Document of

The World Bank

FOR OFFICIAL USE ONLY

Co?. /y P/- $k1-'Report No. 4897-CHA

STAFF APPRAISAL REPORT

CHINA

SECOND INDUSTRIAL CREDI I rI PROJECT (CHINA INVES9MENT BINK I1,

May 15, 1984

Projects DepartmientEast Asia and Pacific Regional Office

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

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CURRENCY EQUIVALENT

Official Rate

1 Yuan (Y) = US$0.492.06 Yuan (Y) = US$1.00

(as of February, 1984)

Internal Settlement Rate

1 Yuan (Y) = US$0.362.8 Yuan (Y) = US$1.o0

FISCAL YEAR

January I to December 31

PRINCIPAL ABBREVIATIONS AND ACRONYMS USED

BOC - Bank of ChinaCCAFM - China Consultants of Accounting and Financial ManagementCIB - China Investment BankCIECC - China International Engineering Consulting CorporationCNTIC - China National Technical Import CorporationDFC - Development Finance CompanyEDI - Economic Development InstituteGDP - Gross Domestic Product

ICB - International Competitive BiddingICBC - Indtistrial and Commercial Bank of ChinaMOF - Ministry of FinancePBC - People's Bank of ChinaPCBC - People's CQ_nstruction Bank of ChinaSDR - Special Drawing RightUNDP - United Nations Development Program

FOR OFFICIAL USE ONLY

CHINA

INDUSTRIAL CREDIT II PROJECT (CEINA INVESTMENT BANK II)

STAFF APPRAISAL REPORT

Table of Contents

Page No.

I. THE INDUSTRIAL SECTOR ................ * . I .. ..... ... .a * 1

Characteristics and Accimpllshments 1Weaknesses ............... I. .......... . 1Con-traints on Growth in the 1980s .......................... 2Government Strategys........... *.... .. 2Recent Developments .................... , 2

II. THE FINANCIAL SECTOR........ 3

Role ..... ........ 3Tnstitutional Background... . ...-. .-.. ... .- ...- ...- 3Investment FinanceR ...................... ...... 3Interest Rae-n.........*-*.-*..-.... ***.-@vv*..........5Bank O0jectives and Role in Industrial and Financial

Secos ector.s .. ..... *.~**a*~...,.. . 5

III. THE CHINA INVESTMENT BANK (CIB).................. . 6

Establishment.... .. .0 ...... . ... .... 6Performance under CIB I .... ...... ..... ........ . ..... . 6CIB II Objectives and Strategy ... 7Management, Organization, Staffing and Traing .g 7Policies and Strategy. . -.. ......... o ......... .-. 12Procedures........ .......... ....................... 13Opertins....i o.... 16Resources and Financial Position.o..-i o ....... 17Accounting System, Audit and Project Completion Report... 18Prospects and Projections........ ......... ....... 18

* IV. THE PROPOSED LOA N/CR E D I T 19

Amount and Maturity. ............................. ., f 19Onlending Terms . . . . . . . . . a. . 20Free Limit, Maximum Subloan Size and Debt/Equity Ratio..... 20Procurement and Disbursement , ...... .... 21

Environmental Safeguards..e.g., ... 22Benefits and Risks ....... *o ....... * 22

This report is based on the findings of an appraisal 'mission to China inOctober 1983. Mission members were Stephen EttLnger (Mission Leader), EdgarSu, and Alain Soulard.

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

Page No.

V. AGREEMENTS REACHED AND RECOM4ENDATIONS........... .........., 23

ANNEXES

1. Policy Statement of the China Investment Bank2. Development Strategy Statement for 1984-19B6 of the China Investment

Bank3. CIB Five-Year Financial and Operational Projections4. Sectoral Distribution of CIB I Subprojects5. Estimated Cumulative Disbursements of the Proposed Loan/Credit6. Selected Dccuments and Data Available in the Proj,et File

CHART

China Investment Bank Organization Chart

MAP

IBRD 17773R - China Industrial Credit II Project

CHINA

SECOND INDUSTRIAL CREDIT PROJECT (CHINA INViESTMENT BANK II)

Loan/Credit and Project Summary

Borrower; People's Republic of China

Beneficiary: China Investmert Bank (CIB)

Amount: $175.0 million equivalent, comprising $105.0 millionequivalent IBRD and SER 65.8 million ($70.0 millionequivalent) IDA_

Terms: Loan: 20 years, including 5 years grace; standardvariable interest rate.

Credit: Standard

Relending Terms: Loan and Credit: 20 years, including 5 years of grace;fixed interest rate of 7.0% p.a., plus commitment feesequal to those under the loan and credit; the Governmentwould bear the interest rate risk on the Bank loan andthe foreign exchange risk between the US dollar and (a)the currency pool for the Bank loan and (b) the SDR forthe IDA credit. Subborrowers would bear the foreignexchange risk between the US dollar and the Yuan.

ProjectDescription: The project furthers the development of CIB, which pro-

vides investment loans for small- and medium-size indus-trial projects needing foreign exchange. The objectivewould be to help raise investment efficiency throughimport of technology and the introduction of improvedproject design and selection methodology. Subborrowerswould be some 60-80 state and collective enterprisesprimarily in coastal provinces and municipalities. Basedon the experience under CIB I, the investments areexpected to have high financial and economic returns.The main project risks relate to the capacity of CIB,which is a young institution, to strengthen its appraisalstandards, especially in the technical, economic andmarketing areas, and to the need for continued governmentcommitment to CIB within the process of economicreform. However, the project provides for recruitment ofadditional technical and economic staff, plus trainingand marketing consultancy for CIB. This will furtherstrengthen CIB's ability to identify and evaluateprojects. Furthermore, the Government's commitment toeconomic reforms and to CIB remains firm.

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Bank FY 1985 1986 1987 1988 1989------- $ millions ---------------

EstimatedDisbursement: Annual 3.0 37.0 70.0 35.,j 30.0

Cumulative 3.0 40.0 110.0 145.0 175.0

Staff Appraisal Report: No. 4897-CHA, dated May 15, 1984

i

CHINA

INDUSTRIAL CRED!, II PROJECT (CHINA INVESTMENT BANK II)

I. THE INDUSTRIAL SECTOR

Characteristics and Accomplishments

1.01 China is ore of the world's ten leading industrial producers, andhas the largest full-time industrial employment (56 million). However,manufacturirg output per capita is only about 25% of the average for middleincome countries and about 4% of that for industrialized market economies.State enterprises comprise only 22% of China's 389,000 industrial enterprises,the rest being urban or rural collectives, but account for 78% of output.Manufactured exports were only 4.1% of gross industrial output in 1982, butaccounted for 55% of total merchandise exports. Textiles were 21% of totalexports, other light industrial products 14%, and heavy industrial goods20%. Industrial exports grew by about 20% p.a. in real terms over 1977-81,and by 10% in 1982 despite the world recession. A wide range of Chinesemanufactures are internationally competitive in terms of production cost, butquality and variety often need more emphasis. Three accomplishments ofChinese industry stand ,out. First, despite periodic disruptions, gross outputhas grown at nearly 10% p.a. since 1957, due to a very high rate of fixedinvestment in industry, averaging 10-15% of GDP. Second, the industrial basewas broadened to produce nearly a full range of machinery and industrial rawmaterials. Third, China has mobilized unskilled labor, rural savings, andlow-grade raw materials to establish a large number of small-scale ruralfactories, bringing extra income and basic goods (albeit often of low quality)to rural areas, and contributing greatly to employment.

Weaknesses

1.02 Chinese industry also has numerous shortcomings. (a) Inputs areused very inefficiently, and total factor productivity has not changed sincethe 1950s; incremental capital/output ratios have risen, overmanning is wide-spread and energy use per unit of GDP is 2-1/2 times that of other developingcountries. (b) The structure of production is unbalanced: heavy industry,with its high demands on scarce capital and energy, has received 80% of totalfixed industrial investment; foreign trade has been relatively neglected.(c) Technology is outmoded in many sectors; while the use of older, labor-intensive equipment is generally sensible given Chinese factor proportions, alot of Chinese equipment and processes produce substandard products or wasteenergy and raw materials. (d) Decisions are badly coordinated: supply anddemand are often mismatched and investments made with insufficient attentionto choice of location, scale, or product mix. Some of these weaknesses arethe result of past policy errors, neglect of medium term economic planning,and two decades of international isolation. Others stem from deficiencies inthe economic system: insufficient incentives to conserve inputs or improveoutput quality, distorted prices, restricted access to imports, and inadequatecontacts between producers and users and among different ministries andregions.

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Constraints on Growth in the 1980s

1.03 It is particularl) important now to correct these weaknesses becausethe conditions which favoredl past industrial success have substantiallyaltered. Most importantly, domestic energy output is likely to expand at nomore than 2% p.a. during the remainder of the 1980s. Raw materials, transportand high level manpower will also be constraints. In addition, in view ofpast industrial over-investment and in order to free more resources for theenergy and transport sectors and for consumption, Government is trying toreduce the resources allocated to industrial investment. But at the sametime, industrial exports will have to expand, in the face of difficult worldmarket conditions, to help offset reduced energy exports, and industry mustremain a principal source of new jobs. It is possible for industry to grow atabout 8% p.a., as called for in Government's long-term prospectus, providedthat China reduces its unit energy and materials consumption, emphasizes lightindustry, and, in general, continues to reform its economic system so as tomake efficiency the main engine of growth.

Government Strategy

1.04 In 1979, Government introduced a policy of adjustment and reform.The adjustment has increased the emphasis on: (a) light industry; (b) maru-factured exports; (c) "modernization" of existing workshops, rather than"capital construction" (which involves building new facilities); and(d) energy conservation. The main thrust of reform has been to decentralizedecision-making and to rely more on incentives and markets to guidedecisions. The changes affecting industry include: (a) profit and foreignexchange retention; (b) wider use of loans and other capital charges;(c) increased use of bonuses; (d) encouragement of foreign partnerships, urbancollectives and very small private enterprises; and (e) limited price changesand more flexible pricing and marketing arrangements. In the Sixth Five-YearPlan (1981-85), about one-third of total industrial investment is to be formodernization, two-thirds for capital construction. To help implement thisprogram, Government is expanding imports of technology, through jointventures, compensation trade (where the equipment supplier accepts Chineseexports: as; payment), licensing agreements, and import of equipment, increas-ingly with technical assistance and/or training attached.

Recent Developments

1.05 The adjustment program was initially fairly successful in control-ling investment and shifting emphasis toward light industry, which also helpedreduce energy consumption. But actual capital construction in 1982 exceededthe plan by 25%, using mainly extra-budgetary finance (para. 2.04), primarilyfor industry and housing. This strained the supply of energy, buildingmaterials and transport capacity, and drained resources from light industryand from high priority energy and transport projects, while output of heavyindustry, in supplying the producer goods demanded, greatly exceeded theplan. Industrial reform had raised the enthusiasm of enterprises for increas-ing output and profits, but had not been accompanied by more extensive pricingchanges to give better allocation signals. Furthermore, there was no measur-able improvement in industrial efficiency. In response, Government hastightened control over investment finance and stopped many low-priorityprojects.

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II. THE FINANCIAI. SECTOR

Ro1e

2.01 As in most centrally-planned economies, China's financial system isrelatively underdeveloped because most fixed Investment and even worklngcapital has been financed through the budget. The financial system has servedm2inly to channel budgetary funds for approved purposes and to help controlstate and collective enterprises. More recently, increased attention has beenpaid to using the banks to mobilize savings, increase investment efficiency,and provide a detailed review of project proposals independeit of the enter-prises and their supervisory agencies.

