEM, and annual consultations on the financial sector, the last one held in March 1996. There is a general agreement between the Chinese authorities and the Bank on the overall content of the reform program, and the likelihood that completion of such reforms will necessarily span more than a decade. The Bank supports the Chinese authorities financial sector reform objectives as recorded in the Third Plenum decisions and is prepared to assist the authorities in speeding their adoption. In the realization of this reform strategy, the Government has requested Bank assistance in a number of areas, including in the transformation of specialized banks into commercial banks; the regulatory and supervisory framework for the NBFIs; further support to PBC in the areas of financial accounting and prudential supervision of banks and nonbanks; and training of the staff of PBC, commercial, policy and nonstate banks and other institutions in the financial sector. The Bank can have a positive impact on the nature and quality of China's financial sector reform program, including its design, the type of measures needed, their speed and sequencing, and their coordination with reforms in the rest of the economy. The challenges for the Bank in designing projects with the regulators, owners, and individual financial institutions is to assure that adequate understanding of reform exists and that political will is sufficient to justify Bank involvement and to assure that incremental progress in reform will be achieved. 3.7 China still has a long way to go towards establishing an efficient market-based financial system. Intricately linked to financial sector reforms are issues related to fiscal and SOE reforms. Financial sector reforms will be high on the agenda for years to come. The Bank is following a multiprong approach in the banking sector consisting of the following main elements: (a) the Bank is continuing the policy dialogue with the authorities on financial sector and SOE reform issues through economic and sector work and dissemination of findings in various workshops and seminars. In addition, annual consultations are held on financial sector issues. As a result, there is a good understanding of the issues and an agreement on the direction of financial sector reforms; (b) the Bank is assisting in the establishment of appropriate banking sector infrastructure-legal, prudential, accounting and payment system-under the ongoing FSTA project. A follow-up project, further to support PBC in the areas of financial - 34 - accounting, regulatory framework for NBFIs, and prudential supervision of banks and nonbanks, is envisaged in FY98. The Bank also plans to assist on the roll out of the new payments and clearance system, being developed under FSTA; (c) a number of operations are planned in support of specialized banks' commercialization in recognition of the fact that their transformation will be gradual and is likely to require a series of operations starting with introduction of modem banking practices and policies and skills upgrading and finishing with their financial restructuring and recapitalization; (d) the Bank and IFC are working together to introduce more competition in the banking sector through ownership diversification of nationwide banks, institutional development of China's first nonstate-owned bank, and support to the new city united banks; and (e) both the Bank, with the support of EDI, and IFC are providing assistance to upgrade banking skills in the commercial banks, policy banks and other institutions in the financial sector. - 35 - 4. THE PROJECT A. PROJECT RATIONALE AND OBJECTIVES 4.1 Gradual, incremental reforms contributed to China's impressive growth rates in the last 17 years. Further, admittedly more difficult, reforms would yield significant dividends and help sustain rapid economic growth. Continuing the gradual reform effort in two areas-state-owned enterprises and the financial sector-are at the core of the Government's reform agenda and are intended not only to increase the efficiency of financial intermediation and resource allocation, but also to facilitate the management of aggregate demand. Unlike other transition economies, the Chinese authorities have adopted a policy of gradualism in their deregulation and reform program and large scale privatization is not now in the cards. Transformation of the formerly specialized banks, the mainstay of banking in China, into commercial banks is considered critical for the pace of future deregulation of the financial sector. The project's primary objective is to gradually change the earlier system of state-directed and policy-oriented credit to a risk- averse and market-oriented resource allocation system through the institutional development and modernization of a core Chinese bank, the China Construction Bank (CCB). 4.2 The proposed project was developed over a period of two years and required extensive diagnostic work by CCB with the assistance of an international consulting firm, financed under an PHRD grant. In addition to the external constraints that are well known and summarized in Chapter 1, Section E, the diagnostic studies have highlighted a large number of internal constraints to CCB's commercialization (Chapter 2, Section D). With the further gradual deregulation of the financial sector, the external constraints are likely to be reduced during the Ninth FYP (1996-2000). The internal constraints are equally if not more binding in view of CCB's (and other formerly specialized banks) past role as fiscal agents of the government. Commercial transformation will be gradual and is likely to require a decade or more. 4.3 The project should be placed in the context of needed financial sector reforms in China and should be perceived as simply the first of a series of operations in support of transformation into a commercial bank of CCB. The main focus of the proposed project is on setting up modem banking practices and policies and procedures at CCB HO, and to gradually understand more about the true financial position of CCB in order to provide owners, regulators and managers with reliable information on which to base future decisions. A second project would focus on deepening the reforms initiated under the first project and address issues of future organizational structures of the large banks; issues of financial restructuring and recapitalization will have to await further reforms in the banking sector and resolution of issues, for example, SOE reforms, that led to the weakening of the bank's financial position in the first place. - 36 - B. PROJECT DESCRIPTION 4.4 The project design is based on the priorities and sequencing of internal reforms identified in the detailed diagnostic studies and CCB's own commercialization program. The project would accord priority to the design and implementation of new financial management and control systems that are comprehensive and reliable and that provide the basic financial information necessary to manage and control the bank's business, and addressing the major issue of credit management, in order to bring this key banking function under control. In addition, the project would focus on designing and implementing a new corporate governance system in line with the country's existing laws and regulations, and in the information technology system development effort in order to provide the information needed to manage the bank and to maximize the availability of scarce technical resources. Above all, the project would accord priority to personnel policies and training of staff and management. The project will have two main components: (a) transformation component and (b) line of credit component. Both components would have as their main objective the institutional development of CCB. C. TRANSFORMATION COMPONENT 4.5 The transformation of CCB into a commercial bank means that CCB must have methodically developed and implemented strategic and business plans; adequate systems and procedures for providing valuable internal management and financial reports; capability of assessing risk and allocating and pricing credit accordingly; products and services that are responsive to market and customer demands; policies and procedures that promote self-regulation and monitoring of its own efficiency, liquidity, profitability and risk profile; and a culture and organizational structure in which managers are willingly and truly held accountable for the bank's financial performance. Given the enormity of the challenge, the transformation component would focus on establishing modern commercial banking systems, and policies and procedures through the provision of services of international experts, data processing and other equipment to support the new systems, training equipment and materials, and training in commercial banking of the management and staff of CCB. The transformation component will be divided into a number of modules detailed below. Module 1: Financial Management 4.6 The existing financial accounting system in CCB has focused on numbers, while the role of financial accounting in management has been ignored. Even so, the current system is ineffective, represented by duplicate accounts and difficulties in producing timely and accurate information. Improving existing financial accounting and reporting systems, and implementing a new system, including a comprehensive control framework, is critical for CCB's transformation into a commercial bank. 4.7 This module would address a number of key areas in financial management, including financial accounting to correspond to international accounting standards, international audit guidelines, asset/liability management, treasury functions, and risk management. A reporting system will be developed to cover all key areas of operations, giving the information needed to successfully manage and operate the bank, measure its -37- performance and manage its risks. The work will include establishing a new chart of accounts and defining reporting requirements. The objective is to make the financial information more timely, accurate and accessible. 4.8 The work on financial accounting will be coordinated with the work being done by the MOF, which is responsible for issuing new accounting standards and regulations in China.0 Until MOF introduces new financial accounting standards, CCB will continue to maintain accounts as required under existing government regulations so that CCB can comply with the law. In addition, CCB will apply international accounting standards to develop the management information necessary to run the bank. The new accounting system will be first tested in a few selected branches before it is adopted CCB systemwide. It is one of the primary goals of the proposed project to assist CCB in establishing accounting systems and procedures that will provide owners, managers and regulators with reliable information on which to base business and regulatory decisions. 4.9 The main deliverables under Module I would include: a new basic accounting system; redesigned chart of accounts; new financial reporting system; redesigned accounting procedures and manual; new accounting organization; accounting control system; internal management accounting; establishment of key functions such as asset/liability management, treasury and market risk Module 2: Internal Audit 4.10 There is currently no real internal audit system in CCB to provide independent information and analysis on financial reports to the management and/or the Board. Under the module, the internal audit function will be organized with direct reporting linkages as specified under the new CCB Charter, and an internal audit manual would be prepared. This internal audit function will conduct the internal audits on the finances and operations of all CCB business units, branches and subsidiaries. 4.11 The main deliverables under this module would include: an internal audit structure; a new set of audit standards; internal audit manual; and effective operations monitoring, including an early warning system. Module 3: Credit Management 4.12 The credit management system was effective when banking and fiscal functions as well as policy and commercial lending coexisted. This system cannot meet the transformation requirements, and has resulted in low credit quality, high amount of past dues, large share of credit at risk, weak internal controls, and noncompliance with regulations. The current risk classification does not reflect borrowers' repayment capability; loan approval is not supported by sufficient information; and there is no clear definition of credit monitoring responsibilities. There is no standardized credit manual to provide guidance for credit operations for the whole bank as the current appraisal 1o Under the FSTA project, MOF and PBC have prepared about 30 accounting standards including for basic banking business. These standards are expected to be gradually introduced in the near future. - 38 - methodology applies only to fixed asset lending, and credit limits do not reflect branch asset quality and management effectiveness. 4.13 Under the new Commercial Banking Law, CCB is to be responsible for its own profit, losses, risk and liabilities. This makes improved credit management activities vital to CCB's survival. In addition to readjustment of credit function at the HO and strengthening of the recently established credit management committee (Loan Committee), credit management will focus on standardized loan approval process throughout the organization, enhancement of project appraisal function, establishment of a comprehensive credit risk management mechanism to determine and monitor the risk for each loan, improved monitoring and reporting process for past due loans, establishment of a credit limit system based on branch assets quality and management effectiveness, and client information management; and establishment of a comprehensive internal coordination and information sharing system. 4.14 Improved credit management will raise the quality of the loan portfolio, introduce policies and procedures that will improve credit risk management, approval and loan monitoring. This module will also address the need to conduct loan portfolio reviews of additional CCB branches, define branch authority for loan approvals, develop and implement loan loss provisioning methodology, and, for problem loans, establish an internal workout unit, and further revise and update the project appraisal manual and the credit manual. 4.15 The main deliverables under Module 3 would include: strengthening of credit function; new credit policies and procedures and manuals; new credit risk management system; improved monitoring and reporting system; establishment of a workout unit; revised project appraisal manual; and a classification system for internal use by CCB management to facilitate their understanding of CCB's risk profile, for comparing risks in different branches and for comparing CCB's risk levels with those in banks in other economies. In addition, a set of periodic internal reports would be prepared that would limit recognition of income on high risk loans and thereby facilitate both management's and MOF's ability to distinguish reported paper profits from real profits, and the extent to which CCB's existing capital is being further impaired by government policies. Module 4: Corporate Governance 4.16 A new charter for the CCB is considered important since it establishes the bank's governance and the framework for managing the bank's business. At present, state- owned banks, with the exception of Bank of China, do not have Board of Directors or well-functioning Supervisory Boards. Under the new Commercial Banking Law and the Company Law, two types of companies can be established in China: limited liability, including wholly state-owned companies and joint stock companies. More recently, the formerly specialized banks have been instructed to reregister under the Company Law. PBC has been entrusted with the task of drafting guidelines to assist the wholly state- owned banks in drafting new charters. The work on CCB's new charter will be coordinated with PBC. The new charter would describe the governance and legal organization structure of CCB, including its relationship with its owner and the rights and -39- responsibilities of various parties. In addition, a basic operational framework (i.e., an internal operational charter) for CCB in a market-based economy will be prepared that will also define and clarify HO-branch relationship and responsibility. 