Report No. 6278-MA

MalaysiaThe Administration of Selected Export IncentivesJanuary 12,1987

East Asia and PacificCountry Programs Department

FOR OFFICIAL USE ONLY

7

Documert of the World Bank

This document has a restricted distribution and may be used by recipientsonly in the prformance of their official duties. Its contents may nototherwisebe disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

Currency Unit - Ringgit (M$)

1985 1986

US$ I M$2e48 M$2.58M$1 = US$0.40 US$0.39

FISCAL YEAR

January 1 - December 31

ABBREVIATIONS

B/E - Bill of ExchangeBKPM - Bank Kemajuan Perusahaan Malaysia BerhadCCC - Credit Guarantee CorporationCOFACE - Compagnie Francaise d'Assurance pour le Commerce ExterieurDL/C - Domestic Letter of CreditECGC - Export Credit Guarantee Corporationn of IndiaECGD - Export Credit Guarantee Department of the UKECICS - Export Credit Insurance Corporation of SingaporeECR - Export Credit RefinanceERP - Effective Rate of ProtectionFTZ - Free Trade ZoneGDP - Gross Domestic ProductGNP - Gross National ProductL/C - Letter of CreditLMW - Licensed Manufacturing WarehouseMECIB - Malaysia Export Credit Insurance BerhadMIDA - Malaysia Industrial Development AuthorityOKB - Oosterreichische Kontrollbank AGPEFG - Preshipment Export Finance Guarantee

FOR OMCIAL USE ONLY

MALAYSIA

THE ADMINISTRATION OF SELECTED EXPORT INCRNTIVES

Table of Contents

Page No.

SUMMARY AND RECOMMENDATIONS ... i..................... viii - vi

I* AN VRIW...... 1

A. Setting the Cont e x t 1

B. The Role of Export Incentives in Industrial andTrade Strategy... 3

C. Issues in the Administration of Selected Export6

The Export Credit Refinancing S chmeem e................. 6Import Duty Drawback and Tariff Exemption............... 9

II. PRIORITY TASKS IN POSTSHIPMENT FINANCE ADMINISTRATION......... 10

A. Weaknesses in the Existing Postshipment CreditInsurance Scee11MECIB's Operations are too S m al l 11MECIB's Insurance Coverage is Limited.m i t ed*** ,... 13Exporters and l3ankers do not Regard MECIB Highly........ 14

B. Measures to Improve the Postshipment CreditInsurance System 15Change the Organizational Structure***,********,,***,*,* 16Strengthen Institutional Links........................ 17Introduce New In6urance Instru ments...............,..... 19Develop MECIB Eprie25

C. Moving to a Market-Based Interest Rate.....o............... 26

D. Issues in Medium- and Long-term Export Financeanc..,.e..... 27

This report is based on the findings of a mission tti#-. v:sited Malaysia inMarch-April 1986. The mission consisted of Vikram Nehru (Mission Leader),Y. W. Rhee and Robert Martin (Consultant). The missiua benefitted greatlyfrom generous assistance provided by the staff of Bank Negara and MECIB.

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.

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III. PMIORITY TASKS IN PRESHIPtENT FINANCE ADKISTRATIONI .......... .31

A. Administrative Mechanisms for Preshipmnt Finace.......... .31Disbursement and Liquidation Mechanisms.................. 32On the Choice Between the B/E and DL/C Systems.......... 33The Certificate of Performance Systemo.................... ?

B. Introducing a Preshipmeit Export FinanceGuarantee (PEFG) ............................. .. **** 37Which Institution Should Handle PEFG?................... 38Some Features of a PEFG System.......................... 38Elements of an Action Program........................... 39

C. Other Issues in Preshipment FinanceAdministration ............... o.o...........o.o...e....o. 41

Domestic Value Added and Local Content Requirements..... 41Number of Production Stages with Access to ECRB.......... 41Definition of Confirmed Export Ordero................... 41Maximum Loan Periods for Preshipent CCR................ 42Interest Rate Spread for Preshipment ECRo............... 42

IV. THE ADMINISTRATION OF DUTY-FREE IMPORT SCHEMSo................ 43

A. Import Licensing for Exporters.o......................o.... 43

Bo The Duty Drawback Scheme . ........................ 44

CS The Prior Exemption S c h e m e 45

D. Some Recommendations for Reformf......orm....o..o.....e.... 46

TABLES IN THE TEXT

Table 1.1 Selected Macroeconomic Indicators.....o..oooeo....o....oo. 2Table 1.2 Projections of Growth Rates for Merchandise Exports

by Major Categories, 1986-90............................ 3Table 1.3 Interest Rates and Discount Rates Under the ECR Scheme.... 6Table 2.1 MECIBs Number of Policyholders and Value of

Exports Insured...............o..............o. .***00 OOo. 12

Table 2.2 MECIB: Financial Results, 1978-85.......................o 12Tabie 2.3 Some Potential Markets for Malaysian Exports with Little

or no Cover Provided by MECIB..oo.................o..... 13Table 2.4 MECIB: Suggestions on Premium Rates and Percentage of

Cover for Bankers' Insurance Policiesoicies..o.o.o..o.o. 22Table 2.5 Lending Activities of BKPM, 1979-85.7 9 - 8S................. 29Table 3.1 Comp&rison of DL/C and B/E Systems.o..ooo......o...... 34Table 4.1 The Administration of Duty-Free tI:art Schemes:

An ........................................... 48

APPENDICES

A. Export Incentives in MalaysiaB. The Establishment and Structure of MECIBC. Further Thoughts on the Organization of MECIB

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SUMMARY AND RECOMMENDATIONS

i. Malaysia's future performance in exporting manufactures will provecritical in developing a strong manufacturing sector, providing employmentopportuniti8es and earning sufficient foreign exchange to maintain an externalbalance consistent with healthy growth. The rapid expansion of manufacturedexports in the past depended heavily on foreign investment in free trade zones(FTZs) and licensed manufacturing warehouse (LMIs) which have developed onlylimited backward linkages with the rest of the economy. Outside FTZs andLMW., the pro4'iction of exportables is encouraged less than the production ofimport substitutes. Tariff and nontariff barriers make it more attractive tosell in the domestic market than abroad. Furthermore, the internationalcompetitiveness of exports tends to suffer to the extent that direct andindirect exporters do not have quick and easy access to preshipment andpostahipuent export finance and duty free imports of intermediate and rawmaterial inputs. Provision of these facilities constitutes a critic2l firststep in reducing the antiexport bias in the incentive structure. As impor-tant, it supports backward linvages and contributes towards strengthening anddeepening Malaysian manufacturing industry. This report, prepared at thebehest of the Malaysian Government, reviews recent proposals to improveMalaysia's pre- and postshipment export finance administration. It also makessome preliminary observations on existing administrative mechanisms throughwhich exporters can import inputs duty free.

Issues in Pre- and Postshipment Finance Administration

ii. Pre- and postshipment export finance is available to Malaysianexporters at preferential interest rates through the Export Credit Refinancing(ICR) scheme. An ECR Task Force proposed that the Government reform thescheme in two phases. Phase I, already implemented by the Covernmenc inJanuary 1986, liberalizes the criteria for product eligibility and the maximumand administrative limits to outstanding export credits to a single exporter(see the Summary Table). Under Phase II, to be introduced in October 1986,the ECR Task Force proposes to: (a) improve upon the existing postshipmentcredit insurance scheme to support the postshipment finance mechanism; and (b)overhaul the preshipment ECR system with the objective of assuring quick andequal access to all firms that generate export value added.

Postshipment Finance Administration

iii. The most important issue with regard to postshipment finance admin-istration is the need to make the postshipment credit insurance system moreeffective. Malaysia Export Credit Insurance Berhad (MECIB) is the onlyorganization in Malaysia that provides postshipment export credit insurance,yets its operations are too small in relation to the value of manufacturesexported by Malaysia; it either does not provide coverage, or provides onlylimited coverage, for several countries that are usually covered by othercredit insurers abroad; and it is not considered "gilt-edged" by the exportingand banking community as credit insurers are in other parts of the world.Most of these weaknesses can be traced to one very important shortcoming inMECIB's organizational structure -- it does not enjoy full government backing.

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In this respect it is unlike any other credit insurer in the world, with theexceptioni of the Export Credit Insurance Corporation of Singapore. Theminimum portfolio size necessary to achieve an appropriate diversification ofrisk is usually so large in relation to the equity base of a credit insurer asto discourage most private sector organizations from entering the field. Theabsence of the Government as the guarantor of last resort in Malaysia leads totwo implications. First, MECIB cannot fulfill its export promotional rolebecause its limited capital base forces it to be very conservative whencovering buyer and transfer risks. Second, exporters and bankers are notsufficiently convinced of MECIB's financial ability to absorb large risks:this apprehension is reinforced each time MECIB declines to offer cover ongrounds that the Xransaction is too large or the country is off-cover.

iv. The report, therefore, recommends that MECIB should underwrite allrisks, commercial and political, in the name and on behalf of the MalaysianGovernment. An appealing feature of this recommendation is that it neitherinterferes with MECIB's existing company structure nor discards MECIB's exper-tise built painstakingly over the years. The role of the Government as theguarantor of last resort should not preclude MECIB from operating on commer-cial principles and setting premium rates high enough to cover claims and addto the claim reserve fund over a period of several years. A GuardianAuthority could represent the Government, and set broad policies through anExport Credit Insurance Council composeJ of representatives from relevantministries and Banh: Negara. It could de1egate underwriting authority foramounts above certain limits co a committee comprising government officialsand bankers. In addition, greater use of the assianment mechanism, wherebyMECIB assigns the proceeds of successful claims to the handling bank ratherthan the exporter, could strengthen institutional links significantly. At thesame time, Bank Negara may need to use its persuasive powers to encouragecommercial banks to ease the collateral terms of postshipment lending if MECIBprovides security against buyer default through the assignment mechanism.MECIB could also reinforce its links with commercial banks by offeringbanker's insurance policies that provide indemnity on their recourse toexporters and, if needed, offer unconditional guarantees to banks for buyers'bills purchased from exporters. Finally, MECIB will need to train staff indesigning and implementing these new insurance mechanisms.

v. The report also discusses two other aspects of postshipment finance.First, it suggests that rediscount facilities at preferential rates ofinterest and the low intermediation margin enjoyed by banks under the ECRcould inhibit the growth of the scheme. Instead, the Government may zonsiderallowing greater play by market forces in determining the interest rate struc-ture of postshipment export finance. Second, the report comments on theadvisability of setting up an export-import bank in Malaysia. It concludesthat the scale of capital goods exports from Malaysia does not justify this,but Bank Kemajuan can meet the demand for medium-term postshipment finance ifneed be, and MECIB could further support this effort by providing exportcredit insurance.

Preshipment Finance Administration

vi. Proposals in Phase II center on two critical areas: (a) the intro-duction of new administrative arrangements for preshipment export finance thatwill improve the disbursement mechanism and allow direct access to indirectexporters; and (b) the establishment of a new preshipment export finance gua-rantee (PEFG) scheme to overcome the collateral-based behavior of commercialbanks by covering potential nonperformance risks of exporters.

vii. New Administrative Arrangements. The new administrative arrange-ments for preshipment export finance proposed by the ECR Task Force includethree important innovations: (i) disaggregating preshipment export loans intofour categories to cover value added, and the purchase of imported inputs,domestic inputs and final output, and specifying a disbursement mechanism foreach; (ii) offering a choice between the bill of exchange (B/E) and thedomestic letter of credit (DL/C) as two alternative instruments foradministering access by indirect exporters to preshipment loans under the ECR;and (iii) allowing preshipment loans under the ECR in parallel on an expectedorder basis using export performance certificates.

viii. The report notes that any effective preshipment finance administra-tive mechanism must have two features without which the entire objective ofthe scheme could be jeopardized. First, at all stages of production, loandisbursements must be tied to the clearance of the material purchase bill andloan liquidation to the clearance of the products sales bill. These tie-upsare critical if a preshipment export finance guarantee scheme is to be intro-duced; they also prevent abuse of the scheme, conserve the financial resourcesof commercial banks and simplify administration. Second, indirect exportersat all stages who contribute to value added for export must have equal accessto preshipment loans under the ECR. This feature is especially helpful inpromoting backward linkages and exploiting the country's full export poten-tial. The report notes that the B/E system does not passess these two criti-cal features, whereas the DL/C system does and therefore recommends that theTask Force consider redesigning the B/E system to include them before offeringit as an alternative to the DL/C system. The report also suggests that theTask Force take into account the administrative requirements of other exportincentives (e.g., duty-free imports or the income tax abatement scheme -- seebelow) before coming to any firm conclusions on the relative merits of the B/Eand the DL/C system as administrative mechanism for preshipment exportlending.

ix. Preshipment Export Finance Guarantee. The second important Phase IIproposal is to set up a preshipment export finance guarantee (PEFG) schemethat will encourage commercial banks to lend preshipment funds to small andinfant exporters. MECIB appears to be the most suitable agency to initiatesuch a scheme, though it will need to keep the administration of the PEFGscheme separate from its other activities related to conventional creditinsurance. Its short-term tasks will include: (i) designing PEFG policiesbased on the new ECR; (ii) conducting a survey of direct and indirect expor-ters; and (iii) organizing overseas study and training programs. In themedium-terms it will need actively to reduce nonperformance risks associatedwith its client firms by providing technical assistance and other development

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services. This is a new area for MECIB, and it will need to display abundantcaution and considerable patience. Ultimately, it should aim to become both amature credit guarantee institution and a dynamic development agency that canplay a catalytic role in implementing Malaysia's new outward-orienteddevelopment strategy.

x. The report also makes other suggestions that may assist in clari-fying or rationalizing several Phase II proposals and thus make them morecoasistent with the objectives of the ECR reform. These are mentioned in theSummary Table.

The Administration of Duty-Free Import Schemes

xi. Malaysia has four separate schemes that permit duty-free imports forexport production, but this report focuses on only two of them - the priorexemption and the duty drawback schemes. These two schemes tend to sufferfrom two imporrant shortcomings: first, obtaining access to them oftenresults in delays and requires considerable effort on the part of exporters;and second, in practice these schemes are available only to final exporters.The inability of direct and indirect exporters to gain eay and quick accessto duty-free imports affects competitiveness and inhibits the formation ofbackward linkages arising frome. export production. In addition, the "domesticavailability test" under the prior exemption scheme (or to obtain an importlicense for products subject to quantitative restrictions) complicates theprocess of obtaining duty free imports. Finally, the monitoring mechanismunder the two schemes appears to be slack and probably does not act as adeterrent for abuse of the system.

xii. The report suggests that the DL/C mechanism can be used as theappropriate vehicle to administer and monitor the prior exemption and dutyfree import schemes for indirect exporters. Those who abuse the system shouldbe prosecuted and prohibited from access to ICR facilities. In addition,other key tasks for reforming the administration of duty-free import schemeswould include: (a) pretabulating input-output coefficients in a book whichwould then become applicable to all exporters; (b) eliminating the "4zomesticavailability test;" (c) abolishing the import licensing requirement; and(d) considering use of the proposed DL/C system to improve the administrationof a range of other export incentives for indirect exporters.

A Postscript

xiii. Since this study was completed in June of 1986, Bank Negara launched thepilot test of the phase II revisions of the ICR scheme on October 15, 1986.Many of the recomendations made in this study were adopted for the pilottest, including the use of the domestic letter of credit (DL/C) for conven-tional preshipment finance and the use of the certificate of performancesystem for preshipment finance based on expected orders.

_mry Tables OWIE3 OIP RZFPWRS RZCWNDSAT1IONS ON XCI

Phas I refogma Coents oa pbhJe II Cooate on retornSam" _t fore refor_ impl m_tad on Jan. 1, 1986 Phse I reforms proposed reform propoSal beyond pba It

Preebi_ t finance dli- Preehipuant loon cot disag- RD change Presbipent loon io dis- DIL and P 1 should not Consider changing tutung of_ at *nd lieid tift Sregotod. Instead. entire gregatd Into iZL. DMI (DOL exceed purchsee bill VAL to ofter do_etic end

_A___S__ loan didbursed to final for tredlng company) nd values. VAL shcold be Iported input purebaeexporter ofter export order VAL; M1 and DIL ore die- equml to aetud value orders baov been eoufirmad.recev1d. bursed at tima of pureba added, or 302 of presbip-

bill clearance In the form must loan, whichever isof peyments tu suppliers, le"s.while VAL Is disbursed oncematerial purcebse bas beencompleted. VAL should beles tban or equal to 305of total preebipa_t lo"n.or actual or expectedorder.

Preebiument finance macba- Preebipm_nt finance only No c¢a_ Introduction of B/S and Btt is Inferior mcbanIsm Restriettag DIJC to up toa"a for fidirect exporters available to final exWor- DL/C mechanis to make pre- to DL.C for several rea- two stages o indirect

ter. shpment finance available eon. B/t systea will need exportrs is apPropriste,to indirect exportere. PC to be improved to take bht celd be extended Ifsystem for prebipuent fi- account of he"e shortecr- considered uece sery. PCnaniung on expected export tags If It Is to be 1--ro- Sytem could *1 o beorder beais. duced before the pilot extended eventually to

cheme is launched. 1/C indirect exporters.system can alao be used toadminister other exportincenttves. Calculationmethod for PC value can beimproved and monitoringmcehaniam establisbed.

