Document of The World Bank

FOR OFFICIAL USE ONLY

Public Disclosure Authorized Report No: 54172-LK

PROJECT APPRAISAL DOCUMENT

ON A Public Disclosure Authorized PROPOSED CREDIT

IN THE AMOUNT OF SDR 37.8 MILLION (US$57.4 MILLION EQUIVALENT) IN PILOT CRISIS RESPONSE WINDOW RESOURCES

TO THE

DEMOCRATIC SOCIALIST REPUBLIC OF

FOR A Public Disclosure Authorized

SMALL AND MEDIUM ENTERPRISE DEVELOPMENT FACILITY PROJECT

August 18, 2010

PREM, Finance and Private Sector Development Unit South Asia Region

This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and Public Disclosure Authorized the updated document will be made publicly available in accordance with the Bank’s Policy on Access to Information.

CURRENCY EQUIVALENTS (Exchange Rate Effective July 31, 2010) Currency Unit = LKR

LKR 112.8 = US$1 US$1.51852 = SDR 1

FISCAL YEAR January 1 – December 31

ABBREVIATIONS AND ACRONYMS

ADB Asian Development Bank LKR AU Administrative Unit LOC Line of Credit AWDR Average Weighted Deposit Rate MOFP Ministry of Finance and Planning BDS Business Development Services NPL Non Performing Loans BOC NDB National Development Bank CB Commercial Bank NTB National Trust Bank CBSL Central Bank of Sri Lanka OP Operational Policy CRW Crisis Response Window PB People’s Bank CV Curriculum Vitae PDO Project Development Objective DB Doing Business PFIs Participating Financial institutions DFCC Development Finance Corporation of PIU Project Implementation Unit Ceylon RERED Renewable Energy for Rural Economic DFD Development Finance Department Development EA Environmental Assessments RoAA Return on Average Assets EPF Employees Provident Fund ROSC Report on the Observance of Standards and ERMF Environmental Risk Management Codes Framework RSF Risk Sharing Facility ETF Employees Trust Fund SEDF South Asia Enterprise Development FIL Financial Intermediation Loan Facility FM Financial Management SIA Social Impact Assessment GDP Gross Domestic Product SLIC Sri Lanka Insurance Company GEF Global Environment Fund SME Small and Medium Enterprises GFC Global Financial Crisis SMI Small and Medium Industries GoSL SMEDeF Small and Medium Enterprise GTZ German Association for Technical Development Facility Cooperation SRMF Social Risk Management Framework HNB TA Technical Assistance IBRD International Bank for Reconstruction and TOR Terms of Reference Development TOT Training of Trainers ICA Investment Climate Assessment UN United Nations IDA International Development Association USAID United States Agency for International IEG Independent Evaluation Group Development IFC International Finance Corporation VAT Value Added Tax IUFR Interim Unaudited Financial Report WP Western Province IMF International Monetary Fund YoY Year over Year

Vice President : Isabel M. Guerrero Country Director : Naoko Ishii Sector Director : Ernesto May Sector Manager : Ivan Rossignol Task Team Leader : Cecile Thioro Niang

SRI LANKA SME Development Facility Project

CONTENTS

Page

I. STRATEGIC CONTEXT AND RATIONALE ...... 4 A. Country and sector issues...... 4 B. Rationale for Bank involvement ...... 5 C. Higher level objectives to which the project contributes ...... 6

II. PROJECT DESCRIPTION ...... 7 A. Lending instrument ...... 7 B. Project development objective and key indicators ...... 7 C. Project components ...... 7 D. Lessons learned and reflected in the project design ...... 9 E. Alternatives considered and reasons for rejection ...... 10

III. IMPLEMENTATION ...... 11 A. Partnership arrangements ...... 11 B. Institutional and Implementation Arrangements ...... 11 C. Monitoring and evaluation of outcomes/results ...... 13 D. Sustainability...... 13 E. Critical risks and possible controversial aspects ...... 14 F. Loan/credit conditions and covenants ...... 17

IV. APPRAISAL SUMMARY ...... 17 A. Economic and financial analyses ...... 17 B. Technical ...... 18 C. Fiduciary ...... 19 D. Social...... 19 E. Environment ...... 20 F. Safeguard policies ...... 20 G. Policy Exceptions and Readiness...... 21

Annex 1: Country and Sector or Program Background ...... 22

Annex 2: Major Related Projects Financed by the Bank and/or other Agencies ...... 32

Annex 3: Results Framework and Monitoring ...... 35

Annex 4: Detailed Project Description ...... 39

Annex 5: Project Costs ...... 55

Annex 6: Implementation Arrangements ...... 56

Annex 7: Financial Management and Disbursement Arrangements ...... 58

Annex 8: Procurement Arrangements ...... 71

Annex 9: Economic Analysis ...... 75

Annex 10: Safeguard Policy Issues ...... 85

Annex 11: Project Preparation and Supervision ...... 92

Annex 12: Documents in the Project File ...... 94

Annex 13: Statement of Loans and Credits ...... 96

Annex 14: Country at a Glance ...... 97

Annex 15: Maps...... 99

SRI LANKA

Sri Lanka: Small and Medium Enterprises Development Facility Project

PROJECT APPRAISAL DOCUMENT

SOUTH ASIA

SASFP

Date: August 18, 2010 Team Leader: Cecile Thioro Niang Country Director: Naoko Ishii Sector Director: Ernesto May General industry and trade sector (25percent); Sector Manager: Ivan Rossignol Micro- and SME finance (25percent); General finance sector (25percent); Banking (25percent)

Project ID: P121328 Environmental category: Partial Assessment Lending Instrument: Financial Intermediary Joint IFC: No Loan Joint Level:

Project Financing Data [ ] Loan [X] Credit [ ] Grant [ ] Guarantee [ ] Other:

For Loans/Credits/Others: Total Bank financing (US$m.): 57.40 Proposed terms: The Credit would be on hardened IDA terms for Sri Lanka, with a maturity of 20 years, including a grace period of 10 years. Financing Plan (US$m) Source Local Foreign Total BORROWER/RECIPIENT 0.00 0.00 0.00 International Development Association 57.40 0.00 57.40 (IDA) Total: 57.40 0.00 57.40

Borrower: Ministry of Finance and Planning Colombo 1, Sri Lanka

Facsimile: 94 11 244 9823 94 11 244 7633

Responsible Agency: Ministry of Finance and Planning Department of Development Finance Colombo 1, Sri Lanka

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Facsimile: 94 11 2449823 94 11 2447633

Estimated disbursements (Bank FY/US$m) FY 2011 2012 2013 2014 Annual 5 23 25 4.40 Cumulative 5 28 53 57.40 Project implementation period: Start: November 1st, 2010 End: October 31st, 2013 Expected effectiveness date: November 1st, 2010 Expected closing date: March 31, 2014

Does the project depart from the CAS in content or other significant respects? [ ]Yes [X] No Ref. PAD I.C. Does the project require any exceptions from Bank policies? Ref. PAD IV.G. [ ]Yes [X] No Have these been approved by Bank management? [ ]Yes [X] No Is approval for any policy exception sought from the Board? [ ]Yes [X] No Does the project include any critical risks rated “substantial” or “high”? []Yes [X] No Ref. PAD III.E. Does the project meet the Regional criteria for readiness for implementation? [X]Yes [ ] No Ref. PAD IV.G.

Project development objective Ref. PAD II.C., Technical Annex 3 The Project Development Objective is to improve access to finance (including term finance) for SMEs affected by the Global Financial Crisis in Sri Lanka

Project description Ref. PAD II.D., Technical Annex 4 Component 1: Financing and Risk Sharing Facility: 1. A line of credit to PFIs to refinance short term and long term SME loans: Based on expected demand, the World Bank would provide a credit line to participating licensed commercial and specialized banks to SMEs. 2. Risk Sharing Facility (RSF) to reduce the banks’ risk of lending to SME borrowers: The purpose of the RSF would be to backstop commercial lenders’ losses in cases of defaults by SME borrowers. The eligible loan portfolios would consist of commercial banks’ loans to a) new SME borrowers; and/or b) SMEs operating in selected sectors; and/or c) SMEs operating in selected regions.

Component 2: Policy and Capacity Enhancement for SME Banking: a) In partnership with the IFC and other development agencies, technical assistance on a matching basis to the commercial banks benefitting from the credit line or risk sharing facility, in order to i) help build capacity to provide lending services to SMEs and ii) ensure that SMEs have the capacity to effectively utilize loans from the banks for the growth of their businesses. b) Technical assistance to strengthen the enabling environment for SME banking, such as undertaking a diagnostic of constraints to SME financing and measures addressing such constraints.

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c) Implementation Support for the Project Implementation Unit (PIU)

Which safeguard policies are triggered, if any? Ref. PAD IV.F., Technical Annex 10

Environmental Assessment (OP/BP 4.01)

Significant, non-standard conditions, if any, for: Ref. PAD III.F. Board presentation: None

Loan/credit effectiveness: (a) Government Legal Opinion (b) Selection of PIU Deputy Project Director for SME Banking Covenants applicable to project implementation:

(a) The Project Implementation Unit will carry out quarterly reviews of the project in accordance with the implementation plans and performance monitoring indicators as agreed with IDA.

(b) The Project Implementation Unit will ensure that: (a) satisfactory financial management arrangements including financial records are maintained; (b) quarterly financial management reports are submitted to IDA no later than 45 days following the end of the reporting period; and (c) audit reports are available within six months after the end of the government fiscal year.

(c) An internal audit unit of MOFP will carry out regular internal audits of the project.

(d) Procurement for the proposed project will be carried out in accordance with the World Bank’s "Guidelines: Procurement under IBRD Loans and IDA Credits " dated May 2004 revised October 2006; and "Guidelines: Selection and Employment of Consultants by World Bank Borrowers " dated May 2004 revised October 2006.

Disbursement Conditions:

(a) Provision of model Line of Credit Agreement between MOFP and PFIs for the line of credit.

(b) Provision of supporting documents to the Risk Sharing Facility (RSF) acceptable to the World Bank. These include: 1) Risk Sharing Facility Service Agreement between MOFP and Sri Lanka Insurance company (SLIC) 2) Model Risk Sharing Facility Agreement between SLIC and PFIs 3) Risk Sharing Facility Operations Manual 4) Terms and conditions of Risk Sharing Facility Account

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I. STRATEGIC CONTEXT AND RATIONALE

A. Country and sector issues

3. Macroeconomic Background. Despite the steady economic growth of Sri Lanka over the past decade, development challenges persist due to the current global economic crisis and the fragile macro-economic environment. Over the past five years, the national poverty headcount ratio has halved, but remains relatively high at 15.2 percent for a country with US$2,053 per capita GDP as of 2009. Major obstacles to growth and poverty reduction have included the lack of economic growth in areas outside the Western province; inadequate infrastructure, particularly in rural areas; the stagnant agricultural sector; the decades-old civil conflict; a large fiscal deficit; access to credit and a lack of advanced skills in the labor force, and inflexibility in the labor market. The macroeconomic impact of the conflict has been estimated at 2-3 percent of GDP growth lost annually.1 The emergence of Sri Lanka from the thirty-year long conflict has signaled new opportunities for the country’s economic growth and development. To support Sri Lanka's economic reform program aimed at rebuilding reserves and strengthening the domestic financial system, the International Monetary Fund has approved a twenty-month Stand-By Arrangement for US$2.6 billion in FY09 of which 3 tranches have been issued.

4. The impact of the Global Financial Crisis (GFC) adds to the strains felt in the Sri Lankan economy in recent years caused by the conflict and by the tsunami. Armed confrontations in the north intensified during 2008 and peaked during the first half of 2009, just when the GFC was most severely felt. The end of the conflict has put strains on public finances due to the need to rapidly launch reconstruction efforts in the conflict-affected areas and the need to provide assistance to a large number of newly internally displaced persons. Overall GDP growth between 2008 and 2009 declined from 6 percent to 3.5 percent and was affected by the GFC. The room for maneuver on the fiscal side will still be limited despite an increase in tax revenue. Data for the first quarter of 2010 suggests that the economy is now recovering (real GDP grew 7.1 percent year over year in 2010-Q1), and there is potential for further growth with the opening up of the North and East and with improved connectivity in the rest of the country. One of the main lessons learned in post conflict countries is that the creation of employment opportunities is critical for faster recovery.

5. SMEs in Sri Lanka have been more acutely affected by the GFC. According to estimates of the Industry Survey of 2008, there are just over 18,000 firms operating in the country of which about 91 percent are small and medium enterprises (SMEs). 2 These firms (excluding micro firms of 1-5 employees), employ 26 percent of the labor force, and represent 17 percent of value added. The geographical distribution of industrial/manufacturing SMEs is currently concentrated in the Western Province of Sri Lanka (see Annex 1). Due to the historical and organic growth path of development of the country’s industrial base, commercial activities are concentrated in the Colombo district and its periphery. While the economy is showing early recovery signs, SMEs have been more affected than large firms by the global crisis in several ways; First, the increase in commercial lending rates up to 25-30 percent for SMEs has led many SMEs to loan defaults, in the context of decreasing sales due to the Global economic slowdown

1 World Bank. "Sri Lanka Poverty Assessment: Engendering Growth with Equity: Opportunities and Challenges" - 2007 2 Annual Survey of Industry – 2008, Department of Census and Statistics 4

(Fig 1). Second, the firms that have survived have increasingly turned to sub-contracting, i.e. to supplying larger firms as part of the supply chain (business to business), in lieu of exporting directly. This recent phenomenon has put additional pressure on the margins of these firms. Third, credit requirements of large firms are expected to rise rapidly with the pick-up in economic activity and, as banks shift from zero-weighted holdings of government securities to corporate lending, they will become increasingly capital constrained. Banks are likely to prefer lending to the large corporate sector and ration credit to SMEs, despite the current need of SMEs for bank financing to meet recent increased orders.

6. The Sri Lankan banking sector has proven resilient to the effects of the global credit crisis, although the system is showing signs of strain. The system remains well capitalized and profitable. However, the performance of corporate and commercial loans and mortgages has deteriorated, and Non Performing Loans (NPLs) on SME portfolios have grown considerably. The NPL ratio for the system as a whole was 8.0 percent at end-Dec. 2009 and higher for loans to SMEs. Capital adequacy was relatively high at 14.9 percent at the end of the same period, since bank credit portfolios contracted significantly under the GFC. However, given the sharp decline in the provisioning ratio, capital adequacy may be overstated.

7. An assessment conducted during project preparation estimated SME credit demand for the period 2010 – 2012 in the range of US$1.5 billion, including US$875 million for long term financing and US$650 million for working capital financing. Annex 1 reports on issues found in the banking sector’s supply of credit to SMEs.

Name of Term Financing $ millions* Short term Financing $ millions the Bank 2010 2011 2012 2010 2011 2012 Bank of 18.44 25.73 33.36 11.33 15.01 24.41 Ceylon Peoples 42.14 50.92 53.21 63.22 76.39 86.92 Bank NDB Bank 47.41 73.75 114.14 31.61 49.17 61.46 DFCC Bank 15.37 17.65 20.28 6.59 7.90 8.69 Hatton National 45.66 57.95 75.51 24.58 30.73 40.39 Bank Commerci al Bank of 42.14 45.66 50.05 28.10 42.14 48.29 Ceylon Wayamba Developm 13.43 15.72 18.00 n.a n.a n.a ent Bank Total 224.59 287.37 364.55 165.42 221.34 270.16 *Converted from LKR May 21, 2010 Source: Financial and operational appraisal of selected banks, World Bank, May 2010

B. Rationale for Bank involvement

8. In line with the national focus on SMEs as stated in the National Strategy for SME Sector Development, the Government of Sri Lanka is concerned that SMEs have been particularly hard hit as a result of the GFC.3 The banking sector in Sri Lanka displays a

3 There is no single, uniform definition of SMEs in Sri Lanka. Most commercial banks use a mix of data for turnover (generally less than Rs300 mill. annually), total asset value (less than Rs100 million, depending on whether land is included), and in some cases number of employees to define SMEs. 5

number of market failures that justify government intervention to support SMEs. Current market constraints to SME lenders include i) lack of technical capacity of banks to lend to SMEs, ii) lack of confidence of banks in SMEs because of an unfavorable economic environment, and iii) maturity mismatch preventing banks from providing long term financing to SMEs.

9. The World Bank is uniquely positioned to provide access to medium and long term funds to Sri Lankan banks, which could in turn on-lend to SMEs. The rationale for World Bank involvement stems from its access to long term funds at favorable terms and from its in- depth world-wide experience in financing credit lines, combined with its expertise in improving access to financial services for SMEs to soften the impact of the Crisis. The Project will leverage long term resources through the Pilot Crisis Response Window Facility, with an objective to help secure additional long terms resources from commercial banks and other donors to expand SME banking in Sri Lanka.

10. The proposed World Bank Project will complement existing credit lines and capacity enhancement facilities provided by the World Bank and other international organizations. The proposed operation builds on the success of the current Renewable Energy for Rural Economic Development (RERED) Project - a Specific Investment Loan with a large financial intermediation loan (FIL) component, which was approved by the Bank in June 2002 (US$75 million equivalent, with US$8 million GEF component) and an Additional Financing credit provided to GoSL in June 2007 (US$40 million equivalent). The proposed SME Development Facility Project will also complement other credit lines currently provided by other international organizations, including the Asian Development Bank, KFW and the European Investment Bank (see Annex 2).

C. Higher level objectives to which the project contributes

11. The Government of Sri Lanka announced in its National Strategy for SME Sector Development a broad array of programs aimed at making SMEs more competitive by applying modern technology to improve production processes and make SMEs more efficient. A priority area articulated in SME policies is broader access to medium-term finance. Moreover, the World Bank 2009-2012 Country Assistance Strategy builds on the Government’s vision for economic development laid out in the Mahinda Chinthana, and calls for an expansion of economic opportunities in lagging regions, for improvements in the investment climate and increased competitiveness in an economy driven by SMEs.4

12. The main aim of the planned Small and Medium Enterprise Development Facility (SMEDeF) Project, under the Pilot Crisis Response Window (CRW), will be to support access to finance for SMEs as a mean to create more productive activities, which in turn will generate jobs. The project will target urban and rural areas in all provinces, ensuring that lagging areas are not left behind and that the credit and productivity gaps between more and less advanced provinces do not widen. The project is fully in line with the objectives of the Pilot CRW of assisting eligible countries in developing, implementing and monitoring programs to manage the poverty, social and economic impact of the crisis.

4 The last two National Development Plans of Sri Lanka, the Mahinda Chinthana 2005 and 2010, both recognize the SME sector as the engine of growth for the national economy. 6

II. PROJECT DESCRIPTION

A. Lending instrument

13. The lending instrument proposed is a Financial Intermediary Loan (FIL), financed by an IDA credit from the Pilot Crisis Response Window (CRW) facility. The project will be financed under an International Development Association (IDA) credit disbursing over a period of three years, on hardened IDA terms.

B. Project development objective and key indicators

14. The Project Development Objective is to improve access to finance (including term finance) for SMEs affected by the Global Financial Crisis in Sri Lanka. Targeted participating financial institutions (PFIs) will include state-owned, private commercial and licensed specialized banks with a national branch network. Targeted end-beneficiaries will include new and existing SMEs in need of financing whose businesses suffered from the effect of the crises (including the GFC and the Conflict), as a way to support SME growth and economic recovery.

15. The development and implementation results will be monitored through several indicators, in line with World Bank Micro, Small and Medium Enterprise (MSME) Finance core sector indicators: (i) number of loans and volume of finance to SMEs across the country supported by the facility, (ii) number of loans and volume of finance supported by the facility that has an original maturity greater than 3 years, (iii) improved portfolio quality of Participating Financial Institutions (PFIs), as measured by decreased NPLs in their SME portfolios supported by the project.

C. Project components

16. The proposed SMEDeF would consist of a Financing and Risk Sharing Facility (RSF) available to both public and private participating financial institutions (PFIs).5 Selection of PFIs in the line of credit and RSF would be based on clearly defined eligibility criteria that would ensure minimum performance and profitability of the PFIs and focus on SME banking. 6 The Project Implementation Unit (PIU) will launch a selection process upon approval of the Project by the World Bank Board of Directors. In preparation of the selection process, with requisite legal support, the PIU will prepare relevant agreements that will be signed with PFIs upon project effectiveness.

17. The project uses an incentive approach to support bank downscaling to supply credit to SMEs. The incentive approach would combine the provision of appropriate financing instruments to banks (line of credit and risk sharing facility) with commitments from participating banks to strengthen their SME lending capability over time. Since the success of the facilities will depend on the application of modern SME lending technologies and risk

5 Subject to World Bank Management review, including the Board of Directors, the Bank team has requested a credit of US$57.4 million equivalent for this operation. 6 These would include compliance with prudential and regulatory requirements of CBSL, and with minimum Non Performing Loan and capital adequacy ratios. 7

management procedures, while the banks can independently access the line of credit or RSF, technical assistance will be mandatory under both facilities. If a bank participates in both facilities, the mandatory technical assistance requirement would only apply for one of the two facilities. The project would also provide complementary technical assistance at the SME level to increase their “bankability”. Annex 4 provides a detailed description of the project components. The following components are proposed:

Component 1: Financing and Risk Sharing Facility (US$41 million equivalent) a. Line of credit to PFIs to refinance short term and long term SME loans (US$28 million equivalent): Based on expected demand, the World Bank would provide a credit line to the Government for on-lending to participating licensed commercial and specialized banks for SME loans.7 Access, modalities and pricing would include features such as competitive interest rates and maturities in line with on–going commercial practices and consistent with the OP 8.30 guideline, to ensure that no market distortions are created, while the technical assistance under component 2a. would be mandatory for all PFIs. This refinancing facility will provide loans with a maximum maturity of 10 years including a maximum grace period of up to 2 years.

b. Risk Sharing Facility (RSF) to reduce the banks’ risk of lending to SME borrowers (US$13 million equivalent): The purpose of the RSF would be to backstop commercial lenders’ losses in cases of defaults by SME borrowers. This well tested instrument would provide an additional incentive for commercial banks to lend to SMEs. The RSF would be issued by Sri Lanka Insurance Company (SLIC) on a portfolio basis. The eligible loan portfolios for the RSF would consist of commercial banks’ loans a) to new SME borrowers; and/or b) to SMEs operating in specific sectors (to be agreed between PFIs and SLIC/GoSL) and/or c) to SMEs operating in selected regions (to be agreed between PFI and SLIC/GoSL). SLIC would provide a limited risk coverage on a 50/50 pari-passu basis with PFIs. The RSF would cover all risks, and be payable on first demand when a loan is in default for a specified number of days.8 The RSF will be managed and implemented by SLIC and SLIC would be the obligor under RSF agreements entered into with PFIs. By sharing the credit risk with PFIs, the facility would leverage lending from banks to SMEs by up to ten times the amounts committed by IDA.

Component 2: Policy and Capacity Enhancement for SME Banking (US$12 million equivalent)

a. Capacity enhancement for lending institutions and SMEs (US$7 million equivalent): In partnership with the IFC and other development agencies, the project would provide technical assistance on a matching basis to the commercial banks benefitting from the credit line or RSF, in order to i) help build their capacity to provide lending services to SMEs and ii) ensure that SMEs have the capacity to effectively utilize loans from the banks for the growth of their businesses. The project will include capacity enhancement and technical assistance to SME clients, to be provided by the PFIs at the branch level. Since capacity

7 See Supply of SME Banking section of Annex 1 8 To be determined in negotiations with banks, estimated to be around 360 days. 8

enhancement activities will be a covenant to accessing component 1 funds, PFIs will be expected to design the training and capacity building activities with the PIU. The PIU will procure consultants with experience in SME banking to perform a diagnostic of each PFI’s capacity needs to establish the type and extent of training and technical assistance required to service the SME sector profitably and sustainably.

b. Support to strengthen the enabling environment for small and medium enterprise financing (US$1 million equivalent): This would include undertaking a diagnostic of constraints and measures addressing such constraints.

c. Implementation support for the Project Implementation Unit (PIU) (US$4 million equivalent): This would include building expertise to manage the project, compensating the Facility Agent to manage the RSF, undertaking a detailed impact evaluation framework for assessing the impact of the project on the targeted clients and other implementation support activities.

18. The project would in addition include an unallocated funding window of US$4.4 million equivalent, which would be available for additional funding for any of the above components.

D. Lessons learned and reflected in the project design

19. The project reflects lessons learned from recent analytical work on SME development. Specific support to SMEs is justified by the fact that SMEs face market failures that need to be addressed in order to grow and contribute to economic growth. SMEs: (i) are more affected by regulation and transaction burdens than larger firms (business environment constraints), (ii) have little access to credit (finance constraints), and (iii) have limited access to information, advisory services, technology and innovation (knowledge constraints).9 On the basis of these lessons, the project proposes to reduce constraints on SME access to finance by providing a credit line and a Risk Sharing Facility specifically targeting SMEs and linked to capacity enhancement at the level of banks and SME beneficiaries.

20. The project also reflects lessons learned from recent analytical work and existing World Bank credit lines and risk sharing facilities in Sri Lanka and other countries. The project will benefit from lessons learned from credit line financing throughout the world (e.g. India, Turkey, China and Bosnia Herzegovina) as well as from the Sri Lanka Small and Medium Industries (SMI) I-IV projects. The project design also builds on a 2006 IEG impact evaluation of World Bank lending for lines of credit. Among other lessons, the IEG evaluation reports that any foreign exchange risk of subloan repayment should be borne by either the end user or the government; in no case should it be the PFI. In addition, one concise statement of lessons learned from credit lines that the World Bank has provided to its client countries throughout the world is the following: “While past experience with financing of credit lines has been mixed, recent evaluations indicate that the problems have stemmed mainly from weak borrower accountability and management capacity, lack of clearly defined and transparent indicators for monitoring of the financial performance of the concerned financial intermediaries as well as poor monitoring of the overall project impact, inadequate demand from ultimate beneficiaries and lack of bankable

9 For an overview of constraints facing SMEs, see IFC, 2004 “SME Strategy”. 9

sub-projects, and inflexibilities in project design that make it difficult to adjust design to reflect changing ground realities”.10 Project design attempts to incorporate these lessons learned.

