Documentof The World Bank Public Disclosure Authorized ReportNo. 15387-CHA

STAFF APPRAISAL REPORT

CHINA Public Disclosure Authorized

CHONGQINGINDUSTRIAL POLLUTION CONTROL AND REFORM PROJECT

May 15, 1996 Public Disclosure Authorized

Environment and Municipal Development Operations Division China and Mongolia Department

Public Disclosure Authorized East Asia and Pacific Regional Office CURRENCY EQUIVALENTS (as of January 31, 1996)

Currency Name = Currency Unit = (Y) Y 1.00 = I00 fen Y 1.00 =$0.11 $1.00 =Y8.32

FISCAL YEAR January I - December 31

WEIGHTS AND MEASURES

I millimeter (mm) = 0.039 inches I meter (m) = 3.28 feet I square meter (m2) = 310.76 square feet I cubic meter (m3 ) = 35.3 cubic feet I kilometer (kIm) = 0.62 miles I hectare (ha) = 10,000 square meters = 15 mu I kilogram (kg) = 2.204 pounds 1 megawatt (MW) = 1,000,000 watts

ACRONYMS

ABC - Agricultural Bank of China CAF - Continuing Advisory Facility CEPB - Chongqing Environmental Protection Bureau CFB - Chongqing Finance Bureau CISDI - Chongqing and Design Institute CISCG - Chongqing Iron and Steel Company (Group) Limited CLB - Chongqing Labor Bureau CMB - China Merchants Bank CM - Chongqing Municipality CSSC - Chongqing Special Steel Company (Group) Limited EAF - EAU - Environmental Audit Unit EBBC - Everbright Bank of China EIA - Environmental Impact Assessment EPB - Environmental Protection Bureau ERR - Economic Rate of Return FRR - Financial Rate of Return GDP - Gross Domestic Product GEF - Global Environmental Facility GOC - Goverinmentof China GVIO - Gross Value of Industrial Output ICB - International Competitive Bidding ICBC - Industrial and Commercial Bank of China JGF - Japanese Grant Facility JV - Joint Venture LIB - Limited International Bidding l LCs - Limited Liability Companies LLSCs - Limited Liability Shareholding Companies LOC - Line of Credit LSE - Labor Service Enterprise MOF - Ministry of Finance Mt - Million Tons NEPA - National Environmental Protection Agency NO, - Nitrogen Oxide NSOE - Nonstate-Owned Enterprise NSRAF - Nonstate Enterprise Restructuring Advisory Facility PBC - People's Bank of China PFI - Participating Financial Institution PIP - Project Implementation Plan PLG - Project Leading Group PMO - Project Management Office PRC - People's Republic of China RAF - Restructuring Advisory Facility RAP - Resettlement Action Plan SAMB - State Asset Management Bureau SAOC - State Asset Operating Company SLC - Single Currency Loan SOEs - State-Owned Enterprises

SO2 - Sulfur Dioxide SPEC - State Environmental Protection Commission TA - Technical Assistance TOR - Terms of Reference TSP - Total Suspended Particulates TVEs - Township and Village Enterprises Ul - Unemployment Insurance ZICC - Zhongxing Industrial and Commerce Company I - 1 -

CHINA CHONGQING INDUSTRIAL POLLUTION CONTROL AND REFORM PROJECT

LOAN AND PROJECT SUMMARY

Borrower: The People's Republic of China

Implementing Agency: Chongqing Municipal Project Management Office

Beneficiaries: Chongqing Municipality, Chongqing Iron and Steel Company (Group) Limited, Chongqing Special Steel Company (Group) Limited, other industrial enterprises, Chongqing Environmental Protection Bureau, Chongqing Labor Bureau, Chongqing State Asset Management Bureau

Poverty: Not applicable

Amount: $170 Million

Terms: 20 years including 5 years of grace, at the standard interest rate for LIBOR-based US dollar single currency loans

Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days after signing, less any waiver

Onlending Terms: From Chongqing Municipality to the participating financial intermediaries: 20 years, including 5 years of grace at the standard interest rate for LIBOR-based US dollar single currency loans, and a commitment charge of 0.75 percent

From Chongqing Municipality to the steel companies: 12 years including 5 years of grace at the standard interest rate for LIBOR-based US dollar single currency loans, plus a spread of 1.2 percent per year and a commitment charge of 0.75 percent. The companies would bear the foreign exchange risk.

From the participating financial intermediaries to the industrial enterprises: up to 12 years including up to 5 years of grace at the standard interest rate for LIBOR-based US dollar single currency loans, plus a spread of not less than 2.0 percent per year and a commitment charge of 0.75 percent. The enterprises would bear the foreign exchange risk. - 11 -

Financing Plan: See Table 4.2

Economic Rate of Return: Industrial Relocation Component: Chongqing Special Steel Company (Group) Limited: 24 percent Chongqing Iron and Steel Company (Group) Limited: 20 percent

Map: IBRD 27875

Project ID Number: CN-PE-3646 - 111-

CONTENTS

1. CHINA: INDUSTRIAL POLLUTION CONTROL AND ENTERPRISE REFORM...... I1 A. Introduction...... 1 B. China's System for Environmental Protection...... 2 C. Chinese Industrial Structure and Performance...... 3 D. China's Reform of Industrial SOEs ...... 4 E. The Bank's Strategy ...... 6 F. Rationale For Bank Activity in Chongqing ...... 8

2. CHONGQING'S ECONOMY AND PROGRAMS FOR INDUSTRIAL POLLUTION CONTROL AND ENTERPRISE REFORM ...... 9 A. Chongqing's Economy...... 9 B. Chongqing's Program for Industrial Pollution Control ...... 11 C. Enterprise Reform Program ...... 15

3. THE PROJECT ...... 18 A. Project Objectives ...... 18 B. Project Performance Indicators ...... 18 C. Project Description ...... 19 D. Project Organization and Management ...... 29

4. THE LOAN, PROJECT COST, FINANCING PLAN, PROCUREMENT, AND DISBURSEMENT...... 31 A. Main Features of the Loan ...... 31

This report is based on the findings of an appraisal mission that visited China in November/December 1995. The report was prepared by: N. Hughes (Senior Operations Officer and Task Manager), H. Broadman (Senior Economist), B. Baratz (Principal Environmental Engineer), J. Saba (Principal Private Sector Development Specialist), R. Heath (Principal Chemical Engineer), R. Roulier (Principal Banking Specialist), P. de Sa (Financial Analyst), ), Y. Zhang (Operations Officer), D. Elsen (Counsel), M. Meunier (Consultant/Steel Engineer), R. Hall (Consultant/Labor Economist), and S. Ferguson (Consultant/Resettlement). The peer reviewers are: P. Harrold (Policy Reform), Y. Ziv (Environment) and F. Montes-Negret (Financial Intermediation). The Division Chief is Katherine Sierra and the Department Director is Nicholas C. Hope. - iv -

B. Project Cost ...... 32 C. Financing Plan...... 33 D. Procurement ...... 33 E. Disbursement ...... 36 F. Monitoring and Reporting ...... 37 G. Accounting and Auditing ...... 37

5. PROJECT JUSTIFICATION AND RISKS...... 38 A. Financial and Economic Benefits of the Project ...... 38 B. Financial Analysis of the Industrial Relocation Component ...... 38 C. Economic Benefits of the Industrial Relocation Component...... 43 D. Environmental Aspects of the Industrial Relocation Component ...... 45 E. Major Project Risks ...... 48

6. AGREEMENTS REACHED AND RECOMMENDATION ...... 50

ANNEXES

Annex 2.1: Chongqing's Economic Structure .55 Annex 3.1: Economic Policy Statement of Chongqing Municipality .61 Annex 3.2: Chongqing Municipality Economic Policy Reform Agenda and Action Plan .65 Annex 3.3: Environmental Protection in Chongqing and the Chongqing Industrial Pollution Control and Reform Project .73 Annex 3.4: Terms of Reference: Hazardous Waste Inventory and Hazardous Waste Data Management System .93 Annex 3.5: Terms of Reference: Consultant Services for a Hazardous Waste Site Selection Study for Chongqing Municipality.97 Annex 3.6: Regulatory Reform Action Plan.101 Annex 3.7: Terms of Reference: Preparation of an Industrial Pollution Control Plan .102 Annex 3.8: Terns of Reference: Operationalizing an Environmental Audit Unit in the Chongqing Environmental Protection Bureau .106 Annex 3.9: Chongqing Special Steel Company (Group) Limited.115 Annex 3.10: Resettlement Associated with the CSSC Relocation ...... 123 Annex 3.11: Zhongxing Industry and Commerce Company, Subsidiary of Chongqing Iron And Steel Company (Group) Limited...... 140 Annex 3.12: Agricultural Bank of China (ABC) ...... 147 Annex 3.13: China Merchants Bank (CMB) ...... 165 Annex 3.14: Everbright Bank of China (EBBC)...... 175 Annex 3.15: Redeploying Surplus Labor ...... 192 Annex 3.16: Technical Assistance for a State Asset Operating Company ...... 202 - v -

Annex 3.17: Project Implementation Plan...... 206 Annex 4.1: Schedule of Disbursements...... 213 Annex 4.2: Bank Supervision Input into Key Activities ...... 214 Annex 4.3: Selected Documents Available in the Project File...... 215

TABLES IN TEXT

Table 2.1: China's and Chongqing's Economic Structure. 9 Table 2.2: China's and Chongqing's Labor Structure .0 Table 3.1: Institutional Performance Indicators .1 9 Table 3.2: Development Objective Indicators .19 Table 4.1: Summary of Project Costs .32 Table 4.2: Project Financing Plan .33 Table 4.3: Procurement Arrangements .34 Table 5.1: Efficiency Gains, 1993 and 2002 .40 Table 5.2: Financial Rate of Return (FRR)-Sensitivity Analysis.41 Table 5.3: Economic Rate of Return (ERR}-Sensitivity Analysis .44 I - 1 -

1. CHINA: INDUSTRIAL POLLUTION CONTROL AND ENTERPRISE REFORM

A. INTRODUCTION

1.1 Pollution associated with China's burgeoning economic growth continues to exact a sizable toll on the Chinese people and on the environment. China's industrial sector generates significant levels of air, water and solid waste pollution. Despite progress in establishing institutions and policies to reduce industrial pollution, there remains considerable scope for improvement, especially in implementation and enforcement. Effectively integrating environmental protection objectives into economic policies, particularly those aimed at reform of industrial state-owned enterprises (SOEs), continues to be a major challenge.

1.2 China's industrial pollution management system relies on a mixture of administrative controls and market-based incentives. These are intended to lead to the abatement of pollution produced by existing facilities and to the adoption of cleaner technologies. Neither the application of administrative controls nor the incentive structure has been effective, and the current regime of fees and fines is deficient for enterprises that fail to meet environmental standards; penalties are small and collection rates are low. Reforms must focus on implementing incentives and disincentives that make it more cost-effective for firms to stop polluting. Also, regulatory institutions must be strengthened, especially their monitoring and enforcement capabilities.

1.3 Industrial pollution control and enterprise reform and restructuring are part of the same process because controlling industrial pollution is integral to transforming Chinese SOEs into modem corporations. Exacerbating the impact of the weak environmental regulatory regime is the fact that many major Chinese industrial polluters are SOEs utilizing obsolete-and polluting-technologies, but lacking autonomy, particularly adequate control over costs and prices, to pass on the cost of pollution control. They therefore have no economic incentive to make needed improvements to comply with environmental standards, and the result is continued pollution of the air, water and land. The alternative of replacing the obsolete highly polluting technology with efficient nonpolluting technology is beyond the reach of most SOEs, which do not generate sufficient retained earnings or have access to sufficient bank financing to support such transformation. In addition, unless this is accompanied by the introduction of modem corporate governance structures in SOEs, including their divestiture of the social service functions they now perform (e.g., provision of housing, education, health care and pensions, among others), the polluting state industries will remain inefficient and unable to afford improved, environmentally beneficial technology. The successful transition of the Chinese economy from a command system to a "" will depend largely on how industrial SOEs can respond to market incentives, including those related to pollution abatement. China cannot afford to slacken the pace of SOE reform and it must deal with industrial pollution.

B. CHINA'S SYSTEM FOR ENVIRONMENTAL PROTECTION

1.4 The legal basis for environmental protection is established under the Chinese Constitution of 1982. Below the Constitution are basic and specific laws, promulgated by the Standing Committee of the National People's Congress. The Environmental Protection Law (EPL) (1989) is a basic law and sets forth four guiding principles: (a)environmental protection must be integrated and coordinated with economic development; (b) pollution prevention should receive as much emphasis as pollution control; (c) polluters should pay for environmental degradation ("polluter pays" principle); and (d) better environmental quality can be achieved through more effective environmental management. The EPL provides for active enforcement by government agencies, prohibits locating new industrial plants near populated and protected areas, and specifies that existing industries may be relocated or closed to comply with the environmental law. Twelve specific laws, e.g., the Water Pollution Prevention and Control Law, the Air Pollution Prevention and Control Law (both recently revised), and the Solid and Hazardous Waste Law govern certain subjects that are addressed more generally by the EPL.

1.5 Underpinning these statutes are more technical and specific regulations. They are issued at the state, provincial, regional and municipal levels (for municipalities having province status). The regulations governing air and water pollution will have to be revised in accordance with the new laws (regulations governing disposal of solid and hazardous waste have yet to be drafted). Supplementary edicts are promulgated as required by local Environmental Protection Bureaus (EPBs) for their own jurisdictions.

1.6 The EPL authorizes the National Environmental Protection Agency (NEPA) to establish national ambient quality and source discharge standards. Provincial and municipal governments can set discharge standards if they are more stringent, or if a national standard does not exist. Emissions standards are generally uniform for a given pollutant across industries, but not necessarily across sectors (e.g., thermal power plants have lower air pollution standards than industrial plants).

1.7 The State Environmental Protection Commission (SEPC), which includes the heads of all relevant ministries and agencies, convenes quarterly to provide policy direction and resolve interagency disputes. SEPC relies heavily on NEPA, which functions as its secretariat. NEPA became an independent agency in 1988, reporting to both the State Council and SEPC. NEPA is responsible for all aspects of environmental policy and environmental management. NEPA also supervises subnational EPBs, established in all provinces and municipalities and in most counties, under local environmental policy commissions. Subnational EPBs bear the main burden of enforcement. - 3 -

1.8 China's approach to regulating industrial pollution has focused on four instruments: (a) environmental impact assessments (EIAs) before approving new projects; (b) the "three synchronization" licensing strategy, which requires project designs to include pollution control abatement measures in the actual investment and proper operation of abatement equipment; (c) pollution levy fees charged against air emissions and wastewater streams that have concentrations of pollutants above permitted levels; and most recently, (d) wastewater discharge permits based on volume (mass) emitted.

1.9 The most comprehensive official statement of China's industrial pollution control strategy is the "Environmental Action Plan: 1991-2000." The Action Plan focuses on the metallurgical and chemical industries, China's two most polluting industries, and sets forth the following objectives: (a) to promote cleaner production technology and more efficient use of energy and other inputs; (b) to improve recovery and recycle the "three wastes" (flue gas, industrial wastewater and solid waste); (c) to improve control over industrial point source pollution; (d) to implement "the polluter pays" principle, by making enterprises responsible for treatment and removal of pollution; and (e) to pursue more rational industrial development in accordance with urban master planning.

1.10 China's major obstacle to controlling industrial pollution is its weak regulatory system, which suffers from: (a) a lack of systematic and comprehensive planning; (b) inadequate enforcement of environmental regulations; (c) inadequate funding of regulatory agencies; and (d) conflicts between economic development and environmental protection. While most municipalities have pollution control plans, they are often too general, incomplete, and not time-bound. The problems inherent in enforcement are typified by the pollution levy system. Fees are typically set considerably below the marginal cost of effluent treatment, which encourages enterprises to pay the fee rather than operate or invest in treatment facilities or cleaner production technologies. Also, by setting fees on a concentration basis, surface water could fail to meet standards even though all enterprises in a watershed individually meet standards. Conversely, if assimilative capacity is high and enterprises are few, the concentration standard could force average compliance costs far above the discharge damage.

1.11 The problem of agency funding is linked to the pollution levy issue. Because EPBs are allowed to retain 20 percent of the fees collected, they have become dependent on pollution levies as revenue sources to cover operating costs. Conflicts between economic growth objectives and environmental protection can be resolved through better planning and management. However, because local governments usually are the effective owners of SOEs within their boundaries, pressures to relax regulations or fee collection inevitably arise.

C. CHINESEINDUSTRIAL STRUCTURE AND PERFORMANCE

1.12 There are about 10 million industrial enterprises in China. Of these, 102,200 are SOEs; 1.9 million are "collectively owned enterprises" (COEs)-rural, township and - 4 - village enterprises (TVEs) and urban collectives; 8.0 million are family or individually owned "private businesses" with no more than seven employees; and 44,500 are "other" enterprises, which include private firms employing more than seven persons, foreign- owned and foreign-domestic joint ventures. In 1978, at the beginning of reform, the share of the gross value of industrial output (GVIO) accounted for by SOEs was 78 percent and for COEs it was 22 percent. Currently, SOEs account for 34 percent of GVIO; COEs account for 40 percent; "private businesses" account for about 12 percent; and "other" firms account for 14 percent.

1.13 Because of significant differences between SOEs and their nonstate counterparts in terms of location, ownership forn, property rights regime, functional structure and the policy environment that govems their conduct and performance, nonstate-owned enterprises (NSOEs) operate more akin to competitive enterprises found in mature market economies. Functionally, SOEs not only carry out productive operations, but also are burdened with the obligation to provide an array of social services, including housing, education, health care, pensions, food services, fuel and retail outlets. By contrast, COEs, for example have no obligation to provide social services (although many choose to do so and charge user fees to workers). As a result, these firms can focus more squarely on commercial objectives. Unlike SOEs, which historically have had access to on-budget subsidies from government agencies and off-budget subsidized credits from (the state- owned) banks, COEs have had to operate in an environment free of direct fiscal and quasi-fiscal government subsidies. Although the nonstate sector has been the major source of employment growth since the opening up of the economy, SOE employment is still growing, and about 70 percent of all urban Chinese industrial workers-about 45 million persons-are employed in SOEs. SOEs also provide about 65 percent of national income tax revenues, account for about 72 percent of industrial net fixed assets, and utilize 70 percent of all bank credit.

1.14 Despite a series of reform initiatives (see below), many industrial SOEs continue to perform poorly. Although total factor productivity for SOEs is rising, its growth is only about one-third to one-half the corresponding rate for nonstate enterprises. SOE losses have been declining, but are still sizable; about 40 percent of all SOEs registered losses in 1994. Explicit and implicit subsidies to SOEs have also been declining in recent years, from about 6 percent of GDP in 1990 to about 4 percent in 1994; but their continued existence poses a risk to containing inflationary pressures and macroeconomic stability.

D. CHINA'S REFORM OF INDUSTRIAL SOES 1.15 The GOC recognizes that to sustain the nation's pace of economic growth, centrally planned and financed growth must be replaced by decentralized economic decision-making, competitive market forces and a liberalized external sector. As a result, reforms have been introduced over the past 18 years in the state industrial sector. The most salient SOE reform experiments involve adopting the modern corporation as a mode of organization; granting increased authority to SOE managers to make business - 5 - decisions; and include implementing labor contracts as altematives to "lifetime employment." In addition, the policy framework has been reformed so that prices and production have been largely decontrolled, and trade and foreign investment increasingly liberalized. The official economic philosophy changed from a "planned economy on the basis of socialist public ownership" to a "socialist market economy" in October 1992. In November 1993, the Third Plenary Session of the Fourteenth Party Congress issued the Decision on Issues Concerning the Establishment of a Socialist Market Economic Structure. This Decision outlines a 50-point agenda for economic reform to be attained by the end of the century, including (a) creating a "modern enterprise system"; (b) encouraging the development of diversified forms of enterprise ownership, especially the "privately owned, individually owned and foreign-invested" sectors; and (c) providing for enterprises of all types to be able to compete on "equal terms." The Decision is the most ambitious plan for China's SOE reform, but it is only a statement of principles. Establishing a program to implement the Decision is the challenge now being undertaken by the Government.

1.16 The "10,000-1000-100-10" enterprise reform experiment, announced in January 1994, is the latest effort in this regard. This reform provides for: 10,000 large and medium SOEs to adopt by 1996 new accounting standards; 1,000 large SOEs to adopt by 1997 new state asset administration regulations; 100 large and medium-size SOEs to be fully "corporatized" by 1996 as limited liability (LLCs) or limited liability shareholding companies (LLSCs) under the Company Law; and 18 municipalities (expanded from the original 10) to undergo "comprehensive" enterprise, economic and social policy reform.

1.17 SOE reforms have made real progress to date, but significant challenges remain. First, restructuring initiatives have not yet appreciably squeezed out economically wasteful resource use in most SOE operations, let alone raised resource productivity to technologically feasible levels. Second, SOE management lacks sufficient autonomy and operates according to risk-reward incentive structures that are not based on market principles. Third, reforms have not fully eliminated distortions in the overall policy regime (e.g. some price controls and subsidies remain). Fourth, self-sustaining factor markets for labor, capital and technology have yet to develop, and without these reform of SOEs is constrained. Finally, the SOE reform program has not adequately stressed the complementary linkage between achieving economic goals and environmentally sustainable development. The existing SOE reform program must be modified to: (a) phase out SOE fiscal and quasi-fiscal subsidies; (b) foster SOE ownership diversification, management autonomy, recombined corporate assets and competitive exit and entry; (c) shed redundant labor and enterprise social service obligations and ensure a government-sponsored "social safety net"; (d) create employment growth conditions, particularly in high value-added services industries; (e) develop an independent, viable financial system; and (f) control and reduce industrial pollution. - 6 -

E. THE BANK'S STRATEGY 1.18 The Bank Group's assistance to China emphasizes environmental protection and enterprise reform, as articulated in the Country Assistance Strategy (CAS) presented to the Board on June 1, 1995, and the Progress Report discussed on March 26, 1996. The Bank's environmental strategy for the industrial sector brings together these two major CAS objectives: it seeks an improved environmental regulatory regime and regulatory enforcement, combined with enterprise reform initiatives. A considerable amount of Bank sector work underpins and validates this approach. The central statement of Bank strategy, China: Environmental Strategy Paper (1992), highlights, among other things, the interrelationships between environmental issues and economic growth and development, to the extent that "until price and enterprise reforms are more extensively undertaken, neither pollution fees or fines nor administrative regulations are likely to carry sufficient force to be systematically applied to encourage the most cost-effective means to reduce environmental degradation." China: Efficiency and Environmental Impact of Coal Use (1991) identifies various means of reducing China's serious SO2 and TSP pollution problem by using coal more efficiently and, in line with the Strategy Paper and the proposed project, continuing enterprise and labor market reform, enhancing technology transfer, employing a municipally-based approach to air pollution abatement, and improving the operating efficiency and technical quality of conventional industrial boilers. The China. Urban Environmental Service Management Study (1994) indicates the need for, among other things, increased financial and social incentives to improve compliance with environmental regulations, better monitoring of environmental conditions, and introduction of hazardous waste regulation-an area largely ignored in most Chinese cities. Finally, China: Issues and Options in Greenhouse Gas Emissions Control (1994) echoes the same central themes, noting, first, the key role of successful economic reform in pollution control of all types, including control of greenhouse gas emission levels, and, second, China's need to improve and modify enforcement of its environmental regulatory system. The CAS also calls for working with the Global Environmental Facility (GEF) in China to reduce greenhouse gas emissions, preserve biodiversity and conserve energy, and with the Montreal Protocol Fund to support a Chinese program for reducing the production of ozone-depleting substances.

1.19 The Bank's industrial sector strategy, as described in the CAS and in the 1995 paper, Meeting the Challenge of Chinese Enterprise Reform, is guided by four principles: (a) creating autonomous corporate enterprises, with clear lines of governance, fully transparent modem accounts, and clearly defined management responsibilities; (b) separating social welfare responsibilities from enterprises; (c) subjecting enterprises to market discipline by eliminating subsidies and promoting competition (or regulation for natural monopolies in infrastructure); and (d) promoting ownership diversity to acquire new technologies, management expertise and financing.

1.20 The proposed project supports the CAS objectives and recommendations of Bank sector work. It addresses Chongqing's environmental problems through investments in modern, clean production technologies, buttressed by support for improving environmental management and enforcement of regulations, as well as restructuring and commercializing local industries through a slate of reform initiatives. The project would help eliminate key point sources of industrial pollution, transforrn enterprises into modem, efficient production units, and ensure that municipal economic reforms are compatible with environmental quality. The project also furthers GEF objectives to reduce greenhouse gas emissions by including an S02 reduction program to be supported under an associated Efficient Industrial Boilers Project, for which GEF financing is being sought. The proposed operation would thus contribute to making Chongqing an environmentally cleaner, more efficient and internationally competitive market economy-one that would be more attractive to both domestic and foreign investors. Moreover, achievements and lessons learned from this pilot operation would have a demonstration effect for other industrial enterprises in Chongqing and in other cities in China.

1.21 Lessons Learned from Previous Bank Group Operations. A review of Bank Group industrial projects in China and elsewhere sheds light on lessons that directly apply to this pilot project. Bank experience in industrial pollution control, as reflected in by the Bank's Industry and Energy Department report, Industry and Environment: Patterns in World Bank Lending, emphasizes pollution prevention as well as control, ambient quality improvement over source reduction, and incentives to comply, and institutional capability to monitor and enforce standards. The same lessons are indicated in the China Environmental Strategy Paper and the report on China's urban environmental services. In ongoing projects developing environmental infrastructure in eight Chinese cities, success in introducing policy, pricing and institutional reforms is closely correlated to the municipality's overall commitment to reform, including that of city services and enterprises. An extended dialogue during preparation of the proposed project, therefore, sought to mobilize support for the project among a broad range of stakeholders and to incorporate in the project design a program combining enterprise and environmental action.

1.22 A study by the Bank's Operations Evaluation Department, Industrial Restructuring: A Review of World Bank Operations, which covers 46 countries over a 14-year period, concludes that both private and public sector industrial restructuring results in only limited success when the overall economic environment is not taken into account. The report also concludes that public sector enterprise restructuring has the best chance of sustainability in China, due to the Governnent's commitment to reform, as evidenced by market competition, reduced subsidies, and increased autonomy for SOE management. Linking sectorally targeted projects that embrace broader policy objectives with enterprise reform concepts, supported by strong ESW was especially noted in the report. Experience in China bears this out. The Bank's industrial lending to China in the 1980s was based on studies identifying subsectors with strong growth potential, targeting major coastal municipalities, and focusing on regional centers of economic growth and reform. By the early 1990s it was clear that the subsectoral approach was not fully effective. Sector studies took too long to complete, they were not always relevant to the Clients' needs and were sometimes rendered irrelevant by economic events. A new - 8 - approach was adopted under the Shenyang Industrial Reform Project (Ln. 3788-CHA, FY95), which placed industrial restructuring within the context of a municipally based reform strategy. The proposed project is the second in the series to take a municipal enterprise reform approach, with the major focus on achieving immediate as well as longer-term environmental benefits. It applies the lessons of the past by incorporating a clear policy focus, monitorable project objectives, and a well-defined investment program.

1.23 The proposed pilot project also applies lessons learned from other countries in transition, e.g., findings in the Bank's Bureaucrats in Business (1995). International experience demonstrates that effective public enterprise reform requires management autonomy and accountability, "hard budget constraints." implementing a neutral regulatory regime, and addressing major externalities, such as industrial pollution. While public enterprise privatization is a key element in SOE reform in other countries, the goal of the Chinese government is to achieve SOE reforn by changing incentive structures; separating government administration from ownership responsibility; and diversifying enterprise ownership, among other things.

F. RATIONALE FOR BANK ACTIVITY IN CHONGQING

1.24 The Bank and GOC have agreed there should be a shift in emphasis from lending to relatively developed areas, such as the Coast, South and East regions, to less developed areas-in particular cities in Central, Southwestern and Northwestern China. Chongqing has been selected because: (a) it is the largest repository of accumulated capital and skills in China's Southwest, yet it must cope with serious enterprise productivity and industrial pollution problems; (b) its municipal government is committed to economic reform, especially reducing industrial pollution and restructuring SOEs; and (c) it has the central government's strong support to experiment with economic reforms.

1.25 Chongqing Municipality has requested Bank assistance to support a program to help reduce industrial pollution and carry out reforms to commercialize and restructure industrial enterprises, particularly SOEs. The Bank is uniquely positioned to respond to CM's request. A Bank-financed operation supporting industrial pollution control and SOE reform would help eliminate key point sources of industrial pollution, provide for transforming enterprises into modern, efficient production units, strengthen environmental regulation enforcement and help assure that CM's economic reform measures are compatible with environmental quality. Thus, the Bank would help transform Chongqing into an environmentally cleaner, more efficient and internationally competitive market economy-one that would be more attractive to both domestic and foreign investors. Moreover, achievements and lessons from this pilot operation would have a "demonstration effect" for other industrial enterprises in Chongqing and in other cities in China. -9-

2. CHONGQING'S ECONOMY AND PROGRAMS FOR INDUSTRIAL POLLUTION CONTROL AND ENTERPRISE REFORM

A. CHONGQING'S ECONOMY

2.1 Economic Structure. Chongqing, the largest city of Sichuan province, with an area of 23,114 km and a population of more than 15 million, has traditionally been one of the most important centers of industry and commerce in Central China. ChongqingIs diversified natural resource base and skilled work force have supported the development of the coal, iron, petroleum refining, metallurgical, chemical, petrochemical, and engineering industries. However, despite its strong historical legacy and rich resource endowments, Chongqing did not benefit from the 1980s boom as much as many of China's coastal cities. While Chongqing has been growing at 10.0 percent per year during 1980-94, today, the urban standard of living in Chongqing is about 10 percent lower than the average for coastal cities, and its rural living standard is lower than the national average.

2.2 During 1980-94, the major change in Chongqing's economic structure was the doubling of the GDP share of the trade and services sector, at the expense of the agricultural and industrial sectors; this compositional change brought Chongqing in line with the rest of the country (Table 2.1). Industry remains the dominant sector in Chongqing, responsible for about 48 percent of the city's GDP, which was Y 54.3 billion in 1994.

TABLE 2.1: CHINA'SAND CHONGQING'S ECONOMIC STRUCTURE

Share of GDP by Sector (in percent) Agriculture Industry Trade and Services Year China Chongqing China Chongqing China Chongqing

1980 30.4 28.7 49.0 55.0 20.6 16.3 1994 18.8 20.2 48.5 47.5 32.7 32.3

Source: China Statistical Yearbook (1995); Chongqing Statistical Yearbook (1995).

2.3 As Table 2.2 indicates, the changes in Chongqing's economy shifted the structure of employment during 1980-94 in ways similar to the country as a whole. Employment in the agricultural sector decreased, while the share of employment in both industry and - 10 -

trade and services increased. In 1994, CM had a total work force of 8.5 million, of whom 2.1 (25 percent) were state workers and staff, including 1.5 million in SOEs. Industry currently employs about 2 million workers. Unemployment in Chongqing in 1994 was officially reported as 60,000 persons, and the official unemployment rate was 2.76 percent. However, as in other cities, a much higher level of disguised unemployment prevails through the practice of keeping redundant workers on the payroll in "job waiting" and other categories.

TABLE 2.2: CHINA'S AND CHONGQING'S LABOR STRUCTURE

Employment (in percent) Agriculture Industry Trade and Services Year China Chongqing China Chongqing China Chongqing

1980 68.7 67.2 18.3 19.5 13.0 13.3 1994 54.3 53.2 22.7 18.2 23.0 28.6

Source: China Statistical Yearbook (1995); Chongqing Statistical Yearbook (1995).

2.4 CM's financial sector is comprised of eight banks (with 1,364 branches) and 1.182 nonbanking financial institutions (94 percent of which are rural credit cooperatives). The Chongqing branch of the People's Bank of China (PBC) supervises all financial institutions in CM. The banking sector in CM is dominated by the Industrial and Commercial Bank of China (ICBC) and the Agricultural Bank of China (ABC). At the end of 1994, ICBC held 56 percent of total bank loans and 47 percent of bank deposits; ABC's corresponding market shares were 18 percent and 19 percent, respectively. Two new banks, China Merchant Bank and Everbright Bank, are in the process of establishing branches in Chongqing. In part, the entry of these two new competitors into CM's banking market is due to the proposed project.

2.5 Chongqing's economy is becoming more competitive. However, the city's state- owned industrial sector is still inefficient and-without reform-will be an impediment to future growth. There are 7,519 industrial enterprises in Chongqing, of which 1,301 (17 percent) are SOEs, 5,962 (79 percent) are collectives, including township and village enterprises, and 256 are "other" enterprises, including joint ventures and private enterprises. SOEs account for 76 percent of CM's GVIO, whereas the more numerous collectives account for 19 percent of GVIO and "other" enterprises account for 5 percent. Of the industrial SOEs, 504 are under CM's budget and 190 are defined as "large and medium." A more detailed description of key aspects of Chongqing's economic structure-in particular the system of state asset management, the social security system, and the financial sector-is contained in Annex 2.1. - 11 -

B. CHONGQING'S PROGRAM FOR INDUSTRIAL POLLUTION CONTROL

2.6 Institutional Organization and Regulatory Authority. The Chongqing Environmental Protection Bureau (CEPB), which was established in 1974, reports to the Mayor's Office and to the Sichuan Provincial EPB. The system of EPBs in Chongqing is organized on three levels: the municipal CEPB, district and county EPBs and subdistrict and village Environmental Protection Offices. The CEPB is responsible for developing local environmental programs and regulations, monitoring ambient and point sources of air, water, and hazardous waste pollution, and enforcing compliance with environmental regulations. The 9 urban districts and 12 county EPBs are responsible for implementing CEPB's programs within their jurisdictions, and for providing CEPB their monitoring results.

2.7 To implement the EPL, the People's Congress of Chongqing Municipality issued the Chongqing Environmental Protection Ordinance (CEPO) in 1990. It specifies seven responsibilities of the district and county-level EPBs:

* Monitor and enforce environmental laws, regulations and standards * Develop and implement environmental plans * Participate in preparation of economic and social development plans * Assist responsible agencies in protecting natural resources * Organize environmental research and education * Investigate and resolve environmental accidents and disputes * Receive complaints on activities resulting in environmental damages

Anne3.3 contains a more detailed description of CM's environmental regulatory framework.

2.8 Industrial Pollution Control Strategy of Chongqing Municipality. Over the last 10 years, CM's environmental strategy has focused on control of industrial air, water and hazardous waste pollution. It has also concentrated on reformning the overall regulatory framework. Preparatory work for the proposed project included four studies assessing CM's initiative in these areas; see paras. 2.12-2.15 below.

2.9 Chongqing has the highest levels of ambient sulfur dioxide (SO2) emissions in China, and possibly in the world. Unfortunately, in recent years the air pollution in CM has worsened, primarily from the increased use of coal with high (3.5-4.5 percent) sulfur content. Added to that are very high ambient levels of total suspended particulates (TSP). Air pollution in CM also results from industrial waste gas emissions (from the metallurgical, pharmaceutical, and chemical industries), from inferior quality transport fuel and from household coal-burning stoves. CM has implemented a number of measures to reduce SO2 emissions. A primary target has been the power sector, which utilizes almost 30 percent of the coal consumed. A total of 720 MW of power generation capacity has been retrofitted with flue gas desulfurization technology, another 400 MW of existing 600 MW capacity has advanced plans for such retrofitting, and all new power - 12 - generation capacity will require it. CM has also experimented with establishing "sulfur control districts," where any coal containing an excess of 2.7 percent sulfur is charged a levy of Y 5/ton. This measure has stabilized SO2 levels, but it has not resulted in any significant reduction.

2.10 In 1987, a wastewater permit system was introduced to control discharges from the top 200 water polluters, who are responsible for 80 percent of wastewater discharges. By 1995, the total industrial pollutant tonnage in wastewater had been reduced from 300,000 to 150,000 tons per year (tpy). This still represents 30,000 tpy more than the estimated assimilative capacity of the surface water system, and permit levels have been further restricted to reach discharge limits.

2.11 Currently the regulations governing hazardous wastes management are inadequate, and hazardous waste disposal is largely uncontrolled. CM recognizes this serious problem and will regulate and manage waste handling and disposal, based on the recently enacted law.

2.12 As part of project preparation, four studies were carried out under Japan Grant Facility (JGF) financing to assess ways the proposed project can support enhancing CM's industrial pollution control strategy. One study examined the adequacy of the air quality monitoring network in CM to define the nature and locations of priority air pollution problems. It also examined consistency between air emission standards and ambient air quality standards applicable in CM. Air quality data, analytical procedures and monitoring problems were reviewed. An urban airshed model recently developed by the Beijing Environmental Research Institute was utilized to examine consistency between air quality standards and regulated emission limits. The study concluded that the air quality monitoring network is inadequate and recommendations for equipment improvements were made. With the exception of SO 2 , air emission standards, if enforced, would provide air quality levels meeting the standards. Further regulatory reforms are needed to reduce S02 emissions so that ambient levels are within standards.

2.13 A second study examined the adequacy of the existing ambient water quality monitoring network and the status of industrial hazardous waste management. It also examined consistency of effluent discharge standards with ambient water quality standards. Water quality data, laboratory facilities and current monitoring programs were reviewed, and attempts were made to collect data on industrial practices for hazardous waste management. Additionally, a water quality model was used to predict changes to water quality after completion of the Three Gorges Dam. The study concluded that the water quality monitoring program must be improved after the dam is completed. Recommendations were also made for equipment and laboratory facility modernization. Although the dam would adversely affect CM's water quality even if existing wastewater discharge standards are met, water quality should remain within acceptable limits. However, serious water quality problems may arise when the dam is completed if enforcement is not improved. The study also concluded that there was effectively no - 13 - institutional capacity or meaningful data for regulating industrial practices in hazardous waste management.

2.14 The third study examined the overall legislative and regulatory framework for environmental management in CM. It studied institutional responsibilities, capacity for implementing legislative mandates, and the practices of the CEPB for industrial compliance monitoring and enforcement mechanisms. The study concluded that the regulatory framework requires some modifications, but is for the most part acceptable. The current system of enforcement (including penalties) has significant shortcomings, particularly with regard to (a) registration of new industry, (b) EIAs, (c) compliance with the "three synchronization requirements" for design, construct and operate appropriate pollution control systems and (d) assessment, collection and utilization of penalties for violators.

2.15 The fourth study examined the health effects of air pollution in CM. Based on data from 1993, a highly significant association of increased cardiovascular disease mortality was found with ambient concentrations of particulates (40 percent increase for 3 100 .g/m increase), SO2 (23 percent increase for 100 p.g/m3 increase) and NO, (37 percent increase for 20 pig/mi3 increase). Independent measurements of fine particles (PM1O/PM2.5) and SO2 were taken in different air quality zones in the city in summer and winter and correlated with cross-sectional health survey data gathered from 3,500 adults and 300 primary school children. Among other findings, a significant association was found between air pollution and reduced pulmonary function. A study of ambient air pollution and the association of hospital admissions, emergency room visits, and daily mortality was begun in February 1995. Preliminary results from the most recent time- series analysis confirm the correlation between high concentrations of particulates and sulfur and excess deaths and health impacts in Chongqing. Results of the study will be finalized in August 1996.

2.16 Iron and Steel Sector Pollution Control Action Plan. CEPB has prepared lists of the top air and water polluters in CM, including 88 industrial air pollution sources and 93 industrial water pollution sources. Of these, 32 industrial enterprises have been identified by NEPA as among the 3,000 worst industrial polluters in China. Mitigation plans are required for all polluters listed, and a major part of the environmental control strategy is based upon the implementation of these plans. Enterprises associated with the iron and steel sector represent a significant number of all the industrial sources on these lists. Recognizing this, CEPB, in conjunction with the iron and steel companies in CM, has prepared a detailed pollution control action plan for this sector. The plan identifies major sources of pollution, necessary mitigation technologies, and associated costs. Analogous plans for the remaining industrial polluters are still to be formulated.

2.17 Source Monitoring. Ambient air and water quality monitoring in CM is performed with two networks: an automatic network consisting of five stations, and a manual network at nine stations, to measure sulfur dioxide, nitrogen oxides, carbon monoxide and suspended particulate matter. The automatic monitoring network is - 14- operated continuously only 12-20 days per month. It is unreliable and subject to frequent breakdowns. The manual network is of limited scope, and only operates over a five- consecutive-day period at a given site once every three months, which does not provide CEPB with meaningful data. Water quality monitoring is conducted by CEPB at seven locations, four on the Yangtze River and three on the Jialing River. At each location a three-point traverse is sampled, one at each bank and one in the center of the river. There are 64 tributaries to these two main rivers and 15 are monitored regularly by local EPBs. Sampling on the rivers is done six times per year at five of the stations, and monthly at the other two stations. Twenty-seven water quality parameters are to be analyzed. The water quality monitoring network is satisfactory, but the monitoring frequency is too low along the tributaries, and monitoring equipment is obsolete.

2.18 Compliance Monitoring. Compliance monitoring is based upon a plan prepared by CEPB in conjunction with the local EPBs. A total of 272 major industrial pollution sources (190 for wastewaters and 88 for waste gases) are monitored regularly. They account for 70 percent of the pollution load. Wastewaters are monitored twice per year, and for waste gases once per year. Another 600 or more medium polluting enterprises are monitored less frequently, and the remaining industries are self-monitoring. The major problem with the compliance monitoring program is insufficient equipment and personnel to increase the number of industries surveyed, the numbers of specific pollutants being monitored, and the frequency of monitoring. The problem is compounded because available equipment is mostly of inferior quality and constantly in need of repair.

2.19 Regulatory Enforcement. The existing set of industrial pollution control enforcement tools-enterprise/investment registration, EIA, the "three synchronization" program, and the pollution levy/discharge permit system-has not been effective in Chongqing. CEPB's registration system is not enforced; consequently, CEPB is not fully aware of the number and nature of new industrial projects and their pollution potential. New projects require an EIA, but compliance is 70 percent for enterprises affiliated with CM, and 50 percent for enterprises affiliated with district and county governments. Industrial enterprises generally comply with the first of the "three synchronizations" because of the need for EPB approval before construction can begin. For the second synchronization, CEPB must inspect the construction site to insure pollution control facilities are being built. Actual site visits occur much less frequently than required because of insufficient personnel. Finally, compliance with the third synchronization is extremely small because enforcement is weak. Overall, compliance is low because of limited penalties.

2.20 In Chongqing fees and fines are collected in a pollution levy fund. The fund is used to: (a) make grants or low-interest loans for pollution control to firms that have paid levies, or (b) retained by CEPB/EPBs for monitoring, research, equipment, supplies, etc. Several problems have developed with this system. First, the charges are too low to encourage enterprises to install and operate pollution control equipment. Second, rather than enforcing the fees on the basis of priority of the biggest polluter (the "polluter pays - 15 - principle") backed up by the threat of temporary or permanent closure, the levies are enforced on the basis of the polluter's ability to pay. Third, proceeds from the fund have been used to pay CEPB/EPB staff salaries, leading to ambivalence about enforcement. Finally, since discharge limits are concentration-based, many industrial enterprises simply dilute their discharges to reduce concentrations and comply.

2.21 Regulatory reform and comprehensive planning for industrial pollution control are necessary elements of a program to reduce industrial pollution.. Currently CM does not have a comprehensive plan to control industrial pollution. In order for CM to develop such a plan, a substantial data base of air and water quality, and enterprise-specific pollution discharge data are essential. CM does not have this data base, nor do they have the necessary sampling and monitoring equipment to develop it. Chongqing has a sound regulatory framework in place, but it must take immediate steps to upgrade enforcement of the system, including compliance monitoring of enterprise registration, EIA requirements, and the "three synchronizations." Levies for exceeding discharge standards must be increased. Finally, CM needs to: (a) identify the nature and magnitude of the hazardous waste problem, (b) locate acceptable disposal sites, and (c) prepare a management plan to deal with this pollution.

C. ENTERPRISE REFORM PROGRAM

2.22 In part because of its interior location with poor transportation links, its rugged topography, and its history as the country's defense production hub, Chongqing has been relatively slow in transforming its state sector-dominated industries. While progress is being made in improving SOE performance-due to proactive SOE restructuring, market pressure exerted by domestic NSOEs, and competition from imports and foreign investment-serious problems remain in Chongqing's large and medium SOEs: suboptimal economies of scale, excessive vertical integration and exaggerated product diversification, utilization of obsolete technologies, low productivity growth, poor product quality, and heavy pollution. Symptomatic of these problems are SOE balance sheet losses: 1994 losses of SOEs in all sectors total Y 4.2 billion (7.7 percent of CM's GDP). While a major portion of industrial SOE losses are "policy losses" in the coal and agricultural support industries (due to controlled prices set below cost), significant "operational losses" are prevalent in textiles, machine tools, chemicals, and light industry.

2.23 In transforming CM's economy to bring it in line with the principles articulated in the Fourteenth National Party Congress' 1993 "Decision" (para. 1. 15), CM has developed a full set of enterprise reforms; these are detailed in CM's "Economic Policy Statement" and "Economic Reform Agenda and Action Plan" (Annexes 3.1 and 3.2). CM has also been chosen by the central government to participate in nationally directed reform experiments: CM is one of 18 cities in the "Comprehensive Urban Reform" experiment; one of two cities to participate in the "Enterprise Bankruptcy Reform" experiment; and it participates in the "Modem Enterprise System Reform" experiment for "corporatization" of 100 SOEs. - 16-

2.24 CM's current enterprise reform program-which has as its centerpiece the transformation of SOEs into modem corporations-builds on more than a decade of reforms prior to the Fourteenth Party Congress. At present, over 40 industrial SOEs have been converted to limited liability shareholding companies (LLSCs), over 200 have been converted to limited liability companies (LLCs), and more than 400 TVEs have been converted to cooperative shareholding companies. Of the SOE shareholding companies, six are listed on the two domestic stock exchanges. One SOE, which is a beneficiary in the proposed project (para. 3.14), has been chosen as one of the 100 enterprises in the national program for corporatization. By the end of 1996 it is expected that 50 percent of CM's industrial SOEs will be converted into either LLSCs or LLCs, and 100 percent will be converted by the year 2000.

2.25 Financial discipline is being imposed by CM on SOEs through the reduction of subsidies to cover losses. All subsidies for "operating losses" were terminated in 1993, and only the coal and agricultural support industries currently receive direct subsidies due to "policy losses." Like elsewhere in China, SOEs in CM receive subsidized credit for technical renovation under CM's budget; they also enjoy working capital and technical renovation subsidies through the financial system due to directed bank credit lent at negative real interest rates. However, with the promulgation of the Commercial Banking Law in 1995, CM's banks must meet market-based performance criteria and are now increasingly making commercially-oriented lending decisions. SOE bankruptcies are occurring only on a limited basis in Chongqing (as elsewhere in China). SOE rationalizations are largely engendered instead through mergers and acquisitions (often involving collective enterprises). There are two main constraints to SOE liquidation: the political consequences of disposing of large numbers of redundant workers; and the regulatory limits imposed on banks as to the amounts of loans they can write off in any one year. The new accounting standards required by national law (1993) have been introduced in all of CM's large and medium industrial SOEs. Independent audits have been conducted in 40 percent of CM's SOEs; the remaining 60 percent will be independently audited by year-end 1996.

2.26 The redeployment of surplus workers (many with marginal skills) arising from the restructuring of SOEs, and the work force requirements of an economy in transition, are placing demands on Chongqing's municipal labor market institutions. In 1995, CM introduced a program to encourage SOEs to create alternative employment opportunities -especially in the service sector-for surplus workers through the creation of new entities known as labor service enterprises (LSEs). SOEs establish LSEs through direct investment, and by leasing or selling facilities. LSEs receive an income tax exemption for the first two years of operation, and a 50 percent tax reduction in the third year. SOEs are also providing extended leave-up to one year-and granting early retirement to redundant workers. Restrictions on the outright dismissal of surplus workers remain, however; there is an annual citywide limit of 2 percent of the total SOE work force. Chongqing's labor market reforms have also focused on developing a "social safety net" to ease the social burdens placed on SOEs. For example, pension insurance is being - 17- pooled and unemployment insurance is being expanded. Still, these programs are nascent; it will be some time before they foster significant labor mobility in Chongqing.

2.27 Overall, CM has numerous initiatives under way to introduce market incentives into its industrial sector to transform SOEs into modem corporations. These reforms have been facilitated by the policy dialogue that has been established through the review of CM's "Economic Policy Statement" and "Economic Reform Agenda and Action Plan" during project preparation. The proposed project includes activities such as the technical assistance to improve corporate governance by reforming state asset management institutions, and to strengthen labor redeployment and training activities (see Chapter 3), which will further help CM's efforts. These activities complement the proposed project's assistance to CM in introducing market incentives to help control industrial pollution. - 18 -

3. THE PROJECT

A. PROJECT OBJECTIVES

3.1 The proposed project supports the Bank's lending strategy in China within a policy framework that focuses on enhanced industrial pollution control linked to enterprise reform and technological restructuring. Moreover, the project supports GOC's efforts to help relatively underdeveloped regions in the interior catch up with the country's faster growing coastal areas. To achieve these objectives, the project would help CM to: (a) achieve a significant reduction in pollution and restructure productive facilities from its most polluting industry, iron and steel; (b) establish a strategy and prepare a long-term plan to achieve a major reduction in pollution for the whole industrial sector by, inter alia, increasing the effectiveness of CM's environmental regulatory framework and pollution management capability; and (c) initiate a pilot effort to assist industrial enterprises in other industrial sectors to restructure their productive facilities, control pollution and transform themselves into modem corporations.

3.2 The project design is based on detailed project preparation work involving policy and feasibility studies (available in the project file) carried out with the assistance of international and Chinese consultants financed with $0.45 million in IDA funds from the China Reform, Institutional Support and Preinvestment Project (Credit 2447-CHA) and $1.6 million in grants from JGF.

B. PROJECT PERFORMANCE INDICATORS

3.3 Project outputs and impacts will be monitored on the basis of institutional performance and development objective indicators agreed upon during negotiations. The level of performance expected is indicated in Tables 3.1 and 3.2, below. - 19-

TABLE 3.1: INSTITUTIONALPERFORMANCE INDICATORS 1997 1998 1999 2000 2001 2002

OBJECTIVE A: CSSC and CISCG/ZICC Net profit before taxesas % of total sales revenue Measuredagainst performance indicators in 5-yearrolling financial projections debt-to-equity ratio 70:30 _ debt service coverage 1:2

OBJECTIVE B: CEPB % of priority polluting firms reporting/monitoredfor 20 35 55 75 90 100 SO2 emissions % of registeredfirms completing ElAs 75 85 95 100 100 100 % cumulative increasein pollution levy revenues 10 20 30 40 50 60 (basedon all pollutants) % of firms completing"third synchronization"approval 30 50 75 100 100 100

OBJECTIVE C % line-of-credit commitment 50 75 100 % line-of-credit disbursement 15 35_ 65 85 100 % EIA mitigation plan compliance 25% (as percentagedisbursements) Net profit amount, and as % of sales Measuredagainst performanceindicators in enterpriserestructuring plans

TABLE 3.2: DEVELOPMENT OBJECTIVE INDICATORS

1995 1999 2000 2001 2002

OBJECTIVEA

3 ShapingbaDistrict 570 per gnm Decrease 44% reduction in particulate monitor - * ambient air quality 2,600tons ambient concentrations compliance per year (tpy)

Jiangbei District 520 per 1nm3 Decrease 22% reduction in particulate monitor - - ambientair quality 3,800tpy ambientconcentrations compliance

Jinkou Farm 220 per ptnm Increase no adversechange in particulate monitor - a;mbientair quality 107 tpy ambientconcentrations asso- compliance ciatedwith relocatedfacility

DadukouDistrict 360 per,nm3 Increase no adversechange in particulate monitor 0 ambientair quality 140tpy ambientconcentrations asso- compliance ciatedwith re-locatedfacility

C. PROJECT DESCRIPTION

3.4 The project includes: (a) support for development and implementation of economic and environmental policy agendas and action plans; (b) relocation of the city's two major polluting steel mills; (c) restructuring advisory facilities for industrial enterprises; (d) a line of credit to support a pilot program in industrial enterprise reform, pollution control and restructuring; and (e) technical assistance (TA) to strengthen - 20 - environmental regulation, surplus labor reemployment and innovation in state asset management.

