Document of

The World Bank

FOR OFFICIAL USE ONLY

FILE CrPYReport No. 2485-CE

STAFF APPRAISAL REPORT

SRI LANKA

SMALL AND MEDIUM INDUSTRY PROJECT

June 8, 1979

Industrial Development and Finance DivisionProjects DepartmentSouth Asia Regional Office

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authoriation.

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CURRENCY EQUIVALENT

Currency Unit = Sri Lanka Rupee

US$1.00 = Rs 15.6Rs 1.00 = US$0.064

ABBREVIATIONS

ADB - Asian Development BankBOC - Bank of CeylonBRI - Building Research InstituteBTT - Business Turnover TaxCBOC - Commercial Bank of CeylonCISIR - Ceylon Institute for Scientific and Industrial

ResearchDFCC - Development Finance Corporation of CeylonDSI - Department of Small IndustriesGCEC - Greater Colombo Economic CommissionGOSL - Government of Sri LankaHNB - Hatton National BankICICI - Industrial Credit & Investment Corporation of IndiaIDB - Industrial Development BoardIDBI - Industrial Development Bank of IndiaIPZ - Investment Promotion ZoneMINSA - Ministry of Industry and Scientific AffairsMRI - Ministry of Rural Industrial DevelopmentMTI - Ministry of Textile IndustriesNAB - National Apprenticeship BoardNDB - National Development BankNERD - National Engineering Research DepartmentNIBM - National Institute of Banking Management of IndiaNIM - National Institute of ManagementNSB - National Savings BankPMB - Paddy Marketing BoardRRI - Rubber Research InstituteUmbrella - United Nations Multi-Sectoral Program of Project

PreparationUNDP - United Nations Development Programme

FISCAL YEARS

Government of Sri Lanka = January 1 to December 31Commercial Banks = January 1 to December 31DFCC = April 1 to March 31

FOR OFFICIAL USE ONLYSRI LANKA

APPRAISAL OF SMALL AND MEDIUM INDUSTRY PROJECT

Table of Contents

Page No.

I. BACKGROUND ........................................... 1

, II. SECTORAL BACKGROUND ............... 3

A. Economic Setting ................................ 3B. Industrial Structure and Performance .... ........ 3C. Characteristics and Role of SMI .... ............. 4D. Industrial Policy Framework ..................... 6E. Financing SMI .10F. Technical Service Agencies .12

III. KEY SMI SUBSECTORS - PERFORMANCE, PROSPECTS, NEEDS ... 13A. Rubber Products .14B. Foundries and Light Engineering .15C. Garments and Handloom Products for Export .16D. Construction and Building Materials .18E- Agroindustries ............................ 19

IV. THE PROJECT ............................ 21A. Objectives, Scope, and Institutional

Arrangements ..................... 21B. Credit Component ...... ............... 24

1. NDB - Small and Medium Industry Fund .242. Special Facilities .293. Participating Credit Institutions .30

C. Technical, Marketing and Management Components 341. Industrial Development Board .352. Other Technical Service Components .383. Preparation, Coordination, and Monitoring 39

V. THE CREDIT .40

VI. PROJECT BENEFITS AND RISKS .44

VII. RECOMMENDATIONS .46

This report is based on the findings of an appraisal mission which visitedSri Lanka during March 1979. The mission comprised N. Barry, C. Bam, V. Goel,S. Kandel (Bank), C. Ahrens and L. Jordan (consultants). D. Cook, N. Barry,T. Russo (Bank), W. Armstrong, L. Jordan, M. Patel and P. Viloria (consul-tants) participated in the project preparation mission of November 1978.

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

Table of Contents (continued)

Annex 1 - Supporting Tables

Table 1 - Indicators of Performance in Large, Medium and Small IndustriesTable 2 - Demand for Credit by Small and Medium Industry (1979-83)Table 3 - Interest Rate Structure of Credit InstitutionsTable 4 - Financial ProjectionsTable 5 - Projected Disbursement ScheduleTable 6 - Costs and Sources of Finance for Technical Service

Components

Annex 2 - Supporting Documents Available in Project File

SRI LANKA

SMALL AND MEDIUM INDUSTRY PROJECT

STAFF APPRAISAL REPORT

I. BACKGROUND

1.01 The Government of Sri Lanka's recent policy reforms and increased* emphasis on expanding the private sector have created a climate in which

prospects for efficient small and medium industry (SMI) development can beexploited. Accordingly, the Industrial Sector mission of April 1978 con-ducted initial analysis of the main SMI subsectors and institutions, andprepared an SMI Project Identification Report. An IDA credit was proposedto finance SMI subloans through commercial banks and to provide technicalservices in selected SMI subsectors through the Industrial Development Board(IDB) and other SMI institutions. In September 1978, GOSL requested an IDAmission to assist in the preparation of the SMI project. The mission ofNovember 1978 found significant potential for expansion and upgrading inseveral SMI subsectors, and reached understandings with relevant ministriesand potential implementing agencies on the design and organization of an SMIproject which would address key constraints. The appraisal mission ofFebruary/March 1979 completed the necessary subsector and institutionalanalysis; reviewed the programs and organizational arrangements planned bythe proposed implementing agencies; and reached tentative agreement on com-ponents, costs, and institutional responsibilities for the SMI project, sub-ject to review by IDA management. Negotiations were completed in May 1979.

1.02 The principal objective of this credit would be to address con-straints hindering rapid growth and productivity improvement of SMIs in orderto increase their contribution to efficient and low cost employment genera-tion, export expansion and economic growth. This report appraises a creditof US$16 million; US$12 million would provide partial refinance for term loansmade to SMIs, and US$4 million would finance (a) services to SMIs in selectedsubsectors, (b) training and advisors to build capabilities of credit and SMItechnical service institutions and (c) policy studies on issues affectingexpansion, export and efficiency prospects of SMIs. The project has majorinstitution-building objectives. To increase viable SMIs' access to credit,an SMI Fund within the newly-created National Development Bank (NDB) would beestablished with the structure and resources to refinance SMI loans; the fivemajor credit institutions would develop or expand SMI units at headquartersand in key branches with trained, specialized staff in SMI project appraisaland supervision; and attractive spreads and a modified credit guarantee schemewould increase incentives for credit institutions to expand SMI lendingactivity. Under the project, the main technical service agencies would focuson providing effective technical, marketing and management services to SMIsin subsectors with expansion potential. The IDB would upgrade its regionalextension network, start a subcontracting exchange to link small manufacturerswith public procurement and private contracts, and build subsector-specificschemes, staff and technical facilities in three major SMI subsectors. Threeother technical service agencies would implement discrete subsector-specificcomponents and provide management training.

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1.03 Since success of the project would depend on capabilities and moti-vation of key personnel in the credit and technical service organizations,US$175,000 of the UNDP Multi-Sectoral Program of Project Preparation (Umbrella)has been allocated for short-term training prior to implementation of the SMIproject. Selected staff of the financial institutions are receiving trainingon simplified SMI appraisal and supervision, and staff of IDB and othertechnical service institutions will be trained in subsector-specific extensionmethods.

1.04 Past Bank Group support for the industrial sector in Sri Lanka hascomprised two loans and two credits to the Development Finance Corporation ofCeylon (DFCC), 1/ IFC equity in DFCC, and a recent IFC loan to the Bank ofCeylon. IFC has also recently approved investments in a synthetic textilemill and in polypropylene bag manufacturing plant. The Asian DevelopmentBank (ADB) also has made a loan to DFCC. IDA and ADB loans to DFCC have beendesigned primarily to meet the credit needs of medium and large private indus-try, although recent loans have included components for smaller enterprises.The IFC US$2 million loan to the Bank of Ceylon is to finance enterprises withplant and equipment valued at less than Rs 6 million (US$385,000); 25% of theIFC loan is allocated to firms defined by GOSL as small enterprises. The IFCproject encompasses organizational improvements in the Bank of Ceylon includingthe introduction of a management consultancy cell within the newly createdIndustrial Projects Department (para 4.22).

1.05 The SMI project would provide an opportunity to address severalareas highlighted in a recent Industrial Sector Mission 2/ by financingstudies to develop an appropriate tariff system and to extend export incen-tives; improving technical and financial assistance in construction andengineering industries; and providing technical assistance to the NDB.

1/ Credit 566-CE ($4.5 million) was fully authorized by December 31, 1977.Disbursements as of May 1, 1979 were $3.7 million, and the credit isexpected to be fully disbursed by the closing date, September 30, 1979,with the exception of one subproject. The utilization of Credit 742-CE($8 million) has been affected adversely by the unification of therupee exchange rate in late 1977 (after the effectiveness of the credit),which reduced DFCC's exposure limit by almost 50%. Nevertheless, due tothe positive private sector investment climate and DFCC's strong efforts,as of May 1, 1979, 37 subprojects for $5.5 million had been authorized,and the credit should be fully authorized by the final date, December 31,1979. Disbursements as of May 1, 1979 at $2 million, were as projectedat time of appraisal. DFCC's average equity and loan assistance per sub-project during 1978 and the first quarter of 1979 was Rs 1.3 million.

2/ The report of this mission expected to be available shortly for distribu-tion to the Executive Directors.

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II. SECTORAL BACKGROUND

A. Economic Setting

2.01 While Sri Lanka has made substantial progress in the social fields,its ability to sustain these programs has been strained by low real GDP growthof about 3% p.a. during 1970-77. The poor economic performance during theseyears was due largely to inadequate investment in the key productive sectors,deteriorating terms of trade and inefficiency of public and private sectorfirms nurtured in a highly protected environment. Taking advantage of thepost-1976 improvements in the trade balance arising from higher internationalprices for tea and rubber, the present Government, which assumed office in July1977, liberalized the foreign trade and payments system, unified the exchangerate at a depreciated level, and encouraged the growth of the private sectorby lifting many price controls. Response by the economy has been favorablewith real GDP growing by an estimated 8.2% in 1978. The economic revival wasbroad based and diversified. Besides a record paddy crop, substantial gainswere registered in manufacturing and construction output. However, gains inplantation crops and associated processing industries were lower than growthin real GDP. In 1978, coconut production was still some 20% below the averagelevel of the 1960-65 period, largely as a result of inadequate producer incen-tives and declining fertilizer application. With the continuation and rein-forcement of economic reforms, prospects for higher rates of expansion in themedium term are good, provided adequate resources are available to financethe substantial public and private investment program. Acceleration in eco-nomic growth is a prerequisite for alleviating the serious unemploymentproblem which Sri Lanka is facing.

B. Industrial Structure and Performance

2.02 Although Sri Lanka continues to be heavily dependent on agriculture,which in 1978 accounted for one-third of GDP and over one-half of employment,the potential of manufacturing industry, contributing about 13% to GDP and10% to employment, has not been exploited fully. Industry comprises a regis-tered segment consisting of 29 large public sector enterprises and 7,700private firms (of which only 5% have plant and equipment with book value ofover Rs 1 million) 1/, and of an unregistered segment of some 20,000 smalland cottage industries. Contributions to the total industrial value addedare divided fairly evenly among public sector corporations (33%), privateregistered firms (33%) and unregistered small and cottage industries (34%).The largest product groups within the manufacturing sector are textiles, foodprocessing and chemical industries, which in 1977 accounted for 74% of indus-trial value added of registered firms. 2/ The registered segment depends to

1/ Ministry of Industries, Private Sector Industries Approved up toDecember 31, 1978.

2/ Central Bank of Ceylon, Review of the Economy, 1977.

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a large extent on imported raw materials; for public sector enterprises andregistered private firms, imports account for about 65% of the total value ofraw materials used. The unregistered small and cottage industries are lessdependent on imported inputs, since they produce a variety of goods whichutilize domestic resources such as coconut fiber, rubber, wood and clay.Total manufacturing employment is estimated at 400,000 of whom about twothirds are in the unregistered segment.

2.03 After high growth in the late 1960s, based on import substitution,manufacturing output grew by only 1.8% p.a. in real terms during 1970-77. Inthe same period, construction activity registered an average negative growthrate of some 2.6% p.a. The poor growth performance of private industry duringthese years is attributed primarily to domestic market constraints and severeforeign exchange scarcities. The imposition of import controls and tightimport rationing which favored public corporations further reduced growth inprivate industrial investment. At the same time, performance in public sectorenterprises was constrained by overstaffing and poor management decisionsstemming from excessive government involvement in day-to-day operations.

2.04 The major reforms introduced by the present Government already haveremoved some of the more serious obstacles to industrial growth and improvedthe investment climate. In 1978, real growth in industrial production, exclud-ing tea, rubber and coconut processing industries, was around 11%. Construc-tion activity grew by an estimated 28%. The recent industrial sector missionconcluded that an industrial real growth rate of some 6-9% p.a. should besustainable over the medium term, provided that: (a) further policy adjust-ments are made regarding trade and fiscal incentives, provision of industrialfinance, and efficient administration of public sector enterprises; (b) gov-ernment planning and implementation capabilities are strengthened; and(c) priority is placed on the expansion of subsectors in which Sri Lanka hascomparative advantage, particularly through the promotion of labor-intensiveindustries. In support of this development strategy, the proposed project'would promote and help finance the creation, expansion, efficiency and exportsof small and medium-scale industrial firms (SMIs). Emphasis on SMIs iswarranted in view of their predominance in private industry, strong links withagriculture and other sectors, relative labor intensity, and potential fordiffusing industrial development and diversifying exports. Furthermore,specialized systems for assisting SMIs are needed due to their more limitedaccess to credit and need for management, marketing and technical services.

C. Characteristics and Role of SMIs

2.05 Definition. For the purpose of fiscal incentives (para 2.12), GOSLpresently defines SMIs as enterprises with less than Rs 1 million ($64,000) inplant, equipment, land and buildings, valued at original costs. The Ministryof Industries is proposing to change this definition to Rs 1 million ($64,000)excluding investment in land and buildings. This increase is considered to be

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justified and provides a sound definition for the SMI target group of the pro-posed project 1/ since: (a) cumulative inflation over the past years makes adefinition of Rs 1 million in total fixed assets too restrictive for efficientoperations in some SMI product groups; (b) expansion of existing SMIs shouldbe encouraged; and (c) SMIs with up to Rs 1 million in plant and equipment arejudged to be those for which simplified appraisal techniques and outside tech-nical services are relevant. Based on this new definition, the SMI sector -would include some 90% of registered private firms and all unregistered firms,account for about three-quarters of industrial employment in Sri Lanka andcontribute over one-half of industrial value added. The same definition isappropriate for SMIs in construction contracting and quarrying, which are notcovered by fiscal incentives.

2.06 Geographical Distribution. About 70% of the registered SMIs arein and around Colombo, with secondary concentrations in the Kalutara, Kandy,Matara, Jaffna, Galle and Kurunegala districts. Unregistered small andcottage industries are more widely dispersed among small towns and villages,the Colombo district representing only about 30% of the total. Regionalindustrial dispersal is one of the prime objectives of the present Government.However, potential in rural areas is limited largely to agro-industries,construction, and some cottage industries; potential in secondary towns isgreater if access to institutional finance and technical and marketing servicesis increased.

2.07 Subsectoral Distribution. The principal SMI subsectors, whichtogether account for 88% of employment and 84% of investment in registeredSMIs, are textiles and garments, light engineering, paper products, rubber andchemical products, food manufacturing and wood products (Annex 1, Table 1).Subsector distribution of unregistered small and cottage industries is similaralthough their products are simpler, e.g. handloom textiles, jaggery, bricks,pottery, wood and coir items. SMIs presently account for roughly 80% ofemployment and 70% of investment in private construction contracting.

2.08 In most of these subsectors, significant expansion opportunitiesexist for SMIs in selected products or services (Chapter III), based on exportpotential and increased domestic demand for consumer goods and constructionmaterials with the higher rate of economic expansion. Prospects in severalSMI subsectors with growth potential are linked closely with other sectorsof the economy. For example, potential for significant expansion of agro-processing activity is linked to increased paddy production and availabilityof coconut husks and seafood. Similarly, the extensive public investment inagriculture is expected to generate additional demand for tools, spares,repair services and construction contracting. Subcontracting between SMIfirms and larger private and public sector enterprises, which is less devel-oped, has considerable potential.

1/ For the purposes of this IDA project, SMIs include those in manufacturing,quarrying, construction, agroprocessing, cottage industries and certainindustrial services. SMIs eligible for subloans are those with originalcost of plant and equipment below Rs 1 million.

2.09 Export Potential. Dependence on exports of tea, rubber and coconuthas been decreasing in the past years. Nevertheless, non-traditional industrialexports in 1978 accounted for only 9% of the total value of exports althoughthis represented an increase from 6% in 1977. 1/ The share of SMIs in thetotal value of non-traditional industrial exports increased from 7% in 1977 to10% in 1978. Although many SMIs produce goods which could be internationallycompetitive, they find it difficult to establish direct contacts with foreignbuyers and to obtain adequate information on export market requirements.However, SMIs have significant potential as indirect exporters, manufacturingcomponents and finished products for larger manufacturing and marketing con-cerns.

2.10 Performance and Efficiency. In 1977, SMIs on average made grossearnings roughly equivalent to 34% of total sales 2/ and 40% of totalinvestment. 3/ SMIs can be efficient in several labor-intensive product linesfor which no major economies of scale exist. In the principal subsectors,SMIs compare well with larger private and public firms in terms of efficientuse of capital and labor. Capital/labor ratios in all major SMI subsectors arelower (Annex 1, Table 1) and value added per unit of labor and capital cost 4/higher than in the larger firms. Nevertheless, many SMIs will need to upgradeproductivity, product quality and capacity utilization to operate profitablyin a liberalized environment. For this purpose, SMIs will require: betteraccess to credit for inputs and fixed investments; and technical assistanceto plan investments, improve production methods and take advantage of domesticand export market opportunities. The proposed project is designed to helpSMIs overcome these constraints.