21. The project also builds on specific in-country experience and crisis response guideline notes. An IEG evaluation of the four Sri Lanka SMI I-IV financial intermediary loans concluded that these operations were successful. The project assisted a broad spectrum of 16,000 SMEs with investment loans to improve their productivity and working capital loans to complement their investments to scale-up operations. The average sub-loan size was US $10,000. Specific outcomes attributed to the Projects included the creation of 22 to 56 employees per beneficiary on average. The Project also builds on lessons from the worldwide IDA/IFC Risk Sharing Facility scheme and from a recent joint GEF/IFC risk sharing scheme for renewable energy in Sri Lanka. Under the GEF/IFC scheme, IFC makes payments to a participating bank on 50 percent of the outstanding principal balance of defaulted loans in the bank’s portfolio, with a GEF partial counter-guarantee up to a certain percentage of the loss (first loss). In addition, the project builds on a large IFC technical assistance (TA) program in Sri Lanka. This includes TA to selected banks and TA to SMEs through Chambers of Commerce (the IFC Southern Development Program) and through financial institutions (the Business Edge program in Sri Lanka). Finally, the World Bank Guidance Note on Using Line of Credit Projects to Support SMEs during the Financial Crisis states that regional, sectoral or other restrictions, in the case of crisis response lines of credit, should be avoided unless there are strong economic reasons for such restrictions. 11

22. The above lessons have been incorporated in the design of the proposed operation as follows: (i) The foreign exchange risk of the Project will be borne by GoSL and losses included in the market on-lending rate charged by the GoSL to the PFIs; (ii) The PIU, staffed by civil servants and contractual staff, has been assigned clear responsibilities for project implementation, with the use of SLIC a Facility Agent for monitoring the RSF (see Annex 6), (iii) a steering committee with participation from GoSL (6 members) and a majority from the corporate and private sector (11 members) has been formed and will be active at all times of project implementation; (iv) project indicators have been established (see section B), and (v) the commercial banks and SMEs have expressed strong demand for credit.12

E. Alternatives considered and reasons for rejection

23. The proposed design was chosen based on the Government’s request and on the World Bank’s assessment – in consultation with commercial banks, SME representatives, IFC, and other donors and government agencies - of the most feasible solution to increase access to finance for SMEs. Alternatives considered at various stages of project preparation included (i) an Apex operation through the Administrative Unit (AU) of the Development Finance

10 India SME Financing and Development Project 11 http://ifcnet.ifc.org/ifcint/psdvp.nsf/AttachmentsByTitle/LOC_during_FinCrisis/$FILE/LOC_FinCrisis.pdf 12 With respect to demand, a banking sector appraisal estimated that the total financing needs under the proposed credit lines would be significantly above US$58 million—the estimate is based on appraising a pipeline of seven commercial banks with a significant SME lending portfolio that are likely to apply for the scheme. Banks surveyed place their estimated demand of SME credit at US$880 million for medium and long term credit and US$660 million for short-term working capital credit during the period 2010-12, an aggregate demand of US$1.54 billion.

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Corporation of Ceylon (DFCC) and (ii) an operation solely focused on export sectors. During a pre-identification mission, the World Bank team discussed these options with the Ministry of Finance and Planning. While implementing the operational aspects of the Project through DFCC AU would have been a well tested option, due to the successful implementation by DFCC of the RERED project and others, the GoSL preferred building sustainable implementation capacity within MOFP. The targeted SME sectors were expanded beyond exports to the domestic and export sectors, after evidence during project preparation showed that SMEs have been affected by the Global Financial Crisis in all provinces and across sectors.

III. IMPLEMENTATION

A. Partnership arrangements

24. The project team consulted with other development partners during project preparation in an effort to coordinate project activities with on-going activities and to benefit from lessons from other institutions. The main partner agencies are the IFC/ South Asia Enterprise Development Facility (SEDF), United States Agency for International Development (USAID), the World Bank’s Gates Foundation Agriculture Finance Support Facility and the Asian Development Bank (ADB). The team is working in coordination with USAID who has already started activities to support value chains in the North and Eastern Provinces through the Connect Regional Economies (CORE) program. The project was designed building on IFC’s existing SME Development programs and investments in Sri Lanka. Annex 2 summarizes past and current programs in Sri Lanka relevant to this project.

25. In addition, the project team liaised with non donor partners, which include the Chambers of Commerce and industry associations representing a broad cross section of SMEs in Sri Lanka.

B. Institutional and Implementation Arrangements

26. The envisaged project is to be implemented through a Project Implementation Unit (PIU) under the Development Finance Department (DFD) of the Ministry of Finance and Planning. The PIU has been staffed with qualified personnel and capable of satisfactorily implementing all aspects of the project. Its responsibilities will include: (i) on-lending to PFIs for final lending to sub-borrowers (ii) reviewing effective functioning of the on-lending facility to final borrowers through PFIs; (iii) on-going monitoring of the PFIs to ensure compliance with project criteria; (iv) responsibility for adherence to all fiduciary and safeguard requirements of the World Bank; and (v) monitoring and evaluation based on key project development indicators. An Operations Manual has been drafted and includes step by step processes and procedures to be followed, including on procurement, financial management, disbursement, determining the eligibility of PFIs, procedures for on-going monitoring of the PFIs and all other administrative processes for recording and reporting implementation, with adequate checks and balances. Annex 6 describes the organizational structure of the PIU and the project’s institutional arrangements.

27. The PIU, formally established in April 2010, will be adequately staffed at all times throughout project implementation, with capacity building supported under the project. The 11

Project Director, also the Director General for Fiscal Policy of MOFP, is serving part time. The following staff have been assigned full time to the PIU: Deputy Project Director (administration), Procurement Specialist, two Project Officers (civil servants under the MOFP); Finance Manager, Social Development and Communication Specialist, Environmental Specialist (staff on external contracts hired at market price per GoSL directive on salary structures). The PIU is planning to recruit external experts compensated at market prices, as required, including a full time Deputy Project Director SME Banking. The PIU will be governed by the Project Steering Committee, which has been formed and whose membership allows for large private sector representation (6 Government representatives and 11 private sector and commercial banks representatives). The proposed governance structure is designed to ensure that an equal playing field is maintained in all decisions linked to the selection and monitoring of PFIs.

28. A Financial intermediary assessment (OP 8.30) was satisfactory for all seven banks assessed in the Banking Sector Review conducted during project preparation. All seven banks are in good financial condition and the future prognosis is healthy. Bank of Ceylon (BOC), People’s Bank (PB) and Wayamba Bank are state-owned, and most of their financing sources are customer deposits. BOC and PB’s leverage is at acceptable levels and their capital adequacy ratio at 13-14 percent, above the regulatory prescription. Wayamba is a small regional development bank with a capital adequacy of 11.8 percent and post-tax return on average assets (RoAA) of 1.2 percent. Profitability of BOC with post-tax RoAA of 0.6 percent and PB with post-tax RoAA of 0.76 percent, though lower than their private sector counterparts, is adequate. NPL ratios are relatively high in Sri Lanka due, inter alia, to the impact of the Global Financial Crisis on banks’ asset quality. The non-performing loan (NPL) ratios of BOC and PB are in the range of 6 to 7 percent, though lower for Wayamba (3.3 percent). In addition to the provisions, the NPL portfolio is also secured by adequate collateral. The private commercial banks satisfactorily meet the capital adequacy ratios (CAR) with Commercial Bank at 13.91 percent, Hatton National Bank (HNB) at 13.2 percent, National Development Bank (NDB) at 17.03 percent and DFCC at 20 percent. Profitability is better at the private institutions with a post-tax RoAA of 1.42, 1.62, 1.87, and 2.2 percent respectively. The NPLs for the private banks are at 8 percent for Commercial, 7 percent for HNB, 2.6 percent for NDB, and 9 percent for DFCC. See Annex 4 for financial information on the pipeline of banks reviewed.

29. Corporate governance in the Sri Lankan banking sector is in good standing. The financial and operational appraisal of a sample of Sri Lankan banks, conducted during project preparation, reports good governance standards. The Central Bank of Sri Lanka (CBSL) has framed detailed Corporate Governance guidelines and has mandated full compliance and disclosure by all banks in their Annual Reports, effective 1st January 2008. Section 7.10 of the Listing Rules of the requires listed companies to comply with the governance rules prescribed by the Exchange and to disclose compliance in the companies’ annual reports. The Securities and Exchange Commission of Sri Lanka and the Institute of Chartered Accountants of Sri Lanka have jointly framed a “Code of Best Practice on Corporate Governance.” These three sets of governance standards fully address the core of corporate governance issues. All the banks surveyed are in compliance with these standards and have disclosed their level of compliance in their Annual Reports. 13

13 The appraisal included Bank of Ceylon, People’s Bank, DFCC Bank, Commercial Bank, Hatton National Bank, NDB Bank. 12

C. Monitoring and evaluation of outcomes/results

30. The World Bank will evaluate progress on the proposed indicators through regular reporting by the PIU and through implementation support missions. The PIU will submit quarterly reports including output and outcome indicators (see Annex 3) and semi-annual financial management reports (FMRs), included in the Operations Manual). The project will also monitor indicators for Bank-wide monitoring of SME projects. The data will come from reports provided by the PFIs. Although the scope of reporting will be significant, the indicators are expected to be effectively monitored. The World Bank team has been working with the PIU to design the required reporting templates in the Operations Manual, and to ensure that the banks are well accustomed to collecting such information from their clients. The PIU has been adequately staffed to ensure provision of the monitoring data. Financial performance of the PFIs will be monitored through independent auditors’ reports and separate letters confirming adherence to prudential norms. Further details on the Results and Monitoring Framework are provided in Annex 3.

31. The monitoring indicators will measure the impact of the PDO, i.e. access to finance, and portfolio quality. Higher level objectives such as the impact of the project on productive activities (as measured by sales and employment) will be measured through impact evaluations. The project will monitor progress toward the project’s outputs and outcomes as defined in the project’s Operations Manual and impact. Appropriate data collection mechanisms will be conducted to obtain information at the PFI level, and at the SME (final beneficiaries) level. Surveys of SME beneficiaries will be conducted and will also include a control group of non-participating SMEs. This approach will help to follow some trends over time and to understand the broader development impact of World Bank assistance to SMEs. Expectations from these surveys will be kept modest and realistic given the costs involved and difficulties in the data collection process, especially data quality, and problems to isolate the effects of other variables from the support provided by the project.

D. Sustainability

32. Project sustainability will be facilitated by Government commitment to increase access to finance to SMEs and Sri Lankan banks’ increasing focus on the SME segment in the aftermath of the Global Financial Crisis. The project’s sustainability will be supported by the Government’s plans to foster SME development (see National Strategy for SME Sector Development, 2002). As discussed in previous sections, the Government has taken several steps toward improving SMEs’ access to finance. This will help ensure that increasing access to finance for SMEs will remain at the center of the Government’s agenda. The project aims to incentivize the banks to expand their SME banking practices so as to build a sustainable SME banking capability within the financial sector in Sri Lanka.

33. In the aftermath of the Conflict and as infrastructure is being rebuilt, Sri Lankan banks are now aggressively rolling out operations in the North and East of the country. Banks indicated that a lot of the expected growth in the North and East will be a result of SME activity. While the World Bank can play an important catalytic role at this stage by providing banks with long term financing that is currently scarce and lowering the risk of new SME

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lending through the proposed RSF, it is expected that, given the positive returns expected for participating banks (see Annex 9), in the future banks will be able to increasingly secure this funding directly. This will lead to sustainability of the operation in the long term. But this capacity will develop over time, as economic activity grows and as the banks develop their SME banking capability.

34. In order to avoid market distortions and to ensure that the borrowers will gain appropriate returns from investments made under this project, the PFIs will follow their respective pricing policies according to market conditions. The largest market advantage that the PFIs will derive from IDA funds is the long-term funding that will facilitate the provision medium and long term financing to SMEs without taking on a significant maturity mismatch. The proposed RSF will be priced to cover expected losses. It is hoped that the Financing and Risk Sharing Facilities, combined with capacity building for SME banking, will enable banks to build profitable SME banking operations.

E. Critical risks and possible controversial aspects

Risk Mitigating Measures Generic Risk (to Project Development Objective) Macroeconomic framework OP 8.30 stipulates that a line of credit be Recovery in global markets and the end of the considered in the context of a satisfactory conflict improve the prospect for Sri Lanka’s macroeconomic framework. The Global exports and tourism industry. The budget for Financial Crisis may lead to a reduction in 2010 projects a fiscal deficit of 8 percent, disposable incomes in major high value down from 9.9 percent in 2009. This risk market segments relevant for Sri Lanka and would be moderate. there can be reduction in demand for Sri Lanka’s exports. In addition, while Sri Lanka’s macroeconomic environment remains reasonably satisfactory, the country’s fiscal position in 2010 could be under stress. External financial sector, implications for The Sri Lankan banking sector has proven Sri Lanka resilient to the effects of the global credit crisis. The system remains well capitalized and The current global financial sector situation profitable. The performance of the banking may have adverse effects on the banking sector has been aided by policy action on the sector in Sri Lanka. part of the Government and the monetary authorities to maintain stability in financial markets. Specifically, profitability was supported in 2009 by a rapid widening of net interest margins as the Central Bank of Sri Lanka (CBSL) has lowered interest rates, enabling banks to reduce their deposit costs and compensate for higher provisioning. This

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risk is low. Project-Specific Economic slowdown Sri Lanka's economy is now showing signs of stabilizing after its service sectors were hit by Developments in the global economy may the global financial crisis, triggering the reduce demand for Sri Lankan goods. slowdown of the domestic economy. Sri Lanka's manufacturing and export sectors were hit hard, but economic activity is now recovering slowly. The IMF has announced a projected growth of 5.5 percent in 2010, while GoSL targets a 7-8 percent growth. This risk is moderate. Lack of uptake from the private sector for 1. The project would be crowded out if the proposed credit line/risk sharing scheme the market failure it attempts to address due to: diminishes, i.e. if medium- and long- term 1. Improved financing conditions for Sri financing became available at competitive Lankan intermediaries and a loss of costs to Sri Lankan financial institutions. In competitiveness of the credit line. this case, the development objective would be served directly by alternative funding of commercial banks, and therefore the 2. Lack of interest from the private development objective is not at risk, but it sector in the proposed instruments. creates a risk to project implementation. In recent months interest rates have been declining; however long term funds remain scarce. This risk is low. 2. The proposed project includes Technical Assistance that combines i) getting a commitment from lenders of bank downscaling and ii) some support on increasing the TA at the level of SMEs to make them more “bankable”. This risk is moderate. Credit risk of SMEs NPLs on SME loans are higher than overall - Overall SME risk NPL levels. The median NPLs among banks - Risk of bailing out unviable SMEs appraised during preparation was 10 percent in May 2010. There are, however, early signs of recovery, with a slight improvement in the NPL ratio as a whole from 8.8 to 8 percent from the third to the last quarter of 2009. Improved prospects for Sri Lanka’s exports should reduce the risk of NPLs. While the project will target sectors affected by the Global Financial Crisis, it will only support bankable SMEs, as screened by participating banks. In addition, the project will include technical assistance to increase the risk management capability of lenders and to

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support SMEs. This risk is moderate. Credit and investment risks GoSL’s investment risk will be mitigated The RSF poses an investment risk to GoSL through the fact that the facility will be operated on a commercial basis, with a strong focus on bank and SME loan portfolio selection for credit risk coverage, charging appropriate fees and capping potential claims. This risk is moderate. Political influence on borrowers Prospective PFIs are government-owned institutions and private sector commercial banks alike. There may be a risk of political interference on selection of sub-borrowers in the government-owned institutions. Selection of the PFIs themselves will be based on a stringent qualitative and quantitative process and will include World Bank no-objection. This risk is moderate. Implementing agency risks Since the Implementation Unit of the Project will be within the Ministry of Finance and Planning, there is a risk of overstretching its capacity as other more urgent matters may arise, as well as risks that MOFP staff may not immediately have the adequate skills and knowledge of bank procedures to implement the Project. The MOFP PIU has started seeking a Deputy Director with long serving experience in SME banking to assist with the technical implementation of the project. The PIU has already been staffed with qualified personnel and is capable of satisfactorily implementing all aspects of the project and will be trained accordingly. This risk is moderate. Lack of client familiarity with financial The PIU is staffed with specialists who will be management, procurement and safeguards trained in Bank fiduciary and safeguard requirements. requirements. Bank staff will work closely with the PIU to support their fiduciary and safeguard oversight activities. The project Operations Manual details the fiduciary and safeguard requirements. PFIs will ensure compliance with the requirements detailed in the Operations Manual, and will include auditing the use of project funds in their annual external audits to carry out compliance checks. This risk is moderate.

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F. Loan/credit conditions and covenants

Negotiations Conditions: None

Board Conditions: None

Effectiveness Conditions: (a) Government Legal Opinion (b) Selection of PIU Deputy Project Director for SME Banking

Disbursement Conditions:

(c) Component 1a): Provision of model Line of Credit Agreement between Ministry of Finance and Planning and PFIs

(d) Component 1b) Provision of supporting documents to the RSF acceptable to the World Bank. These include: 5) Risk Sharing Facility Service Agreement between MOFP and Sri Lanka Insurance company (SLIC) 6) Model Risk Sharing Facility Agreement between SLIC and PFIs 7) Risk Sharing Facility Operations Manual 8) Terms and conditions of Risk Sharing Facility Account

General Covenants:

 Maintain signed subsidiary loan agreements in formats acceptable to the World Bank with all PFIs.  Maintain satisfactory financial management systems for the project, including records and accounts, and prepare financial statements satisfactory to the Bank.  Maintain active Steering Committee at all times of Project implementation.  Provide an audit of annual project financial statements and an audit of entity financial statements prepared in accordance with the International Financial Reporting Standards within six months of each year-end during the implementation period.  Audits to be carried out by the Auditor General in accordance with International Auditing Standards, under terms of reference satisfactory to the Bank.

IV. APPRAISAL SUMMARY

A. Economic and financial analyses

35. SME sub-projects to be funded are not pre-identified and PFIs are not yet selected thus, a traditional economic/financial analysis cannot be conducted. The approach taken is to measure the development results in relation to the amounts intermediated, based on impact evaluations in similar programs in Sri Lanka and around the World and economic growth projections for Sri Lanka. A detailed Net Present Value (NPV) and Internal Rate of Return (IRR) analysis is provided in Annex 9.

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B. Technical

36. The capacity of the MOFP PIU to implement the project was evaluated as satisfactory during project Appraisal in June 2010.

37. Provisions are included in the Project to ensure that lending rates reflect the cost of intermediating the funds including an appropriate credit risk margin as required by World Bank Policy OP 8.30. The final lending rate and the margins charged will be in line with market rates. The rate used by GoSL, the 6-month Average Weighted Deposit Rate (AWDR), has been used in recent World Bank credit line operations in Sri Lanka.14 Current rates on Treasury Bills from 90 days (8.1%) to 5 years (9.9%)

(Rates in %)

26.05.2010 8.10 8.91 9.26 21.05.2010 8.13 8.88 9.23 17.05.2010 9.80 9.90 14.05.2010 8.18 8.88 9.23 07.05.2010 8.24 8.97 9.25 9.52 9.80 03.05.2010 9.60 9.65

Source: Central Bank of Sri Lanka, June 2010

38. The Financial and Operational Appraisal conducted during project preparation confirms that the six banks with a national network reviewed are qualified to act as conduit for re-lending the World Bank’s funds to the SME sector as required under the World Bank Operational Policy directive OP 8.30: 15 (i) licensed banks have been in operation for decades, except NDB which has a history of five years in its present form since its conversion into a commercial bank, (ii) owners and managers of these banks are considered “fit and proper” and provide a good quality governance; the banks: (iii) have good standing with the supervisory authority; (iv) maintain minimum capital prescribed by prudential regulations; (v) have well defined policies and written procedures for management of all types of financial risks; (vi) maintain adequate liquidity; (vii) have positive profitability and acceptable risk profile; (viii) classify their assets and off balance sheet credit exposures at least four times a year and make adequate provisions and have adequate portfolio quality; (ix) have adequate internal audit and controls suited for their specific risk profile; and (x) have adequate management information systems.

14 See Additional Financing for RERED Project. 15 Wayamba Development Bank, a Regional Development Bank, was also reviewed. While the bank is duly licensed, has been in operation for ten years now and meets all the parameters laid down in the Terms of Reference, it is in a transitional stage. GoSL has made the decision to amalgamate all six Regional Development Banks in the country. The appraisal report was unable to confirm the suitability of Wayamba in its current form to act as a conduit for on-lending World Bank’s funds to the SME sector.

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C. Fiduciary

39. Financial Management: The Ministry of Finance and Planning has qualified Government accountants to handle the FM activities of the project. The Ministry is subject to annual audits by the Auditor General of Sri Lanka. Given the private sector involvement in the project and the specialized staff required, the MOFP has established a PIU to handle the financial management tasks of this project. A financial management staff has joined the PIU. An assessment of the financial management capacity and control systems of the PIU was carried out during Appraisal, and judged to be satisfactory. PFIs receiving funds from the line of credit (under Component 1a) will be responsible for disbursing them to the SMEs as well as for maintaining the necessary books and records relating to such disbursements. Sri Lanka Insurance Company (SLIC) will implement the RSF under the overall supervision of the MOFP and the PIU, acting as the RSF Agent (under Component 1b). The proposed project has a moderate financial management risk rating. Further details on financial management arrangements are included in Annex 7.

40. Procurement Appraisal: While the PFIs have a long history of similar experience in other financial intermediary projects in Sri Lanka and have the necessary understanding of procurement requirements, the multi-sectoral nature of this project exposes it to varying degrees of knowledge and experience across the broad band of potential beneficiary SMEs. Procurement under the line of credit facility and the capacity enhancement activities will be carried out with due consideration to economy and efficiency, following local established commercial practices acceptable to the Bank, and in accordance with the provisions of paragraphs 3.12 of the Bank’s Procurement Guidelines and 3.14 of the Bank’s Consultant Guidelines. Annual audits will be conducted to ensure compliance with the agreed practices. The PIU hired consultants for overall project management and monitoring, following the Bank’s Consultant Guidelines. To mitigate potential risks, the PIU has been staffed with a procurement specialist who has exposure and knowledge of government procedures. The assessment rates the procurement risk as moderate.

41. The World Bank will conduct semi-annual post reviews at the level of the PIU and PFIs and, on a random basis, physical inspections will be carried out of the contracts not requiring a prior review. Procurement arrangements have been defined in the Operations Manual. Further details on procurement arrangements are included in Annex 8.

D. Social

42. No social safeguards issues are foreseen under the project. The project will not support any investment requiring land acquisition or associated involuntary resettlement (OP/BP 4.12). 16 While the project will reach out to all provinces of the country, the highest number of SMEs in the country, i.e. over 40 percent, is established in the Western Province, while the second highest percentage of over 20 percent is in the North Western Province. All the remaining provinces have less than 10 percent of the country’s SMEs. The SMEs outside the Western Province also suffer from poor infrastructural facilities, and the same SMEs have been particularly hard hit by three decades of civil unrest. The best market for these goods and services seems to be concentrated in the Western Province, which also encourages concentration of the SMEs in the

16 This does not exclude acquisition of land by SMEs on commercial terms. 19

same province. Furthermore, coverage of bank branches is much less in the Northern and Eastern Province than in the rest of the country. It may thus be inevitable that SMEs in the Western Province may gain more and easier access to loans under the facility than SMEs in the lagging regions. To extend beyond the Western Province, the project will include island-wide awareness programs designed and planned by the PIU.

43. The population of the Eastern and in particular the Northern Province have been subject to long-term displacement, which has resulted in many unsettled land issues due to loss of land documents, secondary occupation of land, encroachments and so forth. This situation may constitute a significant obstacle for the SMEs in these areas to obtain loans, as disputed land cannot serve as collateral. The Divisional Secretaries of the North and East have started the process of resolving title issues and handing over properties to original owners.

44. The labor laws of the country apply to all sectors and provide specific guidelines for dealing with potential negative impacts, such as discrimination in employment, violation of minimum wages, child labor and other cases of labor law violations which are beyond the purview of the project. Their mitigation requires strict adherence to the labor laws of the country by the SMEs.

45. The Social Risk Management Framework (SRMF) identifies social risks under the SME lending program by the participating banks and defines how compliance with the country and World Bank’s social safeguard policies will be monitored. Furthermore, an annual Social Impact Assessment will be conducted to assess broader social impact of the project, regional and sectoral distribution of loans and to identify any unforeseen negative social impacts or obstacles to SMEs’ equal access.

E. Environment

46. The project has been assigned Category “FI” in accordance with World Bank safeguard policy OP/BP/GP 4.01 (Environmental Assessment). The project will not finance pre-identified sets of SMEs or sectors and specific environmental issues have not been identified. The environmental issues associated with SMEs are expected to be varied and will depend on specificities and complexities of the sectors. While no significant issues are foreseen at this point, the possibility that such issues would become applicable for selected SMEs cannot be completely ruled out. The Environmental Risk Management Framework (ERMF) of the project will help to minimize potential risks associated with SMEs that will be supported under the program and outlines a process to ensure compliance with the Sri Lanka and World Bank environmental safeguards policies. A detailed environmental assessment is included in Annex 10.

F. Safeguard policies

47. Environmental Assessment Policies (OP/BP 4.01) will apply to the proposed project. The PFIs as well as sub-borrowers will have to comply with this policy and follow the project Environmental Risk Management Framework, the applicable sections of Operational Manual and other environmental guidance documents developed by the project. No other policy is expected to be triggered by the project.

