Docunent of The World Bank FOR OFFICIAL USE ONLY Report No. P-4842-CE MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 31.7 MILLION TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR A THIRD INDUSTRIAL DEVELOPMENT PROJECT June 28, 1988 This document bas a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY AND EQUIVALENT UNITS Currency Unit - Sri Lanka Rupee US$l (At appraisal--December 1987) = SLRs 30 SLRs 1 = US$0.03 ABBREVIATIONS ADB - Asian Development Bank AWPR - Average Weighted Prime Rate BMR - Balancing, Modernization and Rehabilitation GOSL - Government of Sri Lanka PCIs - Participating Credit Institutions FISCAL YEARS COSL January 1 to December 31 Commercial Banks January 1 to December 31 Development Finance Corporation of Ceylon (DFCC) = April 1 to March 31 National Development Bank of Sri Lanka (NDB) = January 1 to December 31 FOR OMCLIL USE ONLY SRI LANKA THIRD INDUSTRIAL DEVELOPMENT PROJECT (IDP-I1I) CREDIT AND PROJECT SUMMARY Borrower : Democratic Socialist Republic of Sri Lanka. Beneficiaries : Eligible Participating Credit Institutions (PCIs) includ- ing public and private sector comercial banks and development financing institutions. These would include: Bank of Ceylon (BOC', Commercial Bank of Ceylon (CBOC), Development Finance Corporation of Ceylon (DFCC), Hatton National Bank (HNB), National Development Bank (NDB), the Peoples Bank (PB), and Sampath Bank (SB). Technical assistance would be provided to the PCIs, the Presiden- tial Tariff Commission (PTC), Export Development Board (EDB), the Ministry of Industries and Scientific Affairs (4ISA), and the National Telecommunications Commission (NTC). Credit Amount : SDRs 31.7 million (US$43.8 million equivalent) Terms : Standard, with 40 years maturity. Co-Financing : The Asian Development Bank (ADB) proposes to provide US$40.5 million, inclusive of technical assistance of US$1.0 million, for project financing through a parallel line of credit on terms and conditions similar to those cf the proposed Project. Onlending Terms : The Government of Sri Lanka (GOSL) would relend the credit proceeds to eligible PCIs for 18 years including a three year grace period, at a variable rate aligned with the average of the Average Weighted Prime Rate (AWPR) for overdraft facilities prevailing over the previous six month period, less a spread of 4X. Given the absence of facilities in Sri Lanka for hedging long-team foreign exchange risk, GOSL would bear the foreign exchange risk on repayments to IDA. The implicit compensation to GOSL for taking the foreign exchange risk would be variable and set by the market as the difference between the GOSL's onlending rate to the PCIs and the international cost of foreign funds to Sri Lanka. The use of a market determined variable AWPR as a reference point for deter- mins!g GOSL's onlending rate, together with GOSL's fleribible exchange rate management, will ensure that borrowing costs reflect foreign exchange risk on a con- tinuous basis. Based on current interest rates present GOSL compensation would be 3Z. The PCIs would onlend the proceeds to sub-borrowers at market determined rates. On the basis of the present AUPR and spread requirements, the relending rate would be between 13Z-162 p.a. Inter- est rates, foreign exchange compensation rates and spreads would be reviewed semi annually on or about January 1 and July 1 with appropriate adjustment of the This document has a restricted distribution and may be used by recipients only ir the perfonrance of their official duties. Its contents may not otherwise be disclosed without World Bank Pwth"rization. -ii- interest rate and spreads necessary to (i) reflect move- ments in the market reference rate, and (ii) remain positive in real terms vis-a-vis inflation as reflected by the Colombo Price Index. Financing Plan: IDA USS 43.8 million ADR US$ 40.5 million COSL US$ 1.0 million Sponsors US$ 39.0 million Total US$124.3 million Economic Rate of A minimum ERR of 15% would be required for all subprojects. Return (ERR) : Staff Appraisal Report s No. 7230-CE l(ap : No. IBRD 17278 MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO SRI LANKA FOR A THIPD INDUSTRIAL DEVELOPMENT PROJECT 1. The following memorandum and recommendation on a proposed development credit to Sri Lanka for SDR 31.7 million (US$43.8 million equivalent) is submitted for approval. The proposed credit would be on standard IDA terms with 40 years maturity and help finance an industrial development project. The project would be confinanced by AD8 for SDR 29.0 million (US$ 40.5 mil- lion equivalent). 