Document of

The World Bank

FOR OFFICIAL USE ONLY

OS S{3A/P./W

Report No. 6399-PAK

STAFF APPRAISAL REPORT

PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

May 22, 1987

Industrial Development and Finance DivisionSouth Asia Projects Department

This document has a restricted distribution and may be used by recipients ot i in the performance oftheir offici4! duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

Rs 1 = US$0.0571Rs 17.50 = US$1.00

FISCAL YEARS

Government of Pakistan : July 1-June 30Commercial Banks : January 1-December 31

PRINCIPAL ABBREVIATIONS AND ACRONYMS USED

ABL - Allied Bank of Pakistan LimitedDFI - Development Finance InstitutionEDL - Export Development LoanEPB - Export Promotion BureauFBS - Federal Bureau of StatisticsGON - Government of the NetherlandsGOP - Government of PakistanHBL - Habib Bank LimitedIDBP - Industrial Development Bank of PakistanIIC I - First Industrial Investment Credit ProjectIIC II - Second Industrial Investment Credit ProjectMCB - Muslim Commercial BankNBP - National Bank of PakistanNCB - Nationalized Commercial BankNCTT - National Center for Technology Tran4ferNDFC - National Development Finance CorporationPBC - Pakistan Banking CouncilPCI - Participating Credit InstitutionPICIC - Pakistan Industrial Credit & Investment CorporationSBP - State Bank of PakistanSIC - Small Industries CorporationSID - Small Industries DepartmentSSI - Small Scale IndustriesSSI I - First Small Industries ProjectSSI II - Second Small Industries ProjectSSI III - Third Small Industries ProjectUBL - United Bank Limited

FoR OFFICIAL USE ONLY

PAKISTAN

APPRAISAL OF THIRD SMALL INDUSTRIES PROJECT

Table of Contents

Page No.

LOAN AND PROJECT SUMMARY ..................................... iii

I* INTRODUCTION ............... ................................. 1

II. SECTORAL FRAMEWORK I 1

A. Economic Setting *....................... 1B. The Industrial Sector ................................... 2C. Financial Environment .. ........... ... *.* *...... *******. 3D. Small Scale Industries Sector ........................... 5

Policy Environment and Development Strategy.............. 5Characteristics and Performance.......................... 6Growth Subsectors ........ ........................ *.*..... 7Credit Requirements ..................... ................ 7

E. Past SSI Prjcs.............................9F. Rationale for Bank Involvemente.......................... 10

III* THE PROJECT .................................. .. 12

A. Objectives and Scope .................................... 12B. Project Costs and Financing Plan ........................ 13C. Subloan Component ....................................... 14

SSI Fwinanc:ing 8ytm...........................14Participating Credit Institutions ....... ................ 15Monitoring and Coordinating Agency....................... 16Subproject Eligibility Criteria ......................... 17Subloan Terms and Conditions ............................ 17

D. Technical Assistance Components ......................... 18

Technical Assistance for PBC and the PCIs ...... ......... 18Promotion of Export Houses............................... 18Technology and Productivity Fund......................... 21Improvement of SSI Sector Statistics .................... 23

IV. THE LOAN..................................................... 24

A. Terms and Conditions ..................... 24B. Administrative Procedures ............................... 26C. ofnnig.......* 28

This document has a restricted distibution and may be used by recipients only in the performneof their official duties. Its contents may not otherwis be discled without World Dank authorizaton.

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V. BEMEFITS AND RISKS ..... ... ... .e ... 28

A* Benefits .... ........ ......... .......... .. .. .... 28B. Risks ............. e...... .. .. 29

VIo RECOMMENDATION8 ........ .... 30

This report was prepared by J. Pernia and K. J. Lee-O'Mara (ASPID),A. H. Qureshi (RMP), P. Carr and F. Murray (Consultants), following anappraisal mission to Pakistan in March - April 1986. It was updated byJ. Pernia, following a post-appraisal mission in July 1986.

LIST OF ANNEXES

1. Profile of Subprojects Under Credits 1113-PAK and 1499-PAK2. The Nationalized Commercial Banks3. Estimated Project Costs and Financing Plan4. Draft Policy and Strategy Statement of the Small Industries

Department of PBC5. Draft Policy and Strategy Statement for the Technical Assistance

Fund of EPB6. Draft Policy and Strategy Statement for the Technology and

Productivity Fund7. Estimated Schedule of Disbursements8. Documents Available in Project File

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PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

LOAN AND PROJECT SUMMARY

BCTrower: Islamic Republic of Pakistan

Beneficiaries: Participating credit institutions which include:Allied Bank of Pakistan Ltd (ABL), Habib Bank Limited(HBL), Muslim Comercial Bank (MCB), National Bank ofPakistan (UP), United Bank Limited (UBL), andIndustrial Development Bank of Pakistan (IDBP). Theproposed project would also provide funds fortechnical assistance to: the Export Promotion Bureau(EPB), National Development Finance Corporation(NDFC), Pakistan Industrial Credit and InvestmentCorporation (PICIC), IDBP and the Federal Bureau ofStatistics (FBS).

Amountt US$54 million

Terms: The Bank Loan would be lent at the Bank standardiariable interest rate and would have a repaymentperiod of 20 years including 5 years of grace.

Co-financing: The Governmnt of the Netherlands (GMO) would provideUS$12.3 million equivalent (f. 25 million) in grantaid to the Government of Pakistan (GOP) which wouldbe used to co-finance the proposed project and beadministered by the Bank.

Re-lending Terms: The Government would relend the. proceeds of the BankLoan to the six participating credit institutions(PCI) at terms which would provide a spread of 4.751to the PCIs. The final lending rate to subborrowerswould be 141 p.a. initially and would be reviewedperiodically to ensure that it remains consistentwith market rates for industrial term lending anpositive in real terms. For a spread currently at1.331, the Government would bear the exchange andinterest rate risks since the ultimate subborrowersare small scale enterprises, which have relativelylittle capacity to judge and hedge against foreignexchange and interest rate risks. The PCIs wouldrepay their loans over 12 years, including a graceperiod of five years.

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Project Description: The Project would support GOP's strategy for S8Idevelopment, focusing on efficient delivery offinancial resources and technology and exportmarketing services. It would provide loans to SSIsubprojects in growth subsectors; expand thecapabilities of the PCIs in SSI financing; helpdevelop an efficient export marketing infrastructurethrough the promotion of export houses; improve thetechnical performance of industrial enterprises byproviding technical services; and improve theaccuracy and reliability of SSI statistics for futurepolicy and strategy formulation.

Benefits and Risks: Under the proposed project, about 1,300 $SI unitswould be financed resulting in investments of aboutUS$160 million and 28,000 new full-time jobs. Theproject would also support the development of fiveexport houses as part of the Government's broaderstrategy for export promotion; and about sixtyindustrial enterprises would be assisted intechnology updating.

The benefits arising from the project includeexpansion of SSI investments in growth subsectorsand increased access to institutional credit by SSIthrough the banking system; increased product andmarket diversification through the development ofefficient export houses; and improved technicalperformance of industrial enterprises through theprovision of effective technical services.

Aside from a possible economic downturn, there is arisk that the subsidized lending programs, recentlyintroduced by GOP, could affect the rate ofutilization of the subloan component since thesubloan rate under the project would not becompetitive. However, the Government has advised theBank that the size of these subsidized programs willremain small and thus will have no appreciable effecton the project. The risks associated with exporthouses relate to the proper selection of sponsors whocan make the concept work. Careful screeningprocedures by the EPB, the commercial banks and theBank would be established to minimize this risk.There is a risk that the technology fund would notgenerate enough demand in the private sector fortechnology subprojects. Using the developmentfinance institutions (DFI) as the implementingagencies will minimize this risk since they have

developed close contacts with private industrythrough their lending programs.

Estimated Costs:(US$ million)

Local Foreign Total

Subloan Components 116.0 55.0 171.0Technical Assistance

Components 5.5 3.5 9.0

TOTAL 121.5 58.5 180.0

Financing Plan: (US$ million)Local Foreign Total

IBRD 5.0 49.0 54.0CON 3.0 9.5 12.5PCI 42.0 - 42.0Private Sector 70.5 - 70.5GOP 1.0 - 1.0TOTAL 121.5 58.5 180.0

Estimated Disbursements:(USe million)

IBRD FY 88 89 90 91 92 93 94 95

Annual 6.0 12.4 11.8 8.1 6.5 4.9 3.2 1.1Cumulative 6.0 18.4 30.2 38.3 44.8 49.7 52.9 54.0

PAKISTAN

STAFF APPRAISAL REPORT

THIRD SMALL INDUSTRIES PROJECT

I. INTRODUCTION

1.01 Small scele industries (88) development continues to be a highpriority of the Government of Pakistan (GOP) and an important component ofits strategy for achieving industrial employmntt exports and output targets.The strategy continues to rely solely on private investment and activity,with the Government providing support through financial, technical andinfrastructural services. The Bank has supported GOPs strategy by providingcredit, technical and marketing assistance to 881 and by improving theinstitutional arrangements for their delivery through two 8SI projects(parts. 2.21-2.25). In view of the success of the past SSI projects, GOPhas requested financing for a third 88I project to pursue expansion andmodernization of this sector in line with its potential. This report recom-mends a Bank loan of US$54 million and discusses a Dutch government grant ofUS$12.5 million equivalent (f. 25 million) in support of a US$180 millionproject.

1.02 The proposed Third Smell Industries Project (88I III) would continueto provide credit, technical and marketing assistance to enable small scaleenterprises to expand, modernize and compete in the local and export markets.The Bank and the Government of the Netherlands (GON) would provide US$50million and US$7.5 million equivalent, respectively, for on-lending by theparticipating credit institutions (PCI) to SS, which is expected to resultin investments of about US$160 million and about 28,000 full-time jobs inabout 1,300 units. Financial assistance of US$4 million and technical assis-tance of US$1 million would support the development of about five exporthouses, as part of a broader strategy for export promotion. Another US$4million in technical assistance would support technology and productivityimprovements in private industry; improve the collection, processing andanalysis of 88I statistics to increase their reliability and accuracy; andcontinue building capability within the PCIs for project financing withemphasis on staff development and systems improvements in the branches inpursuit of further operational decentralization.

II. SECTORAL FRAMEWORK

A. Economic Setting

2.01 During FY84-86, Pakistan succeeded in maintaining the rapid growthperformance that characterized the Fifth Plan but was les successful inbringing about the structural transformation called for in the Sixth Plan.GDP growth averaging 6.9X p.a. in real terms (above the Plan target of 6.52)was the product of the following sectoral growth ratesS agriculture (3.9%p.a.), industry (8.32 p.a.) and services (7.4X p.a.). The pattern of growthwas, therefore, impressive but somoehat different than Plan projections whichhad called for a more rapid ezpansion in the commodity producing sectors than

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in services. In addition, the diversification of output into minor crops andinto manufactured exports was slow to materialize.

2.02 In the same period, the balance of payments was affected by a numberof factors not foreseen in the Plan, some of which are external to Pakistan(instability in world cornodity markets, sluggish recovery of world trade,and declining migrant workers' remittances) and others which are (at leastpartly) tnder Pakistan's control (the performance of non-traditional exports,shortfalls in aid disbursements). Cur ent account deficits have been averag-ing 3.7X of CUP as against 2.7% in the Plan. With higher deficits and aidshortfalls, the Government has relied on reserve drawdowns and short-termborrowing instruments for financing. By the end of FY86, gross officialreserves had fallen by nearly US$1 billion to a level the equivalent of 6weeks of imports of goods and services; if short-term liabilities (in theform of foreign currency deposits of non-resident bonds and foreign exchangebearer shares, totaling US$644 million) are netted out, adjusted reserves arethe equivalent of only 2 weeks of imports. This is obviously an uncomfort-able position for a country where exports and imports are subject to con-siderable instability.

2.03 Prospects for continued economic expansion appear reasonableprovided that efforts to diversify the economic base and improve domesticresource mobilization are accelerated. The gradual improvement in the policyenvironment has brought about a welcome revival of private sector activityand some structural change that has made the economy less dependent on cer-tain imports (e.g. wheat, petroleum). Nonetheless, the economy remainsstructurally weak with agriculture still heavily dependent on a few key cropsand manufacturing dependent upon high levels of protection. The slow growthof manufacturing exports (especially other than textiles) is a matter ofconcern. The increasing concentration of exports, growing debt service, anduncertain prospects for migrant remittances all underline Pakistan's fragilebalance of payments position. Lack of progress in resource mobilization isanother major concern. To accommodate higher private and public investmentrates without undue pressures on the balance of payments will require areversal of deteriorating public savings and continuing improvement inprivate savings; the freeing up of returns brought about by Islamization ofthe financial system may play an important role in improving returns tosavers, but there are few signs that policies to improve public sectorsavings performance are being put in place. Pakistan's prospects are mademore complicated by the signs of an emerging employment problem. Continuedrapid population growth, the return of migrant workers from the Middle East,and signs of lower employment absorption in key sectors of the economy pointto the prospects for rising unemployment even if high growth rates aremaintained. Developing an appropriate strategy for encouraging the expansionof productive employment opportunities will be of more critical importancethan it has been over the past decade.

B. The Industrial Sector

2.04 Pakistan has a reasonably diversified industrial base. Textiles,which accounted for about 301 of manufacturing value added in the early1970s, now constitute only 151. Other important sectors include foodprocessing, engineering goods, cement and fertilizers. Manufactured and

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semi-manufactured goods represented over 701 of total exports, although morethan half are cotton products. Other major exports consist of carpets,leather products, synthetic textiles and fish products. Since the lateseventies, the Government has assigned a lead role to the private sector inindustrial development, reversing to some extent the nationalizations of themid-seventies, opening up areas for private investment, and reducing invest-ment in public sector enterprises. Private industrial investment grew by anaverage of 17.5% p.a. during FY79-FY86. The private sector, which in FY79accounted for only 27% of manufacturing investment, increased its share to82% in FY86. However, public enterprises remain important, due to theirdominance in a number of key subsectors, i.e., cement, fertilizers,chemicals, petroleum, steel, motor vehicle and heavy engineering. Theimproved policy environment which has contributed to a resurgence of privatesector confidence has led to growth in output and investment. DuringFY79-86, growth of manufacturing value added averaged 9.6X p.a. in realterms, compared to 3.3X p.a. in the preceding five years. Sectoral perfor-mance during FY86 -emained strong, but growth elowed to 8.2%; a similar rateof growth is anticipated for FY87, in line with recent production trends andinvestment levels.

2.05 Although improved industrial performance since FY79 has beennoteworthy, sustained growth will depend on continued improvements in theincentive structure, further relaxation of government controls, increasedavailability of infrastructure, and improved performance by publicenterprises. The industrial sector continues to be promoted in a protectedenvironment, largely sustained by import substitution policies. Exports areconsidered marginal to most production and investment decisions and tend tofluctuate in response to short-run changes in incentives. Quantitativerestrictions need to be removed and the tariff structure requires modifica-tion to provide a more uniform level of effective protection and reduce theimport substitution bias. Although industrial controls have beenliberalized, industry is still hampered by government controls oninvestments, imports, access to foreign exchange, company formation andpriciug. Infrastructure deficiencies, especially in energy, are a majorcause of project delays and undermine capacity utilization. Publicenterprises affected by price controls operate under cost-plus arrangementswhich discourage operational efficiency.

C. Financial Environment

2.06 The Financial Sector. The financial system in Pakistan consists of:*five nationalized commercial banks (NCBs); seventeen foreign commercialbanks; four specialized scheduled banks; nine development finance institu-tions (DFIs); several insurance companies; two leasing companies; two stockexchanges; and a housing finance corporation. The State Bank of Pakistan(SBP), the central bank, regulates and supports the banking system withinoverall policies set by GOP. The Pakistan Banking Council (PBC) oversees andcoordinates the activities of the NCBs and fulfills many of the functionspreviously discharged by their former private shareholders. The Ministry ofFinance monitors tha operations of the other financial institutions. Thecommercial banking sector is the most important part of the financial system,with total assets as of June 30, 1986 of Rs 337 billion, or about 901 of thetotal assets of the system. In turn, the NCBs account for 90% of the banking

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business in the country. NCBs are also important in terms of geographiccoverage# with 7,000 branches throughout the country.

2.07 Two important developments have characterized the financial environ-ment recently. The first is the diversification of functions by the institz-tions in the system. The commercial banks provide term financing to agricul-ture and industry. The development finance institutions complement theirassistance with short-term working capital loans. The investment banks relyon the commercial banks to back up their underwriting commitmAtnts. Leasingcompanies are being established by commercial banks and DFIs. With thesedevelopments, the system has acquired some flexibility, but the generalapproach by GOP and the central bank is one of cautious and measured steps.For example, private banking has not been allowed and only recently has theGovernment announced a restricted relaxation of this policy to allow privateinvestment banks.

2.08 A similar approach has characterized GOP's pursuit of Islamizationof the financial system. Initial but limited steps to abolish "riba", orinterest, from the system were taken in 1981, but it was only from July 1985that all domestic currency transactions have been based on new financingmodes consistent with Islamic principles. New financing arrangementsinclude: (i) mark-up, a sale with a profit margin which varies according tothe term; (ii) Term Finance Certificates (TFCs), bonds with a risk premium;(iii) Musharika, loans designed to meet working capital needs on a profit-sharing basis according to a pre-agreed formula; (iv) Mcdaraba companies,investment funds operating in accordance with Islamic tenets; and (v) hire-purchase and leasing.

2.09 The most important and noticeable effect of Islamization has been amovement towards the freeing of interest rates and a more market-orientedapproach to the pricing of capital. By allowing financial institutions tofreely negotiate rates of return and mark-ups within a range of 10-20% forshort term financing and setting only a minimum of 10% for term lending, theimbalance in some short and longer term rates which existed previously hasbeen corrected. Still, there continue to be special credit programs forpriority sectors with lending rates at below market rates. These programswhich are for small farmers, exports, and locally fabricated and importedmachinery, however, are small and are expected to remain so. As regardsdeposits, the outcome is uncertain. With full conversion to Islamization,returns on deposits in financial institutions will be based entirely on"profit or loss system" (PLS) principles, which do not guarantee a specificreturn. This could lead to the withdrawal of interest-conscious deposit sfrom the system; and since GOP savings schemes will continue to operate onthe basis of interest, some funds could be diverted into these schemes. GOPand SBP are studying the possibility of establishing an insurance or reservefund scheme to maintain stability in PLS returns. In any case, Islamizationhas added flexibility to the system, effectively freeing most interest rates,expanding the number of financing options available and providing the privatesector with increased opportunities to raise funds directly from the publicin equity or quasi-equity forms.

2.10 Interest Rate Structure. Before conversion to Islamization,Pakistan's interest rate structure was characterized by a crossing of rates.Since deposit rates rose while lending rates fell with maturity, the interestrate structure provided a clear incentive for banks to favor short-term

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lending. Under Islamization, with rates of return on TFCs at 14-15X and onmark ups at 10-202, this imbalance in the interest rate structure has beenpartly corrected. Moreover, these rates are substantially positive given thecurrent inflation rate of about 52. Inflation is expected to remain below102 so that these lending rates should remain positive. For the industrialsector, two new lending programs were announced by the Government in June1986, one for the financing of locally fabricated machinery and the other forimported machinery. At lending rates of 32 p.a. and 102 p.a. respectively,these programs appeared to undermine the gains achieved under Islamizationtowards a more market-oriented interest rate regime. However, the 3Xprogram has proved to be small with only Rs 218 million disbursed in the pastyear. Unlike the 32 program, which is a refinancing scheme of SBP, the 102program is to be financed by the NCBs. Since the subsidy is borne by theNCBh and lending is not mandatory, the VCBs have not lent any funds underthis program. During negotiations, the Government advised the Bank thatthese programs will remain small and will have no appreciable effect on theproposed project.