D. Industrial Policy Framework

2.11 The Government is aware of the need to supplement the reforms it hasintroduced with further policy measures to stimulate more rapid growth of out-put, savings and exports. The medium-term development strategy outlined inthe 1978 Budget Speech and in the Medium Term Development Plan (1979-1983),affords industry and specifically SMIs an important role. A detailed reviewof Sri Lanka's industrial policies was made by the 1978 industrial sector mis-sion. The Government has indicated its broad concurrence with the mission'srecommendations for further policy adjustments and already has taken a numberof steps to implement suggested changes, e.g. reductions in import tariffs and

1/ Commerce Department, Ministry of Trade, Trade Statistics 1978.

2/ While this figure appears high, it is important to note that some SMIsemploy several family members who are paid out of profits rather thanreceiving wages.

3/ Total investment equivalent to fixed investment and permanent workingcapital.

4/ Assuming a cost of capital of 15%.

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commitment to developing a more rational tariff structure (para 2.18), movesto equalize export incentives to firms on and off the Investment PromotionZone (IPZ) (para 2.15), and development of the proposed SMI project which wasidentified during the Industrial Sector mission. General policy areas ofrelevance to SMIs and proposed studies to be financed under the SMI project,summarized below, were discussed during negotiations.

2.12 Fiscal Incentives. A major problem with the fiscal incentivesystem prior to 1978 was its complexity, resulting from a multiplicity of over-lapping incentives, the high level of the Basic Corporate Tax, and the cascad-ing effect of the Business Turnover Tax (BTT). The present system, whichalready incorporates some of the 1979 Budget proposals, is simpler. Withinthe system, features of relevance to SMIs are: a five-year tax exemption onprofits of up to Rs 200,000 for new SMIs outside municipalities, an eight-yeartax exemption on export profits for firms established after 1972, and a dutyrebate on imported components of exported items. 1/ The Ministry of Indus-tries recently proposed some differential incentives for SMI. 2/ However,such differential incentives are likely to encourage inefficiency and diminishthe positive impact of import and price liberalization on the domestic allo-cation of resources. During negotiations, GOSL confirmed that it wouldcontinue to exchange views with IDA regarding the development of incentivesaffecting SMI.

2.13 Instead of introducing differential incentives for SMI, the presentsystem of fiscal incentives could be extended to include tax exemptions on aportion of profits of (a) existing SMIs outside municipalities which expand,provided they still qualify under the agreed SMI definition; (b) industriesestablished prior to 1972 if they expand or modernize to meet export orders;and (c) local manufacturers supplying components or finished products tomanufacturing or commercial exporters, based on their relative shares in thedomestic value added of the exported goods. Also, import duty rebates andrefund of the BTT could be extended to SMIs subcontracting to exporters. 3/The proposed project would finance outside assistance to analyze the admin-istrative and technical feasibility of extending fiscal incentives to firms

1/ The total amount of customs duties levied on raw materials imported tomanufacture an export product is expressed as a percentage of the FOBvalue of the product so exported, and this amount is refunded.

2/ Including preferential pricing in public procurement, reserved productgroups, and scaling of fiscal incentives according to SMIs' location infour regional development zones.

3/ The refund of the BTT on export sales and its general reduction froma maximum of 35% to a maximum of 10% of sales have been proposed inNovember 1977.

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which expand and to subcontractors providing components or finished productsto exporters. 1/

2.14 Export Promotion. To encourage direct and indirect exports by SMIs,intensified export promotion policies are necessary. At present, there arenumerous agencies involved in export promotion and regulation. To consolidatethese efforts, the Sri Lanka Export Development Board was established recentlyunder the chairmanship of the President. The Board, which is expected to havewide powers and substantial human and financial resources, should help overcomesome of the problems of small exporters. Export market studies alreadyplanned by the Board include major SMI subsectors as well as potential sub-contracting links between exporters and local SMIs. 2/

2.15 A further element in the Government's export strategy was the estab-lishment of the IPZ in 1978, aimed at attracting foreign investors by grantinga generous package of incentives. The initial response to the IPZ has beengood, with 118 inquiries and 48 approvals during 1978. A few firms havealready begun operations. Subcontracting by SMIs to firms within the IPZoffers limited promise in the short run since most IPZ firms will haveinternational procurement and sales contracts. However, subcontractingopportunities are expected in certain product groups, and SMIs would needbetter information on IPZ requirements, and increased access to fiscalincentives to compete with duty free imports of inputs into the IPZ.

2.16 Public Sector Procurement and Subcontracting. Within the presentindustrial structure in Sri Lanka, considerable potential exists for SMIs toexpand markets through increased access to public sector procurement andthrough subcontracting to larger private manufacturers and commercial firms.Analysis conducted by the appraisal mission indicates that SMI access topublic sector purchasing contracts and tenders could best be increased byimproved information about public procurement opportunities and by helpingSMI improve the quality of their products, rather than through preferentialpricing for SMI products. In supplying the public sector, SMIs could increasetheir sales of such items as equipment spares, educational supplies, andbuilding materials. In subcontracting to private firms, major potentialexists in garment accessories, construction contracting, and rubber products.Under the proposed project, IDB would establish a subcontracting exchange to

1/ Terms of reference and administrative arrangements for this study werediscussed during negotiations; timing, terms of reference, and admin-istrative arrangements will be finalized after GOSL takes decisionson revisions of the Business Turnover Tax and fiscal incentives, whichare under preparation. The estimated requirement for outside technicalassistance is one manyear.

2/ The Export Development Board already has arranged financing for exportstudies and promotion through the Swedish International DevelopmentAgency (SIDA); if additional financing is required for export studiesrelating to major SMI subsectors (e.g. rubber products) this could becovered from the discretionary fund of the SMI project (para 4.04).

9

help link SMIs with government and private purchasers (para 4.39). Managementof the IPZ has agreed to communicate to IDB details on the quantities andquality of input requirements by firms on the IPZ.

2.17 Rationalization in Public Sector Enterprises. Several publicsector enterprises are engaged in jobbing operations with short production

* runs or subsidiary activities which require excessive management time. Someof these activities could be performed more efficiently by private SMIs. TheMinistry of Industries would need to analyze the production mixes of selectedpublic sector corporations (e.g., Hardware, Steel, Leather, Ceramics) todetermine the degree to which they could concentrate on major items requiringlong runs and large equipment. This could increase the efficiency of thecorporations while expanding the scope for private SMIs. Rationalizationcould be an important aspect of a larger strategy and efficiency study onselected public sector corporations; this is planned as part of the IDAindustrial sector work program.

2.18 Import Liberalization and Tariff System. During 1970 to 1977, theexchange and trade system, which was introduced in the late 1950s to promoteimport substitution, depended primarily on severe quantitative restrictionsimposed through import licensing. Since late 1977, quantitative restrictionswere removed for the majority of imports and protection was based mainly ontariffs. The new schedule includes a low duty band covering essential con-sumer goods, most raw materials, spares and machinery, a common "revenue rate,"a high duty band for goods for which adequate production capacity in SriLanka exists to meet domestic demand, and a prohibitive rate on certain luxurygoods. Although the overall level of nominal protection has been reducedsignificantly, protection still remains high. 1/

2.19 Designing an appropriate tariff system has been a major concern ofthe new Government. A Tariff Review Committee, set up in October 1977, hasbeen reviewing selected industrial duty rates and making subsequent adjust-ments based on justified representations by domestic producers, importersand consumers. However, the Committee has not yet done a systematic evalua-tion of the representations. In late 1978, the establishment of a PresidentialTariff Commission with a permanent Secretariat was approved by the Cabinet,with the objective of designing a tariff system based primarily upon theprinciple of effective protection. Financing is provided under the proposed

* project for 2 manyears of outside assistance to the Commission. 2/ Work onthe tariff system should be closely coordinated with the Sri Lanka ExportDevelopment Board, since the terms of reference of these two central agenciesoverlap on all issues regarding export incentives and promotion. Discussions

1/ When the group averages of nominal rates are weighted -by their corres-ponding import volumes and aggregated, the overall weighted nominalrate is about 50%.

2/ During negotiations, terms of reference for the study were discussedand agreement was reached on timing for the study and the substanceof the terms of reference.

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between the appraisal mission and a large number of small entrepreneurs, theTariff Review Committee and other government agencies, indicated that SMIshave responded well to import liberalization. Nominal rates of return werein most cases above 25% before tax, indicating that further reductionsin protective tariff rates would be feasible. Better access to imported rawmaterial and equipment and the buoyant domestic market generally have compen-sated for any reductions in output prices to compete with imports. Only a.small number of SMIs involved either in inefficient assembly operations (e.g.,bicycle assembly) or in uncompetitive production processes (e.g., standardhandloom cloth for local markets) are experiencing serious difficulties.

E. Financing SMI

2.20 Since import liberalization, demand for credit by all sectors ofthe economy has increased rapidly. During 1978, total credit by the bankingsystem rose by 44%, whereas total deposits increased by only 30%. In additionto the sharp increase in the financing needs for trade and imports of rawmaterials and intermediate goods, bureaucratic delays in the disbursementsfrom the Central Bank's refinancing scheme and the the contractionary effectof government operations contributed to a significant liquidity squeeze inthe second half of 1978. As a result, the banks' loan/deposit ratio increasedfrom 0.85 at the end of 1977 to 0.94 at the end of 1978 with most banks exceed-ing their credit ceilings with the Central Bank. In 1978, total industrialcredit expanded sharply and accounted for 27% of total credit. However, dueto heavy bank lending to public sector corporations, lending to privateindustry decreased from 55% of total industrial credit in 1977 to 45% in 1978.

2.21 Of the institutional finance in Sri Lanka, about 85% of industriallending is provided by commercial banks, the remaining 15% being supplied bythe Development Finance Corporation of Ceylon (DFCC) and smaller finance com-panies. Of the 11 commercial banks operating in Sri Lanka, 4 are domesticand 7 are foreign. 1/ The two state-owned commercial banks, People's Bank andBank of Ceylon (BOCT, have extensive branch networks and account for more than90% of industrial credit by the banking system. The two principally privatedomestic banks, Hatton National Bank and Commercial Bank of Ceylon, are muchsmaller but expanding. Most of the industrial credit is in the form ofshort-term loans and overdrafts, with medium and long-term lending amountingto about 20% of the total.

2.22 The Government recently has passed legislation establishing a newNational Development Bank (NDB); its primary roles are to finance public sectorenterprises directly and to promote small enterprise lending. GOSL intendsto use NDB to provide more objective and systematic evaluation of investmentproposals by public sector corporations and to review appraisals and providerefinance for SMI loans by the credit institutions. The chairman and general

1/ The foreign banks concentrate mainly on foreign trade financing.

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manager have been appointed and are working on organization, staffing andoperational policies and on selecting key managerial and technical staff.The proposed project is designed to assist the NDB in developing its SMIrefinancing activities and overall operations (paras 4.06-4.17).

2.23 For the past three years, People's Bank and BOC have been partici-pating in a Joint Credit Scheme with the IDB. Under this scheme, IDB hasformulated and appraised projects, and recommended them for bank financing.While the scheme has helped to improve access to credit by a number of SMIs,it has not proved satisfactory and would be terminated with the initiationof the project. The participating banks are critical of the lack of objec-tivity and thoroughness of IDB's appraisals, since they carry the risk of theloans. Most commercial bank lending to SMIs has been independent of the IDBJoint Scheme. In their own lending decisions, commercial banks use fairlyconservative lending criteria based more on collateral than on projectevaluation. As a result, SMIs have difficulties in securing credit. Dueto its limited rupee resources and lack of a branch network, DFCC has con-centrated mainly on lending foreign exchange resources to the larger firmsalthough DFCC has been increasing its SMI lending activities (para 1.04).

2.24 In response to the liberalized investment environment, credit toSMIs, which accounts for about 7% of lending to private industry, increasedby some 50% in 1978, mainly for working capital. An estimate of potentialdemand for financing by SMIs has been made in Annex 1, Table 2, based onconservative assumptions regarding the economic rate of growth of the sector(6.5% p.a.), the incremental capital/output ratio (ICOR) and permanent workingcapital requirements. Total investment requirements by SMIs are estimated tobe about Rs 2.8 billion from 1979-83. In the past, credit institutionscovered about 20% of private industries' financing requirements, with atraditionally high percentage of self-finance. 1/ Assuming that the proposedproject would increase access to institutional credit by SMIs, it would bereasonable to anticipate that about one-third of total SMI financing require-ments could be covered by the credit institutions. Taking into account anti-cipated levels of international and domestic inflation, credit demand by SMIscould amount to roughly US$12 million per year in current prices.

2.25 In 1978, commercial banks and DFCC lent about US$3 million to SMIsin term credit. The banking system's resource constraints and increasedrequirements for other purposes are expected to limit its ability to sustaina significantly higher level of SMI lending in the medium-term, particularlysince it will take time to change conservative banking attitudes and increaseSMI project appraisal capabilities. Assuming that the banking system will beable to maintain its present level of financing in real terms from its own

1/ The 1966/67 investment survey by the Central Bank showed that excludingstocks and trade credits, self-finance accounted for about 63% of invest-ments, while the banks accounted for 21%. While these figures clearlyare out of date, interviews with businessmen and banks suggest that pri-vate industry, and especially SMIs, still rely heavily on self-financing.

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resources (i.e., on the average US$4.5 million per year in current prices),the financing gap could amount to US$7.5 million per year, or US$22.5 millionover the period 1980-82. The project would provide US$12 million to coveronly part of this potential financing gap since the banks and technicalservice agencies need to build progressively their capacity to handle a higherlevel of operations. Subsector analysis indicates that most demand for creditis expected to be generated in construction and building materials, metal andrubber products, and agro-industrial SMIs.

2.26 Interest Rates and Inflation. Annex 1, Table 3, shows the presentinterest rate structure in Sri Lanka. As part of the recent policy reforms,interest rates were raised substantially to prevent possible capital outflowafter the liberalization of foreign exchange controls, to reflect the higherrates of inflation expected during the transition to a more open economy, andto stimulate medium-term private savings. Commercial banks now pay 7.2% onsavings deposits and 8.5% to 15% on time deposits. I/ Due to liquidity prob-lems and the rising cost of funds, most banks increased their effective lendingrates during 1978. In most cases, they charge 13% to 18% on industrial termloans, including loans to SMIs.

2.27 Several price indices are used in Sri Lanka. According to the mostreliable one, the unpublished Central Bank index, between December 1977 andDecember 1978 the inflation rate amounted to some 14%, mainly reflecting thereduction in food subsidies, relaxation of domestic price controls, andincreased cost of some imports following the devaluation of the rupee. Withfurther price adjustments on the producer and consumer levels and subsidyreductions planned by the Government in the next three years, it is expectedthat the annual rate of inflation will decline gradually to internationallevels by 1981. At the projected rates of inflation, on-lending interestrates of the major credit institutions are expected to remain positive inreal terms.

F. Technical Service Agencies

2.28 Sri Lanka has a number of institutions which provide managerial,technical, and training assistance to SMIs. While their services are useful,the effectiveness of these agencies is constrained by unclear assignment ofresponsibilities, shortages of trained personnel, and inadequate technicalservice facilities. The IDB, an agency of the Ministry of Industries andScientific Affairs (MINSA), is the principal SMI development institutionresponsible for promoting and assisting all SMI subsectors other than tex-tiles and cottage industry. The IDB is a well-established agency, but needsto strengthen promotional activities and subsector services at headquarters

1/ The highest desposit rate is 18%, offered by the National Savings Bank(NSB) on 18 month's term deposits. The resources of the NSB are loanedto the Government at a negative spread to finance the public investmentprogram.

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and key districts, moving from its recent focus on loan-related activities. 1/The Department of Small Industries (DSI), responsible for cottage industrydevelopment, recently has been shifted from MINSA to the newly establishedMinistry of Rural Industrial Development (MRI); DSI, which will continue toconcentrate on household industries, could improve its impact by providingservices to craftsmen rather than limiting its efforts to DSI-owned produc-tion facilities (para 4.42). The Ministry of Textile Industries (MTI)formulates policy and implements programs in the textile and garment sub-sector; the Department of Textile Industries (DTI) under MTI, which isresponsible for development of the handloom industry, plans to increasecollaborative arrangements with private exporters (para 4.41). These arethe principal agencies currently providing technical services 2/ to SMI,although other ministries are providing some assistance to agro-based indus-tries. Training programs are concentrated in two main agencies: the NationalInstitute of Business Management (NIBM), under MINSA, provides production andfinancial management courses; and the National Apprenticeship Board (NAB),under the Ministry of Youth Affairs and Employment, arranges supervised, paidapprenticeships with private industry in a range of trades. The SMI projectwould help increase the effectiveness of these agencies, and improve deline-ation of responsibilities and coordination among credit and SMI technicalservice institutions.

III. KEY SMI SUBSECTORS - PERFORMANCE, PROSPECTS AND NEEDS

3.01 A major objective of the proposed SMI project is to address speci-fic technical, marketing and management problems of SMIs in subsectors with sig-nificant expansion potential and economic impact. Identification, preparationand appraisal missions conducted detailed analyses in major SMI product groups:rubber products, foundries and light engineering, construction and buildingmaterials, garment ancillaries and handloom products for export, and selected*agroindustries. The purpose of these subsector analyses was to:

(a) assess the role, performance and potential for SMIs in theseproduct groups;

(b) determine major constraints hindering growth;

(c) analyze the existing policies and institutional constraintsaffecting the subsector;

1/ IDB's heavy involvement in credit operations has diverted staff attentionfrom IDB's primary role in promotion and technical assistance to SMIs.

