Page 1 PROJECT INFORMATION DOCUMENT (PID) CONCEPT STAGE Report No.: AB1705 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, West District China China 100820 Tel: 86-10-6855 1124 Fax: 86-10-68551125 jk.wu@mof.gov.cn China Development Bank No.29 Fuchengmenwai Stree West District China 100037 Tel: 86-10-6830 Fax: 86-10-68307214 hunaijun@cdb.com.cn Environment Category [ ] A [ ] B [X] C [ ] FI [ ] TBD (to be determined) Date PID Prepared June 21, 2005 Estimated Date of Appraisal Authorization Estimated Date of Board Approval January 30, 2006 1. Key development issues and rationale for Bank involvement China faces a difficult challenge to diversify its sources of growth and to improve the rate of job creation. Micro and small businesses (referred to as �small businesses� hereafter) will have to play a greater role in both. Yet small businesses in China generally lack access to credit from formal financial institutions (�banks� hereafter) and must rely on informal sources. Lack of access to credit has been shown to be a key constraint to the ability of small businesses to grow and create jobs. 1 Many government and industry officials in China share an entrenched perception that small businesses are inherently risky, and thus are not suitable clients for banks. Many experiments in 1 See for example: How Important Are Financing Constraints? The role of finance in business environment , Ayyagari, Demirg��-Kunt, Maksimovic May 26, 2005, as well as survey reports by the PBC and CPDF. Page 2 promoting small-business access to financial resources have experienced unacceptably high loan loss rates. Yet these perceptions and experiences are inconsistent with the growing number of experiences in other countries indicating that a diversified portfolio of small business loans can often be less risky than a less diversified portfolio of loans to large firms. The persistence of this perception in China risks undermining appropriate policy decisions and skewing the design of government interventions geared toward promoting greater access. China also faces the related challenge to fully commercialize the banking system. Among banks� most profound and debilitating weaknesses in China is underdeveloped credit risk management capacity. Collateral-based lending remains the norm, and cash-flow analysis remains limited. The overemphasis on collateral constrains the availability of credit to small businesses which cannot meet banks� collateral requirements, but which can generate adequate cash-flow to service bank loans at commercial rates of interest. Commercializing the banking system also will require that banks differentiate themselves strategically. Too many banks pursue lending to large and state-affiliated firms and the intense competition arguably has led to under-pricing of credit risk in general. As in other countries, small business lending can serve as a key component of new commercially-viable business strategies for many banks in China. For the last several years the Bank has pursued a financial sector AAA program involving advocacy and support for adoption of a number of principles, policies and practices related to extending credit to small businesses. These include the principle of �commercial sustainability� as the necessary foundation for efforts to promote greater access to credit, the liberalization of interest rates as essential to allow for commercial sustainability, and the use of specialized small business lending technologies that have been used with success in other countries. Recently the authorities have liberalized lending interest rates and have formally adopted the principle of commercial sustainability, though some relevant officials continue to express skepticism regarding the latter. Among what remains to be achieved is to import the small business lending technologies that have been perfected in other countries and put them into practice in China so as to demonstrate a successful approach to micro and small business lending and to reinforce understanding of the relevance of commercial sustainability and interest rate liberalization. That is the main intention of this project. Collaboration with the Bank is seen as essential so as to facilitate the ability to gain access to the relevant international experiences and the highest quality of relevant technical expertise, as well as to assist in implementation, monitoring and evaluation so as to ensure the effectiveness of the proposed activities and to attain the specific objectives of the project. 2. Proposed objective(s) In the course of this project, it is expected that: � The credit needs of several tens of thousands of small businesses, the vast majority of which have never before had access to bank loans, will be met; Page 3 � Lending partners and newly recruited and trained lending officers will learn and utilize new business practices and lending technologies to make loans and other financial services available on a mass-market, commercially-sustainable basis to small businesses; � The effort described immediately above will be imbedded within an institutional setting that is intended to build a critical mass of domestic capacity for progressive nationwide scaling-up; 2 and � The process and results will be documented in a comprehensive manner, including by evaluating the outcomes for borrowers who obtain access to bank credit under the project, in order to facilitate nationwide scaling-up. 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 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 impact 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. 3 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. 4 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. 2 Nationwide scaling-up is not itself a development objective of this project. 3 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 delinquencies or de terioration 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. 4 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. Page 4 It is envisioned that the technical support will involve, among other activities, recruiting and training new loan officers, 5 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. CDB is about to contract for international consulting services to assist it in developing the institutional capacity to undertake the proposed business, including a full-time resident advisor who begins work in June 2005. Additional, substantial, international consulting services to assist lending partners in developing the institutional capacity to undertake the proposed business will be contracted under the project. 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. 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 four-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. 5 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 4. Safeguard policies that might apply The project is likely to have minimal or no adverse environmental or social impacts. Beyond the use of a screening mechanism, no further action is required for this project. While micro finance projects generally involve no safeguard risks in terms of directly triggering the Bank�s policies, it is recommended by the EAP Safeguards Secretariat that some of this social development/vulnerable group issues requiring due diligence be covered/guided by a social assessment study which could have a TOR to cover such issues including criteria for selection of project beneficiaries, eligibility criteria (including the poor, ethinic minorities), targeting, gender concerns, etc. 5. Tentative financing Source: ($m.) BORROWER 200 INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT 100 Total 300 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) wb176091 L:\CDB\Lending project\Project Information Document - Concept Stage.doc 7/8/2005 3:27:00 PM