Institutional Background

2.02 China's financial system has included five specialized state banksgrouped under two separate jurisdictions. The People's Bank of China (PBC)has had ministry-level status as a multi-purpose central and commercialbank. Under PBC have been the Bank of China (BOC), responsible for commercialtransactions and loans in foreign exchange, and the Agricultural Bank ofChina, in charge of banking and financial administration in rural areasnationwide. The Ministry of Finance (MOF) has supervised two institutions:the People's Construction Bank of China (PCBC), which has the main financialresponsibility for appraising and disbursing for capital construction in theproductive and social sectors of the economy, through both grants and loans inlocal currency, and the recently-established China Investment Bank (CIB),which lends for investments requiring foreign exchange to modernize or expandindustrial enterprises.

2.03 In September 1983, the State Council reformed the financial systemby formally establishing PBC as the central bank, mandated to supervise thebanking operations of all other financial institutions. The practical impli-cations of this -'ange are still being spelled out. PBC's commercial bankingactivities (taking deposits and providing short-term working capital loans andmedium-term modernization loans) were spun off to form the Industrial andCommercial Bank of China (ICBC). The extension of PBC's supervisory role overthe entire financial system is a further step towards separating MOF's fiscalfunctions from the regular banking activities of the financial system, andprovides an institutional framework within which other financial sectorissues, such as interest rates and the roles of the various specialized banks,can be dealt with. It is also expected to reinforce the ongoing effort toincrease the efficiency of investment by shifting from a grant systemadministered by MOF to a more autonomous credit system. In addition, aFinancial Board of Governors representing MOF and the main banks wasestablished, to improve coordination in policy making and implementation.

Investment Finance

2.04 Fixed investment in China is financed from a variety of sources:state budget grants (from central and local governments), extra-budgetaryfunds of various government agencies, enterprises' retained profits anddepreciation allowances, domestic bank loans and foreign loans. The sharefinanced by state budget grants has fallen steadily, from an average of 85%over 1962-66, to 31% in 1982. Until 1979, the offsetting increase was

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virtually all from enterprises and government agencies; bank loans financedless than 2% of fixed investment. Since then, the role of credit has expandeddramatically: in 1982, domestic bank loans financed 16% of fixed investmentin the state-owned sector, and foreign loans a further 7%, as showi, in Table2.1:

Table 2.1: FINANCING OF FIXED INVESTMENT IN 1982 (STATE SECTOR)

Capitalconstruction Modernization Total…(Y billion) --------------

Source of FundsState budget grants 23.2 3.3 26.5Enterprises and agencies 19.3 19.0 38.3Domestic bank loans 7.3 6.4 13.7Foreign loans 5.7 0.3 6.0

Total 55.6 29.G 84.5

Of which: Heavy industry (21.4) (14.3) (35.6)Light industry (4.6) (6.4) (11.0)

Source: 1983 Almanac of China's Economy (p. II1-82) and 1983 ChinaStatistical Yearbook (p. 360).

Now PCBC passes on budget funds as loans to most enterprises that areprofitable; the state budget grants go mainly for infrastructure, plus certainindustries (e.g. coal mining), which have high priority but low profits. Mostof the investment in light industry (of which 40% is iTI textiles and 30% infood processing) is loan financed. The domestic bank loans for capitalconstruction are mostly from PCBC, using both state budget funds andenterprise and agency deposits; those for modernization are chiefly from ICBCand BOC. Under the new banking system, most of PCBC's modernization lendingis to be transferred to ICBC. All lending is supposed to be in line with theannual national credit plan prepared by PBC and approved by the State Council;however, investment lending for capital construction in 1982 was Y 7.3billion, while only Y 3.5 billion was in the plan. Renewed efforts are nowbeing made to control this lending.

2.05 The shift from grants to loans gave enterprise managers someincentive to economize on investment costs, as higher amortization reducedprofits, which have been one measure of enterprise performance. Theintroduction of limited profit retention increased this incentive, and arecent partial shift from profit remittance to an industrial income tax shouldgo further in this direction. However, given the existing distorLed pricestructure, full reliance on credit would shift investment towards the morefinancially profitable industries, which may not be those with the highesteconomic returns. The success of the financial reforms will therefore remainincomplete without comprehensive price reform.

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2.06 Foreign Exchange Finance. Enterprises whose investments includeforeign exchange costs often look for overseas partners, usually for compensa-tion trade, especially if overseas marketing is expected to be critical anddifficult. Those enterprises which do not need or which fail to obtain suchpartners, turri to BOC or GIB for foreign exchange investment loans. BOCbecame very active in this area only in 1982; until then, it concentrated onshort-term finance. It has been using China's balance-of-payments surplus formost of its investment lending for modernization projects, which exceededUS$600 million in 1983, for 3,300 projects. If that source dries up, BOC maymake greater use of the foreign suppliers' and buyers' credits for which it isthe sole channel. BOC's loan criteria remain primarily commercial, with theability to generate foreign exchange to repay the loan given greatestweight. In some provinces, CIB and BOC meet together with the core agenciesto divide up the investment program; in others, they actively compete forbusiness. The competition is based in part on special terms and exemptionsfor one or the other bank from the Government; these anomalies have arisen dueto the hitherto uncoordinated decision-making in the financial sector.However, they do not seriously affect the competitive position of CIB, nor dothey lead to significant misallocation of resources, and coordination isexpected to improve (para. 2.03).

Interest Rates

2.07 Lending rates to industry, while positive in real terms, are low byinternational standards; however, there are other charges on capital whichreduce the subsidy to capital otherwise implicit in low interest rates. Thehighest local currency rate is for working capital, 7.2% p.a., to discourageexcessive inventories. Fixed investments for modernization are deemed moreprofitable than those for capital construction, and local currency loans forthe former by PCBC and ICBC therefore carry higher rates of 5.04% to 6.48%p.a., compared to 2.4% to 3.6% p.a. for capital construction. Lending rateson foreign currency loans are set partly by reference to internationalrates. However, BOC's rate on US dollar loans for modernization was loweredin 1983 from 10-11% p.a. to 7.5'%-8.5% p.a.. The Government also made anexceptional allocation of $500 million at China's own foreign exchange forselected projects in Shanghai and Tianjin to hasten modernization there; BOCcharges enterprises 2.52% p.a. for these funds to cover its costs. Depositrates for enterprises and agencies are 1.8% p.a. for demand deposits and 3.6%to 5.04% p.a., for time deposits, depending on maturity. As part of itsfinancial and other economic reforms, China needs to develop a more corLsistentinterest rate policy once the banking reorganization is completed.

Bank Objectives and Role in Industrial and Financial Sectors

2.08 The Bank's principal objective in industry and finance is to supportthe program of adjustment and reform focussing on areas where prior experienceand expertise gives it a comparative advantage. The focus is on improvingpolicies and institutions, upgrading technology, conserving energy andpromotJng exports. So far, the Bank's only industrial lending operation hasbeen the first Industrial Credit Project (CIB I - Credit 1313/Loan 2226-CIA),which was approved by the Executive Directors on December 21, 1982. Thatproject's focus on modernization of existing enterprises, with emphasis onimport of technology and exporL promotion, fits in well with the Government'sadjustment strategy. CIB also supports the reform objective of improving

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project quality by introducing comprehensive project appraisal methodologi.esincluding economic cost/benefit analysis. The implementation performanceunder that project has been generally satisfactory (para. 3.02). The May 1983industrial projects reconinaissance mission discussed with the Governmentpos3sble projects ln machine tools, fertilizer, cement and electronics;preparation work on the first two of these has started and is providing theinitial opportunity for the Bank to do extensive work on industrial subsectorsand to assist the Government in subsector planning. All four projects wouldemphasize technological modernization, and the fertilizer and cement projectswould also focus on energy conservation. In addition, a collaborativeresearch project on enterprise management withi the Chinese Academy of SocialSciences is producing factory-level data with a view to understanding howenterprises make investment, production and marketing decisions. Finally, anIDA credit (1462-CHA), equivalent to $50 million, was recently approved for aRural Credit Project that will finance a wide range of activities, includingagroprocessing, through the Agricultural Bank of China, in Guangxi ZhuangAutonomous Region.

III. THE CHINA INVESTMENT BANK (CIB)

Establishment

3.01 The need for a financial intermediary for industrial lendinginvolving import of equipment and technology was identified by the Bank'sfirst economic mission to China in October-December 1980. With advice andassistance from a number of Bank mi.ssions, the Gov-ruiuLent formally establishedCIB in December 1981, when its Charter was approvel by the State Council, asits fifth bank and first development finance compiny (DFC). CIB is officiallyunder the leadership of MOF, and, in practice, remains closely tied to itsparent agency, PCBC, for administrative services, access to enterprises andother agencies, assignment of managers and staff, etc. An initial sharecapital of Y400 million was paid in by the Government in early 1982, and theBank/Association provided CIB's first foreign exchange for lending with a loanof $40.6 million (including a front-end fee of $0.6 million) and a credit ofSDR 28 million (equivalent to $30 million) under CIB I.

Performance under CIB I

3.02 CIB and Government did an excellent job by meeting the sixsubstantive conditions of effectiveness almost on schedule, and CIB I becameeffective April 5, 1983. Subloan approvals have been rapid - 77% of the sub-loan component has been committed in the thirteen months since effectiveness,to 32 subprojects (para. 3.29) -- but disbursement by CIB has been slow ($3.5million) due primarily to factors related to Government procurement procedures(para. 3.26), which CIB is trying to change. The quality of subprojects hasgenerally been good (para. 3.21), but that of appraisal reports uneven, thoughimproving (para. 3.23). The main weaknesses are in economic, marketing andtechnical analysis. CIB has had only a limited impact on subproject design todate, as due to its newness and staff shortages it has tended to becomeinvolved relatively late in the project cycle. The $1.0 million earmarked forpreparation subloans (for potential borrowers to hire expatriate technicalconsultants or make overseas factory visits in connection with preparation of

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their subprojects) has not been utiltzed because foreigrn exchangeliberalization has made it possible for, the enterprises to obtain the rela-tively small amounts needed from other sources, usu:all on softer terms(grants ur local currency loans with permission to ;urchase the foreignexchange at the official exchange rate). This amount will be reallocated tothe investment subloan component, as most overseas study tours, w'ich can onlytake place after subloan approval (para. 3.26), would be financed as part ofthe investment subloans. The $300,000 for technical assistance and overseastraining for CIB has also not been committed yet, except for a small amountused for the April 1984 EDI course (para. 3.13), as CIB has seen no need sofar for expatriate engineering advice beyond that supplied by Bank missions,and is emphasizing domestic rather than overseas training tor now, largelybecause of the lack of knowledge of foreign languages among its staff. Fundsunder this component of CIB I will remain available for use during the CIB IIcommitment period and could be used to finance cerseas post-graduate train-ing, particularly in economics (para. 3.09), and engineering consultancy forsome of the larger subprojects, to be determined on a case-by-case basis.

3.03 Overall, CIB's initial institutional development has been reasonablygood, given the general shortage of people with the relevant qualifications inChina, thc very low mobility of staff between institutions, and the difficul-ties in establishing a new organization, but the pace of progress will need tobe maintained under CIB II and beyond if CIB is to be able to carry out itsgrowing responsibilities effectively.

CIB II Objectives and Strategy

3.04 CIB II would continue the Bank Group's institution-building workwith CIB. During the CIB II commitment period, CIB should begin to moveupstream more into project design, to improve the appraisal work especially ofits weaker branches, and to appraise larger and more complicated projects,including those involving sectoral issues. Towards these objectives, thefocus would be on improving CIB's overall appraisal capaoility, especially intechnical, economic and marketing issues. This would be done through recruit-ment of both senior and junior staff (paras. 3.07 - 3.09), use of outsideconsultancy (paras. 3.08 and 3.10), eynanded training programs (paras. 3.13 -3.14), and revision of CIB's Appraisal Manual (para. 3.22). The Bank, for itspart, would continue to pay particular attention to project implementation,but with some decrease in intensity over time. This institutional strengthen-ing is particularly important because CIB is in its initial period of rapidexpansion and because these early years are crucial for establishing CIB'scredibility with other agencies. At the same time, the development of a DFCis a long-term process which will need to continue well beyond the CIB IIcommitment period.