2.11 Until recently, the nationalized commercial banks had been lending to8SI for fixed investments under their SBP mandatory targets at 112. TheGovernment, however, has decided to increase this rate to 14% to make itconsistent with the rate for fixed investment loans for medium and largeindustry. Under the proposed project, the interest rate will also be 142.Moreover, it will be tied to the rate under IIC II tc ensure consistencybetween the two credit lines. The annual review and adjustment of interestrates by GOP and the Bank, required under IIC II, will also determine thefuture lending rate for all SSI term loans, taking into account inflationarytrends, current borrowing and lending rates and adequacy of spreads for thePCIs to cover administrative and risk costs. These reviews would also serveas a forum for further rationalization of the industrial interest ratestructure.

D. Small Scale Industries Sectcr

Policy Environment and DeveloDment Strategy

2.12 The Government defines small industry units as industrial enterpriseswith fixed assets (excluding land and buildings) not exceeding Rs 10 million(US$570,000). Government policies for industrial development allow SSIs toset up and operate with little regulation, and market signals are the maindeterminants of SSI investments and their viability. Except for locationpermits in line with zoning regulations, licensing is not required to estab-lish an SSI unit. GOP's policy requires SSIs to be *.n the private sector.Subsectors with strong potential, high value added, and limited economies ofscale are promoted, but not reserved, for SSI production. There is a push todevelop S8Is in more remote urban and rural areas, but this objective againis pursued by promotion and provision of services. Until recently, GOPpolicy mandated that credit to SSIs be provided by the NCBs at subsidizedinterest rates as a means of promoting them (para 2.11).

2.13 Technical assistance activities in support of 8SI are mainly aprovincial government responsibility, carried out by semi-autonomous provin-cial agencies known as the Small Industries Corporations (SIC). To a large

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extentp the SICs have focussed their assistance to the sector on providingphysical facilities, developing industrial estates, building and equippingservice centers and establishing training and production centers forhandicrafts. The First and Second SSI Projects supported the SICs in theirprograms for the promotion of new viable enterprises and the provision ofextension services to existing firms. Components under the first two SSIprojects encouraged the SICs to increase interaction with the private sectorby involving private sector entrepreneurs in policy-making through managementcommittees, emphasizing SIC activities which support local entrepreneurs andproviding direct services to the private sector in project preparation,export promotion and extension services. While some SIC activities, espe-cially those with a strong focus on direct relationship with localbusinessmen, have been quite effective in meeting SSI needs for technical andmarketing support, serious deficiencies still exist in the quality of someservices provided and the effectiveness of the delivery system itself.Considering the inherent limitations of these public sector organizations instaffing and funding, alternative channels in the private sector have to bedeveloped. Under the proposed project, this approach will be tried in theareas of export marketing and technology transfer (paras. 3.17-3.33).

Characteristics and Performance

2.14 GOP attaches priority to the SSI sector not only because of itsimportance in meeting social objectiveq, but also industrial developmentobjectives. Generally, small firms are less affected by economic variations,as they have greater flexibility in relation with production schedules andlabor employment. Similarly, small investors are less vulnerable and sensi-tive to political changes. Moreover, SSIs generate a good portion of theircapital needs from the informal capital markets and require less infrastruc-tural support than larger firms. These factors help explain why small scaleindustries cobtinued to grow during the difficult years of the seventies,while the production of larger firms declined. In the 1980s, investments insmall firms represent a share of 181 to 27% of total private industrialinvestment. Currently, SSIs contribute nearly 4.7% of GDP, 27% of industrialvalue added and 30% of manufactured exports and employ about two millionworkers in over 100,000 establishments. The majority of SSIs are located inPunjab and Sind provinces, with a smaller proportion in NWFP and Baluchistan,reflecting population concentrations, raw material sources, availability ofinfrastructure, access to markets and local entrepreneurship. Traditionally,88Is have specialized in processing local raw materials, such as cotton andfood processing and construction materials. Other key activities arefocussed on exports that add value to imported raw materials, includingmanufacturing of carpets, ready-made garments, iy;trts goods, cutlery andsurgical instruments.

2.15 !SIs in Pakistan are labor intensive and, generally, efficient usersof capital; investment cost per job is about US$1,800; the average capital-output ratio of SSIs is about 0.8. SSIs also prove to be efficient producersof goods, especially for the rural markets, where quality requirements areless stringent. For example, small powerloom units were found to producegrey cotton fabrics at a third of the production cost of the mill sector;however, due to quality differences, the powerloom fabric fetched only 80%of the price of the mill-cloth. Compared to some East Asian developingcountries, SSls in Pakistan are more labor intensive and more efficient usersof capital, 'but have lower labor productivity.

Growth Subsectors

2.16 Agro-industries, selected textile products and light engineering areexpected to continue being growth areas in the medium term. In the recentpast, agro-industries accounted for about 30X of SSI investments. The impor-tance of this subsector is likely to increase, as sustained expansion in farmoutput generates larger agricultural surpluses for processing. Substantialcapacity expansion is expected in rice and flour milling, oil extraction andice and cold storage for the fishing, poultry and cash crop sectors. Also,project opportunities in the handling, storage and processing of fruits andvegetables for domestic and export markets could be numerous. Growth in thepowerloom sector, which accounted for about 15% of past SSI investments, isprojected to continue in response to expanding domestic demand for fabrics,particularly in catering to rural requirements. Investments in garmentmanufacturing for exports based on both local cotton and imported blendfabrics are expected to increase substantially. In light engineering, theinvestment level of about 20% will probably continue, concentrating inengineering workshops, in response to maintenance requirement of agriculturalequipment, faster urbanization and industrialization.

2.17 In the past, SSI production for exports concentrated on traditionalproducts such as cotton yarn, cotton cloth, carpets. sports goods andsurgical instruments which were exported mainly to Europe. More recently,however, there has been increasing product and market diversification, demon-strated by exports of leather products, garments, textile made-ups, andprocessed marine products, fruits and vegetables to never markets includingNorth America. The outlook for further growth appears promising, providedthat appropriate policy and institutional support are developed. A centralpolicy problem refers to the present system where only direct exporters areentitled to export incentives. This has caused fragmentation in the exportsector with very small companies trying to export directly despite lack ofexpertise. This problem is being addressed under the Export Development Loanand will be followed-up under this project (para 3.20). A related institu-tional problem is the lack of marketing institutions with strong marketingskills which can assist small producers in export market development. Theseaspects will be addressed in the proposed project (paras. 3.17-3.26).

Credit Requirements

2.18 Past Investments in SSI. Investments in SSI grew in current termsfrom Rs 1069 million in FY81 to Rs 1746 million in FY86 at an average annualrate of 10.41. While this was lower than the projected growth rate of 12Xp.a., it compares favorably with growth in total investments in largeindustry which averaged 8.2% p.a. in the same period. Private investments inlarge industry, however, continued its high growth pattern since the late1970s, averaging 24.1X p.a. and reflecting GOP's policy of promoting privateinvestments and improving the investment climate (para. 2.04):

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Table 2.17: INDUSTRIAL INVESTENTS(FY81-86)

(in current Rs million) /a

8S; Private LSI lb Public LSI Total LSI

1981 1,069 3,291 4,836 8,1271982 1,221 3,252 4,684 7,9361983 1,344 4,068 5,143 9,2111984 1,472 5,655 5,700 11,3551985 1,595 7,469 3,871 11,3401986 1,746 9,387 2,429 11,816

/a Current values are used here to relate to credit requirements.7T Large scale industry.

2.19 Past 88I Loans. SSI loans by the nationalized commercial banks grewfaster than 8SI investments in the same period, from Rs 808 million in FY81to Rs 2,430 million in FY86, averaging about 27.6X p.a. Since NCB loans wereboth for working capital (701) and fixed investments (30X), this is partlyexplained by faster growth in working capital loans reflecting growth in SSIoutput averaging 15.2Z p.a. in current terms in the same period. However,the major reason for this growth appears to be greater willingness by theNCBs to lend to $SI in view of GOP and Bank support (paras. 3.05-3.08). NCBlending operations under 88I II have also grown, with loan commitmentsaveraging about US$3 million per month. The pipeline of loan applications isstrong and, as of December 1986, consisted of about 285 applications amount-ing to about US$20 million.

2.20 Credit Requirements. GOP projects fixed investments in SSI to con-tinue growing at 121 p.a in current terms. Assuming a more conservativegrowth rate of 101 p.a., and using the past financing pattern for S5Iinvestments, the demand for institutional credit by 8SI for PY88-90 would beabout Rs 2,800 million. On this basis, if the Bank were to finance about athird of credit demand for fixed investments, which is roughly equivalent tothe foreign costs of SSI investments, the requirement for Bank funds could beabout US$56 million:

Table 2.20: CREDIT DEKNAND FOR FY88 TO FY90

Fixed Institutional BankInvestments Credit (401) Share (351)

(Rs million)

FY88 2,100 840 295FY89 2,300 920 320FY90 2,600 1,040 365

TOTAL 7,000 2,800 980 /a

/a US$56 million.

E. Past SSI Projects

2.21 The First Small Industries Project (Cr. 1113-PAK) of US$30 millionwas signed in April 1981. In addition to providing funds for term lending,important objectives of the project were to develop the capabilities of theNationalized Commercial Banks (NCB) in SSI financing and to focus the provin-cial Small Industries Corporations (SIC) on promotional and technical serv-ices for 8SI. After a slow start, due mainly to the realignment of functionsamong institutions, implementation quickly accelerated, with the credit fullydisbursed on schedule on December 31, 1985. The subloan component financed654 subprojects, resulting in investments of about US$80 million. Subsectordistribution of subprojects financed was basically as expected duringappraisal, with concentration in agro-industries (39Z), light-engineering(172) and textiles (15X). Average subloan size was about US$42,000, muchlower than the maximum allowable amount of US$200,000, indicating that ade-quate credit access was maintained for smaller units. The subprojectsfinanced generated about 12,800 jobs at a cost per job of about US$6,000.Annual incremental value added is estimated to be about US$50 million. Basedon a sample of subprojects visited, lending decisions made under the creditappeared sound, with careful selection of sponsors and good subprojectappraisal. Ex-post financial rates of return of fully operational sub-projects ranged between 18X and 45X.

2.22 SSI I had a substantial impact on the NCBs' organization and staffingfor SSI lending. At the headquarters of each bank, a Small IndustriesDepartment (SID) was created to undertake project appraisal. Training on SSIlending procedures was imparted to SID officers as well as over 400 branchofficers. Although appraisal initially was centralized at the banks'headquarters, the branches were made responsible for receiving and screeningapplications, loan disbursement and administration and project supervision.Emphasis on project financing, in addition to creditworthiness analysis,sharpened the NCBs' project selection capabilities and improved their systemsand procedures. Given matching maturity funds under the credit, the PCIsincreased their portfolio of SSI loans by blending their own short-termfunds.

2.23 Implementation of the technical assistance (TA) components of sSI Iwere also completed on schedule. The impact of the TA components has beengenerally positive, resulting in the establishment of two service centerswhich provide focussed technical training and services to a pre-identifiedclientele. The project preparation fund was effective in assisting over 600subloan applicants prepare their loan applications and feasibility reportsfor submission to the NCBs. Subsector studies and area development studieshave been prepared and are being utilized to improve project promotion andselection. The export promotion component succeeded in introducing severalPakistani exporters and products to the U.S. market. A completion report onthis project was issued in October 1986.

2.24 Second 8SI Project. The Second 8SI Project (Credit 1499-PAK) ofUS$50 millions, which was signed in July 1984, aimed at a continued build-upof the capabilities of the NCBs in project financing and the provision oftechnical and marketing services. As of December 31, 1986, the subloancomponent of SSI II was already fully committed and about 451 disbursed.Subloans for 1,300 subprojects had been approved. Moreover, there were about

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285 subloan applications amounting to US$20 million at different stages ofprocessing by the NCBs. Based on the current rate of disbursement, it isexpected that disbursement of the Credit would be completed by June 1988,two years ahead of the original closing date. Subsector distribution ofsubprojests was about the same as that under SSI I, with agro-industries,engineering and textiles taking about two-thirds of the Credit. Averagesubloan size was about US$52,000, higher than that under SSI I due to achange in SSI definition from Rs 3 million to Rs 5 million. Reflectingpopulation concentrations, access to raw materials and markots andavailability of infrastructure and skilled labor, most of the subprojectsfinanced are located in Punjab (622) and Sind (31%) provinces, with NWFP (5%)and Baluchistan (21) getting a share similar to that under SSI I. 1/

2.25 Under 8SI II, the PCIs have devoted more staff resources to SSIfinancing, making it an important product line among their numerous bankingactivities. Subproject appraisal was decentralized to the regional officesas more staff were trained to undertake this function. Moreover, training onproject supervision and end-use for branch personnel was emphasized as sub-projects under SSI I started to be implemented and subloan amortizations tofall due. After an initial problem, the collection performance of the NCBsimproved substantially, reaching an average collection ratio of 821 as ofJune 1986. This was the result of an intensive collection drive whichinvolved supervision visits to subprojects and the establishment of moreeffective systems and procedures for collection including timely billing ofclients, more organized and frequent follow-up on defaulting clients, and theuse of authority to automatically offset loan overdues with credit balancesin borrowers accounts. Implementation of the various TA components has beenslower than the subloan component due to difficulties in finding suitableconsultants and counterpart staff; their completion, however, is expected tobe within the original schedule.

F. Rationale for Bank !nvolvement

2.26 Bank's Industrial Lending Strategy. In the past, the Bank's lendingfor the industrial sector in Pakistan was done mainly through the three DFIs,comprising 14 loans and credits totaling US$324 million, of which 11 loansand credits amounting to US$244 million were made to the Pakistan IndustrialCredit and Investment Corporation (PICIC) for medium and large privateindustrial projects, two amounting to US$a0 million to the IndustrialDevelopment Bank of Pakistan (IDBP) for small and medium private sectormanufacturing projects and a US$30 million line of credit to the NationalDevelopment Finance Corporation (NDFC) for public manufacturing enterprises.The Bank's direct industrial lending was mainly for public sector enterprisesamounting to about US$430 million and consisting of industrial imports,fertilizer loans, refinery, engineering and industrial estates.

2.27 Starting with the first SSI project in 1981, the institutional scopeof industrial credit projects was broadened to incorporate term lending by

1/ Annex I provides details of the subprojects financed under the Firstand Second 9SI Credits.

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the five nationalized commercial banks. Moreover, to complement financialassistance, project components were developed to address technical andmarketing problems blocking industrial growth and diversification. Thisbroadening of approach was pursued further under the First IndustrialInvestment Credit Project (IIC I, Credit 1439-PAK) by involving the threeDFIs and the leading NCB in lending to medium and large industries and byinitiating discussions on broader financial and industrial sector policyissues. These discussions were reinforced in the context of the FirstStructural Adjustment Loan (SAL I, Loan 2166-PAK) which dealt with theindustrial sector and focused on reform of the industrial incentive systemand efficiency of public manufacturing enterprises. Under the SecondIndustrial Investment Credit Project (IIC II, Loan 2648-PAK), the ongoingdialogue on financial sector issues is being further pursued to includecapital market development. The Export Development Loan (EDL, Loan 2701-PAK)deals with key export policies and restructuring of export procedures andadministration of export promotion.

2.28 For the future, the Bank's industrial lending strategy would continueto be pursued with three basic instruments: (a) industrial sector and exportdevelopment loans focusing on reforms in industrial regulations, protectionand export administration, broadening the policy dialogue initiated by SAL Iand the EDL; (b) industrial investment credits with multiple institutionalarrangements and incorporating measures to reform financial sector policies,strengthen financial institutions and develop financial markets; and(c) subsector projects in major manufacturing groups (e.g. SSIt engineering,textiles, cement, agro-industry) providing financing of priority investmentprojects including restructuring, technical and marketing services andsubsector-specific policy adjustments.

2.29 Rationale for Bank Involvement. While the SSI sector plays an impor-tant role in meeting GOP's social and industrial development objectives,inadequate access to investment funds, technology and markets continue toconstrain its growth. The informal financial market continucs to p:'ovidemost of SSI financing needs at very high interest rates constraining invest-ments and unduly increasing risks of failure. The only other significantsource of investment funds is the NCBs. Yet the NCBs are constrained fromexpanding their term lending to SSI due to lack of long term resources andthe higher costs and risk associated with SSI lending. Moreover, untilrecently, the lending rate for loans for fixed investments for SSI (11i) waslower than that for medium and large industry (14Z). The formal financialmarkets are also not able to generate the appropriate funds; the capitalmarket in Pakistan relatively underdeveloped and SSI debt instruments wouldbe particularly difficult to trade in the market due to risk perceptions andtraditional ownership structures. The recent increase in the interest ratefor $SI term loans from 11% to 142 will help encourage the NCBs to expandtheir lending to 98I. Nevertheless, as in other countries, special effortswould continue to be needed to improve SSI's access to investment funds.There is a continuing need for the Bank to assist GOP in providing long-termfunds which the NCBs can blend with their short-term resources to lend toSSI. However, the need for Bank assistance will decline as the NCBs, withGOP support, become more and more independent in mobilizing and allocatingfunds for 8SI.

2.30 This decliniing role is reflected in the steady reduction in the shareof IDA/Ban'; financing under the 9SI projects. Under 881 Il IDA financing

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covered 801 of subloans, with the PCIs providing 20S from their ownresources. Under sSI II, the IDA share was reduced to 701, with the PCIsproviding 301. Under the proposed project, the co-financing ratio betweenthe lank and the PCIs would be 60-40. Since subproject sponsors typicallycontribute about 401 of subproject costs in terms of equity, the Bank's sharein subproject financing will decline from 501 in S81 I and 40% in SSI II toabout 351 under the proposed project.

2.31 In the area of technical and marketing services for SSI, the presentgovernment channels have not been very effective in the past in improvingS8I's access to technology and markets. The lank's role is to assist inmaking them more effective through training and advisory services in areaswhere they can be effective, and in developing other channels in the privatesector in areas where the private sector has comparative advantage.

III. TE8 PROJECT

A. Objectives and Scope

3.01 The Third 881 Project would continue to support GOP's strategy for8SI development, focusing on the efficient delivery of financial resourcesand technology and export marketing services. Specifically, the objectivesof the Project are to:

(a) encourage the banks to increase lending to SSI by, among others,keeping the SSI lending rate aligned with the overall interest ratestructure, consistent with other industrial lending rates andreflective of general market rates;

(b) provide finance to SSI subprojects in growth subsectors;

(c) strengthen the financial institutions involved in SSI lending throughtechnical assistance, training and improvement of operating systemsand procedures;

(d) develop a strong export marketing infrastructure through thepromotion of export houses;

(e) improve efficiency of industrial units through a program oftechnology transfer; and

(f) improve the accuracy and reliability of SSI statistics for policyand development strategy formulation.

3.02 The geographic scope of the Third 99I Project would continue to benationwide. However, stronger promotional efforts would be placed on poten-tial growth areas in Baluchistan and North West Frontier Province to increasetheir shore in project lending. Increased decentralization of operationalresponsibility through staff training and procedural streamlining areexpected to broaden the geographical distribution of SSI lending. Anymanufacturing or industrial service activity which falls within the currentSSI definition, meets eligibility criteria and is financially and economi-

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cally viable would be eligible for financing. Based on analyses of 881suboector potential undertaken by consultants under 8S1 I, a more subsector-oriented strategy would be used to strengthen the project selection processand accelerate the development of growth subsectors.

