Philippines - Third Rural Finance Project

Document of The World Bank Report No: 18328-PH PROJECT APPRAISAL DOCUMENT ONA PROPOSED LOAN IN THE AMOUNT OF US$150 MILLION EQUIVALENT TO THE THE LAND BANK OF THE PHILIPPINES FOR A THIRD RURAL FINANCE PROJECT September 23, 1998 Rural Development & Natural Resources Sector Unit Philippines Country Management Unit East Asia & Pacific Region  CURRENCY EQUIVALENTS (Exchange Rate Effective September 8, 1998) Currency Unit = Peso (P) 1 Peso = US$0.0227 US$1.00 = 44 Pesos FISCAL YEAR Land Bank of the Philippines: January 1 - December 31 ABBREVIATIONS AND ACRONYMS ARF - Agrarian Reform Fund BSP - Bangko Sentral ng Pilipinas (The Central Bank) CARP Comprehensive Agrarian Reform Program CLF - Countryside Loan Fund DBP - Development Bank of the Philippines DENR Department of Environment and Natural Resources DOF - Department of Finance EMB - Environmental Management Bureau GOP - Government of the Philippines IDP Institutional Development Plan LBP - Land Bank of the Philippines MLF Micro-finance Loan Fund NGOs Non-Government Organizations PCFC People's Credit & Finance Corporation PFIs - Participating Financial Institutions RBs - Rural Banks TBs Thrift Banks SDI - Subsidy Dependence Index SCL - Single Currency Loan at Libor-Based Floating Rate Vice President:, EAPVP Country Manager/Director: Vinay K. Bhargava, EACPF Sector Manager/Director: Geoffrey B. Fox, EASRD Task Team Leader/Task Manager: Arie Chupak, EASRD  PHILIPPINES THIRD RURAL FINANCE PROJECT CONTENTS Page No. A. Project Development Objective .2 1. Project development objective and key performance indicators .2 B. Strategic Context 1. Sector-related CAS goal supported by the project .2 2. Main sector issues and Government strategy .3 3. Sector issues to be addressed by the project and strategic choices .4 C. Project Description Summary .6 1. Project components .6 2. Key policy and institutional reforms supported by the project .7 3. Benefits and target population .7 4. Institutional and implementation arrangements .7 5. Implementing Institutions .8 D. Project Rationale .11 1. Project alternatives considered and reasons for rejection .11 2. Major related projects financed by the Bank and/or other development agencies . 12 3. Lessons learned and reflected in proposed project design .12 4. Indications of borrower commitment and ownership .13 5. Value added of Bank support in this project .13 E. Summary Project Analyses .14 1. Economic ............................. 14 2. Financial .14 3. Technical .Is 4. Institutional .15 5. Social .15 6. Environmental assessment .16 7. Participatory approach .16 F. Sustainability and Risks .16 1. Sustainability .16 2. Critical risks .17 3. Possible controversial aspects .18  Pace No. G. Main Loan Conditions . ............................................... 18 1. Effectiveness conditions .......................................... 18 2. Conditions for Disbursement .......................................... 18 3. Other .......................................... 18 H. Readiness for Implementation ................................................ 20 I. Compliance with Bank Policies ................................................ 20 Annexes Annex la Project Design Summary ................................................ 21 Annex lb Key Performance Indicators ................................................ 23 Annex 2a Detailed Project Description ................................................ 28 Annex 2b. Credit Operation ................................................ 34 Annex 2c. LBP's Operations, Financial Performance and Projections ......................................... 45 Annex 2d. PCFC Operations, Financial Performance and Projections ......................................... 53 Annex 2e Environmental Technical Services ................................................ 59 Annex 3. Estimated Project Costs and Financing Plan ................................................ 64 Annex 4. Financial and Fiscal Impact ................................................ 65 Annex 5. Procurement and Disbursement Arrangements ................................................ 69 Table A. Project Costs by Procurement Arrangements ................................................ 71 Table B Thresholds for Procurement Methods and Prior Review .......................................... 72 Table C. Allocation of Loan Proceeds ................................................ 73 Annex 6. Project Processing Budget and Schedule ................................................ 74 Annex 7. Documents in Project File ................................................ 75 Annex 8. Statement of Loans and Credits ................................................ 76 Annex 9. Country at a Glance ................................................ 78 Map IBRD 27553  Philippines Third Rural Finance Project Project Appraisal Document East Asia & Pacific Regional Office Philippines Country Management Unit Date: September 8, 1998 Task Team Leader/Task Manager: Arie Chupak Country Manager/Director: Vinay K. Bhargava Sector Manager/Director: Geoffrey B. Fox Project ID: PH-PE57598 Sector: Rural Development Program Objective Category: Lending Instrument: Financial Intermediary Loan Program of Targeted Intervention: [x] Yes [ ] No Project Financing Data [x] Loan [] Credit 1] Guarantee [ Other [Specify] For Loans/Credits/Others: Amount (US$m/SDRm): US$150 million Proposed terms: [ Multicurrency [x] Single currency, specify US$ Grace period (years): 5 years [] Standard Variable [ Fixed [x ] LIBOR-based Years to maturity: 20 Commitment fee: % Service charge: % Financing plan (US$m): Source Local Foreign Total LBP 1.8 0.2 2.0 PCFC 0.2 0.1 0.3 IBRD 64.9 85.1 150.0 PFIs 21.4 - 21.4 Sub-borrowers 42.4 - 42.4 Total 130.7 85.4 216.1 Borrower: The Land Bank of the Philippines (LBP) Guarantor: The Republic of the Philippines Responsible agency(ies): LBP and the People's Credit & Finance Corporation (PCFC) Estimated disbursements (Bank FY/US$M): 1999 2000 2001 2002 2003 2004 Annual 30 40 30 30 19 1 Cumulative 30 70 100 130 149 150 For Guarantees: [] Partial credit [] Partial risk Proposed coverage: Project sponsor: Nature of underlying financing: Terms of financing: Principal amount (US$) Final maturity Amortization profile Financing available without guarantee?: [] Yes [ No [f yes, estimated cost or maturity: Estimated financing cost or maturity with guarantee: Project implementation period: 5 years Expected effectiveness date: 01/15/99 Expected closing date: 06/06/2005 OSD PAD Form: July 30, 1997  - 2 - A: Project Development Objectives 1. Project development objective and key performance indicators (See Annex la & lb) Building on the achievements of the Second Rural Finance Project (Loans 3938, 3939, and 3940-PH), the proposed project would: (a) provide financial support to the rural economy to overcome the difficulties created by the regional financial crisis, and the devaluation of the Peso through the establishment of the Countryside Loan Fund III (CLF III); (b) assist the government in its efforts to alleviate rural poverty through the provision of financial and institutional support to the country's micro-finance system; (c) strengthen: (i) LBP as the main financial institution serving the rural areas, and (ii) PCFC as the country's main conduit for micro-finance; and (d) help to enforce financial discipline on PFIs. Through CLF III the project would assist private sector enterprises, particularly small and medium sized operations, to help implement their expansion and modernization plans, to undertake new sub-projects, and to finance working capital requirements. These enterprises would thus be able to alleviate the operational and financial problems arising from the credit crunch and currency crisis and take advantage of new opportunities created by the recent economic developments. The project would also assist LBP and PCFC in strengthening their institutions and increase their capacity to provide financial services to the rural areas and micro enterprises, respectively. Under the project, LBP and PCFC as well as PFIs would be required to apply high financial standards with regard to solvency, liquidity, profitability, and best management practices, as designed under the proposed Banking System Reform Loan. LBP and PCFC would each prepare an institutional development plan (IDP) to be agreed with the Bank and implemented during the project period. To assist LBP's management and the Bank in monitoring and evaluating project implementation performance, a set of Key Performance Indicators (KPIs) related to project objectives was agreed at negotiations. The KPIs would include: (i) supporting rural development through financing of viable investments (number of sub-loans, total sub-project investments, and estimated incremental jobs created); (ii) strengthening LBP's capacity to finance private sector investments (real increase in equity, private deposit mobilizations, upgrading loan portfolio quality, and streamlining agrarian lending operations); and (iii) strengthening PCFC as a wholesale micro-finance institution by raising its equity and reducing its unit operating costs. More details are in Annex lb. B: Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project (see Annex 1): CAS document number: Document No. 15362-PH (CAS) and R-98-41 (CAS Progress Report) Date of latest CAS discussion: March 24, 1998 The project would especially support two of the CAS main goals. It would (i) improve private business environment by improving availability of long term financing for viable rural investments; and (ii) contribute to poverty alleviation, directly through the financing of micro-finance enterprises and indirectly through job creation as a result of the provision of term lending for investments in the rural areas. The recent CAS Progress Report also reaffirmed the need to respond to both the the new opportunities resulting from the Mindanao peace agreement and the Asian financial crisis by enhancing the country's international competitiveness through, inter alia, strengthening and deepening the financial system. The CAS Progress Report, highlighted the need to intensify Bank's support through technical  - 3 - assistance and quick disbursing loans. In addition, lines of credit for agriculture and industry would be provided in light of constrained availability of tern credit to the private sector. This project would provide some of this credit. Also, because it is directed towards the countryside, it would also provide essential support to the implementation of the Bank's rural development assistance strategy. 