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Document ofThe World Bank

Report No: 1 8083-PH

PROJECT APPRAISAL DOCUMENT

ONA

PROPOSED LOAN

IN THE AMOUNT OF US$150 MILLION

TO THE

DEVELOPMENT BANK OF THE PHILIPPINES (DBP)

FORA

PRIVATE ENTERPRISE CREDIT SUPPORT PROJECT

October 26, 1998

Private Sector Development UnitEast Asia & Pacific Region

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CURRENCY EQUIVALENTS(Exchange Rate Effective May 31, 1998)

Currency Unit = Peso (P)US$1 = P39.00

PI = $0.026

FISCAL YEAR

January I - December 31

ABBREVIATIONS AND ACRONYMS

ADB Asian Development Bank GSIS Government Service Insurance SystemBSP Bangko Sentral ng Pilipinas/ Central JGF Japanese Grant Facility

Bank of the Philippines ICR Implementation Completion ReportCAR Country Assistance Review IFC International Finance CorporationCAS Country Assistance Strategy IICP Industrial Investment Credit ProjectCOA Commission on Audit IRP Industrial Restructuring ProjectDBP Development Bank of the Philippines KfW Kreditanstalt fir WiederaufbauDENR Department of Environment and Natural LOC Line of Credit

Resources ODA Official Development AssistanceDOF Department of Finance OECF Overseas Economic Cooperation FundECAs Export Credit Agencies OED Operations Evaluation DepartmentEIA Environmental Impact Assessment OPG Operating Policy Guidelines of DBPEKB Expanded Commercial Bank or Unibank PDIC Philippines Deposit Insurance Corporation

or Universal Bank PECSP Private Enterprise Credit Support ProjectEMB Environmental Management Bureau PFIs Participating Financial InstitutionsERL Economic Recovery Loan PNB Philippines National BankFRR Financial Rate of Return SME Small and Medium EnterprisesFSAL Financial Sector Adjustment Loan SSS Social Security System-GFIs Government owned Financial T-Bill Treasury Bill

Institutions TTA Training and Technical AssistanceGOP Government of the Philippines

Vice President: Jean-Michel Severino, EAPVPCountry Director: Vinay K. Bhargava, EACPFSector Manager: Hoon Mok Chung, EASPSTask Team Leader/Task Manager: Zafar Shah Khan, EASPS

PhilippinesPrivate Enterprise Credit Support Project

CONTENTS

A. Project Development Objective .................................................................. 2

1. Project development objective and key performance indicators .................................... 2

B. Strategic Context .................................................................. 2

1. Sector-related CAS goal supported by the project ......................................................... 22. Main sector issues and Government strategy ................................................................. 33. Sector issues to be addressed by the project and strategic choices ................................ 6

C. Project Description Summary .................................................................. 6

1. Project components .................................................................. 62. Key policy and institutional reforms supported by the project ...................................... 83. Benefits and target population . ................................................................. 04. Institutional and implementation arrangements ........................................................... 11

D. Project Rationale ............................................................... II

1. Project alternatives considered and reasons for rejection ............................................ I 112. Major related projects financed by the Bank and/or other development agencies ....... 123. Lessons learned and reflected in proposed project design ........................................... 124. Indications of borrower commitment and ownership .................................................. 135. Value added of Bank support in this project ........................................................... 13

E. Summary Project Analyses .......................... 13

1. Economic ...................... 132. Financial ...................... 143. Technical ...................... 144. Institutional ... 14................... 145. Social ...................... 166. Environmental assessment ...................... 167. Participatory approach ............................ 16

F. Sustainability and Risks ............................ 16

1. Sustainability ...................... 162. Critical risks ...................... 163. Possible controversial aspects ............................ 17

G. Main Loan Conditions ............................ 17

1. Effectiveness conditions .172. Other ...................................... 17

H. Readiness for Implementation ............................................ 18

I. Compliance with Bank Policies ............................................ 18

Annexes

Annex Ia. Project Design Summary .19Annex lb. Key Performances Indicators .20Annex 2. Detailed Project Description .22Annex 3. Estimated Project Costs .26Annex 4. Development Bank of the Philippines .27Annex 5. Procurement and Disbursement Arrangements .37

Table A. Project Costs by Procurement Arrangements .39Table Al. Consultant Selection Arrangements ................................. 40Table B. Thresholds for Procurement Methods and Prior Review .41Table C. Allocation of Loan Proceeds .42Table D. Procurement Plan .43

Annex 6. Project Processing Budget and Schedule .44Annex 7. Documents in Project File .45Annex 8. Status of Bank Group Operations in Philippines, IBRD Loans and IDA Credits

in the Operations Portfolio .46Annex 9. Philippines at a Glance .47

PhilippinesPrivate Enterprise Credit Support Project

Project Appraisal Document

East Asia & Pacific RegionPhilippines Department

Date: October 21, 1998 Task Team Leader/Task Manager: Zafar Shah KhanCountry Director: Vinay K. Bhargava Sector Manager: Hoon Mok Chung

Project ID: PH-PE-57624 Sector: PSD Program Objective Category: PV-Private Sector DevelopmentLending Instrument: Loan Program of Targeted Intervention: [ I Yes [x] No

Project Financing Data [x ] Loan [] Credit [] Guarantee [ ] Other [Specifyl

For Loans/Credits/Others:

Amount(US$m): 150.Proposed terms: [ ] Multicurrency [x] Single currency (US Dollar)

Grace period (years): 5 [ ] Standard [] Fixed [X] LIBOR-basedVariable

Years to maturity: 20Commitment fee: 3/4 of 1%

Financing plan (US$m): (Indicative only)Source Local Foreign Total

IBRD 150 150DBP/PFls 50 50Subborrowers 115 115

Total 165 150 315

Borrower: Development Bank of the Philippines (DBP)Guarantor: Republic of the PhilippinesResponsible agency: DBP

Estimated disbursements (Bank FY/US$M): 1999 2000 2001 2002 2003Annual 9.0 54.0 57.0 27.0 3.0

Cumulative 9.0 63.0 120.0 147.0 150.0

Financing available without guarantee?: [ Yes [] NoIf yes, estimated cost or maturity:Estimated financing cost or maturity with guarantee:

Project implementation period: Sept. 1998-June 2003 Expected effectiveness date: February 22, 1999Expected closing date: December 31, 2003

OSD PAD Form: July 30, 1997

A: Project Development Objective

1. Project development objective and key performance indicators (see Annex 1).

The project would augment long-term resources of DBP and, in turn, of a number of banks with the mainobjective of assisting private sector enterprises, particularly small- and medium-sized enterprises, affectedby the credit crunch and currency crisis. Enterprises would, thus, be able to implement their expansionand modernization plans, to undertake new projects, and to finance permanent working capitalrequirements. This would help them to alleviate their operational and financial problems and to takeadvantage of new opportunities created by recent economic developments. Consequently, enterpriseperformance, as measured by efficiency gains, profitability and export earnings, will improve.

The project will also aim at further institutional strengthening of DBP which would, overtime, be able toreduce its dependence on ODA and to mobilize funds from domestic and international markets.

Key performance indicators will be: (i) DBP will abide by BSP's the minimum capital adequacyrequirement and provision for bad and doubtful loans; (ii) DBP will prepare and implement a plan tobring down its past due loans to no more than the overall average for the banks in the Philippines withinthe next three years; and (iii) private enterprises to be financed under the Bank loan will meet the revenueand profit targets as given in the subproject appraisal reports to be prepared by PFIs. Output indicatorswill be: (i) PFIs start lending from the line of credit (LOC); (ii) enterprises have better financial resultsand debt-servicing; (iii) DBP's arrears on retail loans are brought down to the industry average; and (iv)DBP again start mobilizing long-term funds from the capital market without government guarantee.

B: Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project (see Annex 1):

CAS document number: 15362-PH (CAS) and R-98-41 (CAS Progress Report)One of the goals of last CAS (April 1996) was to improve private business environment. The recent CASProgress Report has recognized that despite the Regional financial crisis, the major policy changes asexpressed in the last CAS, and the strategic thrusts of the Bank' assistance strategy, remain valid withsome adjustments needed to respond to both the Asian financial crisis and the new opportunities inMindanao. One of these areas is the continiued assistance to enhance the country's internationalcompetitiveness through, inter alia, strengtlhening and deepening the financial system. According to theCAS Progress Report, the Bank's assistance will intensify in this area through technical assistance andquick disbursing loans, following up previous work on the banking and non-banking sectors. In addition,the Report has supported lines of credit for agriculture and industry. The urgency for this kind of lendingarises because of the sudden drying up of overall foreign capital (net inflow down from US$8 billion in1996 to less than US$1 billion in 1997) and massive drain of portfolio investment (outflow of US$3.5billion in 1997). The economy, and the private sector in particular, is starving for long-term investmentcapital. These operations are envisaged as a transitional measure, as the domestic medium- and long-termmarket develops, and as external confidence is restored.

OED's Country Assistance Review (CAR) of March 1998 has stated that the challenge ahead in thefinancial sector will be to continue supporting the process of rapid financial deepening, while maintaininga healthy and efficient system, and strengthening its resilience to the volatility of short-term capital flows.In the short time, a prolonged Regional crisis may require much greater involvement on the part of theBank in the Philippines' banking sector than hitherto expected. The Bank needs to be ready to help insuch an eventuality on the basis of a prior understanding with the govemment over the remaining policyand institutional reform agenda. CAR has further recomimended that, under the right macroeconomics andinstitutional environment as is expected to remain the case in the Philippines, there is a useful role for theBank in supplementing the supply of private (mostly short- and medium-term) credit with long-termfunds. Thus, the Bank should not consider financial intermediary loans taboo and should re-include themin its instrument menu.

2. Main sector issues and Government strategy:

The proposed project is a private sector development operation, which will be implemented throughfinancial intermediaries with the ultimate beneficiaries belonging mostly to broadly defined industrialsector. The following discussion of sectoral issues relates principally to the financial sector but the mainpoints relating to the industrial sector have also been brought out.

The Philippines'financial sector has come a long way in the last two decades, and the reforms andstrengthening that have been accomplished helped the country withstand the recent Asian financial sectorturmoil with much better resiliency as compared with some other countries in the region. In the 1980s, alarge number of thrift institutions and several commercial banks failed, and total assets in the bankingsystem contracted substantially in real terms; private sector credit contracted by 63%. Intermediationmargins were among the highest in the world. reflecting a lack of effective competition. Two of thelargest financial institutions, the Philippines National Bank and the Development Bank of the Philippines(DBP), both government-owned, became, de ifacto, insolvent. Even the central bank of the countrybecame technically insolvent because of accumulated losses, principally on account of bearing exchangerisk on large assumed foreign indebtedness.

The Government initiated financial sector reforms in the mid -1980s. The Bank has been activelyassisting the Government all along. The Economic Recovery Loan (ERL) was made in 1987, andconcentrated, among others, on restructuring and restoring solvency to PNB and DBP. The FinancialSector Adjustment Loan made in 1989 concentrated on the central bank's solvency, improvements in thebanking related legal framework, streamlining of the process of bank closures including the strengtheningof the Philippines Deposit Insurance Corporation (PDIC), and enhancing effective competition in thesystem. As a result of the reforms already implemented, the central bank has been reconstituted asBangko Sentral Ng Pilipinas (BSP) and solvency restored to it. It is now a more independent centralbank. In addition, the supervisory and regulatory system for the commercial banks has been considerablystrengthened. The deposit insurance institution, PDIC, is now an independent and autonomous body(instead of being, de facto, a department of the central bank under one of the Deputy Governors) workingin collaboration with BSP to minimize the costs of dealing with failing and failed banks. The bankingrelated legal framework is also much improved as a result of substantive amendments made to thelegislation relating to the central bank, commercial banks and PDIC.

The commercial banking system is now much more liberal and open. Compared with 27 commercialbanks in the late 1980s, there are now 54 banks operating in the country including 14 foreign banks.Banking system credit has grown at compounded annual growth rate of 34% over the last five years.During the same period, deposits have grown at an annual rate of 27%. A notable feature of bankingsector development in recent years has been the rapid growth of off-balance sheet activities, particularlytrust account business. Commercial banks dominate the financial system, accounting for 76% of theentire system in terms of assets (end of 1997). Overall, the commercial banking system is healthy with acapital to risk assets ratio of 13.4% (minimum regulatory requirement: 10%), and past dues decliningfrom 6.1 % in 1992 to 2.8% in 1996 before rising to 4.7% at the end of 1997 i.e. several months into theRegional currency and financial sector crisis. The profitability of commercial banking improvedsignificantly in 1994-96 after being flat earlier in the decade. In recent years, commercial banks' return onassets has averaged more than 2% and that on equity more than 18%. In the year ended December 31,1997, profitability deteriorated for understandable reasons, and the returns on average equity and assetsdeclined to 14.9% and 1.7% respectively. Sectorally, commercial banks' portfolio is quite diversified; thethree largest sectors are: financial institutions, real estate and business services; manufacturing; andwholesale and retail trade accounting for 31%, 27% and 15% respectively of total outstanding loans at theend of 1997.

The financial sector reforms undertaken by the Government in the last ten years or so also aimed torestructure and recapitalize PNB and DBP with a view to transforming them into viable institutions. ThePNB is now one of the largest EKB (Expanded Commercial Bank or Unibank or Universal Bank) and hasbeen partially privatized. The DBP, the borrower of the proposed loan, has successfully gone through atransformation and is now a different institution from what it used to be until mid-1980s. It was then ahuge government owned financial sector bureaucracy undertaking all kinds of projects at the behest of thegovernment. It was, de facto, a bankrupt institution. It is now a well functioning organizationundertaking wholesale banking, retail operations, and providing some other financial services. A moredetailed description and analysis of DBP is provided in Annex 4.

Interest rates were deregulated in the early phase of the financial sector reforms. For most part, interestrates are now market determined (except on certain small government directed credit schemes which stillcarry an element of subsidy) and the government intervention is limited and selective, confined to smallenterprises, low income housing and some agricultural programs. Such credit schemes, together,constitute a small proportion of total credit outstanding in the banking sector. It should be noted thatinterest rates in the Philippines have remained positive in real terms for a long time.

The capital market in the Philippines is relatively less developed as compared to other South East Asiancountries. Within the broad capital market, the equities market has grown much faster; the market infixed income securities is still in its infancy. Starting from a relatively small base, the stock exchangeexperienced rapid growth beginning in 1993 and saw some lively trading in the following years but itdeclined rapidly in 1997 from which it has yet to recover fully. To help the development of the capitalmarket, the Bank Group, ADB and some other bilateral agencies have been assisting the Philippines indeveloping new long-term financial instruments through securitization, establishing a new credit ratingagency, and drafting of a new securities law. At some point, the Philippines will also need to overhaul itscontractual savings schemes and the institutional arrangements therefor (i.e. the Social Security System(SSS) and the Government Services Insurance System (GSIS).