2/ Several research institutions have equipment and some staff that couldbe useful in SMI development. However, the orientation and experienceof most staff is academic, morale is low, and the practical output ofthese organizations is limited; while an SMI program should improvecoordination between technical assistance and research and development(R&D) agencies, these agencies as presently structured have limitedpotential for direct assistance to SMIs.

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(d) develop technical and marketing components to assist viableSMIs in selected subsectors; and

(e) estimate the demand for institutional term credit for SMIs.

3.02 This work indicated that in several product groups, SMIs could be

efficient and labor intensive in meeting increased local or export demandprovided that specific constraints were alleviated. The proposed SMI project,outlined in Chapter IV, would address several of these technical, marketing,and management problems, building on some existing programs of IDB and otheragencies. This Chapter summarizes the missions' findings on performance,prospects, needs and existing programs in these subsectors. Estimates ofdemand for institutional credit by subsector are provided; the credit compo-nent would help fill a significant portion of potential credit needs of these

subsectors, estimated at US$12.0 million p.a. No subsector allocations areproposed under the credit component of the SMI project; credit would beavailable to SMIs in a broad range of product and service groups, providedthey meet financial and economic viability criteria (para 4.11). Detailedworking papers on each subsector are available in the project file.

A. Rubber Products SMIs

3.03 Performance and Prospects. Less than 3% of Sri Lanka's rubberoutput is used by local rubber product manufacturers, in spite of Sri Lanka'scomparative advantage in rubber product manufacture. There are about 200registered private firms, of which all but 7 are SMIs, and several hundredunregistered units. 1/ SMIs account for over 80% of output and employment.Most units have less than Rs 200,000 invested in plant and equipment; fixedcosts (book value) per job average about Rs 6,000; and value added/capitalaverages 2.1 vs. 1.2 in larger units (Annex 1, Table 1). Registered privateunits produced over Rs 90 million of rubber products in 1977, mainly tubes,footwear, rubber toys, and rubberized coir products. Exports totalled aboutRs 10 million in 1977, up from Rs 2.5 million in 1976 and Rs 0.2 million in1975. Imports in 1977 were about Rs 22 million.

3.04 Sri Lanka has a comparative advantage in the manufacture of latexand dry rubber products derived from low labor costs and easy access torubber. Labor-intensive processes are suitable for most non-tire products;fixed costs per job would be well under US$1,000 for new or upgraded firms.With a 4:1 ratio of unskilled to skilled workers, absorption of unskilledlabor is high with expansion. Raw materials represent 55-60% of costs inmost rubber products, of which 60-85% is dry rubber or latex. Dry rubber andlatex are available locally at about 50% of international prices, and withliberalization non-rubber inputs can be imported with 5% duty. With plannedexpansion of centrifuged latex capacity, there should be no constraints on theavailability of industrial rubber. While rubber must compete with synthetics

1/ IDB Survey of Rubber Product Industries, 1976-77.

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in some product groups, rubber has superior characteristics for several items(e.g., sporting goods, gloves, rubber bands), and in areas of substitutability,the increased costs of petroleum-based synthetics often give advantages tousing natural rubber. SMIs can be efficient export-oriented units for a rangeof items including footwear, toys, sporting goods, gloves and rice rollers.There also is untapped potential for upgraded SMIs to substitute for at leasthalf of rubber product imports. The minimum economic size for units makingmost molded rubber and latex products is Rs 300-700,000 in plant and equipment.

3.05 Needs to be met for SMIs to realize these export and import substi-tution possibilities are technical, input supply, marketing and credit. In asurvey by IDB, about 90% of rubber product SMIs expressed a need for technicaladvice and product testing facilities. With liberalization, imports of non-rubber raw material are permitted, but quantities required by SMIs often aretoo small for direct imports to be economical; also, most small firms do nothave mixing mills and require outside services for supply of properly mixedcompounds. In marketing, medium scale industries could export directly ifquality, packaging and market information were improved, but smaller unitswill depend upon subcontracting links with larger manufacturers or commercialexporters; it probably is advantageous for the smallest units to build qualitythrough efficient import substitution first, becoming attractive as exportsubcontractors in the future. Finance for modernization, expansion andworking capital was a felt need for about 70% of the rubber product SMIscovered in IDB's survey; most firms are undercapitalized, having had toimprovise with local equipment during the period when imports were restricted.

3.06 Service and Financing Requirements. IDB has initiated sales ofquality rubber and latex compounds to small units and specialized technicalservices on mold use, methods and product upgrading. IDB's program is new,with about 60 SMIs receiving technical assistance and about 25 buying com-pounds and centrifuged latex. In the past, IDB has utilized the facilitiesof Ceylon Institute for Scientific and Industrial Research (CISIR) and theRubber Research Institute (RRI), but these facilities are inadequate forrubber product testing, institutional priorities focus on theoretical researchand as a result, there are considerable delays in servicing private industry.The Cabinet has approved the establishment of a Rubber Products TechnicalService Center under IDB which could more than triple the coverage of theraw material supply program, provide facilities suitable to SMI material andproduct testing needs, and have more trained staff to increase effectivenessof specialized technical and marketing services. The SMI project would helpfinance this Center (para 4.36). With the impetus of these technical, rawmaterial supply, and marketing services, it is anticipated that in 1979-83,roughly US$1 million p.a. would be required in institutional credit to meetfixed and permanent working capital requirements for new rubber products firmsand expansion of existing units which expand.

B. Foundries and Light Engineering SMIs

3.07 Performance and Prospects. In most metal product groups, SMIs con-stitute over 70% of output, investment and employment. There are about 1,000

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registered metal product SMIs, mainly making fabricated metal products, trans-port equipment spares, electrical goods, and foundry products. 1/ These unitsemploy about 20,000, with average fixed investment (book value) per job ofRs 4,400 in fabricated metal products, Rs 4,800 in transport spares, andRs 4,500 in electrical goods. In addition, there are over 2,000 unregistered 2/metal product firms, mainly blacksmiths (60%) and repair workshops. In fabri-cated metal products, electrical accessories, and transportation equipmentand spares, registered SMIs have significantly higher value added/capitalratios. Findings of preparation and appraisal missions indicate that signi-ficant expansion or upgrading potential exists in: ferrous and non-ferrousfoundries; repair workshops; and firms making motor and textile machineryspares, agricultural implements, water pumps and electrical fittings.Prospects are based on growth in local demand (with increased industrial,construction, and agricultural activity), provided that productivity, priceand quality of local products are improved. Most metal product SMIs haveestablished wholesale channels; there is some scope for facilitating publicprocurement and private subcontracting. Export potential is limited sincemetals are imported and competing countries have production and marketingeconomies of scale.

3.08 Service and Financing Requirements. In ferrous and non-ferrousfoundries, technical facilities and services are required to improve qualitycontrol, material use, and patterns. These needs could be met by IDB incooperation with the newly established Foundry Association, composed of large,medium and small foundries. SMIs making motor spares, which will continue tomeet needs of older vehicles, require technical extension and selective mod-ernization to upgrade quality and reduce costs. In implements (hoes, shovelsand wheelbarrows), quality is poor and with expanded demand in public works,construction and agriculture, expansion and quality improvement are priorities.Promotion of regional repair workshops is needed to cope with increased demandfor servicing vehicles and agricultural equipment. While other organizationscan offer useful R&D, IDB is the organization best suited to provide commonfacilities and technical services to metal product SMIs; the proposed SMIproject would help build these services (para 4.37). Credit requirementsfrom 1979-83 could be about US$1.5 million p.a.

C. Garments and Handloom Products for Export

3.09 Garments - Performance and Prospects. Sri Lanka's garment industryconsists of about 60 medium and large scale units and over 1,000 small garmentand tailoring operations. In addition, 26 of the 46 projects approved forthe IPZ and about 10 of the 26 approved joint ventures outside the IPZ areexport-oriented garment manufacturers. Over the last five years, Sri Lanka'sgarment exports have increased rapidly from Rs 6.2 million in 1972 to about

1/ IDB, 1976-77 Survey of Registered SMIs.

2/ IDB, 1975-76 Survey of Unregistered SMIs.

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Rs 300 million in 1978, mainly in shirts and blouses. However, existing andthreatened quotas make future growth prospects uncertain. Smaller, locallyowned units account for about 20% of exports. While perhaps 100 SMIs couldbe efficient export-oriented subcontractors with marginal upgrading, rapidincreases in large scale garment production are likely to cause a decrease inSMI export share; established garment manufacturers are experiencing an exodusof supervising staff, cutters, pattern-makers and sewers to the IPZ and othernew firms. Potential appears greater for promotion of SMI ancillaries to makenon-textile inputs for garments (buttons, zippers, hangers, labels, packingmaterials) since an average of 40% of raw material costs for garments is innon-textile inputs. At present, all but polyethylene bags are imported; labor,representing 15-20% of production costs, constitutes the only significantvalue added locally in garment making.

3.10 Service and Financing Needs. The rapid expansion of the garmentindustry will necessitate training, particularly for production foremen, cut-ters and pattern-makers. The Ministry of Textile Industries (MTI) plans toestablish a Textile Research and Training Institute which would incorporatetraining and technical assistance to small, medium and large garment units.This garment training center would receive support under the SMI project(para 4.40). It is likely that over the next four years, at least 400 cut-ters, 200 pattern-makers and 300 production supervisors could benefit byshort, practical training in basic skills and upgrading of methods. Ancillaryindustries manufacturing inputs for garments could require roughly US$1 mil-lion p.a. of institutional credit p.a. between 1979-1983.

3.11 Handloom Products - Performance and Prospects. With eliminationof previous protection for handloom products, many units find it difficultto compete with imported and local milled cotton and synthetics for standardcloth requirements. The Department of Textile Industries (DTI) estimatesthat only 30% of the total 150,000 weavers are working, each producing anaverage of 580 yards a year, with monthly earnings of about Rs 100. It islikely that handloom products will continue to have difficulty competing forstandard cloth requirements, particularly with private management contractsand replacement of equipment in the mill sector. DTI projects stagnation inlocal sales of handloom cloth, with about 35 million yards annually from 1979to 1982. Export prospects for higher quality handloom products for specializedmarkets look more promising. Cotton has proved resilient in the battle withsynthetics and India has enjoyed a 700% increase in handloom product exportsduring the last five years. However, India has a mixed reputation for qualityand reliability and its product mix is narrow; since handloom production islimited largely to South Asia, there is scope for Sri Lanka to share in thismarket. One major potential market is handloom cloth for Sri Lanka's garmentexport industry which uses Indian handloom fabrics for about 15% of its clothneeds.

3.12 Service and Financing Requirements. At present, exports of hand-loom goods from Sri Lanka are limited to about 10 private firms concentratedin and around Colombo. Unlike India, there is no well-established network ofprivate exporters, middlemen and master weavers providing orders and tech-nical and raw material organization; DTI's attempts to provide such services

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have had limited success due to constraints in staffing and rapid decision-making within a government department. It would be useful to mobilize market-ing and technical expertise of the leading handloom exporters to extend theproduction network to rural areas. DTI is proposing that a private limitedcompany with minority government shares be established for this purpose (para4.41). It probably would be sensible to set up or expand rural units to 25-50looms due to warping equipment and overhead economies. Estimates indicatethat such ventures could have a return on capital of at least 20%, with clothpriced competitively. Export handloom product firms could require roughlyUS$0.5 million p.a. of institutional term credit from 1979-83.

D. Construction and Building Materials

3.13 Performance and Prospects. Programs under the Medium Term Devel-opment Plan and the Government's policies toward private investment haveresulted in a considerable increase in demand for construction contractingand building materials. While construction experienced a real decline of2.6% p.a. in 1970-77, value added exceeded Rs 1.5 billion in 1978, up morethan 20% in real terms over 1977. 1/ Public sector entities accounted forabout one third of the Rs 3 billion of gross output of construction during1978; the remaining two thirds was divided among roughly 6 large, 15 medium,200 small and 5,000 own-account contractors. Similarly in building materials,public corporations are dominant in some basic items (e.g., cement, steel andplywood), but private building material firms consist almost entirely of SMIs.Small industries are particularly active in the manufacture of bricks, tilesand tools, and in the extraction or processing of sand, gravel, and rocks.To meet the Rs 39 billion demand for construction implicit in the Medium TermDevelopment Plan, the 1978 construction output would have to be tripled by1983 and value added increased annually by 18% in real terms. GOSL expectsconstruction activities to generate over 200,000 jobs in the same period.Growth in the public sector is constrained by several factors and mostincreases in construction capacity is expected to come from the private sector.Small contractors and building material manufacturers could have a major rolein this growth. The Accelerated Mahaweli Ganga Development Program and otherirrigation programs will require large quantities of small tools and wheel-barrows and thousands of contract groups removing trees, digging channels,rocklining spillways and building shelters. To meet demands of GOSL's programfor 100,000 houses and private residential and factory construction needs, SMIcontractors and building material manufacturers will need to expand, improvemethods and increase access to credit and contracts.

3.14 Services and Financing Needs. From 1970 to 1977, stagnation in theconstruction industry resulted in little new investment and poor maintenanceof equipment. With their eroded asset and savings base, most SMIs cannotfinance expansion internally and find it difficult to meet credit institutions'collateral and equity requirements. In addition to credit, SMI contractorsneed training and advice on works management and methods improvement. Infor-mation networks and tendering procedures need to be improved to increase SMI's

1/ A summary review of structure and prospects in-the construction industryis available in the Project File.

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access to public and private contracts. Among building material SMIs, produc-tion is limited by inefficient labor utilization and lack of some basic piecesof equipment. 1/ In rock, gravel and sand extraction, improved methods forinitial processing and stockpiling during the dry seasons are needed. Organi-zation among building material manufacturers appears lacking; small producerscould form associations for purchasing raw materials and arranging directsales to contractors. In building materials, skill training and advicein establishing, expanding and operating SMIs are of importance. Since rawmaterials, unskilled labor and a sizeable portion of projected demand forconstruction and building materials are outside the main towns, the networkfor technical extension will need to encompass selected rural areas.

3.15 IDB's regional network places it in a relatively strong positionto provide technical advice and demonstrations in areas where constructionactivity would be concentrated. IDB already has provided thorough projectprofiles for use by bank branch staff in appraising SMI projects in bricks,tiles and stone crushing; IDB plans to establish work centers to demonstrateconstruction and building material methods. The Building Research Instituteof the State Engineering Corporation can provide back-up research servicesto IDB. The proposals for rapid expansion of short term on-the-job trainingby the National Apprenticeship Board in construction and materials shouldbe supported strongly. It is estimated that small and medium scale construc-tion contractors and building material units could require roughly US$3.5million p.a. in fixed investment and permanent working capital financingbetween 1979 and 1983.

E. Agroindustries

3.16 Problems, potential, credit and other assistance requirements havebeen analyzed for: coconut-based industries, rice milling, fish-relatedindustries and processing of manioc, fruits, spices and soybeans. Thisanalysis indicates that, in the short term, sizeable expansion potential orviable modernization prospects exist for: white and brown coir fiber SMIs;rice milling; and fish-related enterprises, particularly ice plants. Expan-sion and modernization in coconut oil and desiccated coconut are limited bypolicies and raw material availability; with policy revisions, the scope forinvestments in balancing and modernization would increase. Problems in fruitprocessing, essential oils and manioc are primarily in improving the produc-tion base, which would fall outside the scope of an SMI project. Large scaleprocessing is appropriate for soybeans.

3.17 Rice Milling - Performance and Prospects. Rice, the most importantfoodgrain crop in Sri Lanka, has accounted for 15% of agricultural GDP. Paddyproduction increased from 40 million bushels in 1960 to 77.5 million in 1970.

1/ Productivity among brick and tile manufacturers could be improved sig-nificantly by introducing pugmills, screw presses and material movingcarts.

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From 1970 to 1977, production dropped below the trend line but 1977 witnesseda record crop of 80 million bushels and this upward trend is expected to con-tinue with improved varieties, increased fertilization, and new irrigationschemes. The Paddy Marketing Board (PMB) handles about one third of nationalpaddy production, of which its 28 mills process 15%, the remaining 85% beinghandled by about 400 private "quota millers" registered with PMB; these quotamillers have an annual rated capacity of 540,000 tons, but actual milling isbelow this level. The remaining two thirds of paddy production are milled byabout 1,500 private non-quota mills. A portion is retained by farmers forhousehold consumption, with custom milling by village units which can handleabout 10 bushels per hour; the remainder is channelled to larger millers whosell in the open market.