Management, Organization, Staffing and Training

3.05 Board of Directors and Managing Committee. CIB's 32-member Board ofDirectors, consisting of the Minister of Finance as Honorary Chairman, PCBCPresident as Chairman, two PCBC Vice Presidents and one PCBC Advisor as DeputyChairmen, 7 Managing Directors and 20 Directors, meets once a year. The Boardreviews and decides on CIB's annual plan, major policies, financial andoperational performance, borrowings of $50 million equivalent or more,appointment of the President and Vice Presidents, and any proposed charter

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amendments. A Managing Committee consisting of the Board Chairman, DeputyChairmen and Managing Directors meets from time to time to deal with all othermajor matters including loan approvals of Y 10 million or more, borrowingsbelow $50 million and appointment of senior officials below Vice President.Loans below Y 10 million are approved by the President.

3.06 Management and Organization. Mr. Zhou Hanrong, the First VicePresident of PCBC and a Deputy Chairman of CIB's Board, has been the Presidentof CIB from the beginning. As he spends the major part of his time in PCBC,day-to-day management of CIB is largely in the hands of the two Vice Pre-i-dents, Messrs. Geng Gengshan (also a PCBC Vice President) and Zhao Hong, bothof whom are also CIB Managing Directors. The Head Office has five departments-- Project Lending; Finance and Accounting; Survey and Research (which hasmainly collected price and market data for subprojects); Coordination andPlanning; and the General and Administrative Office (see organization chart)-- each headed by a Manager or Deputy Manager. In addition, CIB has sevenbranches (para. 3.11). An internal auditor is directly responsible to theManaging Committee. CIB's senior officials hold "Bank Affairs Meetings",chaired by the President or a Vice President, weekly or more frequently, asneeded, inter alia to review all subprojects before they are submitted to thePresident or Managing Committee for approval. The CIB management has exten-sive experience, primarily within PCBC. Although some of the conceptsinvolved in DFC operations and economic appraisal of projects were new tothem, they have been willing to adopt them once clearance was given fromabove.

3.07 Overall Staffing. As of April, 1984, the Head Office had 33 staffand the 7 branches a total of 84. Except for the ten engineers, virtually allcame from PCBC or are new graduates; inter-agency transfers are rare in theChinese system, so other agencies have been reluctant to release qualifiedstaff, despite some appeals from senior officials, and the staff themselveshave often utilized their right to refuse transfer, as career prospects andfringe benefits at CIB appeared less attractive than in their existing posi-tions. On the other hand, PCBC staff risk little by ioining CIB; some who hadconflicts in CIB were quickly re-absorbed into the parent agency. However,the rapid growth of PCBC's own responsibilities has limited the number ofpeople it could make available to CIB. As CIB's operations have been expand-ing rapidly, and CIB has maintained reasinably high employment standards,staff recruitment has still not caught up with the workload. In particular,the Project Lending Department, which now has 13 staff, needs strengthening togive guidance on and to maintain quality control over the appraisal reportssubmitted by CIB's branches. An understanding was reached with CIB on astaffing plan, including inter alia economists, engineers and market analysts,for about an additional ten staff per year in 1984 and 1985 for the HeadOffice (primarily for the Project Lending Department), and an average of somefour per year for each of the branches, with the majority to be experiencedstaff. At negotiations, an assurance was obtained that CIB would implementthis staffing plan.

3.03 Engineering Support. Before CIB I became effective, a DeputyGeneral Manager of the China International Engineering Consulting Cotporation

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(CIECC)k/ was appointed CId's part-time Senior Engineering Advisor, and anagreement was signed between CIB and CIECC for CIECC to provide engineeringconsulting services on CIB's projects. However, the Senior EngineeringAdvisor has been unable to spare sufficient time to review CIB's appraisals,and CIECC's other support has been minimal. The short-term assistance neededby CIB, for reviewing feasibility studies and providing the technical input toappraisal reports, for generally rather small projects, turned out not to bethe sort of work CIECC was interested in or able to arrange on short iotice.In view of the above, CIB has been utilizing engineers from a number of otheragencies, and has been recruiting experienced engineers as regular staff to dothe technical appraisal of subprojects; there are noTw five in the Head Officeone in each of three branches, and two in another branch. As part of thpstaffing plan, each currently existing branch is to have an engineer byDecember 30, 1984, and each new branch within a year of its opening, and threeto five additional engineers are to be recruited for the Head Office by theend of 1985. The most critical need now is for a qualified full-time seniorengineer to supervise the work of the other head office and branch engineers,and to help arrange for outside technical assistance as needed. The employ-ment of a senior engineer, with qualifications and experience acceptable tothe Bank/Association, would be a condition of loan/credit effectiveness. Formore specialized assistance, CIB will continue to tap not only CIECC, but awide range of design institutes, universities and other consulting firms forindependent reviews of the technical proposals from the enterprises and theirsupervisory agencies. When necessary, CIB would employ short-term expatriateengineers as well, for this purpose, financed under CIB I (para. 3.02),although it has not done so yet.

3.09 Economists. Due to the lack of well-trained economists in thebranches or Head Office, CIB's economic work has been rather mechan5"al. Inaccordance with CIB's Appraisal Manual (para. 3.22), economic rates )f returnand net present values have been calculated (for all projects exceeding a $1million loan in foreign exchange), using, as shadow prices, border price or,for a few non-traded inputs, economic production costs calculated earlier byBank staff. But there have been errors in using CIF and FOB prices and inspecifying which incremental output results from the investments, and littleattention has been given to calculation of shadow prices for other non-tradedgoods (with one recent exception), to economic analysis of alternatives, or toother economic issues such as China's or the particular province's comparativeadvantage, or the trade-off between automation and employment. Although theManager of CIB's Survey and Research Department is also CIB's Senior EconomicAdvisor, adequate quality control has not been exercised over economic aspectsof project appraisal. Furthermore, the economic rate of return is not one ofthe initial set of performance measures used to screen projects beforeapplaisal (para. 3.21). As CIB is a pioneer in China in using economiccost/benefit analysis, it is particularly important that it be adequatelystaffed for this. Furthermore, economic analysis is vital for project designand selection in China, where distorted prices make many economically unviableprojects financially profitable, leading to excessive and misdirected

/1 CIECC is an umbrella organization of 1' industry-specific engineeringconsulting firms created using staff ma:'nly from design institutes invarious ministries.

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investment (para. 1.05). Therefore, as a condition of loan/credit effective-ness, CiB would employ economics staff at its Head Office, with qualificationand experience satisfactory to the Bank/Association, to guide the branches intheir economic analysis, review economic aspects of appraisal reports, andcoordinate with other agencies on economic issues relevant to CIB's work. Asqualified economists are in short supply in China, if suitable people cannotbe transferred to CIB, long-term secondment or borrowing of experts at leasthalf time would be acceptable. In addition, as part of the staffing plan, CIBwill hire at least one economist with a post-graduate degree and one with anundergraduate degree who would be sent abroad for post-graduate training. Thenew economics staff would work in conjunction with CIB's present SeniorEconomic Advisor.

3.10 Market Analysis. Market analysis is the third critical area inwhich CIB needs assistance, and is the one which CIB considers most diffi-cult, The most serious problem CIB has faced in its appraisal work so far hasbeen obtaining information about the world market. CIB has signed a satisfac-tory contract with the China Trade Consultants and Technical Service Corpora-tion, under the Ministry of Foreign Economic Relations and Trade, to provideCIB with such information and analysis as is needed for review of its proposedloans. In addition, as part of the staffing plan, CIB will hire at least onetrained market analyst for the Head Office, particularly to help it obtain andanalyze information on the domestic market.

3.11 Branch Network. Branches were established in Shanghai and TianjinMunicipalities and Jiangsu Province in 1982, in Hebei Province in February1983, and in Fujian, lubei and Liaoning Provinces in June-September 1983;together, these account for 24% of China's population and 38% of its indus-trial output. Provinces were selected based on their industrial capacity,export potential, need for foreign exchange, and interest in CIB operations.Hubei is the first interior province, and reflects the fact that, in the faceof competition, need for foreign exchange is becoming as important as exportpotential in CIB's criteria. The pace at which branches were opened was muchfaster than originally planned, because CIB, facing keen competition from BOCand other sources of foreign exchange in Shanghai and to a lesser extentTianjin, needed to broaden its branch network rapidly in order to develop areasonable level of operations. Furthermore, provincial governments and PCBCbranches have been eager to have CIB set up operations in their provinces, andthe PCBC branches have willingly provided the management and core staff forthe new CIB branches. However, such a high rate of expansion placed greatstrain on CIB's Head Office, and CIB has indicated that henceforth only aboutone branch per year will be established.

3.12 Branch Staffing and use of PCBC Subbranch Stafi.-/ As it takes timefor the new branches to recruit their own staff (the average size is 12staff/branch now, but the goal by 1986 is 20 staff/branch), they initiallyhave to rely heavily on the staff of PCBC's subbranches where CIB's projectsare located. The CIB branches which cover a province instead of only onemunicipality such as Shanghai and Tianjin, will continue to need such support,

/2 PC8C usually has a branch in each provincial capital with an average cfsome 90 subbranches under it.

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as it is uneconomic for CIB to set up subbranches (although in some cases oneCIB branch staff is located in a PCBC subbranch). Furthermore, CIB needs torely on PCBC staff with specialized expertise, such as in civil engineering orparticular industries, or knowledge of the enterprises concerned. However,the number of PCBC staff familiar with CIB's project appraisal methodology isvery limited; therefore, CIB needs not only to speed up its own staff recruit-ment and training, but also to give adequate ,raining to PCBC's subbranchstaff who are involved in appraising and supervising CIB's subprojects. Someshort-term rotation between Head Office and branch staff, and even between thevarious branches, would also give the staff a better understanding of theproblems facing the other units, and would help spread knowledge andexperience within CIB.

3.13 Training. As most of the staff selected for CIB were not previouslyfamiliar with development banking, training has been a major and criticalactivity for CIB. The Bank arranged UNDP-financed study tours to DFCs inPakistan and the Philippines in 1982; each study tour consisted of four peoplefor about two months. The Bank's Economic Developmernt Institute (EDI) gave a5-week development banking course, primarily for CIB and PCBC staff, inShanghai in April/May 1982 to 40 participants, and a similar UNDP-financedcourse in Beijing one year later. These development banking courses concen-trated on financial and economic analysis of projects, and have proved veryuseful to CIB. A third course, in March/April 1984 (or-anized by EDI butfinanced under CIB I), included more marketing and technical analysis; afourth, to be financed by UNDP, is scheduled for 1985. CIB has also sentstaff to short-term banking seminars overseas and to long-term domestictraining in finance and English. No staff have been sent for long-termoverseas training, as virtually no one at CIB has both the professional andlanguage qualifications; however, CIB intends to do so, once it has qualifiedstaff who can be spared -- economics courses should be highest priority (para.3.09), as equivalent training is not available in China.

3.14 CIB has conducted in-house seminars on project appraisal, accountingand statistics, and foreign exchange transactions. Most branches have alsogiven their own general courses for CIB and PCBC staff, but more such in-housetraining is needed, especially for the newer branches, to supplement the EDIcourses which have room for only a few key staff from each branch, and it isessential to raise the course quality above what the branches can do them-selves. CIB has therefore selected four people (one each from the HeadOffice, Shanghai Branch, Central Institute of Finance and Banking and theShanghai Institute of Finance and Economics) as a part-time team of trainersto help carry out a program of courses acceptable to the Bank/Association,covering general courses in the various branches, as well as more narrowlyfocussed courses to selected staff from all units. The Deputy Manager ofCIB's General and Administrative Office has been designated as CIB's trainingofficer to coordinate, help organize and monitor these courses, and findplaces for CIB staff in outside courses. An understanding was reached onCIB's training program for 1984 and 1985, which includes six to seven in-houseseminars per year on project appraisal, supervision, and accounting. Anassurance was obtained at negotiations that CIB would carry out this plan.