Despite the reforms already undertaken and the significant progress made, there is now a clear need forfurther reforms and actions. It is not that, in the past, the Government (and the Bank) took only halfhearted measures or showed lack of resolution during implementation. The recent CAR judged the 1989FSAL as "one of the most successful of Bank's financial sector operations anywhere." Financial sectorreforms are inherently a continuous process and, in the Philippines, the need for further actions arose alsofrom internal as well as external developments as a result of globalization of economies and markets,particularly given the openness of the Philippines' own economy. The Regional crisis and its impact onthe Philippines have raised concern with the commercial banks' capital adequacy, loan classification andprovisioning practices, deterioration in non-performing loans, effectiveness of on-site inspection and off-site monitoring, off balance sheet activities, lack of transparency, entry and exit requirements andmechanisms, liquidity in the system, and the availability of term credit. The Government, in consultationwith the Bank and the Fund, has initiated a number of reforms to address these issues and the proposedPhilippines Banking System Reform Loan of the Bank would focus thereon. The proposed PrivateEnterprise Credit Support Project is also a step in the same direction.

The recent Asian financial crisis has aggravated the already severe shortage of long-term debt capital. Upto early 1 990s, a principal source of long term debt capital for the private sector was ODA channeledthrough the government and later through DBP and LBP when all lending programs were transferred outof the government. In the last several years, with stable exchange and interest rates, commercial banksincreasingly used resources raised by themselves to make long term credit available to the private sector.The commercial banks even assumed maturity mismatclh and exchange risks in the process. Directforeign investment became another important source of long term capital. The Asian regional crisischanged the environment very quickly. With the sharp depreciation of the Peso and jump in interest rates,commercial banks were financially squeezed. The overall foreign capital flows dried up (net inflowdeclining from US$8 billion in 1996 to less than US$1 billion in 1997) and there was an outflow of

US$3.5 billion in portfolio investment in 1997. The result has been an acute shortage of long term capitalfor private sector development.

The industrial sector now accounts for 35% of GDP and is composed of manufacturing, construction,mining and quarrying, electricity, gas, and water. Manufacturing is by far the largest component,accounting for 70% of the industrial sector and 25% of GDP. Because of the events of the last quarter in1997, the overall growth of manufacturing slowed to 4% (in gross value added) in 1997 compared with5.6% in 1996. Some sub-sectors still showed vigorous growth e.g. electrical machinery which had agrowth of 30.8% reflecting the increased demand worldwide for semi-conductors.

During the last few years, there has been a gradual shift towards export based industries. This shift hastaken place both for traditional industries such as garments, footwear, food and agricultural processingindustries, and for the newer information and technology intensive sectors. Exports of manufacturedgoods grew at an average rate of 22.6% per annum during 1992-97. As a proportion of the total, exportsof electronics, electrical equipment and parts, and telecommunication equipment grew steadily from 28%in 1992 to 52% in 1997. This increase primarily reflects the high global demand for electronicscomponents. It also reflects the Philippine manufacturers' competitive performance as reflected incontinued strong exports in the very recent past when such exports slowed down from some othercountries in the region. However, the output and exports of traditional industries in recent periods havestagnated and, in the case of some sub-sectors, even declined. For example, the growth in the food sub-sector, which accounted for about 34% of the manufacturing sector in 1996, was drastically reduced toless than I% in 1997 from 6.6% in 1996. Other traditional sub-sectors with negative growth rates includetextile (-3.6%), basic metal (-4.5%), rubber ancl rbber products (-4.9%), and paper and paper products(-7.3%). These declines may be partly a result of changing emphasis (from East Asia to Latin America)on the part of the Philippines' largest market i.e. the U.S. Also, it seems that the Philippinesmanufacturers are falling behind in the needed restructuring and new investments particularly in the lightof relatively high minimum wages and the significant real exchange rate appreciation between 1990 andmid 1997. Even in the information and technology-based industries, which have so far fared very well,the problem is that there is heavy concentratiorn in semi-conductors. Potentially, there is a risk that thissector may migrate to lower wage countries with educated labor, which may be embarking on their firststep towards low technology/information age industrial development. What the Philippines needs now isto step up to higher level sub-sectors of information and technology-based industry.

The Philippines has gone through steady liberalization and deregulation of the economy in recent years.The deregulation of prices and entry into the downstream oil sector and privatization of certaininfrastructure facilities have enhanced the competitive environment. The entry and exit of corporateentities has also been facilitated. The Philippines has moved rapidly on tariff reforms in recent years andhas announced its intention to move to a uniform rate of 5 per cent by 2004 for nonagriculturalcommodities. The industrial sector, however, still remains highly concentrated and fragmented. Thereare large numbers of small, low-productivity enterprises accounting for a small proportion of total valueadded at one end, and a relatively few large enterprises dominating production at the other, with a dearthof medium-size firms. This is not most conducive for competitive new activities and enterprises. Whilepolicies are being reformed, there still seem to be gaps in the competitive regime and in its enforcement.SMEs face particular hurdles in accessing finance, information, technology and skills. The inadequateinfrastructure, particularly transportation, communication, and water supply, is another major constraintfaced by the industrial sector.

The Government is aware that the current environment presents tremendous opportunities as well aschallenges. It also recognizes the urgent need ito undertake new investments and industrial restructuringas part of the effort to enhance competitiveness. Its National Development Plan: Directions for the 21stCentury (Plan 21), emphasized the importance of market competition through further liberalization,deregulation and privatization. In particular, the Government proposes to promote the modernization ofthe industrial sector; continue industrial deepening and diversification; encourage the production of higher

value added products and services; continue the implementation of reforms aimed at trade and investmentliberalization; and enhance the competitiveness of the Philippines as an investment site. These would beachieve through policies that will (a) strengthen the country's macroeconomic fundamentals and ensuremacroeconomic stability and sustained growth; (b) continue the re-orientation of the industrial sector toglobal competition; (c) improve further the investment climate to reduce the cost of doing business; and(d) encourage strong institutional and infrastructure support structures and expanded public-private sectorcoordination.

3. Sector issues to be addressed by the project and strategic choices:

In the wake of the Regional financial crisis, the paucity of long term capital for investment has beenexacerbated because of drying up of the direct foreign investment and massive withdrawal of portfolioinvestment. The proposed project will directly ease this capital shortage particularly for the privatesector, by immediately making available US$146.0 million equivalent in long-term funds for investmentpurposes. The project also supports government policy objectives and priorities by providing long termcapital for private sector development without which industrial deepening, restructuring anddiversification would not be achievable. It is also relevant to note that the Bank is currently conducting anenterprise survey in the Philippines; its results to be available later in the year will also be helpful to DBP,PFIs and the prospective final borrowers in pin-pointing the specific problems being faced by differentsubsectors and suggesting the actions needed to solve these problems.

By the strategic design choice of lending to DBP to qualified PFIs to ultimate industrial borrowers, theproject would ensure proper evaluation and selection of investment projects so that maximum benefit isderived from the new investments. This specific project design would also enable the Bank to help DBPdetermine and embark on its long term goals. One of the principal aims in this regard will be to enableDBP in the future to raise long-term capital from the market without government guarantee. A sum ofUS$4 million is included as TA component in the Bankc loan to support DBP's future institution-buildingwhich would directly or indirectly help achieve the above objective.

C: Project Description Summary

1. Project comnponents (see Annex 2for a detailed description and Annex 3for a detailed costbreakdown):

C.omponent Category Cost Incl. % of Bank- % ofContingencies Total financing Bank-- (US$M) (US$M) financing

Line of Credit Credit 309.0 98.1 146.0 97.3Technical Assistance for DBP's Institution- 6.0 1.9 4.0 2.7Institutional Development building

I__ _ Total 315.0 100.0 150.0 100.0

The main project component is the line of credit (LOC). It would be onlent by DBP to eligible enterprisesthrough participating financial institutions (PFIs). The project will focus on the industrial sector but viableprivate sector projects in other sectors like utilities, power and telecommunications will also be eligiblefor assistance provided these have a strong linkage to manufacturing, and located in the country-side andwould significantly contribute to the provision of essential services, not currently available. There are nomore price controls and quantitative restrictions on industrial subsectors except for the meat and meatproducts subsector which still has excessive protection and will not be financed under the project.Furthermore, those enterprises which require regulatory and/or other non-financial support/adjustment,will not be financed until such changes have been implemented or made a part of subprojectconditionality.

As in the case of IRP (the last Bank loan to DBP), all lending rates will be market based, variable, anddenominated in Peso. DBP will be free to negotiate its onlending rates to PFIs which will, in turn, be free

to negotiate their lending rates to the ultimate corporate borrowers. It is expected that DBP's onlendingrate to PFIs, ar.i PFIs' lending rate to the ultimate corporate borrowers, would start taking into accounttheir relative financial strength and other risk factors and, therefore, would vary from PFI to PFI or fromone corporate borrower to the other in the case of lending by PFIs. In an environment of open exchangeregime and market based interest rates, this methodology would result in a competitive pricing of Bankfunds both at the PFIs and ultimate borrowers levels.

In the absence of market availability of long term funds, the proxy of the rate on the most commonly usedinstrument in the market (91-day T-bill rate) will be used to determine the cost of Bank funds to DBP.The Bank loan will be priced out to DBP based on the weighted average interest rate (WAIR) of 91-dayT-bills for the first three weeks of the month prior to the period, and the rate will be recalculated andrefixed on a monthly basis to ensure close-to-market pricing of new loans, although once loans areestablished, they would normally be reset quarterly. The difference between DBP rate and the Bank'slending rate will accrue to GOP as the guarantee fee (1%) and the fee for providing the foreign exchangerisk cover.

While the subloans will be at variable rate as is the market practice, a one time option to convert thesubloans into fixed rate will be allowed to the sub-borrowers. In the absence of a well developed marketin commercial (or even government) paper of varying maturities which would indicate fixed rate premiumover variable rate, a committee will be set up (with representatives from DOF, DBP and LBP who mayco-opt a technical expert as the fourth member) to determine, on a quarterly basis, the conversionpremium. During negotiations, an agreement was reached with the Government and DBP on the policyapplicable to onlending rates and the fee for foreign exchange risk coverage under the proposed loan.

In order to ensure that the loan is made available to a large number of enterprises, a maximum subloanlimit for an individual company will be US$8 million equivalent; in the case of loan syndications, themaximum subloan will be US$15 million. The free limit (the limit above which Bank's prior approval ofa subloan is required) will be US$8 million for all subloans (as under IRP). Bank loan proceeds wouldalso be available to enterprises for the preparation of their restructuring plans and export studies. Alleligible subprojects will have a minimum FRR of 15 per cent. Detailed onlending terms and eligibilitycriteria, that will be largely consistent with IRP, are given in Annex. 2.

The second project component is DBP's institution building. In the last ten years since the Bank becameactively involved in DBP's restructuring and transformation (in the context of the Economic RecoveryLoan, 1987), the DBP has already come a long way, to a point where it is no longer the old insolventinstitution financing all kinds of government behest projects. It is now a major, solvent, financialinstitution in the country providing a range of financial services. However, given the rapid evolution ofthe financial sector since then and particularly in view of the recent Regional financial crisis, the DBP isnow once again embarking on a major course adjustment, and the Bank will be providing institutionbuilding assistance in the context of the proposed project. The institution is currently in the process ofdefining anew its role and niche in the Philippines financial sector. Whatever the corporate role andstrategy, the aim is to make DBP financially and institutionally strong enough to be able ultimately toraise all required resources independently (without government guarantee) and hedge foreign currencyrisks without government assistance. The Bank's institution building effort will be focused on helpingDBP undertake the following critical actions:

(i) define its long term role and strategies to achieve the goals;(ii) undertake an in depth review of its portfolio and financial condition as a part of annual

audit to be carried out with the assistance of internationally reputed experts/auditors;(iii) devise a scheme to hedge foreign exchange risk in a satisfactory manner;(iv) improve its loan recoveries;(v) convert its existing computer systems to make them Year 2000 compliant;

(vi) strengthen the Treasury functions of DBP through the use of modem computer hardwareand software for information management and analysis; and

(vii) prepare and implement a comprehensive staff-training program to help successfulimplementation of the new corporate strategies and to further develop PFIs staff.

The above thrusts of the Bank's institution building effort are discussed in more detail in the followingsection.

2. Key policy and institutional reforms supported by the project:

Major banking sector objectives currently being pursued by the Government, in consultation with theBank and the Fund, relate to banks' capital adequacy, non-performing loans, loan classification andprovisioning, off balance sheet activities, transparency in financial presentations, entry and exit policiesand mechanisms and systemic liquidity. To the extent that DBP is a major financial institution in thecountry and because the design of the project and the associated conditionality are fully consistent, theproposed project would also help attain some of the same policy reforms and objectives. The proposedloan to DBP does directly help ease one overall sectoral concern i.e. systemic liquidity. By providingUS$146 million equivalent in long term credits, the proposed project is expected to ease the systemicliquidity tightness to some extent.

Given the nature of the proposed project, however, it is clear that it would also pursue institution buildingand reforms in DBP. The main elements of the institutional reform are the following:

Corporate Goals and Strategy. At the time ERL was made in 1987, the Bank agreed with DBP'sgoal of ultimately becoming a wholesale bank by which it was meant to be a banker to other banks. Itwas envisaged that DBP would initially continue to mobilize long-term resources from ODA but thatin course of time and increasingly it would raise resources from the market, and onlend the proceedsto other banks for retailing to the ultimate borrowers. It was understood that DBP would give up (atleast significantly curtail) its retail banking operations. There were two main reasons for this plannedtransformation: First, DBP was expected to focus on mobilizing long-term resources which no otherbank was doing at that time. Second, it was considered that private commercial banks were in a betterposition to hire well-qualified staff and effectively carry out retail banking. DBP has increasedwholesale operations and, at the end of 1997, the wholesale and retail lending was about 50:50 but thetransformation envisaged ten years ago has not fully taken place. (A few large IBRD and KfW loansonlent to the Manila Electric Company and the Philippines Long Distance Telephone Companythrough DBP and a low cost housing finance scheme if properly classified would increase the share ofwholesale operations to about 60%.) The institution has, in fact, obtained a "unibank" or EKB licensewhich indicates an intention to remain active in not only retail commercial banking operations butalso provide other kinds of retail financial services. At the same time, DBP's long-term strategy stillaims at its conversion into a wholesale bank or a long term lending institution for other banks. Itsother products and services would be spun off into several specialized subsidiaries; some of thesubsidiaries would be partly privatized in course of time. DBP has agreed to revisit this issue with theobjective of developing a future role and corporate structure that is more consistent with the changedenvironment wherein many banks have started to mobilize long-term resources (at least before thecurrent crisis) and, therefore, DBP does not have to take up the exclusive role of wholesaleoperations, and, on the other hand, DBP is no more constrained to hire competent staff for retailbanking by offering competitive emoluments. The Bank intends to act as a catalyst and help DBP,with the participation of the government, defiiie its future role and the.strategies to achieve the agreedgoals. During negotiations, assurances were obtained that DBP would complete, by June 30, 1999, astudy of its corporate goals and strategies along with a detailed time-bound implementation plan. Thestudy would be finalized and implemented taking into account Bank's comments.