3.18 Expansion Requirements. On the basis of projected increases inpaddy production, by 1982 an estimated additional 350,000 tons of paddy willneed to be milled annually by private millers. Assuming registered millswill achieve 65% capacity utilization by the end of 1979 and that 60 one-tonparboiling mills will come on stream in 1979 with anticipated utilized capa-city of 48,000 tons/year, more than 100 new one ton/hour private mills will beneeded by 1983. In addition, a sizeable number of village custom millers willneed financing. Requirements for new mills will be influenced by: future PMBprocurement and processing; the Food Commissioner's policies; capacity utili-zation by existing rice mills; and actual increases in paddy production. Thedemand for quality rice will increase as the ration system diminishes; millerswill be under pressure to upgrade facilities with polishers, cleaners, separa-tors, and parboiling tanks. Financing requirements from 1980 through 1983 areestimated to be about US$2 million p.a. for new mills and US$1.5 millionp.a. for modernization. 1/

3.19 Coir - Performance and Prospects. The coir industry is wellsuited to rural SMIs; dispersed land, water and raw material availability,and economic advantages of proximity to supplies militate against large scaleoperations. In 1978, white fiber production was 6,600 tons vs. 96,300 tons ofbrown fiber. About 2,100 tons of white coir yarn were exported during 1978,earning Rs 13.5 million in foreign exchange. An estimated 60% of green nutsused for human consumption are not utilized for coir; in white coir, this isdue to inadequate retting facilities, the distance between nut supply andexisting retting pits, and alternative uses of husks as fuel. In the southalone, it could be possible to collect as many as 80 million additional-greenhusks economically for use in white fiber.

3.20 Service and Financing Requirements. Brown coir fiber units requirefinancing for balancing and modernization to improve quality and productivityin order to meet export requirements. Increased manufacture of white fiberyarn and finished products would lift rural incomes and export earnings

1/ Fixed investment costs are based on locally manufactured equipment.The appraisal mission inspected the facilities of local rice millmanufacturers and found the quality of workmanship to be high.

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provided that several improvements are made: (a) introduction of husk crushersto reduce the retting period from 8-9 months to 3-4 months; (b) selectiveintroduction of decorticators and mechanical fiber beaters; (c) expansion ofimproved household spinning units; (d) expansion of both craft units andmedium scale powerloom factories manufacturing standard mats; and (e) improvedcoordination in the various stages of processing. In the past, DSI programshave been limited largely to about 30 craft production workshops and 80

i affiliated cooperative societies making mats. Annual worker earnings havebeen low, averaging Rs 1,255 due to insufficient or highly priced raw materialsand irregular orders. Recently, DSI has initiated vertically integratedoperations with an investment of about Rs 1.1 million in DSI retting, fiberextraction and household spinning to supply existing DSI finished productcenters. DSI estimates that these activities will generate a surplus of about250 tons of yarn for sale to the private sector in 1979. These facilitieshave been established mainly for demonstration purposes, to encourage selec-tive modernization by the private sector. The DSI plans to shift its orien-tation to technical and organizational assistance to private units. The DSIcould act as a catalyst by: (a) encouraging private retters/extractors tointroduce husk crushers, decorticators and fiber beaters; (b) assisting insubcontracting arrangements to household units with improved spinning equip-ment; and (c) supplying designs. The SMI project would provide consultancyservices and training to DSI in this white coir extension program (para 4.42).Roughly US$1 million of credit p.a. is expected to be needed for moderniza-tion and expansion of brown and white coir processing facilities.

IV. THE PROJECT

A. Objectives, Scope and Institutional Arrangements

4.01 The principal objective of the proposed SMI project would be toaddress constraints hindering rapid growth and productivity improvement ofSMIs, particularly in the key subsectors outlined in Chapter III, to increasetheir contribution to efficient and low cost employment generation, exportexpansion, and economic growth. To meet these objectives, this US$28 millionproject would have two major components, with IDA providing US$12 million forcredit and US$4 million for technical services.

4.02 The project would be national in scope; while attention would begiven to strengthening services for SMIs outside Colombo, a significantportion of the growth is expected in Colombo and secondary industrial towns.New and existing SMI firms engaged in a wide range of small industrial activ-ities would be eligible for credit, provided their projects are financiallyand economically sound. Firms eligible for finance under the project wouldbe those with plant and equipment (original cost) of less than Rs 1 millionbefore the subloan, with a maximum subloan size of Rs 1 million. The targetgroup for technical services would be firms with less than Rs 2 million inplant and equipment; most technical and management assistance components wouldconcentrate on key SMI subsectors with significant expansion potential.

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4.03 Credit Component. Under the credit component, responsibility forsubproject appraisal, on-lending and supervision would lie with the five majorcredit institutions: the two public commercial banks, Bank of Ceylon andPeople's Bank; the two locally controlled private commercial banks, HattonNational Bank and Commercial Bank of Ceylon; and DFCC. Under the project,their SMI activities would be encouraged and supported by:

(a) supplying US$12 million equivalent to help fill thegap between SMI term lending requirements and availableresources for credit to SMIs (para 2.25);

(b) building a separate SMI Refinancing Fund within theNational Development Bank to do rapid subproject reviewand partial refinance of subloans made by the five creditinstitutions to SMIs which meet financial and economiceligibility criteria (paras 4.06-4.17);

(c) improving capabilities of the five credit institutions todo appraisal-based lending, by: assigning SMI specialiststo headquarters and key branches; providing SMI specialistsand management with training in simplified SMI appraisaland supervision; and introducing systems and tools tofacilitate this work (paras 4.20-4.32); and

(d) providing inducements to the credit institutions to increasefinancing of viable SMIs, through provision of attractivespreads, a credit guarantee scheme and a special capitalfacility for entrepreneurs unable to meet the normal equityrequirements but with subprojects of strong economic merit(paras 4.1.3, 4.18, 4.19).

4.04 Technical Service Component. The technical, marketing andmanagement service component would:

(a) reinforce IDB's promotion and technical service programs forSMIs by improving IDB's regional extension network, startinga subcontracting exchange, and establishing subsector schemes,staff and technical facilities in rubber products, buildingmaterials, foundries and light engineering (US$1.9 million,paras 4.33-4.39);

(b) improve the focus and effectiveness of certain other SMItechnical service agencies by providing finance for(i) programs in garment training and export organizationfor handloom products, sponsored by the Ministry and Depart-ment of Textile Industries and (ii) extension programs inwhite coir extraction and processing, under DSI (US$960,000,paras 4.40-4.43);

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(c) finance outside consultants (36 manmonths) for policy studieson export incentives and an appropriate tariff system, whichare issues affecting SMI efficiency, expansion, and exportprospects (US$250,000, paras 2.13 and 2.19);

(d) fund training and advisors for NDB and the participatingcredit institutions to improve SMI lending and generaloperations (US$590,000, paras 4.17 and 4.28); and

(e) provide a discretionary fund to cover unforeseen costoverruns and additional training and technical assistance(US$300,000, para 4.45).

4.05 Financing Plan. The total costs for the SMI project would beabout US$28 million, 1/ of which IDA would cover US$16 million (i.e. 57%).For the credit component, the IDA US$12 million would cover 100% of therefinance for SMI term loans, which would represent an average of 56% ofsubproject costs. Under the technical service elements, the IDA US$4 millionportion would cover costs of equipment, training and advisors to implementthe subsector schemes, upgrade the financial institutions, and execute policystudies. GOSL's contribution of about Rs 18 million (US$1.2 million) wouldcover incremental staff and increased salary expenditures, overheads, andthe cost of land and buildings for facilities associated with the subsectorschemes. The following table summarizes project costs and sources of finance:

1/ Total project costs include an amount of US$190,000 to provide a con-tingency against cost increases or unforeseen changes in respect ofGOSLts contribution to the technical service component. The estimatesfor the elements of the technical service component to be financed byIDA already include amounts for contingencies against cost increases.The discretionary fund would provide for additional contingenciesarising out of unforeseen changes.

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Project Financing Plan(in US$ million)

GOSL/NDB/ CreditIDA TA Agencies Institutions SMIs Total

Credit Component

(a) Term credit for SMIs 12.00 3.00 6.45 21.45(b) Special Capital Fund - 0.51 - 0.51(c) NDB - admin. and

revolving fund - 0.79 - - 0.79Subtotal credit 12.00 1.30 3.00 6.45 22.75

Technical Services

(a) IDB 1.87 0.43 - - 2.30(b) Other technical

services 0.90 0.44 - - 1.34(c) Policy studies 0.25 0.09 - - 0.34(d) Consultancy services

and training forNDB and creditinstitutions 0.68 - - 0.68

(e) Discretionary/Contingencies 0.30 0.19 - - 0.49

Subtotal, services 4.00 1.15 - - 5.15TOTAL 16.00 2.45 3.00 6.45 27.90

B. Credit Component

1. Small and Medium Industry Fund - NDB

4.06 The National Development Bank (NDB) was established on January 5,1979, 1/ to provide term finance to public and selected large private firmsand refinance loans to small enterprises. Its Board of Directors comprisesrepresentatives of the Central Bank, the two state-owned commercial banks andthe Ministry of Finance and Planning. The Secretary of Finance is now NDB'schairman and the former director of the Development Finance Department of theCentral Bank has been appointed general manager. Steps have been taken torecruit the deputy general managers and other key staff; it is anticipatedthat major posts will be filled by mid-1979.

1/ The authorized share capital is Rs 2 billion (US$128 million) of whichRs 600 million has been issued to GOSL (67%), the Central Bank (17%)and the two state-owned commercial banks (16%). Rs 450 million of GOSL'scontribution was paid in and Rs 150 million left on call.

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4.07 Under the Act, 1/ NDB may establish separate administered funds tochannel outside resources to industry, agriculture, or commercial enterprises.The SMI Fund would be established under this provision with separate policies,staffing, financial resources and accounting. Staff of the SMI fund would:review SMI appraisals and refinance sub-loans submitted by the five majorcredit institutions 2/; monitor appraisal, supervision and collection stan-dards; collect repayments of refinanced amounts; and administer project fundsfor technical service components to SMIs (para 4.31).

4.08 Organization and Staffing. The SMI Fund of NDB would be headed bya deputy general manager, 3/ assisted by an outside adviser financed under theproject. The Fund would consist of three main sections: Analysis and Review,with a department head and four analysts; Reporting and Liaison, with a depart-ment head and two analysts; and Finance and Disbursements, with a departmenthead, an accountant, a disbursement officer and three clerical assistants.Two additional staff, one professional and one clerical, would be attachedto Finance and Disbursements to administer the technical service component. 4/Professional staff of the SMI Department should total 13 by January 31, 1980;in addition, the SMI Fund would draw on the services of an economist andengineer of NDB. This number of staff is considered adequate and NDB hasgiven priority to recruiting SMI Fund staff; NDB has advertised for profes-sional staff of the SMI fund and candidates for key positions have beenidentified. During negotiations the Sri Lankan delegation informed theAssociation that prior to credit effectiveness the NDB would have appointedat least the following staff of the SMI Fund, with qualifications and exper-ience satisfactory to NDB and the Association: the Deputy General Manager;the heads of the Analysis and Review, Reporting and Liaison, and Finance andDisbursement Sections; subproject review officers; and the professional staffmember overseeing the technical service component. This minimum staffingwould be satisfactory for effectiveness (para 7.02(i)). NDB intends to havethe head and at least three staff members of the Analysis and Review Sectionreceive outside training in subproject review and refinance prior to crediteffectiveness (para 4.44).

1/ Section 31 of the National Development Bank Act, No. 2 of 1979.

2/ Bank of Ceylon, People's Bank, Commercial Bank of Ceylon, Hatton NationalBank and Development Finance Corporation of Ceylon.

3/ In the initial period, direct responsibility for the Fund would beassumed by the general manager of NDB, who will delegate his authorityafter a suitable period.

4/ The SMI Coordinating Committee (para 4.45) would review progress ofof the technical service components, make recommendations on useby the discretionary fund, and help resolve problems of coordination.

5/ Training in SMI project review, monitoring and refinance would be pro-vided, probably by IDBI and the State Bank of India for six membersof the Fund staff prior to effectiveness. Ongoing training needswould be met under the technical service component of the IDA project.

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4.09 Policies and Procedures. A draft statement of policies and pro-cedures for the SMI Fund which sets out the objectives, eligibility criteriaand review procedures was agreed in substance during negotiations. The state-ment specifies on-lending and refinance rates and provides guidelines forthe special-capital facility and the Fund's monitoring role. The statementalso outlines initial operating procedures, which were discussed and agreedin substance during negotiations. In addition, the statement defines the keyitems to be included in the participation agreements between each of the fivecredit institutions and the Fund (para 4.20). This draft statement of policiesand procedures provides a satisfactory basis for the SMI Fund's operations(see Project File). The statement will be adopted by NDB's Board in a formsatisfactory to IDA prior to effectiveness and any subsequent modificationswould require IDA approval.

4.10 The Analysis and Review Section would review subproject appraisalsprepared by the credit institutions. 1/ For subloans below Rs 500,000(US$32,000), refinance would be granted on the basis of the credit institu-tions' appraisals, provided the subprojects meet eligibility criteria, arefinancially viable, and have appropriate terms. A more detailed review ofsubloans would be done on a sample basis to ensure that standards are main-tained. Subloans above Rs 500,000, would be subject to a more detailed reviewof the technical, financial, marketing and economic aspects. To ensure thatsubloans are reviewed expeditiously, the participation agreements between theSMI Fund and the credit institutions would state the intention of the Fund tocomplete reviews within two weeks. The Reporting and Liaison Section wouldmonitor the SMI lending activities of the participating credit institutions.Quarterly reports from the credit and technical service institutions wouldbe received, reviewed and aggregated for submission to IDA. Supervision stan-dards would be monitored through reports and by occassional field visits to asample of subprojects.

4.11 Eligibility for Refinance. Credit institutions eligible forrefinance would be those which have signed a participation agreement accept-able to IDA, with the NDB (para 4.20). Subprojects eligible for refinancewould involve the creation, modernization or expansion of productive facil-ities of a private or cooperative enterprise involved in manufacturing,mining, construction, agroindustry, fish processing, handicraft production orindustrial services. 2/ The SMI Fund would provide up to 80% refinance forsubloans to existing and new small and medium industries having total fixedassets, excluding land and buildings, with original cost of up to Rs 1 million

1/ To ensure appropriate appraisal standards, the SMI Fund will set outstandardized forms to be used in refinanced subloans with simplifiedforms for subloans up to Rs 500,000 and a more comprehensive formfor subloans above Rs 500,000; draft appraisal and supervision formswere prepared during the appraisal mission.

2/ Defined as: transport and other services which are a part of anindustrial enterprise; repair workshops and other services whichadd value to a product.

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(US$64,000) prior to the proposed subloan. The SMI Fund would refinance sub-loans of up to Rs 1 million for fixed assets l/ and permanent working capital,for subprojects not larger than Rs 2 million (US$128,200). 2/ Sponsors wouldbe required to provide at least 20% of total subproject cost in equity, but ascredit institutions would need to ensure that sub-borrowers have a sound struc-ture, it is expected that on average sponsors will contribute 30% of projectcost. All subprojects would have to be shown to be financially viable.

4.12 Eligible subprojects should also be economically viable. For allsubprojects, banks would assess whether the subproject will improve quality,price competitiveness, or production of an item for which demand can beestablished. For smaller more common subprojects 3/ the credit institutionswould use standard project profiles prepared by the IDB. 4/ Subloans ofabove Rs 500,000 would be subject to a more detailed review by the NDB; atthe outset NDB would be responsible for calculating the domestic resourcecost (DRC) ratio of the larger subprojects. The NDB would also do economicsubsector analysis and review IDB's project profiles. Over time, the creditinstitutions would be expected to develop increased competence in economicevaluation of subprojects.

4.13 Refinance Arrangements. The SMI Fund would refinance 80% of thesubloans to eligible subprojects by the participating credit institutions.On average, the equity participation is expected to be about 30%, refinance56%, and credit institutions 14%. The credit institutions would assume fullrepayment risk on refinance, repayable to the Fund on a fixed schedule deter-mined at the time of approval for refinance. To help ensure that a significantproportion of the project's resources are made available to smaller enter-prises, the credit institutions would receive differential spreads, designedto cover administrative costs based on the size of the subloan. The refinancerate would be adjusted to provide a spread to the credit institution of (i) 5%p.a. in cases of subloans up to Rs 100,000; (ii) 4% for subloans of betweenRs 100,000 and Rs 500,000; and (iii) 3% for subloans of between Rs 500,000 andRs 1 million.

1/ Land and buildings would be financed only if they are necessary com-ponents of the subproject.

2/ In the case of existing SMIs, "subproject" includes subloan and equityportions, excluding working capital, for balancing, modernization andexpansion; it does not include assets of the firm prior to the subloan.In the case of a Rs 2 million subproject, the subloan could cover up toRs 1 million, equity covering the remainder.

3/ E.g. rice-milling, repair workshops, brick and tile manufacture.

4/ IDB has prepared expanded project profiles for 5 major project types andplans to prepare an additional 10 prior to credit effectiveness; theseprofiles would include financial, technical and market information aswell as describe employment and net foreign exchange effects.

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4.14 Terms and Conditions. Refinance granted by the SMI Fund would bedenominated in rupees and onlent by the credit institutions at 15% p.a. forall subloans refinanced. 1/ This rate is reasonable in view of currentinterest rates being charged by commercial banks in Sri Lanka (Annex 1,Table 3) and represents a positive real rate of interest (para 2.26). Thefinal onlending rate and the spreads would be reviewed periodically andadjusted if circumstances change significantly. Since refinance would beused only for term loans, maturities on eligible subloans would be 3-10 years,including a maximum two years' grace; credit institutions would establishappropriate maturities and grace periods for each subloan based on the sub-project's debt service ability and the Fund would review the periods selected.