3.03 To meet the above objectives, the proposed project would have thefollowing components:

(a) subloans for fixed investments and permanent working capital for S8Isubprojects (US$57.5 million);

(b) technical assistance for the financial institutions to train staffand improve operating systems and procedures with emphasis on theirbranch network (US$2 million);

(c) technical and financial assistance for the establishment of exporthouses (US$5 million);

(d) a technology transfer program to promote technology and productivityimprovements of industrial enterprises (US$1.5 million)$ and

(e) technical assistance to the Federal Bureau of Statistics to improveSSI data collection, processing and analysis (US$0.5 million'.

B. Project Costs and Financing Plan

3.04 The costs of the proposed project are estimated to total about US$180million, of which the Bank would finance US$54 million, or about 301. Bankfinancing would be used only for the subloan component, both for M81 sub-projects and the export houses. Subloans would finance 601 of subprojectcosts, on average; sponsors would contribute about 40Z of subproject costs.Bank financing would cover 601 of subloan amounts while the PCIs wouldprovide the other 401. The Government of the Netherlands (CON) would addgrant funds amounting to US$7.5 million equivalent for subloans. For thetechnical assistance components, grant funds from CO amounting to US$5million equivalent would cover direct costs; GOP, through budgetary alloca-tions of the implementing agencies, would cover all indirect localadministrative and staff costs estimated at about US$1.0 million. Thecomponents, cost estimates and financing sources are sumarized below 1/:

1/ Detailed cost estimates can be found in Annex 3.

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(USs million)

PrivateBank CON PCI Sector GOP Total

A. Subloan Components

1. SSI Subloans 50.0 7.5 39.0 65.0 - 161.52. Subloans for Export Houses 4.0 - 2.5 3.0 - 9.5

Subtotal 54.0 ?.5 41.5 68.0 - 171.0B. Technical Assistance Components /a

1. Training and Consultancy - 2.0 0.5 - - 2.5Services for PCIs and PB'S -

2. Promotion of Export Houses - 1.0 - 1.0 0.5 2.53. Technology Transfer - 1.5 - 1.5 - 3.04. SSI Statistics - 0.5 - - 0.5 1.0

Subtotal - 5.0 0.5 2.5 1.0 9.0

GRAND TOTAL /b 54.0 12.5 42.0 70.5 1.0 180.0=sz =5 === =z= P_

la Including contingencies.7T Including taxes

C. Subloan Component

SSI Financing System

3.05 With the introduction of the S8I lending program under the First SSIProject, GOP abolished the special credit schemes jointly administered by theprovincial Small Industries Corporations and the NCBs which proved to beineffective. These schemes were not only small and fragmented due to thecumbersome institutional arrangements, but also resulted in overlappingresponsibilities, institutional frictions, delays in loan processing andfinally, poor loan recovery performance. Moreover, concerns with lendingdrew the SICs away from the other important functions of SSI promotion andextension services. SSI I succeeded in rationalizing institutional roles byassigning the lending function completely to the commercial banks andreorienting the SICs toward technical assistance.

3.06 Currently, the NCBs have sole responsibility for the SSI lendingsystem. To ensure S8I's access to credit, annual targets for loans to thesector, expressed as net increments to the amount of outstanding SSI loans,are set by the State Bank of Pakistan based on GOP's Annual Development Planprojections for SSI investments and value-added growth. These are thendivided among the five banks on the basis of deposit size. Achievement oftarget levels is monitored monthly; the targets themselves are revised duringthe year in reaction to actual credit demand from SSI for investment andworking capital. Since these targets have been quite conservative in rela-tion to S81 needs, contributing about 30Z of SSI requirements, they have not

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resulted in undue allocation to SSI. On the other hand, they do not repre-sent a constraint since they can be exceeded, as they have been in recentyears. However, due to lack of long term funds and, until recentlyt thelower lending rate for SSI term loans, the NCBs preferred to lend for workingcapital, which was at a higher rate, and were not too eager to go beyond theminimum required. Since IDA funds were made available in FY82 with attrac-tive spreads, SSI loans by the commercial banks have increased substantially,meeting about 40% of SSI investment requirements, up from about 30% in prioryears. Moreover, with the availability of long term funds from IDA, fixedinvestment loans have increased.

3.07 The SSI sector, however, still draws most of its financing from theinformal credit markets, financing its needs from these sources at very highinterest rates. This has constrained investments in the SSI sector andincreased risks of failure. While the commercial banks with GOP and IDAsupport have expanded their exposure to SSI from 30% to 40% of investmentrequirements since FY82, further expansion is constrained by lack of matchingmaturity funds and, in the past, by the lending rate of 11 p.a., which islower than the lending rates for large industrial term loans and commercialloans. The Government has decided to raise the interest rate for SSI from11% to 14% p.a. in line with the current interest rate structure, and theproject, in support of this policy reform, would provide additional long termfunds to be blended with the funds of the NCBs.

3.08 SSI III would continue building within the NCBs their capabilitiesfor SSI project financing by: improving subproject selection through betterproject appraisal skills; improving systems and procedures to shorten loanprocessing time; strengthening credit discipline to improve loan recovery;and expanding training and advisory services to reach more branches asdecentralization is increased.

Participating Credit Institutions (PCI) 1/

3.09 The five nationalized commercial banks would continue to be the creditinstitutions responsible for appraisal, supervision and collection of sub-loans under the proposed project. In addition, IDBP, which is relinquishingits role as the monitoring agency, would become a participating creditinstitution (para. 3.12). In order to encourage the PCIs to become moreindependent in SSI financing, they would be required to increase their co-financing of subloans from the current 30% to 40Z of subloans and wouldcontinue to bear full credit risks of all subloans regardless of source. Theimplementation of the first two SSI Projects by the PCIs, with the assistanceof IDBP and PBC, has demonstrated their capability for selection of suitableproject sponsors, and for appraising and supervising SSI subprojects. Thus,under the proposed project, all PCIs will be given full delegated authorityon subloan sanctioning with ex-post review by PBC and the Bank on a samplingbasis. Refinance of subloans found defective would not be authorized by theBank. The staffing levels of the PCIs at their headquarters aresatisfactory. However, under the proposed project, more attention would begiven to training and increasing staff at the circle, zonal and branch levelsas further decentralization of lending authority is undertaken. The proposed

1/ A detailed discussion on the NCBs is attached as Annex 2.

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project would provide technical assistance to the PCIs through PBC to upgradestaffing and iwprove systems and procedures, especially outside of head-quarters (para. 3.16).

3.10 Conditions for Participation. The basic eligibility requirement forparticipation in the proposed project by a PCI is that it continues to meetthe requirements and standards of SBP and PBC in the case of an NCB, andthose of the Ministry of Finance in the case of IDBP. These minimum require-ments refer principally to meeting statutory reserve requirements and under-going regular inspection and examination of accounts by responsibleauthorities. Over and above these minimum requirements, the following par-ticipation conditions have to be met by a PCI: (a) maintenance of adequatestaffing levels with officers qualified to handle SSI term financing atheadquarters and the branches; (b) adoption by its Board and issue of acircular spelling out the policies, procedures and strategy for implementa-tion of the proposed project; and (c) maintenance of collection and portfolioinfection levels acceptable to the Bank (para. 3.11).

3.11 Collection and Portfolio Infection Criteria. To be eligible toparticipate under the proposed project, an MCB would be required to maintaina minimum collection level, defined as follows: the cumulative cash collec-tions under all the 8SI and IIC projects of a PCI should be, at least, 752 ofcumulative amounts due. Moreover, a minimum cumulative collection ratio of852 on all foreign currency term loans should be maintained. Finally, theinfection of the portfolio by arrears should not exceed a 152 level. In thecase of IDBP? the minim collection and maximum portfolio infection targetswould be those required for participation under IIC II. These have been setannually up to FY90 in consultation with WMi' and the Asian Development Bank(ADB), as part of the ongoing portfolio upgrading of IDBP; achievement oftargets is reviewed semi-aDnually by GOP, ADB and the Bank. Subloanauthorizations under the project would be suspended until a PCI shall havetaken concrete steps to address its collection and arrears problem, satisfac-tory to the Bank. These thresholds would be monitored semi-annually. As ofJune 1986, all the VCRs have met the collection and portfolio infectioncriteria. IDBP also achieved its collection targets for FY86.

Monitoring and Coordinating Agency

3.12 PBC would be the sole apex agency for the proposed project and IDBP,rather than serving as the apex unit as it did under S8I I & II, would becomea full participating credit institution. After five years of experience inSSI project financing under the first and second projects, the PCIs, with theassistance of IDBP, have developed sufficient capability for projectappraisal and supervision. The role of the apex agency, therefore, willchange from that of project review to that of monitoring and coordination andpolicy guidance. IDBP's expertise in project work would be more useful indirect project lending as a PCI, while the functions of coordination andmonitoring are more germaine to PBC's role. PBC has already established anSS! department under the direction of a member of the board for this purpose.

3.13 PBC's draft SBI Policy and Strategy Statement was discussed andagreed during negotiations (para. 6.02 d). This statement specifies PBC'sobjectives, functions, organization and staffing, work program and reportingrequirements under the proposed project (Annex 4). During negotiations,

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agreement was reached on the appropriate staffing level for the SmallIndustries Department of PBC (para. 6.01 f).

Subprojgct Eligibility Criteria

3.14 As in the previous 8SI Projects, an eligible enterprise would bedefined as a small enterprise which is privately-owned, and is engaged orintends to engage in manufacturing, repair, processing, industrial services,or agro-processing. In view of urgent need and lack of appropriatefinancing, privatel-owned hospitals and clinics would become eligible,subject to a maximua li_it of 10X of the total loan amount. Each PCI wouldhave to submit its first hospital/clinic subproject for Bank review orapproval before it is given full delegated authority in subloan approvals.An eligible subproject would involve the establishment, expansion and/orbalancing, modernization and replacement (BER) proposals of an eligibleenterprise which meet the following criteria:

(a) the fixed assets of the enterprise (excluding land and buildings)valued at the original cost should not exceed Rs 10 million beforethe granting of the subloan; this is the current SSI definition;

(b) the incremental fixed cost per job should not normally exceedRs 200,000 to encourage labor-intensive technologies;

(c) working capital financing would be allowed only as part of a fixedinvestment subloan and for permanent working capital needs sinceseasonal working capital financing it available from the NCBs;

(d) a minimum of 301 of subproject costs should be provided by thesponsor in the form of equity to encourage sound capital structuring.

For small subprojects with subloans below Rs 3 million (US$170,000), the PCTQwould perform financial analysis to determine financial viability and useproject profiles, prepared under 58I I, to assess economic merit. For sub-projects with subloans of Rs 3 million and above, appraisal reports wouldbe more detailed and include a DRC calculation.

Subloan Terms and Conditions

3.15 Sublending terms and conditions would be similar to those under 88III, but adjusted to reflect changed conditions and facilitate effectiveimplementation:

(a) the maximum subloan allowed would be Rs 10 million (US$570,000) tospread the funds among many subborrowers and to avoid an overlap withIIC II which allows for a minimum subloan size of US$500,000;

(b) the proportion of subloan amounts financed by the PCIs would beincreased to 401, to spread foreign exchange funds to more sub-projects and encourage local resource mobilization;

(c) subloans may be applied to factory buildings but only up to a maximumof 251 of a subloan to discourage over-investment in buildings; ankfunds may not be used to finance purchase of land;

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(d) subloan maturities would be at least three years and up to a maximumof ten years with a grace period of up to two years;

(e) the lending rate would be 14Z p.a. initially which is consistent withthe lending rate under IIC-Il (para 2.11); and

(f) subloan commitments which are not at least partially drawn downwithin twelve months from comuitment would be automatically cancelledto facilitate project completion.

D. Technical Assistance Components

Technical Assistance for PBC and the PCIs

3.16 Under past SSI and IIC projects, the Bank has provided funds to PBCand the PCIs to assist them in building capability for project financingthrough staff training and systems improvement and in developing a healthyproject pipeline through subsector analysis and area potential studies.Under the proposed project, US$2.0 million would be provided to extend thetechnical assistance to the PCI regional offices and branches as furtherdecentralization of operations is pursued. Through PBC, the PCIs have sub-mitted their detailed training and research requirements. The proposedtraining consists of a basic program for staff new to project financing, anadvanced program for more senior staff and overseas training for key manage-ment personnel. The research proposal extends subsector and area potentialstudies beyond those completed under past projects, including a study on theimpact of the past S8I projects and on a credit clearing system. Thesestudies would require about 50 person months of foreign consulting and 100person months of local consulting. During negotiations these proposals,including terms of reference, were discussed and agreed upon (para. 6.01 e).

Promotion of Export Houses

3.17 Background. Pakistan's export sector is highly fragmented withthousands of small exporting companies and a high concentration on a fewproduct areas. This situation has resulted in lack of scale economies inexport marketing, poor marketing practices and skills and inadequate commit-ment to long-term product and market development. In world markets,Pakistan's exports have a poor reputation reflecting inconsistency inquality, delivery and standardization and resulting in low price realization.The successful experience of East Asian countries in developing export housessuggests that a similar strategy, adapted to Pakistani conditions, can serveas a catalyst in rationalizing and generally upgrading the export sector. 1/

1/ In reference to the Korean model, for example, significant differencesin the current export environment of both countries are noteworthy:Ci) Korea exports a far greater range of products through a far fewernumber of well organized trading companies; (ii) there is a high degreeof interaction between public and private sectors for export promotion,and between large and small firms through supply and subcontractingarrangements; and (iii) the Korean private sector is supported by aneffective and extensive overseas representation bv the anva"mnant

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Pakistan's export performance can improve if organizations are developedwhich can take a long-term view and apply better management and marketingskills to export trade. Export houses play this role by exploiting economiesof scale in overseas marketing by operating on a scale and with resourcesotherwise unavailable to small exporters.

3.18 In 1981, GOP promoted the concept of export houses and issued theExport House Order of 1981. Under this program certain facilities wereprovided to export houses, including (i) import entitlement, (ii) advanceRMR (Raw Material Replenishment) license, (iii) foreign exchange allowancefor market research, product adaptation and development, and (iv) a permitto set up display centers abroad with necessary foreign exchange allowance.Twenty-six exporters, engaged mainly in cotton textii e exports, registeredtiiemselves under the Export House Order. By 1983, despite fairly rapidindustrial growth and the provision of special incentives, only eleven firmsrecorded export earnings of over Rs 10 million; most of their exports con-tinued to concentrate on textile products and very little linkage with sup-pliers and subcontractors was developed. The main reasons for lower thanexpected results appear to be three-fold. First, export incentives areavailable only to direct exporters. Since these are quite significart, ashigh as about 22% of FOB value, for example, in the case of garment exports,manufacturers try to export directly, despite lack of export marketingexpertise, to avail cf export incentives. This is the major cause of thefragmentation in the export sector. Second, the selection of export housesfor registration was quite loose since the incentives to be provided weremodest. Thus, of the 26 houses registered many were small operations, withlittle management and marketing expertise and commitment to long-term exportdevelopment. Finally, the incentives were quite modest. What the exporthouses require most is appropriate financial and technical assistance indeveloping their foreign marketing operations since government trade repre-sentation overseas is weak.

3.19 Objectives. The objective is to increase the volume, the diversity,the destinations and the profitability of Pakistan's manufactured exports bypromoting export houses which can apply skills and resources to exportmarketing with a long-term commitment. A good expor'. house would serve as avehicle for consolidating suppliers, improving market reputation throughquality control and consistent performance and promoting product and marketdiversification. Under the Export Development Loan, the Bank is addressingpolicy issues related to the export incentive system and providing assistancein improving the administration of the government export program. Theproposed TA component would complement these initiatives on the policy andadministrative fronts by developing the marketing infrastructure. Whileexport houses may not be the only answer to the export development problem,they are eepecially relevant to Pakistan's situation which is characterizedby many small manufacturers with limited financing, difficulty in accessingthe necessary imported inputs, lack of quality control and export marketingexpertise and inadequate marketing support overseas.

3.20 Necessary Policy and Institutional Adjustments. The establishment ofa climate under which an export house can flourihbegins with a governmentcommitment to the development of the concept and the provision of assistanceand incentives to enable a company to operate efficiently on the supply sideand profitably in the market place. A major factor contributing to exportdevelopment is the government's commitment to reform in key policy -areas such

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as exchange rate policies, movement towards a free trade regime, and thedevelopment of an incentive system providing appropriate support for exportdevelopment. Policy reforms are being addressed under the Export DevelopmentLoan (EDL). For the proposed project, an immediate change in policy regard-ing export suppliers is needed to make export houses viable. Export incen-tives available to final exporters should be made available to suppliers tothe export houses selected under the project. Unless this change is made,any unit, regardless of size, would want to continue exporting directly toavail itself of export incentives. This policy change is provided for in adated covenant of the EDL. It would also be a condition of disbursement forthis component (para. 6.04 a).

3.21 To cultivate more interaction between public and private sectors inexport promotion activities, the proposed project would assign specific rolesto the Federal Export Promotion Bureau (EPB), the Federation of PakistanChamber of Commerce and Industry (FPCCI), and the banking sector: the EPBwould be responsible for the administration of the technical assistance fund,and would participate in the selection of eligible export houses and monitortheir performance; the FPCCI would act as a liaison between the Governmentand the private sector, promote the export house concept, and participate inthe selection and monitoring of export houses; participate in marketingactivities and disseminate market information; and the NCB's would beresponsible for appraising, supervising, disbursing and collecting the sub-loans for the export houses and providing export finance under the ExportRefinance Scheme.

3.22 Organization of Export Houses. An export house would be an existingcompany, trading in either a wide variety of products or a particular productgroup, provided they are non-traditional. The basic principles guiding itsoperation would be based on professional management of the marketing andselling functions and profitable operation. An export house could typicallycommence operations as the overseas marketing wing of an existingmanufacturer-cum-exporter. The corporate objective of the export house is toextend markets and products at a level of profitability to ensure its owndevelopment and the development of its suppliers which, in this case, areexpected to be mainly small- and medium-size producers.

3.23 The operational strategy would initially focus on the development ofone market area. The model recommended is based on the operation of a sub-sidiary marketing company located in that market and managed by a profes-sional marketing manager with extensive knowledge of, and contacts in, themarket place. The manager's main function would involve the setting up andmanagement of a commission-only sales force. His responsibilities wouldinclude calling on key accounts, monitoring of market development, assistingin new product development, liaison with the head office in Pakistan, andoverseeing day-to-day management functions. The staff would include anassistant manager on posting from the Pakistan head office, who would receiveon-the-job training in foreign marketing management. The subsidiary opera-tion would require, at least, an office space and, under some circumstances,warehousing and showroom space. In the head office, a manager and supportingstaff would be required to fulfill the functions of processing orders, liais-ing with suppliers, organizing for production, maintaining quality control,developing products and providing general administration.

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3.24 Financial Structure. Considering the size of existing export housesin Pakistan and the requirements in the export market, the most appropriatelevel of operation would require a capitalization ranging from Rs 25 millionto Rs 50 million (approximately US$1.5 million to US$3 million). At thislevel, the company would be sufficiently large to hire capable staff, estab-lished market tie-ups with foreign buyers and compete in a competitivemarket. An export house would be required to provide 30-401 of the capitalrequirement as equity; the remaining 60-70X would be financed under SSI IIIwith the Bank and the NCBs providing debt financing based on a 60:40 ratio.Over a three-year period, these capital funds would finance establishmentcosts, the development and implementation of comprehensive corporate andmarketing plans, product development costs, salaries and overheads.Furthermore, export houses would be eligible for the existing ExportRefinance Scheme, i.e., pre- and post-shipment creditst for trading capital.