2. Main sector issues and Government strategy: The Philippine economy has recovered from its poor performance of the early 1990s and has been growing for the last 4 years. However, the recent East Asian financial crisis has impacted negatively on the Philippine economic growth and the stability of the banking sector. Real GNP growth decelerated from 6.9 percent in 1996 to 5.8 percent in 1997, with a projection of a further decline to a negligible level in 1998. Currently inflation is exceeding 10%, unemployment as of April 1998 is reported to have risen sharply to 13.3%, estimates of the fiscal deficit have rapidly escalated, the Peso has weakened and following a period of decline, market interest rates have begun to rise. The East Asian currency and financial disturbances in the latter half of 1997 revealed some weaknesses in the Philippine economy. The liberalization of capital account transactions in 1992 encouraged the inflow of foreign capital that led to a real appreciation of the peso while the nominal exchange rate remained stable. The stable peso and higher domestic interest rates relative to interest rates abroad, led to dollar-denominated borrowings by a number of companies and banks. This led to the extension of dollar-denominated loans which generally were unhedged by borrowers. Hence, the substantial depreciation since July 1997 exposed a number of borrowers to liquidity and solvency problems. Because of a decade of structural adjustment effort assisted by Bank and IMF, a relatively shorter period of credit growth and reliance on private capital flows, the Philippines' financial problem seems to be of a different order of magnitude than those of neighboring countries. Net foreign capital inflow declined sharply from about $8 billion in 1996 to below US$1 billion in 1997, while the current account deficit widened in 1997 to about $4.5 billion. This was mitigated by an increase in Philippine overseas workers' remittance of 15 percent to about US$11.5 billion in 1997. Speculative attacks against the peso reduced international reserves by about US$3.4 billion in 1997. These led to the substantial reduction in the BSP's intervention in the foreign exchange market. The commercial banking system is now mruch more liberal and open. Compared with 27 commercial banks in the late 1980s, there are now 54 banks operating in the country including 14 foreign banks. Credit has grown at an annual rate of 34% over the last five years and deposits have grown at an annual rate of 27%. Total assets of the banking system increased by 22 percent in 1997. Universal and commercial banks account for about 80 percent of these assets with thrift and rural banks accounting for the remainder. Overall, the commercial banking system appears to be healthy with a risk assets to equity ratio of about 7.5 (BSP requirement is 10), past due ratio was at its lowest point in 1996 (2.8%) but increased to 4.7% at the end of 1997. Profitability of commercial banks was substantially improved between 1994 to 1996 slightly exceeding 18% and 2% on equity and assets, respectively. As a result of the regional financial crisis, profitability in 1997 declined to about 15% on equity and 1.6% on assets. The banking system and the corporate sector, however, still experienced stress from the financial shocks as evidenced by the current tightness in the credit environment. Credit of commercial banks during the fourth quarter of 1997 and the first half of 1998 was stagnant. While the commercial banks as a group experienced healthy profit levels in 1997 due to widening gross interest margins, a number of them had problems on rising non-performing loans, increased incidences of rollovers, falling real estate collateral values, and compliance with legal reserve requirements. On the other hand, thrift banks and rural banks experienced greater stress from the crisis. At the end of 1997, the gross non-performing loans of thrift  -4 - banks and rural banks were reported to be 10 percent and 14 percent respectively. The stress faced by these banks has contributed to the credit squeeze in the rural economy particularly among the micro, small and medium enterprises. The regional crisis and its impact on the Philippines have raised concern about the commercial banks' capital adequacy, loan classification and provisioning practices, increase in non-performing loans, effectiveness of on-site inspection and off-site monitoring, off balance sheet activities, inadequate transparency, exit and entry requirenments, liquidity in the system, and the availability of term credit. The government, in consultation with the Bank and the Fund, has initiated a number of reforms to address these issues. The proposed project is also one step in the same direction. The credit squeeze while more severe among the small and medium borrowers also resulted in the slowing down in private consumption and investment. Unemployment is expected to be well over 10 percent by end 1998 compared with 8.7 percent in 1997. Non-prime corporate borrowers are suffering from the reduced availability of credit. As a result, the country's fiscal position is a concern in view of the possible slow down in revenue collection. The pace of recovery from the sharp economic slowdown of 98 will depend on the depth and duration of the regional crisis and the effectiveness of the macro-economic and structural policies of the new administration. This means the adoption and continuation of reforms that promote macro-economic stability and investor confidence in the financial market which will enable the corporate and the banking sector to recover from the stress brought about by the credit squeeze and the currency depreciation. The administration is determined to adopt policies that would strengthen the banking system's capacity to be more resilient to future financial shocks. Likely measures include: (i) improvement of the prudential and supervisory systems and implementation of measures that would enable the authorities to deal expeditiously with problem banks, and (ii) the reduction of peso intermediation costs to reduce disparities between intermediation in different currencies. The poor, however, will be provided assistance within a policy environment that promotes a viable and sustainable financial market. The policy for microenterprise lending has clearly been laid out in the recently enacted law on Poverty Alleviation. The law supports the provision of microfinance services within a policy environment that promotes a viable and sustainable financial market. It categorically states that the government will only provide funds for capability building of microfinance institutions. The proposed implementing rules and regulations also clearly espouse the use of market-based interest rates. The country would need substantial support from both the Bank and the IMF to recover and resume a sustained growth path in the near term. Government policy of strengthening the financial sector as stated above and easing the the problems created by the credit crunch would be supported by the Bank through the Banking System Reform Loan and the two lines of credit to LBP and DBP, the Third Rural Finance Project (TRFP) and the Private Enterprise Credit Support Project, respectively. The TRFP would also assist government policy on poverty alleviation through the availabilty of credit facility for the financing of viable micro-enterprises. Its fiscal impact would also be positive. 3. Sector issues to be addressed by the project and strategic choices: While the financial crisis will weed out or hasten the demise of weak and non-competitive enterprises, including possibly banks, it is not certain that the weeding out process will be confined to such firms. The banks, in their desire to protect their balance sheets from exposure to failing firms, especially those with unhedged dollar denominated loans, might not care or exert effort to distinguish between good and bad firms. A general credit squeeze is much easier to implemrnent than a discriminating credit policy. Staying liquid while exploiting high yielding TBills, or taking a position in the foreign exchange market  - - is a survival strategy that several banks have adopted, leading to a degree of failure in the credit market. Indeed, mission interviews indicate that the financial crisis has hit good borrowers which would otherwise be considered creditworthy and viable, especially the small and medium scale rural enterprises, who have been caught between reduced bank funding and higher credit requirements due to the depreciation of the Peso and resulting increased cost of inputs and higher receivables. Export- oriented firms are also finding it difficult to take advantage of weak Peso due to a lack of credit. The proposed project would address these issues project component (a). Clear evidence of strong demand for medium and long term credit for rural investment has been shown by the fact that funds under CLF I and II which were set up to meet this demand at market rates have been drawn down substantially ahead of target. There continues to be an absence of medium and long term Peso denominated financial instruments within the banking system, and given the financial crisis, this is unlikely to change in the near future. Without such resources, either banks have to finance investments using short term resources, leading to maturity mismatches in the banking sector, or else investors are exposed to the financial risk of not having their short term loans rolled over. Additional Bank resources to support rural investment through a wholesale credit line would help to plug this gap and enable the Participating Financial Institutions (PFIs) and their clients to better match the maturity of their funding to the maturity of their project or loan. This issue would be addressed through the CLF component of the proposed project project component (a). The increasing amount of micro-enterprise activities in the country results in a considerable demand for micro-enterprise loans in the rural sector. The loan demand of micro-enterprise clients range from P25,000 to P100,000 for working capital and small capital investments. Due to the perceived costs associated with small lending, most commercial banks do not