4.15 SMI Fund Resources. The SMI Fund's resources would comprise theUS$12 million IDA credit component plus an initial NDB contribution of Rs 20million (US$1.3 million). Approximately 5% of the Rs 20 million NDB contribu-tion would be used to cover the Fund's initial operating neeeds in the first1-2 years; Rs 8 million would be used to establish the Special Capital Facility(para 4.18) and the balance would cover the lag between NDB's disbursementsand reimbursement by IDA. The Rs 20 million is an initial estimate and duringnegotiations agreement was reached that NDB would provide resources as neededto cover additional operating expenditures of the SMI Fund. It is estimatedthat roughly 50% of total subproject financing would be for imported equipmentand inputs. 2/

4.16 Projected Financial Results. It is proposed that the SMI Fund'sspread be set at about 2% p.a. This spread is appropriate in view of theFund's operating costs and NDB's contribution. It is expected that, afterthe second year of operations, the Fund would begin accumulating operatingcash surpluses; before this, the low level of average outstandings and deferralof interest on Special Capital Facility loans would result in small operatingcash losses, which would be partially offset by income from the investment ofthe unutilized portion of the NDB contribution. It is anticipated that, bythe third year, average outstandings will total Rs 114 million (US$7.3 million)and, by the time the credit component is fully disbursed in the fourth year,outstandings will average about Rs 140 million (US$8.6 million) and a cashsurplus of Rs 1.0 million (US$64,000) would be earned by the Fund. This sur-plus would represent a return on the NDB contribution of around 8%. A detailedfinancial projection has been prepared and is summarized in Annex 1, Table 4.

4.17 Institutional and Training Needs. The NDB would need to take anumber of steps prior to project effectiveness. In particular, suitable staffneed to be recruited and trained for the SMI Fund. Training, financed underthe UNDP "Umbrella" would be arranged for 6 SMI Fund Staff at IDBI and theState Bank of India, with 4 trained before project effectiveness (para 4.44).

1/ Credit institutions would be obliged to charge the fixed rate on thefull subloan (including the 20% not refinanced) and lend on the sameterms and conditions. However, they would not be bound by this rateon short-term advances.

2/ The estimate is based on an analysis of patterns in existing SMIsand recent SMI loans by the credit institutions.

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Ongoing training needs, financed under the technical service component, wouldprovide overseas training for 3-5 SMI Fund staff per annum. The SMI Fundwould have to have a number of qualified staff acceptable to IDA prior tocredit effectiveness (para 4.08). Policies and initial operating proceduresfor the Fund have been developed and agreement in substance on these policiesand procedures was reached at negotiations. Other institutional support willinclude the appointment of an outside advisor for the SMI Fund who will assistin developing the Fund and implementing procedures. In addition, a top leveladvisor and consultancy services, financed under the project, would assist inthe establishment of NDB's overall operations. Candidates for the top leveladvisor position were discussed during negotiations; it was agreed that theAssociation would arrange for the election of a suitable candidate acceptableto GOSL and the NDB, and second him to Sri Lanka. Discussions have takenplace with the Industrial Credit and Investment Corporation of India (ICICI)in India on providing consulting services to assist NDB in setting up pro-cedures, establishing systems for finance, supervision and managementinformation, and offering training and assistance in appraising initialprojects of public sector corporations. One general advisor for two man-years and 24 manmonths of consulting assistance in these general aspectsare provided.

2. Special Facilities

4.18 Special Capital Facility. It is proposed that Rs 8 million(US$510,000) of the Rs 20 million NDB contribution to the SMI Fund be allocatedto a Special Capital Facility to assist entrepreneurs who are unable to putup the minimum equity participation. Under guidelines which have been dis-cussed and which form part of the SMI Fund's draft policy statement, thefacility would be used only in exceptional cases covering no more than 5% ofthe subprojects refinanced, and finance would be available only for subprojectsof high economic and financial merit. Loans would be limited to a maximumof 10% of total subproject cost with equity participation of at least 10%.Loans under the Special Facility would bear interest at an onlending rate notdiffering markedly from commercial rates, with a maximum maturity of 10years, but allowing up to five years' grace during which time interest couldbe capitalized. Applications and recommendations of the credit institutionswould be reviewed by the Fund, with special consideration to subprojects whichalso receive recommendations by IDB.

4.19 Credit Guarantee Scheme. To encourage credit institutions to relaxcollateral requirements for subloans refinanced by NDB, the Central Bank wouldmodify the existing Small Industries Credit Guarantee Scheme to accommodatesubloans refinanced by the SMI Fund. The existing scheme is administered bythe Central Bank and is restricted to projects under the IDB Joint Scheme;with the modified scheme, the credit institutions would apply for partialguarantee of subloans without requiring a recommendation by IDB. The coveragewould be altered to provide SMI subloans with a guarantee of the lower of 60%of the subloan or Rs 400,000. A 1% p.a. premium on the outstanding amountguaranteed would be payable by the institution out of its spread. Applica-tions for coverage would be made separately, but approval of the subloan

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by the SMI Fund would facilitate rapid review of the application by theCentral Bank. Once the default experience is known, premiums would beadjusted accordingly. The above mentioned aspects of the existing guaranteescheme which require modification were discussed at negotiations and agree-ment reached on changes required from GOSL. A modified scheme with character-istics acceptable to IDA would need to be in place by credit effectiveness.

3. Participating Credit Institutions

4.20 The terms and conditions of participation by the five credit insti-tutions (para 4.03) are to be governed by individual agreements, which willset out duties, responsibilities and obligations of NDB and the respectivecredit institution. Each agreement would stipulate the institution's duty to:(i) recruit, assign and train suitable SMI staff; (ii) prepare appraisals ofa satisfactory standard for each subloan; (iii) supervise subprojects toensure that funds have been properly utilized and progress is satisfactory;(iv) adhere to the terms of lending and repayment of refinance; 1/ (v) ensurethat procurement and disbursement standards are met; and (vi) submit quarterlyreports on SMI activity, subproject portfolio and arrears in a format suitableto the NDB. The features of the participation agreements were discussed withmanagement of NDB and the credit institutions during the appraisal mission.Draft participation agreements were discussed during negotiations and agree-ment was reached on the substance of these agreements. Participation agree-ments will include placement of an agreed minimum of trained SMI appraisaland supervision staff at head office and key branches; SMI staff commitmentsby each credit institution are noted in paras 4.22-4.27. At least two creditinstitutions would need to sign a participation agreement prior to effective-ness; one agreement would need to be with People's Bank or Bank of Ceylon,and the other with Hatton National Bank, Commercial Bank of Ceylon, or DFCC.NDB's statement of policies and procedures would specify that credit insti-tutions eligible for refinance from the SMI Fund are those which have signeda participation agreement satisfactory to IDA.

4.21 The State Banks. Both state banks, Bank of Ceylon (BOC) and People'sBank, have extensive branch networks covering urban and rural areas: BOC has11 regional offices, 24 district offices and 92 branches, while People's Bankhas 16 regional offices and 217 branches. 2/ Together, BOC and People's Bankaccount for about 86% of commercial bank lending in Sri Lanka. 3/ Roughly 80%

1/ Repayment schedules for refinance would be established for groups of sub-loans submitted together by each credit institution, i.e., repayments fora given group would be made quarterly at the same time.

2/ In addition, BOC has 450 agricultural service centers and pay officesand People's has 277 savings branches. These offices are not fullservice branches and function largely as deposit and repayment col-lection centers.

3/ At December 31, 1977; loans and advances include trade bills butexclude guarantees and acceptances.

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of both banks' lending is short term 1/, although many of the short termadvances are rolled over regularly into what is effectively long term finance.Lending policies still rely heavily on collateral, but the banks have realizedthe need to base credit decisions on project appraisals. This shift has beendelayed, however, due to lack of trained personnel. The expansion of thebranch network and the increase in business, particularly since liberalization,has put a strain on the banks' staff. These constraints also have made theintroduction of formal systems of loan supervision and procurement difficult.Both banks are attempting to overcome these weaknesses through a program ofstaff recruitment and training. Bank of Ceylon, with IFC assistance, has madesome progress in decentralizing lending decisions, developing appraisalprocedures, and establishing an Industrial Projects Department at headquarters.The proposed project would assist the banks in improving project-based lendingby helping establish sound appraisal, procurement and supervision practicesand standards for SMI lending, which could influence other areas of operation.Both banks would have an SMI unit at head office and designate officers at keybranches who would be responsible for the appraisal and supervision of SMIsubprojects.

4.22 Bank of Ceylon. Industrial lending accounted for 26% of total BOCloans and advances outstanding at December 31, 1977, and although no separatefigures are maintained for SMIs, a survey of major branches indicates thatSMI loans account for 4% of industrial advances. Industrial lending is underthe overall control of an assistant general manager at head office with threeprofessional staff with some experience in project appraisal. The BOC plansto increase the size of this unit by a further 8-10 officers, through recruit-ment and internal promotion. These officers, supervised by a senior officerresponsible for SMI lending, will form the head office SMI unit. In addition,SMI officers of submanager or assistant manager status would be trained andassigned to the 24 key branches for appraisal and supervision of SMI loans.SMI officers, their regional and branch managers, and industrial appraisalpersonnel from the head office unit are to undergo training in SMI lending(para 4.28) and BOC has undertaken to assign them to SMI work for a suitableperiod. BOC's regional and branch managers' delegated approval limits areappropriate to this project, being Rs 400,000 in subloan size for regionaloffices and Rs 150,000 for larger branches and district offices. Members ofthe head office SMI unit will conduct the appraisals for subloans larger thanRs 400,000. In addition, the head office unit will be responsible for assist-ing branches on complicated projects and supervising the branch SMI staff.The BOC also intends to appoint a qualified engineer, who will be available toassess technical aspects of larger SMI projects. IFC's $2 million loan toBOC for small and medium industries 2/ would also be handled by the industrialunit at head office. IFC is providing institutional support to BOC; a pre-liminary reorganization approach paper has been completed, and a three year

1/ Short term is defined as up to one year; medium term is classified as 1-5years and long term as over 5 years.

2/ This loan provides financing for firms with up to Rs 6 million in assetsand therefore will mostly be used for firms larger than those coveredunder the proposed SMI project.

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program to analyze and implement needed changes in organization, proceduresand management information systems is being developed. The proposed SMIproject could finance some consulting assistance to BOC for this work, throughuse of the discretionary fund (para 4.45). Two UNDP-financed advisors willbe supplied to assist with project appraisal and supervision procedures andbusiness advisory services; the late arrival of these advisors has delayedcredit effectiveness of the IFC loan but the loan should be effective shortly.Under the proposed IDA project, it is anticipated that BOC will processroughly 350 subloans over the three year commitment period, of which 280 areexpected to be approved at branch or regional level (47% by value) and 70 athead office level.

4.23 People's Bank. Industrial advances accounted for about 37% of totaloutstandings of People's Bank at June 30, 1978. Available figures for lendingto SMIs indicate that advances in 1978 were mainly in short term loans andoverdrafts. People's collateral requirements are less stringent than BOC'sbut the majority of advances are made on the basis of security. The SmallIndustries Unit of the Development Department is to be expanded to a managerand four officers who will appraise subloans above Rs 400,000 and oversee SMIlending. activity. People's also intends to appoint an engineer who would beavailable to the SMI unit. Twenty key branches, which are expected to accountfor at least 80% of SMI business, will each have an officer assigned to SMIappraisal and supervision; in the case of the larger branches, a second officerwill be assigned as needed. These officers, their branch managers and headoffice staff are to undergo training (para 4.28) and will be assigned to SMIduties. Further institutional support would be provided under the projectfor a study of staff development policies and management information systems(para 4.29). Delegated approval authority is presently being increased fromRs 10,000 to Rs 50,000 for branch managers and to Rs 400,000 for regionalmanagers, which would be appropriate for this project. It is anticipatedthat roughly 350 subloans will be appraised at regional and branch levels ofPeople's Bank under the proposed project. The head. office unit, which will.appraise the larger projects, supervise the branch staff and appraise subloanproposals from branches that exceed delegated authority, is expected toprocess a further 50 subloans.

4.24 The Private Banks. The two Sri Lankan controlled private banks,Hatton National Bank (HNB) and the Commercial Bank of Ceylon (CBOC) 1/ havea restricted branch network concentrated in the urban areas: HNB has 23operating branches, of which 19 are outside Colombo, and has permission toopen three more; CBOC has nine branches, three of which are in Colombo.In total, the two banks account for 11% of commercial bank credit in Sri

Lanka. 2/ In the past, the private banks have concentrated on trade andcommercial lending, particularly export financing, but both banks have made

1/ Both banks have overseas banks as minority shareholders: Grindlays (UK)has 27% of HNB and Standard Chartered (UK) has 40% of CBOC.

2/ CBOC accounted for 6% and HNB for 5% at December 31, 1977.

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policy decisions to expand their limited lending to SMI. Both banks recog-nize the need for and have begun using appraisals as a basis for creditdecisions. They also have been able to institute a formal system of subloansupervision and adopt relatively good procurement standards for the few loanshandled by each branch. Both banks are vulnerable to high staff turnover,primarily to Lne Middle East, due to the sound training they provide inexport financing and foreign exchange operations, and both are facing staffconstraints. A number of the staff of both banks have undergone training inappraisal and supervision of small industry projects.

4.25 Hatton National Bank. Industrial lending accounted for 27% of HNB'stotal advances in 1978 but only a small portion was loaned to SMIs. To imple-ment the proposed project and increase SMI lending, a head office SMI unitwill be formed, with two officers under the deputy general manager. In addi-tion, two officers will be assigned to SMI lending at each of the four keybranches expected to account for the bulk of SMI lending. These officersand the branch managers will participate in the SMI training program. HNBproposes to delegate approval authority of Rs 100,000 to branch managersand larger subloans will be approved at head office. It is anticipated thatHNB will account for about 10% of the proposed credit, approving about 50subloans at branch level and 45 at head office.

4.26 Commercial Bank of Ceylon. The CBOC has made relatively fewindustrial loans and has only advanced Rs 1.8 million to SMIs, mostly onoverdraft. To increase this lending and to implement the project, CBOC wouldestablish a head office unit with two industrial appraisal officers reportingto the deputy general manager, and would place SMI appraisal officers in twokey branches; a third branch would be added at a later date. SMI officersand branch managers are to participate in the training program. Initially,branch managers will have approval authority for subloans up to Rs 50,000;larger projects will be approved at head office. The CBOC is expected toaccount for roughly 10% of the credit in about 100 subloans.

4.27 Development Finance Corporation of Ceylon. The DFCC is a privatelyowned 1/ DFC which has received a total of $24.5 million in four loans andcredits from IBRD/IDA and $5 million from the Asian Development Bank, whichis currently considering a further loan of up to $10 million. Although DFCCconcentrates on loans to and investments in medium to larger scale companies,it has 78 loans outstanding to small scale industries amounting to Rs 19.7million. The DFCC proposes to establish a separate SMI unit which will alsohandle small scale loans under the ADB and other IDA lines of credit. Theunit wiil be headed by a senior loan officer reporting to the general manager,with four SMI officers and access to DFCC's engineering staff. The staff iswell qualified and will upgrade SMI appraisal and supervision skills furtherin the SMI training program.

1/ DFCC's shares are held 45% by Sri Lankan companies and individuals, 25%by State owned bodies and 30% by foreign shareholders, including a 10%holding by IFC.

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4.28 Training and Institutional Needs. Local and overseas training,financed under the UNDP "Umbrella," is to be provided, with Indian institu-tions being the major source of assistance (para 4.44). Overseas trainingfor appraisal staff of headquarters' SMI units will be provided by the StateBank of India between July 1 and September 1, 1979; 12 appraisal staff willreceive 8 weeks' training and apprenticeship in SMI appraisal and supervi-sion. Training in Sri Lanka by the National Institute of Banking Management(NIBM) of India in cooperation with the Central Bank has been launched. FromJune 15-September 15, NIBM will conduct and supervise four three-week courseson SMI project appraisal and supervision for 100 SMI appraisal officersselected for key branches and head offices of the five credit institutions.Course materials are based on cases and project profiles; standard appraisaland supervision forms are to be utilized in training sessions. In addition,three one-week appreciation courses for branch managers are planned forJune-September. The two state banks have been allocated 35 positions each onthe three-week course, 20 each on the appreciation course and 4 each on theoverseas program. The private banks and DFCC each have 10 positions for thetwo local courses and 2 positions for overseas training. Ongoing trainingneeds would be met from funds allocated under the technical service component.

4.29 A major institutional benefit of the credit component is the assist-ance it will give to the commercial banks in introducing project appraisals asthe basis of credit decisions; it is anticipated that this shift in approachand building of skills will have a direct influence on credit policy in otherlending areas. Other requirements, particularly for regular supervision ofsubloans and detailed management reporting, are also expected to influencethe practices and procedures at the banks. The project would finance onemanyear of consultancy services to help improve staff development policies andmanagement information systems in People's Bank. These studies would parallelsimilar efforts by IFC with the Bank of Ceylon and would represent the firststage in an institutional upgrading program for People's Bank.

C. Technical, Marketing and Management Component

4.30 Elements of the technical service component, outlined in para 4.04,would: (a) strengthen subsector-specific and general technical, managerialand marketing assistance to SMIs; (b) finance training, advisors and studiesfor NDB and the five financial institutions (paras 4.17, 4.28 and 4.29); and(c) fund studies on export incentives and effective protection, which involvepolicy issues affecting SMIs (paras 2.13 and 2.19). The following sectionoutlines the roles of the technical service agencies under the project,describes training and advisory assistance financed under the UNDP "Umbrella"to prepare the implementing agencies for these roles, and describes mechanismsto ensure effective coordination.