3.25 Selection Criteria. Since the purpose is primarily to catalyze, theproposed assistance would be limited to the development of about five exporthouses. However, in view of the novelty of the proposed approach, initiallyonly two export houses would be considered. Following a review by GOP andthi3 Bank, up to three more export houses could be assisted. To select theexport houses the following criteria would be used: (i) an applicant companyshould have an export development plan and a commitment to the concept with arecord of export earnings averaging at least Rs 15 million p.a. in the pastthree years; (ii) the company should be a manufacturer-cum-exporter and beaccustomed to dealing with SSIs on a sub-contracting basis; (iii) the companyshould have the financial capability to generate at least 301 of the requiredpermanent working capital and also to meet the terms and conditions of thesubloans under the proposed project; (iv) the company should present a firmcorporate plan and an achievable marketing plan. The EPB would prescreenapplicant export houses according to the above criteria. The lending commer-cial bank would appraise the subloan proposal of a selected export house andsubmit to the Bank approved applications for final review and authorization.

3.26 Proposed Assistance and Cost Estimate. The proposed project wouldsupport the organization of five medium-scale export houses; provide assis-tance in training, establishment of overseas offices and promotionalactivities; and extend permanent working capital on a long-term basis. Theproject would provide US$5 million in foreign exchange denominated in twoparts: the first amounting to US$4 million will cover permanent workingcapital, to be provided through the NCBs at a 14X interest rate and with aten-year maturity and a grace period of up to two years. The other partamounting to US$1 million would be for technical assistance in the form ofgrants for training, organizational activities, promotions, market researchand advisory services from foreign export houses. The technical assistancegrant of US$200,000 each would have to be matched by the recipient exporthouse and would be provided through EPB under terms and conditions spelledout in Annex 5.

Technology and Productivity Fund

3.27 A recently completed report on technology policy suggests that aprerequisite for increasing ac;quisition of technology in Pakistan are policyadjustments which increase industrial competition through reduction in importprotection, stimulation of export production and deregulation of theactivities of domestic enterprises. Industrial policy reform was the focus

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of the Pirst Structural Adjustment Loan and is being followed-up under theExport Development Loan. Future industrial sector and export developmentloans would broaden the policy reform initiated under SAL I and the EDL,focusing on protection and industrial regulations (para. 2.28).

3.28 Complementing policy reform, the purpose of this component is todevelop institutional arrangements which could support the technical develop-ment of industrial enterprises. There are two main sources of technology forthe industrial sector in Pakistan: foreign companies outside the country andtechnical institutions within the country. While larger firms have access tothe technology of foreign companies, smaller enterprises as a group, find itmore difficult and have to depend on intermediaries, e.g., machinery sup-pliers and local technical institutions, to acquire technology. By andlarge, the marketing of machinery and equipment (hardware) in the country isreasonably efficient with the existence of many indenters and agents repre-senting a variety of foreign suppliers. The weakness lies in the provisionof technical services (software) required to enable industry to master, adaptand improve upon technology supplied by the hardware.

3.29 In Pakistan, there are several public sector technical institutionswhich are supposed to provide private industry with software for technologyand productivity improvements. The larger ones are the Pakistan Council forS-cientific and Industrial Research, Pakistan Standards Institute, PakistanIndustrial Technical Assistance Center, Pakistan Design Institute, MetalIndustry Research and Development Center. The quality of these institutions,however, is suspect, since they have had little contact with privateindustry, have become largely "academic" and supply-oriented and have a poorimage among private industrialists. Moreover, due to permanent constraintsin staffing and funding, many of them have little to offer private industryin terms of technology updating. 1/

3.30 Objective. To develop alternative sources of technical services inthe private sector and to generate demand-oriented technology and produc-tivity upgrading proposals, this component would provide through the threelargest development finance institutions (DFI) partial grants to privateindustry for the financing of eligible and viable "technology subprojects"such as technical consulting services, technical training programs, technicalcollaboration packaging or small R&D projects which either introduce newtechnology or improve an existing one in private industry.

3.31 Eligible Expenditures. A list of eligible technology "subprojects",prepared by the DFIs, were discussed at negotiations. Eligible expenditureswould be for 50% of costs of consultancy services, training, materials andsmall equipment. The other 50% would have to be contributed by the applicantenterprise. Initially, the subprojects would emphasize assignments whichdeal with simple and practi:al technology and productivity improvements thatcan be implemented with little or no investment outlay by clients.Recommendations should be easily implementable and their benefits and impactreadily quantifiable and realizable in the short term. As experience underthe Fund grows, more complex subprojects can be considered.

1/ World Bank Report No. 6151-PAK.

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3.32 Implementing Arrangements. The three largest DPIs in Pakistan,namely NDFC, PICIC and IDBP, would be the implementing agencies for thiscomponent. A technology and productivity fund of US$500,000 would be placedwith each of the DFIs. The DFIs would be responsible for developing detailedpolicies and procedures for the fund (Annex 6), promoting the fund, solicit-ing proposals from private industry, appraising the eligibility and viabilityof each subproject, submitting approved proposals for Bank approval, disburs-ing the funds and supervising the subprojects. The National Center forTechnology Transfer (NCTT), a government agency under the Ministry of Scienceand Technology, would be responsible for a semi-annual operations audit ofthe fund, documentation of the experience and a detailed cost and benefitstudy at the completion of the project.

3.33 Funding. The project would provide US$1.5 million for the technologyand productivity fund. Normally, the project financing would cover 50% ofsubproject costs with the balance to be paid by the sponsoring privateenterprise. It is estimated that these subprojects would involve about 100person-months of foreign consultancy and another 100 person-months of localconsultancy. Cost sharing would be treated initially on a case by case basisand would be reviewed after some experience has been gained. The projectwould also provide NCTT with funds to cover its monitoring costs for threeyears, estimated to be US$45,000.

Improvement of SSI Sector Statistics

3.34 Current Status. To date, the Federal Bureau of Statistics (FBS) haspublished two studies on on the SSI sector: the Survey of Small andHousehold Manufacturing Industries (SHMI), 1976-77 and the Census ofManufacturing Industries, 1980-81. The former covers the informal sector,i.e., small manufacturing establishments with fixed assets (excluding valueof land) rnot exceeding Rs 2 million and all household manufacturing units,while the latter covers those manufacturing establishments registered underthe Factories Act of 1934. In addition, the 1983-84 survey of SHMI has beencompleted and will be issued by the end of December 1986. Annual updates ofSSI statistics up to FY85 is currently based on a simple extrapolation usinga constant growth rate which is the average growth rate between the FY77 andFY81 surveys. SSI statistics up to FY85 were arrived at by compounding theFY77 data by a growth rate of 7.3% p.a. Preliminary findings of the FY84survey show that the growth rate between FY81 and FY84 was not 7.3% but 8.4%.This "new" average growth rate will now be used to correct data from FY81 toFY85 and to update SSI statistics annually from FY86 onwards until the nextsurvey. Under the present methodology, annual SSI statistics are clearlyunreliable and cannot provide an adequate basis for reviewing sector perfor-mance and performing meaningful statistical and economic analysis.

3.35 Planned Census of Establishments. The basic problem is the absenceof a census of establishments from which FBS can derive a reliable samplingframe for annual surveys to update the statistics. FBS plans to conduct thefirst ever census of establishments in both urban and rural areas and isrequesting Bank assistance. The census would cover all large, small, andhousehold establishments and would provide a sampling frame which would formthe basis for conducting various sample surveys to be undertaken annuallysubsequently. The FBS expects to undertake the census on quinquennial basisand, during the intervening years, sample surveys of small and householdmanufacturing industries. This approach will not only establish the data

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base but also generate more reliable annual data with the base year set bythe quinquennial census.

3.36 Estimatet Cost and Proposed Assistance. The estimated cost forconducting the Census of Establishments include: (a) local currency costsof Rs 5 million covering salaries and allowances for staff; (b) foreignexchange costs of about US$500,000 covering vehicles (US$100,000), training(US$70,000), consultants (US$80,000), and printing/cartographic equipment(US$250,000). The training program would focus on strengthening the FBSability for statistical and economic analysis. Consultancy services would berequired to assist FBS in designing the census and surveys, trainingenumerators and statisticians and in data processing, interpretation andanalysis. The project would finance the foreign exchange cost of US$500,000while GOP would finance the local currency cost of Rs 5 million.

IV. THE IDAN

A. Terms and Conditions

4.01 Subloan Component. Under the proposed project, the Bank wouldprovide a Loan of US$54.0 million for the credit component. The proposedBank Loan of US$54.0 million would be made to the Government of Pakistan atthe Bank standard variable interest rate with a repayment period of 20 yearsincluding 5 years of grace. The Loan would be on-lent in local currency tothe six participating credit institutions under terms and conditions to bespelled out in subsidiary loan agreements between GOP and the six PCIs at aninterest rate which would allow the PCIs to receive a spread of 4.75X p.a.At the proposed initial lending rate of 141 p.a. to the subborrowers, GOPwould on-lend the loan proceeds to the PCIs at 9.251 p.a. CON would provideto GOP grant funds amounting to US$7.5 million equivalent (f. 15 million)which would be on-lent to the PCIs and SSI subborrowers on the same terms andconditions as the Bank loan. GOP and the Pakistan Banking Council (PBC)would also enter into and sign an administrative agreement which would spellout PBC's responsibilities as the monitoring and coordinating agency.

4.02 The PCIs, upon approval by their respective boards of directors,would issue to their offices and branches a circular which would spell outoperating policies and procedures, eligibility criteria, and terms and condi-tions governing their sublending activities under the project. Similarly,PBC, upon approval by its board, would submit to the Bank its policy andstrategy statement detailing policies, procedures, strategy and work programand staffing of its Small Industries Department. Drafts of the subsidiaryloan agreement, the administrative agreement, PBC's strategy and policystatement and the PCIs' circular were discussed and agreed upon during nego-tiations (para. 6.03).

4.03 Completion of the following steps would be conditions of Loaneffectiveness:

(a) signing of subsidiary loan agreements by GOP and at least two PCIs(para. 6.03 a);

(b) approval by their respective boards of directors and issue by thesesignatory PCIs of their circular governing operating policies and

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procedures, eligibility criteria and sublending terms and conditions(para. 6.03 c); and

(c) signing of the administrative agreement by GOP and PBC(para. 6.03 b).

4.04 Technical Assistance Components. The US$5.0 million for technicalassistance would be provided by the Government of the Netherlands to GOP as agrant. In turn, GOP would pass on these fund as grants to the respectiveimplementing agencies as budgetary allocations. The US$1.0 million for thepromotion of export houses would be disbursed through the Export PromotionBureau (EPB) to finance technical assistance expenditures of the selectedexport houses. The US$1.5 million for the technology and productivity fundwould be passed on to the three development finance institutions (NDFC, PICIC& IDBP) for disbursement on a grant basis to eligible private industrialunits for approved technology "subprojects". The US$500,000 for the improve-ment of SSI statistics would be disbursed to the Federal Bureau of Statisticsto meet foreign expenditures associated with the proposed census of estab-lishments and annual surveys of the SSI sector. The US$2.0 million fortraining and consultancy services for the PCIs would be disbursed to PBC whowould administer the funds on behalf of the PCIs.

4.05 Completion of the following steps would be conditions of disbursementfor CON grant funds for each respective TA component:

(a) for the TA fund of US$1.0 million for export houses, approval andissue by EPB of a statement of policy and strategy acceptable to theBank; approval by the Ministry of Commerce and issue of a circularallowing suppliers to the selected export houses to avail of exportincentives currently available to direct exporters (para. 6.04 a);and

(b) for the technology and productivity fund, approval by their boardsand issue by the DFIs of a statement of policy and strategy, accept-able to the Bank (para 6.04 b).

4.06 Relending Terms. For the subloans, the lending rate would be ini-tially 14X. Given the current inflation rate of 52 and projected inflationof below 10X, the lending rate is substantially positive and is expected toremain so (para. 2.11). To ensure that the final lending rate would remainpositive in real terms and consistent with the overall interest ratestructure, the rate would be reviewed annually in conjunction with the reviewrequired under IIC II. To provide sufficient incentives to the PCIs toexpand their SSI lending and to compensate for higher administrative costsand risks of SSI lending, the PCIs would receive an interest spread of 4.75%p.a. PBC, as the monitoring and coordinating agency, would receive funds inits regular budget financed by the NCBs to cover its administrative costs.

4.07 Repayment Terms. Based on past experience, the average maturity ofsubloans would be about 8 years, including a year's grace period. Since thecredit component is expected to be disbursed in four years and the lastsubloan would have a grace period of one year, the repayment schedule of thePCIs to GOP would be calculated on a fixed schedule of 12 years inclusive ofa five-year grace. This would approximate a back-to-back repayment schedule,while avoiding the complexity of a composite amortization schedule based on

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repayment schedules of very many subloans. The PCIs would be allowed to userecycled funds arising from maturity mismatchea in individual subloans onlyfor lending to SBI units which meet the eligibility criteria.

4.08 Exchange and Interest Rate Risks. As in other recent IDA/IBRDcredits/loans for 8SI projects, GOP would carry the exchange and interestrate risks, since SSI units do not have the capability to plan and hedgeagainst risks emanating from exchange and interest rate adjustments.

B. Administrative Procedures

4.09 Refinance Arrangements and Special Account. All subloans which areapproved by the PCIs and subsequently authorized by the Bank are eligible forrefinance up to 60X of subloan amounts (para. 3.09). A PCI can claimrefinance against subloan disbursements from the Bank on a periodic (e.g.monthly) basis by furnishing PBC a certification that disbursements have beenmade, and required procurement procedures have been followed. PBC wouldconsolidate requests for refinance from the PCIs and submit them to the Bankon a periodic basis, with a copy to Habib Bank Ltd (HBL) which will handlethe Special Account for this project. HBL would refinance the PCIs on thebasis of these requests out of the special account to be opened in it forthis project. The Bank would then reimburse the special account on the basisof the requests for refinance submitted by PBC. Each PCI would keep, in acase-by-case file, documents evidencing disbursements and procurement ofgoods. These files will be opened to inspection by Bank and PBC reviewmissions. Upon loan effectiveness, the Bank would disburse into a specialaccount in HBL US$5 million which would serve as the revolving fund.

4.10 Procurement. Procurement procedures under the proposed project wouldbe the same as those established under the past S8I projects which were foundncceptable to the Bank. Considering the great number of small items to beprocured and consistent with normal practices for 8I projects, internationalcomyetitive bidding would not be required. The procurement of goods would beas follows: goods costing US$50,000 equivalent or more per item orUS$100,000 equivalent or more per contract procured outside Pakistan shall belet through international shopping on the basis of at least three competitivequotations; for goods procured locally or goods procured outside Pakistanwith single items costing less than U8$50,000 or combined items costing lessthan US$100,000 equivalent, the existing procedures of the participatingcredit institutions are considered adequate; the PCIs would also have tocertify that these goods were purchased at reasonable and competitive prices,due account being taken also of other relevant factors such as time ofdelivery, quality and reliability of goods and availability of maintenancefacilities and spare parts. 1

4.11 Under their current procedures, the PCIs require their clients toobtain and submit three competitive quotations. As in the past 88I projects,the PCIs would be required to maintain records of the method of procurement,summarizing offers and awards per subproject. PBC would periodically reviewthese records which are kept in the files of PCI branches. Based on PBCreports on these reviews, Bank supervision missions would examine somerecords on a sampling basis.

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4.12 Procurement for equipment, vehicles and materials to be providedunder the TA components procured outside the country shall be let throughinternational shopping on the basis of at least three responsive pricequotations. For goods procured locally, the procurement procedures shall bethose of the Government for local competitive bidding, which, in general,have been found acceptable to the Bank. For consultants to be employed underthe proposed project, the respective implementation agencies would follow theguidelines for the use of consultants issued by the Bank in August 1981. Allterms of reference and appointment of consultants would be subject to priorBank approval.

4.13 Disbursements and Retroactive Financing. For the credit component,all disbursements for foreign or local expenditures made by the PCIs would befinanced equally at 60% of subloan amounts. Disbursements would be madeagainst certified statements of expenditures for which appropriate documenta-tion would be retained by the PCIs and made available for PBC/Bank supervi-sion missions. The Bank's reimbursement would be limited to expendituresmade by a subborrower not more than 180 days prior to the Bank's receipt ofPBC's request for reimbursement. However, to assist the PCIs in financingsubloans which continued to be committed despite full commitment of SSI IIretroactive financing up to US$5 million equivalent would be allowed forexpenditures incurred on or after July 1, 1986.

4.14 For the technical assistance components, the Bank would disburse outof the GON funds 100% of expenditures for consultants and training; of CIFcost of imported equipment and supplies; and of the ex-factory cost of localequipment and supplies. For imported equipment and supplies which are pur-chased locally, the Bank would disburse 75%. The disbursement percentageshave been calculated in compliance with the Bank policy that th^ proceeds ofthe Loan would not be disbursed on account of payment for taxes and dutieslevied by the government. Withdrawal applications would be submitted to theBank by the implementing agency concerned. Disbursement of the technicalassistance funds for the PCIs would be channeled through PBC. The Loan isexpected to be committed in three years. A disbursement schedule based onthe latest regional subsector disbursement profile is given in Annex 7.

4.15 Reporting, Accounts and Audits. The participating creditinstitutions would submit semi-annual progress reports on commitments,disbursements, collections and arrears under the project to PBC. PBC wouldconsolidate the report for transmittal to the Bank. In addition, the PCIswould maintain proper accounts for subloans including supporting disbursementand procurement documents, which would be audited annually, according tocurrent practice which is acceptable to the Bank. Currently, the PCI auditsare undertaken by qualified local private auditing companies, acceptable tothe Bank. Since all the subloans would be disbursed on the basis of cer-tified statements of expenditures (SOE), the audit reports would need toinclude a special opinion by the auditors on the adequacy of SOB procedures.Past audit reports of the PCIs have been submitted on time. However, theydid not contain a special opinion by the auditors on the SOE. The PCIs wereasked to submit the SOE opinion and this was complied with on September 30,1986. After full disbursement of a subloan, a participating credit institu-tion will prepare a subproject completion report, comparing actual vs.projected costs and benefits of the sukproject. PBC would consolidate thesereports and include them in its semi-annual report to the Bank.

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4.16 The technical assistance implementing agencies would prepare andsubmit semi-annual progress reports directly to the Bank. Accounts specificto the components would be maintained separately and would be auditedannually according to current practice, acceptable to the Bank. Auditreports should be submitted to th lank no later than six months after theclose of the fiscal year.

C. Co-financing

4.17 Co-financing by CON in the amount of US$12.5 million equivalent(f. 25 million) will be used to co-finance the proposed project. For thispurpose, CON and the Government of Pakistan would enter into a DevelopmentGrant Agreement (DGA) which would spell out the premises and the terms andconditions of the grant and specify that the execution of the proposedproject would be in accordance with the Loan Agreement and be administered bythe Bank. The DCA would also specify that withdrawals out of the grant wouldbe through the Bank under standard Bank procedures. For this purpose, CONwould deposit the first tranche of the grant with the bank upon effectivenessof the grant. CON expects to disburse the grant in tranches of f.lO millionin CY 1987, f.10 million in CY 1988 and f.5 million in CY 1989.

4.18 The Bank and CON would enter into an Administration Agreement whichwould spell out the role of the Bank as administrator of the grant on behalfof CON. The agreement would specify that the Bank would administer the grantand supervise the project under its standard procedures and that the Bankwould provide to CON copies of its regular supervision and project completionreports.

4.19 The Government of the Netherlands has agreed in principle with COPthat it will provide about US$12.5 million equivalent (f. 25 million) ofgrant funds to co-finance the proposed project. During negotiations, CONrepresentatives confirmed this agreement and provided CON's comments on theproposed project based on the report of its appraisal mission in August 1986.The conments were accepted and reflected in the minutes of negotiations andin otber project documents. Signing of the Development Grant Agreement byCON and COP and the Administrative Agreement between CON and the Bank wouldbe conditions of disbursement for the US$4 million subloan component for theexport houses (pars. 6.04 a).