lend to micro-enterprises. This market niche is being served by micro-finance institutions that are mostly comprised of rural banks, cooperative rural banks, credit cooperatives, and credit NGOs. With the increased demand for micro-enterprise credit and the reluctance of commercial banks to expose themselves to this type of portfolio, the government has recently created the People's Credit and Finance Corporation' (PCFC) which provides wholesale funds to micro-finance institutions. Recognizing the role of micro-enterprise loans in poverty alleviation, the PCFC has been given the task of lead financial institution in micro-finance. It has so far accredited 86 MFIs of which 46 are either rural banks or cooperative rural banks. At present, PCFC is operating with limited funds, which are mostly directed. Availability of wholesale funds for onlending to MFIs for micro-enterprises in the P25,000 (about US$625) to P100,000 (about US$2,500) range is severely limited. Most MFIs (especially credit NGOs) rely on donations, grants and a limited volume of commercial lending; they are not able to easily source finance for this type of lending. These issues are addressed by project component (b). Wholesaling of funds, particularly aid resources is necessary because of the large number of banks and MFIs in the Philippines. The use of a wholesale mechanism allows for competition within the PFIs and the MFIs and gives access to funds to any qualified institution. Its effective implementation requires the Apex Institutions to operate efficiently and in addition, accredit and provide training to PFIs/MFIs. Both Apexes (LBP and PCFC) have drafted Institutional Development Plans (IDPs) to strengthen their ability to do this. Support for this under Part (d) of the Project is given to PCFC whilst LBP is supported under Part (c). PCFC was incorporated and registered with the Securities and Exchange Commission in 1996. Its charter calls for eventual privatization.  C: Project Description Summary 1. Project components (see Annex 2for a detailed description and Annex 3 for a detailed cost breakdown): Component Category Cost Incl. % of Bank- % of Contingencies Total financing Bank- _ (US$M) (US$M) financing CLF III A fund, at market interest rates, Credit 207.1 95.8% 145.0 up to 75% available through LBP to accredited PFIs on of sub- a short, medium or long term basis to project finance private rural sub-projects that are costs economically and technically sound, including those which are under financial distress induced by the current financial crisis. Micro Finance Loan Fund (MLF) Credit 6.7 3.0% 5.0 up to 75% Resource lent by LBP to PCFC at market of sub- rates would form the MLF which would project provide finance for working capital and costs small capital investment of micro- enterprises. Sub-loans under this component would range from P25,000 (US$625) to P100,000 (US$2,500). Main MFI conduits would be rural banks and cooperative banks. Strengthening LBP. An IDP agreed with IDP 2.0 0.9% None N/A the Bank and to be adopted by LBP would focus on ensuring LBP's sustainability while continuing its rural lending expansion. Specifically it would focus on (i) improving the quality of LBP's commercial loan portfolio, (ii) reducing unit losses on agrarian lending; (iii) continuing the policy of automation of systems and management information flow; (iv) staff training, (v) mobilization of medium and long term Peso resources; and (vi) making adequate arrangements for capital build up. Strengthening PCFC. Under this IDP 0.3 0.2% None N/A component, PCFC would also implement an Institutional Development Plan (IDP) to be prepared by PCFC and agreed with the Bank. This would include build up of PCFC's capital base and strengthening of its staff capability to implement its various types of micro-finance programs. Total 216.1 100.0% 150.0 69.4%  -7- 2. Key policy and institutional reforns supported by the project: The project has no direct policy component, but is consistent with the policy of a liberalized financial sector where onlending rates by LBP and the various participating financial institutions are negotiated freely. No major institutional reforms are involved, but the project would contribute towards institutional development of LBP and PCFC, PFIs, and MFIs. 3. Benefits and target population: The CLF III would directly assist small and medium sized economic entities operating in the Philippines rural areas. Based on the loan uptake of CLF I & II, it is estimated that about 700 economic entities would obtain credit under the project (in the first round of lending). These would benefit from the restructuring of their economically and technically viable, but financially distressed businesses, or else from the establishment of new, or expansion of existing viable entities. The Micro Finance component would assist micro enterprises in the rural areas and be targeted towards those businesses which are too small to receive regular commercial finance, but larger than the Grameen style clients of PCFC's ADB and IFAD supported programs. About 100 PFIs would benefit from being retailers of CLF III. The availability of more medium term financial resources would help the PFIs to improve the structure of their balance sheets, allow them to service their clients better and contribute to their profitability. Some 50 MFIs, mainly rural banks and credit co-operatives, would similarly benefit from an expansion in the availability of term credit for onlending. The institutional strengthening components for LBP and PCFC would both strengthen the institutions themselves and assist in improving the delivery of financial services to the rural areas. 4. Institutional and implementation arrangements: The loan would be made to the Land Bank of the Philippines (LBP) with the guarantee of the Republic of the Philippines. It would, therefore, make no demands on public sector financial resources and be independent of the administrative capacity of government line agencies. The CLF III component would be operated as a wholesale banking fund guided by an agreed policy manual. The main elements of the policy manual would include: eligibility criteria of sub-projects; Participating Financial Institutions (PFIs) accreditation criteria; market interest rates; subsidiary and sub-loan maturities; appraisal; disbursement; environmental protection; and supervision of sub-projects. These are detailed in Annex 2b. LBP would be responsible for implementing the agreed Institutional Development Plan (IDP). The IDP would be annually reviewed and if warranted, adjustments to the respective strategy, actions, and targets would be made. In addition a semi-annual report on the outstanding issues and implementation of the IDP would be prepared by LBP with contributions from the various departments involved in implementing the IDP. Part of the IDP would involve preparation and implementation of the project training and Technical Assistance (TA) programs. The preparation work for these would be completed by November 30, 1998. The programs would be updated annually and be submitted by LBP for Bank review by November 30 of each year commencing in 1999 for the immediately succeeding year. In carrying out the training program LBP will employ consultants whose qualifications, experience, and terms and conditions are satisfactory to the Bank. Details on the principles, targets, and timetable regarding the implementation of the IDP are provided in Annex 2a.  -8- The micro-finance component would be carried out by PCFC. The credit element would based on an agreed policy manual which would cover: sub-borrowers' eligibility criteria, Micro Finance Institutions (MFIs) accreditation criteria, interest rate structure; appraisal and supervision of micro enterprises; and sub-loan disbursement arrangements. The funds for implementing the credit element of this component would be lent by LBP to PCFC from the proceeds of the IBRD loan to LBP. LBP's on-lending rates to PCFC would be variable and adjustable every quarter. It would be based on the 91 day Thills rate. PCFC would also be responsible for the preparation of its IDP and its implementation. This would be reviewed annually and updated as necessary. Progress reports would be submitted to the Bank every six months. More details are provided in Annex 2a (IDP) and Annex 2d (credit). Land acquisition and resettlement. Although the project will not finance land acquisition, LBP will have to ensure that land acquired for sub-project implementation would be on the basis of a freely negotiated agreement between buyer and seller. No involuntary land transactions will take place under the project. 5. Implementing Institutions Land Bank of the Philippines (LBP, for more details see Annex 2c) Ownership & Orzanizational Structure. LBP was established in 1963 with authorized capital of P 1.8 billion as the agency responsible for financing agrarian reform. Under the new Land bank Act of 1995, (RA7907) its authorized ordinary share capital was increased to P 7.8 billion all of which is Government owned. P 7.4 billion has now been paid up, through allocation from reserves. Additionally, SSS (the social security fund) holds P 1.2 billion of LBP preferred shares (yielding 14%). LBP has recently submitted an application for a further increase in total authorized capital to P 25 billion. LBP is controlled by a Board of nine Directors, including the Secretary of Finance (Chairman); the President of LBP, (Vice-Chairman); the Secretaries of Agrarian Reform; Agriculture and Labor and four other Board members appointed by the President of the Philippines to represent the Agrarian Reform beneficiaries, the landowners and the private sector. LBP is now divided into three main sectors: (i) the Agrarian and Domestic Banking Sector (ADBS), (ii) the Institutional Banking Sector (IBS), and (iii) the Operations and Support Sector (OSS). Through over 300 branches, ADBS now has nation wide cover and the relative importance of branch banking is growing. Within the branches, LBP services its two types of client (agrarian2 and commercial). IBS is still large compared to branch banking in terms of lending, and generates about 65% of loan business (down from over 80% in 1994), mainly through Head Office. OSS, which is head office based provides support to the earning parts of the bank, including manpower services, facilities management, controllership, treasury, and market research. LBP is the main financial institution in the Philippines that provides agricultural and rural credit through rural financial institutions and cooperatives to small farmers, fishermen, agricultural enterprises, and non-farm investments. Since July 1990, LBP, through its Program Lending Group (PLG), has successfully managed three bank-financed credit funds: the Agricultural Loan Fund (ALF, Loan 2570- PH), the first Countryside Loan Fund (CLF I, Loan 3356-PH), and CLF II (Loans 3938, 3939, and 3940- PH). PLG is managing not only the Bank credit funds but also those of ADB, IFAD, and OECF. It is 2 Agrarian Loan is defined by LBP as production loans made to small farmers (up to 5 hectares of land, rice and corn up to 7 hectares), who are basically agrarian reform beneficiaries. It does not include other agricultural lending which is part of LBP's commercial banking operation.  - 9 - staffed with qualified and experienced officers and management and was able over the years to deepen its exposure and experience in carrying out a wholesale banking operation. LBP is continuing to upgrade, through a regular and continuous training program, its own staff, and those of the PFIs and cooperatives. Finally, in terms of its experience, knowledge and institutional set up, LBP is qualified and suitable to implement the proposed project. Resources and Assets. LBP has substantially expanded its available resources over recent years to a total of P168 billion (US$4.2 billion) as of March 31, 1998. These comprise equity P15 billion (9%), of which P12 billion is from retained profits; GOP deposits P77 billion (46%), private deposits P44 billion (26%), bills payable (including loans from the Bank, ADB, OECF, IFAD) P18 billion (11%) and other liabilities of P14 billion (8%). On the assets side, cash and investment in Government securities together totalled P54 billion or 32% of its total assets, and net loans (including interbank loans) P98 billion (58%), investments in non govemrnent securities, (3%), bank premises and other fixed assets (3%) and other assets (4%). Lending Operations. LBP substantially expanded its lending portfolio during the last four years (1993 - 1997) at an annual nominal rate of 30% resulting in LBP's total gross loan portfolio increasing from P32.3 billion in December 1993 to P93.7 billion now (US$2.4 billion). This expansion was mainly in commercial lending (including to commercial agriculture and government agencies). Wholesale term lending under ALF, CLF I and CLF II, which uses Bank resources has grown at about 18% p.a. and now amounts to P6.5 billion or 7% of the loan portfolio. This wholesale lending has been both profitable and successful. Repayments have been excellent, and as of 1997 year end, there were no past dues from Participating Financial Institutions (PFIs). After seven years, LBP has only had one bad debt under this program, for a negligible amount of P0.5 million or less than one hundredth of one percent of the present outstanding balance. Portfolio Quality. The quality of LBP's commercial loan portfolio is about average for large commercial banks in the Philippines. Net non performing loans improved from 2.8% in 1995 to 2.3% in 1996 but declined slightly to 2.7% in December 1997. This latter figure was in line with the average for Philippine commercial banks at the same date (2.5%). However if agrarian loans3 are omitted from the analysis, LBP has fractionally less net past dues (2.49%) than the commercial banking sector average. Since 1995, the collection rate on agrarian loans and the quality of the agrarian portfolio has improved as LBP has provisioned adequately in line with the Institutional Strengthening Action Plan (ISAP) agreement under the Second Rural Finance Project (SRFP). Impact of the Recent Financial Crisis and Peso Devaluation. Although LBP has foreign exchange borrowings and deposits amounting to about US$900 million, these are fully hedged; either the funds are reinvested or relent in matching currencies, or else, as in the case of multilateral and bilateral borrowings (about US$500 million), the foreign exchange risk is borne by Government. Indeed as at mid February 1998, LBP's unhedged foreign exchange risk amounted to only US$4.2 million, or about 0. 1% of total assets. The main direct impact of the recent Peso devaluation on LBP therefore was to increase the size of both total assets and total liabilities by roughly the same amount, therefore slightly weakening its Risk Assets:Equity ratio. A second but more important point is the effect that the devaluation has had on LBP's clients and their ability to service their loans. This appears to be more problematic than the direct effect and in the period December 1997 to March 1998, the level of past dues on commercial loans has increased significantly. Overall, by March 1998, LBP's net past dues have increased to 6.2% of total net loan portfolio. 3 See footnote 2 above.  - 10- Profitability. Liquidity and Solvency. LBP has made profits in each of the past ten years, with nominal profits averaging about P1.7 billion (US$ 60 million) from 1994 -1997. Real returns to equity have averaged about 7% for the same period. In 1997, LBP's neit profit before tax of P1.7 billion was just under 1.1% of total year end assets, below the Philippine commercial bank average for 1997 of 1.64%. This lower return is because part of LBP's profit, which comes entirely from its commercial banking operations, is used to subsidize its agrarian lending. LBP has always maintained adequate liquidity, and its Risk Assets to equity ratio, has remained within the 8:1 ratio covenanted under the Second Rural Finance Project (SRFP). Outstanding Issues. Since SRFP, LBP has solved the issues which it had in relation to Land Reform Bonds and its relationship with the Agrarian Reform Fund. The main issues which it will face over the years to come are (i) increasing its equity; (ii) ensuring that the quality and profitability of the commercial loan portfolio improves; (iii) reducing the unit losses on agrarian lending (through reducing operating costs and improving revenue - better collection and higher interest rates, if possible) and increasing outreach to small farmers and rural entrepreneurs; and (iv) resource mobilization, particularly medium and long terin. These issues are addressed under the project through LBP's IDP. People's Credit and Finance Corporation (PCFC (for more details see Annex 2d) Ownership and Organizational Structure. PCFC is a govemment owned and controlled corporation registered in 1995 as a finance company with the Securities and Exchange Commission (SEC) under the Corporation Code. It is responsible for providing funds to rnicrofinance institutions for onlending to micro-enterprises in the rural areas. It is initially capitalized at P100 million by the National Livelihood Support Fund, a fund supervised by LBP. A recently passed law, Republic Act 8425, the Social Reform and Poverty Alleviation Act, has required an increase in PCFC's capitalization by an additional P 500 million to be provided by the national government over a four year period. PCFC is controlled by a Board of Directors, including three LBP officials (LBP's President sits as vice- chair of the PCFC Board), of the PCFC President, the Chairperson of the National Anti-Poverty Commission, Undersecretary of the Department of Finance and three private sector representatives, appointed by the President of the Philippines. The PCFC President who responsible for day today operation of PCFC, is assisted by two vice-presidents, one for the Operations Group and another for the Finance and Administration. Under Executive Order No. 148 and the relevant provision of Republic Act 8425, PCFC will be privatized. The law provides that when the ownership of the majority of the issued voting stocks of PCFC shall have passed to qualified private investors, it shall be considered a privately organized entity subject to the laws and regulations generally applied to private corporations. A privatization plan is currently under preparation. Resources and Assets. PCFC has resources amounting to P349.9 million as of March 31, 1998. These comprise equity P100.5 million (28.7%) of which P0.5 million is from retained earnings; bills payable (including a loan from the ADB-IFAD) P242.3 million (69.2%) and other liabilities P7.1 million (2%). On the assets side, loans receivable totaled P217.5 million (62.2%); investments in government securities P70.6 million (20.2%); deposits in banks P59 million (16.9%) and other assets P2.8 million (0.7%). As a finance company, PCFC is not authorized to mobilize deposits from the public; it can only source funds from a limited number of creditors.  - 11 - Lending Operations. PCFC operates as a wholesale lending institution for microenterprise loans. It operates two loan windows: the HIRAM (Helping Individuals Reach their Aspirations through Micro- credit) Lending Program and the ADB-IFAD Grameen Program. It has a network of 87 active conduits comprised of rural banks, cooperative rural banks, cooperatives, credit unions and credit-granting NGOs. As of March 1998, PCFC has served a cumulative total of 70,725 end-borrowers. Accumulated loan releases under HIRAM reached P 754.8 million as of end March 1998. Total loans outstanding were P213 million. Total approved credit lines under the ADB-IFAD window amounted to P 136 million for 9 conduits, but total loan releases to only P 8.5 million. Portfolio Quality. In its almost two years of operation, PCFC has maintained a high portfolio quality. It has a very high loan collection rate and has a past due ratio of only 0.78%. PCFC has adopted the standards set by BSP for non-bank and quasi-banking financial institutions and has strictly imposed the BSP general loan loss provisioning of 2%. Profitability, Liquidity and Solvency. PCFC has made nominal profits in its first two years of operations. Although nominal profits were made in both 1996/7 to 1997/8, they were insufficient to cover for inflation. Real return on equity was -3% in the year to March 1997 and -7% in the year to March 1998. The negative profitability can be chiefly attributed to the small lending volume and PCFC's relatively high operating cost. PCFC maintains a very high liquidity position. Its current ratio is 3.1:1 which provides ample room for generating a bigger volume of microenterprise loans. Its Risk Asset to Equity ratio is very