4.17 The main deliverables under Module 4 would include: a draft charter and corporate governance structure; HO branch relationship and an operational framework, i.e., internal operating charter, for the CCB in a market-based economy. Module 5: Strategic and Business Planning 4.18 Historically, CCB, being part of the state planning system, had little need for a formal strategy or planning documents. In a commercialized environment, CCB needs to develop its own strategic planning function in order to direct its own strategy and business planning. A formal business plan is essential to developing effective operating plans for CCB. It would translate the business strategy into plans that can be used to prepare detailed work plans at the business unit, department and branch levels. It would establish a total context and blueprint for change. The formal business plan would clarify the business direction, and would serve as the baseline for setting goals, objectives and key performance indicators at several levels within the bank. 4.19 The main deliverables under Module 5 would include: establishment of a strategic planning function, market research function and preparation of a guiding document on CCB's strategic priorities in the next five years; and three-year rolling business plan. Module 6: Human Resource Management and Training 4.20 CCB faces its biggest challenge in converting its human resource into human capital. This module will focus on the development and implementation of key elements of human resource management and training strategy. It will assist CCB in: (a) reforming the current personnel management policies and processes, including compensation and reward system; and (b) establishing a comprehensive organization- wide human resource data base and management system, including recruitment, transfers, human resource costing and career development. 4.21 The training component will focus on the development of a core commercial banking curriculum and delivery of a program for meeting priority training needs of management and core staff. Given the size of CCB, the magnitude of skill gaps and the need for new and different skills and knowledge of staff in all functions throughout the organization, the training component will focus on creating indigenous capacity for training in commercial banking and finance. One existing CCB training institute will be upgraded, training equipment provided and training materials developed, and training of trainers emphasized. The training program will be carried out through domestic and limited overseas training and secondment to the service provider(s) of selected staff. 4.22 In terms of immediacy of need, the training program will focus on: (a) two groups of about 20 trainers, each with a 12-week program in three parts spread over a period of 9 to 12 months. These trainers would be drawn from the existing core of professional staff and cadre of trainers from universities associated with CCB. These -40 - intensive programs would offer formal instruction of about 30 hours per week, together with another 20 hours of case work, lab work, group sessions, i.e., the equivalent of one year of full-time studies; (b) a number of short-duration awareness-building training courses targeted at bank executives to provide them with an overview to the strategic (business, financial and risk) management, including process and change management, of a commercial bank; (c) courses for managers/department heads on commercial banking, financial and risk management, commercial lending and human resource management to provide more detail regarding the daily management issues associated with managing the operations of a commercial bank; and (d) courses for the HO staff and staff of the branches selected for the testing of the new systems to be developed under the project, including in international accounting standards, international auditing guidelines and management accounting and reporting to introduce fundamental knowledge and skills for establishing clear financial reporting framework for bank's commercialization. In addition, courses would be provided for foreign language proficiency. Initially, a large proportion of training effort would rely on foreign experts in the design and delivery of training programs; once the training process is internalized and a number of trainers trained, CCB would gradually undertake training programs on their own. 4.23 The main deliverables under Module 6 would include: a comprehensive human resource management and policy information supporting system and a coherent strategy and effective policies and procedures for the use of human resources, a new performance evaluation and reward system, and a core commercial banking curriculum. Other deliverables would include the upgrading of a training facility, training of trainers as well as management and core staff Module 7: Information Technology 4.24 The information technology component would focus on the refinement and updating of an information technology strategy. While CCB has made significant progress in automating core business like deposit taking and in building technical and network architectures, the IT organization is compartmentalized, resulting in lack of information and communication flow across departments. There is no explicit alignment between IT planning and business strategy, and the focus is on networking and not on transaction processing or management information systems. The CCB IT strategy is to provide a computing and network infrastructure, and organizational capability to build a CCB-wide management information system, facilitate the design and implementation of essential banking systems, and permit CCB to offer technology based products and services. The overall objective is to improve the core functional and operational processes through the use of computer based systems at HO and throughout the extensive branch structure. 4.25 The objective under the proposed project would be to establish a CCB-wide enhanced information technology strategy and IT organization structure supported by well-defined standards and architectural models, procurement processes and system development and implementation methodologies. This will facilitate hardware and application software compatibility throughout the organization while ensuring the portability of best practice from one location to another without duplicate investments in -41- application development effort. While recognizing the need to support the ongoing development of improved products and services to the CCB customer base, the application software development component of the IT strategy will prioritize the design and implementation of essential management information and decision support systems covering financial reporting, management accounting, asset-liability management (ALM), risk and credit management, funds management and personnel management. 4.26 The main deliverables under this Module would include: a computerized management information and control system, including financial management, credit management, asset-liability management, funds management, personnel management, comprehensive planning system, and revised standards and methods and a new information technology strategy and organization. D. DELIVERY MECHANISM FOR TECHNICAL ASSISTANCE 4.27 The various modules included under the institutional development program would all require the services of international experts, both short-term and long-term, limited hardware and office equipment, and training, including overseas training, training of trainers, seminars/workshops, and training materials and equipment. While there are a number of alternative mechanisms for obtaining the necessary expertise for the program, the preferred approach for the provision of assistance for CCB's institutional development program, to be financed under the proposed loan, will be through the establishment of a flexible technical cooperation arrangement with a reputable international commercial bank, involving, if needed, a consortium with other specialized firms (for example, accounting, information technology and training). The institutional development program and its sequencing, tailored to the needs and absorptive capacity of CCB, will be finalized after detailed on-site discussions between CCB management and the service provider. In order to ensure that knowledge gained from the additional work on CCB during project implementation can be easily replicated to other formerly specialized banks, an Advisory Group consisting of representatives of MOF, SPC, PBC and CCB, and chaired by PBC, would be established. The Advisory Group would meet twice a year to monitor progress of the project, and would also provide a forum for addressing issues and external constraints to CCB's commercialization. 4.28 CCB will associate itself with a foreign bank and/or a consortium of banks and specialized firms and enter into a cooperation agreement. A technical assistance agreement would be signed between the two parties. Under this agreement, the foreign service provider will deliver a comprehensive agreed-on technical assistance program covering all major functional areas of banking to CCB for a fee. The foreign service provider will have the full range of skills, policies and procedures, systems and operations of a working bank to draw on to provide the proposed agreed-on technical assistance. In terms of proposed sequencing of the various modules, financial accounting, strategic planning and credit management along with training will be initiated first (see Figure 4.1 below). Terms of reference for CCB's institutional development program are in Annex 6. CCB has, since June 1996, already held preliminary discussions with a number of foreign banks and consulting firms in Asia, Western Europe and North America, who have expressed an interest in associating themselves with CCB. Signing of - 42 - the technical cooperation agreement between CCB and the foreign service provider, satisfactory to the Bank, will be a condition of loan effectiveness. FIGURE 4.1: SEQUENCING OF CCB's INSTITUTIONAL DEVELOPMENT PROGRAM FY 1998 FY 1999 FY 2000 FY 2001 FY 2002 Financial Management Standards & Procedures Reporting & Control Systems Organization Internal Audit Standards & Procedures Early-warning System Credit Management Principles & Procedures Portfolio Review Loan Workout Strategic & Business Planning Strategic Planning Business Planning Economic & Market Analysis Corporate Governance Charter Corporate Governance Structure HO-Branch Organization Human Resource management & Training Training Personnel Policies & Systems Upgrading Training Center Information Technology IT Development Strategy MS E. CREDIT COMPONENT 4.29 The proposed line of credit component would also support CCB's institution building. Under the new Commercial Banking Law, the formerly specialized banks have been made responsible for their profits and losses, and banks have been given the autonomy to reject projects that are considered uneconomic/unprofitable. With the establishment of the policy banks, the formerly specialized banks are no longer required to make policy loans on their own account. As per PBC regulations, the proposed line of credit would be treated outside the scope of the annual foreign currency credit plan of PBC, and CCB would have full autonomy in the determination of interest rates, i.e., interest rates charged of the final beneficiary would not be subject to government administered rates. Similarly, CCB would have full autonomy in the selection of subprojects, sectors and final beneficiaries, i.e., CCB would not have to follow the priorities established by the state planning authorities. 4.30 As part of its commercialization initiatives, branches have been given authorization limits for lending in accordance with management and portfolio quality, and economic outlook in different regions. Various credit departments have been - 43 - merged. Under the transformation component, CCB's credit functions will be further strengthened, a new credit manual prepared and loan approval procedures standardized, loan monitoring and reporting process improved, newly established loan workout unit strengthened, and provision made for training and enhancing staff skills in credit management. 4.31 The staff of CCB's credit evaluation department and of its consulting arm, CICC, which would undertake appraisal of some of the subprojects on behalf of CCB, are capable of undertaking technical appraisal of projects, thanks to CCB's past role as a bank funding government priority investment program. Financial and enterprise appraisal however needs strengthening and will be provided for under the transformation component. The credit component would be like training on the job; it would strengthen the capacity of CCB's HO and branches to select profitable projects and creditworthy borrowers, and to monitor and supervise progress during their implementation. F. ONLENDING ARRANGEMENTS 4.32 The proposed Bank loan to China would be on standard Bank terms for single currency US dollar loans, with 20 years' maturity including five years' grace. As a condition of effectiveness, MOF would make available the proceeds of the Loan to CCB under a Subsidiary Loan Agreement on terms and conditions satisfactory to the Bank, which will include: interest at the Bank's LIBOR-based US dollar single currency loans with foreign exchange risk and commitment charges to be the responsibility of CCB." CCB would onlend the proceeds of the Loan to the final beneficiaries in foreign currency at the variable rate at which funds are onlent to CCB by MOF plus a spread to be determined by CCB on a case-by-case basis. The main elements of determining interest margin-cost of appraisal and loan processing, administrative overhead, risk assessment, commitment fee, and an appropriate profit margin-and the concept of pricing designed to achieve these goals was agreed during appraisal. The risks associated with foreign exchange and variable interest rate would be borne by the final borrowers. Although the maturity of individual subloans will be based on projected cash flow of the borrower and on CCB's credit policies, in no instance will the final maturity or grace period of a subloan exceed 12 and 5 years, respectively. 4.33 Eligibility Criteria. Agreement was reached during appraisal that CCB will appraise subprojects and supervise, monitor and report on subprojects in accordance with the following eligibility criteria for selection of subprojects: (a) eligible subborrowers will include SOEs, private, collectives, town and village enterprises and joint venture enterprises; (b) the subborrower should have a sound financial position and prospects. The subborrower will have to submit financial statements audited by independent auditors so that CCB would have clear balance sheets in order to assess their true financial position and creditworthiness; (c) CCB would not extend any loans to enterprises which are not current on their past debt obligations to CCB; (d) each This approximates the cost of CCB's offshore borrowing on its own account in recent years (see Chapter 2, Section B). - 44 - subproject financed by CCB should have a minimum financial rate of return of 12 percent and a minimum economic rate of return of 12 percent; (e) the subborrower should be able to finance at least 30 percent of the subproject's total investment cost from its own resources unless otherwise agreed with the Bank; (f) the subproject must meet the government's environmental standards and have the written approval of the relevant level environmental protection bureau; and (g) maximum exposure to a single subborrower under the proposed loan can not exceed $30 million. 