V. BENEFITS AND RISKS

A. Benefits

5.01 The small scale industries sector is one of the most dynamic segmentsof tie Pakistan economy and plays a major role in achieving COP's economicand social objectives. The proposed project would support COP's strategy formodernizing and expanding the sector by making investment funds more readilyavailable and by providing effective marketing and technical services. TheBank loan would fill a significant portion of the resource gap for 88I lend-ing and assist GOP and the banking system mobilize and allocate appropriateresources for this sector. By providing funds at the formal market interest

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rates, the average cost of funds for 88I investments and operations (whichare still largely financed by the informal market) would decline, therebystrengthening the sector's financial position and encouraging further 8SIinvestments. At the same time, by discouraging interest subsidization, theS8I lending program would improve project selection, encourage labor-intensive options, prevent diversion of funds and allow the banking system tooperate profitably and expand its 881 portfolio. Long-term Bank funds wouldblend with commercial bank short-term funds to increase term transformationat prudent levels. Application of project-based lending methodology by thebanks would improve project selection by complementing the traditionalcreditworthiness approach of comercial banks.

5.02 it is anticipated that about 1,300 subprojects would be financed,resulting in investments of about US$160 million. As in the first and secondprojects, it is expected that most subloans would be for smaller units, withsubloan amounts averaging about US$60,000. The subprojects financed areexpected to generate about 28,000 new full-time work places at a cost per jobof about US$6,000. These investments are expected to produce additionalgoods and services worth about US$100 million.

5.03 The SSI credit delivery system, started under the first project, hasproved to be basically sound and would continue to be strengthened under theproposed project. The project would continue to assist the PCIs to improveand expand their institutional capability for 58I financing, with increasingemphasis on their branches. The entry of IDBP as a sixth PCI would provideborrowers with another alternative source of financing and improve bankingservices through greater competition. Staff training and systems improve-ments within the PCIs would shorten loan processing time, improve projectimplementation and strengthen the PCIs' project supervision and loan collec-tion systems.

5.04 The promotion of export houses is expected to initiate rationaliza-tion of the highly fragmented export sector and provide a vehicle for greaterexport product and market diversification. With better marketing skills, theexport houses would help improve Pakistan's image as a supplier to worldmarkets by improving performance in delivery, product standardization andquality. By providing a system whereby suppliers can avail of export incen-tives currently available only to direct exporters, this component wouldencourage backward linkages in the export production sector. The technologyand productivity fund would provide technical services to improve the techni-cal performance of private industry. Experience under this component wouldbe used to develop institutional arrangements for a technology deliverysystem in future. The technical assistance for the Federal Bureau ofStatistics would improve data collection, processing and analysis and providemore reliable and accurate information for future policy and strategyformulation.

B. Risks

5.05 Investments in the sector and the operating performance of individualenterprises are dependent on overall political stability. Should adversedevelopments occur, particularly during the current political transitionphase in Pakistan, the 881 sector will be affected, although to a lesser

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extent than large industries which require greater investments and havegreater visibility. The country continues to suffer from infrastructuraldeficiencies which can discourage investments, affect operating performanceand reduce overall efficiency. Hotvever, compared to large industryt smallindustries require less infrastructure and therefore would be less affectedby these deficiencies.

5.06 If GOP were to expand the subsidized lending programs introduced lastyeart this could affect the rate nif utilization of the subloan component,since the subloan rate of 14X under the project would not be competitive withthe subsidized rates. However, the 32 lending program for locally fabricatedequipment is expected to remain small. In FY86, only about Rs 218 millionwas disbursed. The 10% lending program for imported machinery has notmaterialized because the NCBs which will have to bear the subsidy are notprepared to do so voluntarily. The Government has advised the Bank thatthese subsidized programs will ramain smell and will have no appreciableeffect on the proposed project. The annual interest rate review requiredunder this project will be used to monitor the size of these subsidizedprograms and their effect on the project.

5.07 Success in the promotion of export houses would be dependent on thepolicy change allowing indirect exporters equal export incentives as directexporters; the proper selection of entrepreneurs who understand the concept,are willing to invest in it and have the management capability to make theconcept work and on the support provided by the technical assistancecomponent. The policy change is being undertaken under the ExportDevelopment Loan and will, in addition, be a condition of disbursement forthis component. To ensure proper selection of entrepreneurs, assistanceunder this component will be limited to a total of five export houses, willstart with two export houses, and will require rigid screening procedures bythe lending commercial banks, the Export Promotion Bureau and the Bank.Technical assistance is being provided to allow the selected export houses toemploy consultants and receive training from successful export houses in EastAsia.

5.08 The technology and productivity program is basically an experiment indeveloping alternative sources of technical services in the private sector.As such, its success depends on the response of the private sector both onthe demand side from those who require technical services and on the supplyside from those with the capability to provide the services. Placing thefund in the DFIs which have established close contact with private industrythrough their lending programs gives the experiment a good chance of suceeding.DFIs, moreover, can complement the provision of technical services with theprovision of investment funds, if needed for technology upgrading. UsingNCTT, an independent government agency, to monitor the program will providethe Bank with an independent assessment of this pilot component.

VI. RECOMMENDATIONS

6.01 During negotiations, GOPOs agreement on the following were confirmed:

(a) the raising of the interest rate for SSI term loans from 112 p.a. to141 p.a. in line with the current market rate for industrial term

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lending in the country; and an annual review and appropriate adjust-ment of the SSI lending rate in conjunction with those under IIC II(paras. 2.11 and 4.06);

(b) conditions of participation for the PCIs (paras 3.10-3.11);

(c) on-lending terms and conditions, margins, eligibility criteria andrefinance arrangements (paras. 3.14-3.15, 4.06-4.09);

(d) budgetary allocations by government agencies and the PCIs as counter-part funds for the technical assistance components of the project(para. 3.04);

(e) procedures for procurement, disbursement, reporting, accounting andauditing (paras. 4.10-4.16);

(f) staffing patterns and details on technical assistance for participat-ing credit institutions and the SID of PBC (paras. 3.13, 3.16); and

(g) conditions for retroactive financing (para. 4.13).

6.02 During negotiations, drafts of the following documents were discussedand agreed on:

(a) subsidiary loan agreement between GOP and the six PCIs;

(b) administrative agreements between GOP and PBC;

(c) circular containing operating policies and procedures of the par-ticipating credit institutions;

(d) policy and strategy statement of PBC;

(e) policy and strategy statement for the technical assistance funds ofEPB; and

(f) policy and strategy statement for the technology and productivityfund.

6.03 The following would be conditions of Loan effectiveness:

(a) signing of the subsidiary loan agreement between GOP and at leasttwo PCIs, satisfactory to the Bank (para. 4.03 a);

(b) signing of administrative agreement between GOP and PBC, satisfactoryto the Bank (para. 4.03 c); and

(c) approval by the respective boards of the signatory banks and issue ofcirculars containing operating policies and procedures under theProject, satisfactory to the Bank (para. 4.03 b).

6.04 The following conditions would have to be met before disbursements ofthe Dutch grant and/or the Bank loan for specific components are allowed:

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(a) for the export house TA and subloan components, approval and issue byEPS of a statement of policy and strategy acceptable to the Bank;approval by the Ministry of Commerce and issue of a circular allowingsuppliers to the selected export houses to avail themselves of exportincentives currently available to direct exporters (para. 4.05 a);and signing of the Development Grant Agreement between GOP and GON andof the Administrative Agreement between CON and the Bank (para. 4.19);and

(b) for the technology and productivity component, approval by theirboards and issue by the DFIs of a statement of policy and strategy,acceptable to the Bank, for the technology and productivity fund(para. 4.05 b);

6.05 The proposed Project constitutes a suitable basis for a Bank Loanof US$54 million at the standard variable interest rate and a Dutch govern-ment grant aid of US$12.5 million equivalent (f. 25 million) for theGovernment of Pakistan, under conditions outlined in Chapter IV.

-33-ANNEX 1Page 1 of 5

PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

Profile of Subprojects Financed Under Credits 1113-PAX AND 1499-PAK 1/

1. Commitments and Disbursements. The First 8S1 Credit (Cr. 1113-PAK) wasfully disbursed and closed on schedule on December 31, 1985. As of March 31,1986, one year and six months after the Second SSI Credit's (Cr. 1499-PAK)effectiveness, the five participaring credit institutions (PCI) had approved for928 subprojects subloans amounting to US$48 million, or 701 of the total amountof US$69 million equivalent available for subloans. 2/ Disbursements to sub-projects by the PCIs have reached US$21 million, or 42Z of approvals and 30X ofthe total amount available. Currently, there are about 200 subloan applicationsat different stages of processing with the PCIs amounting to about US$14million. Average monthly rate of approvals increased to about US$3 millionduring first quarter of 1986 compared with U'S$2.5 million during 1985. Based onthe current rates and the pipeline of subprojects, comuitment and disbursementof the subloan component are likely to be completed by December 1986 and June1988, respectively.

2. Collection Performance. The average collection performance of the PCIsundor SSI I & II as of February 28, 1986 improved to 79X of total amounts duecompared to 641 in September 1985. This is better than the 751 cash collectionrate required as a condition for participation under IIC II. Improvement inperformance was achieved by an intensive collection drive by the PCIs whichinvolved the inspection of all subprojects under S8I I and half of subprojectsunder SSI II. Moreover, systems and procedures for collection were improvedincluding timely billing of clientsa more frequet and organized follow-up ondefaulting clients, application of presure on defaulting clients through threatof penalties and use of authority to debit client accounts to pay off arrears.The banks also reviewed delayed projects under 8SI I and adjusted the amortiza-tion schedules of deserving cases. These rescheduled cases account for 31 oftotal amounts due.

3. Subloan Characteristics. The average subloan size under SSI IIincreased to US$52,000 compared with USt42,000 under S3I I. The increase isdue to the change in SSI definition (from Rs 3 million to Rs 5 million), alarger proportion of above free-limit cases, and more loans for expansionsubprojects. The ratio of above free limit cases increased to 61 in number and201 in amount under the second credit compared to 41 and 151 respectively underthe first credit. As IDA requirement was 50:50 in amount, the distributionindicates that smaller enterprises had adequate access to these credit lines.

1/ Data on Credit 1113-PAK are actuals based on PCR information; data onCredit 1499-PAK are estimates.

#%& nS-Rhnwt ;_ rtnA _*:-s A '% # T kw^

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ANNEX 1Page 2 of 5

4. The financing pattern and subloan utilization characteristics are shownin Tabl 1:

Table 1

Second Credit First Credit

Financing:

Average Maturity 7 years, 7 months 7 years, 3 monthsSponsors Equity 62Z 67%PCI Financing 12X 7%IDA Financing 26% 26Z

Utilization:

Factory Buildings 12Z 20XMachinery & Equipment 73Z 65%Permanent Working Capital 15% 15%

The average sponsors equity contribution was 62% under the second and 67% underthe first credit compared with the minimum requirement of 30%, indicating muchhigher domestic resource mobilization than anticipated and stronger capitalstructuring of subprojects by the commercial banks. As anticipated, reductionin the share of IDA financing increased PCI cofinancing from 7% to 12%. This,in turn, reduced financing by the informal market (shown as part of owner'sequity) reducing average cost of borrowing and strengthening SSIs' financialposition.

5. Over-investment in buildings in some of the subprojects under the firstcredit has been rectified by limiting eligibility of building expenditures. Theaverage expenditure on buildings reduced from 20% to 12%. Most of the subloansfinanced local and imported but locally available goods. Under the first creditabout 10 and under the second credit only about 6% of the subloan amounts wereused in foreign exchange for direct imports by sub-borrowers. The foreignexchange application of funds including indirect foreign costs is estimated tobe about 30%.

6. Subproject Characteristics. The first credit financed 433 new and 221BMRS (balancing, modernization, replacement and expansion)-subprojects while theSecond Credit as of March 31, 1986 financed 648 new and 280 BMRE subprojects.Under the first credit, 35% of the subprojects belonged to the five subsectorsidentified at appraisal as growth areas, namely light engineering,textiles/garments, surgical instruments, sports goods and leather products.Under the second project, 71% of the subprojects belonged to the identifiedgrowth areas namely light engineering, textiles/garments and agro-industry(including agro-processing such as oil extraction, cotton ginning, rice/flourmilling and fruit/vegetable processing). Subsectoral distribution of sub-projects is shown in Table 2.

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ANNEX 1Page 3 of 5

Table 2: SUBSECTORAL DISTRIBUTION OF SUBPROJECTS

(Re million)Second Credit First Credit

Subsectors No. Amount No. Amount

1. Textiles and GarmentsWeaving 66 48.9 54 22.7Finishing 6 9.4 8 7.6Specialized Textiles 41 30.6 27 13.8Carments 20 23.2 16 12.6

2. Surgical Instruments 26 21.7 16 10.53. Leather and Leather Goods 12 12.8 12 5.44. Sports Goods 7 6.6 2 1.55. Light Engineering

Workshop 53 39.2 40 21.5Rerolling 33 30.3 16 11.0Wires and Cables 11 8.0 7 4.5Agri-Implements 27 18.5 20 10.6Electrical Goods 14 9.3 12 7.1Others 10 12.1 5 3.5

6. Furniture and Wood Products 34 23.4 21 12.57. Oil Extraction 68 53.7 45 27.08. Cotton Ginning 62 53.4 44 33.19. Ice and Cold Storage 109 70.3 75 38.510. Marble Processing 9 7.8 9 6.211. Printing an Packing 40 40.8 28 19.112. Fruits and Vegetables and Other 32 29.0 24 16.0

Agro-Business13. Rice/Flour Milling 47 27.4 35 16.714. Hotel 14 15.5 11 7.415. Poultry Farm and Feeds 38 28.0 27 15.616. Miscellaneous 149 155.1 100 54.2

§28 775.0 654 378.4

7. UnderWM second credit, the amount of loans going to NWFP andBaluchistan was about 40X more than under the first credit; in relative terme,however, these provinces received a smaller share under the second credit,indicating difficult project promotion problems in these areas. Due toimplementation delays, the project promotion and development work for theseprovinces included in the TA component under the second credit has not had anyimpact yet.

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ANNEX 1Pals 4 of 5

Table 3: GEOGRAPIICAL DISTRIBUTION OF SUBLOANS

Second Credit First Credit

Punjab 621 60XSind 31Z 30XNWFP 51 8ZBaluchistan 2Z 21

8. The average subproject size in fixed assets (excluding land andbuildings) was Rs 623,000 under 881 I and Rs 1.0 million under SSI II comparedwith the size definition of Rs 3 million and Res S million, respectively.Subprojects under the second credit with total assets upto Rs 1.0 million andabove Rs 3 million were 231 and 151 respectively while under the first creditthey were 271 and 13X respectively; most of the financing, therefore, wassmaller subprojects. The distribution is detailed in Table 3 belowt

Table 4: SIZE DISTRIBUTION OF SUBPROJECTS

(Rs in Million)Second Credit First Credit

1. FIXED ASSETS EXCLUDING LAND AND BUILDINGS No. Amount No. Amount

a- Rs Less than Rs 100,000 53 4,298 38 1,860b- Rs 100,000 to Rs 499,000 300 124,396 210 53,482c- Rs 500,000 to Re 999,000 353 341,964 249 146,980d- Rs 1000,000 to Rs 1999,000 182 335,456 128 144,189e- as 2000,000 and above 40 142,304 29 61,181

Total 928 948,418 654 407,692

2. TOTAL ASSETS

a- Less than Rs 500,000 80 33,170 63 38,325b- Rs 500,000 to Rs 999,000 135 147,045 117 119,910c- Rs 1000,000 to Rs 1999,000 424 855,360 287 508,195d- Rs 2000,000 to Rs 2999,000 150 447,945 106 212,340e- Rs 3000,000 and above 139 762,640 81 201,617

928 2p2462160 654 1p0809287

9. Economic Impact. The US$26 million under the first credit and the US$34million (upto March 1986) under the second credit have resulted in total invest-ments equivalent to about US$80 million and US$130 million, respectively. The654 subprojects under the first credit generated employment for 12,800 personsat an investment cost per job of Rs 84,000 compared to the eligibility criterionof Rs 100,000 per job. Under the second credit, the 928 subprojects areexpected to create new jobs for about 24,000 persons at an investment cost perjob of Is 94,000. This ex ante figure of 24,000 jobs appears to be an overes-timate and has, therefore, reduced the cost per job lower than that under the

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ANNEX 1Page 5 of 5

first credit when adjusted for inflation and devaluation. The subprojects underboth credits are almost totally dependent on local raw materials (97X). Foreignexchange earnings under the first credit are estimated to be Rs 65 million whileincremental value added is estimated to be Rs 680 million; most units financedproduce for the domestic market.

10. Participation by PCIs. Table 4 shows the number of subprojects approvedby each PCI. Under the first credit, National Bank of Pakistan and United Bankwere the most active while under the second credit, Habib Bank became the mostactive in consonance with its status as the largest bank in Pakistan. PCIinvolvement in these credits generally reflect their relative sizes, i.e., threelarge banks and two smaller banks, since participation is coordinated by PBC andcompetition is encouraged according to relative size.

Table 5

No. of Subprojects CommittedBank Second Credit First Credit

Habib Bank 290 156National Bank 231 172United Bank 198 172Muslim Commercial Bank 98 98Allied Bank Ill 56

11. Lending Quality. Based on a field sur4ey of 101 of the subprojectsfinanced under these credits, the lending decisions made appear to be generallysound and the quality of appraisal satisfactory. The PCIs have improved theirappraisal of the marketing and technical aspects of subprojects which was foundto be weak under the first credit. The PCIs ensure that, in cases of sub-projects involving complex processes, the sponsors obtain the necessary techni-cal know-how through foreign collaboration or by employing qualified personnel.Of the 65 subloans reviewed, 24 were found to have inadequate procurement anddisbursement practices, such as inadequate competitive quotations fromsuppliers. Weaknesses were noted also as regards assessment of sub-borrower'scapability to provide the required equity funds, availability of raw material inproject locations and assessment of market demand. Discussions with some bor-rowers revealed dissatisfaction concerning long loan processing duration andstringent collateral requirements. The provincial Small Industries Corporationsalso pointed out lack of cooperation by PCIs in sharing information concerningstatus of subproject applications prepared by them. These findings have beenprovided to the PBC for discussions with the PCIs and for appropriate action.

-38-ANNEX 2Page i of 9

PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

The Nationalized Commercial Banks (NCB)

Background

1. Overview. The financial system in Pakistan consists of: (i) fivenationalized commercial banks (NCB); (ii) seventeen foreign commercial banks(PCI); (iii) four specialized commercial banks; (iv) nine development financeinstitutions (DWI); (v) several insurance companies; (vi) two leasingcompanies; (vii) two stock exchanges; and (viii) a housing financecorporation. The NCBs, with about 7,000 branches, dominate the financialsystem accounting for about 851 of total assets. The State Bank of Pakistan(SBP), the central bank, regulates and supports the financial system withinoverall policies set by GOP. The Pakistan Banking Council (PBC), an inter-mediary agency between GOP and the NCBs, oversees and coordinates theactivities of the NCBs and fulfills many of the functions previously dis-charged by their former private shareholders. The Ministry of Financemonitors the operations of the other financial institutions.