4.31 Requests for authorizations and for disbursements from the IDACredit would be channelled through the SMI Fund of NDB; a cell within theDisbursement Unit of the Fund would vet requests from the implementing agenciesfor pre-allocated portions of the technical service component, submit themto IDA, and prepare reports on planned vs. actual implementation. The SMI

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Coordinating Committee (para 4.45) would meet at least quarterly to reviewprogress on the technical service component, discuss requests, decide on theuse of the US$300,000 discretionary and contingency fund, and discuss anyproblems of policy or project implementation. The technical service agencieswould prepare an overall implementation plan and annual work programs satis-factory to IDA and submit quarterly progress reports through NDB. Thesereports would include status of GOSL budget allocations for the program,actual technical staffing and consultancy relative to the number and quali-fications outlined in the detailed implementation plan, physical progress oninstalling and operating necessary technical service facilities, and coverageand impact of the major elements (paras 4.35-4.43). The implementation planwas agreed in substance during negotiations.

4.32 Most technical service elements would address specific problems ofSMIs in priority subsectors with local or export market expansion potential.IDB would be the major SMI technical service agency, with responsibility forgeneral and most subsectoc-specific promotion and extension schemes. Theproject would assist IDE in expanding and upgrading its organization andstaffing, make extension work more systematic, and provide financing fortraining, specialists and technical facilities. In addition, DSI and MTIwould implement certain subsector schemes and NIM would expand its managementtraining programs for SMI. The project would increase the effectiveness ofthese agencies by clearly delineating responsibilities and providing mechanismsfor policy and working level coordination (para 4.45). The elements, costsand sources of finance for the technical service component are summarizedbelow and detailed in Annex 1, Table 6.

1. Industrial Development Board

4.33 Responsibilities. As the principal SMI technical service agency,IDB would shift emphasis from credit appraisal activities and would beresponsible for: (a) providing SMI project identification, promotion andextension services in the regions; (b) implementing subsector schemes to meetspecific needs of SMIs in rubber and metal products, construction materialsand selected agroindustries; (c) establishing a subcontracting exchange toassist SMIs in obtaining procurement and private subcontracting orders; and(d) preparing and updating expanded project profiles for use by the creditinstitutions in subproject appraisal.

4.34 Financing. IDA financing for these IDB programs is estimated tobe about Rs 29 million for equipment, foreign training and consulting ser-vices. GOSL financing, to cover incremental staff, other recurrent costsand investments in land and buildings associated with technical serviceelements, is expected to total about Rs 10 million over a 3 year period.Most components are designed to be self-supporting within three years ofcommencement of operations (Annex 1, Table 6).

4.35 Organization and Staffing. To implement these programs, IDBmanagement has prepared an organization and staffing plan which involves:reorganizing at headquarters along subsector lines; increasing the numberof head office specialized staff positions; providing short term outside

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training to about 30 technical specialists before and during project imple-mentation; and upgrading salary levels of both regional extension staff andtechnical officers at headquarters. During project preparation and appraisal,IDB (with the missions) developed detailed programs, organization and staffingto implement the regional, subsector and subcontracting schemes. Details werediscussed during negotiations and agreement in principal reached on sequencingof staffing, training, and investments to help ensure successful implementa-tion; these steps were recorded in the minutes of negotiations. Subsectordepartments at headquarters would have a core of technical specialists,strengthened initially by advisors; these departments would prepare projectprofiles for use by the banks in appraisal, provide technical advice to firmson improvement of productivity and quality, assist in marketing, and managecommon service facilities. In the regional and district offices of IDB, theproject would not require additional staff above those in IDB's 5 year plan;however, the coverage and effectiveness of regional promotion and extensionprograms is expected to increase markedly with training and since IDB staffwould no longer be directly involved in SMI loan appraisals, which haveabsorbed 70-80% of regional staff time during the last 3 years. Duringnegotiations, the Sri Lankan delegation confirmed that regional staff wouldbe trained in promotion and extension by Technonet Asia before and during theproject (para 4.44), that merit and general salary and benefit increases wouldbe introduced, and that a monitoring and evaluation system would be installed.

4.36 Rubber Products. To meet the needs outlined in paras 3.05 and 3.06,the SMI project would finance a Rubber Products Service Center under IDB toprovide: (a) advice on production methods, management and marketing; (b) pro-duct testing and development facilities and (c) supply of rubber compounds andlatex. The Center would be headed by a director, reporting to the generalmanager, with broad responsibilities for semi-autonomous administration of thecenter. Technical staff would include a marketing officer, product developmentofficer, quality control officer, extension officer and other technical andsupport staff. Technical officers would receive short-term overseas training.before or during project implementation, and an advisor would be financed forabout three years. The Center would require about Rs 16 million: Rs 4.5million in expatriate technical assistance and training; Rs 10.2 million inequipment; and Rs 1.2 million in land and buildings. Incremental operatingcosts, covered by GOSL during the first two years, would be about Rs 500,000.After year two, revenues from tests and sales of rubber compounds and indus-trial latex are expected to be sufficient to cover recurrent costs of theCenter and to begin accumulating surpluses for recovery of fixed investments.

4.37 Foundries and Light Engineering. IDB would establish an EngineeringTechnical Service Department at headquarters, consolidating the operations ofthe engineering workshop and engineering section of the extension servicesdepartment. This department would: (a) manage workshop, foundry and electro-plating common facilities servicing SMIs in Colombo and adjacent districts,(b) provide consulting and training to new and existing metal product SMIs,and (c) offer back-up services to technical facilities managed by the regionaloffices. Estimated costs for additional equipment would be Rs 3.6 millionfor the workshop, foundry and electroplating facilities; costs for outsidetraining of staff and consultancy would be about Rs 3.0 million. An advisor

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would spend one year helping establish the Engineering Center, and specialistsin heat treatment and electroplating would be hired for one to two monthseach. The SMI project also would finance common service facilities atMatara and Jaffna; 1/ IDB's surveys indicate that sufficient demand existsfor common services in engineering and heat treatment in these two areas.These centers would be managed by the regional offices of IDB to assure rapidresponse to client needs. Costs for each center would be about Rs 1 millionin equipment and Rs 525,000 in land and buildings, with an estimated Rs 50,000in annual incremental operating costs.

4.38 Construction Materials. The Industrial Development Board would havemajor responsibilities in technical and marketing assistance for buildingmaterials and construction SMIs. IDB would establish a Center under theConstruction Materials, Chemicals and Minerals Department which would beresponsible for: (a) developing improved products and processes for brickand tile manufacture, raw material extraction and processing and other keyconstruction materials in conjunction with BRI, (b) providing assistance toregional work centers and (c) conducting demonstrations and training programsfor firms in and around Colombo. Regional IDB work centers would be estab-lished; at the outset, about four centers would provide demonstration andtraining to private entrepreneurs and to voluntary groups which have networksfor diffusing improved methods to village groups. Estimates for equipmentcosts are Rs 600,000 for headquarters and Rs 300,000 for each work center.An advisor financed under the UNDP "Umbrella" would assist in detailed plan-ning for the centers, and the IDA project would finance one manyear of consul-tancy services.

4.39 Subcontracting Exchange. The marketing department of IDB wouldorganize a subcontracting exchange to (a) assist SMIs in gaining knowledgeof potential public procurement or private orders, (b) communicate to largeenterprises the production capabilities of potential SMI contractors, and(c) assist SMIs in meeting required quality standards and delivery schedules-(para 2.16). The subcontracting exchange would be operated by a deputydirector of marketing, with an assistant director and two development officersresponsible for the data bank and contacts; and a mechanical engineer and twotechnical assistants responsible for ascertaining production capabilities ofpotential SMI subcontractors and assisting them with production and qualityproblems. 1/ This staff would be expected to be in place prior to the arrivalof the consultant and the equipment for the subcontracting exchange. Totalstaffing costs including administrative, technical and clerical staff would beRs 100,000 annually. IDA would finance the cost of equipment (Rs 100,000),training and consultancy services, probably from the Bombay SubcontractingExchange (about Rs 1.5 million). The consultant, hired for 9 months, wouldhelp set up the data bank, sponsor the assistant director for 3 months'apprenticeship in Bombay and assist in implementation of the exchange.

1/ in cases of rubber and metal products and construction materials, thesubcontracting exchange would liaise closely with marketing officersin the specialising departments.

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2. Other Technical Services

4.40 Garment Training. The Ministry of Textile Industries (MTI) wouldestablish a Garment Training Center to provide training and plant level tech-nical assistance to small, medium and large garment units in cutting andpattern-making, production supervision and quality control (para 3.10). TheCenter would be part of the planned Textile Research and Training Institute,and would be staffed with; (a) 3 expatriate specialists in cutting roomtraining, production supervision and quality control, for 2 years each andoutside training (Rs 4.9 million); (b) permanent MTI training and administra-tive staff (Rs 300,000 annually) and counterparts seconded from privatemanufacturers to help give courses (Rs 300,000 annually in fees). Fixed costsare estimated to be Rs 2.5 million in equipment and vehicles, and Rs 600,000for land and buildings. IDA would cover costs of expatriate staff, equipmentand vehicles. Actions expected before arrival of consultants and installationof equipment would be allocation of funds by GOSL to cover staff, overhead,land and buildings, and recruitment of permanent and local consultancypersonnel.

4.41 Handloom Products. DTI plans to promote and participate in a privatelimited handloom production and export company with majority private shares(para 3.12). The private shareholders and board members would be leaders inproduction and exports of high quality handloom fabric and finished products.The company would select about 50 largely defunct handloom cooperatives andDTI centers in rural areas primarily in Puttalam, Kurunegala, Gampaha andKalutara districts which are relatively accessible to Colombo, are nearfinishing facilities planned for completion in mid-1980, and have rela-tively strong traditions in making quality handloom products. In year 1, thecenters would operate about 15 looms each in existing buildings; in year 2,buildings would be expanded for 50 looms to achieve an economic size to coverminimum overheads. By the end of year 3, employment is expected to be about2,200 with significant increases in weavers earnings at a fixed cost per jobof Rs 3,000. Estimated capital costs for the 3-year implementation periodwould be about Rs 6 million, with about Rs 2 million for broad looms and otherequipment and Rs 4 million for additional buildings. IDA would finance upto Rs 5 million in equipment, vehicles and materials representing part of theinvestment of MTI/DTI in the handloom production and export company. Theremainder would be financed through private and government equity contribu-tions and bank loans. The Minister of Textile Industries has given basicapproval to establishing this private limited company and the leading handloomproducts exporters have expressed considerable interest in participating.Conditions for disbursement for the handloom company would be: (a) legalestablishment of the company with statutes and participation satisfactory toIDA; and (b) issuance of implementation and financing plans agreeable to IDA.The statutes for the company are under preparation and on basic elements ofthe implementation plan were discussed during negotiations.

4.42 Coir Products - DSI. The Department of Small Industries (DSI) plansto: (a) refocus its efforts on promotion and extension to private householdindustries rather than limit activities to DSI-owned or affiliated facilities

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and (b) avoid overlap with IDB by focussing on very small household enterprises.Under the project, DSI would be strengthened to provide extension services tothe white coir industry. Staff would be hired, redeployed and trained toprovide extension services in white coir retting, extraction and spinning.The project would promote introduction of husk crushers, decorticators, andmechanical fiber beaters, improved household spinning units, and handicraftunits, and would encourage links with private powerloom firms and organizationamong various stages. The DSI and the Ministry of Rural Industrial Developmentplan to have the coir extension unit headed by an assistant director, assistedby 2 fiber technologists, 17 supervisors, 30 demonstrators and support staff

* with redeployment of the 30 coir demonstrators by January 1980. The UNDP"Umbrella" would finance initial training, probably in India and the proposedIDA project would finance additional training and an expatriate specialistfor one year, for a cost of about Rs 2 million. Incremental costs of aboutRs 100,000 annually would be financed out of the budget of the Ministry ofRural Industrial Development. Steps necessary prior to the arrival of theadvisor would be completion of redeployment and recruitment of DSI extensionstaff to implement the coir extension component.

4.43 National Institute of Management (NIM). Under the SMI project, NIMplans to provide short technical and management training sessions to smallenterprises in the regions. Sessions would be practical, utilizing case andincident studies. Participants, selected by IDB regional managers, would befrom similar SMI subsectors to facilitate exchange of ideas. NIM would offerabout 50 such training sessions each year. NIM would use technical specialistsfrom IDB and the private sector to complement NIM's management/accountingfocus. Members of the Small Industry Chamber of Commerce would be used inthese sessions. Under the UNDP "Umbrella" Project, funds have been allocatedfor NIM to prepare the structure, content and materials for these sessions andto identify with IDB key areas and subsectors. The SMI project could financepart of the costs for the actual training from the discretionary fund, if NIMcan justify to the SMI Coordinating Committee the need for partial subsidies.

3. Preparation, Coordination and Monitoring

4.44 UNDP "Umbrella". An estimated US$175,000 of the UNDP Multi-sectoralProgram of Project Preparation has been allocated to provide short term trainingand consultants to NDB, participating institutions and SMI technical serviceagencies to prepare staff and components for project implementation. Thenumbers, duration, and sources of this training have been noted in the creditand technical service component sections. About 185 staff of the financialand SMI technical service institutions will receive local training; 40 willreceive short term training with appropriate Asian institutions, mainly inIndia; and about 15 manmonths of foreign and local consulting will be financed.Training and consulting services are expected to take place between April 15and September 30. Final arrangements have been made for several of the com-ponents; for others training would begin in June. IBRDI/IDA is the executingagency for the "Umbrella". The Director of Planning of the Ministry of Financeand Planning (MINFIN) has agreed to be responsible for administrative arrange-ments and accounting; staff from MINFIN have been deployed and an administra-tive officer has been hired for this purpose.

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4.45 Coordination and Monitoring. The implementing agencies would carryout their specific activities and responsibilities autonomously within thebroad framework of objectives, guidelines, and procedures agreed between GOSLand IDA in the Credit and Subsidiary Loan Agreements, participation agreements,and implementation plan. In view of the complementary nature of the activitiesof the various agencies, mechanisms would be established to allow for adequatecoordination at district and headquarters levels. At district and regionallevels, coordination would be achieved by/providing for regular meetingsbetween the regional and branch managers of banks and the regional managersof IDB; the field staff of other relevant agencies would be consulted. Atheadquarters level, an SMI coordinating committee would be established, whichwould meet quarterly or more freqeuently if necessary. The core members wouldcomprise: the additional Secretary, MINSA; General Manager, NDB; Directorof Planning, MINFIN; Chairman, IDB; and a private representative of SMI. 1/These members would invite representatives of other agencies to attend (e.g.DSI, DTI, the financial institutions, Plan Implementation) depending upon thematters to be discussed. One professional and one clerical staff of the SMIFund of NDB would handle routine requests for withdrawals for pre-allocatedtechnical service components and would supply the coordinating committee withquarterly progress reports on credit and technical service components. Therole of the SMI coordinating committee would be to: (a) review quarterlyprogress reports prepared by NDB, IDB and the other implementing agencies;(b) examine operational or coordination problems raised by any of the imple-menting agencies; (c) make recommendations for action by the responsibleagency to improve the efficiency and effectiveness of project implementation,overcome administration problems and ensure achievement of agreed projectobjectives; (d) decide on use of the US$300,000 discretionary and contingencyfund, based upon requests by the implementing agencies; and (e) make recom-mendations of policies affecting SMI. Since this committee would deal withmulti-agency coordination and monitoring, quarterly meetings are consideredsufficient. Much of the coordination will be handled on an agency-to-agencybasis, with regular meetings as required. During negotiations, agreement.was reached on coordinating mechanisms and on the composition and responsi-bilities of the SMI coordinating committee; the SMI coordinating committeewould be established not later than 30 days after credit effectiveness.

V. THE CREDIT

5.01 Lending Arrangements. The proposed credit of $16 million, includinga $12 million credit component and a $4 million technical assistance component,would be made to the Government of Sri Lanka on standard IDA terms and condi-tions. The credit is expected to be committed in about 3 years and disbursedin about 4 years. Annex 1, Table 5 shows the estimated schedule of disburse-ments. GOSL would onlend the proceeds of the credit component to NDB for theaccount of the SMI Fund to cover the Fund's disbursements for refinancing

1/ The private SMI representative is likely to be the chairman of theSmall Industry Chamber of Commerce.

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eligible SMI subloans made by the participating credit institutions (4 com-mercial banks and DFCC) under terms and conditions outlined in a SubsidiaryLoan Agreement. These proceeds would be loaned to NDB in rupees, with GOSLbearing the foreign exchange risk on repayments to IDA. The SMI Fund wouldpay to GOSL an interest charge of 9% on the rupee amounts of the creditcomponent disbursed and outstanding to its account. Repayment to GOSL for thecredit component would be on the basis of a fixed amortization schedule. TheSMI Fund also would be responsible for administering disbursement of the tech-nical service component, the bulk of which would be preallocated to coverspecific items of training, technical and advisory services and equipment forthe participating institutions or for specific consultant studies (Annex 1,Table 6). The proceeds of the technical service component would not be repay-able to GOSL, although the participating agencies are expected to recover partof the costs incurred by charging fees for some of their technical services toSMI.

5.02 Onlending Terms. The credit institutions would charge a standardinterest rate of 15% to SMI subborrowers on subloans refinanced by the SMIFund. At present and projected rates of inflation, this rate of interestwould be marginally positive in real terms and is similar to the rates commer-cial banks charge to larger clients on term loans made out of their internalresources. The interest rates on refinanced amounts charged to the creditinstitutions by the SMI Fund would vary between 10% and 12% depending onsubloan size, so as to encourage lending to smaller projects and reflect therelatively higher costs and risks involved. Thus the SMI Fund would earn anaverage spread of about 2% p.a. on its refinancing operations, which would beadequate to cover administrative costs and yield an appropriate return on itscapital. The framework of rates and spreads proposed is shown in the tablebelow. The continued appropriateness of these rates and spreads would bemonitored during the commitment period, and they could be revised, withagreement of GOSL and IDA, in light of operating experience and to reflectchanges in market conditions.