4.34 Appraisal Methodology. The appraisal report for each subproject would cover: (a) an in-depth analysis of the operations and financial position of the borrowing enterprise; (b) a market analysis of the enterprise's current and future products and services; (c) assessments of the subproject's environmental and social impact; (d) an evaluation of the subproject's technical, financial, economic and managerial aspects; (e) a description of the subproject's procurement arrangements and its compliance with the procurement guidelines of the Bank; and (vi) an assessment of the enterprise's ability to service the loan and its overall prospects. The first two subprojects, one in each of the two sectors of manufacturing and infrastructure, will be subject to the Bank's prior approval. After that, CCB would submit every fourth subproject for prior Bank approval, based on the submission of a full appraisal report. For other subprojects, while CCB will do a full appraisal of subprojects and keep these on file for the Bank's ex-post review, it will submit a summary description of the enterprise and subproject, including the expenditures to be financed, relending terms and conditions and amortization schedule and other essential features to the Bank, requesting its authorization to make withdrawals. Maximum subloan size would be the equivalent of $20 million. G. ENVIRONMENTAL AND SocIAL ASPECTS 4.35 The project has a Category B rating, as the line of credit might finance some subprojects in manufacturing and infrastructure sectors with potentially adverse social or environmental impacts. Under the policy and administrative requirements for environmental assessment of development projects in China, environmental impact assessment (EIA) reports, environmental action plans (EAP) and environmental assessments (EA) are carried out by the project sponsors. These documents are submitted to the relevant level environmental protection bureaus for their review and approval. PBC also requires financial institutions to pay particular attention to Environmental Protection Law and Environmental Management Guidelines for Construction Project (PBC Documents No. 1994-24, dated February 6, 1995) when extending loans for fixed assets. Financial institutions are prohibited from extending loans for projects that do not have the approval certificate of the relevant level environmental protection bureaus. In addition to the general environmental laws, there is also a regulation issued in June 1993 on Strengthening Environmental Impact Assessment Management for Construction Projects financed by international financial institutions. The existing Chinese regulations and requirements are in accordance with Operational Directive 4.01, and acceptable to the Bank. CCB's guidelines for appraisal of fixed asset investment effective since March 1996 require the inclusion of environmental protection programs and remedies approved by the environmental protection authorities (Chapter - 45 - III, Article 19). CCB would be required to ensure that the recommendations, including appropriate mitigation measures, of the approved EAs have been adequately incorporated into the subproject feasibility studies and investment approval and loan documentation. Qualified environmental consultants would carry out an annual environmental quality assurance check of a selected sample of subprojects financed under the project to assess the implementation from an environmental standpoint. The annual environmental quality assurance report would be submitted to the PMO and the Bank. If the report identifies shortcomings in the environmental performance of the subprojects, the same would be taken up with NEPA. This was confirmed during appraisal. 4.36 The notional pipeline of projects proposed to be funded under the credit component of the project indicates that none of the proposals would require resettlement. During appraisal an agreement was reached with CCB that the candidate subprojects will try to avoid the need for resettlement. However, in the event that resettlement is required, a separate Resettlement Action Plan (RAP) will be prepared for each of such enterprises. In accordance with the Land Administration Regulation of the People's Republic of China (1986) and related amendments (1988), and Implementation Regulations for Land Administration of the People's Republic of China (1991), the preparation of RAP is the responsibility of the project sponsor, in consultations with the local governments. In case the project sponsor is a local government, the Land Management Bureaus have the responsibility for implementing land acquisition and resettlement. Resettlement impacts that would invoke the need for a RAP include requisition of land that affects the livelihood of 200 or more persons, and/or involuntary relocation of housing. CCB will review all subprojects for possible resettlement impacts. 4.37 If resettlement impacts are suspected, CCB will prepare a brief report on the proposed subproject which describes land requisition requirements, relocation of housing, the number and characteristics of project-affected people, and the anticipated impacts. A labor reassignment plan should also be provided by the enterprise. The brief report will be submitted to the Bank for a decision on the following options: (a) no need for a RAP; (b) proceed with a RAP; (c) modify the proposal to avoid resettlement impacts; and (d) reject the proposal, for resettlement or other reasons. If option (b) is selected, the proponent should conduct a socioeconomic survey for the project affected households, with the purpose of gaining a better understanding of the resettlement impacts, identify mitigation options, and document baseline situations. CCB has prepared a Resettlement and Rehabilitation policy framework acceptable to the Bank reconciling national laws with Bank policies on social impact, and specifying the instruments and processes to deal with resettlement and adverse social impacts that may be identified during the appraisal of subprojects. The policy framework specifies standards and the cutoff point beyond which preparation of a full-scale RAP will be necessary. CCB's policy framework for resettlement and rehabilitation aspects is included as Annex 12. 4.38 The proposed project under the credit management module of the transformation component would assist CCB to strengthen its own corporate policy and procedures, and capacity to screen loans and incorporate EA and involuntary resettlement recommendations into the loan appraisal process to ensure monitoring and compliance -46 - with environmental regulations and for social assessment. Both areas would be further strengthened in the new credit and project appraisal manual to be prepared under the project. In addition to the training program proposed under the transformation component for CCB's credit evaluation staff and its consulting arm during the implementation of the project, a two-week seminar is proposed to be conducted for CCB staff before loan effectiveness. This seminar/workshop would focus on appraisal techniques, including enterprise and project financial and economic analysis, pricing of loans, and social and environmental assessment. H. PROJECT ORGANIZATION AND MANAGEMENT 4.39 CCB will be responsible for the overall implementation of the project as it has been for project preparation. CCB established a Leading Group, headed by its Executive Vice President, for the diagnostic studies. A project management office (PMO) has been in place since 1994. It will be strengthened as the project mode shifts from detailed design to implementation. Also after the completion of the diagnostic studies, CCB's President has taken over as the head of the Leading Group for project preparation and implementation. Initially, four working groups were established as counterparts to the consultants for the four diagnostic studies. Since the completion of the studies, eight separate teams have been established to detail the scope and design of the project, and the need for external assistance. 4.40 To provide unified coordination and management of the transformation component during implementation, CCB would establish a joint management team, consisting of key CCB operational staff under the Director, Policy Research Department (which is directly under the President of CCB), and staff of the international commercial bank/external consultants selected to provide expert commercial banking services. During appraisal, assurances were obtained that the PMO would be strengthened with competent staff in adequate numbers, functions and responsibilities, acceptable to the Bank. The PMO will furnish the Bank with periodic progress reports on project implementation and meeting performance indicators; and not later than October 31, 1999, the PMO will prepare a mid-term report and hold a mid-term review with the external service provider, the Advisory Group (para. 4.27 ) and the Bank to assess whether the project is making satisfactory progress in meeting its objectives. 4.41 With Bank assistance, the PMO has prepared a project implementation plan (PIP), attached as Annex 7 to the SAR. The proposed project would be implemented over a six- year period from 1998 to 2003. The terminal date for subproject submission is June 30, 2001, and the loan Closing Date for disbursements is June 30, 2003. CCB will prepare and submit to the Bank not later than six months after the Closing Date, a plan designed to ensure the continued achievement of the Project's objectives. -47 - FIGURE 4.2: TRANSFORMATION COMPONENT MANAGEMENT CCB Project Leading Group CCB Project Manager SriePoie C 1 -4 cloordinator Module 1, Financial Module 1, Financial Management Management IModule 2, Internal Adit iiii ............. -Module 2, InternalAu=dit Module 3, Governance &........ __Module 3, Governance& Tranization Organization Module 4, Credit Modoule 4, Credit dManagement Management Module 5, Strategic & odule 5, Strategic & Buusiness Planning Bcas,lusiness Planning a x i Module 6, Human Module 6, Human Resource Management & Resource Management & Training Training Model 7, Information Model 7, Information ITechnologv Technoloy '-- Project Management Office--- I. PROJECT PERFORMANCE MONITORING INDICATORS 4.42 Project outputs and impacts will be monitored on the basis of institutional development objective indicators for CCB were agreed during appraisal. In addition, indicators have been developed on the impact of the proposed project on the broader set of financial sector issues. Some of the areas, common to all commercial banks in China, include issues related to governance mechanism, loan loss provisioning and tax policies. WVhile many of the performance monitoring indicators for CCB's institutional development program are by necessity qualitative in nature (formal business plan, new financial management and internal control systems, new credit management system, human resource management policy), a few quantitative indicators--quality of loan portfolio, training of key operational staff and management-have also been included. Project performance monitoring indicators are detailed in Annex 8. -48- J. PROJECT COST AND FINANCING 4.43 The total project cost is estimated at $1,250 million equivalent (net of local taxes). Component costs are summarized in the table below. The cost of institutional development program is estimated at $54 million equivalent, including foreign exchange costs of $30 million, representing the cost of external banking experts, equipment, and training. The line of credit will finance about 25-30 subprojects with a total investment cost of $1,200 million equivalent. The notional pipeline of subprojects indicates that the proposed Bank loan would cover about 20 percent of the total financing required. Project Costs and Financing Plan, as reviewed and discussed at Appraisal, is shown in Tables 4.1 and 4.2 below. During appraisal, it was agreed that CCB would provide any additional funds, if needed, from its own resources in order to carry out the project. TABLE 4.1: PROJECT COSTS (in $ million equivalent) Project components Local Foreign Total Transformation Component 24 30 54 Consultants Services - 7 7 Equipment 18 16 34 Training 4 5 9 Contingency 2 2 4 Credit Component 997 200 1,197 Total 1,021 230 1,251 TABLE 4.2: PROJECT FINANCING PLAN (in $ million equivalent) Source Local Foreign Total IBRD 230 230 Transformation - 30 Credit 200 CCB 265 265 Transformation 24 - 24 Credit 241 - 241 Enterprises 394 394 Credit 394 - 394 Other 362 362 Credit 362 - 362 Total Financing 1,021 230 1,251 IBRD - 230 230 CCB 265 - 265 Enterprises 394 394 Other 362 362 - 49 - K. PROCUREMENT AND DISBURSEMENT 4.44 Procurement of goods under the project will be in accordance with the Bank's Guidelines for Procurement dated January 1995 and revised in August 1996. The procedures for procurement of goods under the line of credit would be the same as those for earlier Bank-financed financial intermediary projects, which the Bank has reviewed and found satisfactory. Individual contracts with an estimated value of $5 million and above would be procured under international competitive bidding (ICB). The China Model Bidding Documents as agreed between MOF and the Bank will be used for all ICB procurement. The Bank's standard review and approval procedures (from bidding documents to the contract awards) would be applied to all ICB packages. Local qualified bidders participating in ICB for procurement of goods would receive a preference in bid evaluation of 15 percent of the CIF price or the prevailing custom duty applicable to nonexempt importers, whichever is the lower. Contracts below $5 million would be awarded after evaluation and comparison of quotations solicited from at least three qualified suppliers from at least two countries. National shopping may be used where the desired goods are ordinarily available from at least three sources at competitive prices. These contracts would be subject to post-review by the Bank, and CCB would maintain all relevant documents in its record for this purpose. Goods of a proprietary nature may be procured by direct contract, subject to the Bank's prior agreement. 4.45 The procedures for procurement of goods under the transformation component are as follows. Individual contracts in excess of $1 million would be procured under ICB, and the Bank's standard review and approval procedures would be applied. Individual contracts between $500,000 and $1 million would be procured under national competitive bidding, and would be subject to the Bank's prior review. These contracts would be subject to post-review by the Bank, and CCB would maintain all relevant documents in its record for this purpose. All consultancy services will be procured in accordance with the Guidelines for Selection and Employment of Consultants by World Bank Borrowers, dated January 1997. Consultancy contracts will follow the Bank's Standard Form of Contract for Consultant's Services. All consultancy contracts in excess of $100,000 for firms and $50,000 for individuals would be subject to the Bank's prior review. Regardless of the contract value, consulting contracts would be subject to the Bank's prior review for terms of reference, establishing cost estimates, procedures, short lists, and selection criteria. 4.46 The following agreements have been reached for the procurement of the main service provider for the transformation component: (a) CCB would send a letter to the potential service providers inviting their expression of interest. Along with the letter, CCB would provide the service providers with summaries of the proposed scope of work, financial sector environment in China and a confidentiality agreement; (b) upon receipt of letters of intent and signed confidentiality agreement, CCB would provide the interested parties with a detailed scope of work, type of expertise required, tentative estimates for the intensity of job, evaluation criteria, and copies of the detailed diagnostic studies and, if necessary, briefings by CCB and Bank staff; (c) the proposals submitted by the service - 50 - providers would be evaluated and ranked under an explicit criteria to be agreed in advance between the Bank and CCB; and (d) detailed on-site discussions with top ranked service provider(s) in order to finalize an institutional development program, sequencing, deliverables and work mode. 4.47 To facilitate efficient disbursement, a special account in dollars with an authorized initial allocation of $_ million (based on four months of estimated average disbursement) would be established. It would be replenished monthly or whenever the special account was drawn down to 50 percent of its initial deposit, whichever occurred first. Disbursements would be made on the basis of statements of expenditures for: goods contracts for institutional development program valued at less than $1 million equivalent; consulting services contracts valued at less than $100,000 for firms and $50,000 for individuals; subloans; and training expenditures. CCB would retain documents supporting the statements of expenditures and would make these documents available for inspection and review by Bank supervision missions. All other disbursements will be made against fully documented expenditures. The projected disbursement schedule (AnnexL) is based on standard disbursement profile for financial intermediary loans in China. L. ACCOUNTING AND AUDITING 4.48 CCB will maintain separate project accounts and will consolidate financial reports on individual project components for inspection by Bank supervision missions. Auditing of the proposed project will be conducted by independent auditors acceptable to the Bank. During negotiations, assurances would be obtained from CCB that the following annual audited reports would be submitted to the Bank within six months after the end of the financial year commencing from 1997: (a) project accounts, including the auditor's opinion on the use of the Special Account and statements of expenditures; and (b) CCB's financial statements together with essential schedules and other operational data. Any significant error that may have been discovered during the audit, and any major weaknesses in internal controls, should be reflected in a management letter submitted by the auditors to CCB. - 51 - 5. PROJECT RISKS AND BENEFITS 5.1 The development of an efficient market-based financial system in China will be a gradual process that would require sustained efforts over many years and will need to be supported by a series of Bank operations. The proposed project, by assisting in a well managed transformation of a core Chinese commercial bank, would institutionalize the principal building blocks and establish a framework for improving individual financial institutions. The project would complement the capacity building and financial sector infrastructure upgrading activities under the ongoing FSTA and the proposed FSTA-II projects. The strengthened legislative, regulatory and supervisory framework, as well as the institutional development of large banks, will help improve the prudence of bank operations and the quality of banking services, and contribute to a more efficient mobilization and allocation of financial resources. Commercialization of the specialized banks is critical for the pace of future liberalization of the financial sector, and is also intimately linked to the issues of enterprise and fiscal reforms in China. Banks will have to develop in due course a healthier relationship with enterprises, and monitor enterprises' performance and financial positions and impose market discipline, similar to the role played by banks in market economies. 