2. History. The commercial banking system in Pakistan predates thecountry's independence. Most banking functions before independence, however,were carried out by numerous branches of foreign and Indian banks havingtheir main offices in Bombay, Calcutta, and Delhi. Most of them closed theiroffices upon partition, so that Pakistan had to rebuild its banking system.The oldest "Pakistani" bank was incorporated in 1941 by the Habib group ofentrepreneurs, with headquarters in Bombay. The Australasia Bank (now form-ing the Allied Bank) was established in Lahore early in 1947. In the sameyear, another moslem bank, the Muslim Commercial Bank was organized inCalcutta. With the transfer of the headquarters of Habib Bank and MuslimCommercial Bank to Karachi immediately after partitiorf, Pakistan started outwith only three banks. In July 1948, the State Bank of Pakistan (SBP) wasestablished as the central bank of the country. One of its first functionswas the issuance of currency to replace Indian currency notes in circulationas a transition measure. The second important function was the promotion ofbanking companies. A Banking Companies Act was passed in 1948, and the firstbank to be established after independence, was a government bank, theNational Bank of Pakistan, in November 1949. The existing Pakistani banksalso were encouraged to expand and the branches of foreign banks allowed tocontinue their activities undisturbed. In the late 1950s, commercial bankingexpanded rapidly and new private banking institutions, such as the NationalCommercial Bank in 1957 and the United Bank Ltd. (UBL) in 1959, were created.In the 1960s, two other important banks were established--Commerce Bank andStandard Bank and by the early 1970s there were 13 Pakistani banks.

3. As banking grew, GOP felt the need to review the effectiveness ofbanks in promoting economic development. In 1959, a Credit EnquiryCommission was appointed to examine the provision of credit to agriculture,business and industry, with particular emphasis on primary producers andsmall businesses. The Commission found a tendency for credit to gravitatetowards established groups of entrepreneurs and to be unavailable to smallindustrial and atricultural nroducers. and recommended that ma&aurem bp tAkan

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ANNEX 2Page 2 of 9

to redistribute financial resources. Acting on these generalrecommendations, during the 1960s, GOP sought to channel credit to targetedsectors mainly through specialized institutions and other schemes financed bySBP. However, within the commercial banking system little was changed; in1972, GOP saw the need to enact a Banking Reforms Act which expanded sig-nificantly SBP's control authority over the banks, to the extent of removingdirectors and management, if necessary. Capital and reserve requirementswere raised and reinvestment of a percentage of profits made compulsory. GOPfelt that the banks were failing to play an effective role in ensuring awider and more equitable dispersal of the benefits of economic growth.Together with banking reforms, SBP introduced more specialized credit schemesfor small producers in agriculture and industry, this time enjoining greatercommercial bank participation.

4. Nationalization. These measures proved to be a prelude to theNationalization of Banks Act of 1974, whereby the SBP and all the commercialbanks incorporated in Pakistan were brought uncer direct governmentownership. The directors and management of the banks were removed andreplaced by government appointees. The Pakistan Banking Council (PBC) wasestablished to coordinate the activities of the local commercial banks, whichwere merged to form the present five NCBs. Under Government direction, thebanking system was encouraged to expand its operations and geographicalpresence, with a view to redirecting banking services and resources to sec-tors and areas considered important in the national economic interest. Atthe same time, GOP continued to permit the establishment of foreign bankswith fewer controls; these banks continued to limit their operations to themore profitable areas of foreign trade financing. As recently as in 1982,three additional foreign banks were allowed to enter the Pakistani bankingindustry.

Present Structure

5. With assets of Rs 320 billion or about 902 of the total assets of thefinancial system as of June 30, 1985, and a network of 7,000 branches, com-mercial banks play a dominant role in Pakistan's financial system. In turn,the five NCBs account for about 94% of deposits, 90% of advances and 87X ofthe commercial banks' net profits.

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ANNEX 2Page 3 of 9

Table 1: THE COMMERCIAL BANKING SYSTEM,KEY INDICATORS, 1983-1985 /a

NCF,s CBss1983 1984 1985 1983 1984 1985

Deposits (Rs billion) 159.7 175.1 200.1 10.3 11.3 n.a.Advances (Rs billion) 91.6 100.4 116.5 10.2 10.0 n.a.Total Assets (Rs billion) 225.3 246.7 292.4 28.6 26.4 n.a.Advances/Deposits (X) 57.4 57.3 58.2 99.0 88.5 n.a.Capital and Reserves (Rs billion) 4.5 5.3 6.5 0.8 0.8 n.a.Capital/Deposit (Z) 2.8 3.0 3.3 7.8 7.1 n.a.After Tax Profits (Rs billion) 0.74 0.97 1.23 0.12 0.23 n.a.After Tax Return on Total Assets Z 0.30 0.64 0.42 0.52 0.87 n.a.Operating Costs as X of AverageTotal Deposits 3.0 3.1 3.1 5.2 5.2 n.a.

Number of Branches /b 6,931 6,777 6,713 59 58 n.a.

* 7a As of December 31.7i As of June 30.

Sources Grindlays Bank, June 30, 1984 and Pakistan Banking Council

6. Through the years, Pakistani banks have developed a branch systemabroad. Branches were first established in the United Kingdom. Morerecently, the overseas branch system has expanded as Pakistan's foreign tradediversified and as increasing numbers of Pakistani nationals migrated toEurope, the Middle East, Europe, and Africa. By 1985, the NCBs had 115branches abroad which contribute significantly to deposits via workers'remittances and to profits through foreign exchange and trade operations.

Table 2: FOREIGN BRANCHES OF NCBs(as of 1985)

Continental Middle OtherUSA UK Europe East Places Total

HBL 1 16 5 28 15 65NBP 4 8 2 2 6 22UBL, 1 10 - 13 - 24MCB - 2 - - - 2ABL - 2 - - - 2

Total 6 .38 7. 43 21 115= == = = 8 ==

Sources Pakistan Banking Council.

7. The NCBIs boards and chief executives are appointed by GOP. Inrecent years, care has been taken, where possible, to maintain continuity of

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ANNEX 2Page 4 of 9

adopted different administrative structures. Some are cuite centrallymanaged while others are significantly decentralized. Some emphasize foreigntrade activities, others domestic operations. These different managementstyles, operational divergence, and traditionally different clientele havemade for diversity and healthy competition within the system. Three of thefive banks--Habib, National, and United--are much more important in terms ofthe volume of their operations and their impact on the economy. Of theremaining two--Allied and Muslim--the latter is more aggressive andefficient. Allied is the smallest accounting for about 5X of the operationsof the NCBs. Table 3 presents the situation from 1983 to 1985.

Table 3: COMPARATIVE POSITION OF THE NCBs

Capital Netand Reserves Deposits Advances Profit

…(R----------------.(s billion)…-- --(Rs million)-

1983 1984 1985 1983 1984 1985 1983 1984 1985 1983 1984 1985

Habib Bank 1.9 2.2 2.8 55.0 62.0 70.7 31.6 35.7 41.2 351 328 640United Bank 1.0 1.3 1.5 41.5 44.6 48.9 25.0 26.4 31.1 149 338 206National Bank 1.0 1.1 1.3 40.6 44.4 52.5 19.0 21.5 26.9 143 196 232Muslim Bank 0.5 0.5 0.7 15.7 16.9 19.9 10.9 11.2 11.9 88 88 146Allied Bank 0.2 0.2 0.2 6.9 7.2 8.0 5.1 5.5 5.4 12 12 6Total 4.6 5.3 6.5 159.7 175.1 200.0 91.6 100.3 116.5 743 962 1,230

Source: Grindlays Bank, June 30, 1984 and Pakistan Banking Council.

8. The PBC plays an important coordinating role for the NCS system. Itis also the communications link with the Government, enabling the banks toput before the Government proposals on banking legislations and regulations.Also, the PBC formulates policy guidelines for the banks, reviews theirperformance, determines areas where corrective measures are needed andprovides trained staff through a central training and career developmentsystem. The PBC, however, has no legislative or regulatory functions. Thefirst remain with GOP authorities and are essentially contained in theBanking Companies Ordinance of 1962. The latter is the jurisdiction of theSBP which establishes reserve requirements, credit controls and allocations,interest rate levels and structure, and guidelines on banking fees.

Recent Performance

9. DeDosits. Overall deposits have doubled from Rs 66.0 billion in 1980to Rs 130.9 Aillion in 1985. Traditionally the banks have tapped personalsavings, and have expanded the base of personal deposits from 64% of thetotal in 1978 to 72% in 1983. The importance of government deposits has beenreduced from 7.5% tn 5%. Corporate savings have remained relatively constantat about 17%. Other deposits from foreign and domestic constituents havedeciined in importance, down from 10.5% to 6%.

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ANNEX 2Page 5 of 9

Table 4: COMMERCIAL BANKS - DEPOSITS(Rs billion)

z(March) (t!arch)

1980 1981 1982 1983 1984 1985 1985

Demand Deposits 22.8 27.2 28.3 34.0 33.9 32.0 24Savings Deposits 26.8 30.0 33.1 42.8 51.6 58.6 45Fixed Deposits underOne Year 8.2 8.4 10.3 13.8 15.9 16.5 13Fixed Deposits overOne Year 8.2 9.7 12.4 18.1 22.2 23.8 IR

Total Deposits 66.0 75.3 84.1 108.7 123.6 130.9 100==== ~=== ==--- = . ===== a===== ==

Source: Pakistan Banking Council.

10. The second important development is the savings promotion effort ofthe commercial banks in recent years to reach larger numbers of depositors,even in the most remote areas of the country. Between 1980 and 1984 thenumber of depositors increased from 15.4 million to 20.2 million while theaverage size of account rose from Rs 4,550 to Rs 6,100. The growth indeposits was achieved without significant increases in average interestrates, still around 6.25%, but rather through branching and marketingefforts.

11. The third important development is the growing importance of fixedterm deposits, which have tripled by between 1980 and 1985. Noteworthy isthe development of time deposits of over five years maturity, which sincetheir introduction in the third quarter of 1981 have grown to Rs 10.4 billionor 8.6% of total deposits as of March 31, 1984.

12. With respect to other resources, the noticeable variations are inincreased borrowings from the SBP representing greater use of specializedcredit lines, particularly for export financing. In 1978, borrowings fromSBP represented 8.3% of total resources while in 1984 they stood at around13%. The other important change in the resource base of the commercialbanking system is the continuous growth of the capital and reserve accounts,and the important equity contribution to the NCBs by GOP during 1981. Whilein 1978 capital and reserves of the system stood at only Rs 1.9 billion, in1983 this increased to Rs 5.3 billion due to an increase in paid-in capitalsubscribed by GOP and SBP. The NCBs have been allowed to strengthen theircapital by retaining profits after tax; in the past they were required toremit all profit to the Government. An important improvement has taken placein the capital/deposit ratio, increasing the stability of the system and ofindividual banks. As a result, the combined profits of five NCBs increasedfrom Rs 150 million in 1975 to Rs 1,230 million in 1985 (Table 1).

13. Advances. Bank credit grew at an even faster rate than depositstreflecting greater use of SBP's refinance credit lines, and some relaxationof Credit ceilings by the State Bank. In 1978, total credit was 69.7% of

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ANNEX 2Page 6 of 9

bank deposits, while in 1982 it constituted 78.4%. Under the credit alloca-tion guidelines issued by the SBP, the expansion of credit was directed todifferent sectors of the economy in about the same proportion as in previousyears. The following table compares the commercial banks' portfolio bysector between 1978 and 1982.

Table 5: COMMERCIAL BANKS ADVANCES BY ECONOMIC SECTOR(Rs billion)

As of June 30 1978 1979 1980 1981 1982 _Agriculture, forestry,hunting and fishing 2.7 2.6 3.5 4.3 3.7 6.3

Mining and quarrying 0.2 0.3 0.5 0.7 0.5 0.9Manufacturing 13.0 16.1 16.9 20.6 21.1 36.8Construction 1.0 0.9 1.1 1.2 1.2 1.9Electricity, gas, water,and sanitary services 0.3 0.2 0.4 0.5 0.5 0.9

Commerce 9.0 11.0 12.9 13.9 16.1 28.1Transport, storage andcommunication 0.5 0.5 1.1 0.7 0.7 1.2

Services 2.9 3.9 6.3 7.5 8.5 14.8Others 2.5 3.7 4.2 4.8 5.1 9.1Total 32.1 38.7 46.7 54.3 57.4 100.0

=== S= 5 i: =_

Source: SBP 1983/1984 Annual Report.

14. These figures show the continued predominance of the manufacturingsector with 37% of bank credit. The second most important sector iscommerce, absorbing 28% of bank advances. Given the marked improvement inindustrial investment since 1982, the proportion of credit of the manufactur-ing sector is estimated to have increased to around 40x. The figures showsomewhat uneven treatment of the manufacturing sector and an expansion rateslightly below the overall expansion of credit. This is due to the reductionin government investment in manufacturing in the past three years because ofits policy of limiting public sector and promoting private investment in thesector. The slack was picked up by the private sector only gradually, andeven then the credit demand from private industrialists did not compensatefor the very large drop in demand by public industrial enterprises.

15. Profitability. With the measures taken by GOP and PBC since 1979,the overall performance and profitability of NCBs have improved considerably.The combined net profit after tax of the NCBs increased from Rs 150 millionin 1978 to Rs 1,230 million in 1985, at an annual compound growth rate of36%. However, profitability remains relatively low and the performance amongNCBs is mixed. As of December 31, 1985, Habib Bank's profits before taxeswere Rs 640 million, or 52% of the combined profits of the NCBs although itstotal assets were 37% of the NCBs. In 1985, return on total assets rangedfrom 0.91% for HBL to 0.28X for Allied Bank, the smallest NCE. All NCBs, toa certain extent, continue to suffer from the problem of overstaffing due tostrong labor unions. In 1985, personnel cost as a percentage of deposits ofNCBs averaged 1.89% ranging from a low of 1.63X for HBL to a high of 3.03X

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ANNEX 2Page 7 of 9

for Allied Bank. The relatively low profitability of NCBs is caused mainlyby: GOP's monetary policy of maintaining very high reserve requirements (35%of deposits); the credit allocation policy, which directs NCBs to financepriority sectors at low interest rates; a large network of low profitbranches in rural areas; non-payment of interest on loans to the publicsector; and general overstaffi'ng.

Table 6: EARNINGS OF NCBs(Rs million)

1985Share % Increase

1981 1982 1983 1984 1985 X over 1981

NBP 31 99 143 196 232 19.0 648HBL 122 273 351 328 640 52.0 425UBL 43 29 149 338 206 16.5 379MCB 33 44 88 88 146 12.0 342ABL 6 5 12 12 6 0.5 0Total 235 450 743 962 1,230 100.0 423

un -= 2=5= inrn u uu-

Source: Crindlays Bank, June 30, 1984 and PBC.

Role in Industrial Financing

16. Since 1979, the SBP has assigned to the NCBs a role in industrialterm lending by giving them specific targets. These allocations, if notutilized, cannot be channeled to other credit operations by the banks.Initially, there was some reluctance by the banks to participate in thescheme. This reluctance was due to the low interest spread provided by termloans. By regulation these loans could only earn 11 p.a. while workingcapital loans normally earn 14X. Recently, with the introduction ofParticipation Term Certificates, the disincentive was rerdoved partially.Also, the more innovative banks found ways to make these operations moreprofitable by insisting on collateral business such as letters of credit,working capital loans, collections and foreign exchange.

17. Term lending by NCBs has increased sharply since FY83 (Table 7).With Islamization of the banking system and the use of Term FinanceCertificatest returns on term lending have increased making it moreattractive. In 1985, it is expected that actual disbursements of term loansto industry during the year will increase further to Rs 2.0 billion. Therapid growth of this activity was also aided by the partial liberalization ofinterest rates through the adoption of Participation Term Certificates. Atthe same time, the banks have sought and SBP has allowed the acceptance oftime deposits with fixed maturities of five on more years, which have gainedacceptance rapidly without significant cost increases. This factor hasreduced the risk of conversion of short term deposits into longer term loans.

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ANNEX 2Page 8 of 9

Table 7: NCBs, FIXED INDUSTRIAL INVESTMENTALLOCATIONS AND UTILIZATION

(Re million)

Allocation Utilization /a Percent

FY81 576 387 67FY82 1,736 1,374 79FY83 1,579 1,387 88FY84 1,837 1,604 87FY85 2,195 1,716 /b 78FY86 2,059 845 Th 41 /c

1a Net of repayments.ii; As of June 13, 1985.Tc Six months only.

Sources SBP.

Prospects

18. The development of the commercial banking sector in Pakistan will beshaped by at least five major factors. The first is the overall performanceof the Pakistan economy and the demands that the different sectors will makeon the banks for funds and services. While the prospects are for continuedgrowtht internal and external pressures on the economy have increased andneed to be addressed through structural adjustments to ensure continuedgrowth. The second factor has to do with the future savings rate; Pakistanpresently has a relatively low rate of domestic savings at 7T of nationalincome. There is scope for increased savings particularly as incomeincreases, becomes more widely distributed and inflation is checked. Thethird factor is the introduction of Islamic concepts and practices into theeconomy, particularly in the financial sector, and the related issue of theinterest rate structure as a result of Islamisation. Initial experience hasshown that Islamization thus far has resulted in gradual freeing up of inter-est rates. Under a full Islamic banking system, scope exists for increasingbank deposits through attractive yields and for the banks to allocate theseresources to credit demands on a profitable basis.

19. The fourth factor consists of the policies that SBP will pursue,particularly with respect to reserve requirements, credit ceilings, creditallocation, and other regulatory functions. Recent experience and statementspoint to the likelihood of relatively flexible and judicious management ofthe system with a preference to deregulate as needed. An example is therecent freeing up of service charges which banks can now charge on a competi-tive basis. The interest rate ceiling on term loans has been removed whilethat on short term working capital loans has been increased from 15% to 20S.These policy initiatives will allow the system to develop in accordance withthe needs of the economy and permit it greater internal efficiency. The lastfactor is the role of PBC in guiding and coordinating the ICBs' activities.While the banks' improving performance could justify greater independence and

-46-ANNEX 2Page 9 of 9

competition among themselves, PBC's coordinating role would continue to beneeded, particularly in new areas of activity, such as use of Islamicinstruments, leasing and industrial term financing. Provided that PBC wouldcontinue its soft-glove approach which it has utilized up to now with muchsuccess there does not seem to be a practical contradiction between NCBindependence and PBC coordination. However, the relationship between the PBCand the banks will continue to depend much on personalities involved and, tothat extent, is uncertain.

20. The two important policy issues relevant to the commercial bankingsystem are: the levels and structure of interest rates, and the creditallocation system. SBP is charged with regulating both. In the past, thelevels and structure of the interest rate have been utilized by SBP to pursuetwo contradictory objectives: increase the rate of savings through attractivedeposit rates and promote investment in priority sectors and activities byoffering low cost financing through the commercial banks. The result hasbeen a crossed interest rate structure which had to be subsidized either byGOP, the non-preferred sectors or the banks. The financial authorities hadrecognized the problem but were nevertheless reluctant to address this issuedirectly and publicly in view of GOP's preoccupation with the Islamization ofthe economy. With the adoption of Islamic instruments both for deposits andloans, some freeing of interest rates have occurred. However, some distor-tions continue to exist; the distortions related to SSI lending are beingaddressed under SI III; an annual review of interest rates required underthis project and IIC II will be used to monitor continued rationalization ofthe interest rate structure by Covernment.

21. The banking system in Pakistan has traditionally been subject toquantitative credit controls. These have taken the form of credit ceilingsand credit allocation measures. GOP has maintained these controls because ofthe interest rate distortions of the recent past; with the elimination ofinterest rates, credit management by quantitative allocation will continue tobe used until the new Islamic system is fully introduced, GOP argues thatthis policy is in keeping with the needs of a developing economy with limitedresources and the need for maintaining fiscal stability. SBP monitors creditlimits and allocations closely and re-adjusts them periodically. While thesystem appears rigid and cumbersome, so far it has been managed quiteflexibly with little rigidities in practice.

