Page 1 PROJECT INFORMATION DOCUMENT (PID) APPRAISAL STAGE Report No.: AB2372 Project Name China: Commercially Sustainable Micro and Small Business Finance Region EAST ASIA AND PACIFIC Sector Micro- and SME finance (90%); Banking (10%) Project ID P096285 Borrower(s) MINISTRY OF FINANCE OF CHINA Implementing Agency The Ministry of Finance Sanlihe, Xicheng District Beijing100820 Tel: 86-10-6855 1124 Fax: 86-10-68551125 Email: jk.wu@mof.gov.cn China Development Bank No.29 Fuchengmenwaidajie Xicheng District Beijing 100037 Tel: 86-10-6830 7209 Fax: 86-10-68307214 Email: tanbo@cdb.com.cn Environment Category [ ] A [ ] B [] C [X] FI [ ] TBD (to be determined) Date PID Prepared June 21, 2005 Estimated Date of Appraisal Authorization October 30, 2006 Estimated Date of Board Approval February 12, 2007 1. Key development issues and rationale for Bank involvement Despite spectacular achievements, China is confronted with many challenges in maintaining sustainable economic growth, protecting the natural resources and environment; and addressing the rising economic, social and regional inequalities. To meet these challenges, China needs to diversify the sources of economic growth and raise the efficiency of resource allocation, preferably to those that contribute to employment without exerting undue pressure on the already strained environment and heavy demands on natural resources. One potential source for growth is micro, small and medium enterprises (MSMEs), which have contributed importantly to GDP growth, job creation and export earnings. Within the MSME sector, micro and small enterprises (MSEs) will play an indispensable role in meeting these challenges. Promoting MSEs, the majority of which are privately owned, is a government priority in the drive to build a well-off and harmonious society. While MSMEs as a whole remain credit constrained, it is the MSEs that have over time become the forgotten segment. Banks have tended to consider enterprises in the upper end of the SMEs Page 2 2 as more bankable, and microfinance (especially in the rural area) has at least received attention from NGOs and donors. The reasons behind the lack of access to finance by MSEs are numerous and complex. One is that Government officials and banks in China share an entrenched perception that lending to MSEs is inherently risky, in part because past attempts at reaching out to MSEs resulted in unacceptably high losses by banks. Another is a long-standing credit culture biased towards collateral and guarantees. Lacking the ability to process the soft information that is characteristic of MSEs, banks rely heavily on collateral and credit guarantees. Regulatory policies also perpetuated the “collateral worship” as non-secured lending was discouraged. As most MSEs do not possess the kind of collateral required by banks and have difficulty arranging for guarantees, MSE lending became either an impossible or extremely costly proposition. Evidence from a number of countries indicates that a diversified portfolio of MSE loans can often be less risky than a concentration of large loans. 1 The persistence of the misperceptions in China risks both undermining appropriate policy decisions and skewing the design of government interventions to promote access by MSEs to the capital necessary to grow, create new jobs and improve incomes. 2 China faces a related challenge to commercialize the banking system. Commercializing the banking system will also require that banks differentiate themselves strategically. Most banks pursue lending to large and state-affiliated firms and the intense competition has led to under- pricing of credit risk in general. Increased competition resulting from financial liberalization is expected to push many banks towards the lower end of the market. Thus, MSE lending could serve as a key component of new business strategies for many banks in China. But to be successful, they need to adopt lending technologies more suited to MSEs. In the past, banks tended to apply the same corporate lending techniques to micro and small lending, only to find non-performing loans on the rise, which served to further entrench the notion that MSE lending was risky. The overemphasis on collateral constrains the availability of credit to MSEs which cannot meet banks’ and supervisors’ collateral requirements, regardless of whether their cash-flow is adequate to service bank loans at commercial rates of interest. This situation is changing. In recent years, financial sector reform has progressed considerably, and banks have become more commercially oriented. Bank supervision and financial policies have also improved. Lending interest rates have been largely liberalized, and banks are now encouraged by the authorities to lend to MSEs. In line with the priority the Government attaches to MSE development, and now that the necessary policies are in place, it is important to launch an MSE lending and bank capacity building project aimed at improving the market potential in China, adopting tried and tested 1 As an example, the EBRD small business program, as well as the Procredit Banks in Europe and Central Asia, have built an impressive track record of lending to small businesses with low delinquency, default and loss rates. 