5.2 Two main risks, the pace and direction of the Government's overall reform program, especially in fiscal and enterprise areas, and a management inexperienced in commercial banking, may make it difficult for the project from achieving all its objectives. Other risks include resistance to change from vested interests, including local governments, and the complexity and size of CCB. 5.3 A slowdown or a reversal in SOE reforms due to political and social considerations and continuing flow of credits under government directives to loss-making enterprises can have serious implications for the state banks, which are already burdened by a high proportion of nonperforming loans. However, the likelihood of major slippage in the reform program is considered low. Given its large size and provincial structure, China has tended to spread reforms over several years, usually after considerable experimentation and adaptation. Under the Government's SOE reform program, about 1,000 key SOEs are being transformed to form the core of modem enterprise system with a strengthened corporate governance, and local governments have been given freedom to experiment with reforms of other SOEs, including through liquidation, sale, ownership diversification, mergers and restructuring. In the last few years, a large number of small SOEs have been divested, largely through leasing arrangements, and medium and large SOEs corporatized under the Company Law. Hard budget constraints were already evident in 1996, when almost half of industrial SOEs incurred losses, and their aggregate profitability declined to less than 1 percent of GDP. In the absence of new credits from the banking system and/or government subsidies, large number of workers are being laid off or receiving partial pay. Some firms even went bankrupt as they were unable to meet - 52 - their wage bills. The authorities are determined that state enterprise reforms should proceed; recent statements of senior officials suggest that reform of SOEs would continue to be a major focus of the Government's reform program during the Ninth FYP. The authorities are also gradually reducing the stock of bad loans in the books of the four large state banks through write-off of bad loans; with government approval, about Y 20 billion in bad loans of the four state commercial banks were written off in 1996 and another Y 30 billion in write-offs has been targeted for 1997. The Bank is supporting enterprise reforms through both nonlending services and lending operations. The attached matrix (Annex-3) reflects most recent discussions and agreements with the authorities on financial sector reforms. In fiscal policy, the Government's priority is to broaden the tax base, eliminate tax exemptions, strengthen tax administration, and rationalize extrabudgetary revenues and expenditures. Improvements in tax administration and streamlining of tax exemptions are starting to yield dividends. 5.4 CCB is the first large Chinese bank that agreed to undergo detailed diagnostic work by international experts, and fully cooperated during the course of consultants' work. It is only because of the courage shown by the senior management of CCB and because of their desire to transform the institution into a viable commercial bank that the problems detailed in this report are being identified and addressed. In assessing and sharing information on their current situation and in authorizing comprehensive diagnostic studies, the management of CCB has taken the first step toward transformation and has positioned the institution in the forefront of reforms in China. The CCB President has embraced the mandate for reform and has evidenced an understanding of the prerequisites for and key steps in the process of transformation. A large number of CCB staff from various operational departments and branches were closely associated with the work of the consultants in carrying out the diagnostic studies and in prioritizing and detailing the various project components. A number of study tours to commercial banks in Asia, Europe and North America have driven home the point within CCB that transformation into an international-standard commercial bank will be a long drawn effort and will not be feasible without a heavy dosage of technical assistance. The President of CCB, associated in the past with China's rural sector reforms, has taken personal charge of the transformation effort and full ownership of the proposed project. 5.5 As mentioned in Chapter 2, Section E, CCB has already undertaken a number of initiatives and/or conducting experiments in a number of areas, including zero growth employment policy, new labor contract system, credit management, merger/closure of unprofitable branches, new staff incentive system that ties an annual bonus to branch performance, asset/liability ratio management in selected branches, and accorded priority to skills upgrading of management and staff. Strengthened managerial and operational capacity of CCB to be developed mainly through technical cooperation agreement with reputable international commercial banks/specialty firms should contribute to reducing the risk of management inexperience. In order to minimize the risks associated with the size and complexity of the organization, the proposed project is designed as a first step in CCB's commercialization and is considered consistent with the organization's absorptive capacity. - 53 - 6. AGREEMENTS REACHED AND RECOMMENDATION 6.1 During negotiations, assurances would be obtained on the following: (a) with the Borrower, that it would: (i) make available the proceeds of the loan to CCB under a subsidiary Loan Agreement, on terms and conditions satisfactory to the Bank. (para. 4.32); and (ii) establish an Advisory Group consisting of representatives of PBC, MOF, SPC and CCB (para. 4.27). (b) with CCB, that it would: (i) maintain the Project Management Office with staffing, composition and functions acceptable to the Bank (para. 4.40); (ii) appraise and propose subprojects and supervise, monitor and report on subprojects in accordance with the eligibility criteria and methodology acceptable to the Bank (paras. 4.33 and 4.34); (iii) require all subborrowers to submit financial statements audited by independent auditors (para. 4.33); (iv) not extend credit to enterprises which are not current on their past debt obligations to CCB (para. 4.33); (v) submit the first subproject in each of the two sectors of manufacturing and infrastructure and every subsequent fourth project to the Bank for prior approval (para. 4.34); (vi) furnish the Bank with semiannual progress reports by June 30 and December 31, on project implementation and meeting performance indicators (para. 4.40); (vii) by October 31, 1999, prepare a mid-term report and hold a mid- term review to assess progress in meeting project objectives (para. 4.40); and (viii) furnish the Bank with the audited project accounts within six months of the end of each fiscal year (para. 4.48). - 54 - 6.2 Conditions of Loan Effectiveness. The additional conditions of loan effectiveness are: (a) signing of the Subsidiary Loan Agreement, satisfactory to the Bank, between MOF and CCB (para. 4.32); and (b) signing of the technical cooperation agreement, satisfactory to the Bank, between CCB and a qualified service provider (para. 4.28). 6.3 Recommendation. Subject to the foregoing, the proposed project would be suitable for a loan of $230 million to the People's Republic of China. The loan would be for a term of 20 years, including a grace period of 5 years, at the Bank's standard variable interest rate for LIBOR-based US dollar denominated single currency loans. -55- ANNEX 1 ANNEX 1: SELECTED ECONOMIC INDICATORS, 1991-96 1991 1992 1993 1994 1995 1996 Annual Average Growth (%) GDP 9.2 14.2 13.5 12.6 10.5 9.5 GDP per capita 7.8 12.9 12.2 11.3 9.3 8.5 Investment 9.3 12.2 24.8 10.5 19.1 9.3 Exports 15.5 15.3 9.2 28.1 9.6 4.6 Imports 15.9 28.3 30.5 9.3 5.0 8.8 As percent of GDP Investment 34.8 36.2 43.3 39.9 40.5 40.4 Savings 37.6 37.2 41.3 41.2 42.0 41.5 Exports 16.2 16.3 14.4 22.0 21.0 17.7 Imports 13.4 15.3 16.4 20.6 19.4 16.5 Resource balance 2.9 1.0 -2.0 1.4 1.6 1.2 In $ billion Exports 65.8 78.6 86.5 118.8 142.0 144.8 Imports 54.3 64.4 86.3 95.3 110.1 114.5 Current account balance 12.9 6.0 -12.2 7.2 1.5 1.1 Foreign direct investment 3.4 7.2 23.1 31.8 33.8 35.5 Level of Reserves 44.3 21.3 23.0 53.6 75.8 107.8 ANNEX 2: SELECTED INTEREST RATES, 1985-96 1985 1985 1986 1987 1988 1989 1990 1990 1991 1992 1993 1993 1994 1995 1996 1996 Apr. Aug Apr. Aug. May July May Aug. Nominal Deposit Rates Sight 2.88 2.88 288 2.88 2.88 2.88 288 2 16 180 1.80 2.16 3 15 3.15 3 15 297 1 98 1-Year 6.84 7.20 7.20 7.20 8.64 11 34 1008 864 7 56 7.56 9.18 10.98 10.98 1098 9 18 7.47 3-Year 7.92 8.28 8.28 8.28 9.72 13.14 11 88 1008 828 828 1080 12.24 1224 12.24 1080 828 Nominal Lending Rates 6-Month Working Capital 7.92 7.92 7.92 7.92 9.00 11.34 900 8.64 810 8.10 8.82 9.00 9.00 900 9.72 9.18 1-3 Year 5.76 8.64 8.64 8.64 9.90 12.78 1080 1008 9.00 9.00 10.80 12.24 12.24 13 50 13 14 1098 3-5 Year 6.48 9.36 9.36 9.36 10.80 14.40 11.52 10.80 9.54 9.54 12.06 13.86 13.86 15.12 1494 11.70 Real Deposit Rates Lg Sight -6.42 -6.42 -3.62 -4.42 -15.92 -15.12 -0.22 -0.94 -1.60 -4.60 -12.54 -11.55 -20.95 -13.95 -353 -4.52 1-Year -2.46 -2.10 0.70 -0.10 -10.16 -6.66 698 5.54 4.16 1 16 -5.52 -3 72 -13.12 -6.12 268 0.97 Real Lending Rates I Working Capital -0.78 -0.78 4.12 0.02 -6.00 -6.66 4.90 4.54 1.90 1.30 -15.18 -15.00 -10.50 -5.90 3.22 2 68 1-3 Year -2.94 -0.06 4.84 0.74 -5.10 -5.22 6.70 5.98 2.80 2.20 -13.20 -11.76 -7.26 -1 40 664 448 3-5 Year -2.22 0.66 5.56 1.46 -4.20 -3.60 7.42 6.70 3.34 2.74 -11.94 -10.14 -5.64 022 844 5.20 Ig Adjusted for CPI. Lh Adjusted for producers' goods price indice. Source: PBC, China Statistical Yearbook 1996. ANNEX 3: FINANCIAL SECTOR REFORMS MATRIX Overall objective of reforms: Establish a financial system that efficiently mobilizes and allocates resources in a safe and sound manner to support rapid, stable, and sustainable growth. Objective/Area Phase I (1-2 years) Phase 11 (3-5 years) Phase III (6-10 years) A. POLICY FRAMEWORK [Reduce the role of government in directing resources] Credit plan Reduce the share of the credit plan subject to Restrict credit plan to policy banks only Eliminate credit plan project-by-project allocation Securities market quotas Eliminate provincial quotas for share and bond Eliminate aggregate quotas issues; introduce aggregate quota Interest rate policy SC delegate decisions on interest rates to Monetary Allow commercial banks the freedom to set their Liberalize interest rates completely Policy Committee. Simplify interest rate structure, own lending rates for a small proportion of their increase frequency of interest rate adjustments; raise asset portfolio; increasingly widen the bands lending rates to real positive levels, increase spreads within which lending rates can fluctuate to reasonable level Sell increasing proportion of treasury bonds at Sell all bonds at market rates; all rediscounting Sell all bonds at auction market interest rates; initiate auctions for small done at market rates portions of bond issues; shift to rediscount facility by PBC Tax policy Review tax laws applying to financial institutions Reduce tax rates on financial institutions; make implementation of tax laws more rule-based B. CENTRAL BANK OPERATIONS I Improve the Central Bank's management of monetary aggregates.1 Legal Framework Promulgate and implement detailed rules and Review implementation of Central Bank laws and regulations related to new Central Bank law revise where necessary Control of monetary Abolish direct lending by PBC for policy purposes Restrict indirect funding of policy loans through Remove policy loans from PBC's balance sheet aggregates (except for agricultural procurement) discounting; eliminate PBC lending for agricultural procurement Objective/Area Phase I (1-2 years) Phase 11 (3-5 years) Phase Ill (6-10 years) Actively use reserve ratios, ALM, and discount Further expand use of indirect instruments Use indirect policy instruments as principal facility to manage monetary aggregates; expand mechanism for managing monetary aggregates open market operations Institutional Development Develop and extend payments system Complete China National Automated Payment System Strengthen PBC supervisory capabilities, develop Reorganize PBC branches into regional central strategy for reorganizing PBC branches bank branches with clear supervisory responsibilities Vest PBC with authority to establish loan classification and provisioning methodologies C. STATE COMMERCIAL BANKS [Transform state commercial banks into genuine commercial banks.] Legal framework Promulgate and implement detailed rules and Review implementation of commercial banking law implementation regulations related to new commercial banking law and revise where necessary Bank's divest nonbank financial institutions Create legal and regulatory structures to enforce 00 security interests and loan collection Review economies of scale and ownership structure Based on review results, prepare plans to Implement bank restructuring plans of banks restructure banks into smaller units and diversity bank ownership Establish clear licensing procedures for banks; allow entry of new domestic banks Competition policy Initiate entry of foreign banks in Renminbi Expand entry of foreign banks in Renminbi business business Institutional Development Implement new accounting system and upgrade management information system Conduct portfolio audits Assess bank capital adequacy Resolve bad debt problem and achieve international standards of capital adequacy Introduce risk-based provisioning Ensure adequate provisioning for bad debts Introduce sound ALM practices and risk management techniques in lending; introduce sound loan approval procedures and develop credit appraisal skills Objective/Area Phase I (1-2 years) Phase 11 (3-5 years) Phase III (6-10 years) Conduct human resources needs audits Develop comprehensive training programs; introduce modem personnel management techniques D. POLICY BANKS [Shape operations of policy banks consistent with financial sector and public finance objectives.] Policy and institutional Issue detailed implementing regulations related to development charters of policy banks Limit the operations of the State Development Bank Transfer "soft" windows to the MOF (SDB) to projects with high risk, long gestation, or low financial (but high social) profitability Set annual lending limits for policy banks consistent with development of commercial banking sector SPC, SETC and SDB to confer on SDB lending program, with veto power for SDB Increase SDB autonomy to identify and finance part of public investment program in line with its mandate Introduce incentives for loan collection in agency Introduce competition in selection of agency relationship relationship Liability management Extend explicit sovereign backing for all PBC Consider tapping equity market for new capital if borrowing policy bank's performance merits; evaluate need for continued sovereign backing Set policy bank bond rates in relation to commercial Review scope for policy bank bond issuance lending rates for loans of equal maturity, introduce directly to public; extend maturity of bonds to voluntary placement of policy bank bonds reduce term transformation risk Maintain prohibition of policy bank deposit taking Policy banks to provision for bad debt and adequately account for interest in suspense Asset Management Level of "soft" lending in SDB to vary in Policy banks to introduce and identify guarantees accordance with budgetary support as part of lending program SDB/SIDC to evaluate quality of assets acquired from former SICs; SIDC equity contribution to be given same degree of scrutiny as SDB loans Objective/Area Phase 1 (1-2 years) Phase 11 (3-5 years) Phase 111 (6-10 