2. Background. Over the last decade GOSL has made significant progress in liberalizing its exchange rate regime and trade, finance and industrial policies by removing import restrictions, simplifying the investment approval process, rationalizing the export incentive structure, curtailing budgetary support to public manufacturing enterprises (PMEs) and reducing trade weighted average nominal tariffs to 15%. As a result, the share of the previously dominant public manufacturing sector of total manufacturing output has been reduced from 60% to 40%, and a more efficient and dynamic private sector has developed, achieving a robust growth performance of about 132 p.a. during 1983-87. The policy focus and technical assistance programs under IDA's small and medium scale industry (tMI) and industrial development projects (IDP) have strengthened financial intermediaries' capabilities to make industrial term loans, contributed significantly toward the successful liberalization of trade and industrial policy, and provided considerable support for the development of private sector industrial enterprises. In its Industrial Policy Statement (IPS) published in March 1987, GOSL attached continued high priority to the development of private sector industry as a means to diversify the country's economic base and generate enough employment opportunities to reduce the high level of unemployment. However, although significant progress has been made in achieving economic liberalization, GOSL still requires considerable support to expand and reform the industrial finance system and to continue to implement agreed reform programs to address a number of structural weaknesses, such as public industrial sector inef- ficiencies, poor adoption of appropriate technology, absence of a developed capital market, and shortages of critical human skills. 3. Rationale for IDA Involvement. As noted above IDA has worked closely with GOSL since 1977 to develop and implement a broad based program of trade, industry and financial policy reforms which would create a suitable environ- ment for the increased participation of the private sector in an area once dominated by public manufacturing enterprises; the broad objectives of this approach were initiated under the ongoing First and Second Industrial Development Projects--Cr.1401-CE and Cr.1692-CE--and are now spelt out in GOSL's IPS. The credit component under the ongoing IDP projects has also progressed satisfactorily with commitment and disbursement ahead of schedule; performance of subprojects with ex-post economic rates of return ranging from 15X-40% and average collection performance (80%) have also been satisfactory. The proposed project forms an integral part of IDA's sectoral development strategy and is closely related to the ongoing IDP projects and a proposed Public Enterprise Restructuring Project now under preparation which would -2- focus on the role, structure and efficiency of a number of public enterprises in major subsectors including cement, textiles, and telecommunications. The thrust of the proposed project reflects a continuation of an incremental, broad-based operational strategy to achieve a well-balanced, synergic policy and structural framework conducive to industrial development. This approach recognizes that the project's efforts in supporting industrial financial institutions and private sector enterprises Are likely to succeed only if conceived in the context of the overall industrial/trade/financial sector framework and supported by necessary policy and institutional reforms. To make this approach viable in the context of an investment project the proposed project is designed to support continued implementation of the reform programs already agreed with GOSL under IDP-I and IDP-II and would also provide support for the implementation of GOSL's IPS and an IMF's Struc- tural Adjustment Facility (SAF). 4. Project Objectives. The overall objectives of the proposed project are to channel funds to private industries, strengthen the credit delivery system and address issues which constrain development of a more efficient private manufacturing sector. More specific project objectives are to (a) ensure a stable, more competitive flow of term finance to private industry by widening participation to include commercial banks and increasing the range of services offered by them; (b) continue institution building programs for DFCC and NDB, including implementation of strategy/corpotate planning recom- mendations aimed inter alia at service diversification and enhanced human resource development program; (c) assist in developing a more efficient capital market to increase the sources of equity finance for industry; (d) strengthen industrial technology development by assisting in formulation of a detailed technology development program; (e) assist GOSL to prepare and implement its Second Export Development Plan (FY88-FY92); (f) assist GOSL to implement the next agreed phase of tariff reform; (g) provide training for GOSL/PCI staff to implement environmental impact assessment guidelines; and (h) assist GOSL to prepare the regulatory framework to establish an independ- ent commercial telecommunication authority. 