Economic and Environmental Policy Agenda and Action Plans

3.5 Chongqing's Economic Reform Agenda and Action Plan. CM has developed a reform program to implement the 1993 Decision of the 14th Party Congress (para. 1. 15) and subsequent reform initiatives. CM's policy agenda and action plan focuses on (a) corporatization and managerial autonomy of SOEs and TVEs, (b) divesting SOEs of their social welfare functions, (c) SOE fiscal and quasi-fiscal budget constraints, (d) developing measures to facilitate merger or bankruptcy of nonviable SOEs, (e) facilitating labor mobility through retraining and redeployment of surplus workers, (f) developing a market-based corporate government system for managing state assets, (g) separating investment decision-making from government planning, (h) promoting competition in the financial sector by facilitating entry of foreign banks and nonbanking financial institutions, (i) developing a market in residential housing by increasing housing sales and rents, 6) expanding unemployment insurance to cover 100 percent of Chongqing's labor force, (k) establishing municipalwide integrated pension, medical insurance and industrial injury compensation funds, (1) downsizing and consolidating CM, and (m) improving environmental planning, monitoring and enforcement with a priority to reducing industrial pollution. The policy dialogue between CM and the World Bank during project preparation has become an important element in fostering Chongqing's economic reform program, especially as it affects SOEs. A detailed description of the program is contained in CM's "Economic Policy Statement Letter" (Annex 3.1) and "Chongqing's Economic Reform Agenda and Action Plan" (Annax.2).

3.6 Environmental Action Plans. A study of the environmental regulatory system in Chongqing, which was carried out as part of project preparation, identified the lack of environmental planning, management and enforcement, as the major impediments to dealing with Chongqing's severe industrial pollution problem. Building on an iron and steel sector pollution control plan developed during project preparation, the project would finance TA to help CM develop the data bases necessary to prepare a pollution control plan for the whole industrial sector. This would include a plan to deal with solid and hazardous wastes, which have largely been ignored in Chongqing and elsewhere in China (only in 1996 will legislation be in place to deal with this problem). The project would help CM to develop a management system for site selection, storage and disposal of solid and hazardous wastes. The project would also assist CM to strengthen regulatory enforcement backed up by incentive measures to improve compliance with industrial pollution control standards. These initiatives, and the plans that would lead to their implementation, are discussed in the following paragraphs. Annex 3.3 has a full account of all the environmental activities undertaken under this project.

3.7 Iron and Steel Sector Pollution Control Action Plan. All enterprises in the steel sector are part of either the Chongqing Iron and Steel Company (Group) Limited - 21 -

(CISCG) or the Chongqing Special Steel Company (Group) Limited (CSSC). Iron and steel production is a major source of pollution in CM, representing 12 of the 88 largest sources of industrial air pollution, and 7 of the 93 largest sources of water pollution. CSSC and CISCG have prepared a priority pollution control action plan and investment schedule for the steel sector, consisting of eight priority investments targeted to reduce or eliminate major pollution problems in the sector. During negotiations, assurances were obtained that CM would carry out an action plan acceptable to the Bank to control pollution in the iron and steel sector. The investments are prioritized on the basis of environmental impact, and the first two priority investments identified in the plan- namely shutdown of existing steel mills, and their relocation/replacement with modem nonpolluting steel-making facilities for both CISCG and CSSC-constitute the industrial relocation component of this project. Both relocated plants will meet national, provincial and municipal environmental regulations. Specifically, the plan consists of (a) a list of priority mitigating measures to be taken by each iron and steel plant to assure compliance with Chinese environmental regulations for air, water, and solid waste management, (b) a capital cost estimate for each measure and (c) an implementation schedule consistent with sector restructuring objectives and environmental priorities.

3.8 The projects identified in the plan (in order of priority) are presented below:

CISCG (ZICC) (Jiangbei) Shutdown and relocate CSSC Steel Mill (Shapingba) Shutdown and relocate CISCG Coke oven (Dadukou) Cleanup of coke oven gas CSSC Rolling mill (Shuangbei) Install air and water pollution control equipment CISCG Iron Alloy Plant (Chang Sou) Install dust control equipment CSSC Refractory Plant (Shuangbei) Install dust control equipment CISCG (Jiang Jin) Install dust control equipment CISCG Seamless Pipe Plant (Ba Lan) Install wastewater treatment facilities

3.9 Industrial Pollution Control Strategy and Action Plan. CM has successfully implemented a permit system for controlling major industrial wastewater polluters, and has achieved significant reductions in industrial pollutant loads. Air pollution levels, however, have considerably worsened over the last 10 years, primarily from the rapidly growing energy use from boilers fueled by high-sulfur coal. Waste gases from industrial processes (particularly metallurgical, pharmaceutical, and chemical industries) are also a major air pollution source. In consequence, major efforts have to be made to control and reduce air pollution levels; and the two steel plant relocations provide an important demonstration effect (paras. 3.12-3.14). Also, CM is just beginning, with the help of TA under this project, to deal with the problem of solid and hazardous waste pollution. The steel sector pollution control plan discussed above, is therefore simply the first step to preparing a pollution control plan for the industrial sector as a whole. The study will start after one year of ambient air and water quality monitoring data obtained with the new equipment to be financed under the project, the hazardous waste inventory and site selection studies have been completed, and the Environmental Audit Unit (EAU) in CEPB is operational. CEPB will establish a Task Force to work with Consultants for the - 22 - duration of the assignment (six months). CEPB will (a) review ambient air, water quality and pollution source data bases, (b) identify industrial enterprises that contribute 90 percent of industrial pollution as priority polluters, and (c) evaluate costs and prepare least-cost solutions for the priority list. During negotiations, assurances were obtained that CM would prepare an industrial pollution control strategy and action plan satisfactory to the Bank submit the plan to the Bank nol later than December 31, 1998 and subsequently implement it. Detailed TORs to assist CM in preparing environmnental action plans are provided in Annexes 3.4-3.7.

3.10 Environmental Regulatory Enforcement Action Plan. A study prepared by an international consultant as part of project preparation and financed by JGF provided recommendations for environmental regulatory reform in Chongqing. An environmental regulatory enforcement plan has been developed to include the following measures: (a) enforcement of the CEPB registration requirement for industrial projects; (b) compliance with EIA requirements; (c) adding air quality standards for lead and polycyclic aromatic hydrocarbons, (d) implementing new municipal regulations establishing an SO2 emission levy system; (e) modifying the levy system to include all pollutants; (f) enforcement of the "third synchronization" monitoring of pollution control measures; and (g) increasing the number of enterprises monitored and the amount/collection of levy charges. To meet data processing needs for these activities, an information data processing center has been included in the technical assistance component to CEPB. During negotiations, CM provided the Bank with a plan for the municipalwide implementation of the SO2 levy system, which would be approved and implemented by CM prior to Loan effectiveness. The regulatory reform action plan, including a schedule of actions and performance indicators, is presented in Annex 3.6. During negotiations assurances were obtained from CM that it would (a) carry out an environmental regulatory enforcement plan satisfactory to the Bank; and (b) as part of its annual report to the Bank prepare an annual report on CM's environmental status, which would include performance under each of the action plans and the CSSC RAP, as well as data on its current environmental status and changes from the previous year.

3.11 Associated GEF Project. In parallel with the proposed project, an Efficient Industrial Boilers Project is being developed for support totaling about $32.8 million from the Global Environmental Facility (GEF). Both projects involve the restructuring and modernization of heavy industry with the explicit intention of lowering emissions of both greenhouse gases and air pollutants, and promoting least-cost alternatives for pollution control. The GEF project seeks to reduce pollution and improve the energy efficiency of small and medium coal-fired industrial boilers by acquiring foreign advanced technology, adapting it to Chinese conditions, and broadly disseminating it throughout China. Chongqing, which has some of the highest concentrations of SO2 in the world, can significantly reduce both sulfur and particulate emissions through the adoption of more energy efficient and cleaner industrial boilers. According to CM, small and medium boilers account for as much as one-half of the municipality's coal consumption and associated air pollution. CM has therefore embarked on a program to implement a municipalitywide S02 pollution levy system (para. 3. 10). The GEF project - 23 -

associated with the proposed project is expected to be appraised in July 1996 and approved in November 1996.

Industrial Relocation Component

3.12 Chongqing's largest and most polluting industry is iron and steel. The project would support closing down and relocating the two most polluting steel plants from a highly populated urban setting, to achieve the goal of (a) reducing industrial pollution in the urban center, and (b) replacing obsolete and inefficient industrial facilities with modern highly efficient plants that can meet both Chinese and international environmental and efficiency standards. Feasibility studies carried out by local consultants with the assistance of international consultants, and revised during project appraisal (see Annexes 3.9-3.11), indicate that both relocations are environmentally, financially and economically justifiable. During negotiations, assurances were obtained that CSSC and CISCG would carry out a program of closure, physical relocation and restructuring of production facilities, as well as financial restructuring, according to feasibility studies agreed with the Bank.

3.13 The Chongqing Special Steel Company (Group) Limited (CSSC) was established in 1934 to produce steel blooms for further processing in CSSC's mills. Among all Chongqing's industrial enterprises, it is the worst air polluter, the sixteenth worst water polluter, and one of the largest producers of solid industrial wastes, which are dumped on the banks of the Yangtze River. This plant is located in a congested urban area of Chongqing and poses an immediate health hazard to the local population. CSSC's 10 small highly polluting electric arc furnaces (EAF) at the old site would be closed, and a single modem, environmentally sound 100-ton EAF would be located in a rural area. Resettlement of the affected population is presently under way (paras. 5.29-5.30). The plant's capacity will be about 20 percent greater than the old plant, a level of output justified by economic scale and market research projections. The proposed relocation is the highest priority action in a steel sector pollution control plan. An EIA of this relocation has been prepared by the Chongqing Iron and Steel Design Institute (CISDI), reviewed by the Bank and approved by NEPA. The financial, economic and environmental justification of this relocation is contained in Chapter 5. Additional information on CSSC is in Annex 3.9.

3.14 The Zhongxing Industry and Commerce Company (ZICC) was established in 1939 as a facility to make steel for CISCG. Its two open-hearth furnaces representing 1940s technology have already been closed. A remaining EAF will be closed in 1998. ZICC is located in the densely populated city center (Jiangbei district) on the north shore of the Jialing River. Its air emissions have never been treated and represented a major source of air pollution in the city. The new plant will be located in CISCG's main steel- making complex in the Dadukou district, and will produce 300,000 tons per year (tpy) of continuous cast steel billets for CISCG's Dadukou medium-section rolling mill. This relocation is the second highest priority action in the steel sector pollution control plan. An EIA of the relocation has been prepared by CISDI, reviewed by the Bank and - 24 - approved by NEPA. The financial, economic and environmental justification for this relocation is contained in Chapter 5. Additional information on CISCG can be found in Annex 3.11.

Restructuring Advisory Facilities

3.15 A major innovation under the project has been to establish independent restructuring advisory facilities to assist SOEs and NSOEs prepare restructuring plans setting forth pollution control and commercial objectives and related strategies. For each firm receiving advice, the final product would be a restructuring plan and investment proposal that would be expected to meet both the domestic feasibility requirements of the State Planning Commission and the creditworthiness standards of banks wishing to finance these enterprises.

3.16 A restructuring advisory facility (RAF) was established through the award of a contract bv CM on June 28, 1995 to international and local consultants. The contract is funded by a Japanese grant of $1.1 million equivalent. The RAF's services are available to medium and large industrial SOEs selected through a competitive process, that can meet minimun eligibility criteria: (a) completion of an environmental audit by CEPB; (b) conversion to an LLC or LLSC under the Company Law, and (c) submission of independently audited financial statements in accordance with the new accounting standards. The RAF has the right to exercise its independent judgment as to (i) the enterprises it accepts and (ii) the recommendations it incorporates in feasibility and restructuring plans. The first four enterprises were selected on September 20, 1995 and draft restructuring plans for all four have been completed. During appraisal, it was decided that the rest of the enterprises to be selected would also be subject to an additional eligibility criterion, that is, they would be ranked according to the severity of their pollution problem prior to being ranked on their technical, financial and economic merits. Four additional enterprises were selected on January 25, 1996 and the final two were selected by the end of March 1996. A key feature of the RAF is that by September 1996 it is expected that 10 enterprise restructuring plans will have been completed by the RAF and will be available for PFI consideration.

3.17 A nonstate enterprise (NSOE) restructuring facility (NSRAF) is expected to be established by the end of June 1996 to prepare plans for industrial NSOEs intending to apply for a loan under the line of credit (LOC). NSOEs are defined as enterprises with less than 51 percent of their capital owned by the state or by entities that are less than 51 percent owned by the state. The NSRAF would be composed of two local independent consultants, chosen through public tender, using the same TOR, tendering procedures and contract formats used to establish the RAF. NSOEs would be able to choose either consultant. The NSRAF enterprise eligibility criteria, evaluation and competitive selection procedures would follow those applied by the RAF. NSRAF funding of $250,000 would be provided under the project to CM. A continuing advisory facility (CAF) will be established after the RAF and NSRAF contracts have expired. The CAF would be available to industrial enterprises meeting all LOC eligibility requirements. An - 25 - enterprise could choose any independent consultant and include in the amount borrowed under the LOC the reasonable cost for the consultant's preparation of its restructuring plans, provided the consultant's qualifications and TOR are satisfactory to the PMO and the Bank.

Line-Of-Credit Component (LOC)

3.18 An LOC would be established as a pilot program to support industrial enterprises that are participating in enterprise reforrn, restructuring productive facilities and cleaning up pollution. Reliable demand estimates prepared by the RAF indicate a need for an LOC of about $60 million. Initial PFI estimates indicate they would be able to mobilize counterpart resources to support an LOC of $50 million. Under the circumstances, an LOC of $60 million is proposed to be available on a first-come/first-served basis to any industrial enterprise that could meet the following eligibility criteria: (a) is a limited liability (shareholding) company or otherwise established as a legal entity; (b) has a completed EIA by CEPB, and has agreed to a mitigation plan satisfactory to the Bank; (c) has a satisfactory resettlement plan (if applicable), prepared according to the Resettlement Principles and Procedures agreed upon during negotiations; (d) has adopted the new accounting standards and its financial statements have been audited by independent auditors; (e) has a satisfactory RAF/NSRAF restructuring plan (or other restructuring plan prepared according to the RAF/NSRAF methodology) demonstrating the technical feasibility, market potential and financial viability of the proposed investment and (f) has been appraised and found creditworthy by a PFI.

3.19 Borrowing Limits. To ensure that NSOEs gain access to the LOC, a minimum of 10 percent of the total amount of the LOC would be available to them. The LOC would finance goods and services required for enterprise restructuring and pollution control. Local counterpart financing would be provided by the beneficiary and the PFI, in accordance with prudent debt-equity limits. To prevent any enterprise from monopolizing the LOC, no single company could borrow more than 20 percent or group company more than 25 percent of the LOC total. Moreover, enterprises would have to ensure that they would be able to finance at least 25 percent of the subproject's total investment from their own resources.

3.20 Financial Intermediation. Recently, the financial system in China has undergone rapid and fundamental changes, such as the promulgation of the new Commercial Banking Law, which focuses on banks as independent entities. The implications of this are only gradually becoming clear. The requirement that each bank be responsible for its own profit and loss and asset quality has made banks reluctant to assume new risks. Consequently, only ABC among the banks that traditionally have lent to industry in Chongqing has received head office approval to participate. This project has been a catalyst in enhancing competition in Chongqing's banking sector. Everbright Bank of China (EBBC), which established a representative office in Chongqing in 1994, has received head office approval to establish a branch and participate in the project. China Merchants Bank (CMB) has also received head office approval to establish a - 26 - branch in Chongqing and participate in the project. Appraisal of these three banks has been completed, and included, inter alia, the extent to which the bank: (a) is currently in compliance with PBC regulations, (b) has the ability to evaluate the risks associated with proposed projects, (c) has the capacity to mobilize counterpart funds, and (d) presents an external audit of its accounts for the most recent fiscal year reflecting a satisfactory financial condition. All three PFIs demonstrated during appraisal that they are financially sound and have the potential for carrying out the function of financial intermediary under the LOC component. During negotiations, assurances were obtained that ABC, CMB and EBBC would, by December 31, 1996, adopt training programs satisfactory to the Bank to strengthen their institutional capabilities in credit policy procedures and analysis, and project appraisal and supervision. Assurances were also obtained that PFIs would furnish the Bank with independently audited annual financial statements within six months of the end of each fiscal year.

3.21 The Agricultural Bank of China was established in 1951. In 1979, it became one of four "specialized banks," and, since 1994, it has been categorized as a "state commercial bank." At the end of 1994, it had 63,816 branches or offices, and 552,709 employees. Although ABC is subject to the official government credit plan, through its rural network it is able to mobilize deposits that can be lent outside the plan. At the end of 1994, ABC had total assets of Y 1,253 billion ($150.6 billion equivalent), total deposits of Y 605.0 billion ($72.7 billion), total loans of Y 595.3 billion ($71.6 billion), total equity of Y 44.8 billion ($5.4 billion) and net profit of Y 2.7 billion ($324.5 million). As of December 31, 1994, ABC's Chongqing Branch had total assets of Y 17.4 billion ($2.1 billion), total deposits of Y 5.6 billion ($673.1 million), total loans of Y 5.9 billion ($709.1 million), total equity of Y 0.4 billion ($48.1 million) and net profits of Y 14.2 million ($1.7 million). See Annex 3.12 for a detailed description and financial statements.

3.22 The China Merchants Bank (CMB) was established in 1987 as a commercial bank. It is subject to the provisions of the Commercial Banking Law, the regulations of PBC, and is outside the official government credit plan. It has 17 branches and total staff of 3,100. At the end of 1994, it had total assets of Y 44.7 billion ($5.4 billion), total deposits of Y 25.6 billion ($3.1 billion), total loans of Y 21.2 billion ($2.5 billion), total equity of Y 3.7 billion ($444.7 million) and net profits of Y 0.7 billion ($84.1 million). A detailed annex with financial statements is contained in Annex 3.13.

3.23 The Everbright Bank of China (EBBC) was established in 1992 as a "nationwide" commercial bank. It is subject to the provisions of the Commercial Banking Law and the regulations of PBC. EBBC has 10 branches and a total staff of 1,594. At the end of 1994, EBBC had total assets of Y 20.2 billion ($2.4 billion), total deposits of Y 11.9 billion ($1.4 billion), total loans of Y 6.6 billion ($793.3 million), total equity of Y 1.4 billion ($168.3 million), and net profit of Y 0.3 billion ($36.1 million). See Annex 3.14 for a detailed description including financial statements. - 27 -

3.24 Appraisal Methodology. During negotiations, assurances were received from the PFIs that they will appraise subprojects and supervise, monitor, and report on subprojects in accordance with procedures satisfactory to the Bank Appraisal procedures will focus on (a) an analysis of the viability of the enterprise undertaking the subproject, (b) an evaluation of the subproject's EIA mitigation plan, (c) an evaluation of the subproject's technical, financial, economic and managerial justification, (d) a market analysis of the justification for expanding existing product lines and/or introducing new ones, (e) an evaluation of procurement arrangements, and (f) an assessment of the enterprise's debt service capability. PFI loan agreements with subborrowers will include appropriate financial and management covenants, and covenants governing the implementation of EIAs and RAPs (if appropriate). Subborrowers will bear the foreign exchange risk. PFIs will bear the credit risk and will establish appropriate terms and conditions for each subloan subject to the following:

(a) Interest Rate and Fees. Subborrowers will pay a commitment fee of 0.75 percent on the undisbursed balance of any subloan. The minimum interest margin will be 2.0 percent above the rate provided by the Bank but is expected to vary based on (i) the PFI's cost of appraisal and loan processing; (ii) administrative overhead; (iii) repayment risk assessment and (iv) an appropriate profit margin;

(b) Maturity. Although the maturity of individual subloans will be based on projected cash flow of the borrower and on the credit policies of the PFI, in no instance will the grace period or final maturity of a subloan exceed 5 or 12 years, respectively;

(c) Rate of Return. Each subproject financed by the LOC will have a financial rate of return (FRR) of not less than II percent, and an economic rate of return (ERR) of not less than 11 percent.

(d) Bank Approval/Review. The first two subprojects for each PFI will be subject to World Bank approval. For subsequent subprojects below $5.0 million for ABC and below $3.5 million for CMB and EBBC, the PFI will submit a summary description of the enterprise and subproject, including the expenditures to be financed, relending terms and conditions and arnortization schedule to the Bank, requesting its authorization to make withdrawals. Subsequent loans above these specified amounts will continue to require Bank prior approval, based on the submission of a full appraisal report.

During negotiations, assurances were obtained that the PFIs would make subloans in accordance with procedures and on terms and conditions satisfactory to the Bank - 28 -

Technical Assistance Component

3.25 Chongqing Environmental Protection Bureau. Technical assistance would be provided to CEPB in four key areas: (a) improving the ambient air and water quality monitoring networks and providing source monitoring mobile equipment; (b) helping establish environmental audit capability; (c) developing hazardous waste management and disposal plans, and an overall pollution control plan for the industrial sector; and (d) establishing a data processing information center. The monitoring TA would involve provision of 11 automatic and 28 semiautomatic monitoring stations, four mobile vans, one laboratory and related equipment. The environmental audit specialists will be trained in Beijing at the NEPA Center for Clean Production Technology. An international expert in industrial environmnentalauditing will work with NEPA staff in preparing the training program and in assisting CEPB perform environmental audits at eight industrial facilities. TORs for the international experts to train the environmental audit unit and prepare the hazardous waste plans are presented in Annexes 3.4. 3.5 and 3.8. During negotiations, CM provided assurances that it would establish an EAU in CEPB, with TOR, staff and resources acceptable to the Bank and provide the Bank with a satisfactory signed contract with international consultants to train EA U staff one month after Loan effectiveness. A cost summary of this TA is as follows:

Equipment $4,867,000 Technical Assistance 313,000

Total $5I180000

3.26 Redeploying Surplus Labor. A critical factor for the success of CM's economic reform program depends upon dealing with the much larger number of workers that are expected to become redundant in the future. CM will establish a Surplus Labor Employment and Training Center at a total cost of $853,000 equivalent, of which the Bank would finance foreign exchange costs totaling $590,000 (62 percent of the total cost), including equipment amounting to $490,000 and TA of $100,000. The Center would provide training and job placement to surplus workers, using an integrated approach involving curriculum development and training in emerging job skills, and labor market information and job placement assistance. The Center will also provide guidance to enterprises' own redeployment and training efforts, as well as to Chongqing Labor Bureau's (CLB) county and district employment and training offices. It is envisioned that, initially, the Center will concentrate on serving the "at risk" workers of the SOEs and the steel companies being restructured under the project. CEPB and CLB have agreed to cooperate in the development of training courses in the Center that will meet the needs of enterprises for skilled environmental and pollution control personnel. During negotiations assurances were obtained from CM on the Center 's organizational structure, and on CM's provision of the physical facilities, construction and renovation requirements, and staffing needs. A description of the Center and the TOR for this TA is contained in Annex 3.15. - 29 -

3.27 SOE restructuring with separation of 2 percent of the involved work force (CM guideline percentage), will place demands on the unemployment insurance (UI) system if alternative employment is not found. Also, the present scope of coverage of the Ul system needs to be expanded. CM needs to assess the interactions between the UI system and CM labor market demand, the adequacy of UI financing, and identify measures needed to maintain the financial solvency of the Ul system. The Bank would provide $30,000 for consultant services and $10,000 for computing equipment to support the development of a UI data base and management system.

3.28 Model State Asset Operating Company. According to CM's state asset management regulations, state asset operating companies (SAOCs) are entities established under the Company Law entrusted with the management of state assets, with the state asset management bureau (SAMB) acting as owner on behalf of the state. SAOCs are to be organized through conversion of manufacturing and service line bureaus into LLCs with 100 percent state ownership. SAOCs will not be operating companies, but will more closely resemble investment holding companies. To advance reform of its state asset management system, CM has decided to create a new, model industrial SAOC that is innovative in its design, structure, operation and management. Specifically, CM intends to establish, with international and local expertise, a cross-sectoral SAOC. TA of $120,000 would provide international best practice and local advice regarding corporate organizational, functional and financial structures; portfolio management; investment and dividend policy. The TORs and budget for the contract are contained in Annex 3.16.

3.29 During negotiations, assurances were obtained from CM that it would carry out the institutional strengthening under the project in accordance with a time-bound program satisfactory to the Bank.

D. PROJECT ORGANIZATION AND MANAGEMENT

Project Leading Group and Management Office

3.30 The Chongqing authorities set up a Project Leading Group (PLG) in April 1995 to oversee the project. The Leading Group is headed by a Deputy Mayor, and comprises the director of the planning commission and the vice directors of the planning commission, economic commission, finance bureau, system reform commission, CEPB, CLB, ABC, CMB and EBBC. The Leading Group will be maintained throughout the project implementation period.

3.31 Under the PLG, the Chongqing Municipal Management Office of the World Bank's Capital Utilization (PMO) has been established to carry out the administrative work of the project. The PMO comprises staff from the same agencies as those represented in the Leading Group. Its responsibilities include (a) providing coordination among various project stakeholders; (b) monitoring project implementation, with special emphasis on meeting performance indicators; (c) preparation of a project implementation plan; and (d) providing periodic reports to the World Bank on the progress of project implementation. During negotiations, assurances were obtained from CM that (i) PMO - 30 - will maintain a resettlement unit and will establish by December 31, 1996 an environmental unit to coordinate implementation of the RAP and environmental aspects of the project, (ii) furnish the Bank with annual progress reports by July 30, on project implementation and meeting performance indicators; and (iii) not later than March 31, 1999 CM will prepare a mid-term report and hold a Mid-Term Review with all project participants to assess whether the project is making satisfactory progress in meeting its objectives. Assurances were obtained at negotiations that CM would maintain (a) the PLG, with composition and functions acceptable to the Bank; and (b) the PMO, with competent staff in adequate numbers, functions and responsibilities, acceptable to the Bank

Project Implementation Plan (PIP)

3.32 With Bank assistance, the PMO has prepared a PIP (Annex3.17) aggregating the individual PIPs of each project component, to enable the PLG and PMO to carefully plan, sequence and schedule the activities and corresponding resources that will be required to complete project appraisal and undertake project implementation. The proposed project would be implemented over a six-year period from 1997 to 2002. The closing date for subproject commitments is June 30, 2001, and the loan closing date for disbursements is December 31, 2002. - 31 -

4. THE LOAN, PROJECT COST, FINANCING PLAN, PROCUREMENT, AND DISBURSEMENT

A. MAIN FEATURES OF THE LOAN

4.1 The People's Republic of China will be the Borrower of the proposed Bank single currency loan of $170 million. GOC and CM have selected LIBOR-based US dollar single-currency loan terms for the project in order to facilitate management of the foreign exchange risk of their borrowings by more closely matching the currency of their liabilities with that of their net trade flow, about 75 percent of which are US dollar denominated. They selected the LIBOR-based product in order to preserve the full maturity of the loan, compared to the fixed-rate option that would have resulted in a 15- year loan. The Borrower judges that it can manage any interest rate risk. China is eligible for single-currency loans under the expanded program. This loan together with other FY96 single currency loans represent about 42 percent of the fiscal year IBRD lending program to China, well within the 50 percent volume guideline approved by the Bank.

4.2 During negotiations, assurances were provided that (a) the proceeds of the loan will be made available by the Borrower to CMfor 20 years including 5 years of grace at an interest rate equal to the standard interest rate for LIBOR-based US dollar single currency loans at the time offunds commitment; and (b) CM would relend the proceeds of the loan (i) at the standard rate for LIBOR-based US dollar single currency loans plus a spread of 1.2 percent per year to CSSC and CISCG for 12 years including 5 years of grace, and (ii) at the standard rate for LIBOR-based US dollar single currency loans to PFIs for 20 years including 5 years of grace, allowing the PFIs to retain the "rollover " between the maturities of the subloans and the maturity of the Bank loan to be relent for similar purposes. The final date for submission of subloan applications will be June 30, 2001. The closing date of the loan will be December 31, 2002. The commitment fee of 0.75 percent per year would be passed on to the subborrower.

4.3 In order to set out the respective obligations of the entities involved, the following agreements will be entered into: (a) a Loan Agreement between the Borrower and the Bank; (b) a Project Agreement between CM and the Bank; (c) a Project Agreement between CSSC, CISCG and the Bank; (d) a Project Agreement between the PFIs and the Bank; (d) Subsidiary Loan Agreements between CM and CSSC, CISCG and the PFIs; and (e) Subloan Agreements between the PFIs and the enterprises. As a condition of loan effectiveness, CM, the steel companies and the PFIs would execute subsidiary loan agreements satisfactory to the Bank - 32 -

B. PROJECTCOST

4.4 The capital cost estimates on individual project components are summarized below in Table 4.1. Based on a projected Bank Loan of $170 million, the estimated cost of the project is $478.1 million (Y 4.0 billion), with a foreign exchange component of $151.4 million (25 percent). The project cost includes interest during construction of $18.1 million.

TABLE4.1: SUMMARYOF PROJECTCOSTS

Y million $ million % Foreign Local Foreign Total Local Foreign Total Exchange

CSSC Relocation 512.99 367.64 880.63 61.66 44.19 105.85 22.8 CISCG Relocation 358.13 216.32 574.45 43.04 26.00 69.04 23.2 Line of Credit 956.80 416.00 1,372.80 115.00 50.00 165.00 30.3 Environmental Monitoring System 186.03 42.68 228.71 22.31 5.18 27.49 18.7 Labor Redeployment Center 3.58 5.24 8.82 0.43 0.63 1.06 59.4 TAto SAOC 4.24 2.00 6.24 0.65 0.10 0.75 32.1

TotalBASELINE COSTS 2,021.77 1,049.88 3,071.65 243.09 126.10 369.19 26.0

Physical Contingencies 112.07 33.36 145.43 13.47 4.01 17.48 22.9 Price Contingencies 124.38 6.32 130.70 14.95 0.76 15.71 4.8 LOCContingency 108.16 83.20 191.36 13.00 10.00 23.00 43.5 TotalPROJECT COSTS 2,366.38 1,172.76 3,539.14 284.51 140.87 425.38 26.1

Interest during construction la 62.90 87.36 150.26 7.56 10.50 18.06 58.1 Incremental work capital 288.12 -- 288.12 34.63 -- 34.63 0.0

TotalFINANCING REQUIRED 2,717.40 1,260.12 3,977.52 326.70 151.37 478.07 25.4

La Interest during construction is based on onlending rates for disbursements of both local currency and foreign currency loans to CSSC and CISCG.

4.5 The base cost estimates for CSSC of $105.9 million and for CISCG of $69.0 million are expressed in January 31, 1996 prices. These estimates were prepared by the Chongqing Iron and Steel Design Institute (CISDI). Civil works have been estimated based on current actual construction costs. The machinery and equipment estimate is based on detailed equipment lists and the latest international price quotations prepared by CISDI and reviewed by international consultants. The exchange rate used to convert base cost estimates from yuan to the dollar is Y 8.32 to $1.

4.6 Cost estimates for the Line-of-Credit Component are based on estimates made during appraisal. Cost estimates of the TA component are based on historical costs of international and local consultants, and off-the-shelf equipment prices in China. - 33 -

C. FINANCING PLAN

4.7 The financing plan for the overall project is shown in Table 4.2. The proposed Bank loan would cover about 36 percent of the total financing required, and would cover 100 percent of foreign exchange costs and 6 percent of local costs. Local banks would provide the bulk of local currency financing, arnounting to 31 percent of total financing required. Beneficiaries (CM, CSSC, CISCG and industrial borrowers) would provide 5, 9, 5 and 14 percent, respectively, of total financing.

TABLE 4.2: PROJECT FINANCING PLAN (in $ million equivalent)

Percentage Source Local Foreign Total of Financing

World Bank 18.5 151.4 170.0 35.6 CSSC 42.0 - 42.0 8.8 CISCG 25.5 - 25.5 5.3 Domestic banks 148.3 - 148.3 31.0 Industrial enterprises 69.0 - 69.0 14.4 CM 23.4 - 23.3 4.9

Total Financing Required 326.7 151.4 478.1 100.0

D. PROCUREMENT

4.8 CM has assigned the China National Instrument Import and Export Corporation (CNIIEC) as the lead foreign trade agency to the project, and assigned two local trade agencies, Southwest Technology Import and Export Corporation (CNTIC) and Chongqing Machinery and Electrical Equipment Tendering Company (CQMEETC), to work under CNIIEC. These procurement agencies are experienced and have the necessary institutional capacity to manage the procurement under the project. Procurement under the project will be in accordance with the Bank's Guidelines for Procurement published in January 1995 and revised in January 1996. The model bidding documents specifically prepared for China based on the Bank's standard documents will be used for all procurement activities under the project. Table 4.3 summarizes the procurement arrangements. - 34 -

TABLE 4.3: PROCUREMENT ARRANGEMENTS ($ million) ProcurementMethod Project Component ICB NCB OthersLa NBF 1h Total

CSsc Land and Civil Works - - - 24.8 24.8 Equipment(including freight andduties) 42.9 6.5 13.6 11.8 74.8 (42.9) (6.5) (6.2) (55.6) Engineering/ - - 4.0 2.0 6.0 Installation and Utilities - 19.4 19.4 Others(working capital increaseand IDC) - - 6.4 30.4 36.8 (6.4) Subtotal 42.9 6.5 24.0 88.4 161.8 (42.9) (6.5) (12.6) (0.0) (62.0) CISCG/ZICC Land andCivil Works - - - 14.3 14.3 Equipment(including freight andduties) 29.2 4.5 16.6 6.7 57.0 (29.2) (4.5) (4.2) (37.9) Engineering L - - 3.0 1.0 4.0

Installation and Utilities - - - 7.8 7.8 Others(working capital increaseand IDC) - - 4.1 11.8 15.9 (4.1) (4.1) Subtotal 29.2 4.5 23.7 41.6 99.0 (29.2) (4.5) (8.3) (0.0) (42.0) Credit Line Industrial Subloans 20.0 - 40.0 128.0 188.0 (20.0) (40.0) - (60.0) Environmental Regulation Working Capital Increase - - - 21.4 21.4 Equipment 3.4 - 1.5 0.9 5.8 (3.4) (1.5) (4.9) TechnicalAssistance and Training - - 0.3 - 0.3 (0.3) (0.3)

Subtotal 3.4 - 1.8 22.3 27.5 (3.4) (1.8) (0.0) (5.2) Labor Reemployment Center Buildings - - - 0.5 0.5 Equipmentand Materials - - 0.5 - 0.5 (0.5) (0.5) TechnicalAssistance and Training - - 0.1 - 0.1 (t I) (0. 1)

Subtotal - - 0.6 0.5 1.1 (0.6) (0.0) (0.6) State Asset Administration Technical Assistanceand Training - - 0.1 - 0.1 (0.1) (0.1) Working Capital Increase - - - 0.6 0.6 Subtotal - - 0.1 0.6 0.7 (0.1) (0.0) (0.1) TOTAL 95.6 11.0 90.2 281.3 478.1 (95.6) (11.0) (63.4) (0.0) (170.0)

12 Other procurementmethods include intemationaland national shopping,direct contracting,consultants services, training, and financing of Bank interestduring construction. a NBF denotesnon-Bank financing. & Engineeringservices constitute a part of the major equipmentcontracts. Notes: Figures in parenthesisare amountsto be financedby the Bank; figuresinclude contingenciesand may not total exactly due to rounding. 4.9 For the two environmental projects in the steel sector, procurement contracts have been reviewed and those contracts to be procured through international competitive bidding (ICB) procedures have been identified. Contracts with an estimated value of $0.5 million and higher with an aggregate value of $29.2 million for CISCG and $42.9 million for CSSC, would be procured under ICB. Contracts with aggregate values of $30.5 - 35 - million for CSSC and $28.2 million for CISCG would be awarded through non-ICB procedures. Contracts with an estimated value of $0.2 million and higher but below $0.5 million, with an aggregate value of $11 million, would be awarded through national competitive bidding (NCB) procedures satisfactory to the Bank. Contracts with an estimated value of less than $200,000 would be awarded through shopping procedures (up to an aggregate value of $10 million for international shopping and $11 million for national shopping); those contracts with an estimated value of $100,000 and higher awarded after evaluation and comparison of quotations solicited from at least three qualified suppliers from at least two eligible countries; and those contracts with an estimated value below $100,000 awarded after evaluation and comparison of quotations solicited from at least three qualified suppliers. All ICB contracts with a value of $0.5 million and above would be subject to Bank prior review procedures, and all other contracts would be subject to postreview, and CSSC and CISCG would retain all relevant documents in their records for this purpose. All contractors bidding on contracts valued at $10 million or above would be prequalified.

4.10 For the line of credit component, the PFIs would review the contract packages and methods of procurement for the various industrial subprojects. The procedures for procurement would be the same as those for Bank-financed China Investment Bank projects, which the Bank has reviewed and found satisfactory. Individual contracts with an estimated value of $5 million equivalent or above would be procured under ICB. Contracts below $5 million, up to an aggregate value of $35 million, would be awarded through national shopping procedures in accordance with the Bank's procurement guidelines, after evaluation and comparison of quotations solicited from at least three qualified suppliers, except proprietary equipment, which would be procured by direct contracting, subject to the Bank's prior agreement. The Bank's standard review and approval procedures (from bidding documents to the contract awards) would be applied to all ICB packages with a value of $5 million and above. All other procurement contracts would be subject to postreview by the Bank, and PFIs would maintain all relevant documents in their records for this purpose. PFIs would also be responsible for the overall supervision of procurement by subborrowers.

4.11 Procurement of the goods (para. 3.25) for the CM project entities, including CEPB, would be through ICB for contracts with an estimated value of $200,000 and above. Contracts with an estimated value of less than $200,000 would be awarded through shopping procedures, up to an aggregate value of $1,800,000. Contracts valued at less than $100,000 would be awarded through national shopping procedures up to an aggregate of $900,000. Contracts with an estimated value of $100,000 and higher would be awarded after evaluation and comparison of quotations solicited from at least three qualified suppliers from at least two eligible countries; contracts with an estimated value below $100,000 would be awarded after comparison of quotations solicited from at least three qualified suppliers. A separate category for NCB has not been specified as all of the items to be procured are expected to be imported for the CM project entities. All procurement through shopping procedures, whether national or international, would be carried out by one or more of the assigned trade agencies, and would be supervised by the - 36 -

PMO. All ICB contracts with a value of $200,000 and above would be subject to Bank prior review procedures. The PMO would be responsible for maintaining all necessary procurement records to allow Bank postreview.

4.12 Local qualified bidders participating in ICB for procurement of goods would receive a preference in bid evaluation of 15 percent of the CIF price or the prevailing custom duty applicable to nonexempt importers, whichever is the lower. The consultants retained for technical assistance and training activities, with an aggregate value of $0.9 million, under the project (paras. 3.25-3.28) will be recruited in accordance with the Bank's Guidelines for the Use of Consultants by its Borrowers. Consultancy contracts will follow the Bank's Standard Form of Contract for Consultant's Services, and with firms above $100,000 and with individuals above $50,000, would be subject to Bank prior review. Regardless of contract value, contracts below these amounts would be subject to Bank prior review for termns of reference and single source selection of consultant firms. Excluding the line of credit, about 76 percent of the loan proceeds would be subject to prior review. This would not include any works contracts since they are not financed under the Loan.

E. DISBURSEMENT

4.13 The Bank loan would be disbursed as follows: (a) for all components other than the LOC, disbursement would be against: (i) 100 percent of foreign expenditures for directly imported equipment and materials; (ii) 100 percent of local expenditures for locally manufactured items on an ex-works basis; (iii) 75 percent of expenditures for other items procured locally; (iv) 100 percent of the expenditure for consulting services and training; and (v) 100 percent of interest during construction capitalized under the subsidiary loan agreement with the steel companies accrued on or before June 20, 2001 and (b) for the LOC, disbursements would be made against 100 percent of amounts paid under subloans.

4.14 To facilitate efficient disbursement, a special account in dollars with an authorized allocation of $10 million (based on four months of average disbursements) would be established. It would be replenished monthly or whenever the special account was drawn down to 50 percent of its initial deposit, whichever occurred first. Disbursements for would be made on the basis of statements of expenditure for: goods contracts for industrial relocation valued at less than $500,000 equivalent; goods contracts for institutional strengthening valued at less than $200,000 equivalent; consulting services contracts valued at less than $100,000 for firms and $50,000 for individuals; subloans; interest during construction; and training expenditures. The project entities would retain documents supporting the statements of expenditure and would make these documents available for inspection and review by Bank supervision missions. All other disbursements will be made against fully documented expenditures. The projected disbursement schedule (Annex 4.1) is based on composite standard disbursement profiles for urban and industrial projects in China. -37 -

F. MONITORING AND REPORTING

4.15 Satisfactory procedures for monitoring, evaluating, and reporting on the project have been agreed upon by CM, CSSC, CISCG and the PFIs. PMO would furnish the Bank with semiannual and annual progress reports. The timely implementation of the project is critical and depends on adequate financial resources being made available when needed. For this reason, the annual project progress reports would include, inter alia, project entities' proposals regarding project costs and financing plans for the following year. The scope and content of the project progress reports have also been agreed on. Given the complexity of this project, supervision requirements are likely to be higher than the Bankwide average. An indicative Bank supervision plan is presented in Annex 412. Key performance indicators for project monitoring and reporting are described in Table 3. 1.

G. ACCOUNTING AND AUDITING

4.16 Separate project accounts would be maintained by all project entities concerned. The PMO will consolidate financial reports on individual project components submitted by entities concerned for inspection by Bank supervision missions.

4.17 Auditing of the proposed project will be conducted by the Chongqing Audit Bureau under the guidance of State Audit Administration's Foreign Investment Audit Bureau. This arrangement is satisfactory to the Bank. During negotiations, assurances were received from CM that the following annual audited financial reports would be submitted to the Bank within six months after the end of the financial year commencing from 1996: (a) project accounts, including the auditor's opinion on the use of the Special Account and statements of expenditures; and (b) financial statements of CSSC, CISCG and the PFIs. Any significant errors that may have been discovered during the audit, and any major weaknesses in internal controls, should be reflected in a management letter submitted by the auditors to CM. - 38 -

5. PROJECT JUSTIFICATION AND RISKS

A. FINANCIAL AND ECONOMIC BENEFITS OF THE PROJECT

5.1 The financial rate of return (FRR) for the Industrial Relocation Component was calculated on an incremental basis, comparing a projected situation without the project where it was assumed that the existing furnace capacity are either shut down (the case of CISCG) or continue to operate without the new investment (the case of CSSC), with a projected case that assumes that the new investment is installed. The profits from the projected case without project are subtracted from the profits in the situation where the project is developed. The incremental increase in profits is applicable to the investment cost (including interest during construction and permanent working capital) of the new facilities. The economic rate of return (ERR) for the investments is also calculated on an incremental basis, and financial costs and benefit flows are adjusted, where appropriate, to reflect improved environmental quality, as well as the economic opportunities forgone or realized.

5.2 For the LOC component, no attempt was made to quantify the financial and economic benefits, since the subprojects to be financed will be selected on a competitive basis during project implementation. For the TA component, while the economic and social benefits are expected to be significant, it was difficult to quantify them.

B. FINANCIAL ANALYSIS OF THE INDUSTRIAL RELOCATION COMPONENT

The Steel Market in China

5.3 Although the steel industry in China has turned in a remarkable performance by increasing crude steel production from 66 million tons (Mt) in 1990 to 91.5 Mt in 1994, expansion has not kept pace with demand, and China is now the world's largest importer of steel. China's rolled steel imports amounted to 23 Mt in 1994 (about 25 percent of apparent consumption), a peak year in imports second only to 1993 when 33 Mt of steel products were imported. The Government forecasts that crude steel yearly production will reach 120 Mt by the year 2000, while demand is expected to be about 180 Mt. In fact, China will not become self-sufficient in the foreseeable future, and will have to rely on sizable steel imports.

5.4 The steel industry in China was established through a central planning system whereby each plant was assigned a product mix to serve a specific list of consumers. In 1993, the Government introduced market-oriented reforms in an attempt to reduce the control of the Ministry of Metallurgical Industry over the industry, lift price controls, reduce customs duties, and eliminate systems of licensing and quotas that distorted foreign trade in the sector. At the same time, the Government started a process of reform - 39 - of state-owned enterprises, to establish a modem enterprise system that conforms with market-economy practices. These reforms are pushing the enterprises into a market environment. Most raw materials and finished products are sold at market prices, while enterprises are given the right to sell increasing portions of their output to unassigned customers.

5.5 Steel prices were liberalized in early 1993, in a context of strong demand and severe shortages, which led to sharp rises in price levels. Demand growth and prices eased in 1994, as a result of the Government's economic austerity program and the reimposition of managed prices in April 1994, in the form of "guiding" prices for 10 steel products designed to control inflationary pressures. Steel companies' shipment prices can now only fluctuate on a band of ±10 percent from the guiding prices. After the speculative boom of 1993, the Chinese steel market hit a low point in 1994 but is now recovering, with prices on the rise. Current market prices are still below the top bracket of these "guidelines."

5.6 Domestic competition is reduced by the fact that China is geographically a large country and still backward in transportation. The major factor affecting the companies' price behavior is import competition, i.e. the landed import price of similar categories of steel products. At present, CSSC's and the ZICC plant production costs are a little higher than the world average for the similar range of products. Nevertheless, due to transport costs, their domestic selling prices compare favorably with average production costs and are comfortably below foreign import prices for similar products delivered to Chongqing.

5.7 The Government is progressively opening the domestic market to international competition. Import quotas and licenses for steel were eliminated in 1994. Current tariffs on imported steel for CSSC's and CISCG's products range from 5 percent on semifinished products like billets to 15 percent in reinforcing bar, which is still high by international standards. In addition, there is a value-added tax of 17 percent on all domestic and foreign products based on the price including the import tariff.

Improvement in Productivity and Operating Efficiency

5.8 The restructuring of CSSC's organization and physical facility will improve its productivity and operating efficiency. Such improvements can be quantified in terms of the value-added increase and the increase in value-added per employee as shown in Table 5.1. - 40 -

TABLE 5.1: EFFICIENCY GAINS, 1993 AND 2002

CSSC CISCG 1994 2002 1994 2002

Value-added (Y million) 335 435 1,349 1,394 No. of employees 18,278 17,578 49,167 35,555 Value-added per employee (Y'000) 18.3 24.8 27.4 39.2

5.9 The efficiency gains resulting from the project arise primarily in the following areas:

(a) CSSC's move to better quality and higher value-added products;

(b) closing down a obsolete and inefficient plant; and

(c) investment in environmentally effective equipment that will greatly reduce consumption of inputs like energy and electrodes. Considering their advantages in terms of high yield, energy saving, and adequate environmental controls, state-of-the-art technologies like the EAF, the refining ladle and the continuous cast machine are seen as key elements to modernize the steel industry in China.

5.10 At present, CSSC cannot meet quality specifications for special steel products. As a result, over the past five years, its output has shifted to carbon steel (35 percent of total production in 1990, 48 percent in 1994), where quality requirements are lower. The new plant would improve quality and lower production costs, enabling CSSC to return to specialty steel production (mainly gear steel, spring steel and free-cutting steel), where the company has a strong market share and can have a significant impact in the automotive, railway and machinery sectors.

5.11 Currently ZICC is not capable of making the quality or type of semifinished steel most in demand, and its current operations are a threat to the safety of workers and to the general public. The new plant will produce a different product mix. The type of billets/ wire rods to be produced are carbon and alloy construction , welding wire, cold heading steel, and high-quality carbon steel. These type of steels are important to the construction industry and machinery and automobile producers.

5.12 The alternative of not replacing CSSC's and ZICC's old steel-making shops is not environmentally sound or economic because of unacceptable levels of pollution, declining quality of output at both enterprises, the additional foreign exchange required to import cast billets for the companies' rolling mills, and the higher costs of transporting landed imports to Chongqing. -41 -

Assumptions for the Financial Analysis

5.13 The base cost estimates for the investments, expressed in January 1996 prices, were derived from estimates prepared by the project entities and CISDI, in collaboration with international consultants. Physical contingencies are calculated at 10 percent of the base costs estimates. Price escalation for foreign costs was calculated on the basis of anticipated annual international price movements of 3 percent. Price escalation for costs expressed in terms of local currency is calculated on the basis of projected local inflation rates of 10.5 percent for 1996, 8.5 percent for 1997, 7.0 percent for 1998, 6.5 percent for 1999, and 6.2 percent thereafter. Imported equipment and materials would be subject to tariff duties.

5.14 The financial projections use prevailing selling prices and input costs in real terms over the economic life of the project. Net sales revenue was calculated after deducting the value-added tax. CSSC's old steel shop is expected to be closed in the first quarter of 1999, while the new plant is being commissioned. In either case (with or without projects) ZICC's remaining EAF is expected to be shut down in 1998. Capacity utilization of the new CSSC facilities is assumed at 50 percent in the first full year of operation, 85 percent the second year and 100 percent thereafter, and for the new CISCG facilit ,-s at 50 percent the first year and 100 percent thereafter. Fixed assets were depreciated using the straight-line method over 20 years.

Financial Rates of Return (FRR)

5.15 The financial analysis indicates that CSSC's project will generate a positive financial rate of return of 17 percent (see Table 5.2) and a net present value of $51 million. The project is most sensitive to declines in sales revenues. A combined 10 percent drop in average selling prices, a 10 percent increase in operating costs, plus a 20 percent increase in capital costs reduce the FRR to 11 percent, which still represents a comfortable risk margin for changes in the economic environment of the project. CISCG's project is a little more vulnerable to changes in the economic conditions. Starting with positive financial rate of return of 17 percent, the combined "worst case" scenario would bring the project's FRR to 10 percent. Both projects are more sensitive to declines in steel prices. However, selling prices would have to decline by 20 percent in the case of CSSC and 24 percent for CISCG to make the net present value turn negative at a discount rate of 11 percent (the base standard FRR used in China). TABLE 5.2: FINANCIAL RATE OF RETURN (FRR)-SENSITIVITY ANALYSIS

CSSC CISCG

0. Base-case scenario 17% 17% 1. Selling price: -10% 15% 14% 2. Operating costs: +10% 16% 15% 3. Capital cost increase: +20% 15% 14% 4. "Worst case" scenario (1+2+3 together) 11% 10% - 42 -

Future Finances of the Companies

5.16 CSSC and CISCG, like other large firms in China, have adopted general accounting systems in accordance to international standard practices, and their accounts are periodically inspected by city tax authorities and the municipal government auditing bureau. CSSC's and CISCG's financial situation have been affected by the austerity program established by the Central Government in 1993. Credit has been severely tightened resulting in a "triangular debt crisis." Customers cannot pay invoices for steel shipped and steel suppliers have experienced significant increases in accounts receivable. The offsetting liability is an increase in short-term debt to finance working capital and accounts payable.