years) E. OTHER BANKS AND NON-BANK FINANCIAL INSTITUTIONS ISeparate nonbank financial institutions from the banking system and strengthen regulatory oversight.) Legal framework for NBFIs Prepare a law covering the operation and supervision of NBFIs; complete severance of ownership links between banks and NBFIs Credit cooperatives Separate rural credit cooperatives from the ABC; Provide a clear framework for rural credit prepare ground for transforming urban credit cooperatives under Central Bank supervision; cooperatives into banks start transforming urban credit cooperatives into banks Trust and investment Restrict enterprise deposits in trust and investment Restrict government lending to trust and Restrict ownership of trust and investment corporations corporations investment corporations corporations by local governments Leasing and finance companies Restrict ownership of trust and investment corporations and finance companies Insurance companies Promulgate rules and regulations under new insurance law Establish oversight authority for insurance companies separate from PBC Pension funds Establish oversight authority for pension funds separate from PBC Mutual funds Transfer supervision of mutual funds to CSRC F. CAPITAL MARKETS (Increase efficiency, stability, and transparency of capital markets and lower systemic risk.] Primary market treasury bonds Preannounced annual schedule of government Sell limited government debt directly to retail debt issues; make savings bonds available investors through savings bonds throughout the year for retail investors Primary market:equities Exchanges to enforce eligibility criteria Enforce better disclosure at time of prospectus issue Expand auction of IPOs Allow enterprises to set IPO dates Objective/Area Phase 1 (1-2 years) Phase 11 (3-5 years) Phase III (6-10 years) Secondary market development Shanghai, Shenzhen and Wuhan exchanges to Draw up standards for the recognition of regional Permit dual or multiple listing in exchanges other set standards for mutual recognition of bond trading centers as exchanges; initiate dual listing than Shanghai and Shenzhen certificates; start study on dual listing in exchanges To reduce share price volatility reintroduce Introduce capital gains tax or share turnover tax Consider opening "A" shares market to foreign daily price limits investors Market infrastructure Leave selection of underwriters for share issue Encourage diversification of underwriting Permit foreign underwriters to compete in the to the market techniques domestic market Establish standards for credit rating agencies Credit rating made precondition for IPO Eliminate government approval for share issues Regulatory framework Pass the draft securities law, clarify overlapping Clarify legal regime for mutual funds and other jurisdiction of PBC and CSRC institutional investors Enlarge the CSRC and strengthen its supervision Form CSRC regional offices capacity Source: The Chinese Economy. Fighting Inflation, Deepening Reforms, A World Bank Country Study, May 1996 I CHINA CONSTRUCTION BANK ORGANIZATION CHART Head Office Policy Personnel Domestic Research Funds Accounting and Internal Funding and Credit Managed Assets informalon Department Planning aountg an Auditing Household Management Funds Oversight Barnt Technolo Cenng (Research Department Department Dant Department Deposi t Department Department Department Center Institute) Department Department Cinda Trust China China China and Investment International Disciplinery Retired Party Head Otfice Investment Investment Cnsulling Capial Office Stf Office Committee Labor Union Logistics Bank Corporation Corporation Corporation at Head Ofice Center Representative Representative Representative Representative Representative Prvnl Hong nKong Office in Otlice in Office in Office in Office in B e f FScIlT tl riig SafTann Branch London Tokyo Seoul Singapore Frankort()I Municipal Prefecture Level Secloral Branches Branches (330) County Level Sub-Banches S ie Opprating Deposit Ols ard Takin Offi)ces (8071) -63- ANNEX5 ANNEX 5: CHINA CONSTRUCTION BANK FINANCIAL STATEMENTS TABLE 1: BALANCE SHEET AS OF DECEMBER 31 (Y million) ASSETS 1991 1992 1993 1994 1995 1996 Cash 1,959 4,180 9,206 11,004 11,090 10,870 Deposits at PBC 82,326 79,189 110,242 134,849 186,583 261,215 Required Reserves 27,972 39,923 54,937 75,079 105,905 141,670 Excess Reserves 54,354 39,266 55,305 59,770 80,678 119,545 Due from Banks 48,113 55,499 92,749 132,879 83,858 69,834 Gross Loans 260,326 345,871 459,949 557,053 777,798 995,458 Less: Loan Loss Reserves 305 526 1,021 3,713 4,977 5,809 Net Loans 260,021 345,345 458,928 553,340 772,821 989,649 Securities and Investments 9,909 20,573 24,229 47,477 77,299 101,102 Receivables (net of Loss Reserves) /a 6,222 9,955 17,580 29,353 48,777 71,643 Fixed Assets 4,976 6,748 12,490 19,413 26,276 42,789 Less: Accumulated Depreciation 654 965 1,556 2,712 4,260 7,002 Net Fixed Assets 4,322 5,783 10,934 16,701 22,016 35,787 Other Assets 1,770 4,416 17,635 56,588 49,314 33,437 Total Assets 414,642 524,940 741,503 982,191 1,251,758 1,573,537 Channeling 2 255,100 291,447 324,183 415,345 470,911 551,765 Government Investment 159,413 170,281 184,439 190,414 187,831 173,266 Loans 95,687 121,166 139,744 224,931 283,080 378,499 GRAND TOTAL 669,742 816,387 1,065,686 1,397,536 1,722,669 2,125,302 LIABILITIES Total Deposits 211,638 323,581 404,312 584,633 803,610 1,166,465 Due to Banks 34,320 21,110 61,354 107,759 69,550 70,638 Borrowing from PBC 73,290 93,634 169,859 155,505 147,056 110,755 Accounts Payable 27,633 23,957 37,844 48,745 64,654 68,149 Bonds Issues 9,002 14,481 15,474 14,627 13,976 14,047 Long-term Borrowing n/a n/a 7,597 17,774 31,965 35,798 Guarantee Sum 4,012 4,685 5,138 1,527 4,692 5,592 Other Liabilities 11,955 8,207 1,664 2,656 58,801 44,052 Total Liabilities 371,850 489,655 703,242 933,226 1,194,304 1,515,496 Channeling /b 263,212 289,512 328,232 425,019 488,355 564,296 Government Investment Funds 164,764 166,664 185,927 196,363 193,784 178,818 Agency Funds 98,448 122,848 142,305 228,656 294,571 385,478 Total Liabilities & Channeling 635,062 779,167 1,031,474 1,358,245 1,682,659 2,079,792 Total Equity L 34,680 37,220 34,202 39,291 40,010 45,510 Paid-in Capital 32,495 35,124 33,679 35,317 35,316 35,438 Capital Surplus 105 2,297 2,103 6,227 Earned Surplus 341 1,323 1,903 2,894 Undistributed Profits 2,185 2,096 77 354 688 951 GRAND TOTAL 669,742 816,387 1,065,676 1,397,536 1,722,669 2,125,302 -64- ANNEX5 La The Regulation on Financial Management of Financial Institutions issued by MOF requires a separate loss provision for receivables starting from the year 1993. 1 These can be regarded as managed funds for which CCB should not assume risks. & CCB's total equity includes: Paid-in Capital: converted from various fixed investment finds under the pre-1993 accounting system, and transfers from the Capital and Earned Surpluses. Capital Surplus: government funding for incremental fixed assets, net income from fixed assets financed by government grants, and revaluation surplus on fixed assets. Earned Surplus: surplus from the development fund under the pre-1993 accounting system, and 10 percent of after-tax profits under the current accounting system. Notes: audited balance sheets for 1991- 95, and unaudited for 1996 Source: CCB. -65- ANNEX5 TABLE 2: INCOME STATEMENT FOR YEARS ENDED DECEMBER 31 (Y million) 1991 1992 1993 1994 1995 1996 Interest Income 15,465 22,214 35,060 56,520 74,214 92,706 Interbank Income 5,760 8,879 16,444 24,115 28,401 24,108 Fees & Commissions 290 343 541 731 1,108 1,036 Exchange Income 15 18 12 344 337 565 Other Operating Income 22 35 124 135 367 452 Gross Revenue 21,552 31,489 52,181 81,845 104,427 118,867 Interest Expense 7,354 11,383 18,929 29,878 46,144 63,563 Interbank Expense 1,526 9,115 18,550 31,303 32,137 24,034 Fees & Commissions Expense 257 361 697 1,012 1,495 2,302 Exchange Loss 3 8 1 254 25 310 Operating Expense /a 2770 5421 9813 15918 19045 26,747 Other Operating Expense 29 18 42 84 117 152 Business Tax & Surcharges 856 1,191 1,913 2,961 4,136 5,172 Gross Expense 12,795 27,497 49,945 81,410 103,099 122,280 Operating Profit 8,757 3,992 2,236 435 1,328 -3,413 Investment Income 190 239 461 2,507 4,973 8,430 Nonoperating Income 13 7 84 256 165 272 Less: Nonoperating Expense 140 213 224 267 388 692 Net Nonoperating Income -127 -206 -140 -11 -223 -420 Adjustments, Previous Year -- -- -- 67 94 176 Total Profit 8,820 4,025 2,557 2,998 6,172 4,773 Indexed Interest Subsidies -- -- -- -- 2,800 2,068 Income Tax 2,940 2,455 1,406 1,649 1,855 1,488 Net Income 5,880 1,570 1,151 1,349 1,517 1,217 La Operating expense includes salaries, leasing, electronic equipment operating cost, repairs cost, provision for possible losses, and other. Source: CCB. -66- ANNEX5 TABLE 3: STRUCTURE OF LOANS AND DEPOSITS, AS OF DECEMBER 31 Y million Percent 1993 1994 1995 1996 1993 1994 1995 1996 LOANS Purpose of Loans Working Capital 142,281 197,123 342,197 471,945 30.93 35.39 44.00 47.41 Fixed Assets 317,668 359,930 435,601 523,513 69.07 64.61 56.00 52.59 Gross Loans 459,949 557,053 777,798 995,458 100.00 100.00 100.00 100.00 Loan Maturities Maturing in < l year 114,918 152,853 281,116 250,463 24.98 27.44 36.14 25.16 Maturing in 1-3 years 70,030 67,927 104,582 219,562 15.23 12.19 13.45 22.06 Maturing in > 3 years 247,990 287,983 322,190 355,533 53.92 51.70 41.42 35.72 Other 27,011 48,290 69,910 169,900 5.87 8.67 8.99 17.07 Gross Loans 459,949 557,053 777,798 995,458 100.00 100.00 100.00 100.00 Loan Classifications Past due (< 3 years) 15,441 21,518 57,828 109,135 3.36 3.86 7.43 10.96 Stale (>3 years) 7,774 7,387 20,671 41,851 1.69 1.33 2.66 4.20 Dead Loans 484 786 1,910 3,695 0.11 0.14 0.25 0.37 Good Loans 436,250 527,362 697,389 840,777 94.85 94.67 89.66 84.46 Gross Loans 459,949 557,053 777,798 995,458 100.00 100.00 100.00 100.00 DEPOSITS Source of Deposits Enterprise Deposits 217,264 337,353 436,037 632,995 57.60 57.70 54.26 54.27 Individual Deposits 159,918 247,280 367,573 533,470 42.40 42.30 45.74 45.73 Other 27,130 6.71 Total Deposits 404,312 584,633 803,610 1,166,465 100.00 100.00 100.00 100.00 Deposit Maturities Demand Deposits 251,820 344,064 435,122 563,177 62.28 58.85 54.15 48.28 Maturing in < 1 year 20,200 35,451 64,598 76,861 5.00 6.06 8.04 6.59 Maturing in 1-3 years 98,877 153,001 248,413 376,948 24.46 26.17 30.91 32.32 Maturing in > 3 years 6,285 7,184 10,752 16,343 1.55 1.23 1.34 1.40 Other 27,130 44,933 44,725 133,136 6.71 7.69 5.57 11.41 Total Deposits 404,312 584,633 803,610 1,166,465 100.00 100.00 100.00 100.00 Source: CCB. -67- ANNEX5 TABLE 4: LOAN Loss PROVISIONING (Y million) 1991 1992 1993 1994 1995 1996 Beginning Reserve 238 305 526 1,021 3,713 4,977 Provision for Possible Loss 87 1,226 1,999 2,971 1,655 2,256 for Loans 87 1,226 1,984 2,922 1,547 2,146 for Receivables n/a n/a 15 49 108 110 Loan Loss Recovered 6 1 1 1 6 13 Less: Loan Loss Written-off 18 172, 294 369 520 1,950 Adjustment -8 -834 -1,196 138 231 623 Ending Reserve 305 526 1,021 3,713 4,977 5,809 Gross Loans 260,021 345,345 459,949 557,053 777,798 995,458 Provision as % of Prior Year 0.05 0.47 0.58 0.65 0.30 0.29 Reserve as % of Current Year 0.12 0.15 0.22 0.67 0.64 0.58 Source: CCB. -68- ANNEX5 TABLE 5: PROJECTED BALANCE SHEET AS OF DECEMBER 31 /a (Y million) 1997 1998 1999 2000 ASSETS Cash 12,523 13,308 14,142 15,028 Deposits at PBC 284,286 353,349 441,114 552,972 Required Reserves 180,456 235,559 307,488 401,380 Excess Reserves 103,830 117,790 133,626 151,592 Due from Banks 110,373 126,626 145,272 166,663 Loans (net of Loss Reserves) 1,194,487 1,485,022 1,846,223 2,295,278 Securities and Investments 149,888 208,720 290,644 404,724 Receivables (net of Loss Reserves) 96,206 135,112 189,753 266,490 Fixed Assets (net of Accumulated Depreciation) 24,324 25,567 26,873 28,253 Other Assets 48,892 47,550 46,727 46,962 Total Assets 1,920,979 2,395,254 3,000,748 3,776,370 Channeling 200,687 207,442 214,424 221,641 Government Investment 433,029 535,576 662,407 819,274 Loans 633,716 743,018 876,831 1,040,915 GRAND TOTAL 2,554,695 3,138,272 3,877,579 4,817,285 LIABILITIES 1997 1998 1999 2000 Total Deposits 1,390,753 1,810,258 2,338,149 3,033,718 Due to Banks 92,320 106,364 122,545 141,187 Borrowing from PBC 134,018 127,939 122,135 116,595 Accounts Payable 90,841 107,677 127,635 151,290 Bonds Issues 16,654 18,179 19,845 21,663 Long-term Borrowing 57,537 77,194 103,567 138,949 Guarantee Sum 4,996 5,155 5,320 5,490 Other Liabilities 56,319 52,746 55,866 40,487 Total Liabilities 1,843,438 2,305,512 2,895,062 3,649,379 Channeling 663,567 782,336 928,721 1,109,432 Government Investment Funds 207,048 214,016 221,220 228,665 Agency Funds 456,519 568,320 707,501 880,767 Total Liabilities & Channeling 2,507,005 3,087,848 3,823,783 4,758,811 Total Equity 47,602 50,423 53,797 58,474 GRAND TOTAL 2,554,607 3,138,271 3,877,580 4,817,285 Ratios (%) Equity/Total Assets 2.48 2.11 1.79 1.55 Loans/Deposits 85.89 82.03 78.96 75.66 /L- Under the Strategic Planning Module of the Transformation Component, the project would assist CCB in the preparation of 5-year strategic plan and 3-year rolling business plan. The projections in this table are simply an extrapolation of the trend in the last 5 years. The authorities are discussing the need and ways to increase the capital base of the 4 state banks. Source: CCB. -69- ANNEX5 TABLE 6: PROJECTED INCOME STATEMENT FOR YEARS ENDED DECEMBER 31 /a (Y million) 1997 1998 1999 2000 Interest Income 118,149 151,794 194,505 249,558 Interbank Income 45,776 58,105 73,750 93,599 Fees & Commissions 1,815 2,323 2,973 3,805 Exchange Income 552 707 905 1,158 Other Operating Income 602 771 987 1,263 Gross Revenue 166,894 213,700 273,120 349,383 Interest Expense 71,789 91,842 116,982 149,169 Interbank Expense 52,653 67,396 86,267 110,422 Fees & Commissions Expense 2,450 3,136 4,014 5,138 Exchange Loss 41 52 67 86 Total Operating Expense 30,700 38,916 49,435 62,579 Business Tax 1 13,352 17,096 21,850 27,951 Gross Expense 170,985 218,438 278,615 355,345 Operating Profit -4,091 -4,738 -5,495 -5,962 Investment Income 9,668 11,682 14,029 17,066 Nonoperating Income 259 324 406 508 Less: Nonoperating Expense 560 673 808 970 Net Nonoperating Income -301 -349 -402 -462 Total Profit 5,276 6,595 8,132 10,642 Income Tax / 1,741 2,176 2,684 3,512 Net Profit 958 1,197 1,476 1,932 Ratio Total Profit/Total Assets 0.27 0.28 0.27 0.28 Total Profit/Gross Revenues 3.16 3.09 2.98 3.05 Net Profit/Equity 2.01 2.37 2.74 3.30 /a See footnote I of the previous. L Assuming 8 percent business tax. & Assuming 33 percent income tax. Source: CCB. -70- ANNEX6 ANNEX 6: TERMS OF REFERENCE FOR INSTITUTIONAL DEVELOPMENT PROGRAM 1. The institutional development program of China Construction Bank (CCB) is based on a series of diagnostic studies conducted by an international consulting firm during 1995-96. The diagnostic studies, which focused on the Head Office and two provincial branches of CCB, covered four broad areas: Organization and Management, Financial and Management Accounting, Information Technology, and Human Resource Development. In the last two years, CCB has, within the confines of the financial sector environment in China, initiated a number of reform measures for its transformation into a commercial bank. The institutional development program is divided in to a number of modules. The priorities and sequencing of these modules reflect priorities assigned by CCB management, and also recognizes interdependencies among the modules. The program and its sequencing will be finalized after detailed on-site discussions with and the input of the potential service provider(s). 2. The long term objective is to assist CCB in its efforts to transform from a formerly specialized bank to an international standard commercial bank. This implies that CCB must have methodically developed and implemented strategic and business plans; adequate systems and procedures for providing valuable internal management and financial reports; capability of assessing risk and allocating credit accordingly; products and services that are responsive to market and customer needs; policies and procedures that promote self-regulation and monitoring of its own efficiency, liquidity, profitability and risk profile; and a culture and organization structure in which managers are willingly and truly held accountable for the bank's financial performance. In view of the large number of constraints and the size of the bank, and the prevailing financial sector environment, it is recognized that full commercialization will take a number of years. 