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Policies and Strategy

3.15 General PolLcies and Emphasis. CIB's major operational and finan-cial policies, within the framework of its Charter and the national economicplans, are outlined in its Policy Statement (Annex 1), and specific areas ofemphasis for the next two years are in its Development Strategy Stateent,(Anne, 2). Minor amendment;; to the original Statements approved by CItWsBoard in November 1982 were agreed between Bank and CIB staff, and wereapproved by CIB's Managing Committee in Kly 1984. At negotiations an assur-ance was obtained that CIB would exchange views with the Bank/Association onany proposed changes in its Policy Statemnnt, Development Strategy Statement,Charter, Supplemental Regulations or Lending Procedures. CIB will continue tofocus mainly on relatively small- and medium-sized modernization projects ofexisting state or collective enterprises, but will also lend for expansionprojects (some of which are classified as capital construction). The ceilingfor foreign exchange lending for any one subproject has therefore been raisedfrom $8 million to $15 million (para. 4.04). CIB can help cofinance largerprojects. Emphasis is being expanded from only dir ct export projects, whichwere the only ones initially readily able to repay loans in foreign exchange,to include indirect export and import-substitutios,projects as well, now thatChina has liberalized access to foreign exchange.- Sectoral emphasis remainson textiles and other light industries, but CIB has been expanding its scopeto include chemicals, machinery, electronics, building materials, metallurgy,etc., in accordance with demand for loans.

3.16 CIB now lends local currency only in conjunction with foreignexchange, and only for fixed investment; its borrowers obtain the necessarycomplementary working capital loans from ICBC. In addition to lending, CIB isalso permitted to take equity participations, provide guarantees, participatein loan syndications, and develop consultancy services to its borrowers, par-ticularly in project preparation and finance; however, CIB has no immediateplans in these directions.

3.17 Interest Rates. CIB's 8% p.a. lending rate in foreign exchange isbased on its cost of funds, Government's interest rate policies and the ratescharged by BOC on similar loans. (Under CIB I, Government onlent the proceedsof the Bank loan and IDA credit to CIB at a fixed interest rate of 6.9% p.a.,plus the Bank and IDA commitment fees; including the front-end and commitmentfees, the total cost of these funds to CIB ainounted to 7.4% p.a., thus givingCIB a net spread of 0.6% p.a.) This 8% p.a. rate strikes a balance betweenthe need to be competitive with BOC, which lends for similar projects mostlyat 7.5-8.5% p.a. (para. 2.07), and the importance of being in a positionwithin 1-2 years to borrow from commercial sources (para. 3.36). As worldinterest and inflation rates have fallen over the past 18 months, CIB's rateis now less out of line with international rates, and would be at leastmarginally positive in real terms over the life of CIB's loans, given

/3 CIB requires its borrowers to repay foreign currency loans in foreignexchange. For enterprises which will not directly generate foreignexchange, the loan repayments in foreign exchange have to be guaranteedby the supervising agencies or local authorities which have retainedforeign exchange at their disposal.

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projected world inflation rates. Furthermore, given the divergence betweeneconomic and financial prices in China, it is more efficient for economlccost/benefit analysis rather than interest rates to be the main detel:minant ofloan allocations by CIB. At negotiations, assurances were obtained that: (a)CIB would onlend the blended loan/credit at not less than 8& p.a.; (b) CIBwould inform the Bank/Association, in time for an exchange of views, inadvance of any proposed change in its interest rates; (c' Government wouldtake the impact on CIB's operations into account in determining the foreignexchange lending rates of other Chinese banks; (d) CIB would inform theBank/Association promptly after changes in the foreign exchange lending ratesof other Chinese banks; and (e) from time to time at the request of any party,Government and CIB would e.change views with the Bank/Association on theimpact of such changes in other rates on CIB's operations, and on CIB'slending rates in the light of CIB's cost of funds and profitability, and ofinterest and inflation rates in China and internationally.

3.18 CIB's local currency lending rate has been 3.6% p.a., the nationalrate for most capital construction loans; however, this is lower than the5.04% p.a., charged by PCBC or the 5.04 - 6.48% p.a. charged vy ICBC onmodernization loans (para. 2.07). CIB chose its lower rate, with MOFapproval, to help compete against BOC, which processes loans faster because itdoes less appraisal, and which generally charges a slightly lower foreignexchaage interest rate. Furthermore, as CIB has so far obtained all its localcurrency resources from Government as paid-in capital, it receives the full3.6% p.a. spread, which is more than adequate, on its local currency lending,and 3.6% p.a. is a positive real rate given China's average inflation rate of2% p.a. in 1981-1983.

Procedures

3.19 Project Cycle. Project i.deas get deveLoped, and brought to CIB, ina variety of ways. Some ideas originate at the enterprise level, others upthe chain of comnand at the supervising corporation, city or provincial tech-nical bureau responsible, or even the technical ministry. (In a number ofcases, for example, a ministry decided that it wanted to introduce a newproduct line into China, and then selected the most suitable enterprises toproduce it.) In some provinces, it is then up to the enterprises to shoparound for finance; in others, the core agencies (the Planning, Economic andImport-Export Commissions, and the Finance Bureau) take the lead in allocatingand arranging the finance. There is likewise considerable variation, both byprovince and by individual project, in the stage of development at whichprojects are first brought to CIB; this can range from only a rough projectconcept for which an indication of likely finance is sought before proceedingwith design and feasibility studies, to a fully designed project with thespecific equipment already selected. At this point, CIB is quite willing tobe offered the latter to finance, as this economizes on its hard-pressedstaff; however, over time, CIB should try more often to get involved furtherupstream where it can contribute to project design. To do so effectivelyrequires that CIB build up its staff and earn credibility with the provincialcore agencies and technical buraaus.

3.20 In all cases, however, there are certain formal Government proce-dures that must be followed; CIB's own comprehensive Lending Procedures, whichwere approved by the Ministry of Finance and were issued on April 2, 1983,

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incorporate these requirements. First, an enterprise must prepare a projectproposal, and have it approved by its supervising bureau and the city or pro-vincial planning commission. If the investment cost exceeds Y 10 million, theState Planning Commission must approve as well, and if it exceeds Y 100million it must then go to the State Couni.l. The enterprise can then applyfor finance by sending a copy to the CIB branch to review. If the projectproposal is acceptable, the branch forwarce it, plus its owrn brief report, toCIB's Head Office. If the branch's submission is approved by the Head Office(there is as yet no delegation to any branches), the project enters the pipe-line of eligible projects. The enterprise then prepares a feasibility staAy,usualy with the help of a design institute, and sometimes with CIB's help infinancial analysis, for submission to the relevant authorizing agencies andthe CIB branch. The CIB branch then begins appraising the project, and whenthe authorizing agencies hav-i approved the feasibility study (often afterconsulting CIB) and issued a "Project Design Authorization," the CIB branchcan complete its appraisal and submit its appraisal report to the Head Officefor final approval. Only then can the foreign equipment suppliers be selectedand the detailed cost determined, prior to subloan signing.

3.21 Project Selection. The most critical decision point for CIB iswhether to admit a project into its pipeline; while modification of projectsis still possible at the appraisal stage, outright rejection is politicallydifficult then. Project Lending Department and other CIB Head Office managershave visited virtually all of the projects brought to the branches, and havebeen quite conscientious in screening out the ones that appeared unsuitable --some 20-30% of the applications, usually due to poor market prospects, butalso sometimes based on financial prospects or enterprise management. Inaddition, other enterprises have been told that their projects could enter thepipeline only after more preparation work was done. As a result, on the basisof extensive factory visits, Bank missions have concluded that most projectsselected by CIB have been good ones.

3.22 Project Appraisal. With the help of other Chinese experts and theBank, CIB prepared an Industrial Projects Appraisal Manual which has been usedby its branches since it was distributed in March 1983. This is the firstsuch manual in China, and it has enioyed very good reception from variousGovernment agencies. With help from the Bank, the Agricultural Bank of Chinais developing a similar manual for its agricultural and processing opera-tions. PCBC has distributed CIB's Appraisal Manual widely to its staff asreference material, but has not yet adopted the economic cost/benefit analy-sis. In general, CIB's Appraisal Manual is comprehensive, and with goodunderstanding of it satisfactory appraisal reports can be prepared. However,based on CIB's experience to date, the Appraisal Manual can be improved, par-ticularly to make it more easily applied. The Bank has already providedsuggestions for improving the Appraisal Manual, almost all of which have beenaccepted by CIB, as have CIB's branches (at a conference in January 1984)based on their experiences. CIB hopes to have a draft revision ready byJune/July 1984 for discussion with the Bank/Association. At negotiations, anassurance was obtained that the Appraisal Manual and the instructions for its

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use would be revised, satisfactory to the Bank/Assoct4tion, and the revisionissued for use by all branches by December 31, 1984.-

3.23 CIB's staff have been trying to apply the Appraisal Manual conscien-tiously in their appraisal work. The quality of reports from the more experi-enced branches has been improving; for example, some explanations are nowgiven of design alternatives that were rejected and of the reasons for markedyear-to-year changes in enterprise performance. But the quality of appraisalreports has been quite uneven; the greatest problems have been in reports pre-pared by the newer CIB branches and by PCBC subbranches (para. 3.12).Although the Head Office has sent about half of the reports it received backto the branches for revision, it has still not been able to impose consistentquality controls, due to shortages of staff (para. 3.07) and pressure oftime. Nevertheless, on average CIB's appraisal work is improving and someappraisal reports are as good as those of much more experienced DFCs. Withthe staff strengthening proposed under the project, revision of the AppraisalManual, and continued close Bank supervision, further significant improvementsare expected, although this will be a long-term process.

3.24 Procurement and Disbursement. CIB prepares an annual program aroundOctober for the following year, covering projected quarterly disbursements andthe construction materials and other inputs needed. This annual program issubmitted to the State Planning Commission for incorporation into China'soverall annual materials plan. During the year, CIB can submit revisions asnecessary. Local procurement of equipment and material is done, according toGovernment regulations, either through material supply agencies or directly bythe enterprises. Civil works for the projects are carried out by domesticconstruction enterprises or, if they have the capability, by the borrowingenterprises themselves. For imported equipment and technology contracts below$3 million, at least three price quotations are elicited from qualifiedsuppliers. To date, there has been one contract above $3 million, for whichinternational competitive bidding (ICB) is normally to be used (para. 4.06),but the Bank/Association granted an exception to ICB due to the specific needsof the subproject. The China National Technical Import Corporation (CNTIC),under the Ministry of Foreign Economic Relations and Trade, negotiates andhandles all procurement from abroad under CIB I, as well as otherBank/Association-financed projects.

3.25 CIB disburses upon delivery of local equipment, or in accordancewith contracts for civil works. For imported equipment and technology, CIBhas so far been disbursing from its foreign exchange revolving fund (para.3.31), and subsequently submitting detailed invoices and other necessarydocumentation in accordance with Bank Group reimbursement procedures (para.4.07). Disbursement of large amounts might, however, be made through lettersof credit to be opened with BOC and its correspondent banks overseas.

3.26 The time lag between CIB's approval of a subloan and the subloansigning and subsequent procurement under it has been unusually long for a DFC,

/4 This is about 14 months behind the schedule envisioned in CIB I, becauseCIB and the Bank agreed that more experience in using the Manual wasdesirable in order to make a more satisfactory revision.

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because most provinces do not permit enterprises to prepare detailed designsor make investigative tours abroad, which are necessary ig most cases givenChina's relative .4solation, until the subloan is approved-/ (para. 3.20).CNTIC then must wait until the overseas tour is completed, which involves onaverage about six months, before starting final contract negotiations. Andonly after these negotiations, wheni the foreign exchange cost is determined,will CIB sign the subloan agreement. Moreover, the enterprises often have tosend staff to Beijing to learn the details of CIB's procurement and disburse-ment procedures. The average time from subloan approval to disbursement istherefore estimated at nine months for subprojects which do not requireoverseas stuay tours, generally the smaller ones, and 15 months for thosewhich do.