5.17 By June 30, 1995, CSSC faced a major liquidity problem. With accounts receivable and short-term liabilities increasing rapidly in 1995, CSSC was forced to increase its short-term debt to the equivalent of almost one year of sales. In addition, CSSC has been unable to meet international quality specifications for special steel products and has moved to lower value-added products (para. 5.10). CM has reached agreement with CSSC on a financial restructuring to bring its debt service obligations in line with projected cash flow until the full startup of the new installations (para. 5.19). After the relocation, CSSC's profitability should improve. Net income, as a percentage of sales, should improve from 2 to 9 percent when the project reaches full production by 2001.

5.18 CISCG's profitability will also improve under the project, and net income, as a percentage of sales, should improve from 2 to 5 percent when the project reaches full production by 2002. When CISCG became a limited liability company in 1995, it was authorized to convert into equity a significant portion of its debt, and this allowed the company to keep its total debt within reasonable levels. Total indebtedness will improve further with the project, and total debt-to-equity is expected to decline from 73:28 in 1994 to 42:58 in 2002. However, during 1996-98 costs will rise faster than revenues and debt repayments will increase substantially (about $126 million equivalent will be due banks over the three-year period), and CISCG will be unable to meet the proposed debt service covenant under the project, without an injection of new equity to enable the company to achieve the required debt service coverage of 1.2 (para. 5.19).

5.19 By the end of 1995, CSSC had proceeded with a financial restructuring of its Balance Sheet, by means of a conversion into equity of Y 250 million of debt and accrued liabilities. Details of the operation are as follows: conversion into equity of (a) Y 223.5 million of accrued liabilities (unpaid taxes) and (b) Y 32.1 million of long-term State and Municipal loans (for technical renovation). The financial restructuring-together with the fact that actual 1995 results were better than the forecasts presented to the Bank during appraisal-has substantially improved the financial-situation of the company. Financial projections prepared by the Bank now indicate that CSSC should be in a position to comply with the financial covenants of the project. During negotiations, assurances were received that CM will provide additional equity (i) not later than - 43 -

December 31, 1999 to CSSC of Y250 million, (ii) unless otherwise agreed, not later than December 31, 1997 to CISCG of Y 140 million and (iii) thereafter, provide the steel companies with such additional equity as shall be needed to carry out their five-year investment plans. As a condition of disbursement for the CSSC relocation, CSSC will provide additional equity and/or debt financing with a maturity of at least six years in an aggregate amount of at least $53,733,400 equivalent. Additional assurances were obtainedfrom CSSC and CISCG that they will: (a) furnish the Bank with audited annual financial statements within six months of the end of each fiscal year, (b) maintain a debt/equity ratio of 70:30 or better; (c) maintain a debt service coverage ratio of at least 1. 2; and (d) furnish to the Bank for review, by October 31 of each year from 1996 to the year 2002, rolling five-year financial plans, including projected income statements, sources and uses offunds and balance sheets, and supported by production, marketing and investment plans, including: (i) a detailed analysis of production cost trends and inventory levels; (ii) analysis of operational and financial budget variances for the current fiscal year; and (iii) financing arrangements for the investments proposed over the five-year period

C. ECONOMIC BENEFITS OF THE INDUSTRIAL RELOCATION COMPONENT

Assumptions for the Economic Analysis

5.20 The main assumptions used in determining the ERR for the industrial relocation component are similar to those used in the financial analysis with some adjustments. Economic capital costs expressed in January 1996 prices were obtained from the financial base capital costs after: (a) deduction of duties and taxes on equipment and spare parts; and (b) provision for the opportunity costs of land of the Jinkou farm, site of the CSSC relocation, based on intensive cotton production, which has a higher rate of return than its present use (less intensive orange growing and dairy production), and no land acquisition is required for the new ZICC plant.

5.21 The real prices of inputs and outputs in economic terms were assumed to remain unchanged at their end-1995 levels over the life of the projects, except for a I percent annual increase in scrap due to a long-term trend in rising demand, which-will compel producers to rely increasingly on higher cost imported scrap. The economic price of steel was derived from its projected international spot price in the East-Asian market, delivered to a Chinese port. Import parity prices were calculated by adding unloading, port handling, and economic inland freight from the port to the main consuming units in the Chongqing region. The economic value of imported tradable inputs (like steel scrap) was based on their projected international FOB prices, plus marine freight from their point of origin to a Chinese port, plus economic inland freight to the plant sites in Chongqing. The economic costs of exportable inputs (like and ferroalloys) were derived by deducting from the FOB export price at a Chinese port the economic inland freight prices between the steel companies' sites and the port, and by adding the economic inland transportation costs between the plants and the consuner centers. The main transfer point (ocean to river) is the port of Nanjing on the Yangtze River. The total freight charges - 44 -

from Chongqing to Nanjing are $20.00 per ton, In economic terms, these charges are three times higher (para. 5.22).

5.22 Nontradable inputs were converted to their economic value by applying specific shadow prices: (a) electricity is valued at its long-run marginal costs in China, and the tariff was therefore increased to Y 0.37 ($0.044) per kWh; (b) no shadow wage rates were used for labor, since wages plus nonoperational expenses already reflect the cost to the company of the social services provided to its labor force, including housing, education, hospitals, social security (pensions and unemployment, accident and health insurance), food services and fuel and retail outlets; (c) railfreight tariffs were adjusted from an average of $0.01 per kilometer to the estimated economic costs of $0.03 per kilometer.

Economic Rates of Return (ERR)

5.23 As in the financial projection, the economic rate of return for the two companies are estimated for a base-case scenario. Three sensitivity tests, summarized in Table 5.3, have been undertaken to assess the impact of deviations from basic key assumptions, that is, a 10 percent reduction in sales revenue, a 10 percent increase in operating costs, and a 20 percent increase in capital costs. A "worst case" scenario has been added, reflecting the compound effect of these three sensitivities.

5.24 Under this approach CSSC's project generates a positive Economic Internal Rate of Return of 24 percent. A combined 10 percent drop in average selling prices and a 10 percent increase in operating costs, plus a 20 percent increase in capital costs, reduce the ERR to 15 percent, which represents a comfortable margin if the economic environment of the project changes. CISCG's project has a lower ERR (20 percent). Its main risk lies in the decline of the market price for steel below projected levels. The "worst case" scenario would still imply in a positive ERR of 12 percent. Given (a) the strong and sustained demand growth for steel in China, which is expected to extend into the first decade of the twenty-first century, (b) the likelihood that domestic production will continue to be unable to meet demand, and (c) the geographic protection against foreign imports provided by Chongqing's inland location, it is likely that output prices will remain favorable over the life of the project, and that price fluctuations over the short term represent an acceptable risk. TABLE 5.3: ECONOMic RATE OF RETURN (ERR}SENSITIVITY ANALYSIS

CSSC CISCG 0. Base-case scenario 24% 20% 1. Selling price: -10% 20% 17% 2. Operating costs: +10% 22% 18% 3. Capital cost increase: +10% 21% 17% 4. "Worst case" scenario" (1+2+3 together) 15% 12% - 45 -

D. ENVIRONMENTAL ASPECTS OF THE INDUSTRIAL RELOCATION COMPONENT

5.25 EAs have been completed for both steel plant relocations. They were prepared by CISDI, reviewed by the Bank, and approved by NEPA. Copies of both approved EAs have been submitted to the Board. During negotiations, assurances were obtained from CSSC and CISCG that they would implement the findings of their respective EIAs.

5.26 CSSC Relocation. CSSC is situated on the Jialing River in the densely populated Shapingba district. Ambient dust levels in this area are about 570 micrograms/Nm3 (World Bank guidelines consider values above 100 micrograms/Nm3 polluted). On average, about 44 percent of the dust pollution and 7 percent of SO2 emissions in this district are caused by the steel plant. It is also responsible for 19 percent of industrial wastewater discharges in the district (including 58 percent of the chemical oxygen demand and 89 percent of the oil and grease). The plant also produces 50,000 tons/year of slag, of which less than I percent is recycled, and is simply dumped on the banks of the Jialing River, leaving an unstable tip of 700,000 tons, which periodically slips into the river. Because of the increased production, the new plant is expected to produce 39 percent more slag than the old plant, but 87 percent will be reusable. A slag processing plant to be built on the old site to recycle the slag and clean up the river bank, significantly reducing the solid waste problem and making it manageable and environmentally acceptable.

5.27 Because of their age, condition and location, the equipment cannot be retrofitted with necessary pollution control equipment to comply with environmental discharge standards. The existing facility has been identified by CEPB as a priority pollution source (based on the annual mass discharge of pollution), and by the steel industry as the highest priority polluter in their sector strategy for pollution control (based upon impacts to human health).

5.28 Installation of the modem steel-making facilities at the Jinkou Farm site, with the pollution control systems listed below, will increase ambient levels of dust and S02 by less than 0.1 percent and nitrogen oxides by about 4 percent.

* Second-hole evacuation and baghouse for dust control from the EAF, and the refining furnace;

* Dust and S02 control from a proprietary scrubber of Chinese design, sanitary and industrial wastewater control facilities to remove suspended solids, oil and grease, chemical oxygen demand, biological oxygen demand, decreased water use (35 percent), increased water recycling (92 percent); and

* Slag reprocessing facility to handle new slag and diminish existing slag pile.

5.29 A Resettlement Action Plan (RAP) for the CSSC investment prepared prior to appraisal includes resettlement of 3,018 individuals in 1,014 households. A socioeconomic survey of all 1,014 households on the affected site (Jinkou Farm) was subsequently carried out, and the RAP was revised during appraisal to take into account - 46 - the results of the survey. The survey clarified that: (a) 100 percent of the affected households were headed by CSSC employees; (b) non-CSSC workers are all family members in these households, and their incomes are all derived from sources outside Jinkou Farm, and therefore their livelihoods would not be affected by the project; (c) no additional impacts had occurred; and (d) survey data provide an adequate baseline of living standards and incomes to enable monitoring and evaluation of resettlement progress. The PMO has established a resettlement unit to: (i) ensure that resettlement policies and procedures are followed; (ii) provide coordination and liaison with stakeholders, (iii) supervise mitigating actions, monitor RAP perforrnance indicators and evaluate implementation progress; and (iv) provide periodic reports to the Central Government and the Bank.

5.30 Personal income will increase substantially because steel mill salaries are two-to- four times farm wages. A 38,000 m2 apartment complex will be built, equal to the area of the dismantled housing, with modem plumbing, lighting, heating (natural gas). Existing housing is mostly without these services, and depends on polluting high-sulfur coal for heating and cooking. Workers will have access to other services (medical, middle and vocational education) and benefits (retirement, social security) not available before the project. During appraisal, agreement was reached on terms of reference, selection criteria and procedures for an external monitor for the RAP. CM approved the revised RAP on December 25, 1995 and a contract was signed on December 29, 1995 with Yuzhou University for the external monitoring of the RAP. The survey of affected people and summary of resettlement impacts, TORs for external monitoring, as well as the organizational structure, policies and procedures for resettlement are contained in Annex 3.AQ. During negotiations, assurances were obtained from CSSC that it will carry out resettlement at the Jinkou Farm in accordance with the RAP agreed with the Bank

5.31 ZICC Relocation. The plant is located in the Jiang Bei District on the north bank of the Jialing River in one of the most densely populated (35,000 persons/krn2 ) and highly polluted sections of the city. Ambient dust pollution in this area is about 520 micrograms/Nm3 (World Bank guidelines consider values above 100 micrograms/Nm3 polluted). On the average, about 22 percent of the ambient dust levels are the result of dust emissions from this plant. The ZICC plant releases 63 percent of all industrial dust emissions, 19 percent of all NO, emissions and 17 percent of total industrial wastewater discharges in this district. Also, 43,700 tons of slag are produced annually, none of which is recycled. It should also be noted that the untreated wastewater discharges are released 1,800 meters upstream of one of the main drinking water intakes for CM.

5.32 Because of their age, condition, and location, the furnaces cannot be retrofitted with necessary pollution control equipment to comply with environmental discharge standards. The existing facility has been identified by CEPB as a priority pollution source in CM (based on the annual mass discharge of pollution), and by the steel industry as the second highest priority in their sector strategy for pollution control (based on impacts to human health). - 47 -

5.33 Installation of the modem steel-making operation at the Dadukou steel complex, with the pollution controls listed below, will not result in any increases to ambient air pollution at the relocation site. Negligible emissions generated by the new facilities will be more than offset by shutdown of several small furnaces currently operating at the new site. In fact, there will be a net decrease in ambient dust levels of about 8 percent at the new site. Since the new site is part of existing production operations, there are no resettlement issues. Equipment to be acquired include:

* Large baghouse for dust control from the EAF, refining furnace, and furnace hood exhaust gases;

* Cyclone separators at all solids transfer points, closed water recirculation system for EAF, refining furnace, vacuum degasser, and casting facilities, including solids separation, oil skimming, chemical treatment;

* Sanitary wastewater treatment facilities;

* Noise suppression; and

* Recovery and recycle of about 84 percent of the slag.

5.34 Other Benefits. Improved environmental management, monitoring and regulation is a prerequisite for the planning, design, and enforcement of measures to improve air and water quality and the safe disposal of wastes. The air and water monitoring networks and hazardous waste management and disposal techniques supported under the project will be essential elements in establishing an overall industrial pollution control plan, and an important tool for CEPB in applying existing regulations and in collecting hard data on which to base planning for more effective regulation. Establishing CEPB's capability for industrial environmental audits is also a key part of making the regulatory system more effective. The project would help accelerate the pace of overall reform in Chongqing. The specific benefits expected include: (a) strengthening CM's environmental regulatory policy and incentive structure and achieving more environmentally sustainable industrial growth; (b) initiating improvement of environmental conditions in the city center; (c) establishing a pilot program for market-based SOE reform, to enhance enterprise productivity, efficiency and capacity to meet environmental standards; (d) creating an independent restructuring capability to achieve more rapid industrial transformation; and (e) introducing new initiatives in state asset management and surplus labor redeployment.

5.35 During negotiations, assurances were obtainedfrom CSSC and CISCG that any future use of the sites of the steel plants being closed down would be in accordance with applicable environmental standards.

5.36 Sustainability. Project investments are expected to be financially sustainable. CSSC's and CISCG's plant production costs are now slightly higher than the world average for a similar range of products, but, due to transport costs, their domestic selling - 48 - prices compare favorably with average production costs or are comfortably below foreign import prices for similar products delivered to Chongqing. The profitability of both plants is expected to improve after relocation, and financial analysis indicates financial rates of return of 17 percent for both plants. While analysis shows sensitivity to declines in steel prices, selling prices would have to decline by 20 percent for CSSC and 24 percent for CISCG to make the net present value turn negative at a discount rate of 11 percent. Subprojects to be financed by the line of credit should also be financially sustainable since their approval would require satisfactory environmental assessments and restructuring plans demonstrating the technical feasibility, market potential and financial viability of the proposed investments, as well as the firms' creditworthiness. Sustainability of the institutional and policy reforms to be introduced cannot be so easily assured. However, an acceptable basis for continued reform is promised by CM's commitment to reform coupled with covenanted performnance objectives and project support for: preparing an Industrial Pollution Control Action Plan; establishing an EAU in CEPB and strengthening its enforcement capacity; and providing restructuring advisory facilities to help enterprises meet both commercial and environmental objectives.

E. MAJOR PROJECT RISKS

5.37 CM has made a strong commitment to implement the project and to undertake the major reforms involved. Nevertheless, the very depth of the agreed reform program gives rise to a major risk that CM may be unable to maintain the political will to carry through the full range of reforms. Reducing this risk is project conditionality on implementation of the reform action plans, agreed performance indicators, maintenance of a strong project management organization, and the mid-term review with its potential to reinvigorate the reform progress if needed. A sustained commitment to industrial pollution control and reform would also justify the Bank's consideration of a follow-up operation. The political risk is in any case considered justified in view of the serious pollution situation demanding immediate action on many fronts, the potential benefits of the reforms for CM and their demonstration effects for other Chinese municipalities. A second significant risk relates to the commitment of the PFIs to implement the line-of-credit component. Chinese banks are now responsible for their own profitability and asset quality, and have become reluctant to take on additional risks. The project mitigates the risk of lagging PFI participation by establishing restructuring advisory facilities to help enterprises prepare viable restructuring plans for PFI review, and by fostering a continuing dialogue between PFIs and consultants operating the facilities.

5.38 The risk posed by the counterparts' lack of experience in implementing a Bank- financed project, particularly CEPB, which will require strong political support to improve regulatory performance, would be mitigated by the leadership of CM's senior officials, under the direction of the PLG, the commitment of stakeholders, and intensive Bank monitoring and supervision, particularly in the early project stages. The challenge of coordinating this rather complex project would similarly benefit from CM's political commitment and leadership as well as continuing Bank oversight and support. A risk - 49 - inherent in a transition economy is delays and cost increases in implementing industrial pollution control and enterprise restructuring, especially considering the debt burden of most SOEs and therefore the need for debt restructuring. This risk is being addressed by the RAFs, through their assistance to enterprises in preparing sound financial restructuring plans. Finally, the risk that Chongqing's financial system will be unable to mobilize sufficient counterpart resources has been minimized by requiring each PFI to estimate carefully its capability to marshal counterpart funds and to prepare a corresponding estimate of foreign exchange required from the line of credit. There are no significant technical risks in the industrial relocation component. The proposed electric- arc furnace steel-making technology has been in use for some time in developed as well as developing countries. Moreover, assuming sustained growth of the Chinese economy, there appears to be sufficient demand to accommodate the two projects' planned capacity. - 50 -

6. AGREEMENTS REACHED AND RECOMMENDATION

6.1 During negotiations, CSSC and CISCG submitted letters confirming that the feasibility studies for the relocation of these companies consist of (a) the studies prepared by the Chongqing Iron and Steel Design Institute and CSSC and CISCG, and (b) Annexes 3.9-3.1 1 of the SAR as revised during negotiations (para. 3.12).

6.2 The following assurances were obtained during negotiations:

(a) From the Borrower that it would make available the proceeds of the proposed Bank loan to CM, on termnsand conditions satisfactory to the Bank (para. 4.2).

(b) From CM that it would:

(i) carry out an iron and steel sector pollution control plan satisfactory to the Bank as part of the economic policy agenda of the project (para. 3.7);

(ii) prepare an industrial pollution control strategy and action plan satisfactory to the Bank, submit the plan to the Bank not later than December 31, 1998, and implement it thereafter (para. 3.9);

(iii) carry out an environmental regulatory enforcement plan satisfactory to the Bank (para. 3. 10);

(iv) furnish the Bank with annual progress reports by July 30, on project implementation and meeting performance indicators (para. 3.31), as well as on CM's environmental status, including the status of all environmental action plans, and the CSSC RAP (para. 3.10);

(v) provide the physical facilities, staffing requirements and operational budget for the Surplus Labor Employment and Training Center (para. 3.26);

(vi) by March 31, 1999 prepare a mid-term report and hold a mid-term review to assess progress in meeting project objectives (para. 3.31); - 51 -

(vii) carry out the institutional strengthening of CM's agencies under the project in accordance with a time-bound program satisfactory to the Bank (para. 3.29).

(viii) maintain the PLG and PMO with staffing, composition and functions satisfactory to the Bank, including a resettlement unit, and by December 31, 1996, establish an environmental unit (para. 3.31);

(ix) onlend the proceeds of the proposed Bank loan to PFIs for 20 years, including 5 years of grace, at the standard interest rate for LIBOR-based US dollar single currency loans (para. 4.2);

(x) onlend the proceeds of the proposed Bank loan to CSSC and CISCG for a term of 12 years, including 5 years of grace, at the standard interest rate for LIBOR-based US dollar single currency loans plus a spread of 1.2 percent (para. 4.2);

(xi) furnish the Bank with the audited project accounts within six months of the end of each fiscal year (para. 4.17); and

(xii) not later than December 31, 1999, provide additional equity to CSSC of Y 250 million (para. 5.19); not later than December 31, 1997, and unless otherwise agreed, provide additional equity to CISCG of Y 140 million and thereafter provide the steel companies with such additional equity as shall be needed to carry out their five-year investment plans (para. 5.19).

(c) From CSSC and CISCG that they would:

(i) carry out a program of closure, physical relocation and restructuring of production facilities and their financial restructuring, according to the feasibility studies agreed with the Bank (para. 5.19);

(ii) furnish the Bank with independently audited annual financial statements within six months of the end of each fiscal year (para. 5.19);

(iii) maintain a debt service coverage ratio of at least 1.2 times and a debt:equity ratio of 70:30 (para. 5.19);

(iv) furnish to the Bank, by October 31 of each year, a rolling five-year financial plan containing (a) projected income statements, statements of sources and uses of fumds, and balance sheets; (b) a detailed analysis of trends in production costs and inventory levels; - 52 -

(c) an analysis of operational and financial performance vis-a-vis planned targets; and (d) financing arrangements proposed over the five-year period (para. 5.19);

(v) implement their respective ElAs (para. 5.25); and

(vi) carry out future activities at the sites of the steel plants being closed down in accordance with environmental standards satisfactory to the Bank (para. 5.35).

(d) From CSSC that it would carry out resettlement at the Jinkou Farm site in accordance with the agreed upon RAP (para. 5.30).

(e) From PFIs that they would:

(i) by December 31, 1996, adopt training programs to strengthen their institutional capabilities in credit policy, procedures and analysis, and project appraisal and supervision (para. 3.20);

(ii) furnish the Bank with independently audited annual financial statements within six months of the end of each fiscal year (para. 3.20);

(iii) appraise subprojects in accordance with procedures satisfactory to the Bank (para. 3.24); and

(iv) make subloans in accordance with procedures and on terms and conditions satisfactory to the Bank (para. 3.24)

(f) Not later than one month after the effective date, CM would:

(i) establish an EAU with TORs, staffing and resources acceptable to the Bank (para. 3.25); and

(ii) provide the Bank with a satisfactory signed contract with international consultants to train the staff of the EAU (para. 3.25).

6.3 As conditions of Loan effectiveness, CM would:

(a) adopt a plan satisfactory to the Bank for implementing the SO2 levy system in Chongqing (para. 3.10); and

(b) CM and the steel companies and CM and the PFIs would execute subsidiary loan agreements satisfactory to the Bank (para. 4.3). - 53 -

6.4 As a condition of disbursement of Part B.1 (CSSC relocation), CSSC would provide additional equity and/or debt financing, with a maturity of at least six years, in an aggregate amount of at least $53,733,400 equivalent (para. 5.19).

6.5 Based on the above assurances, the proposed project would be suitable for a loan of $170 million for a period of 20 years, including 5 years of grace, at the standard interest rate for LIBOR-based US dollar single currency loans, to the People's Republic of China.

- 55 - ANNEX 2.1

ANNEX 2.1: CHONGQING'S ECONOMIC STRUCTURE

A. STATE ASSET MANAGEMENT

1. Basic legislation required for reform of state asset management is in place, and policy direction from the National Administrative Bureau of State-Owned Property is provided to clarify property rights and the transfer and disposition of state assets. Still, municipalities retain some discretion in establishing procedures and making institutional arrangements for administering state assets. Chongqing's state asset management structure follows the national multitiered pattern: a State Asset Management Committee (SAMC) headed by the Mayor and including 14 heads of CM departments and line bureaus, which sets policy and appoints managers. District and county-level governments have identical structures. The policy framework is set out in CM Document 170, entitled "Opinions on State Asset Management System Reform Experiment," July 23, 1994.

(a) The State Asset Management Bureau (SAMB). The policy decisions of SAMC are carried out by its executive arm, SAMB, a separate CM department with a staff of 30. The current head is also a Deputy Director of the Finance Bureau. Under SAMC are three forms of asset organization: State Asset Operating Companies (SAOC), Group Enterprises (GE) and very large enterprises (primarily infrastructure). SAMB's broad mandate includes (a) coordinating information between SAMC and the enterprises, (b) setting indicators and incentive structures for SAOC performance, (c) recommending management appointments and dismissals, (d) representing the state shares in LLCs and LLSCs; (e) registering state assets; (f) approving mergers and other transfers of state assets; (g) drafting local regulations for state asset management; and (h) authorizing individuals and legal entities to manage or dispose of state assets.

(b) The Supervisory Committees (SC). To implement the 1994 regulations, SAMB intends to establish an SC for each major entity reporting directly to it. Each SC is required to have 15 members serving a term of three years, and on behalf of SAMB, inspects enterprises to ascertain implementation of relevant laws and regulations.

(c) The State Asset Operating Companies (SAOC). According to CM Document 170 (1994), SAOCs in CM are entities established under the Company Law with SAMB as the founder, organized according to three forms: (i) companies formed from line bureaus and other agencies; - 56 - ANNEX 2.1

(ii) companies that are existing large enterprises, corporatized and then "entrusted" with the management of shares, and (iii) assets of smaller enterprises and companies, and existing investment companies to be "entrusted" with shares or assets of companies and enterprises. The purpose of SAOCs is to separate the functions of government as owner, manager and regulator of enterprises; to create a more competitive environment to strengthen the enterprises, and support development of a modem enterprise system. Two SAOCs, Huamao and Huajin, were established in 1994, and three to five more were planned for 1995.

(d) Group Companies. Three existing large enterprises were approved for "entrustment of state assets" in the form of group companies: China Silian Instrument Group, Chongqing Iron and Steel Group, and Huaxi (West China) Packing Group. Quinling Auto Group and the Chongqing Special Steel Group are soon to be approved for this status. These group companies act as holding companies and as management agents for CM assets in a large number of smaller enterprises with various ownership structures and degrees of functional relationships.

(e) Property Rights Transaction Center. Pursuant to CM Document 200 of 1994, a Property Right Transaction Center is to be established under the direction of Chongqing's System Reform Commission. The Center will act as intermediary in the transfer of all forms of property rights through public auctions, tenders, leases, and trading. The Center intends to encourage (but not require) use of its services for private transfers, and would act as agent for the state in liquidation of bankrupt state enterprises. It would develop procedures for documenting and registering property transfers and would also train independent intermediaries to carry out transfers. The scope of the Center's activities is ambitious but its priorities are not clear.

B. SOCIAL SECURITY SYSTEM AND THE LABOR MARKET

2. CM initiated social security reform in October 1986 by establishing three municipal pension funds (urban enterprises, rural enterprises, and civil servants) that currently cover practically all industrial and trade, and service workers in Chongqing. In 1990, CM developed a plan for a unified social security system to include four separate funds covering pension, medical, unemployment and industrial injury under a single Social Security Administration (SSA). The three pension funds, which will be integrated under SSA in 1997, supported some 400,000 retired workers in 1993, and are responsible for paying 70 percent of enterprise retirees' pensions, with the balance remaining as an obligation of the enterprises. A industrial injury insurance fund will be established before the end of 1995, and unemployment and medical insurance funds will be implemented in 1997. - 57 - ANNEX 2.1

3. In 1992, an Unemployment Insurance (Ul) program was introduced, which is funded by a I percent enterprise payroll tax and a 2 yuan per month employee contribution. Presently about 1,500,000 workers are covered by UI, mainly in the SOEs and urban cooperatives. In 1994, 7,650 individuals received unemployment benefits and as of June 1995, there were just under 10,000 recipients. It is estimated that the number of UI recipients will increase to about 20,000 by the end of 1995. The benefit payment ranges between Y 86 and Y1 50 per month-depending on the individual's wages, other social payments, and length of employment-with the average monthly wage around Y 220 per month. The maximum period of unemployment benefits is 24 months and presently the average length of payment is 18 months. In 1994 expenditures from the UI fund were: 57 percent unemployment benefits including 10 percent for medical insurance; 15 percent job training; 15 percent job creation; 8 percent administrative costs; 5 percent contingency funds. Although the UI fund has been running a modest surplus, in 1995 it is expected to break even. Problems are being encountered in collecting the I percent UI enterprise payroll tax and there are difficulties in establishing an accurate payroll base upon which to apply the 1 percent levy. In 1993 only about 75 percent of the UI contributions that were due were actually collected.

4. In 1994, Chongqing municipality had a total work force was 8.5 million, of whom 2.1 million, or 25 percent, were state workers and staff, including 1.5 million in SOEs and 539,000 in urban collectives. Private enterprises employed 45,000 workers and another 152,000 were self-employed. Rural collectives and self-employment involved 614,400 workers. Contract workers numbered about 400,000, with 77 percent employed in SOEs. The remaining contract workers were about equally divided between collectives and other enterprises. Most of the contract workers were in manufacturing, 58 percent, or in commerce, 12 percent.

5. Unemployment, as officially reported, is relatively modest in CM. In 1994 there were about 60,000 reported unemployed, an official unemployment rate of 2.76 percent. The Chongqing Labor Bureau (CLB) projects that unemployment at the end of 1995 will be around 70,000, or 3 percent. The projected 3 percent official unemployment rate reflects an implicit policy of "no dismissals that create higher levels of unemployment." An example of this policy is the constraint placed on restructuring SOEs that no more than 2 percent annually of their work force may be made redundant. Even so, as there are 1.5 million employees in SOEs overall, the number of workers involved could be as high as 30,000, although not all would necessarily become unemployed. A wide range of steps can be taken by SOEs under the "Measures on Redeploying Surplus Workers in State-Owned Enterprises," which would outplace or alternatively employ redundant workers, as well as provide for early retirement or forms of extended leave with some payment. Indeed, the basic thrust of the Measures is to have SOEs provide for a "positive" redeployment of the redundant workers, i.e., avoid creating actual unemployment.

6. Clearly the officially reported unemployment rate does not fully reflect the unemployment and underemployment situation in Chongqing. For example, adults living - 58 - ANNEX 2.1 on farms are automatically considered employed. Rural underemployment, including seasonal unemployment, is extensive. The CLB estimates that in 1994, 1.5 million rural workers left for urban jobs in Chongqing and elsewhere in China. It is estimated that the number of surplus workers in urban SOEs is around 250,000.

7. Nevertheless, Chongqing's substantial economic growth has been creating new jobs. In 1994, according to the official statistics, 62,000 net new jobs were created. While SOEs lost about 5,000 jobs, this was offset by an increase of 28,000 jobs (166 percent increase) in urban private enterprises and the number of self-employed increased by 64,000, or 72 percent. In 1993, however, about 85,000 jobs were lost, largely in SOEs and urban collectives while jobs increased 127,000 in 1992 and 215,000 in 1991.

8.- The CLB has developed mechanisms for job placement and training, and unemployment insurance. SOEs, however, retain responsibility for the skill preparation of the labor force and redeployment of surplus workers. The CLB operates 69 labor exchange offices, 22 unemployment offices, 17 employment training center and 80 labor service companies, which provide employment for about 4,000 individuals. The employment training centers have a capacity (largely at the job entry level) to serve 4,000 individuals. The Education Commission is responsible for 36 secondary vocational schools and 81 technical schools, also geared toward entry-level skills. It also operates several tertiary polytechnics, which provide higher-level technical skills. SOE training includes 113 skilled work schools, largely entry-level training. SOEs also operate 60 technical schools providing inservice mid-level skills, and 27 worker and staff colleges providing inservice high-level technical skills and instructor training. In sum, there are 210 SOE training facilities with a potential capacity for training 60,000 individuals annually. In addition, the unions also operate entry-level skill training facilities, as well as a technical institute and a workers' university, which in total train about 14,000 workers a year.

9. Most of Chongqing's job training capacity is for entry-level skills for new entrants to the labor force, with little of it geared toward the retraining or upgrading of adult workers whose skills are obsolete. Further, the instructional programs are narrowly skill-focused and use outmoded instructional methodologies and only limited training facilities. Similarly CLB's employment assistance activities such as job development, matching and placement are not well developed or suited for the emerging needs in Chongqing's changing economy and labor market. Therefore, a priority need in the reform of Chongqing's labor market is to develop improved training and employment measures to redeploy the increasing number of surplus workers who will be entering the labor market.

10. Given present concerns at both national and regional levels about social stability, it is unlikely that significant increases in open unemployment will be tolerated. In addition, labor market information and services are quite limited, and no system exists for providing direct financial assistance to surplus workers. Also, the ability of SOEs to - 59 - ANNEX 2.1

provide training (other than on-the-job) is also limited; and the creation of service companies by SOEs as an alternative to actually shedding labor represents only a partial solution to the surplus labor problem.

C. FINANCIAL SECTOR

11. The financial sector in Chongqing, at the end of 1994 consisted of eight banks with 1,364 branches and 1,182 nonbanking financial institutions (94 percent of which are Rural Credit Cooperatives). Investment needs in Chongqing continue to exceed the financial sector's ability to gather deposits as demonstrated by a systemwide loan-to- deposit ratio of approximately 136 percent. The system historically was extremely dependent on borrowings from PBC. Pursuant to PBC's effort to exercise more effective macro control, however, PBC centralized its lending and now channels funds through bank headquarters, which then onlend to the provincial and city branches. As a result, during 1994 and 1995, local PBC funding has largely been replaced by interbranch and interbank borrowings.

12. Limited deposit-gathering capacity and capital positions of the local branches impede the system's ability to serve the needs of local enterprises. Total financial institution loans at the end of 1993 totaled Y 36.7 million (up 20.8 percent from 1992). Year-end deposits in financial institutions were Y 28.1 million, showing an increase of 24.5 percent during 1992. Bank loans (Y 31.0 million) and deposits (Y 22.8) constitute 84.2 percent and 47.0 percent, respectively, of the systemwide loans and deposits. The banking sector is dominated by the Industrial and Commercial Bank of China (ICBC) and the Agricultural Bank of China (ABC). At the end of 1993, ICBC held 55.6 percent of total bank loans and 47 percent of total bank deposits. ABC's corresponding market share percentages were 18.4 percent and 19 percent, respectively. ABC's position is further enhanced by the control it has exercised over the Rural Credit Cooperatives (RCCs). RCC loans and deposits at the end of 1993 were Y 2.9 billion and Y 3.9 billion, respectively.

13. Although the total funds raised in the capital markets are small compared with bank intermediation, securities markets are being encouraged and are --growing in importance. Significant capital market transactions in 1993 included: (a) issuance of Y 30 million bonds by the Chongqing Investment Fund for the benefit of the Three Gorges project, (b) three local firms were approved to issue Y 71.2 million in bonds at the Shanghai and Shenzhen stock exchanges, (c) three large securities firms were approved for operations in Sichuan. Bonds issued in Chongqing in 1993 totaled Y 562.3 million.

14. Competition is currently impeded by a number of legal and logistical factors that result in the high concentration of loans detailed above. Even if borrowers are allowed to move freely between institutions, the dominant position of two or three banks and effective sectoral and product segmentation will continue to impede competition. Sectoral and product segmentation diminish the banks' attempts to provide better service - 60 - ANNEX 2.1 to their customers, restrict their deposit bases, and contribute to loan quality problems as banks and customers feel excessively bound to and dependent on each other.

15. The Chongqing Branch of PBC supervises all financial institutions in Chongqing. Prior to the enactment of the Commercial Banking Law on May 10, 1995, the branch's primary function was to supervise implementation of the credit plan. Under the new banking law, the scope, functions, and organizational structure of PBC are being adjusted and PBC branches have yet to clearly define their regulatory and monitoring role. One of the central issues faced by PBC at present is how to divide supervisory powers between PBC headquarters and branches in light of the bank's decisions (under the new Banking Law) to constitute themselves at the Headquarters level as a single legal person.

16. Since the promulgation of the Provisional Rules on the Management of Credit Funds (effective February 1, 1994), the local PBC Chongqing Branch has worked to introduce balance sheet ratios as a way to evaluate management and to measure bank financial soundness. Under the new Banking Law, four ratios (capital adequacy, loans to deposits, current ratio, and a large exposure rule) replace the provisional ratios that the PBC branch had previously been promoting. - 61- ANNEX 3.1

ANNEX 3.1: ECONOMIC POLICY STATEMENT OF CHONGQING MUNICIPALITY

December 11, 1995

Mr. Nicholas Hope Director China & Mongolia Department The World Bank Washington, DC 20433

Dear Mr. Hope:

In order to establish the socialist market economic system in Chongqing Municipality (CM) so that its economy can meet international economic rules and practices, as required by the State; and to ensure successful cooperation between the Chongqing Municipality (CM) and the World Bank in the implementation of the Chongqing Industrial Pollution Control and Restructuring Project (CIPCRP), so as to lay the foundation for future cooperation, we have prepared the Chongqing Municipality Economic Policy Reform Agenda and Action Plan (Attachment 1), based on economic rules and international practices, as well as on the suggestions of the Appraisal Mission. The Economic Reform Agenda and Action Plan can be summarized as follows:

Economic Reform Objectives of Chongqing

The basic framework of the socialist market economic system will be established by the end of 1998. The major components of this framework include:

(a) a reoriented and restructured municipal government economic management system, which mainly relies on macroeconomic, indirect means, and is in conformity with the requirements of a socialist market economy;

(b) a modern enterprise system in conformity with a socialist market economy, under which: (i) enterprise property rights and other rights and obligations are clearly defined, (ii) enterprise governance structures give managers authority to operate with full autonomy in decision-making, (iii) enterprises are subject to "hard fiscal and quasi-fiscal budget constraints" and other features of a business disciplining, competitive environment, such as market-priced capital, labor and other factors of production; (iv) governmental social service and regulatory functions are - 62 - ANNEX 3.1

separated from the commercial, productive functions of enterprises, (v) fluid capital, labor and technology markets develop, (vi) there is greater attention paid to the development of modem, high value-added services sectors, (vii) scientific enterprise management is practiced, and (viii) there is openness to foreign flows of trade, investment capital and other assets;

(c) a diversity of enterprise ownership structures, under which various enterprise forms can develop in tandem, compete vigorously with one another and enjoy neutrality in treatment under the economic laws, regulations and other measures, with the growth of the nonstate, private sector being especially encouraged;

(d) a social security system, which covers the whole of society and is conducive to the growth of a socialist market economy and social stability; and

(e) a program to protect the environment-a program that is based on the principle that economic development and environmental protection can proceed in tandem, and thereby society benefits on both counts.

Major Economic Reform Tasks

I1. There will be an acceleration of reforms in state-owned enterprises under municipal government control (MCSOEs), so that the modem enterprise system can be established as soon as possible. Principal reforms include the following: First, in accordance with the Regulations on the Transformation of Enterprise Management Mechanism, the "14 Autonomous Rights" will be fully delegated to enterprises, and done so in a way that they may really enjoy the exercise of those rights. Second, enterprises will be transformned,based on the Company Law, into limited liability shareholding companies, limited liability companies, or companies solely owned by the state. In this regard, there will continue to be transformation of MCSOEs into fully autonomous shareholding companies, with the goal of completing the transformation process for approximately 50 percent of MCSOEs by 1996, and approximately 100 percent by the year 2000. Third, building on the progress already made in the last several years in eliminating CM fiscal (budgetary) subsidies for operational losses to industrial MCSOEs, fiscal subsidies for technical renovation to industrial MCSOEs will be eliminated by 1998; remaining fiscal subsidies to industrial MCSOEs-for policy losses-that currently includes only coal production, chemical fertilizer and plastic films (for agriculture), will be eliminated dependent on the Center's policy changes in these sectors. Quasi-fiscal subsidies to industrial MCSOEs- those provided through the financial system-will be reduced and - 63 - ANNEX 3.1

eliminated as progress continues to be made in commercializing the financial sector; see paragraph 6 below. Fourth, in accordance with the relevant laws, for those enterprises whose liabilities exceed their assets, or who have suffered persistent losses without any prospect for recovery, bankruptcy proceedings will be initiated, or they will be closed down without any protection.

2. Encouragement and support of development of the nonstate sector. The government will provide broad investment opportunities and a favorable policy framework and social environment for the growth of the nonstate economy. The sector will enjoy an "enabling environment" that provides a "level playing field" vis a vis state enterprise firms.

3. Establishment of a market-oriented state asset management system. This will include the State Asset Management Committee (SAMC) and its executive, the State Asset Management Bureau (SAMB); and several State Asset Operating Companies (SAOCs) or State Asset Group Companies (SAGCs) authorized to carry out state asset management responsibilities. SAMB will assign the state's ownership rights to SAOCs or SAGCs, which will exercise these rights by appointing members of, and/or serving on, boards of directors of the underlying SOEs. SAMB will operate as a bona fide independent bureau, will have a full-time director and its functions will not be subordinated to those of other CM bureaus. SAOCs or SAGCs will act as trustees for the state, seeking to retain and increase the value of state assets through monitoring SOEs' performance based on market-oriented criteria; investment and dividend policy will also be established in accordance with commercial objectives. SAOCs or SAGCs will be organized as limited liability or limited liability shareholding companies. They will be managed by full-time directors and be independent from sector line bureaus, which, over time, will be phased out or transformed into independent trade associations.

4. Dealing with surplus workers, strengthening job training and improving the labor market. The unemployment insurance fimd will be augmented to provide assistance to additional surplus workers separated from their jobs. A job retraining program, involving the joint efforts of SOEs and CM, also will be established to facilitate surplus workers making the transition, where appropriate, to new jobs. The employment system reform will be accelerated to convert, by 1998, all regular employees to the contractual employment system in enterprises under CM's jurisdiction.

5. Improvement and integration of the social security system. By approximately 1997, a unified social security system, managed by the Social Insurance Bureau, will be in place. This will help ensure that the - 64 - ANNEX3.1

CM's market economy can continue to develop while providing for social stability. While its coverage is being expanded through pooling, both across different types of work units and regions, the pension system in CM will be gradually transforrned into a regime under which the collection and delivery of pensions are integrated, their administration is delinked from enterprises, and they incorporate individual accounts. Significant medical and industrial injury insurance reforms are also under way.

6. Strengthening the financial sector and development of the capital market. Banking institutions will be strengthened so as to provide for a vibrant and competitive financial sector, allowing for effective intermediation of savings into needed investment. In line with the new Commercial Banking Law, CM's commercial banks will be given the decision-making autonomy necessary for operating in a market economy. Efforts will be made to encourage new entrants in the financial sector, including foreign financial institutions, to establish operations in CM.

7. Government reorganization and the rationalization and consolidation of government functions. As a major component of the reorganization, the number of government employees and agencies will be reduced. The government functions related to the economy will be rationalized, so that the government will no longer directly manage enterprises and will not interfere with enterprise operations.

8. Mitigating industrial pollution and environmental damage. There will be a strengthening and extension of municipal regulations to protect the environment, particularly against the effects of industrial pollution, and an upgrading of the capabilities of government agencies to ensure that environmental regulations are enforced.

The Chongqing Municipality Economic Policy Reform Agenda and Action Plan, has been prepared based on the conditions of the social and economic development in the municipality, and has taken into full consideration the suggestions of the World Bank Appraisal Mission. This action plan has been discussed and reviewed by the relevant government agencies. We are committed to complete in time the reforms in various fields as provided in the action plan. The Chongqing Municipality welcomes the World Bank's CIPCRP supervision team to monitor jointly with CM the implementation of the action plan and other facets of the CIPCRP.

People's Governnent of Chongqing People's Republic of China - 65 - ANNEX 3.2

ANNEX 3.2: CHONGQING MUNICIPALITY ECONOMIC POLICY REFORM AGENDA AND ACTION PLAN

DECEMBER 11, 1995

|Reforrn Objectivcs Actions Taken Actions to be Taken andTheir Rponsibility I iTiming IA.MODERN ENTERPRISE SYSTEM SOE Manage- Separateenterprise manage- Municipal regulationpromul- All but 2 of the 14 Autonomous Economic ment Auton- ment functionsfrom state's gatedin 1993regarding the trans- Rights fall under CM's control; Commission omy exerciseof ownershiprights fer of 14 AutonomousManage- trading rights and investment (EC) and System functions,and ensureSOE ment Rights establishedin the rights areunder the Center's Reform Com- managementis autonomous StateCouncil's New Operating control. CM will complete mission(SRC) andaccountable for perform- Mechanismof July 1992. As of transferof the 12 rights to all ancebased on market- April 1994,the majority of the 14 SOEsin CM by endof 1998; oriented criteria. rights weretransferred to the also by end-1998,CM will apply majority of SOEsin CM; for to the Centerfor the transferof someSOEs, all rights had been the 2 other rights to CM's SOEs transferred.Contract Responsi- (if they havenot been bility Systemabolished Decem- transferredby that time). ber 1993. Conversionof Establishthrough corporati- By 1995conversion of 40 SOEs By end-1996,conversion of EC and SRC SOEs into zation commerciallyoriented into limited liability shareholding approximately50 percentof Shareholding enterprisestructures. Define companies(LLSCs) and200 SOEsinto LLCs/LLSCs will Companies clearly enterprises'legal pro- SOEsinto limited liability com- takeplace, andconversion of perty rights, including the panies(LLCs) had taken place approximately 100percent will right to disposeof assets (not all in industrial sector); 7 take placeby 2000. Reformof accordingto the law. LLSCs are listed on stock ChongqingIron & SteelCorp. exchanges.CM was askedto underCenter's 100 Enterprise nominate I SOE to participatein Reformexperiment to be com- theGOC's "100 Modem Enter- pleted by 1996. priseSystem Experiment;" CM nominatedChongqing Iron & SteelCompany, whose reform plan hasbeen acceptedby the Center. 2 SOEs havebeen selectedby CM to participate in SichuanProvince's 80 SOE Modem EnterpriseReform Program. CM has organizedan interagencyLeading Group, chairedby the Mayor to develop enterprisereform policies. Divesting To let enterprisesfunction as CM is one of 18 cities chosenby CM agencieshave prepared a EC and SRC Social Service commercialentities without Centerfor the "Comprehensive plan for "optimizing the capital Functions social burdensand to focus Reform" experiment,which, structureand strengthening the from SOEs' on productive activities; to amongother things, will involve performanceand managementof Operations ensuregovemment provides capital replenishmentand tech- SOEs" and an "urban compre- social services,consistent nical renovation,dealing with hensivereform" plan for this with the generalpractice in surplus workers,reducing debt, experiment. The planshave marketeconomies. divesting from SOEshistorical been approvedby CM and the social burdens,such as pensions, Center,and are being imple- housing(see section C below), mented. By 1996 CM will select schools,hospitals, etc. CM has I or 2 other SOEsto experiment selected66 enterprises(mostly with transferringschools and industrialSOEs) to participate in medical facilities to govemment its "comprehensiveexperiment." administration. 32 of the 66 firms have devel- oped action plans for reform; CM has produced 12 generalpolicy documentssetting out guidelines for this experiment. 3 middle and preliminary schoolsof Chongqing Iron & SteelCorp. l ______transferredto CM auspices. - 66 - ANNEX 3.2

Reform Objectives Actions Taken Actions to be Taken and Their Responsibility ______T im ing Hardening the To establisha businessdis- Reformssince 1987 havebegun When the Central authorities FmanceBume u Fiscal and ciplining economicenviron- to remove industrialsector SOE allow coal prices to be eom- (FB), EC Quasi-Fiscal ment. fiscal subsidiesfor "operating pletely set by the market, CM Budget Con- losses;"such subsidieswere will terminateall fiscal subsidies straint on endedin 1993. In the industrial to that sector;likewise for rele- SOEs sector,only coal production and vant agricultural-supportindus- agriculture-supportfirms (chemi- tries. Currently there are no cal fertilizer and plastic film pro- plansto reduceor terminate ducers)receive fiscal subsidies- existing nonindustrialSOE fiscal to cover "policy losses;"these subsidies. Technicalrenovation subsidiesare aboutY 81 million creditsto industrial SOEs (1994). CM also provides, throughCM's budgetwill ter- through its budget,technical minateyear-end 1998. Reduc- renovationcredits to industrial tion or elimination of quasi- sector loss-makingSOEs-Y 68 fiscal subsidiesis dependent million. Thus, total fiscal subsi- upon Center's and CM's policies dies to industrial sectorSOEs is for commercial bankingreform Y 149 million, which amountsto (seeC below). about 4% of aboutof CM's total Y 3.56 billion budgetexpendi- tures. Total fiscal subsidiesto all other SOEs,i.e., outside of the industrial sector,are much larger -Y 294 million for operating andpolicy losses,and Y 54 mil- lion for technicalrenovation credits (about 10%of budget expenditures). In addition, like elsewherein China, CM's indus- trial and nonindustrialSOEs enjoy quasi-fiscalsubsidies: CM's SOEsaccount for the bulk of bank credit, lent at negative real interest rates. Reform of To more effectively imple- Like othergovemments in China, CM expectsthere to be a gradual EC and SRC Bankruptcy ment existingenterprise CM has shiedaway from active accelerationof bankruptcies, Policy bankruptcymeasures. encouragementof bankruptcy- e.g., perhaps5 to 6 industrial as long as an adequate"social SOEswill file for bankruptcyin safety net" is missing. Still, 1996,and CM wants to quicken within the past 5 years, three bankruptcyprocedures. CM will medium and small industrial also encourageenterprises to SOEs havegone throughsuccess- mergeor acquirefirms on the ful bankruptcyproceedings (the vergeof bankruptcy. largestwas a knitting mill with 3000 workers), andfive others have begunthe process.CM has drafted "Measuresfor Bank- ruptcy of ChongqingSOEs." CM is one of 2 municipalitieschosen by the centralgovernment in the "Bankruptcy Reform" experi- ment, which, amongother things, will deal generallywith devising guidelines,including workers' andcreditors' rights, for economicallyefficient, socially effective implementationof bankruptcy policY. Corporatiza- Define TVE property rights, Conversionofn VEs into cooper- Increasepace of TVE corporati- SRC of munici- tion of TVEs establishfor TVEs autono- ative shareholdingcompanies zation. It is expectedthat by pality and town- mous managementrights and (CSCs)is being taken asan inter- 1996,one third of TVEs will be ship and village registerTVEs as indepen- mediatestep toward conversion convertedin CSCs;all new levels. dent legal persons. into LLSCs andLLCs. Local- TVEs will be CSCs. Also, TVE level regulationfor CSCs adopted group companieswill be formed. on 1/1/95;Center is drafting nationalCSC law (expectedin 1996). As ofJuly 1995, 1,988 TVE conversionsinto CSCs,221 TVE conversionsinto LLCs and 23 TVE conversionsinto LLSCs 1 have taken place. -67 - ANNEX 3.2