3. The international commercial bank or international consulting firm or some combination of banks and firms (hereafter, referred to as the "Service Provider") selected to deliver technical assistance will utilize the diagnostic studies and on-site discussions with CCB management in order to finalize CCB's institutional development program tailored to CCB's overall strategy and priorities. The Service Provider will also be provided with various reports, including reports prepared by the World Bank, on China's financial sector developments, to familiarize the Service Provider with the environment under which CCB operates. The Service Provider should arrange for, and will be responsible for, all the services required by CCB under the institutional development program. Formation of a consortium with other banks and/or consulting firms is encouraged under terms of the contract, but this option must be specified in the Service Provider's proposal and contract documentation. -71- ANNEX6 4. The institutional development program has been structured in seven modules: (a) financial and management accounting; (b) internal audit; (c) credit management; (d) corporate governance; (e) strategic and business planning; (f) human resource management; (g) information technology; and (h) training. CCB accords top priority to financial accounting, strategic planning and credit management. It is estimated that about 30 person-years of services of consultants, both short-term and long-term, will be required. Financial and Management Accounting 5. It is one of the primary goals of the institutional development program to establish accounting systems and procedures that will provide owners, managers and regulators with reliable information on which to base business and regulatory decisions. CCB needs to introduce a new chart of accounts, implement accounting policies and procedures, improve data capture at lower levels by establishing a system of check and balances in the initial recording of transactions, establish a system for independent verification of transaction authenticity, and institute a process by which data submitted by lower levels is analyzed and variances with prior periods are identified and explained. 6. This module would address a number of key areas in financial management, including financial accounting to correspond to international accounting standards, international audit guidelines, asset-liability management, treasury functions, and risk management. A reporting system will be developed to cover all key areas of operations, giving the information needed to successfully manage and operate the bank, measure its performance and manage its risks. The work will include establishing a new chart of accounts and defining reporting requirements. The objective is to make the financial information more timely, accurate and accessible. 7. The work on financial accounting will be coordinated with the work being done by the Ministry of Finance (MOF), which is responsible for issuing new accounting standards and regulations in China. Until MOF introduces new financial accounting standards, CCB will continue to maintain accounts as required under existing government regulations so that CCB can comply with the law. In addition, CCB will apply international accounting standards to develop the management information necessary to run the bank. The new accounting system will be first tested in a few selected branches before it is adopted CCB systemwide. 8. The main deliverables under Module I would include: a new basic accounting system; redesigned chart of accounts; new financial reporting system; redesigned accounting procedures and manual; new accounting organization; accounting control system; internal management accounting; and strengthening and/or establishment of key functions such as asset-liability management, treasury and market risk. -72- ANNEX6 Internal Audit 9. As part of the development of a new financial and management system, CCB will need to restructure the internal audit function and provide for it to report directly to the President (or to a newly established Board of Directors), rather than having all information filtered through all lowers levels in the bank. Under this module, the internal audit function will be organized with direct reporting linkages as specified under the new CCB Charter, and an internal audit manual would be prepared. This internal audit function will conduct the internal audits on the finances and operations of all CCB business units, branches and subsidiaries. 10. The main deliverables would include: an internal audit structure; a new set of audit standards; internal audit manual; and effective operations monitoring, including an early warning system. Credit Management 11. Under the Commercial Banking Law of 1995, CCB has been made responsible for its own profit, loss, risk and liabilities. This makes improved credit management activities critical. The credit functions within CCB need to be further strengthened, new standard loan approval procedures established, and risk-based monitoring system developed. Greater emphasis needs to be placed on formal and commercial-oriented credit assessments, independent and accurate loan reporting, and on compliance with prudential regulations and with the bank's own policies. 12. In addition to strengthening of the recently reorganized credit functions, credit management will focus on standardized loan approval process throughout the organization, enhancement of project and credit appraisal function, establishment of a comprehensive credit risk management mechanism to determine and monitor the risk for each loan, improved monitoring and reporting process for past due loans, establishment of a credit limit system based on branch assets quality and management effectiveness, and client information management, and establishment of a comprehensive internal coordination and information sharing system. This module will also address the need to conduct loan portfolio reviews of at least an additional eight branches, develop and implement loan loss provisioning methodology, and, for problem loans, establish an internal workout unit, and further revise and update the project appraisal manual and the credit manual. 13. The main deliverables under Module 3 would include: reorganization of credit function; new credit policies and procedures and manuals and improved monitoring and reporting system; revised project appraisal manual; establishment of a workout unit; new loan classification system; and loan portfolio reviews of branches. -73- ANNEX6 Corporate Governance 14. Under the new Commercial Banking Law and Company Law, CCB needs to prepare a new charter that would describe the governance and legal organizational structure of CCB, including its relationship with its owner and the rights and responsibilities of various parties. In addition, a basic operational framework for CCB in a market-based economy will be prepared that will also define and clarify HO-branch relationship and responsibility. 15. The main deliverables under this module would include a draft charter and corporate governance structure, HO-branch relationship, and an operational framework, i.e., an internal operational charter. Strategic and Business Planning 16. In a market-based commercialized environment, CCB needs to develop its own strategic planning function in order to direct its own strategy and business planning. A formal business plan would translate the business strategy into plans that can be used to prepare detailed work plans at the business unit, department and branch levels. The formal business plan would clarify the business direction, and would serve as the baseline for setting goals, objectives and key performance indicators at several levels within the bank. 17. The main deliverable under this module would include the establishment of a strategic business planning function, market research function and preparation of a guiding document on CCB's strategic priorities in the next five years, and three-year rolling business plan. Human Resource Management 18. This module would focus on the development and implementation of key elements of a human resource management strategy. It will assist CCB in reforming the current personnel management policies and processes, including a new compensation and reward system, and establishing a comprehensive organization-wide human resource data base and management system, including recruitment, transfers, human resource costing and career development. 19. The main deliverable under this module will be a comprehensive human resource management and policy information supporting system and a coherent strategy and effective policies and procedures for the use of human resources, a new performance evaluation and reward system. Information Technology 20. CCB information technology strategy is to provide a computing and network infrastructure, and organizational capability to build a CCB-wide management -74- ANNEX6 information system, facilitate the design and implementation of essential banking systems, and permit CCB to offer technology based products and services. The overall objective is to improve the core functional and operational processes through the use of computer based systems at HO and throughout the extensive branch structure. 21. The main objective of the information technology module will be to establish a CCB-wide enhanced information technology strategy and information technology organization structure supported by well-defined standards and architectural models, procurement processes and system development and implementation methodologies. Hardware and application software will be made compatible throughout the organization. The application software development component of the information technology strategy will prioritize the design and implementation of essential management information and decision support systems covering financial reporting, management accounting, asset- liability management, risk and credit management, funds management and personnel management. 22. The main deliverables under this module would include a computerized management information and control system, including financial management, credit management, asset-liability management, funds management, personnel management, comprehensive planning system, and revised standards and methods and a new information technology strategy and organization. Training 23. This module will focus on the development of a core commercial banking curriculum and delivery of a program for meeting priority training needs of management and core operational staff. The training module will emphasize the creation of an indigenous capacity for training in commercial banking and finance. Training materials will be developed and training of trainers, drawn from the existing core of professional staff and cadre of trainers from colleges and universities associated with CCB, will be emphasized. 24. The training program will be carried out through domestic and limited overseas training and secondment to foreign financial institutions of selected CCB staff. In terms of immediacy of need, the training program will focus on: (i) training of two groups of about 20 trainers; (ii) a number of short-duration awareness building training courses, targeted at bank executives to provide them with an overview to the strategic business, financial and risk management, including process and change management, of a commercial bank: (iii) courses for managers and department heads on commercial banking, financial and risk management, commercial lending, and human resource management; and (iv) training courses for the HO staff and staff of selected branches in the new systems to be developed under the institutional development program, including in international accounting standards, international auditing guidelines, management accounting and reporting to introduce fundamental knowledge and skills for establishing -75- ANNEX6 clear financial reporting framework for CCB's commercialization. In addition, course will be provided for foreign language proficiency. 25. CCB accords priority to financial accounting and controls, strategic planning and credit management. In terms of proposed sequencing of the various modules, these priorities will need to be taken into account. ANNEX 7.1: PROJECT IMPLEMENTATION SCHEDULE FY1998 FY1999 FY2000 FY2001 FY2002 FY2003 Q1 Q2 Q3 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3 Q4 Loan Timing Signing Effectiveness Closing Transformation Component TA Services Provider Contract Award Contract Signature ' Services- : Training On/Off-Job Training Upgrading a Training Facility Training Materials Information & Technology Software Development/Purchases Hardware Purchases - M 1 Line of Credit Component Subloan Approval Loan Disbursements . .. . . .~. .~ . Z a ANNEX 7.2: PROJECT IMPLEMENTATION PLAN FOR INSTITUTIONAL DEVELOPMENT PROGRAM FY 998 FY 1999 FY 2000 FY 2001 FY 2002 Financial Management Basic Accounting System __: ?? Viam: Chart of Accounts _ _MEM_ Ed ' _i ms Financial Reporting System fr 386 Accountants' Manual p _ Accounting Function Organization pe Risk Management and Control System e._: iy l: Accounting Software :: _ Test Run _ :_: Internal Audit Internal Auditing Standards, Principles & Procedures Operations Monitoring System Early-warning System *: Credit Risk Management Credit Management Principles & Procedures 4 .gR Credit Management Manual Credit Management Software :------------- Portfolio Review .... V: ..........: Loan Workout _ __ ;i & Strategic & Business Planning Strategic Planning 2 NW Business Planning Methodology & Procedures / IS 4 .( ata Economic & Market Research Function 1)ig?z:: ; *M Governance & Organization Charter 3 SillSP Corporate Governance Structure M 5_0% Head Office-Branch Relationship _O_S:FAf_ E _ ts_ Human Resource Management & Training On\Off-Job Training Training Planning ____:?_: Training Materials :Wif___M Personnel Management & Incentive System . ._i . .M.E.F. Comprehensive Human Resource Management System _&_ewsts:_an _ : a Upgrading a Training Center ___iatWAWill _ :R_: M M 5_:_0 Information Technology IT Development Strategy :4t__@_as4 ____e__fr__(W::' Comprehensive Operations Processing Network ? :7 A . Computerized Management Information System _______: s : i ! 5: : z ANNEX 8: PROJECT PERFORMANCE MONITORING INDICATORS Objective: The main objective of the proposed project is to support the transformation into a commercial bank of China Construction Bank. Input and Process Indicators Output and Outcome Indicators Impact Indicators CAS-Related Indicators Underlying Assumptions Finalization of the technical coop- A new CCB Charter describing the A new corporate governance sys- Development of market-based Authorities will within the next two eration agreement between CCB governance mechanism tem for all state-owned financial financial institutions leading to years issue regulations on the appli- and service provider. institutions in China increased efficiency of resource cation of the new Commercial allocation Banking Law and the Company Law as they pertain to the four spe- cialized banks About 30 person-years of com- A formal business plan to serve as Gradual changes in MOF's loan Human resource development in an The autonomy recently given to mercial banking experts the baseline for setting goals, loss provisioning and write-off important sector. specialized banks will be further objectives, budgets and key per- policies and guidelines to reflect reinforced during the 1996-2000 formance indicators at several more correctly the actual asset plan period levels within CCB quality of banks. A new financial management and Improvement in the quality of loan internal control system, including portfolio due to increased autonmy, (a) an internal financial accounting new and/or improved systems, and system based on international upgrading of staff skills. accounting principles that can pro- vide management with accurate and timely information to take informed decisions; and (b) new internal audit policies and proce- dures to assure compliance with existing legal/prudential require- ments and with CCB's own poli- cies and procedures. New internal guidelines for asset The authorities will continue grad- classification, risk assessment and ually to deregulate the financial provisioning; and independent sector as well as further reform the 00 portfolio reviews of additional SOEs during the 9th FYP eight CCB branches. Input and Process Indicators Output and Outcome Indicators Impact Indicators CAS-Related Indicators Underlying Assumptions A new credit management system, including a revised credit manual, project appraisal manual and a standardized loan approval process, and a risk management system A new human resource manage- ment policy, including a labor con- tract system, and formal programs for recruitment, training, perform- ance evaluation, promotion, trans- fer and compensation and reward A core curriculum for meeting pri- ority training needs, and training of 30 trainers, and 200 managers/ senior staff and 2,000 operational staff I 10 00 -80- ANNEX9 ANNEX 9: BANK SUPERVISION INPUT INTO KEY ACTIVITIES Timing Main Activities Skill Requirement Staff-Weeks 09/97 Project Launch Financial Economist 8 Institutional Development Specialist Credit Specialist 02/98 General Supervision Financial Economist 6 Institutional