5. Project Description. The total cost of the project, including tech- nical assistance TA , is estimated at US$124.3 million equivalent, with a foreign exchange component of US$84.3 million (68Z). IDA would provide a credit component of US$36.0 million equivalent for term lending through eligible PCIs to medium/large scale private and mixed public manufacturing enterprises and a TA comeonent of US$7.8 million equivalent. ADB would provide US$40.5 million (inclusive of US$1.0 million for TA) through a paral- lel line of credit. Subprojects eligible for financing would involve new investment and the balancing, modernizing and rehabilitation (BMR) of private enterprises in the industrial, agro-industry and industrial services sectors. A limited number of public enterprises with private sector shareholdings or operating under private sector management service contracts would be eligible for BHIR on a case by case basis. All subprojects would need to be finan- cially viable, and an environmental impact assessment in accordance with GOSL's environmental impact guidelines would be carried out for all subloans above US$500,000. The PCIs would calculate ERRs on all subloans above US$250,000 or subprojects producing products with a nominal tariff protection of 50% or more; the ERR threshold would be 15%. Subject to meeting agreed -3- eligibility conditions, two development financing institutions and five commercidl banks would participate in the project. Eligibility conditions for commercial bank participation would include appropriate staff levels, maximum risk asset/equity ratios and minimum annual profitability, provisions for bad debt and collection ratios. Project funds are expected to be fully utilized within seven years. A breakdown of costs and the financing plan are shown in Schedule A. Amounts and methods of procurement and of disburse- ments, and the disbursement schedule are shown in Schedule B. A timetable of key project processing events and the status of Bank Group operations in Sri Lanka are given in Schedules C and D, respectively. A map is also attached. The Staff Appraisal Report, No. 7230-CE dated June 28, 1988 is being dis- tributed separately. Agreed Actions. As conditions for credit effectiveness it has been agreed that (i) GOSL should present to Cabinet and IDA proposals incorporat- ing appropriate legal and administrative measures to achieve substantial improvements to the existing debt recovery framework; and (ii) at least two PCIs which have fulfilled all other relevant conditions of participation should have signed a Subsidiary Loan Agreement with GOSL. Agreement has also been reached with GOSL on (a) PCI strategies, operating policies, training programs, portfolio monitoring criteria, financial ratios, subproject reviews, lending terms and conditions, and reporting requirements; (b) the use of the Average Weighted Prime Rate (AWPR) as the market reference rate for setting term lending rates and on semi-annual reviews of the mechanism for determining interest rates and spreads and appropriate adjustments as necessary to reflect movement in the market reference rate and remain posi- tive in real terms vis-a-vis inflation rates; (c) an implementation program to revise the tariff structure as agreed under the IMF SAP; (d) an action program to prepare proposals to reduce undue legal and administrative delays in recovery of debt; (e) the timetable for a core action program for implementing the Second Export Development Plan (PY88-PY92); (f) a timetable for the review of the regulatory and tax environment for capital market transactions; (g) an action program to dev-lop a policy framework and institutional support for industrial technology development; (h) an action program to strengthen operations of the DFCC and NDB; and (i) joint IDA/ADB performance review criteria for monitoring of the reform process. 