2 Additional areas that require attention include overhauling and expanding the existing credit information registry system, various loan guarantee schemes and institutions, and various subsidized lending programs. Page 3 3 techniques. 3 It is also important to imbed these practices and approach in an institutional framework that can enable eventual nationwide rollout and scaling up. The proposed project will provide this vehicle and attempt to address the above constraints to MSE finance. At the same t ime, it will contribute to reinforcing the Government’s policy objective of encouraging flows of funds to emerging private entrepreneurs and small enterprises. The Government therefore attaches a high priority to the project and has included the proposed loan in its three-year borrowing plan from the Bank. The proposed project has developed from the Bank’s financial sector work program, designed to assist China in reform and development of the financial sector. Bank’s advocacy for commercially sustainable microfinance has been an integral part of this program. Furthermore, through deep engagement and continued dialogue with the authorities, the Bank has established substantial credibility and is ideally placed to play a lead role in supporting a specific operation to promote bank lending to MSEs. The Bank’s involvement in the proposed project will further advance work in this area. Through the project the Bank will help develop an appropriate mechanism for channeling funds; ensure access to high quality technical expertise; continue to engage relevant stakeholders in the policy dialogue necessary to create an increasingly facilitative regulatory environment; and work with partners to ensure adequate monitoring, evaluation and propagation of the learning and experiences inherent in the project. 2. Proposed objective(s) The proposed project will support the Government’s priority program to catalyze the expansion of commercial lending to the emerging segment of MSEs that are strongly competitive and privately owned, but in need of funds for working and investment capital. The project also aims to strengthen the capacity of banks to provide lending to MSEs on a mass-market and profitable basis. The ultimate objective is to promote expansion of private sector MSEs across China, and the potential resulting increases in job creation, income growth, and poverty reduction. These objectives are fully consistent with the Country Partnership Strategy for 2006-2010, Report No. 35435, discussed by the Board on May 23, 2006. The proposed project will contribute to Pillar 4 of this strategy: financing sustained and efficient growth . Specifically it will contribute to deepening financial intermediation by expanding access to financial services, through the establishment of a sustainable mechanism of financing for MSEs. By improving access to financial services for this fast growing segment of the economy, the project will play a role in helping the MSEs build assets and increase incomes, thus contributing to employment generation and hence poverty reduction. 3. Preliminary description The project will finance a line of credit to the China Development Bank (CDB) (estimated at $100 million, $90 million of which will be used for on-lending and $10 million for technical 3 Over the last decade a large number of multilateral donors, NGOs and quasi-official institutions have been operating pilots to promote access to credit, mostly by poor households but also MSEs. These programs have experienced a range of outcomes in terms of repayment rates. Few, if any, have proven commercially sustainable and none is scaleable. Page 4 4 assistance). Under the project, CDB will establish and build a business unit and business line designed to achieve the objectives of the program, and will utilize its own financial resources in addition to the Bank loan proceeds in order to increase the impa ct of the project. CDB’s business line will involve lending to partner banks and other financial institutions (“lending partners”) for the purpose of on-lending to the target clientele, as well as arranging for technical support to lending partners to ensure they have the institutional capacity to make a high volume of loans to small businesses on a commercially sustainable basis using the business practices and lending technologies to be promoted under the program. 4 Lending partners are envisioned to include both existing commercial banks and possibly greenfield microfinance institutions that are emerging as a result of recent changes in regulatory policies. 