Reform Objectives Actions Taken Actions to be Taken andTheir Responsibility I ______Tim ing Increasing To create an "enabling envi- Notwithstanding remainingfiscal CM is committed to strength- EC and SRC Interenterprise ronment" for all types of and quasi-fiscalsubsidies to some ening the enforcementof mea- Competition enterprises-regardlessof SOEs,current policy generally suresthat ensurea nondiscrimi- and Creatinga ownershipstructure. Also to ensuresnonstate and stateenter- natory, competitiveenviron- Market for createa "market for corpo- priseshave equal accessto, and ment. Disposition rate control," where mergers pay similar prices for, infrastruc- and Recombi- and acquisitionscan be ture elementsand factorsof pro- nation of carriedout. duction (labor, capital and tech- Assets nology); andensures neutrality in tax treatmentas betweenowner- ship forms. In 1994,35 enter- prisesmerged or acquiredanother 42 firms. CM has drafted "EnforcementRegulations Against Counterfeitand Price Fraud in Industrial Goods" and "Notice for Opinionson Advanc- ing EnterpriseMergers." CM has createda PropertyRights TransactionMarket. Implementa- Establishan accountingsys- New accountingprinciples based In 1995, 100%of CM's SOEs FinanceBureau tion of a Mod- tem basedon intemational on intemationalstandards were will have their accountsprepared em Account- standards. establishedthroughout China by by the independentaccounting ing System the Central authorities in July institutions. CM will increase and Establish- 1993. All CM's SOEs have the professionaltraining of local ment of Inde- implementedthese principles. accountants. pendent CM hasensured local financial Accounting accountantsare certified and have Entities receivedtraining. CM has about 35 independentaccounting and about35 independentauditing r:ntities; a few such entities are stateowned; someare subsidia- ries of Beijing basedfirms; most are local partnerships.In 1993, 20% of CM's SOEshad their accountsprepared by such insti- tutions; in 1994,40% did so. The SOEscan choosewhich entity to go to. Accountsare tumed into ______the Finance Bureau. ______Shedding Improve the efficiency of Sheddingof surplus labor has To further augmentthe UlIn LaborBureau SurplusLabor SOEsburdened by surplus occurredin measuredfashion. to assistsurplus workers(as well from SOEs labor, while at the sametime UnemploymentInsurance (Ul) as unemployednew graduates), improve the functioning of fund is being strengthened(see in 1996 considerationwill be labor market institutionsto sectionD below). The basic given to securinga portion of assistin the reemployment offices of an EmploymentService the educationtax on SOEs as of surplusworkers. havebeen established."Tempo- well as other revenuesources rary Measuresto ResettleSurplus from CM's budget. If World Workers of SOEsof Chongqing" Bank support for the Surplus has beenissued and imple- Labor Employmentand Training mented. CM's pilot program GuidanceCenter (SLETGC) is providesfor theoutplacement of approvedin 1996,the SLETGC, surplusworkers to Labor Service which will providespecialized Enterprisesand the service(ter- reemploymentand retraining tiary) sectoras well asearly assistanceto surplus workers, retirement. Eachyear, not more will be establishedin 1997. than 2% of the surplusworkers in SLETGC will also assistSOEs the 66 enterprisesparticipating in in strengtheningtheir own CM's ComprehensiveReform redeploymentefforts, as well as experimentcan be shed. assistthe LaborBureau's other employmentand trainingcenters I_inserving surplusworkers. - 68 - ANNEX 3.2

Reform Objectives Actions Taken Actions to be Taken and Their Responsibility Timing Improving the Increaselabor mobility by By end 1994,over one-half of By 1998,the labor contractBureau Labor Market replacing the systemof SOE employmenthad been systemwill cover 100%of the permanentemployment with changedfrom permanentto SOEs. The network of employ- a labor contractsystem. contractstatus. Newly recruited ment offices will be integrated. employeeswill be hired as con- tract workers. "Labor force Mar- kets" (serving skilled workers) and"Brain Power Exchange Centers" (servingprofessional workers)have beenestablished in the urbandistricts, the operations of which are partly computerized. Five counties havealso estab- lished similar centersand markets. Strengthen Improve the functioning of Severalprofessional training Develop by end-1999a coor- Labor Bureau Job Training job training programsto centershave been established, dinated,strengthened job train- Activities assistsurplus workers in and programsfor professional ing system,involving thejoint meetingthe skill require- training within enterpriseshave efforts of SOEsand the munici- ments of restructuredenter- beencreated in someenterprises, pal govemment. prisesor wholly new ,employment opportunities. B. STATE ASSET MANAGEMENT Assignmentof To clearly delineatestate The Municipal Party Committee SAMB will be strengthenedas SAMB StateOwner- assetownership rights; to andCM have approved"Sug- an independentagency, with ship Rights in ensureassignment of state's gestionson the Trial Institutional newly trained staff. By year-end SOEsUnder ownershiprights is carried Reformof StateAsset Manage- 1996,asset valuations of all Control of out in accordancewith ment." A municipal State Asset SOEs underCM will be CM market-orientedprinciples. ManagementCommittee completed. (SAMC). headedby a Vice Mayor hasbeen established. A StateAsset Management Bureau (SAMB) has also beenestab- lished,which essentiallyserves as the SAMC's executive secretariat.(See below for further structureof stateasset managementinstitutions.) In 1995,asset valuations of most SOEswere completed. Exerciseof To establishState Asset Two StateAsset Operating CM's plan is to add by year-end SAMB, SAOCs Assigned OperatingCompanies Companies(SAOCs) have been 1995:3-5 SAOCsand authorize and SAGCs StateOwner- (SAOCs) or State Asset establishedas LLCs with 100% 2 more SAGCs. In general,as ship Rights in GroupCompanies (SAGCs) stateownership (machinery and more SAOCsare createdand SOEsUnder entrustedwith stateasset consumergoods distribution); SAGCs are authorized,LBs will Control of managementresponsibilities and 4 SAGCs havealso been be phasedout and transformed CM on that, in the exerciseof authorizedto carry out stateasset into tradeassociations. Market Basis assignedstate's ownership managementresponsibilities. rights through the participa- Much of CM's supervisionof tion on boardsof directors, stateassets is still vestedin Line help ensureSOEs (i) have Bureaus(LBs). CM has com- appropriatecapital structures pleted draft overall operational for competitive market framework, including policy on performance,(ii) establish SAOCs' operationswith respect clear performancecriteria to dividend and investment basedon commercialobjec- allocation (with the objective of tives, (iii) use information basing such allocationson market systemsand financial tools principles). to monitor performance,and (iv) assesstechnological trendsand developmarket- ing strategies. Ensureindi- viduals from theseinstitu- tions representingthe state on boardsof directors have the ability to assess(i)-(iv). Goal is to organizethese SAOCsor SAGCsas LLSCs l ______or LLCs. - 69 - ANNEX 3.2

form jectives ActionsTaken to be Takenand Their -Responsibility

C. SUPOR 'iG REFOR~MS ______Investment Liberalizecommercial In line withthe Center's policy, Withinthe scope of the Center's PC System investmentdecisions from the economyis divided intothree looseningof investmentlimita- Reform govemmentplanning (much sectorsfor investmentpolicy pur- tions in the "competitivesector", like commercialproduction poses:(i) "social sector"(public CM willcontinue its reformin decisionshave been liberal- health,education, the arts, sports, this area; plan is for full invest- ized). broadcasting,etc.), in which ment decision-makingin this investmentfor "unprofitable" sectorto be transferredto enter- projectsis funded directlyby prises by 1998. CM's budget,and for "profitable" projectsis financedon the same terms as the "basicsector"; (ii) "basicsector" (energy, urban infrastructure,telecommunica- tions, majorraw materials,public utilities,etc.), in which invest- ment projectsare financed by the local and/orstate development banksat below-marketinterest rates or, in special cases,through grants;and (iii)"competitive sec- tor," in whichprojects are financedthrough commercial banks,who are to be given auto- nomy in loan decision-making, subjectto state macroeconomic limitationson investmentlevels as implementedby local govern- ments. With respectto the "com- petitivesector," although the New OperatingMechanism of 1992 liberalizedgovemment investmentlimitations, they were reinstitutedin 1994(in part, to controlfor overheatingof the economy);currently a seriesof govemmentapprovals-some tromthe Center,others from CM-are required for virtually all investmentprojects in the .______"competitivesector" Foreign To facilitatelocal enterprise CM's reforms in theseareas CM's scope of futureacdon in MOFI*EC, Exchange competitionand interna- generallyfollow center's reforms. these areasis largely dependent CustomnsBureau System, tional flows of capital, However,because of CM's on center'sapproval. and PBC-CM ForeignTrade goods,services, technology Yangtzelocation it has been and Foreign and managementskills. treated for FDIand trade matters Investment equivalentto the 14 special coastal cities. For example, incometax on foreignfunded firms in productivesector is 24% (rather than 33% for all other firms and foreignfunded fimis in unproductivesector) and CM has twodevelopment zones (an eco- nomiczone and a science& tech- nologyzone), which enjoy a foreign fundedfirtn incometax ceiling of 15%. In line with cen- ter's nationwidedirective, CM abolishedforeign currency con- trol and quota systemon January 1.1994. - 70 - ANNEX 3.2

Reform Objectives ActionsTaken Actionsto be Taken and Their Responsibility _mTiming Tax System Throughtax revenue-sharingCM participatedas one of 9 CM's scope of futureaction in FinanceBureau Refom betweencenter and munici- municipalitiesin an experiment this area is largelydependent on and Tax Bureau pality,to obtain a nationally to devise a tax-sharingformula. center's approval. CM will consistentand fairer distri- As of January 1, 1994,the new establisha currentaccount and butionof revenues,and formulawas introducednation- capital account("fiscal double throughan enterprisetax wide: (i) VATis shared(75%, accounting")budgetary system regime,to introducetrans- central;25%, local);(ii) II com- by 1996. Also being developed parencyand equal treatment moditytaxes are payableto cen- by CM (for completionin 1996) of enterpriseforms. ter; (iii) tumovertaxes on ser- is an incometransfer vices are payableto localgovem- redistributionsystem to give aid ments. Incometax on enterprises to CM's poorestcitizens. are payableto respectivecontrol- ling govemments.Notwithstand- ing exceptionsfor special,coastal and riversidecities, enterprise incometax rate is 33%. Under new tax law,CM established branchesof state and landtax institutionsand definedtheir responsibilities.According to the Center's regulations,head of revenuebureau has been reappointed,and the jurisdic- tional limitsof regionsand county financeand tax institu- tions have been defined. FinancialSec- Promotecompetition and In 1994,PBC-CM obtained Encouragebranches of foreign CM and PBC- tor Reform corporatizationin the finan- authorityfrom PBC-HQ for licen- banks to be establishedin CM CM cial sector. sing of a representativeoffice in and foreign investmentin CM's CM of a foreign bank. In 1995, localbanks. Delinktrust com- CM was selectedby the Centeras paniesfrom parentbanks in one of nine cities to be opened to accordancewith the Commercial foreign bank branches;several BankingLaw. applicationsby foreignbanks are pending. Also,several nonbank financialinstitutions have been established,including seven trust companiesand an investment fund management company. In 1995,CM's 45 UrbanCredit CorporatizeRural CreditCoop- PBC-CM Cooperatives(UCCs) were con- eratives(RCCs) in 1996-97. solidatedinto an association, which was made intoa corpora- tized, ChongqingUrban Credit Cooperative Bank. Strengthenthe powerof The new CommercialBanking Requirecalculation and submis- PBC-CM PBC-CMto regulateand Law establishesrules for manag- sionof ratios on a quarterly supervisethe financial ing ratios of the commercial basis. Assurebranch compli- sector. banks. PBC-HQand HQ of anceor establisha time-bound CM's banks are establishing programfor compliance. Estab- appropriateratios for CM branch- lishPBC-CM's capacity to level implementation. examineloan qualityand ratio complianceof CM branchesof commercial banks. jTransforma- Strengthenthe abilityof the Reformobjectives have been Commercialbanks will be PBC-CMand tion of Spe- banks to make market- definedto increasethe banks' requiredto adopt balancesheet CM's commer- cializedBanks orientedcredit decisions. autonomyand accountabilityfor ratios by 1996. Establishby cial bank into Commer- their creditdecisions. 1996reform programs within the branches cial Banks banks to improveskills for ana- lyzing,monitoring and manag- ing risk in a market economy. Defineand identifypolicy Specializedbanks have been EncouragePBC-HQ to issue PBC-CMand and commercialcomponents directedby their headquartersand guidelinedefinitions for distin- CM's commer- of loan portfolios. by PBCto evaluatetheir portfo- guishingbetween policy and cial bank lios and to identifypolicy and commercialloans. branches commercial components. Increaseaccounting trans- New accountingstandards intro- EncouragePBC-HQ to issue PBC-CM parencyof banks' perfor- ducedin July 1993to more accu- guidelinesclassifying loans mance. rately reflectthe financialcondi- accordingto levels of risk and tions of commercialbanks. probabilityof repayment. EncouragePBC-HQ and MOF to issue guidelineson loan-loss provisionsand interestnon- accrual so that banks clearly state expensesand accurately _reflect income and capital. - 71 - ANNEX 3.2

Reform Objectives Actions Taken Actions to be Taken and Their Responsibility _ Timing Housing Sys- To monetize and commer- CM issued on December 28, Rents will be increased to cover Housing Man- tem Reform cialize the provision of resi- 1994 the Decision on Deepening all elements of costs by 1998, agement Bureau, dential housing, relieving Housing System Reform. Rents and to full market price by 2000. Housing Reform this social burden from on public houses have begun2 to Estimated that by 2000, one- Office, Con- enterprises' operations. To be increased, from Y 0.25/m I third of urban residents will live struction Bureau develop the real estate month in April 1994 to Y 0.84/ in privately owned housing. market. m /month in June 1995. Phased- Provident funds (with contribu- in sales of existing and new pub- tions by the enterprises and lic housing have been speeded workers) will be established to up. Development of housing finance housing construction and market has begun to relieve enter- to be used to foster housing pur- prises of the burden of allocating, chases; state contributes land. constructing and managing hous- Independent housing manage- ing; for example, housing con- ment/construction companies, struction is generally done organized as LLSCs/LLCs, will through attached housing com- be established, date undefined. panies, some of which are inter- enterprise establishments (about 100exist in CM). D. SOCIAL SECURITY REFORM Unemploy- Improve income mainte- The Ul fund has been established, It is intended to expand Ul cov- Employment ment Insur- nance support for unem- and is managed by the Employ- erage to 100% of workers in Bureau ance Fund ployed workers by replacing ment Bureau, which is under the CM. covering workers in all SOE-based system with Labor Bureau. The Ul fund nonstate sectors. Action is municipal government man- covers 80% of workers in SOEs dependent on issuance of insur- aged system, with substan- and collectives. As of August ance law now being drafted by tially improved financing 1995, in addition to the employer Center. If this law is passed in and administrative opera- contribution, each employee con- 1996, then full Ul coverage tions. tributes Y 2/month into the Ul expected by 1998. fund. Pension Fund Improve and expand CM's Three pension pools have been Pension reform plan approved SocialInsurance capacity to provide pension created or are being created: (i) and will be fully implemented in Bureau (SIB) insurance by pooling into a existing pool is for urban enter- 2000. Worker contribution will CM-managed social insur- prises; planned pools are for (ii) rise from 3% to 8% (1996- ance fund, and creating indi- CM workers (to start in 1996) 2000). Reform will develop vidual pension accounts that and (iii) rural, TVEs (start-date Individual Account (IA) system, otherwise have been admin- undetermined). Characteristics of ending current mode of contri- istered by work units. existing urban enterprise pool butions/payments passing from for all ownership enterprise forms SIB to to worker; in urban area; currently covers rather, they will be deposited 1.5 million workers; current pay- directly in a worker's IA held at ments are to 400,000 pensioners; either SIB or banks (thus delink- contribution rates are 27% pay- ing enterprises from administer- roll tax for work unit and 3% of ing the pensions). Part of 27% individual worker's wage; end- work unit contribution will go 1994 accounts: total contributions into a worker's IA; the rest to Y 806 million, total payments "adjustment" pool. lAs can take Y 807 million, reserve Y 160 additional workers' deposits to million; pool reserve at end-1993 strengthen personal pensions. was Y 300 million: Y 140 million Reform will make part of an used to subsidize pension-deficit individual's pension receipts firms; only about 70% of payroll linked to his/her contributions. tax is actually paid: under- or To learn about World Bank- nonpayers are firms with young supported pension reform initia- work forces or those with losses. tives in China, CM will make A plan has been developed to contact with authorities in the integrate by 1997 the pension, four cities (Beijing, Chengdu, medical insurance and industrial Ningbo, and Yantai) participat- injury insurance funds under the ing in the Bank's "Enterprise, Social Insurance Bureau (part of Housing and Social Security theLabor Bureau). Proiect." Medical Strengthen and unify on a Plan for reform currently being New plan, which will be placed SIB Insurance municipalwide basis (rather drafted. under SIB, will maintain exist- Fund than on an enterprise- ing employer-employee cost- specific basis) medical sharing (except for major medi- insurance. cal, which is employer-funded). Current payroll tax varies from firm to firm; new plan will be uniform within CM. Reform expected to be implemented by 1997. Industrial Establish a robust munici- Plan for reform is still being Plan to be implemented by 1996. SIB Injury Insur- palwide fund (rather than drafted. anceFund enterprise-specific funds). I - 72 - ANNEX 3.2

Refomm Objectives |ActionsTaken |Actionsto beTaken and Their |Responsibility ± j~~~~~~~TimingJ E. MUNICIPAL GOVERNMENT FUNCTION AND ORGANIZATION REFORM _ Changethe Realign the role of the muni- Planshave developed by various Implementationof plansto reori- EC, PC and Economic cipal govemmentto be con- interagencyleading groups(some ent economicfunction of CM other depart- Policy Func- sistentwith that called for in plansare alreadypartiaily imple- beganin 1995. Full implemen- ments concemed tion of CM the Center's prescriptionof a mented)to reducesignificantly tation is set for 1998. socialist market economy. CM's micromanagementof the local economy,including but not limited to SOEs,and to rely more on macropolicy tools. Reorganiza- Consolidate,rationalize and In 1992there were 277 municipal Some bureauswill be abolished PCand Person- tion of CM reducethe sizeof the muni- govemmentdepartments and or reducedin size; sometrans- nel Institutional cipal govemment. organizations;by 1994,the num- formed into industrial trade Office ber wasreduced to 153. CM has associations;most of the Line stoppedestablishing new Bureaustaff will be separatedto agenciesand hiring net additional establishindependent SAOCs. staff; staff has beendecreasing. Neither the tradeassociations CM's PersonnelAdministration nor the SAOCswill have gov- has developedan overall reorga- emment administrativefunctions nization plan. Part of plan is to (seesection B above). Imple- createa professionalcivil service mentationof reorganizationplan for CM. beganin 1995 and is to be com- pleted by end-1995. Overall, staff of CM will be reducedby 20%. F. ENVIRONMENTAL REFORM Industrial Modify industrialdischarge Standardsfor industrialdis- Implementstudy's recommen- CEPB Pollution standardsso that they are chargesof gases,wastewaters and dationsfor changingstandards Standards uniformly consistentwith air hazardouswastes and standards into legal/regulatoryframework and water quality standards for air/waterquality are part of afterstudy is approved;study is and technically and econo- existing regulatory regime. expectedto be completedby mically rational. According to the agreedresearch year-end1995. Recommenda- scopeand content,the regulatory tions can be included into legis- reformresearch of the standards lation by 1997(1996-provin- for air, water andother wastes cial approvaland 1997-imple- havebeen basically finished. mentation). Enforcement Replaceexisting policy, Industrial pollution is monitored. Notify enterprisesof expected CEPB Policy which in somecases is based Noncompliant enterprisespena- new standardsfor environmental on polluter's ability to pay, lized accordingto ability to pay. performance(1996). Penalties with policy basedexclu- Study to reform regulatory basedon polluter's damageto sively on polluter's damage regimewas completedSeptember environment (1997). to society. 1995. Institutional Improve complianceof Monitoring programmaintained Improve and expandmonitoring CEPB Enforcement industrialenterprises, for gasesand wastewatersof capability, expandnumber of Enhanceinstitutional capa- major industrial polluters. industrial enterprisesmonitored bilities-in terms of both and improve accuracyof mea- quantity andquality-for surementsby 1996in response compliancemonitoring. to adoptedregulatory reforms. Environmen- Establishpollution problem Regulatoryregime includes Environment Audit Unit to be CEPB tal Audits of and cost-effectivemitigating permitting and environmental establishedto perform auditsfor Industry measures. assessmentof existing facilities all enterprisefacilities, whether when subjectto renovation new, renovatedor old, by 1996. investmentsand of new invest- Environmentalaudit resultsand ment additions,but not of por- recommendationswill be usedas tions of existing facilities unaf- a condition of credit approval by fected by investment, commercialbanks for further I______I______Ienterprise _ development. - 73 - ANNEX 3.3

ANNEX 3.3: ENVIRONMENTAL PROTECTION IN CHONGQING AND THE CHONGQING INDUSTRIAL POLLUTION CONTROL AND REFORM PROJECT

1. Introduction. Pollution associated with China's burgeoning economic growth continues to exact a sizable toll on the Chinese people and on the environment. China's industrial sector generates significant levels of air, water and solid waste pollution. Despite progress in establishing institutions and policies to reduce pollution, there remains considerable scope for improvement. In particular, effectively integrating environmental issues into economic policies, especially those aimed at reform of industrial enterprises, continues to be a major challenge. The pollution management system relies on a mixture of administrative command and market-based incentives expected to lead to adoption of cleaner technologies.

2. The legal basis for environmental protection is established under the Chinese Constitution of 1982. Below the Constitution are basic and specific laws, promulgated by the Standing Committee of the National People's Congress. The Environmental Protection Law (EPL) (1989) is a basic law. The EPL sets forth four guiding principles: (a) the need to integrate and coordinate environmental protection with economic development; (b) emphasizing pollution prevention as well as pollution control; (c) establishing the principle that the polluter pays; and (d) emphasizing environmental management as key to better environmental quality. The EPL also reflects the need for active enforcement by government agencies, and addresses industrial pollution issues by prohibiting the locating of new industrial plants near populated and protected areas, and specifying that existing industries may be relocated or closed to comply with environmental law.

3. The EPL authorizes the National Environmental Protection Agency (NEPA) to establish national ambient quality and source discharge standards. Provincial and municipal governments can set discharge standards if they are more stringent, or if no national standard exists. Emissions standards are generally uniform for a given pollutant across industries but not necessarily across sectors (e.g., thermal power plants have lower air emission standards than industrial plants).

4. Chongqing, the largest city in Sichuan province, with an area of 23,114 km2 and a population of 15.12 million at the end of 1993, has traditionally been one of the most important centers of industry, commerce, and distribution in central China. Chongqing's industrial structure is based on heavy industry-steel, nonferrous metals, machine building, vehicular, cement, pharmaceuticals, fertilizer and other chemicals-that reflect older technologies, which predate China's and Chongqing's concern with environmental impacts and now require relatively high investment to control pollution. However, much -74 - ANNEX 3.3 of the plant and equipment. Also, before the 1980s, plant siting reflected a desire to minimize infrastructure investment, even if that strategy sited a highly polluting industry in the city center. Local coal has a very high sulfur content, and with a wet and windless climate, Chongqing has one of the highest ambient levels of sulfur dioxide in the world. In the most polluted urban districts, ambient dust concentrations are as much as five times the level acceptable for maintaining human health, liquid effluents are often discharged into the Yangtze or Jialing Rivers, and most solid industrial wastes are simply dumped on-site.

5. Chongqing's System for Environmental Protection. The Chongqing Environmental Protection Bureau (CEPB) was established in 1974. It includes the Chongqing Institute for Environmental Science, and is responsible for a wide variety of environmental activities, including environmental assessment, pollution management planning, developing new regulations and standards, and pollution control technology research and development. Chongqing Municipality (CM) also has 21 county and district EPBs. Both CEPB and the EPBs are responsible for air and water quality monitoring and source monitoring of atmospheric emissions and effluent discharges from industrial enterprises within their respective political jurisdictions. No regular program for monitoring of hazardous wastes is currently conducted.

6. Ambient air quality monitoring is conducted with manual and automatic monitoring networks. The manual network consists of portable samplers and the automatic network consists of five permanent stations all located in downtown Chongqing. Each of the 21 county/district EPBs is responsible for air quality monitoring. However, because of limited resources, only nine EPBs conduct manual monitoring at a single site in their respective jurisdiction. The manual monitoring protocol (established by NEPA) consists of five-day campaigns during each of the four seasons. On any monitoring day, four 15-minute samples are taken once every six hours. This represents annual monitoring coverage of about 0.25 percent, which is too small a sampling window to provide accurate data on air quality levels. Parameters monitored include dust (suspended and settleable), sulfur dioxide (SO2), and nitrogen oxides (NOx).

7. Ambient water quality monitoring is conducted manually at seven predetermined locations on the Jialing and Yangtze rivers, which is adequate coverage given the current hydrological regime. Three sites are in the downtown area, where sampling is done once a month (in the other areas once every other month). At a given site, three samples are collected: one at each bank, and one in midstream. Average results are reported. Since most pollution occurs at the rivers edge, this procedure biases water quality on the low side. Approximately 25 water quality parameters are analyzed. The classes of pollutants analyzed include organics (phenol, BOD, COD, oil), trace heavy metals (copper, lead, mercury) and nutrients (nitrogen, phosphorus). Another shortcoming is that several toxic organics are not measured, and the measurement frequency is too low (particularly near water intakes). Two additional monitoring locations will be required in the future due to altered water flows resulting from the Three Gorges Dam. - 75 - ANNEX 3.3

8. About 150 staff members in all EPBs have direct responsibility for source monitoring at the approximately 8,000 industrial enterprises in CM. Since both staff numbers and monitoring equipment are severely limited (particularly in the district/ county EPBs) source monitoring for compliance with standards focuses on the largest polluters (about 200), which are monitored two to four times per year. Another group of about 600 enterprises that are next in priority are monitored once or twice a year, and the remaining enterprises are responsible for self-reporting.

9. Industrial enterprises in CM are estimated to be responsible for over 7 million tons of solid waste annually, of which 600,000 tons are believed to be hazardous (toxic organics, toxic metals, radioactive, etc.). At present there are no national regulations for hazardous waste management, although legislation has recently been promulgated.

10. Fees are collected by the EPBs based upon data collected from their monitoring program. If it is determined that an enterprise is exceeding standards, it is given a schedule to comply with the norm in a manner consistent with the severity of the pollution. Normally, compliance is required in three years. During the interim, the enterprise is allowed to continue its polluting operation and continues to pay the fee.

11. Fines may also be imposed upon enterprises that engage in environmental practices considered illegal. For example, failing to operate an existing pollution control system, falsifying pollution data, or failure to pay pollution fees. In addition to fines, an enterprise may be closed by the mayor (temporarily or permnanently)for illegal activities. In practice, few enterprises in CM have been either fined or shut down.

12. Pollution fees are collected by the Chongqing Finance Bureau (CFB), of which about 20 percent are used to cover operational expenses of the EPBs, while the remainder are returned to enterprises in the form of low interest (3 percent) loans for investments in pollution control. Enterprises which have paid the pollution fees are given priority.

13. In addition to the limited resources available to EPBs for enforcement, a number of factors make the entire system relatively ineffective. First, pollution fees are normally set considerably below the costs associated with financing and operating requisite pollution control systems. Thus, enterprises normally internalize pollution fees as part of their operating costs and continue to pollute, since this is the most economic tactic. Also, collection of fees is prioritized on the polluters ability to pay, rather than on its damage to society. And since the low interest loans are granted as a matter of preference to enterprises who paid the fees, less economic highly polluting industries are neither fined nor do they have access to concessional financing for cleanup. Finally, major polluting enterprises are often such a political and economic force that EPBs are under political pressures to renegotiate pollution fees downward or relax regulations in the interest of employment or economic development.

14. Chongqing's largest and most polluting industry is iron and steel. The project would support removal of Chongqing's two most polluting steel plants from a highly populated urban setting, to achieve the goal of (a) reducing industrial pollution in the urban - 76 - ANNEX 3.3 center, and (b) replacing obsolete and inefficient industrial facilities with modern highly efficient plants that can meet both Chinese and international environmental and efficiency standards. Feasibility studies carried out by international and local consultants and revised during project appraisal, indicate that both relocations are environmentally, financially and economically justifiable.

15. Iron and Steel Sector Pollution Control Action Plan. All enterprises in the steel sector are part of either the Chongqing Iron and Steel Company (Group) Limited (CISCG) or the Chongqing Special Steel Company (Group) Limited (CSSC). Iron and steel production is a major source of pollution in CM, representing 12 of 88 largest sources of industrial air pollution, and seven of 93 largest sources of water pollution. CM has prepared a priority Iron and Steel Sector Pollution Control Action Plan and investment schedule consisting of eight priority investments targeted to reduce or eliminate major pollution problems in the sector. The investments are prioritized on the basis of environmental impact, and the first two priority investments identified in the plan-namely shutdown of existing steel mills, and relocation/replacement with modern nonpolluting steel-making facilities for both CISCG and CSSC-constitute the industrial relocation component of this project. Both relocated plants will meet national, provincial and municipal environmental regulations and Bank guidelines. Specifically, the plan consists of (a) a list of priority mitigating measures to be taken by each iron and steel plant to assure compliance with Chinese environnmentalregulation for air, water, and solid waste management, (b) a capital cost estimate for each measure and (c) an implementation schedule consistent with sector restructuring objectives and environmental priorities.

16. The projects identified in the plan (in order of priority) are presented below:

CISCG (ZICC) Steel Mill (Jiangbei) Shutdown and relocate CSSC Steel Mill (Shapingba) Shutdown and relocate CISCG Coke oven (Dadukou) Cleanup of coke oven gas CSSC Rolling mill (Shuangbei) Install air and water pollution control equipment CISCG Iron Alloy Plant (Chang Sou) Install dust control equipment CSSC Refractory Plant (Shuangbei) Install dust control equipment CISCG Blast Furnace (Jiang Jin) Install dust control equipment CISCG Seamless Pipe Plant (Ba Lan) Install wastewater treatment facilities

17. The Chongqing Special Steel Company (Group) Limited (CSSC) was established in 1934 to produce steel blooms for further processing in CSSC's mills. Among all Chongqing's industrial enterprises, it is the worst air polluter, the sixteenth worst water polluter, and one of the largest producers of solid industrial wastes, which are dumped on the banks of the Yangtze River. CSSC's 10 small highly polluting electric arc furnaces (EAFs) at the old site would be closed, and a single modern, environmentally sound 100- ton EAF would be located in a rural area. Resettlement of the affected population is presently under way. The plant's capacity will be about 20 percent greater than the old plant, a level of output justified by economic scale and market research projections. The - 77 - ANNEX 3.3 proposed relocation is the highest priority action in a steel sector pollution control plan. An EA of this relocation has been prepared by CISDI, reviewed by the Bank and approved by NEPA.

18. CSSC is situated on the Jialing River in the densely populated Shapingba district and poses an immediate health hazard to the population. Ambient dust levels in this area are about 570 micrograms/Nm3 (World Bank guidelines consider values above 100 micrograms/Nm3 polluted). On average, about 44 percent of the dust pollution and 7 percent of sulfur dioxide emissions in this district are caused by the steel plant. It is also responsible for 19 percent of industrial wastewater discharges in the district (including 58 percent of the chemical oxygen demand and 89 percent of the oil and grease). The plant also produces 50,000 tons/year of slag, of which less than I percent is recycled and is simply dumped on the banks of the Jialing River, leaving an unstable tip of 700,000 tons, which periodically slips into the river. Because of the increased production, the new plant is expected to produce 39 percent more slag than the old plant, but 87 percent will be reusable. A slag processing plant to be built on the old site to recycle the slag and clean up the river bank, significantly reducing the solid waste problem and making it manageable and environmentally acceptable.

19. The existing plant operates ten, 10-ton EAFs and three coal-fired boilers. The No. I and 2 EAFs at the No. I Steel-making Shop have canopy hoods to capture particulate emissions. The capture efficiency of these hoods is approximately 40 percent according to CSSC personnel. The eight remaining furnaces and the three coal-fired boilers are not equipped with pollution controls. Because of their age, condition and location, the equipment cannot be retrofitted with necessary pollution control equipment to comply with environmental discharge standards. The existing facility has been identified by CEPB as a priority pollution source (based on the annual mass discharge of pollution), and by the steel industry as the highest priority polluter in their sector strategy for pollution control (based upon impacts to human health).

20. Installation of the modem steel-making facilities at the Jinkou Farm site, with the pollution control systems listed below, will increase ambient levels of dust and sulfur dioxide by less than 0.1 percent and nitrogen oxides by about 4 percent.

* Second-hole evacuation and baghouse for dust control from the EAF, and the refining furnace;

* Dust and sulfur dioxide control from a proprietary scrubber of Chinese design, sanitary and industrial wastewater control facilities to remove suspended solids, oil and grease, chemical oxygen demand (COD), biological oxygen demand (BOD), decreased water use (35 percent), increased water recycling (92 percent); and

* Slag reprocessing facility to handle new slag and diminish existing slag pile. - 78 - ANNEX 3.3

21. Emission Standards for the Metallurgical Industry. Table I below lists the emission standards that are applicable to iron and steel plants. Allowable emissions are based on the stack height of each source since the air quality impact of a source is dependent on plume height.

Table 1: ALLOWABLE POLLUTANTEMISSIONS FOR THE METALLURGICAL INDUSTRY

Emission rate (kg/hr) Concentration Stack Sulfur Hydrogen Carbon Lead Dust Height (m) Dioxide Fluoride Chlorine Chloride Monoxide (mg/mr) (mg/mr)

20 - - 2.8 1.4 - - - 30 52 1.8 5.1 2.5 160 - - 45 91 - - - - 50 - 4.1 12.0 5.9 - - 2001A 60 140 - - - 620 - - 80 230 - 27.0 14.0 - - - 100 450 - 41.0 20.0 1,700 34 - 120 670 24.0 - - - 47 -

/a This value applies to the particulate matter concentration in the exhaust gases from steel-making furnaces and industrial boilers. The concentration is not dependent on stack height.

22. Ambient Air Quality Standards. The quality standards for NOR, TSP and S02 are listed in Table 2. The standards for Chongqing are designated as Class II for rural areas and Class III for urban areas. The standards for Class III areas are less restrictive than the standards for Class II areas. The existing site of the CSSC is a Class III area and the new site is a Class II area.

Table 2: AMBIENT AIR QUALITY STANDARDS FOR TSP, S02 AND NOx

Concentration, mg/mi3 Pollutant Average Time (ClassIl Class lll TSP 1-hour 1.00 1.50 24-hour 0.30 0.50 Annual 0.06 0.10 S02 1-hour 0.50 0.70 24-hour 0.15 0.25 Annual 0.10 0.15 NOX 1-hour 0.15 0.30 Annual a 0.11 0.11

La Annual average NOx air quality standard is the US standard

23. Existing Air Quality. Ambient concentrations of NOx, TSP and S02 were measured at Shuang Bei, near CSSC's existing plant, and at the new site (Jinkou Farm) in 1991, 1992 and 1994. In 1991 and 1992, samples were collected four times per day (0700, 1100 1500 and 1900) for five days in the months of January, April, July and - 79 - ANNEX 3.3

October. Therefore, a total of 80 samples were collected per year for each of the three pollutants. The duration of each sample was approximately 20 minutes. Ambient concentrations were measured hourly in June, July and August of 1994 and the duration of each of these samples was 20 minutes. The continuous monitoring data collected in 1994 for the months of June, July and August were averaged and this value was entered as the July 1994 average in Table 2 for the existing new site. Comparing the July 1991, 1992 and 1994 pollutant concentrations reveals that these averages are generally consistent.

Table 3: SUMMARY OF AMBIENT TSP, SO2 AND NOXCONCENTRATIONS FOR THE EXISTING CSSC PLANT AND THE NEW SITE (mg/m3)

Existing Plant New Site Year Average Average Nitrogen Oxide (NO,) 1991 0.09 0.04 1992 0.07 0.04 1994 1994-Estimate 0.10 0.03 Annual Mean=0.09 mg/m3 Annual Mean=0.04 mg/ m3

Sulfur Dioxide (SO2) 1991 0.24 0.13 1992 0.31 0.15 1994 1994-Estimate 0.28 0.06 Annual Mean=0.27 mg/m3 Annual Mean=0.11 mg/m3 Total Suspended Particulate (TSP) 1991 0.60 0.26 1992 0.43 0.28 1994 1994-Estimate 0.67 0.23 Annual Mean=0.57 mg/m3 Annual Mean=0.26 mg/r 3

24. Annual Average Total Suspended Particulate (TSP) Concentration for the New Site. The analysis performed for the existing plant was repeated for the new site. The estimated annual mean TSP concentrations for 1991, 1992 and 1994 are 0.26, 0.28 and 0.23 mg/m3 . Based on this analysis, the estimated background annual mean TSP concentration for the new site is 0.26 mg/m3 . The annual TSP Class II air quality standard is 0.06 mg/m3 . Based on these air quality estimates, the new site is not currently meeting the annual TSP air quality standard. - 80 - ANNEX 3.3

25. Annual Average Sulfur Dioxide (SO2) Concentration for the Existing Plant and New Site. The annual mean estimate for 1994 for both the existing plant and the new site were determined by use of the same procedure followed by TSP. The annual means for 1991, 1992 and 1994 for the existing plant are 0.24, 0.31, and 0.28 mg/mr3 and the means for the new site are 0. 13, 0.15 and 0.06 mg/m3. Based on these averages, the 3 annual mean SO2 concentration for the existing site is 0.27 mg/mr and for the new site the 3 annual mean is 0.11 mg/m . The annual SO2 air quality standard for Class II and Class III areas is 0.10 mg/m3 and 0.15 mg/m respectively, and the new site is slightly above the annual SO2 air quality standard.

26. Annual Average Nitrogen Oxide (NO.) Concentration for the Existing Plant and New Site. The same procedure that was used to estimate annual means for S02 and TSP was applied to the NO, data. The annual mean NO, concentration for the existing plant is 0.09 mg/m3 and for the new site the mean is 0.04 mg/m3 . An annual NOX standard has not been established for Chongqing; therefore, the US National Ambient Air Quality Standard (NAAQS) of 0.11 mg/m will be used. Both the existing and new site are in compliance with this NO, standard.

27. Air Quality Impact of the Proposed Project. The Chongqing Iron and Steel Design Institute (CISDI) used a dispersion model approved by both NEPA and CEPB. This is a Gaussian model and contains algorithms for complex terrain and particle settling. The model was modified for dispersion conditions in the Chongqing area based on the results of wind tunnel studies. The documentation and users' guide for this model has not been translated; therefore, a model approved by the US EPA was used to verify the results of the Chongqing dispersion model. The Industrial Source Complex Long- Term (ISCLT2) model was used to evaluate the air quality impact of emissions from the existing plant and the proposed new facilities. ISCLT2 is also a Gaussian model that contains several options. The model is capable of handling multiple sources, including point, volume and area sources. Source emission rates can be treated as constant throughout the modeling period, or may be varied by month, season, hour of the day, or other optional period of variation. Multiple receptor networks can be specified in a single run, including a mix of Cartesian and Polar coordinates.

28. The ISCLT2 model was used to evaluate three scenarios: (a) air quality impact of the existing sources on the area outside of the existing plant and at the new site; (b) the air quality associated with locating the new EAF and related facilities at the existing site; and (c) the improvement in air quality at the existing site if the new EAF is located at the new site, and the degradation in air quality to areas surrounding the new site.

29. Air Pollution Controls. The new 100-ton EAF will use second-hole evacuation to control emissions from the furnace. These emissions will be ducted to a baghouse. The estimated control efficiency of this baghouse is greater than 99 percent. Emissions of particulate matter (PM) from the Refining Furnace (RF) will be ducted to the same baghouse. The system used to charge materials to the EAF and RF will be controlled by a dust collector. The efficiency of this baghouse is also greater than 99 percent. - 81- ANNEX 3.3

Emissions of PM and SO2 from the new boiler will be controlled by a wet scrubber. The design of this scrubber is proprietary. The estimated control efficiency for PM is 95 percent and for SO2 the control efficiency is 80 percent. The average particulate matter concentration in the scrubber exhaust gases is 0.08 mg/mt. The coal-feeding system to the boiler is also controlled by a baghouse with a control efficiency greater than 99 percent.

30. Emissions of NO., S02 and from the Existing EAFs and the New EAF. Table 4 lists the emissions from the 10 EAFs and other facilities at the existing plant along with the planned emissions from sources at the new site. These emissions were calculated by CSSC and CISDI. There are three steel-making shops at the existing CSSC plant. The No. I Steel-making shop has four 10-ton EAFs and the No. I and 2 EAFs have canopy hoods to control particulate emissions. The No. 2 and 3 Steel-making Shops each have three 10-ton EAFs. None of these furnaces are equipped with air pollution controls. The new EAF will utilize second-hole evacuation and these fumes will be ducted to a baghouse. Emissions from the refining furnace and torch cutting of the continuous cast billets will be exhausted to the same EAF baghouse. The boiler emissions will be ducted to a wet scrubber that will control PM, NOX, and SO2 emissions. The total particulate emissions from the ten 10-ton EAFs and related facilities at the existing plant are more than 20 times greater than particulate emissions from the new facilities.

Table 4: NO,, SO2 , ANDTSP EMISSIONSFROM THE NEW FACILITIES ANDTHE SOURCESTHAT ARE SCHEDULEDTO BE SHUTDOWNAT THE EXISTING CSSC PLANT

Emission Rate, Tons/Year Source TSP SO) NO,, Existing CSSC Plant No. 1 Steel-making Shop 573 15 66 No. 2 Steel-making Shop 863 7 44 No. 3 Steel-making Shop 1,170 148 61 TOTAL 2,606 170 171 New Facilities 100-Ton EAF and Refining Furnace (RF) 55 3 73 Charging System for EAF and RF 5 0 0 Coal-Fired Boiler 41 105 584 Coal Feeding System for Boiler 6 0 0 TOTAL 107 108 657

31. Table 5 lists the S02 and PM emissions in the Shapingba District and the total emissions from the existing plant and the proposed new facilities. The existing plant accounts for 76 percent of the total particulate emissions in the Shuang Bei District and 7 - 82 - ANNEX 3.3 percent of the SO2 emissions. Particulate emissions from the new facilities account for only 6 percent of the total for the Shapingba District.

Table 5: SUMMARY OF PARTICULATE MATTER (PM) AND SULFUR DIOXIDE (SO 2 ) EMISSIONS IN THE SHAPINGBA DISTRICT (Tons/Year)

Pollutant Shuangbei Existing Percent Shapingba New Percent Area Plant of Total Area Facilities of Total

PM 3,451 2,606 76 2,352 148 6.3 SO2 2,478 170 7 7,190 157 2.2

32. Predicted Air Quality Impact of the Existing CSSC Plant and the Proposed New Facilities. The ISCLT2 model was executed using the same source input and meteorological data that was used in the Chongqing model. If the estimated background concentrations are added to the predicated air quality impacts due to emissions from the new facilities, then an estimate of the ambient air quality after the new facilities go into operation can be obtained. These ambient air quality levels assume that no change in emissions from other sources will occur prior to startup of the new facilities. The ambient air quality levels are listed in Table 6 for NO,, SO2, TSP.

Table 6: ANNUAL AVERAGE CONCENTRATIONS (mg/mi3 )

Shuang Bei Monitoring Station Ban Bian Jie Monitoring Station Estimated ISCLT2 Total Estimated ISCLT2 Total Background Model Ambient Background Model Ambient Concentration Prediction Concentration Concentration Prediction Concentration

NO, 0.08 0.0007 0.08 0.04 0.0017 0.04 S02 0.25 0.0004 0.25 0.11 0.0001 0.11 TSP 0.32 0.0004 0.32 0.26 0.0001 0.26

33. Industrial And Sanitary Wastewaters. The majority of sanitary and industrial wastewater in the Shuangbei and Shapingba areas are discharged to the Jialing River without treatment. This river is also the major source of industrial and drinking water for the Shapingba District. The annual average flow rate is 69.41 billion m3 and the average concentration of suspended solids is 2.37 kg/m3 . The total volume of industrial wastewater discharged to the Jialing River from sources located in the Shuangbei and Shapingba areas is approximately 42.6 million m3 per year. CSSC discharges the greatest amount of chemical oxygen demand (COD) and oil and grease. The total COD discharge per year is 4,894 tons and CSSC discharges approximately 2,852 tons, or 58 percent of - 83 - ANNEX 3.3 the total. Total oil and grease discharges are 446 tons per year and CSSC discharges is 395 tons, or 89 percent of the total.

34. The total water consumed by the existing plant is 7,909,500 m3 per year and the expected consumption by the new plant is 5,170,000 m3 per year, a decrease of 35 percent. Except for pretreatment of the continuous caster water, there is no sanitary or industrial wastewater treatment at the existing plant and the water recycle rate for the caster is only 22 percent. The new plant will contain both sanitary and industrial wastewater treatment facilities and the recycle rate for industrial water usage will increase to 92 percent. The industrial wastewater treatment system will control suspended solids, oil and grease and COD; the sanitary system will control suspended solids and biological oxygen demand (BOD). It is expected that the quality of the water discharged to the Jialing River from the wastewater treatment system will be significantly better than the water quality of the river. The No. I monitoring station is adjacent to the new site, No. III is adjacent to the existing site, and No II is approximately 1.5 km southwest of station No. I. The average values of temperature, pH, oxygen, COD, BOD5, oil and grease are presented below:

Table 7: AVERAGE WATER QUALITY AS MEASURED AT THREE SAMPLING STATIONS ON THE JIALING RIVER

SamplingStations No. I No. 11 No. III Parameter Low High Low High Low High Class III Flow Flow Flow Flow Flow Flow Standard

Temperature °C 12.0 28.2 12.0 28.3 12.3 28.2 pH 8.24 8.15 8.24 8.16 8.16 8.14 6.5-8.5 Dissolved 9.6 5.9 9.6 6.4 9.5 6.2 >5mg/I 02 per mg/l COD 11.9 7.5 11.6 7.8 5.5 7.7 <15mg/I BOD5 1.5 0.5 1.9 0.8 2.2 0.6 < 4mg/I Oil and Grease 0.06 0.04 0.08 0.04 0.04 0.04 <0.05mg/l

35. A modeling study was performed to deterrnine the probable effect on water quality in the vicinity of the new and existing plant after completion of the proposed project. These results indicate that water quality will improve slightly due to the elimination of discharges at the existing plant and the significant reduction in discharges at the new plant. Because contaminant loadings are quite high upstream of the new and existing plant and the impact of the existing plant is small, water quality will not change significantly.

36. Noise and Noise Abatement. The three existing steel-making shops of CSSC are located near the center of the plant and are removed from residential areas. Noise from these facilities does not significantly impact these residential areas. The new site is located on the Jinkou Farm. North of the proposed plant boundary is farmland and to the - 84 - ANNEX 3.3 northeast and south are residential areas. The Jianling River forms the southeast border of the plant boundary. Noise from the proposed new facilities is not expected to significantly impact any existing residential area.

37. Solid Wastes. Production of specialty steel at the existing site is accompanied by the production of solid wastes such as oxide and reducing slag, scale, coal ash and waste refractories. The majority of the slag is stored along the west bank of the Jialing River and as the storage pile increases in height, the slag pile becomes unstable and slips into the river. It is estimated that 700,000 tons of slag have been produced by the three steel- making shops. Slag accounts for 84 percent of the total solid waste produced and less than 1 percent is reused. Of the total solid waste produced, 19.5 percent is reused and this is mainly scale.

38. When the new 100-ton EAF goes into operation, approximately 63,000 tons/year of solid waste will be produced. This represents an increase over the existing steel- making facilities of 39 percent; however, 87 percent of this amount will be reused and the amount disposed will be reduced by 78 percent. It is anticipated that 40,000 tons of slag and 2,100 tons of scale generated at the new plant will be reused and up to 75 percent of the coal ash will also be reused. Furthermore, a slag processing plant with a capacity of 100,000 tons/year will be built to process the slag at the existing plant and thereby gradually reduce the amount stored, as well as slag that is inadvertently discharged into the Jialing River. The proposed slag processing plant will be sheltered on three sides by higher terrain, thus reducing the frequency of emissions due to windblown dust. Dust control measures such as water sprays will be utilized to reduce emissions during slag crushing and screening operations. A drain field will be installed in the slag yard and the slag quench water will be collected, neutralized and recycled. The management of solid wastes at the proposed new facilities will result in a much higher reuse rate of waste materials and a significant decrease in the amount of wastes disposed. The Jialing River will not be impacted by these disposal practices.

39. Impact of the Proposed Project on Living Quality. The new facilities will be constructed on the Jinkou Farm site. All farm worker abodes (1,014) will be replaced with new and greatly improved housing units. The new residential area will be constructed in the northeast corner of the Jinkou Farm site. The new abodes will be designed to comply with the current domestic flatlet standard. These housing units will contain a water supply, electric power, natural gas and a drainage system that is connected to a sanitary wastewater treatment facility. Farm workers displaced by the proposed project will become employees of CSSC, will reside in the new residential area and will be eligible to all the benefit associated with employment by CSSC. These workers will receive training so they can acquire the skills necessary to perform their new jobs efficiently. The quality of the environment in the vicinity of the Jinkou Farm will not deteriorate when the new facilities come on line. "State-of-the-art" air and water pollution controls will ensure that no degradation in air or water quality will occur. A resettlement action plan (RAP) satisfactory to the Bank was approved by Chongqing Municipality on December 25, 1995 and a contract was signed with Yuzhou University - 85 - ANNEX 3.3 on December 29, 1995 to carry out external monitoring of the RAP. The project management office will supervise the activities of all entities involved in the RAP and will liaise with the external monitor.

40. The Zhongxing Industry and Commerce Company (ZICC) was established in 1939 to make steel for its parent company, CISCG. Its two open-hearth furnaces representing 1940s technology have already been closed. A remaining EAF will be closed in 1998. ZICC is located in the densely populated city center (Jiangbei district) on the north shore of the Jialing river. Its air emissions have never been controlled and represent a major source of air pollution in the city. The new plant will be located in CISCG's main steel-making complex in the Dadukou district, and will produce 300,000 tons per annum (tpa) of continuous-cast steel billets for CISCG's Dadukou rolling mill. This relocation is the second highest priority action in the steel sector pollution control plan. An EA of the relocation has been prepared by CISDI, reviewed by the Bank and approved by NEPA.

41. The plant is located in the Jiangbei District on the north bank of the Jialing river in one of the most densely populated (35,000 persons/kmi2 ) and highly polluted sections of the city. Ambient dust pollution in this area is about 520 micrograms/Nm3 (World Bank guidelines consider values above 100 micrograms/Nm3 polluted). On the average, about 22 percent of the dust pollution, 19 percent of NO, emissions and 17 percent of total industrial wastewater discharges in this district are caused by the ZICC steel plant. Also, 43,700 tons of slag are produced annually, none of which is recycled. It should also be noted that the untreated wastewater discharges are released 1,800 meters upstream of one of the main drinking water intakes for CM.

42. Because of their age, condition, and location, the furnaces cannot be retrofitted with necessary pollution control equipment to comply with environmental discharge standards. The existing facility has been identified by CEPB as a priority pollution source in CM (based on the annual mass discharge of pollution), and by the steel industry as the second highest priority in their sector strategy for pollution control (based on impacts to human health).

43. Installation of the modern steel-making operation at the Dadukou steel complex, with the pollution controls listed below, will not result in any increases to ambient air pollution at the relocation site. The few emissions generated by the new facilities will be more than offset by shutdown of several small furnaces currently operating at the new site. In fact, there will be a net decrease in ambient dust levels of about 8 percent at the new site. Since the new site is part of existing production operations, there are no resettlement issues. Equipment to be acquired include:

* Large baghouse for dust control from the EAF, refining furnace, and furnace hood exhaust gases; - 86 - ANNEX 3.3

* Cyclone separators at all solids transfer points, closed water recirculation system for EAF, refining furnace, vaouum degasser, and casting facilities, including solids separation, oil skimming, chemical treatment;

* Sanitary wastewater treatment facilities-,

* Noise suppression; and

* Recovery and recycle approximately 84 percent of the slag.

44. Existing Air Quality at the CISCG Qiao Yuan (HQY) Plant. Ambient concentrations of NOX, SO2, TSP were measured at three locations near the Hong Qiao Yuan Plant. The monitoring station closest to the proposed location of the new facilities is Second Steel and the annual average TSP concentration is 0.36 mg/m3 . The Jiu Gong Miao monitoring site is northwest of the proposed site of the new EAF. The predominant wind direction in this area is north northwest; therefore, pollutant emissions from the existing steel-making operations will not normally impact this monitoring station. The Shape Steel monitoring site is east of the proposed new facilities and pollutant concentrations at this location are similar to those measured at the Second Steel monitoring station. The annual average TSP concentration at this station is 0.36 mg/m3 .