Policy Statement. Now that DBP is an EKB, it is subject to new rules and regulation of BSP,covering such aspects as capital adequacy, provisioning, limits on equity investments etc. It has,

therefore, revised its Policy Statement to incorporate the needed changes/additions. Its adoptedpolicies are consistent with the new requirements of BSP for financial prudence for commercialbanks. The Statement also reflects decisions regarding its major or special thrusts. The revised PolicyStatement was discussed and agreed with the preappraisal mission and later approved by DBP'sBoard on June 26, 1998. Once DBP completes its corporate goals and strategies review (see aboveparagraph), the Policy Statement may need to be revised again. Any future changes in the PolicyStatement will be subject to the Bank's prior approval. There is a policy issue that has not been dealtwith in earlier or current policy statements, i.e., DBP's dividend policy. This policy is covered underthe Law (Republic Act 7656) and requires DBP to pay out 50% of its pre-provision net profit asdividend to the government. Basing dividend payment on profits before making provisions fordoubtful and bad debts is not consistent with sound financial and accounting policies as it may erodethe equity base, particularly in inflationary periods. During negotiations, an agreement was reachedwith the government and DBP that actions will be taken to pay dividends only out of inflation-adjusted profits after provisions and taxes.

Comprehensive Financial Review. Being a government owned institution, government auditors(Commission on Audit- COA) have been auditing DBP's accounts. The audit has focused largely oncompliance with various regulations and has so far been satisfactory. It is, however, considerednecessary that the audit of DBP's accounts should, in future, be done in greater depth to ascertain thequality of its portfolio, adequacy of provisions, and other related aspects of its financial position. Thepresent government auditors need to engage the services of international experts who can help themto carry out such an audit and to build-up relevant expertise for future purposes. This would reassurethe Government and DBP's present and fiture creditors that DBP meets (or how it could meet) theinternational standards and best practices. It would also be a timely check of the impact of recentregional crisis on DBP's financial condition and indicate any needed remedial or financialstrengthening measures. Furthermore, sooner or later, DBP has to test the market again to raise longterm funds. In addition, DBP is currently considering the option of privatizing some retail branchesand/or spinning off some functions in the form of partially privatized subsidiaries. It would beparticularly necessary to provide DBP's operational and financial record, audited and certified byprivate sector independent auditors/experts of international repute or with their assistance, as aprelude for such operations. As a condition of negotiations, DBP has entered into a Memorandum ofAgreement with COA in regard to the tenns of reference, process, and timetable for the proposed in-depth audit beginning 1998 with the audit of 1998 accounts.

* Hedging Foreign Exchange Risk. So far DBP's long term foreign currency resources, with twoexceptions, have been obtained from ODA sources through the government. The government, interms of a formal agreement between itself and DBP, assumes the foreign exchange risk on theseresources. The government charges a fee for assuming the exchange risk. The fee charged has so farbeen adequate to cover the actual exchange losses. However, the government understandably wishesnot to assume the exchange risk on foreign exchange resources which are ultimately utilized by theprivate sector. In any case, it is expected that DBP would be gradually weaned away from ODAresources and start raising funds commercially without government guarantee. To the extent DBPraises such funds in foreign currencies, it should be able to find ways to manage the exchange riskinvolved either by self-insurance or by using the exchange risk cover mechanisms available in themarket or a combination of alternatives. DBP has agreed to carry out a study with the assistance ofinternational experts to determine its options and choices for managing/hedging foreign exchangerisk. During negotiations, an agreement was reached with DBP on the TOR of the study onmanagement of foreign exchange risk on its foreign borrowings and the completion of study by June30, 2000.

* Improving Loan Recovery. At the end of 1997, DBP's arrears on its retail banking operations were8.4 per cent of total retail loans outstanding that was considerably higher than the national average ofcommercial banks at 4.7 percent as of the same date. DBP has initiated special efforts to reduce this

gap between its own past dues and the national average for commercial banks, with some success inthe early part of 1998. During negotiations, DBP agreed to reduce its arrears on retail bankingoperations to no more than the national average for commercial banks latest by December 31, 2000.

* Compliance with Year 2000 Computer Needs. DBP attaches high priority to the conversion of itscomputer systems to make them Year 2000 compliant. It is planning steps that would ensure thecollection and processing of information by hardware, software and data feeds to continue smoothlyafter December 31, 1999. In addition, it needs to meet with all regulatory guidelines regarding Year2000 issues. DBP has already completed an inventory of its hardware, application systems, and datafeeds and adopted a plan for their replacement and/oir up-grading. During negotiations, it was agreedthat the proposed TA component for the project will include the financing of necessary importedequipment and that this sub-component will be completed by December 31, 1999.

* Strengthening Treasury Function. DBP plans to improve its Treasury function, particularly thematching of assets and liabilities and optimal utilization and placement of funds at it disposal. Thiswould require the installation of necessary computer hardware and software. At present, DBP has aMoney Market System only which is not Year 2000 and European Monetary Union (EMU) compliantand can not process Fixed Rate Treasury Notes transactions. The bulk of the transactions are in FixedRate Treasury Notes so most of the documentation and bookings are done manually. DBP also needsa system that can strengthen Asset and Liability Management. Furthermore, a treasury system isneeded to computerize the operations. Having a treasury system that includes a derivatives modulewill facilitate compliance with derivative license. Presently, these transactions are still being servicedmanually. The new computerized systems will help to consolidate data and reports, perform technicalanalysis, support the growing demand of clients, strengthen internal controls, and improve riskmanagement. During negotiations, it was agreed that the proposed TA component for the project willinclude the financing of necessary imported equipment and that this subcomponent will be completedby June 30, 2000.

* Staff Training. DBP will be introducing new financial products and, at the same time, itsmanagement and staff, as well as those of PFIs, will have to be more cautious of the quality control atthe entry of all financial products to assure a good quality of portfolio. Consequently, more extensivestaff training is needed in handling new financial products and credit risk analysis. Additionaltraining is also envisaged for environmental risk assessment and mitigation of such risk. Bank staffdiscussed and agreed with DBP on a broad framework for its medium-term-training program(including its estimated cost and financing plan). It was also agreed that DBP will prepare a detailedannual training program and present it to the Bank for comments by October 31 of the preceding yearduring project implementation. This would be reconfirmed during negotiations.

3. Benefits and target population:

One of the major negative impacts of the still continuing Regional financial crisis has been the paucity ofinvestment capital; working capital shortages have also become endemic. As a result, the neededrestructuring of industrial enterprises (including modernization and upgrading of plants), which requiresadditional capital, has considerably slowed down. This is, in tum, affecting the competitiveness of thePhilippine's industrial sector and its export potential. Layoffs are a natural consequence and are alreadyreported at more than 40,000 in January-April 1998 in the formal sector. The employment gains of recentyears are in danger of being reversed because of slow job creation following the reduced overalleconomic growth. The proposed loan will provide the ur,gently needed funds for private sectorinvestment. It would help enterprises to restructure and also meet their permanent working capitalrequirements. The project will, therefore, help minimize the negative impact of the Regional financialcrisis on the Philippines' private sector development. Enterprises will be able to improve their operationalefficiency and productivity and, thus, maintain/enhance their global competitiveness.

The project will have major institutional development impact on DBP. This aspect has been discussed indetail in C2 above. Finally, the lending under the line of credit will help to restore the confidence of bothlocal and foreign investors and would serve as a catalyst for further domestic and foreign investment.

4. Institutional and implementation arrangements:

The loan will be made to DBP which will, as the wholesale bank or the apex institution, relend theproceeds to a number of participating financial institutions, PFIs, which will be the institutions that willselect the final borrowers, appraise the specific investment projects and administer the individual loans.The PFIs would be duly accredited institutions. The financial intermediaries already accredited under theIndustrial Restructuring Project (Loan 3287-PH) and which have remained sound and in good financialstanding would maintain their status as PFIs, at their option. Other financial institutions interested inparticipating would be accredited by DBP using criteria which include: (a) a track record of profitableoperations and sound capitalization; (b) an ability to maintain a sound and healthy portfolio asdemonstrated by the PFI's level of arrears; (c) a qualified management team of good reputation; (d)adequacy of trained staff, established systems and procedures to be an efficient and reliable provider ofretail credits; and (e) project analysis capability and experience in corporate finance. Failure to meetthese criteria would disqualify PFIs from further participation in the project. The accreditation of PFIswill be regularly reviewed during Bank supervision.

DBP has adopted a set of Operating Policy Guidelines (OPG) which outlines the policies and proceduresthat will apply to its wholesale role under the project. The OPG spell out, among other things, thefollowing: accreditation criteria for PFIs, exclusion of DBP as a retailer of funds under the proposedproject, sub-project eligibility criteria and minimum and maximum subloan sizes, conditions and interestrates to the PFIs, on-lending terms, conditions and interest rates to sub-borrowers, minimum loanparticipation by PFIs and minimum equity contribution by sub-borrowers, procurement, free limit andsubproject documentation requirements, and conformance with environmental laws. These policies togovern the use of the proposed loan are generally satisfactory. During negotiations, assurances wereobtained from DBP that it will follow OPG during project implementation and that OPG will be revisedonly after consultation with and agreement of the Bank. The approval of OPG, satisfactory to the Bank,by DBP's Board will be a condition of loan effectiveness.

The PFIs, which would bear the subloan credit risk, would be responsible for subproject appraisal andsupervision. DBP would review the documentation submitted by the PFIs for subproject approval todetermine whether the eligibility criteria for subborrowers and subprojects have been met. Neither theWorld Bank nor DBP would duplicate the credit or project analysis of the PFIs and pass upon individualsubloan applications except for very large projects involving subloan amounts beyond the free limit ofUS$8 million.

The responsibility for supervision and monitoring of PFIs will rest primarily with DBP, and cover notonly the aspect of the use of the Bank loan proceeds but also the PFIs' overall financial condition. TheBank will itself supervise and monitor DBP's performance, making sure also that DBP's supervision andmonitoring of the PFIs is effective. The Bank will receive semi-annual and annual reports from DBP; inaddition, there will be regular supervision visits by Bank staff. There will be a requirement for DBP tosubmit its audited annual account within six months of the close of its financial year. Furthermore, theBank will undertake a mid-term review of onlending rates and critical project conditions and adjustmentswill be agreed with DBP, as necessary.

DBP will be responsible for the implementatiion of the technical assistance component of the project.

D: Project Rationale

1. Project alternatives considered and reasons for rejection:

Alternative 1. The Bank would have extended the loan directly to a number of PFIs but it would be too

difficult to appraise and supervise a large number of banks. The last IRP had 34 PFIs. Furthermore, thisalternative would tantamount to administrative allocation of funds whereas the proposed arrangementwould induce competition among PFIs in the utilization of funds.

Alternative 2. The Bank would have selected a few enterprises and made direct loans to them. Thiswould confine Bank's assistance to a small number of enterprises. The Bank had a very satisfactoryexperience with IRP and basically the same project design has been replicated.

2. Major related projectsfinanced by the Bank and/or other development agencies (completed, ongoingand planned):

Sector issue Project Latest Supervision(Form 590) Ratings

_________ ________ (Bank-financed projects only)Implementation DevelopmentProgress (IP) Objective (DO)

Bank-financedTo support efficient industrial Industrial Restructuring Project. HS Srestructuring and development of US$175 millions in 1990DBP. (completed).

Other development agenciesTo augment medium- and long-tenn IFC US$75 millions in 1997 for Farfinancial resources of banks and East Bank & Trust Co.their efficient allocation.

Same as above IFC US$60 millions in 1998 for FarEast Bank & Trust Co.

To support SMI financing. DBP 11-ADB US$100 millions in1991 (completed).

To augment term resources of DBP. ADB US$50 million credit lineplanned for 1998 to finance smallinfrastructure projects

To finance cottage enterprises. Cottage Enterprise Finance Project.KfW's DM 17.5 million loan in 1991(completed).

To provide technical and other Industrial Support Servicessupport services for the industrial Expansion Program. OECF'ssector. Y22,500 million loan in 1994

(completed)

To augment term resources of DBP. DBP III. JEXIM's Y31,500 millionloan in 1996. (Amount fullycommitted.)

IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory)

3. Lessons learned and reflected in the project design:

OED has issued in March 1998 its Country Assistance Review (CAR) for the Philippines. The report hasconcluded that the overall impact of the Bank's financial assistance has been highly satisfactory.Domestic financial markets have become considerably stronger, deeper, and better regulated since thecrisis of mid- 1980s. Along with the Bank, the Government deserves high credit for its strongcommitment, decisive action , and exemplary leadership. The report has, however, pointed out that the

financial sector in the Philippines still needs further deepening and strengthening. In particular, theregulatory and supervisory regime has to be improved. As regards the Bank's assistance to SMEs, thereport calls it "an effective credit allocation program, but a modest job-generating one". The report hasrecommended that the Bank's future country assistance strategy should, inter alia, include financialintermediary loans. Under the right macroeconomic and institutional environment, as is expected toremain the case in the Philippines, there is a useful role for the Bank in supplementing the supply ofprivate (mostly short and medium-term) credit with long-term funds.

The ICR on IRP, prepared in July 1995, had noted three main lessons: (a) efforts should be directed todevelop the private sector, (b) the Government should have a firm commitment to create conducive policyenvironment, and (c) DFIs should give more attention to environmental protection in their operations.

The proposed project is consistent with the recommendations of the CAR and also takes into account thelessons from IRP. The Bank loan proceeds will be used by private sector only. As OED's report hasstated, the Government has an impressive record of creating a conducive policy environment and is fullycommitted to this objective. PFIs under IRP have complied with Bank's guidelines as well as those of thecountry on pollution control and similar assurances will be obtained under the proposed loan. Inaddition, new procedures and staff training will be introduced for reviewing environmentalaspects of subprojects (see E6).

4. Indications of borrower commitment and ownership:

The Government and DBP have a very good record of project implementation. DBP has achievedsubstantial institutional growth and has an excellent operational relationship with PFIs. It has helpedprepare this project with great speed and has promptly provided all the information requested by the Bankduring the processing of the project. DBP has shown keen interest in the project and it is expected that itwould implement it as successfully as the last credit line--IRP.

5. Value added of Bank support in this project:

The Bank will provide much needed long-term financial resources for the private sector. As a result, theenterprises which have cut down their operations due to working capital shortages and shelvedrestructuring plans due to credit squeeze, will be able to normalize their operations and implement theirinvestment plans, particularly taking advantage of new opportunities created by the Peso devaluation. Allthis will be beneficial to the economy. The institution-building of DBP would enhance its ability to raiselong-term funds from the capital markets without government guarantee.

E: Summary Project Analysis (Detailed assessments are in the project file, see Annex 7)

1. Economic:

Cost-Benefit Analysis: Not applicable; Cost Effectiveness Analysis: Not applicable

The paucity of long-term funds, resulting from the current financial crisis, has adversely affected theprivate sector, particularly small- and medium-sized industrial enterprises. They are facing seriousdifficulties in maintaining their operations and/or restructuring their production facilities in response tothe changed country and regional economic environment. The proposed Bank loan will help to restore theeconomic activity, with all its benefits in terms of productivity gains, employment, exports, etc., byinjecting much needed long-term funds for private sector enterprises. The subprojects to be financedunder the proposed loan will have a financial rate of return of not less than 15 per cent, ensuring theircommercial viability. As the price distortions in the industrial sector in the Philippines are already verysmall, the economic rate of return of these subprojects should also be highly satisfactory. The project isalso considered to be the best option for assisting private enterprises because using a wholesale approachprovides every-financial institution operating in the country, that meets the accreditation criteria, theopportunity to participate in the project and accommodate its clients. Furthermore, the government (whichwill carry the foreign exchange risk for a fee) and DBP will be able to recover the cost of channeling the

proposed loan (see E2 below).