3.27 Supervision. On June 30, 1983, CIB issued a comprehensive andsatisfactory Project Supervision Manual for its staff, following closely theprocedures of PCBC. The Supervision Manual covers the full cycle from loanagreement to project completion report. CIB is now giving priority tosupervision work, which is being done by the projects staff in the branches.The Project Lending Department oversees the branches' monitoring of projectimplementation. New graduates will need to be trained in project supervision,but most staff transferred from PCBC are already familiar with this. An in-house seminar on project supervision is planned for 1984 (para. 3.12).

3.28 Repayments. According to CIB's Lending Regulations and PolicyStatement, the maturity of CIB's loans normally does not exceed seven years,and the longest period does not exceed twelve years, including a grace periodof two to three years. A short average loan period is possible because of thehigh financial profitability of most industries to which CIB lends. The graceand repayment periods are based on the incremental profits and depreciationallowances which will be used to service the loans. At negotiations, anassurance was obtained that Government would enable enterprises to obtain theforeign exchange needed for payments to CIB. If any enterprise does not havesufficient retained foreign exchange for interest and princlpal payments onits foreign exchange loan from CIB, the supervisory agencies and localgovernment will provide the balance, or the enterprise will have to purchaseit from BOC (at the internal settlement rate).

Operations

3.29 As of April 30, 1984 (13 months since CIB I became effective), CIBand the Bank/Association have approved 32 subprojects (21 "A" subprojects,either above the free limit of $1 million or one of the first three from eachbranch, and 11 "B" ones), totalling $52.5 million and Y 136 million. Subloanagreements have been signed for 24 of these, and procurement contracts for18. Disbursements amounted to only $3.5 million and Y 33.4 million, due tothe delays noted in para. 3.26. CIB's operations have been distributed widelyover various industrial subsectors (Annex 4). Of the 32 subprojects, 15 comeunder the Ministry of Light Industry, six under the Ministry of Textiles, fourunder the Ministry of Health (for pharmaceuticals), three under the Ministryof Machine Building and two each under the Building Materials Administration

5/ CIB is trying to get this rule relaxed, but the outcome is uncertain.

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and the Ministry of Electronics. The borrowers are state enterprises exceptfor tthree urban collectives. CIB has not financed any joint-ventures. Onlyfour of the subprojects (in Tianjin and Shanghai) are classified as capitalconstruction; the rest are for modernization. Tianjin accounts for 45% of thetotal value of approvals, Jiangsu 25% and Hebei 13%. Thirteen of the subloansate in Jiangsu, nine in Tianjin, five in Hebei, two in Shanghai, two in Fujianand one in Hubei. Approval of the first loans by the newest branch, inLiaoning Province, is expected shortly. Also, no loans have yet been made inprovinces where there is no CIB branch, and only a few are now in the pipe-line. Prior to CIB I effectiveness, CID approved ten local currency loanstotalling Y 47 million, but has discontinued such lending.

3.30 The average size of the subloans is $1.6 million, and of theassociated local currency loans Y 4.3 million. The subloans are for 3-10years, including grace periods from I to 3 years. Two of the subloans,totalling $1.4 million, are entirely for financing import of technology. Theprojected financial rates of return to the enterprises range from 13% to 80%p.a., with an unweighted average of 33% p.a., and the economic rates of returnof the "A" subprojects also from 13% to 80% p.a., but averaging 41% p.a. (12%p.a. is the minimum acceptable). The financial rates of return average lessthan the economic ones due to import and sales taxes and because, in mostcases, the sales prices received by the enterprises are below border prices.One somewnat disturbing pattern is that most of the subprojects are verycapital-intensive, often creating no incremental employment. This resultslargely from the concern of exporting enterprises for the quality of output,which they feel can best be ensured by the more automated processes. On thepositive side, not only have most CIB subprojects introduced advanced techno-logy and promoted exports, but a number of them have conserved energy andreduced pollution as well.

Resources and Financial Position

3.31 Resource Position. Since its establishment, CIB has received sharecapital of Y 400 million from the Government and $70 million onlent by Govern-ment from CIB I with a fixed amortization schedule for 20 years (para. 4.02).Of the paid-in share capital, CIB used Y 28 million to purchase $10 millionfrom the Government as a revolving fund for its foreign currency lending. CIBthen borrowed Y 140 million from PCBC at 1.8% p.a., and with it bought afurther $50 million in foreign exchange to increase its revolving fund to $20million and to have additional foreign exchange for lending, including tocover any gap between CIB I and CIB II. As of the end of 1983, the localcurrency resources available for approval were Y 212 million and the foreigncurrency $60.2 million (not including the $20 million revolving fund)(Annex 3, Table 3).

3.32 Financial Performance. CIB's audited profit and loss statement for1983 is in Annex 3, Table 4. Because of the commitment fee on CIB ., and thefact that CIB had not yet collected any interest on its foreign currencysubloans, and does not collect front-end or commitment fees from its borrow-ers, CIB's financial expenses exceeded interest income on loans. Overall,however, its expenses have been more than adequately covered by interestincome from FBC (at 1.8% p.a.) on its deposited share capital, leaving netincome after taxes in 1983 of Y 5.14 million, representing a return of 1.3%p.a., on equity. CIB's 0.6% p.a. foreign exchange spread and 3.6% p.a. local

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currency spread give it an average spread of 2.0% p.a. copared to expectedadministrative costs of only some 0.2% p.a. of portfolio _

3.33 Financial Position. Annex 3, Table 5 shows CIB's audited balancesheet as of December 31, 1983. The long-term debt/equity ratio was only 0.4:1well within the agreed ceiling of 5:1 under CIB I (para. 4.05).

Accounting System, Audit and Projection Completion Report

3.34 CIB's accounting manual, incorporating the Bank's comments and basedon Wesl>rn accounting principles, was issued in January 1983. The internalsettlement rate of Y 2.8 = $1 is used to convert foreign exchange in theaccounts. Overall, China's accounting and audit profession is not welldeveloped, and the Bank is helping to provide technical assistance to build upthe capability of the newly-established State Audit Office. At negotiati"ns,assurances were obtained that, as under CIB I, (i) CIB would keep accountswhich would be audited annually, by independent auditors acceptable to theBank/Association, in accordance with appropriate auditing principles consis-tently applied, (ii) the audit report would be submitted to the Bank/Association within six months after the end of each fiscal year, and (iii) CIBwould prepare a CIB II project completion report, within six months aftercompletion of disbursements. CIB's accounts are being audited by the ChinaConsultants of Accounting and Financial Management (CCAFM); they havecompleted the audit of CIB's 1983 accounts satisfactorily and on schedule. Aspart of the audit, CCAFM will also advise CIB on its management inforinationand accounting systems. CCAFM was established in March 1982, by the Pub'ieFinance Society of China and the Accounting Society of China, with its headoffice in Beijing. It has audited the accounts of some joint ventures andbranches of foreign petroleum companies operating In China, and has signedcooperation agreements with several international accounting firms. CCAFM'skey staff have received two-year training in these firms in the USA andEurope.

Prospects and Projections

3.35 Operations. While there are a variety of foreign exchange sourcesavailable (para. 2.06), demand exceeds supply, and it has remained quitedifficult for many enterprises, especially small- and medium-scale ones, toobtain foreign exchange for investment. CIB, as of April 1984, had built up apipeline of 43 subprojects totalling $93 million, of which approximately 20%is for light industry, 13% for textiles, 33% for chemicals, 11% for machinebuilding, 8% for pharmaceutical, and 15% for other subsectors (electronics,metal working, paper, building materials, tourism and fisheries). In light ofCIB's progress to date in appraising projects, the remaining $17 million ofCIB I for subprojects is expected to be fully committed around June 1984.This leaves about $75 million in the pipeline to be financed under CIB II;although a number of these projects will eventually be dropped or financed by

/6 These costs are unusually low for a DFC because of (a) China's salarystructure, (b) administrative support from PCBC, and (c) minimal risk ofloan default due to guarantees from supervisory agencies and tightGovernment financial control over unterprises.

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other sources, CIB branches are already looking at a significant number ofpotential projects not yet approved by the Head Office for entry into thepipeline.

3.36 Resources. CIB's forecasts of approvals, commitments and disburse-ments for 1983-88, together with the underlying assumptions, are in Annex 3,Table 1. In the light of the present subproject pipeline, the potentialdemand for CIB's financing in the various provinces, CIB's absorptivecapacity, and the recommended $175 million for CIB II, CIB estimates that itstotal loan approvals would increase by an average of 29% p.a. over 1984-88from Y 432 million (including $90 million J.n foreign exchange) in 1984to Y 1,200 millicn (including $250 million) in 1988. The approvals in the sixyears 1983-88 would total $930 million and Y 1,905 million. In addition toits Bank/Association funds and the fore.Ign exchange already purchased fromGovernment (para. 3.31), CIB hopes to raise foreign exchange from othersources as well, starting with $40 million irn 1985.

3.3t For local currency, CIB will continue to rely upon Government sharecapital, supplemented by low-interest loans from PCBC. While Government haspaid in Y 400 million against CIB's authorized share capital of Y 4 billion,it has indicated that it is not prepared to increase its paid-in amountautomatically within this limit. In CIB's projections, the assumption used isthat Government would provide half of the additional local currency neededstarting in 1986, as paid-in share capital; this matter is still underconsideration by Government.

3.38 Financial Performance. CIB's projected income statements for 1984-88 are in Annex 3, Table 4. Assuming a net spread of 0.6% p.a. on CIB'sforeign currency lending, 3.6% p.a. on its local currency lending through 1985and 2.1% p.a. thereafter, CIB's net profit would increase from Y 5.1 millionin 1903 to Y .18.8 million in 1987, before dropping to Y 12.4 milLi,n in 1988when CIB's five-year income tax holiday expired, and the rate of return onavera3e equity would increase from 1.3% to 2.9%, before dropping back to 1.5%in 1c88.

3.39 CIB's projected balance sheets for 1984-88 are in Annex 3,Table 5. Based on the above assumptions, CIB's total assets would grow fromY 550 million at the end of 1983 to Y 2,813 m'illion in 1988, an average annualrate of growth of 39%. Its long-term debt would grow from Y 151 million in1983 to Y 1,845 million in 1988, but the long-term debt/equity ratio wouldonly reach 1.9:1. It should be noted that CIB has an exceptionally strongfinancial position for a DFC, due to its large equity base and low loandefault risk.

IV. THE PROPOSED LOAN/CREDIT

Amount and Maturity

4.01 The proposed loan/credit would be for $175 million, based on CIB'sinstitutional progress and hence its absorptive capacity, with allowances forother foreign exchange raised or planned to be raised by C13. The Bank loanwould be $105 million equivalent and the IDA credit SDR 65.8 milLion

- 20 -

($70 million equivalent), based largely on the overall country lendingprogram. The loan and credit would be made to the People's Republic ofChina. State Council approval of the Development Credit Agreement and LoanAgreement would be a condition of loan/credit effectiveness. All of theloan/credit would be for subprojects; CIB's technical assistar.ce and trainingneeds over the period would be financed from CIB I (para. 3.02). The fundsare expected to be committed to some 60-80 subprojects over 18-20 months.Subprojects could be submitted to the Bank/Association for approval untilJune 30, 1987. To the extent feasible, the credit would tie committed first.Back-to-back repayment of the subloans and Bank loaa would not be appropriatebecause the subloans would have unusually short maturities averaging about 5-6years. Therefore, as for CIB I, the Bank loan would be of fixed amortizationon the standard country terms for China, which are 20 years including fiveyears grace on principal. On behalf of the Government, CIB would pay the costof the front-end fee ($262,500) in advance.