Dandlnag riak arisin from None No ehange Creation of Preah1pment MECrB appears moat suitable Nediu,m-tor tasks mneb o:exporters nonperformance Expert Fiane Guarantee to administer PE scea (a) considering introdai-

(PMP) scheme. Short-term taskts 9,t1.Le tion of smell emport..(a) designang PEFC policies assistance program; s ni

In lime with row WM (b) considering spinningschbne; of f P110 scebma into

(b) create sepsrate wing In separte instituiton.5301 for Me1 withsepartce budget, staff.capital. etc.;

(c) coaduct actual and po-tential Indirect smellexportere surve, oneprepare potential PE10policybolder profiles;and

(d) develop overseas studyprogram.

Suary TablePage 2

Phase I reforms Comments on phase 11 Comments on reformsIssues Before reforms implemented on Jan. 1, 1986 Phase II reforms proposed reform proposals beyond phase II

llandling risks arising from NECIS set up in 1977 to No change Some changes being consid- M4ECB's operations must ex- Unconditional Export Creditbuvers nonpayment provide export credit in- ered in MECIB's insurance ,and if Malaysian exporters Guarantee instrumeAts only

surance. Rut MECIS remains instruments. are to diversify markets to be Introduced if assign-small, Its insurance cover- and develop aggressive mar- ment and bankers' insuranceage is limited and keting strategies. To policies fail.exporters and bankers do accomplish this, it isnot regard It highly. important to:

(a) cheane the organiza-tional structure of theexport credit insurancesystem by making MFCIBan agent of the Govern-ment;

(b) strengthen litnks be-tween NECIS, commercialbanks and exporters;

(c) introduce bankers' in-surance policies, andif necessary, uncondi-tional export creditguarantees; and

(d) develop NECI8's exper-tise In marketing andrecourse risk under-writing.

Eligibility Final exporters who are Final exporters who are Indirect and direct Should be explicitly stated Eliminate domestic valuemanufacturers only. based manufacturers only, with exporters, as well as that access to preshipment added and local contenton positive list. domestic value added of at export trading companies ECR is sliowed up to 2nd requirements, once equal

least 20X and local Input and export manufacturers stage indirect exporters export Incentives are givenof at least 30%, based on (no change in domestic (up to 3rd stage if final to all indirectnegative list, value added and local exporter is trading exporters. Consider

content requirements as company). allowing ECR for indirectwell as negative Ilst and exporters beyond 2nd stageapplication procedures), for cases in which further

backward linkages areimportant.

Agregate LanAmountftreahipmen and Post-

shipment) rS 3 million HS 5 million ho limit

Maximum Limit KS 10 million No limit No change

Minimum Limit M$ 20,000 No change MS 10,000 for ECR on actualorder basis; MS 3 million Flexibly adjust the minimexport PC for ECRI on export PC depending onexpected order basis. export2rs' reactions in

Phase It.

S- Tble

Phase I reforms Co.aencs on phase Ir C0nents on reformsIssues Before reforms implemented on Jan. 1, 1986 Phase II reforms proposed reform proposals beyond phase II

Loan BasePreshipient Loan AOP: 50S of order No change AOB: 80? of order

BOB was not available EOB: 70% c' precedingquarter's export PC(or export PC ofcorresponding quarterof prevIous year).

Postshipment Loan 100% of f.o.b. value No change 102 of c.i.f. value

Loan PeriodPreshtipment Loan. Maximum 1 months Nto change maximum 4 moneths Depending on production

periods of eertain pro-ducts, the maximm loanperiods could be appliedflexibly.

Postehipuent Loan M4aximmI 3 months No change Naximum 6 months

Interest Bates (Annual)Porxporters

Preshipment Loan 5S helow BA (6 months) rate No change 2% below BA rate

Postshipment Loan 5X below BA (6 months) rate No change 1% below BA rate Gradually transform to amrket-based discountingscheme.

Spread for Handlins BanksFreahipment 1.5? No cbange 2.5%

Postehipment Loan 1.521 No change No change

ECR - Export Credit Refinancing Scheme PtL - Foretgn Input Loan PC - Performance Certificate.AOS - Actual Order Basis DIL - Domestic Input LoanEOB - Expected Order Basis DOL - Dopestic Output LoanBA - Bankers' Acceptance (Bank Bumiputra & VAL - Value Added Loan

Malayan Banking)

MALAYSIA

THE ADMINISTRATION OF SELECTED EXPORT INCENTIVES

;. AN OVERVIEW

1.01 The pressure on Malaysia to expand its exports, particularly ofmanufactures, is greater than ever before. The Covernment unveiled recentlyan Industrial Master Plan for 1986-90 which emphasizes an outward-orienteddevelopment strategy. The overall thrust of the plan is to promote exports byencouraging resource-based and other manufacturing industries with extensivebackward linkages. To support this recent shift in emphasis towardsencouraging manufactured exports, the Government is also keen to improve andstrengthen the administration of export incentives. This report, prepared atthe request of the Government, reviews recent proposals to improve uponMalaysia's existing pre- and postshipment export finance administration. Italso makes some preliminary observations on existing administrative mechanismsthrough which exporters can import intermediate inputs and raw materials dutyfree.

1.02 This chapter places the discussion of export finance administrationand duty-free import administration in the context of Malaysia's overallstrategic imperatives. Section A of this chapter, therefore, sets the contestof the report by describing briefl' Malaysia's present economic situation andits strategic options for the future. Section B notes the role of export pro-motion and the administration of export incentives in the context of an over-all trade and industrial development strategy for the medium term. Finally,Section C indicates some important issues in the administration of selectedexport incentives and sets the stage for the discussion in the remainingchapters of this report.

A. Setting the Context

1.03 Malaysia, with its small population, rich natural resources, andstrategic location, is heavily dependent on international trade for itseconomic well-being. Exports account for more than half of total GDP, and lodo imports. The importance of international trade and the attraction of thecountry's relatively free foreign exchange markets to foreign investors have,over the years, proved to be of enormous benefit to the economy. During the1970s, when commodity prices fared well and international trade grew at Ahealthy pace, Malaysia enjoyed a growth rate of over 8X p.a., amongst thehighest in the developing world. By the same token, however, the economy isvery sensitive to downturns in international economic activity and trade. In1981-82 the terms of trade fell by over 10%t, but growth was maintained bycountercyclical fiscal policies which culminated in unsustainably large publicsector and external current account deficits (Table 1.1).

Table 1.1: SELECTED MACROECONOMIC INDICATORS

1976-80 1981-82 1983-85

CDP growth (% p.a.) 8.6 6.2 5.5Current account balance (% of GNP) /a -1.2 -14.1 -3.1Public sector deficit (X of GDP) /a 11.6 17.9 6.8Terms of trade (1978=100) /a 110.5 98.8 102.8Gross exports /b (Z of GDPF/a 57.3 50.8 54.7

/a End of period.Th Includes non-factor services.

Source: Government of Malaysia, Fifth Malaysia Plan, 1986-90, March 1986;Treasury.

1.04 The period since 1983 has been marked by strenuous efforts atattaining external and internal balance. Much progress has been made, but notwithout cost. In 1985, nominal GNP actually tell by 2.1% under the combinedweight of lower public spending, declining commodity prices, stagnation in theexports of manufactures and higher interest payments on external debt. Thereduction in growth and the consequent retrenchmen- of labor, together withthe return home of thousands of Malaysian workers laid off by neighboringSingapore's shrinking construction sector, has swollen the ranks of theunemployed and placed considerable pressure on the Government to introducepolicies aimed at the immediate resumption of growth.

1.05 The challenge that faces Malaysia is the generation of a pace andpattern of growth that will create employment opportunities for the expandinglabor force and yet be consistent with its other objectives of maintaining aprudent level of external debt and public confidence in the MalaysianRinggit. But the events of early 1986 have unequivocally altered Malaysia'sresource position and given it considerably less room to maneuver. Both palmoil and crude petroleum prices have fallen dramatically, and most projectionsindicate only a modest recovery in future years. Rubber exports are expectedto decline steadily in volume terms, and forest products, sawn timber and ply-wood exports face a relatively bleak future. Consequently, it is imperativethat if Malaysia is to relax the foreign exchange constraint that it will facein the future, exports of manufactures will need to grow at about 6% p.a. inreal terms to support growth at around 4% p.a. (Table 1.2). By historicalstandards, this does not seem a particularly difficult task. However, thestagnation of manufactured exports in 1985 (nominal growth of 0.7%) points tofundamental problems that will need to be addressed by the Government. Inparticular, Malaysia's manufactured exports are dominated by textiles, whichface growing protectionism in industrial countries, and electronics, whichappears to have lost much of its initial growth momentum. The diversificationof markets requires ag2ressive martketing strategies supported by competitive-ness in prices, and product diversification requires a deepening and

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strengthening of the manufacturing sector itself. Therefore, a cogent, com-prehensive and well coordinate' industrial and trade strategy will be at theheart of Malaysia's efforts to build an economic future that is able to with-stand shocks inflicted by the world environment.

Table 1.2: PROJECTIONS OF GROWTH RATES FOR MERCHANDISE EXPORTSBY MAJOR CATEGORIES, 1986-1990

(X p.a. at 1978 prices)

1980-85 1986-90

Agriculture 5.8 4.4Forestry -0.7 2.3Mining 1.3 -0.3

Manufactures 16.4 6.0

Total 7.4 4.1

Source: World Bank, Malaysia: Industrializing a Primary Producer, ReportNo. 5908-MA, June 1986.

B. The Role of Export Incentives in Industrial and Trade Strategy

1.06 A recent study on investment and production incentives in MalaysiaY1revealed that:

(a) the average level of effective protection granted to manufacturingin 1982, estimated at 23%, appears low by international standards.However, the dispersion between and within industries is high andgrew between 1979 and 1982;-V

1/ Government of Malaysia, Malaysia: Industrial Policy Studies Project,December, 1984.

21 The only two years for which measurements of effective protection areavailable. In 1982, 13 industries had ERPs of greater than 100% comparedwith 16 in 1979. On the other hand, 18 industries had negative ERPs in1982 compared with 10 in 1979. There were 28 industries in 1982 withERPs between 50% and 100% compared with 20 in 1979.

(b) in addition, there is a significant antiexport bias in the incentivestructure -- the average ERP for exporting and import-competingactivities in 1982 was 12X and 24%1 respectively;

(c) the structure of protection incentives appears to discriminateagainst small firms and non-FTZ (free trade zone) activities; and

(d) several trade and investment policy incentives combine to produce anadministratively complex, and sometimes inefficient, system.

1.07 The implications of th se incentives have already been analysed in arecent report of the World Bank._ Both tariff and nontariff policy instru-ments are responsiblg,for shaping the present structure of incentives in themanufacturing sector"/. Relatively inefficient and high cost domesticindustries hdve sprung up where protective barriers have been particularlyhigh, such as tires and tubes, automobiles and automotive parts, rubber foot-wear, confectionery, etc. These industries have drawn investment resourcesaway from potentially efficient, export-oriented industries which receivelittle encouragement through the incentive system. The bulk of Malaysia'sexports of manufactures are produced by firms located in its free trade zones(QTZs) or operated as licensed manufacturing warehouses (LMWs) which areunaffected by import barriers. These firms have been able to establish few,if any, backward linkages with the rest of the economy. Outside these freetrade areas, most industries (except for textiles) have geared theirproduction for the domestic market. Exports that do originate from outsidePTZs and LMWs are dominated by a small number of final stage manufactures.Protection from the forces of international competition has been complementedby an industrial licensing system which has tended to blunt the cost-reducingand efficiency-enhancing effects of free entry by domestic entrepreneurs, allof which ultimately affects the export competitiveness of Malaysian productsin the international market.

1.08 As a matter of priority, therefore, the Government will need toreduce the fairly large disincentives to export that affect production andinvestment decisions outside FTZs and LMWs. To achieve this, policies willneed to be introduced that lower trade barriers, increase manufacturingefficiency and reduce the antiexport bias implicit in the incentive system.The Government took a few steps recently in this direction: import duties onraw materials and components were reduced uniformly to 21; 101 of value addedin export production was made tax deductible and the export allowance was

3/ World Bank, Malaysia: Industrializing a Primary Producer, Report No.5908-MA, June 1986.

4/ Nontariff policy instruments include import quotas (prohibitive in thecase of some iron and steel products, automobiles and sugar, andimportant in timber and cement); local content programs in the automobileindustry; price controls on some manufactured items which tend to have aprotection effect; government purchasing guidelines and tax relatedincentives.

abolished; and double deduction for tax purposes was permitted for exportcredit insurance premiums. In addition the Industrial Coordination Act wasliberalized somewhat and a new set of investment promoti measures is to beintroduced soon. But the two reports referred to above - recommend reformsthat go beyond these recent changes. In substance these studies haverecommended replacing quotas with tariffs, eliminating local contentrestrictions, reviewing price controls, reconsidering the "buy Malaysia"policy, increasing the neutrality of tax and tax-related intentives betweendifferent industries, and liberalizing the licensing system beyond the recentchanges in the Industrial Coordinatioa Act.

1.09 The introduction of these policies will alter the present structureof incentives, inevitab'.y reducing the level of implicit subsidies granted tosome existing industries, and increasing it for others. This, in turn, willrequire individual firms to invest in new machinery, initiate new managementpractices, seek new markets, improve production efficiency or alter productmix. To give existing industries sufficient time to adjust to the new policyenvironment, change will have to be introduced gradually and according to apreannounced timetable.

1.10 The first step to lowering the antiexport bias would include givingexporters the opportunity of purchasing their intermediate inputs and rawmaterials at internationally competitive prices and allowing them access *.oexport finance. This could be achieved by providing automatic and duty freeaccess to imported inputs, access to credit for both direct and indirectexporters, and export credit guarantee facilities for pre- and postshipmentloans. Korea's example has shown that these incentives, aimed specifically aCpromoting the generation of export value added, can make a material differenceto a country's overall export performance. Introducing these new incentivesrequires building institutions, creating new systems and changing existingpractices and modes of thinking. It is a time-consuming task, requiringpatience and perseverance. Only by starting immediately will Malaysia havethe requisite administrative infrastructure to support its export efforts inthe 1990s and beyond. There is some evidence to suggest that existing exportincentives reach only between 100-200 manufacturers and contribute to theskewed distribution of exports in manufacturing. On the other hand, of the8,000-odd manufacturing establishments in Malaysia, 95% are small and mediumscale producers who have had only limited access to export incentives and haveconsequently,not had the opportunity to earn foreign exchange, directly orindirectly.- The task ahead is challenging, but as the experience ofsuccessful East Asian countries has demonstrated, small and mediummanufacturers can make important contributions to exports and growth, providedthey have equal access to export incentives.

5/ Government of Malaysia, 1984, op. cit.; World Bank, June 1986, op. cit.

6/ Out of a total of 8,343 manufacturing establishments in 1982, 6,205 weresmall (with less than 50 workers) and 1,688 were medium-sized (with 50-199 workers). See Lim, Chee Peng, Small Industry in Malaysia, BeritaPublishing, 1986, P. 17.

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C. Issues in the Administration of Selected Export Incentives

1.11 Mal4sia already operates a large number of export promotion schemesand policies," but this report focuses primarily on issues related to exportfinancing facilities; to a lesser extent, and in a very preliminary fashion,the report also touches on issues concerning the administration of the importduty drawback and exemption schemes.

The Export Credit Refinancing Scheme

1.12 The Covernment introduced an export credit refinancing (ECR) schemeon January 3, 1977 to make export credits cheaper and more readily avail-able. Under the ECR scheme, Bank Negara uses a bills rediscounting facilitythat allows commercial banks to extend export finance at concessionary ratesand then rediscount their substitution bills. In the process, commercialbanks are allowed to enjoy a maximum margin of 1.51 and the interest rate onexport credits to final exporters has been allowed to fluctuate between 3Z and71 below the bankers' acceptance rate (Table 1.3).

Table 1.3: INTEREST RATES AND DISCOUNT RATES UNDER THE ECR SCHEME( p.a.)

Interest rate Bank NegaraWith effect from to exporters rediscount rate

January 1977 5.5 4.0April 1977 4.5 3.0October 1981 8.0 6.5April 1982 7.0 5.5October 1982 6.0 4.5May 1983 5.0 3.5October 1984 6.0 4.5July 1985 5.0 3.5

Source: Bank Negara.

1.13 Despite its impressive growth, Malaysia's export financing system isstill in its infancy. In its very first year, the ECR facilities rediscountedM$138 million worth of export credits or only 3% of manufactured exports; ithad risen to M$1,436 million in 1985 for the first nine months alone, or about151 of manufactured exports. By way of comparison, the corresponding ratio in

7/ See Appendix A for a list of export incentives available in Malaysia.

most advanced developing countries, with well developed export finance systemstends to be anywhere between 50% and 902.

1.14 A preliminary assessment of the ECR scheme by a World Bank team in198581 noted the following issues:

(a) that preshipment financing has been somewhat neglected, whereaspostshipment financing has been given too much emphasis. As aresult, the 802 share of postshipment financing in total exportcredits refinanced through the ECR scheme is extremely high, andcorrespondingly, the share of preshipment financing is very low;this appears to be contrary to the experience of most developingcountries, including advanced developing countries, where typicallythe ratios are just the reverse (80% for preshipment and 20% forpostshipment);

(b) that greater emphasis has been placed on providing compensatoryexport incentives through preferential interest rates, and insuffi-cient attention was paid to ensuring that exporters had quick andeasy access to financing; the report pointed out that access, andnot cost, is invariably the critical constraint in export finance;

(c) that the positive list system identifying goods eligible for ECRfacilities was inconsistent with the principle of treating equally,in terms of access to financing, all manufacturing and tradingactivities contributing to the export effort; and

(d) that tnough the ECR scheme met the production financing needs ofexporters, it did not meet the inventory financing needs of tradingcompanies.