2. Financial:

NPV= Not applicable; FRR= Not applicable

Fiscal impact:

As the project would be implemented by DBP and the private sector, it would not require any governmentcounterpart funding. The actual cash flow to the government depends on future inflation and interestrates, but in the base case, assuming a 12% T-bill rate, 7% inflation and a nominal 6% cost of Bankfunds, the net cash flow to the government is estimated to rise from about P 87 (US$2.2 million) in yearone to about P 825 million (US$21 million) by year five, before falling as the foreign exchange risk fundbecomes drawn on. Direct inflows to the government would include a Guarantee Fee of 1% p.a. (aboutUS$1.5 million per year once funds are fully disbursed) and adequate foreign exchange risk coveragefees, averaging about 3.3% of the outstanding balance. lin addition, under present legislation there wouldbe gross receipts tax of 0.65% p.a. on loans from DBP to the PFIs and about a further 1% on the largerloans to sub-borrowers (together totaling about US$2.1 million p.a. by year 5). In addition, thegovernment would benefit from taxes on incremental profits of DBP, PFIs and subborrowers. Total taxeson incremental profits are estimated at about US$1 1 million p.a. upon full disbursement of the Bank loanand start of full capacity operation by subborrowers. Finally, DBP, after its future institutionaldevelopment, should be able to borrow with out government guarantees and, to this extent, government'sfuture contingent liabilities will not increase. The project would, thus, have a positive fiscal impact.

3. Technical:

Technical aspects of the project relate to the capability of DBP and PFIs to appraise technology,suitability of plant and equipment, cost estimates, etc. of subprojects proposed for their financing and tosupervise their implementation. The Bank experience under IRP indicates that both DBP and PFIs havenecessary expertise for this purpose and would appraise and supervise subprojects satisfactorily.

4. Institutional:

a. EXECUTING AGENCIES:

The Borrower of the proposed loan will be the Development Bank of the Philippines (DBP). It wasestablished in 1958 to succeed an institution set up a decade earlier to help in the rehabilitation andreconstruction of the Philippines after World War 11. The mandate given to DBP was to help in thenational development by financing projects in all sectors. For the next three decades, DBP operated as anall-purpose development finance institution. Operationally, it was guided by govemment directives andeventually financed government development programs in all sectors, and provided funding to largeprojects of doubtful viability and to distressed companies at the behest of the government. Efforts tostrengthen its operations were unable to stop or reverse the deterioration in its financial condition. Itbecame a large politicized bureaucracy with low collections and poor portfolio. By the mid 1980s, therewas no hiding the fact that DBP had became financially insolvent.

A new government initiated a major restructuring and rehabilitation program in 1986, which wasundertaken with the active support of the Bank in the context of the Economic Recovery Loan of 1987.DBP was given a new Charter, and a new management took over. DBP was freed of many of its non-performing assets (transferred to a new Asset Privatization Trust) and relieved of the correspondingliabilities. Board composition was changed with greater representation of the private sector. Systems andprocedures were revised and streamlined. The institution was drastically downsized with staff reducedfrom 3,500 to 2,000. The orientation of DBP was changed to become principally a wholesale bank bywhich it was meant to be a banker to other banks, particularly in providing long term capital.

The restructuring and rehabilitation of DBP was successfully implemented and the institution wastransformed as envisaged. By the end of 1996, DBP's whole sale loans accounted for 64% of total loans.DBP also became a profitable and viable finaincial institution although the profitability declined (mainlydue to higher provisions) and the financial position came under some stress in the last completed year,1997 (because of the Regional financial crisis which adversely affected DBP's borrowers). DBP's totalassets now amount to P 105 billion and its equity to P 13 billion. Its net income increased about 25%between 1995 and 1997 but was almost totally offset by an increase in expenses, the principal item ofwhich was the write off and provisions (see the following para). The return on equity in 1996, the lastcompleted year before the Asian financial crisis, was 15.6%, that on average assets was 2.8%. Both weresatisfactory but both declined significantly in 1997, to 9.8% and 1.4% respectively.

In the second half of 1997, due to depreciation of the currency and higher interest rates, many businessesin the Philippines suffered severe stress. As a result, DBP's past due loans increased appreciably. DBPhas made considerably higher provisions for bad and doubtful loans for the year ended December 31,1997. At the same time, it has put in place a task force headed by an Executive Vice President to manageproblem loans with specific objective of reducing and restructuring past due and problem loans. The taskforce reviews all loans and ensures that appropriate action plans are put in place for those which areshowing any signs of stress. This has helped to keep the rate of increase in DBP's past dues at a levelwhich is lower than the overall average for commercial banks in January-April 1998. It should be notedthat the portfolio problems are confined to DBP's retail banking operations.

While DBP's operational transformation proceeded as envisaged until 1995-96, there has lately been anoticeable increase in retail banking operations. In 1995, the institution obtained the EKB license whichallows it not only to undertake the normal commercial banking but also to provide many other financialservices which are typically provided by merchant/investment banks. DBP increased its retail bankingbranches from 57 to 72. Between 1995 and 1997, its retail portfolio increased by 80% while thewholesale portfolio increased by 37%; by the end of 1997, on an outstanding basis, the retail andwholesale portfolios were almost equally divided (A few large IBRD and KfW loans onlent to the ManilaElectric Company and the Philippines Long I)istance Telephone Company through DBP and a low costhousing finance scheme if properly classified would change these percentages significantly). DBP'scurrent strategy still aims at the ultimate transformation into a wholesale bank based on decisions taken inmid-I 980s. However, this strategy seems to have lost its relevance due to changed banking sectorenvironment and new developments within EIBP and needs to be re-assessed. DBP would, therefore,undertake, by mid-1999, an in-depth review of its future role and niche in the Philippines financial sectorand prepare a new corporate strategy and its implementation plan.

As mentioned in Section C4, DBP will onlend the Bank loan proceeds to accredited PFIs following itsselection criteria. DBP has been very careful in selecting PFIs and, as a result, its loan recovery underwholesale operations is almost 100 per cent. Also, PFIs have financed viable and creditworthy subprojectsand, therefore, their loan recovery is also highly satisfactory. The Bank's previous loan for the IndustrialRestructuring Project (Loan 3287-PH) was onlent to 34 PFIs which, in turn, onlent to 76 privateenterprises. At the end of 1997, only two sublborrowers were in arrears with overdue amount of P10.7million. It is expected that the DBP will select sound PFIs for the proposed project and they will maintaintheir past standards of subproject selection and financing.

b. PROJECT MANAGEMENT:

The information on this subject is covered in Section C 4 above. It may, however be mentioned that theproposed project is similar to the very successful Industrial Restructuring Project made in 1990, and DBPis, therefore, experienced in project management, including the implementation andsupervision/monitoring. No particular difficulty is expected in project management.

S. Social: Not applicable. There will be no involuntary resettlement as the Bank loan will be used mainlyfor industrial projects and the maximum subloan size is not very large at US$8 million for standardsubloans and US$15 million for syndicated subloans.

6. Environmental assessment: Environmental Category []A [x] B [] C

The environmental assessment will be done for individual subprojects by PFIs during projectimplementation under the supervision and guidance of DBP. DBP had implemented a Training andTechnical Assistance grant of SEK10.5 million for strengthening the institutional infrastructure forenvironmental protection as part of IRP. DBP is quite strong in this area and has closely supervised andguided PFIs during the implementation of IRP. It will play the same role under the proposed project. TheBank proposes to make this project as a model for financial intermediary operations for environmentalprotection purposes. Consequently, PFIs' capacity to recognize and properly handle the environmentalrisks will be further developed through: (i) review of generic EIA outlines prepared by the EnvironmentalManagement Bureau in the Philippines by the Bank, (ii) application of IFC's checklist during subprojectappraisal and a format for an annual report by DBP on its and PFIs' due diligence practices to besubmitted to the Bank, and (iii) training of DBP and PFIs' staff under a regional program to be offered byIFC in early 1999.

7. Participatory approach:

The Bank staff had detailed discussions in the field with the Bankers' Association of the Philippines,Federation of the Philippines Industries, Chamber of Commerce and Industry, and commercial banks.They advised on fund requirements of the industry, private enterprise problems, impact of the financialcrisis, and terms and conditions of the Bank loan. In addition, the Bank staff had consultations with theofficials of the Asian Development Bank, UNIDO, Japan Exim-Bank, and the Overseas EconomicCooperation Fund in view of their existing/planned assistance to DBP and/or the industrial sector andexchanged information on mutual experiences, plans and strategies for assistance to the private sector inthe Philippines.

F: Sustainability and Risks

1. Sustainability:

The project's sustainability is assured because: (a) DBP is a well-established institution and the recentGovernment decision to allow DBP to offer market based emoluments to its staff will further help in itsdevelopment, and (b) PFIs are quite conservative in their investment decisions and will select only highlyviable and creditworthy projects for financing. Also, the current financial crisis is expected to pass inabout two-year time and, thereafter, DBP and PFIs should be able to mobilize funds on their own,particularly after further institutional development of DBP.

2. Critical Risks (reflecting assumptions in the fourth column of Annex 1):

Risk Risk Rating Risk Minimization Measure

Annex 1, cell "from Outputs to Objective"

The government may back track or slow down on N The government has an impressiveits strategy to develop financial and private sectors record of reforms and has continuedand to promote private financing of economic commitment to stronger and deeperactivities. reforms.

Demand for long-term funds may decrease and/or N PFIs and enterprises have repeatedlyPFI may become too risk-averse under present indicated strong demand for long-termcircumstances and, as a result, the loan may not be funds.utilized on time.

Annex 1, cell "from Components to Outputs"

The government may influence DBP in its N DBP is now a fully autonomousonlending decisions. organization. The past experience

does not show govt. interference in itslending decisions.

DBP may renegade on its commitment to M DBP management is very serious inimplement the institutional development program. carrying out the institutional

development program and necessarylegal assurance will be obtainedduring loan negotiations.

Overall Risk Rating NRisk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N (Negligible or Low Risk)

3. Possible Controversial Aspects:

None

G: Main Loan Conditions

1. Effectiveness Conditions.

* DPB's Board of Directors would have approved the Operating Policy Guidelines (OPG) satisfactoryto the Bank.

* DBP would have executed subsidiary loan agreements, satisfactory to the Bank, with at least fiveaccredited PFIs.

2. Other

* DBP will not revise its Policy Statement without mutual agreement between the Bank and DBP.* DBP will pay dividend out of inflation-adjusted profits after provisions and taxes.* DBP will apply its Operating Policy Guidelines to the project which will include:

0 accreditation criteria for PFIs0 subproject eligibility criteria and maximum subloan size0 minimum loan participation by PFIs and minimum equity contribution by subborrowers0 procurement guidelines0 conformance with environmental laws and guidelines0 free limit and subproject documentation requirements

* Relending terms, conditions, and rates to PFIs.* Onlending terms, conditions, and interest rates to subborrowers.* Reporting and auditing requirements.* DBP's accounts for 1998 and later years will be audited with the assistance of internationally reputed

experts who will particularly focus on the portfolio, provisions, and related financial issues. Theselection of experts and their TOR will require the Bank's prior approval. The use of foreign expertswill be discontinued after the local expertise has reasonably developed.

* DBP will commission a study on feasibility of hedging against foreign exchange risk on its borrowings.The study would be completed by June 30, 2000.

* DBP will preparc a revised corporate stratcgy and its implemcntation plan by June 30, 1999 andfinalize and implcment it after incorporating Bank's conuncnts.

* DBP will convert its computer systems to makle them Year 2000 compliant.* DBP will strengthen its Treasury function.* DBP will furnish to the Bank for commcnts a detailed staff training program for each year, focuscd on

new financial products and credit risk analysis, by October 31 of preceding year during the projcctimplementation period.

* DBP will reduce the percentage of its arrears on retail loan portfolio to a level that would not exceedthe industry average for commercial banks in the Philippines by December 31, 2000.

* The Bankl will have a mid-term revicw of onlending rates and critical project conditions.

H. Readiness for Implementation

[] The engineering design documents for the first year's activitics are complete and ready for thestart of project implementation. [xl Not applicable.[ ] The procurement documents for the first year's activities are complete and ready for the startof project implementation. [x] Not applicable[x] The Project Implementation Plan has been appraised and found to be realistic and ofsatisfactory quality.[I The following items are lacking and are discussed under loan conditions (Section G):

1. Compliance with Bank Policies

[x I This project complies with all applicable Bank policies.

Task Team Leader Zafar Shah Khan, EASPS

Sector Manager: Hoon Nok Crung,EXS4S

Country Director: Vinay CPF

Annex laProject Design Summary

Philippines: Private Enterprise Credit Support Project

Narrative Summary Key Performance Monitoring and Critical AssumptionsIndicators Evaluation

Sector-related CAS Goal: -Policy, regulatory, and Govt. laws, regulations, and The Government willImprove private business institutional framework procedures continue its policy ofenvironment including becomes more conducive liberalization and privateavailability of long-term for investment and banks' sector development.finance sound development.Project Development DBP and PFIs increase term DBP and central bank Enterprises will be ready toObjective: lending to private statistics on the banking restructure and borrow forAlleviate term credit enterprises sector operation. their permanent workingconstraint for private capital needs.enterprises.Outputs: LOC becomes available. PFIs' periodical reports. LOC will alleviate the creditPFIs start lending from DBP complies with capital constraint and improveLOC. adequacy requirement and financial performance ofDBP starts mobilizing funds provisions. subborrowers.from capital markets. Enterprises carry-out DBP's periodical reports. The debt-servicing of DBP'sDBP's arrears on retail restructuring. retail borrowers willloans come down to the DBP long-term funds from improve.industry average. non-ODA sources increase.Enterprises have betterfinancial results.

Project Components/Sub- LOC is committed within DBP's periodical reporting. There is sufficient demandcomponents: two years. for long-term funds.Line of credit. DBP submits its revised Govt. and DBP are fullyInstitutional development of corporate strategy by June committed to furtherDBP. 30, 1999. institutional development

DBP carries out its staff and autonomy of DBP.training program.Independent experts willassist in the external auditof DBP beginning 1998.DBP will commission astudy of hedging FX riskDBP will put in place amore effective credit riskassessment and loanrecovery program.

Annex lbPhilippines: Private Enterprise Credit Support Project

Key Performances Indicators

Project Objectives Key Performance Indicators Base Line 1998 1999 2000 2001 2002 2003Year (1997)

A. Alleviate term credit . Impact Indicator P 15.5 b. P 11.3 b. P5.4 b. P7.1 b. n.a. n.a. n.a.constraint for private DBP increases its long-term borrowingenterprises (draw downs)

Output Indicator P 64.1 b. P 64.3 b. P 66.5 b. P 69.7 b. n.a. n.a. n.a.DBP increases term lending to enterprises(total outstanding)

B. Maintain and/or further Impact Indicatorsstrengthen DBP's financial Auditors to perform a comprehensive audit Agree with Perform audit same same same sameposition of DBP auditors on for previous

TOR for yearexpanded audit

Complete a study and implement its lHire Finish Study Implementrecommendations for hedging foreign consultants recommen-exchange risk dationsInstall computer equipment to improve 30% 100%treasury operations.