Onlending Terms

4.02 Government would onlend both the loan and credit to CIB under aSubsidiary Loan Agreement, satisfactory to the Bank/Association, the signingof which would be a condition of loan/credit effectiveness. As under CIB I,both IDA and Bank funds would be onlent for 20 years including five yearsgrace, with CIB allowed to roll-over the funds. Government would charge CIB afixed interest rate of 7.0% p.a., plus the Bank and IDA commitment charges.Government would thus bear the risk from the --riable Bank interest rate, asunder CIB I. Including the front-end and commitment fees, the total cost ofthese funds to CIB would be about 7.4% p.a., compared to its onlending rate of8% p.a. Thus the net spread to CIB on Bank/IDA funds would be 0.6% p.a., asunder CIB 1. By onlending to CIB denominated in US$ valued at the date ofwithdrawal, Government would also bear the foreign exchange risk between theUS$ and (a) the currency pool index (for the Bank loan portion) and (b) theSDR (for the IDA credit portion). These arrangements have been maintainedbecause it would be too complicated and burdensome for CIB to pass theseinterest rate and foreign exchange risks on to its subborrowers, most of whomhave no experience with foreign borrowings. As subloans would also bedenominated in US$, valued at the date of withdrawal, subborrowers7yould betaking any foreign exchange risk between the US$ and Chinese Yuan.-

Free Limit, Maximum Subloan Size and Debt/Equity Ratio

4.03 Free Limit. Under CIB I, the free limit was $1.0 million, one ofthe highest frae limits for a first loan/credit to a DFC. A few of thebranches have now demonstrated reasonable competence in subproject appraisal(para. 3.22), and the free limit for them should be increased. On t..e otherhand, appraisal work by some new branches is no better than that of theoriginal branches at the start of CIB I. The problem is generally

/7 Most subborrowers, who would earn sufficient foreign exchange, would notface this risk, as they would repay directly in US$; however, those whoearned primarily local currency would have to convert it into US$ at theinternal settlement rate, which Government might change from time totime.

- 21 -

particularly acute when the appraisal is done primarily by PCBC sub-branchstaff (para. 3.12). To date, CIB's head office has not been able toconsistently impose adequate quality control on the branches. There wouldtherefore be two free limits~ $2.0 million for the branches agreed betweenCIB and the Bank/Associatiorn, and $1.0 million for the other branches. Anunderstanding was reached at negotiations that branches receiving the higherfree limit would be those which were adequately staffed and trainied and hadconsistently met reasonable appraisal standards, and that initially only theShanghai and Tianjin branches would have the higher free limit. An estimated50% of the subprojects by number and 75% by amount would be above the freelimits. The first three subprojects from each branch (whether financed underCIB I or CIB II), regardless of size, would remain subject to Bank/Associationapproval. To allow some leeway, the aggregate free limit would be $60million.

4.04 Maximum Subloan Size. CIB may onlend for individual subprojects upto $15 million in foreign exchange, an increase from the present $8 million.Where justified, exceptions to this ceiling could be made, with the approvalof the Bank/Association. This high limit reflects the fact that: (a) CIBwould be taking virtually no financial risk; and (b) in general it is for thelarger of the medium-sized projects that CIB's appraisal is most valuable,because these projects are more likely to involve major technology import,serve nationwide or international markets which must be studied, and have manylinkages to other industries. However, the average subloan size is stillexpected to be $2-3 million.

4.05 Debt/Equity Ratio. Under CIB I, CIB's long-term debt/equity ratiois not to exceed 5:1. At negotiations, an assurance was obtained that thiscovenant would remain unchanged under CIB II. CIB's projections are for adebt/equity ratio of 1.9:1 by 1988 (para. 3.39), but even if Governmentprovided no more equity, the debt/equity ratio would not reach 5:1 until 1988.

Procurement and Disbursement

4.06 Procurement. As under CIB I, individual contracts of at least$3 million equivalent would be awarded after international competitive bidding(ICB), including prior Bank/Association review of bid doci.ments, unless CIBand the Bank/Association agree otherwise. CIB should spell out the case forany exceptions in its appraisal reports. A preference equal to 15% of thec.i.f. cost or the customs duty, whichever is lower, would be extended tolocal manufacturers in the evaluation of bids. Contracts below $3 millionwould be awarded after evaluation and comparison of quotations solicited fromat least three qualified suppliers. The existence of adequate competition tohelp ensure reasonable prices would continue to be examined as part of theBank/Association review of all subprojects above the free limit. Allcontracts of more than $1 million but less than $3 million would be subject topost-review by the Bank/Association. Only about 4-8 contracts are expected toexceed $3 million. Government has authorized CNTIC to handle all importsunder CIB I and this project. CNTIC might delegate their procurement respon-sibilities for small contracts to qualified loc2al import-export corporations,with CIB's concurrence.

- 22 -

4.07 Disbursement. Disbursement would be made against full documentationfor 100% of: (a) foreign expenditures on goods and services for subprojects;and (I-) the ex-factory price of locally-manufactured equipment for subprojectsunder contracts procured througlh ICB. Disbursements are expected to becompleted by June 30, 1989. The projected disbursements are slower t.an thedisbursement profile of DFr lending in the East Asia and Pacific Regior forthe initial two years, based on CIB's experience to date (paras. 3.02 and3.26), but the final years of the profile are telescoped because theloan/credit is expected to be fully committed in FY86, and disburszmentsshould not extend for more than three years beyond then (Annex 5).

Environmental Safeguards

4.08 In recent years, China has been paying increasing attention toenvironmental questions, and has established standards and controls for wastedisposal. Already, project feasibility studies cover environmental aspects;CIB would continue to give c-reful attention to this in its appraisal reports,as would the Bank/Associatiot. in reviewing those appraisals.

Benefits and Risks

4.09 Under CIB I, the Bank played a major role in the establishment ofChina's fifth bank and first DFC. CIB is already having a positive impact onChina's industrial investment program by se-iecting generally good projects andusing an improved project appraisal methodology. As CIB moves upstream more,its contribution to project design will increase. Although some projects thatCIB screens out or rejects may obtain finance elsewhere, the general shortageof foreign exchange for investment, plus Government efforts to hold down totalinvestment, and the influence that CIB's decision will have on other agencies,ensure that CIB's project selection will help determine which projectsultimately are undertaken. There also remain long-term prospects for majorspillover effects, especially through improving the project appraisal work ofChinese central and local planning agencies and other banks. By demonstratingthat locally-sponsored projects can be designed and evaluated from thenational perspective, CIB could also give further impetus to decentralization.

4.10 In a narrow sense, the project risk is low, because CIB has beenfinancing generally good subprojects, and the Bank will continue to reviewcarefully the bulk of CIB's sublending (para. 4.03). However, the project'ssuccess in its broader objective of introducing new project appraisal methodo-logy to China depends largely on CIB overcoming its weaknesses in the criticalareas of technical review, market estimation and economic analysis ofsubprojects, and its general shortage of qualified appraisal staff. ContinuedBank Group support is essential for building up CIB in these areas (paras.3.07-3.10).

4.11 Less tractable are longer-term risks related to Governmentcommitment to the economic reform framework within which CIB operates, and toCIB itself. Although the path of reform in China, as elsewhere, has not beenentirely smooth, Government is commirted to continuing the rLocess. ThusGovernment appears unlikely to retreat into the more rigidly planned invest-ment program which would tend to undermine CIB's role. Furthermore, as of nowGovernment's commitment to CIB remains strong, as indicated by a recent StateCouncil circular to ministries and local governments supporting an enhanced

- 23 -

role for CIB. The Bank will also continue to stress to Government theimportance of more comprehensive project appraisal, particularly economiccost/benefit analysis, and price reform in improving the efficiency ofindustrial investment.

V. AGREEMENTS REACHED AND RECOMMENDATIONS

5.01 The following would be conditions of loan/credit effectiveness:

(a) employment of a senior engineer with qualifications and experienceacceptable to the Bank/Association (para. 3.08);

(b) employment of economics staff at the Head Office, withqualifications and experience acceptable to the Bank/Association(para. 3.09);

(c) State Council approval of the Development Credit Agreement and LoanAgreement (para. 4.01); and

(d) signing of a Subsidiary Loan Agreement, satisfactory to theBank/Association (para. 4.02).

5.02 At negotiations, the following assurances were obtained:

(a) from CIB that it would implement its agreed staffing and trainingplans (paras. 3.07 and 3.14);

(b) from CIB that it would exchange views with the Bank/Association onany proposed changes in its Policy Statement, Development StrategyStatement, Charter, Supplemental Regulations or Lending Procedures(para. 3.15);

(c) from CIB that it would: (i) onlend the blended loan/credit at notless than 8% p.a.; (ii) inform the Bank/Association, and exchangeviews, on any proposed change in its interest rates; and (iii)inform the Bank/AssociatLion promptly after changes in the foreignexchange lending rates of other Chinese banks (para. 3.17);

(d) from Government that it would: (i) take the impact on CIB operationsinto account in determining the foreign exchange lending rates ofother banks; and (ii) at the request of any party, exchange viewswith the Bank/Association and CIB on such impact and on CIB'slending rates (para. 3.17);

(e) from CIB's that its Appraisal Manual and the instructions for itsuse would be revised, satisfactory to the Bank/Association, and therevision issued for use by all branches by December 31, 1984 (para.3.22);

(f) from Government that it would enable enterprises to obtain theforeign exchange needed for payments to CIB (para. 3.28);

- 24 -

ig) from CIB that (i) it would maintain accounts which would be auditedannually by independent auditors acceptable to the Bank/Association;(ii) the audit report would be submitted to the Bank/Associationwithin six months after the end of each fiscal year; and (iii) itwould prepare a CIB II project completion report within six monthsafter the completion of disbursements (para. 3.34);

(h) from Government, that (i) the free limit under the project would be$2 million for such branches as agreed between CIA and the Bank/Association, and $1 million for all other branches; (ii) theaggregate free limit would be $60 million; and (iii) the first threesubprojects from each branch would remain subject to Bank/Associationapproval (para. 4.03);

(i) from CIB that the maximum subloan size under the project would be$15 million (para. 4.04); and

(j) from CIB that it would not exceed a 5:1 long-term debt/equity ratio(para. 4.05).

5.03 At negotiations, the following understandings were reached:

(a) CIB, under its staffing plan, would employ about an additional tenstaff per year in 1984 and 1985 for the Head Office and an averageof some four per year for each of the branches, with the majority tobe experienced staff, and including engineers, economists and marketanalysts (paras. 3.07-3.10);

(b) CIB's training program for 1984 and 1985 would include six to sevenin-house seminars per year, on project appraisal, supervision andaccounting (para. 3.14); and

(c) branches receiving the $2 million free limit would be those whichwere adequately staffed and trained, and had consistently metreasonable appraisal standards; initially, only the Shanghai andTianjin branches would have this free limit (para. 4.03).

5.04 With the above conditions and assurances, the project is suitablefor a Bank loan of $105 million for 20 years, including 5 years grace, at thestandard variable rate, and an IDA credit equivalent to $70 million(SDR 65.8 million) on standard terms. The Borrower would be the People'sRepublic of China.

- 25 -

ANNEX 1Page 1

CHINA

INDUSTRIAL CREDIT II PROJECT

Policy Statement of the China Investment Bank I/

1. The China Investment Bank (hereinafter called CIB) is designated bythe Chinese Government as a specialized bank to raise resources from abroad inorder to make investment loans. It shares the workload and cooperates withother financial institutions of the country, in order to accelerate thesocialist modernization program.

2. CIB's main activities are as follows:

(a) Raising long- and medium-term foreign exchange funds from abroad:At present, CIB acts mainly as an intermediary, borrowing frominternational institutions (the World Bank, etc.). Henceforth, CIBwill also borrow long- and medium-term foreign exchange funds onfavorable terms with low interest rates from other foreign banks, inaccordance with the development of its operations. With theapproval of the Government, CIB may also raise funds by issuingsecurities abroad;

(b) Providing investment loans to domestic enterprises: the loans aremainly to finance medium and small projects, especially theexpansion, modernization and technical transformation projects ofexisting enterprises;

(c) Handling World Bank-financed projects entrusted by the Ministry ofFinance and the World Bank;

(d) Gradually developing consultancy services to borrowing units; and

(e) Undertaking other banking operations.