1..15 As a consequence of the World Bank's preliminary assessment, theGovernment of Malaysia established a task force comprising officials from BankNegara and six leading commercial banks to review the ECR scheme and recorwMendmeasures for its improvemcat. The review was conducted in two phases. PhaseI was completed in early 1986 with the announcement of several revisions tothe ECR scheme beginning January 31, 1986:

(a) List of eligible goods. The "positive list" was replaced by a"negative list" listing only those goods not eligible for both post-shipment and preshipment financing under the ECR. The "negativelist" is composed of goods that are (i) excluded for strategicreasons (e.g., arms and ammunition); (ii) banned by law (e.g.,

8/ World Bank, Export Financing and Insurance in the Promot.on of Malaysia'sManufactured Exports, May 20, 1985.

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hallucinogenic drugs); and (iii) ined'le raw materials that havenot undergone significant processing._

(b) New refinancing limits. The administrative limit on totaloutstanding export credits available to a single exporter under theEOM scheme was raised from M$3 million to M$5 million. In addition,the maximum limit of M$10 million per exporter was abolishedaltogether; applications for loans in excess of M$5 million willneed to be approved by Bank Negara which will base its decision onthe financial position of the company, the value of exports sold oncredit terms and the destination of exports.

(c) Eligibility criteria. Only products with a domestic value added ofat least 20X and which use a minimum local raw material cntent of302 will be eligible for financing under the ECR scheme,

1.16 Under Phase II of the review, the Task Force set up three committeesto look into different aspects of the ECR scheme, namely the MechanismCommittee, Insurance Committee, and Procedures and Documentation Committee.The Mechanism Committee has already submitted a report, the InsuranceCommittee is now drafting its findings and the Procedures and DocumentationCommittee is expected to embark on its task only after the recommendations inthe mechanism and insurance reports are approved.

1.17 The mission was able to review the proposals of the MechanismCommittee and the preliminary findings of the Insurance Committee. Indeed,most of the remainder of this report contains the mission's views on thevarious recommendatjyls and suggestions expressed by both Committees. Amongstthe more important _ proposals for Phase II are:

(a) the introduction of a preshipment financing mechanism to improveindirect exporters' accessibility to working capital finance at thepreshipment stage;

(b) the improvement of existing postshipment insurance schemes tosupport the postshipment financing mechanism; and

(c) the introduction of a preshipment finance guarantee scheme toimprove access by exporters to the preshipment finance facility.

9/ The purpose of this last provision is consistent with the broadergovernmental objective of encouraging greater domestic value added inresource-based exportable manufactures.

10/ Comments on this aspect of the January 31st revisions are in para. 3.28of this report.

11/ The relatively less important proposals for Phase II such as periods andcoverage of financing are mentioned in the next two chapters.

The emphasis on preshipment finance in the Phase II proposal is entirelyappropriate, and reflects the enormous amount of institution building thatstill remains to be done in this area. However, for purposes of exposiFion,this report discusses issues in postshipment credit insurance in Chapter 2before it enters the more difficult and complex problems associated withpreshipment financing in Chapter 3.

Import Duty Drawback and Tariff Exemption

1.18 Under the import duty exemption scheme, the Minister of Finance isempowered by Section 14 of the Customs Act to exempt payments of import dutiesand surtax on imported inputs used in the production of goods destined foreither the export 'or the domestic market. Exporters are allowed full exemp-tion from import duty on imported components and raw materials that are notmanufactured locally, or, if manufactured locally, are not of acceptablequality or price. The duty drawback scheme, on the other hand, provides forduty drawback of both import and excise duties paid on inputs used in exportproduction. All imported inputs used in export production are eligible forduty drawback, and refunds are handled under an advanced payments basis.

1.19 The purpose of an import duty drawback or prior exemption scheme isto recompense exporters for any loss of competitiveness in internationalmarkets that may be caused by paying import duties on imported inputs. Tosome extent the schemes adopted in Malaysia tend to reduce the antiexport biasinherent in the incentive structure, but do not eliminate it altogether forseveral reasons. First, manufacturers tend to prefer selling to the domesticmarket because exports do not enjoy the same level of implicit subsidies as doimport substitutes. Second, these schemes as they are presently designed andadministered, do not recompense exporters who are forced to acquire inputs inthe domestic market at higher than c.i.f. import prices owing to theprevalence of import quotas, outright bans, or local content regulations.Third, these schemes do not benefit indirect exporters at all, and thereforedo not encourage or strengthen backward linkages. Finally, the full benefitof these schemes is reduced to the extent that it costs the exporters time andresources to obtain access to them.

1.20 It was noted earlier that introducing well designed and administeredduty drawback and prior exemption schemes would be a significant step towardsreducing the antiexport bias in the incentive structure. Furthermore, throughproper design and administration, these schemes can, and indeed should, reachindirect exporters, avoid any abuse of the system and yet remain costless tomanufacturers. This provides the focus of Chapter IV of this report. It mustbe emphasized here that the mission had insufficient time to analyze thedrawback and exemption schemes in detail, and therefore the findings in thisreport must be considered as only preliminary and tentative.

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II. PRIORITY TASKS IN POSTSHIPMENT FINANCE ADMINISTRATION

2.01 Chapter 1 outlined the strategic options confronting Malaysia, theimportance of industry and trade policy to export prospects, and issues relat-ing to the ECR scheme and compensatory fiscal incentives to exporters. Thischapter delves into the specifics of the ECR scheme, and focuses on prioritytasks in postshipment finance administration. After a brief description ofthe Government's proposals on postshipment finance in this introduction, therest of the chapter concentrates mostly on postshipment credit insurance.

2.02 As noted earlier (para. 1.17), the ECR Task Force made a number ofreCommendations under Phase II of its deliberations. In regard to postship-ment finance, these also included proposals to:

(a) continue refinancing for 100% of the f.o.b. value of export orders,but include freight and insurance charges in the post-shipmentcoverage if such payments are made to Malaysian companies;

(b) increase the refinancing period from 90 to 180 days plus a standarden route period for each country of destination;

(c) reduce the minimum amount of postshipment finance for each exporterapplication from M$20,000 to M$1O,000, though applications forsmaller amounts can be entertained provided that refinancingrequests are bunched so as to exceed this minimum; and

(d) introduce an effective insurance and guarantee system to coveroverseas political and commercial risks so that access topostshipment finance is eased.

2.03 It is normal in many other developing countries to finance exportersfor freight and insurance charges in c.i.f. contracts, but restricting financeto goods shipped only by Malaysian carriers is unfortunate because thecompetitiveness of Malaysia's export products in international markets maysuffer unduly. Raising the maximum refinancing period would place Malaysianexporters on the same footing as their competitors who, increasingly often,are offering 180 day credit terms for consumer and light engineering goods.The postshipment ECR facility is not available for sales on sight draft termsor cash against documents and this is in line with the practice of manycountries offering postshipment credit schemes. The introduction of an effec-tive postshipment credit insurance scheme, however, is a difficult task and isthe focus of the next two sections in this chapter.

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A. Weaknesses in the Existing Postshipment Credit Insurance Scheme

2.04 Export credit insurance promotes exports by:

(a) providing exporters an effective umbrella of protection against therisks of nonpayment by foreign buyers;

(b) encouraging exporters to:

(i) liberalize payment terms to traditional customers as a meansof increasing business;

(ii) seek new buyers in existing markets; and

(iii) diversify into new, unfamiliar and sometimes riskier markets;

(c) facilitating access to postshipment finance by sharing risks carriedby commercial banks.

The objectives of export credit insurance and those of the ECR scheme havemuch in common, but export credit insurance facilities are an important compo-nent of the institutional framework supporting Malaysian exporters irrespec-tive of whether financing is available through the ECR scheme or not.Malaysia Export Credit Insurance Berhad (MECIB) ' the only organization inMalaysia which provides export credit insurance.-/ An analysis of the short-comings of the export credit insurance scheme in Malaysia, therefore, inevit-ably becomes a discussion of MECIB's operations and experience.

MECIB's Operations are too Small

2.05 MECIB offers a whole turnover comprehensive export credit insurancepolicy, renewable annually, covering an exporter's sales worldwide and underwhich revolving credit limits are established for each of the exporter'sbuyers. There is a choice between a "contracts" policy which covers risks ofnon-payment by the buyer from date of contract and a "shipments" policy whichcovers risks from date of shipment. In addition, the exporter can choosebetween a global policy covering exports to all countries or a selectedmarkets policy which excludes some markets requested by the exporter.

2.06 Despite an impressive range of policies 131 offered by MECIB, itsoperations cover only a tiny fraction of Malaysia's manufactured exports(Table 2.1). Since 1982, the number of policies held with MECIB has stagnatedat around 106, a small figure in comparison to the number of firms in Malaysiainvolved in export activities. The total value of exports covered by

12/ For a brief description on the establishment and structure of MECIB, SeeAppendix B.

13/ Which includes policies for special requirements such as capital goodscontracts on a medium- or long-term basis, construction contracts etc.

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MECIB 141 has never exceeded 2X of manufactured exports from Malaysia. Thiscompares very unfavorably with other developing countries using similarschemes.

Table 2.1s MECIB: NUMBER OF POLICYHOLDERS AND VALUE OF EXPORTS INSURED,1978-85

1978 1980 1982 1984 1985

Number of policyholders 21 80 103 107 106Exports declared (1M$ millions) 11 97 119 153 119Share in exports of manufactures (X) 0.3 1.5 1.6 1.3 1.0

Source: MECIB.

2.07 As a consequence of its small operation, MECIB is unable to coverits operating costs. Ignoring investment income derived from the initialpaid-up capital, the insurance account after seven years' operations shows nosigns of breaking even (Table 2.2). Annual premium income is only just overhalf of administration expenses, leaving noihing for claims. The investmentincome, however, has been more than sufficient to create a surplus in mostyears and has increased the capitalization of MECIB.

Table 2.2: MECIB: FINANCIAL RESULTS, 1978-85(in M$ '000) /a

1978 1980 1982 1984 1985

Premium income 56 422 430 760 457Claims - 72 2,169 233 216Administration expenses 367 707 786 833 801

Net operational deficit 311 357 2,446 306 560Investment income n.a. n.a. 1,718 1,420 1,577

Net surplus n.a. n.a. (728)/b 1,114 1,017

/a Rounded to nearest thousand.7i Brackets indicate net loss.

Source: MECIB.

14/ i.e., the value of exports declared by the policyholders.

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MECIB's Insurance Coverage is Limited

2.08 The global schedule of markets In MECIB's comprehensive policycomprises a list of 199 countries with no less than 44 totally off cover, anda further 30 with low monetary ceilings. Other credit insurers appear to bemore liberal in several of these markets (Table 2.3), and many continue tocover new business even in the face of transfer delays. MECIB provided a listto the mission of some 40 credit limit applications amounting to M$27 millionand 6 enquiries for medium term contracts amounting to X$138 million for whichcover had been rejected or, in the case of some revolving credit limits, can-celled as a result of the suspension of cover on various countries sinceAugust 1984.

Table 2.3: SOME POTENTIAL MARKETS FOR MALAYSIAN EXPORTSWITH LITTLE OR NO COVER PROVIDED BY MECIB

Destination MECIB Attitude of Berne Union memberscountry current Number Number providing Number

ceilings reporting full or off cove,(M$ million) restrictive cover

Bangladesh 1 5 4 1Egypt 2 20 20 -Iran 5 18 17 1Pakistan 2 15 14 1Romania 2 17 16 1Yemen AR 1 15 15 -fugoslavia 10 20 20 -Brazil off cover 21 21 -Ethiopia off cover 16 14 2Iraq off cover 19 18 1Nigeria off cover 19 9 10North Korea off cover 8 3 5El Salvador off cover 10 6 4Syria off cover 13 12 1Yemen DR off cover 11 11 -

Source: MECIB; Berne Union.

2.09 Declining cover for so much business feeds exporters' and bankers'disillusionment with MECIB's credit insurance scheme (see para. 2.12).MECIB's basic principle of cover on a whole turnover basis to create a largepool of risk end an adequate underwr;ting reserve cannot flourish if too muchrisky business is declined. It tends to lose policyholders and spreads anegative impression about the usefulness of the credit insurance scheme.

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2.10 MECIB's prudence stems from its private company structure. MECIB'spaid-up capital structure does not permit it to take on too many risks. As aconsequence it tries to generate a cash surplus every year even if it meansnot offering cover on a large number of potential markets. This runs contraryto the needs and purpose of a national export credit insurance scheme for thepromotion of exports.

2.11 Declining cover on buyer creditworthiness grounds makes for prudentcommercial practice since the potential for recoveries on insolvencies anddefaults is low. However, cover for political risks is altogether differentfrom cover for buyer risk. Losses stemming from political risk arise mainlyfrom transfer delays. Upon a transfer claim, the credit insurer suffers onlya loss of interest. Risks stemming from transfer delays cannot be estimatedby standard actuarial methods and cannot generally be covered by the privateinsurance market. The world's officially-backed credit insurarce institutionsowe their existence to covering transfer risks, but sometimes when transferdelays do take place, losses are incurred. However, official credit insurersare expected to conduct their business at no net cost to the taxp ,-er over aperiod of several years. The cycle of transfer losses and recoveries makesthis possible. In the U.K., the Export Credits Guarantee Department (ECGD)transfers annual surpluses into the Government's consolidated fund and earnsinterest at market rates on the accumulated balance; in times of deficit itpays interest, also at market rates.

Exporters and Bankers do not Regard MECIB Highly

2.12 Discussions with exporters and bankers revealed that they did notregard MECIB as capable financially of honoring claims made by its clients.MECIB's track record on claims payments does not justify this pegception,though improvements can be made in claims payments procedures. Theperception that MECIB will not honor claims made by its policyholders stemspartly from the reputation of another credit guarantee organization, CreditGuarantee Corporation (CGC), which does not have a particularly good record ofmeeting claims promptly. In addition, MECIB is vi'wed as a private organiz-ation and without official government backing, which places narrow limits onits financial strength.

2.13 Large exporters displayed little interest in credit insurancebecause they either continue to command secured terms from their buyers underletters of credit or sell to long established customers. They demonstratedlittle awareness that credit insurance could make new exporting opportunitiesless risky, and appeared satis£ied with selling to traditional markets andbuyers. In the few instances that they had approached MECIB for cover oflarge orders, MECIB had declired because of its limited insurance coverage and

15/ See Appendix C.

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prudent country limits.161 This merely tended to reinforce the negativeimpressions that they already held of MECIB.

2.14 Small exportersp on the other hand, appeared to be more conscious ofthe need for credit insurance protection, particularly if new at exporting.But like their larger brethren, they found MECIB's long list of closed andrestricted markets very frustrating. In addition, several complained of beingunable to obtain adequate postshipment finance because of collateral demandsby commercial banks who either failed to advise their client, of the roleMECIB could play to ease their situation, or advised them that a MEC[B policywas an inadequate substitute for a collateral.

2.15 Bankers clearly did not consider MECIB gilt-edged in the way bankersin other countries regard their official credit insurance institutions. Theprivate company structure of MECIB and limited paid-up capital did not inspiresufficient confidence. Bankers would not accord a MECIB insurance policy thesame standing as a letter of credit from a wAl known overseas bank, thusdiscouraging any move away from letters of credit to win new business.

2.16 But even more disturbing is the banking practice of grantingpostshipment finance on the strength of an exporter's collateral securityrather than on "buyer paper". It follows that even the full acceptance of aMECIB i;.surance policy as subst.tute for a first-class irrevocable letter ofcredit will not alter the basic collateral approach of bankers. The prefer-ence for collateral security to buyer paper appeared to be strongest amongstMalaysian banks. In contrast, the two international banks interviewed by themission prided themselves on being trade banks and claimed that they evaluatedpostshipment financing on a project basis with due regard to the standing ofthe buyer whose paper secured the debt. However, in practice, MECIB has notfound the international banks any more receptive to credit insurance thanMalaysian banks.

B. Measures to Improve the Postshipment Credit Insurance System

2.17 The previous section noted that the existing postshipment creditinsurance system is weak because MECIB's operations are small in relation tothe country's exports, its insurance coveragp is limited, and it is not highlyregarded by the exporting and banking community. Rectifying these short-comings will require the joint efforts of the Government, MECIB, exporters andcommercial banks. In particular, it will be necessary to: (a) change theorganizational structure of MECIB; (b) strengthen institutional links;(c) introduce new insurance instruments; and (d) develop MECIB expertise.

16/ For example, MECIB was unable to cover a M$12 m single order to Iraqbecause it was off cover. The exporter concerned stated that they couldsignificantly increase their M$75 m export business if MECIB covered itssales to Iraq and other Middle-East buyers.

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Change the Organ(wational Structure

2.18 The export credit insurance scheme in Malaysia was !g up alongsimilar lines to its contemporary sister in Singapore, ECICS, - and togetherthey are unique in the world in providing export credit insurance withoutgovernment financial backLng'. All the other export credit insurance schemes,both in developed and in developiug countries, have been unable to fulfilltheir role of promoting exports w'thout their Governments standing asguarantors of last resort. MECIR's various shortcomings, described in theprevious section, stem primarily from its lack of government backing. EvenECICS has failed to fulfill,its. 'proper national role despite much highercapitalization; however, wit'hin 12 months of its formation the SingaporeGovernment acknowledged this by supporting the insurance of contractsindividually too large in relation to ECICS' paid-up capital.