45. Measured concentrations of NOX,and SO2, at the Shape and Second Steel sites are similar and concentrations of these two pollutants are somewhat less at the Jiu Gong Miao monitoring site. The annual average TSP, NON,and SO2 concentrations at the site of the new facilities are best represented by the measured values at the Second Steel and Shape Steel monitoring station. Therefore, the annual ambient average TSP, NOR, and SO2 concentrations at the proposed site of the new EAF and related facilities are 0.36, 0.33, and 0.049 mg/M3 , respectively.

46. Existing Air Quality at the ZICC Plant. Continuous monitoring data were collected in 1994 for the months of June, July and August at the monitoring station located near the ZICC plant. The average pollutant concentrations for each of the three months are presented in Table 8.

Table 8: MEASUREDPOLLUTANT CONCENTRATIONS NEAR THE ZICC PLANT (mg/m3 )

Pollutant June July August

Total Suspended Particulate, TSP 0.55 0.51 0.55 Sulfur Dioxide, SO2 0.10 0.10 0.09 Nitrogen Oxide, NO, 0.08 0.07 0.08 - 87 - ANNEX 3.3

47. Air Quality Impact of Proposed Project. The ISCLT2 model approved by the United States Environmental Protection Agency, was used to evaluate air quality based on emissions from the existing plant and predicated emissions from the proposed facilities. The model was used to evaluate four scenarios: (a) the air quality impact due to emissions from the sources that are scheduled to be shut down at the ZICC plant; (b) the air quality impact due to emissions from the sources that are scheduled to be shutdown at the HQY plant; (c) the air quality of the new EAF and related facilities at the HQY plant; and (d) the net air quality impact resulting from emissions from the proposed new facilities and the emission reductions associated with the shutdown sources at the ZICC and HQY plants. Table 9 below shows the change in pollutant emissions resulting from the shutdown of existing facilities and addition to the new steel-making plant.

Table 9: POLLUTANT EMISSIONS (Tons/Year)

Source Particulate Matter Sulfur Dioxide Nitrogen Oxide ZIC Idled Sources 3,789 76 260 HQY Idled Sources 144 14 4 HQY New Sources 137 26 65 Emissions Decrease 3,796 64 199 Percent Decrease 96.5% 71% 75%

48. Air Pollution Controls. The new 60-ton EAF will use second-hole evacuation to control emissions from the furnace. These emissions will be ducted to a baghouse. The estimated control efficiency of this baghouse greater than 99 percent. Emissions of particulate matter (PM) from the Refining Furnace (RF) will be ducted to the same baghouse. The system used to charge materials to the EAF and RF will be controlled by a dust collector. The efficiency of this baghouse is also greater than 99 percent. Emissions from the stock bin during raw material handling and transfer operations will be controlled by a baghouse with a control efficiency greater than 99 percent. The concentration of particulate matter in the baghouse exhaust will be less than 50 mg/Nm3 .

49. Table 10 indicates that ambient air quality will improve when the ZICC sources are idled. Because emissions of SO2 and NO. are negligible from the ZICC plant, only the results for TSP are presented. Predicated annual average TSP concentrations were calculated by use of the ISCLT2 dispersion model. The difference between the measured concentration and the model prediction at each location represents the air quality that will result after ZICC is shut down. The improvement is greatest southeast of the ZICC plant due to the prevailing NNW and NW winds. The overall improvement to TSP air quality ranges from 6 to 51 percent.

50. Water discharge at the new plant will be 72.1 m3 per hour with 95.2 percent recirculated. Wastewater treatment will control suspended solids, COD, grease and oil. - 88 - ANNEX 3.3

A sanitary system will control suspended solids and BOD. Water returned to the Yangtze River will be of significantly better quality than the intake water. Table 11 lists the expected concentration of suspended solids (SS), oil and grease and CODs in the waste water discharge from the proposed new facilities. These concentrations meet or exceed the National and Chongqing discharge standards for these three pollutants.

Table 10: MEASURED AND PREDICATED ANNUAL AVERAGE TSP CONCENTRATIONS IN THEVICINITY OF THEZICC PLANT

Distance and Measured- Direction from Measured Predicated Predicated Percent ZICC Sources Concentrition Concentrftion Concentration Change (jig/mr) (jig/m ) (jg/m 3) 400m NEla 520 75 445 14 200m WSW 520 106 414 20 300m WNW 520 79 441 15 400m NW 520 33 487 6 300m SE 520 264 256 51 600m SE 520 135 385 26 la Location and measured annual average TSP concentration at the ZICC monitoring site. This annual average concentration was assumed to be representative of the other locations in the vicinity of the ZICC plant.

Table 11: PROCESS WASTEWATER DISCHARGES AND CHINESE WASTEWATER DISCHARGE STANDARDS FOR THE PROPOSED PROJECT

Chinese Pollutant Concentration Discharge Discharge Source Pollutants (mg/l) Standard la (mg/l) Tons/Yr All Process SS <70 70 4.4 Sources Oil and Grease <8 10 1.01 COD <10 100 63.2 la There are no World Bank effluent limitations for these process sources (vacuum degassing and continuous casting machine).

51. Noise from the present facilities does not significantly affect residential areas and no effect is expected from the proposed plant. Slag, roll scales, coal ash and used refractories are solid waste products of steel-making. About 84 percent of total slag will be recovered and recycled. Roll scale and coal ash will also be recycled in the new plant. The Yangtze River will not be adversely affected by the disposal practices for the residue. -89 - ANNEX 3.3

52. CSSC and CISCG/ZICC have environmental protections departments whose function it is to: (a) develop recordkeeping procedures and inspect polluting control equipment and make recommendations to improve its performance.; (b) provide environmental training and education to operator personnel; (c) conduct research to further reduce pollutant emissions and wastewater discharges; (d) do source testing of waste gas volume, particulate matter and S02 four times per year; (e) measure noise generated by the EAF, baghouse fans and exhaust; (f) sample the main outfall from the wastewater treatment plants for pH, COD, suspended solids, oil and grease; (g) measure TSP and SO2 levels in January, April, July and October, with sampling performed for three days and four times per day; and (h) monitor ambient noise levels once per year for three days.

53. As part of the project preparation, four environmental studies financed by the Japanese government were carried out to assess the adequacy of CM's environmental management practices, monitoring networks and regulatory structure. An Air quality management study provides designs and associated costs for an ambient air quality monitoring network and an emission monitoring program in Chongqing. In addition, it assesses the adequacy of the existing regulatory framework for air pollution control in Chongqing to achieve the ambient air quality standards in the urban area. SO2 and suspended particulate matter are the major sources of air pollutants in Chongqing. The study found that the existing industrial emission standards for SO2 are not adequate to achieve the Class III (least stringent) annual average ambient standard for S02 in Chongqing. The study also found that nonindustrial sources (primarily cooking stoves) are major contributors to ground-level ambient concentrations of SO2 . The study concludes that an industrial control strategy alone is insufficient to produce acceptable air quality.

54. The study considers least-cost means for reducing emissions of S02 . For the industrial sector, it recommends initiating a program of boiler efficiency improvements or restricting boiler emissions. For nonindustrial sources, the study recommends a broad strategy of switching fuels from coal to either natural gas, sulfur-fixed briquettes, or electricity. The study concludes that application of these two control measures in the first five years of a control strategy will achieve 78 to 80 percent of air quality improvement required in most polluted areas. Acid deposition, another harmful by-product of coal burning, is severe in Chongqing, as indicated by pH measurements of rainwater in and around the city. The acidity of rainwater in Chongqing occurs mainly as a result of the scavenging of air pollutants as rain falls through the pollution layer, rather than as a result of long-range transport of acidic compounds.

55. The water quality management study provides designs and associated costs for an ambient water quality monitoring network for the Yangtze and Jialing river in Chongqing, and for an effluent monitoring programn. In addition, it assesses the adequacy of the existing regulatory framework for water pollution control in Chongqing to achieve ambient water quality standards in the two rivers within and below the city. It predicts the likely impact on wate quality of construction of the Three Gorges Dam. -90 - ANNEX 3.3

56. Currently, the water quality standards for COD, BOD, ammonia and oil are exceeded at one or more water supply intakes on the Jialing River; water quality standards for phenol and oil are exceeded at one or more water supply intakes on the Yangtze River. If all effluents were treated to met the existing effluent standards, the water quality at the municipal water supply intakes would meet the water quality standards for all pollutants except oil (owing to high background concentration upstream).

57. An analysis was made of the water quality implications of the existing effluent standards for discharges that are predicted for the year 2010, after the Three Gorges Dam has been completed. It is projected that the concentrations of pollutants at the municipal water supply intakes along the Jialing and Yangtze river will be higher than concentrations in 1993. Nonetheless, the concentrations of pollutants in the two rivers both within the city and below the small towns will meet Class III water quality standards with some exceptions; concentrations of phenols, oil, COD, BOD5 , and ammonia- nitrogen will all exceed the standard at some of the water supply intakes. The study concludes that the existing industrial effluent standards, if rigorously applied, are stringent enough to safeguard river water quality in the Yangtze and Jialing rivers in terms of industrial pollution until 2010 and after commissioning of the Three Gorges Dam. However, a major program to treat municipal wastewaters will be required to meet overall water quality standards in both rivers.

58. Assessment of the Regulatory Framework Pollution Control in Chongqing examines the effectiveness of the regulatory framework for industrial air and water pollution control in Chongqing. It assesses the adequacy of the existing environmental laws, programs, and regulations in Chongqing; of compliance monitoring programs for controlling industrial pollution; and of enforcement of environmental regulations. The purpose of the study is to identify changes in the environmental regulatory framework that will be needed to improve its effectiveness in achieving the environmental standards in Chongqing.

59. Two national environmental programs have been especially successful in pollution prevention and treatment in Chongqing. They are the "Three Synchronizations" Program and the Pollution Levy System. Approximately 70 percent of all environmental investments in Chongqing are a direct result of the Three Synchronizations program. The pollution levy system has produced the second largest investment in industrial pollution control in Chongqing; it has also provides financial support to CEPB and the local EPBs. However, the study notes that requiring individual plants to install treatment facilities may preclude the more cost-effective construction of centralized treatment, and enterprises continue to pay fees and fines because they are lower than the marginal cost of building treatment facilities.

60. Although the existing compliance monitoring program in Chongqing covers big polluters generating approximately 80 percent of the total pollution load in the urban area and meets the basic requirements specified by NEPA, it is not adequate to detect smaller -91- ANNEX3.3 violations of emission and effluent standards. Both the frequency of monitoring and the rate of coverage of industrial enterprises are inadequate. This has led to weak enforcement of environmental regulations and standards. An expansion of the monitoring program by the municipal and local EPBs, and the expansion of self-monitoring by industries is recommended.

61. The study concludes by acknowledging that the effectiveness of the regulatory framework for industrial air and water pollution control is closely linked to economic and social conditions in Chongqing, and to economic and social development policies. To achieve the environmental goals and targets in Chongqing over the long term, an integrated approach to economic development and environmental management will be needed.

62. An air pollution health impacts study, still in progress, is examining the health effects, including morbidity, mortality, and reproduction associated with high concentrations of air pollutants in Chongqing. Data from 1993 confirms that Chongqing has some of the highest ambient concentrations of TSP and SO2 in the world, far in excess of World Health Organization recommended limits. Based on data from 1993, a highly significant association of increased cardiovascular disease mortality was found with ambient concentrations of particulates (40 percent increase for 100 jig/m3 increase), 3 SO2 (23 percent increase for 100 j.g/m increase) and NO, (37 percent increase for 20 gg/ 3 m increase). Independent measurements of fine particles (PM1O/PM25 ) and sulfur dioxide were taken in different air quality zones in the city in Summer and Winter, and correlated with cross-sectional health survey data gathered from 3,500 adults and 300 primary school children. Among other findings, a significant association was found between air pollution and reduced pulmonary function. A 12-month study of ambient air pollution and the association of hospital admissions, emergency room visits, and daily mortality was begun in February 1995. Preliminary results from the most recent time- series analysis confirm the correlation between high concentrations of particulates and sulfur and excess deaths and health impacts in Chongqing. The study is expected to be finalized in August 1996.

63. Based on these studies, and with Bank support, CM has embarked on a program to strengthen its environmental regulatory framework, particularly its planning, monitoring and enforcement capabilities. As a matter of priority, the planning process has focused on iron and steel, industry's most polluting sector. Implementation of an Iron and Steel Sector Pollution Control Action Plan (see paras. 15-16) is receiving major support under the Chongqing project's industrial relocation component. The steel sector plan is a first step in preparing a pollution control plan for the industrial sector as a whole. The project is providing technical assistance to assist CEPB to prepare such a plant. The project also supports the development of a regulatory enforcement action plan, which will be the vehicle for implementing the main recommendations of the study to assess Chongqing's regulatory framework, discussed above. -92 - ANNEX 3.3

64. CM has successfully implemented a permit system for controlling major industrial wastewater polluters, and has achieved significant reductions in industrial pollutant loads. The main environmental problem in the industrial sector is air pollution, which has considerably worsened over the last 10 years, primarily from the rapidly growing energy use from boilers fueled by high-sulfur coal. Waste gases from industrial processes (particularly metallurgical, pharmaceutical, and chemical industries) are also a major air pollution source. In consequence, major efforts have to be made to control and reduce air pollution loads; and the two steel plant relocations provide an important demonstration effect (paras. 3.12-3.14). Also, CM is just beginning, with the help of technical assistance under this project, to deal with the problem of solid and hazardous waste pollution. The steel sector pollution control plan, discussed above, is therefore simply the first step to preparing an Industrial Pollution Control Strategy and Plan for the industrial sector as a whole. With the assistance of international consultants, CEPB would (a) review ambient air, water quality and pollution source data bases , (b) identify industrial enterprises that contribute 90 percent of industrial pollution as priority polluters, and (c) evaluate costs and prepare least-cost solutions for the priority list. Detailed Terms of Reference are provided in Annexes 3.3, 3.4 and 3.5.

65. An Environmental Regulatory Enforcement Action Plan has been developed to include the following measures: (a) enforcement of the CEPB registration requirement for industrial projects; (b) compliance with EIA requirements; (c) adding air quality standards for lead and polycyclic aromatic hydrocarbons, (d) implementing municipal regulations establishing an S02 emission levy system; (e) implementing new state regulations applying the levy system to all pollutants exceeding standards; (f) enforcement of the "third synchronization" monitoring of pollution control measures; and (g) increasing the number of enterprises monitored and the amount/collection of levy charges.

66. Associated GEF Project. The proposed project is linked to the Efficient Industrial Boilers Project supported by the Global Environmental Facility (GEF). Both projects involve the restructuring and modernization of heavy industry with the explicit intention of (a) improving efficient energy use, (b) lowering emissions of both greenhouse gases and air pollutants, and (c) promoting least-cost alternatives for pollution control. The GEF project seeks to reduce pollution and improve energy efficiency of small and medium coal-fired industrial boilers by acquiring foreign advanced technology, adapting it to Chinese conditions, and broadly disseminating it throughout China. Chongqing, which has some of the highest ambient concentrations of SO2 in the world, can significantly reduce both sulfur and particulate emissions through the adoption of more energy-efficient and cleaner industrial boilers. According to CM, small and medium boilers account for as much as one-half of the municipality's coal consumption and associated air pollution. CM has therefore embarked on a program to implement a municipalitywide SO2 pollution levy system. 93- ANNEX 3.4

ANNEX 3.4: TERMS OF REFERENCE: HAZARDOUS WASTE INVENTORY AND HAZARDOUS WASTE DATA MANAGEMENT SYSTEM

1. Background. A law governing prevention and control of solid and hazardous waste was adopted by the Sixteenth Meeting of the Eighth National People's Congress on October 30, 1995. It is expected to become effective in April 1996. Once the law on hazardous wastes becomes effective, it will become the responsibility of the Chongqing Environmental Protection Bureau (CEPB) to implement it in Chongqing Municipality (CM). It is estimated that approximately 600,000 tons of such materials are generated annually in CM. Industry is the primary generator of these wastes, although smaller amounts may be associated with other sectors (e.g., hospitals, laboratories, etc.). At present, little if any hazardous wastes are believed to be collected, transported, and disposed in a manner that may be considered environmentally acceptable.

2. A first step in implementing the law on hazardous waste is the establishment of a data base reflecting existing conditions , and a monitoring framework that can be used to regularly update the data base.

3. Objective. The overall objective of this assignment is for the Consultant to assist CEPB in establishing a data base on current hazardous waste management practices in CM and developing a computerized system to keep the data base up to date. To achieve this objective, the Consultant will focus on the following tasks:

- Task A. Assess current hazardous waste management practices and identify data needs;

* Task B. Prepare a hazardous waste inventory;

* Task C. Establish a hazardous waste data base, a monitoring and reporting program and an automated system for data base management; and

* Task D. Define CEPB's institutional needs to maintain and update the hazardous waste data base.

4. Manner of Study Conduct. It is expected that the Consultant will work closely with counterparts from CEPB in order to obtain and analyze requisite data, secure information relating to enterprise hazardous waste management practices, and obtain approvals for site visits to specific enterprises. CEPB will establish a Task Force to work directly with the Consultant for the duration of the assignment. 94- ANNEX3.4

Task A: Assess CurrentHazardous Waste ManagementPractices and Identify Data Needs

5. The Consultantwill review any hazardous waste surveys carried out to date, and organize the information in terms of hazardous waste generation, temporary storage, transport, and disposal practices. He should pay particular regard to data collection and/or reporting procedures,definition and classificationof hazardous waste, sampling and analytical methods used, and data on industrial classification and location in ChongqingMunicipality. 6. Based upon a review of this information,the Consultantwill establish critical data elements in the earlier surveys that were either not collected or are of questionable validity. He will then develop a methodologyfor a supplementarysurvey to identify, characterize and quantify hazardous waste management practices that were not adequately addressed previously (this can usually be determninedby mass balance, productionschedules, transporter records, etc.). 7. The survey is to include sources of hazardous wastes not likely to have been covered in earlier surveys, e.g., hospitals,pharmacies, research laboratories,etc., and pay particular attention to on-site storage/disposalpractices, transport practices,and ultimate disposal or treatmentschemes. It should consistof two elements: questionnairesand site visits. 8. The Consultant will design both: (a) questionnaire(s)to be sent to hazardous waste generators,transporters, and disposal/treatmentfacilities, and (b) hazardous waste managementevaluation site survey data sheet(s)to be used by CEPB staff in conjunction with their site visits to the aforementionedfacilities.

9. Both questionnaireand site survey data sheets should include, but not be limited to, details (flow rate and chemical composition) about raw materials, intermediate products, by-products, and main products, storage facilities (volume, safety and environmentprotection measures, age, physical condition,etc.), transporterdetails (loads carried, frequency, container integrity, driver experience/training,etc.) and treatment/ disposal characteristics (appropriatenessof technology, performance level relative to environment, health and safety standards, etc.). Informationcollected should include laboratory capabilities, sampling, monitoring and analytic procedures and reporting procedures,as well as the age and conditionof the equipmentand facilities. 10. The Consultantwill design a program of site visits and questionnairemailings to collect necessary informationfor the preparationof the hazardous waste inventory. Site visits should give priority to facilities known or suspected of requiring significant attention to hazardouswaste management. 11. The Consultantwill then accompanythe CEPB Task Force on the site visits and provide field training in the conduct of site surveys and use of site survey data sheets prepared under Task A. -95 - ANNEX 3.4

Task B: Prepare a Hazardous Waste Inventory

12. Based upon the information collected, the Consultant should prepare an inventory of hazardous waste management in Chongqing Municipality. The report should include statistical data on arnounts and types generated, sources (by specific enterprise, and sector), current practices (by amount and type of waste) for storage, transport, disposal] treatment, and fines/levies imposed and collected.

13. A section of the inventory should include statistical information on data collection, and reporting: actual analysis versus estimated values, monitoring and reporting frequency, understanding of which wastes are to be considered hazardous, inclusion of all potential sources, levels of quality control and quality assurance practiced by various entities involved with hazardous waste.

14. The inventory should include details on gaps and uncertainties in collected data.

Task C: Establish a Hazardous Waste Data Base, a Monitoring and Reporting Program and an Automated System for Data Base Management

15. Based upon the survey results, and the data gaps identified, the Consultant should establish data reporting and monitoring requirements for management of hazardous wastes in CM.

16. The Consultant should then examine CEPB hardware and software capabilities as well as staff skills for data storage and report generation. He should then develop the necessary computer software for a hazardous waste data management system to process, and store, at least the following basic data:

* Inventory of hazardous waste generators and sources

* Inventory of temporary waste storage facilities

* Inventory of waste transporters

* Inventory of waste treatment/disposal facilities

* Analysis and monitoring

* Penalties and levies imposed/collected

17. The Consultant should then collaborate with CEPB in determining their data reporting needs and design the software output/report generation system to satisfy these needs.

18. He should then test the software, operationalize it and train select CEPB staff in its maintenance and use. -96 - ANNEX3.4

Task D: Define CEPB's Institutional Needs to Maintain and Update the Hazardous Waste Data Base

19. The Consultant should prepare two programs, one for institutional strengthening and the second for monitoring. The monitoring program should be designed so that at the time hazardous waste management legislation is officially adopted, it can readily be adapted into an enforcement program.

20. Items for each element of the action program should include, but not be limited to the following:

Institutional Strengthening

* Identify necessary skills, and technical staff needed to perform monitoring and reporting.

* Prepare a training schedule for skills acquisition. Specify venue (local or international), institutions, type (course instruction, study tour, international consultant deployed to CM etc.), and costs (local, foreign).

* Prepare an inventory of equipment needs for sampling, monitoring, and analyzing hazardous wastes, consistent with the number of technical staff to be trained. Provide cost estimates (foreign/local) for both acquisition of this equipment, and its continued maintenance including quality assurance and quality control.

Monitoring and Reporting

* Prepare an annual program of site visits and questionnaire mailings for CEPB to update their hazardous waste inventory and maintain the hazardous waste data base current. The program should be specific for each generator, storer, transporter and operator of disposal/treatment facilities for hazardous waste. It should include, but not be limited to: frequency of visit to each enterprise, frequency of questionnaire mailing to each enterprise, nature of information to be collected (new, updated, confirmatory), instrumentation to be taken (site visit), and number of technicians to be deployed (site visit).

* The program of site visits and questionnaire mailings should be based upon the amount and degree of risk associated with the hazardous wastes involved at a particular facility or operation, and an assessment as to the degree to which appropriate hazardous waste management procedures have been found on the previous site visit. - 97 - ANNEX 3.5

ANNEX 3.5: TERMS OF REFERENCE: CONSULTANT SERVICES FOR A HAZARDOUS WASTE SITE SELECTION STUDY FOR CHONGQING MUNICIPALITY

1. Background. There are no regulations in China for disposal of hazardous wastes. It is estimated that approximately 600,000 tons of such materials are generated annually in Chongqing Municipality (CM) from the industrial sector. Disposal is the responsibility of the generator, and few generators are willing to incur the additional time or expense for proper disposal. Therefore, little if any hazardous wastes are disposed of in a manner that is considered environmentally acceptable.

2. Under the new law on solid and hazardous wastes, CEPB is charged with the responsibility of implementing the law in CM.

3. The services requested herein will help CEPB identify suitable locations in CM that can accommodate the volumes and types of hazardous wastes identified in the hazardous waste inventory prepared under separate terms of reference.

4. Objectives. The objectives of this support effort are as follows:

* Develop a suitable set of criteria, and ranking system upon which to base the selection of hazardous wastes disposal sites; and

* Identify several potential sites in CM that satisfy these criteria and that can be developed to meet the hazardous waste disposal requirements of CM for the next 10 years.

5. Manner of Study Conduct. The work effort is to be divided between an international consultant and a Chinese consultant. The international consultant will be responsible for planning the work effort, identifying data needs, and preparing the English version documentation. The Chinese consultant will be responsible for identifying Chinese institutions that are likely to have the required data, assisting the international consultant in data collection and analysis, and preparation of the Chinese version reports.

6. The scope of services to be provided include the tasks listed below. Detailed descriptions of the level of effort follow.

* Task 1. Review results of hazardous waste inventory - 98 - ANNEX 3.5

* Task 2. Establish site selection criteria and evaluation scheme

* Task 3. Collect necessary data for site evaluation

* Task 4. Identify candidate sites

Scope of Services

Task 1: Review Results of Hazardous Waste Inventory

7. The Consultant will review the Hazardous Waste Inventory prepared under separate Terms of Reference, which would have identified major generators of hazardous wastes in CM, their physical location, and amounts and types of wastes they produce annually. The Consultant should categorize types of wastes by an internationally recognized classification scheme for hazardous waste (e.g., UNEP, UNDP, WHO, etc.). Such schemes normally distinguish hazardous waste on the basis of their physical, chemical and/or biological activity (e.g., organic, inorganic, toxic, flammable, reactive, explosive, radioactive, bioactivity, etc.). The amounts of wastes produced annually in each category by each enterprise should be summarized.

Task 2: Establish Site Selection Criteria and Evaluation Scheme:

8. The Consultant will establish a set of criteria upon which to base the site selection process. The criteria should include, but not be limited to, the following items:

* Maximum potential volume of wastes that can be accommodated,

* Land area required

* Location of groundwater table

* Direction/flow rate of groundwater

* Current/projected uses of groundwater ( well location and withdrawal rate)

* Underlying geologic structure (including permeability and reactivity)

* Mineral resources

* Proximity to:

* Protected and/or ecologically significant areas (wetlands, critical habitats, rare/endangered species, forest preserves etc.) - 99 - ANNEX 3.5

* Infrastructure elements (power/transmission lines, water supply pipelines, gas or oil pipelines, sewage pipelines, rail lines, highways, airports, etc.)

* Sources of hazardous waste generators

* Residential areas (existing or planned)

* Surface waters (current, and projected with completion of Three Gorges)

* Current and projected water use

* Current and projected flood levels

* Structures of significant cultural, religious, historical, archaeological, political interest

* Sensitive receptors (hospitals, schools etc.)

* Seismicity

- Prevailing wind direction

- Site preparation requirements (including access road development)

- Cost estimate, time necessary to prepare site

9. With the above criteria, and any additions the Consultant deems appropriate, the Consultant will formulate a site evaluation scheme. A common scheme for example is to assign relative weights to each criteria based upon an assessment of its relative importance, and utilize these weights in assigning scores for each criteria. Candidate sites are then selected on the basis of their overall scores. The Consultant may select other evaluation schemes , if they are deemed more appropriate.

10. The Consultant will meet with appropriate authorities in CM (e.g., Planning, Land Use, etc.) to review current and future land use plans for CM and existing and potentially available locations within CM which may be considered in the site selection analysis.

Task 3: Collect Necessary Data

11. The siting criteria developed in Task 2 will establish requirements of a data base upon which to identify potential sites (see Task 4). The Consultant should prepare a list of all data needs (e.g., water table levels throughout CM before and after completion of Three Gorges Dam, geologic maps, seismicity maps, etc.). The list of data requirements should then be discussed with officials of CEPB who should then provide recommendations for the likely institutions (State, Provincial, and Municipal) who collect - 100 - ANNEX 3.5

and/or receive this data. The Consultant should supplement CEPB recommendations with his own knowledge of Chinese institutions.

12. The Consultant should then collect all necessary data identified from the siting criteria from the institutions. Any data that are unavailable, or are not collected should be noted, and discussed in the Consultant's report.

Task 4: Identify Candidate Sites for Hazardous Wastes Disposal

13. The Consultant should review data collected in Task 3, and identify a sufficient number of potential sites to accommodate at least twice the estimated amounts of any category of hazardous wastes anticipated for the next 10 years ( i.e., if 10,000 tons are expected, than disposal capacity for 20,000 tons should be included). Requiring twice the amount of storage should provide sufficient margin of protection if some of the selected sites are not available.

14. Not all hazardous wastes are compatible. In some instances, mixing two types of hazardous wastes (e.g., sodium cyanide and hydrochloric acid) can lead to by-products (deadly cyanide gas) that are more dangerous than the original waste. Therefore, the Consultant may require several disposal sites (or several physically isolated "cells" at a given disposal site) for categories of hazardous wastes that cannot be mixed together.

15. Priority lists of candidate sites should be prepared for each category of compatible waste.

Reporting

16. At the completion of each Task, the Consultant should prepare a report describing the results obtained, any problems encountered, and a schedule for the remaining work program.

17. At the completion of all Tasks, a draft final report should be prepared in both Chinese and English for review by officials of CEPB and the World Bank, respectively. The report should describe the work program, major findings, conclusions and recommendations. Any data gaps should be identified and recommendations made on which data are to be collected, and how they are to be collected analyzed and reported. Uncertainties introduced by the existing data gaps should be discussed in terms of how they might influence the Consultants' siting recommendations . -101- ANNEX 3.6

ANNEX 3.6: REGULATORY REFORM ACTION PLAN

Reporting No. Objectives Actions to be taken Schedule Requirements/Indicators I Registration of new ' CEPB establishes mechanism ' One month after Bank loan * Number of firms registering industrial projects to receive all approved project effectiveness with CEPB with CEPB applications from: municipal/district planning commissions or municipal/ district economic commissions

* CEPB will petition Sichuan ' By December 31, 1996 Total penalties collected Provincial Govemment to establish a penalty for failure to register Number of firms failing to * CEPB sets up MIS tracking * Six months after Bank loan register with CEPB system effectiveness 2 Increase compliance * CEPB sets up MIS tracking * Six months after Bank loan of industrial projects system effectiveness with environment impact assessment --Enterprise notification One month after registration Number of firms informed of (EIA) regulations EIAIEIF requirement -- EIA/EIF deadline to firms -- Three to six months after Number of firms preparing notification EIA/EIF -- Waming -- One month after deadline Number of firms required to prepare EIA/EIF but did not -- Penalty (Y 10,000-50,000) -One month after waming Total penalties collected 3 Air quality standards * Standards to be adopted by ' By December 31, 1996 for lead and poly- CEPB. cyclic aromatic * CEPB submits monitoring plan ' September 1996 * Send monitoring plan to Bank hydrocarbons for lead, PAH. Plan to include: for approval (PAHs) --Number of sites * Results of air quality --Location of sites/reason monitoring (Pb, PAH) at all --Frequency of measurement sites --Method of measurement * CEPB implements monitoring * By December 31, 1997 * All monitoring data compared ______plan to new standards 4 Reduce sulfur * Implement plan establishing * Commencing July 1, 1996 ' Number of enterprises dioxide (SO2 ) boiler SO2emission levy system monitored emissions ' Annual revenues from the SO2 emission levy 5 Enforce Third Syn- * CEPB implements enforcement * Six months after Bank Loan * Number of approvals for: chronization program effectiveness - First synchronization * Number of firms verified for: - Second synchronization - Third synchronization 6 Increase pollution * CEPB submits five-year plan * One month after Bank Loan ' Send plan to Bank levy collections for increasing pollution levy effectiveness collections * CEPB implements five year ' One month after Bank approval 0 Comparison of targets with plan for increasing pollution of plan actual performance: levy collections - Number of firms monitored - Number of firms to be for emissions monitored for gaseous - Number of firms monitored emissions for effluents - Number of firms to be - Total number of firms monitored for liquid effluents noncomplying - Total number of firms to be - Average levy monitored collected/noncompliant firm - Average levy to be collected - Total levies collected from each noncompliant ftrm - -102 - ANNEX 3.7

ANNEX 3.7: TERMS OF REFERENCE: PREPARATION OF AN INDUSTRIAL POLLUTION CONTROL PLAN

1. Background. Chongqing Municipality (CM) is situated in Sichuan Province and is a large heavily industrialized and heavily polluted jurisdiction at the confluence of the Yangtze and Jialing rivers.

2. A World Bank project has been prepared to assist CM in their program of industrial restructuring and industrial pollution control. As part of this program, CM has identified the iron and steel sector as a major polluter in CM. To control pollution in the iron and steel sector, an industrial relocation subcomponent that consists of shutting down obsolete polluting steel production capacity of two plants where they are responsible for major air pollution impacts, and their replacement/relocation with new modem nonpolluting steel production capacity in unpolluted areas. These two shutdown, relocation and replacement riieasures are the two priority action items in an overall plan Chongqing Municipality (CM) has prepared to control pollution in the iron and steel sector of CM. 3. This study will produce an overall industrial pollution control plan for all remaining industrial sectors in CM.

4. Under an environmental subcomponent of the World Bank project, assistance will be provided to CEPB for several activities that are to be used in the preparation of this plan. These activities include: (a) expanding and modernizing the ambient air quality (AQ) monitoring network CM;

(b) expanding the water quality monitoring network and improving ambient water quality (WQ) sampling and analysis capabilities of CEPB;

(c) enhancing CEPB capacity for source monitoring of industrial enterprises for gaseous emissions to the atmosphere and liquid discharges to surface waters for increased enforcement of environmental discharge standards; (d) establishing a hazardous waste inventory and data management system;

(e) identifying suitable sites in CM for hazardous waste disposal; and

(f) establishing and operationalizing an environmental audit (EA) unit in CEPB. -103 - ANNEX 3.7

5. Items (d), (e) and (f) are subjects of separate Terms of Reference. 6. Assistance to be provided herein is intended to utilize the information produced from the six activities identified in para. 4 in preparing the industrial pollution control plan for CM.

7. Objective. Objectives of this assignment are to prepare a plan for reducing major environmental impacts from industrial pollution in CM for the ninth five-year plan starting in 1996, and introduce CEPB to procedures for establishing enforcement priorities for control pollution in the industrial sector. 8. To achieve the objectives, the Consultant will work closely with CEPB staff on the tasks identified below, and subsequently discussed in greater detail:

* Task A. Review air and water quality data bases

* Task B. Review industrial enterprise source monitoring data base and hazardous waste inventory

D Task C. Identify industrial enterprises that contribute to 90 percent of industrial pollution discharges to air, water, and hazardous waste

* Task D. Evaluate pollution control costs and economic viability for priority industrial polluters

D Task E. Prepare an industrial pollution control plan including a schedule of actions and implementation timetable 9. Work Program. The study will start after one year of ambient air and water quality monitoring data with the new equipment has been obtained, the hazardous waste inventory and site selection studies have been completed, and the EA Unit in CEPB is operational. All of these data will be required to prepare this plan. Therefore, it is expected that CEPB will establish a Task Force to work with Consultants for the duration of the assignment (six months). Consultants for this study will be Chinese technical specialists. Task A: Review of air and water quality data base

10. The Consultant will review information collected from the continuous ambient air quality monitoring network and ambient water quality monitoring program. The data should represent at least one year of continuous air quality measurements from the modem monitoring network and one year of water quality measurements from the expanded network . In conjunction with these data, the Consultant should also review information collected from the meteorological stations ( included as part of the air quality monitoring program) to determine localized wind patterns through CM, and river flow data for the Yangtze and Jialing rivers. Meteorological and hydrological data should represent the same time period as the air and water quality data. - 104 - ANNEX 3.7

II. With this information, the Consultant should identify specific localities within CM that represent the most serious conditions of air or water pollution. These localities or pollution "hot spots" should be presented on a map of CM along with the monitoring locations for air and water quality, meteorology and river flows. Task B: Review industrial enterprise source monitoring data base and hazardous waste inventory 12. The Consultant should review results of CEPB's industrial enterprise source monitoring program of gaseous emissions, liquid effluents, and hazardous waste inventory (to be completed under separate Terms of Reference).

13. Based upon this information , the Consultant should prepare preliminary lists of priority industrial polluters using tons of pollutant per year as the priority criteria. The list should include all the enterprises whose cumulative release of a pollutant represents 90 percent of all industrial discharges for that pollutant. Separate lists should be prepared for each of the major air pollutants (dust, sulfur oxide, etc.)and water pollutants ( BOD, toxic metals, phenol, etc.) for which CM has existing discharge standards. A single list should be prepared from the hazardous waste inventory [para. 4, item(d)] identifying all enterprises with serious hazardous waste problems.

14. Industrial enterprises identified on the preliminary lists of priority industrial polluters described in para. 13 should be located on the same map utilized in Task A ( see para. 11), which has already identified pollution "hot spots."

15. The completed map should depict both pollution "hot spots" and priority industrial polluters. The next Task will be a refined analysis to estimate contributions the priority industrial polluters make to the overall pollution levels in the "hot spots."

Task C: Identify the industrial enterprises that contribute 90 percent of industrial pollution discharges 16. Results of Tasks A and B provide a tentative link between priority industrial polluters and pollution "hot spots." In this task, the relationship between levels of pollution in the " hot spot" and amounts of pollution released by the priority industrial polluters will be more accurately estimated using mathematical dispersion models. These models will be used to calculated contributions to ambient pollution levels of air and water from the individual pollution discharges of the various priority industrial polluters .

17. The Consultant will utilize pollutant discharge data from the industrial enterprises source monitoring program conducted by CEPB, and the meteorological and hydrologic data, in conjunction with the air and river pollutant dispersion models to predict the incremental contributions of the enterprises to air and water quality.

18. In cases where several priority industrial polluters are located near the same "hot spot," the Consultant will use these models to identify the incremental contributions of each priority industrial polluter to overall levels of air and water quality. -105 - ANNEX 3.7

19. Dispersion models that are to be used should be limited to those that are utilized by environmental authorities of developed countries in support of their regulatory activities, and designed for the unique terrain, meteorology, and hydrologic conditions found in Chongqing.

20. The Consultant should use the modeling results to revise ( if necessary) the preliminary lists of priority industrial polluters prepared under Task B. He should then plan and perform a series of site visits to support the findings of his analysis regarding the severity of pollution in the "hot spot" and the likelihood the priority industrial polluters are responsible. Discussions with local EPB officials or local people living in these areas should be conducted to provide further evidence.

Task D: Evaluate pollution control cost for priority industrial polluters

21. A program of environmental audits should be designed that starts with priority industrial polluters located in the "hot spot." The Environmental Audit Unit of CEPB should then begin environmental audits in accordance with this schedule. Results of the environmental audit program would be enterprise-level recommendations on most appropriate pollution control technological options and the associated costs (enterprises relocation may be considered as an option).

22. Based upon the costs for pollution control provided in the environmental audits, the enterprises should perforn a preliminary analysis to determine if their factory would remain profitable if it adopted these pollution control measures. If an enterprise cannot remain viable, i.e., a priority industrial polluter that cannot become clean and remain profitable , it should be recommended for closure and decommissioning costs estimated. The enterprises recommended for closure should be compared to the existing list of plants CEPB maintains for closure/relocation for consistency and agreement. The remaining enterprises are to be included in the industrial pollution control plan .

Task E: Prepare industrial pollution control plan including a schedule of actions 23. The Consultant should develop a priority plan of industrial pollution control. Priority should be given to the enterprises located in the "hot spots" whose annual rate of pollutant discharge per unit of pollution control investment cost is highest. In short, priority would be given to those areas most heavily polluted by industry and to the industries in those areas that would remove the greatest amount of pollution at the lowest cost. 24. The environmental audit program may require several years to complete. The industrial pollution control plan should start with industries in the most polluted "hot spot" and continue to the next most polluted "hot spot" and so forth. A schedule of pollution control actions should be prepared to eliminate a significant percentage of all industrial discharges during the ninth five-year plan. - 106 - ANNEX 3.8

ANNEX 3.8: TERMS OF REFERENCE: OPERATIONALIZING AN ENVIRONMENTAL AUDIT UNIT IN THE CHONGQING ENVIRONMENTAL PROTECTION BUREAU

I. Background: Chongqing Municipality (CM), situated in Sichuan Province, is a large heavily industrialized and heavily polluted jurisdiction located at the confluence of the Yangtze and Jialing Rivers.

2. A World Bank project has been prepared to assist CM in their program of industrial reform. As an input to the preparation of an industrial pollution control plan for CM, a program of environmental audits will be required. The scope of analysis for an environmental audit (hereafter referred to as an "Audit") is presented in the Attachment.

3. CEPB has agreed to establish an environmental audit unit (EAU) within its organization to assist enterprises in preparing Audits. The World Bank project has included a component of technical assistance to CEPB so that they can develop the necessary skills to perform Audits and thereby assist participating enterprises in meeting this requirement.

4. Objectives. The objectives of this support effort are as follows:

* Provide professional staff of the EAU practical, hands-on field experience and training in perforrning Audits of industrial enterprises

* Provide detailed specifications for monitoring equipment and international training for strengthening monitoring capabilities and analytical skills of the EAU professional staff

* Prepare a priority program of industrial enterprise Audits and provide initial support to the EAU in implementing the Audit program

5. Work Program. For this assignment, the Consultant would be required to provide the services listed below. The scope of services to be provided include the tasks listed below. Detailed descriptions of the level of effort are presented subsequently.

* Task 1. Design and provide cost estimates (local/foreign) for a mobile van outfitted for performing industrial environmental audits -107 - ANNEX 3.8

* Task 2. Collaborate with China National Cleaner Production Center (NEPA) in the design and presentation of a industrial environmental audit training program for CEPB staff

* Task 3. Prepare a schedule of specific factory-level environmental audits

* Task 4. Implement the environmental audit program

* Task 5. Arrange a study tour for CEPB in industrial environmental auditing

Task 1: Design and provide cost estimates (local/foreign) for a mobile van outfitted for performing industrial environmental audits

6. The Consultant will prepare detailed specifications of the types and costs of sampling, monitoring, and analytical equipment required to make CEPB's EAU operational. Equipment recommendations should be based upon the scope of Audits as defined in the Attachment after the Consultant reviews the inventory of industrial enterprises operating in CM.

7. A mobile van fitted with the monitoring equipment (of foreign and/or Chinese manufacture) will offer EAU greatest mobility and flexibility to conduct Audits. However, the Consultant is free to recommend alternate arrangements if it is believed that they would be more efficient and cost-effective. The Consultant should design and provide detailed cost estimates (capital/operating, foreign/local) for a fully equipped and operational mobile van for EAU.

Task 2: Collaborate with the China National Cleaner Production Center (NEPA) in the design and presentation of an industrial environmental audit training program for CEPB staff

8. The Consultant will review training material prepared by China National Cleaner Production Center (CPC) for cleaner production industrial audits. With this material as a base, the Consultant will work with CPC staff to modify their training material for use in the preparation of a manual for industrial environmental audits. CPC will then prepare a Chinese-language version of the environmental audit training manual. The Consultant will then collaborate with CPC staff in designing a training program that combines lectures with field work. Field work should consist of working with CEPB staff of their Environmental Audit Unit (EAU), i.e., the trainees, in actually performing enterprise level industrial environrental audits. Consultant responsibilities for the field work portion of the training program are discussed under Task 4.

Task 3: Prepare a schedule of specific factory level environmental audits

9. The Consultant should prepare a schedule of enterprise site visits and Audit preparation. As discussed above, the Consultant will work with EAU staff in preparing the Audits of the industrial enterprises. - 108 - ANNEX 3.8

10. As part of schedule preparation, the Consultant will develop a screening procedure for use by EAU staff in determining whether a Type I and/or Type II Audit will be required (see Attachment). All environmental audits (Type I and Type II) include examination of the following elements: environmental management responsibilities, estimates of pollutant discharges, plant operational efficiency, worker health and safety, and environmental impacts of plant operation. A Type I Audit is usually conducted for industries that are not highly polluting or for which little is known. It relies heavily on existing data, visual observations, engineering estimates of good practice, etc. A Type II Audit includes extensive data collection, detailed engineering calculations, and extensive analysis of process data and company health records. A Type II Audit is usually conducted for industries known to be highly polluting or if a Type I Audit indicates a Type II Audit is required.

11. The Consultant will also develop checklists for both Type I and Type II Audits that will assure satisfactory collection of all inforrnation consistent with the requirements presented in the Attachment. These checklists will guide EAU staff in collecting all necessary data for any industrial enterprise environmental audit.

Task 4: Implement the environmental audit program

12. Based upon the enterprise-level industrial environmental audit schedule developed in Task 3, the Consultant should accompany EAU staff and provide field instruction in implementing the environmental audit program. The Consultant will be required to actively participate and ensure that every staff member of the EAU has successfully participated in at least three Type I Audits and one Type II Audit. It is suggested that the EAU trainees be placed into two groups for the field program. Tlhus the Consultant will be required to participate in at least eight (six Type I and two Type II) Audits.

Task 5: Arrange a study tour for CEPB in industrial environmental auditing

13. The Consultant will arrange an overseas study tour of two weeks' duration for four CEPB staff members and accompany them on the tour. Possible countries selected for the tour should be those where industrial environmental auditing is either a regulatory requirement or has become an important environmental management tool. The Consultant should make specific arrangements for: meetings/visits with representatives of government, industry, and consulting firms specializing in environmental auditing, incountry field trips to industrial enterprises that have or are being audited, and meeting with environmental management of these industrial enterprises. - 109 - ANNEX 3.8

ATTACHMENT

SCOPE OF WORK: INDUSTRIAL ENTERPRISE ENVIRONMENTAL AUDIT

Objectives

I. Objectives of an environmental audit include the following:

(a) To establish current levels of environmental, health and safety liabilities of a particular industrial facility;

(b) Determine cost characteristics (capital/operating, local/foreign) to eliminate any environmental liabilities to an industrial facility;

(c) Define appropriate management procedures to assure a sustained program of environmental compliance;

Levels of Environmental Audits.

2. Type I Audits assess the environment, health and safety features, and operational efficiency of a particular facility in a broad manner by utilizing existing data and fast estimation techniques. A preliminary review of operational efficiency is conducted as part of the environmental audit. This operational efficiency review evaluates current conditions and potential for improvements of a facility and related costs for these improvements. For facilities which are uneconomic, the audit focuses on estimating costs for decommissioning and cleanup.

3. Type II Audits are the same scope, but more comprehensive than the Type I audits. They would nornally include review of detailed heat and material balances, extensive review and independent verification of pollutant discharge data, extensive review of company records on hazardous waste generation and management, and worker health and safety statistics, and data collection and analysis of environmental impacts.

4. Audits of both Type I and Type II consist of the tasks discussed below. Wherever applicable, distinctions in task requirements for a Type I and a Type II audit are presented. Audits are to include both the core processing area as well as any offsite or infrastructure units dedicated to the production facility.

5. The decision for a Type I or Type II Audit is made by the Auditor - 110 - ANNEX 3.8

Environmental Audit Activities

6. Environmental Management Organization. Examine the current environmental management organization in the plant, assess its adequacy in terms of staff (both numbers and skills), management effectiveness monitoring capacity, coordination with other parts of enterprise and any government agencies responsible for environmental management and worker safety and health.

7. Regulatory Framework. Determine: (a) applicable state, provincial and/or municipal standards/regulations regarding atmospheric emissions, liquid effluents, solid waste disposal, worker health and safety, which are to be complied with by the facility; (b) in the absence of such norms, appropriate values from the World Bank, European Union or internationally recognized organizations (WHO, ILO, etc.) may be used; (c) determine the status of any necessary environmental, health and safety, permits! approvals/licenses, etc.

8. Obtain a recent history of environmental, worker health and safety fines and penalties charged to the enterprise.

9. Plant Pollution Characterization.

(a) Atmospheric Emissions. Ascertain chief pollutant parameters, and deterrnine emission levels at all locations including:

* stack emissions

* process (noncombustion process vents or chimneys) * fuel combustion * incinerators

* fugitive

* stockpiled raw materials, products * waste disposal areas * fuel storage

* leaks

* pumps, valves, instrument connections, flanges, * piping, process vessels

* storage tanks

* leaks and vents

Assess performance characteristics of any installed air pollution control equipment (removal efficiencies, operational availability, operating costs, -111- ANNEX 3.8

etc.), compare performance to design values, examine any operational or design problems.

(b) Effluent Discharges. Ascertain chief pollutants, and determine discharge levels and flow characteristics at all locations (including leaks): pipeline discharges, contact process waters, and noncontact process waters.

Assess performance characteristics of all water pollution control equipment (removal efficiencies, operational availability, operating costs, etc.), compare performance with original design, examine any particular design or operational problems.

(c) Solid Wastes. Type I: examine disposal practices (visit storage and disposal sites) and ascertain the physical/chemical /toxicological nature of the material being discarded. Collect and review any water quality data existing on nearby ground or surface waters.

Type II: Analyze water quality of ground and/or surface waters in the immediate disposal area. Review, in detail, disposal site preparation/ construction and how it is operated. Determine physical/chemical characteristics of ground/surface waters, conduct leachate tests.

(d) Storage-Solids, Liquids, Gases. Examine all storage facilities of raw materials, products, by-products, for leaks, mechanical integrity, safety, and appropriate design (standards used, materials of construction, fabrication, techniques, containment facilities-berms, spacing, volumes, etc.) and physical condition (evidence of rust, corrosion, etc.)

10. Operational Efficiency Review

(a) Prepare material, heat (Type II), and water balances for the facility, and clearly identify measurements versus estimates.

(b) Review: (i) quality of fuel and material inputs with relationship to plant design, and examine impacts on environmental pollution, (ii) the scope for more efficient use of inputs (e.g., energy, water, raw materials) by improving operations and maintenance, (iii) the scope for more efficient use of outputs (e.g., by-product recovery , utilization or sales).

(c) Evaluate: (i) whether changes in process technology or product mix could provide more cost-effective ways to prevent pollution at the source (including solid waste), (ii) whether end-of-pipe/end-of-stack cleanup would be part of a least-cost approach to pollution abatement at the facility. -112 - ANNEX 3.8

11. Occupational Safety and Health (OSH)

(a) Type I: Examine general attention management pays to OSH issues. Assess safety practices, condition of OSH equipment (goggles, protective shoes, fire extinguishers etc.), monitoring systems and medical records. Review the emergency action plan. Attention should focus on hazardous nature of raw materials, products, by products and wastes, spill control/ cleanup procedures, emergency response procedures, and warning (alarm) systems.

(b) Type II: Assess hazards and risks, evaluate monitoring, and evaluate monitoring systems in depth (check to ensure they are operating properly). Examine medical records of employees, interview company medical personal and examine safety equipment, observe emergency drills/ procedures in detail.

(c) Review employee safety training program and employee medical examination program.

12. Impact Assessment

(a) Determine existing levels of air and water quality (surface and ground waters), and estimate the relative contribution of the industrial facility to overall pollution levels.

(b) Discuss enterprise activities with local environmental authorities to compare findings with official information concerning discharges to air, water, and soil, and any associated environmental impacts.

(c) Estimate any health/epidemiological impacts: Type I-compare ambient levels with ambient standards of WHO, ILO, etc. Type II-Same as Type I, but also meet with local public health officials and collect any pertinent statistics on public health (mortality, morbidity, episodal events, etc.).

13. Improvement Program

(a) Identify opportunities. Examine opportunities to improve environmental performance, including rehabilitation of existing pollution control equipment, installation of alternative or additional control equipment, enhancement of inhouse cleanup procedures, alternate process technologies, alternate raw materials, recycling/reuse of by-products or waste products.

(b) Estimation of costs. Provide an estimate of costs for the necessary environmental improvement program. Distinguish between those recommendations and costs necessary to comply with standards -113 - ANNEX 3.8

(regulations, standards, norms) and recommendations which reflect good engineering practice. Costs should include both capital and operation/ maintenance costs (local and foreign).