conservative at 2.2:1. Outstanding Issues. PCFC is potentially a critical agency for the poverty alleviation program of the government in the countryside. To fulfill its task of providing private microfinance institutions funds for onlending to a vast number of micro-enterprises in the countryside, PCFC will need to be strengthened. Its present situation of low profitability but sound liquidity and solvency mainly reflect the fact that PCFC is a very new organization, which is still a long way from full development. Main issues to be addressed include: (i) weak equity base; (ii) inability to generate profits in real terms; (iii) need for improvement of its operating efficiency and (iv) lack of necessary personnel, inadequately trained staff and problem of retaining professional staff. These issues are addressed in PCFC's IDP. D: Project Rationale 1. Project alternatives considered and reasonsfor rejection: An alternative option for the design of this type of rural finance project, which has been used in some other countries, would have been for the Bank to lend directly to several retail financial institutions, without using the wholesale concept. Given the characteristics of the Philippine banking sector in rural areas (there are several hundred different banks which are creditworthy) such an approach would have necessarily restricted the number of potential participants. Furthermore a project which achieves only moderate cover in this way would have been costly to prepare as each of the pre-determined FIs would have needed to be appraised at the project preparation stage. Using a wholesaling approach provides every financial institution operating in the country, that meets the accreditation criteria, the opportunity to participate in the project and accommodate their own clients. Given that wholesale banking procedures have already successfully operated in the Philippines, the retail option was rejected and the project has been prepared as another wholesale operation using an existing conduit.  - 12- 2. Major related projects financed by the Bank and/or other development agencies (completed, ongoing and planned): Sector issue Project Latest Supervision (Form 590) Ratings (Bank-financed projects only) Implementation Development Progress (IP) Objective (DO) Bank-financed $100 million in 1986 (completed) Agricultural Credit Project S S $150 million in 1991 (completed) Rural Finance Project S S $150 million 1996 (ongoing, $105 Second Rural Finance Project S S million disbursed)) Other Development Agencies ADB $75 million Cooperative Credit Project ADB/IFAD $34.7 million Micro-Finance Project OECF $50 million equivalent Agriculture Credit. (completed) IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) 3. Lessons learned and reflected in the project design: The broad lessons that emerge from the review of the previous agricultural and rural finance projects are: (i) directed credit by crop or type of investments, at subsidized interest rates, did not sustain economic growth, improve credit delivery mechanism in the rural areas, or increase access of rural borrowers to formal credit facilities; (ii) heavy arrears and poor financial conditions of the apex financial institution or the selected PFIs severely constrained sub-projects' sustainability; (iii) private financial resource mobilization is extremely important for institutional sustainability and; (iv) strong financial institutions along with qualified and experienced management and staff at headquarters, branches and field offices, are crucial to project success; and (v) when interest rates either fell significantly below or moved well above prevailing market rates, serious implementation problem have emerged: above market-rates resulted in slow disbursement, while below-market rates led to concentration of credit to relatively wealthier and large clients. These lessons have been incorporated in the design of the proposed project. The ongoing Second Rural Finance Project (SRFP) is progressing well in all its components. Disbursement under the CLF II has reached about US$100 million (about 2/3 of the loans in two years after effectiveness), financing some 590 sub-projects with total investments of about P4.3 billion. With regard to the Institutional Strengthening Action Plan (ISAP), the main progress was in the performance of private sector resource mobilization and an increase in equity. KPI targets for the period have largely been met. The specific lessons learned from the ongoing SRFP and incorporated in the proposed project are: (i) due to the volatility of interest rates it is necessary to shorten the period in which the market reference rate is being calculated from one quarter to at most a monthly basis in order to better reflect the market; (ii) the premia for conversion from variable to fixed rates and the associated prepayment penalties require regular review and adjustment, if warranted; (iii) accreditation criteria for PFIs, particularly the cut off points, need to be periodically reviewed and adjusted to market conditions; (iv) within the institutional development plan (IDP), more attention should be given to the lending concentration issues and collection matters; and (v) IDP targets should be reviewed and updated more often than in the past to reflect better the new challenges and issues that LBP needs to cope with.  - 13 - 4. Indications of borrower commitment and ownership: The proposed borrower, LBP has requested this project. It has a very good record of project implementation, has achieved substantial institutional growth, and has excellent operational relationship with the PFIs. All project preparation relating to LBP activities including the drafting of the related policy manuals, are being undertaken by the borrower, through its Program Lending Group which is headed by a Vice President of LBP. PCFC, which would implement the comparatively small (US$5 million) Micro-finance Component is a relatively new agency which falls under LBP supervision. It has indicated commitment to the project by participating fully in the detailed preparation of the Micro- finance component, including the drafting of a policy manual and its Institutional Development Plan. 5. Value added of Bank support in this project: The Bank's ongoing program of Adjustment and Policy based lending seeks to help the government establish a stable macro-economic and financial environment through balance of payments and budgetary support. The latest element of which is the proposed Banking System Reform Loan (BSRL). Expansion of the regular lending program to include this project would complement the measures to be undertaken under the BSRL and would address the constrained availability of term credit for the private sector and assist in institutional development of the credit delivery system. Before the crisis, the local financial market had started to develop confidence in term credit due to strong economic and business prospects in the real sector and macro-economic stability, brought about by a decade of structural reforms. The financial crisis has brought severe credit problems, forcing rationing and shortening of loan horizons. Making available lines of credit for longer term loans which private credit markets are loathe to provide at present will help restore confidence in the financial markets and address the liquidity and working capital constraints currently faced by the business sector. Despite the limited size of the proposed project, compared with the overall need for term credit to the rural sector, a new loan of this type from the Bank would be an important signal for restoring investor confidence in Philippine markets. In addition, the progress that LBP has made in developing itself as an independent financial institution in the nineties is to a large extent due to its association with the Bank. This development would be further enhanced through the proposed project. The proposed project fits comfortably within the agreed framework of Bank assistance to the Philippines. It is in line with the need to expand the Bank's regular lending program in the rural sector in response to growth opportunities. In addition, it addresses the critical but temporary difficulties of firms that remain economically viable but face financially-related problems brought about by the volatility of both the exchange rate and interest rates and a degree of market failure in the financial sector. Finally, its micro-finance loan package which is designed to address unfulfilled demand for credit by micro-and-small scale enterprises provides strong support to the Banks commitment to poverty alleviation. The Bank's contribution to the institutional strengthening component (although not financed by it) was critical under SRFP. By its involvement in this project, the Bank would be able to continue to support the further institutional strengthening for LBP which has become increasingly important as a result of the financial crisis. Furthermore, through involvement in this project the Bank would be in a position to make a ground breaking contribution to the development of a wholesale micro-finance institution, with the good possibility that far reaching lessons on the successful implementation of this type of operation could be learned.  - 14- E: Summary Project Analyses (Detailed assessments are in the project file, see Annexes 4 and 2e). 1. Economic The likely impact of the project on the economy as a whole would be that it would contribute toward maintaining growth and as a result help to boost confidence. The additional availability of medium term finance at market rate, will help ensure that viable firms would be able to finance their continuing operations. Without this financing, some of these viable firms might have been forced to retrench as a result of their banks trying to become more liquid. Given that the fiscal impact of the project is likely to be positive (see below), government has a strong incentive to guarantee a loan of this type. As this is a credit operation, with no predetermination of investment, no quantitative assessment of the likely economic rate of return has been made. All sub-projects will be screened for ex ante financial viability (see below). The level of price distortion in the Philippines is not high (and is decreasing). Consequently, there is a reasonable expectation that the investments financed under the project would show sound ERRs, particularly those involved with job creation in the rural areas, where the shadow price of labor is well below the financial price. 