2.19 Providing exporterp with the opportunity to obtain an all-riskinsurance, -policy, and covering exports to most (if not all) countries andbuyers within certain prudent underwriting limits, is a practice to bestrongly recommended. This practice, consistently applied, will attract alarge number of exporters and thus create the broad premium base and largerisk pool so necessary for successful underwriting.

2.20 There are five possible ways in which the Government can back exportcredit insurance facilities: (i) through a government department or govern-ment agency; (ii) through a private sectcr insurance company or financialinstitution acting as a commission agent in the name and for the account ofthe Government; (iii) through an organizationally autonomous but whollygovernment-owned corporate entity or public ,und; (iv) through a government-controlled corporate entity which is jointly owned by the Government andprivate sector insurance and banking entities; and (v) in cooperation withprivate sector insurance entities which assume, for their own account, someagreed-upon percentage of the commercial and political risk.

2.21 This report does not discuss the pros and cons of each option inrespect of Malaysia's requirements. However, a recent report prepared byconsultant from the official Austrian credit insurance institution, OKB, -

looked specifically into this issue and redowmended strongly that MECIB shouldunderwrite all risks, commercial and political, in the name and on behalf ofthe Malaysian Government. In other words, the OKB report suggested that MECIBshould act as the "sole agent of th Malaysian Governmept" in the field ofexport credit insurance. This system has featured succ ssfully for decades inthe Federal Republic of Germany as well aa in Austria, but the OKB reportadapts it well to Malaysia's needs.

17/ Export Credit Insurance Corporation of Singapore.

18/ Oesterreichische Kontrollbank Aktiengesellschaft, Study on the Status andStructure of MECIB, April 1984.

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2.22 The central recommendations of the OKB report are well conceived andcould suit Malaysia's requirements. An appealing feature of the recommenda-tions is that it does not interfere with MECIB's existing company structure,and it ensures that MECIB's export credit insurance expertise, built overyears, will continu-e to be used. MECIB will operate as the aget of theGovernment which will be represented by a Guardian Authority, The Guardianauthority, with powers conferred on it by parliamentary decree, should beresponsible for setting broad policies through an extort credit insurancecouncil composed of representatives from relevant ministries and BankNegara. Certain underwriting authority could be delegated further to asmaller "Export Credit Insurance Committee" comprising representatives of fourministries and, because underwriting is a matter of professional skill, atleast three bankers.

2.23 However, there are certain amplifications and modifications that canbe made to the OKB report. These, and other details of the proposed neworganiz.ational structure are given in Appendix C.

Strengthen Institutional Links

2.24 A successful export effort requires close and strong institutionallinks between exporters, banks and the export credit insurance agency. Therole of the export credit insurance agency is primarily to help exporters gainaccess to postshipment finance by reducing the risk of lending for exports bybanks. In considering how MECIB's credit insurance operations can fulfillthis function, it is well to remember that MECIB has already an assignmentmechanism available to banks which is not sufficiently used and appreciated toachieve its purpose. Since this mechanism exists and does not involve MECIBadopting new underwriting and operational techniques, it is important toconsider its operations and implications.

2.25 Exporters taking out export credit insurance with MECIB submitproposal forms outlining the anticipated volume of their exports worldwide forthe next 12 months, broken down by country of destination and by terms ofpayment. MECIB then issues a comprehensive contract policy or comprehensiveshipments policy according to whether the exporter requires to cover risksfrom date of contract or date of shipment. The policy describes veryprecisely the risks coveredj0 he revolving credit limit mechanism, thepercentage of loss covered,- the calculation of loss in case of a claim, themethod of declarations made and payment of premium. The policy definesvarious conditions that have to be observed by the exporter including the

19/ The Guardian Authority could be either the Ministry of Trade or theMinistry of Finance. The Ministry of Trade may be preferred for itsobvious interest in promoting exports The annual budget may need toinclude allocations to cover insurance liabilities incurred by theGovernment, as is the case for ECGD in the U.K.

20/ Eighty-five percent for all causes of loss other than buyer repudiationwhere there is a 20% first loss clause.

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obligation to declare all exports globally for the 12 month period covered bythe policy. Exporters' claims may be declined in the event of a dispute withthe buyer which results in the loss of the case, or failure to resolve thedisputet or if they otherwise breach the terms of their policies or creditlimits.

2.26 The most commonly accepted method employed by a bank to protectitself when lending money against an exporter's extension of credit to aforeign buyer is for the bank to obtain from the exporter's credit insurer an"assignment of proceeds" of the exporter's credit insurance policy. However,irrespective of the assignment of proceeds to the bank, the credit insurerstill considers the exporter as the party responsible for providing theevidence, in the event of a claim, that the subject loss was not in any waydue to the policyholder's nonperformance under the contract of sale.Accordingly, if an exporter fails in a claim against the credit insurer, thesecurity of the assignment which the bank thought it obtained will not behonored. Claim failures are generally due to an exporter's non-performance,or the exporter's noncompliance with the terms and conditions of the insurancepolicy. A vital policy condition is the buyer credit limit approval. Thisarea of doubt for banks can be removed by MECIB copying all credit limitapprovals to the bank.

2.27 Banks throughout the world vary in their attitudes towards therelative collateral value of the proceeds of such an assignment, but forexport financing on short credit terms, the majority of countries operate onthe security afforded by assignment. Only a relatively few continue tooperate more advanced systems of direct insurance or guarantees to banks inrelation to the bulk of export credit insurance.

2.28 Banks usually place considerable trust in their government-backedexport credit insurance organizations and find that the majority of claims aremet. Indeed, many credit insurers tend to pay ex gratia where possible ratherthan decline a claim for the sake of their reputation and to prevent anydamage to the country's export effort. In France, for example, the onlysecurity provided by COFACE is assignment, yet it is understood that banksreduce their collateral requirements on their clients by an amount at leastequal to the COFACE cover. Nearer by, Hong Kong also operates only onassignments to banks.

2.29 Some countries, for example the United Kingdom and India, havereinforced their links with banks even for short-term postshipmentfinancing. In the UK the development of the short term comprehensiveguarantee to banks was aimed sp-cifically at persuading banks to reduce theirinterest rates on postshipment credits. Early in 1960 the ECCD concluded anagreement with the banks that in return for the protection of an ECGDguarantee, the banks would reduce their lending rates to 5/8% over the baserate. Since the charge imposed on the exporter for this facility (additionalto the premium on the underlying credit insurance) is 0.75%, this supplemen-

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tary guarantee tends to attract medium an small size firms who would other-wise pay 3X or more above the base rate.21/

2.30 Neither assignment nor more sophisticated direct insurance orguarantee mechanisms (para. 2.35) will be sufficient to generate a minimumlevel of demand for credit insurance. It seems imperative that in introducingPhase II of the ECR scheme and establishing MECIB as a government agency, BankNegara will need to use its enormous persuasive powers to encourage commercialbanks to ease the collateral terms of postshipment lending depending upon theavailability of buyer or MECIB security. This will be of considerable benefitto small and medium exporters who experience collateral limitations.

2.31 However, the Government should resist the temptations to make theavailability of ECR facilities to exporters conditional upon obtaining exportcredit insurance from MECIB. Such an arrangement may be beneficial to MECIB,but it would run counter to the original objective of promoting exports andwould not provide MECIB an incentive to constantly improve its insuranceservices and provide better support to the export community. Instead, BankNegara will need to help MECIB on the initial stages to advertise its servicesand educate the banking and export communities on the advantage of the exportcredit insurance scheme.

Introduce New Insurance Instruments

2.32 Despite the value of assignments to banks, a direct form ofguarantee or insurance given by the credit insurer directly to a bank is moreeffective in ensuring adequate financial access for new and small exporters.There is an overwhelming case for a banker's guarantee or insurance where longcredit terms are involved becaum the financing burden can be considerableeven for the largest companies.-/

2.33 Though short-term credit is more easily borne by exporters andrelatively few countries have felt the need to develop bankers' guarantees,some countries have developed a form of direct guarantee or insurance to banksto overcome the resistance of commercial banks in easing their collateralrequirements. Some guarantees, such as that provided by ECGD in the U.K.,have induced banks to lend at less than market rates.

2.34 Two systems have been developed to provide comprehensive guarante13 /or insurance covering an exporter's entire sales on credit for over a year:-3

21/ The mechanics of this type of guarantee are explained in para. 2.39.

22/ It is interesting to note here that in France, the assignment systemoperates even in the medium term field; but this is possible becausemedium-term financing is provided by a government-sponsored bank, theBanque de Commerce Exterieure.

23/ In contrast, bankers' guarantees for medium term credit are usuallyspecific to each contract of sale.

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(a) an indemnity to a bank against recourse loss arising from either theinsolvency; or protracted default by an exporter in which the creditinsurer shares a portion of such loss (System A); and

(b) a 100l unconditional guarantee to a bank relating to buyers' failureto pay a particular bill or bills (System B).

2.35 Insurance policy 24/ to banks against exporter recourse risk(System A). Under this system there are two parallel policies. One insurancepolicy protects the exporter against loss arising from nonpayment from thebuyer or the buyer's country. The other protects the bank should recoursehave to be taken against the exporter (Figure 1). For example in India thebanker's policy relates to one exporter only. Claim proceeds under theexporter's policy are assigned to the bank. If MECIB were to provide similarloss coverage, then from the bank's point of view the exporter's insuranceassignment would produce 85% of an unpaid bill plus 66-2/3% of the uninsuredamount of 15X if and when recourse proceedings against the exporter fail.Recourse by the bank would, however, be for 100% of the bill should theexporter's claim on MECIB fail, in which case cover to the bank would be lessoverall, namely only the 66-2/3% provided in the banker's insurance policy.

2.36 This system has the advantage that it can be installed with littledisturbance to existing banking procedures and that MECIB would rely largelyon banks, with considerable knowledge of their clients, continuing to appraisetheir recourseworthiness. Of course, if the banks do not sufficiently modifytheir recourse criteria to take account of the combined effect of the MECIBcredit insurance proceeds assignment and MECIB's recourse risk participation,then the system will produce only marginal benefit tv the smaller exporterswith little collateral to offer.

2.37 This system can also be modified to provide every encouragement tobanks and exporters to use MECIB. MECIB can provide an "all exporter" policyto banks on more generous terms as an alternative to the "individual exporter"policy. As exporters included in MECIB's bankers' insurance policy must takeout an underlying insurance policy, banks may find it difficult to persuadeall their client exporters to acce,'t the arrangement. A compromise negotiablebetween MECIB and the banks could be a policy covering all exporters in aparticular product group or homogeneous group. A suggestion on how premiumrates and percentage of cover c.,n differ between different types of bankers'insurance policies is given in Table 2.4. Of course, MECIB management will

24/ The terms "guarantee" and "insurance" are often used interchangeably, butin this report they have been used with a precise meaning in mind. An"insurance policy" provides indemnity against net loss arising fromcertain events taking into account savings, counter claims, etc., andsuch a policy is conditional upon performance or compliance with otherconditions. A guarantee, on the other hand, is an instrument whichguarantees that if a debtor does not pay at due date, the guarantor willstand unconditionally in his place.

- 21 -

FIGUtRE I

MECIB INSURANCE POLICY TO BANK PROVIDINGINDEMNITY ON ITS RECOURSE TO EXPORTER

| RPORTE 0 ODEBTBUER

4?~~~c

w

BIANt

1. Bankts pay premoium for their policies. Exporters pay for theirw#holeturnover credit insurance policies.

2.. Bankers' insurance policies art further "cured by an "ssigentof exporters' wholeturnover policy.

- 22 -

need to do considerable additional work to refine these preliminary estimates,taking into account cash flow projections, capital availability etc.

Table 2.4: MECIB: SUGGESTIONS ON PREMIUM RATESAND PERCENTAGE OF COVER FORBANKERS' INSURANCE POLICIES

Monthly Percentage ofpremium recourse coverrate to bank

…___________ (x) …-----------

Bankers' individual exporter policy 0.05 60

Bankers' all exporter policy 0.025 85

Bankers' exporter group policy 0.035 75

2.38 The cost of combining the guarantee/insurance to banks with thebasic credit insurance policy can vary considerably because premium rates onexporters policies depend on volume of exports, diversification of markets,terms of payment and exporting experience. For example, the combined annual-ized premium for a shipment on up to 180 day credit under an irrevocableletter of credit for an "A" market could be as low as 0.9% of the insuredamount. The other extreme could be the premium for a shipment on 180 daycredit without an irrevocable letter of credit in a "D" market, which could beas high as 6% of the insured amount. The high premium rate reflects the veryhigh buyer risk associated with the terms of payment and the market cate-gory. Premium rates charged by MECIB for exporters' insurance policies arecomparable with those charged by other credit measures. Exporters in othercountries competing for the same business in a high risk market on similarpayment terms will likewise be obiiged to include such high risk premiums intheir invoice price. It may also be borne in mind that from this yearonwards, premia payable by banks. and exporters to MECIB on credit insuranceare subject to double deduction tax relief. Consequently the actual cost tothe bank and the exporters of the different MECIB covers becomesinsignificant.

2.39 Comprehensive unconditional guarantee to banks (System B). Thecomprehensive unconditional guarantee to banks involves two complementaryinsurance/guarantee instruments: (i) an exporter's wholeturnover compreher.-sive credit insurance policy, and (ii) a comprehensive guarantee to the bank(Figure 2). An exporter who holds a credit insurance policy requests theinsurer to issue a guarantee to the bank. The exporter is, therefore, respon-sible for paying a premium charge on both his policy and the banker'sguarantee. The supporting documents needed under the system would include:

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(a) an exporter's recourse and premium agreement with the insurer, underwhich the exporter agrees to pay the premium for the banker'sguarantee and accepts the credit insurer's right of recourse to himfor any payments made to the bank under this guarantee;

(b) a banker's facility letter -- in standard terms agreed to by thecredit insurer -- offering the exporter a revolving 12-month financefacility (not larger than the total agreed liability at any one timecovered in the banker's guarantee) under which the buyer's billswill be purchased by the bank without recourse; and

(c) an invoice and bill of lading to be submitted by the exporter to thebank with each bill to be purchased, and a warrantee that each billdrawn on the buyer: (i) relates to goods shipped; (ii) is insuredunder a credit insurance policy and that all terms of that policyhave been complied with; (iii) is within the buyer revolving creditlimit approved by the credit insurer; and (iv) is not drawn on anybuyer who is already in default on the bill.

2.40 The buyer's accepted bill of exchange is purchased by the bankwithout recourse to the exporter. The bill is guaranteed by the creditinsurer to the bank three months after due date if payment is not receivedunder the bill for whatever reason, commercial or political. Upon payment tothe bank the credit insurer is entitled to take recourse on the exporter forthe full amount paid. Separately the credit insu-:er examines whether theexporter has a legitimate claim under his credit insurance policy and uponacceptance of the claim sets off 85% against the 100% amount due underrecourse. This leaves the exporter with a 15% liability to the insurer, theamount he would have lost had he possessed only a credit insurance policyassigned to the bank since the bank would then have recourse for the 15%shortfall.

2.41 Fundamental to the credit insurer's unconditional guarantee to banksagainst nonpayment by the buyer is the credit insurer's underlying security inthe underwriting of the buyer and buyer's country risk. However, the guaran-tee introduces a new type of risk as far as the credit insurer is concerned,namely expoeter recourse risk for the difference between the proportioncovered by the guarantee and the insurance. Thus, a completely new skill hasto be learned by the credit insurer -- that of recourse risk underwriting.The recourse risk can be reduced to the extent that the credit insurer doesnot issue a banker's guarantee until the exporter has proven to be reliablefor at least a year or two under the basic credit insurance policy.

2.42 Important to the success of the bankers' guarantee scheme in promot-ing exports is that the credit insurer's criteria for recourse are differentfrom a banker's. The credit insurer takes a calculated risk based on theunderlying security of a spread of approved buyer credit limits, provenexpertise and performance of the exporter and the exporter's acceptance of thecredit insurer's guidance on methods of containing buyer risks. There is nocollateral base for the insurer's recourse and his recourse right ranks onlyas general creditor.

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FIGURE 2

MECIB UNCONDITIONAL GUARANTEE TO BANK FOR BUYERS'

BILLS PURCPASED FROM EXPORTER

ACCEPTED BILLEXPOT-RBUYER

BILL PURCHASED BY

M E C I B BANK WITHOUT RECOURSE

TO THE EXPORTER

JOII1E ST IC

BANK

Exporters pay premia for both their wholeturnover credit insurance policies

and guarantees to banks.

- 25 -

2.43 Further features can be added to unconditional guarantees such ascover for interest lost between due date of bill and payment of claim. Alsoit is possible for the guarantee to apply from date of shipment against a pro-missory note issued by the exporter to the bank to secure an advance prior toacceptance. Because the exporter's credit insurance offers less cover forrepudiation and is edged by dispute provisions, the recourse risk prior toacceptance is higher for the credit insurer and this must be considered beforethe scheme is introduced. Another possible variant is for the unconditionalguarantee to cover less than 100%, thus leaving the bank with some stake inthe risk. There is much to commend this, provided banks do not look for dis-proportionate collateral from the exporter for the unguaranteed portion.