(c) Recommendations. Provide recommendations to improve environmental performance by identifying alternative options such as upgrading, modifying process equipment, upgrading modifying pollution control equipment, improvements in process monitoring and control, end-of-pipe cleanup, etc. Discuss costs and possibly cost recovery associated with each option. Recommendations should be made on a priority basis with an indication of the likely improvements to the local environment, worker safety and health, etc. that may be realized Highest priority should be given to those recommendations that offer the greatest improvements.

14. Role of Participating Industrial Enterprises. Participating industrial enterprises will be responsible to provide the following support, and should be so informed sufficiently far in advance by the environmental audit team, so that all preliminary information the audit team requires would be available at the time of the EAU visit.

15. The industrial enterprise would be required to:

* Make available a counterpart team of at least one technical person knowledgeable in the areas identified above,

* Prepare a background study on environmental issues concerning the current and planned operations of the industrial enterprise which will include, but not be limited to the following information:

* Name of the enterprise

* Ownership Structure of the Enterprise

* Management Structure of the Enterprise

* Particularly environment, health and safety-planning and operation

* Number of employees, both overall, and numbers assigned to each major processing area

* Description of major unit processes, and any hazardous materials used or produced

* Material balance, water balance, heat balance

* Summary of environmental data and source of data -114 - ANNEX 3.8

* Identification of any worker safety/health issues

* Brief description of emergency management program, identify personnel responsible

* Plant layout drawings (including any offsites)

* Provide full access to the facilities of the industrial enterprise, including authorization to collect environmental/pollution samples (if necessary) conduct observations, make drawings, and measurements, take photographs (subject to mutual agreement) interview plant personnel (both workers, and management) and otherwise carry out the objectives of the diagnostic and detailed audits. -115 - ANNEX 3.9

ANNEX 3.9: CHONGQING SPECIAL STEEL COMPANY (GROUP) LIMITED

1. Chongqing Special Steel Company (Group) Limited (CSSC) is a state-owned company established in 1934. The plant is located on the Jialing river in the populated Shapingba district of Chongqing City, Sichuan Province. Production of finished steel products averages 220,000 tons annually. The Company employees about 17,000 people. CSSC is fourth in the gross of industrial output, fifth in employment and sixth in net fixed assets, and has a good potential for restructuring into an efficient market-oriented enterprise.

2. Existing steel-making facilities consist of 10 small electric-arc furnaces (EAFs) of 1950s technology. They are in poor condition, obsolete, inefficient and have no pollution control equipment. Of all the sources of industrial air pollution in the Shuangbei region of Chongqing City, CSSC is the largest offender. The plant is also a major polluter of the Jialing River through the discharge of untreated waste water, raw sewage, and the disposal of slag. Because of their age and condition and the lack of space, these furnaces cannot be retrofitted to bring them into compliance with environmental standards.

3. CSSC's planned program is to build a new steel-making plant capable of meeting all environmental standards. The plant will be located on a greenfield site 5 km from the existing operation. This facility will produce 450,000 tons of continuous cast steel blooms, which will be shipped to the existing plant and rolled into 376,000 tons of finished products. A 1.5 km railway link may be built by the Chongqing Railway Bureau, but this investment of about $8 million has not yet been approved by the Ministry of Transport. Until this railway link is built, CSSC intends to transport by truck its entire annual blooms production. Studies submitted by CSSC to the Bank (available in the project files) show that road transportation is only slightly more expensive than the rail alternative and this has a marginal impact on the total operating costs of the company.

4. The major production equipment will be a 100-ton EAF, a ladle metallurgy with a vacuum degasser, and a continuous casting machine. Environmnentalcontrol facilities will include: (a) large baghouse for control of the EAF, ladle furnace and furnace hood systems; (b) cyclone separators for various conveyors, storage bins and boilers; (c) closed water recycle systems for the EAF, ladle furnace, vacuum degasser and casting facilities; (d) solid separation, oil skimming and chemical treatment for recycle water; (e) sanitary treatment facilities; (f) noise abatement facilities; and (g) extensive plantings and greenery.

5. There is not sufficient space at the present site to accommodate all facilities required for the new steel-making operation including the environmental control -116 - ANNEX 3.9

equipment. Areas adjacent to the existing site are heavily populated. Acquiring additional land at this location would be expensive and disruptive. The proposed plant site is known as the Jinkou Farm. This site is close to the existing rolling and finishing mills so that transportation costs will be minimized. CSSC's rolling mills are old but have been reasonably maintained. At some point, however, CSSC will have to replace them with new, high-speed computer controlled mills. The planned staffing for the new steel plant is 1,600 employees. They will all come from the existing plant that currently has a work force of 2,290. Those workers not being transferred to the new facilities will continue to be employed by CSSC in service trades.

6. When the existing steel-making shop is shut down in early 1999, air quality in the area near the plant will be significantly improved by decreased concentrations of NOR, S02 and TSP. Water consumption at the new plant will be 35 percent lower than the old plant because of recirculation. Wastewater treatment will control suspended solids, oil and grease and chemical oxygen demand. A sanitary system will control suspended solids and biological oxygen demand. Water returned to the Jialing River will be of significantly better quality than the intake water.

7. Under present practices, slag is piled on the west bank of the Jialing river and much of it ends up in the river, causing pollution. The new plant will have a slag processing facility. Slag will be processed to reclaim the metallics and convert the remainder to useful products. Moreover, slag stored at the old site will be processed thus reducing this pollution problem. The new facilities will have no significant negative effect on air quality at the new location.

The Market

8. The approximate apparent consumption of specialty steel in China is estimated at 6.4 million tons for 1994. Government experts expect the demand for specialty steels to reach 10 million tons by the year 2000. This is an increase of 3.6 million tons or 56 percent over current levels. China is not self-sufficient in special steels. Estimates also indicate China will not become self-sufficient in this steel sector in the foreseeable future.

9. With the age and condition of CSSC's furnaces, it is difficult to meet the quality specifications for special steels. While chemical specifications can usually be met the problems of steel cleanliness and segregation cannot. As a result, the product mix has been shifting to a lower-quality steel products such as standard carbon grades. The principal markets served by CSSC are the transportation including automotive, machinery and tool industries. Approximately 50 percent of CSSC's products are shipped to customers in the local region. The remaining production is delivered to key manufacturers in other parts of China.

10. CSSC is designated a "Key" company in the production of special steels in China. CSSC is China's first producer of free-cutting steel and valve steel, as well as second of spring steel, essential inputs to the automotive industry. CSSC is expected to play a major role in the industrialization of China by keeping pace with the growth of their -117 - ANNEX 3.9 transportation equipment, the machinery and tool industry customers. The company accounts for about 4 percent of China's special steel production and about 19 percent of the special steel produced in Sichuan Province. With the planned steel shop, the company will be able to maintain this marketplace share in the beginning of the next century.

11. CSSC's planned selling prices average $540 per ton. This compares with average product costs of $412 per ton. Despite its inefficient steel-making operations, CSSC is cost-competitive on an international basis. This reflects the fact that wages in China are extremely low. As seen in Table 1, selling prices are comfortably below foreign import prices for similar products delivered to Chongqing.

Table 1: CHANGES IN CSSC's FINISHED PRODUCTS MIX

1994 2000 Sales Sales Import Sales Sales volume price parity volume price (tons) ($/t) ($/t) (tons) ($/t)

Carbon Steel 109,341 418 508 83,644 418 Alloy 42,276 490 706 125,467 490 Spring Steel 32,471 500 682 75,280 500 Free-cutting Steel 21,334 521 660 41,822 521 Valve Steel 3,382 1,430 n.a. 50,187 1,430 High-speed Steel 3,360 2,301 n.a. 0 2,301 Stainless Steel 14,550 1,433 n.a. 0 1,433 Others 713 536 n.a. 0 536

Total/Average price 227,427 561 376,400 605

Project Cost And Financing Plan

12. The capital cost estimate is summarized in Table 2. -118 - ANNEX 3.9

Table 2: CAPITAL COST ESTIMATE ($'000)

Description Import Local Total

Land Preparation and Civil Works - 20,622.04 20,622.04 Equipment (including freight and duties) 41,670.00 19,869.73 61,539.73 Engineering 2,518.00 5,005.00 7,523.00 Installation and Utilities - 16,160.83 16,160.83 Subtotal 44,188.00 61,657.60 105,845.60 Contingencies: Physical 4,418.80 6,165.76 10,584.56 Financial 662.82 7,923.80 8,586.62 Subtotal 49,269.62 75,747.16 125,016.78 Interest during Construction 6,433.75 7,563.35 13,997.10 Working Capital Increase - 22,800.02 22,800.02 TOTAL REQUIRED FINANCING 55,703.37 106,110.53 161,813.90

13. A summary of the proposed financing plan with capital expenditures of $125.02 million plus interest during construction and working capital requirements is as follows:

Table 3: FINANCIALPLAN ($'000)

World Bank Loan 62,000.0 Bank Loan 35,309.7 Domestic Bank Loan (Working Capital): 15,960.0

Total Financed Amount 113I269.7

Equity Contribution: Capital Increase 30,120.5 Cash Generation 18,423.7 Total Equity Contribution 48,544.2

Total Financing Plakn 161,813.9 -119 - ANNEX 3.9

Disbursement of the Loans and Equity

14. Table 4 summarizes the disbursement forecasts by sources of funds.

Table 4: DISBURSEMENT PLAN ($'000)

Sources of Funds 1995 1996 1997 1998 1999 Total

Cash Generation 2,228.9 3,419.3 4,200.0 4,200.0 4,375.5 18,423.7 Capital Increase - 1,122.6 7,927.2 18,606.2 2,464.5 30,120.5

Total Equity 2,228.9 4,541.9 12,127.2 22,806.2 6,840.0 48,544.2

World Bank Loan - 14,000.0 30,000.0 18,000.0 62,000.0 DomesticBank Loan - 7,061.9 17,654.9 10,592.9 15,960.0 51,269.7

Total Loans - 7,061.9 31,654.9 40,592.9 33,960.0 113,269.7

TOTALDISBURSEMENT 2,228.9 11,603.8 43,782.1 63,399.1 40,800.0 161,813.9

Financial and Economic Rates of Return

15. Financial and economic evaluations (Figure 1) were undertaken on an incremental basis comparing a projected situation without the project where it was assumed that the existing plant continues to operate without the new investment with a projected case which assumes that the new investment is installed. The profits from the projected case without project are subtracted from the profits in the situation where the project is developed. The incremental increase in profits is applicable to the investment cost of the new facilities. The economic analysis started with the financial statements presented in the Financial Evaluation, adjusting the inputs and outputs to reflect the economic values of the national resources employed.

16. Under this approach CSSC's project generates a positive financial rate of return of 17 percent and a net present value of $51 million. The project generates an Economic Internal Rate of Return (ERR) of 24 percent. The risks of the project were evaluated by applying sensitivity analysis to the ERR. A combined 10 percent drop in average selling prices, a 10 percent increase in operating costs, and a 20 percent increase in capital costs reduce the ERR to 15 percent, which represents a comfortable margin for changes in the economic environment of the project. The project is more sensitive to declines in steel prices. However, selling prices would have to decline by 20 percent in financial terms and by 30 percent in economic terms to make the Net Present Value turn negative (at a discount rate of 11 percent, the base standards FRR used in China). -120 - ANNEX 3.9

Table 5: SENSITIVITY TEST ON INTERNAL RATES OF RETURN

Financial Economic Rate of Return Rate of Return

1. Base case 17% 24% 2. Sale Revenue down 10% 15% 20% 3. Operating Costs up 10% 16% 22% 4. Capital Costs up 20% 15% 21% 5. "Worst case"(2+3+4) 11% 15%

Financial Situation of CSSC

17. CSSC's balance sheet has been affected by the austerity program established by the Central Government in June 1993. Credit has been severely tightened resulting in what is translated as a "triangular debt crisis." Customers cannot pay invoices for steel shipped and steel suppliers have experienced significant increases in accounts receivable. The offsetting liability is an increase in short-term debt to finance working capital and accounts payable. Accordingly, as of September 1995, CSSC faced a major liquidity problem and the company's debt was such that it made it difficult to borrow on pure commercial basis. To cover the exponential rise in working capital, CSSC was forced to increase its short-term debt to the equivalent of almost one year of sales.

18. To ensure that (a) the company can be financially solvent until the new plant is built, (b) the additional financing required to complete the relocation subproject can be obtained, and (c) CSSC can meet its debt equity and debt service coverage requirements under the project, sufficient CSSC equity contributions and local bank financing must be made available. During negotiations, CSSC informed the Bank that by the end of 1995, the company had proceeded with a financial restructuring of its Balance Sheet, by means of a conversion into equity of Y 250 million of debt and accrued liabilities. Details of the operations are as follows: conversion into equity of (i) Y 223.5 million of accrued liabilities (unpaid taxes); and (ii) Y 32.1 million of long-term State and Municipal loans (for technical renovation). The financial restructuring-together with the fact that actual 1995 results were better than the forecasts presented to the Bank during appraisal-has substantially improved the financial situation of the company. Financial projections prepared by the Bank now indicate that CSSC should be in a position to comply with the financial covenants of the project. During negotiations, agreement was also reached with CM on the modalities of a capital injection of Y 250 million in order to allow CSSC to meet its equity contribution to the project.

19. In addition, during negotiations, agreement was reached that CSSC will: (a) maintain a long-term debt/equity ratio of 70:30 or better; (b) maintain a debt service -121- ANNEX 3.9 coverage ratio of at least 1.2. and (c) furnish to the Bank for review, by October 31 of each year from 1996 to the third year after the startup of operations of the new facility, its rolling five-year financial plans, including production, marketing and investment plans, in the formnof projected financial statements. Such plans will be supported by: (i) a detailed analysis of production cost trends; (ii) analysis of operational and financial budget variances for the current fiscal year; and (iii) financing arrangements for the investments proposed over the five-year period. In addition, CSSC will submit to the Bank its annual accounts audited by independent accountants.

20. Based on the projected product mix and operating margins under the base-case scenario, the profitability of CSSC should improve substantially during the next 10 years. Net income is expected to increase from a negative $1.5 million in 1995 to about $29 million when the project reaches full production by 2001. Expressed as a percentage of sales, it should improve from I to 4 percent over the sarne period. However, the projected high total-debt-to-equity ratios during the construction period and the low debt service coverage projected during the first 10 years of operations indicate the need for further capital injections by CM before the full commissioning of the new plant. - 122 - ANNEX 3.9

Figure 1: CSSC-FINANCIAL AND ECONOMIC RATE OF RETURN CALCULATIONS ($ million)

1/ FINANCIAL RATE OF RETURN

Projection 2002 1996 1997 1998 1999 2000 2001 to 2013 Capital Costs Total Project Cost -27.8 -59.8 -51.4 0.0 0.0 0.0 0.0 Increase in Incremental Working Capital 0.0 0.0 0.0 -1.3 -12.4 -8.8 0.0 OperatingCosts & Revenues Incremental Revenue 0.0 0.0 0.0 6.6 52.1 83.8 83.8 Incremental Operating Cost 0.0 0.0 0.0 16.5 30.1 38.6 38.6 Incremental Gross Operating Income 0.0 0.0 0.0 -9.9 21.9 45.2 45.2 INCREMENTAL NET BENEFIT -27.8 -59.8 -51.4 -11.2 9.5 36.4 45.2

FTNANCIAL RATE OF RETURN: 17.4 NET PRESENT VALUE: 50.5 (discount rate:) 11%

2/ ECONOMIC RATE OF RETURN

Projection _ 1996 1997 1998 1999 2000 2001 2002 Capital Costs Total Project Cost -27.2 -55.8 -47.4 0.0 0.0 0.0 0.0 Increase in Incremental Working Capital 0.0 0.0 0.0 -1.3 -12.4 -8.8 0.0 OperatingCosts & Revenues Incremental Revenue 0.0 0.0 0.0 19.4 77.8 117.9 117.9 4 ...... Incremental Operating Cost -0.0 0.0 0.0 28.9 45.0 55.1 55.2 Incremental Gross Operating Income 0.0 0.0 0.0 -9.5 32.8 62.8 62.7 INCREMENTAL NET BENEFIT -27.2 -55.8 -47.4 -10.8 20.4 54.0 62.7

ECONOMIC RATE OF RETURN: 24.2 NET PRESENT VALUE: 110.6 (discount rate:) 11% -123 - ANNEX 3.10

ANNEX 3.10: RESETTLEMENT ASSOCIATED WITH THE CSSC RELOCATION

Schedule 1 Results of the Socioeconomic Household Survey for CSSC Jinkou Farm

Schedule 2 The PMO Resettlement Unit

Schedule 3 Terms of Reference for External Monitor of Resettlement

Schedule 4 Resettlement Policy Framework and Procedures Process -124 - ANNEX 3.10

Schedule 1-Results bf the Socioeconomic Household Survey for CSSC Jinkou Farm

Table 1: GENERAL CHARACTERISTICSOF THE PROJECT-AFFECTEDPEOPLE

Number Percent

Total affected households (to be relocated) 1,014 Non-CSSC households 0

Affected people 3,018 Male 1,559 51.66 Female 1,459 48.34

Education No education 161 5.35 Primary school 431 14.28 Middle school 915 30.32 High school 704 23.33 Higher education 229 7.59 Children (age <16 years) 578 19.15

Health status Good 2,974 98.542 Average 34 1.127 Poor 8 0.265 Disabled 2 0.066

Registration Nonagricultural 2,890 95.76 Agricultural 128 4.24 -125 - ANNEX 3.10

Table 2: AGE AND GENDER

Age group Male Female Total Percent

5 and under 72 66 138 4.57 6-15 years 225 215 440 14.58 16-25 years 168 158 326 10.80 26-35 years 329 295 624 20.68 36-45 years 309 276 585 19.38 46-55 years 201 205 406 13.45 56-59 years 80 72 152 5.04 60-69 years 102 109 211 6.99 70 and over 73 63 136 4.51

Total 1,559 1,459 3,018 100.00

Percent 51.66 48.34 100.00 -126 - ANNEX 3.10

Table 3: EMPLOYMENT CHARACTERISTICS

Male Female Total Percent

Employer (includes retired) Jinkou State Farm/CSSC Active 497 207 704 23.33 Retired 184 215 399 13.22 Other SOE Active 376 435 811 26.87 Retired 32 65 97 3.21 Collective 13 17 30 0.99 Self-employed 19 10 29 0.96 Farmers 22 64 86 2.85

Unemployed Working age 80 97 177 5.86 Over 60 years 7 44 51 1.69

Subtotal 2,384 78.99

Students (16 and over) 31 25 56 1.85 Children (0-15 years) 297 281 578 19.15

Total 3,018 100.00

Occupation Type Agriculture 22 64 86 5.18 Manufacturing/process 693 551 1,244 74.94 Service 47 39 86 5.18 Institute (school) 13 17 30 1.81 Management 149 65 214 12.89

Total 924 736 1,660 100.00

Work Location for non-CSSC Workers Near Jinkou State Farm 470 54.02 Near CSSC (Shuangbei) 47 5.40 Chongqing 347 39.89 Elsewhere 6 0.69

Total 870 100.00 -127 - ANNEX 3.10

Table 4: ANNUALHOUSEHOLD INCOME AND EXPENDITURE

CSSC Other Total

Total income (excluding bonus) (Y million) 5.480 4.145 9.625 Percent 56.9% 43.10% 100.00%

Income earners 1,103 1,053 2,156

Average income per worker (includes retired) 4,969 3,936 4,464 Average household income - - 9,493 Average income per capita - - 3,189

Total expenditures (Y million) - - 7.240 Average per household - - 7,141 Food - - 4,635 Clothing - - 1,143 Average per capita - - 2,399

Average saving per household - - 2,352 Percent of income - - 24.8%

Note: Wage income for state/collective employees; net income for farmers and self- employed.

Table 5: ANNUALHOUSEHOLD SAVINGS RATE

Range Number of households Percent

0-10% 12 1.18 10-20% 225 22.18 20-30% 599 59.07 30-40% 117 11.53 40-50% 40 3.94 >50% 21 2.07

Total 1,014 100.00 -128 - ANNEX 3.10

Table 6: MAIN SOURCE OF INCOME BY AGE STRUCTURE

Age structure CSSC Other SOE Other No income No response Total

Below 16 years 0 0 0 575 0 575 16-49 years 590 728 127 160 59 1,664 50-60 years 302 131 14 21 0 468 Over60years 211 49 4 47 0 311

Total 1,103 908 145 803 59 3,018

Table 7: AGE OF HOUSING STOCK

Years Number Percent

1-5 133 13.12 6-10 146 14.40 11-20 194 19.13 21-30 353 34.81 Over 30 188 18.54

Total 1,014 100.00

Averagefloor spaceper household 37.8 m2

Table 8: YEARSAT PRESENTLOCATION

Years Number Percent

1-5 298 29.39 6-10 475 46.84 11-20 169 16.67 Over 20 72 7.10

Total 1,014 100.00 -129 - ANNEX 3.10

Table 9: PERSONAL ASSETS OF HOUSEHOLD

Item Number Percent of households

Automobile 3 0.3 Motorcycle 14 1.4 Bicycle 45 4.4 Color TV 730 72.0 Refrigerator 713 70.0 Washing machine 722 71.0 Air conditioner 44 4.3 Record/CD player 21 2.1 Fan 976 96.0 Video player 50 4.9 Black & white TV 276 27.0 No response 35 3.5

Total 1,014 -130- ANNEX3.10

Table 10: SUMMARY OF IMPACTS AND ENTITLEMENT FOR PEOPLE ON THE JINKOu FARM

Law or Proposed Type of Impact Quantity Units Legal Entitlement Regulation Entitlement Relocation of 1,004 - households State (CSSC) will Municipal Law Same as legal entitlement. State Houses 2,980 - people provide comparable for Dismantling New housing conditions will (rented by housing at no cost to Buildings be much improved. Subsi- CSSC staff) occupants, including dized rental fees will moving costs. increase slightly. Relocation of 10 - households CSSC compensates State Law of Owners will receive state Private Houses 38 - people based on market val- Land Manage- housing and compensation (owned by ues. Staff are entitled ment; State Labor for house. CSSC staff) to state housing. Law Transfer of Jobs 704 - laborers Reassignment and State Owned In- Since merger, CSSC is and Incomes retraining of workers dustrial Enterprise reassigning workers. Higher ()inkou State by employer. Operating Mecha- salaries and allowance are Farm workers) nism Adjustment being paid. Family Mem- 1,133 - laborers No entitlement Not applicable. Compensation for any lost bers' Jobs and required. income during move. Incomes (not affected) Loss of Agri- 500 - Y'000 Farm production and State Farm Agricultural production has cultural Produc- (gross reve- income belongs to Regulations been sold off (cattle) or tion nue) State Farm. reduced (oranges). Loss of Tempo- 7 - hectares State workers are not State Owned This was a temporary policy rary Vegetable entitled to farmland on Enterprises to benefit Jinkou Farm Production company propcrty. workers during the transi- tion. Land Requisi- 1.3 - km ROW CM Railway Dept. to State Law of Based on Laws. Final tion for Railway 2.0 - hectares compensate property Land Manage- alignment is to be surveyed between CSSC 0 - houses owners based on land ment; Municipal in 1996. and Jinkou values. Regulations Farm _ _ I I_ I -131- ANNEX 3.10

Schedule 2-The PMO Resettlement Unit

General

1. The PMO is responsible for coordinating and supervising implementation of the Chongqing Industrial Reform and Pollution Control Project. In accordance with World Bank requirements for project-related resettlement, the PMO will also be responsible for coordinating and supervising resettlement implementation. The PMO has established a Resettlement Unit with staff and responsibilities detailed below. The organizational structure is shown in Figure 1.

Figure 1: ORGANIZATIONAL STRUCTURE FOR RESETTLEMENT

Staffing

2. The Resettlement Unit will have two staff appointed:

| Mr. Wen Rujun, as Head (in addition to other duties)

* Ms. He Lili, as Vice Head (also part-time).

Responsibilities

3. Coordination: to coordinate project-related resettlement aspects and liaise with: (a) all project enterprises regarding potential and identified resettlement issues; (b) relevant local agencies (e.g., CM, Labor Bureau, Land Management-Bureau, Housing Bureau, etc.); and (c) the World Bank. -132 - ANNEX3.10

4. Policy Framework: to implement the resettlement Policy Framework and proceduresfor all enterprisesunder the Line-of-Creditcomponent.

5. Supervision: (a) to regularlycheck that implementationis proceeding according to plans; (b) to ensure that key targets are met on time; and (c) to follow up and ensure compliancewith any subsequentremedial actions requiredby the World Bank or PMO.

6. Monitoring& Evaluation: (a) to periodicallymonitor and evaluatethe progress of resettlementimplementation based upon the ResettlementAction Plan(s);(b) to update the resettlement implementationschedule(s); and (c) to update financial progress and schedule(s).

7. Reporting: (a) to receive quarterly progress reports from CSSC and other relevant enterprises;(b) to consolidatethe reportsinto one documentthat incorporatesthe PMO's commentsand recommendations;and (c) to deliver quarterlyreports to the World Bank.

8. Advisory Services: (a) to advise project enterprisesof World Bank resettlement policies and requirements;(b) to assist enterprisesin the preparationof the Resettlement Action Plan; and (c) to provide guidance concerningto proper implementationof these plans.

PerformanceIndicators

9. The followingare the key performanceindicators that the PMO ResettlementUnit will use the monitorand evaluationthe resettlementprogress:

• physicalprogress of constructionfor the residentialcomplex - availabilityof resettlementfunds and disbursements - number of workerstransferred * number of families relocatedto new residences * incomelevels (salariesand bonuses)of affectedworkers * housing conditions(floor space,quality, amenities,safety) * social services (schooling,health care, recreation,etc.) * workingconditions (physical stress, air & noise quality, safety,mental stress) * human resourcedevelopment (training, apprenticeship, etc.) * productivityof workers (based on ratingsof station supervisor) * public opinion (survey the levels of satisfaction for workers and family members) * number of grievancesand how resolved. Format of QuarterlyProgress Reports

10. The followingis an outline for the PMO ResettlementUnit to follow for quarterly progressreports to be submittedto the World Bank. The first progress report should be receivedby the World Bank four weeksprior to the first supervisionmission. -133- ANNEX3.10

* Introduction-key issues since last report

* Descriptionof Progress of Project Implementation-engineering/construction

* Details of Resettlement Progress-update implementation schedule and describe:

* status of key targets (refer to Section 9 of the CSSC RAP)

* physicalprogress and numberof people relocated * financialprogress and personalcompensation * Resultsof Public Opinionand SocioeconomicSurveys

* summarizeand assess findingsof the externalmonitor

* describefindings made directlyby PMO ResettlementUnit * includecomments from CSSC ResettlementUnit

D DiscussKey Issues and RemedialActions

* describeissues/problems and review previousremedial actions

* give results of follow-up(problem resolved or still exists)

D presentnew or revisedremedial actions

* Conclusions and Recommendations-identify critical tasks for subsequent quarter. -134 - ANNEX 3.10

Schedule 3-Terms of Reference for External Monitor of Resettlement

Background

1. The Chongqing Industrial Reform and Environmental Control Project includes restructuring and pollution control investments for industrial enterprises. Some new or rehabilitated production facilities involve land requisition and/or relocation of housing. Since the World Bank is providing financing for the Project, the resettlement impacts must be handled according to World Bank procedures, as stipulated in Operational Directive 4.30 (1990).

2. At present, only the CSSC steel plant relocation component of the project involves resettlement. In accordance with World Bank requirements, a Resettlement Action Plan has been prepared that describes the impacts and plans for mitigation or compensation of the affected population. However, should enterprises financed under the Line-of-Credit component of the Project involve resettlement, a separate Resettlement Action Plan will be prepared for each relevant enterprise.

3. The World Bank requires monitoring and evaluation of resettlement implementation. This will include internal monitoring by the implementing agency (e.g., CSSC) and by the coordinating agency-the Project Management Office (PMO). The World Bank also requires external monitoring by an independent party.

Objectives

4. The objective of the external monitoring is to provide an independent assessment of resettlement implementation, to ensure it meets World Bank standards. The key criteria for successful resettlement include improvements in living standards and income levels. The Resettlement Action Plan is designed to minimize adverse impacts and provide the means for improved living standards and incomes. The external monitor will be required to develop and implement a monitoring system at the household level to document the socioeconomic effects related to Project implementation. The evaluation will be based on the eleven resettlement criteria stated in Section 4.5 of the CSSC Resettlement Action Plan.

Qualifications of the External Monitor

5. The external monitor should possess the following characteristics:

* a nongovernment agency that is independent from the Project components,

* good skills in social science, particularly socioeconomic impact assessment, and

* previous experience in providing similar services to clients. -135 - ANNEX 3.10

Scope of Services and Specific Tasks to be Performed

6. The present scope of services only pertains to resettlement related to the CSSC component of the Project. If additional enterprises have resettlement, the scope of services and contract can be amended to incorporate these additional monitoring activities.

(a) Review baseline conditions for affected households, utilizing existing data from the Resettlement Action Plan, the public opinion survey and the socioeconomic household survey conducted by CSSC.

(b) Develop a monitoring system that can provide accurate and reliable results for a representative sample of the affected population. The monitoring methodology should include new household surveys, but the information from existing surveys should be fully utilized.

(c) Design a survey form that can monitor the following criteria:

- mitigation measures or compensation provided, D employment (job reassignment) situation, D annual income levels of all directly affected workers, * annual income levels of other family members in households to be relocated, * annual household expenditures and savings, D housing conditions of families to be relocated, D private expenditures on new housing (decorations and furnishings) * levels of social services for households to be relocated, and 3 public opinions and grievances related to resettlement.

The proposed survey form should be discussed with the PMO and tested on 20 households. After revisions, the form should be sent to the World Bank for no objection before the survey is conducted

(d) Conduct an annual household survey of income levels and living standards.

(e) Collect periodic information on public opinions, grievances, and progress on selected mitigative measures (i.e., key activities or remedial measures). -136 - ANNEX 3.10

(f) Prepare reports to be submitted to the PMO, including:

* an interim report at mid-year * a comprehensive report at year-end, which will be included in the PMO's annual report on the environmental impact of the Project * the content of the comprehensive report is shown in Attachment A.

Schedule and Level of Effort

7. The services should commence by March 1, 1996 and will continue for a period of five years. The anticipated level of effort for these services will depend upon the methodology and staffing used. However, the PMO has established an upward contract limit on fees and disbursement of Y 125,000 for these services.

Other Conditions

8. The external monitor will report to the Head of the PMO's Resettlement Unit.

9. The external monitor will have access to resettlement monitoring reports prepared each quarter by the PMOYsResettlement Unit.

10. A schedule of payments will be negotiated, which are tied to the delivery and acceptance of monitoring reports.

11. The contract may be amended to expand the scope of services to other enterprises that may require a Resettlement Action Plan. -137 - ANNEX 3.10

Attachment A-Contents of the Comprehensive External Monitoring Report

1. The following is the suggested format for the comprehensive report.

Introduction - reference earlier reports and work

Methodology - general methodology applied - describe work that lead up to this report

Resettlement Progress - overview (reference PMO reports) - independent comments

Housing Conditions - compare old and new - monetary compensation (10 private houses) - level of satisfaction - implementation issues

Employment and Net Incomes - employment status - household incomes - household expenditures - savings levels - private expenditures on new housing - employment issues

Social Services - schools, health clinics, infrastructure, etc. - compare old and new

Public Opinion - results of surveys - compare with previous results

Grievances - document occurrences - mechanisms to handle and outcomes

Other Issues - to be determined (e.g., health, vulnerable groups, etc.)

Recommendations - remedial actions to be taken - status of previous actions

Conclusions - overall evaluation

2. The comprehensive report should also contain detailed tables of monitoring/ survey statistics to justify to the statements in the report. -138- ANNEX3.10

Schedule 4-Resettlement Policy Framework and Procedures Process

I. The Chongqing Industrial Reform and Pollution Control Project may include resettlement impacts for enterprises under the Line-of-Credit component. To date, four enterprises have been selected for financing but none of these proposals require resettlement. Other enterprises will be identified in 1996 that could have resettlement impacts. In order to comply with World Bank OD 4.30, the following Policy Framework and procedures process will be used for this project.

General Policy

2. The candidate enterprises will try to avoid the need for resettlement.

3. If resettlement is required, a separate Resettlement Action Plan will be prepared for each enterprise .

Defining Resettlement

4. Resettlement impacts that would invoke the need for a Resettlement Action Plan include:

(a) requisition of land that affects people's livelihoods, and/or

(b) involuntary relocation of housing.

5. Although the investment scheme may involve the reassignment of an enterprise's workers, this impact, in itself, does not invoke the need for a Resettlement Action Plan.

Procedures Process

6. Review all subprojects, being prepared by the Restructuring Advisory Facility or local consultants, for possible resettlement impacts.

7. If resettlement impacts are suspected, prepare a brief report on the proposed project which describes land requisition requirements, relocation of housing, the number and characteristics of project affected people, and the anticipated impacts. A labor reassignment plan should also be provided by the enterprise.

8. Submit the brief report to the World Bank for a decision on the following options:

* no need for a Resettlement Action Plan * proceed with a Resettlement Action Plan * modify the proposal to avoid resettlement impacts * abandon the proposal, for resettlement or other reasons.

9. If option (b) is selected, the proponent should conduct a socioeconomic-economic survey for the project-affected households. The purpose is to gain a better understanding -139- ANNEX3.10 of the resettlement impacts, identify mitigation options, and document baseline conditions.

10. Prepare a comprehensive Resettlement Action Plan that covers the following aspects:

* the proposed scheme * baseline conditions * resettlement impacts * relevant laws and regulations * resettlement principles and criteria * compensation entitlement * proposed plans to mitigate impacts * cost of resettlement plans and financing * implementation schedule (physical and financial) * capacity for implementing the proposed actions * monitoring and evaluation.

Note: the Resettlement Action Plan for CSSC can be used as a model but it should deal with the above aspects in a level of detail that corresponds to the types and degree of impacts.

11. Submit the Resettlement Action Plan to the World Bank for approval or modifications.

12. Finalize the Resettlement Action Plan and get approval from the Chongqing Municipality.

13. Include the new Resettlement Action Plan within the supervision activities of the PMO's Resettlement Unit, and add to the scope of the external monitor. -140- ANNEX3.11

ANNEX 3.11: ZHONGXING INDUSTRY AND COMMERCE COMPANY, SUBSIDIARY OF CHONGQING IRON AND STEEL COMPANY (GROUP) LIMITED

1. Zhongxing Industry and Commerce Company (ZICC) was established in 1939 as the Number 3 Steel Making Company of the Chongqing Iron and Steel Company (Group) Limited (CISCG). The plant is located in the Jiang Bei District of Chongqing, a densely populated area on the north shore of the Jialing River. ZICC operated two open-hearth furnaces, a 10-ton electric-arc furnace (EAF), some small rolling mills and associated equipment. Production volume has been almost constant over the last five years averaging 160,000 tons per year. The product mix, however, has changed to more lower- quality items. 2. CISCG operates a completely integrated plant located in the Dadukou District of Chongqing. It employs about 50,000 people. Of that, ZICC accounts for 5,700 or 11 percent. Much of the labor is employed in activities not directly concerned with steel making (housing, food service, education, health care, property maintenance, etc.), and the company still has 19,000 retired persons in its payroll. CISCG produced almost 900,000 tons of finished products in 1994 (plates, wire rods, silicon sheet, and structural shapes).

3. The emissions from ZICC's furnaces and lime kiln are exhausted into the air without treatment and constitute the largest source of air pollution in the Jiangbei district, the business center of Chongqing City. Wastewater returned to the Jialing River is a serious cause of water pollution. The shutdown of this steel-making operation is the top priority of CISCG's environmental improvement program. 4. The proposed course of action is to install a new 60-ton EAF and continuous billet caster within CISCG's steel complex, so that it can benefit from the existing infrastructure and auxiliary equipment. This will reduce substantially the capital requirements of the project. ZICC's facilities will be entirely shut down by 1999 and the new plant will produce 300,000 tons of continuous cast billets. New facilities will include: (a) one 60-ton Electric Arc Furnace; (b) one continuous Billet Caster; (c) Materials Handling Facilities; (d) Ladle Metallurgy Furnace; (e) Vacuum Degasser; and (f) Wire Feeding Machine. Only 8 hectares of land will be required for the new steel shop. Currently occupying the land is a scrap storage yard, a billet storage facility and a machine shop. Part of the land is hilly and unoccupied. The present ZICC steel-making facilities are manned by 632 workers, while the new ones will employ 600. A total of 420 of the present workers will be transferred to the new plant. Of the remaining 212 people, 86 will retire based on the general practice of the company, 91 will be placed in other jobs within CISCG, and 35 will be employed in other industries. -141- ANNEX 3.11

5. The new operation will be equipped with the latest pollution controls, meeting all Chinese environmental standards. Environmental controls to be installed include: (a) large baghouse for control of the EAF, ladle furnace and furnace hood systems; (b) cyclone separators for various conveyors, storage bins and boilers; (c) closed water recycle systems for the EAF, ladle furnace, vacuum degasser and casting facilities; (d) solid separation, oil skimming and chemical treatment for recycle water; (e) sanitary treatment facilities; (f) noise abatement facilities; and (g) extensive plantings and greenery. The new facilities will have no significant negative effect on air quality at any location. No acquisition of land is required for this project. 6. Since virtually all of ZICC's production will go to an existing CISCG mill, the economic and financial analysis have been conducted on an incremental basis for the Chongqing Iron and Steel Company (Group) Limited (CISCG). CISCG is designated a "Key" company for the production of steel in China and it is expected to play a major role in the industrialization of China by assisting in the growth of the construction, transportation equipment, and machinery industries. 7. In June 1995, CISCG was transformed into a state-owned limited liability company. As a result, the company has obtained more autonomy of management, and is reforming its organization structure in order to make it more responsive to market forces. Some of its subsidiaries can now be restructured by means of joint ventures, mergers, or listing in the stock exchange. In accordance with the new principles, noncore activities of the group, like hospital, school, housing, will separate from CISCG. The Market 8. With the proposed steel-making plant at ZICC the product mix of CISCG will change, as seen in Table 1. The billets of the new EAF will be supplied to CISCG for rolling on an existing medium section mill built in 1991, while the existing wire rod mill will be renovated to cope with the increase in production. The company will then be able to produce yearly 600,000 tons of plates, 260,000 tons of heavy structurals, 280,000 tons of medium structurals (supplied in billets by the new EAF), and 200,000 tons of wire rods per year. The quality of the steel and resulting finished products will be considerably higher than the ones currently being produced. 9. Output of the medium section mill will serve mainly the coal mining industry, the automotive industry, the shipbuilding industry and raw material for seamless tubes and local rerollers. The principal markets for plates are plate fabricators, construction, and the ship and barge-building industry. The fabricators produce a range of industrial equipment including steam boilers and pressure vessels. Structural sections are used in construction for industrial and commercial buildings, bridges, and power plants. Wire rods are used in the building construction and steel parts industries. 10. Despite antiquated steel-making equipment, ZICC is currently competitive with foreign steel on a delivered basis in Chongqing. As seen in Table 1, when tariffs and transportation charges are added to foreign steel prices, c.i.f. Nanjing, CISCG's prices are -142 - ANNEX 3.11 lower. Moreover, the planned prices for the new medium section products are also in line with those of foreign material delivered to Chongqing, at $350 per ton. This compares with average product costs of $265 per ton.

Table 1: CHANGES IN CISCG's FINISHED PRODUCTS MIX

1994 2000 Sales Sales Import Sales Sales volume price parity volume price ('000 tons) ($/t) ($/t) ('000 tons) ($/t)

Plate 501.3 440 520 600.0 520 Wire Rod 93.1 304 380 200.0 380 Seamless Tube 15.1 586 n.a. 0.0 - Silicon Plate 92.5 450 n.a. 0.0 - Heavy Sections 14.4 442 520 260.0 520 Medium Sections 167.8 331 350 280.0 350 Light Sections 6.5 310 340 0.0 -

Total/Average price 890.8 1,340.0

Project Cost and Financing Plan

11. Capital required for the project is estimated at $98.97 million including interest during construction. The Capital Cost Estimate is summarized in Table 2: Table 2: CAPITAL COST ESTIMATE ($'000)

Description Foreign Local Total Land Preparation and Civil Works - 11,646.81 11,646.81 Equipment (including freight and duties) 25,040.84 21,810.36 46,851.20 Engineering 959.18 3,232.01 4,191.19 Installation and Utilities - 6,355.80 6,355.80 Subtotal 26,000.02 43,044.98 69,045.00 Contingencies: Physical 2,600.00 4,304.50 6,904.50 Financial 650.00 6,476.40 7,126.40 Subtotal 3,250.00 10,780.90 14,030.90

TOTAL PROJECT COST 29,250.02 53,825.88 83,075.90

Interest during Construction 4,066.30 - 4,066.30 Working Capital Increase - 11,830.00 11,830.00

Subtotal 4,066.30 11,830.00 15,896.30

GRAND TOTAL 33,316.32 65,655.88 98,972.20 -143 - ANNEX 3.11

12. A summary of the proposed financing plan with capital expenditures of $83.1 million plus interest during construction and working capital requirements is shown in Table 3: Table 3: FINANCIAL PLAN ($'000) World Bank Loan 42,000.00 Short tern Loan (Working Capital) 11,800.00 Total Financed Amount 53,800.00 Equity Contribution 45,172.00 Total Equity Contribution 45,172.00 Total Financing Plan 98,972.00

Disbursement of the Loans and Equity

13. Table 4 summarizes the disbursement forecasts by sources of funds.

Table 4: DISBURSEMENT PLAN ($'000)

Sources of Funds 1996 1997 1998 1999 2000 Total

Cash Generation 3,353 5,107 11,322 8,390 - 28,172 Capital Increase - 17,000 - - - 17,000

Total Equity 3,353 22,107 11,322 8,390 - 45,172

World Bank Loan - 11,981 17,976 12,043 - 42,000 Domestic Bank Loan - - - 7,700 4,100 11,800

Total Loans - 11,981 17,976 19,743 4,100 53,800

TOTAL DISBURSEMENT 3,353 50,088 23,298 18,133 4,100 98,972

Financial and Economic Rates of Return 14. Financial and economic evaluations for CISCG (Figure 1) were undertaken on an incremental basis, comparing a projected situation without the project with a projected case where the new investment is installed. The profits from the projected case without project are subtracted from the profits in the situation where the project is developed. The incremental increase in profits is applicable to the investment cost of the new -144 - ANNEX 3.11 facilities. The economic analysis started with the financial statements presented in the Financial Evaluation, adjusting the inputs and outputs to reflect the economic values of the national resources employed. 15. In the situation without project it was assumed that ZICC's EAF is shut down in late 1999. CISCG's annual production remains steady at the projected 1,080,000 tons. Because of the mix changes by increasing the shipments of wire rods (to 195,000 tons), and heavy and medium structurals (to 375,000 tons), while discontinuing sales of seamless tube, silicon plate and light sections. Plate production would remain stable at about 510,000 tons. Nonsteel revenues, representing 16 percent of sales in 1994 and 20 percent in 1995, are expected to decrease to 10 percent of sales thereafter. 16. The projected situation with ZICC's new electric-arc furnace takes the projected situation without the project and super imposes the planned steel-making shop. CISCG's yearly production increases to 1,340,000 tons, including 260,000 tons of heavy sections, and 280,000 tons of medium sections. In order to calculate the rates of return, these incremental cash flows calculated in both financial and economic terms are applied to the ZICC investment, including the capital cost, interest, depreciation, and operating costs associated with revarnping CISCG's existing wire rod mill. Under this evaluation, ZICC's new electric-arc furnace investment generates a financial internal rate of return (FRR) of 17 percent, and an Economic Internal Rate of Return (ERR) of 20 percent. 17. The risks associated with the project were evaluated by applying sensitivity analysis to the ERR, as shown in Table 5. The project is most sensitive to declines in sales revenues. A 10 percent drop in average prices of the project output reduces the ERR to 17 percent. The economic evaluation also indicates the project is sensitive to increases in the operating costs, but not in an way that could seriously jeopardize its feasibility. The "worst case" scenario, whereby the project would suffer simultaneously from a decrease of 10 percent in sales, an increase of 10 percent in the operating costs and an increase of 20 percent in the capital costs would still generate an ERR at the acceptable level of 12 percent. Selling prices would have to decline by 24 percent in financial terms and by 30 percent in economic terms to make the Net Present Value turn negative (at a discount rate of 11 percent).

Table 5: SENSITIVITY TEST ON INTERNAL RATES OF RETURN

Financial Economic Rate of Return Rate of Return

1. Base case 17% 20% 2. Sale Revenue: down I0% 14% 17% 3. Operating Costs: up 10% 15% 18% 4. Capital Costs increase: up 20% 14% 17% 5. "Worst case" scenario (2+3+4) 10% 12%

18. CISCG is well advanced in the process of getting government approval for the construction of a new wire rod mill within its premises. If approval is obtained for this -145- ANNEX3.11 facility, the existing wire rod mill, built in the mid-i 980s but of antiquated technology, will not be renovated and will be closed instead. Production will be shifted from the heavy structurals and medium sections mills to the new wire rod mill, and the final product mix of CISCG will be the following: 600,000 tons of plates, 460,000 tons of heavy and medium structurals, and 300,000 tons of wire rods per year. CISCG was not able to provide guarantees that this new mill will be constructed and ready for operation by the time the new EAF is commissioned, but an alternative case prepared by the company and reviewed by the Bank (available in the project files) shows that the new wire rod mill would enhance further the profitability of the project. Financial Condition of CISCG 19. CISCG's balance sheet has been affected by the austerity program established by the Central Government in June 1993. Credit has been severely tightened resulting in what is translated as a "triangular debt crisis." Customers cannot pay invoices for steel shipped and steel suppliers have experienced significant increases in accounts receivable. The offsetting liability is an increase in short-termndebt to finance working capital and accounts payable. Benefiting to the fact that the company belongs to the small group of companies having been selected as models for enterprise reform, CISCG has reacted quickly to this situation. When it became a limited liability company, CISCG was authorized to convert into equity of a significant portion of its debt, and this allowed the company to keep its total debt within reasonable levels. 20. CISCG's profitability will improve under the project, with net income expected to increase from about $3 million in 1994 to about $29 million when the project reaches full production by 2002. As a percentage of sales should improve from 2 to 5 percent over the same period. Total indebtedness will improve further with the project, as total debt- to-equity is expected to decline from 73:27 in 1994, to 42:58 in 2002. However, during 1996-98 costs will rise faster than revenues and debt repayments will increase substantially (a total of $126 million will be due local banks over the three-year period), and CISCG will be unable to meet the debt service covenant under the project without a new debt-equity conversion allowing the company to achieve the required debt service coverage of 1.2. 21. During negotiations, assurances were received that unless otherwise agreed, by December 31, 1999, CM will provide additional equity to CISCG of Y 140 million, and that CISCG will: (a) maintain a debt/equity ratio of 70:30 or better; (b) maintain a debt service coverage ratio of at least 1.2; and (c) furnish to the Bank for review, by October 31 of each year from 1996 to the third year after the startup of operations of the new facility, its rolling five-year financial plans, including production, marketing and investment plans, in the forn of projected financial statements. Such plans will be supported by: (i) a detailed analysis of production cost trends; (ii) analysis of operational and financial budget variances for the current fiscal year; and (iii) financing arrangements for the investments proposed over the five-year period. In addition, CISCG will submit to the Bank its annual accounts audited by independent accountants within six months of the end of the fiscal year. -146 - ANNEX 3.11

Figure 1: CISCG-FINANCIAL AND ECONOMICRATE OF RETURN CALCULATION ($ million)

1/ FINANCIAL RATE OF RETURN

Pro jection 1996 1997 1998 1999 2000 2001 to 2013 Capital Costs Total Project Cost 0.0 -53.4 -23.3 -10.3 0.0 0.0 Increase in Incremental Working Capital 0.0 0.0 0.0 -7.7 -4.1 0.0 Operating Costs & Revenues Incremental Revenue 0.0 0.0 0.0 99.6 119.4 119.4 Incremental Operating Cost 0.0 0.0 0.0 84.5 99.0 99.0 Incremental Gross Operating Income 0.0 0.0 0.0 15.1 20.4 20.4 INCREMENTAL NET BENEFIT 0.0 -53.4 -23.3 -2.9 16.3 20.4

FINANCIAL RATE OF RETURN: 17.3 |NET PRESENT VALUE: 23.5 (discount rate:) 11%

2/ ECONOMIC RATE OF RETURN

Proj ection 1996 1997 1998 1999 2000 2001 Capital Costs Total Project Cost 0.0 -50.7 -20.6 -10.3 0.0 0.0 Increase in Incremental Working Capital 0.0 0.0 0.0 -7.7 -4.1 0.0 Operating Costs & Revenues Total Incremental Revenue 0.0 0.0 0.0 119.0 139.9 139.9 Incremental Operating Cost 0.0 0.0 0.0 99.2 116.6 117.1 Incremental Gross Operating Income 0.0 0.0 0.0 19.8 23.3 22.8 INCREMENTAL NET BENEFIT 0.0 -50.7 -20.6 1.8 23.3 22.8

ECONOMIC RATE OF RETURN: 20.4 NET PRESENT VALUE: 31.6 (discount rate:) 11% -147- ANNEX3.12

ANNEX 3.12: AGRICULTURAL BANK OF CHINA (ABC)

1. The Institution. The Agricultural Bank of China was established in August 1951. In subsequent years, it was repeatedly merged into PBC, thereby losing its independent identity.' In 1979, however, it was reestablished and, until recent years operated as one of the four "Specialized Banks." With the establishment of policy banks in 1994, ABC accelerated its efforts to transform into a "commercial bank" responsible for its own profits and losses. At present, it is categorized as one of the State Commercial Banks.2 At the end of 1994, ABC had a total staff of 552,709 deployed in 63,816 branches, subbranches, operating offices, savings offices, etc. Both openings and closings of branch locations remain subject to approval by PBC. As of December 31, 1994, ABC had assets of Y 1,253 billion and capital of Y 44.8 billion. Although ABC remains subject to the official government credit plan, increasingly its growth is influenced by its capacity to mobilize deposits and incrementally to comply with ratio guidelines detailed in the Commercial Banking Law. In contrast to the other Specialized Banks, ABC benefited by is supervision of the Rural Credit Cooperatives from which it was able to gather rural deposits. It was also the beneficiary in China of early liberalization in agricultural prices and introduction of market-based incentives that fostered dramatic growth in agricultural production. China's reforms started in the countryside in 1979 when the "production-related contract responsibility system" was introduced and helped increase agricultural production and stimulated a rise in farmers' income. As a result of reforms in the agricultural economy, production in township and village enterprises (which were the first to adopt market economy principles) outpaced production increases in other sectors. On the other hand, ABC continues to carry burdens of (a) a network that was established to mirror administrative jurisdictions rather than to meet market needs or to generate profits, (b) the overhang of loans to loss-making agricultural communes and sales/marketing organizations that now no longer exist, and (c) operating policies and procedures designed to assure adherence to state directives rather than to assure efficient and profitable operation.

After being established in 1951, it was merged in 1952, reestablished in 1955, merged in 1957, reestablishedin 1963,merged in 1965,and finally reestablishedin 1979.

2 Chinese banks are currently designatedas (a) Policy Banks (The State DevelopmentBank of China, The Agricultural Development Bank of China, The Export Import Bank of China); (b) State CommercialBanks (The Industrialand CommercialBank of China, The AgriculturalBank of China, Bank of China,and The People's ConstructionBank of China);and (c) NationwideCommercial Banks (Bank of Communications,CITIC IndustrialBank, EverbrightBank of China, Hua Xia Bank), and Other Commercial Banks (including China Investment Bank, China Merchant's Bank, Guangdong DevelopmentBank, ShanghaiPudong Development Bank, and four others). -148 - ANNEX 3.12

2. Documents Provided. To facilitate appraisal, ABC has provided (a) audited financial statements for December 31, 1994, and (b) a copy of the State Council Decree that reestablished the bank in 1979. In addition, the Chongqing branch provided extensive details on its financial position and performance and responded to extensive data requests from the World Bank..