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Safeguard Policies Triggered by the Project Yes No Environmental Assessment (OP/BP 4.01) [X ] [ ] Natural Habitats (OP/BP 4.04) [ ] [ ] Pest Management (OP 4.09) [ ] [ ] Indigenous Peoples (OP/BP 4.10) [ ] [ ] Physical Cultural Resources (OP/BP 4.11) [ ] [ ] Involuntary Resettlement (OP/BP 4.12) [ ] [ ] Forests (OP/BP 4.36) [ ] [ ] Safety of Dams (OP/BP 4.37) [ ] [ ] Projects on International Waterways (OP/BP 7.50) [ ] [ ] Projects in Disputed Areas (OP/BP 7.60) [ ] [ ]

G. Policy Exceptions and Readiness

48. The project will need to comply with all applicable World Bank policies. There will be no specific policy exception.

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Annex 1: Country and Sector or Program Background SRI LANKA: SME Development Facility Project

1. Macroeconomic Background.

1. Despite the steady economic growth of Sri Lanka over the past decade, development challenges remain in the aftermath of the Global Economic Crisis and the fragile macro- economic environment. Over the past 5 years, the national poverty headcount ratio has halved, but remains relatively high at 15.2 percent for a country with US$2,053 per capita GDP as of 2009. Major obstacles to growth and poverty reduction have been the lack of economic growth in areas outside Western province; inadequate infrastructure, particularly in rural areas; the stagnant agricultural sector; the decades-old conflict; a large fiscal deficit; access to credit and a lack of advanced skills in the labor force, and inflexibility in the labor market. The macroeconomic impact of the conflict is estimated at 2-3 percent of GDP growth annually.17 The emergence of Sri Lanka from the thirty-year old conflict has signaled new opportunities for Sri Lanka's economic growth and development. To support Sri Lanka's economic reform program aimed at rebuilding reserves and strengthening the domestic financial system, the International Monetary Fund has approved a twenty-month Stand-By Arrangement for Sri Lanka amounting to about US$2.6 billion.

2. Overall GDP growth between 2008 and 2009 declined from 6 to 3.5 percent. Like most other countries in the South Asia Region, the export sector was the main channel through which the Global Financial Crisis (GFC) hit Sri Lanka. Direct impacts through the financial sector were muted, in large part because Sri Lankan financial institutions did not have any exposure to “toxic” assets. During the first 10 months of 2009, total exports were more than 15 percent lower than during the same period in 2008. As a result, in the first half of 2009, economic growth slowed to only 1.8 percent (against 6.3 percent during the same period in 2008). As the Sri Lankan economy teetered on the brink of a balance of payments crisis, banks cut back lending and consumer spending slowed. Data for the first quarter of 2010 suggest that the economy is now recovering (real GDP grew 7.1 percent yoy in 2010-Q1), but all sectors have further growth potential.

3. The impact of the Global Financial Crisis adds to the strains felt in the Sri Lankan economy in recent years due to the conflict and the tsunami. Armed confrontations in the north intensified during 2008, and peaked during the first half of 2009, just when the GFC was most severely felt. The end of the war has put strains on public finances due to the need to rapidly launch reconstruction efforts in the war-affected areas and the need to provide assistance to a large number of newly internally displaced persons. The room for maneuver on the fiscal side will be limited despite an increase in tax revenue. One of the main lessons learned in post conflict countries is that employment opportunities are critical for faster recovery. The Government’s focus on the SME sector is therefore critical as they constitute 91 percent of the total number of enterprises, 40 percent of employment (including microenterprises) and 20 percent of the industrial value added in the country.18

17 World Bank. "Sri Lanka Poverty Assessment: Engendering Growth with Equity: Opportunities and Challenges." 2007 18 SME Development Program II – ADB -2007-Technical Assistance Consultant’s Report 22

4. The Sri Lankan banking sector has proven resilient to the effects of the global credit crisis, although the system is showing signs of strain. The system remains well capitalized and profitable. However, the performance of corporate and commercial loans and mortgages has deteriorated, and NPLs on SME loans have grown considerably. The NPL ratio for the system as a whole was 8.0 percent at end-Dec. 2009 and higher for loans to SMEs. Capital adequacy was relatively high at 14.9 percent at the end of the same period, since bank credit portfolios contracted significantly under the GFC, though it may be overstated given the sharp decline in the provisioning ratio.

Table 1: Banking Sector Financial Strength Indicators Percent 2004 2005 2006 2007 2008 Sept. 2009 Gross Non-performing 9.15 7.05 5.63 5.15 6.32 8.82 loans/ Total loans Provisions/NPL 63.8 65.8 66.9 64.5 60.9 47.4 ROA before tax 1.7 1.9 1.9 1.9 1.9 2.1 ROE 18.1 16.4 15.2 14 13.4 14.7 Loans/deposits 75.9 78.8 86.3 88.1 87.0 73.6 CAR 11.4 13.4 13.3 14.1 14.5 14.5 Liquid assets ratio 33.8 31.7 30.4 30.4 31.3 38.6 Source: Central Bank of Sri Lanka - Annual Audited Accounts 1/September numbers not annualized.

5. Nevertheless, as a result of the global credit crisis and the ensuing uncertainty, lending volumes have fallen while exposure to government securities has skyrocketed. Since end‐2008, commercial bank loan volumes have decreased by 3.9 percent, whereas securities holdings increased by over 130 percent.19 The share of domestic credit provided to the private sector was only about 29 percent of GDP, comparing very poorly to the low income country average of 40 percent of GDP (fig. 1). In comparison to similar countries, private sector credit/GDP in Sri Lanka was low even in 2007 (at 33 percent) and, unlike most comparator countries, domestic credit to the private sector decreased from 2007 to 2008, from 33 to 29 percent. It has been slowly picking up since November 2009; however, with the increasing public debt there could be a crowding out effect. On the demand side, factors highlighted by firms include the high cost of finance and collateral requirements, the mismatch between the supply of bank loan maturity (short) and the demand by firms for medium-long terms loans. 20 Other issues perceived by firms as constraints to obtaining credit include complex application procedures. Banks complain about lack of reliable financial information, poor quality of applications and difficulty in liquidating collateralized assets.

19Source: Central Bank of Sri Lanka (CBSL) Bank Supervision Department and individual commercial banks. 20 World Bank (2005), Sri Lanka Investment Climate Assessment 23

2. SMEs in Sri Lanka and Impact of the GFC

6. In line with the national focus on SMEs, the Government of Sri Lanka is concerned that SMEs have been particularly hard hit as a result of the GFC, and has requested World Bank support.21 According to estimates of the Industry Survey of 2008, there are just over 18,000 firms operating in the country, of which about 91 percent are SMEs. 22 These firms (excluding micro firms of 1-5 employees) employ 26 percent of the labor force and represent 17 percent of value added. The geographical distribution of industrial/manufacturing SMEs is currently concentrated in the Western Province of Sri Lanka (fig 2). Due to the historical and organic growth path of development of the country’s industrial base, commercial activities are concentrated in the Colombo district and its periphery. Table 2 and Fig 2 below give the principle activities and geographic distribution of industries in Sri Lanka. 23 Data on the other two main sectors, Services and Agriculture related establishments are not available.

Table 2: SME data for Main Industries24 Fig 2:Geographical distribution of SMEs by (Manufacturing, Mining and Electricity, Gas and provinces (manufacturing only) Water – 2007

SME TOTAL Number/Value (Rs.) 18,069 No. of % to Industry establishments Division 91%

Number/Value (Rs.) 263,127 Persons % to Industry engaged (No.) Division 26%

Number/Value (Rs.) 367,223,271,475 Value of % to Industry output (Rs.) Division 17%

Number/Value (Rs.) 150,702,462,942 Value added % to Industry (Rs.) Division 17%

21 There is no single, uniform definition of SMEs. Most commercial banks use a mix of data for turnover (generally less than 300 mill. annually), total asset value (less than Rs100 million, depending on whether land is included), and in some cases number of employees to define SMEs. 22 Annual Survey of Industry – 2008, Department of Census and Statistics, CBSL. 23 Industries as classified under UN definition 24 SMEs included in the table are SMEs having >5 and <100 persons engaged. 24

7. Access to finance is a key supply side constraint. SMEs in Sri Lanka, compared to larger- scale corporates, are less likely to use banks to finance investments (see figure 3). They are also less well diversified in terms of products and markets, and entered the crisis with thin cushions and fewer built up reserves. Even without these shocks, access to finance is generally a constraint for SMEs around the world. Figure 3: Use of External Finance by SMEs and Large firms in Sri Lanka and Comparator Countries Financing constraints for enterprises in many developing countries have spurred 60 a series of studies to evaluate the effect Large SME of these constraints on firm growth.25 50 These studies have shown that financial 40 development allows enterprises to overcome financing constraints with 30 positive repercussions for investment, 20 17 innovation and economic growth. Other 11 empirical studies have documented the 10 link between financial market 0 imperfections, firms’ financing constraints, firm growth and economy- wide growth. Relaxing liquidity constraints seems to improve firms’ and 26 Investment Climate Survey, World Bank, left to right sorted by the a country’s growth. average firm use of external finance

8. Despite declining interest rates, and improved liquidity in the financial sector in recent months, access to finance for SMEs remains significantly constrained. For instance, Sri Lanka’s SMEs do not use commercial banks to finance investments to the extent that comparator countries do (see Fig 3 above). This may be explained by demand but it may also be explained by the risk aversion of banks. The GFC has led to a reversal in the recent years’ trend toward lower Non Performing Loan (NPL) ratios in the banking sector (from 5 percent in 2007 to 8.8 percent by end 2009). An SME banking sector assessment conducted during project preparation revealed that NPLs on Banks’ SME banking portfolio ranged from 2.7 percent to 11.5 percent.27 This higher risk of lending to SMEs—exacerbated by an uncertain global environment— makes banks reluctant to extend credit to SMEs. While some banks have restructured the debt of affected SMEs, this trend has not occurred across the country, as capacity in conducting risk management for SMEs varies among banks and bank branches. The lack of a backstopping facility and lack of knowledge of banks with regard to SME lending are key obstacles to the lack of access to finance for SMEs in Sri Lanka.

25 Rajan, Raghu, and Luigi Zingales (1998). “Financial Dependence and Growth.” American Economic Review 88, 559-587. AND Beck, Thorsten, Asli Demirgüç-Kunt, and Vojislav Maksimovic (2005). “Financial and Legal Constraints to Firm Growth: Does Firm Size Matter?” Journal of Finance 60, 137-177. 26 Banerjee, Abhijit V., and Esther Duflo (2008), “Do Firms want to borrow more? Testing Credit Constraints using a Directed Lending Program” 27 These numbers are based on survey conducted as part of the preparatory work for this project. It included the top 7 banks in Sri Lanka, which together represent 75 percentof the banking assets to SMEs. 25

9. The findings from the 2005 Investment Climate Assessment points to access to finance as a large obstacle to growth (see Box 1). The main firm constraints to accessing finance are high interest rates and the value and type of collateral required from banks. Based on an SME Banking Assessment conduced as preparation for this project, in 2009, the average rate of interest for term loans was between 12 - 16 percent, while working capital loans have been granted at 13- 19 percent, down from higher levels in recent years. In this connection, while lending rates, after peaking in September 2008, have been on a downward trend, there is segmentation in the market, with rates charged to SME clients exceeding by far those offered to larger corporate clients. Moreover, the 2006 Financial Sector Report on the Observance of Standards and Codes (ROSC) for insolvency and creditor rights highlights high bank interest spreads, enforcement of unsecured rights, credit risk management and weak implementation frameworks for corporate insolvency laws as areas requiring strengthening in Sri Lanka.

Figure 4: Getting Credit Indicator: Doing Business 2010 Getting Credit 160 150 Strength Depth of of legal credit 140 127 rights informatio 120 112 113 index (0- n index (0- Economy Year Rank 10) 6) 100 India 2010 30 8 4 80 71 71 61 Pakistan 2010 61 6 4 60 43 Sri Lanka 2010 71 4 5 40 30 30 Banglade sh 2010 71 7 2 20 15

Nepal 2010 113 5 2 0 Afghanista n 2010 127 6 0 Bhutan 2010 177 2 0

10. The financial sector is expected to be a continued source of strength but remains risk- averse. Sri Lanka’s domestic financial system, although it is well-capitalized and prudential regulations generally meet modern standards, is shallow with total banking sector credit accounting for about just under half of GDP, less than regional averages. After surviving the consequences of the tsunami, the ethnic conflict and now the GFC, the Sri Lankan banking sector has been understandably conservative faced with the high uncertainty of late 2008 and early 2009. In response, the central bank has eased monetary policy and has taken steps to reactivate credit activity. This has been effective in decreasing lending rates but lending volumes remain constrained, especially to SMEs, due to the unavailability of collateral to lend for the already affected enterprises, the lack of reliable financial information on SMEs and the availability of less risky investment options like government securities.

26

Key Investment Climate Bottlenecks Facing Sri-Lankan SMEs in 2005

Firms face a number of severe constraints leading to low productivity. The most recent survey of enterprises in Sri Lanka reveals a number of constraints faced by the private sector.28 The most critical of these are: (a) poor availability, reliability and very high cost of electricity, (b) economic and regulatory policy uncertainty and c) macroeconomic instability and (d) access to finance (availability and cost). It is noteworthy that cost of financing for small firms is the third most important constraint. Other constraints include labor regulations, transportation, skills and education of available workers, and anti-competitive or informal practices.

Factor Market Inefficiencies Access to finance especially for SMEs is limited. Despite a vibrant banking sector, access to finance comes across as the most serious constraint for firms. The share of domestic credit provided to the private sector was only about 33 percent of GDP in 2008, comparing very poorly to the lower middle income average of 75 percent of GDP. Amongst the factors highlighted by firms include the high cost of finance and collateral requirements as well as complex application procedures. Banks complain about lack of credit information, poor quality of applications and difficulty in liquidating collateralized assets. Sri Lanka’s lowest ranking (148) in Doing Business 2010 for registering property. It takes about 83 business days on average, (41/2 months) to register a property lease, 8 separate procedures and the process costs 5 percent of the property value. Access to land is hampered by the long wait time for a legal title primarily because every transaction requires information or approval from a few different offices (the municipality to the national land registry to the zoning.) A typical firm must still wait more than a year before it has full legal title to land. This is nearly four times the length of time required in the rest of SSA; and this long wait is associated with significant costs. Sri Lanka has some of the most rigid employment regulations in the world. All regulations aim to provide job security to formal sector workers who represent about 15 percent of the workforce. Although it is relatively easy to hire workers in Sri Lanka it remains difficult to fire them: the island’s Difficulty of Redundancy index stands at 60 compared to a regional average of 41.3, according to the Doing Business Indicators Report 2010. It is also costly to fire workers. Along with the cost and difficulty involved in laying off workers, the severance payments required are determined by a discretionary process which penalizes well capitalized firms.

Infrastructure bottlenecks Electricity cost in Sri Lanka is amongst the highest in South Asia. A high proportion of firms in Sri Lanka (41 percent) perceive electricity as a major constraint compared to the average of lower middle income countries (20 percent); it is slightly higher than the average of firms in South Asia (39 percent). Electricity supply is insufficient, unreliable and prohibitively expensive at about US$0.40 per kwH). The economic impact of poor electricity services on enterprises is crippling: the ICA survey indicates that firms need to wait at least 83 days for a new service connection, a little less than double of the South Asia average of (48 days) and there is a heavy reliance on generators. The survey also revealed that manufacturing firms lost an average of 14 percent of sales due to power supply disruptions.

Regulatory burden High cost of business registration encourages informality. The cost of registering a business is estimated at more than US$870. Business registration still takes a long time (average of 28 days) mostly due to the time to register with the department of Labor to obtain EPF and ETF registration. The registry is inadequately maintained, name searches are conducted manually and the registry is not a reliable source of information for the business community. The cost of registering a business in Sri Lanka is 5.9 percent of income per capita (at least US$89.00 depending on the share capital of the enterprise). The largest costs are associated with a registration fee at the Companies Registry. The cost of registering a business is therefore a major hurdle for informal enterprises. The business licensing regime is complex and inefficient. Businesses complain about unnecessary requirements for licenses, a lack of coordination between local and state level administration as well as between line-ministries and a duplication of procedures. In addition, annual licensing fees are set arbitrarily and seem to change without sufficient prior notice. Much of the problem is caused at municipal level due to an imbalance between the assigned responsibilities and the funding of local governments. Licensing fees are, next to the property tax, the major income source of municipalities. A thorough review of the number and types of licenses is required with the objective of streamlining procedures and reducing the time and compliance costs for firms. The tax burden for firms is still crippling. The high tax rates (63.7 percent of profit), the multiple taxes (around 62) and the bureaucratic burden of compliance all lead to a crippling tax burden. A medium sized firm in Sri Lanka pays an equivalent of around 41.4 percent of its profits in taxes compared to 23.8 percent in SSA on average. This is one of the highest fiscal burdens of countries surveyed in the Doing Business 2010 report.

28 Investment Climate Assessment of Sri Lanka, World Bank, June 2005 27

3. Impact of the Global Financial Crisis in Sri Lanka

11. The slowdown in the real sector as a result of the global economic downturn affected the growth of export-led industries through decreased orders, and put a particular strain on SMEs within these sectors. A review of export turnovers between 2007 and 2009 by size of exporters shows that SMEs’ sales volumes were consistently more affected than those of larger firms.29 The impact of the GFC on exports in turn led to a slow down of the domestic economy and also hurt the domestic sector. An overall increase in unemployment of 1.3 percent followed between y-o-y in Q2-2009, driven by unemployment hikes in industry (+7.5 percent) and services (+1.9 percent).

Table 3: Economic activities integrated more with the Figure 5: Job Losses during Oct 08 June 09 by Market global economy recorded ‘worst performance’ Orientation Q1-2009 Q2-2009 Tea -40.9 -11.7 Minor export crops -5.3 -2.0 Gem mining -27.1 -6.0 Export crop processing -12.0 3.0 Textile, apparel and leather 5.4 -8.9 Chemicals, petroleum, rubber and plastic 0.2 -0.9 Non-metalic mineral products -8.7 -1.9 Electricity, gas and water -2.5 4.3 Import trade -12.1 -15.9 Export trade -0.7 -12.0 Hotels and restaurants -16.7 -0.4 Cargo handling and aviation -10.1 3.0 Source: UNDP, Dec 2009

Crisis Response in Sri Lanka

12. The Sri Lankan authorities took several steps to support sectors affected by the GFC. The Government of Sri Lanka introduced a first stimulus package of LKR 16 billion (0.4 percent of GDP) in December 2008 and a second stimulus package of LKR 8 billion (0.2 percent of GDP) in May 2009. These provided incentives to the tea, rubber, cinnamon, and garments export sectors (including a fertilizer subsidy), as well as rewards under the Export Development Reward scheme (including 5 percent of export incentives). While the stimulus package has reportedly had positive effects on some sub-sectors (tea factories, garment manufacturers), export-led sectors have been showing worrisome signs of performance.

Impact of the GFC on Small and Medium Enterprises

13. While the economy is showing early recovery signs, SMEs have been more affected than large firms by the global crisis in several ways. First, the increase in commercial lending rates up to levels as high as 21 percent in Sept 2008, translating into rates reaching 25-30 percent for

29 For example, while export revenues increased by 22 percent for large firms in the tea sector between 2007 and 2008 despite the global crisis, they contracted by 3.25 percent for SMEs. Rubber exports also showed an increase in export sales of 13.4 percent for large firms, in stark contrast with the 12.5 percent contraction in rubber exports of SMEs. Source: World Bank analysis of Export Performance indicators -1999-2008, Sri Lanka Export development Board 28

SMEs, has led many SMEs to loan defaults, in the context of decreasing sales due to the Global economic slowdown (Fig. 6). Second, firms that have survived have increasingly turned to sub- contracting, Figure 6: Trends in lending rates in Sri Lanka i.e. to supplying larger firms as part of the supply chain (business to business), in lieu of exporting directly. This recent phenomenon has put additional pressure on their margins. Third, credit requirements of large firms are expected to rise rapidly with the pick-up in economic activity. As banks shift from zero- weighted holdings of government securities to corporate lending, they will become increasingly capital constrained. Banks are likely to prefer lending to the relatively easier corporate sector and ration credit to SMEs, despite the current need of SMEs for bank financing to meet recent Source: World Bank financial crisis monitoring increased orders.

14. The constraint on access to funding for SMEs and the impact of high debt servicing on their balance sheets has been putting these firms in a difficult position to recover from the global crisis. This is in turn is affecting the ability of these SMEs to invest in capital goods, environmentally friendly technologies, and job creation.

4. Demand for and Supply of SME Banking.

15. Approximately 17.9 percent of the total portfolio of the banks under review consists of SME financing. This includes both long term and short term facilities to the sector. As reflected in the table given below the share of SME portfolio of the seven banks declined from 20 percent in 2008 to 18 percent in 2009.

Table 4 $ million* 2008 2009 SME Total SME % % Bank Total Portfolioportfolio Portfolio portfolio Bank of Ceylon 1794.632 50.046 2.79 1865.75 58.826 3.15

People's Bank 2279.288 34.242 1.5 2584.832 40.388 1.56 NDB Bank 489.924 29.852 6.09 485.534 30.73 6.33

DFCC Bank 384.564 162.43 42.24 339.786 140.48 41.34 Hatton National 1620.788 805.126 49.67 1545.28 763.86 49.4 Bank Commercial Bank 1617.276 546.994 33.82 1554.06 468.852 30.17 of Ceylon Wayamba 63.216 5.268 8.33 66.728 7.024 10.53 Development Bank TOTAL 8249.688 1633.958 19.81 8441.97 1509.282 17.88 *Converted from LKR May 21, 2010

29

16. Since all major players in the SME financing business are included in the selected sample, it can be reasonably assumed that approximately 75 percent of the banking sector financing to SMEs in the island is covered in the above calculation.

17. Major sectors financed were food processing units such as tea factories, confectionaries, restaurants, milk based industries etc.; rubber products such as tire retarding, rubber processing and molded rubber products; wood based products such as furniture manufacturing, wooden construction material; agro base industries including paddy milling, fiber milling, coconut oil milling etc.; fishery, dairy, poultry, horticultural projects and service sector businesses such as transport, health care, and tourism; apparel garments, light engineering business and metal products are the key business in the manufacturing sector.

18. As a consequence of the Global Financial Crisis banks’ portfolio quality in the SME sector has dropped and NPL ratios of the SME portfolio have increased at a faster rate than that of the corporate sector for all banks except BOC. Initially, the GFC affected export oriented projects such as tea, apparel and garments, horticulture, rubber based industries and subsequently it was spread to the supplier lines. The banks have taken steps to restructure and reschedule SME loans to cushion the impact during the recent period. A comparison of the overall NPL ratio and SME NPL ratio for the period 2007 – 2009 is in the following table.

Table 5

Appraised Bank Overall NPL Ratio SME NPL Ratio 2007 2008 2009 2007 2008 2009 Bank of Ceylon 3.24 4.51 5.50 7.02 5.62 4.42 Peoples Bank 5.83 6.73 6.65 8.09 9.61 10.11 NDB Bank 1.60 2.28 2.62 2.75 3.13 6.00 DFCC Bank 6.24 9.10 10.46 7.00 12.00 12.00 Hatton National Bank 2.96 5.19 6.84 4.05 8.37 11.52 Commercial Bank of 7.70 7.30 8.90 7.80 5.80 10.80 Ceylon Wayamba Development 3.21 2.67 3.28 2.40 2.14 2.71 Bank Median 3.24 5.19 6.65 7.00 5.80 10.11

19. Based on the SME Banking Assessment conducted, estimated SME credit demand for the period 2010 – 2012 is expected to total around US$875 million for long term financing and US$650 million for working capital financing. A summary is below:

30

Table 6

Name of Term Financing $ millions* Short term Financing $ millions the Bank 2010 2011 2012 2010 2011 2012 Bank of 18.44 25.73 33.36 11.33 15.01 24.41 Ceylon Peoples 42.14 50.92 53.21 63.22 76.39 86.92 Bank NDB Bank 47.41 73.75 114.14 31.61 49.17 61.46 DFCC Bank 15.37 17.65 20.28 6.59 7.90 8.69 Hatton National 45.66 57.95 75.51 24.58 30.73 40.39 Bank Commerci al Bank of 42.14 45.66 50.05 28.10 42.14 48.29 Ceylon Wayamba Developm 13.43 15.72 18.00 n.a n.a n.a ent Bank Total 224.59 287.37 364.55 165.42 221.34 270.16 *Converted from LKR May 21, 2010 Supply of SME Banking in Sri Lanka

20. A market assessment of the SME banking sector was conducted and the following points highlight the issues and current operational practices of lending institutions.

ISSUES IN THE SME SECTOR IN SRI LANKA RECOMMENDATIONS

 Banks use different criteria in categorizing SMEs to suit their Common classification for SMEs needs to be operations and portfolio strategy. There is no uniform and agreed adopted-Common classification criteria for SME definition. A concerted effort is now being made to arrive at a sector should be established with the common definition for official adoption. endorsement of all related government institutions/ministries, banks and other  Most domestic commercial banks and some specialized banks stakeholders. are actively engaged in SME financing. Capacity building is needed for both SME  All the subsidiaries of foreign banks and some of the local entrepreneurs and the lending institutions - banks are constrained in their reach as their branches are Most of the entrepreneurs in the SME sector lack confined to Colombo city and suburbs. The local domestic banks technical, managerial. Accounting and marketing without a large branch network are (NTB), skills while the participating credit institutions Panasia Bank and Union Bank. also need training in appraisal, M&E and more  In general all the banks operating in the SME sector are more importantly a change in attitude. aligned towards medium size borrowers except the RDBs, Credit appraisal process is not up to which are more aligned towards small and micro sector. State expectations in almost all banks and needs banks also to a lesser degree than RDBs have some focus on the immediate attention and improvement. small enterprises area. Longer term credit lines to banks to lend to  All the major banks are aggressively moving in to the North the SME sector are required as the banks are and East Provinces to exploit the post conflict opportunities that faced with the problem of managing their fund are emerging in those areas. mismatch.  The main business sub-sectors financed in the SME sector are Setting up a Credit Guarantee Fund for SME agro industries, food processing, fisheries, wood based financing. products, animal husbandry, horticulture, construction, retail The Banks should adopt differentiated appraisal and other small service related businesses. techniques for corporate clients and SMEs.