Develop MECIB Expertise

2.44 MECIB's present organization and staffing provides some slack toabsorb an increase in the number and volume of comprehensive insurance pol-icies. In addition, the assignment of policies, which is alreety available,presents no problem. Thus, the provision of assignment, and the correspondingmodification of collateral requirements by banks could possibly be achieved bythe October deadline set by the Government.

2.45 However, the bankers' postshipment insurance policy (System A) willbe difficult to introduce before March 1987. Development of this scheme willrequire the setting up of a new underwriting group in MECIB to examine bankrequests for recourse cover. Since this system is well tried and tested byECGC in India, it is recommended that an ECGC expert be invited for a periodof about six months to help set up the documentation and systems and train thestaff.

2.46 The comprehensive unconditional bankers' guarantee to banks, as runby the U.K., will require further study by MECIB and Bank Negara in collabor-ation with commercial banks. Given its complexity, it should only be con-sidered if the assignment and bankers' insurance mechanisms fail. Its estab-lishment will need some technical assistance to banks and training in recourserisk underwriting for MECIB perhaps by an ECGD expert. It will still be sometime, therefore, before such a system can be introduced. Bearing in mind thatunconditional guarantees should be issued only to exporters that have had atleast one year's experience of MECIB's comprehensive credit insurance policy,the introduction of the unconditional guarantee system must, in any event, bea gradual process.

2.47 It must be noted that unless the Government indicates its intention,even in principle, to proceed in the direction of a government-backed exportcredit insurance system, it is impracticable for MECIB to embark upon expans-ionary measures for (i) marketing and setting up training courses and seminarsfor bankers and exporters; (ii) developing new technical expertise, and(iii) recruiting expertise from outside Malaysia. MECIB will also need toprepare a projection of the expenses involved in these necessary expansionarymeasures. Therefore, given an early government decision on the futurestructure of the export credit insurance system, a possible time frame for theintroduction of the new insurance instruments could be:

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October 1986 - full implementation linking postshipment exportfinancing by credit insurance policy assignment;

March 1987 - full implementation of bankers' insurance policyrelating to exporter recourse;

March 1988 - gradual implementation of the comprehensive guaranteesystem to banks, depending upon need.

C. Moving to a Market-Based Interest Rate

2.48 The interest rate on export credits that are refinanced under theECR scheme has been allowed to fluctuate between 3% and 7% below the banker'sacceptance rate. Bank Negara sets the ECR rediscoupt rate and commercialbanks are allowed a 1.5% spread. The reasons for the subsidy are to improveexporter competitiveness in overseas markets and encourage medium and smallexporters.

2.49 In practice, however, it is access to postshipment finance whichconstrains medium and small exporters, not the interest rate. In interviews,small exporters complained that many export orders have had to be foregonebecause collateral limits had already been reached and the banks were unwill-ing to lend more. Some had approached MECIB for export credit insurance inthe hope that this would influence collateral requirements by the banks, butwith little success. Strengthening the export credit insurance system, there-fore, will go further towards improving access than low interest rates.

2.50 Besides, below market interest rates have created several problemswhich inhibit the ECR scheme more than encourage it. For example, since BankNegara provides subsidized rediscount facilities for export credits, it has noalternative but to limit the margin enjoyed by banks. Since the inception ofthe scheme, the spread has been kept to 1.5%. However, banks in Malaysia tendto earn spreads somewhere between 3% to 4% on their other lines of credit andsometimes even higher. The marginal profitability of the ECR scheme is corre-spondingly lower, particularly if the exporter is selling to relativelyriskier borrowers. Some bankers indicated that export credits through the ECRcommanded very low priority in their banks's activities because they hadalready hit their liquidity ratio limits, and profitability considerationssuggested concentration in other lines of lending. The limited postshipmentcredit that is provided, therefore, tends to fall short of demand, andconsequently is rationed to large low-risk customers.i?! Small and mediumexporters, the ECR's target group, tend to get left out.

25/ This tendency gets exacerbated further by the reluctance of banks to takethe quality of the buyer paper into consideration.

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2.51 Postshipment finance, in effect, provides credit to the buyer. Bycharging a2 ?w rate of interest, part of the subsidy is, in fact, passed on tothe buyer.- Some may consider this necessary to improve the competitivenessof Malaysian exports. However, other than for ce;,tal goods imports sold oncredit terms extending over several years, the interest rate does not have asignificant impact on competitiveness. In fact, a better and more effectivemethod of improving competitiveness would be to employ industrial and tradepolicy instruments as well as the exchange rate. The objective of providingpostshipment ECR facilities backed by export credit insurance should berestricted to diversifying markets and buyers.

2.52 Thust the Government needs to consider allowing greater play bymarket forces in the delineation of the postshipment ECR interest ratestructure. Sudden and complete liberalization may not achieve the desiredresults, particularly if the export credit insurance system is not well estab-lished. Instead, the Government could consider moving gradually towards amarket based system by allowing initially a margin for banks that is closer to3%. Subsequently, the ECR postshipment rediscount rate can be allowed to riseover a period of, say, 12 months until it is equivalent to the regular redis-count rate for commercial bills and the administratively determined margin canthen be removed.

D. Issues in Medium- and Long-Term Export Finance

2.53 There is considerable debate amongst government officials andbankers in Malaysia on the advisability of establishing an export-importbank. There are, however, considerable differences in opinion on the natureand role of such an institution. Some see it as an important channel forsubsidized, medium-term postshipment finance to exporters of capital goods whootherwise cannot compete against the low interest rates offered to buyers bycompetitor countries in East and South East Asia. Others see it as a one-stopagency for all exporters to obtain pre- and postshipment finance, exportcredit insurance and/or guarantees. Given these differences of opinion, itmay be appropriate to first review briefly the role of export-import banks inmost developing countries where they have been established.

2.54 Medium- and long-term arrangements usually become necessary whencountries have developed the capacity to export machinery and equipment orexecute turnkey projects, construction works or consultartcy services abroad.Financing is required at different points from the pretender stage to the

26/ For example, official direct export credit and subsidy programs by majorindustrial countries involved a total subsidy that ranged between US$1.5billion and US$3.0 billion in 1980. See Heywood Fleisig and CatherineHill, the Benefits and Costs of Official Export Credit Pr6grem. f'.Industrialized Countries: An Analysis, World Bank Staff WkikNo. 659, October 1984.

- 28 -

completion of the order.271 For example, during the pretender and posttenderstages, financing could be needed for bid bonds, performance guarantees,advance payment guarantees and retention money guarantees. At the preshipmentstage, the exporter will need to finance the procurement of imports and equip-ment from both domestic and foreign sources and payment for labor, consultancyservices, etc. Finally, postshipment loans, in the form of either supplier orbuyer credits extend deferred payments facilities to overseas buyers. Export-import banks in developing countries do not supply all of these financingneeds, and practice amongst them varies widely and is evolving constantly. Inthe OECD too, arrangements vary from country to country. In the USA, forexample, Exim bank provides fixed-rate long-term credit to buyers for only aportion of the total transaction (typically 45% to 65%); the rest is suppliedby commercial banks. The Eximbank of Japan provides the major portion of eachofficially insured buyer or supplier credit at fixed rates. In the UK andIreland, all export credits are supplied by individual banks.

2.55 In the case of Malaysia, the first question that needs to be raisedis whether the volume of capital goods exports and/or provision of construc-tion and turnkey services abroad justifies the establishment of an export-import bank. The answer is probabl: no. Roughly 31% of Malaysia's exportsare manufactures, of which only 7% ('500 million) are machinery and equip-ment. This compares to 15% for Ind;., and 28% for Korea. Malaysia also doesnot execute many turnkey or construction projects abroad. The relative impor-tance of capital goods exports reflects the weak manufacturing base of theeconomy. Of greater importance to Malaysia at this stage, therefore, appearsto be the need to develop the manufacturing capacity, efficiency and competi-tiveness of the engineering and construction industries.

2.56 Should medium- or long-term export finance arrangements be required,institutions already exist which are capable of providing medium-term post-shipment finance for capital goods B ports at competitive rates. BankKemajuan (BKPM) is such an agency. Established in 1979 after a 1975 studyby Bank Negara, BKPM was to provide medium- to long-term financing to hightechnology and export oriented industries. However, after representation fromthe shipping industry, the Minister of Finance decided that BKPM should con-centrate its lending to activities on local shipyard involved in the con-struction and repair of ships (Table 2.5). In addition, BKPM lends to shipbuyers, provides bridging finance to shipyards when progress payments do not

27/ For a good description of various financing requirements, see Inter-national Trade Center UNCTAD/GATT, The Financing of Exports fromDeveloping Countries, Geneva, 1984. For descriptions of systems in OECDcountries, see OECD, The Export Credit Financing System in OECD MemberCountries, Paris, 1982.

28/ Bank Kemajuan Perusahaan Malaysia Berhad (BKPM), or the IndustrialDevelopment Bank, is the front running candidate to don the mantle of anexport-import bank should the Government decide to create one. Otherdevelopment finance institutions were not visited as they will be thefocus of a forthcoming study this year by the World Bank.

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match expenditures on raw materials and inputs, and provides guarantee facili-ties for Malaysian shipping operators purchasing ships abroad.

Table 2.5: LENDING ACTIVITIES OF BKPH, 1979-85(M$ million)

1985 1979-851980 1982 1984 Jan-July Cumulative

Malaysian buyers - 16.4 33.4 21.8 87.4Shipyard capital expenditure 1.6 - - - 27.6Shiprepair discounting facility 7.0 - 0.6 3.0 15.6Leasing facility 0.6 - - - 0.6Bridging facility - 5.7 9.5 3.8 36.0Guarantee facility - 7.1 1.6 - 8.7

Total 9.2 29.2 45.1 28.6 175.9

Source: BKPM, Assessment of Bank Kemajuan's Performance and Contribution(1979-July 1985), p. 9.

2.57 BKPM started with authorized capital of M$100 million and paid-upcapital of M$20 million (increased to M$40 million in 1982). In addition, itreceived a 15 year loan of M$100 million from the Government at an interestrate of 6% capitalized over 5 years, and has a M$100 million line of creditwith Bank Negara at 3% p.a. interest of which it has used only M$10 million.Finally, it has reserves of M$90 million and committed funds of aboutM$50 million.

2.58 BKPM will need to remain a force in the shipbuilding industry formany years to come. In addition, it is proposing to depart from its tradit-ional lending lines by financing capital investments in metal-based engi-r.eering products, including electronics and electrical equipment. It has onlybegun, very tentatively, to enter medium-term postshipment financing byextending an 8 year maturity suppliers credit for the recent sale of acatamaran to Australia.

2.59 By its own reckoning, therefore, BKPM will have to concentrate ocfinancing domestic investments in industry. This would be inconsistent withits operation solely as an export-import bank, for which little business isprojected for the next several years. Some interest has been expressed byThailand, Indonesia, Kampuchea, Bangladesh and Nigeria in turnkey projects forpalm oil processing mills, but with the recent downturn in palm oil prices, itis unlikely that this will be translated into orders. In any event, invest-ment costs for a palm oil processing factory amount to about M$3 million, andBKPM's comfortable resource position could easily accommodate the financing ofsuch orders if they materialize.

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2.60 BKPM is restricted to providing loans with maturities of seven yearsor more at fixed interest rates (7.5% p.a.). The Malaysian IndustrialDevelopment Finance Berhad (MIDF) lends at maturities between five and sevenyears. No development finance institution, however, lends at maturities oftwo to five years on the assumption that commercial banks should be perfectlywilling to do so. However, in the field of postshipment finance, commercialbanks tend only to lend sLort term (up to 180 days), and this is furthersupported by the ECR scheme. On the other hand, small machinery and equipmentincluding processing mills, are normally sold in international markets oncredit with maturities of two to five years. Exporters of these products maywell be placed at a disadvantage vis-a-vis their competitors if they areunable to obtain postshipment financing at fixed interest rates for suchperiods. BKPM should, therefore, be allowed to lend at maturities below sevenyears, particularly for postshipment financing.

2.61 Finally, BKPM should not involve itself in assuming postshipmentfinance risks on its own account. MECIB has special insurance policies tocover risks associated with medium-term export credits, and with governmentbacking will be ready to do so. Medium and long-term export credit risksshould only be undertaken by a member of the Berne Union with access toinformation on the "Consensus Agreement" and the "credit matching" processestablished between members to avoid the effects of a crippling credit race.For example, in the Australian catamaran purchasc, BKPM had to consult theBerne Union, through MECIB, about competitors' terms. Certainly, the scale ofMalaysia's exports of capital goods does not justify the duplication ofMECIB's activities within BKPM. The United States in the only country in theworld to have two organizations represented on the Berne Union - the Exim Bankfor large projects and the Foreign Credit Insurance Association (FCIA) for allthe normal medium- and stort-term exports.

2.62 To'summarize, the scale of Malaysia's capital goods exports does notappear to justify the establishment of an export-import bank. However, anydemand for medium-term postshipment financing can be met by BKPM, whose mainactivitiest nevertheless, will need to remain in financing domestic invest-ments. Finally, any suppliers' credits extended by BKPM should be backed byMECIB, which has special ir':urance policies for medium- and long-term exportcredits.

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III. PRIORITY TASKS IN PRESHIPMENT FINANCE ADMINISTRATION

3.01 For Phase II, the ECR task force has concentrated its efforts onpreshipment finance administration. This emphasis is appropriate and reflectsthe urgent need to deepen and strengthen the manufacturing sector byencouraging and supporting back w7d interindustry linkages. The MechanismCommittee's report (para. 1.16)- aims at improving the preshipment ECRsystem by assuring equal access to all firms that generate export value added,including small and infant producers, direct and indirect exporters, andtrading companies. Bank Negara Malaysia projects that the Phase II reformswill increase the level of export credit refinancing from M$1.7 billion in1984 S8,between M$4 billion and M$5 billion a year within a short period oftime.-' The rest of this chapter reviews these proposals of the ECR TaskForce. Section A begins by reviewing preshipment finance mechanisms that willallow indirect exporters equal access to export loans. Section B looks atissues posed by the introduction of a preshipment finance guarantee scheme,and finally Section C addresses other issues associated with theadministration of the preshipment finance system.

A. Administration Mechanisms for Preshipment Finance

3.02 The most important proposal made by the Mechanism Committee is toapply the bill of exchange (B/E) and the domestic letter of credit (DL/C) astwo alternative instruments for enabling quick and easy direct access to thepreshipment ECR by indirect exporters.

3.03 A B/E is an order written by a seller (drawer) ordering a buyer(drawee) to pay a specific amount of money at a specified time. While a sightB/E is payable immediately upon being presented to the drawee, a usance B/Eallows a delay in payment. The drawee of a usance B/E accepts it when it ispresented to him, and thus acknowledges in writing his obligation to pay thesum indicated on the face of the draft. In the B/E method proposed by theMechanism Committee, an indirect exporter that agrees to fill an indirectexport order is the drawer and a direct exporter that orders inputs from anindirect exporter based on a confirmed export order or an expected exportorder is the drawee of a usance B/E. An ECR-handling bank grants preshipmentfinance to the indirect exporter on behalf of the direct exporter as itdiscounts the usance B/E accepted by the latter. Therefore, the preshipment(production) loan granted to the indirect exporter under the B/E system isactually an advance payment to the indirect exporter made by the directexporter.

29/ Bank Negara Malaysia ECR rask Force, Report of the Mechanism Committee onPhase II of the Export Credit Refinancing Scheme, March 25, 1986.

30/ Bank Negara Malaysia, Review of the Export Credit Refinancing Scheme:Progress Report to the World Bank, April 1986.

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3.04 A DL/C is a document created by a commercial bank based on aconfirmed export order received by the direct exporter or an exportcertificate of performance issued to the direct exporter. By opening theDL/C, the commercial bank declares to the indirect exporter (which receives anorder to supply inputs or outputs to the final exporter) that the bank willpay, on behalf of the final exporter, a draft drawn on it when the indirectexporter submits, together with the draft, a receipt that commodities havebeen delivered to the final exporter. Under the DL/C system proposed by theMechanism Committee Report, the indirect exporter gains access to a preship-ment loan directly based on the receipt of a DL/C, just as the final exportergains access based on the receipt of an export order or an export certificateof performance.

Disbursement and Liquidation Mechanisms

3.05 Whichever preshipment finance mechanism is ultimately chosen by theTask Force, disaggregating preshipment loans will considerably improve theefficiency with which they are disbursed, prevent abuse of the system, improveaccess by direct and indirect exporters to ECR facilities, and not lead tocomplex procedures or administration. The Mechanism Committee has proposedthat a preshipment export loan be disaggregated into:

(a) a loan for generating value added (VAL);

(b) a loan for purchasing domestically produced intermediate inputs(DIL);

(c) a loan for purchasing imported intermediate inputs (FIL); and

(d) a loan for purchasing domestically produced finished goods (DOL).

This method of disagSregation departs significantly from the present practicein two ways: first, production financing becomes available for indirectexporters; and second, inventory financing, in the form of a domestic outputloan (DOL), becomes available to trading companies. These are importantimprovements in the right direction.

3.06 The Mechanism Committee has proposed that preshipment loans must bedisbursed directly to direct or indirect exporters involved at differentstages of manufacturing. To achieve this, DILs (or, for that matter, DOLs)will need to be disbursed when the domestic input (or output) purchase bill iscleared upon delivery of the product by the supplier. Similarly, FILs willneed to be disbursed only when import bills are cleared. Finally, VALs willonly be disbursed once DILs and FILs are disbursed and the inputs are alreadyin the exporter's warehouse.