Development Specialist 10/98 Major Supervision Financial Economist 8 Institutional Development Specialist 04/99 General Supervision Financial Economist 4 Institutional Development Specialist 10/99 Mid-term Review Financial Economist 8 Institutional Development Specialist Credit Specialist 04/00 General Supervision Financial Economist 4 Institutional Development Specialist 10/00 Major Supervison Financial Economist 6 Institutional Development Specialist Credit Specialist 04/01 General Supervision Financial Economist 4 Institutional Development Specialist 10/01 General Supervision Financial Economist 4 Institutional Development Specialist 04/02 General Supervision Financial Economist 4 Institutional Development Specialist 10/02 General Supervision Financial Economist 4 Institutional Development Specialist 04/03 General Supervision Financial Economist 4 Institutional Development Specialist 10/03 PICR 6 TOTAL 70 -81- ANNEX10 ANNEX 10: PROCUREMENT ARRANGEMENTS TABLE 1: SUMMARY OF PROPOSED PROCUREMENT ARRANGEMENT ($ million equivalent) Procurement Method Project Elements ICB NCB Other/a NBF/b Total Cost Part A: Transformation Consultants Services 7.0 - - - 7.0 (7.0) - - - (7.0) Training - - 5.0 4.0 9.0 - - (5.0) (0.0) (5.0) Equipment - 1.5 14.5 18.0 34.0 - (1.5) (14.5) (0.0) (16.0) Part B: Line of Credit /c Subloans 50.0 - 150.0 997.0 1,197.0 (50.0) - (150.0) (0.0) (200.0) TOTAL 57.0 1.5 169.5 1,019.0 1,247.0 (57.0) (1.5) (169.5) (0.0) (228.0) /a Including international and national shopping, direct contracting, consultants, services, and training. /b Non-Bank financing. & Estimates only, as actual subprojects are firmed up through the implementation period. Notes: Figures do not include contingencies; those in parenthesis are amounts to be financed by the Bank -82- ANNEX 10 TABLE 2: PROPOSED PROCUREMENT STEPS Procurement Methods Steps Consultants' Services 1 CCB to send letter to potential service providers inviting their expression of interest (Early-April, 1997, completed), 2. CCB to prepare draft Request for Proposals with Bank help (April-May, 1997); 3. Bank to review and clear the draft RFP (May 1997); 4. CCB to issue the RFP to the service providers who have responded to the letter of invitation (End-May, 1997); 5 CCB to evaluate and rank under the agreed criteria the technical proposals, and send the evaluation to the Bank for concurrence (End- August, 1997); 6. CCB and top ranked service provider(s) to hold detailed discussions to finalize the institutional development program (September 1997), 7. Bank to review and clear the draft contract for consultants' services and the institutional development program (September 1997); and 8 CCB to award the contract to the selected service provider(s) (October 1997). Goods * International Competitive I Subborrower to prepare draft bidding documents including the invitation Bidding to bid, and furnish them through CCB to the Bank for review and concurrence; 2 Subborrower/bidding company to publish the invitation to bid in at least one newspaper of national circulation and preferably also in Development News (UNDP); 3. Subborrower to evaluate bids, and furnish through CCB the Bank for clearance a detailed evaluation report with recommendation for contract award; 4. Subborrower to award the contract to the lowest evaluated bidder. * National Competitive Bidding I. CCB to prepare draft bidding documents; 2. CCB/bidding company to publish the invitation to bid in a national newspaper; 3 CCB to furnish the draft contract to the Bank for review and concurrence; and 4. CCB to award the contract to the lowest evaluated bidder. * International and National 1. Subborrower to request for quotations from at least three suppliers in two Shopping different countries under international shopping and three local suppliers under national shopping; and 2. Subborrower to evaluate quotations following sound practices, and place the purchase order to the accepted supplier. -83 - ANNEX 11 ANNEX 11: ESTIMATED DISBURSEMENT SCHEDULE (Amounts in $ million) Transformation component Credit component Semester Cumulative Semester Cumulative FY98 December 31, 1997 1 1 - - June 30, 1998 2 3 10 10 FY99 December 31, 1998 5 8 15 25 June 30, 1999 2 10 25 50 FY00 December 31, 1999 4 14 30 80 June 30, 2000 6 20 40 120 FY01 December 31, 2000 4 24 30 150 June 30, 2001 5 29 30 180 FY02 December 31, 2001 1 30 8 188 June 30, 2002 8 196 FY03 December 31, 2002 2 198 June 30, 2003 2 200 -84- ANNEX 12 ANNEX 12: RESETTLEMENT AND REHABILITATION POLICY FRAMEWORK SECTION 1: INTRODUCTION A. The Project 1. The main objective of the China Construction Bank Transformation Project is to assist in the gradual transformation into a commercial bank of the China Construction Bank (CCB). Like other formerly specialized banks, CCB is faced with a number of internal and external constraints to commercialization. The proposed project, perceived as the first of a series of operations, has at its main focus: setting up modem banking practices, policies and procedures; addressing the major issue of credit management; and training in commercial banking of the management and core operational staff of CCB. 2. The project will have two components: (a) transformation component, and (b) credit component. The subprojects to be financed under the line of credit would be identified during project implementation. Most of the subprojects are expected to be medium-sized projects in the manufacturing sector, although a few may be in the infrastructure sector. The notional pipeline of projects to be funded under the credit component indicate that none of the subprojects would require involuntary resettlement. However, it is possible, even though the probability is low, that small scale land acquisition or economic displacement of local populations may result from individual subprojects. This policy framework has been prepared in the event that resettlement is required for any of the subprojects to be financed under the line of credit and to ensure compliance with the World Bank's Operational Directive (OD) No. 4.30. 3. In World Bank assisted projects, final borrowers or subproject sponsors are expected to take all necessary measures to mitigate adverse social impacts. The costs associated with mitigation of adverse social impacts on project affected persons, such as relocation of affected persons or restoration of livelihoods, will be met by the subproject sponsors. The general guidelines of this Resettlement and Rehabilitation Policy Framework are to be followed by all subprojects under the line of credit component involving involuntary resettlement. Where adverse social impacts are identified, plans for resettlement and rehabilitation (R&R) will need to be prepared based on policies and procedures laid out in this framework. Implementation of these plans will be agreed to as an integral part of the subproject agreement between the borrowers and CCB. -85- ANNEX 12 B. Policy Framework 4. Every effort will be made to avoid or minimize the need for land acquisition and resettlement for land acquired for any subprojects. In the unlikely and exceptional event that any of the subprojects under the line of credit require additional land, houses and other assets, and the resettlement of people losing the totality of their land and/or houses or significant part thereof becomes unavoidable, CCB has adopted this Resettlement and Rehabilitation Policy Framework (the Policy Framework). 5. The principle objective of the Policy Framework is to ensure that all Project Affected Persons (PAPs) will be compensated for their losses and provided with rehabilitation measures to assist them to improve, or at least maintain, their pre-Project living standards and income earning capacity. 6. The Policy Framework lays down the principles and objectives, eligibility criteria of PAPs, entitlements, legal and institutional framework, modes of compensation and rehabilitation, peoples participation features and grievances procedures that will guide the compensation, resettlement and rehabilitation of the PAPs. C. Project Affected People (PAPs) 7. The PAPs include the following persons to be identified by the baseline information collected for each of the Inventories and Resettlement Action Plans (RAP) as specified in Sections E and F and Section 5 of this Policy Framework: (a) Persons whose place of business or employment, and/ or agricultural land is in part or in total affecting (permanently or temporarily) by the subprojects (b) Persons Whose houses are in part or in total affected by the subprojects (c) Persons whose businesses are affected in part or in total (temporarily or permanently) by the subprojects; and (d) Persons whose crops (annual and perennial), trees and fixed assets are affected in part or in total by the subprojects D. Principles and Objectives 8. The principles outlined in the World Bank's OD 4.30 have been adopted in preparing this Policy Framework. In this regard the following principles and objectives would be applied: (a) Acquisition of land and other assets, and resettlement of people will be minimized as much as possible. Where land acquisition is unavoidable, the project will be designed to minimize adverse impact on the PAPs, especially the vulnerable groups. -86- ANNEX 12 (b) All PAPs will be compensated, relocated and rehabilitated, if required, so as to improve their standard of living, income earning capacity and production capacity, or at least to restore them to pre-Project levels. (c) All PAPs residing in, or cultivating land, or having rights over resources within the subprojects area as of the date of the socioeconomic survey are entitled to compensation for their losses and/ or income rehabilitation. Lack of legal rights to the assets lost will not bar the PAPs from entitlement to such compensation, rehabilitation and relocation measures. (d) The rehabilitation measures to be provided are: (i) compensation at full Replacement cost for houses and other structures; (ii) agricultural land for land of equal productive capacity acceptable to the affected production teams or compensation for land acquisition and resettlement subsidy for farmers affected by land acquisition; (iii) dislocation allowance and transition subsidies; (iv) full compensation for crops, trees and other similar agricultural products at market value, and (v) other assets, and appropriate rehabilitation measures to compensate for loss of livelihood. (e) Replacement houseplots, place of business and agricultural land will be as close as possible to the land that was lost, and acceptable to the PAPs. (f) Land-for-land is the preferred option according to the Land Administration Regulation (Section 2, B). Land-for-land may be substituted by cash provided that: (i) land is not available in the proximity of the subproject area; (ii) PAPs willingly accept cash compensation for land and all assets on it, , and receive full replacement value without any deductions for depreciation; and (iii) cash compensation is accompanied by appropriate rehabilitation measures which together with project benefits results in restoration of incomes to at least pre-subprojects levels. (g) The resettlement transition period will be minimized, land-for-land and/or cash compensation provided to the PAPs, and rehabilitation measures completed prior to the expected start-up date of works in the respective subprojects. (h) Resettlement plans will be implemented following consultations with the PAPs, and will have the endorsement of the PAPs. (i) The previous level of community services and access to resources will be maintained or improved after resettlement. (j) Any acquisition of, or restriction on access to resources owned or managed by PAPs as common property will be mitigated by arrangements ensuring access of those PAPs to equivalent resources on a continuing basis. -87- ANNEX 12 (k) Financial and physical resources for resettlement and rehabilitation will be made available as and when required. (1) Resettlement programs will include adequate institutional arrangements to ensure effective and timely design, planning and implementation of resettlement and rehabilitation measures. (m) Adequate arrangements for effective and timely internal and external monitoring will be made on implementation of all resettlement measures. (n) Wherever possible the subprojects will ensure that local residents in the affected areas benefit from the services and facilities created for, or by, the subprojects. E. Inventories 9. In case less than 200 people are affected under any subproject, an Inventory for such a subproject will be prepared by the subproject sponsor(s) and furnished to CCB, the local authorities and the World Bank for their concurrence. Each inventory will be prepared in accordance with the guidelines provided below and will include: (a) the baseline information described in Section 5 of this Policy Framework; (b) detailed compensation and other rehabilitation entitlements for affected persons/production teams; (c) location, area and category of the replacement residential, business and agricultural land to be provided, if that be the case; (d) a time-bound action plan for implementation; and (e) a detailed budget and source of funds for the various compensation and rehabilitation measures. 10. The baseline information will be completed no later than six months prior to the estimated date for commencement of the works for the subprojects. Each inventory will be furnished to CCB and the local authorities for consideration no later than three months prior to the actual initiation of the works under the subprojects and reviewed by CCB within 30 days after that. The World Bank would review the inventories during supervision. Compensation, resettlement and rehabilitation activities will only commence after the CCB and the local authorities have found acceptable the respective inventory. The compensation, resettlement and rehabilitation activities will be completed at least one month before the beginning of works. F. Resettlement Action Plans (RAPs) 11. In case 200 or more people are affected under any of the subprojects under the line of credit, a full Resettlement Action Plan for each subproject will be prepared by the respective subproject sponsor in accordance with the provisions of this Policy Framework. The RAP will be furnished to the CCB and the local authorities for review and the World Bank for its concurrence. -88- ANNEX 12 12. Each RAP, in addition to the information to be provided under an Inventory will include: (a) a detailed socioeconomic survey of PAPs in accordance with Section 5 herein; and (b) arrangements for external monitoring and evaluation. Each RAP will be completed no later than six months prior to the estimated date for commencement of the works under the subprojects. Each RAP will be furnished to the World Bank for consideration no later than two months prior to the actual initiation of the works under the subprojects. Compensation, resettlement and rehabilitation activities will only commence after the World Bank has found acceptable the respective RAP and the CCB and the local authorities have approved it. The compensation, resettlement and rehabilitation activities will be completed at least one month before the beginning of works for each scheme. SECTION 2: INSTITUTIONAL AND LEGAL FRAMEWORK A. Institutional Framework 13. All subprojects involving involuntary resettlement will be required to carry out a socioeconomic survey (survey) to determine the impact on the affected area and the affected population. The survey will determine whether or not the subproject would need preparation of a RAP or other local development plan to offset adverse impacts and access to benefits by the affected communities. The main sequential steps involved in the resettlement approval process are as follows: (a) Subproject sponsor furnishes preliminary information report on the proposed subproject to CCB and the local authorities at the earliest possible stage. The preliminary survey report would contain basic information on: (i) the proposed location of project; (ii) the total area of land required for the physical component of the subproject, the type of land, current land use and possible impacts of land use change, and the proposed strategy for land acquisition; and (iii) the people to be affected by the subproject including those losing homes, land or livelihoods; and those deriving benefits (employment, electricity, etc.) from the subproject. (b) CCB will, after its review and consultations with the local authorities, submit a report on the proposed subproject to the World Bank for a decision on whether a RAP is required. (c) When the number of persons affected by the subproject exceeds 200, a detailed socioeconomic survey has to be accompanied by the preparation of a full RAP (Section F). If a survey determines the social impacts to be below the threshold for a full RAP, an Inventory will be prepared (Section E). All Inventories and