31

Annex 2: Major Related Projects Financed by the Bank and/or other Agencies SRI LANKA: SME Development Facility Project

List of recent relevant sector specific Bank projects (ongoing and completed)

Product Project Amt IP DO Sector Specific Issues ID (US$m) Rating Rating addressed Pipeline/Recently Approved P113709 Sustainable Tourism Development 18.00 NA NA SME Matching Grants Project for tourism related enterprises and technical assistance for capacity building Ongoing P074872 Community Development and 51.0 S S Inclusive finance, Livelihood Improvement "Gemi access to credit Diriya" Project P086747 Community Livelihoods in 64.7 MS S Inclusive finance, Conflict Areas(NEAP) access to credit P087145 Second Community Development 75.0 NR NR Inclusive finance, and Livelihood Improvement access to credit Project P076702 Renewable Energy for Rural 115.0 MS S Access to finance, Economic Development long-term lending facilities to SMEs in the renewable energy area. E.g. solar power and mini hydro power Completed IP= Implementation progress, DO=Development Objective, S= Satisfactory, MS=Moderately Satisfactory, NR = Not Rated, NA – Not Applicable

Donor Matrix on SME related projects : ongoing and recently completed projects

Ongoing Project Donor Description of Project Sector specific issues Amount addressed IFC,Royal Norwegian Enhance access to finance for small firm Access to finance and US$5.2 - Government, and the owners,-improve the performance and capacity building for SMEs Million Dutch Government: competitiveness of the small and medium and Participating Financial South Asia Enterprise enterprise sector, Institutions. RSF Schemes Development Facility- facilitate the establishment of enabling for Selected banks for SME Sri Lanka and conditions for small enterprise development lending, Tools for SMEs Maldives (SEDF)

32

USAID: CORE Provide capacity building and facilitation Access to Finance and US$13.5 m Program for market linkages ,assist small capacity building for SMEs businesses to access new markets, provide technical assistance to upgrade small businesses and facilitate access to finance and capital equipment with emphasis on the Eastern Province

KfW Bankengruppe SME investment financing to be used for Access to Finance: EUR 20.1 granting sub loans and lease to finance investment and working Million medium and long-term investments in capital loans fixed assets , primarily relating to imported capital goods , by private sector enterprises in Sri Lanka. European Investment SME investment financing Access to Finance EUR 50 Bank(EIB) – DFCC Million Global Loan II

EIB – Post Tsunami SME investment financing : dedicated Access to Finance EUR 70 Reconstruction credit line to industry, tourism and other Million sectors affected by the Tsunami disaster

Completed Projects JBIC: Promote stable and balanced economic Access to Finance, SME Yen(¥) 9,619 Small and Micro growth in Sri Lanka through providing capacity building Million Industrial Leadership capital to small and micro industries, and Entrepreneur developing managerial, accounting, and Promotion Project technical skills of small and micro III(SMILE III) - industries and strengthening institutional capabilities of intermediary financial institutions. JBIC: Small and Micro Credit lines to SMEs and capacity Access to finance and 3 Billion LKR Industrial Leadership building entrepreneurship and Entrepreneur development for SMEs Promotion Project (SMILE II) - ADB: Strengthen the enabling business Access to finance and US$60 Million Small & Medium environment for SMEs capacity building for Enterprise Sector Catalyzes investment by improving PFIs, SMEs and SMEs access to commercial finance Development Program Business Development Enhances the capacity of business (SMESDP) “Sahanaya” development services providers to Services. Term loans to efficiently and effectively deliver SMEs services to SMEs. JBIC: Provide technical assistance and low Access to finance and Yen (¥)5,236 E-Friends II cost loans for waste minimization, technical assistance to Million resource recovery, energy savings and SMEs for environment pollution control and abatement in friendly adoption of industrial enterprises technology

33

ADB:Southern The loan scheme is mainly for the Access to finance and US$15 Million Province Regional purchase of machinery and equipment, capacity building Economic vehicles, construction of factory, building and/for financing of permanent Advancement Project working capital requirements for SMEs (“Dasuna”) GEF Small Grants Ecotourism, Organic Farming, Coral Community level US$133,000 Program Reef Restoration, Forest conservation employment creation Tour Guides training, Turtle and conservation and social development, Financial access Resource Centre in the Dry Zone and Mitigating Human Elephant Conflict ADB Protected Area Management and Financial access to SME ADB: US$17 m GEF and Government Wildlife Conservation Project and community level GEF: US$9 m of Netherlands (GoN) organizations GoN: US$4 m. Donor Description of Project Sector specific issues Amount addressed USAID Tsunami Relief and Reconstruction Financial access and US$134.5 m Activities stress GTZ- Capacity Improve competitiveness of the Small Capacity building and - Building for and Medium Enterprises (SMEs) by. Financial access and Competitiveness and -Improvement of Frame conditions for stress SME development and qualified Qualified Employment Employment generation employment. and Promotion of -the integration of small and medium Micro, Small, and enterprises into internationally Medium competitive value chains Enterprises(CBCQE) -abour market oriented human resource development

GTZ-Promotion of the Enhanced and improve in a sustainable Capacity building for - Microfinance Sector manner services offered by selected Micro Financial microfinance institutions (MFIs) to the institutions to lend poorer sections of society as well as effectively and micro and small enterprises are sustainably. Netherlands/USAID/N Grant and loan scheme to SMEs affected Financial access and US$100 Million orway by the Tsunami stress Tsunami -Back to Business Project

34

Annex 3: Results Framework and Monitoring SRI LANKA: SME Development Facility Project

Results Framework

PDO Outcome Indicators Use of Outcome Information To improve access to  Increased outreach: increased finance (including term lending (including term lending) to finance) for SMEs affected SMEs by all PFIs under credit30 YR 1-2 gauge whether PFIs as a result of the Global  facility. manage to expand lending to Financial Crisis in Sri o As measured by increased SMEs while reducing NPLs and Lanka. number of SME beneficiaries improving the profitability of o As measured by increased their SME business, and also volume of loans to SME gauge the behavior of benefiting beneficiaries SMEs against the outcome indicators.  Improved Portfolio Quality: As measured by decreased Non Performing Loans (NPLs) ) in SMEDeF Project Portfolio ( measured by % that are at least 90 days past due)

Intermediate Results Results Indicators for Each Use of Results Monitoring One per Component Component Component One: Component One: Component One: Financing and RSF: PFIs Evidence of timely and satisfactory have better access to term progress toward the delivery of YRs1-2 persisting low level of financing and are able to Component 1 outputs, as planned, lending to SMEs may signify increase longer term (5 including the following specific continued risk aversion among year+) lending to SMEs. measures: bankers, reflecting slow progress with project  Increased volume of lending from implementation. credit facility to PFIs on market-based Yr 2 results monitoring will be interest rates used to speed up project  Increased number of new SME implementation. YR3 use the outcome borrowers under RSF portfolio information for project

evaluation.

30 Defined as maturity of at least 3 years. 35

Component Two: Component Two: Component Two: Policy and Institutional Development Technical Evidence of timely and satisfactory YRs1-2 gauge compliance of Assistance: progress toward the delivery of PFIs with the project Component 2 outputs, as planned, requirements of putting in place including the following specific (a1) Strengthened measures the necessary technologies, capacity within the PFIs to systems and practices to deal reduce banks’ transactions  Increased number of PFIs, which with credit risk and transactions costs, better manage risks introduce enhanced credit scoring costs related to SME lending. related to SME lending techniques and practices/products for Make any adjustments to the and make SME banking a SME lending as agreed under the TA. project design, as necessary. profitable venture Yrs1 slow progress with  Increased number of loan officers achieving any of the results trained under Project indicators flags project design

(a2) Better access to or implementation problems  Improved access of SMEs to capacity enhancement/ credit-specific Business Development business development Yrs2-3 results monitoring will Services (BDS) as measured by services (BDS) for SMEs be used to address the design percentage of SMEs getting loan after and/or implementation training by Participating Financial problems so as to speed up the Institutions (PFIs) implementation of the project.

YR3 use the outcome information for project evaluation. (b) Support to  Findings of the diagnostic Strengthen the Enabling affecting SMEs and recommendations Environment for SME to address them shared with relevant Banking authorities for action.

36

Arrangements for Results Monitoring

Project Outcome Indicators Baseline YR1 YR2 YR3 Frequency Data Responsibility and Collection for Data Reports Instruments Collection

Cumulative number of active 0 60 170 280 PFIs and PFIs and PIUs SME loans (< 36 months PIU Reports maturity) PFI s and PIUs

PFIs and Cumulative number of active 0 60 170 280 PIU Reports PFIs and PIUs SME loans (>36 months maturity) PFIs and PFIs and PIUs 3 Months PIU Reports

Cumulative volume of loans to (quarterly) 0 4 9 14 SMEs (<36 months maturity, PFIs and

US$m equivalent) PIU Reports 3 Months Cumulative volume of loans to 0 4 9 14 (quarterly) SMEs (>36 months maturity, US$m equivalent)

10% <10% <9% <8% PFI SMEDeF Project Portfolio

Quality (NPL (% ) of >90 days)

Component I: Financing and

Risk Sharing Facility

Volume of Lending to 0 8 18 28 PFIs and PFIs and PIUs PFIs(Cumulative US$m 6 monthly PIU Reports equivalent)

37 0 PFIs and Number of new SME borrowers PIUs= 200 500 1,000 under RSF portfolio 6 monthly Reports (cumulative) Component II: Policy and Institutional Indicators

Cumulative no. of PFI 0 2 4 6 introducing 6 monthly processes/products/management systems specific to SME Cumulative percentage of 0 20% 30% 50% 6 monthly SMEs getting loan after training by PFIs

Cumulative no. of PFI loan 0 75 250 400 PFIs and officers trained in SME PIU Reports 6 monthly Banking products and credit risk management 0 Findings drafted recommendations PIU Reports PIU Completion of findings of the drafted and shared diagnostic affecting SMEs and with relevant Yearly recommendation to address authorities for action them made available.

38 Annex 4: Detailed Project Description SRI LANKA: SME Development Facility Project

1. The proposed SMEDeF is a three-year Financial Intermediary Loan consisting of a credit line and risk sharing facility available to both public and private participating financial institutions (PFIs).31 Selection would be based on clearly defined eligibility criteria that would ensure minimum performance and profitability of the PFIs and focus on SME lending. 32

2. The project uses an incentive approach to support bank downscaling to supply credit to SMEs. The incentive approach would combine the provision of appropriate financing instruments to banks (line of credit and risk sharing facility) with commitments from participating banks to strengthen their SME banking capability over time. Since the success of the facilities will depend on the application of modern SME lending technologies and risk control procedures, while the banks can independently access the line of credit or Risk Sharing Facility, technical assistance will be mandatory under both facilities. If a bank participates in both facilities, the mandatory technical assistance requirement would only apply for one of the two facilities. The project would also provide complementary technical assistance at the SME level to increase their “bankability”.

3. Definition of SMEs: Multiple definitions are currently used in the financial sector to categorize SMEs and there are on-going discussions to provide a common definition of SMEs in Sri Lanka. For the purpose of this project, an enterprise would be classified as an SME if it meets any of the following criteria i) any borrowers of loans of up to 10 million rupees [US$90,000 equivalent], excluding consumption and housing loans and ii) for loans over 10 million rupees [US$90,000 equivalent], enterprises with an annual turnover under 300 million rupees [$US 2.6 million equivalent]. The aforesaid classification will be subject to subsequent changes or modifications that may be issued or adopted by the Central Bank of Sri Lanka and/or Government of Sri Lanka.

Component 1- Financing and Risk Sharing Facility

Component 1.a. Line of Credit to refinance short and long term loans for SMEs nationwide.

4. Based on established demand, the Government of Sri Lanka will provide a credit line to participating Licensed Commercial and Licensed Specialized banks for SMEs across Sri Lanka. However, the PFIs are encouraged to lend to SMEs outside the Western Province (WP) given that almost 50 percent of the Gross Domestic Product (GDP) has been centralized in a single province (WP). Government’s development policy is to create more economic opportunities outside the WP and also create employment opportunities for the rural population mainly targeting the youth. The access, modalities and pricing would include features such as competitive interest rates and maturities in line with on–going commercial practices and World

31 Subject to World Bank Management review, including the Board of Directors, the Bank team has requested a credit of US$57.40 million for this operation. 32 These would include compliance with prudential and regulatory requirements of CBSL, and with minimum Non Performing Loan and capital adequacy ratios.

39 Bank Operational Policy OP 8.30 (along the lines of a 6-month AWDR, so that no market distortions are created).

5. The Project Implementation Unit (PIU) of the Development Finance Department (DFD) of the Ministry of Finance and Planning will lend to the PFI at a 6-month Average Weighted Deposit Rate (AWDR) which will be revised every six months based on the AWDR published by the Central Bank. The PIU will issue a Request for Expressions of Interest to eligible PFIs. The eligibility criteria for PFIs are given in the Operating Guidelines in Appendix 1. The review process will be carried out by the PIU. The PIU will enter into a subsidiary loan agreement with all the selected banks. All PFIs need to have an SME strategy and are required to participate in the Technical Assistance program on a cost sharing basis. The selected PFIs will be able to on- lend to the sub borrower at the market rate agreed with the respective clients, based on their creditworthiness. The credit line will be used to provide working capital (up to 3-year maturities) as well as term loans (over 3 years) to the SME clients. The project will require that at least 50 percent of the financing be attributed to loans with a maturity of at least 3 years. The line of credit will refinance up to a maximum of 100 percent of the loan. The maximum size of the loan will be US$530,000 equivalent, however loan sizes are expected to average US$50,000 equivalent. The participating financial Institutions will be required to inform the borrowers to follow relevant environment and other industrial relations laws of the country. The details are given in the Environmental and Social Risk Management framework prepared by the Government, available on the MOFP project website. The Project Implementation Unit will conduct an annual Social and Environmental assessment covering a representative sample to ensure compliance.

6. Any private enterprise operating in Sri Lanka that has a viable commercial/economic activity and fulfills the SME criteria is potentially eligible. Availability of funding will be subject to PFIs’ creditworthiness assessment. In addition, the proposed business activity should comply with the established Social and Environmental Risk Management Framework. The borrower should be encouraged to register with the relevant government authorities, Registrar of Companies or local government authorities.

7. Consultations by both GOSL and IDA have revealed that SMEs in the apparel, food and beverage, leather, tourism, fisheries and agro industries were affected by the GFC as well as the thirty-year long conflict. In addition, the enterprises and individuals in the North and Eastern provinces were more affected by the conflict and commercial activities were not attractive in those areas in the past due to restricted access to the rest of the economy. Except for the state banks, very few private sector banks operated in these areas. During the past year, economic and commercial activities have been revived and the improvement of infrastructure has enhanced the connectivity to the economic centers in the rest of the country. Therefore, with the increased number of bank branches in these areas, access to credit has improved. This facility will enable the PFIs to extend credit facilities in the North and Eastern Provinces, the emerging provinces such as Southern Provinces and North Central Provinces and also in lagging provinces such as Uva and Sabaragamuwa Provinces.

8. As the government’s stated policy is to encourage SME banking, government will provide assistance to PFIs to improve their institutional capacities to cater to this preferred sector. The

40 Central Bank has already discussed with the banks setting up provincial SME centers with well trained staff who can act as a resource to the whole province. The technical assistance under the Project will also provide an opportunity to enhance this capacity building effort on a cost sharing basis. Detailed operating guidelines for the credit line are provided in Appendix 1.

Component 1b: Risk Sharing Facility (RSF) to reduce the risk of lending to SMEs

9. This sub-component is designed to improve access and terms of SME credit by providing an appropriately designed Risk Sharing Facility mechanism for loans provided to SMEs by eligible PFIs. It has been demonstrated that RSFs can leverage loans to SMEs from commercial banks and other financial institutions, provided they offer the right incentives, and have predictable, streamlined payment processes. For this project design, the incentives have drawn on lessons learned from (i) past RSF schemes in Sri Lanka; (ii) experience with RSF schemes implemented by the Bank, notably in Madagascar (Integrated Growth Poles Project, P083351), Ghana (Micro, Small and Medium Enterprise Project, P085006) and India (Small and Medium Enterprise Financing and Development Project). Guiding principles based on international best practice include: (a) share risk on a partial basis with the participating financial intermediaries, to provide the appropriate incentives, minimize moral hazard and leverage funding; (b) leverage the financial institutions oriented to SMEs and their commercial incentives to apply due-diligence on the borrower; (c) establish ex-ante eligibility criteria for financial institutions’ participation; (d) use a streamlined portfolio approach (versus credit by credit guarantee); (e) establish a “stop loss” mechanism to terminate the issuance of new guarantees to a poorly performing PFI ; (f) associate technical assistance to participating banks and SMEs to support SME lending techniques and financial capability and (i) establish appropriate performance monitoring.

10. The RSF is a risk-sharing facility that will be proposed to commercial banks and other eligible financial institutions in Sri Lanka that wish to actively develop SME banking and expand their client base. It is aimed at encouraging these financial institutions to lend to SMEs by partially back-stopping potential losses resulting from non-payment of their respective SME loan portfolios.

11. Sri Lankan banks and financial institutions, suffering the aftershocks of recent conflict and the economic downturn, display risk aversion towards SMEs, particularly in light of the recent spike in NPLs that occurred as a result of these recent events in Sri Lanka. Few banks practice modern SME lending techniques, and most require borrowers to provide collateral (generally real estate) for all loans, sometime in excess of 100 percent of the principal borrowed. It is hoped that the combination of technical assistance on SME lending coupled with the RSF will improve access to finance for SMEs who often lack collateral but have adequate cash-flow to service debt. It is expected that the focus on new borrowers will facilitate access to finance by SMEs in the former conflict-affected areas, which have had very limited access to financial services in recent years.

12. Eligibility criteria for PFIs will be the same as for Component 1a. All eligible PFIs may elect to participate in the RSF scheme, which will cover 50 percent of loans to agreed portfolios of SME borrowers, on a pari-passu basis with PFIs, up to a stipulated ceiling of 20 percent cumulative losses on the guaranteed portfolio (i.e. the RSF will pay maximum claims of 10 percent of the guaranteed portfolio). All loans to SME borrowers that meet the agreed eligibility

41 criteria will be included in the covered portfolio. The 20 percent ceiling should comfortably cover all expected losses. There will also be a stop-loss mechanism that may result in the suspension, reduction or cancellation of the unused facility amount when arrears and claims reach pre-determined trigger levels. Claims can be made once a covered loan is in arrears for a specified period, with supporting documentation. 33

13. As new loans with a maximum tenor of seven years can be guaranteed during the life of the Project, the RSF will remain in effect after project closing. Claims can continue to be made for up to 8 years from project closing, and PFIs will share 50 percent of all subsequent recoveries with Sri Lanka Insurance Company (SLIC), the Facility Agent. SLIC will continue to have responsibility for honoring valid claims for the life of the RSF. Reserves will be constituted up- front and may elect to continue the scheme after the Project closes, which will be adequate to meet claims over the life of the facility. These reserves will be kept in a dedicated account to be maintained at the Central Bank of Sri Lanka (CBSL) or at a commercial bank acceptable to IDA, and can only be used to pay claims to the PFIs during project implementation. Prior to project closing, the GoSL will have provided funds to replace IDA resources, sufficient to meet claims that may arise subsequent to project closing. IDA funds remaining in the dedicated account at project closing (IDA disbursements less claims paid) will be returned to IDA.

Leveraging structure

14. The Risk Sharing Facility (component 1b) will leverage GoSL resources and capabilities: US$13 million equivalent in reserves for the RSF is expected to mobilize up to US$130 million equivalent of new loans to SMEs.

RSF Premium

15. For component 1b (RSF), it is proposed that PFIs pay an initial premium on the average outstanding covered portfolio of 1 percent per annum, which should be sufficient to cover expected losses over the life of the facility as it is the intention to maintain this as an ongoing and commercially viable credit insurance mechanism post project closing, SLIC may wish to risk adjust premia periodically based on individual PFI performance under the facility.

16. Annex 7 provides further detail on disbursement procedures.

Component 2: Policy and Capacity Enhancement for SME Banking

Component 2.a Capacity enhancement to Support SMEs and SME Banking

17. In partnership with the IFC and other development agencies, this component will provide capacity enhancement through training and technical assistance to the commercial banks that will benefit from the credit line or RSF, in order to help build capacity in lending services to SMEs and to ensure that SMEs have sufficient capacity to effectively utilize loans from the banks for the growth of their businesses. The project will concentrate on providing capacity enhancement and technical assistance on SME banking at the PFIs’ branch level.

33 To be determined in negotiations between the banks and GoSL, but in any event will be no less than 270 days.

42

18. Training and Technical Assistance will be compulsory for all the participating banks that take up the credit line or the risk sharing facility. Further, it is proposed that banks which do not meet the eligibility criteria for the Line of Credit and RSF may be deemed eligible for technical assistance to enable them to meet the criteria. The PIU will perform a diagnostic of each PFI’s capacity needs, with support from an adviser with international experience, to establish the type and extent of training and technical assistance required to service the SME sector profitably and sustainably. All banks have their traditional training menus that have been serving their various corporate objectives. A number of them also carry out the training using both in house and outside experts. Training in these institutions has traditionally included appraisal mechanisms regarding financial, economic, environmental, legal, documentation, among others. Earlier assessments on some of banks in Sri Lanka indicate that the banks lack experience in segmenting their product lines, including SMEs and that their risk management functions are weak. These will be areas of focus by this project as they are the basis of good SME lending and banking. Some banks do provide technical assistance to SMEs in terms of debt restructuring and appraisal documentation. However, banks have not been involved in providing training to SMEs in record keeping and accounts, financial management, human resources, marketing, or quality assurance, although they have highlighted these areas as critical for the SME sector to be banked. Box 1 below provides more details on the modalities and scope of the TA interventions.

19. A number of donors and other interventions are involved in capacity building to banks and SMEs, including training and technical assistance. IFC is supporting selected private banks and chambers of commerce, especially in the poorest districts of Galle, Matara, Hambantota, Ratnapura in the southern part of the country. The training and TA being offered by IFC in these Southern districts through the Business Edge Training Program, a cost sharing training program, cuts across various elements of good business practices that the SMEs need. The program has 38 modules that can be utilized for training depending on the needs expressed by SMEs, individually or as a group. After a needs assessment is completed, relevant modules are selected and used to train the SMEs. The modules have been revised to reflect the needs of the SMEs as determined through diagnostic studies and experiences gained from its application in many other countries. The project will evaluate its replicability in the rest of the country through the PFIs. The project will also link with the USAID-funded project on Connecting Regional Economies (CORE) that will support the training and technical assistance to value chain participants in good business practices, including record keeping and accounts, project proposals, etc; market linkages, productivity improvements and investment promotion. This project is targeting horticulture, fisheries, tourism, logistics, livestock/dairy and IT services in the following districts in the north and east of the country: Ampara, Batticaloe, Trincomalee, Vavuniya, Jaffna, Mulathivu, Anuradhapura and Monaragala. The project will also link with the intervention on the establishment of warehouse receipts financing mechanisms that are being planned by the Bank in the north and east of the country (supported through the Food Price Crisis Response Trust Fund), in which participating banks will be expected to work with community organizations and SMEs so that they can utilize warehouse receipts as collateral for loans and to participate in the provision of capacity enhancement for those involved. This is expected to reduce the risks inherent in agri-based SMEs and to increase the flow of credit to these communities in these two provinces. The training and technical assistance to be carried out in these two interventions will

43 be coordinated with that being provided under the project to avoid duplication and wastage of resources.

20. The project will use the proven training and technical assistance models, such as Business Edge and mechanisms that have already worked in Sri Lanka to provide the necessary services to the participating banks and SMEs. The expected end result is that the participating banks acquire the know-how to lend to more SMEs using appropriate financial and non financial products. Diagnostic assessments will be performed for participating financial institutions to determine their capacity and technical assistance needs and those of the SMEs that they will be providing loans to. The assessments will help determine the appropriate mix of capacity enhancement and technical assistance tools and delivery mechanisms that can leverage the current knowledge and relevant delivery mechanism in Sri Lanka.

Box 1: A Step by Step Process for the Provision of TA to PFIs and SMEs

1. TA to PFIs: Since the long term success of the credit facility is tied to the change in mindset required of banks, PFIs will have access to funds under the credit facility only if they enter into a Technical Cooperation Agreement with the PIU. The TA program will likely be based on a matching component that could go up to 50 percent, to be determined at implementation once the PFIs have been identified. A service provider with extensive experience in SME banking will be competitively procured and engaged by the PFI to provide TA to build its capacity to serve the SME market. The selected service provider will work with the PFI to execute the agreed training and TA program based on the agreed technical cooperation agreement. The service provider may use the outcomes of the ongoing successful IFC pilot of three banks to expand SME banking in Sri Lanka, in addition to global best practices.34 Lessons from the IFC pilot show that a critical success factor so far, also a key goal of the SMEDeF project, is to build the institutional and human resource capacity of PFIs to effectively service the SME client market. The IFC pilot has provided TA to banks in key areas. These include setting up SME banking units, devising SME strategies, improving risk management practices including for the SME banking portfolio, adopting integrated risk management frameworks, credit scoring models and technologies specific to SMEs, channel/branches’ productivity improvements, and performance management systems. Based on IFC’s earlier TA programs with selected banks, products introduced in Sri Lanka have included supply chain financing, leasing, and working capital products relevant to SMEs operations. Additional features that may be incorporated in this program include:  simple, client-responsive, standardized loan product design,  fixed monthly repayments to enforce credit discipline,  underwriting decisions based on loan officer analysis of the potential borrowers ability to repay (focusing on combined business and household cash flow and debt service capacity),  loan officer incentive compensation that encourages number of new clients reached (rather than the size of loans) and high rates of loan repayment,  close monitoring and immediate response to signs of repayment problems,  use of specialized and standardized accounting, risk management and management

34 The service provider could use other relevant training programs to complement the IFC pilot.

44 information systems and  identification of change agents within the bank.