System Conversion to Y2000 10% 100%

Put in place a more effective credit risk 80% 100%assessment and loan recovery program

Performance IndicatorsDBP will maintain a satisfactory capital Not less than same same same same same sameadequacy ratio of net worth to risk adjusted 10%assets

DBP will reduce its ratio of arrears to retail DBP's arrears at DBP's arrears same same sameloans to a level not less that of national 8.4% compared to be notaverage for commercial banks. to 4.7% for more than

commercial commercialbanks banks

In compliance with BSP regulations, DBP 1% 2% 2% 2% 2% 2%will increase its general provision for bad

Annex lb

Project Objectives Key Performance Indicators Base Line 1998 1999 2000 2001 2002 2003Year (1997)

and dreadful loans (in addition to specificprovisions)

C. Enhance operational Impact Indicators 40% 70% 100%efficiency and Appraise and approve subloans (by number)competitiveness ofprivate sector enterprisesbased on commercialviability and Bank-agreed criteria

Implement subprojects 20% 40% 70% 100%(by number)

Output Indicators 10% 25% ' 60% 100%Subprojects operate at a minimum of 80% (by number)capacity

Subprojects have a minimum FRR of 15% 10% 25% 60% 100%(by number)

Enterprises have a debt-service coverage of 10% 25% 60% 100%at least 1.5 times, a current ratio of at least (by number)1.5:1 and a long-term debt/equity ratio of nomore than 60:40.

Enterprises service their debt as per 100% 100% 100% 100%

agreement with PFIs (by number)

Annex 2Detailed Project Description


Project Component 1 - US$309 million (total tentatively estimated cost of component)

Line of Creditfor Equipnient and Permanent Workinig Capital.

The line of credit (LOC) for US$146.0 million will be the main project component, accounting for 97.3%of the Bank loan. The loan will be made directly to DBP, and will be guaranteed by the Republic of thePhilippines. The Bank loan will finance principally plant and equipment to be purchased by privatesector corporate borrowers; permanent working capital financing will also be eligible. In addition,expenditure incurred by the borrowers in preparing plans for their corporate restructuring and for exportmarket exploration and development will also be eligible. Medium and long term financing only will beeligible. Refinancing will not be allowed. While DBP will be the Borrower, the LOC will be madeavailable to the ultimate users of the Loan proceeds through a number of Participating FinancialInstitutions (PFIs).

Relending Mechanisnm, Termns and Conditions

SELECTION OF THE PARTICIPATING FINANCIAL INSTITUTIONS (PFIs). The DBP will select theparticipating financial institutions, PFIs, from among those which are in good standing of BSP. Theaccreditation criteria will include: (a) a track record of profitable operations and sound capitalization: (b)an ability to maintain a sound and healthy portfolio as shown by the institution's level of arrearages; (c) aqualified management team of good reputation and (d) adequacy of trained staff, established systems andprocedures to be an efficient and reliable purveyor of retail credits. DBP will also include the off balancesheet items of PFIs as a new criticism. The PFIs accredited under the IRP (Loan 3287-PH) will continueto be eligible, at their option, provided DBP certifies that they continue to meet the eligibility criteria.

SECTORAL ELIGIBILITY. There is no sector and subsector specific eligibility list. The loan proceeds willbe available for use by the private corporate sector belonging to broadly defined industrial sector. Inaddition, private sector corporate borrowers in the land transport, power and other utilities,telecommunication, and storage sectors (except industrial estates) would be eligible to borrow for viableprojects provided they have a strong linkage to manufacturing, are located in the country-side, and wouldsignificantly contribute to the provision of essential services, not currently available. However, projectsin the meat and meat products subsectors will not be eligible because these products still have excessiveprotection. In addition, projects, which require regulatory and/or other non-financial support/adjustment,will not be eligible for financing until the required changes have been implemented or made a part ofsubproject conditionability.

RELENDING MECHANISM. Under contractual arrangements satisfactory to the Bank, DBP would pass onthe proceeds of the Bank loan to the PFIs which would onlend the funds to Specific Eligible PrivateSector Enterprises. DBP will not lend the project funds directly to eligible enterprises, in line with itswholesale banking function. It would establish a separate project account to channel project funds to thePFIs and to accumulate repayments by PFIs to DBP until they become due for repayment under the Bankloan. The funds (loan principal) thus accumulated would be used for further on lending for similarpurposes and on similar conditions.

COST OF FUNDS TO DBP AND FOREIGN EXCHANGE RISK. The World Bank-would lend to DBP at itsstandard variable rate. However, the Bank loan will be priced out to the DBP based on the weightedaverage interest rate of 91-day T-bills, the most commonly used instrument in the market. The differencebetween DBP's interest rate thus determined and the World Bank lending rate minus a guarantee fee of

Annex 2

1% p.a. would be the fee to the government for assuming the exchange risk. This would be adjustedevery six months in line with the movements in the two rates and shall be paid to the Bureau of Treasury.Since domestic interest rates in the Philippines are market-determined and the capital account isessentially open, this market-based variable formula provides a reasonable estimate of FX risk.

RELENDING RATE OF DBP TO PFIs. In line with market conditions, it is anticipated that DBP lending toPFIs would be at variable rates and in local currency. It is expected that the on-lending rate betweenDBP and the PFIs would approximate the cost to the PFIs of borrowing similar funds in the market. Inaddition, DBP would start taking into account the relative strength and other risk factors of each PFI indetermining the onlending rate.

ON-LENDING RATE OF PFIS TO SUBBORROWERS. PFIs will be free to charge market rates of interest,allowing them flexibility in assessing risks and differences in creditworthiness, or covering administrativecosts associated with individual clients or loans. This mechanism is also expected to increase competitionamong the PFIs whichi would bear the full credit risk of each subloan made.

ELIGIBLE SUBPROJECTS. The Project would finance technically, financially, environmentally, andeconomically sound investment subprojects of viable private sector corporate borrowers. The maximumsubloan amount to be lent to any individual company by PFIs would not exceed US$8 million equivalent;in case of loan syndication, this limit would be set at US$15 million equivalent. For each subproject, thePFIs would be required to finance at least 1(0% of the financing package from their own funds; this mayinclude the working capital loans they normally extend. The minimum equity contribution by thesubborrower would be 30% of total project cost for new projects; for expansion and modernizationprojects, subborrowers are required to maintain a maximum 50:50 debt-equity ratio and a minimum debtservice coverage ratio of 1.5 during the life of the subloan. New subprojects would be subject to aminimum debt service coverage ratio of 2.0. Any variation from these ratios will require the Bank's priorconsultation. Subprojects would have to yield a financial rate of return of not less than 15% in real terms.

MATURITIES AND GRACE PERIODS. The maturity of equipment and permanent working capital subloanswould vary from 3 to 15 years and 3 to 7 years, respectively. The maximum grace period would be 3years for subloans.

ELIGIBLE EXPENDITURES. The proceeds of the loan would be used to finance 100% of amounts disbursedunder subloans. Project related expenditures made within 90 days of receipt of subloanapplication/information by the Bank would be eligible for financing. In addition to financing investmentsin plant and equipment, expenditure incurred by eligible subborrowers for restructuring plans and toexplore and develop foreign markets for their products would be eligible.

FREE LIMIT AND SUBPROJECT DOCUMENTAT-ION REQUIREMENTS. The free limit would be set at US$8million. The proposed free limit would allow the Bank to focus subloan evaluation efforts on larger andmore complex projects. If the Bank's share in the subloan made by the PFI were below the free limit, theBank would not carry out an individual subproject review, but would make periodic sample analysisduring supervision missions. DBP would submit to the Bank the original subloan application (submittedby the subborrower to the PFI); the PFI's credit evaluation and appraisal report, and the subloanagreement between the subborrower and the PFI. The Bank would, then, issue authorization to withdrawfunds for approved subprojects. If the Bank's share in a subloan is above the free limit of US$8 million,DBP will carry out an independent appraisal of the subprojects before seeking the Bank's approval. Thesubproject documentation submitted to the Bank would then have to include, in addition to the itemsmentioned above, a separate feasibility study of the investment project and an extensive analysis of theoperational and financial condition of the subborrower.

DISBURSEMENTS. The Bank would disburse against 100% of expenditures for the subloans financed byDBP to the PFIs up to the financing share made up by the eligible expenditures and requested for therespective subproject. A Special Account (revolving fund) of US$10 million would be established in

Annex 2

DBP to finance the Bank's share of subloans, thus helping to expedite project execution. For withdrawalsmade from the loan account on the basis of Statements of Expenditures, DBP would ensure that allsupporting documentation is being adequately maintained and that it would be available for review uponthe Bank's request. DBP would submit to the Bank a monthly statement of the transactions of the SpecialAccount. The Bank loan is expected to be disbursed in about five years, based on the disbursementprofile for IRP with some adjustment.

PROCUREMENT. Procurement procedures for goods, works, and services financed with loan funds wouldcomply with those customary for industrial development finance operations and consistent with theGuidelines for Procurement under IBRD Loans and IDA Credits as of January 1995 and revised inJanuary and August 1996 and September 1997. DBP and PFIs will satisfy themselves that the goods,works, and services to be purchased are for the investment subprojects and are reasonably priced, byensuring that the subborrowers have canvassed the main sources of supply and purchased from the mostadvantageous source. Contracts above US$5 million equivalent will normally be procured byInternational Competitive Bidding (ICB). Exceptions to ICB in large contracts will be allowed in thefollowing cases: (a) Direct contracting would be used in rnodernization or expansion projects ifstandardized equipment or proprietary parts are needed for compatibility with existing equipment; (b)Limited International Bidding (LIB) would be used for the machinery that is available only from a limitednumber of suppliers worldwide; and (c) where the procedures are otherwise justified for technicalreasons. Contracts below US$5 million would be awarded after evaluation and comparison of quotationssolicited from at least three qualified suppliers from at least two countries. Goods of a proprietary naturemay be procured by direct contacting, subject to the Bank's prior agreement.

All consultancy services will be procured in accordance with the Guidelines for Selection andEmployment of Consultants by the World Bank Borrowers, dated January 1997 and revised in September1997. Furthermore, all consultancy assignments will follow the Bank's Standard Request for Proposalsdated January 1997, revised in September 1997, which includes the Standard Form of Contracts.

All consultancy contracts in excess of US$100,000 equivalent for firms and US$50,000 equivalent forindividuals, and all contracts for selection of consultants through single source selection, or forassignments of a critical nature, would be subject to the Bank's prior review. Regardless of the contractvalue, consulting contracts would be subject to the Bank's prior review and approval for terms ofreference.

SUPERVISION AND MONITORING. Given the importance of DBP's institution building, the project will beactively supervised and its progress closely monitored. Adequate budgetary provision will be made. Inthe immediate future, emphasis will be on (i) the progress made by DBP on redefining its role andfunctions and determination of strategies to achieve the agreed goals, (ii) the in depth review of DBP'sfinancial condition and portfolio during annual extemal audit with the assistance of experts ofinternational repute, (iii) designing a new suitable scheme to cover foreign exchange risk, (iv) a newsystem of reporting on DBP's and PFI's environmental due diligence practices. Apart from these specificaspects of institution building, the normal progress of the project and loan utilization will be monitoredthrough semi-annual and annual reports that DBP would be required to submit to the Bank. DBP will berequired to submit to the Bank its audited annual accounts within six months of the close of its financialyear. In addition to the monitoring of the project progress through reporting, the project will besupervised by regular field visits by the Bank staff. The Bank would also undertake a mid-term reviewwith focus on adequacy of onlending terms and other critical project conditions during itsimplementation.

The principal responsibility for supervising the PFIs will rest with DBP, and that for supervising thesubprojects and the ultimate corporate borrowers would rest with the PFIs. The Bank will through itsown supervision make sure that DBP and PFIs discharge their supervision responsibilities satisfactorily.

Annex 2

Project Component 2 - US$6 million (total cost of component)

TA for DBP 's Institutional Development

As analyzed in detail in Annex 4, DBP would undertake, within 1998, a critical review to determine itsfuture role and strategies to achieve those goals. Whether DBP becomes predominantly a wholesalebank, or a major Expanded Commercial Bank (EKB or unibank or universal bank), or amerchant/investment bank are three major options. The Bank is acting as a catalyst in this process whichwould be completed by June 30, 1999. Once decisions have been made about its future role, there will bethe need to formulate suitable policies to achieve the goals that DBP would set for itself; there will also bea need to acquire the needed management and staff expertise.

A specific aspect of DBP institution building is to help promote its financial credibility in the financialmarkets (domestic as well as international) so that it may, in course of time, raise long term funds on itsown without government guarantee. Towards this end, the Bank will be assisting DBP to have an in-depth review of its financial condition and portfolio undertaken with the assistance of independentauditors/experts of international repute, as a part of its annual audit beginning 1998.

Another specific aspect of DBP's institution building is to find ways to manage foreign exchange risk onits borrowings in foreign currencies. So far, the government, for a fee, has assumed the exchange risk butit is now reluctant to continue the arrangement. DBP proposes to commission a study to be undertaken byoutside experts to suggest a suitable scheme tco manage/hedge the risk.

As a part of the Industrial Restructuring Project (Loan 3287 - PH) made in 1990, the DBP hadimplemented a TTA grant of SEK 10.5 million to strengthen its institutional infrastructure forenvironmental protection. Considerable progress has been made and DBP's coverage of environmentalaspects in its reports is generally satisfactory. To further strengthen environmental protection, theproposed project provides for (i) a review by the Bank's Environment Unit of the generic EIA preparedby the Philippine Environment Management Bureau, (ii) application of the IFC's checklist duringsubproject appraisal and (iii) an annual report by DBP (according to a prescribed format to be prepared bythe Environment Unit on its and PFI's environmental due diligence practices to be submitted to the Bank.In addition, the Project also provides for the training of DBP and PFIs' staff at a regional program to beoffered by IFC in early 1999.

DBP will strengthen its Treasury functions, particularly in the areas of matching assets and liabilities, andoptimizing the management of its financial resources through procurement and installation of necessarycomputer hardware and software. DBP will al[so convert its computer systems to make them Year 2000compliant.

DBP will prepare and implement a staff training program to improve credit risk analysis skills andproficiency in new products and services.

Annex 3Estimated Project Costs


Project Component Local Foreign Total-----------------------US $ million--------------------

Line of Credit Component!' 163.0 146.0 309.0

Technical AssistanceFinancial Review -- 0.3 0.3Systems Conversion to Y2000 1.5 1.7 3.2Strengthening of Treasury -- 1.3 1.3Study of Hedging against FX Risk 0.1 0.1 0.2Staff Training 0.4 0.6 1.0

Total 2.0 4.0 6.0

Total Project Cost 165.0 150.0 315.0

Financing Plan

IBRD -- 150.0 150.0DBP/PFls 50.0 00.0 50.0Subborrowers 115.0 -- 115.0

Total Financing 165.0 150.0 315.0

' Tentative estimates including land, buildings, machinery & equipment, duties, contingencies, etc. Finalestimates would depend on individual subproject cost estimates that PFIs would prepare at the time ofsubproject appraisal.