3.07 The Mechanism Committee recommends that a preshipment export loanmust not exceed 80Z of the value of an actual order or 70% of the value of an

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expected order.311 However, it is unclear whether the Committee proposes thatthe VAL should not exceed 30% of the preshipment export loan, the value of theexport order or the certificate of performance. It may also be appropriate toclarify that (a) the maximum VAL amount should be either the actual valueadded or 30% of the preshipment loan amount, whichever is lower; and (b) bothDIL and FIL cannot exceed the value of the purchase bills on which they arebased. Finally, once the dust from the Phase II reforms has settled, BankNegara may consider bringing forward disbursements from VAL to the point whenthe domestic and imported input purchases have been confirmed, rather thanwhen DIL and FIL have been disbursed.

3.08 The disbursement mechanis-as proposed by the Mechanism Committee workin such a way as to disburse preshipment loans first to indirect exporters andthen to final exporters. However, for designing administrative arrangements,there needs to be further articulation of the mechanism for preshipment exportloans disbursements. In doing so, one basic principle with regard to dis-bursements and liquidation needs to be followed. At all stages of productionand sales for export, disaggregated preshipment export loans (particularlyDILs and FILs) should be disbursed only after clearance of the materialpurchase bills and in the form of payments to the supplier; similarly, theaggregate preshipment export loan should be liquidated only when the productsales bill clears and the seller receives payment.

3.09 These simple procedures save funds for banks and reduce costs forexporters by ensuring that loans are disbursed only when payments are due (andnot in advance of payment); prevent abuse by disbursing loans in the form ofpayments to suppliers and liquidating loans from receipts of product sales;minimize risks to purchasers and commercial bankers by preventingdisbursements in advance of payments, and creating quasi-collateral from thematerials that are bought; and achieve administrative efficiency by relyingupon a well established system of clearing trade bills employed by commercialbanks in their day-to-day business.

On the Choice Between the B/E and DL/C System

3.10 In addition to the principle stated in para. 3.08, another importantprinciple in preshipment finance is that automatic accass should be assuredfor all firms that generate export value added at all stages of production.The Mechanism Committee report states correctly that the DL/C system is moresuitable than the B/E system for the administration of the preshipment ECR,particularly because it supports and promotes backward linkages. But theCommittee has also proposed the parallel application of the two systems sothat individual exporters can choose between the two, partly because it feltthat exporters and commercial bankers are not yet ready for the immediateapplication of only the DL/C system for the preshipment ECR scheme.

3.11 Table 3.1 compares the two systems. The B/E system, as it ispresently formulated, is vastly inferior on two important considerations.

31/ The same ceilings apply to DOL.

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Table 3.1: COMPARISON OF D L/C AND B/8 SYSTEMS

B/8 System (Proposed in theD L/C System Mechanism Committee Report)

1. Wxport Loan Disbursement/Liquidation

(a) Risk-taking - Buyer (final exporter) does not - Buyer (final exporter) takes thetake the non-performance risk of non-performance risk of thethe seller (indirect exporter) Indirect exporter.

- Final exporter's bank takes only - Final exporter's bank takes non-non-performance risk of the final performance risk of both the finalexporter. and the indirect exporters.

- Lending bank's risks are reduced by - Lending Rank's risks are notquasi-collaterals created with reduced since no quasi-collateralsmaterial financed by the domestic are created with material financedand foreign input loans. by domestic and foreign input loans

(b) Neutrality between - Since dtsbursement mechanisms of - For purchase of inputs, foreigndomestic and imported domestic and foreign input loans inputs are preferred, because lessinputs are identical, neutrality is risk is involved in foreign than in

maintained in choosing between domestic input loans, therebydomestic and imported inputs. discouraging increased export value

added.

(c) Supplier's incentive - Indirect exporters have strons - Indirect exporters may have lessto perform well incentives to perform well, because incentive to perform well since

no payment is expected in the event advance payment is received.of non-performance.

(d) Waste of funds - There is no possibility for a waste - There is some possibility for aof funds, since preshipment loans waste of funds, since preshipmentare disbursed only upon clearance loans are disbursed beforeof material purchase bills. clearance of material purchase

bill.

2. Equal Access to Export Loan - Fqual access is assured under the - Equal access is not assured underfor All Export Value Added DL/C system and backward linkages the B/E system and backward

are promoted. linkages are not promoted.

3. Letters of Credit - Draft drawn by supplier is backed - Draft drawn by supplier is notby L/C (drawee is lending bank). backed by L/C (drawee is purchaser

or final exporter).

(a) Buyer's non-payment - There is no risk of buyer's non- - As far as lst staRe indirectrisk payment and indirect exporter's exporter is concerned, there is no

bank takes only indirect exporter's such risk, but for 2nd stagenon-performance risk. indirect exporter, there is a risk

unless the B/E system Is repeatedfor the latter.

(b) Back-to-back credit - Back-to-back D L/C can support - Back-to-back credit is not possiblebackward linkages to any stage. beyond the first stage.

4. Risk pooling - Due to I (a), I (c) and 3 (a) it is - Due to I (a), I (c) and 3 (a), itmuch easier to design the is more complex to design a PEFGPreshipment Rxport Finance scheme.Guarantee (PEFG) schemes.

5. Demand for the instrument by - Mutual demand exists because - Many indirect exporters may temanddirect and indirect exporters indirect exporters need D LlCe for ECR based on the B/E system (if

productton loans while direct their supplier's financing needsexporters need n L/Cs for domestic are resolved), but most finalinput loans. eAporters would try to select only

a few reliable indirect exportersfor such a scheme.

6. Demand by commercial banks - Due to I (a), I (c), and 3 (a), - Due to I (a), I (c) and 3 (a),lending banks would like to handle lending banks will probably selectas many D LICs as possible (if PRFG only a few select clients for theis well developed). B/E system.

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First, it places the entire burden of risks on the final exporter's commercialbank because loan disbursement are not tied to the clearance of the materialpurchase bill and loan liquidation is not tied to the clearance of the productsales bill (para. 3.08). The B/E system fails to minimize risks and con-sequently makes it very difficult to design and operate an effective preship-ment export finance guarantee scheme (para. 3.18). This will undoubtedlyinhibit the use of the preshipment export finance facility under the ECR. Andsecond, the B/E system fails to ensure that equal access is possible forindirect exporters, particularly beyond the first stage. The DL/C system onthe other hand has already proved itself in Korea. A similar scheme, calledback-to-back inland L/Cs is now being operated in Bangladesh, and Mexico hasinstalled its own version. It may be possible to redesign the B/E systemalong the same lines as the DL/C system (though without using letters ofcredit) so as to meet the requirement of equal access and appropriateallocation of risk. Unless this is done, it would not be an appropriatealternative for the DL/C system. The DL/C system, conceptually at least, isready for implementation under the pilot scheme scheduled for October 1986.

3.12 The DL/C system has several further benefits that need to be takeninto account by the Mechanism Committee when deciding upon the relative meritsof the two systems. In particular, as discussed in Chapter IV, the DL/Cmechanism generates documents which could prove useful in ensuring thatindirect exporters also get access to other export incentives that arepresently denied them, most notably the prior exemption of import duty and thenew value added based income tax allowance for exporters. In some successfuldeveloping countries, the DL/C system acts as the cornerstone for organizingthe administration of export incentives, particularly as they apply toindirect exporters. In choosing the appropriate mechanism to administerexport incentives for exporters, both direct and indirect, the ECR Task Forcewill need to note that: (a) the instrument must be able to verifyindependently and automatically that the supply of intermediate inputs orfinished products sold by the indirect exporter are, in fact, purchased by anddelivered to the final exporter; (b) both the indirect and the final exporterare encouraged strongly to use the instrument to receive export incentives;and (c) that the instrument is part of an efficient mechanism used bycommercial banks in handling trade related papers.

3.13 The DL/C system satisfies these requirements. In the case of afinal exporter who is supplied inputs by one indirect exporter, the sequenceof events under the DL/C system looks something like this:

Step 1: Upon receiving an export order based on an export L/C,the final exporter opens two parallel back-to-back L/Cs-- one to purchase inputs from a domestic supplier, andthe other to purchase imported inputs from a foreignsupplier.

Step 2: When the import purchase bill and the domestic purchasebill clear, the commercial bank disburses the fundsimmediately to the foreign and domestic suppliers, andtwo loan amounts, one a FIL and the other a DIL, areentered as outstanding against the name of the finalexporter.

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step 3: Once the FIL and DIL are disbursed, the bank disbursesthe VAL to enable production to commence.

Step 4: Liquidation of the aggregate preshipment export loan(i.e. FIL + DIL + VAL) occurs when payments are receivedby the final exporters once the export L/C is negotiated.

These four steps can apply equally well to each and every indirect exporter,except that their initial order is received in the form of a domestic L/C andnot an export L/C. The Mechanism Committee has proposed only two stages ofbackward linkages to be supported by the DL/C system, though an additionalstage may be added if the final exporter happens to be a trading company. Itmust be stressed that the same disbursement mechanisms apply to all exporters,irrespective of whether they are final exporters or indirect exporters orwhether they are first or second-stage indirect exporters. The very laststage indirect exporter, however, poses something of a problem. For thiscase, the Mechanism Committee needs to issue a guideline stating that anypurchase bill and receipt (not backed by an L/C) will be sufficient evidenceto disburse a DIL. However, in regard to the FIL and VAL for the last stageindirect exporter, it will be hard to justify any relaxation of the usualdisbursement requirements.

The Certificate of Performance System

3.14 One of the important innovations being considered by the ECR TaskForce for the Phase II reforms is to offer preshipment loans on an expectedorder rather than actual order basis. The advantages of such a system wouldbe to simplify procedures for well established large exporters, and to allowproduction to feed inventories so that exporters can respond to ordersquickly. The administrative instrument to be used for the purpose is acertificate of past performance (PC) to be issued by a commercial bank.

3.15 The certificate of past performance must contain the value of exportorders expected in the next three months on the basis of some indicator ofpast performance. The Phase II recommendations propose that this indicatorshould be equivalent to the value of exports delivered by the exporter overthe previous three months or that of the corresponding quarter in the previousyear. However, the Committee might consider an alternative formula thatsmooths cy i,cal fluctuations by taking the average performance over the past12 months.-

3.16 The Committee also states that an exporter cannot be allowed to useECI facilities on the basis of actual orders and expected orders at the sametime. However, switching from one to the other could be allowed as long asthe total amount of the preshipment export loan does not exceed either the

32/ Value of Export Certificate of Past Performance- (Preceeding 12 months export value t 4)

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value 35,the PC or the maximum loan allowable on the basis of an actual exportorder,- whichever is greater.

3.17 Certain other conditions need to be imposed for the smenth function-ing of the certificate of performance system for which Bank Negara would needto set up a monitoring and control mechanism. First, to prevent potentialabuse or misuse of the PC system, only one authorized bank should be allowedto issue a PC for each exporter. Second, new PCs should only be issued onceexports are completed under the previous PC. Third, constant and systematicchecks will need to be made to ensure that the gap between actual and expectedexport orders does not exceed the proposed figure of 20Z. Fourth, Bank Negaracould implement flexibly the M$3 million minimum export PC, depending upon theperformance and reactions of small and medium scale exporters. Finally, as amedium-term objective, Bank Negara could consider the possibility of extendingthe certificate of performance system to indirect exporters as they becomemore important to the export process.

B. Introducing a Preshipment Export Finance Guarantee Scheme

3.18 The principal aim of the ECR scheme is to ensure that all exporters,direct or indirect, small or large, trading companies or manufacturers, haveequal access to export financing. However, even with the best administrativearrangements and mechanisms, commercial banks are unlikely to change theirconservative lending practices overnight. They will continue to demand coll-ateral, which in Malaysia often means land and buildings. Smaller exporters,who can play a very important role in the country's export efforts, and thoselarger exporters who have already borrowed up to their collateral limits, findthat even with confirmed orders from reputable buyers abroad, they are turneddown for preshipment loans. To overcome the hesitation of commercial banks,the Task Force proposes to set up a Preshipment Export Finance Guarantee(PEFG) scheme. Such schemes now operate in Korea, India, Sri Lanka andIndonesia, and are being considered seriously in Mexico and Thailand.

3.19 The Insurance Committee of the Task Force has pointed out certainkey features that a PEFG scheme should have:

(a) PEFG policies should be optional, and not a mandatory requirement,for receiving preshipment export loans under the ECR;

(b) final and indirect exporters will require separate PEFG coverage;

(c) underwriting risks needs to be shared between the PiFG agency andthe commercial banks; and

(d) wholeturnover and specific guarantee policies should be offered inparallel to exporters.

33/ i.e. 80% of the export order according to the Phase II proposal.

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Which Institution Should Handle PEFG?

3.20 Two agencies are being considered as potential candidates for theadministration of the PEFG scheme: MECIB and the Credit GuaranteeCorporation. The main purpose of the Credit Guarantee Corporation (CCc) hasbeen to provide guarantees for loans to small businesses and cottage typeindustrial firms. These guarantees have been provided solely on the basis ofcredit investigations conducted by the commercial banks and without anyindependent risk evaluation by CGC. Though most firms receiving CGC guar-antees do not export, experience in the provision of guarantees could proveuseful in the context of PEFC. However, it appears that CCC is a weakorganization without: (a) a strong capacity to evaluate sources of creditrisks inherent in small and medium size firms; and (b) enough capability toimprove the development potential of small firms by providing technical,marketing, and3 nagerial assistance (which would gradually reduce theircredit risks). _ If such a capacity had been accumulated and such capabilitytad been acquired, then they would have become serious contenders foradministering the fledgeling PEFG Agency.

3.21 MECIB's main activities, on the other hand, have been to administerthe export credit insurance and guarantee schemes that cover importers' non-payment risks. Only very recently did MECIB introduce a PEFG scheme thatcovers nonperformance risks of exporters. MECIB's PEFG scheme covers up to501 of the value of an export LIC. The PEFG scheme offered to individualexporters who hold NECIB's comprehensive policy on a revolving basisencourages commercial banks to open irrevocable L/Cs in favor of the supplierof imported (or domestic) inputs needed for export production. The guaranteepremium (ranging from 2% to 5% of the amount covered) is borne by theexporter. NECIB has prepared another PEFG scheme which is a whole turnoverpolicy for commercial banks that covers two thirds of the value of all exportloans granted by the policy-holding commercial bank. One of the large commer-cial banks has expressed interest in the scheme, but this has yet to betranslated into action.

3.22 Therefore, neither MECIB nor CGC have built a strong capacity toevaluate credit risks associated with small manufacturing firms. Nor haveeither acquired skills and experience needed to assist small potentialexpor.ers. Between the two, however, MECIB appears to be the more suitable,partly because it has already offered, or considered offering PEFG policiesand it appears to have sufficient capital to support PEFG operations at leastin its initial stages.

Some Features of a PEFG System

3.23 It needs to be noted that the objective and operation of the PEFGscheme are entirely different from postshipment credit insurance and guarantee

34/ See Aswin Kongsiri, A Study of the Credit Guarantee Corporation ofMalaysia, April 24, 1982.

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schemes to which MECIB has grown accustomed. The objective of theconventional credit insurance and guarantee schemes is to cover exportersagainst the possibilities of nonpayment by foreign buyers. A PEFG scheme, onthe other hand, covers banks against the possibilities of exporters defaultingon preshipment loans provided by commercial banks. Thus, PEFG schemes are notonly concerned with assessing risks associated with a completely differentgroup (exporters, as opposed to foreign buyers), but they can actively attemptto reduce those risks. In other words, PEFG schemes can also take on themantle of a development organization, and the success or failure of itsdevelopment orientation will depend upon incremental export value addedgenerated by its members as a direct result of its activities. Thisrepresents an entirely new area of operations, particular for MECIB. Enteringdevelopment activities to reduce nonperformance risks associated with certaingroups of exporters will consume enormous time and effort and will requirecareful planning. Meanwhile, MECIB will need to concentrate its energies ondeveloping effective PEFG policies in the initial stages. In the medium term,it will need to, like its predecessors in Korea and Taiwan, China, considerwhether it should take a more active role in developing the efficiency andcompetence of its clients in its own interests and in the broader interests ofthe country.

Elements of an Action Program

3.24 MECIB is on the threshold of a completely new and unknown field ofoperations. It will need to enter with all due modesty, and a gradual andpatient approach cannot be overemphasized. The experience of the moresuccessful developing countries shows that:

(a) organizational structures or specific policy formulas of PEFGagencies are less important in explaining success than a closeinvolvement with clients, a deep understanding of their constraintsand a capability to provide assistance to improve their performance;and

(b) without long learning periods and painstaking efforts, success hasoften eluded PEFGs.

3.25 Short Term Tasks. The following tasks are considered key componentsfor the establishment of a PEFG scheme:

(a) PEFG Policies Should Take Account of Phase II ECR Proposals.Existing PEFG policies operated by MECIB do not yet include theparticipation of indirect exporters. Given the objectives of thepreshipment ECR scheme, the major focus of PEFG policies will needto shift to indirect exporters in the future. In view of the risk-sharing characteristics (among handling banks) of the proposed pre-shipment loan disbursement and liquidation mechanism, it isabsolutely critical that when designing its PEFG policies, MECIBunderstand fully every detail of the DL/C and B/E scheme as well asthe entire ECR system. It must also be noted that the character anddetailed content of the PEFG policies, as well as risk analysis,will depend crucially on whether the ECR scheme adopts the DL/C or

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the B/E system. It is therefore recommended that MECIB immediatelybecome a member of both the Mechanism and the Procedures andDocumentation Committees.