7. Benefits. Direct benefits of the lending component would include about US$110.0 million of additional fixed and permanent working capital investment, with about $70 million in incremental annual output once projects have become ,ully operational. The expected direct creation of 8,500 jobs and its multiplier effects is particularly important in the light of rising unemployment; in addition the productivity of workers in existing enterprises would be increased through BMR. Export volumes would depend on the composi- tion of subprojects presented by the PCIs. Subproject performance is expected to be strong, with economic and financial rates of return in excess of 15Z. Through the TA component, the project is also expected to yield direct benefits in improving manufacturers' access to debt/equity financing by strengthening the capital market and to appropriate technology needed to improve competitiveness. It would also ensure a stable, more competitive flow of term finance to private industry by widening participation of credit -4- ingtitutiong to iazlude commercial banks and increasing Lh range of serv- ices. Technical assistance to upgrade the PCIs' operations and to improve their suboactor analysis and promotion efforts are expected to result in an increased proportion of term landing to subsectors with stronger forward and backward linkages (e.g. agro industries, rubber products, chemical and engineering industries). Improvements in tsriff structure and export incen- tivea would encourage increased investment in efficient industrial enterprises based on Sri Lanka's comparative advantages. 8. Risks. The success of the lending component would depend on tlhe effective operation of the PCIs. The risk is expected to be manageable since satisfactory policies, procedures and standards to appraise the economic and financial viability of projects and to supervise implementations are in place. As an additional safeguard, participation oi the two government PCIs (the BOC and PB) would only be considered after completion of the comprehen- sive operating reviews being carried out under the Third SMI Project (Cr.1860-CE), to be followed by initial implementation. Another risk of the lending component is that an adequate number of eligible subprojects might not materialize due to the continuing ethnic conflict. However, since the actual pipeline and loan projections for the PCIs indicate credit demand well in excess of the amounts to be provided under the project and no other lines of credit are presently available, full commitment of the IDA credit is expected to be achieved within four years. Moreover, most of the industrial activity and subprojects are concentrated in areas not directly affected by the conflict. Since the proposed project supports the implementation of previously agreed trade and industrial policy reform proposals, there should be few political or institutional objections to the project. As the project also provides support for implementation of GOSL's Industrial Policy State- ment and the recently agreed SAP, it will help ensure that the risk involved in implementing a fairly comprehensive policy reform program is minimized. 9. Recommendation. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approved the proposed credit. Barber B. Conable President Attachments Washington, D.C. June 28, 1988 -5- SCHEDULE A SRI LANKA THIRD INDUSTRIAL DEVE WPMENT PROJECT ESTIMATED COSTS AND FINANCING PLAN Estimated Costs: /a Local Foreign Total T(Ut Million) …-- Subproject Investment 38.0 75.5 113.5 Technical Assistance 2.0 8.8 10.8 Institutional Development of PCIs 0.5 1.8 2.3 Tariff Reforms - 0.1 0.1 Export Development 0.1 0.4 0.5 Technology Development 0.3 1.7 2.0 Telecommunications 0.7 3.8 4.5 Capital Market Development 0.1 0.5 0.6 Unallocated 0.3 0.5 0.8 Total Project Cost 40.0 84.3 124.3 -t m== /a Inclusive of duties and taxes of about US$15 million. Financing Plan: Local Foreign Total --U$ Million)…-- ADB - 40.5 40.5 GOSL 1.0 - 1.0 IDA - 43.8 43.8 Sponsors 39.0 - 39.0 Total 40.0 84.3 124.3 SCHEDULE 8 SRI LANKA THIRD INDUSTRIAL DEVEWPNENT PROJECT PROCUREMENT METHOD AND DISIURSEMENTS Procurement Method Project Element ICs LCB Other /a Total Cost -----…(US$ Million)----Z- Subproject Investment 12.6 75.7 25.2 113.5 (4.0) (24.0) (8.0) (36.0) Technical Assistance /b 10.8 10.8 (7.8) (7.8) TOTAL 12.6 86.5 25.2 124.3 (4.0) (31.8) (8.0) (43.8) NOTE: Figures in parenthesis are the respective amounts to be financed by the Association. Disbursements (US$ Million) Category Amount Percentage Subloans for Goods an# Works 36.0 100X of foreign expenditures, 10OZ of local ex-factory cost and 701 of local expenditure for other items procuied locally. Technical Assistance 7.0 Goods 1001 of foreign expenditures, 1001 of local es-factory cost and 70X of local expenditure for other items procured locally. Consultants Services 1OOX Refw'4ing oc PPF 0.8 Amount due Tot, 43.8 Estimated IDA Disbursements: IDA FY 89 /c 90 91 92 93 94 95 …?U---------rSS Million) …------ _ Annual 7.0 6.0 8.0 10.0 7.0 3.0 2.8 Cumulative 7.0 13.0 21.0 31.0 38.0 41.0 43.8 /a Includes procurement by LIB, international and local shopping. 