RAPs shall be prepared with the full participation of the PAPs (Section 4). (d) Subproject sponsors shall prepare the Inventories/RAPs and submit them to CCB, the local authorities and the World Bank for review/concurrence. -89- ANNEX 12 (e) After the comments from CCB, the local authorities and the World Bank have been incorporated by subproject sponsor(s), CCB and the local authorities verify the adequacy of the report in light of policies, principles and procedures set out in this Policy Framework, and convey the decision to subprojects sponsor(s). (f) CCB forwards the approved RAP along with other related project documents to the World Bank with recommendation for clearance. (g) After obtaining concurrence of the World Bank, CCB executes the loan agreement which would also contain terms and conditions related to implementation of the plans agreed to in the RAP. 14. Although the primary responsibility for enforcement of this Policy Framework and implementation of the resettlement and rehabilitation plans rest with the subproject sponsors, the oversight responsibility shall vest with CCB in coordination with the respective local government authorities in each of the subproject areas. CCB shall also carry out regular supervision as required by the World Bank, to ensure that the provisions of the Policy Framework are satisfied. B. Legal Framework 15. The Land Administration Regulation of the People's Republic of China (passed by the 16th session of the 6th National Congress in June 1986, and revised by the 5th session of the 7th National Congress in December 1988); the Implementation Regulations of the Land Administration Regulation (issued by the State Council in January 1991); the Administrative Regulation on Demolishing and Removal of Housing in Urban Areas (issued by the State Council in March 1991); and relevant provincial regulations constitute the legal framework governing the implementation of this Policy Framework. SECTION 3: ENTITLEMENT POLICY 16. The entitlement policy aims to enable PAPs to replace the assets they have lost on account of the project, to recover and to improve upon their pre-subproject living standards within the shortest possible time. In general, the R&R package would consist of (a) provision for replacement assets or its cash equivalent, where replacement is not feasible; (b) rehabilitation grants to compensate for temporary disruption in life and economic activities; (c) either employment or training, capital and enterprise support for income restoration in case of loss of livelihoods; and (d) provision for replacement of community facilities and services for affected communities. 17. PAPs losing agricultural land will be entitled to the following types of compensation and rehabilitation measures: (a) For the majority of schemes, the land will be reallocated within the village by the village authorities. According to the Land Administration -90- ANNEX 12 Regulation, in situations where land reallocation is not possible, the PAP will be paid a maxim compensation and resettlement subsidy equivalent to 10 times of the average annual production output value of the land in the previous three years. If this is not sufficient to restore the livelihoods of the PAPs to the pre-Project level, the compensation/subsidy may be raised to a maximum of 20 times of the average annual output value of the land in the previous three years. (b) For subprojects where land is acquired by the Land Administration Bureau, the general mechanism for compensation of lost agricultural land will be through provision of payment of land compensation and resettlement subsidy equivalent to a maximum of 20 times the average annual output value of the land in the previous three years (the previous subparagraph). (c) These amounts will be paid to the village/production teams whose land is affected and will be used for: (i) increasing land areas under cultivation if land is available; (ii) intensification of agriculture through provision of irrigation, improved agriciitural practices, etc.; and (iii) development of non-agriculture based income generation activities. PAPs will be compensated for the loss of standing crops, fruit or industrial trees, as well as any fixed assets at market prices. (d) PAPs whose land is temporarily taken by the works under the subprojects will be compensated for their loss of income, standing crops and for the cost of soil restoration and damaged infrastructure. 18. PAPs losing houses and auxiliary structures will be entitled to the following compensation and rehabilitation measures: (a) PAPs whose houses are being acquired by the subprojects will be provided replacement housing within easy commuting distance of their existing homes. (b) PAPs will be provided with compensation at full replacement value, without any deduction for depreciation, for any structures and fixed assets affected by the subprojects. (c) A pre-determined Dislocation Allowance according to the prevailing rates of the subproject areas will also be provided 19. If the house and/or structure is only partially affected by the subprojects, the sponsors may, if its is acceptable to the PAP, acquire the entire structures with full compensation or provide cash compensation for the portion affected as mutually agreed between the PAPs and the sponsors. -91- ANNEX12 20. PAPs losing business will be entitled to the following compensation and rehabilitation measures: (a) The mechanism for compensating loss of business will be: (i) the provision of alternative business site of equal size and accessibility to customers, satisfactory to the PAP; (ii) cash compensation to the owner for lost business structure reflecting full replacement cost of the structures, without depreciation and the cost of transfer; and (iii) cash compensation for the loss of income during the transition period. (b) PAPs will also be provided compensation at full replacement cost, without depreciation for any other fixed assets affected in part or in total by the subproj ects Section 4: People's Participation 21. The subproject sponsors would be required to carry out the Inventories/RAPs with the participation of the people in the subprojects areas and their representatives. A broad acceptance of proposed measures by the PAPs -- including relocation areas and replacement lands, and proposed income restoration measures for R&R, and cost-sharing or administrative arrangements for access to benefits and services -- will be a necessary condition for approval of the Inventories/RAPs by the relevant local authorities. 22. PAPs will participate throughout the various stages of the planning and implementation of the Inventories and RAPs. For these purposes and prior to the preparation of Inventories and RAPs, the PAPs will be informed of the provisions of this Policy Framework at public meetings. 23. Each household PAP will be fully informed by the relevant township and village governments of their entitlements and rehabilitation choices under the respective Inventory or RAP. Section 5: Baseline Information 24. Inventories. The baseline information for inventories will include for each affected village/production team: (a) number of persons in each household, main and sideline occupation household members, and income from those occupations; (b) number, type, and area of the houses, sheds or other domestic structures existing in the village, and the domestic structures lost to the sub-project; (c) total amount of agricultural land by category held by the village/production team, and the category and area of agricultural land lost to the subproject; -92- ANNEX 12 (d) the per capita land holding in the respective production team; (e) quantity and types of crops and trees lost; (f) business lost including structures, land and other fixed assets; (g) productive assets lost as a percentage of total productive assets; (h) quantity and category of other fixed assets affected by the subprojects; and (i) temporary damage to productive assets. 25. Resettlement Action Plans (RAPs). The baseline infromation for RAPs will be collected and processed on a household basis. The objective is to assess the resettlement impact on individual households, and to ensure that, not only is the village/community better off as a whole, but each household within the village/community has also been rehabilitated. The basic categories of information remain the same as listed in paragraph 24. However, it is recommended that the socioeconomic data be tabulated by primary occupation, to facilitate the presentation of any variations in the status of PAPs. Section 6: Implementation Arrangements Implementation Schedule 26. A detailed implementation schedule of the various activities to be undertaken will be included in each Inventory and RAP. 27. Payment of compensation and furnishing of other rehabilitation entitlements (in cash or in-kind), and relocation if that be the case, will be completed at least one month prior to the scheduled start-up date of works in the respective subproject site. Complaints and Grievances 28. Since any Inventory/RAP will be carried out with the full participation of the PAPs, it is expected that no major grievance issue will arise. However, to ensure that the PAPs have avenues for redressing their grievances related to any aspect of land acquisition and resettlement, detailed procedures of redressal of grievances have been established in this Policy Framework. The objective is to respond to the complaints of the PAPs speedily and in a transparent manner, without resorting to complicated formal channels to the extent possible. 29. The procedures are as follows: (a) Stag., any person aggrieved by any aspect of the Inventories/RAPs can lodge an oral or written grievance to the Village Administration Committee or the Neighborhood Committee, and/or township or district land administration authorities. -93- ANNEX 12 (b) Stage 2, if the aggrieved person is not satisfied with the decision of the grass-roots authorities at Stage 1, he/she can present the case to the land administration authorities from those immediately above the Stage 1 level through the highest authorities of the respective subproject area. (c) Stage 3, if the PAP is still dissatisfied with the decision of the higher authorities, the case may be submitted for consideration by the Peoples' Court in accordance with the "Civil Procedure Act". (d) The procedures for redressal of grievances and the appeal process will be publicized among the PAPs. Monitoring of Social Impact 30. Monitoring of resettlement impacts will be carried out by the subproject sponsors as an integral part of the implementation of the plans, and will cover the subproject and post-subproject periods. It will assess achievements against key implementation targets and objectives and, accordingly, make corrections in the plans where necessary. Periodical monitoring reports will be submitted to CCB and the relevant local government authorities. In addition, CCB shall carry out implementation assessments on their own to verify whether the plans are being implemented as approved. -94- ANNEX 12 ENTITLEMENT MATRIX Type of loss/impacts Definition of entitled Definition of entitlement Application guidelines Organization(s) person/unit responsible Acquisition of House * Owned by work unit * Legal Residents * Replacement housing * Transportation allow- * Subproject sponsors/ owned by work unit but ance per household, borrowers with local provided to PAP, trans- payable to legal resi- government authorities portation allowance, dents only. Allowance and subsidy for tem- as per existing rates in porary accommodation subproject provinces * Privately Owned (self- * Legal Residents * Replacement housing * Household with * Subproject sponsor/ built or purchased) with full ownership to disabled families will borrower with local PAP, transportation be accommodated in government authorities allowance and lower stones temporary rent subsidy * Nonlegal residents * Nonlegal residents who * The minimum period of * Subproject sponsor/ can prove residence for residence for this borrower with local a minimum period not entitlement will in government authorities exceeding 3 years will accordance with the be entitled to housing existing rules in on a cost-sharing basis different subproject between the respective areas subproject sponsor and the resident * Rented housing * Tenants * Tenants entitled to * Transportation subsidy * Subproject sponsor/ transportation subsidy as per existing rules in borrower with local subproject areas government authorities Other Urban Structures * Medium enterprises * Township or Collective * Replacement land, * Subproject sponsor/ owning institution relocation cost and borrower with local compensation for lost government authorities income during transition period * Employee * Compensation for lost salary, and reemploy- ment at relocated enterprise * Private commercial * Owners * Alternative site, com- establishments pensation for lost structure and invest- ment, loss of income during transition period, support for reestablishment of enterprise -95- ANNEX 12 Type of loss/impacts Definition of entitled Definition of entitlement Application guidelines Organization(s) person/unit responsible Acquisition of Agricultural land * Owned by Collective * Collective * Compensation for land * Subproject sponsors/ acquired borrowers with local government authorities * Farmer with contracted * Farmer losing land who * Replacement land * Land Agency will land or working on can be accommodated provided by collective determine if the collec- land managed by the by collective tive is able to adjust collective affected farmers or if investment for alternate enterprise is needed Farmer losing all land * Retraining and who cannot be accom- investment for job modated within the creation in collective/ collective township enterprises Structural investment * Collective * Full compensation * Subproject sponsors/ on agricultural land, borrowers with local e.g., well, tubewell, etc. government authorities * Farmer * Full compensation * Subproject sponsors/ borrowers with local government authorities Standing crop, fruit and * Farmer * Full compensation for * Fruit trees will be other trees crops and trees compensated for timber as well as for lost income from fruit Temporary stalls/shops * Entrepreneur * Assistance to find * Subproject sponsors/ alternate site on public borrowers with local land, and permit from government authorities commercial agency Unauthorized stalls and * Entrepreneur * Persuasion to obtain a * The entrepreneur will * Subproject sponsors/ businesses license; if license is be persuaded to obtain borrowers with local obtained within one a license; if the license government authorities month they will be is obtained within 30 provided alternate site days, PAP will be and compensation for treated at par with loss of income, after those with license and obtaining license entitled to replacement site and compensation for lost income Public infrastructure/ * Public agency * Compensation for all * Subproject sponsors/ Common property lost infrastructure/ borrowers resources facilities or restoration of all infrastructure, public facilities, etc. -96- ANNEX 13 ANNEX 13: DOCUMENTS AVAILABLE IN PROJECT FILE 1. "China Financial Sector Review: Financial Policies and Institutional Development," June 29, 1990 (Report No. 8415-CHA, The World Bank). 2. "China Banking Sector Reforms: Current Status and Issues," June 27, 1995 (Report No. 13492-CHA, The World Bank). 3. The Chinese Economy: Fighting Inflation, Deepening Reforms, A World Bank Country Study, 1996. 4. Diagnostic Studies of The People's Construction Bank of China Organization and Management Financial Position and Performance Human Resource Development Information Technology Strategy Integrated Implementation Plan 5. "External Environment and Commercialization of State Banks," Beijing SINOC International Investment Consulting Co. Ltd., February 1996. 6. China Construction Bank Project Appraisal Guidelines, March 1996. 7. China Construction Bank Annual Reports, 1988-1995. 8. China Financial Outlook, The People's Bank of China. RUSSIAN 1 FEDERATION q KAZAKSTAN J.. HELONGMA-• Northeast 1 70.45% UZBEKISTAN MONGOLIAN ONGO A- JUN" KYRGYZ • REPUBUC k JAPAi ...a--,,, se o JAPAN T;A KISTAN ANING . Jclpn n NAJIANGA DEM. PtOPLE'S )S.REP OF KOREA Eb SH? REP0ý Northwest KOREA 8.22% NNG GANSU SHAN HNA ~ åOfl ~~~~1~ HENAN - ZAHBSHANGHAISHI Fust cino H Eastin Sout west 8.36% Middle East ;l,.Elt H,äNG 26.35% NEPAK 7 SICHUAN South CHINA 22.36 PA CI lc CHINA CONSTRUCTION BANK OCEAN TRANSFORMATION PROJECT 1GUIZHOU Loan Distribution of Tyw China Construction Bank, 1995 YUNNAN G * GUANGM2 GUZANGOONG 7 SHARE OF LOANS, %: GREATER THAN 25 O KNG(U) 191 a1 20 TO 25 * NATIONAL CAPITAL . VIETNAM 12 TO 20 - PROVINCE BOUNDARIES 2 9T112 .=' REGION BOUNDARIES H. D PEP NAN PHIIPPI4ES LESST AN9 INTERNATIONALBOUNDARJES 'l> N4 CATALOGUERSIFILE CONFIDENTLAL Report No.: 16317 CHA Type: SAR