5 Consistent with CDB’s role and its financial sector development strategy, under this project CDB does not intend to engage directly in small business lending, but rather will launch and nurture the development of this new market with the goal that lending partners (commercial financial institutions) will increasingly engage in the conduct of the business. The project has an expected duration of five years at which time the technical assistance funds will have been fully utilized and the on-lending component fully disbursed. It is envisioned that the technical support will involve, among other activities, recruiting and training new loan officers, 6 strengthening lending policies and procedures, putting in place accounting, risk management and management information system prerequisites, supporting loan application preparation, screening and decision-making, and supporting loan monitoring and collections. The initial focus of the program will be on borrowers characterized as micro and small whose credit needs would be consistent with a targeted average loan size under the project of under $10,000. Several reasons lie behind the decision to focus on the smaller end of the potential client market, including the desire to provide a better training opportunity for the relatively large number of new loan officers that will be required, the likely relatively lower income strata and currently limited access to bank credit of the target clientele, and the portfolio diversifications benefits of a larger number of smaller loans. Eventually larger borrowers may be considered in those lending partners that have performed well and can demonstrate the capacity to undertake such lending on commercially sustainable basis. 4 The business practices and lending technologies are characterized by client-responsive loan product design (e.g., loan maturities, repayment schedules, collateral requirements), interest rates adequate to cover the costs of lending plus a reasonable profit, rigorous loan officer recruitment and training practices, compensation packages that provide financial incentives to loan officers to attract new clients and to collect loans, close monitoring of borrowers and loan repayment status, rapid response to del inquencies or deterioration in borrowers’ financial condition, and specialized and standardized accounting, risk management and management information systems. Group lending is not envisioned to be employed in the program. 5 Both the PBC and CBRC have committed to exploring ways to promote specialized greenfield microfinance institutions, including reshaping of regulatory framework to encourage private and foreign participation in specialized MSE finance institutions. 6 Only in exceptional circumstances will existing loan officers be retrained under the project, though this is envisioned under the nationwide scaling-up for which this project is designed to lay the foundations. Page 5 5 There will be no sectoral targeting under the project. Loans will be for working capital and investment. It is envisioned that the lending partner branches involved in the project initially will be those located in urban and peri-urban areas, with roll-out during the project to increasingly rural areas. CDB will assume the full credit risk of its loans to lending partners, and lending partners will assume the full credit risk on loans to the target clientele. No government- sponsored guarantee programs are envisioned to be utilized under the project. Measurable project outputs will be: · The number of loans made and the number of small businesses that gain access to loans under the program (to be measured in the tens of thousands during the five-year life of the project); · The number of new loan officers trained in the lending technologies (to be measured in the several thousands); and · The commercial sustainability of the program as measured initially in terms of low portfolio past-due and default rates (e.g., <2% and <1%, respectively) In addition, the business practices and lending technologies propagated under the program are intended to serve as a foundation for new business opportunities and financial sustainability without the need for government subsidy for a steadily increasing number of banks throughout urban and rural China, including by adopting international standard credit risk management and other practices. 4. Safeguard policies that apply OP 4.01 Environmental Assessment (EA) Yes The safeguards team endorsed the team's approach to EA which was to require each PFI to establish a system of screening and project review which would identify any potential issues. The team presented a detailed annex on the procedures and the agreed institutional arrangements. The safeguards team suggested that the task team consider positive interventions regarding environmental enhancement and preservation to complement the compliance approach. Negative lists will be used that would involve screening proposed subprojects that would be ineligible for financing due to their environmental implications. For all eligible loans, the loan applicant would need to show that all applicable permits and licenses have been secured in accordance with Chinese law. The presumption of the team is that, due to the size of the loans and the eligibility criteria, it is likely that most subprojects would not require an EIA. The monitoring program would cover the types and sizes of loans in the event that changes may need to be made as the project processes. The safeguards team endorses the approach of the task team and the proposed assignment of Category FI. The responsibility for safeguards compliance and clearance of the project is hereby transferred to EASPR. Page 6 6 5. Tentative financing US$m BORROWER 0.00 INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT 100.00 GERMANY: KREDITANSTALT FUR WIEDERAUFBAU (KFW) 53.78 BORROWING COUNTRY'S FIN. INTERMEDIARY/IES 4,391.92 Total: 4,545.70 6. Contact point Contact: Jun Wang Title: Sr Financial Sector Spec. Tel: 5788+7657 Fax: 5861 7800 Email: jwang3@worldbank.org Location: Beijing, China (IBRD)