Annex 4The Development Bank of Philippines

DBP Before and After Rehabilitation.

The origin of DBP was the Rehabilitation Finance Corporation (RFC) which was created in 1947 toprovide credit facilities for the rehabilitation and reconstruction required after World War 11. Elevenyears later in 1958, the Development Bank of the Philippines (DBP) was established with a mandate ofnational development by providing expanded lending operations for all sectors in the economy. In 1986,through Executive order No. 81 and a new Charter, the DBP implemented its major rehabilitationprogram.

For almost three decades until 1986, the DBP operated as an all-purpose development financinginstitution. Its coverage was all sectors of the economy and its main objectives were to increase foodproduction, develop small and medium and export industries, encourage countryside development, andpromote wider wealth distribution. Operationally, it was guided by government directives and eventuallyfinanced government development programs, behest projects, and distressed companies, including somevery large projects. Efforts to strengthen its operations and financial position were unable to stop orreverse the deteriorating trend in DBP's operations. DBP faced major financial problems due to lowcollections and poor loan and investment portfolio; it survived only through government financing anddeposits. By the mid-1980s, DBP was bankrupl: and required a full-scale and complete institutionalrehabilitation and financial restructuring.

DBP's rehabilitation in 1986 was initiated by a new government with Bank assistance and participationunder its Economic Recovery Loan of 1987. The Bank's active involvement in DBP transformation andprogress has continued in the context of FSAL anLd IIC both made in 1989, and IRL in 1990. Therehabilitation started with a new DBP Charter which formed the basis for its financial restructuring andsustainable operations. DBP was freed of many of its non-performing assets (transferred to thegovernment's Asset Privatization Trust) and provided new capital which was required to implement arehabilitation program. The program called for DBP's financial restructuring, down-sizing throughprivatization of a number of its retail banking branches, a new organizational structure and corporateculture with a drastic reduction in total staff, increased private sector representation on its Board, andlending thrusts for agriculture, small and medium scale enterprises, and housing. During 1987-1989period, DBP implemented its institutional strengthening program which called for the improvement ofcritical management and functional areas, e.g., credit, financial, treasury, planning, budgeting, internalcontrols/audit, MIS, and human resource management.

The institutional development of DBP has since continued. It has evolved into an institution withbasically three operating categories-wholesale, retail, and a special funding unit called Window IIIoperations. DBP's rehabilitation was a success both in financial and institutiorial aspects. It has sinceposted record profitability and growth in operations. DBP now has a smaller but more effectiveorganization and operates as a fairly autonomous financial institution mindful to remain financially soundand sustainable. It assists government programs on an agency basis that protects its financial integrity,i.e., no funding and credit risks. While its goal ito privatize its retail banking branches is still to beachieved, DBP is taking its development banking role beyond providing term financing.

In February 1998, new amendments to DBP's charter were approved. These amendments have madeDBP more autonomous and independent of the govemment. As a result, DBP is no longer covered by thegovernment's standardized salary levels. When implemented, DBP should be able to attract and retainqualified staff. Its Board of Directors is now authorized to approve and adopt DBP's staffingrequirements without prior approval of the Department of Budget and Management of the govemment. Anew part-time chairman will henceforth chair the Board meetings while the former full-time chairmanwill become the full-time president and CEO.

Annex 4

DBP Changing Role and Functions

The new DBP Charter calls for DBP's role and functions to be complementary to the private sector in itsoperations. It has a license as an Expanded Commercial Bank (EKB or unibank or universal bank) and is,therefore, legally authorized to undertake the full range of commercial banking activities and, in addition,also provide many other financial services which go beyond traditional commercial banking (i.e., those inthe nature of investment/merchant banking). On the other hand, at the time of its last major restructuringin the context of the Bank's ERL made in 1987, it was agreed that DBP would, in course of time, becomeprincipally a wholesale bank, and gradually give up (or at least reduce considerably) its retail bankingoperations. In the role of a wholesale bank, DBP was expected initially to become the principal channelfor ODA assistance to the private sector but, later, to be able to raise funds on its own standing withoutgovernment guarantee.

In fact, DBP has become one of the largest financial institutions in the Philippines, with three principalcategories of operations: (a) wholesaling of long term resource, obtained from ODA through thegovernment's blessings; (b) normal retail banking; and (iii) "Window 111" operations which are"developmental" in nature, i.e., do not qualify unlder the normal commercial criteria of viability (these arefunded by up to 30% of annlual profits and are thus limited). During 1995-1997, retail banking operationsincreased more rapidly than the wholesale operations, and, at the end of 1997, wholesale and retailportfolios outstanding were almost equally divided.

DBP's future course of evolution and development in not entirely clear at this stage. Under its currentstrategy, DBP itself would remain a development bank doing mainly wholesale banking operations in themedium term. Its other activities would be spun-off into other companies which will either be wholly-owned DBP subsidiaries or joint ventures with private (including foreign) sector partners, e.g., in theareas of insurance brokerage, investment banking, venture capital, and leasing operations. It wouldcontinue its retail banking although, relatively, on a smaller scale. Sale or privatization of its retailbanking branches and/or creation of a joint venture subsidiary to handle retail banking would bepostponed. Meantime, DBP would restructure and improve its branch banking in preparation for itsultimate "privatization." However, the privatization could be accelerated through the conversion of athrift bank currently being rehabilitated by DBP as its commercial bank subsidiary together with astrategic partner (possibly with a foreign bank).

In the longer term, however, as the Philippine economy and financial sector are further developed andterm finance becomes more generally accessible in the market, DBP's wholesale operations coulddiminish. Under this situation, the operational focus would be on the EKB functions. DBP may stillremain a major financial institution in providing innovative development and financial advisory services.This would require the development of necessary core competencies, the current management plans are toacquire them not only through training but also through the recruitment of external expertise includingforeign as necessary.

The institution would have to make a final choice as to its future role and functions. It may decide tobecome predominantly a wholesale bank raising long term resources (domestically as well as in foreigncurrencies) on its own standing without government guarantee. Or, it may decide to become a majorEKB undertaking not only commercial banking activities but also providing all kinds of other financialservices. Either choice would be justified and should be acceptable. However, DBP should notundertake, on one hand, the full range of activities that other private sector institutions do and in directcompetition with them, and on the other hand, to enjoy special privileges and arrangements with thegovernment, e.g., becoming the designated channel for all ODA loans to the private sector with theguarantee of the government. DBP has agreed to review and prepare new corporate goals and strategywhich would help it to remain financially viable, sustainable, and respond to the changing economic andfinancial sector environment. The new strategy and its implementation plan will be completed by June30, 1999.

Annex 4

Organization, Management, Staff Policies

Organization and Management. With the recent amendments to its Charter, DBP will be governed by aBoard of Directors composed of nine members to be appointed by the President of the Philippines. TheChairman will be elected from among the members and his main function will be to preside over theBoard meetings. He will, therefore, be a part time Chairman. The President and CEO will also be amember of the Board. At least four members will be from the private sector. The new Charteramendments are significant in that the Charter now provides full autonomy to the Board for DBP'saffairs, including approval of its budget, staffing and compensation which heretofore were subject togovernment's prior approval. The President and CEO is the only full-time management staff who is alsoa member of the Board-previously, the chief operating officer was also the vice-chairman and a boardmember; this position has been abolished. This arrangement is appropriate as it more clearly separatesmanagement from the policy making Board of Directors.

Following the Charter amendments and rethinking about its role and functions, a reorganization isimminent. The present organization structure provides for five major functional areas called sectors:financial resource sector (treasury, resource development & mobilization, and trust services); operationssector (administration, accounts/loans servicing, client/insurance services); marketing sector (institutionalbanking, merchant banking, mortgage banking); wholesale banking sector (upgraded from the group levelin 1997); and branch banking (branch services and branch credit, with a 72 branch network). The supportgroups include comptroller's office, human resource, credit policy, strategic planning and research, andlegal; all these report to the CEO. The internal audit appropriately reports to the Board. It is expected thatthe new organization would result in streamlined and quicker decision making.

Staffing. During the early period of the 1986 rehabilitation program, DBP reduced its staff from 3,500 to2,000 mainly through an early retirement scheme. However, by the end of March 1998, its staff hadincreased to over 2,900. Almost one-fourth are officer level (equivalent to division chief or supervisorylevel) with the remaining 75% considered "rank and file" starting with grade 4 to grade 22 while grade 23up to 31 would cover the officer level. Most of the additions in staff occurred in the branches as theseincreased from about 57 to 72 branches, five regional offices and two agencies. DBP's goals are tomaintain the staff at the 3,000 level despite its growing operations and to decrease the number of gradesleading to a flatter organization. To implement its new salary scheme now that it does not have to be tiedto the civil service level and structure, DBP plans to engage external consultants to undertake anintegrated process analysis and formulate corresponding job descriptions. Private sector comparators willbe utilized to establish the salary levels and ranges. Initial indications are that salaries of the rank and filestaff are up to or above comparators; the salary gaps exist starting with the junior officers level and iswidest at the executive vice-president levels. DBP will also examine the experience of other governmentfinancial institutions such as the central bank and the Land Bank. After the completion of the consultants'study, salary adjustments are expected but would probably be implemented selectively and in phases.

Most of DBP staff are experienced and trained in project finance. However, DBP has recruited selectivestaff from the private sector banks to handle the new products and services such as short-term workingcapital financing and investment banking. Most of its training in new areas are provided on the job.Training of its staff in the wholesale banking group was provided by a grant under the Bank's FSAL andinvolved the criteria, systems, and procedures in assessing the participating financial institutions (PFIs).Now that DBP will have the authority to fix its own salary levels, it expects to improve retention of itsexperienced staff as well as its recruitment from other private sector financial institutions to handle newproducts and services. Part of its strategy is to obtain the needed expertise through joint ventures withstrategic partners both domestic and foreign.

Policies and Procedures. DBP's major policies are contained in its revised Policy Statement which wasapproved by its Board on June 26, 1998. The revisions reflect its current strategies and policies resultingfrom amendments to its Charter and introduction of new products and services under its EKB license.

Annex 4

The Policy Statement has provisions regarding capital adequacy, single borrower (group) exposure,adequacy of provisions, and its commitment to environmental protection and sustainable development. Ithas provisions for DBP's autonomy in its decision making and for its financial viability (it will assistgovernment programs on an agency basis without assuming funding or credit risks and such activities willbe off balance sheet). The revised Policy Statement is satisfactory except in one respect . A law(Republic Act 7656) requires DBP to pay annual divided to the government at the rate of 50% of profitsand that, too, of the pre-provisions profits. This payout ratio is to high and may result in the erosion ofequity in inflationary periods. It would be prudent for DBP to pay dividend out of inflation-adjustedprofits after provisions. When the review about its future role and strategies has been completed, DBPmay need to amend the Policy Statement once again.

As regards procedures, the system for accreditation of participatory finanicial institutions, PFIs, isnoteworthy. Set up with the assistance of the Bank, DBP has good accreditation standards and processesfor its wholesale banking. Financial institutions are examined in sufficienlt detail to ensure that theycomply with agreed criteria, e.g., adequate track record of profitable operations, sound portfolio andfinancial condition, adequate trained staff and competent management. The limits for each institution arereviewed annually.

DBP's direct loan operations are properly appraised to ensure their viability and suitability for financing.Subproject end-use and supervision is done throughl its branch network. DBP also has a "credit policysupervision" group reporting to the president; this group assists in maintainiing DBP's portfolio qualityand credit processes through regular monitoring and reviews of credit policies.

Aided by computerization, the management information system is efficient and working well. By early1998, DBP had computerized its general ledger system which complies with the new charts of accountsprescribed by the Bangko Sentral ng Pilipinas (BSP). The branches are now all linked up with the headoffice which facilitates monthly reports and consolidation of accounts. Computerization also facilitatesthe preparation of regular reporting required by BSP. Internally, each unit prepares regular reports on itsoperations. Various reports are also prepared for specific committees. For example, the assets/liabilitiesmanagement committee receives the following: weekly reports-liquidity position, deposit/lending rates,market and foreign exchange highlights; monthly reports-projects in the pipeline, DBP financialperformance, institutional banking group (IBG) and branch credit group (BCG) loan portfolio.

Due to the unusual rise in the level of past dues, a special task force headed by an EVP was formed tomonitor and implement special and intensive collection efforts. Detailed listing of statistics on past dueaccounts and responsible account officers has been prepared and weekly and even more frequent meetingsare held to monitor progress of agreed action plans. These include regular visits, preparation of work outarrangements, loan restructuring and additional financing as necessary. Data and information requestedfrom DBP have been readily available; DBP's management information and accounting systems areoperating well and considered adequate though they would have to be made Y2000 compliant.

Operations and Financial Situation

Changing Mix of Operations. Three years after ERL (1987) which envisaged the transformation of DBPinto a wholesale bank, its wholesale lending was understandably still a small proportion of its totaloperations; the ramp up takes time. Thus in 1990, wholesale lending represented 12% of totaloutstanding portfolio. But given the emphasis on this line of business, wholesale lending grew to 64% oftotal loans by the end of 1996. Since then, there has again been a change. In 1995, DBP obtained theEKB license and, this combined with certain special operations, resulted in an expansion of retailbanking. The number of retail branches increased from 57 to 72, spread all over the country and severalregional offices were opened. Between 1995 to 1997, its retail loans increased from P17.3 billion toP31.8 billion (i.e., by 80%) while its wholesale loans increased from P23.9 billion to P32.7 billion (i.e.,by 37%). Its portfolio is now divided almost equally between wholesale and retail. One reason for theincrease in retail lending share in 1997 was the implementation by DBP of a policy-based program for

FPage 31 Annex 4

shipping modernization and funding of a P5 billion loan to the Home Development Mutual Fund-bothtreated as retail operations. DBP has raised long terms funds independently throtugh one Euro-dollar issuefor US$175 million of medium term maturity. DBP's operations during 1995-97 are shown in the table.

DBI' Loan Portfolio(Peso billion)

1995 1996 1997Retail 17.3 20.1 31.8Wholesale 24.0 26.5 32.7

Total 41.3 46.6 64.5

The total portfolio increased by 56% during 1995-97, which was in linle with increases recorded by otherbanks in the country during the same period.

Financial Condition. DBP's financial performance during 1995-1997 is summarized in the followingtable:

Summary of DBP's Financial Performance1995-1997

(Peso millions)

1995 1996 1997Total Assets 67,531 75,726 105,243Total Loans 40,486 47,191 64,411Total Deposits 11,633 14,292 15,104Total Borrowings 38,897 42,982 71,154Net Income 3,656 4,240 4,540Administrative Expenses 1,645 1,945 2,301Profit after Tax 1,901 2,054 1,316Return on Assets (%) 2.98 2.87 1.45Returns on Equity (%) 15.5 15.6 9.8Admin. Expenses/Net Interest Income (%) 45 46 51

DBP's net income increased about 25% between 1995 and 1997. However, this almost was totally offsetby an increase of more than P650 million in administrative expenses. Payroll type expenses increased by28% between 1995 and 1997 and all other administrative expenses increased by a sharp 87%. The mostsignificant increases occurred in loss on acquisition of assets, bad debt and investment write-offs,professional fees, and promotional and staff assistance expenses. A number of these items such as loss onacquisition of assets, (which refers to assets repossessed for sale), bad debts, and professional fees maynot reoccur at the same level in the future.