2. TA to SMEs via PFIs The training to SMEs will be offered through the Business Edge Training Program, which is currently being implemented by IFC to train SMEs in three private commercial banks in Sri Lanka. This is a cost-sharing training program between PFIs and SMEs. This program is a holistic one that looks into the elements of good business practices that SMEs need based on their interaction with the PFIs. It is expected that the selected consultants will do a “training needs assessment” with full cooperation of the PFIs. Based on the IFC pilots, areas that particularly constrain SMEs’ access to banking include: record keeping and accounts, financial management, human resources, marketing and product quality. From such a diagnostic, the service provider will be able to determine which module(s) would be applicable to a specific set of SMEs. For instance, during its diagnostic, the IFC pilot aggregated data on various reasons for rejecting an SME loan application. Based on the ‘reasons’ for rejection, the service provider firm created tailored modules to train the SMEs that were rejected for that particular reason. During the training, relevant branch managers and SME Relationship Officers also participated in this training to ensure continuity. In essence, after the needs assessment is completed, relevant modules are selected and customized to train the SMEs. The modules have been revised to reflect the needs of the SMEs as determined through diagnostic studies and experiences gained from its application in many other countries. Business Edge has so far been successfully applied in Sri Lanka and other countries around the world (Vietnam, China).

Component 2.b: Support to Strengthen the Enabling Environment for SME Banking

21. Access to credit is crucial for economic growth and is the engine for private sector development. While access to credit varies from one jurisdiction to another, constrained access to finance remains among the top three limitations on private sector growth in the developing world. More than half of private firms in emerging markets have no access to credit. The number of firms that use loans to finance investments in the developing world is half the number of those of firms operating in OECD countries.

22. There is no comprehensive assessment of the constraints to SME banking in Sri Lanka. To effectively strengthen the enabling environment for SME Banking, it is important to identify and understand the constraints affecting the access and cost of funding of SMEs in Sri Lanka. It is also important to identify the measures that can be undertaken to create a more enabling environment for SME banking.

23. In addition, it is important to assure that viable SMEs are given an opportunity to survive, rather than be made subject to liquidation when faced with temporary financial difficulties. Thus it is necessary to ensure that there are mechanisms in place to enable the rehabilitation and recovery of productive enterprises through not only the court system but also non-judicial means. Having an effective out of court mechanism for SMEs will go a long way to strengthen the long term viability of SMEs. This component will help in devising an out of court mechanism for revival of viable SMEs facing temporary financial difficulties.

45 24. A movable property registry increases the range of collateral that can be used to raise funds and improves access to finance by SMEs. The Secured Transactions Act No.49 of 2009 provides for the securing of obligations relating to movable property and provides for including purchase agreement, finance leasing agreement, conditional transfer or mortgage of any movable property. This component could fund the implementation of the movable collateral registry.

25. The Project may carry out activities such as (i) assessment to identify the legal and regulatory issues that constrain SME Banking; (ii) establish an out of court mechanism for rehabilitation of troubled SMEs; and (iii) improve access to finance through setting up the movable collateral registry.

Component 2.c. Implementation Support and Monitoring

26. Implementation support would include support to the Project Implementation Unit, including i) building expertise to manage the project, ii) compensating the Facility Agent to manage the RSF, and iii) undertaking a detailed impact evaluation framework for assessing the impact of the project on the targeted clients.

27. The project would in addition include an unallocated funding window of US $4.4 million, which would be available for additional funding for any of the above components. The amounts allocated to each component will remain flexible and could be reallocated between the components during implementation as necessary.

46 Appendix 1: Draft Operating Guidelines

Part 1. Financing and Risk Sharing Facility Arrangements

Component 1.a Line of Credit Measure Arrangement/Entity 1. Loan Amount and Total Estimated Project Cost = US$57.40 million, Financing Sources comprising IDA US$57.40 Million equivalent 2. Borrower Democratic Socialist Republic of Sri Lanka

3. Executing Agency Department of Development Finance of the Ministry of Finance and Planning - Project Implementation Unit (PIU)

4. Estimated Commitment Two and half years for the Credit Component Period 5. Service Charge to Standard Service Charge levied by the International Government of Sri Lanka Development Association (IDA) (GoSL) 6. Interest Rate to Participating  6-Month Average Weighted Deposit Rate (AWDR), Financial Institutions (PFIs) which is the weighted average of the interest rates paid to depositors by all commercial banks on interest-bearing term deposits, as issued weekly by the Central Bank of Sri Lanka (CBSL), or another appropriate rate to be determined during project implementation by GoSL in consultation with IDA or another appropriate rate to be determined by GoSL in consultation with IDA during project implementation.  Rate subject to revision every six months.

7. Interest Rate from PFIs to Market rates as determined by PFIs will be charged to Final Borrowers their clients.

Maturity Structure of Credit and Sub-loans

8. IDA to GoSL 20-year maturity

9. PFIs to GoSL Amortization based on an aggregate of withdrawals for individual subloans, repayable in equal semi-annual installments, payment commencing up to twenty four months after the date on which the PFI made the first withdrawal. 10. Sub-loans  Working Capital Loans (with tenor up to 3 years)  Investment Loans  Maximum ten year maturity, including maximum two-year grace period.

47  Maximum maturity not to exceed useful economic life of equipment financed. 11. Applicant Eligibility  Any private enterprise operating in Sri Lanka Criteria that fulfills the SME criteria is potentially eligible.  Definition of SMEs: combination of two indicators i) borrowers of loans of up 10 million rupees, excluding consumption and housing loans and ii) for loans over 10 million rupees, enterprises with an annual turnover under 300 million rupees.  Must have a viable activity and subject to PFIs’ creditworthiness assessment.  Must be involved in an activity that complies with the established Social and Environmental Risk Management Framework.

12. Maximum Amount of Maximum of LKR 60,000,000 [US$530,000 Refinancing equivalent] for any one subproject

13. Portion of Sub-loan Maximum of 100 percent of PFI total sub-loan amount Refinanced for a specific subproject.

Component 1.b Risk Sharing Facility (RSF)

14. Participating Financial Institutions  Selected PFIs based on the eligibility criteria outlined below who undertake an agreed program of technical assistance. 15. Portfolios of loans eligible  All SME loans to new borrowers nationwide for the eligible PFI which meet the eligibility criteria  All SMEs operating in specified sectors; and/or nationwide (to be agreed between PFIs and GoSL/SLIC); and/or  PFIs may elect coverage of one or more of the above portfolios, subject to appropriate overall RSF ceilings by sector, region and PFI in order to ensure appropriate risk management and RSF diversification. These ceilings will be set out in the RSF operations manual guidelines.  All SMEs operating in selected regions (to be agreed between PFIs and GoSL/SLIC)  Maximum tenor seven years, including maximum two-year grace.  Maximum maturity not to exceed useful

48 economic life of equipment financed, where applicable.  Other than tenor, loans will be subject to the same Applicant Eligibility Criteria described above (11) for applicable sub-loans 16. Terms of the coverage:  On a portfolio basis, the RSFs will cover 50 percent of first loss up to a maximum loss of 20 percent of eligible portfolio. The maximum eligible portfolio and covered amount will be agreed with PFI and subject to a legal agreement between the PFI and Sri Lanka Insurance Company. PFIs will pay a premium to be determined, based on discussions and risk assessments to be finalized at implementation, on the amount of the outstanding portfolio, payable quarterly in arrears. A flat annual administration fee may also be payable. 17. Ramp-Up Period  The Ramp-Up period will end at Project closing, or earlier if Portfolio reaches maximum portfolio balance as defined in the RSF Agreement. Facility may be suspended or unused balance cancelled if certain triggers on levels of NPLs or cumulative claims are breached. These triggers will be defined in the RSF Operations manual guidelines and in the subsidiary RSF agreements between SLIC and PFIs.

18. Facility Agent  Sri Lanka Insurance Company (SLIC)  Prepare, negotiate, and sign - on its own account as obligor - subsidiary risk sharing agreements with PFIs. Monitor timely preparation and submission by PFIs of quarterly reports and all documentation regarding claims under the RSF.  Submit disbursement requests to dedicated account holder for claims and payments  Inform PIU and IDA from time to time regarding the progress of the RSF, provide quarterly reports on outstanding portfolios, claims and recoveries under the RSF, and assist IDA supervision and/or evaluation missions.  Maintain all underlying records and documentation from PFIs on portfolios, claims and recoveries  Monitor loans in arrears and claims for individual PFIs. If loans in arrears and claims exceed agreed triggers, administrator will inform

49 PIU and suspend or cancel coverage of new loans until such arrears fall within agreed parameters or other agreed remedial steps are taken.  Calculate and invoice PFIs for all premia and fees due  Review and verify documentation regarding claims and recoveries by PFIs, and undertake periodic audits of covered portfolios and claims at PFIs. Report any irregularities to PIU and IDA.  Maintain close contact with the PFIs to ensure all concerns are adequately addressed.  Perform other tasks and functions as are necessary to achieve the objectives of the RSF. 19. Reporting Requirements of PFIs  PFI to submit to SLIC periodic (at least quarterly) reports, in a format to be agreed, providing details of new and outstanding loans in the covered portfolios, status of loans (current, or details of arrears), claims, recovery actions, and recoveries. 20. Eligible Claims  Once a covered loan is in arrears for [360] days, a claim may be submitted to SLIC at the time of the PFI’s next quarterly report, along with underlying loan documentation, including proof of agreed collection efforts. SLIC will have period of [30] days from receipt of full documentation to verify the claim, before requesting payment of valid claims to the account holder, which shall make payment within 10 days of receipt. 21. Recoveries  As long as there are outstanding claims paid, PFIs will share 50 percent of all recoveries received on defaulted loans up to the balance of any of the claims paid on that loan. 22. Life of the RSF  As new loans with a maximum tenor of seven years can be guaranteed during the ramp-up period, the RSF will remain in effect after project closing, and claims can continue to be made for a period of 8 years from project closing. SLIC will continue to have responsibility for administering the RSF and honoring legitimate claims for the life of the RSF. Implementation Arrangements 23. Responsibility of  Process disbursement requests for loans Project Implementation Unit (PIU) approved by PFIs.

50  Post review loan applications ensure that the loans are provided to the target group and proper safeguard procedures are followed.  Process disbursement requests for Technical Assistance for capacity building, beneficiary training and technical assistance.  With respect to sub-loans, Technical Assistance, and RSF, maintain disbursement records and accounts of each PFI, keep supporting disbursement documents, and keep bank accounts relating to disbursement.  Maintain Project Accounts  Appoint SLIC to act as both obligor and facility agent in respect of RSF  Ensure that audit of the designated account and dedicated RSF account are carried out annually  Inform IDA from time to time regarding the progress of the Project, provide regular reports on the progress of the Project, and assist IDA supervision and/or evaluation missions.  Maintain SMEDF Credit Program-related statistical records.  Obtain progress report on an agreed format form the PFIs and compile the consolidated report for submission to the IDA.  Monitor timely submission by PFIs to PIU of subproject quarterly progress reports and estimates of credit and Technical assistance withdrawals for the next two quarters.  Submit quarterly Financial Monitoring Reports (FMRs) on the Project and other reports as required by GoSL and IDA.  Perform project support activities, procurement of consultant services, award of contracts, and monitoring of Technical Assistance assignments.  Assess completeness of external auditor's confirmation on annual compliance of PFI eligibility, and take appropriate measures if PFI does not meet the eligibility criteria  Perform monitoring of environmental and social safeguards using annual environmental audits and social Assessments and check safeguard compliance screening of the PFIs.  Prepare the Project legal Agreements with IDA and with requisite legal support.

51  Maintain close contact with the PFIs to ensure all concerns are adequately addressed.  Perform other tasks and functions as are necessary to achieve the objectives of the Project. 24. Loan Approval The following are subject to approval by IDA: Procedures  Review Technical assistance (TA) Cooperation Agreements between PFIs and MOFP.

25. Environmental/Social In accordance with national standards and procedures as Assessment Requirements mentioned in the Environment and Social Risk Management Framework 26. Sub-loan Documentation  Sub-loans involving refinancing: (i) PFI Requirements to be confirmation of assessment of creditworthiness of furnished for Approval of sub-borrower including description of business(es); ; Refinancing (iii) list of goods and services to be financed; (iv) project costs and financing; (v) PFI confirmation that terms and conditions of sub-loans include adequate insurance of subproject assets; (vi) timetable for implementation; (vii) evidence of full compliance with the Social and Environmental Assessment and Management Framework ; (viii) financial and justification of the subproject; (x) any other information as agreed between IDA and PIU.

27. Procurement Procedures For TA implemented by PFIs: procurement will follow established commercial practices acceptable to the Bank and detailed in the Operations Manual.

For TA implemented by PIU - Technical Assistance:  Only consultant services which have been included in agreed procurement plans shall be contracted  Consulting service contracts for firms: o $200,000 equivalent or above per contract: shall follow QCBS or QBS procedures o Below $200,000 equivalent per contract: may follow established private sector practices, acceptable to the Bank  Contracts with individuals: Shall be selected after reviewing CVs of at least three potential candidates  Single/sole sourced contracts: Shall be selected only after justification is provided and agreed with the PIU  Prior Review: Consultants services provided by firms estimated to cost above $500,000 equivalent per contract, single source selection of consultants

52 (firms) for assignments estimated to cost above $50,000 equivalent per contract, and individual contracts estimated to cost above $200,000 equivalent per contract, will be subject to prior review by the Bank  Post review: All other contracts will be subject to post review by IDA on an agreed sample basis. 28. Disbursement Procedures  Documentation evidencing expenditures to be kept by the PIU in respect of all technical assistance programs, for audits and for review by World Bank missions.  Reimbursement available for project-related expenditures made within 120 days prior to World Bank/PIU receipt of sub-loan/subproject proposals together with corresponding subproject documentation.  Open a dedicated RSF Account at the CBSL (or other agreed bank) for the RSF. PIU would be responsible for keeping track of these Accounts.  Under the delegated authority of the MOFP, the SLIC will be able to draw funds from this account to make RSF payments claimed by the PFIs. 29. Audit Requirements  Annual audit of Designated Account and RSF dedicated account by Auditor General and separate opinion on FMR.  Annual external audit of PFIs’ financial statements and its compliance with the Eligibility Criteria. 30. Exchange Risk GOSL would bear all foreign exchange risk.

31. Assessment of Compliance The Supervision Department of CBSL or other relevant with Prudential Regulations regulatory agencies would confirm that PFIs conform to by PFIs prudential regulations, taking into account the Eligibility Criteria for each PFI.

PART 2. Eligibility Criteria for Participating Financial Institutions

1. In order to become eligible to participate in the Small and Medium Enterprise Development Facility Credit Program and to maintain their eligibility, financial institutions must meet the following criteria:

(a) The PIU should receive a satisfactory statement from the PFI outlining:  A proposal as to how they would plan to utilize the credit facility, how they are/propose to be internally organized to market SME banking, evaluate the subproject proposals and manage subsequent follow-up monitoring and loan recoveries  Name of the senior officer who will be in charge of SMEDeF credit operation and key team staff;

53  Lending institutions should submit the institution's SME business strategy and operating policies, and  Details of their existing term lending programs and portfolio management scheme, if any.

(b) Except as the PIU and IDA shall otherwise agree, a profitable operation for at least two full years of operation preceding its application for participation, attested to by unqualified audit reports from independent auditors acceptable to the Central Bank of Sri Lanka.

(c) The PFI should furnish to the PIU, a certificate from the external auditors acceptable to CBSL within 90 days of the date of audited financial statement, stating that the financial performance of the PFI concerned is in conformity with the applicable financial criteria outlined below, in accordance with standard guidelines.

1. A minimum after tax profit equivalent to 10 percent p.a. on average shareholders' funds; 2. A maximum gross non-performing asset ratio of 9 percent ; 3. Compliance with minimum capital adequacy ratios for tier-1 and tier-2 as required by Central Bank of Sri Lanka (CBSL); 4. Credit exposure (loans and leases) to one party or any one group of companies must not exceed 30 percent of the PFI's total capital funds (shareholders’ funds); 5. Credit exposure (loans and leases) to any one sector, as defined in the UN Standard Classification of Economic Activities, must not exceed 30 percent of PFI's total credit portfolio; 6. Have a national geographical outreach in the country or plans to set up a wide branch network; 7. Have a strategy to increase SME banking, including dedicated SME Division with clear implementation timelines; 8. Willing to commit to technical assistance on a 50/50 cost sharing basis with IDA 9. Have advanced IT systems in place (Core Banking Solution) at corporate level and robust Management Information Systems at branch level.

(d) After fulfilling the eligibility criteria, the PFI shall continue to meet the eligibility criteria aforementioned to the satisfaction of PIU, GoSL and IDA, which will monitor the PFI’s compliance annually. If the PFI fails at any time to satisfy the above specified criteria the GoSL and IDA reserve the right to suspend sub-loan authorizations under the SMEDeF Project until the PFI has taken specific steps to address its problems in a manner acceptable to GoSL and IDA.

(e) PFIs selected based on the eligibility criteria outlined above need to undertake an agreed program of technical assistance.

2. Compliance with Ministry of Finance and Planning/Central Bank of Sri Lanka guidelines on prudential regulations, capital adequacy, classification of risk assets, provisioning, single borrower exposure limit, sector exposure limits, and disclosure and reporting requirements.

54 Annex 5: Project Costs SRI LANKA: SME Development Facility Project

Local Foreign Total Project Cost By Component and/or Activity US $million US $million US $million

Component 1: Financing and Risk Sharing Facility 41.00 41.00

Of which

Line of Credit 28.00 28.00

Risk Sharing Facility 13.00 13.00

Component 2: Policy and Capacity Enhancement for 12.00 12.00 SME Banking

Of which 7.00 7.00 Capacity Enhancement for SME Banking

Support to Strengthen the Enabling Environment for 1.00 1.00 SME Banking

Implementation Support and Monitoring 4.00 4.00

Unallocated 4.40 4.40

Total Baseline Cost Physical Contingencies Price Contingencies Total Project Costs1 57.40 57.40 Interest during construction Front-end Fee Total Financing Required 57.40 57.40

55 Annex 6: Implementation Arrangements SRI LANKA: SME Development Facility Project

Proposed Implementation Arrangements

1. The envisaged project is to be implemented through a Project Implementation Unit (PIU) at the DFD/MOFP. The PIU has been staffed with qualified personnel and capable of satisfactorily implementing all aspects of the project. Its responsibilities will also include: (i) on-lending to PFIs for final lending to sub-borrowers (ii) Reviewing effective functioning of the on-lending facility to final borrowers through PFIs; (iii) on-going monitoring of the PFIs to ensure compliance with project criteria; (iv) responsibility for adherence to all fiduciary and safeguard requirements of the World Bank; and (v) monitoring and evaluation based on key project development indicators. The eligibility criteria for PFIs’ creditworthiness and internal operating practices and procedures have been determined by the World Bank in close collaboration with DFD/MOFP.

2. The PIU was formally established on April 29, 2010. The Director General, Department of Fiscal Policy of the /MOFP has been appointed as the Head of the PIU. The PIU will be adequately staffed at all times during project implementation, with capacity enhancement provided by the Project. The PIU will recruit external experts funded under the Project, as required, and has designated the Sri Lanka Insurance Company to act on its behalf as Facility Agent under the RSF Scheme. The Government of Sri Lanka is covering the costs of the civil servants working under the Project, as well as some operational expenses.

3. Staffing arrangements for the Project Implementation Unit are as follows:  Project Director (Part Time)  Deputy Project Director – Administration (Full time - MOFP staff)  Deputy Project Director – SME Banking (Full time -Technical– Minimum 15 years SME Banking Experience)  Project Finance Manager (Full time)  Procurement Specialist (Part time)  Two Project Officer(s) (With project financing experience ; Working in the refinancing programs would be an added qualification, Academic qualifications (Finance, Engineering, Environmental)  Social Development and Communication Specialist – On contract basis  Environmental Specialist on contract basis

4. The Project Steering Committee was formed on June 14, 2010. It includes 6 representatives from the Government and 11 representatives from the private sector and commercial banks. Its membership is as follows:  Secretary to the Treasury  Additional Secretary, Policy, Ministry of Industry and Commerce  Assistant Governor, Central Bank of Sri Lanka  Project Director, PIU

56  Director General, Development Finance Department, Ministry of Finance and Planning  Director General, Department of Legal Affairs, Ministry of Finance and Planning  Seven Private Sector Representatives  Four Bank representatives

5. Under Component 1b (RSF), Sri Lanka Insurance Company will act as Facility agent of the RSF. The terms of its mandate will be detailed in a Risk Sharing Facility Agent Service Agreement signed between GoSL and SLIC.

57

Annex 7: Financial Management and Disbursement Arrangements SRI LANKA: SME Development Facility Project

Country Issues

1. The project is designed to operate through the banking system of Sri Lanka regulated by the Central Bank of Sri Lanka (CBSL). The Report on Standards and Codes on Accounting and Auditing for Sri Lanka (ROSC) 2004 had assessed the accounting and auditing institutional framework for the banking sector and had opined that the framework is in conformity with the Accounting Standards issued by the Institute of Chartered Accountants (ICASL), though there are some gaps in their practice. All commercial banks must publish audited financial statements within five months of the end of the financial year. Included among mandatory reporting required under the Act are provision of a monthly statement of assets, liabilities, and liquidity ratios; quarterly statements on nonperforming assets; risk-based capital calculations; and year- end financial statements, including detailed notes and accounting policies. The financial statements of the banks must be audited by a selected qualified auditor from the list maintained by the Director of the Central Bank’s Supervision Department.

2. The Country Financial Accountability Assessment (CFAA) for Sri Lanka published in June 2003, highlighted gaps and weaknesses in the institutional framework for public financial management through which the funds will flow to the banking system. The assessment covered a wide range of processes including financial management and reporting practices at the three levels of government, public audit, and parliamentary control of public funds. Though the GoSL has initiated some steps to address some of these weaknesses through the Bank financed Public Sector Capacity Building project, significant gaps remain in the functioning of the institutional framework relating to financial management. Specifically financial reporting and internal auditing within Government require substantial strengthening. Currently there is no institution in Sri Lanka providing comprehensive training in government internal audit. Overall, fixed asset management within the public sector is inadequate. A program has been initiated to strengthen and improve the overall fixed asset management system, but the results of this would be long term.

3. Keeping in mind the above country issues, the task team has carried out an assessment of the financial management systems and processes of the implementing entities to identify the fiduciary risks involved and have devised the project financial management arrangements and risk mitigation steps based on that assessment.

Brief Project Description, Implementing entities and arrangements

4. The project is a Financial Intermediary Loan (FIL) proposed to be financed through an IDA credit of the Crisis Response Window (CRW) facility for SDR $ 37.8 million (equivalent to US$57.4 million), with a duration of three years. The proposed project components and their outlays are: (a) Financing and Risk Sharing Facilities (US$41 million equivalent) and (b) Policy and Capacity Enhancement for SME Banking (US$12 million equivalent), with an unallocated envelope of US$4.4 million equivalent.

58

5. The Ministry of Finance and Planning (MOFP) will be the principal implementing entity for the project and will be responsible for the overall coordination and management of the project. A Project Implementation Unit (PIU) has been set up to handle the day- to-day project management activities as well as the administration of Component 1 (a) the Line of Credit to provide refinancing to SMEs. The project implementation will be subject to the oversight and supervision of a Project Steering Committee, chaired by the Secretary of the MOFP. The PIU will be responsible for day to day project management and to ensure coordination between the participating financial institutions involved in the project. The PIU will be responsible for project financial management arrangements and activities.

6. Component 1 (b): The Risk Sharing Facility (RSF) will be implemented by the Sri Lanka Insurance Company ( SLIC). The MOFP has designated SLIC as the Facility Agent for the RSF. The participating financial institutions (PFIs) will act as the second level implementing agencies. A dedicated account will be opened for RSF in CBSL or at a commercial bank and the total funds allocated to RSF will be transferred to this LKR account from the designated account at the beginning of the project. The GoSL will bear the exchange risk the between the USD and the LKR. Any exchange loss will be borne by the GoSL. While the ownership of this account is with MOFP, SLIC under the delegated authority of the MOFP will be able to draw funds from this account only for the purpose of paying RSF claims made by the PFIs. The details of the delegation of authority and the purpose for which funds of this account can be withdrawn by the SLIC will be stipulated in the RSF Service Agreement between MOFP and SLIC. By the project closing date all IDA funds in the RSF dedicated account will be refunded to IDA by the MOFP as specified in the financing agreement. The Financing Agreement will also include a condition which states that an amount sufficient to cover outstanding RSF liabilities will be deposited to the RSF dedicated account by GoSL to pay claims of the RSF. All RSF claim payments subsequent to the closing date will be paid out of the GoSL funds in the dedicated account of the RSF.

Financial Management Assessment – MOFP

7. The Ministry of Finance and Planning of Sri Lanka executes the function of monitoring the economic and financial affairs of Sri Lanka. The Secretary to the MOFP is the chief accounting officer. The Ministry has qualified government accountants to support the FM activities of the project. The Ministry is subject to annual audits by the Auditor General of Sri Lanka. Given the private sector involvement of the project and the necessity of the specialized staff required, the MOFP is has established a PIU which will, inter alia, handle the project financial management tasks of this project.

Financial Management Assessment – PIU

8. The PIU has been established to implement the project activities and will be responsible for the overall financial management of the project. A Director General of the MOFP has been appointed as the Head of the PIU who shall be the primary contact person for the Bank on all matters concerning the project. The head of PIU will be responsible for the day to day management of the activities implemented under the project and will be supported by a full time

59 Finance Manager (FM) who will be responsible for carrying out project financial management activities. The FM will be supported by two assistants who will be seconded from the MOFP.

9. The FM will be responsible for all project financial management activities including project budgeting, disbursement planning and forecasting, operation of the Designated Account (DAs) including claiming replenishments, disbursement of project funds, maintaining books and records for project financial transactions, submission of quarterly FMRs to World Bank for the project, preparation of annual project financial statements and interact with project auditors on the audit issues and their follow up.

10. The PIU will be responsible for preparing and submitting the Interim Unaudited Financial Reports (IUFRs) to the Bank. PIU shall ensure that IUFRs of the project are prepared and submitted to the World Bank not later than forty five days after the end of each calendar quarter, covering the quarter. The PIU will follow the GOSL Financial Regulations (FRs). The internal controls stated in the FRs are considered to be adequate for accounting and reporting the utilization of the project funds.

11. The PIU has prepared a comprehensive financial management manual as part of the operations manual that includes, among other things, procedures for selecting SMEs for project funding, disbursement arrangements to the PFIs, internal audit project financial reporting and external audit.

12. The FM capacity and the FM arrangements of the PIU were assessed during project preparation and concluded that PIU has the capacity to handle the FM aspects of the project in compliance with the Bank’s fiduciary requirements.