3. Under the direction of the overall national construction policy andD' ional economic plans, and in conformity with the unified financial policy

the nation and CIB's own operational regulations, CIB shall selectp.jjects, make loans and handle other related operations. The projectsselected by CIB must be incorporated in the nation's fixed asset investmentplan. The borrowing units shall apply to the material supplying units forrequired materials in accordance with government regulations, or purchase themthemselves.

4. CIB shall select projects on the basis of the following basiccriteria: the products are suitable for sale and urgently needed fordeveloping the national economy; the projects are technically, financially and

1/ As revised in May 1984, and approved by CIB's Managing Committee.

- 26 -

ANNEX 1Page 2

economically viable, are under adequate business management, involve modestinvestment costs, yield results quickly, and have the ability to repay bothforeign and local currency loans.

5. CIB will require the borrowing units to make detailed feasibilitystudies before project approval. .^. ioan will be approved only af-ar CIB hasmade a thorough review and appraisal of the feasibility study and is assuredthat all the criteria have been met in acordance with CIB's "Industrial CreditProjects Appraisal Manual."

6. GIB shall make foreign currency investment loans and local currencyinvestment loans. Foreign currency investment loans will be used mainly forimport of technology and equipment, while local currency loans will coverlocal costs of ancillary domestic equipment and construction. CIB's maximumforeign currency lending to one enterprise shall be US$15 million. Forprojects exceeding that amount, CIB may finance them jointly with otherinstitutions.

7. The ratio of long-term debt of CIB to its equity (including paid-incapital, legal reserves and retained earnings) shall not exceed 5:1. Thetotal exposure of CIB in an enterprise shall generally not exceed 20% of CIB'sequity.

8. The interest rate on foreign currency investment loans shall be theborrowing rate plus a fixed margin. The interest rates on local currencyinvestment loans shall be in line with the relevant rates, as specified by theGovernment.

9. The period of CIB's loans (from the time of loan agreement to thedate when the principal and interest are fully repaid) shall normally notexceed seven years, with the longest not exceeding twelve years. The periodof each loan shall be determined on a case-by-case basis and shall bespecified in the loan agreement. The loan period includes the constructionperiod (which will be the grace period) and the repayment period. Theconstruction period shall be based on the construction plan as spelled out inthe project feasibility study, while the repayment period shall be based onthe projected annual cash flow available for loan repayment after the projectis completed and production started.

10. The borrowing units shall first repay foreign currency investmentloans and then repay local currency investment loans. When a borrowing unitis delinquent in repayment of principal and interest during the repaymentperiod, the penalty rate on the overdue portion shall be 20% above theoriginal rate. When any loan is diverted to other uses, it shall be dealtwith in accordance with CIB's "Lending Regulations for Trial Use."

11. According to the Subsidiary Loan Agreement between the ChineseGovernment and CIB, the foreign exchange risk on foreign currency investmentloans extended by CIB shall be borne by the Chinese Government and theborrowing units respectively. CIB shall draw up concrete provisions in itsrelevant regulations for implementation of the above-mentioned principle.

- 27 -

ANNEK IPage 3

12. CIB shall ensure that the borrowing units choose the most suitableand most economical technology and equipment for importation. Internationalcompetitive bidding should be used for procurement contracts amounting indi-vidually to over US$3 million. Comparison of quotations may be used forcontracts amounting individually to below US$3 million. When the lattermethod is used, the quotations of at least three acceptable equipmentsuppliers should be generally obtained.

13. Borrowing enterprises which need to employ foreign consultants orto have their own staff make investigations abroad for project implementation,may obtain preparation subloans or may use their foreign exchaage investmentloans to pay su^h expenditures, after CIB's approval.

14. During the loan period (including the construction period and therepaymcnt period), CIB shall conduct systematic inspection and supervision ofthe projects in accordance with its "Supervision Regulations for Loan-FinancedProjects (For Trial Use)," to ensure the proper utilization of the loanproceeds, accelerate construction, improve management, maximize the economicbenefit of the investments anl ensure loan repayment on schedule.

15. CIB shall adopt various measures to vigorously recruit and trainoperational staff and raise orerational standards, and shall graduallyestablish branches and sub-br:Anches based on operational needs and theconditions of staff recruitment and tralning.

- 28 -

ANNEX 2Page 1

CHINA

INDUSTRIAL CREDIT II PROJECT

Development Strategy Statement for 19$4-1986 of theChina Investment Bank ..!

To facilitate the gradual expansion of its operations and toaccomplish its assigned tasks, the China Investment Bank (hereinafter calledCIB) will follow a development strategy in the period 1984-1986, as spelledout below:

1. CIB will follow the national policy of "actively carrying outtechnical transformation in existing enterprises and maximizing economicefficiency." In the coming few years, CIB's lending will mainly assistexisting enterprises to implement their modernization and transformation aswell as expansion projects.

2. In the coming few years, CIB's lending wLll fc.cus mainly on projectswhich involve modest investment cost, yield result; quickly and are clearlyable to repay. Thus, CIB will select projects primarily from the textile andother light industrial sectors. At the same time, CIB will select someurgently-needed projects with sound economic benefits from the chemical,machinery, electronics, metallurgy, building material and other sectors.

3. CIB's assistance will be provided mainly for implementation ofsmall- and medium-scale projects. In general, total foreign currency lendingto one project shall not exceed US$15 million (but may finance larger projectswith the sponsoring enterprises' own funds or through cofinancing with otherinstitutions); total ancillary local currency lending to one project shall notexceed 30 million yuan.

4. Projects financed by CIB in the coming few years should mainly bethose whose products can be exported to generate foreign exchange or can beimport substituting to save foreign exchange. Thus, CIB will initiallyoperate in the coastal provinces and municipalities where it is convenient todevelop export trade, and will gradually expand to interior provinces andcities in which the industrial foundation is relatively strong and foreignexchange generating and saving projects are relatively densely located.

5. CIB will actively assist the borrowing enterprises to preparefeasibility studies in accordance with state regulations and will thenappraise projects satisfactorily on the basis of such studies, so thatprojects which are technically, financially and economically viable will beselected. CIB's branches will review enterprises' loan applications whichwill be subject to final review and approval by the Head Office.

1/ As revised in May 1984, and approved by CIB's Managing Committee.

- 29 -

ANNEX 2Page 2

6. CIB shall vigorously recruit and train specialized staff who arefamiliar with international finance, foreign and domestic trade, industrialeconomics, engineering, foreign languages, etc., in order to raise itsoperational standards. CIB will assign the China Trade Consultants andTechnical Service Corporation (CTC) to supply international and domesticmarket and price information which S. needs in project appraisal in accordancewith the agreement signed between QIB and CTC. When necessary, CIB willassign the China International Engineering Corporation (CIECC) or other localconsulting firms to undertake technical appraisal work on CIB's projects. Inaddition, CIB can also hire foreign and domestic advisors oa a shcrt-termbasis to assist its technical staff to appraise and supervise projectssatisfactorily.

- 30 -

ANNEX 3Table I

CHINA

CHINA INVESTMENT BANK

CIB Five-Year Financial and Operational Projections

Actual and Projected hperations, 1983-88(Yuan million)

1983 1984 1985 1986 1987 1988(Actual & ---- (Projected)-------------…---audited)

Loan Approvals /aLocal currency 165.2 180.0 260.0 360.0 460.0 500.0Foreign currenc, /b 139.4 252.0 364.0 504.0 644.0 700.0

(US$ million) ff' (49.8) (90.0) (130.0) (180.0: (230.0) (250.0)

Total Approvals 304.6 432.0 624.0 864.0 1.104.0 1.200.0

Loan Commitments /cLocal currency 76.1 179.1 220.0 310.0 410.0 480.0Foreign currency /b 48.7 216.7 308.0 434.0 574.0 672.0

(US$ million) (17.4) (77.4) (110.0) (155.0) (205.0) (240.0)

Total Commitments 124.8 395.8 528.0 744.0 984.0 1,151.0

Loan Disbursements /dLocal currency 33.7 76.4 180.1 236.0 325.5 419.0Foreign currency /b 10.9 98.0 227.4 336.6 463.4 589.4

(US$ million) (3.9) (35.0) (81.2) (120.2) (165.5) (210.5)

Total Disbursements 44.6 174.4 407.5 572.6 788.9 1.008.4

Loan Repayments /eLocal currency 4.8 6.8 15.9 19.0 29.0 83.4Foreign currency./b - - 7.3 49.6 139.2 253.7

(USs million) (2.6) (17.7) (49.7) (90.6)

Total Repayments 4.8 6.8 23.2 68.6 168.2 337.1

Loans OutstandingLocal currency 28,,i 98.5 262.7 479.7 776.2 1,111.8Foreign currency /b 10.9 108.9 329.0 616.0 940.2 1,275.9

(US$ million) (3.9) (38.9) (117.5) (220.0) (335.8) (455.7)

Total outstanding 39.8 207.4 591.7 1.095.7 1,716.4 2,387.7

Assumptions:/a Local currency loans would be approved together with foreign currency loans at the

ratio of Y2 to US$1./b Converted at US$1 - Y 2.80.Ic 50% of local eurrency and foreign currency loan approvals of the current year

would be committed (contract signed) during the year, and the remaining 50% ofapprovals would be committed the following year.

/d Disbursements would be made as follows, in relation to commitments:Foreign currency loans : 30% in the current year, 60% in the following yearand 10% in tho third year.Local currenr.y loans : 20% in the current year, 75% in the following year and5% in the third year.

/e Based on the rerayment schedules of the loans made in 1983, subloan repayments areprojected to follow the following pattern (by year):

Foreign currency loan (after 3-years' grace): 15%, 35%, 35%, 10%, 5%.Local currency loans (after 2-years' grace): 10%, 30%, 25%, 20%, 15%.

/f Rollover funds included: $2.6 million (1986), $17.7 million (1987), and$49.7 million (1988).

AEP Projects Depart-entMay 1984

- 31 -4NNEX 3Table 2

CHINA

CHINA INVESTMENT BANK

Actual and Projected Cash Flow Statements, 1983-88(Yuan million)

1983 1984 1985 1986 1987 1988(Actual ---- (Projected) …& audited)

SourcesNet income before tax 5.53 4.30 5.30 13.62 23.13 33.90Add: Noncash items

Provisions for losses 0.01 0.04 0.12 0.22 0.34 0.48Depreciation 0.01Amortization of front-end fee 0.08 0.12 0.12 0.12 0.12 0.12Accrued expenses 0.07

Subtotal 5.70 4.46 5.54 13.96 23.59 34.50

Paid-in capital - - - 125.00 175.00 200.00Domestic borrowings 140.00 - - 125.00 175.00 200.00International borrowings 5.23 98.00 220.10 285.90 313.30 290.10Surplus 0.04

Subtotal 145.27 98.00 220.10 535.90 663.30 690.10

Loan collectionsLocal currency 4.84 11.16 15.90 19.00 29.00 83.40Foreign currency - - 7.30 49.60 139.20 253.70

Subtotal 4.84 11.16 23.20 68.60 168.20 337.10

Total Sources 155.81 113.62 248.84 618.46 855.09 1,061.70

UsesLoan disbursements

Local currenc: loans 33.65 76.40 180.10 236.00 325.50 419.00Foreign currency loans 9.33 98.00 227.40 336.60 463.40 589.40

Subtotal 42.98 174.40 407.50 572.60 788.90 1,008.40

Increase of accounts receivable 0.29 - - - -

Purchase of equipment 0.18 -Front-end fee 1.68 0.74 - - - -Taxes 0.39 0.75 1.40 2.71 4.37 21.46

Total Uses 45.52 175.89 408.90 575.31 793.27 1,029.86

Surplus (Deficit) 110.29 (62.27) (160.06) 43.15 61.82 31.84

Cash and Bank BalancesYear-end 510.29 448.02 287.96 331.11 392.93 424.77

AEP Projects DepartmentMay 1984

- 32 -ANNEX 3Table 3

CHINA

CHINA INVESTMENT BANK

Actual and Projected Resource Position, 1983-88

As of December 311983 1984 1985 1986 1987 1988

(Actual & ----------------- (Projected) -------------------audited)