In the second half of 1997, due to the depreciation of the currency, higher interest rates and problems inthe region, many businesses in the Philippines suffered severe strain. As a result, DBP's past-due loans in1997 increased to 4.2% which when compared to the overall average for the commercial banks in thePhilippines at 4.7% appear low, but one needs lo take into account that the relevant comparison on anindustry basis is against retail past-dues, which puts DBP (with 8%) well ahead of the industry average.Part of the increase can be explained by a small number of large loans which are in the process of beingrestructured and at that stage, the past-due level should reduce.

As mentioned before, a task force, to manage problem loans with the specific objective of reducing andrestructuring past-due and problem loans, reviews and ensures that appropriate action plans are put in

Annex 4

place for all loans which are showing any sign of stress. At the same time, DBP increased its bad debtprovisions significantly in 1997 by creating a 1% general provision on loans which was in line with BSPregulation. It is planned to increase the general provision by a further 1% in 1999. As all write-offs andpast due loans have been in the retail sector, the level of general provision which is related to exposures inthat sector is effectively 2%.

DBP has not had any bad debt problems to date with wholesale loans which represent 51 % of totallending at the end of 1997. These loans are all made to qualified PFIs for onlending to specificcustomers. The ultimate customer credit risk is carried by the PFI and DBP's credit risk is with the PFI.The majority of the PFIs are well established licensed banks, and DBP has a fairly good system in placeto determine and monitor credit lines at these institutions. The credit lines incorporate both wholesale andmoney market facilities and are reviewed on a regular basis. Whilst in terms of scale a PFI loss, if it wereto occur, could be greater than any retail loan loss, it should be noted that this is only likely to arise in thevent of the failure of another bank. In such a scenario, DBP has a further fall-back position wherebyunder its loan documentation, provision is made to take over the PFI loans to customers made as a resultof the DBP facility. Even though the PFI itself would have failed, one would expect DBP to be able torecover at least a proportion of the loans from the businesses concerned.

Return on equity increased marginally in 1996 to 15.6% but declined significantly in 1997 to 9.8% whichwas mainly due to the creation of the 1% general provision, and also due to the continuing upward drift ofadministrative expenses. Return on assets followed a similar pattern, remaining relatively flat between1995 and 1996 and declining significantly to 1.45% in 1997.

Liquidity Management. DBP's resource base is as follows:

1995 1996 1997(Peso millions)

Private Deposits 3,046 4,061 7,042Government Deposits 8,587 10,231 8,062Borrowings

Retail 11,541 13,045 30,361Wholesale 27,356 29,937 40,793

DBP is heavily reliant on borrowings to fund its activities. It has two main sources of borrowings-ODAwhich funds its wholesale activities, and bank borrowing which is utilized to fund a significant proportionof its retail activities. In relation to wholesale lending, it generally does not have any negative fundingmaturity mismatch. It lends for shorter periods than the maturity of the ODA facility and does riot carryany interest or exchange rate risk. However, in relation to its retail lending, the position is quite different.DBP's deposit base is small, and despite an increase of P3 billion in 1997, it only represents 22% of totalretail lending. It also has govemment-type deposits which fund about 25% of retail lending. Theremainder of its retail lending is funded by borrowings from banks, domestic and international. Thelargest international facility was a Eurobond Issue in 1993 of US$175m (P6.9bn), and was due forrepayment in one installment in July 1998; this has been done by borrowing short-term in foreignmarkets. Historically in the Philippines, most banks, funded themselves short-term and provided loans onvarious terms without taking any action to protect the maturity mismatch. DBP, which is funded up to80% by long-term resources from ODA and ECA, had an Eurobond facility due for repayment in July1998, but a sinking fund to enable redemption was not built. Because the currency had been effectively"pegged" to the dollar for many years, there was an expectation that the funds could be rolled over or anew loan easily arranged. Due to the recent currency turmoil, banks including DBP have now becomemuch more conscious of the need to match the maturity profile of their assets and liabilities and also toprotect themselves against currency and interest rate fluctuations. DBP's action in this regard shouldfocus particularly on retail assets and liabilities, and DBP should take steps to build a retail deposit base

Annex 4

to fund activities in that area unless retail lending is reduced substantially as a result of rethinking aboutits future role.

Equity Investments. Total equity investments at the end of 1997 amounted to P1.1 billion. In relation toDBP's total assets, these are very small. In general the equity investments are in related businesses suchas a data center, services corporation and stock brokerage. In some cases, DBP owns one hundred percentof the shareholding, whereas in others, such as the stockbrokerage and depository firms, it is in a minorityposition. These investments are generally valued at cost and an allowance is made for possible potentiallosses.

Financial Projections. Given the impact of the Regional financial crisis, there are more than normaluncertainties not only for the financial sector but also for the real sectors. Nevertheless, DBP hasprepared financial projections for the next three years, making conservative assumptions. The projectionsinclude the balance sheets, income statements, cash flow statements, financial performance indicators,and a schedule of deposits and borrowings identifying as far as possible the sources of borrowings to fundfuture operations. Projected balance sheets and income statements together with indicators of financialperformance are attached. These show continued satisfactory financial conditions and operationalperformance although the operating results are not projected to be as profitable as in1995 - 1997 years (this is partly a result of making conservative assumptions given the setbackexperienced in 1997 including higher provisions for bad debts.)

Annex 4

Attachment IActual and Projected Income Statements 1997-2000

(Peso millions)

1997 1998 1999 2000Actual ------------- Projected ---------------------

Operating IncomeInterest on Loans & Advances 5,765 7,778 8,313 8,751Earnings on Funds & Securities 2,192 2,058 2,079 2,465Other Income 1,217 729 765 798

Total Operating Income 9,174 10,565 11,157 12,014

Operating ExpensesCost of Funds 4,601 6,363 6,562 7,016Salaries and other People Costs 1,106 1,119 1,207 1,328Other Admin Expenses 1,234 1,188 1,278 1,394Provision for Bad Debts 737 1,102 748 457Gross Receipts/FCDU Tax 180 209 390 420

Total Operating Expenses 7,858 9,981 10,185 10,615

Income before Tax 1,316 584 972 1,399Provision for Tax 0 159 163 129

Profit after Tax 1,316 425 809 1,270

Flage 35 Annex 4

Attachment 2

Actual and Projected Balance Sheets 1997-2000(Peso millions)

1997 1998 1999 2000Actual --------------- Projected ---------------

AssetsCash and Deposits with Banks 4,868 4,267 4,621 6,536Loans and Advances 64,087 64,271 66,526 69,702Investment in Bonds, Securities and 17,064 17,226 18,425 19,672Inter BankFixed Assets 1,057 1,034 1,103 1,160Equity Investments 1,124 857 746 742Other Assets 17,043 17,916 17,810 17,715

Total Assets 105,243 105,571 109,231 115,527

Liabilities and Shareholders FundsDeposits :15,104 15,123 15,879 16,832Borrowings 71,154 71,714 73,865 77,558Interest and Fees Payable 4,011 3,711 3,989 4,931Deferred Credits 1,782 1,395 1,465 1,538Shareholders Equity 13,192 13,628 14,033 14,668

Total Liabilities and Net Worth 105,243 105,571 109,231 115,527

Annex 4

Attachment 3

Summary of Key Financial Indicators(Peso millions)

1995 1996 1997 1998 1999 2000--------- Actual ---------- ------ Projected ---------

Operating Statistics (P million)

Operating Income 7,348.0 8,417.0 9,174.0 10,565.0 11,157.0 12,014.0Cost of Funds 3,692.0 4,177.0 4,601.0 6,363.0 6,562.0 7,016.0Net Interest Income 3,656.0 4,240.0 4,573.0 4,202.0 4,595.0 4,998.0Salaries and Other Personnel Expenses 849.0 1,002.0 1,106.0 1,119.0 1,207.0 1,328.0Net Income (after tax) 1,901.0 2,053.0 1,316.0 425.0 809.0 1,270.0Total Assets (P Billion) 67.5 75.7 105.2 105.6 109.2 115.5

Financial Ratios (P billion)

Efficiency- Salaries etc./ Net Income(%) 44.7 48.8 12.1 10.6 10.8 11.5Capital Adequacy

Capital/Total Assets 18.7 18.1 12.5 12.9 12.9 12.7Earnings Performance (Percentages)

Average Yield on Loans:Retail 14.8 14.1 11.0 11.0 12.0 12.3Wholesale 8.7 8.7 10.7 13.3 13.3 13.3

Average Cost of Borrowings 7.9 7.6 7.8 8.7 10.2 10.3Return of Assets 2.8 2.7 1.25 0.4 0.7 1.1Return on Equity 15.1 14.9 9.9 3.1 5.8 8.7

Ratio of Retail/Wholesale 35 39 41 39 39 39

Annex 5Procurement and Disbursement Arrangements


Procurement

Procurement methods (Table A)

1. Procurement procedures for goods, works, and serviced financed with loan funds would complywith those customary for industrial development finance operations. DBP and PFIs will satisfythemselves that the goods, works, and services to be purchased are for the investment subprojects and arereasonably priced, by ensuring that the subborrowers have canvassed the main sources of supply andpurchased from the most advantageous source. Contracts above US$5 million equivalent will normally beprocured by International Competitive Bidding (ICB) in accordance with Bank procurement guidelines("Guidelines for Procurement under IBRD Loans and IDA Credits" of January 1995 revised in Januaryand August 1996 and September 1997), including the use of Bank's standard bidding documents. Inevaluating ICB tenders, a margin of 15% of the c.i.f. or c.i.p bid price or actual custom duties, whicheveris less, would be allowed for preference to domestic manufacturers. All ICB packages will be subject toBank prior approval. Exception to ICB in contracts costing more than US$5 million equivalent will beailowed in the following cases: (a) Direct contracting will be used in modernization or expansion projectsif standardized equipment or proprietary parts are needed for compatibility with existing equipment; (b)Limited International Bidding (LIB) will be used for machinery that is available only from a limitednumber of suppliers worldwide; and (c) where the procedures are.otherwise justified for technicalreasons. These cases would be subject to Bank prior approval.

2. Other procurement would follow established commercial practices which are satisfactory to theBank. Contracts below US$5 million equivalent would be awarded after evaluation and comparison ofquotations solicited from at least three qualified suppliers from at least two countries. Goods ofproprietary nature may be procured by direct contacting, subject to the Bank's prior agreement.

Prior review thresholds (Table B)

3. All contracts above US$500,000 for goods to be procured under the TA component of the projectwill be subject to Bank's prior review. All consultancy services will be procured in accordance with theGuidelines for Selection and Employment of Consultants by World Bank Borrowers, dated January 1997revised in September 1997. Consequently, contracts will follow the Bank's Standard Requests forProposals dated July 1997, revised in April 1998, which includes the Standard Forms of Contracts.

4. All consultancy contracts in excess of US$100,000 equivalent for firms and US$50,000equivalent for individuals, and all contracts for selection of consultants through single source selection, orfor assignments of a critical nature, would be subject to the Bank's prior review. Regardless of thecontract value, consulting contracts would be subject to the Bank's prior review and approval for terms ofreference.

Disbursement

Allocation of loan proceeds (Table C)

5. The Bank would disburse against 100% oif expenditures for the subloans financed by DBP to PFIsup to the financing share made up by eligible expenditures and requested for the respective subproject.

Annex 5

Use of statements of expenses (SOEs):

6. Disbursements would be made on the basis of statements of expenditures for subloan contractsvalued at less than US$5 million equivalent; contracts for goods for DBP's institutional developmentvalued at less that US$500,000 equivalent; consulting services contracts valued at less than US$100,000for firms and US$50,000 for individuals; and training expenditure of up to US$50,000. DBP would retaindocuments supporting the statement of expenditures and would make these statements available forinspection and review by Bank supervision missions. All other disbursements will be made against fullydocumented expenditures. The projected disbursement schedule is based on standard disbursement profilefor financial intermediary loans in the Philippines.

Special account:

7. To facilitate efficient disbursement, a special account in dollars with an authorized initialallocation of US$ 10 million (based on four months of estimated average disbursement) would beestablished. It would be replenished monthly or whenever the special account was drawn to 50 per cent ofits initial deposit, whichever occurred first.

Financial Management Requirements

8. DBP has been a borrower of several Bank loans including credit lines. Subloan accounts of DBPand its financial statements are prepared in accordance with generally accepted accounting principles andhave been acceptable to the Bank. The Commission on Audit (COA) is responsible, under the Philippinesconstitution, to carry out an external audit. COA has carried out audits on the Bank financed projects andthe financial statements of the DBP and has expressed satisfactory opinions. Based on the aboveassessment, the DBP financial management system is considered capable of producing timely andaccurate information on the status of subloan disbursements financed by the project.

One of the project objectives is to improve overall financial management of DBP operationswhich goes far beyond ensuring adequate project related financial management. In order to achieve thisobjective, the Government, the Bank and DBP have agreed to require COA to carry out expandedfinancial statement audits and submit long-form audit reports commencing with the Financial Statementsto be prepared for the year ending December 31, 1998. Agreement of COA and DBP to carry out anexpanded audit based on terms of reference acceptable to the Bank and with the assistance of aninternationally acceptable experts auditors was a condition of negotiation which was fully met. The auditshall be conducted in accordance with the International Auditing Standards issued by the InternationalFederation of Accountants. The auditors would also follow the latest guidelines on Audit and Accountingfor Banks and Savings Institutions issued by the American Institute of Certified Public Accountants. Theaudit will assess, inter alia, the adequacy of systems of internal control, quality of the loan portfolioincluding the adequacy of loan loss provisioning, exposure risks on key projects, borrowing groups,connected parties or major economic sectors and the quality of liquidity, asset and solvency management.The auditors are also required to make recommendations on capital fund adequacy based on the abovereview. Detailed terms of reference for COA and the assisting auditors, as agreed, are given in the ProjectImplementation File. The agreements would ensure that the international consultants will activelyparticipate in the expanded audit and the services of the international consultants will be contracted aslong as considered necessary by the Government and the Bank.

It is expected that the quality of the COA audits and the resulting recommendations to DBPmanagement will enhance the financial soundness of DBP. The Bank will follow up on theimplementation of the recommendations through its supervision of project implementation.

Annex 5

Annex 5, Table A: Project Costs by Procurement Arrangements(in US$ rmillion equivalent)

Expenditure Category Procurement Method Total Cost(including

contingencies)ICB NCB Other N.B.F

1. Works 80.00 80.00(0.00)

2. Goods 40.00 174.00 214.00(28.00) (121.00) (149.00)

3. Services 1.00 1.00(1.00) (1.00)

4. Miscellaneous 20.00 20.00(0.00) (0.00)

Total 40.00 - 175.00 100.00 (315.00)(28.00) (122.00) (0.00) (150.00)

Note 1: (a) N.B.F. = Not Bank-financed includes elements procured under parallel cofinancing procedures, consultanciesunder trust funds, any reserved procurement, and any other miscellaneous items.

(b) Figures in parenthesis are the amounts to be financed by the Bank loan.(c) Other includes procurement under limited international bidding, direct contracting, and international shopping.(d) Miscellaneous items include taxes, duties and freight, etc.