Financial Management Assessment – Sri Lanka Insurance Company (SLIC)

13. SLIC a state-owned corporation, was founded in 1962 and is a large and strong insurance company in Sri Lanka. SLIC is a limited liability company incorporated under the Sri Lanka Companies Act No 7 of 2007. At present, the GoSL owns 90 percent of the shares of SLIC. SLIC has over 120 branches island wide with an asset base of over LKR 71.8 billion with a life fund of over LKR 43 billion and over one million policies in force. The Company has been given an AA- in September 2009 by Fitch Ratings which makes SLIC the first insurance company in Sri Lanka to receive a global rating from an international rating agency (Fitch Ratings London). The company has obtained a rating of AA- for National Insurer Financial Strength and an A+ for National Long Term Credit for the past three consecutive years, and has been awarded ISO 9001 for quality management systems. The company has LKR 71.8 Billion (USD 640 million) in assets under management, and offers both life and non-life products to over 1 million policyholders.

14. The SLIC will designate staff to handle all activities of RSF including financial management. SLIC will be responsible for entering into RSF agreements as obligor with PFIs, monitoring quarterly reports sent by PFIs, and ensuring payment of valid claims received from PFIs. . Staffing and administrative arrangements satisfactory to IDA will be in place prior to disbursement of any funds in support of RSF. Staff will include a fully qualified chartered

60 accountant to ensure the accuracy of the claims made by the PFIs. The staff will be using the existing systems and procedures of SLIC which were assessed during project preparation. The SLIC has a sound internal control environment and a reliable financial reporting system. The SLIC is subject to continuous in-house internal audits and annual external statutory audits. Hence, it is concluded that SLIC has the financial management arrangements and capacity to process the RSF component of the project.

FM Risk Assessment Table

Initial Residual Risk Risk Risk Remarks/Description Mitigating Measures. of risks INHERENT RISK Country level Participating M Risk associated with There is a well M financial PFIs adopting functioning banking institutions (PFIs) inadequate credit system in Sri Lanka. The do not have standards in granting regulatory and adequate credit loans supervisory framework policies and risk for PFIs is specified in the assessment Banking Act, Monetary standards Law Act and the Exchange Control Act. The regulatory and supervisory function relating to PFIs is carried out by the Bank Supervision Department of the Central Bank based on the internationally accepted standards for bank supervision set out by the BASEL Committee for Banking Supervision. Entity level – PIU The PIU at the H FM capacity of the PIU M MOFP has no has been strengthened by prior experience hiring qualified FM staff in handling FM including a Fellow aspects of similar Member of ACCA as the Finance Manager projects. Entity level – PFIs Participating FIs L L are well established banks that are fully in compliance with

61 the Central Bank regulations. Project level Risk of selecting H Risks associated when Selected PFIs will be M the appropriate the project funds are subject to rigorous criteria SMEs to participate being provided to on portfolio quality and in the credit line SMEs with potentially compliance with adequate high credit risk prudential norms. PFIs through the will also be subject to participating financial mandatory TA on SME institutions. banking to enhance their capacity. Overall Inherent M M Risks Control Risks

Budgeting L All participating L PFIs have their own budgeting procedures and the project will be taken into consideration in budget formulations and revisions Staffing L All participating L PFIs have qualified staff with experience in handling SME loans Funds Flow M Delays in transfer of There will be clear and M funds to simple guidelines in the participating RSF operations manual financial institutions for payment of claims. in RSF Accounting and M Both MOFP and Interim un-audited L Reporting PFIs have well financial report formats established will be generated from accounting financial the existing information reporting systems. systems to comply with The format and IDA reporting content of project requirements. specific reports can be produced from the existing information systems. Internal Controls L Both PIU and PFIs L have well

62 established internal controls systems Auditing L PFIs are already All participating banks L required to submit will submit their annual audited financial audited financial statements and other statements to PIU. The reports to Central audit of project Bank of Sri Lanka. financial statements The MOFP is will be conducted by audited by the the Auditor General of Auditor General of Sri Lanka and will be Sri Lanka submitted to IDA within 6 months from the financial year end Overall Control M M Risks

Disbursement Arrangements

15. A Designated Account (DA) in US Dollars will be maintained at the Central Bank of Sri Lanka. The DA will be operated by the PIU of the MOFP. Withdrawal applications will be prepared and processed by the PIU and replenishments to the DA will be based on IUFRs.

16. Two LKR dedicated accounts will be opened under the name of the MOFP. One account will be used for RSF and the other LKR account will be used to incur expenditures of all other components.

17. IDA will advance funds to the designated account maintained at the CBSL and the funds will be further advanced to the two LKR accounts, to meet estimated disbursements for next 6 months, as forecasted within the interim unaudited financial reports (IUFRs).

18. The proceeds of the Credit would be disbursed against eligible expenditures in the following categories, inclusive of taxes:

63

Category35 Amount of the Financing Amount of the Percentage of Allocated (expressed in Financing Allocated Expenditures to US$ equivalent) (expressed in SDR) be Financed

(1) SME Credit line 28,000,000 18,440,000 100% (2) Risk Sharing 13,000,000 8,570,000 100% Facility (3) Goods and consultants’ services 4,610,000 under Component 2 (a) 7,000,000 100%

and Component 2 (b) of the project (4) Goods and 1,000,000 100% consultants’ services 660,000 under Component 2 (b) of the project (5) Incremental 4,000,000 100% operating costs, 2,640,000 training and services

under Component 2 (c) (6) Unallocated funds 4,400,000 2,880,000 100%

Total Amount 57,400,000 37,800,000 100%

Fund flow and Financial Management arrangements for Component 1 a: Credit Line to refinance short and long term loans for SMEs

19. This component provides a line of credit to Participating Financial Institutions (PFIs) who satisfy the eligibility conditions laid out by the project. PFIs will be responsible for approving the loans to SMEs following their own loan screening procedure after ensuring that the eligibility criteria specified by the Project Operations Manual are met. The procedures for screening by the PFIs of potential loan applications from SMEs are determined by PFIs’ policies and guidelines and subject to regulation and supervision by the Bank Supervision Department of the Central Bank of Sri Lanka and are adequate to ensure objectivity and transparency of the screening process. Once the loan has been approved, PFIs will forward a Loan Refinance Application Form to the PIU (with appropriate supporting documents) requesting the financing of the approved loan amount.

20. MOFP will open a dedicated account operated by the PIU to make payments requested by the PFIs.

35 Categories (3), (4) and (5) were combined into a single disbursement category in the Financing Agreement

64 21. LKR DAs for the project will be maintained by all PFIs at institutional level. The PIU will transfer the funds under Component 1a to the DAs of the PFIs directly from project LKR account maintained at a commercial bank. Operating separate LKR DAs by the PFIs will ensure transparency in the project fund flows and will facilitate the tracking of project disbursements during supervision.

22. PFIs receiving funds from the line of credit will be responsible for disbursing them to the SMEs as well as for maintaining the necessary books and records relating to such disbursements. The PFIs will monitor the use of funds by SMEs through their standard loan monitoring systems to ensure that the disbursed funds are utilized for their approved and intended purposes. The PFIs will submit quarterly financial reports to the PIU detailing the disbursement to SMEs. After the close of the financial year, the PFIs will also submit a copy of their annual financial statements and statutory audit reports to the PIU. The disbursement of the line of credit funds from the PFI to the SMEs will be treated as disbursements for eligible expenditures for IDA reporting purposes. If IDA determines that these disbursements are used for ineligible expenditures, the amounts should be refunded to IDA.

Funds flow and Financial Management arrangements of the Risk Sharing Facility

23. Risk Sharing Facility (RSF): SLIC will implement RSF under the overall supervision of the MOFP and the PIU. The SLIC will act as the principal obligor and as facility agent for which an annual fee is paid.

24. A dedicated account will be opened at the CBSL or in a commercial bank in the name of MOFP for the RSF. In order for the RSF established under the project to be sound, reserves are required to back up the underlying commitments undertaken by GoSL. Therefore, all IDA funds allocated for the RSF will be transferred to this dedicated RSF account at the beginning of the project. Under the delegated authority of the MOFP, the SLIC will be able to draw funds from this account to make RSF payments claimed by the PFIs. The actual claims paid out of this RSF account by the SLIC will be treated as expenditures under RSF component in the IUFR. The MOFP will be entirely responsible for the custody of this account, will be responsible for the monitoring of the receipts and payments of funds into the account and will be responsible for preparing the necessary financial reporting. As stipulated in the Financing Agreement MOFP will return all IDA funds remaining in the RSF account to IDA once the project is closed.

25. When a PFI submits a claim to the SLIC, it will check the authenticity of the claim made by the PFI using the quarterly monitoring reports submitted by the PFI and will withdraw funds from the RSF account and make the payment. The legal agreement between MOFP and SLIC stipulates that funds of the RSF account can only be used by the SLIC to make payments for the RSF claims made by the PFIs. The quarterly internal audits conducted by the management audit department of the MOFP and the annual independent audit conducted by the Auditor General of Sri Lanka will provide additional assurance to MOFP and IDA that funds in the RSF account is only used by SLIC to pay claims requested by PFIs.

65 Disbursements of funds under Component 2

26. The PIU will use the project LKR account to incur expenditure under component 2 of the project. All payments under component 2 will be certified by the Finance Manager of the PIU under the relevant delegated authority as per financial regulations of GoSL.

27. The proposed IDA credit will provide 100 percent financing for the project activities under Component 2, including taxes and duties. Incremental operating cost under component 2 (c) include incremental recurrent expenditures incurred on account of the Project for office equipments and supplies, office refurbishment, maintenance of office equipment, telephone and other communication charges, office rent, bank charges, advertising cost, the fees payable to the Risk Sharing Facility Agent and salaries of contracted staff, but excluding salaries of officials of the Recipient’s public service.

Retroactive Financing

28. The expenditures incurred by PIU that fulfill the following criteria are eligible for retroactive financing: (a) the activities financed are included in the project description; (b) the payments are for items procured in accordance with applicable Bank procurement procedures; (c) such payments do not exceed 20 percent of the loan amount; and (d) expenditures were incurred by the GoSL on or after November 1, 2009.

29. The first audit of the project should cover the expenditures retroactively financed.

Accounting Policies and Procedures

30. The PIU will install an off the shelf accounting software following the double-entry accounting system to maintain project accounts. The PFIs current systems and practices of recording and accounting for loans is sufficiently detailed and adequate for the purpose of generating project specific reports as specified in the FM manual. These accounting system are computerized and have sufficient capacity to handle the high volume of financial transactions.

31. The PIU's accounting practices are governed by GoSL financial regulations. There are no material differences between the accounting framework of the PFIs and the GoSL. The accounting guidelines and policies of the project will be detailed in the FM manual. The PIU will maintain accounts on the cash basis of accounting and will also comply with the government finance regulation. The project specific accounting and reporting procedures will be laid down in the financial management manual that will be prepared by the PIU.

32. The staff designated by the SLIC to withdraw funds from the RSF account will maintain accounting records of the RSF payments made to PFIs.. The SLIC’s current financial reporting systems that were assessed and concluded to be satisfactory during appraisal will be used to maintain the project specific accounting records.

66 Staffing

33. The PIU has the requisite staff cadre including a Finance Manager (FM) responsible for the financial management of the project. The MOFP has seconded a fully qualified Chartered Accountant to the PIU on a fulltime basis to work as the Finance Manager. The Finance Manager has sufficient experience in both public and private sector and has the capacity to handle the FM activities of the project. The finance manger will be supported by two finance assistants. All finance staff of the PIU are expected to work on a full-time basis for the project. PIU staff will be hired and paid according to the Management Circular 33 issued by the Management Services Department of MOF.

34. All the PFIs have qualified staff and project related transactions will be executed as part of their regular work.

35. SLIC will designate staff to handle all activities of RSF including financial management. The requirement to have satisfactory staffing and administrative arrangements in place prior to commencement of activities under RSF will be specified in the RSF Framework Agreement between MOFP and SLIC. Staff will include a fully qualified chartered accountant to ensure the accuracy of the claims made by the PFIs. The staff will be using the existing systems and procedures of SLIC which were assessed during project preparation.

Internal Controls

36. The PIU follows the government financial regulations and circulars. These regulations address all aspects of procedures and controls necessary for authorizing, approving, executing, recording, and reporting expenditure. These procedures/controls are considered to be adequate and any additional internal control procedures will be specified in the financial management manual to bridge any gaps and to promote outcome/output focused accountability. In addition, the FM manual will also contain disbursement and reporting procedures required by IDA.

37. The SLIC has a sound internal control environment and a reliable financial reporting system stipulated by the Companies Act. The SLIC is subject to continuous in-house internal audits and annual external statutory audits. The latest audit report of the SLIC had an unqualified audit opinion on its financial statements.

38. The PFIs operate within internal control framework as stipulated by in the Companies Act, Banking Act, Monetary Law Act and the Exchange Control Act and regulations of the CBSL. These rules and regulations prove adequate controls necessary to authorize, approve, execute, record, and report expenditures.

Budgeting

39. The national budget will include a budget line item for the Project. The approval of the Cabinet of Ministers and the Parliament for the project budget line item has been obtained for 2010.

67 40. The PFIs will submit their cash forecasts under the Project on a quarterly basis to PIU. The Finance Manager will use these forecasts to prepare the six months cash forecast stated in IUFRs. The PFIs will include the project funds into their annual budgets as a separate fund source.

Financial Reporting

41. The PIU will be responsible for the overall financial reporting of the project including the disbursements made under the Component 1. The PIU will use IUFRs to report to IDA on a quarterly basis. The formats of IUFRs, designed in accordance with the guidelines issued by IDA will be agreed during negotiations. For disbursements made under the project one consolidated IUFR will be prepared by the PIU. For component 1, since IDA will treat the disbursements from the PFIs to the eligible SMEs as project expenditures, IUFRs are based on the disbursements made by the PFIs. For RSF, the IDA will treat amounts paid for claims made by the PFIs as expenditures. The PIU will prepare and submit a single IUFR to the IDA consolidating disbursement reports sent by all PFIs and SLIC. In addition, the PFIs will report periodically to the PIU on the financial progress of the Project. The FM at the PIU will consolidate the financial performance reports and send them to IDA.

42. For loans granted by PFIs under the project, accounting records will be kept by the respective PFIs. These PFIs will account for the project funds transferred from the CBSL DA using their own accounting systems. Each PFI will be responsible for financial management for the funds allocated to them.

43. The Secretary of the MOFP will be responsible for the appropriate and diligent use of project funds. The Project Director and the Finance Manager of the PIU in turn will be accountable to the Secretary for the use of project funds.

Internal Audit

44. Internal Audit is an important part of the overall governance and financial management arrangements for the project. MOFP has a Management Audit Department which has sufficient capacity to conduct the internal audits of the project. The project activities carried out at the PIU, SLIC and PFIs will be subjected to internal audits conducted by this department. The SLIC and the PFIs through their legal agreements with the MOFP will agree to allow the Management Audit Department of the MOFP to audit the SME loans granted and RSF claims paid under the project. This will provide further assurance on the legitimacy of the claims made by the PFIs under the RSF and the use of RSF funds.

45. The internal auditor will report to the Secretary to the MOFP with a copy to the Project Director to initiate necessary follow up actions. The internal audit report and the follow up action taken will be presented to Project Steering Committee and shared with the IDA. The overall scope of internal audit services will (i) evaluate the internal control systems of PIU, SLIC and PFIs and the integrity of project financial information produced by PFIs; (ii) assess whether the projects funds have been used for the purpose intended and whether the funds have reached the intended recipients, (iii) assess the internal controls over disbursements made from the project designated account (iv) appraise the economy and efficiency of resource utilization in

68 accordance with the credit agreement; and (vi) determine whether PFIs have complied with the FM manual, and other existing laws and regulations.

46. The internal audit plan for PIU and PFIs will be cleared by IDA by loan effectiveness and will be included in the Financial Management Manual.

External Audit

47. The external audit of the project will be carried out annually by the Auditor General of Sri Lanka. As a part of the project external audit, the Auditor General will audit the disbursements of the designated account maintained by the MOFP and the RSF dedicated account operated by SLIC under the delegated authority of MOFP. Project Accounts and FM arrangements at PFIs will be covered by the statutory auditor of the respective PFI during the annual audit. The audited financial statements of the PFIs will be submitted to the PIU within 6 months from their financial year end. The project external audit reports will be submitted to IDA within six months from the financial year end.

48. Presently, all commercial banks in Sri Lanka are audited by an auditor acceptable to the Central Bank of Sri Lanka and all commercial banks must publish their audited financial statements within five months of the end of the financial year. The PFIs participating in the credit line and/or RSF are required to ensure that their statutory auditor will cover a reasonable percentage of the SME portfolio of the bank during the annual statutory audit. This requirement will be incorporated to the legal agreement between the MOFP and the PFI. All PFIs will submit a copy of their annual audited financial statement to the PIU within six months from their financial year end. The PFIs will submit their annual financial statements and audit reports to the PIU which will review them

Audit Reports

49. The following audit reports will be monitored in Audit Reports Compliance System (ARCS).

Implementing Audit Report Auditor Date Agency PIU Project Annual Financial Statements Auditor General June 30

50. Financial Covenants

. Audited annual project financial statements to be submitted to IDA no later than six months of the following fiscal year . Consolidated project IUFRs to be submitted to IDA no later than 45 days following the end of the reporting quarter.

69

Supervision Plan 51. The proposed project has a Moderate financial management risk rating. The project is implemented by PFIs with sound capacities. Hence, consistent with the risk based approach to supervision, the supervision activities will consist of visits to PIU and PFIs, supplemented by desk reviews of internal & external audit reports, quarterly financial reports and dialogue with the project staff as needed. The Bank will carry out a field level FM supervision mission at least once every six months. The FM Supervision Missions will assess the adequacy of the FM arrangements at the PFIs. As and when required, other financial management supervision tools such as SOE reviews and joint missions with procurement will be used in an effort to periodically monitor the adequacy of financial management arrangements.

Fund flow Diagram

IDA Funds flow Account ownership

RSF Claims payments

Refinancing of SME loans Payments made for project activities Designated Central Bank Account (US$)

TOD

MOFP/PIU

LKR RSF

PFIs SLIC

Payments for consultants, training, etc PFIs

70 Annex 8: Procurement Arrangements SRI LANKA: SME Development Facility Project

A. General

1. Procurement for the proposed project would be carried out in accordance with the World Bank’s "Guidelines: Procurement Under IBRD Loans and IDA Credits" dated May 2004, revised October 2006 and May 2010; and "Guidelines: Selection and Employment of Consultants by World Bank Borrowers" dated May 2004, revised October 2006 and May 2010, and the provisions stipulated in the Financing Agreement. The various items under different expenditure categories are described in general below.

2. Procurement to be carried out by the PIU and financed under component 2 of the project would include: (i) office refurbishment and procurement of furniture, equipment, and facilities for the PIU office under national competitive bidding or shopping procedures; (ii) consultant services for assisting the PIU in project monitoring and specialist areas; and (iii) non- consulting services for promotional events, and establishing and maintaining an SME database. All procurement carried out by the PIU will be in accordance with the Bank’s Guidelines.

3. Selection of Consultants: Consultants will be contracted by the PIU for (i) conducting diagnostic studies and other assessments, and (ii) legal services. Additionally, individuals will be hired to support the PIU in project management, and monitoring, including a SME banking specialist.

4. Consultant firms will generally be selected based on the quality and cost-based selection (QCBS) method. The following methods may also be used, when more appropriate:  Quality-based selection (QBS)  Least-cost selection (LCS)  Selection based on consultant’s qualifications (CQS) for contracts estimated to cost below $200,000 equivalent per contract  Single source selection (SSS)  Individual consultants.

5. Short lists may be composed entirely of national consultants, for contracts estimated to cost below $200,000 equivalent per contract, in accordance with the provisions of paragraph 2.7 of the Bank’s Consultant Guidelines.

6. The Bank’s standard request for proposal documents will be used for selecting consultants to be contracted by the PIU. In the case of individual consultants, selection will be made after reviewing the CVs of at least three potential candidates. If an individual is to be single sourced, a clear justification will be provided for Bank’s review.

7. Procurement of Goods and Works financed under the Line of Credit (LOC) Facility will be carried out by the SMEs, following local established commercial practices acceptable to the Bank, and in accordance with the provisions of paragraphs 3.12 of the Bank’s Procurement Guidelines. The maximum sub-loan permissible will be $530,000, while the average will be in

71 the order of $50,000. Works to be financed under the LOC facility would include refurbishment and extension works. Goods to be financed under the LOC facility would include machinery, plant and equipment, plant components, vehicles, commodities, and raw materials.

8. Technical Assistance Services for the PFIs and SMEs, financed under the Capacity Enhancement Scheme, will be procured by the PFIs following local established commercial practices acceptable to the Bank, and in accordance with the provisions of paragraphs 3.12 of the Bank’s Procurement Guidelines and 3.14 of the Bank’s Consultant Guidelines. PFIs will identify in detail all activities to be financed under each TA program, in their implementation plans.

9. The procurement procedures to be used for each procurement method as well as model contracts are presented in the Project Operational Manual.

B. Assessment of the agencies’ capacity to implement procurement

10. Project Implementation Unit (PIU). An assessment of the capacity of the PIU set up in the Ministry of Finance and Planning, to implement procurement activities was carried out by the Bank’s designated procurement specialist in June, 2010. A staff within the Ministry of Finance and Planning has been assigned to work in the PIU in the capacity of procurement specialist. The appointed staff has a general understanding of government procurement procedures, which are in line with the Bank’s guidelines. Specific guidance, particularly in the area of selection of consultants, would be provided by Bank staff. Goods and services required for project startup have been identified and the procurement plan has been prepared.

11. Potential Participating Financial Institutions (PFIs). Assessment of the capacities of potential PFIs to implement procurement was based on recent reviews carried out under the ongoing Sri Lanka Renewable Energy for Rural Economic Development (RERED) financial intermediary lending project, and consultations with a sample of commercial banks. Several commercial banks have long years of experience in SME banking and are familiar with procedures required under financial intermediary lending, and specifically under Bank financing. Each bank has its own set of SME banking operating guidelines, which include detailed assessment report formats for loan proposal and refinancing applications. The banks’ branch extension officers carry out extensive site visits, and conduct background checks of potential beneficiaries. Value for money and supplier/contractor assessments are carried out based on information from past and current loans, the chambers of commerce and industries, and from site visits to suppliers’/agents’ premises. Payment for large value goods is generally made directly by the PFI to the supplier, under a letter of credit, with shipment in the name of the beneficiary SME.

12. Small, and Medium Enterprises (SMEs). An assessment of the procurement practices followed by SMEs was based on site visits and consultations with a sample of SMEs currently availing of loans from commercial banks. Documents and records maintained at the SME offices generally provide adequate information on purchases made using loan financing.

13. The private sector in Sri Lanka follows in general well-established commercial practices for the purchase/procurement of goods, works and services. Past experience, good reputation,

72 long operating life, reliable after-sales service, and secondary market value, are the underpinning principles of the local practice. SMEs generally solicit quotations (written and/or verbal) from local suppliers/agents, and rely on the comparative market network, through the various chambers of industries at the national and provincial levels. For replacement equipment, SMEs generally purchase from a single source the same brand already being used, to ensure standardization, continuity of after-sales service and spare parts stocking. Second-hand or reconditioned goods are purchased, with a certificate of quality assurance issued by a certified valuation expert. Leasing through commercial banks is another option used. In some specific sectors, raw materials are purchased through forward pricing under a long-term contract. SMEs at the “medium” end may obtain quotations directly from the manufacturers but they tend to be very selective, based on past experience and other commercial considerations, to ensure value for money. In the case of new ventures, SMEs carry out detail background checks on suppliers through consultations with other local clients, visits to manufacturers’ premises, and through internet searches. Consequently, the established commercial practices in Sri Lanka can be considered to be consistent with the Bank’s principles with respect to economy and efficiency.

C. Key Issues and Risks

14. The key issues and risks concerning procurement for implementation of the project have been identified and include:

 PIU staff may not be available throughout the project period, as a result of staff turnover and transfers.  PFIs may not have adequate staff for carrying out procurement activities, overseeing SME activities, and reviewing the documentation, as a result of staff turnover and transfers  PFI’s and/or SMEs may not follow commercial practices acceptable to the Bank.

15. The corrective measures which have been agreed are:

 A procurement specialist has been appointed to the PIU, from within the Ministry of Finance and Planning, for the entire duration of the project.  The PIU procurement specialist will be trained on the Bank’s guidelines and procedures, and will provide guidance to the PFIs as necessary.  The Project Operational Manual, which includes the PFI/SME Banking Operating Instructions, will detail the procedures and applicable documents to be used, and the commercial practices acceptable to the Bank which will be followed by PFIs and SMEs.  The GoSL/PFI subsidiary Agreement for the line of credit facility will include specific provisions to ensure that procurement of goods carried out by the PFIs and SMEs follows commercial practices acceptable to the Bank, as detailed in the Operational Manual.  PFIs will commission annual external audits to ensure that sub-loans are used for the purposes intended, with due attention to economy and efficiency, and in accordance with the commercial practices acceptable to the Bank, as detailed in the Operational Manual.  In the case of purchase or leasing of second-hand/re-defined/reconditioned goods, the Bank’s: Additional Procurement Advice on the New Policy Framework for "Eligibility of Expenditures in World Bank Financing", first issued on June 7, 2004, shall apply to

73 determine the conditions under which such procurement is allowed under the LOC facility. These conditions will be detailed in the Operational Manual.  A negative list of goods which cannot be financed under the project will be detailed in the Operational Manual.  The Bank’s designated procurement specialist will carry out post reviews of PIU activities and PFI external audit reports, and provide timely feedback on findings and recommendations.

16. The overall procurement-related project risk is rated “moderate”.

D. Procurement Plan

17. The Borrower developed a procurement plan for procurement to be undertaken by the PIU, for the 36 months of project implementation, which provides the basis for the procurement methods to be followed. The team reviewed and approved the procurement plan on August 9, 2010. It will also be available in the project’s database and in the Bank’s external website, without indicative costs. The Procurement Plan will be updated in agreement with the Bank’s Team annually or as required to reflect the actual project implementation needs and improvements in institutional capacity.