Local Currency Funds (Yuan million)

Resources available for approvals atbeginning of the year 372.00 211.94 40.29 (209.01) (292.20) (364.44)

Paid-in capital - - - 125.00 175.00 200.00

Government loan - - - 125.00 175.00 200.00

Net income 5.14 3.55 3.90 10.91 18.76 12.44

Loan collections - 4.80 6.80 15.90 19.00 29.00

Total 377.14 220.29 30.99 67.80 95.56 77.00

Approvals of Investment loans duringthe year (165.20) (180.00) (260.00) (360.00) (460.00) (500.00)

Resources Available for Approvals 211.94 40.29 (209.01) (292.20) (364.44) (423.00)

Foreign Currency Funds (US$ million)

Resources available for approvals atbeginning of the year - 60.20 145.20 55.20 177.80 55.50

International borrowings 70.00 175.00 40.00 300.00 90.00 300.02

Foreign exchange.purchased 40.00 - - - -

Revolving fund 20.00 20.00 20.00 20.00 20.00 20.00

Loan collections - - - 2.60 17.70 49.70

Total 130.00 255.20 205.20 377.80 305.50 425.20

Approvals of subloans during the year (49.80) (90.00) (130.00) (180.00) (230.00) (250.00)

Res urces Available for Approvals(Excluding Revolving Fund) 60.20 145.20 55.20 177.80 55.50 155.20

AEP Projects DepartmentMay 1984

- 33- ANNEX 3

Table 4CHINA

CHINA INVESTMENT BANK

Actual and Projected Profit and Loss Statements, 1983-88(Yuan million)

1983 1984 1985 1986 1987 1988(Actual -- … ---- (Projected) …& audited)

IncomeInterest income from loans:

Local currency 1.16 2.29 6.50 13.36 22.61 33.98Foreign currency 0.12 4.79 17.52 37.80 62.25 88.64

Interest tncome from depositsLocal currency 6.07 5.03 1.67 1.33 1.44 149Foreign currency 0.42 2.80 2.24 1.68 1.12 1.12

Total Income 7.77 14.91 27.93 54.17 87.42 125.23

ExpensesFinancial expenses 1.79 8.69 20.09 37.52 60.73 87.26Administrative expenses 0.44 1.46 2.00 2.39 2.80 3.17Overseas training and - 0.42 0.42 0.42 0.42 0.42

foreign consultancyProvision for bad debts 0.01 0.04 0.12 0.22 0.34 0.48

Total expenses 2.24 10.61 22.63 40.55 64.29 91.33

Income Before Taxes 5.53 4.30 5.30 13.62 23.13 33.90

Industry and Commerce Tax 0.39 0.75 1.40 2.71 4.37 6.26

Tncome Tax - - - 15.20

Net Profit 5.14 3.55 3.90 10.91 18.76 12.44

Ratios:As % of average total assets

Total income 1.4 2.5 3.6 4.7 4.9 5.1Financial expenses 0.3 1.4 2.6 3.2 3.4 3.5Administrative expenses 0.1 0.2 0.3 0.2 0.2 0.1Total expenses 0.4 1.8 2.9 3.5 3.6 3.7Income before tax 1.0 0.7 0.7 1.2 1.3 1.4Net profit 0.9 0.6 0.5 0.9 1.1 0.5

Net profit as % of averageEquity 1.3 0.9 1.0 2.3 2.9 1.5Paid-in capital 1.3 0.9 1.0 2.3 3,1 1.6

EP Projects DepartmentMay 1984

- 14 -ANNEX 3Table 5

CHINA

CHINA INVESTMENT BANK

Actual and Prolected Balance Sheeto. 1983-88(Yuan million)

As of December 311983 1984 1985 1986 1987 198,8(Actunl --------------- (Projected)-----------------& audited)

ASRFTS

Currant AssetaCansh and bank deposit 510.29 448.02 287.96 331.11 392.93 424.77Current maturities of long-term loanal,ocat currency 6.80 15.90 19.00 29.00 83.40 148.00Foreign currency - 7.30 49.60 13S.20 253.70 370.20

Total current nsaets 517.09 471.22 356.56 499.31 730.03 942.97

Loan PortfolioLocal currency 28.81 98.50 262.70 479.70 776.20 1,111.80Foreign currenty 9.33 108.90 329.00 616.00 940.20 1,275.90

Total loan portfolio 38.14 207.40 591,70 1,095.70 1,716.40 2,387.70

Leass provision for losses (0.01) (0.05) (0.17) (0.39) (0.73) (1.21)Least current maturities (6.80) (23.20) (68.60) (168.20) (337.10) (518.20)

Net loan nortfolio 31.33 184.15 522.93 927.11 1,378.57 1.868.29

Deferred ChargesFront-end fee 1.68 2.42 2.42 2.42 2.42 2.42Less: amortization (0.08) (0.20) (0.32) (0.44) (0.56) (0.68)Other deferred ebarges 0.47

Net deferred charges 2.07 2.22 2.10 1,98 1.86 1.74

Total long-term assets 33.40 186.37 525.03 929.19 1,380.43 1,870.03

TOTAL ASSETS 550.49 657.59 881.59 1.428.40 2,110.46 2,813.00

LIABILITIES AND NET WORTH

Current liabilitiesAccounts payable 0.08 - - - -Current maturities of long-term debts - - - - 13.18 13.18

Total current liabilities 0.08 - - - 13.18 13.18

Long-term liabilitiesLocal currency debtGovernment loan - - - 125.00 300.00 500.00Construction Bank loan /a 140.00 140.00 140.00 140,00 140.00 140.00

Foreign currency debt 5.23 108.90 329.00 614.90 928.20 1,218.30Less: current maturities - - - - (13.18) (13.18)

Total long-term liabilities 145.23 248.90 469.00 879.90 1,355.02 1,845,12

Total liabilities 145.31 248.90 469.00 879.90 1,368.2C 1,858.30

Net WorthPaid-in capital 400.00 400.00 400.00 525.00 700.00 900.00Retained earnings 5.18 8.69 12.59 23.50 42.26 54.70

Total net worth 405.18 408.69 412.59 548.50 742.26 954.70

TOTAL LIABILITIES AND NET WORTH 550.49 657.59 881.59 1,428.40 2,110.46 2,813.00

RatiosLong-term debt/equity 0.4:1 0.6 1 1.1:1 1.6:1 1.8:1 1.9:1Total debt/equity 0.4:1 0.6:1 1.1:1 1.7:1 1.8:1 2.0:1

/a For purchasing foreign exchange $50 million.

AEP Projects DepartmentRay 1984

- 35 -

ANNEX 4

3HINA

SECOND INDUSTRIAL CREDIT PROJECT

Distribution of CIB I Subprojects(as of April 30, 1984)

No. of Amount ofsubprojects % subloans %

($'000)

A. Sectoral Distribution

Industry

Paper and paper products 2 6.2 8,000.0 15.2Textiles and clothing 8 25.0 8,148.5 15.5Pharmaceuticals 4 12.5 4,570.0 8.7Packaging materials 2 6.2 2,355.0 4.5Printing (nontextile) 4 12.5 3,638.0 7.0Machinery and Electronics 3 9.4 2,900.0 5.5Building materials 2 6.3 2,350.0 4.5Metal works 3 9.4 10,293.0 19.6Miscellaneous 4 12.5 10,240.0 19.5

Total 32 100.0 52,494.5 100.0

B. Geographical Distribution

CIB Branch

Shanghai 2 6.3 4,351.0 8.3Jiangsu 13 40.6 13,005.5 24.8Tianjin 9 28.1 23,360.0 44.5Hebei 5 15.6 6,873.0 13.1Hubei 1 3.1 1,355.0 2.6Fujian 2 6.3 3,550.0 6.7

Total 32 100.0 52,494.5 100.0

AEP Projects DepartmentMay 1984

- 36 - ANNEX 5

CHINA

SECOND INDUSTRIAL CREDIT PRCJECT

Estimated Cumulative Disbursements of the Proposed Loan/Credit /a(US$ million)

Bank/association Estimated Disbursement profile forfiscal year cumulative "IDF Sector Loans" insemester disbursements East Asia and Pacific Region

FY85First 0.5Second 3.0 10.3

FY86First 15.0 30.6Second 40.0 57.4

FY87First 75.0 85.9Second 110.0 111.7

FY88First 130.0 132.1Second 145.0 147.0

FY89First 160.0 157.2Second 175.0 164.2

FY90First 169.0Second 172.3

FY91First 175.0

Closing Date: June 30, 1989

/a The projected disbursements start slowly based on the CIB I experience todate, and then match the relevant disbursement profile (rounded to thenearest $5 million) through FY88. The "tail" of the disbursement profilefor FY90 and FY91 is telescoped into FY89 because the loan/credit areexpected to be fully committed in FY86, and disbursements should notextend for more than three years beyond then.

- 37 -

ANNEX 6

CHINA

SECOND INDUSTRIAL CREDIT PROJECT

Selected Documents and Data Available in the Project File

Many relevant documents are available in the project file for thefirst China Industrial Credit Project. The additional documents are asfollows:

B. Basic Documants Relating to the Project.

B-1 Draft Statute of China Trade Consultants and TechnicalService Corporatio'-

B-2 Business _ . -- Agreement between CIB and ChinaTrade Consultan, kFebruary, 1984)

B-3 Provisional Methods of External Procurement and Settlementfor CIB Foreign Exchange Loan Projects (May 24, 1983)

B-4 CIB Lending Procedures (for Trial Use), (Promulgated byMOF on April 2, 1983)

B-5 China Consultants oZ Accounting and Financial Management:Articles of Association and CVs of Key OfWicers(December, 1982)

B-6 Agreement on Technical Evaluation of the Industrial ProjectsEntrusted by CIB to CIECC (February 1983)

B-7 CIB - Schedule of Periodic Reports to IBRD

- 38

CHINACHINA INVESTMENT BANK

Organization Chart(As of AprIl 30, 1984)

BOARD OF DIRECTORS

HONORARY CrWRMAti: Wang Bingq[an.Mfr.0er of Finance

CHAIRMAN: Wu BoshanVice Minister ot RnoncePresident of Popte'sConstruction Bank ofChlno

MANAGING COMMirEE:A

BOARD CHAIRMANIT RALADEPUTY BOARD CHAPMAN (3) - CHIEF AU

MANAGING DIRECTORS (7) Boo Sh

PRESIDENTZhou Ha_nrng

|ViCE PRESIDENT|Geng Genrgshan

GENERAL & ADMINISTRATiVE COORDINATING & PLANNING PROJECT LENDING RNANCE & ACCOUNTING SURVEY & ESEARCHOFRCE DEPARTMENT DEPARTMENT DEPARTIVENT DEPARTMENT

MANAGER MANAGER: MANAGER:DEPUTY Ms Chen Jinglanng Uing Han Deng Hailkuel MANAGER:

O!IRCE MANAGER Tong TionshenUu .kJnin DEPUTY MANAGER ACTING DERPlY MANAGER: DEPUTY MANAGER:

Wang Furrong Guon Xland ms. Wang Ujuan

NO. OF STAfI 5 4 13 3 5

LIAONING BRANCH

Total No of Board Directors = 32 A IANCH MANCH _(IncludIng Honorary Chairman, TAT nG Fu AChairman, Deputy Chalrman) TING Pu

ACTiNG DEPUTTotal No. of Staff In Head Office = 33 BRANCH MANAGERS(Including Senior Manogement) Li Yutlan

Lu Chunling

lotal No. of Staff In Brcnches = 84 NO. OF STAFF:

AEP Prjects DepartmentAprl 30, 1984

VICE PRESIDENTThno Hong

SHANGHAI BRNCH ThANJIN BRANCH JKANGSU BRANCH HEBEI BRANCH RULAN BRANCH HUBEI BRANCH

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