PROPOSED LENDING RATES AND SPREADS /a

Size of Credit Institution's SubloanLess than Rs 100,000- Rs 500,000-Rs 100,000 Rs 500,000 Rs 1 million

Final onlending rate 15 15 15Spread to the credit

institution 5 4 310 11 12

Spread to SMI Fund 1 2 3Interest to GOSL 9 9 9

/a All rates in percent per annum.

5.03 Capital Contribution to SMI Fund. For the purposes of the proposedproject, an initial capital contribution of Rs 20 million would be made byNDB to the SMI Fund. The uses of this contribution are outlined in para 4.15.Additional resources would be made available to the SMI Fund by NDB as needed.The surplus generated by the Fund after the second year of operation wouldhelp restore and protect the real value of this capital.

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5.04 Subloan Sizes and IDA Review. The maximum size of subloan for anysubproject eligible for refinancing would be Rs 1 million ($64,000). The SMIFund would refinance 80% of the amount of eligible subloans. The averagesubloan size, for subprojects requiring financing for fixed assets and per-

manent working capital and costing Rs 50,000 to Rs 2 million, is expected tobe about Rs 200,000; about 1,000 subprojects in this size range are expectedto receive financing under the proposed credit. In view of the large number and

relatively small sizes of subloans, simplified review and approval procedureswould be used to keep administrative costs and processing times within rea-sonable bounds. The SMI Fund would review in detail only the appraisals ofsubprojects requiring subloans in excess of Rs 500,000. On refinancing appli-

cations for smaller subloans, a more rapid review and approval procedure wouldbe used, designed to check that adequate information has been provided tojustify the eligibility of the subproject, its financial viability and theadequacy of proposed subloan terms. Periodically, the SMI Fund would under-take sample analyses of appraisal reports submitted for the smaller refinancedsubloans to check that appropriate appraisal standards are being maintained.Prior review and approval of subprojects by IDA would not be required. Author-ization to make withdrawals from the credit account regarding subloans of upto Rs 750,000 would be granted by IDA following receipt of periodic statementsbriefly describing subprojects approved by the SMI Fund for refinancing duringthe preceding period. However, authorization requests regarding subloans inexcess of Rs 750,000 would be accompanied by a copy of the credit institu-tion's appraisal and the SMI Fund's review memorandum, for vetting by IDA ona post-authorization basis. This procedure is expected to result in detailedreview by the SMI Fund of about 150 subprojects, of which about 40 would bechecked by IDA. In addition, selected samples of appraisals and reviewscovering all five credit institutions would be examined by IDA during fieldsupervision missions.

5.05 Procurement. The credit institutions would be responsible forensuring that procured items for subprojects are suitable, reasonably pricedand that sponsors have canvassed main sources of supply. For subloans aboveRs 750,000 ($48,000), the SMI Fund also would review this aspect. Importeditems costing over US$10,000, would be procured on the basis of severalquotations, in accordance with standard practice for DFC projects. However,as it might be difficult and costly to obtain several quotations for many ofthe smaller orders, this procedure would be required only in the cases ofthese larger procurement contracts. Credit institutions would be required tomaintain records of the method of procurement and to monitor the utilizationof subloan funds through their regular supervision activities. These procure-ment procedures are considered to be satisfactory, SMI Fund staff and IDAfield supervision missions would review implementation of these proceduresas part of the regular supervision of the project. Procurement of goods underthe technical services component would be in accordance with GOSL proceduressatisfactory to IDA.

5.06 Disbursement Procedures. All subloan disbursements, for both for-eign or local expenditures, would be eligible for refinancing by the SMI Fundup to 80% of the total subloan amount. IDA would disburse 100% of the subloanamounts refinanced by the SMI Fund. Since sponsors are expected to contribute

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an average of 30% of subproject costs (minimum sponsors contribution 20%), IDAfinancing would cover about 56% of total subproject costs (para 4.13). Sincethe average foreign exchange content of subprojects is estimated at 50% (para4.15), IDA funds would cover a small proportion of local costs. In view ofthe large number of subprojects involved and small subloan size, the normalDFC procedures of disbursing against documented expenditures on individualsubproject accounts would be inappropriate for most subprojects. Accordingly,in the case of subprojects with refinanced amounts equivalent to US$40,000 orless, the Fund would claim reimbursement from IDA for refinance to subloans onthe basis of periodic certified statements of expenditure itemizing its dis-bursement to credit institutions for authorized subprojects. For thesesmaller subprojects, documentation would not be submitted to IDA for reviewbut disbursement by the SMI Fund would be made subject to receipt of document-ation evidencing subproject expenditures (excluding permanent working capital)and would be limited to expenditures incurred up to 90 days prior to receiptof the refinance application by the SMI Fund. This documentation would beretained by the SMI Fund for inspection during IDA supervision missions.During credit negotiations, agreement was reached that all statements of ex-penditure, together with supporting documentation, will be audited at leastannually. For subprojects with refinanced portions above US$40,000, fulldocumentation of expenditures on fixed assets (excluding permanent workingcapital) would need to be submitted to IDA. In the case of the technicalservice component, IDA would disburse (a) 100% of foreign expenditures forequipment imported directly and for locally manufactured equipment purchaseddirectly from a factory; (b) 80% of expenditures for other equipment procuredlocally; and (c) 100% of total expenditures for consultant's services andoverseas training. For the amounts allocated for preidentified items, with-drawal applications would be submitted directly to the SMI Fund. Priorapproval of the SMI coordinating committee would be required for use of thediscretionary funds to finance additional items or cost overruns (para 4.45).Authorization by IDA for financing of goods and services under the technicalservice component would be required; requests for disbursement by IDA wouldbe fully documented.

5.07 Repayment Schedule to GOSL. The maximum maturity for subloansrefinanced by the SMI Fund would be 10 years, including 2 years of grace.As the commitment period for subloans will be about 3 years, repayments bythe credit institutions would stretch over about 13 years. A fixed amortiza-tion schedule for repayment of the $12 million credit component from the SMIFund to GOSL is proposed, with a 13 year term including 4 years of grace (theexpected disbursement period). The alternative of repaying GOSL on the basisof a composite schedule made up of the sum of amortization schedules of theindividual subloans would be overly complex to administer for such a largenumber of subloans. Since the average maturities of subloans will be lessthan 10 years (probably 5-7 years), in the initial years the SMI Fund willreceive an excess of repayments from the credit institutions over the repay-ments due to GOSL. Such an excess would be used to augment refinancingoperations, and provide a valuable cushion to enable the Fund to continue itsoperations if there are delays in obtaining additional resources when theproposed IDA credit is fully committed.

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5.08 Reporting, Accounts and Auditing. The SMI Fund would submit quarterlyreports on its activities to IDA. The main report would be an aggregation ofthe individual quarterly reports by participating credit institutions-coveringactivity, portfolio data, collection and arrears performance and supervisionresults. In addition, the SMI Fund would submit a quarterly statement of itsown activity in refinance and details of disbursements against the technicalassistance component. Both sets of reports would have a content and formatsatisfactory to IDA and would be accompanied by an overall review of the SMIsector in Sri Lanka. A separate detailed statement of account for the Fundas a whole, prepared by the Finance and Disbursement Section also would besubmitted. An annual statement of accounts for NDB including the SMI Fundwould be audited by the Auditor General of Sri Lanka, or a designated privatefirm, which would submit a report in a form satisfactory to IDA not later thanthree months after the close of each fiscal year. If the Auditor Generaldesignates a private firm to audit the accounts of the Fund, the appointmentwould be for at least the duration of the project to ensure continuity.

VI. PROJECT BENEFITS AND RISKS

6.01 Benefits. The proposed SMI project would address the major con-straints hindering more rapid expansion and productivity improvements by SMIs.Access to term credit would be increased for a wide range of small and mediumscale manufacturing and service industries. The IDA credit would fill a sig-nificant portion of the gap in resources available for SMI lending. It isanticipated that about 1,000 subprojects would be financed, with subprojectcosts, including sponsors' equity, totalling Rs 335 million (US$21.5 million)and an average subloan size of Rs 200,000 (US$11,800). Roughly 50% of sub-loans are expected to be below Rs 100,000 (US$6,500), 35% between Rs 100,000and 500,000; and 15% for Rs 500,000 to Rs 1,000,000. These subloans, whichwould be extended to new and existing SMIs, are expected to result in incre-mental direct employment of at least 20,000, since in most SMI subsectorsincremental fixed cost per job averages well under US$1,000, and in coir,handlooms and several building materials product groups fixed costs perjob average below US$500.

6.02 Although the technical, marketing and management service componentsare expected to have a significant impact on growth and productivity of SMIsin priority subsectors, benefits are difficult to quantify. Coverage underthe technical service component is expected to include but not be limitedto SMIs receiving credit under this project. In the case of IDB, it is likely,that 600-1,000 firms in rubber products, engineering and construction will benefit from specialized services and the subcontracting exchange, and thatan additional 1,000-1,500 firms would benefit from the improved district levelpromotion and extension network. These programs are expected to result inimproved productivity, sales and employment; IDB and the appraisal missionhave devised a system to monitor coverage and impact. The handloom exportcompany is expected to result in a significant increase in earnings for atleast 2,000 rural weavers when fully operational. The Garment TrainingCenter could cover about 900 production supervisors, cutters and pattern-makers in three years, as well as providing inplant advice.

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6.03 One of the major anticipated benefits of the project is itsinstitution-building impact. Policies, procedures and staffing arrangementswould be implemented to enable the SMI Fund of NDB to provide rapid subprojectreview, refinance and monitoring of SMI subloans made by the five major creditinstitutions of Sri Lanka. The project would seek to improve attitudes andcapabilities of these credit institutions in making loans available to eco-nomically and financially viable SMIs, on the basis of project evaluationrather than collateral. The Industrial Development Board would shift its focusfrom aparnisnl of subloans, reorganizing at headquarters along subsectorlines to provide effective assistance to firms in priority product groups.

6.04 Risks. The National Development Bank only recently has been estab-lished, and top management is iust now recruiting key staff. The success ofthe SMI refinance scheme will depend upon relatively rapid establishment ofeffective policies, procedures and staff wTithin the SMI Fund of the NationalDevelopment Bank. However, while the NDB is new, GOSL has decided that NDBwill be the refinancing agent for industrial loans, and steps taken and plannedin licate that the SMI Fund will be able to execute its responsibilities undertti?e roject. The previous director of the Central Bank Development FinanceDePart-ent has been appointed General Manager of NDB and top managementexpects that kev positions will be filled by early July. Some strong can-didates with requisite experience have been identified for positions ofdeputy general manager and unit chiefs, and training with IDBI in Indiawill be provided before project effectiveness and during implementation.The project would finance an outside advisor for the SMI Fund and fourmanyears of outside assistance to NDB to help launch its overall operations.

6.05 Another risk is that the credit institutions will be slower thanexpected in moving from collateral to appraisal-based lending and that accessto credit, particularly to smaller borrowers, will be limited. However, thestructuring of differential spreads, the scope of the credit guarantee scheme,the emphasis on short-term practical training for branch-level staff and thediffusion of simplified project profiles are expected to help increase thecredit institutions' willingness and ability to make small project loans.

6.06 Other risks are associated with the innovative and ambitious natureof the technical service components. Successful implementation of the sub-sector schemes will require a significant reorientation by IDB and the othertechnical service agencies, and a sizeable increase in coverage and impactof IDB's staff and programs. The project involves a number of steps toincrease IDB's ability to attract and retain qualified staff by introducingmerit increases, incorporating short term local and foreign training opportun-ities, and increasing the use of local and outside consultants. Specific sub-sector programs, organizations and staff requirements have been developed toprovide a focus for the technical service efforts. Mechanisms for coordina-tion and monitoring of the technical service components have been incorporatedinto the project to help ensure successful implementation of the variouscomponents.

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6.07 Finally, the rapid development of SMIs envisioned with this projectdepends on the continuation of the favorable private investment environment.GOSL has taken a number of steps to "free the economy"; reintroduction ofcontrols would tend to retard development in the SMI sector. However, thisis unlikely in view of GOSL's policy statements.

VII. RECOMMENDATIONS

7.01 During negotiations, agreement was reached between IDA and theGovernment of Sri Lanka on:

(i) onlending terms, conditions, margins and subprojecteligibility criteria (paras 4.11, 4.13, 4.14, 4.17);

(ii) administrative arrangements and financing of advisorsand consultants, including substance of terms ofreference and timing for engagement of consultants(paras 4.17, 4.28, 4.36-4.42);

(iii) implementation program and timetable for technical servicecomponents (para 4.31);

(iv) GOSL's budgetary allocations of about Rs 18 million(US$1.2 million) to cover incremental costs for staff,overheads, land and buildings for the technical servicecomponents over the three-year commitment period (para4.05) and steps planned to upgrade salary and benefitlevels of IDB's technical and managerial staff atheadquarters and regional offices (para 4.35);

(v) GOSL's consideration of suggested modifications inpolicies affecting SMI; IDA and GOSL maintaining adialogue on development of incentives for SMI (para2.12); and agreement on administrative arrangements andtiming for completion of terms of reference for carryingout two major policy studies; (paras 2.13 and 2.19);

(vi) institutional responsibilities and mechanisms forcoordination and monitoring (paras 4.03, 4.04, 4.45);

(vii) procedures for procurement, disbursement, reporting,accounting and auditing (paras 5.01, and 5.04-5.08).

7.02 Conditions of effectiveness would be the following:

(i) establishment of the SMI Fund by NDB, including NDB Boardapproval of a statement of policies and procedures for theSMI Fund agreeable to IDA, paying in of an initial Rs 20million capitalization, and recruitment and training ofagreed minimum staff (paras 4.07-4.17);

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(ii) incorporation by the Central Bank of modifications in theSMI Credit Guarantee Scheme (para 4.19); and

(iii) signing of participation agreements, satisfactory to IDA,between NDB and at least two credit institutions (para 4.20);

(iv) signing of a subsidiary loan agreement, satisfactory toIDA, between GOSL and the NDB (para 5.01).

7.03 Conditions for disbursement from the IDA Credit to cover a portionof MTI's investment in the handloom production and export company to bepromoted by GOSL would be: legal establishment of the company with statutesand participation satisfactory to IDA and issuance of implementation andfinancing plans agreeable to IDA (para 4.41).

7.04 The proposed project constitutes a suitable basis for an IDA Creditof $16 million with standard terms, on conditions outlined in Chapter V.

SRI LANKA

INDICATORS OF PERFORMANCE IN LARGE INDUSTRIES AND SMIs

Share in % of total -/ Ratio in RupeesValue Added per

Number Value Fixed Fixed Investment Value Added Rupee of Fixedof firms Added Investment Employment per Employee per Employee Investment

Textiles and Garments 36 27 35 32- 7,400 1.64

Large 2 8 26 10 17,300 10,900 0.63SMIs 34 19 9 22 2,800 12,700 4.56

Light Engineering 25 15 19 26 5,200 8,400 1.63

Large 3 6 6 7 6,700 13,400 2.00(Electrical appliances) (0.5) (4) (2) (2) (7,300) (30,400) (4.18)(Mechanical machinery) (0.2) (1) (1) (1) (3,200) (8,300) (2.60)(Metal products) (1.6) (1) (2) (2) (9,200) (5,600) (0.62)(Transport equipment) (0.4) (-) (1) (1) (6,000) (8,000) (1.33)(Scientific equipment) (0.2) (-) (-) (-) (18,500) (6,200) (0.33)SMIs 22 9 13 19 (4,600) 6,700 1.45(Electrical appliances) (4) (3) (3) (4) (4,500) (10,500) (2,33)(Mechanical machinery) (3) (2) (5) (7) (4,300) (4,600) (1.07)(Metal products) (10) (2) (3) (4) (4,600) (7,100) (1.53)(Transport equipment) (3) (1) (2) (3) (4,800) (5,100) (1.07)(Scientific equipment) (2) (1) (-) (W) (7,000) (3,400) (1.66)

Paper Products and Printing 3 9 4 3 8.800 40,900 4.65 1

Large - 2 1 - 11,100 61,900 5.60 ZISMIs 3 7 3 3 8,300 8,300 4.38

Wood Products 6 3 2 6 2,700 8,200 3.00Large - - - - - - -SMIs 6 3 2 6 2,700 8,200 3.00

Rubber Products and Chemicals 11 15 20 15 9,300 14,600 1.57

Large 2 7 12 5 15,500 18,700 1.21SMI8 9 8 8 10 6,000 12,300 2.08

Food Manuifacturing 8 24 15 11 9,100 30,800 3.39

Large 1 22 11 6 11,700 48,100 4.10SMIs 7 2 4 5 5,300 5,300. 1.09

Basic Metal Products 1 21 1 1 3,700 44.500 12.00

Large 0.3 1 - - 4,700 51,800 11.00SMIs 0.7 1 1 - 3,700 41,900 12.50

Non-metallic Mineral Products 6 2 2 5 3,200 4,700 1.47

Large 0.4 1 1 0.3 4,500 5,200 1.14 0 SMIs 5.6 1 1 0.7 2,500 4,400 1.75 c

Other Subsectors 5 1 2 2 8,200 9,300 1.14 e .Large - - - - 13,200 6,600 1.00SMIs 5 1 2 2 7,700 9,600 5,00

Total 100 100 100 100 6,800 14,000 2.06

Large 8 47 57 30 12,700 21,400 1.69SMIs 92 53 43 70 4,200 10,800 2.56

1/ Figures do not add to 100 due to rounding

Source: Ministry of Industries and Scientific Affairs, 1977 Annual Survey of Approved Industries;only 2428 firms were covered, about 40. of the total registered firms in 1977.