E. Frequency of Procurement Supervision and Reviews

18. In addition to the prior review supervision to be carried out from Bank offices, the capacity assessments of the implementing agencies has recommended six-monthly supervision missions to carry out desk reviews and visit the field if necessary.

19. All ICB contracts estimated to cost above $600,000 equivalent per contract (though not envisaged at this time), consultant services provided by firms estimated to cost above $500,000 equivalent per contract, individual contracts estimated to cost above $200,000 equivalent per contract, selections and contract awards to PIU managers, procurement consultants, inspection agents and legal advisors irrespective of the contract value and risk rating, and all single source contracts, will be subject to prior review by the Bank. These thresholds will be identified in the procurement plan and are subject to revision, following capacity assessment reviews during project implementation.

74 Annex 9: Economic Analysis

SRI LANKA: SME Development Facility Project

1. Expanding SME Access to Finance: Background

1. A large body of literature provides robust evidence that financial development and access to financial services lead not only to income growth, but also to poverty reduction, better health, education, and gender equality outcomes.36 The empirical finance and growth literature has been motivated by a recurring observation that small and medium size enterprises in many developing countries face significant financing constraints. Hence, industry and firm- level data have been used to address the causality issue.37 A World Bank Enterprise Survey of over 50,000 firms in more than 70 countries highlights that SMEs rank access to finance as one of their top constraints to growth. These studies have shown how financial development allows enterprises to overcome financing constraints with positive repercussions for investment, innovation and economic growth. Other impact evaluations of relaxing credit constraints to small and medium firms in the South Asia region have documented such firm growth, increased productivity and investment that, “if it is the medium-sized firms that are constrained, the productivity loss due to the misallocation of capital caused by credit constraints may be potentially very large: indeed, we argue that it may be large enough to explain the entire productivity gap between India and the US.”38 An impact evaluation of a World Bank program to expand access to previously unbanked SME’s in Mexico has had similar results.39 Relaxing liquidity constraints seems to improve firms’ and a country’s growth.

2. Past impact evaluations in Sri Lanka of SME financing operations from 1988-1994 have led to outcomes where sustainable impacts have been measured and satisfactory outcomes reported in terms of a) employment generation and b) the deepening of the financial system.40 For example, employment among SME beneficiaries of credit supported by the World Bank increased by more than 8 percent a year, more than three times as fast as general employment growth. Also, a quarter of beneficiary SMEs moved up the value chain of production by undertaking more complex transactions, which likely resulted in specialization needed for industrial upgrading and ultimately higher growth rates. From the banks’ perspective, the results were also positive. The credit to SMEs also resulted in a sharp improvement in loan recovery rates from less than 70 percent to better than 95 percent. In most cases, PFIs improved their financial positions, and as part of the program, the development finance institution implementing the credit line program was privatized.

36 Global Monitoring Report 2009 (Draft) 37 Rajan, Raghu, and Luigi Zingales (1998). “Financial Dependence and Growth.” American Economic Review 88, 559-587. AND Beck, Thorsten, Asli Demirgüç-Kunt, and Vojislav Maksimovic (2005). “Financial and Legal Constraints to Firm Growth: Does Firm Size Matter?” Journal of Finance 60, 137-177. 38 Banerjee, Abhijit V., and Esther Duflo (2008), “Do Firms want to borrow more? Testing Credit Constraints using a Directed Lending Program” 39Bruhn, Miriam and Inessa Love (2009), “The Economic Impact of Banking the Unbanked: Evidence from Mexico” A paper presentation at the Conference on Entrepreneurship and Growth, November 19-20, 2009, Washington DC, World Bank Group. 40 IEG, (1997), “World Bank Support for the Small and Medium Industries in Sri Lanka: An Impact Evaluation. “World Bank Group, Washington DC.

75 3. Nonetheless, Financial Institutions in Sri Lanka have been reluctant to significantly expand SME lending in view of:

(a) high costs and risks relative to other market segments, (b) lack of understanding of the SME market, its potential for bankability and emerging international good practices on SME lending; (c) a mismatch between the collateral required by banks and the collateral SMEs have. (d) SME capacity limitations in applying for and utilizing loans.

4. All these issues, whether on credit supply or demand side, have been exacerbated by the Global Financial crisis, which initially caused bank liquidity to dry up for banks (banks liquidity subsequently improved, but it was not invested in SME lending), and has resulted in some good companies defaulting due to external and internal shocks beyond their control (e.g. the prolonged conflict, tsunami, and the global financial crisis). Increasing access to finance may be particularly effective to jump start their activities.

2. Significant economic benefits expected to be derived from this project

Political Economy: Benefits to Different Actors in the Economy

5. The Project’s expected benefits can be measured among various actors in the economy:

- Benefits to Government: Whilst analysis of the IDA loan at the government level is not relevant, the operation is aimed at improving financial intermediation to a sector of the economy that has proven to be a dynamic force for economic growth globally. Bolstering the prospects of the SME sector will help support economic growth, which is the single most important contributing factor to reducing a country's debt burden. Additionally, higher fiscal revenues from better growth outcomes could be expected to reduce fiscal pressures. - Benefits to the PFIs, include: (a) access to long-term funding; (b) new profitable SME lending products; (c) enhanced credit policies and procedures; (d) access to new clients and (e) portfolio diversification. - Benefits to the SMEs include: (a) access to increased amounts of credit and appropriate financial products; and (b) opportunities to use previously ineligible movable collateral, thus increasing SMEs ability to leverage their own capital (if the secured transactions mission gives us additional information for the regulatory reform. - Benefits to the public at large include: (a) increased credit flows to underserviced firms; (b) increased access to credit for marginalized groups; (c) increased employment as a result of expanded SME economic activity; (d) formalization of the economy

6. This analysis benefits from an impact evaluation of four previous World Bank credit lines to SMEs in Sri Lanka from 1985 to 1994 as well as global best practices evaluated by the World Bank Group and other institutions. 41 Before analyzing specific benefits of this project, it may be important to set the scene of the possible effect of such interventions in improving the efficiency of SME lending markets. Esther Duflo and Abhijit Banerjeeat of MIT,

41 IEG, (1997), “World Bank Support for the Small and Medium Industries in Sri Lanka: An Impact Evaluation. “World Bank Group, Washington DC.

76 through an impact evaluation of a program relaxing credit constraints to small and medium firms in India, have documented such firm growth, increased productivity and investment that the authors argue, “if it is the medium-sized firms that are constrained, the productivity loss due to the misallocation of capital caused by credit constraints may be potentially very large: indeed, we argue that it may be large enough to explain the entire productivity gap between India and the US.”42 For this project, the economic and social benefits are expected to be the following:

(i) Improved bank efficiency in catering to the SME market. By providing TA to selected banks on state of the art SME lending practices, the project will mitigate the institutional obstacles that may make lending to SMEs expensive. More specifically, the project will improve the credit culture and risk management systems in the selected financial institutions overall (i.e. beyond the market segment targeted).

(ii) Systemic change in the perception of the bankability of SMEs will lead to expanded and sustainable credit. The project will facilitate credit expansion to small and medium businesses for selected institutions which will have a demonstration effect i.e. that will prove to the market that lending to the segment can be profitable.43 Having developed a strategic focus on the SME sector and applied new banking models, an IFC study shows that banks are reporting income growth rates and returns on assets in SME banking that exceed those of their overall banking operations.44 Hence, the benefits of credit expansion will not be limited only to participating financial institutions.

(iii) Improved eligibility of SMEs to access banks will increase demand for credit. The project will provide training for SMEs that are almost bankable, i.e. training to firms on the cusp, which banks have barely rejected. The training will be provided via participating banks, which are in a position to know how to help SMEs improve their business skills in accessing credit. IFC’s product Business Edge has been extremely successful in providing training to banks to train SMEs.

(iii) Job generation and economic growth Third, the project is expected to enable participating financial institutions to diversify their lending away from the current focus on large businesses or public sector entities. Literature has established that this shift is particularly important as SMEs are an important engine of growth and job generation.45 In Sri Lanka, the SME sector indeed constitutes 80-90 percent of the total number of enterprises and 40 percent of employment.46 The IEG evaluation of WB credit targeting SMEs in Sri Lanka shows that “most

42 Banerjee, Abhijit V., and Esther Duflo (2008), “Do Firms want to borrow more? Testing Credit Constraints using a Directed Lending Program” Massachusetts Institute of Technology. 43 IFC (2007), “Benchmarking SME Banking Practices in OECD and Emerging Markets.’ The study profiled 11 “good practice” banks from OECD and emerging markets, and received data from a number of these banks, on income and ROAs for operations in the small enterprise (‘SE’) and medium enterprise (‘ME’) segments. SME banking operations for these banks have been growing rapidly and are profitable. Describing these trends, one bank explains, “SMEs represent 10 percent of our portfolio numbers, but they generate 50 percent of our banking income.” 44 Ibid. 45 Ayyagari, Meghana, Thorsten Beck, and Asli Demirgüç-Kunt. 2007. “Small and Medium Enterprises across the Globe.” Small Business Economics 29: 415-434. 46 SME Development Program II – ADB -2007-Technical Assistance Consultant’s Report.

77 of the smallest firms became larger, graduating to larger sizes at a rate that exceeds the experience in other countries.”47

(v) Improved Investment Climate: Possible reforms of the legal, regulatory and supervisory framework to improve the ecology of finance in general will enhance market efficiency and improve the investment climate.

(vi) Equitable Development and Social Stability Since a component of the project aims to target new SME borrowers, credit will likely flow to the north and east of the country where new economic activity is naturally springing as a consequence of the end of the war. The project will thus contribute to economic and regional diversification and social stability.

7. Improved Access to Finance will translate into increased productivity, investment and firm growth. The benefits are not only to firms. In fact, a significant body of research points to a close link between inclusive financial systems, rapid growth and better income distribution.48

3. Costs and Benefits of this Project

8. This section attempts to present a cost benefit analysis which is mostly qualitative. The costs of the project will total US$57.40 million equivalent.49 The components are (i) Financing and Risk Sharing Facility (US$41 million equivalent), (ii) Policy and Capacity Enhancement for SME Banking (US$12 million equivalent), among which US$8 million equivalent has been earmarked for Capacity enhancement to PFIs and SMEs; and (iii) Unallocated funds ($4.4 million equivalent). Conducting a standard net present value and internal rate of return analysis for the project is not straightforward. Many of the benefits are not easy to quantify, other than making broad estimates of the increases in systemic liquidity, credit and the ensuing benefits.

Cost of Line of Credit (LOC)

9. Of the project’s components, only the LOC (US$28 million equivalent) and its directly- associated technical assistance to financial institutions (estimated at US$3 million equivalent out of the US$7 equivalent allocated for the LOC and RSF) are susceptible to meaningful NPV analysis. The beneficiaries of the LOC and associated technical assistance are the financial institutions. The costs of the project are for the LOC component. As shown in Table A.9.1 the NPV and IRR of the LOC are both positive at US$492,000 and 21.34 percent, respectively. This means that the project may have its desired effect of demonstrating to risk-averse banks that SME portfolios can be profitable.

10. The costs of the project for the LOC component include: (a) the cost for the financial institutions of borrowing LOC funds; plus, (b) overhead costs

47 IEG, (1997), “World Bank Support for the Small and Medium Industries in Sri Lanka: An Impact Evaluation. “World Bank Group, Washington DC. 48 For a summary, see, for example, Patrick Honohan et. al., “A Note on Financial Access Indicators”, World Bank, 2005. 49 This does not include interest and commitment fees.

78 (c) the cost of the technical assistance itself. (Based on previous successful practices of TA to Banks in Sri Lanka and all over the world, participating banks will co-share the cost of the TA ($2 million) (d) the cost of capital required to support the on-lent loan portfolios of the financial institutions; (e) the costs of provisions on SME lending using LOC funds;

Benefits to PFIs

11. An NPV and IRR analysis show the quantitative benefits that PFIs could derive from the project. The benefits that can be quantified in order to conduct an NPV analysis are those that arise from the substitution of increased amounts of credit for informal borrowing, producing a one-for-one increase in borrower incomes. Further benefits, such as the positive impact on incomes from the ability to finance new economic activities and improvements in the supply and pricing of inputs could be substantial but cannot be estimated.

Table A.9.1: NPV and IRR of the LOC for PFIs

Item (values in ,000s US$) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

LOC On Lending (Avg. Balance) 10,000 10,000 8,000 (10,000) (10,000) (8,000)

Overhead costs 2.00% (200) (400) (560) (560) (560) (360) (160) 0

Cost to PFIs of TA (1,000) (1,000) (1,000) LOC Cost of Funds to PFIs 6.00% (600) (1,200) (1,680) (1,680) (1,680) (1,080) (480) 0 Avg. Rate on LOC On-lending 15.00% 1,500 3,000 4,200 4,200 4,200 2,700 1,200 0 Credit Losses on LOC On-Lending 3.00% (300) (600) (840) (840) (840) (540) (240) 0 Minimum 1% Provision Costs 1.00% (100) (200) (280) (280) (280) (180) (80) 0

Net Benefit/(Cost) (700) (400) (160) 840 840 540 240 0

Discount Rate 9.00% NPV 492 IRR 21.34%

Assumptions:

1. There is a 66 months repayment from PFI to GoSL, made at the beginning of each year 2. 9% discount rate based on Central Bank of Sri Lanka’s estimate 3. 6% discount rate for LOC Cost to PFI based on current Average Weighted Deposit Rate (AWDR) rate of 6%

79 4. Credit Losses of 3% is based on discussions with banks at Pre-appraisal mission 5. Minimum 1% Provision Costs is based on CBSL requirements 6. Overhead costs are based on an Assessment of the Banking System conducted during project preparation 7. The total value of TA to PFI of US$3 million equivalent is based on Project component 2b which has allocated $7 million for TA for both LOC and RSF.

Benefits to SMEs

12. Expected benefits of the LOC for SME borrowers are extremely high because of the substantial difference between LOC on-lent finance and SMEs alternative sources of financing, (the informal sector or not borrowing). LOC funds are expected to be on-lent to SMEs at rates in the range of 15 percent per annum, whereas borrowing the same funds informally carries interest rates in the 25 to 100 percent range.50 The major benefit to SME is expected to be increased profitability for SMEs, which should result from the ability to borrow at a lower cost to expand their businesses. However, that potential is very difficult to quantify. The direct benefit derived by SMEs from the LOC consists of the amount of funds on lent (US$ 28 million equivalent) times the annual average reduction in interest costs (10 to 80 percentage points – i.e. US$1.6 million to US$12.8 million per annum).

Benefits of Line of Credit: Financial Outreach, Employment generation, Increased PFI profitability.

13. The project will encourage participating financial institutions to diversify their lending away from the current focus on large businesses or public sector entities, and into SMEs. A portfolio diversification of the banks will lead to broader outreach, employment generation and SME expansion. Based on an evaluation of previous WB credits targeting SME’s in Sri Lanka, “most of the smallest firms became larger, graduating to larger sizes at a rate that exceeds the experience in other countries.”51

1. Outreach

14. Based on an SME banking assessment conducted on the leading SME banks in Sri Lanka, SME lending is low with an average of the share of SME loan portfolio of less 20%. The following section will attempt to predict the additional financial outreach this project will have in terms of number of additional SME active loans.

 High Case Scenario: If there is a total disbursement of the credit line facility of $28 million and an uptake of all the technical assistance to PFIs and SMEs of 7 million, total 35 million), outreach can

50 UNDP (2004), Informal Markets for Financial Services in Sri Lanka. See http://www.undp.org/legalempowerment/reports/National%20Consultation%20Reports/Country%20Files/23_Sri%20Lanka/23_6 _Sri_Financial_Sector.pdf 51 IEG, (1997), “World Bank Support for the Small and Medium Industries in Sri Lanka: An Impact Evaluation. “World Bank Group, Washington DC.

80 Table A.9.2: Outreach as Measured by Incremental number of active account borrowers52

LOC (incl. be measured based on World Bank guidelines on SME active 53 Disbursement TA) (US$ core MSME indicators. Based on an assessment borrowers of SME banking done in preparation for this million) project, the average loan size will be about $50,000. The guidelines project outreach to be 100% 35,000,000 1,400 1,400 SME active borrowers due to the credit line and corresponding technical assistance (Table A.9.2). 75% 26,250,000 1,050 Low Case Scenario: If there is a disbursement of only 75 percent, at $26.25 million and based on the same assumptions as above, outreach will be 1,050 SME active borrowers due to the credit line and corresponding technical assistance (Table A.9.2).

2. Employment generation

15. Estimates of employment generation benefits range from 23,100 to 78,400 additional employees as a result of the Project.

1) Assumptions: Based on the IEG evaluation of World Bank credits to SMEs in Sri Lanka, the ‘average beneficiary’ expanded employment by 22 to 56 employees.”54 This was during the conflictunder a growth rate of 6 percent, and though the World Bank groups also predicts an economic growth rate of 6 percent for the next few years, this is a conservative prediction, as there is also a peace premium which may have further positive results in terms of employment and growth. 55

a) Low Case Scenario: (a) Taking the lower end of the disbursement scenario of 75 percent with an expected outreach of 1,050 SMEs (table A.9.2 above), and (b) an average of 22 additional employees per average firm (based on IEG estimates) would result in 23,100 additional jobs, whereas the higher average of 56 additional employees per firm would result in 58,800 additional jobs. (see table A.9.3)

b) High Case Scenario: (a) Taking the higher end of the disbursement scenario of 100 percent, with an expected outreach of 1,400 SMEs and (b) an average of 22 additional employees per average firm, would result in 30,800 additional jobs, whereas the higher average of 56 additional employees per average firm would result in 58,800 additional jobs. (see table A.9.3)

52 Outreach Indicator is measured per guidelines of OPCS MSME core indicators (see URL.msmecoreindicators) 53 Outreach Indicator is measured per guidelines of OPCS MSME core indicators (see URL.msmecoreindicators) 54 IEG, 2004, pg 39. 55 PREM note on Sri Lanka, 2010.

81 Table A.9.3: Additional Employment Generation

# SMEs in # SMEs in Low Additional Additional High Disbursement Additional Jobs Employment Additional Jobs Employment Disbursement (75%) Generation Generation (100%) 1,050 22 23,100 1,400 22 30,800 1,050 56 58,800 1,400 56 78,400

16. Employment is a particularly important goal in a post-conflict situation. According to a study by Guimares, and strongly emphasized in the government strategy, Mahinda Chintana:56 Vision for a New Sri Lanka 2006-2016, Sri Lanka is a society in which “if jobs are not created the cohesion of the social fabric may be in jeopardy, especially taking into account the violent convulsions in the recent past. Job creation must be treated as a major, if not the major, objective of any development strategy.” The SME development facility is likely to be an effective employment generation tool.

4. Difficult to quantify benefits:

17. TA to SMEs: Technical assistance to SMEs can be a very important instrument to help SMEs overcome the barriers that prevent their becoming effective, productive firms. Clearly, the experience in Japan, Korea and Singapore reviewed by Lall et al suggests that when correctly structured TA to SMEs can be very productive.57 Levy suggests that an important aspect of the structuring of this assistance is reliance on private sector firms.58 Based on those findings, this project intends to provide technical assistance to SMEs via commercial banks. The goal focused and sustainable: use participating banks, which are in the best position to know what is required to access credit, to train quasi bankable SMEs on how to access banking services. The increased access to credit of quasi financially suitable SMEs would greatly impact the outcome indicators above. It addition, the program administered by IFC, Business Edge, creates local capacity to carry out SME banking skills training (as well as improving management skills) and will therefore create local knowledge (within participating banks) to sustainably carry out such programs in the future.59

18. Increased access to finance may lead to less informality. Since access to bank credit typically requires compliance with tax and employment legislation, firms are more likely to incur such formalization costs once bank credit is more widely available at lower cost. It is found that formalization rates increase with financial deepening, especially in sectors where firms are typically more dependent on external finance.60

56 Guimares (2006) 57 Lall et all (1996), “Building Sri Lankan Competitiveness: A strategy for Manufactured Export Growth,” Report for the Government of Sri Lanka national Development Council, volume 1. 58 Levy, Brian (1994), “Technical And Marketing Support Systems For Successful Small And Medium Enterprise In Four Countries,” Policy Research Working Paper No. 1400. Washington DC: World Bank. 59 http://www.ifc.org/ifcext/mekongpsdf.nsf/Content/BizEdge_Program 60 By Luis A.V. Catão, Carmen Pagés, María Fernanda Rosales, IDB Working Paper Series No. IDB-WP-118. November 2009.

82 Cost of Risk Sharing Facility (RSF) Facility

19. Based on accepted frameworks for measuring risk sharing schemes, the RSF’s costs to the government would be the following:61 to be financially sustainable a risk sharing scheme has to break even, by balancing costs with revenues. In the case of a public scheme, it is not necessary to generate a profit, since the scheme serves the general interest of promoting economic development.

20. On the cost side, there are three main components: loan losses, administration expenses and the cost of servicing public debt that is incurred by the Government to endow the Facility with its capital and to cover any losses.62 It is difficult to estimate probable losses for a portfolio of SME loans, as banks in Sri Lanka do not break down loan portfolios by segment, and there is virtually no data on historic default ratios and losses given defaults. More information is being sought, and the pricing will be determined based on findings and negotiations with PFIs under the RSF facility. Hence, an analysis of financial sustainability is difficult to anticipateex ante. Pricing of the RSF may be subsequently modified based on performance of individual PFIs.

Benefits of Risk Sharing Facility (RSF): Leveraging of Public Resources to Increase Investment of the Private Sector

21. Despite a significant debate in the literature regarding the role fulfilled by credit guarantees, governments across the world are increasingly utilizing credit guarantee schemes to support SMEs. This credit rationing is typically justified based on information asymmetries, the high costs of processing smaller credit transactions, and constraints in the enforcement of contracts. Levitsky (1997a) and de la Torre et al (2006) summarize some of the debate issues: “The most frequent cited justification for credit guarantee schemes is as substitute for collateral where the collateral market operates imperfectly due to cumbersome and costly repossession processes, political difficulties in the realization of assets pledged by certain sectors or uncertainty about the value of collateral, which lead to excessive collateral requirements.”63 This may explain why public credit guarantee systems are widespread. Graham Bannock and Partners (1995) show at least 85 countries with some type of government credit guarantee program. Herrero Calvo and Pombo Gonzalez (2001) provide an overview of public credit guarantee systems around the world.

22. Recent success stories, such as FOGAPE in Chile, have generated renewed interest in the field. Bennett et al (2005) analyze some recent successful experiences of credit guarantee systems in developing countries and demonstrate that financial sector deepening has occurred in the case study countries and that it can reasonably be attributed in part to the operations of credit guarantee schemes. De la Torre et al (2006) identify FOGAPE among the main pro-market interventions using traditional government instruments that have been considered a success story in terms of fostering market activity while minimizing the problems that have characterized

61 Salvatore Zecchini & Marco Ventura, 2006."Public Credit Guarantees and SME Finance," ISAE Working Papers 73, ISAE - Institute for Studies and Economic Analyses - (Rome, ITALY). 62 The debt service cost, being equal to the State’s average borrowing cost, could be considered as a proxy for the opportunity cost of funding the Fund. 63 De la Torre, Augusto and Segio Schmukler, 2005. Innovative Experiences in Access to Finance: Market Friendly Roles for the Visible Hand. Latin America Regional Studies Series, World Bank, pg. 33

83 previous guarantee schemes. Benavente et al (2006) develop a theoretical model showing that under certain conditions, like in FOGAPE’s case, credit guarantee systems can improve access to credit for borrowers with viable projects that would otherwise be excluded due to lack of collateral, without increasing moral hazard. See Llisteri (2007b) on viewpoints held with respect to the role of credit guarantee programs and a review of best practices in operating guarantee schemes, in addition to Levitsky (1997b).

23. Previous experience of other IDA/IFC Risk Sharing Facilities in Africa sheds some light on the leveraging of public sector resources.64 In Madagascar, for example, under a similar scheme as the one this project plans, a US$3 million equivalent IDA investment leveraged US$30 million in IFC and private sector financing.65 The Madagascar RSF scheme commenced on June 13, 2006, and as of June 2008, 1,206 loans had been granted totaling US$30.31 million equivalent, of which US$26.72 million had been disbursed (utilization of the US$25 million facility stands at 77.17 percent in Madagascar MGA, and both banks have exceeded their targets).

24. Based on these lessons learned and the design of the RSF scheme, the program is projected to leverage up to US$10 of funding for every US$1 of public money from private and public bank resources. An uptake in bank lending via the US$13 million equivalent Risk Sharing Facility (RSF) in Sri Lanka could leverage about US$130 million in private lending (see Table A.9.4), which would pave the way for creating a sustainable and profitable market for SME lending. Through the demonstration effect of the profitability of SME banking, the economic value added of the RSF, though, would be much larger, in the sense that the scheme would help the financial market for SME lending move from a suboptimal equilibrium to a higher welfare (optimal) equilibrium of supply and demand for SME lending.

Table A.9.4: Leveraging of RSF investment for Private Lending IDA Risk Sharing Facility Investment Leveraging of Private Lending Country (US$ million (US$ million) (US$ million) equivalent) Madagascar 3 13 30 Sri Lanka 13 108.3 130

64 Task Force Report on IDA-IFC Partial Credit Guarantee Facilities, September 2009, World Bank Group. 65 WBG Smart Lessons “IDA and IFC Increase Access to Finance for SMEs in Madagascar: The First Successful Initiative of Its Kind,” November 2008.

84 Annex 10: Safeguard Policy Issues SRI LANKA: SME Development Facility Project

Key Safeguards Issues

1. The project will be categorized under safeguards category FI. The SMEs that will be finally supported are not known at Appraisal and therefore, in order to rule out any potential environmental or social impacts, the client has prepared a Social Risk Management Framework and an Environmental Risk Management Framework which will serve as a guide to manage any potential environmental impacts including an exclusion/negative list of activities that will not be eligible for financing.