3. Ownership and Governance. The bank is 100 percent government-owned. As with other formerly "Specialized Banks," ABC has not historically had a Board of Directors or a Supervisory Board. Until the effort in the last several years to separate policy and commercial lending, the Specialized Banks functioned under the direct guidance of PBC and implicitly were not themselves responsible for their profits or losses or their own asset quality. With the establishment of Policy Banks in 1994 and the enactment of the Commercial Banking Law in 1995, the State Commercial Banks are now strengthening their internal management and acting with increased autonomy as they become responsible for their own financial position and performance. Unlike banks categorized as "Nationwide Commercial Banks," the "State Commercial Banks" are not yet subject to the full set of requirements outlined in the Commercial Banking Law. Nevertheless, ABC is preparing itself in a number of ways for an unspecified future day on which it will be required to comply with the Commercial Banking Law. In this regard, the bank is drafting a Charter, monitoring its asset and liability ratios, more carefully evaluating creditworthiness of borrowers, and evaluating the possible advantages of alternative organizational structures, e.g., a Board of Directors, Board of Supervisors, etc.

4. Financial Position and Performance. Financial statements are audited and signed by "China Certified Accountants." Due to changes in Chinese accounting standards in the last several years (e.g., introduction of accrual accounting) and to major differences in presentation, it is difficult to draw comparisons between December 31, 1994 data and that presented in earlier years. Assets at December 31, 1994 consisted primarily of (a) loans (47.5 percent), (b) "trust" or "agency" assets (24.2 percent), and (c) amounts due from PBC (12.1 percent). The single largest source of funding is provided by deposits (28.2 percent). Deposits consist primarily of individual savings accounts (46.4 percent), followed by "agricultural deposits" from RCCs (25.4 percent) and by Industrial and Commercial firms (28.2 percent). Although capital adequacy calculations on a risk-weighted basis have not yet been released, a simple capital/assets calculation reveals a low level of capitalization, i.e., 3.6 percent. Profitability (Y 526 million) is low at 0.04 percent of assets.

5. Transformation to a Commercial Bank. In November 1992, the Third Plenum of the Fourteenth Congress of the Communist Party and the State Council mapped out a strategy of financial sector reform. In its "Decision Concerning Financial Sector Reform," the State Council stated "after separating policy-oriented business, existing state-owned specialized banks shall transform as soon as possible into state-owned commercial banks and operate as modem commercial banks." As a result of these decisions, the Agricultural Development Bank of China (ADBC) was formerly -149 - ANNEX 3.12 established on November 18, 1994. Thirty percent of the assets and part of the personnel of ABC went to ADBC. Because ADBC's offices will only go down to the provincial level (in 1995), ABC signed an agreement with ADBC under which ABC acts as the agent for ADBC for business beneath the provincial level. The business taken over by ADBC includes "policy-oriented" activities previously conducted by ABC, e.g., directed purchasing of agricultural products, poverty alleviation and other directed programs. In these selected areas, ADBC assumed both the existing stock and the mandate for the future flow of policy lending.

6. Freed of much of the burden associated with its previous role, ABC has moved rapidly to fashion its new role in a market economy and to improve its own operational capabilities. Certain items continue to remain outside its own domain for decision- making, e.g., continued macro control under credit targets established by the government, administratively established interest rates, personnel policies that are not autonomously selected, etc. Nevertheless, ABC is making impressive strides in selecting a viable target market, in identifying and managing risk, and in improving its own policies and procedures. Its program for reform includes the following key points:

(a) Customer Focus. ABC has placed an increased focus on the customer as the basis of its marketing efforts. ABC is acting to preserve its strength in the rural areas while at the same time moving aggressively to serve selected customer segments in the growing and profitable urban area.

(b) Structural Adjustments. ABC management recognizes that the existing branch network is inefficient and that it was established to mirror administrative levels within the government and not to serve market needs. Efforts are now under way to improve the network by opening new offices in attractive (economically vibrant and growing) areas while closing, merging, or downsizing offices which cannot be justified based on existing or prospective financial performance.

(c) Focus Branches on Operational Activities. Provincial and even subprovincial branches have in the past focused more on management and conveying government directives than they have on providing financial services. An effort is now under way to move staff from administrative roles into operational responsibilities.

(d) Liability Structure. ABC (similar to other Specialized Banks) has historically relied on PBC for funding. Today, ABC is increasing its efforts to mobilize deposits, to increase deposit types, to optimize service quality in order to retain deposits, and to expand services so that it can act as an agent in various fee-generating activities. The goal of these efforts is to improve the liability mix and, thereby, to lower the bank's cost of funds. -150 - ANNEX 3.12

(e) Asset Management. Historically, the Specialized Banks acted more as a conduit of funds in a planned economy than as independent parties allocating credit based on a borrower's capacity to repay. Today, ABC is acting to improve its loan assessment capabilities and is attempting to readjust its loan structure to lower its risk and to improve its profitability.

(f) Establish Branch Targets for Performance. Clear targets are today being established for branches and subbranches in areas such as deposits, lending, and fee generation.

(g) Manage Personnel. ABC management recognizes that its staff levels are too high and that efficiency levels are too low. Action has been taken to limit expansion of staff, to improve staff quality, and to go to the market to obtain certain needed technical skills.

7. ABC and The World Bank. In the past, the World Bank has provided four lines of credit to ABC as a financial intermediary in four separate Rural Credit projects. In each of these projects, modest amounts of funding have also been provided to improve ABC's operational capabilities; in each project, ABC's performance has been quite acceptable. At present, however, ABC and the World Bank are processing a fifth loan- the primary purpose of which will be to assist ABC in transforming into a viable commercial bank. In preparation for this fifth loan, Anderson Consulting has been engaged and is currently conducting studies in two pilot branches. Anderson's work will focus on (a) assessing the financial position, performance and controls at the branch level, (b) conducting a strategic analysis of market conditions, and (c) assisting the branch in drafting a business plan.

8. Based on the work currently being performed by Anderson Consulting, ABC will adjust its own business strategies and act to remedy defects identified in the course of the Anderson diagnostics. A recent World Bank mission worked with ABC management to determine how a proposed $45 million in technical assistance under the proposed fifth loan to ABC could best be used. Areas identified by the mission and discussed with ABC management focus on: (a) improving planning functions, (b) improving the legal and organizational structure of the bank, (c) improving financial policies and procedures, (d) improving human resource development policies and introducing more effective training, and (e) enhancing information technology.

9. Credit Approval Process. As part of its efforts to improve loan quality, ABC has recently separated loan appraisal and loan approval functions. In addition, the bank has articulated seven specific principles for credit management (e.g., provide support to profitable and creditworthy borrowers and deny funds to those that are unprofitable or that fail to service their obligations, extend funds based on the banks own asset/liability position and based on the bank's own need for liquidity, etc.). In identifying customers, ABC focuses largely on nonstate sectors but does not deny funds based on ownership; rather, the bank's focus is on profitability and safety in its lending decisions. -151- ANNEX 3.12

10. Compliance with the Commercial Banking Law and with Prudential Regulations. Despite efforts to improve its own position, ABC carries a very heavy historical burden. Capital to assets is low (3.6 percent on a nonrisk-adjusted basis) and levels of past due loans are high.3 At present, the terms of the Commercial Banking Law do not require ABC to satisfy the capital adequacy, loan to deposit, asset quality or other standards specified by the Law or by PBC. Rather, the formerly specialized banks and PBC are now working together to determine over what period the banks will be required incrementally to achieve full compliance with the new Law. In this regard, ABC is working both with the authorities and with the World Bank to prepare itself for future compliance.

11. The Chongqing Branch. The Chongqing branch has provided detailed financial information, including projections for 1995-99. Typical of other banks in Chongqing, ABC has historically been dependent on PBC for supplemental funding. PBC support has more recently been replaced by increased deposit mobilization and by Head Office support. At December 31, 1994, the branch's loan-to-deposit ratio (although coming down) was still in excess of 100 percent. As a result, the branch will need the support of the Head Office in providing adequate levels of counterpart funds in the CIPCRP.

12. Expectations for Line of Credit Usage. The Chongqing branch of ABC anticipates using $20 million under the CIPCRP.

13. Conclusion. ABC has historically been one of the pillars of the financial system in China and has been the main conduit of government support to the rural sector. Increasingly, the bank is challenged to define a new target market and to create operating procedures suitable for its autonomous role in a market economy. Efforts to date to change have been impressive. ABC is working both with the authorities and with the World Bank to define a time-bound program under which it will transform itself from a "Specialized Bank" operating in a centrally planned economy into a sound commercial bank responsible for its own decisions and for its asset quality, its profits, and its losses in a market economy.

3 A survey of its branchesin 1994 showedthat "past due" loans were 12 percent(versus the guideline in the more recently published PBC guidance of 8 percent or less), and "stale" loans were 9 percent (versus PBC guidanceof 5 percent or less). The numbers,however, are somewhat misleadinggiven that MOF/PBCdefinitions of "past due" include only those principalpayments that are (a) past due more than six months (yu qi) and less than three years, and (b) those that are past due more than three years (cui shou) includingthose that are "dead" (dai zhang). A number of ABC's branches follow a more conservativepractice of categorizingloans as past due immediatelyafter the maturity date has passed rather than waiting six months. The inconsistencyin how definitions are applied often make comparisonsfrom one bank to another (or even one branch to another)quite misleading. -152- ANNEX3.12

ATTACHMENT 1

AGRICULTURAL BANK OF CHINA-FINANCIAL STATEMENTS 1a (Y'000,000) BALANCE SHEET

Years Ended 12/31 1990 1991 1992 1993 1994

ASSETS Cash 6,600 7,100 8,756 13,436 15,180 PBC Total 72,800 85,900 85,860 117,161 151,170 Interbank Total 16,800 27,800 57,807 39,494 63,972 Net Loans 377,200 457,500 546,377 652,636 595,309 Foreign Exchange 10,700 17,200 27,340 37,961 0 Bonds 4,600 6,100 7,983 10,304 Net Investments 29,678 Net Fixed Assets 6,700 7,200 7,826 20,990 25,036 Net Other Receivables Other Assets 44,900 56,200 90,765 126,368 66,819 TrustlAgency "Assets" 13,500 21,500 34,950 37,946 305,889 TOTALASSETS 553,900 686,500 867,664 1,056,296 1,253,053 LIABILITIES Total Deposits 264,000 331,900 413,094 518,383 604,983 Interbank Liabilities 27,600 30,100 45,738 31,862 74,272 DuetoPBC 143,900 175,000 208,112 278,513 84,748 Bonds+Financial Depo 1,000 1,500 1,860 968 9,131 Foreign Exchange 8,700 14,700 23,432 35,757 0 Other Liabilities 65,000 79,600 106,219 121,207 415,454 Trust/Agency "Liabilities" 13,700 21,700 35,167 38,150 19,665 TOTAL LIABILITIES 523,900 654,500 833,622 1,024,840 1,208,253 Total Capital 30,000 32,000 34,042 31,456 44,800

TOTAL FOOTINGS 553,900 686,500 867,664 1,056,296 1,253,053 CapitalChart Paid in Capital 42,690 Capital Surplus 1,410 Reserve/Retained 174 Undistributed Profit 526 Other 0 Total Capital 30,000 32,000 34,042 31,456 44,800

La Explanation of the blanks in the following financial statements: since 1993 substantial improvement has been made in the quality of financial information and accounting methods. As a result, especially in earlier years, financial data are often either not available or are not comparable to those presented in later years. - 153 - ANNEX 3.12

INCOME STATEMENT

Year Ending 12/31 1990 1991 1992 1993 1994

Interest Income 75,500 93,013 149,145 122,919 Interest Expense -66,700 -78,889 -128,791 -95,977 Other Operating Income 785 892 816

Operating Expenses -5,496 -8,077 -14,781 Commissions/Services -1,117 -1,360 -2,361 BusinessTaxes -2,040 -2,957 -3,899 Other Expenditures -4,327 -6,113 -6,520

Profit on Operations 1,929 2,739 197 Nonoperating income 174 Investment Income 1,435 Loss adjustment previous year -93 Nonoperating expenses -544 Income tax -643

"Net Profit" 1,600 1,929 2,739 526

Chart of Deposit Types

Industrial & Commercial 57,500 71,400 97,511 116,587 170,602 Agricultural Deposits 85,300 102,800 118,340 149,154 153,711 Savings Deposits 121,200 157,700 197,243 252,642 280,670 Other Deposits

Total Deposits 264,000 331,900 413,094 518,383 604,983

Chart of Loan Types

Bills, Remittance, OD Short Term Loans 511,380 Long Term Loans 67,205 Loans+ Inv Exp <1 yr 15,361 Loans to Finance Co 4,161 Working Capital 313,500 378,300 448,199 536,305 Fixed Assets 7,600 10,000 13,918 16,902 Agricultural Loans 56,300 69,500 84,693 99,661 Total Loans 377,400 457,800 546,810 652,868 598,107 Less: Loss Reserves 200 300 433 232 2,798

Net Loans 377,200 457,500 546,377 652,636 595,309 -154 - ANNEX 3.12

Year Ending 12/31 1990 1991 1992 1993 1994

Chart of PBC Assets

Required Reserve 34,000 43,100 51,805 63,721 86,207 Deposits in PBC 38,800 42,800 34,055 53,440 57,036 Financial Deposit/PBC 7,927

Total PBC Assets 72,800 85,900 85,860 117,161 151,170

Chart of Interbank Activities

Balances with Banks 16,800 27,800 57,807 39,494 Due From Banks 26,645 Call Loans to Banks 37,327

Total Assets 16,800 27,800 57,807 39,494 63,972

Due to Banks 27,600 30,100 45,738 31,862 54,584 Call Loans/Banks 19,688

Total Liabilities 27,600 30,100 45,738 31,862 74,272

Chart of Trust and Agency Activities

Trust Activities 5,500 12,100 25,044 27,038 Agency Activities 8,000 9,400 9,906 10,908 Agency as ADBC 287,893 Agency as PBC 17,996

Total "Assets" 13,500 21,500 34,950 37,946 305,889

Trust Activities 5,500 12,100 25,044 27,038 Agency Activities 8,200 9,600 10,123 11,112 Agency as ADBC Agency as PBC 19,665

Total "Liabilities" 13,700 21,700 35,167 38,150 19,665 -155 - ANNEX 3.12

Year Ending 12/31 1990 1991 1992 1993 1994

Provisioning for Bad Loans La

Reserve for dead loans (year start) 200 300 433 232 Provision for dead loans Dead loans written off Reserve for dead loans (year end) 300 433 232 2,798

Total Loans 377,400 457,800 546,810 652,868 598,107

Balance Sheet Ratios

CAPITAL ADEQUACY Total Capital 32,000 34,042 31,456 44,800 Risk Weighted Assets Ratio LOAN/DEPOSITS Total Loans 457,500 546,377 652,636 595,309 Total Deposits 331,900 413,094 518,383 604,983 Ratio 137.8% 132.3% 125.9% 98.4%

La Approximately 16 percent (Y 95 billion) and 3 percent (Y 17.8 billion) of ABC's loans at 12/31/94 were characterized as "past due" (i.e., overdue more than six months) or "stale" (i.e., overdue more than three years). "Bad" loans are a subset of "stale" loans; the amount at 12/31/94 is not available. -156 - ANNEX 3.12

ATTACHMENT 2

ABC CHONGQING BRANCH-FINANCIAL STATEMENTS (Y'000) BALANCE SHEET

Years Ended 12/31 1990 1991 1992 1993 1994 ASSETS Cash 22,910 28,550 29,220 59,160 68,030 Reserves at PBC 281,260 352,940 427,100 547,490 704,200 Deposits at PBC 60,110 71,310 103,430 145,830 304,700 Interbank Deposits 2,296,660 2,914,190 4,117,910 12,466,010 9,205,360 Net Loans 2,984,180 3,766,390 4,575,400 5,570,730 5,924,540 Foreign Exchange 45,180 58,120 174,870 228,730 412,700 Securities 38,020 51,020 65,020 80,390 21,330 Net Investments 203,920 Net Fixed Assets 49,750 82,920 84,990 257,890 313,380 NetOtherReceivables 17,940 20,820 33,120 7,850 47,580 Other Assets 4,100 3,220 29,680 82,910 198,240 Trust Activities 51,420 53,900 61,490 1,650 16,140 Agency (PBC) 440 850 870 830 3,810 Total Assets 5,851,970 7,404,230 9,703,100 19,449,470 17,423,930 LIABILITIES Total Deposits 1,936,150 2,554,910 3,087,720 4,136,920 5,620,390 Interbank Deposits 2,496,800 3,043,420 4,423,920 12,868,420 10,501,210 Borrowed from PBC 797,070 1,076,420 1,388,920 1,498,920 17,300 Bonds Issued 9,800 14,210 12,000 2,920 80 Foreign Exchange 45,180 58,120 174,870 228,730 412,700 Other Liabilities 133,780 128,840 94,720 124,250 463,570 Trust & Investment 4,510 6,800 5,670 1,710 Agency 119,240 142,830 153,840 181,790 6,040 TOTAL LIABILITIES 5,542,530 7,025,550 9,341,660 19,043,660 17,021,290 Total Capital 309,440 378,680 361,440 405,810 402,640 TOTAL FOOTINGS 5,851,970 7,404,230 9,703,100 19,449,470 17,423,930 Capital Chart Paid in Capital 280,040 318,510 331,690 375,270 375,440 Capital Surplus 460 -280 2,540 21,770 12,060 Retained Earnings 930 Undistributed Profit 28,940 59,890 27,210 8,770 14,210 Other Total Capital 309,440 378,680 361,440 405,810 402,640 -157 - ANNEX 3.12

INCOME STATEMENT

Year Ending 12/31 1990 1991 1992 1993 1994

Interest Income 382,000 432,180 615,690 977,490 1,233,880 Interest Expense 297,110 310,310 474,480 820,510 948,060 Net Interest Income 84,890 121,870 141,210 156,980 285,820 Provision for Loss 1,260 4,130 19,240 28,210 36,430 Other Operating Income 2,730 8,200 12,130 20,320 6,130 Revenue after Provision 86,360 125,940 134,100 149,090 255,520

Admin & Operating Expenses 44,230 50,200 76,980 108,390 195,650

Nonoperating Revenue 1,260 1,590 790 1,810 1,360 Nonoperating Expenses 970 2,510 11,190 3,380 11,110 EBT 42,420 74,820 46,720 39,130 50,120

Business Taxes 13,480 14,930 19,510 30,360 35,910

"Net Profit" 28,940 59,890 27,210 8,770 14,210

(Profit taxes are consolidated at HO level)

Detailed Chart of Administrative and Other Operating Expenses

Salaries 7,490 8,170 10,740 15,240 44,050 Travel, Conferences, 4,910 10,580 15,640 23,280 35,290 Utilities, Trans & Misc Rent 2,480 3,520 5,240 8,860 6,050 Computer Communic. 1,480 1,190 2,660 4,760 5,340 Fee Expenses 1,740 4,080 8,420 5,240 18,410 Security 1,260 4,130 19,240 28,210 36,240 Depreciation 3,780 4,520 6,270 11,190 28,550 All Other Exp 21,090 14,010 8,770 11,610 21,720

Total 44,230 50,200 76,980 108,390 195,650 -158- ANNEX3.12

Year Ending 12/31 1990 1991 1992 1993 1994 Capital Changes Total Capital/Start 280,500 309,440 378,680 361,440 405,810 Year's Net Profit 28,940 59,890 27,210 8,770 14,210 New Capital Issued Dividends Adjustments(+ or-) 9,350 -44,450 35,600 -17,380 Total Capital/End 309,440 378,680 361,440 405,810 402,640

Chart of Loan Types Bills, Remittance,OD Working Capital 1,541,350 1,772,040 2,287,800 2,850,370 2,768,150 Fixed Assets 243,320 274,450 324,530 438,510 664,000 AgriculturalLoans 1,199,510 1,720,590 1,963,080 2,290,360 2,500,850 Total Loans 2,984,180 3,767,080 4,575,410 5,579,240 5,933,000 Less: Loss Reserves 690 10 8,510 8,460 Net Loans 2,984,180 3,766,390 4,575,400 5,570,730 5,924,540 Chart of Loan Maturities Maturing in < I year 2,660,500 3,427,230 3,871,140 4,095,100 3,936,050 Maturing in 1-3 years 185,250 119,120 464,600 1,126,920 1,383,860 Maturing in > 3 years 138,430 220,730 239,670 357,220 613,090 Total Loans 2,984,180 3,767,080 4,575,410 5,579,240 5,933,000 Chart of Deposit Maturities Demand Deposits 1,243,950 1,615,970 1,934,560 2,021,430 2,954,570 Maturing in < I year 48,950 72,320 70,470 345,350 274,030 Maturing in 1-3 years 643,250 865,100 1,072,820 1,743,090 2,140,890 Maturing in > 3 years - 1,520 9,870 27,050 250,900 Total Deposits 1,936,150 2,554,910 3,087,720 4,136,920 5,620,390 Chart of DepositTypes Ind. & Commercial 191,300 258,020 337,580 417,830 1,191,350 AgriculturalDeposits 232,240 309,850 371,770 382,660 164,870 SavingsDeposits 920,990 1,192,810 1,485,660 2,016,050 2,841,980 Other Deposits 591,620 794,230 892,710 1,320,380 1,422,190 Total Deposits 1,936,150 2,554,910 3,087,720 4,136,920 5,620,390 -159- ANNEX3.12

YearEnding 12/31 1990 1991 1992 1993 1994

PBC Loan Categories PBC Req. Loan Category: Past due (< 3 years) 119,120 464,600 1,126,920 1,383,870 Stale (>3 years) 635,570 571,310 479,490 632,760 Bad Loans 85,160 68,360 77,730 180,300 All Other Loans 2,927,230 3,471,140 3,895,100 3,736,070 Total Loans 3,767,080 4,575,410 5,579,240 5,933,000 % Past Due S8% 3.2% 10.2% 20.2% 23.3% % Stale •5% 16.9% 12.5% 8.6% 10.7% % Bad •2% 2.3% 1.5% 1.4% 3.0%

Provisioning for Bad Loans

Opening Reserve 2,020 0 690 10 8,510 Provision for bad loans 1,260 4,130 19,240 28,210 36,430 Bad loans written off 3,280 3,440 19,920 19,710 36,480 Closing Reserve 0 690 10 8,510 8,460 Total Loans 2,984,180 3,767,080 4,575,410 5,579,240 5,933,000

Balance Sheet Ratios

CAPITAL ADEQUACY Total Capital 378,680 361,440 405,810 402,640 Risk Weighted Assets 3,637,850 4,269,400 5,176,830 4,637,150 Ratio 10.4% 8.5% 7.8% 8.7% LOAN/DEPOSITS Total Loans 3,767,080 4,575,410 5,579,240 5,933,000 Total Deposits 2,554,910 3,087,720 4,136,920 5,620,390 Ratio 147.4% 148.2% 134.9% 105.6% LIQUIDITY Current Assets 1,772,040 2,287,800 2,850,370 2,768,150 Current Liabilities 1,688,290 2,005,030 2,366,780 3,228,600 Ratio 105.0% 114.1% 120.4% 85.7% LARGE EXPOSURE Loans to I Borrower 26,050 33,660 41,700 133,200 Total Capital 378,680 361,440 405,810 402,640 Ratio 6.9% 9.3% 10.3% 33.1% -160 - ANNEX 3.12

Year Ending 12/31 1990 1991 1992 1993 1994 Chart of Fixed Assets Fixed Assets at Cost 63,450 101,070 108,020 292,120 375,410 Accum. Depreciation 13,700 18,150 23,020 34,230 62,030 Net Fixed Assets 49,750 82,920 85,000 257,890 313,380 Chart of FX Assets and Liabilities Cash At PBC and Interbank 36,670 19,680 37,670 43,690 118,520 Loans 8,090 12,220 121,840 178,070 284,670 Trust and Agency Collections LCs and Guarantees Other 420 26,220 15,360 6,970 9,510 Total FX Assets 45,180 58,120 174,870 228,730 412,700 Deposits 19,540 30,240 43,730 36,840 104,510 Interbank 3,650 1,300 58,980 156,050 276,180 Bonds Issued Trust and Agency Collections/customers LCs & Gtee/customers Other 21,990 26,580 72,160 35,840 32,010 Total FX Liabilities 45,180 58,120 174,870 228,730 412,700 Chart of Receivables WC Exp Sundries 510 150 240 270 Foreclosed Assets 1,220 1,560 50 Equipment not received 6,370 3,930 Equipment not received 1,600 800 Other Receivables 17,430 11,480 26,590 7,530 47,580 Prov for Bad Accts

Net Receivables - 17,940 20,820 33,120 7,850 47,580 Chart of Other Assets Reserves 55,350 89,750 Rehabilitation Exp 51,340 Rep off start up exp 12,850 Other Receivables All Other Assets 4,100 3,220 29,680 27,560 44,300 Prov for Bad Aects Net Other Assets 4,100 3,220 29,680 82,910 198,240 -161- ANNEX 3.12

PROJECTED BALANCE SHEET

Years Ended 12/31 1995 1996 1997 1998 1999

ASSETS Cash 68,030 69,391 70,779 72,195 73,638 Reserves at PBC 913,310 958,978 1,006,927 1,057,273 1,110,137 Deposits at PBC 491,780 526,205 563,039 602,452 644,623 Interbank Deposits 9,609,360 9,801,547 9,997,578 10,197,529 10,401,480 Net Loans 7,109,670 8,176,121 9,402,539 10,812,919 12,434,857 Foreign Exchange 45,650 53,950 64,740 77,190 83,166 Securities Net Investments 225,250 236,513 249,338 260,755 273,793 Net Fixed Assets 329,040 345,490 362,750 380,900 399,930 Net Other Receivables 63,720 64,994 66,294 67,620 68,972 Other Assets 198,050 202,011 206,051 210,172 214,376 Trust Activities Agency Activities 3,810 4,001 4,201 4,411 4,632 Other 7,830 7,987 8,146 8,309 8,475 Total Assets 19,065,500 20,447,188 22,002,382 23,751,725 25,718,079 LIABILITIES Total Deposits 7,025,480 7,376,754 7,745,592 8,132,871 8,539,515 Interbank Deposits 11,097,620 11,130,900 11,098,120 10,968,390 10,700,200 Borrowed from PBC 17,300 18,165 19,073 20,027 21,028 Bonds Issued 80 84 88 92 97 Foreign Exchange 45,650 53,950 64,740 77,190 83,166 Other Liabilities 465,680 1,434,553 2,577,670 3,987,923 5,736,705 Trust & Investment Agency 6,040 6,342 6,659 6,792 6,928 TOTAL LIABILITIES 18,657,850 20,020,748 21,511,942 23,193,285 25,087,639 Total Capital 407,650 426,440 489,440 558,440 630,440 TOTAL FOOTINGS 19,065,500 20,447,188 22,001,382 23,751,725 25,718,079 Projected Capital Paid in Capital 375,440 375,440 375,440 375,440 375,440 Capital Surplus 18,000 25,000 36,000 48,000 65,000 Retained Earnings Undistributed Profit 14,210 26,000 38,000 55,000 70,000 Other 40,000 80,000 120,000 Total Capital 407,650 426,440 489,440 558,440 630,440 -162 - ANNEX 3.12

PROJECTED INCOME STATEMENT

Year Ending 12/31/ 1995 1996 1997 1998 1999

Interest Income 1,447,200 1,591,920 1,754,900 1,936,220 2,128,840 Interest Expense 1,176,400 1,284,670 1,416,430 1,544,730 1,683,190 Net Interest Income 270,800 307,250 338,470 391,490 445,650 Less: Provision for Loss 290 320 350 400 440 Other Operating Income 30,800 33,880 37,260 40,980 45,070 =Revision after Provisions 301,310 340,810 375,380 432,070 490,280 Admin & Operating Expenses 248,040 271,840 290,120 325,130 363,140 Nonoperating Revenue 4,230 4,650 5,110 5,620 6,180 Nonoperating Expenses 790 870 950 1,040 1,150 =EBT 56,710 72,750 89,420 111,520 132,170 All Taxes 42,500 46,750 51,420 56,520 62,170

Net Profit 14,210 26,000 38,000 55,000 70,000

Projected Admin & Other Op Costs

Salaries 45,760 50,330 55,360 60,890 66,980 Travel, Conferences, Utilities, Trans &Misc 38,810 42,690 46,950 51,640 56,800 Rent 10,660 15,720 17,290 19,010 20,910 Computer Communic. 15,870 19,870 22,950 20,240 27,760 Fee Expenses 20,250 22,300 24,530 26,980 29,670 Security 2,620 2,880 3,160 3,470 3,820 Depreciation 31,400 34,540 37,990 41,780 45,950 AllOther Expenses 82,670 83,510 81,890 101,120 111,250

Total 248,040 271,840 290,120 325,130 363,140 -163 - ANNEX 3.12

Past Due Loan and Interest Chart (as of 12131/94)

A B C D E F G(=E+F) # of Loan Interest "P' "I" Total "P'+"I" Loans Amount Accrued Past Due Past Due Past Due

Loans with "P" or "I" overdue:

1-90Days 7,905 80,306 80,306 6,263 86,569 91-180Days 15,810 160,612 160,612 12,142 172,754 181-365Days 23,715 245,918 245,918 1,917 247,835 1-3 years 19,763 203,265 203,265 1,598 204,863 >3 years 11,857 122,959 122,959 41,989 164,948

Subtotal 79,050 813,060 813,060 63,909 876,969

Loans without Overdues:

In Grace Period In RepaymentPeriod

Subtotal 993,639 5,119,940

Total Loans 1,072,689 5,933,000

Note: Chinese Banks capture ONLY the principal and interest PAYMENTSpast due. Their internal systems generally do not allow them to capture the actual total amountof principal and interest which is associatedwith a past due paymentand which, therefore,is impairedand at risk. -164 - ANNEX 3.12

SECTORAL CONCENTRATION OF BORROWERS (as of 12/31/94)

Sectoral Distribution # of Loans Loan Amount % of Total

Loans for Industry 112,892 2,052,300 34.6 Loans for Commerce 87,721 2,273,250 38.3 Loans for Agriculture 781,954 498,200 8.4 Loans for Construction Loans for Transportation Loans for Energy All Other Loans 90,122 1,109,250 18.7 TOTAL LOANS 1,072,689 5,933,000 100.0

OWNERSHIP OF BORROWERS (as of 12/31/94)

Ownership Category # of Loans Loan Amount % of Total

STATE-OWNED: SOEs (Central Government) 15 127,000 2.1% Local Government 409,161 3,533,446 59.6% NONSTATE-OWNED: Foreign Owned 0 0 Joint Venture 25 380,804 6.4% Private Individuals

Private Companies - 127,143 286,060 4.8% Collective Ownership 536,345 1,321,050 22.3% ALL OTHER LOANS 284,640 TOTAL LOANS 1,072,689 5,933,000 100.0% -165- ANNEX3.13

ANNEX 3.13: CHINA MERCHANTS BANK (CMB)

1. The Institution. The China Merchants Bank' was established in April 1987 and, as of the end of 1994, operated 6 branches2 in addition to the Head Office, 11 subbranches, and over 70 operations and representative offices (including one in Hong Kong). Locations are concentrated in rapidly growing markets and have been selected not based on administrative jurisdictions but rather on market demand, sound development principles, and approval of PBC. As of December 31, 1994, CMB had assets of Y 44.7 billion and capital of Y 3.7 billion. Staffing at the end of 1994 totaled in excess of 3,100. CMB is outside of the official government credit plan; its growth is controlled exclusively by asset/liability ratios specified in the Commercial Banking Law, by regulations of PBC and by the bank's own assessment of profit potential and risk inherent in expansion. 2. Documents Provided. To facilitate appraisal, CMB has provided (a) audited financial statements3 for December 31, 1994, (b) its Banking License (issued by PBC), (c) its Legal Person License (issued by the Industrial and Commercial Administration Bureau), and (d) its Foreign Exchange License (issued by the State Foreign Exchange Administration Bureau), and (e) responses to a data request from the World Bank. 3. Ownership. At inception in 1987, CMB was fully owned by the Hong Kong Merchants Bureau Shekou Industrial Finance Company Group, which was in turn fully owned by the Ministry of Communications. In 1987, Hong Kong Merchants Group capitalized the bank with initial equity of Y 100 million. In 1989, new share capital was issued (Y 400 million) to seven new shareholders. In 1994, the number of shareholders rose to 98 by virtue of a new 1.8 billion share offering. At present, the sectoral distribution of shareholders is: transportation (70.4 percent), manufacturing (6.5 percent), finance (5.5 percent), commerce and trade (0.81 percent) and others (16.9 percent). The top 22 shareholders control 85.3 percent of the stock, and the largest 2 owners4 hold

Chinesebanks are currentlydesignated as (a) PolicyBanks (The StateDevelopment Bank of China, The AgriculturalDevelopment Bank of China, The Export Import Bank of China); (b) State CommercialBanks (The Industrial and CommercialBank of China,The AgriculturalBank of China, Bankof China,and The People's Construction Bank of China);and (c) NationwideCommercial Banks (Bankof Communications,CITIC Industrial Bank, Everbright Bank of China,Hua Xia Bank),and Other CommercialBanks (includingChina InvestmentBank, China Merchant'sBank, Guangdong DevelopmentBank, Shanghai Pudong Development Bank, and four others).

2 HeadOffice in Shenzhenplus separatebranches in Shenyang,Beijing, Wuhan, Shanghai, Chengdu, andGuangzhou.

3 Financialstatements are "audited"by Zhonghua(Shekou) Certified Public Accountants.

4 Hong KongMerchants Bureau Shipping Limited Liability Company and China OverseasShipping Group. -166 - ANNEX 3.13

27.8 percent and 13.0 percent, respectively. Of the 22 largest shareholders, 8 are limited liability companies, 3 are investment companies, and the majority of the remainder are provincial-level transportation bureaus, transportation groups or companies. Through ownership of shareholders, the Hong Kong Merchants Group (wholly owned by the Ministry of Transportation) controls 32.1 percent of the stock. Through ownership of the Hong Kong Merchants Group and of other shareholders, the Ministry of Transportation controls 69.2 percent of the stock of the bank. Seventy-five percent of capital is denominated in renminbi, with the remainder in foreign currencies. 4. Governance and Management. The highest ownership control over the CMB is exercised by the Shareholders' Meeting. Both a Board of Directors and a Board of Supervisors report to the Shareholders. An Executive Committee (or President's Committee) reports directly to the Board of Directors and has a dotted line reporting channel to the Board of Supervisors. 5. Financial Position and Performance and Loan Composition. Assets5 consist primarily of loans (47.3 percent), due from banks (13 percent), due from PBC (11.6 percent), deferred assets (7.4 percent), and investments (2.4 percent). Loans are predominantly to SOEs (40.9 percent); the second largest borrower concentration by ownership is in joint ventures (17.8 percent). The largest sectoral concentrations of loans are: manufacturing6 (30.4 percent), basic industries7 (23.5 percent), trade' (20.6 percent), and raw materials9 production (15.4 percent). Less than 15 percent of loans are made with tenures beyond one year. Fifty percent of loans are made in the Shenzhen economic zone. Domestic loans constitute 86.3 percent of loans. Loans are denominated in both local currency and foreign currencies, 52.7 percent and 47.3 percent, respectively. The largest borrower exposure constitutes 6.6 percent of capital (versus PBC limit of 15 percent) and the largest 10 borrowers constitute an exposure of 44.9 percent of capital (versus PBC restriction of 50 percent). The major source of funding comes from deposits, giving CMB a relatively healthy 82.6 percent loan-to-deposit ratio. Mandated activities also constitute a significant part of assets (12.8 percent) and are fully financed by mandated deposits. Profitability is high at 2.8 percent return on the average of December 31, 1993 and December 31, 1994 assets. 6. Asset Quality. Past due, stale, and dead loans are low by Chinese banking standards at 2.8 percent, 0.07 percent and 0.02 percent, respectively (versus PBC guidelines of 8 percent, 5 percent, and 2 percent).

Unlessotherwise noted, financial data describedis that of 12/31/94since details on 12/31/95are not yet available.

6 Includingtextiles, cars, equipment, etc.

7 Includingenergy, communications, transportation, etc. 8 Includingboth wholesale and retail. 9 Includingoil, iron and steel, etc. -167 - ANNEX 3.13

7. Operating Controls and the Credit Approval Process. In 1994, PBC directed CMB to take the -lead in the financial sector by fully relying on asset liability ratios to control the banks sound growth. As a result, CMB constituted an Asset Liability Committee and has been tracking compliance with each of 10 ratios promulgated by PBC. Key in the banks efforts to control risk and enhance profitability is its focus on asset quality. Its four major principles for approving loans are: (a) prospective borrowers must conform to the bank's credit policies and must demonstrate by projections the ability to repay the proposed loan, (b) the loan must be used for a purpose which will support favorable development of the sector and the borrower's technological improvement, (c) all loans advanced must be covered by an excess of collateral and/or by guarantees from one or more guarantors, and (d) the increase in the bank's loans must leave the bank in compliance with all regulations of PBC. Specific prohibitions exist for loans (a) to loss-making enterprises, (b) to enterprises that have past due loans, and (c) enterprises with low efficiency or limited repayment abilities. 8. At December 31, 1994, of 223 of the 2,078 staff members in CMB were assigned to Credit Departments. To assure compliance with these requirements, lending authority is delegated to seven levels within the bank: (a) Subbranch Manager, (b) Manager of a Branch Credit Department, (c) Manager of a Branch, (d) Branch Credit Committee, (e) Manager of the Head Office Credit Department, (f) Head Office Vice President responsible for Credit, and (g) Head Office Credit Committee and the President's Council. 9. Compliance with the Commercial Banking Law and with Prudential Regulations. CMB appears to be well capitalized, profitable, and liquid. It monitors its compliance with all PBC requirements. Although historically well above prudent loan- to-deposit ratios, it has recently brought this ratio down to more acceptable levels. 10. The Chongqing Branch. The Chongqing operation is now in the startup phase with actual opening of the branch scheduled for early 1996. Current plans are for a staffing of approximately 30 individuals. Capital allocation is yet to be determined. Virtually all of the loans processed under the project will require Head Office approval. 11. Expectations for Line of Credit Usage. The China Merchants Bank anticipates using approximately $20 million. 12. Objectives for the Year 2000. Current CMB plans envision the bank growing to assets of Y 200 billion, profits of Y 4 billion, and staff of 10,000 by the year 2000. The branch network would then include 32 domestic branches and 4 foreign operations (branch or representative offices). 13. Conclusion. CMB continues to grow rapidly but is supporting its asset growth with acceptable levels of profitability and with new equity issues. It has taken a lead in the financial sector by pioneering asset and liability management, by establishing a modem management and governance structure, and by focusing on profitable and rapidly growing markets. Its entry into the Chongqing market should foster competition and improve the quality of financial services available to Chongqing enterprises. -168- ANNEX3.13

ATTACHMENT 1

CHINA MERCHANTS BANK-FINANCIAL STATEMENTS 1a (Y'O00) BALANCE SHEET Years Ended 12/31 1990 1991 1992 1993 1994 ASSETS Cash 7,378 13,092 29,222 194,300 362,960 Reservesat PBC 52,343 167,317 286,236 539,813 1,447,940 Deposits at PBC 79,416 406,868 368,850 911,927 3,725,190 Interbank Deposits 334,950 713,469 1,012,548 1,254,460 5,814,580 Net Loans 2,066,444 2,981,385 4,829,192 7,924,330 21,159,470 Securities ST Securities/Invest 28,400 28,886 87,804 215,160 1,055,290 LT Investments 39,847 569,500 832,560 Net Fixed Assets 20,642 25,253 39,334 103,250 732,480 Net Other Receivables 20,576 39,040 45,747 238,210 563,650 Deferred & Other 75,834 191,243 620,664 490,900 3,308,940 Trust Activities Mandated Activities 1,386,512 2,117,923 3,052,466 3,381,080 5,728,750 TOTALASSETS 4,072,495 6,684,476 10,411,910 15,822,930 44,731,810 LIABILITIES Total Deposits 1,247,462 2,628,162 4,773,357 9,554,800 25,628,830 Interbank Deposits 385,687 563,019 509,392 174,470 2,698,340 Borrowed from PBC 215,000 80,000 220,000 300,000 665,800 Remittance 5,742 36,717 32,344 84,010 251,700 Misc A/P 124,464 129,331 185,178 457,770 796,810 OtherLiabilities 184,584 356,882 886,025 470,490 4,819,060 Mandated Deposits 1,416,520 2,337,519 3,071,666 3,566,480 6,203,730 TOTALLIABILITIES 3,579,459 6,131,630 9,677,962 14,608,020 41,064,270 Total Capital 493,036 552,846 733,948 1,214,910 3,667,540 TOTALFOOTINGS 4,072,495 6,684,476 10,411,910 15,822,930 44,731,810 Capital Chart Paid in Capital 400,000 400,000 500,000 500,000 1,122,730 Capital Surplus 69,726 121,809 189,201 338,060 1,711,700 Retained Earnings 21,859 27,294 42,070 UndistributedProfit 1,451 3,743 2,677 376,850 833,110 Other Total Capital 493,036 552,846 733,948 1,214,910 3,667,540 la Explanation of the blanks in the following financial statements: since 1993 substantial improvementhas been made in the quality of financial informationand accountingmethods. As a result, especially in earlier years, financial data are often either not availableor are not comparableto those presentedin later years. -169 - ANNEX 3.13

Income Statement

Year Ending 12/31/ 1990 1991 1992 1993 1994

Interest Income 190,964 234,416 289,636 588,719 1,619,471 Interest Expense 55,123 84,706 113,011 236,388 793,612 Net Interest Inc 135,841 149,710 176,625 352,331 825,859 Provision for Loss 8,477 2,290 21,168 30,426 46,496 Other Operating Income 41,566 71,077 154,465 257,442 688,281

Revenue after Provision 168,930 218,497 309,922 579,347 1,467,644

Admin & Operating Expenses 96,899 116,076 132,419 104,761 513,575 Nonoperating Revenue 9,110 535 3,415 23,286 97,971 Nonoperating Expenses 8,436 1,021 1,451 31,672 2,685 EBT 72,705 101,935 179,467 466,200 1,049,355

All Taxes 17,605 23,025 38,632 89,350 216,240

Net Profit 55,100 78,910 140,835 376,850 833,115

Chart of Administrative and Other Operating Expenses

Rent & Utilities 1,101 1,761 3,590 7,510 51,783 Salaries 1,078 1,489 3,379 7,009 31,759 Exp for new outlets 727 1,921 4,037 10,464 20,456 Depreciation 538 1,186 3,628 9,529 26,571 Postage 446 1,180 1,982 4,376 10,167 Promotion & Advert. 293 1,249 2,597 5,881 5,881 Dividends 46,963 39,212 36,266 All Other Exp 45,753 68,078 76,940 59,992 366,958

Total 96,899 116,076 132,419 104,761 513,575

Chart of Tax Expenses

Bus Tax+Surch. 8,326 10,186 15,136 29,830 79,930 Profit Taxes 9,279 12,839 23,496 59,520 136,310 Other Taxes

Total Taxes 17,605 23,025 38,632 89,350 216,240 -170 - ANNEX 3.13

Year Ending 12/31/ 1990 1991 1992 1993 1994

Capital Chart Total Capital/Start 445,081 493,036 552,845 733,947 1,214,910 Year's Net Profit 55,101 78,910 140,834 376,846 833,105 New Capital Issued 1 101,098 622,727 Dividends -8,032 -12,048 -16,065 -210,201 Adjustments (+ or-) 886 -7,053 -44,765 314,318 996,798 Total Capital/End 493,036 552,845 733,947 1,214,910 3,667,540 Chart of Loan Types Bills, Remittance, OD 8,920 90,680 89,740 481,160 Working Capital 1,028,720 1,582,900 2,090,680 5,113,790 12,102,690 Fixed Assets 99,500 58,300 41,960 433,830 All Other Loans 937,130 1,250,044 2,610,479 1,910,900 9,118,200 Total Loans 2,074,270 2,981,924 4,832,859 7,939,680 21,220,890 Less: Loss Reserves 7,826 539 3,667 15,350 61,420 Net Loans 2,066,444 2,981,385 4,829,192 7,924,330 21,159,470 Chart of Loan Maturities Maturing in < 1 year 6,447,770 18,045,980 Maturing in 1-3 years 1,491,910 3,174,910 Maturing in > 3 years Total Loans 2,074,270 2,981,924 4,832,859 7,939,680 21,220,890 Chart of Deposit Maturities Demand Deposits 7,297,030 20,351,730 Maturing in < 1 year 1,347,710 4,491,230 Maturing in 1-3 years 910,060 785,870 Maturing in > 3 years Total Deposits 1,247,462 2,628,162 4,773,357 9,554,800 25,628,830 Chart of Deposit Types Ind. & Commercial 1,135,990 2,435,032 4,499,370 8,429,860 19,414,810 Agricultural Deposits Savings Deposits 54,970 117,490 268,570 462,030 1,568,660 Other Deposits 56,502 75,640 5,417 662,910 4,645,360 Total Deposits 1,247,462 2,628,162 4,773,357 9,554,800 25,628,830 -171- ANNEX 3.13

Year Ending 12/31/ 1990 1991 1992 1993 1994

PBC Loan Categories PBC Req. Loan Category: Past due (<3 years) 70,367 125,314 172,862 594,492 Stale (>3 years) 7,864 18,523 13,676 15,478 Bad Loans 3,152 5,031 4,089 4,122 All Other Loans 2,900,541 4,683,991 7,749,053 20,606,798

Total Loans 2,981,924 4,832,859 7,939,680 21,220,890

% Past Due 58% 2.36% 2.59% 2.18% 2.80% % Stale •5% 0.26% 0.38% 0.17% 0.07% % Bad •2% 0.11% 0.10% 0.05% 0.02%

Provisioning For Bad Loans

Reserve at start 5,791 7,826 539 3,667 15,350 Provision Expense 2,035 2,423 21,835 30,160 46,070 Bad loans written off -9,710 -18,707 -18,477 Reserve at End 7,826 539 3,667 15,350 61,420

Total Loans 2,074,270 2,981,924 4,832,859 7,939,680 21,220,890

Balance Sheet Ratios

CAPITAL ADEQUACY Total Capital 552,846 733,948 1,214,910 3,667,540 Risk Weighted Assets 7,624,300 17,272,660 Ratio 15.9% 21.2% LOAN/DEPOSITS Total Loans 2,981,385 4,829,192 7,924,330 21,159,470 Total Deposits 2,628,162 4,773,357 9,554,800 25,628,830 Ratio 113.4% 101.2% 82.9% 82.6% LIQUIDITY Current Assets 3,115,050 11,229,640 Current Liabilities 7,318,980 19,395,960 Ratio 42.6% 57.9% LARGE EXPOSURE Loans to I Borrower 88,073 133,640 241,880 Total Capital 552,846 733,948 1,214,910 3,667,540 Ratio 12.0% 11.0% 6.6% -172 - ANNEX 3.13

Year Ending 12/31/ 1990 1991 1992 1993 1994

Chart of Fixed Assets

Fixed Assets at Cost 21,859 27,293 44,746 120,773 778,830 Accum. Depreciation 1,218 2,041 5,412 17,523 46,350

Net Fixed Assets 20,641 25,252 39,334 103,250 732,480

Chart of FX Assets

Cash 3,547 4,066 12,066 60,240 73,684 At PBC and Interbank 98,715 394,764 278,803 555,042 880,078 Loans 901,790 1,316,180 2,437,140 3,570,830 9,939,860 Trust and Agency 13,940 222,636 54,980 237,610 490,080 Collections 555 1,186 563 30,640 182,773 LCs and Guarantees 66,062 139,886 446,150 408,614 520,969 Other 180,649 203,598 1,249,047 1,301,952 4,674,849

Total FX Assets 1,265,258 2,282,316 4,478,749 6,164,928 16,762,293

Chart of FX Liabilities

Deposits - 850,560 1,288,970 2,593,820 4,678,190 11,557,050 Interbank 48,431 63,789 97,935 46,400 94,368 Bonds Issued Trust and Agency 4,020 209,060 54,980 237,610 436,300 Collections/customers 555 1,186 563 30,640 182,773 LCs & Gtee/customers 66,062 139,886 446,150 408,614 520,969 Other 190,438 607,382 1,238,383 659,028 2,415,194

Total FX Liabilities 1,160,066 2,310,273 4,431,831 6,060,482 15,206,654

Chart of Deferred and Other Assets

Deferred Assets 913 2,866 5,617 12,607 144,968 GuaranteesIssued 7,883 12,788 3,228 7,692 819,470 CollectionsReceivable 555 1,187 596 30,639 182,773 Export LCs Receivable 862 9,378 15,330 28,444 364,530 All Other Assets 65,621 165,024 595,893 411,518 1,797,199 Prov for Bad Accts

Net Other Assets 75,834 191,243 620,664 490,900 3,308,940 -173 - ANNEX 3.13

Year Ending 12/31/ 1990 1991 1992 1993 1994

Chart of Investments

ST Investments Securities 27,600 13,886 87,804 215,160 726,000 Stocks 800 800 12,669 Self-Operated Securities 71,443 Customer's Securities 11 Other ST Investments 14,200 245,167

Subtotal 28,400 28,886 87,804 215,160 1,055,290

LT Investments Securities 355,880 502,262 Stocks 39,847 Other LT Investments 213,620 330,300

Subtotal 0 0 39,847 569,500 832,562

Reserve for Risk 690 2,760

Net Investments 28,400 28,886 127,651 783,970 1,885,092

Chart of Receivables

Accounts Receivable 6,798 14,290 16,506 38,777 200,942 Past Due Interest 13,778 24,750 29,241 Other Receivables 199,833 364,048

Subtotal 20,576 39,040 45,747 238,610 564,990

Prov for Bad Accts -400 -1,340

Net Receivables 20,576 39,040 45,747 238,210 563,650 -174- ANNEX3.13

OWNERSHIP OF BORROWERS (as of 12/31/94)

Ownership Category # of Loans Loan Amount % of Total

STATE-OWNED: SOEs (Central Government) Local Government

Subtotal 8,679,344 40.9

NONSTATE-OWNED: Foreign Owned Joint Venture

Subtotal 3,777,318 17.8

Private Individuals Private Companies

Subtotal 2,376,740 11.2

Collective Ownership 3,204,354 15.1

ALL OTHER LOANS/LEASES 3,183,134 15.0

TOTAL LOANS 21,220,890 100.0 -175- ANNEX3.14

ANNEX 3.14: EVERBRIGHT BANK OF CHINA (EBBC)

1. The Institution. The Everbright Bank of China (EBBC) was established in August 1992 upon approval of the State Council and the People's Bank of China. It is categorized as a Nationwide Commercial Bank' and, as of the end of 1995, had established eight branches2, two subbranches and a number of representative offices. Locations are selected not based on administrative jurisdictions but rather on economic regions, market demand, sound development principles and the approval of PBC. As of December 31, 1994, EBBC had assets of Y 20.2 billion and capital of Y 1.4 billion. By December 31, 1995, assets and capital had grown to Y 33.7 billion and Y 1.6 billion, respectively. Staffing at the end of 1995 totaled 1,594. EBBC's growth is controlled by asset/liability ratios specified in the Commercial Banking Law, by regulations of PBC and by the bank's own assessment of profit potential and risk inherent in expansion.