2. Financial (see Annex 4): Fiscal Impact: As the project would be implemented by government corporations (LBP and PCFC) and the private sector, it would not require any Government counterpart funding. The actual cash flow to Government depends on future inflation and interest rates, but in the base case, assuming a 12% Thill rate, 7% inflation and a nominal 6% cost of WB finance the the net cash flow to Government estimated to rise from about P50 (US$1.1 million) in year one to about P720 million p.a. (US$14 million) by year five, before falling as the foreign exchange risk fund becomes drawn on (For details, see Annex 4). Direct inflows would include a Guarantee Fee of 1% p.a. (about US$ 1.5 million per year once funds are fully disbursed) and adequate4 foreign exchange risk coverage fees, averaging about 3.3% of the outstanding balance. In addition, under present legislation there would be gross receipts tax of 0.65% p.a.on the loan from LBP to the PFI and about a further 1% on larger loans to sub-borrowers (together totalling about US$2.2 million p.a. by year 5). In addition, Government would benefit from incremental taxes (currently at 34%) on the incremental profits of LBP, PCFC, the PFIs and the sub-borrowers. Total, incremental taxes on incremental profits are estimated to amount to about US$7 million p.a. at full development. Sub-borrowers: The project would provide credit assistance to sub-borrowers in supporting their investment which in turn would contribute to improvement of their business activities and/or welfare. The main financial impact of the project results from about $210 million of investment under the first round use of credit by small and medium sized rural based private businesses. These sub-projects will all be assessed as financially viable prior to investment and the ongoing interest rate to them will be market based (likely to be of the order of 7-10% in real terms). Consequently, only sub-projects which show sound ex ante financial rates of return will be supported. Under the similar CLF I and CLF II programs, ex ante financial rates of return have typically been in the 15% to 30% range, and similar results for SME investment would be expected under this project. Micro finance sub-borrowers would 4 On the basis that the differential between real Peso 91 day Thill rates and real WB dollar lending rates remains the same as the average of the past five years, the FX fee paid to Government would be about 25% higher than needed to compensate for currency depreciation, assuming that purchasing power parity between the Peso and the dollar were maintained (see Annex 5(d).  - 15 - receive credit which would otherwise have been unavailable. Investments under this component would normally be in fast turnover items. PFIs: The project would have a positive impact on the profitability of PFIs because they are free to set their own spreads, and therefore, provided their managements' judgments are good, they would only participate in the project if they perceive it as profitable. As it would be a repeater project for most PFIs they would have a reliable basis for this. Participating in the project would also help to improve the liabilities side of PFIs' balance sheets, in that it would increase the average maturity of their resources. LBP & PCFC. The project would contribute towards the profitability of both these institutions. In LBP' s case, based on performance under CLF I and II, the incremental contribution to profitability is likely to be of the order of P70 million per year (US$ 1.4 million). Projections for PCFC indicate that on-lending these funds will contribute about P4 million (US$80,000) annually to its profit at full development. 3. Technical: Most of the project is a repeater type operation with no significant technical impact or risk. The Apex, the PFIs and the sub-borrowers would all be operating in areas in which the technology is known. The one new area, which involves about 3% of the project cost is the wholesale micro-finance component. This is technically new in the Philippines, and the project will be breaking new ground in this regard. 4. Institutional: Because of IDPs for both LBP and PCFC, the Project will have an important impact in strengthening those institutions. LBP is a capable institution which has handled previous wholesaling projects well. The institutional strengthening would be geared towards its other operations (commercial, retail and- agrarian lending) and includes assisting in its maintaining a sound financial condition in the face of the currency crisis and ensuring that prudent levels of earnings are retained in the face of pressures from Government (LBP's shareholder) to pay more dividends than would be commercially justified. PCFC is a new institution, and its strengthening would be directed towards developing of its effectiveness as a wholesale finance institution through which funds can be efficiently channeled. 5. Social: The project is expected to have a positive impact on employment. Indications from CLF II are that incremental employment is generated based on an investment of about US$10,000 per job. Consequently, some 20,000 incremental jobs could be expected from the CLF III component. In addition, the provision of critical financial support to economically sound, but financially distressed businesses would be important in reducing business closures and associated layoffs. The PCFC component would be expected to have a significant impact on poverty alleviation through making credit available to micro-enterprises. This would have a particular effect on underemployment through borrowers being able to make more profitable use of their own time and to a lesser extent, hire part time labors. In line with other micro finance initiatives, it is anticipated that the majority of beneficiaries from this component would be women.  -16- 6. Environmental assessment: Environmental Category [] A [x] B [ ] C Adequate arrangements and procedures would be maintained to ensure that sub-projects with adverse environmental impact will not be financed under the project. LBP will specify that sub-borrowers for CLF mI funded projects would comply with all laws and regulations of the Philippines related to environmental protection, consistent with environmental guidelines of the Bank. LBP would be in charge of supervising compliance. To reduce the risk that sub-projects with undesirable environmental or social impacts would be financed by CLF, the following measures would be taken. The existing procedures and guidelines agreed under SRFP among LBP, the Department of Environment and Natural Resources (DENR), and the Environmental Management Bureau (EMB) would prevail and be applied under the proposed project. All sub-projects would comply with the Presidential Decree 1586 and its related regulations, which describes the Philippine environmental legal requirements for new investments. For the following generic sub- projects: poultry and piggery, agro-processing, land clearing, and fish and pond development, and any other sub-project as the Bank may require, an Environmental Impact Statement (EIS), as required by the above Presidential Decree and in line with the guidelines established under SRFP, would be prepared. The Environmental Unit (EU) of LBP would provide LBP, PFIs, and related sub-projects with environmental technical assistance and coordination services. To enable performance evaluation in respect to environment, the EU will conduct, on a spot check basis, environmental audits of the projects endorsed. These should be done in the presence and assistance, to the extent possible, of the PFIs. The higher of 10% of the approved sub-projects which require environmental clearance, or 50 sub-projects would be audited and the level of compliance is expected to be no less than 80%. For more details see Annex 2e. 7. Participatory approach The primary project beneficiaries are the sub-borrowers, the PFIs (including commercial banks, thrift banks, rural banks, micro-finance institutions and NGOs) LBP and PCFC. During the course of preparation, Bank Staff met with representatives of all of these groups to discuss the Project concept and to try to ensure that project design was in line with their needs and that the proposed procedures were well understood and acceptable. No controversial issues arose. Full stakeholder participation is assured as the project is a demand driven operation and as investments under the project are entirely determined by the participants themselves on a commercial basis. F: Sustainability and Risks 1. Sustainability: Sustainability of the CLF III operation depends on the profitability of the program to the sub-borrowers, PFIs, MFIs, PCFC, and LBP. In the long term sustainability would also require the effective mobilization of term resources to substitute this proposed loan when it becomes repaid. Medium term sustainability is highly likely. * Experience from the ALF, CLF I and II operations has shown that the type of term financing available is attractive to sub-borrowers, the majority of which would be expected to make profitable use of the available funds. The fact that loans are fully collateralized would mean the small proportion of sub projects which went wrong would not jeopardize program sustainability. * LBP is a financially sound and well established institution with qualified management and staff. It can therefore be expected to remain in a financial condition which allows it to continue to effectively implement this type of wholesale banking operation.  - 17 - * The program requires an adequate number of active PFIs. There are now about 120 PFIs accredited with LBP, some 50 of which are active under CLF I and II. They are quite conservative in their lending decisions and will be likely to select only viable and creditworthy sub-projects. Inevitably, over the course of the project, poor results from individual PFIs would cause some of them to lose their accreditation: however, these would be substituted by others. 