(b) Keep the Administration of PEFG Separate Within MECIB. Given thebasic differences that exist in the approach toward PEFG and conven-tional credit insurance, the administration of the two operationsshould be kept distinct to the extent feasible in terms of riskanalysis, policies, accounting, budget, staffing and capital.Senior management and overhead facilities, of course, will need tobe the same. At the outset, the PEFG operation will need to recruithighly qualified staff and conduct training programs.

(c) Organize Overseas Studies and Training Programs. MECIB shouldorganize overseas training programs for its staff, particularly insome of the more successful agencies. In selecting countries forstudy, priority should be given to those with similar preshipmentloan disbursement and liquidation mechanisms to the proposed systemin Malaysia. In addition, MECIB staff should study the advantagesand disadvantages associated with a PEFG agency run as part of asmall industry credit organization or as part of a regularconventional credit insurance agency.

(d) Conduct a Survey of Small Direct and Indirect Exporters. Currently,little data is available on numbers and types of direct and indirectexporters, backward linkages of final exporters and potential demandfor preshipment finance under the ECR scheme and guarantees underthe PEFG scheme. It is important that this information be collectedon a priority basis to guide MECIB and Bank Negara officials informulating strategies, designing insurance and guarantee instru-ments, marketing guarantee policies and setting targets. A surveycould be conducted in two phases, the first phase concentrating onexisting direct and indirect exporters, and the second phase iden-tifying potential direct and indirect exporters.

3.26 Medium Term Tas , Over the medium term, MECIB may consider follow-ing the example of Korea - by expanding its PEFG wing into extensionactivities designed to provide technical, managerial and marketing assistanceto small exporters. The advantage of maintaining a separate PEFG organizationwithin MECIB is that policymakers could have the option in later years to spinit off into an entirely new and independent institution. This may becomenecessary if PEFG-linked extension programs are considered necessary andbecome a success.

35/ Korea Credit Guarantee Fund (KCGF).

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C. Other Issues in Preshipment Finance Administration

3.27 Apart from the major issues concerning preshipment finance mechan-ism for access to the ECR by indirect exports and the preshipment exportfinance guarantee scheme, the Task Force has proposed a number of otherreforms under Phase II. A large number of them are appropriate and in theright direction. Only those which could either be improved or need to bereconsidered are given below.

Domestic Value Added and Local Content Requirements

3.28 One of the Task Force's recommendations is that ECR facilities willbe available to those products with at least 20% value added and 30% localcontent. Though the objective of these requirements is to promote the use oflocal raw materials and encourage greater domestic value added in exportindustries, they might equally discourage the growth of very efficient export-oriented activities, and contrary to their original intention, actuallyinhibit the strengthening of industry in the long run. The more appropriateapproach to encouraging and promoting domestic value added in exports is toassure equal export incentives to all firms generating export value added,while letting exporters choose freely between imported and domestic inputs.The experience of countries that have successfully developed their manufact-uring sectors by encouraging exports of manufacturers suggests that theprovision of equal incentives at all production stages, rather than mandatorylocal content requirements, accelerates domestic value added in exports.Therefore, it is recommended that the ECR's local content and domestic valueadded requirement be reconsidered and dropped altogether, once equalincentives are assured to all firms generating export value added.

Number of Production Stages with Access to ECR

3.29 In its report, the Mechanism Committee appears unclear on how manyproduction stages in the export process should be allowed access to ECR. Inprinciple, any number of stages in the production chain should get equalaccess, but for practical and administrative reasons it may be appropriate tolimit it to two. In other words, ECR facilities should be available to finalexporters, their input suppliers and, in turn, their input suppliers. Wheretrading companies are the final exporters, ECR facilities should be availableto the trading company and up to three stages of indirect exporters that maybe involved in the production of the export product. In addition, as themanufacturing sector acquires greater depth, and more experience in exportfinancing is gained, the number of stages of indirect exporters covered by theDL/C system could gradually increase from the recommended two to any numberconsidered appropriate at the time.

Definition of Confirmed Export Order

3.30 To prevent the abuse of preshipment export loan facilities extendedon the basis of actual export orders, it is important to define what exactlyconstitutes an export order. In principle, orders must be confirmed andverifiable, but the Task Force will need to determine what kind of document-ation will be considered necessary to satisfy this requirement. In the

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interests of minimizing red tape, the number of documents required should befew and easy to obtain. On the other hand, orders by telex may be consideredinsufficient evidence of authenticity.

Maximum Loan Periods for Preshipment ECR

3.31 The Mechanism Committee, in its report, proposes to increase themaximum loan period for preshipment export finance from three months to fourmonths. This stipulation should be applied flexibly by Bank Negara toaccommodate selected products which have longer production periods.

The Interest Rate Spread on Preshipment ECR

3.32 For the preshipment ECR scheme, the Task Force proposes an increasein the maximum spread allowed to commercial banks from 1.5% to 2.5%. Thisincreased spread will definitely generate greater interest amongst commercialbanks in using the scheme. At present 70% of outstanding loans under the ECRscheme are concentrated in seven banks - five foreign and two local. Fit even2.5% is probably below the average intermediation margin enjoyed by commercialbanks in Malaysia, particularly with regard to loans given to small export-ers. In addition, lending costs under the preshipment ECR scheme could behigher than average. To ensure that commercial banks take further interest inthe preshipment ECR, Bank Negara may need to increase intermediation margins abit more. Subsequently, depending upon movements in trade policy, effectiveprotection and the international environment, Bank Negara could consider rais-ing the refinancing rate gradually until it is equal to the standard rate forrediscounting commercial bills.

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IV. THE ADMINISTRATION OF DUTY-FREE IMPORT SCHEMES

4.01 The first step in reducing the antiexport bias inherent in thepresent structure of investment and production incentives is to ensure thatexporters are able to import intermediate inputs and raw materials duty-free. In addition, arrangements for providing duty-free imports to exportersis one of the few export incentives which are both acceptable to GATT andcannot be faulted by Malaysia's trading partners. The administration of duty-free import arrangements has to be quick and accessible equally by small andlarge, or direct and indirect exporters. Complicated or cumbersome adminis-trative procedures tend to defeat the very purpose for which they are set up.

4.02 Malaysia has four separate schemes that permit duty-free imports forexport production: free trade zones, licensed manufacturing warehouses, theimport duty drawback scheme and the prior exemption scheme. The discussion inthe remaining sections of this chapter focus on the latter two schemes. Thereader should note that all observations, conclusions and recommendation inthis chapter are very preliminary and tentative, and therefore should beinterpreted with due caution. The mission was hard pressed for time in itscrowded schedule, and in accordance with the wishes of the authorities, thisarea of the mission's work was given a lower priority.

A. Import Licensing for Exporters

4.03 Before exporters can obtain access to the Government's duty drawbackor prior exemption facilities, they need to obtain a licence to importproducts subject to quantitative restrictions and listed in Schedules 2 and 3of the Customs Act 1978 and 1981. To do this, an application must be made tothe Domestic Trade Division of the Ministry of Trade and Industry along with ajustification for the need to import rather than use domestically producedinputs. The Ministry then conducts its own enquiry into the capability ofdomestic producers in supplying quality-equivalent products at competitiveprices, for which it invites the opinions of users and producers. Only if itis convinced that such a capability does not exist, does it issue a license toimport, but on the condition that exports of the final products must takeplace within six months of the input's import date.

4.04 The requirement of the "domestic availability test" denies exportersa free choice between using domestic and imported inputs and jeopardizes theircompetitiveness and reputation in international markets. Exporters are thebest judges of the needs of their customers, the cost alternatives betweensourcing inputs from different suppliers, technology requirements, etc.Fierce competition in international markets demands that exporters, bothdirect and indirect, deliver quality products on time and at the rightprice. To be able to do this, they must be able to operate under the sameconditions as their competitors in Korea, Hong Kong or elsewhere, which meansthat they must be assured of quick and automatic access to duty-free importsif they so require.

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4.05 The challenge of import administration lies in ensuring that directand indirect exporters alone are given this special privilege without others(that is, those producing for the domestic market) abusing the system.Unfortunately, the "domestic availability test" fulfills neither of these tworequirements. It introduces delays and uncertainty into the productionprocess, often denies exporters their preferred choice of importing certaininputs and, by also granting import licenses for domestic sales using the samemechanism, makes monitoriag and control very difficult. Instead, a system isneeded which is strictly for exporters, both direct and indirect, withimmediate access to duty-free imported inputs and without the nece2sity ofobtaining an import license. Such a mechanism is discussed later in thisreport (para. 4.15).

B. The Duty Drawback Scheme

4.06 The duty drawback system for manufactured exports under Section 99of the Customs Act is an individual drawback system that rebates duties paidby exporters on their imported raw material and intermediate inputs on a case-by-case basis. Unlike the import licensing system and the duty exemptionsystem (para. 4.10), the duty drawback scheme does not impose a "domesticavailability tqst" and covers all imported inputs. However, it is availableonly to final exporters.

4.07 The duty drawback system operates in two stages. First comes theapproval of the drawback facility for individual export manufacturers on aproduct-by-product basis. Then comes the procedure for claiming a drawback ofduty. In the first stage, the most important hurdle is to obtain approval forthe input-output coefficient formutla which relates the physical amount ofimported input (allowing for waste during the production process) required toproduce a unit of output to be exported. Once this formula is approved byCustoms, it is a relatively mechanical process for Customs to calculate theamount of duty to be repaid to the exporter. In the second procedural stage,documents need to be submitted proving that the import of inputs has takenplace and the export of the final product occurred within one year from thedate of import.

4.08 The Government has emphasized the importance of speed in the dutydrawback facility by placing a self-imposed time limit of two weeks fromapplication for use of the draw-back facility to its approval and three weeksfor payment of refunds from the date of claim. In additiont input-outputcoefficients have been approved with some leniency, though Customs subject ahandful to a careful audit. This system appears to have worked well, andprovided that demand for the duty drawback scheme remains limited, couldcontinue to serve the needs of Malaysia. The amount of duty refunded underthe drawback scheme in 1985 was only about M$13 million, or less than atwentieth of the duty foregone under the prior exemption scheme (para. 4.10).However, should there be an increase in the demand for this scheme, thepresent system of approvals for input-output coefficients may either be abusedor prove to be a bottleneck. Instead, Customs could issue a book comprisingpretabulated input-output coefficients in the same manner as the Koreans.This will allow customs officers to calculate the amount of duty drawback atthe time of export without any requirement for prior approval for use of the

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drawback facility. In addition, exporting firms will no longer be required tokeep books of accounts detailing the use of raw materials and componentsspecifically for the purposes of the scheme. Of course, items not listed inthe published document will need to be subject to the original procedure, andupdated versions of the input-output coefficients book will need to bepublished periodically.

4.09 It was noted earlier that the duty drawback scheme is primarily forfinal exporters. In fact, provisions for indirect exporters do exist, but forlack of proper administrative arrangements, is seldom used. Under theseprovisions, the export manufacturer approved under the scheme can claim onbehalf of other firms involved in the production of the final product.

C. The Prior Exemption Scheme

4.10 The Customs Act, 1967 allows exemption from payment of import dutieson inputs used not only in the production of exports (Section 14) but also inthe production of goods sold in the domestic market. Duty exemptions can onlybe granted by the Minister of Finance, whose decision is based on the adviceof the Special Advisory Committee on Tariffs (SACT). SACT is chaired by theDeputy Secretary General of the Ministry of Trade and Industry, and countsamongst its members representatives from the Ministry of Finance, Customs andIIDA (which also acts as the Secretariat). SACT meets once a week to handleall matters relating to tariffs, including duty exemptions.

4.11 The procedure for obtaining prior exemption approval requiresexporters to submit past export performance records, planned export values andinput-output coefficients to MIDA's Tariff Division. Based en the analysis ofthe Tariff Division, which includes an investigation of whether the product isavailable locally, SACT recommends duty exemption to the Minister of Finance,who in turn informs the exporter by letter.

4.12 As noted earlier, import duties can also be exempted for importedinputs used in the production of goods sold in the domestic market. Hereagain, the "domestic availability test" is applied as the basis for thedecision. It follows that if import duties are exempted for both exportingand import-substitution firms, both on the basis of the "domestic availabilitytest", then the Government may as well remove the import duty altogther andsave itself the administrative costs of the initial reviews process and therenewal of exemptions once every two years.

4.13 Monitoring the use of the duty exemption scheme lies with Customsand not MIDA, and does not appear to be particularly strict. In fact, thereare no strong penalties for the misuse of the schemes. For example, ifCustoms does discover that duty-free imports to be used for export productionare, in fact, used in the production of goods sold in the home market,apparently the exporter has only to clear the unpaid duties. The relativelyliberal approach towards offenders and the lax monitoring mechanism probablyexplain the scheme's immense popularity. Users of the scheme who exploit itsweaknesses could stand to benefit significantly. Duty exemption in 1985amounted to M$2,317 million, or almost twenty times the amount reimbursedunder the duty drawback scheme. Of course, the level of nominal protection

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granted to import-competing industries is reduced to the extent that duty freeimports are sold in the domestic market, though the effective protection ofimport-substitution industries using duty-free imported inputs will rise.However, the duty exemption scheme, as it is presently administered, does notprovide free trade status for all firms that generate export value added.Though indirect exporters are supposed to be entitled to access, the absenceof appropriate administrative arrangements do not permit the authorities toimplement the spirit of the rules and regulations.

D. Some Recommendations for Reform

4.14 Perhaps the most important shortcoming of the existing administra-tive system for allowing duty-free imports for export production is its res-triction, in practice, to final exporters. By denying indirect exporters theoppottunity to obtain quick and easy access to duty-free imports, not onlycotid the quality, price and reliability of final exports suffer, but thecreation of backward linkages arising from export activity would be discour-aged. In addition, duty-free import administration is complicated by the needto obtain import licenses for quota-restricted items, the "domesticavailability test" and the case-by-case basis for calculating the input-outputcoefficients for imported inputs. Finally, the monitoring mechanism for theduty-free import administration is not sufficiently strict, and there are nopenalties for abuse of the system.

4.15 Ensuring quick and easy access to duty-free imports for exportproduction, whether by direct or by indirect exporters, is a matter of toppriority. Furthermore, duty-free import administration needs to be simple,easy to enforce and cost relatively little. The DL/C system, recommended forthe ECR preshipment mechanism, appears to be the appropriate vehicle on whichto base the administration of duty-free imports for indirect exporters. Itmay be recalled that the DL/C system allows indirect exporters to obtainforeign input loans, domestic input loans and value added loans on thestrength of the export L/C received by the final exporter. Thus, the L/Copened by the indirect exporter's commercial bank to import foreign inputstalong with a copy of the indirect exporter's DL/C and the master export L/C onwhich it is based should together constitute sufficient evidence to Customsthat the imported items are eventually to be used in export production.Customs also record the export of final exports, which can be used as a checkt- ensure that import of the inputs did result finally in export delivery. Ape:iod of one year may be considered a reasonable gap between the import ofinputs and the export of the final product. If the final ,roduct is notexported within one year, the Government can demand payment of duty withinterest. Subsequent instances of failure to export would need to beinvestigated, malafide actions could be prosecuted and the violator given astiff penalty which could include disbarment from access to ECR facilities.

4.16 The other advantages of the DL/C scheme would also work in favor ofthe duty-free import administration scheme. In particular, the preshipmentexport finance guarantee scheme that will back the DL/C system will not onlyallow small or infant exporters immediate access to finance, but will alsoprovide them access to duty-free imports.

- 47 -

4.17 Several concomitant reforms will also need to be considered alongwith the use of the DL/C mechanism for duty-free import administration (seeTable 4.1)s

(a) The input-output coefficient formula to be used by Customs in deter-mining whether an appropriate quantity of inputs is being importedin relation to the final order (including allowance for waste)should no longer be determined on a case-by-case basis. Instead,Customs, in collaboration with the Ministry of Trade and Industrywill need to calculate input-output coefficients and publish theresults in a book, similar to the one issued in Korea, forexample. This can be updated from time to time on the basis of newinformation. Items not listed in the book will continue to beapproved quickly on a case-by-case basis, but once approved, thesame coefficients will apply for all exporters.

(b) The precondition for an efficient and easily administered duty-freeimport system is the elimination of the "domestic availabilitytest". As was noted earlier, this test causes delays and avoidablecosts to the exporters which could ultimately have long term harmfuleffects without leading to genuine inter-industry linkages based onefficiency and competitiveness. Equal export incentives to all,including indirect, exporters will go much further in promotingbackward linkages than the "domestic availability test".

(c) The import licensing requirement for exporters can be abolishedaltogether. Even under the existing system, approval for duty draw-back or duty exemption should imply automatic approval for importeven if there is a quantitative restriction on the import of theproduct. Under the proposed system, there will be no need for anyapproval at all. Evidence of an export order, or an expected exportorder, together with government-approved input-output coefficients,will be sufficient justification for the import of inputs duty free,whether they are subject to quantitative restrictions or not.