Note 2: The procurement arrangements given in Tables A and B are of an indicative nature. This project is basically a creditline operation where PFIs will select and approve subloans during project implementation. It is only at that stage thatcontract sizes will be determined and procurement: arrangements will be made.

Annex 5

Annex 5, Table Al: Consultant Selection Arrangements (optional)(in US$ million equivalent)

Consultant Selection Method Total Cos!Services (including

Expenditure contingencies)Category

QCBS QBS SFB LCS CQ Other N.B.F.

A. Firms 0.70 0.70(0.70) (0.70)

B. Individuals 0.30 0.30(0.30) (0.30)

0.70 0.30 1.00

Total (0.70) (0.30) (1.00)

Note: QCBS = Quality- and Cost-Based SelectionQBS = Quality-based SelectionSFB = Selection under a Fixed BudgetLCS = Least-Cost SelectionCQ = Selection Based on Consultants' QualificationsOther = Selection of individual consultants (per Section V of Consultants Guidelines), Commercial Practices, etc.N.B.F. = Not Bank-financed.Figures in parenthesis are the amounts to be financed by the Bank loan.

Annex 5

Annex 5, Table B: Thresholds for Procurement Methods and Prior Review

Expenditure Contract Value Procurement Contracts Subject toCategory (Threshold) Method Prior Review /

Estimated Total ValueSubject to Prior

ReviewUS $ millions US $ millions

1. Works

2. Goods LOC 5.00 ICB 40.00TA 0.50 ICB/other modes 1.00

3. Services 0.10 QCBS and Individual 1.00Selection

4. Miscellaneous

Total value of contracts subject to prior review: 42.00

Annex 5

Annex 5, Table C: Allocation of Loan Proceeds

Expenditure Category Amount in US$ Financing Percentagemillion

Part ALine of credit component 146.00 100% of amounts disbursed under subloans

Part BGoods 3.00 100% of foreign expenditures, 100% of local

expenditures (ex-factory cost) and 75% of localexpenditures for other items procured locally.

Consultant services and training. 1.00 100% of expenditure.

Total 150.00

Annex 5

Annex 5, Table ]D: Procurement Plan

International Competitive Bidding (ICB)An Indicative List of Actions and Time-Frame for a Typical Procurement Package

Activity Responsibility No. Days

1. Draft bidding documents including advertisement Borrower 60

2. Reviews bidding documents Bank (HQ) 14

3. Publish Specific Procurement Notice Borrower 7

4. Issuance of bidding documents and preparation of bids Borrower/bidder 45

5. Bid opening Borrower I

6. Evaluation of bids Borrower 30

7. Review of bid evaluation report Bank (HQ) 14

8. Approval of evaluation Borrower 15

9. Issuance of award Borrower 7

10. Preparation of contract Borrower 15

1 1. Furnish copy of signed contract to Bank Borrower 7

Annex 6Project Processing Budget and Schedule


Planned Actual(Atfinal PCD stage)

A. Project Budget (US$000) 219.0

B. Project ScheduleTime taken to prepare the project (months) Tlhree monthsFirst Bank mission (identification) 03/09/1998 03/09/1998Pre-Appraisal mission departure 05/14/1998 05/14/1998Negotiations 06/25/1998 08/31/1998Planned Date of Effectiveness 02/22/99 / /19

Prepared by: Development Bank of the Philippines

Preparation assistance: None

Bank staff who worked oni the project included:Name Specialty

Zafar Shah Khan Task Team Leader/FinanceTomoko Matsukawa Guarantee Operations

Aloysius Ordu Industrial SectorMargaret Png Legal Counsel

Vimala Abraham DisbursementCecilia Vales Procurement

Carla Sarmiento Team Assistant

Consultants who worked in the project included:Name Specialty

Jin Lacey Banking SectorZamir Hasan Financial InstitutionsRavi Nangia Financial Economist

Carlo Punsalan Development Banking

Annex 7Documents in the Project File*


A. Project Implementation Plan

Prepared by the Development Bank of the Philippines

B. Bank Staff Assessments

A note on1 the financial sector in the PhilippinesA note on the corporate/industrial sector in the Philippines

C. Other

Various data and information provided by DBP on its operations, resources, portfolio, and financialposition

*Including electronic files.

Annex 8Status of Bank Group Operations in Philippines

IBRD Loans and IDA Credits in the Operations Portfolio

DifferenceBetween expected

Original Amount in US$ Millions and actualFiscal disbursements a/

Project ID Year Borrower PurposeIBRD IDA Cancellations Undisbursed Orig Frm Rev'd

Number of Closed Projects: 126

Active ProjectsPH-PE-4566 1998 REP OF PHILS EARLY CHILD DEV. 19.00 0.00 0.00 19.00 0.00 0.00PH-PE-4576 1998 GOP WATER DISTRICT DEV. 56.80 0.00 0.00 56.80 3.80 0.00PH-PE-4595 1998 GOP COMMUNITY BASED RESO 50.00 0.00 0.00 50.00 2.77 0.00PH-PE-51386 1998 GOP SZOPAD SOCIAL FUND 10.00 0.00 0.00 9.75 1.50 0.00PH-PE-37079 1997 GOP AGRARIAN REFORM COMM 50.00 0.00 0.00 46.72 3.12 0.00PH-PE-40981 1997 SUBIC BAY METRO. AUTH. SECOND SUBIC BAY 60.00 0.00 0.00 58.92 37.92 0.00PH-PE-4602 1997 REP OF PHILS. THIRD ELEM EDUCATION 113.40 0.00 0.00 110.40 35.56 0.00PH-PE-4613 1997 GOP WATER RESOURCES DEVE 58.00 0.00 0.00 56.01 18.52 0.00PH-PE-4571 1996 GOP TRANS GRID REINFORCE 250.00 0.00 0.00 153.24 -43.91 0.00PH-PE-4611 1996 GOP MNLA 2ND SEWERAGE PR 57.00 0.00 9.00 48.00 31.99 1.00PH-PE-4614 1996 LBP RURAL FINANCE II 150.00 0.00 0.00 34.58 -27.42 0.00PH-PE-4567 1995 GOVT OF THE PHILS WOMENS HEALTH & SAFE 18.00 0.00 0.00 15.77 3.72 0.00PH-PE-4584 1994 NPC AND PNOC LEYTE CEBU GEOTHERMA 211.00 0.00 0.00 31.86 31.85 0.00PH-PE-4607 1994 GOV OF PHILIPPINES LEYTE LUZON GEOTHERM 227.00 0.00 0.00 87.31 79.89 0.00PH-PE-4609 1994 SBMA SUBIC BAY FREEPORT 40.00 0.00 0.00 3.18 1.99 0.00PH-PE-4568 1993 GOP URB HEALTH & NUTRITI 0.00 70.00 0.00 51.36 31.59 0.00PH-PE-4589 1993 GOP IRRIG OPER SUPP II 51.30 0.00 0.00 20.08 17.30 0.00PH-PE-4599 1993 GOVT. OF PHILIPPINES TAX COMPUTERIZATION 63.00 0.00 0.00 23.98 24.01 0.00PH-PE-4538 1992 GOP SECOND VOCATIONAL TR 0.00 36.00 0.00 10.18 9.06 0.00PH-PE-4592 1992 GOP MUNICIPAL DEV III 68.00 0.00 0.00 30.83 26.88 7.84PH-PE-4597 1992 GOP HIGHWAY MANAGEMENT P 150.00 0.00 0.00 47.36 43.31 -.77PH-PE-4558 1991 GOVT. OF PHILS. ENV. & NAT. RES. MGT 158.00 66.00 0.00 17.00 13.71 0.00PH-PE-4572 1991 ROP COMMUNAL IRRIG. II 46.20 0.00 3.34 14.77 18.13 .93PH-PE-4552 1990 R.P. COCONUT FARMS DEVT. 121.80 0.00 .85 35.38 36.24 19.84

Total 2,028.50 172.00 13.19 1,032.48 401.53 28.84

Active Projects Closed Projects TotalTotal Disbursed (IBRD and IDA): 1,160.22 6,824.59 7,984.81

of which has been repaid: 42.17 3,652.48 3,694.65Total now held by IBRD and IDA: 2,145.13 3,213.37 5,358.50Amount sold 0.00 31.35 31.35

Of which repaid : 0.00 31.35 31.35Total Undisbursed : 1,032.48 41.23 1,073.71

a.Intended disbursements to date minus actual disbursements to date as projected at appraisal.

Note:Disbursement data is updated at the end of the first week of the month.

Annex 9

Philippines at a glanceEast Lower-

POVERTY and SOCIAL Asia & middle.-Phillppines Pacific Income Development diamond'

1997Population, mid-year (millions) 73.4 1,753 2.285 Life expectancyGNP per capita (Atlas method, US$) 1.220 970 1,230GNP (Atlas method, US$ billions) 89.6 1,707 2.818

Average annual growth, 1991-97

Population (%) 2.3 1.3 1.2 GNP GrossLabor torce (%) 2.7 1.4 1.3 Gmss

per -- prmatyMost recent estimate (latest year available, 1991-97) capita enrollment

Poverty (% of populahon below nabonal poverty line) 54Urban population (% of total population) 56 32 42Life expectancy at birth (years) 66 69 69Infant mortalKy (per 1,000 live bifths) 36 38 36Child malnutrition (% of children under 5) 30 16 .. I Access to safe waterAccess to safe water (% of populaton) 85 84 84Illiteracy (% of population age 15+) 5 17 19 !Gross primary enrollment (% of school-age population) 116 115 -I1 Phlippines

Male .. 118 116 - Lower-middle-income groupFemale .. 116 113

KEY ECONOMIC RATIOS and LONG-TERM TRENDS1976 1986 1996 1997 r----

;Economic ratioeGDP (US$ billions) 17.2 29.8 82.8 82.2Gross domestic investment/GDP 32.9 16.0 24.0 24.8 TradeExports of goods and services/GDP 19.3 26.3 40.5 49.0Gross domestic savings/GDP 26.9 19.9 15.2 14.5Gross national savings/GDP 27.7 19.3 19.3 18.8

Current account balance/GDP -6.4 3.2 -4.8 -5.2 1n.stInterest payments/CDP 1.0 3.8 2.1 2.3 Domestic InvestmentTotal debt/GDP 35.1 94.5 49.7 vingsTotal debt service/exports 16.9 33.7 14.4 ..Present value of debt/GDP ..Present value of debtlexports ..

IIndebtedness1976-86 1987-97 1996 1997 1998-02 I

(average annual growth)GDP 1.8 3.2 5.7 5.3 I PhilippinesGNP per capita -0.8 1.4 4.5 3.3 .. ---Lower-middle-Income groupExports of goods and services 6.0 9.5 15.4 17.5

STRUCTURE of the ECONOMY1976 1986 1996 1997 Growth rates of output and Investment (%1

(X of GDP) 20Agricufture 29.3 23.9 20.6 18.7 20Industry 35.7 34.6 32.1 32.2

Manufacturing 25.4 24.6 22.8 22.3 lo 92 93 94 95 96 97

Services 35.1 41.5 47.3 49.2 -20 9

Pnvate consumption 62.3 72.1 72.8 72.5 ,-301General govemment consumption 10.8 8.0 11.9 13.0 i GD - 0 GDPImports of goods and services 25.2 22.4 49.3 59.4 I

(average annual growth) Groh197646 1987-7 1 1997 Gowthrates of exports and imports I%Agricuture 1.4 1.8 3.0 3.7 25TIndustry 0.7 3.1 6.3 6.0 '20

Manufacturing 0.5 3.0 5.6 4.2 isServices 3.2 3.9 6.5 5.4 1so

Private consumption 2.4 3.7 5.3 3.7General govemment consumption -0.3 3.9 5.2 0.6 jGross domestic investment -3.2 6.3 15.6 9.2 1 92 93 94 95 55 97

Imports of goods and services 2.1 11.3 16.7 14.4 i Expors a ImporbGross national product 1.5 3.8 6.9 5.5

Note: 1997 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with s Income-group average. If data are missing, the diamond willbe incomplete.

Annex 9

Philippines

PRICES and GOVERNMENT FINANCE1976 1986 1996 1997 Inflatlon (%)

Domestfc prtces(% change)Consumer prices 9.2 0.8 8.4 5.1Implicit GDP deflator 8.3 3.0 7.8 6.0 10°

Govemment finance(% of GDP, includes current grants) °Current revenue 13.0 18.9 92 93 94 s5 96 97Current budget balance .. 1.4 G, GDP deflator - CPIOverall surplus/deficit -5.0 0.3

TRADE1976 1986 1996 1997

(USS millions) I Export and Import levels (USS mililons)Total exports (fob) .. 4,842 20,543 25,228 40,000_

Coconut oil .. 333 571 673 35,000Sugar .. 103 136 83 ,30.000}

Manufactures .. 2,672 17,106 21,488 20 Total imports (ci) ,, 5,044 31,885 36,355 120,000

Food 193 1,578 1,435 10.0* *

Fuel and energy ., 869 3,008 3,074 5,000Capital goods .. 839 10,472 14,369 94 5 9 --

o 9 92 93 94 9s 98 97Exoort r rce index /1995= 100) 76 100 Imort Drice index (1995=100) .. 61 101 i 'Exps * mportsTerms of trade 1995=100) .. 124 99

BALANCE of PAYMENTS1976 1986 1996 1997

(USS millions) I Current account balance to GDP ratlo (%)Exports of goods and services 3,262 7,702 27,627 34,359 i FpT I- -F 947 FImports of goods and services 4,381 5,868 41,371 50,477 9 2 3 1 2 3 i

95 | 97Resource balance -1,119 1,834 -13,744 -16,118 - I .

Net income -253 -1,321 9,202 10,735 '- 2 iNet current transfers 268 441 589 1,080 ,3*|

Current account balance -1,105 954 -3,953 4,303

Financing items (net) 1,051 184 8,060 7,666Changes in net reserves 54 -1,138 -4,107 -3,383 ,e

Memo:Reserves includino oold (USS millions) .. . 11.745 8.768Conversion rate tDEC. localAUSS) 7.4 20.4 26.2 29.5

EXTERNAL DEBT and RESOURCE FLOWS1976 1986 1996 1997

(USs millions) Composition of total debt, 1996 (USS millions)Total debt outstanding and disbursed 6,039 28,204 41,214 -

IBRD 316 3,017 4,666 4,194IDA 27 92 193 195 A: 4,666

G: 7,969 s: 193Total debt service 571 2,961 5,778 .. , C: 405

IBRD 35 406 766 638 . 0IDA 0 1 3 3 73079

Composition of net resource flowsOfficial grants 61 401 246 ..

Officialcreditors 212 198 -310Private creditors 883 294 1,859 . F.t2,817 E:12,085Foreign direct investment 132 127 1 408 E. 10lPortfolio equity 0 0 1,333

World Bank programCommitments 226 151 528 60 A -IBRD E - BilateralDisbursements 102 197 457 305 8- IDA D- Other mutilateral F-PrivatePrincipal repayments 14 170 426 336 Ic -IMF G - Short-termNet flows 88 27 31 -31Interest payments 20 238 343 303Net transfers 68 -210 -312 -335

Development Economics 9/15198