7i Consulting services would be recruited in line with the World Bank's Guidelines for the Use of Consultants. /c Estimated disbursement for FY89 includes retroactive financing of US$4.0 million to cover expenditures incurred afte-: January 1, 1988, and US$750,000 refunding of an existing PPF. -7- SCHEDULE C SRI LANKA THIRD INDUSTRIAL DEVELOPKENT PROJECT TIME TABLE OF KEY PROJECT PROCESSING EVENTS (a) Time taken to prepare: Seven months (b) Prepared by: Government with IDA/ADB assistance (c) First IDA mission: December 1987 (d) Appraisal mission departure: March 1988 (e) Negotiations: May 23, 1988 (f) Planned Date of Effectiveness: October 1988 (g) List of Relevant PCRs and PPARs: First Small and Medium Industries Project (Cr.942-CE) (PCR Date: May 22, 1987) .4.. SCHEDULE 0 Page 1 of 2 Sat LANKA THIRD IDUMTRXAL DEVRlCFHY5 PROJECT ?NRE STATVO Of BANK GROU OPERATIONS INE SRI LANKA A. STATUKDET Of DANK LOAS AND IDA CREDITS -As of March 31, 1988) s/ UsW Million Amount Loon or (net of cancellations) Credit go. Year 8orrower Purposo Dank IDA Undisbursed b/ Minv loans and twenty four credits fully disbursed 107.1 318.66 1017 1980 Sri Lanka Smllholder Rubber Rehabilitation 12.0 2.18 1048 1980 Sri Lanka Sixth Power 19.5 2.41 1079 1981 Sri Lanka Second Rural Development 33.5 8.53 1160 1981 Sri Lanka Village Irrigation Rehabilitation 30.0 14.61 1166 1981 Sri Lanka Mahaveli CGngp Development III 90.0 42.76 1182 1982 *Sri Lanka SKI II 30.0 0.97 1210 1982 Sri Lanka Seventh Power 36.0 6.74 1317 1982 Sri Lanka Forestry I 9.0 8.21 1363 1983 Sri Lanka Third Rural Development 23.0 26.36 1401 1983 Sri Lanka Industrial Development Project I 25.0 3.08 1494 1984 Sri Lanka Kahaweli Gang& Development IV 30.0 39.26 2437 1984 Sri Lanka Nahaveli Ganga Development IV 12.1 12.07 1537 1985 Sri Lanka Major Irrigation Rehabilitation 17.0 12.42 2517 1985 Sri Lanka Second Roads 24.0 12.56 1562 1985 Sri Lanka Fourth Tree Ct: ps 55.0 49.69 1692 1986 Sri Lanka Industrial Development I1 20.0 10.99 1697 1986 Sri Lanka Municipal Management 13.0 12.50 1698 1986 Sri Lanka Second Vocational Training 15.0 15.37 1700 1986 Sri Lanka Water Supply and Sanitation 37.0 41.28 1736 1987 Sri Lanka Ninth Power 52.0 53.82 1776 1987 Sri Lanka Agriculture Reseach 18.6 21.36 1860 1987 Sri Lanka SKI III 20.0 21.78 1883 1988 Sri Lanka Emergency Recon. and Rehab. 78.0 76.30 TOTAL 143.20 982.26 495.25 Of which has been repaid 59.34 7.96 Total now Held by Bank and IDA 80.27 974.30 Amount sold 3.59 Of which repaid 3.59 Total Undisbursed 24.63 470.62 495.25 u~mos=sa ma.Su= UU=U a/ The status of the projects listed in Part A is described in a separate report on all B ank/IDA-financed projects in execution, which is updated twice yearly and circulated to the Executive Directors on April 30 and October 31. b/ As credits are denominated in SDRs (since IDA Replenishment IV), undisbured SDR credit balances are converted to dollars at the current exchange rate between the dollar and the SDt. In some cases, therefore, the undisbursei boalance indicates a dollar amount greater than the original principal credit amount 4xpressed in dollars. -g- SCHEDULE D Page 2 of 2 B. STATEMENT OF IFC INVESTMENTS (As of March 31, 1988) Year Obligor Type of Business Amount (US$ Million Loan Euity Total 1970 Pearl Textile Textiles 2.50 0.75 3.25 1978/80/83 The Development Finance Corporation of Ceylon Development Banking - 0.45 0.45 1978/81 Bank of Ceylon Development Banking 7.00 - 7.00 1979/81 Cyntex Textiles 3.15 0.54 3.69 1979 Mikechris Industries Polypropylene Bag 0.89 0.10 .99 1980/84/85 LOLC Leasing 3.00 0.34 3.34 1981 Taj Lanka Hotels Hotel 19.30 .70 20.00 Total Gross Commitment 35.84 2.88 38.72 Less: Cancellations, Terminations, Repayments, and Sales 24.04 1.61 25.65 Total Commitments now held by IFC 11.80 1.27 13.07 Total Undisbursed ______ _____ _____ ______ _____ _____ _____ _ ,____ ______ __ BRD 17278 SRI LANKA INDUSTRIAL DEVELOPMENT PROJECT .JA'TNA/ National Capital / - - District Boundaries mLAfnu- . 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