2. Critical Risks The main risk to the success of the CLF III operation is associated with the possible deepening of the financial crisis to a level which would substantially curtail the ability of LBP and the PFIs to carry out this project. Under severe crisis, credit demand from sub-borrowers would also be substantially dampened, and rapidly changing conditions could cause investments which ex-ante were viable to become losers ex post. Overall this macro-economic risk, which is directly related to the overall performance of the economy appears acceptable, but the perception of it could change quickly over time. Therefor it will be important to reassess it if there is any delay in project processing. Another concern on the implementation side is that the introduction of agreed policy measures could be thwarted or postponed by political considerations, thereby weakening LBP as a financial institution and reducing its capacity to effectively implement both the lending programs under the project and its own institutional strengthening action plan. Risk Risk Rating Risk Minimization Measure Demand for credit under CLF III may decrease due to M CLF III Funds under the project deepening of the financial crisis and PFIs may become would be made available at market extremely risk averse. As a result, the loan may not be rates, but with longer term than utilized on time. generally available. This should keep them attractive - for reinvestment or restructuring - if not for new investment. PFIs and potential sub- borrowers have indicated strong demand for long term funds which is confirmed by the uptake rate of CLF II. Political interference in LBP's lending operations and M LBP is a fully autonomous bank. Past policy decisions may prevent full IDP implementation. experience does not indicate Govt. intcrference in its lending decisions to SMEs. There may be opposition to some of the IDP measures, particularly prudent linkage of LBP's dividends (to Govt.) to profit in real terms. This is dealt with through specific loan covenant. PCFC may not achieve the necessary volume of lending N Focusing PCFC's IDP towards to allow it to have low enough unit costs to be an effective market development and effective wholesaler training of MFIs. Overall Risk Rating M Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N (Negligible or Low Risk)  - 18- 3. Possible Controversial Aspects The project proposes to finance economically viable businesses which are under financial stress. This would include the finance of working capital, and would have the effect of lengthening the maturity of sub-borrowers' debts. While this is unusual for a Bank project, it is a timely response to the financial crisis and responds to the perceived needs of SMEs in the Philippines. G: Main Loan Conditions 1. Effectiveness Conditions: * The approval by LB's Board of: (i) the Institutional Development Plan (IDP); and (ii) the Policy Manual for CLF III. 2. Conditions for Disbursement * The signing of a Memorandum of Agreement satisfactory to the Bank between LBP and PCFC to reflect the detailed arrangement regarding the operation and obligations associated with MLF. * The approval by the PCFC Board of (i) its IDP along with the related time table; and (ii) the Policy Manual for the Micro-Finance operation. 3. Other Conditions * LBP would exclude itself from retailing the CLF III except for up to US$15 million which would be used to accommodate LBP's own clients whose operations are viable but under financial distress. * LBP would operate CLF on a commercial basis and the latter's net profit would remain within the Fund as LBP's investments. * LBP would submit to the Bank: (i) quarterly progress reports with regard to the CLF Im component two months after the end of each quarter, i.e. on February 28, May 3 1, August 31, and November 30, of each year commencing with May 31, 1999 ; and (ii) semi-annual report with regard to the IDP on March 15, and September 15, each year, commencing on September 15, 1999; (iii) a mid-term review on project implementation and operational issues on March 31, 2001; and (iv) LBP's written contribution to the project's Implementation Completion Report within six months after the loan closing date. * LBP and the CLF III accounts would be annually audited. The annual audit would be conducted by an independent auditor acceptable to the Bank and would follow Terms of Reference (TORs) in accordance with appropriate auditing principles, as approved by the Bank, and such audit, along with auditors' report on LBP, CLF III, the Project's Special Account, and Statements of Expenditure related to project activities would be submitted to the Bank within six months after the end of LBP's fiscal year. * LBP would follow existing guidelines and procedures for environmental protection and would take the necessary actions as detailed in Chapter E6 of the PAD and Annex 2e.  - 19 - * The project annual training program would be submitted for Bank review by November 30 of each fiscal year commencing on November 30, 1998. * LBP would maintain the following financial indicators: equity to risk assets would not be less than 10%, the liquidity ratio would be not less than 45% of short term liabilities, and net past due loans to equity of not more than 33% commencing on January 1, 1999, not more than 30% commencing on July 1, 1999, and not more than 25% commencing on January 1, 2000. * LBP would take all the necessary actions to ensure that dividends would be paid only on profit in real terms (after provisions for possible loan losses and adjustment for the impact of within year inflation). * The Policy Manual (PM) for the CLF III would be issued, incorporating agreement with the Bank as noted below. Further changes in the PM would not be made without the Bank's prior concurrence: (i) Eligibility criteria for CLF III including minimum funding requirements and equity contribution of PFIs and sub-borrowers as discussed in Annex 2b of the PAD; (ii) Interest rates structure as discussed in Annex 2b of the PAD; (iii) PFIs Accreditation Criteria; (iv) Sub-project appraisal and computation of ERR and FRR; (v) Sub-project review, disbursement and supervision; (vi) Sub-loan maturity; (vii) Conformity with environmental laws and regulations; (viii) Principles regarding acquisition of land and compensation therefor. PCFC * PCFC would exclude itself from retailing the Micro-finance Loan Funds (MLF) and would operate the MLF on a commercial basis and the latter's net profit would remain within the MLF as PCFC's investment; * PCFC's dividend payments would be made only after: (i) allowing adequate provisioning for loan losses, (ii) adjusting for the impact of within year inflation, and (iii) when profits allowed, retaining earnings at a level equal to at least 15% of the growth of PCFC's loan portfolio; * During project implementation PCFC would maintain the following financial ratio: (i) risk assets to net equity of not more than 7:1, (ii) a maximum of net past due to equity of not more than 15%, and (iii) liquid assets to short term liabilities of at least 25%; * PCFC would submit to the Bank (i) quarterly progress report with regard to the MLF component two months after the end of each quarter, i.e. on February 28, May 31, August 31, and November 30, of each year commencing on May 31, 1999; (ii) semi-annual report with regard to the IDP on February 28, and August 31 of each year commencing on August 31, 1999; (iii) a mid-term review on project implementation and operational issues on March 31, 2001; (iv) audited accounts along with auditor's report on PCFC, and statements of expenditure related to project activities within six months after the end of PCFC's fiscal year; and (v) part two of the component's Implementation Completion Report within six months after the loan closing date.  - 20 - * PCFC would follow existing guidelines and procedures for environmental protection and would take the necessary actions as detailed in Chapter E6 and Annex 2e of the PAD. * The PCFC training program would be submitted for Bank review by November 30 of each year, starting November 30, 1999. * Policy Manual (PM) for the MLF would be issued, incorporating agreement with the Bank as noted below. Further changes in the PM would not be made without the Bank's prior concurrence: (i) Eligibility criteria for borrowing under the MLF including minimum funding requirements and equity contribution of accredited conduits and sub-borrowers as discussed in Annex 2b of the PAD; (ii) Interest rates structure as discussed in Annex 2b of the PAD; (iii) Conduits Accreditation Criteria; (iv) Sub-project appraisal; (v) Sub-project review, disbursement and supervision; (vi) Sub-loan maturity; (vii) Conformity with environmental laws and regulations. H. Readiness for Implementation The Program Lending Group (PLG) of LBP, has been in operation since July 1990. The PLG has managed successfully three bank-financed credit funds: the Agricultural Loan Fund (ALF, Loan 2570- PH), the first Countryside Loan Fund (CLF I, Loan 3356-PH), and CLF II (Loans 3938, 3939, and 3940- PH). PLG is managing not only the Bank's credit lines but also those of ADB, IFAD, and OECF. PLG is adequately staffed with qualified and experienced officers and management and was able, over the years, to deepen its exposure and experience in carrying out a wholesale banking operation. Finally, in terms of its experience, knowledge and institutional set up, LBP is qualified, suitable, and ready to implement the proposed project. T. Compliance with Bank Policies This project complies with all applicable Bank policies, i.e. OP and BP 4.01 on environmental impact, OP and BP 10.02 on financial management, and OD 8.30 on Financial Intermediary Lending. Task Team Leader: Arie Chupak Sector Manager: Geoffrey B. Fox Country Director: Vinay K. Bhargava  - 21 - Annex la Project Design Summary Philippines Third Rural Finance Project Narrative Summary Key Performance Indicators Monitoring and Critical Assumptions Evaluation Sector-related CAS Goal: (CAS Objectives to Bank Mission) (a) improve private business (a) Policy, regulatory, and (a) Govt. laws, Govt remains environment including institutional framework regulations, and committed to a market availability of medium and long becomes more conducive for procedures introduced. driven financial sector term financing.; private sector activities and banks' sound development.; (b) Alleviate poverty (b) Poverty incidence has been (b) Progress reports on (b) Govt. remains reduced. poverty. committed to poverty reduction. (Development Project Development Objectives to CAS Objectives Objectives) (a) provide financial support to (a) LBP and PFIs increase (a) LBP's quarterly and (a) private sector will the rural economy to overcome term lending to private semi annual reports as positively respond to the difficulties created by the enterprises in the rural areas; well as BSP statistics; the new framework and regional financial crisis and increased resource augment the CLF to finance availability; LBP viable investments in the rural continues not to be areas; subject to undue political pressure with regards to its operational policy. (b) assist the government in its (b) PCFC and MFIs to increase (b) PCFC's quarterly (b) There is strong efforts to alleviate rural poverty lending and providing financial. progress reports. underlying demand for through the provision of financial services to micro-enterprises micro-finance; Govt and institutional support to the facilitates institutional country's micro-finance system. development of PCFC. Project Outputs (Output to Development _________________________ ~~Objectives) Lending to viable economic * Total investments of sub- M&E would be regularly The economy remains entities in the rural areas to projects. undertaken by the LBP sufficiently bouyant for improve their economy, increase * Number of sub-projects and PCFC and be well run enterprises to employment opportunities, and financed. reviewed by Bank be financially sound. thus indirectly contribute to * Increase in employment. missions. poverty alleviation.  - 22 - Providing micro-finance on a * Number of micro enterprises commercial basis which would financed under the project directly assist micro enterprises and their total investments. and alleviate poverty. PCFC continues to Strengthening PCFC as the * PCFC operates effectively, enjoy Govt support and wholesale micro-finance meets growth targets and is is able to raise adequate institution. financially sound. equity. The effect of the Strengthening LBP as the main * LBP increases its outreach to financial crisis on financial institution serving the rural areas, improves its LBP's borrowers does rural areas. operational efficiency and not have an excessively remains financially sound. adverse effect on LBPs own financial condition. LBP continues not to be subject to undue political pressure with regard to its interest rate, lending and dividend policies. Project Components (Components to Outputs) CLF HII * Number of loans. Program Lending Group Strong private sector * Total sub-project of LBP. demand for CLF investment. resources. * Estimated incremental jobs created. Micro-Finance * Number of sub-borrowers PCFC Strong MFIs and sub- * Volume of Loans Provided borrowers demand for *:PCFC's operating costs micro-financing. * PCFC real increase in equity. LBP ID)PI * Real-profitability and CORPLAN of LBP. Management and staff increase in equity. commLitted to IDP's * Improvement in quality of targets. Commercial Lending, * LBP's SDI. * Proportion of private V deposits. * LBP's agrarian lending costs.  - 23 - Annex lb Philippines Third Rural Finance Project Key Performance Indicators Key Performance Indicators (KPIs) have been developed both to measure the effectiveness of the Credit Components and the IDPs for both LBP and PCFF. Credit Component On the Credit component, KPIs for CLF III measure (i) the investment made under project sub-loans, which is a proxy for its economic impact, (ii) the number of sub-projects financed, which indicates the degree to which the project has widened its outreach and (iii) ex ante assessment of incremental employment, which is an indicator of the social benefits achieved. KPIs for the MLF would measure (i) the number of subloans and (ii) amount of loan releases. Institution Building. LBP's IDP is aimed at (i) maintenance of LBP's solvency & liquidity; (ii) ensuring LBP's sustainability and profitability, (iii) taking steps to make Agrarian Lending becomes more important and more sustainable, (iv) improving the quality of commercial loan portfolio; and (v) resource mobilization. * Achievement of (i) will occur if LBP adheres to the various indicators which are included in the IDP and in some cases form loan covenants viz: Risk assets:equity ratio less than 10:1, Liquidity above 45%; Net non performing loans to equity ratio less than 25%, provisions to at least meet an agreed formula related to levels of past dues and restructured loans. * Sustainability and profitability are important areas,.and KPIs are established for both. - real rate of return on capital as a profitability measure, and LBPs Subsidy Dependency Index (SDI)'as an indicator of sustainability. * There are many factors required to make agrarian lending more sustainable and important. Targets for these include: Agrarian lending to reach 15% of loan portfolio by 2002 Real growth of agrarian lending to exceed 10% p.a. Current collection rate from co-ops to exceed 90% Provisioning formula to be met Agrarian operating costs down to 6% by 2002 Necessary agrarian provisions down to 4% by 2002 Interest collection on agrarian lending to increase to at least 10.5% on net loans by 2001. To take account of these, a composite KPI for agrarian lending is set, based upon parameters set out in Appendix A. In addition, the Agaraian SDI is targetted to fall to 150%, by year 5. A  -24 - figure that implies that if the opportunity cost of funds is taken into account, the income from agrarian collections would need to increase by 150% for there to be no subsidy. * Measures to improve commercial loan quality (relating gross and net past dues to total portfolio and on reduction in loan concentration) are included in the IDP, while the relationship between net past dues and equity will be covenanted under the loan. * KPIs are set to measure both the proportion of private deposits and the improvement in maturity of resources. The success of PCFC's IDP will be monitored through its achievement of an adequate capital increase, the reduction in its operating costs and the achievement of real profis within three years. Key Performance Indicators LBP (Jan - Dec Year) 1999 2000 2001 2002 2003 PCFC (Apr - Mar Year) 1998/99 1999/00 2000/01 2001/02 2002/03 Indicator CLF Lending Number of Sub-Loans (Cumulative) 60 180 380 550 700 Amount of Sub-Project Investment (P M) 2,200 4,300 6,300 7,700 8,500 Estimated Incremental Jobs (Cumulative) 800 3,000 7,000 11,000 15,000 MLF Lending Number of Sub-Loans (Cumulative) 500 1,400 2,600 3,700 4,800 Volume of Sub-loans ex reflows (P M) 50 125 200 230 230 Strengthening LBP Profit in Real Terms (+ve ROE) No target 2% 3% 5% 7% SDI to be less than No target 0 -2% -3% -3% Proportion Private Deposits 30% 35% 40% 45% 50% % of Peso liabilities with over 1 yr maturity 5% 6.5% 8% 10% 12.5% Agrarian Index (see appendix A) 50 65 70 80 90 Agrarian SDI lower than 225% 200% 180% 160% 150% Strengthenina PCFC Increase in Capital - Net Equity (P Million) 200 200 250 300 350 Operating Costs as % Average Net Loans 5.5% 5.0% 4.7% 4.6% 4.5% Real Return on Capital No target No target positive positive positive Proiect Classification at Mid-Term and Completion Reviews At completion and mid-term reviews, the project's outcome will be classified as 'Highly Satisfactory', 'Satisfactory', 'Unsatisfactory' or 'Highly Unsatisfactory', depending upon the extent to which it has reached its objectives. It is proposed to use criteria based on the Key Performance Indicators (KPIs) as a major input in making this classification. Consequently, 70% of the project's classification will be determined by achievement of the pre set indicators shown in Appendix B, and 30% based on the qualitative asessment of the Mid-Term and the Implementation Completion Reporting teams. This latter assessment will pay particular attention to the achievement of improved confidence of the Banking  - 25 - System, the way in which LBP has adapted to change over the project period and the overall management of the project. Calculation Details. Calculation would be done by assigning a weighting of 70% to the actual KPI achievement and 30% to the qualitative assessment. Assuming that the project were rated as Satisfactory on the qualitative assessment and that the achievement of KPIs were as in the example given in Appendix B, the calculation would be as follows. With a weighted average score of 2.9, the project would be classified as Satisfactory. Weighting Numerical Grade in Weight Score in Example times Example Score/Grade Objective KPI Achievement (see Appendix B) 70% 2.88 2.016 Qualitative Assessment of ICR Mission on other 30% S = 3.0 0.900 factors__ _ _ _ _ _ __ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Total 100% 2.916 Note: HS = 4; S = 3; U = 2; and HU =1.  - 26 - Appendix A. KPI Scoring for Agrarian Lending To become More Important and More Sustainable Net Agrarian Loans as Proportion of net Basis under 10% 10 - 12.4% 12.5 - 15% + Loan Portfolio 14.9% Score 0 5 8 10 Real Disbursement Growth over Previous Basis zero or neg 0 - 4.9% 5 - 9.9% 10% & Year over Score 0 5 10 15 Current Collection Rate from Co-ops based Basis below 70% 70 - 79% 80 - 89% 90% + on one year earlier releases Score 0 5 10 15 Provisioning Formula to be Met Basis Not Met Met Score 0 10 Agrarian Operating Costs (excl provisions) Basis 12.1% + 9.1 - 12% 6.1 - 9% 6% & as percent of Av Net Outstanding Loans under Score 0 5 10 15 Annual Provisions needed to meet formula Basis 10.1% + 7.1 - 10% 4.1 - 7% 4% & as % of Av net outstanding loans under Score zero 10 15 20 Actual Interest Rate on Agrarian Loans - Basis below 8% 8 - 9% 9 - 10.4% 10.5% + Collections of interest (include service charge)/Av Net Outstanding Loans Score 0 5 10 15  ANNEX B Key Performance Indicators at Mid Term and Completion Mid Term Completion Importance Benchmarks for Mid Term Benchmarks for Completion Example at Complton Target Target Weighting if less than target if less than target Actual Bank Numerc Grade 2000/01 2002/03 A B A B Out-tumr Grade Grade X Weigo INDICATOR CLF Lending Amount of Sub-Project Investment (P M) 6,300 8,500 15.0% 4,200 1,200 7,000 4,000 9o0o HS 4 0.6 Max % CLF li Loans Past Due 2.5% 1.5% 15.0% 3.0% 6.0% 2.0% 4.0% 3% U 2 0.3 Estimated Incremental Jobs (Cumulative) 7,000 15,000 10.0% 4,000 1,000 8,000 2,000 9000 S 3 0.3 MLF Lending Number of Sub-Loans (Cumulative) 2,600 4,800 2.5%/o 1,500 600 3,000 1,200 2000 U 2 0.05 Max % Past Due Loans 2.0% 2.0% 2.5% 3.5% 7.0% 3.5% 7.0%o 3.0% S 3 0.075 Strenathening LBP Profit in Real Terms (+ve ROE) 3% 70% 10.0% 2.0% -2.0% 4.0% 0.0% 6% S 3 0.3 SDI to be less than -2% -3%/6 10.0% I 0.0% 10.0%