2. Documents Provided. To facilitate appraisal, EBBC has provided (a) audited financial statements3 for December 31, 1994, (b) preliminary unaudited financials for December 31, 1995, (c) its Banking License (issued by PBC), (d) its Foreign Exchange License (issued by the Industrial and Commercial Management Bureau), (d) authorization to open the Chongqing Branch (issued by PBC), (e) its Bank Charter, (f) a comprehensive manual of operating procedures including credit approval processes, and (g) responses to a data request from the World Bank. In addition, the Chongqing branch provided extensive details on its financial position and performance.

3. Ownership and Governance. The bank is owned 100 percent by the China Everbright Group Limited. The Group was founded in 1990 in Beijing as a comprehensive enterprise conglomerate. It is a 100 percent state-owned enterprise under an approval by the State Council and operates at a ministerial level (similar to the China International Trust and Investment Corporation-CITIC). The group was originally focused on real estate and investment activities but has increasingly turned to banking

Chinese banks are currently designatedas (a) Policy Banks (The State DevelopmentBank of China, The Agricultural Development Bank of China, The Export Import Bank of China); (b) State CommercialBanks (The Industrialand CommercialBank of China, The AgriculturalBank of China, Bank of China,and The People's ConstructionBank of China); and (c) NationwideCommercial Banks (Bank of Communications,CITIC Industrial Bank, Everbright Bank of China, Hua Xia Bank), and Other Commercial Banks (including China Investment Bank, China Merchant's Bank, Guangdong DevelopmentBank, ShanghaiPudong Development Bank, and four others).

2 Head Office, Heilongjiang,Shenzhen, Shanghai, Qingdao, Dalian, Changchun, and Chongqing.

3 Financialstatements are audited by Zhong Shi CertifiedPublic Accountants. Recognizingthe value in extemal audit, managementis consideringan attempt to become the first Chinese bank to have a real audit conductedand has alreadyinitiated conversations with severalintemational audit firms. - 176 - ANNEX 3.14 activities. In 1990, the group was registered in Beijing and, at present, carries a dual registration (Hong Kong and Beijing). Senior managers of the group and of the bank were previously with PBC. Ms. Qiu Qing (Chairman of the Board of both the group and the bank) has been associated with the financial system in China for over 40 years and served previously as an Executive Vice Governor of PBC. The bank's highest policy- making organ is its Board of Directors, to which the President Mr. Tang Gengyao reports. At present, a number of proposals are under consideration to strengthen the role of the Board of Directors, e.g., formation of an Executive Committee, an Asset Liability Committee, and a Credit Policy Committee.

4. Although current plans are for the group to remain 100 percent state-owned, the group is now considering options to diversify its ownership of the bank. In 1996, the group intends to issue new shares and, thereby, reduce its ownership to 51 percent. The sale of new stock would be designed to enhance both the bank's capital position and its governance and operational capabilities. Although in principle all potential owners are welcome, PBC will "qualify" potential shareholders and will, in all probability, disallow foreign ownership; both state and nonstate owners, however, will be considered. Also in 1996, the group and the bank will apply for PBC approval on how the bank will divest itself of nine securities firms (which at the end of 1994 accounted for 8.4 percent of the bank's assets).

5. Financial Position and Performance. Assets4 consist primarily of (a) Cash, Due from PBC, and Interbank Deposits (25 percent), (b) Loans (37 percent), and (c) Investments and various other assets (38 percent). Approximately 40 percent of assets (and of fumding sources) are denominated in foreign currencies. Of Y 6,590 million in loans at the end of 1994, 2.5 percent of loan principal payments were past due. Over 60 percent of loans had been approved for working capital purposes and were due to mature within one year. Thirty percent of loans were for industry and 24 percent were for commerce. Nearly 59 percent of assets are funded by deposits-of which 39 percent are "on demand." The maturity structure of time deposits is not disclosed. Profitability (by Chinese banking standards) was relatively healthy with profits (Y 260 million) after all taxes and loan-loss provisions producing a 1.28 percent return on assets.

6. Credit Approval Process. At year-end 1994, of 818 staff members in EBBC, 82 were assigned to Credit Departments, and 46 were assigned to credit-related departments (Planning and Treasury, Banking, Internal Audit). Within the Credit Department, a "Marketing Officer" is responsible for identifying acceptable customers, conducting an initial investigation, disbursing loans, maintaining customer contact, and following up for collection. The Marketing Officer is responsible for evaluating the prospective borrower's management, legitimacy, safety and profitability. Written analyses must address internal management, repayment capability, profitability, credit record, and

4 Unless otherwisenoted, financialdata describedis that of 12/31/94since details on 12/31/95are not yet available. -177 - ANNEX 3.14 vulnerability to external impacts. In addition, the Marketing Officer is responsible for confirming the existence and value of potential collateral. In conclusion, the Marketing officer's report must present the officer's own opinion on the applicant's repayment capability, and on the prospective benefits and inherent risks of the proposed loan.

7. The Marketing Officer's report is then sent to a separate "Approval Officer" who is responsible for evaluating and approving the credit analysis and then making an appropriate recommendation to the Credit Department General Manager. Approval limits at each level are based on both the tenure and the proposed amount for a loan. Approval limits are delegated as follows:

(a) For loans with a tenure of less than one year: (i) if the amount is less than Y 5 million, the General Manager of the Credit Department, (ii) between Y 5 and 30 million, the responsible Executive Vice President, (iii) in excess of Y 30 million, the Head Office Credit Committee;

(b) For loans of one to five years: (i) if less than Y 10 million, the responsible Executive Vice President, (ii) if greater than 10 million, the Head Office Credit Committee;

(c) For loans of five to ten years: (i) if less than Y 5 million, the responsible Executive Vice President, (ii) in excess of Y 5 million, the Head Office Credit Committee

8. Compliance with the Commercial Banking Law and Prudential Regulations. The bank's loan-to-deposit ratio is low (by Chinese standards) at 55.5 percent. Unlike most other banks in China, EBBC is now calculating its capital adequacy on a "risk- weighted" basis pursuant to the guidelines published by PBC. At year-end 1994 "capital adequacy" was calculated at 13.7 percent. As of December 31, 1994, EBBC was well within the Commercial Banking Law and PBC guidelines for past due loans, loans/deposits, capital adequacy, liquidity, and large exposures. As part of its participating in the project, EBBC will present periodic statements of compliance with the Commercial Banking Law and with the PBC prudential regulations.

9. The Chongqing Branch. During 1994 and 1995, EBBC maintained a Representative Office in Chongqing, which is being designated as a Branch in 1996. The Chongqing office was (during 1994 and 1995) fully engaged in gathering deposits and making loans. As of December 31, 1994, loans of Y 276 million were outstanding; these constituted 37 percent of assets of Y 742 million. The single largest concentration of ownership by borrower is local govenmment(48 percent), followed by SOEs (21 percent), and collective ownership (15 percent). Loans to deposits were slightly under 90 percent. In the Chongqing office at the end of 1994 were staff of 84, of which 8 were in the Credit Department and 4 were in Internal Audit.

10. Expectations for Line-of-Credit Usage. The Chongqing branch of the Everbright Bank of China anticipates using between $15 million and $20 million. -178- ANNEX3.14

11. Objectives for the Year 2000. According to current plans, EBBC targets for the year 2000 include assets of Y 120-150 billion, 10-15 branches, 15-20 subbranches, and 100-150 representative offices. In addition to its expressed financial targets for its future development, EBBC management has identified the following five priorities and principles for its future efforts:

(a) To focus on development within the context of a market economy, complying with the Commercial Banking Law, addressing the needs of customers, functioning efficiently, and relying on itself for its own profits and losses;

(b) To completely perfect its system of asset/liability management;

(c) To improve its system of risk prevention and management;

(d) To deepen its internal reforms and regulatory systems; and

(e) To strengthen its control and management over its branch system.

12. Conclusion. In the short period since its founding, EBBC has demonstrated impressive growth. The pace of its growth appears to be controlled, based on management's own assessment of its ability to manage the growth. The bank's focus on international management approaches, its compliance to date with prudential regulations issued by PBC, and its desire to improve its own operating policies and procedures suggest that it will provide borrowers and depositors with a viable alternative to older state-owned banks that may increasingly be burdened with inadequate control systems and high levels of nonperforming debt. The Chongqing Branch has been adequately staffed to process credit requests under the project; its entry into the Chongqing market will present a challenge to existing financial institutions and will encourage competition and improve customer service. -179 - ANNEX 3.14

ATTACHMENT 1

EVERBRIGHT BANK OF CHINA-FINANCIAL STATEMENTS La (Y'000) BALANCE SHEET

Years Ended 12/31 1992 1993 1994 1995

ASSETS Cash 164 9,965 13,428 55,123 Reserves at PBC 35,758 521,527 1,188,518 1,768,688 Deposits at PBC 91,867 1,527,689 1,347,141 1,595,806 Interbank Deposits 705,831 2,247,600 2,785,178 4,895,880 Net Loans 1,097,063 2,758,723 6,568,083 12,532,033 Foreign Exchange Securities 696,483 457,188 238,781 Net Investments - 13,000 169,592 927,041 1,565,414 Net Fixed Assets 10,562 56,930 166,361 Net Other Receivables 5,091 26,587 204,160 781,620 Other Assets 703,265 921,477 6,571,690 8,697,950 Trust Activities 11,541 973,516 Agency Activities 10,000 240,915 Leasing 25,966 99,196 97,908 173,939 TOTAL ASSETS 2,678,005 8,989,401 20,238,806 33,686,026 LLABILITIES Total Deposits 802,323 3,489,066 11,880,244 19,044,817 Interbank Deposits 518,662 3,122,860 1,526,581 2,762,936 Borrowed from PBC 190,000 445,000 1,352,000 560,000 Bonds Issued Foreign Exchange Other Liabilities 363,826 882,260 3,746,138 8,601,687 Trust Activities 25,741 1,046,927 Agency 84,654 268,923 72,648 TOTAL LIABILITIES 1,874,811 8,023,840 18,799,627 32,089,015 Total Capital 803,193 965,561 1,439,179 1,597,011 TOTAL FOOTINGS 2,678,004 8,989,401 20,238,806 33,686,026 CapitalChart Paid in Capital 775,000 775,000 775,000 775,000 Capital Reserves 13,873 16,283 148,738 142,230 Retained Earnings 13,672 192,632 298,084 Undistributed Profit 14,320 160,606 322,809 381,697 Other Total Capital 803,193 965,561 1,439,179 1,597,011 la Explanation of the blanks in the following financial statements: since 1993 substantial improvement has been made in the quality of financial information and accounting methods. As a result, especially in earlier years, financial data are often either not available or are not comparable to those presented in later years. -180 - ANNEX 3.14

INCOME STATEMENT Year Ending 12/31 1992 1993 1994 1995

Interest Income 28,515 330,999 1,186,927 2,024,988 Interest Expense 15,472 160,727 809,770 1,398,894 Net Interest Income 13,043 170,272 377,157 626,094 Provision for Loss 5,791 15,504 Other Operating Income 5,484 24,219 140,906 392,426 Revenue after Provision 18,527 188,700 502,559 1,018,520 Admin & Operating Expenses 3,221 17,996 126,786 486,119

Nonoperating Revenue 971 805 1,427 Nonoperating Expenses 489 8,936 1,592 EBT 15,306 171,186 367,642 532,236 All Taxes 986 10,581 107,904 229,853 Net Profit 14,320 160,605 259,738 302,383 Chart of Administrative and Other Operating Expenses Salaries 0 1,460 12,424 36,305 Rent and Utilities 1,515 4,149 27,861 62,886 Travel, Propaganda, Entertainment, 923 5,155 49,177 40,602 Post, etc. Computer Communic. 97 1,908 6,658 15,972 and Maintenance Depreciation 0 279 4,243 13,719 Fee Expenses 138 333 1,976 14,979 All Other Exp 547 4,712 24,447 225,130 Total 3,220 17,996 126,786 486,119 Chart of Tax Expenses Bus Tax+Surch. 986 10,581 44,832 80,918 Profit Taxes 63,072 148,935 Other Taxes Total Taxes 986 10,581 107,904 229,853 -181- ANNEX 3.14

Year Ending 12/31 1992 1993 1994 1995

Capital Chart Total Capital/Start 775,000 803,193 965,561 Profit B4 Income Tax 14,320 160,606 322,809 New Capital Issued Dividends Adjustments (+ or-) 13,873 1,762 150,810 Year-End Capital 803,193 965,561 1,439,180 Profit Taxes 63,072

After Tax Capital 803,193 965,561 1,376,108

Chart of Loan Types

Bills, Remittance, OD 70,780 Working Capital 503,870 1,772,230 4,046,950 Fixed Assets 385,780 425,530 566,390 All Other Loans 207,413 566,644 1,905,466 Total Loans 1,097,063 2,764,404 6,589,586 Less: Loss Reserves 5,681 21,503

Net Loans 1,097,063 2,758,723 6,568,083

Chart of Loan Maturities

Maturing in < 1 year 503,863 1,782,494 4,280,896 Maturing in 1-3 years 593,200 981,910 2,308,690 Maturing in > 3 years

Total Loans 1,097,063 2,764,404 6,589,586

Chart of Deposit Maturities

Demand Deposits 180,840 1,603,286 4,642,954 Maturing in < I year Maturing in 1-3 years Maturing in > 3 years Total Time Deposits 621,500 1,885,760 7,237,290

Total Deposits 802,340 3,489,046 11,880,244 -182 - ANNEX 3.14

Year Ending 12/31 1992 1993 1994 1995 Chart of Deposit Types Ind. & Commercial 504,580 3,175,050 11,033,520 Agricultural Deposits Savings Deposits 25,140 246,520 Other Deposits 297,760 288,876 600,204 Total Deposits 802,340 3,489,066 11,880,244 PBC Loan Categories PBC Req. Loan Category: Past due (< 3 years) 164,590 Stale (>3 years) Bad Loans All Other Loans 1,097,063 2,764,404 6,414,996 Total Loans 1,097,063 2,764,404 6,579,586 % Past Due •8% 0.0% 0.0% 2.5% % Stale <5% 0.0% 0.0% 0.0% % Bad <2% 0.0% 0.0% 0.0% Provisioning for Bad Loans Reserve for bad loans (year start) Provision for bad loans 5,681 15,822 Bad loans written off Reserve for bad loans (year end) Total Loans 1,097,063 2,764,404 6,589,586 Balance Sheet Ratios CAPITAL ADEQUACY Total Capital 803,193 965,561 1,439,179 Risk Weighted Assets 10,518,520 Ratio 13.7% LOAN/DEPOSITS Total Loans 1,097,063 2,758,723 6,568,083 12,532,033 Total Deposits 802,323 3,489,066 11,880,244 19,044,817 Ratio 136.7% 79.1% 55.3% 65.8% LIQUIDITY Current Assets 2,589,730 Current Liabilities 5,041,740 Ratio 51.4% LARGE EXPOSURE Loans to 1 Borrower 80,500 Total Capital 803,193 965,561 1,439,179 1,597,011 Ratio 5.6% -183- ANNEX3.14

Year Ending 12/31 1992 1993 1994 1995

Chart of Fixed Assets Fixed Assets at Cost 11,087 60,892 Accum. Depreciation 525 3,962 Net Fixed Assets 10,562 56,930 Chart of FX Assets in ($'000 on B/S @) 5.80 8.45 Cash 1,125 1,657 At PBC and Interbank 116,726 251,457 213,450 Loans 26,810 130,655 331,858 Trust and Agency 4,000 22,700 7,682 Collections 79 58 1,688 LCs and Guarantees 10,262 40,697 157,287 Other 53,555 9,158 221,579 Total FX Assets 211,432 455,850 935,201 Chart of FX Liabilities Deposits 29,293 198,282 437,441 Interbank 90,000 79,360 16,756 Bonds Issued Trust and Agency 4,000 22,700 7,682 Collections/customers 79 58 1,688 LCs & Gtee/customers 10,262 40,697 157,287 Other 16,157 56,933 172,384 Total FX Liabilities 149,791 398,030 793,238

Chart of Investments ST Gov't Bonds 299,000 Other ST Investments 123,468 119,909 LT Gov't Bonds Other LT Investments 13,000 46,214 508,364 Other Investments Prov for Bad Accts 90 232 Net Investments 13,000 169,592 927,041 -184 - ANNEX 3.14

Year Ending 12/31 1992 1993 1994 1995

Chart of Receivables Interest Receivable 4,875 13,495 74,664 AR under Frwrd Trans 52,184 Bills for collections 99 7,112 76,923

Other Receivables 116 6,000 513 Prov for Bad Accts 20 125 Net Receivables 5,090 26,587 204,159 Chart of Other Assets FX Settlement w/PBC 73,794 173,958 401,760 Interbank Loans 569,845 383,256 3,108,864 Internat'l Clearing 59,477 296,378 1,373,203 Sec/under Repo Agr. 1,227,938 Deferred Assets 12,921 53,402 Branch Reconciliation 39,264 176,227 All Other Assets 148 15,699 230,296 Prov for Bad Accts Net Other Assets 703,264 921,476 6,571,690 -185 - ANNEX 3.14

SECTORAL CONCENTRATIONS OF BORROWERS (as of 12/31/94)

Sectoral Distribution # of Loans Loan Amount % of Total

Loans for Industry 1,978,860 30.0 Loans for Commerce 1,605,730 24.4 Loans for Agriculture Loans for Construction Loans for Transportation Loans for Energy All Other Loans 3,004,996 45.6

TOTAL LOANS 6,589,586 100.0

Note. All other loans include foreign trade enterprises, foreign-funded enterprises, mortgage loans, buyer's and seller's credit, packing credit, and other trade financing facilities. -186- ANNEX3.14

ATTACHMENT 2

EBBC CHONGQING BRANCH-FINANCIAL STATEMENTS (Y'000)

BALANCE SHEET Years Ended 12/31 1994

ASSETS Cash 1,076 Reserves at PBC Deposits at PBC 32,851 Interbank Deposits 149,940 Net Loans 276,436 Foreign Exchange Securities 211,124 Net Investments Net Fixed Assets 316 Net Other Receivables 558 Other Assets 17,025 Trust Activities 35,900 Agency Activities Interbank Loans 16,898 TOTAL ASSETS 742,124 LIABILITIES Total Deposits 308,023 Interbank Deposits 14,178 Borrowed from PBC 43,000 Bonds Issued Foreign Exchange Other Liabilities 300,017 Trust Activities 75,600 Agency TOTAL LIABILITIES 740,818 Total Capital 1,306 TOTAL FOOTINGS 742,124 Detailed Chart of Capital Paid in Capital Capital Surplus Retained Earnings 1,306 VJndistributedProfit Other

Total Capital 1,306 -187 - ANNEX 3.14

INCOME STATEMENT

Year Ending 12/31 1994

Interest Income 15,133 Interest Expense 14,991 Net Interest Income 142 Provision for Loss Other Operating Income 8,930

Revenue after Provision 9,072

Admin & Operating Expenses 6,778 Nonoperating Revenue Nonoperating Expenses 63 EBT 2,231 All Taxes 926

Net Profit 1,305

Chart of Administrative and Other Operating Expenses

Rent & Utilities 2,892 Computer & Commun. 711 Fees 362 Supplies 259 Travel Expenses 186 Salaries 127 Personal Taxes 139 All Other Expenses 2,102

Total 6,778

Chart of Tax Expenses

Bus Tax+Surch. 926 Profit Taxes Other Taxes

Total Taxes 926 -188 - ANNEX 3.14

Year Ending 12/31 1994

Changes in Capital Total Capital/Start Year's Net Profit 1,306 New Capital Issued Dividends Adjustments (+ or -) Total Capital/End 1,306 Chart of Loan Types Bills, Remittance, OD 252 Working Capital 275,184 Fixed Assets All Other Loans 1,000 Total Loans 276,436 Less: Loss Reserves Net Loans 276,436 Chart of Loan Maturities Maturing in < 1 year 276,436 Maturing in 1-3 years Maturing in > 3 years Total Loans 276,436 Chart of Deposit Maturities Demand Deposits 142,051 Maturing in < 1 year 154,699 Maturing in 1-3 years 11,273 Maturing in > 3 years Total Deposits 308,023

Chart of Deposit Types Ind. & Commercial 279,200 Agricultural Deposits 14,203 Savings Deposits Other Deposits 14,620 Total Deposits 308,023 -189- ANNEX3.14

Year Ending 12/31 1994

PBC Loan Categories PBC Req. Loan Category: Past due (< 3 years) 6,800 Stale (>3 years) Bad Loans All Other Loans 269,636

Total Loans 276,436

% Past Due <8% 2.5% % Stale <5% 0.0% % Bad <2% 0.0%

Provisioning for Bad Loans Reserve for bad loans (year start) Provision for bad loans 0 Bad loans written off - 0 Reserve for bad loans (year end) Total Loans 276,436

Balance Sheet Ratios

CAPITAL ADEQUACY Total Capital 100,000 (HO allocation) Risk Weighted Assets 177,645 Ratio 56.3% LOAN/DEPOSITS Total Loans 276,436 Total Deposits 308,023 Ratio 89.7% LARGE EXPOSURE Loans to 1 Borrower 45,000 Total Capital 100,000 (HO allocation) Ratio 45.0% (temporary/startup) -190- ANNEX 3.14

Year Ending 12/31 1994

Chart of Fixed Assets

Fixed Assets at Cost 343 Accum. Depreciation 27

Net Fixed Assets 316

Chart of FX Assets

Cash 498 At PBC and Interbank 30,381 Loans 12,103 Trust and Agency Collections 14,266 LCs and Guarantees Other 3,210

Total FX Assets - 60,458

Chart of FX Liabilities

Deposits 34,317 Interbank Bonds Issued Trust and Agency Collections/customers LCs & Gtee/customers Other 26,141

Total FX Liabilities 60,458 -191- ANNEX 3.14

OWNERSHIP OF BORROWERS (as of 12/31/94)

Ownership Category # of Loans Loan Amount % of Total

STATE-OWNED: SOEs (Central Government) 5 58,000 21.0% Local Government 23 132,100 47.8%

NONSTATE-OWNED: Foreign Owned Joint Venture 10 25,130 9.1% Private Individuals Private Companies 2 6,300 2.3% Collective Ownership 16 42,540 15.4%

ALL OTHER LOANS 13 12,366 4.5%

TOTAL LOANS 69 276,436 100.0% -192 - ANNEX 3.15

ANNEX 3.15: REDEPLOYING SURPLUS LABOR

Introduction

1. In the restructuring of Chongqing's enterprises, worker redundancies will result, which creates a potential economic and social problem for the Chongqing Municipality (CM). In order to help address this problem, measures were undertaken in February 1995, to assist the state-owned enterprises (SOEs) in redeploying their surplus workers, including provisions for job creation, retraining, job placement and early retirement. In addition, measures are being undertaken to expand the unemployment insurance system.

A. SURPLUS LABOR EMPLOYMENT AND TRAINING GUIDING CENTER

2. CM has decided to set up, under the Chongqing Industrial Pollution Control and Reform Project, a Surplus Labor Employment and Training Guiding Center (Center) to provide specialized assistance in redeploying surplus workers. The Center incorporates both job retraining and job placement and other employment assistance services that are tailored to the needs of surplus workers. The main goal of the Center is to support the SOE restructuring effort through the retraining and job placement of their surplus workers.

Overview of the Surplus Labor Employment and Training Guiding Center

3. The Center has three objectives:

(a) Providing redeployment assistance to surplus workers through the Center's job placement and training activities;

(b) Assisting SOEs in their own labor redeployment efforts through technical assistance and other support provided by the Center; and,

(c) Providing improved procedures, techniques, materials and other support to CM's employment exchanges and training centers in order to strengthen their ongoing activities.

4. The Center's multifaceted approach will greatly assist CM in addressing the surplus labor problems arising from its SOE restructuring effort and in strengthening its labor market institutions in providing employment assistance to the labor force in general. It is anticipated that the availability of improved training and employment assistance will help reduce worker resistance to SOE restructuring and lessen social pressures. Of the three objectives of the Center outlined above, some key aspects need to be stressed. -193 - ANNEX 3.15

5. First, in providing redeployment assistance directly to surplus workers, it is envisioned that the Center will concentrate on serving the "at risk" workers of the SOEs and the steel companies being restructured through the project. The unemployed from other enterprises, such as those expected by CM to go into bankruptcy each year, would also receive priority attention. Similarly, the assistance provided to SOEs will concentrate on those SOEs participating in the line of credit. The Center would provide assistance and technical support to the SOEs in improving their own retraining and skill upgrading efforts through the sharing of course materials and training techniques, including short-term modular skill upgrading courses as well as assisting in the upgrading of SOE instructional staff. In addition, the Center would provide assistance and technical support to the SOEs in carrying out their work force redeployment efforts including worker testing, skill assessment and job counseling, job outplacement and referral to training.

6. Second, the Center would (a) develop expanded and improved job skill training courses focused on emerging job opportunities in the changing economy, particularly in the service sector, utilize updated training equipment and improved facilities; (b) design specialized courses and training techniques suited for adult workers; (c) develop improved course curriculum and materials as well as training aids, including audiovisual materials; and (d) provide for instructor training and upgrading to teach the new skills and use of the improved training methodologies. Computerization of the strengthened procedures, as well as the Center's administrative and management systems, would also be provided.

7. Third, in the Center the basic labor exchange functions of worker testing, assessment and counseling would be expanded and improved; job development and job vacancy procedures would be strengthened; job matching and placement activities would be improved as would the procedures for referral to job training and post-training placement. A labor market information system would also be developed that would provide increased job opportunity information and the identification of job skill content to assist in the design of training courses and to ensure that the skills provided meet labor market and enterprise requirements.

8. Last, the strengthened employment assistance techniques and procedures developed by the Center will have general systemic application and help improve the functioning of the Chongqing labor market. Close links between the Center and the CM's other ongoing employment assistance and training efforts would be established so that the new techniques, procedures and other innovations would be made available to the Labor Bureau's Employment Management Service and Training Center Administration, and the Education Commission's vocational and technical training activities.

Specific Functions of the Center

9. Labor Market Information. Collecting employment information and building up a data base in order to develop specific job and training information for the general -194 - ANNEX 3.15 unemployed and SOE surplus workers, to be provided through information and counseling services. In addition, an annual plan for job training, job placement and other employment assistance to be provided for the CM labor market will be prepared.

10. Design of Training Courses. The development of training courses and training materials and aids, including audiovisual, which will meet the emerging skill demands of the labor market and be tailored to the needs of surplus workers.

11. Conduct Training Courses. Carry out a program of modular training and retraining courses for surplus workers using audiovisual and other training aids.

12. Skill Certification. Develop a skill testing capacity and certification program to ensure that the trainees achieve the level of proficiency required by the labor market.

13. Job Placement. Provide job matching and placement for surplus workers with priority for those who have successfully completed job retraining.

14. Testing and Counseling. Carry out job aptitude testing and counseling and other employment guidance for job placement and referral to skill training.

15. Staff Training. Develop and conduct a program of staff training, including the upgrading of training course instructors.

16. Guidance and Assistance. Provide guidance and assistance to the district and county-level Employment and Training Centers (ETCs) on teaching materials, methodology and training equipment. Also provide guidance on job matching and placement techniques and other employment assistance services to the labor exchanges.

Meeting Labor Market Demand

17. Key to the success of the Center in redeploying surplus workers is the development of good labor market information particularly the identification of occupations most in demand in order to guide job training efforts. The Labor Bureau, in determining the initial occupations to be trained for in the Center, focused on the service sector as this area has the greatest job growth. Consideration was also given to the modest skill and education levels of most of the redundant workers. Further, the intention is to maximize the number of unemployed to be trained by conducting medium length, but intensive courses that would enhance the Center's impact, and to ensure training opportunities for female job seekers as well as for males.

18. Based on the above strategy and job vacancy and skill demand information from the local ETCs, training is to be provided in four occupational areas: computer operator including computerized accounting; electrician; driver, including vehicle maintenance skills; cooks, and waiter/waitresses. -195- ANNEX3.15

19. A major focus will be on the computer occupations, which are in very high demand given the expanded use of computers in the new enterprises, particularly in the service sector. Also the expansion of road transport has created a demand for qualified drivers with vehicle maintenance skills. The rapid growth in new commercial and office buildings has also created a need for electricians with updated skills. The popularity of Sichuan's cuisine throughout China and the expansion of hotels and restaurants has generated a great demand for cooks as well as skilled waiters/ waitresses.

20. The Labor Bureau fully recognizes the need to have the Center's training continue to focus on the jobs and skill requirements most in demand. To achieve this, several actions are to be pursued. As part of the Center's employment services technical assistance effort, a more structured labor market information capacity, including the use of employer surveys, will be developed. Such labor market information and analysis will be used to develop an annual training plan for the Center. Further, the project's Restructuring Advisory Facility (RAF) will solicit as part of the enterprise's restructuring and feasibility plan information on the loan applicant's work force. Information such as anticipated redundancies, workers to be retrained and jobs to be created will be of great value to the Labor Bureau in working out cooperative efforts, especially in assisting the restructured enterprise in meeting its work force skill needs. Similarly, the environmental and pollution control components of the Project are expected to create needs for workers in this area, the Labor Bureau intends to work closely with the environmental authorities in helping to meet the new skills that will be required.

21. The Center, in the initial four occupations, is expected to train annually about 1,000 individuals, of whom one third will be in the computer area and another one third as drivers, with the remaining one third roughly equally divided among the other occupations.

Structure of the Center

22. The Center, which incorporates the staff and facilities of an existing labor exchange and employment training center, will have a supervisory structure that will oversee the development of the new activities and services and manage the day-to-day work of the training and employment service components.

23. In addition to the executive management function, there will be an Employment Information Office; Technical Ability Assessment Office; Training Service Office; Program Office; and, an Office of Administration. A total of 23 additional staff will be provided for these offices.

24. The Center will be managed directly by the Chongqing Labor Bureau and its development will be under the leadership of the Project Management Office (PMO) of the Planning Commission, which is overseeing the project. -196 - ANNEX 3.15

Center Facilities

25. The Center will be established at the present site of the Jiang Bei District Employment Training Center and Labor Exchange Office, which are adjacent to each other. Four additional floors will be built above the labor exchange office to create training facilities, classrooms and offices. Renovation of existing classrooms, dining facilities and trainee housing will also be undertaken. In addition, two floors of current space now occupied by another CM agency will be returned for Center use. The funds for the construction and renovation of the Center will be provided by CM.

Center Budget

26. The total Center costs to be financed by the project are $589,000, with $490,000 or 83 percent for equipment. The remaining $99,000 is for technical assistance expert services, other support and study tours. The construction and renovation costs, which will be provided by CM, are estimated to be Y 3.0 million. Also, CM will provide for such ongoing costs as the additional staff's salaries and the Center's operations (see Attachment 1)

B. UNEMPLOYMENTINSURANCE MANAGEMENT SYSTEM

27. Technical assistance financed under the project for the development of an unemployment insurance (UI) management system is the second part of the redeploying surplus labor. An unemployment insurance system is a key labor market mechanism in that it provides an income safety net for the unemployed. At present, only 10,400 persons receive unemployment benefits, but it is expected that the number of recipients will increase in the future.

28. The unemployment insurance system now covers 80 percent of the workers in SOEs and collectives and it is hoped to cover all workers including those in the nonstate sectors over the next few years. In addition to the 1 percent enterprise payroll tax, each employee also contributes 2 yuan per month to the UI fund.

29. The unemployment insurance system is administered through the 22 districts and counties in Chongqing. In each of the 22 local administrative areas, employers' and employees' UI contributions are collected and payments paid to the UI benefit recipients. The UI funds collected in the 22 local areas, however, are pooled to the CM Employment Bureau. CM-wide data bases need to be developed that would include the unemployment insurance premiums paid by employers; the contributions made by the employees; the UI benefits paid to the unemployed; a register of the UI recipients including their employment and other individual data; the local areas administrative expenses; training subsidies and other employment program expenses; as well as information on the enterprises job vacancies, hiring and the status of the individual's labor contract. Key management information from the local areas data bases, particularly the financial data, needs to be networked into a CM-wide data base. In addition to the operational and administrative utility of the needed unemployment insurance management system, much -197 - ANNEX 3.15 of the information in the data base would be useful in developing improved labor market information.

30. To assist the. Labor Bureau in the development of a strengthened and integrated unemployment insurance management system, the project provides for $40,000 for a foreign expert as well as PC and other equipment and support at the central CM Employment Bureau. For cost details see Attachment I-Summary of Bank-Financed Costs for Redeploying Surplus Labor.

31. It is anticipated that the Labor Bureau in the development of its activities under the project will consult with and draw upon related work to be carried out in Deyang, through the Bank's Labor Market Development Project. Much of the work in this project will be informative and helpful to key aspects of both the Center and Unemployment Insurance Management System efforts. -198 - ANNEX 3.15

ATTACHMENT 1

SUMMARY OF BANK FINANCED COSTS FOR REDEPLOYING SURPLUS LABOR Cost ($) SurplusLabor EmploymentAnd TrainingGuiding Center Equipment 490,000 PCs and other trainingequipment and supportmaterial Other Support 23,000 Trainingstaff members,miscellaneous service and generalsupport needs InternationalTechnical Assistance Expert 45,000 One employmentservices expert for job matchingand placement,testing and counselingand developmentof labor market information. The consultant expert would be engaged for three months. The unit cost per consultant month is $15,000,which covers fee, internationaltravel, per diem and related cost. Local TrainingExperts 10,000 For courseand curriculumdevelopment and the preparationof training materials and aids Study Tours 22,000 Internationalstudy tours for three persons-Director of Center, Center Train- ing DepartmentDirector and EmploymentServices Manager-to observe establishedprograms and activitiesfor training and employmentof surplus workers. The studytour would be up to one month and wouldcost $7,000 each ($3,000 travel and $4,000per diem and related costs-$150 per/day X 26 days) SubtotalCenter Costs From WB Loan 590,000 UnemploymentInsurance Management System InternationalTechnical Assistance Expert 30,000 An internationalUI managementsystem expert for two months@ $15,000 unit cost as above Equipmentand Other Support 10,000 SufficientPC capacity with supportingequipment suitable for UI manage- ment system as well as specializedsoftware, handbooks/manuals, materials/ supplies and travel of staff to assess other China Ul systemmanagement activities SubtotalUT Management System Costs from WB Loan 40,000 Total WB CIPCRPLoan Cost for RedeployingSurplus Labor 630,000 Note: In addition,CM would be providingY 3.0 million for the constructionand renovationof the Center's facilities, includingconstruction a four-storyaddition for training facilities and offices, as well as upgradingtrainee housing,dining facilitiesand renovatingexisting classrooms. -199- ANNEX3.15

ATTACHMENT 2

TERMS OF REFERENCE FOR REDEPLOYING SURPLUS LABOR

Background

1. The People's Republic of China and the World Bank have developed a project for pollution control and industrial reform in Chongqing, China. Chongqing Municipality (CM) is located in Sichuan Province and Covers an area of 23,114 km2 and has a population of 15.1 million. Chongqing is the most important industrial city in southwest China and is a regional economic hub with a GDP of $6.2 billion in 1994.

2. The industrial sector In CM employs 1.98 million workers. Of the total industrial output value of $3.0 billion, that produced by state-owned enterprises (SOEs) accounts for approximately 76 percent of industrial output, with the balance produced by town and village enterprises (TVEs), collectives, joint ventures (JVs), limited-liability joint-stock companies (JSCs), private enterprises and combinations of these entities. There are 7,519 industrial enterprises in CM, of which 263 are large and medium sized, including 245 SOEs and 18 TVEs or other nonstate forms of ownership.

3. CM has been designated by the central government as one of the pilot cities for economic and industrial reform and as one of the 18 cities to undergo enterprise system reform. CM is also making major efforts at strengthening pollution control and environmental protection.

4. Given the World Bank's interest in industrial restructuring and its involvement in several other industrial reform projects in China, CM has requested the Bank's assistance in its reform and restructuring efforts. The Chongqing Industrial Pollution Control and Reform Project links industrial policy reform, restructuring of industrial enterprises, pollution control and strengthening of environmental regulatory policy.

5. In the restructuring of Chongqing's enterprises, substantial worker redundancies will result. It is estimated that overall there are potentially 300,000 surplus workers. Recently 14 enterprises have gone bankrupt, another 115 enterprises are on the verge of bankruptcy and 76 others have ceased production. These enterprises involve 52,000 employees.

6. To support industrial policy reforrn, the project includes the establishment of a Surplus Labor Employment and Training Guiding Center (SLETGC) to provide specialized assistance in redeploying surplus workers. The project also provides for the development of a strengthened management system to improve the administration and operation of the unemployment insurance program. - 200 - ANNEX 3.15

Expert Services to be Provided

7. The services of two international experts are required. One expert would provide assistance in the development by the SLETGC, to provide specialized employment service procedures and techniques for the job placement of surplus workers. The second expert would provide assistance in the development of an unemployment insurance management system.

8. Employment Service Expert to provide advice to the Center on basic labor market exchange functions such as worker testing, assessment and counseling; job development and job vacancy procedures, job matching and placement processes, as well as procedures for referral to skill training and post-training job placement. Also, advice would be provided on developing a labor market information program, particularly the development of job vacancy information and support to developing the Center's annual training plan. The advice would include assistance in the development of written precedes, forms, records, reports, operational tools and techniques; and, the development of an employment services manual.

9. The employment services expert should have at least 10 years' experience in managing employment service programs, as well as experience in providing international technical assistance with experience in China or conditions comparable to China desirable.

10. The assignment would be for up to three months and the consultant's contract should not exceed $45,000, which is to cover consultant fees, per diem and international travel to and from China.

11. Unemployment Insurance (UI) Management Expert to provide advice to the Employment Bureau on a computerized UI management system, including the development of an integrated data base for administering Ul activities in 22 local-level administrative areas within the Chongqing Municipality (CM). Included would be assistance in the development of data bases, which would include the premiums paid by employers; the contributions made by employees; the UI benefits paid to the unemployed; a register of the U! recipients including their employment and other individual data; the local area's administrative expenses, training subsidies and other employment program expenses; as well as information on the enterprises job vacancies, hiring and the status of the individual's labor contract. Key management information from the local areas data bases would be networked into a computerized CM-wide data base. The advice would include assistance in the development of a written procedures manual including forms, records, and management reports as well as guidance on computerization including input to equipment requirements and operating software.

12. The unemployment insurance management expert should have at least 10 years' experience in managing UI programs as well as experience in providing international technical assistance with experience in China or conditions comparable to China desirable. -201- ANNEX 3.15

13. The assistance would be for up to two months and the consultant's contract should not exceed $30,000, which is to cover consultant fees, per diem, and international travel to and from China.

14. The Labor Bureau will provide the above consultants with office space, translation and interpreter services and local transportation. - 202 - ANNEX 3.16

ANNEX 3.16: TECHNICAL ASSISTANCE FOR A STATE ASSET OPERATING COMPANY

1. Background. Chongqing Municipality (CM) has adopted an enterprise reform agenda to implement reforms initiated at the national level, taking advantage of Chongqing Municipality's (CM) status as a comprehensive experimental city under the "10,000-1,000-I00-10" reform program. CM's agenda, to be carried out in two phases, Phase 1 (1994-1996) and Phase 11(1997-1998), lists eight broad objectives:

(a) establishing a modem enterprise system, including a new system of state asset management;

(b) establishing an open and more competitive market system, including commodity, financial, real estate, securities and labor markets;

(c) transferring governmental functions from direct economic management to regulation and indirect macroeconomic management, while ceding economic and commercial activities to nongovernmental organizations and professionals;

(d) establishing a unified social security system;

(e) deepening rural economic reform through (i) decentralization of governmental functions, (ii) encouragement of nonstate forms of economic activity such as organizing town and village enterprises into cooperative- shareholding companies and other forms of independent, legal persons, and (iii) expanding individual contract rights on arable land;

(f) encouraging new investors, including foreigners, through Joint Ventures, BOT arrangements and management contracts, to participate in CM's economy, including its infrastructure, power, and communications sectors and expansion of technology zones;

(g) accelerating education and technology reform; and

(h) accelerating legal reform.

2. The Modern Enterprise System. The agenda for establishing a modem enterprise system in the Municipality over the next three years consists of five steps:

(a) defining and restoring property rights-a program for accounting reform, asset valuation, and enterprise restructuring. - 203 - ANNEX 3.16

(b) establishing a new state asset management system;

(c) organization of productive enterprises under the Company Law (1994), with shares of certain large and medium companies offered to the public and to staff, and the organization of town and village enterprises into cooperative shareholding companies with clearly defined property rights;

(d) the reduction of enterprises social burdens through splitting out of surplus labor and social assets and functions through various means; and

(e) encouraging proper rights transfers through several means.

The State Asset Management System in Chongqing

3. The State Asset Management Committee (SAMC). Chongqing's organization and reform agenda for state asset management follows the national pattern of a multitiered structure: a State Asset Management Committee (SAMC), a State Asset Management Bureau (SAMB) and State Asset Operating Companies (SAOC) or Group companies (GC). The framework for CM's state asset management policy is set out in CM Document 170, entitled "Opinions on State Asset Management System Reform Experiment," July 23, 1994. SAMC is headed by the Mayor and includes the heads of CM's main governmental departments and line bureaus. SAMC represents the owners' interests, sets policy and appoints the management of the next level. The district and county-level governments have set up identical structures.

4. The State Asset Management Bureau (SAMB). The policy decisions of SAMC are carried out by its executive arm, the State Asset Management Bureau, an independent department of CM. SAMB's broad mandate includes coordination of information between SAMC and the enterprises, setting indicators and incentive structures for SAOC performance, recommending management appointments and dismissals, iesolving disputes between various SAOCs or their constituent parts, monitoring state property rights transfers, and generally introducing systems to permit effective supervision of state asset performance.

5. The Supervisory Committees (SC). To implement Chapter 3 of the CM July 1994 "Opinions," SAMB intends to establish a Supervisory Committee for each major entity reporting directly to it (this would include the State Asset Operating Companies and the Group Companies}. According to the July 1994 Opinion, each SC is to have 15 members, at least 5 of whom have other duties. Each member serves a term of three years. Each SC is to act on behalf of SAMB to inspect the enterprises to ascertain their implementation of the performance indicators and other relevant laws, regulations and CM Documents. (SC, being constituted by SAMB, is not the Supervisory Board as required by the Company Law. The latter is intended to be a part of the internal structure of the corporation while the former is a separate control imposed by the owner from outside the corporate structure). - 204 - ANNEX 3.16

6. The State Asset Operating Companies (SAOC) and Group Companies (GC). According to CM 1994 "Opinions," SAOCs in CM are entities established under the Company Law entrusted with the management of state assets, with SAMB as founder on behalf of the state. SAOCs are to be organized through conversion of line bureaus into companies under the Company Law. (The bureaus to be converted are mostly manufacturing, tradables and services, but not health, infrastructure, grain, etc.) Generally, these SAOCs are intended to be organized as LLCs. They will not be operating companies but more closely resemble holding companies. A few, very large enterprises will be designated GCs and act as SAOCs being "entrusted" with the management of shares (if corporatized) or assets of smaller enterprises and companies. A few existing investment companies will also be "entrusted" with shares or assets of companies and enterprises.

7. Employees and management of SAOCs and GCs, including members of their Boards of Directors cannot be civil servants. Ways and means to structure and implement performance-based incentives for SAOC and GC management are currently under consideration by CM.

8. Two SAOCs currently exist as wholly state owned companies. They are Huamao State Asset Operating Company (commercial and service enterprises) and Huajin State Asset Operating Company (machine tools). Huajin differs significantly from Huamao. Unlike Huamao, which is diversified in its subsidiaries, activities and ownership, Huajin is the machine tool line bureau reformed into an SAOC.

9. Three GCs have been approved to act as SAOCs: China Silian Instrument Group, Huaxi Packing Group and the Chongqing Iron and Steel Company (Group) Limited. Two others, Quinling Auto Group and the Chongqing Special Steel Company (Group) Limited are in the process of approval.

An Innovative SAOC

10. To advance its reform efforts, CM has decided to create a new, model industrial SAOC that is innovative in its design, structure, operation and management. Specifically, CM intends to establish, with international and local expertise, a cross-sectoral SAOC [formed as a limited liability shareholding company (LLSC) per Chapter III of the Company Law] as a modem enterprise. This new SAOC would manage the state's assets in three or four different, but economically related industrial sectors. This would serve to intensify the formation of a "modem enterprise system," as articulated in the Decision of the Fourteenth CPC Third Plenum in November 1993, and the development of CM's capital market.

11. Objectives. The assistance being sought by CM is described in these Terms of Reference (TOR) would provide best international practice and advice as to corporate organizational functional and financial structures; methods for share (or portfolio) management; and investment and dividend policy. At the same time, the advice would be - 205 - ANNEX 3.16 based on Chinese national and CM particular reforms aimed at the establishment of a modem enterprise system.

12. Mode of Assistance. A team of three internationally experienced experts/ scholars drawn from an international firm (the Consultants) would provide training and advice based on theory and practice from international experience as well as other areas in China. Assistance would be provided in three stages: (a) on-site visit in CM (for two weeks) to disseminate international and other China practices and to collect information about the sectors/enterprises to be included in the model SAOC, including a seminar; (b) two weeks of consultant services (performed at their home base of operations) for preparation of a draft report, including recommendations for structuring and operating the pilot SAOC, to be sent to CM; and (c) return to CM (for two weeks) to finalize the report and assist in the implementation of its recommendations through a seminar. A modest amount of follow-on advice will be provided as may be requested by SAMB, the extent of such additional advice and remuneration for it, to be agreed in advance, subject to the budget limits set forth below.

13. In addition to the work of the international firm, local experts (individuals, not firms) drawn from a cross-section of the CM community, such as scholars, local auditors, and enterprise managers, would participate in the seminars and also provide advice and inputs into the design of the model SAOC. These local experts would be selected pursuant to separate Terms of Reference and contract terms. The Consultant team and the local experts would coordinate and cooperate to the fullest extent feasible.

14. Qualifications, Counterpart and Proposed Budget. The Consultant tearn would consist of three persons. The tean as a whole would have extensive experience in modem corporate organization, management consulting, management information systems and corporate finance. One would be senior, with acknowledged international expertise, while the other two would have at least 10 years' experience, including experience in China. Familiarity with the Chinese language would be helpful, while at least one team member should be fully experienced with China's enterprise reform policies and progress. The counterpart would be SAMB. A Project Monitoring Office has been established in Chongqing to facilitate the Project. The budget to implement these TOR for the international Consultant is not to exceed $75,000, inclusive all Consultants' fees, costs, and expenses, including travel and subsistence. There will be a separate, additional budget and contracts between CM and the local experts, not to exceed $25,000 equivalent. Finally, there will be a separate amount not to exceed $20,000 for foreign study tours by Chongqing's SAMB, under the supervision and coordination of the international consultant and local experts. These costs are to be financed under the project. -206 - ANNEX 3.17

ANNEX 3.17: PROJECT IMPLEMENTATION PLAN

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ANNEX 4.1: SCHEDULE OF DISBURSEMENTS

Bank/IDA Bank fiscal year Semester Cumulative Project Profileda 4$Smillion)_...... (K

1997 &b First 9.5 9.5 5.9 3.0 Second 16.5 26.0 15.3 10.0

1998 First 20.0 46.0 27.0 24.0 Second 22.0 68.0 39.8 36.0

1999 First 24.0 92.0 54.1 50.0 Second 22.5 114.5 64.4 60.0

2000 First 18.0 132.5 77.9 71.0 Second 15.0 147.5 86.8 84.0

2001 First 8.5 156.0 91.8 90.0 Second 6.5 162.5 95.6 94.0

2002 First 5.0 167.5 98.5 96.0 Second 2.5 170.0 100.0 100.0 la Disbursementprofile for China (compositefor urban and industrialsectors). Lb Includesinitial Special Accountdisbursement of $1Omillion. -214 - ANNEX 4.2

ANNEX 4.2: BANK SUPERVISION INPUT INTO KEY ACTIVITIES Approximate ExpectedSkill Staff inputs Dates Activity Requirements (Staff-Weeks) 10696 Missionto Initiate Implementation Environment/Resettlement 8 and Supervision Engineering FinancialAnalysis Economics 03/97 SUPERVISIONMISSION Environment/Resettlement 6 ReviewReform Program Procurement FinancialAnalysis Economics 10197 SUPERVISIONMISSION Environment/Resettlement 6 Status of the Project Engineering FinancialAnalysis 05/97 SUPERVISIONMISSION Engineering 6 Review Reform Program FinancialAnalysis Economics 11/98 SUPERVISIONMISSION Environment/Resettlement 6 Statusof the Project Procurement FinancialAnalysis 05/99 SUPERVISIONMISSION Environment/Resettlement 10 Mid-TermReview Engineering Procurement FinancialAnalysis Economics 11/99 SUPERVISIONMISSION Environment 5 Status of the Project FinancialAnalysis 0/00 SUPERVtSIONMISSION Environment 5 Review Reform Program Engineering Economics 11/00 SUPERVISIONMISSION Environment 5 Status of the Project FinancialAnalysis 05/01 SUPERVISIONMISSION Environment 5 Review Reform Program Engineering FinancialAnalysis Economics 11/01 SUPERVISIONMISSION Environment 5 Status of the Project FinancialAnalysis Economics 05/02 SUPERVISIONMISSION Environment 5 Status of Project Completionand FinancialAnalysis compliancewith covenants Economics 11/02 SUPERVISIONMISSION Environment/Resettlement 8 Preparationof ICR Engineering FinancialAnalysis Economics

Note: Supervisionmission will be coordinatedwith supervisionof other EA2EMprojects -215 - ANNEX 4.3

ANNEX 4.3: SELECTED DOCUMENTS AVAILABLE IN THE PROJECT FILE

1. Assessment of the Regulatory Framework for Industrial Pollution Control in Chongqing. Resourcesfor the Future.Washington, D.C. October, 1995.

2. Environmental Control Programnfor Chongqing Special Steel Company (Group) Limited. USX Engineers and Consultants,Inc. Pittsburgh, and Chongqing Iron and Steel Design Institute, Chongqing. October 1995.

3. Environmental Control Program for the Zhongxing Industry and Commerce Company. USX Engineering Consultants,Inc., Pittsburgh, and Chongqing Iron and Steel Design Institute, Chongqing. October 1995.

4. Improving Air Quality Management in Chongqing. Draft Final Report. EnviromnentalResources Management.London. May 1995.

5. Resettlement Action Plan for the Chongqing Special Steel Company (Group) Limited. October 1995.

6. RestructuringAdvisory Facility. Variousreports. Knight WendlingConsulting, Ltd., Adderbury,UK

7. PolicyDocuments produced by the ChongqingMunicipal Government. 1992-1995.

8. "Acid Rain in SouthwesternChina," by D. Zhao, J. Xiong, Y. Xu and W. H. Chan. Atmospheric Environment, Vol. 22, 1988. UK.

9. Contract for Consultants' Services between Chongqing Municipal Planning Commissionand Knight WendlingConsulting Ltd. June 28, 1995.

10. Chongqing Industrial Reform, Water Quality Management. Draft Final Report. Binnie & Partners Consulting Engineers. May 1995.

11. Financial and Economic Projections for Chongqing Special Steel Company (Group) Limited.

12. Financial and Economic Projectionsfor Chongqing Iron and Steel Company (Group) Limited.

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Report No- 15387 CHA Type: SAR