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AMEX 3

PAKI STAN

THIRD SMALL INDUSTRIES PROJECT

Estimated Project Costs and Financing Plan

~~~~~{I(S$ million)

Bank Bank PrivateComponent Foreigp Local GCO GOP PCI Sector Total

A. SSI Subloan Component 45.0 5.0 7.5 - 39.0 65.0 161.5B. Technicai Aest. for PCI - - 2.0 0.5 - 2.5C. Export Houses

Subloans 4.0 - - - 2.5 3.0 9.5Training - - 0.4 - - 0.4 0.8Marketing Activities - - 0.3 - - 0.3 0.6Market Research,Planning and Development - - 0.3 - - 0.3 0.6

Administrative Cost - - - 0.5 - - 0.5

Subtotal 4.0 - 1.0 0.5 2.5 4.0 12.0

D. Technology TransferTechnology Transfer Fund - - 1.5 - - 1.5 3.0

Subtotal - - 1.5 - - 1.5 3.0

S. SSI StatisticsOverseas Training - - 0.1 - - - 0.1Equipment & Vehicles - - 0.3 0.2 - - 0.5Staff Costs - - - 0.3 - - 0.3Consultants - - 0.1 - - - 0.1

Subtotal - - 0.5 0.5 - - 1.0

GRAND TOTAL 49.0 5.0 12.5 1.0 42.0 70.5 180.0== =5 u=u- =5= :u=r= ~= ==

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ANNEX 4Page 1 of 11

PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

Draft Policy and Strategy Statement of the Small Industries Department of PBC

I. BACKGROUND

1. The Government of Pakistan is negotiating with the World Bank a Loanof US$54 million for the development of the small industrial sector inPakistan. This is in continuation of the two earlier agreements signed bythe Government of Pakistan with IDA on April 24, 1981 and July 10, 1984 inrespect of Credits of US$30 million and US$50 million, respectively.

2. The World Bank Loan of US$54 million and a grant from the Governmentof the Nettherlands of about US$12.5 million for SSI III would consist of thefollowing components: (a) subleans for fixed investment and permanent work-ing capitml for SSI subprojects (US$57.5 million); (b) technical assistancefor the financial institutions to train staff and improve operating systemsand procedures with emphasis on their branch network (U8$2 million); (c)technical and financial assistance for the establishment of export houses(US$5 million); (d) a technology transfer program to promote technology andproductivity improvements in private industry (US$1.5 million); and Ce)technical assistance to the Federal Bureau of Statistics to improve SSI datacollection, processing and analysis (US$0.5 million). PBC would be involvedin the implementation of the first three components.

II. INSTITUTIONAL ARRANGEMENTS

3. Under the proposed arrangements, the six participating banks, namelyAllied Bank of Pakistan Limited, Habib Bank Limited, Industrial DevelopmentBank of Pakistan, Muslim Commercial Bank Limited, National Bank of Pakistanand United Bank Limited, will be responsible for subproject appraisal,relending, supervision and collection. Each participating credit institution(PCI) will enter into a Subsidiary Loan Agreement vith the Government ofPakistan directly. The Pakistan Banking Council will sign an administrativeagreement with the Government of Pakistan for the coordination and monitoringof the project. The PCIs will disburse the approved subloans to the sub-borrowers and claim refinance of 40S of the subloans from Pakistan BankingCouncil, the administrator of the credit, who will be responsible for reviewof subloan applications submitted by the participating banks, refinancing andadministering part of the Technical Assistance Component (para 2(b) above).

III. OBJECTIVES

4. 'the main objectives of the SSI II are to: (a) promote the develop-ment of, 8I units, preferably those which are export oriented and/or areeffici''t in Import substitution by providing finances for long-termrequi-0*ent; (b) increaso the availability of development credit for SSIunits; (c) identify and assist those subsectors which have immediate growthpotential; (d) promote development of 551 unwits based on local raw materials;(e) suggest policy reform in order to encourage greater efficiency in the $88sector; (f) provide special assistance in promoting 8SI projects in under-

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ANNEX 4Page 2 of 11

developed areas; (g) provide finances to SSI subprojects with high financialand economic returns; (h) strengthen the financial institutions involved inSSI lending through technical assistance, training and improvement of operat-ing systems and procedures; (i) promote a financial environment whichencourages the financial institutions to expand their SSI lending by allowingthem to mobilize appropriate resources and operate profitably on their SSIportfolio; (j) establish a stronger export marketing infrastructure throughthe promotion of Export Houses; (k) improve efficiency of industrial unitsthrough a program of technology transfer; and (1) improve the accuracy andreliability of SSI statistics for policy and development strategyformulation.

5. These objectives will be achieved by providing credit speedily to SSIunits based on appraisal and monitoring of the end-use. Necessary publicityfor the use of this credit will be made through the branch network of theparticipating banks, Chambers of Commerce and Industry and local TradeAssociations, Small Industries Corporations, Export Promotion Bureau and thelocal media. SSI Cells already established at the Circle Offices will be ofimmense help. The number of designated branches of the participating bankswill be more than those designated in the preceding credits. The operatingsystem of the participating banks will be improved through training of staffconcerned and upgrading their knowledge for appraisal and supervision ofdevelopment lending.

IV. GENERAL POLICtES AND GUIDELINES

6. Size of the Subloan. The maximum loan limit under the credit will beas under: (a) the subloan allowed would not exceed Rs 10.0 million; (b)subloans under the credit will be provided for the development of small scaleindustries up to a maximum debt-equity ratio of 70:30 in the total cost ofthe project. The entrepreneur will provide funds from his own resources formeeting at least 301 of the total cost of the project; and (c) refinance tothe extent of 60X of the total subloan amount approved will be provided bythe World Bank to the participating banks and the remaining 401 of the sub-loan amount shall be met by the bank concerned from its own resources.

7. Purpose of the Subloan. The loan can be utilized for any of thefollowing purposes for the establishment of new small industrial units andfor balancing, modernization, replacement or expansion of existing smallindustrial units: (a) construction of factory buildings (not to exceed 25Sof the loan amount); (b) purchase of machinery and equipment; (c) machineryinstallation cost; and (d) permanent working capital requirements.

8. The permanent working capital will be provided only when the loan isrequired for financing of fixed cost also. The banks may also considerfinancing of the expenditure already incurred in respect of the above itemson reimbursement basis provided the same has been made within 120 days of thedate the application reaches PBC.

9. Utilization. The scheme is expected to start on or about September1987. At least 501 of the credit will be utilized for subloans of less thanas 7.5 million. The participating banks will aim at equitable distributionof credit funds among the provinces and other areas. Notional lending tar-gets for each of the provinces will be as under:

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ANNEX 4Page 3 of 11

Punjab 451Sind 27XNW"F 20XBaluchistan 8Z

10. The credit will be notionally allocated to the participating banks inthe following ratios. However, utilization will be on a first come firstword basis.

Habib Bank Limited 20.0%National Bank of Pakistan 20.01United Bank Limited 20.01Industrial Development Bank of Pakistan 20.0XMuslim Commercial Bank Limited 12.5XAllied Bank of Pakistan, Ltd. 7.51

11. Eligibility Criteria. A small enterprise which is privately-ownedand is engaged or is intending to engage in manufacturing, repair,processing, industrial services or agro-processing will be eligible forfinancing under the credit. Privately-owned hospitals/clinics will also beeligible for financing subject to a maximum ceiling of 101 of the total WorldBank loan.

12. An eligible subproject will involve the establishment, expansionand/or BMR proposals of an eligible enterprise which are financially andeconomically viable and meet the following criteria: (a) the fixed assets ofthe enterprise (excluding land and buildings) valued at original cost shouldnot exceed Rs 10 million before the granting of the loan; (b) the incrementalfixed cost per job will not normally exceed Rs 200,000; (c) working capitalfinancing would be allowed only as part of a fixed investment subloan andonly for permanent working capital needs; (d) a minimum of 30X of subprojectcosts will be provided by the sponsor in the form of equity; (e) the maximumsubloan allowed would be Rs 10 million; (f) at least 501 of the credit willbe for subloans of less than Rs 2.5 million to maintain credit access forsmaller subprojects; (g) the loan will not be allowed for any of the follow-ing purposes: purchase of land; purchase of locally-reconditioned or second-hand machinery; purchase of an existing unit (change of ownership); andpayment of Government taxes, duties, etc.; and (h) preference will be givento labor-intensive projects. In case of new projects, cost of fixed assets(excluding cost of land) per full time job created should not exceed Rs 0.20million. For existing projects, incremental cost of fixed assets (excludingcost of land) per additional full time job created should not exceed Rs 0.20million.

13. In respect of government policy the following guidelines will befollowed:

(a) Projects included in the restricted list. Prior approval of theMinistry of Industries/Investment Promotion Bureau is required forsetting up projects which are included in the list of restrictedindustries. The prospective sponsors of projects will, therefore,before approaching the participating banks for financial assistance

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ANNEX 4Page 4 of 11

under the credit, obtain approval of the Ministry ofIndustries/Investment Promotion Bureau.

(b) Projects included in the negative list. For setting up an industrialunit which is included in the negative list of the ProvincialGovernment(s) for location and sponsorship, necessary approval willbe required. However, for proposals recommended by the SmallIndustries Corporations/Boards, such approval will not be required.

(c) Projects using imported second hand machinery. Prior approval ofthe Ministry of Industries/Investment Promotion Bureau will berequired for setting up projects involving import of second handmachinery except under NRI. In the case of machinery imported underNRI, financial assistance will be available only for civil works,purchase of other assets and permanent working capital.

(d) Projects using imported raw material. Prior approval of the Ministryof Industries/Investment Promotion Bureau will be required for set-ting up projects in which more than 60% of the raw material isimported provided the value of such import exceeds 20X of the totalinvestment in fixed assets.

V. APPLICATION AND PROCEDURE FOR APPROVAL

14. Procedure. The following procedures will be followed:

(a) the participating banks have already designated their mainbranches/Circle Offices/Zonal and Regional Offices all over thecountry for receipt of loan applications under the credit.Prescribed application forms for loan under the credit can beobtained free of cost from any of these branches/offices;

(b) the prescribed application forms duly filled in will be submittedto any of the designated branches/offices of the participating banksconvenient to the intending borrower;

(c) the financial, economic, technical, managerial and marketing aspectsof the proposal will be evaluated by the participating banks;

(d) the participating banks will scrutinize the proposal thoroughly andafter satisfying itself about the eligibility and viability of theproject will sanction the subloan; and

(e) the participating banks will disburse the approved subloan to thesubborrowers and claim refinance of 60% of the subloan from PakistanBanking Council who will be responsible for review of subloanapplications submitted by the participating banks for refinancing.

15. Lending Rate For Subloans up to For Subloans aboveRs 2.5 million Rs 2.5 million

World Bank to GOP variable variableOn-lending rate to PCIs 9.00X 10.00XOn-lending rate to subborrowers 14.00X 14.00%

-52-ANNEX 4Page 5 of 11

16. Amortization Period

(a) For repayment to GOP by 12 years inclusive of 5 yearsparticipating banks grace period.

(b) For repayment to banks by Minimum 3 years to maximumborrowers 10 years, inclusive of up to

two years' grace period inequal quarterly/half-yearlyinstallments of theprincipal amount and theinterest accruing thereon.

17. The participating banks shall repay the principal amount of the loanmade available by Government of Pakistan in such instalments according to theprovisions of the Loan and Subsidiary Loan Agreements. However, if any bankdefaults in the performance of any of its obligations under this Agreement,GOP shall inform the World Rank of such default. After review of the circum-stances involved, the GOP may declare the bank concerned ineligible to par-ticipate in further financing under the credit and shall declare the wholeof the outstanding balance of the loan at the time of default to be repayableimmediately. Upon such declaration being made, the bank shall repay to GOPthe amount required to be repaid by the declaration.

18. Responsibility/Risk for Repayment of Subloan. The respective par-ticipating banks will bear the credit risk of all subloans regardless ofsource.

i1. Exchange Risk. Full exchange risk will be borne by the Government ofPakistan. Foreign exchange payment on import of machinery/equipment, etc.will be denominated in Pak Rupees by conversion of the bill of exchangeamount at the prevalent rate of exchange.

20. Bank Charges. The participating banks will be allowed to charge thefollowing from the subborrowers:

(a) Exchange and commission : According to their normal practice

(b) Project examination fee : 1/4 of 1X of the approved loan

(c) Documentation fee : 1/4 of 1X of the approved loan

(d) Commitment fee : 1/4 of .Z p.a. of the undisbursedamount commencing 3 months afterthe date of the sanction letter.

(e) Monitoring fee : In accordance with banks' TA/DA Rules.

21. Security. The matter of security for the subloan is left to thediscretion of the participating banks. However, the following isrecommended: (a) first mortgage of the entire fixed assets of the subproject(present and future); and (b) personal guarantees of the directors of aLimited Company.

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ANNEX 4Page 6 of 11

22. Procurement of Machinery. Machinery/equipment may be procured fromany of the member countries of the World Bank including Switzerland againstcash license from CCI&E. Local machinery will be procured from firms ofrepute. The participating banks will ensure that:

(a) the goods and services procured locally out of the proceeds of asubloan are purchased at reasonable and competitive prices, dueaccount being taken also of other relevant factors such as time ofdeliveryt quality, reliability of the goods and availability ofmaintenance facilities and spare parts thereof; and

(b) goods and services procured outside the territory of Pakistan andestimated to cost US$50,000 or more per item or US$100,000 or moreper contract shall be procured through international shopping on thebasis of at least three competitive price quotations.

23. Recycling of "redit Funds. Any funds repaid by the subborrowers butnot yet due for repayment to GOP may be utilized by the participating banksin granting loans to small industries meeting the eligibility criteria underthe Loan.

VI. PROCEDURE FOR PBC'S APPROVAL OF PROPOSALS FOR SUBWLOANS AND PROVISION OFREFINANCE

24. All disbursements for foreign or local expenditures made by theparticipating banks will be financed by the Covernment of Pakistan throughPakistan Banking Council, the administrator of the Credit, up to 60% of thesubloan amount. In order to obtain refinance from Pakistan Banking Council,the participating bank will submit to it the following: (a) a copy of theappraisal of the subproject to which the subloan has been provided; (b)evidence of a corresponding disbursement by the participating bank in respectof the subloan for which the authorization has been sought; (c) a certificateto the effect that the provincial government's approval/clearance in respectof the project, if required, has been obtained; (d) a certification by theparticipating bank that procurement procedures referred to in the SubsidiaryLoan Agreement have been followed. PBC will not issue authorization fordisbursement of funds by way of refinance for expenditures financed out ofthe proceeds of a subloan if such expenditures shall have been made more than120 days prior to the receipt by PBC of the application for approval ofrefinancing of the said subloan; and (e) the disbursement of refinance by PBCto the participating banks will be governed by the above procedure and provi-sions of the Subsidiary Loan Agreement and the Loan Agreement.

25. Revolving Fund. Under the institutional arrangements for theproposed World Bank Loan, the Pakistan Banking Council will have a revolvingfund and the World Bank will advance a sum of US$4 million from the proposedLoan to create the revolving fund as soon as the Loan is declared effective.The PBC will usa this fund to accommodate the refinancing needs under theproposed project. The rationale for maintaining this minimum balance is thatin case of unusual delay in replenishment, this cushion will be used formeeting the refinancing needs of the participating banks during the interimperiod. In the meantime, PBC will provide details of the cases financed tothe World Bank for reimbursement.

-54-ANNEX 4Page 7 of 11

26. Procedure for Obtaining Refinance from the Pakistan Banking Council.The procedure to be followed for obtaining refinance from the PakistanBanking Council on disbursement of a part or whole of a subloan will be asunder:

(a) The participating banks will send their cases to PBC for refinance ona fortnightly basis on every alternate Thursday. The request forrefinance shall be accompanied by: (i) a promissory note payable ondemand made in favor of Government of Pakistan in respect of theamount of the refinance required; (ii) certification by the par-ticipating bank that the expenditure for which refinance is claimedas has been made and that appropriate documentation in respectthereof is retained by the bank; and (iii) a certification by thebank that procurement procedures referred to in the Loan Agreementhave been followed.

(b) On receipt of the request from the bank accompanied by the abovementioned documents, PBC will reimburse the amount within seven daysfrom the date of receipt of the request at 50% of the subloan amountto the bank concerned.

27. Closing Date for Disbursement of Refinance. Applications forapproval of subloans and requests for reimbursement of funds (refinance)shall be submitted to Pakistan Banking Council on or before 9/30/1991. Theclosing date of the credit will be 12/31/1992.

VII. PARTICIPATING BANKS' LOANING PROCEDURE

28. Loan Application. The designated branches will obtain loan applica-tions from the intending borrowers under the project on the prescribedapplication form. The branch manager will ensure that the application formhas been properly filled in and all the requisite information/papers havebeen submitted by the applicant. On receipt of the application from thebranches on the prescribed form together with the supportinginformation/papers, the officer/ executive in-charge of the SSID in theZonal/Circle Offices will evaluate and scrutinize the proposal.

29. Purpose of the Loan. Subloans will be utilized for the financing ofenterprises engaged in manufacturing, repair, processing, industrial servicesor agro-processing. Preference, however, will be given to those projects inthe private sector which conform to the Government of Pakistan InvestmentSchedule having following special features:

(a) export oriented and/or efficient import substituting projects;

(b) agro-industries like manufacturing of agricultural implements; and

(c) industries based on locally available technical know-how, skills,machinery and spares, and raw materials.

30. Project Evaluation Criteria. Only economically viable projects willbe eligible for financing. In determining the viability of projects, thefollowing criteria, among others, will be kept in view:

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ANNEX 4Page 8 of 11

(a) Technical Feasibility

Technical feasibility means the suitability of the manufacturingprocess, the overall engineering viability of the project and theavailability and sufficiency of raw materials, labor, machinery andequipment, managerial and technical capability.

(b) Financial Feasibility

(i) Debt/equity ratio. The total long-term debt inclusive of theproposed World Bank loan should not exceed 70% of the sum oflong-term debt and equity;

(ii) Return on investment. Projected income must show reasonablereturn on investment. In case of subprojects involving loanamounts over Rs 3.0 million, the internal rate of return is to becalculated while in other cases involving loan amounts up to Rs3.0 million, the accounting rate of return (net profit divided bytotal net assets) for a period of four years is to be calculated;and

(iii) in addition, production costs as well as proposed selling pricesmust be reasonably competitiie with alternative source of supply.

(c) Economic Feasibility

(i) Foreign exchange savings and earnings. The project is to con-tribute to the reduction of trade imbalance through the manufac-ture of export-oriented and/or import substitution goods;

(ii) Regional dispersal of investment. The participating banks shallaim at an equitable distribution of credit funds among theprovinces and other areas;

(iii) Employment generatione Priority is to be given to labor-intensive projects with Rs 0.20 million project cost per job;

(iv) Equitable distribution of income. To spread the benefits of thecredit to as wide a base as possible;

(v) Conformity with overall economic policies. The project should beconsidered in relation to the National Five-Year DevelopmentPlan;

(vi) In addition to the above, the project components should havecomplied with the existing requirements of other governmentagencies, e.g., pollution control, social security, labor laws,etc.; and

(vii) For subloans over Rs 3.0 million, the participating banks will berequired to calculate domestic resource cost (DRC) as a measure-ment of economic viability.

-56-ANNEX 4Page 9 of 11

31. Prior Clearance of Provincial Government. The participating bankswould ensure that prior clearance of the respective provincial government,if required, has been obtained regarding the location and sponsorship of theproposed subproject.

32. Procurement of Assets-Procedure. Each participating bank will ensurethat the procurement procedure referred to in the Subsidiary Loan Agreementis followed and the purchase prices quoted are reasonable, competitive andconsistent with the prevailing market prices.

33. Eligible Expenditures. The eligible expenditures will be fixedassets in the form of building, machinery, equipment and working capital.Working capital will be eligible for financing only for the permanent workingcapital portion of a project and only when part of a fixed investmentsubloan. This should be considered taking into account the feasibility,profitability and the optimum production cycle of the project. The permanentworking capital will be payable as part of the fixed loan.