(d) Consideration could be given to use the proposed DL/C system foradministering a range of other export incentives for indirectexporters. For example, the Government has introduced an income taxabatement scheme whereby exporters can deduct 10Z of value added inexport products from their taxable income. Under the presentarrangements this is restricted to final exporters. Only thoseindirect exporters supplying their products to final exporters inFTZs or LMWs can benefit from the scheme. The DL/C systefm providesan opportunity of extending this to all indirect exporters aswell. The calculation of value added could be based on the value ofthe domestic L/C and the material purchase bills for inputs.Similarly, the administration of other export incentives, such asexemption from excise duties and sales taxes, could be strengthenedthrough using the administrative infrastructure supported by theDL/C system.

Table 4.it ntE AtMMSrE rta?N ot DWTr-FRg TOPORt xoes: 40 ovDIgmt

seperatioe of "importadmiistrationo for

export produetion" ftom lupoeitton ofi"iport eadinistration "domestic avaitbi- Inwmt-outeut "forwim " D_amento snd oroceduret Safeguard an sotor- Access for Indirct aces" for

for domestic sLe.e lit, cat admtnoitrsti rolndto liAti tug sacnImm &MO et,T geioll m.rtor-ttropo Current 1 t a ;j r to etUrr d f r oposed worrectn ao Cur t _ l t Q _eThe dmtniat*tatio of System syste System st_m System syetem sqtem ssteu system sytem system System *Yet*M "y tes

tmet Licese. *ot Aolish tmposed Sbould be Apears to Abolish impot Letter to Abolish Not ssts_ttic AbolUs import Not eSy Abolish Net emay Abolish i tortsparated mport Ii- eliminaerd rely o ha ghF- Iteeingt for 'Simistry of import li- litesiqg ftr iport tiomnseg foe

ttoing for ly segregato exporter Tade dad comsing for sxorde, ltcening mortereexporters relationship lcIustry exporters for es-

onad-boo porters

Duty drawback eche" Separated; jlb choe Not No change Porule Elinate Docments No chage So aeed; but to ned; Not easy 0 VC Sarisfcttory No cbhaduty drawback needed imposd needed apirovel Drawback confirming needed Copana to imaorred stem _ddiS allowed I process in Faclity exports and (excert for asked to inpct-output (deloped only for Dtraebck proctdure; iported torsale- hp Itosorted accounting for zCa) aexporters Facility uses formla iaputs related Snput-output boos ere not ca be

procedure booke Isd information) account ing needed spplidcould prove in advace by booksto be hot- Customstleneck Ifdexandincrea"ss

Duty exemption schem Separated Sbould be imposed Should be Formula Use formula Past export Actual and Weli-dealKned Should Sn ti- Not eas 0 D /C NOt easy Should aoanreonly partly; *eparated eliminated aporoval books issued records expected ex- sveex iS nut tute well-d- systex easier accessduty e*eop- completely, process at tn advance by port orders available aLgned *sestn (developed once pretdp-tSon also duty ncx- tIlaA is Customs /a Including checking ganP for ECt) Meet financegranted for tion should ad-hoc and indirect er- between can be CuatanteeImports used be li-lted to could be port orders *ctual/e- aPplied Scheme istn manufac- exporter, tine-cov- based on 0 pected *xport establishedturtlo goods otberwis it *uning sod L/C (davel- orders codfor domestic would be arbitrary oped for M0R) exPort con-sale better to nletion

reduce dutyto zero

/aFor expcted export Ordrer the Performance Certificate (FC) system develnoed for ECR could be used.

- 49 -

4.18 Of necessity, these recommendations are broad and only directionalin nature. A great deal of further preparatory work needs to be undertaken tooutline the next steps and fill in some of the details. Once the ECR TaskForce has completed its work and the preshipment finance administration isoperational, it is recormended that the Government set up an Interagency TaskForce for Streamlining Duty-Free Import Administration with representativesfrom all the relevant agencies including the Ministry of Finance, Ministry ofTrade and Industry, MIDA, Customs, Federation of Malaysian Manufcturers, BankNegara and SACT. Unlike the ECR Scheme for which the responsibility lies withBank Negara, new duty-free import administration schemes will need to be thejoint responsibility of the Ministry of Finance, Customs and the Ministry ofTrade and Industry.

Appendix APage 1

EXPORT INCENTIVES IN MALAYSIA

A. Fiscal Incentives

Under the Investment Incentives Act 1968 11

Export allowance: 5% of f.o.b. value of export sales isdeductible from company income for incometax purposes. Since January 1, 1986, thishas been replaced by a new provision whichallows 10% of value added for export to betax deductible.

Tax deductibility of Costs incurred for promoting exports, forexport promotion costs: example on advertising or participation in

trade fairs, can be deducted twice fromcompany income for tax purposes.

Accelerated depreciation Investment in plant and machinery used forallowance: export production (at least 20% of total

production must be exported) can be depre-ciated at 40% p.a. in addition to theinitial 20% p.a. allowance.

Under the Customs, Excise and Sales Tax Acts

Duty drawback: Drawback of import duties and surtax ispermitted for imported inputs used in themanufacture of exports. In addition, 90%of duties and surtax are reimbursable uponthe re-export of imported goods.

Excise duty exemption: Export items are not subject to exciseduty. In addition, sugar and intoxicatingliquor, when used in the preparation ofexport products (i.e. food products,alcoholic preparations) are not subject toexcise tax.

Sales tax exemption: Export items are not subject to salestax. Drawback of sales tax is alsopermitted for exports of indigenous goodsby a trezing company, or when importedgoods re-exported.

1/ Only for resident companies in Malaysia exporting either manufactures orsemimanufactures.

Appendix APage 2

B. Monetary Incentives

Export Credit at Concessional Rates

The Export Credit Refinancing Scheme, begun in 1977, providespostshipment and preshipment finance at interest rates that are roughly 52below the bankers' acceptance rate.

C. Special Incentives

Import duty exemption: Exporters are allowed to importintermediate inputs duty free provided thatthey are not available locally.

Free trade zones: Intermediate inputs can be imported duty-free into a free trade zone provided thatall the output is exported

Customs bond: Provided that a company exports at least80% of total production, it can import rawmaterials and intermediate inputs duty-free. Prior approval for domestic marketsales is required, and if given, importduties are levied as if such goods arebeing imported into Malaysia for the firsttime.

Appendix BPage 1

THE ESTABLISHMENT AND STRUCTURE OF MECIB

MECIB was established by the Government in 1977 as a public limitedliability company on the basis of a joint venture of the Government and com-mercial banks and insurance companies operating in Malaysia. The Governmenthas a majority shareholding of 53.6%.

The prime purpose of MECIB is to issue export credit insurancegurantees and policies. Its structure and organization followed closely thatof a similar body, the Export Credit Insurance Corporation of Singapore(E.C.I.C.S.), established some 18 months earlier.

The authorized capital is M$150 million, the issued and paid upcapital M$15 million. In addition there is a stand-by guarantee by share-holders up to 25 times of the original shareholdings, amounting to anadditional M$125 million.

MECIB's operations are supervised by a Board of Directors andimplemented through the General Manager and a Special Credit Committee.

The Board of Directors at present consists of six governmentofficials:

Ministry of Trade and Industry - 2 DirectorsMinistry of Finance - 2 DirectorsMinistry of Primary Industries - 1 DirectorBank Negara Malaysia - 1 Director

and representative directors from each of four banks and one insurancecompany. Traditionally the Board has been chaired by the Secretary-General,Ministry of Trade and Industry.

A Special Credit Committee consisting of four senior bank officialsrepresented on the Board of Directors and the General Manager of MECIB arecollectively empowered to approve credit limits above the General Manager'slimit up to a figure of $5 million. Above that the approval of the Board ofDirectors is also required.

The day to day administration and management of the company anddevelopment of new facilities for Board consideration and approval is theGeneral Manager's responsibility. He is supported by a management, submanage-ment and a clerical staff team, presently totalling 24 employees.

MECIB is a full member of the highly reputed International Union ofCredit and Investment Insurers (known as the "BERNE UNION") through which itobtains first hand reports and evaluation of country risks and buyer defaultsworld-wide as well as technical advice from the longer established members.

Appendix CPage 1

FURTHER THOUGHTS ON THE ORGANIZATION OF MECIB

Machinery for Paying Claims

1. The financial structure for meeting claims must aim at putting MECIBin a position to effect payments not later than the due date under the policyor guarantee. No credit insurer -- government or private -- can survive ifthe rights of the insured to receive prompt settlement as provided in lawunder the insurance or guarantee is not meticulously observed.

2. A brief description of the mechanism of the Export Credits GuaranteeDepartment (ECGD) of the United Kingdom may provide some useful pointers forthe Malyasian Government. ECGD is an independent government department underMinistry of Trade and Industry. The Secretary of ECGD, its top official, isthe Accounting Officer answerable to the House of Commons Public AccountsCommittee.

3. A simple Act of Parliament empowers the Secretary of State for Tradeand industry to issue guarantees to promote export earnings and stipulates theGovernment's maximum contingent liability (currently about E 32 billion).This theoretical figure is based on an estimate of ECGD's outstandingliabilities at any one time. For short term cover the figure is half theestimated total turnover under comprehensive policies and guaranteesrepresenting a twice a year rollover of insured transactions on terms up to180 days.

4. ECGD's receipts and payments are accounted for in the appropriationaccount of the Vote for International Trade. Annually ECGD estimatespotential claims and administrative expenses, premium earnings, recoveries andnational interest. In all postwar years before 1981 (with the one exceptionof a short period in the fifties when Brazil ran out of foreign exchange) theestimate and out-turn was always in surplus. The Vote was then fixed at anominal figure of b 100 m (nowadays E 1,000 m). In fact, the Vote is dividedinto subheads for ECGD's different activities, but the same principle appliesunder each subhead.

5. Administratively all receipts and payments are made daily to theaccount of the Paymaster-General, keeper of the Consolidated Fund. ECGD doesnot have monies of its own. Interest at the Government's calculated rate (notfar different to the bank base rate) is notionally paid and taken into accountin the Vote estimates. This interest is calculated on the aggregate netsurpluses paid into the Conslidated Fund over past years, or if the aggregateis a net deficit then the reverse applies. The latter situation occurred in1984/85 because of massive transfer claims (mostly medium-/long-term capitalgoods business) not yet balanced by a sufficient flow of recoveries. All ofECGD's claim payments and other disbursements are met on time as thedepartment is authorized to issue checks on behalf of the Paymaster-General.

6. In giving guarantees and insurance cover, ECGD operates as far aspossible on commercial lines and is requried to undertake this business at netcost to the Conslidated Fund taking one year with another. This also complies

Appendix CPage 2

with GATT requirement that export credit insurance should not represent asubsidy. Taking one year with another has not precise meaning, but a ten yearperiod is often quoted by Berne Union member countries. ECGD in parallel withthe Vote mechanism maintains a notional, but very vital, Trading Account usingthe open year's accounting principle (which MECIB employs) in order to monitorthe expected out-turn of its business on a commercial basis, set reservetargets and adequate premium rates. Such analysis has recently led to higherrates of premium to meet the present adverse international conditions.

7. The United Kingdom system described above might be adaptable to thesituation in Malaysia if, as is proposed in the OKB report, the Governmentassumes export credit insurance liabilities. There is, however, the problemthat for some period to come the new Malaysian credit insurance scheme willprobably have to be run with an annual deficit to the public purse, partlybecause a measure of aggresive underwriting against risk will be necessary togenerate increased exports and partly because MECIB has an insufficient volumeof insurance to produce adequate premium income. Other credit insurers aresuffering transfer delays even on short term business, particularly when coveris kept sufficiently open in the markets involved to keep some businessgoing. However, credit insurers regard transfer payments as an asset, buttime must elapse before realizaton in the form of recoveries.

8. It may be advisable in Malaysia, therefore, to create a buffer orreserve fund out of which claims can be promptly paid with occasional replen-ishment. MECIB has, since inception, accumulated a surplus of about M$4 mil-lion over and above the paid-up capital of M$i5 million. Upon MECIB's estab-lishment as Agent of the Government it would be reasonable to transfer thissurplus into an Underwriting Fund to be held by the responsible Ministry. Theannual budgetary allocation would then be related to topping up the fund whennecessary to maintain the agreed level; similarly, a surplus would betransferred to public funds.

9. The transfer of M$4 million from MECIB to the responsible Ministry'sUnderwriting Fund would -- based on preliminary 1985 figures -- leave MECIRwith approximately M$12 million in fixed deposits. About M$1.2 million annualinterest from this plus MECIB's management fees (assume 25X of 1985 premiumearnings of M$467,414) would produce about M$1.3 million income for MECIBagainst M$800,OOO administrative costs. Thus, transfer of M$4 million to anUnderwriting Fund would leave MECIB in a viable situation to manage the CreditInsurance Scheme. This takes no account of increased business which shouldflow from the various measures discussed in this report.

10. The OKB report suggests that in the initial stages the percentage ofpremium to be retained by MECIB might have to be relatively high, but theabove calculation suggests that MECIB could begin immediately with a fee basedon 25% of premium which compares reasonably with the experience of othercredit insurers.

Appendix CPage 3

Chain of Authority for Underwriting and Payment of Claims

11. The OKB report suggests that the General Manager should have reducedunderwriting authority and that above this reduced limit the authoritiesshould be as follows:

Export Guarantee Committee - Short-term - K$15 million for singlecases

Export Guarantee Council - Short-term - Over M$15 million per case

Medium- andLong-term - All cases exceeding the

General Manager's respon-sibility

12. The Export Guarantee Council would decide on country limits,grading, opening or closing cover on markets and any special conditions ofcover; also be responsible for major decisions on premium rates, etc.

13. As regards claims the OKB report suggests all examination andprocessing to be undertaken by MECIB, with perhaps a discretionary limit forapproval of small cases, and the Special Guarantee Committee to be empoweredto authorize all claim payments above this limit.

14. When considering the above suggestions, there are two fundamentalunderwriting principles to bear in mind:

(a) the evaluation of country risks; and

(b) the evaluation of buyer creditworthiness.

15. Once unlimited cover (for 'A' and 'B' markets) or a specific ceilingon a market has been determined by the Council, underwriting individual casesfalls solely under category (b) above. Submission of an individual case tothe body which has already determined a country ceiling and other conditionsof cover serves no purpose. The only need for such referral arises if inrelation to a restricted market the individual case threatens to dominate thelimit at the expense of other business known to one or other ministry to be inthe pipeline. A rule of thumb could be that after completing the underwritingof a case which represents over half the country limit it should be submittedto the Council for decision as to priority or review of the ceiling toaccommodate all anticipated business. The proposed constitution of theCouncil would be very suited to this type of decision.

16. Also fundamental to export credit insurance is the ability to givequick decisions on individual cases. For the exporter, foreign competitionrules out delays. Therefore, MECIB's General Manager requires substantialdelegated underwriting authority (he is the top professional underwriter)within country ceilings whether he is committing the MECIB Board as at presen1tor the responsible Ministry.

Appendix CPage 4

17. In addition, decisions beyond his limit should reside in onespecialized body -- the proposed Export Guarantee Committee -- and becauseunderwriting is a matter of professional skills the Committee should includebankers (say 3). Then, following the practice of the UK ECGD's AdvisoryCouncil (th: body to which the highest case decisions must be submitted), andone banking member is entrusted to countersign on behalf of the Council as awhole upon the recommendation of ECGD officials. Recommendations onindividuals cases are taken by hand to a city banker selected by the officialon grounds of immediate availability, taking care to avoid one whose bank isinvolved in financing the business. This system was adopted with success bySCICS, Singapore, the bankers in question being members (or alternate members)of the Executive Committee.

18. Since in the OKB proposals a Ministry will be the Insurer, it may bedesirable as a matter of form for the joint underwriting decision of GeneralManager and Committee banker-member to be confirmed by the Ministry's repre-sentative (or alternate) on the Special Guarantee Committee on an ad hocbasis. While medium-/long-term cases are few in number it may not be toodifficult to submit individual cases to the Council, or to a quorum of theCouncil, in urgent cases. The principle to observe is to avoid as far aspossible underwriting by Committee. This only works satisfactorily withgroups of experts meeting at very frequent intervals.

Claims Payment Approvals

19. There are two categories of claims pa!'aent decisions:

(a) claims "as of right," and

(b) ex gratia claims.

20. If a policyholder has an admissible claim then he is in law entitledto payment. Adjudicating the claim is a professional task and submission to acommittee is purposeless and may delay the settlement process, itself a legaloffence and detrimental to the scheme's credibility. It is suggested that theGeneral Manager should have a claims payment authority set sufficiently highto avoid freluent reference outside MECIB, and cases above the GeneralManager's limit should be submitted for confirmation by one Committee orCouncil member representing the Ministry responsible for the insurance scheme.

21. An ex gratia claims case is another matter. If the General Manageris doubtful about whether a claim is under the terms of the policy payable "asof right" Council opinion should be taken as refusal or authorization of pay-ment may be irregular. Where it is clear that because of some policy breachby the Exporter the claim is not payable "as of right" it may nevertheless bedesirable to pay ex gratia for reasons of good will, support of exports, etc.In this respect the General Manager's power of decision should be very limitedand decision should be by Committee or Council as payment ex gratia is amatter of policy. Some delay in ex gratia cases is excusable as the policy-holder is not entitled to payment in the first place.

Appendix CPage 5

22. It is well to remember that the way claims are settled also affectsthe financing bank. Confidence in MECIB's insurance and assignment must notbe lost through delay, even in ex gratia cases, as this affects bankers'confidence in the credit insurance organization.