SRI LANKA

DEMAND FOR CREDIT BY SMIs (1979-1983)

(in millions of Rupees)

IN 1978 PRICES

1/ 2/ 3/GDP at Factor Cost Manufacturing GDP at Factor Cost Construction and Quarrying GDP Total of Manufacturing and Construction GDP

at Factor Cost at Factor Cost

1978 34.903 5,247 1,660 6,9071983 45X617 7,021 92,i88 709

Incremental value1979-1983 10,714 1,774 1,028 2,802

Share of SMIs in Manufacturing and Registered SMIs Unregistered SMIs Construction SMIs Total of Manufacturing and Constructionin Construction SMIs

1. 1978 876 1,747 747 3,3702. 1983 1,173 2,337 1,231 4,741

3. (2-1) Incremental value 297 590 484 1,3711979-1983

4. Assumed ICOR 5/ 2 0.5 1 1

5. (3 x 4) Total fixed investment 594 295 484 1,373

6. Assumed ratio: fixed investment/ -/permanent working capital 1 I 1 1

7. (5 x 6) Total permanent working capital 594 295 484 1,373

8. (5 + 7) Total investment 1,188 590 968 2,746

9. Credit financing in percent -/ 40 30 30 3410. (8 x 9) Credit demand 475 177 293 945

II. Credit demand in US dollars 8/ 30.5 11.3 18.8 60.6

1/ ALL GDP estimates are based on Central Bank figures made available to the Appraisal Mission. Revised figures, based on a new methodology for compiling nationalaccounts, have been produced recently, which indicate a somewhat larger contribution by industry. However, these revised figtures have not been used in thistable since the new methodoloay is still beine chacked for accuracv and consistencv.

2 Assuming a real growth rate of 6.04 p.a. slightly higher than growth of GDP.

3/ Assuming a real growth rate of 10.5% p.a.4/ The share of SMIs in manufacturing GDP has been estimated at 16.5% of total for registered firms and 33% of total for unregistered ones. This coincides

with the Industrial Sector Report. The share of SMIs in construction is assumed to be 45% and is based on detailed analysis by the SMI mission and byprevious consultants. These shares are assumed to remain constant over the period 1979-83.

5/ Since a large part of future investment will have to be for replacement of worn out equipment as well as for expansion, the assumed ICORs are probablyunderestimates, The ICOR for the economy has been estimated at 3.7 and for industry at 3.0.

61 Based on analysis of some 500 SMI subprojects. Although the statistical basis available indicates significantly higher ratios, this conservativeassumption has been adopted due to the usually heavily depreciated book value of fixed assets.

7/ Taking into account the traditionally high level of self finance in industry and the limited access to trade credit and bank loans by SMIs in Sri Lanka,credit demand has been estimated at 34% of total investment requirements on the average.

8/ Assuming a constant exchange rate of Rs.15.6 per US$.

SRI LANKA

INTEREST RATE STRUCTURE(in percent)

A. DEPOSIT RATES

Treasury Savings Fixed DepositsBills Deposits 3 months 6 months 9 months 12 months

1. People's Bank 9.0 7.2 8.5 11.0-12.0 12.5-13.5 14.0-15.0

2. Bank of Ceylon 9.0 7.2 8.5 11.0-12.0 12.5-13.5 14.0-15.0

3. Hatton's Bank 9.0 7.2 8.5 11.0-12.0 12.5-13.5 14.0-15.0

4. Commercial Bank of Ceylon 9.0 7.2 8.5 11.0-12.0 12.5-13.5 14.0-15.0

5. DFCC 1/ - _

6. National Savings Bank - 8.4 - 12.0 15.0 0

B. LENDING RATESLarge Public Prime Rate for

SMIs Industries Corporations Private BorrowersSecured Unsecured

1. People's Bank 14.5 14.5-17.5 14.5-15.0 14.0 14.0

2. Bank of Ceylon 14.0-14.5 14.5-17.5 14.0-15.5 13.0-14.0 14.5

3. Hatton's Bank 15.0-17.0 15.0 - 14.5

4. Commercial Bank ofCeylon 16.0-17.0 18.0-20.0 15.0-18.0 - 15.0 14.0

5. DFCC 12.0-12.5 - 13.0-13.5 - - ||

Source: Information supplied to the SMI appraisal mission by commercial banks, DFCC and CentralBank of Ceylon.

1/ NSB's rates are 18% for 18 month fixed term deposits.

-51- ANNEX 1Tabl e 4(Page 1)

SRI LANKA SMI PROJECT

FINANCIAL PROJECTIONS

A. ASSUMPTION5

1. Number of sub-loans by size of sub-loans:

O-luO,000 50%100-500,00u 35%500-1,000,000 15%

100%

2. Amount ,f refinance:

Sub-Loan Subproject Average Sub- Average AverageCategory Size * Project Size Sub-Loan Refinance

0-100,000 0-143,000 89,000 62,500 50,000100-500,000 143-714,000 357,000 250,000 200,000500-1,000,000 714-1,429,000 1,072,000 750,000 600,000

* Assuming 30% average sponso, participation.

3. Number of Sub-loans:

Breakdv,, Average Size of Weighted Total Credit Number ofC.atorory by NuabeI Refinance Average Allocation Sub-Loans

0-10n,300 50 50,000 2.5m 13.5 25.272 505100-500,OoO 35 200,000 7.Om 37.8 70.762 353500-1 ,000 , 0C 1i 60(,0)0 9.0m 48.7 91.166 152

100 18.5m 100.0 187.2 *a 1,010

-12 millior at $1 - Rs 15.6Also vx4Saes that Special Capital F,cility paid out of Y10B contribution.A'e,age iae: Rs 185,350.

4. Utilization: by commitment

1st year 25% - 46.8m 3372nd year 35% - 65.5m 3373rd year 40% = 74.9m 336

187.2m 1,010 projects

5. Disbursements assumed at 80% in year of commitment and 20% in following year.

6. Average maturity: 7 years including grace.

7. Special Capital Facility:

Disbursement in same year as commitmentUtilization: 1st year 30%; 2nd year 40%; 3rd year 30%.Maturity: 10 years with 5 years grace.

8. NDB-SMI Fund admini3trative expenses:

Pre -operating (1/2 year) 1.0Aauual: lst year 1.3

2rd year 1.4( 3rd year 1.6

6th year 1.7(See attacned) * 10% p.a. escalation.

S). lechnical Service Component Disbursements:

Local costs: total Rs 3 m all ir year 1.Foreign coacs: Rs 59.4(%) v.

10. Credit Institutiana' share of refinance

Number ofSubprojects, 0-100,000 100-500L020 500-1,000, 0o

People's 45 35 30BOC 30 35 40DFCC 5 12 10HUB 10 9 10CBOC 10 9 10

l00% 100% 100%

- 52 -ANNEX 1Table 4(Page 2)

B. CALCULATIONS

1. Repayments

lst year 18,5 2.6 2.6 2.6 2.6

18.5 - 2.7 2.7 2.7

2nd year 31.5 - 4.5 4.5 4.5

31.5 - - 4.5 A.5

3rd year 36.5 - 5.2 5.2

36.5 - - 5.2

4th year 7.5 - - 1.17.5

188.0 2.S 9.8 19.5 25.8

2. Jutstandinge - Refinance:

Disbursements 37.1 62.1 73.0 15.0

Repayments 2.6 9.8 19.5 25.8

NET MOVEMENT 34.5 52.3 53.5 (10.8'

Cumulative 34.5 86.8 140.3 129.5

AVERAGE OUTSTANDING 17.3 60.7 l3.6 134.9

3. Outstandings - SEcial Capital Facilty:

Disbursements 2.3 3.2 2.3

Repayments -

Cumulative 2.3 5.5 7.8 7.8

AVERAGE OUTSTANDING 1.2 3.9 6.7 7.8

4. Income to the SMI Fund:

On refinaa.ce @ 22 p.a. .35 1.21 2.27 2.70

On SCF @ 15% p.a. deferred!!/ r.52 I, 1.l7

CASn INFLOW .35 1.21 2.27 2.70

5. Net Cash Position of the SYT Fund

Incomie .35 1.21 2.27 2.70

Costs l.0'/ 1.3 1.4 1.6 1.7

(1L0) (.95) (.19) .67 1.00

Cumulative (1.0) (1.95) (2.14) (1.47) (.47)

6. NDB Revolving nd Coutributtion

EstimateAd ReqIireme- 20.0 17.70 14.5 12.2

Less SCF disbursements 2.3 3.2 2.3 -

17.70 14.5 12.2 12.2T,wo mentai lat on:

Refinance disbursements(incr.) 6.2 10.3 18.9 22.2

T.A. disbursements (local' _/ 3.l - -

Inverted 8.5 4.2 (6.7) (10.0)

c .apitalized for up to 5 years.2/ Assuming thaL cash surpluses are not applied to further SCF disbursements.

2! Assumes local costs all in first year - foxeign.

-53 ANNEX Table 4(page 3)

7. Income from Invested Funds at 10 p.a. .85 .42

8. Overall Cash/Profit Position

Cash Profit/Loss (1.0) (.95) (.19) 67 1.00

Invested income .85 .42 - -

(1.0) (.10) .23 .67 1.00

Cumulative (1.0) (1.10) (.87) (.20) .80

9. Share of ProJects (Number)

0-100,000 100-500,000 500-1,000,000 Total

People's 227 124 46 397

BOC 152 124 61 337DFCC 25 42 15 82HNB 51 32 15 98

CBOC 50 31 15 96

Total 505 353 152 1,010

10. Share of Projects (Value)I/

Average Size X

People's 160.5 11.3 24.8 27.6 63.7 34

BOC 204.7 7.6 24.8 36.6 69.0 37DFCC 227.4 1.2 8.4 9.0 18.7 11

HNB 183.2 2.5 6.4 9.0 17.9 10CBOC 184.4 2.5 6.2 9.0 17.7 9

Total 25.3 70.6 91.2 187.1 100

i1. Ase!y_efinan Rate and _pread

0-100,000 25.272 x 5 126.36100-500,000 70.762 x 4 . 283.0g.500-1,000,000 91.166 x 3 - 273.50

187.200 682,90

Spread = 3.6% weighted average.Refin. rate 11.4% on average.

12. Forecast Profit and Loss/Cash Flow Statemenc

1st Year 2nd Year 3rd Year 4th Year

Income: Refinance spread @ 2% ,35 1.21 2.27 2.70

SCF interest @ .5% .18 .59 1.01 1._1

Operating Income .53 1.80 3.28 4.41Interest on funds invested .85 .42 - -

Total Income 1.38 2.22 3.23 4.41

Expenses: Administrative Costs 1.30 1.40 1.60 1.70Pre-operating Costs 1.00 - -_

Total Costs 2.30 1.40 1.60 1.70

Profit -/|Loss (.92) .82 1.68 2.70

Cash Flow: Deduct SCF interest deferred .18 .59 1.01 1.71

Operating Cash Flow (1.20) .23 .67 1.00

1/ Tax exempt for the firGt 10 years.

1/ Based on average sizes in A2.2/ Tax exempt for the first 10 years.

ANNEX 1_ 54 _ Table 5

SRI LANKA

SMALL AND MEDIUM INDUSTRY PROJECT

EST'ILATFD SCHEDTLE OF DISBURSEMENTS FOR ThE PROPOSED CEEDIT

Disbursements

IDA Fiscal Year and Quarter By Quarter CumulativekUS$ ' 030)

FYS0

To December 31, 1979 180 180March 31, 1980 800 980June 30, 1980 .L,OCO 1,980

FY81

To September 30., 1980 1,200 3,180December 31, 1980 1,200 4,380March 31, 1981 1,500 5,880June 30, 1981 1,500 7,380

FY82

To September 30, 1981 1,500 8,880December 31, 1981 1,500 10,380March 31, 1982 1,400 11.780June 30, 1982 1,200 12.980

FY83

To September 30, 1982 1.100 14,3e0December 31, 1982 1,1CC 15,180March 31. 1983 340 13,520

June 30, 1983 300 820

FYL4

To Septembet 30, 1983 '68C l0,

ANNEX ITable 6

SRI LANKA

SMALL AND MEDIUM INDUSTRY PROJECT

COSTS AND SOURCES OF FINANCE FOR TECHNICAL SERVICE COMPONENTS

(Rs '000)

Cost and Source of FinanceResponsible Institution Purpose Element IDA GOSL/Agency Total

1. Industrial Development Board Rubber Products Technical a) Advisor - 3 manyears 3,930 - 3,930Service Center b) Outside training - 24 manmonths 570 - 570

3 c) Equipment / 10,200 - 10,200d) Land and buildings - 1,200 1,200e) Staff and other operating expenses - 500 500

Subtotal, Rubber 14,700 1,700 16,-40

Engineering Technical Service a) Advisor - 1 manyear 1.500 - 1,500Centers b) Outside training - 40 manmonths 1,500 - 1,500

c) Equipment for headquarters 1/ 3,600 - 3,600d) Equipment for regional centers 2,000 - 2,000e) Land and buildings - 1,050 1,050f) Staff and other operating expenses - 1,400 1,400

Subtotal, Engineering 8,600 2.450 11,050

Construction Material - a) Advisor - 1 manyear 1,500 - 1,500Technical Service and Work b) Outside Training - 24 manmonths 750 - 750Centers c) Equipment for headquarters 1/ 600 - 600

d) Equipment for regional centers 1/ 1,200 - 1,200e) Land and buildings - 900 900f) Staff and other operating expenditures - 1,050 1,050

Subtotal, Construction 4.050 1,950 6,000

Subcontracting Exchange a) Advisor ( 9 msanmonths) 980 - 980b) Outside training - 10 manmenths 520 _ 520c) Equipment 1/ 100 - 100d) Staff and other operating costs - 500 500

Subtotal. Subcontracting Exchange 1,600 500 2,100

2. Ministry of TextileIndustries Garment Training Center a) Consultants (72 manmonths) 5,800 - 5,800

b) Equipment 1/ 2,500 - 2,500c) Land, buildings - 600 600d) Staff and other operating costs - 1,500 1,500

Subtotal, Garments 8,300 2,100 10,400

3. Peivate Ltd. Co. withDepartment of TextileIndustries as shareholders Handloom production and export Equipment, vehicles and materials 3,700 4,500 8,200

company

Subtotal, handlooms 5,700 4,500 8,100

4. Department of Small White coir extension services a) Advisor (12 manmonths) 1,310 - 1,310Industries b) Staff training 690 - 690

c) Staff and other gperating expenditures - 300 3C0

Subtotal, Coir 2.000 300 2,300

5. National Development Bank Training and technical assistance a) General advisor to NDB (24 mannooths) 2,600 - 2,600b) SMI advisor (24 manumonthe) 2,600 - 2,600c) Consulting to NDB (24 mannunths) 2,600 - 2,600d) Consulting to People's Bank (12 manmonths) 1,300 - 1,300e) Training for SMI Fund (15 manmonths) 470 - 470f) Training for credit institutions and local 930 1,410 2,340

Subtotal, WIR ans ereftt Tnstturtions 19.500 1,410 11,0106. Permanent Tariff Review

Commission Study to develop appropriate a) Consultant (24 manm-nths) 2,620 - 2,620Tariff System

7. Ministry of Industries/ Study on eaport incentives a) Consultant (12 manmonths) 1,310 - 1,310Finance

8. NDB/CGordiating Coitte a) Discretionary Fud/Contingencie- 4,680 3,000 7

Total Technical Service Components A06_ a912 .92297

1/ List of equipment and estimated costa available.

56 - ANNEX 2Page 1

SRI LANKA

APPRAISAL OF SMALL AND MEDIUM INDUSTRY PROJECT

Supporting Documents Available in Project File

A. The Manufacturing Sector and Financial System

Al. Central Bank of Ceylon-Review of the Economy (1977).

A2. Selected tables and extracts from the Surveys ofManufacturing Industry by the Ministry of Industry andScientific Affairs and from the Survey of UnregisteredIndustries by the Industrial Development Board.

A3. Background papers on principal SMI subsectors:

a) Metal Products;

b) Rubber Products;

c) Selected Agroindustries;

d) Construction Contracting and Building Materials; and

e) Textiles and Garments.

B. Reports and Draft Documents Relating to the Project

Bl. Draft amendments to Small Industry Credit GuaranteeScheme of the Central Bank of Ceylon.

B2. National Development Bank-Draft Statement of Policies andProcedures for the Small and Medium Industry Fund.

B3. Draft Participation Agreement between the NationalDevelopment Bank and Credit institutions.

B4. Draft terms of reference for studies to develop anappropriate tariff system based on the principalof effective protection.

ANNEX 2Page 2

- 57 -

C. Selected Working Papers Prepared by Bank Staff

Cl. Proposed changes to organization, staffing, programsand budgets of the Industrial Development Board,Department of Small Industries, and Department ofTextile Industries to implement subsector specifictechnical service schemes under the Project.

C2. Outline of training and technical aspistance programunder the UNDP Umbrella Project and the SMI Project.

C3. Working papers and background information on CreditInstitutions participating in the Project.

I