34. Cost Per Job. A subproject should be labor-intensive with fixed costper job (excluding land) of Rs 0.20 million. The fixed cost per job shouldbe calculated by dividing the fixed cost with number of jobs created(employees). Subprojects vith investment cost per job exceeding Rs 0.20million could be financed on an exception basis, if they are shown to havestrong economic merit in which case a domestic resource cost ratio (DRC)would be calculated.

35. The Zonal/Circle Executive will ensure that each subloan applicationhas been thoroughly scrutinized and is complete in all respects. Thereafter,for proposals involving loan amounts up to Rs 3.0 million, form SSI-I shallbe filled in by the bank. In case of proposals involving loan amounts ofover Rs 3.0 million, form SSI-II shall be filled in by the bank. This dis-tinction has been made for the use of Forms SSI-I and SSI-II. There will,however, be no "Free" and "Above Free" limits. The Zonal/Circle Office willforward the loan application together with the relevant form (SSI-I or II)duly filled in and other relevant documents/papers/data to the SSID, HeadOffice/Circle Office.

36. Maintenance of Subloan Proposal Register

(a) At Zonal/Circle Offices. All subloan proposals shall be entered intoa register to be maintained at the Zonal/Circle Offices. Date-wisefull particulars of each loan application will be recorded. Thisregister will also contain columns to record the disposal instruc-tions of the Zonal/Circle Executive and the SSID, H.O., concerning aparticular subloan application.

(b) At Head Offices. Likewise, subloan applications received by theSSID, B.O., will be recorded in register as mentioned above,processed accordingly and submitted to the Pakistan Banking Councilfor obtention of refinance.

37. Reggment of Subloan. The subloans are term loans payable in instal-ments within a period of a minimum 3 years to a maximum 10 years, inclusiveof up to two years grace period. Repayment will start from the data An nor

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ANNEX 4Page 10 of 11

specified schedule drawn at the time of approval of subloan considering themerits on case to case basis.

38. Recovery of Interest by the Banks. The banks will charge interest onsubloans including permanent working capital at 142 on quarterly rests asusual. The interest to the Government of Pakistan will be paid semi-annuallyon June 30 and December 31.

39.* Security Documentation. Subloans will be secured againstsecurities7margins as specified by SBP under Small Loan Scheme consideringthe proposal on case to case basis. However, branches will ensure thatsubloans will be disbursed only after obtaining the charge documents andcompleting all the formalities regarding security.

40. Operational Procedures - Obtention of Refinance. In terms of theoperational policies and procedures laid down under World Bank Loan, the SSIDof each bank will obtain funds from Government of Pakistan through PakistanBanking Council and show it as borrowing under the Vorld Bank Loan. Eachparticipating bank will maintain a credit register which will contain detailsof the refinance obtained from Government of Pakiscan through the PakistanBanking Council such as: date of availment, due date of payment ofinstalments, due date of payment of interest, and the date of repayment ofthe subloan.

41. Reporting Requirements. The Pakistan Banking Council, asadministrator of the credit, will monitor the progress of the credit and itsimpact on the economy. For this purpose, the participating banks will submitperiodical progress reports on commitments, disbursements, collections andarrears under the project to PBC at such intervals as would be fixed by itwhich, in turn, will consolidate the report for transmittal to the WorldBank. The participating banks will also provide relevant information as performs listed below: (a) half yearly report by subborrower (Form PB-1); (b)half yearly statement showing cumulative position of loan applications (FormPB-2); (c) half yearly statement of loans approved/disbursed (Form PB-3); (d)half yearly statement showing the position of loans disbursed (Form PB-4);(e) half yearly statement showing cumulative position of approvals, disburse-ments and outstandings (Form PB-5); (f) half yearly statement showing thecollections (Form PB-6); and (g) half yearly statement showing arrearages(Form PB-7).

42. Accounts and Audits. The participating banks will maintain properaccounts for subloans and documentation on procurement decisions,disbursements, performance and repayment records. These accounts will beaudited annually according to current practices.

43. Project Supervision. The end-use supervision of subprojects financedunder the Loan shall be made by the participating banks. The progress andoperations of the project shall be monitored by the banks through visitsand/or collection of relevant data at regular intervals. In case of failureor problems faced by the financed projects, the Zonal/Regional Office of thebank responsible for supervising the subproject shall adopt remedial measuresin consultation with its Read Office.

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ANNEX 4Page 11 of 11

44. Mandatory Credit Target and the Credit Ceiling

(a) The refinance obtained by the banks from GOP would be counted asliability of the bank for purposes of maintenance of statutory cashreserve and liquid assets.

(b) All subloans to be extended under World Bank Loan for smallindustries will be counted towards the credit ceiling, which willbe effected from the date of the grant of the subloan till the datethe banks get reimbursement from the Government of Pakistan.

(c) All subloans extended under the World Bank Loan will be countedtowards the achievement of mandatory credit targets fixed by the SBP.

VIII. SMALL SCALE INDUSTRIES DEPARTMENT OF THE PCIs

45. The SSI Departments at Head Offices of the participating banks willhove the following minimum staff:

1. Head of the Department/Division One2. Manager SSID-IDA One3, Credit Analyst One4. In-charge End-Use One5. Engineer One6, Economist One7. Administrative Officer OneS. Others One

The S8I Cell at the Circle Offices will have the following strength of staffto cope with the work.

1. Financial Analyst One2. Engineer One

46. Training. PBC will organize training for the officers of pa:ticipat-ing banks in SSI project appraisal and supervision methodology. The trainingwill be conducted locally with the assistance of local training institutions.In case of senior officers, the training will take the form of overseason-the-job training with leading development financial institutions, etc.The costs of such training will be financed by the World Bank, but localcosts will be borne by the participating banks.

IX. COORDINATION WITH THE PROVINCIAL SMALL INDUSTRIES CORPORATIONS/BOARD (SIC)

47. The provincial small industries corporations/board provide technicalassistance to SSI in terms of project identification and promotion, projectpreparation, training and extension services. The participating creditinstitutions should take steps to coordinate their $8SI lending activitieswith the SICs with a view to assisting their clients who are in need of theSIC services. At the national level, close coordination between the SICs andthe PCIs would be maintained under the auspices of PBC through regular meet-ings and exchange of information.

-59-ANNEX 5Page 1 of 3

PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

Draft Policy and Strategy Statement for the Technical Assistance Fund of EPB

Introduction

1. Pakistan's export sector is highly fragmented with a multitude ofsmall export companies and high concentration in a few product areas. As aresult, Pakistan's exports have been constrained by an inability to exploiteconomies of scale in foreign marketing. Poor marketing practices and inade-quate commitment to long-term export development have characterized mostexport activities. The successful experience of East Asian countries indeveloping export houses suggests that a similar strategy, adapted toPakistan conditions, can serve as a catalyst in rationalizing and generallyupgrading the export sector. In reference to the Korean Model, for example,significant differences in the current export environment of both countriescan be identified: (i) Korea exports a wide range of products through a fewernumber of well organized companies; (ii) Korea demonstrates a high degree ofinteraction between public and private sectors for export promotion andbetween large and small firms through supply and subcontracting arrangements;and (ii) the Korean private sector is supported by effective and extensiveoverseas trade representation by government. Under the Export DevelopmentLoan, the Bank is addressing policy issues related to the export incentivesystem and providing assistance in improving the administration of thegovernment export program. Under the Third Small Industries Project, this TAcomponent for the promotion of export houses intends to complement theseinitiatives on the policy and administrative fronts with efforts to developthe marketing infrastructure.

Objectives

2. As a TA component of the Third Small Industries Project, the Bankwould provide a Technical Assistance (TA) Fund for Export Houses in theamount of US$l million. This would be passed on by GOP to EPB and the par-ticipating export houses as a grant. The fund wi.l be used by the par-ticipating export houses for the following purposes:

(a) to train export house executives in effective management and opera-tions of an export house;

(b) to assist the export houses in market research and promotionalactivities aimed at target markets; and

(c) to provide advisory services from successful foreign export housesfor the development of Pakistan's export houses under this scheme.

Technical Assistance Program

3. Participants. The Export Promotion Bureau (EPB) will be responsiblefor the administration and monitoring of the TA Fund. Both the EPB and theexport houses under the project will require foreign consultancy services to:

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(i) establish the monitoring system and to train staff of EPB in promotingexport houses and monitoring their performance, including their suppliers;and (ii) assist the export houses in planning, organization and initialoperations. The TA Funds would ae allocated under the following guidelines:

Amount (USQ) Consultants

(a) Export Promotion Bureau 60,000 6 months atUS$10,000/month

(b) Export Houses Training 300,000 About 6and Management Development man-months per

export house

(c) Market Research, Market Planning, 300,000 On a project toproject basis

(d) Promotional Activities in 340,000 Project basisTarget Markets

TOTAL 1,000,000

4. Training: The training component would include provisions for con-sultants (up to a six-month period) for training Pakistani management in theorganization and mar.agement of a trade house, the development and installa-tion of a corporate plan, and a short training program, where necessary, in amedium-size foreign general trading company.

5. Market Research. Each export house would be assisted in undertakingmarket r'search in target markets, developing the correct approach to sellingand providing a basis for new product development and changes in marketdemand specification.

6. Promotional Activities. These include marketing activities requiredby the export companies in their effort to penetrate the U.S. market includ-ing the costs of trade fair participation, sales literature, advertisementand public relations.

Procedures

7. Applications. All participating export houses are eligible for thetechnical assistance. An export house should plan its developmental require-ments over a three-year period in the form of training, market research andpromotional activities; these plans would be the basis for their applicationto EPB for the TA fund.

8. Appraisal. The EPB, with the assistance of its project consultant,would evaluate the proposal submitted by each export house, particularly withreapect to the feasibility of the firm's development program over a three-year period and the availability of the counterpart funds of the export houseto cover 50Z of costs. The time frame and the order of magnitude would varydepending on the export products and the marketing strategy.

9. Approval. Applications approved by EPB should be submitted to theBank for final authorization. Upon approval by the Bank, a formal letter of

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approval including the terms of approval and tthe procedure for disbursementwill be issued to the applicant by EPB.

10. Disbursement. The disbursement will be administered by EPB. Thedesignated disbursement officer of EPB would maintain a separate file foreach export house. Claims for payment against a particular approval will bemade under the signature of the General Manager of an export house and willbe accompanied by supporting documents.

11. Monitoring. The project consultant to the EPB would design themonitoring system, by which the EPB would monitor the performance of eachexport house and the TA Fund disbursement. The monitoring system would coverthe following elements: (i) disbursements approved, (ii) disbursementsactually made to each export house, and (iii) export performance and overseasmarketing activities of each export house. The PB8's report containing ananalysis of the information generated by the monitoring system would be sentto the Bank for review, semi-annually.

\K '*-62-

ANNEX 6Page 1 of 3

PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

DriftE licy and Strategy Statement for the Technology & Productivity Fund

'' Sckground. It is generally accepted that the most importantmeshdaresJfor improving the technical capabilities of industrial enterprisesin Pakistan are matters of policy. Reduction of protection from external andioternal competition is a central policy measure; this would encourageindustrial enterprises to improve technology and productivity to be competi-tive in product quality and price. Industrial policy reform is being pursuedby GOP with Bank assistance under industrial sector and export developmentprojects. Complementing policy reform, the purpose of the Technology andProductivity Fund (TPF) is to develop institutional arrangements which couldsupport the technical development of industrial enterprises, particularly ofsmall and medium scale enterprises.

2. There are two main sources of technology for the industrial sector inPakistan: foreign companies outside the country and technical institutionswithin the country. While larger firms have access to the technology offoreign companies, smaller enterprises as a group, find it more difficult andhave to depend on intermediaries, i.e., machinery suppliers and local techni-cal institutions, to acquire technology. By and large, the marketing ofmachinery and equipment (hardware) in the country is reasonably efficientwith the existence of many indentors and agents representing a variety offoreign suppliers. The weakness lies in the provision of technical services(software) required to enable industry to master, adapt and improve upontechnology supplied by the hardware.

3. In Pakistan there are several public sector technical institutionswhich are supposed to provide private industry with software for technologyand productivity improvements. The quality of these institutions, however,is suspect, since they have had little contact with private industry, havebecome largely "academic" and supply-oriented and have a poor image amongprivate industrialists. Moreover, due to permanent constraints in staffingand funding, many of them have little to offer private industry in terms oftechnology updating.

4. Objective. To develop alternative sources of technical services inthe private sector and to generate demand-oriented technology and produc-tivity upgrading proposals, the TPF would provide through the three largestdevelopment finance institutions (DFI), namely NDFC, PICIC and IDBP, partialgrants to private industry for the financing of eligible and viable "technol-ogy subprojects" such as technical consulting services, technical trainingprograms and technical collaboration packaging which either introduces newtechnology or improves an existing one in private industry.

5. Elgibility Criteria. Firms eligible for assistance would be manufac-turing enterprises which are existing clients of the DFI concerned. Prioritywould be given to firms with past export performance and to companies engagedin the manufacture of machinery and equipment whether for the local or exportmarket. Focusing assistance on these enterprises would improve export com-

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ANNEX 6Page 2 of 3

petitiveness of exporting enterprises and would have a broad technologyimprovement impact on user industries of the capital goods manufacturers.

6. Eligible Activities. Activities which would be eligible for costsharing under the TPF would include:

(a) Productivity Consultants and Technicians to assist in analyzing andimplementing: i} cost reduction and quality improvement moves whichfirms could make with or without additional fixed investment butwhich would increase sales volume with a focus on improving materialhandling, processing methods and tooling to increase productionefficiency and achieve consistent quality; (ii) choice ofprocess/product technology which would be compatible with a sig-nificant expansion in exports to more demanding markets; (iii) set-ting up of Productivity Cells with specific work plans and withmeasurable achievements on projected yields and quality ofproduction; or (iv) shared R and D effort to increase productionefficiency.

(b) Supervisor Training. Trainers and materials to develop and implementsupervisor training in formal sessions and on the shop floor toimprove the efficiency and effectiveness of supervisory functions,and enable needed improvements in productivity and technology.

(c) Design and Product Adaptation. Consultancy and small material orcapital expenditures to undertake design and product adaptation inresponse to identified market opportunities at unit level or throughgroup cooperation and action.

(d) Exposure to plants in competing countries and to other factoriesoperated with foreign collaborators to tap the strong capabilitiesamong Pakistani manufacturers to adapt appropriate production prac-tices of others.

(e) Workshops, seminars and firm level work by potential collaborators orinstitutions which see potential for expanding under exports, withsuch exercises directed at productivity and technology improvement.

(f) Expenditure not exceeding US$25,000 incurred on: (i) acquiringdesign/process know-how; (ii) R&D, especially of developmental naturewith a view to adapting product to export demand; (iii) prototypeimport; and (iv) jigs, fixtures and tools.

7. Eligible Expenditures. Eligible expenditures would be for 50% ofcosts of consultancy services, training, productivity studies and smallequipment and materials. The other 50% would have to be contributed by theapplicant enterprise or group of enterprises. Initially, the subprojectswould emphasize assignments which deal with simple and practical technologyand productivity improvements that can be implemented with little or noinvestment outlay by clients. Recommendations should be easily implementableand their benefits and impact readily quantifiable and realizable in theshort term. As experience under the Fund grows, more complex assignments canbe considered.

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Page 3 of 3

8. Implementing Arrangements. The three largest DFIs in Pakistan,namely NDFC, PICIC and IDBP, would be the implementing agencies for thiscomponent. A technology and productivity fund of US$0.5 million will beplaced in each of the DFIs. The DFIs would be responsible for promoting thefund, soliciting proposals from private industry, appraising the eligibilityand viability of each subproject, submitting approved proposals for Bankapproval, disbursing the funds and supervising the subprojects. The NationalCenter for Technology Transfer (NCTT) a government agency under the Ministryof Science and Technology, would be responsible for a semi-annual operationsaudit of the fund, documentation of the experience and a detailed cost andbenefit study at the completion of the project.

9. Funding. The Bank would provide US$1.5 million for the technologyand productivity fund. Normally, Bank financing would cover 50% of sub-project costs with the balance to be paid by the sponsoring privateenterprise. It is estimated that these subprojects would involve about 100person-months of foreign consultancy at US$10,000 p.m. an,' another 100person-months of local consultancy at US$5,000 p.m., respectively. However,cost sharing would be treated initially on a case by case basis and would bereviewed after some experience has been gained. Out of the US$1.5 million,the Bank would also provide NCTT with funds to cover its monitoring costs forthree years, estimated to be US$45,000.

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ANNEX 7

PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

Estimated Schedule of Disbursements a/

IBRD Fiscal Year Semi Annually Cumulative

1988 July-December 2.2 2.2

January-June 3.8 6.0

1989 July-December 5.3 11.3

January-June 7.1 18.4

1990 July-December 6.4 24.8

January-June 5.4 30.2

1991 July-December 4.4 34.6

January-June 3.7 38.3

1992 July-December 3.3 41.6

January-June 3.2 44.8

1993 July-December 2.7 47.5

January-June 2.2 49.7

1994 July-December 1.6 51.3

January-June 1.6 52.9

1995 July-December 1.1 54.0

a/ Assuming Board presentation in June 1987.

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PAKISTAN

THIRD SMALL INDUSTRIES PROJECT

Documents Available in Project File

A. General

1. Feasibility Studies Based on the Agricultural and Mineral Resourcesof Baluchistan, IACP, 21 volumes.

2. Study on Small Scale Industries, GOPA Consultants, 11 volumes.3. Industrial Policy Statement, Ministry of Industry, June 1984.4. Investment Incentives and Opportunities in Pakistan, Ministry of

Industry, November 1985.5. National Accounts of Pakistan (Product and Expenditure), PBS,

Nay 1985.

B. Subloan Component

1. An Analysis of Banks Balance Sheets, Grindlays Bank, 1984.2. Annual Report, State Bank of Pakistan, 1984-85.3. Annual Report, ABL, 19854. 38th Annual Report and Accounts, MCB, 1985.5. Annual Report, HBL, 1985.6. Annual Report, NBP, 1985.7. Annual Report, UBL, 1985.8. Annual Report, IDBP, 1985.9. Government-Sponsored Corporations, Ministry of Finance, 1983-84.10. Some Thoughts on Non-Interest Banking in Pakistan - Concepts,

Practices and Possibilities, by Abdul Jabbar Khan, President NBP,Nay 1985.

11. Growth of Pakistani Banking, MCB, June 20, 1982.12. Charter for Improving the Performance of Nationalized Commercial

Banks, PBC, unpublished report.

C. Promotion of Export Houses

1. Plans and Performance. Export Promotion Bureau. January 1983 -June 1985.

2. Pakistan's Export of Principal Commodities for the Year (July-June1984-85). Export Promotion Bureau, 1986.

3. Import and Export Policy, 1985-86, (Vol. II), Ministry of Commerce,1985.

5. Federation of Pakistan Chambers of Commerce and Industry, AnnualReport, 1983-84, FPCCI, 1985.

D. Technology Transfer Program

1. National Centre for Technology Transfer, undated.2. Pakistan Industrial Technical Assistance Centre, undated.3. Institutional Infrastructure Building of National Centre for

Technology Transfer, NCTT, February 1986.4. Annual Report 1984-85, PCSIR.

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ANNEX 8Page 2 of 2

5. Pakistan Council of Scientific and Industrial Research, February 1986.6. PCSIR Processes in Commercial Production, PCSIR, February 5, 1985.

E. Improvement of SSI Sector Statistics

1. Census of Manufacturing Industries, 1980-81. Federal Bureau ofStatistics, January 1984.

2. Survey of Small and Household Manufacturing Industries, 1976-77.Federal Bureau of Statistics, March 1982.

3. An Informal Note of the Need for Technical Assistance. FederalBureau of Statistics. March 20, 1986.