Social Safeguards

2. No social safeguards issues are foreseen under the project. The project will not support any investment requiring land acquisition or associated involuntary resettlement (OP/BP 4.12). The Social Management Framework identifies social risks under the SME lending program by the participating banks and defines how compliance with the country and World Bank’s social safeguard policies will be monitored. Furthermore, an annual Social Impact Assessment (SIA) will be conducted to assess broader social impact of the project, regional and sectoral distribution of loans and to identify any unforeseen negative social impacts or obstacles to SMEs equal access.

3. In preparation of the Social Risk Management Framework, mapping of SMEs across districts in the targeted sectors was done, including number of employees (men and women) and other relevant characteristics. The mapping and profiling helped to determine baselines and support the monitoring of the project indicators.

4. The highest number of SMEs in the country, i.e. over 40 percent, is established in the Western Province while the second highest percentage of over 20 percent is in the North Western Province. All the remaining provinces have less than 10 percent of the country’s SMEs. The SMEs outside the Western Province also suffer from poor infrastructural facilities, and the same SMEs have been particularly hard hit by three decades of conflict.66 Furthermore, the best market for these goods and services seem to be concentrated in the Western Province which also encourages concentration of the SMEs into the same province. Hence, while the project will reach out to all provinces of the country, available statistics indicate that SMEs in the selected sub sectors of apparel, tourism and agri-business are largely centered around the Western Province, and coverage of bank branches is likewise much less in the Northern and Eastern part than in the Western part of the country. It may thus be inevitable that SMEs in the Western Province gain more and easier access to loans under the facility than SMEs in the lagging regions. To extend beyond the Western Province the project will include island-wide awareness programs designed and planned by the PIU discussed above.

66 ADB Technical Assistance Consultant’s Report (July 2007), Sri Lanka: Preparing Small and Medium Enterprises Sector Development Program II

85 5. The population of the North and East has been subject to long-term displacement, which has resulted in many unsettled land issues due to loss of land documents, secondary occupation of land, encroachments, among others. The District Secretaries in particular district in North and East are in the process of settling all the unsettled land issue on priority basis and then the land owners would be able to use the tile as collateral. Until this situation is resolved, SMEs could face significant obstacles in these areas to obtain loans as disputed land cannot serve as collateral. Likewise, the availability of the improved access to loans may aggravate any dispute over the land in question.

6. Under the proposed project, SMEs from all sectors and regions will be eligible to receive loans except those in the World Bank negative list. SMEs in the sectors of tourism, agri-business, apparel and footwear among other sectors are likely to have a large number of loan applicants. The population of the North and East is in the process of contributing to the National Gross Domestic Product, in particular in the agriculture and fisheries & aquatic resource sectors. Sector-wise impacts of the project are anticipated largely depending on the nature of work/ jobs involved in the different SMEs. In the tourism sector, labor is largely divided as organized and casual/ informal. There is the risk of engaging children in casual labor in tourism. Likewise, the apparel sector employs both skilled and unskilled labor with a majority of the employees being women. Furthermore, trade unions in the apparel sector are not common and the few unions that exist are considered to be ineffective. Agri-business sector encounters different kinds of issues depending on the variety of products and therefore it is difficult to generalize their issues. For example, employees of small holding tea estates that would belong under the category of SMEs would face an issue of something similar to bonded labor and these areas are characterized by considerable social problems. That is, unlike other employees in other sectors, the estate workers lose not only their livelihood but their entire social setting if they opt to leave the job as they live and work in the same estate space.

7. Violation of the national labor laws by borrowing SMEs would be a significant reputational risk for the project. However, it is observed that the SMEs in Sri Lanka do abide by the Labor laws well due to the fact of rigorous /stringent monitoring of the Officers of the Labour Department. The MOFP can ensure that such issues are identified and brought to the attention of relevant authorities through the SIA that will be conducted after the first year of project implementation, and which will assess the broader social impact of the project. Compliance to labor laws is monitored by the Labour Department through the regional labor offices in the Divisional Secretariats. Non-complying entities will be brought under the legal framework of the country and prosecuted. For example, if an organization has not paid EPF and ETF the Regional Labour Department office will issue a red notice for non submission of the monthly EPF and ETF contributions. If the organization complies at this stage the matter will be closed. However, if it fails to comply, the Regional Labour Department will prosecute the Organization and its Directors. Likewise, issues of sexual harassment will be dealt by the Department of Police

Environmental Safeguards

8. The project will not finance a pre-identified set of SMEs or sectors and specific environmental issues have not been identified. The environmental issues associated with SMEs

86 are expected to be varied and will depend on specificities and complexities of the sectors. While no significant issues are foreseen at this point, the possibility that such issues become applicable for selected SMEs cannot be completely ruled out. The Environmental Risk Management Framework (ERMF) of the project will help to minimize potential risks associated with SMEs that will be supported under the program and a process to ensure compliance with the Sri Lanka and World Bank environmental safeguards policies has been put in place. ERMF includes an environmental risk categorization of potential SME sectors in Sri Lanka and a negative list of projects that will not be eligible under this program. In addition, certain sites have been identified where projects should not be located and a list of sites that are considered sensitive and therefore would require more rigorous Environmental Assessment process based on the guidelines of the National Environmental Act (NEA) of Sri Lanka. The Framework and the safeguards section of the Operations Manual have provided the project team, including the Project Implementation Unit (PIU) and Participating Financial Institutions (PFIs), with an environmental screening tool and guidelines for actions for the type of environmental safeguards actions that are feasible to take based on the likely presence/absence of environmental issues, the magnitude of issues, the size of the sub-project, and locality.

9. The PIU will also prepare a sector specific guidance document within the first three months of project effectiveness focused on SME sectors and covering baseline environmental information on existing SMEs (if available), details of potential environmental issues that could arise due to different sectors, standards to be maintained and generic environmental mitigations actions for each sector. This document will be prepared building on the World Bank’s Pollution Prevention and Abatement Handbook of 1998, IFC’s Environmental, Health and Safety Guidelines for Industries and Central Environmental Authority’s Industrial Pollution Control Guidelines.

10. The participating SMEs that develop sub-projects are responsible for conducting sub- project specific Environmental Assessments (EAs) based on terms of reference developed by the PFIs or Central Environmental Authority/Project Approving Agencies and agreed with the PIU and the World Bank for high risk projects, as well as obtain the Environmental Protection Licenses and other clearances as needed. In addition, to receive assistance through SMEDeF, these sub-projects should also conform to the ERMF of the project and any other guidance documents specified.

Institutional capacity for safeguards management

11. The project, a financial intermediary loan to be implemented by the Ministry of Finance and Planning, Government of Sri Lanka, is to be managed by the PIU set up at the Ministry.

Institutional and implementation arrangements

12. The PIU has recruited two specialists who will be responsible for overall social and environmental safeguards of the project.

13. The approach of using technical consultants from a pool of consultants pre-identified to undertake pre- environmental assessments of sub-projects will be adopted as and when required

87 to support the Environmental Specialist of the PIU and PFIs. The PIU and the PFIs will be primarily responsible for performing the screening and appraisal processes with the support of the PIU (where necessary) for each sub-project and the SMEs will be responsible to prepare the environmental assessments and obtain nationally applicable licenses and clearances as part of the loan application process.

14. The Loan Officers of the PFIs will review sub-project specific environmental screening and decisions taken based on the screening, sub-project specific EAs / Environmental Management and Monitoring Plans (EMPs) / Environmental Codes of Practices (EcoPs) / Environmental Check Lists (ECLs) in consultation with the PIU specifically in regards to high risk projects. The PFIs will be also responsible in advising sub-borrowers (participating SMEs) of any shortfalls or inadequacies prior to submissions of final documents. If technical understanding of the project is lacking, both PFIs and PIU should use the service of a suitable technical consultant to assist in checking if the sub-project is in compliance with the ERMF and has all required licenses and clearances and advise the sub-borrowers if they are not in place and report to PIU/PFI on their status. Depending on the sector, technology used, scope and environmental screening outcomes, certain sub-projects (as identified in the ERMF) will also require prior review of the World Bank prior to finalization of the loan approval process

Public Consultations and Disclosure

15. An initial consultation was held on May 24, 2010 with potential PFIs, Chambers, industry associations and industry participants to provide an understanding of the project and to present the draft ERMF and Social Management Framework. Taking concerns of the SMEs in reference to using one standard process to obtain environmental clearances, based on the NEA and World Bank policies, ERMF has provided a screening methodology to identify the vigor of EA to be conducted. The ERMF was disclosed to the public for review and comments on June 10, 2010.

Monitoring and Evaluation

16. One year after project start, an independent social assessment will be undertaken to review which SMEs have benefitted in terms of sector, location, and wider impact. This will enable the project to assess whether the project inadvertently has favored certain regions or sectors, and whether eligible SMEs are able to access the loans in a transparent and equitable manner. In case inequities, distortions or unintended negative social impacts are identified, mitigatory actions can be put in place to address these.

17. Overall monitoring of environmental compliance will be the responsibility of the PFIs. In addition, the PIU and the World Bank will monitor samples of sub-projects as part of the implementation support activities. Independent post-environmental audits will be conducted by PIU annually for sub-projects identified to consist of moderate to high environmental risks. This will ensure that participating SMEs continue to adhere to the environmental safeguards requirements particularly of risky projects.

88 Appendix 1: Conflict & Reconciliation Assessment

SRI LANKA: SME Development Facility Project

Based on the application of the Reconciliation and Conflict Filter Assessment Guidance67

Key Issues Description of Issues Risk Measures to address the Issues Rating Rating of residual risk I. Project Context Main social and political risks Sri Lanka has recently come out of an S With the end of the conflict and the M and conflict generated needs: armed conflict and has been through successful completion of 1. Risk of continued years of instability. Resettlement of Presidential and General elections in political tensions displaced people is ongoing in the April 2010, regional economic North. The risk of inter and intra activity has improved. Improvement communal tensions by various of the connectivity within the interested parties exists. Efforts to country has increased access to new further reconciliation through robust markets and economic opportunities. political processes may either happen slowly or stall thereby exacerbating tensions.

Risks & opportunities relating The main challenge to the project is to M Eligibility criteria for accessing M to reconciliation and inter- avoid that increased financing to Small loans are the same for all SMEs, but ethnic trust: and Medium Enterprises (SMEs) certain sectors have a higher 1. Risk of project become vehicles for, or perceived as concentration of SMEs, and these promoting parochial promoting, parochial interest groups at are not evenly distributed across the interests the expense of more equitable and country. Stakeholder associations 2. Main benefits of project balanced access by eligible SMEs in across districts and provinces will be will go to the Western different parts of the country. Such a consulted in all locations to establish province situation would create tensions at both whether “bankable” SMEs have local and national levels. equal access to loans under this Most of the SMEs are located in the project and identify issues or areas Western Province which is also better that could lead to tension. These serviced by banking facilities than forums will be consulted to ensure other Provinces, the project can be that all groups are taken into expected to benefit primarily the consideration across the country. Western part of the country, although the PAD states that the SMEs in the North and East as having suffered both from the economic crisis and from the years of conflict. Concerns raised by stake- Projects/project activities may be M During preparation, an initial M holders and non-stakeholders: perceived as a vehicle for the unequal mapping of the potential 1. Unequal access to access to finance of different regions beneficiaries (SMEs) was resource base and communities. Certain SMEs conducted, based on a mapping of  supported through the project may be business activity in the targeted identified more with one particular sectors (tourism, apparel and region or ethnic or religious group agribusiness). The project has a rather than others. This is a risk to the national coverage and will closely project. monitor the sector and location of SMEs that gain access to financing Loan criteria will be standardized through the financial intermediaries across the country – but the majority (banks) selected through the project,

67 Refer to Reconciliation and Conflict Assessment Guidance: Sri Lanka, Application of Reconciliation and Conflict Filter to Operations

89 of SMEs are located in the Western and address any unintended part of the country, which also has the bottlenecks or obstacles to equity of best coverage of banking facilities, access. whereas other areas have very few SMEs and very limited banking facilities at present.

Issues in project management The project does not directly target M Access to project funding by L and administration: SMEs. Instead, it targets selected financial institutions will be based 1. Project administration financial institutions who in turn will on standardized selection criteria centralized and provide access to finance on SMEs. and conditional upon complying unrepresentative of local There is a risk that certain sectors and with environmental and social and regional concerns. regions will be under-served by safeguards. Both access and financial institutions compliance will be monitored through annual audits and through periodic monitoring of the project indicators. Key Design Features aiming Consultations with stakeholder at Inclusion and associations across districts and Transparency: provinces will take throughout 1. Community project implementation to identify participation the specific problems across various 2. Social audits sectors and geographic areas and to get feedback on eligibility criteria for SMEs.

A Social Impact Assessment (SIA) will be conducted for the overall project after the first year. The independent SIA will review which SMEs have benefitted in terms of sector, location, and wider impact. This will enable the project to assess whether the project inadvertently has favored certain regions or sectors, and whether eligible SMEs are able to access the loans in a transparent and equitable manner. In case inequities, distortions or unintended negative social impact is identified, mitigatory actions should be put in place to address these. II. Outcome level Project impact on equity in At national and provincial levels, M The independent SIA will review L access and outcome across perceptions may appear that different which SMEs have benefitted in different communities: regions or communities at local and terms of sector, location, and wider 1.Project being perceived provincial levels enjoy different access social impact. In case inequities, as increasing inequities to project resources and benefits. This distortions or unintended negative between regions and/or would also include cases where non- social impact is identified, communities locals access funding to set up new mitigatory actions should be put in SMEs place to address these.

Following the large-scale displacement of population both in the North and East, most returning IDPs have lost The Divisional Secretaries of the their land documentation, and many North and East have started the 2.Difficulties with using cases of unsettled land disputes, process of resolving title issues and land as collateral, secondary occupation of land exist, handing over properties to original particularly in the which serves as an obstacle to using owners. North land as collateral

90

Other social and political At national and provincial levels, M A Social Impact Assessment (SIA) L risks, incl. public perceptions perceptions may appear that different will be conducted for the overall of project: communities at local and provincial project after the first year. The levels enjoy different access to project independent SIA will review which 1. Project being perceived resources and benefits. Most of the SMEs have benefitted in terms of as increasing inequities SMEs are located in the Western sector, location, and wider impact, between regions Province which is also better serviced incl. compliance with WB 2. SMEs loans may be in by banking facilities than other safeguards and national legislation violation of national Provinces, the project can be expected on environment and labor issues. environmental and to benefit primarily the Western part This will enable the project to assess labor legislation of the country, although the PAD whether the project inadvertently states that the SMEs in the North and has favored certain regions or East as having suffered both from the sectors, and whether eligible SMEs economic crisis and from the years of are able to access the loans in a conflict. transparent and equitable manner. In SMEs supported through the project case inequities, distortions or may be in violation of environmental unintended negative social impact is or labor laws and regulations which identified, mitigatory actions will be would constitute a reputational risk put in place to address. Compliance with existing labor laws and regulations will be monitored through the existing institutions. Furthermore, the Continuous Social Impact Assessment will monitor the beneficiary SMEs on sample basis, incl. their compliance with labor laws. A regional awareness program has been designed to disseminate good environmental and social development practices among SMEs across the country.

III. Overall Conflict and Reconciliation rating M

H: High S: Substantial M: Moderate L: Low

91 Annex 11: Project Preparation and Supervision SRI LANKA: SME Development Facility Project

Planned Actual PCN review 03/16/2010 03/16/2010 Initial PID to PIC 03/17/2010 03/23/2010 Initial ISDS to PIC 03/17/2010 03/23/2010 Appraisal 06/08/2010 06/10/2010 Negotiations 07/30/2010 08/09/2010 Board/RVP approval 09/21/2010 Planned date of effectiveness 11/01/2010 Planned date of mid-term review 04/03/2012 Planned closing date 03/31/2014

Key institutions responsible for preparation of the project: Ministry of Finance and Planning, Government of Sri Lanka

Bank staff and consultants who worked on the project included Name Title Unit Cecile Thioro Niang Task Team Leader SASFP Ann Rennie Lead Financial Sector Specialist SAFP Asta Olesen Senior Social Development Specialist SASDS Aurora Ferrari Peer Review ECSF1 Aza Rashid Program Assistant SASFP Chau-Ching Shen Senior Finance Officer CTRFC Darshani De Silva Environmental Specialist SASDI Guillemette Jaffrin Peer Review AFTFW Henry Bagazonzya Senior Financial Sector Specialist SASFP Ina Hoxha Extended Term Consultant SASFP Lohita Karunasekera Consultant SASFP Minneh M. Kane Lead Counsel LEGES Miriam Witana Procurement Specialist SARPS Nadeera Rajapakse Environmental Consultant SASDI Nagavalli Annamalai Lead Counsel LEGPS Per Kjellerhaug Peer Review CSAR5 R.K. Ramamoorthy Consultant SASFP Sameena Dost Senior Counsel LEGES Sashikala Jeyaraj Program Assistant SASFP Sriyani M. Hulugalle Senior Economist SASFP Sunil Chandrasiri Consultant SASFP Supul Chamikara Wijesinghe Fin. Management Specialist SARFM Susan Maslen Counsel LEGCF Thao Le Nguyen Senior Finance Officer CTRFC Varsha Marathe Peer Review SASFP W.D. Premachandra Consultant SASFP

92 Bank funds expended to date on project preparation: 1. Bank resources:224,147.31 2. Trust funds: 0 3. Total: 224,147.31

Estimated Approval and Supervision costs: 1. Remaining costs to approval: 75,000 2. Estimated annual supervision cost: 100,000

93 Annex 12: Documents in the Project File SRI LANKA: SME Development Facility Project

Ayyagari, Meghana, Thorsten Beck, and Asli Demirgüç-Kunt. 2007. “Small and Medium Enterprises across the Globe.” Small Business Economics 29: 415-434.

Barth, James, Gerard Caprio Jr. and Ross Levine (2004), “Bank Regulation and Supervision: What Works Best?” Journal of Financial Intermediation 13, pp. 205-248.

Banerjee, Abhijit V., and Esther Duflo (2008), “Do Firms want to borrow more? Testing Credit Constraints using a Directed Lending Program” Massachusetts Institute of Technology.

Beck, Thorsten, Ross Levine, and Norman Loayza (2000), “Finance and the Sources of Growth”, Journal of Financial Economics, 58 pp.261-300

Benavente, J. M., A. Galetovic, and R. Sanhueza, 2006. Fogape: An Economic Analysis. Mimeo, World Bank.

Bennett, F., H. Billington, and A. Doran, 2005. Do Credit Guarantees Lead to Improved Access to Financial Services? Recent Evidence from Chile, Egypt, India, and Poland. Department for International Development, London, Financial Sector Team, Policy Division Working Paper.

Bruhn, Miriam and Inessa Love (2009), “The Economic Impact of Banking the Unbanked: Evidence from Mexico” A paper presentation at the Conference on Entrepreneurship and Growth, November 19-20, 2009, Washington DC, World Bank Group.

Business Edge Program http://www.ifc.org/ifcext/mekongpsdf.nsf/Content/BizEdge_Program

De la Torre, Augusto and Segio Schmukler, 2005. Innovative Experiences in Access to Finance: Market Friendly Roles for the Visible Hand. Latin America Regional Studies Series, World Bank.

Djankov, Simeon, Caralee McLiesh and Andrei Shleifer (2005) “Private Credit in 129 Countries”, NBER Working Paper No. 11078.

Graham Bannock and Partners Ltd., 1997. Credit Guarantee Schemes For Small Business Lending – A Global Perspective, Volume I – Main Report.

Herrero Calvo, A. and P. Pombo Gonzalez, 2001. Los Sistemas de Garantia para la Micro y la PYME en una Economia Globalizada, Spain. See http://www.redegarantias.com/pdfs/Los_Sistemas_de_Garantias.pdf

IFC (2007), “Benchmarking SME Banking Practices in OECD and Emerging Markets”

IEG, (1997), “World Bank Support for the Small and Medium Industries in Sri Lanka: An Impact Evaluation. World Bank Group, Washington DC.

94 Lall et all (1996), “Building Sri Lankan Competitiveness: A strategy for Manufactured Export Growth,” Report for the Government of Sri Lanka national Development Council, volume 1.

Levy, Brian (1994), “Technical And Marketing Support Systems For Successful Small And Medium Enterprise In Four Countries,” Policy Research Working Paper No. 1400. Washington DC: World Bank.

Levitsky, J., 1997a. SME Guarantee Schemes: A Summary, The Financier - Analyses of Capital and Money Market Transaction 4, 5-11.

Levitsky, J., 1997b. Best Practice in Credit Guarantee Schemes, The Financier - Analyses of Capital and Money Market Transaction 4, 86-94.

Llisteri, J.J., 2007. Alternativas operativas de sistemas de garantías de crédito para la mipyme. Sustainable Development Department Best Practices Series, Banco Interamericano de Desarrollo.

Llisteri, J.J., Rojas, A., Manueco, P., Sabater, V.L., and Tabuenca, A.G., 2006. Sistemas de garantía de crédito en América Latina: Orientaciones Operativas. Banco Interamericano de Desarrollo.

Luis A.V. Catão, Carmen Pagés, María Fernanda Rosales, IDB Working Paper Series No. IDB- WP-118. November 2009.

OPCS MSME core indicators (see URL.msmecoreindicators)

Patrick Honohan et. al., “A Note on Financial Access Indicators”, World Bank, 2005. SME Development Program II – ADB -2007-Technical Assistance Consultant’s Report.

PREM note on Sri Lanka, World Bank Group, 2010.

Rajan, Raghu, and Luigi Zingales (1998). “Financial Dependence and Growth.” American Economic Review 88, 559-587. AND Beck, Thorsten, Asli Demirgüç-Kunt, and Vojislav Maksimovic (2005). “Financial and Legal Constraints to Firm Growth: Does Firm Size Matter?” Journal of Finance 60, 137-177.

UNDP (2004), Informal Markets for Financial Services in Sri Lanka. See http://www.undp.org/legalempowerment/reports/National%20Consultation%20Reports/Country %20Files/23_Sri%20Lanka/23_6_Sri_Financial_Sector.pdf

World Bank Group, Global Monitoring Report 2009.

95 Annex 13: Statement of Loans and Credits SRI LANKA: SME Development Facility Project Difference between expected and actual Original Amount in US$ Millions disbursements Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev’d P118870 2010 Emergency Northern Recovery Project 0.00 65.00 0.00 0.00 0.00 53.21 -9.00 0.00 P113709 2010 Sustainable Tourism Development Project 0.00 18.00 0.00 0.00 0.00 17.16 0.00 0.00 P087145 2010 2nd Comm Devt and Livelihood 0.00 75.00 0.00 0.00 0.00 56.05 -17.93 0.00 Improvement P113402 2010 Higher Education forTwenty First Century 0.00 40.00 0.00 0.00 0.00 37.88 0.00 0.00 P113036 2010 N&E Local Services Improvement 0.00 50.00 0.00 0.00 0.00 48.83 0.00 0.00 P107847 2010 Provincial Roads Project 0.00 105.00 0.00 0.00 0.00 99.98 0.00 0.00 P097329 2008 Public Sector Capacity Building 0.00 22.60 0.00 0.00 0.00 15.35 9.34 0.00 P093132 2008 Dam Safety and Water Resources Planning 0.00 65.33 0.00 0.00 0.00 52.80 22.39 0.00 P100390 2007 Sri Lanka: Puttalam Housing Project 0.00 32.00 0.00 0.00 0.00 16.32 7.88 1.85 P086411 2006 Sri Lanka - Road Sector Assistance 0.00 198.10 0.00 0.00 0.00 41.18 -62.97 22.87 P084580 2006 Education Sector Development Project 0.00 70.00 0.00 0.00 0.00 12.31 -10.48 -7.13 P081771 2005 E-Sri Lanka Development 0.00 53.00 0.00 0.00 0.00 18.98 17.63 0.00 P083932 2005 North East Housing Reconstruction Progra 0.00 118.00 0.00 0.00 0.00 34.17 -7.25 0.00 P086747 2004 Community Livelihoods in Conflict Areas 0.00 76.70 0.00 0.00 0.00 42.86 26.47 22.65 P050740 2004 HEALTH SECTOR DEVELOPMENT 0.00 84.00 0.00 0.00 0.00 8.62 -16.83 -6.22 P058067 2003 Second Community Water 0.00 39.80 0.00 0.00 0.00 0.14 -3.66 -4.82 P050741 2003 Relevance and Quality of Undergrad. Educ 0.00 40.30 0.00 0.00 0.00 4.96 0.55 0.00 P076702 2002 Renewable Energy for Rural Economic 0.00 115.00 0.00 0.00 0.00 22.73 -28.36 5.59 Dev. Total: 0.00 1,267.83 0.00 0.00 0.00 583.53 - 72.22 34.79

SRI LANKA: STATEMENT OF IFC’s Held and Disbursed Portfolio (in Millions of US Dollars) Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic. 1998 Apollo Lanka 3.88 0.00 0.00 0.00 3.88 0.00 0.00 0.00 1996 Asia Power 0.00 2.27 0.00 0.00 0.00 2.27 0.00 0.00 2003 CBC 0.00 9.96 0.00 0.00 0.00 9.96 0.00 0.00 2004 CBC 0.00 2.89 0.00 0.00 0.00 2.89 0.00 0.00 2003 Dialog 48.75 0.00 0.00 0.00 13.75 0.00 0.00 0.00 1999 Fitch Srilanka 0.00 0.07 0.00 0.00 0.00 0.07 0.00 0.00 1997 Packages Lanka 0.00 0.17 0.00 0.00 0.00 0.17 0.00 0.00 1999 SAGT 12.65 3.62 0.00 0.00 12.65 3.62 0.00 0.00 2000 Suntel 1.18 4.20 0.00 0.00 1.18 4.20 0.00 0.00 Total portfolio: 66.46 23.18 0.00 0.00 31.46 23.18 0.00 0.00

Approvals Pending Commitment FY Approval Company Loan Equity Quasi Partic. Total pending commitment: 0.00 0.00 0.00 0.00

96 Annex 14: Country at a Glance SRI LANKA: Crisis Response SME Development Facility

Sri Lanka at a glance 12/9/09

Lower- POVERTY and SOCIAL Sri South middle- Development diamond* Lanka Asia income 2008 Population, mid-year (millions) 20.2 1,543 3,702 Life expectancy GNI per capita (Atlas method, US$) 1,780 986 2,078 GNI (Atlas method, US$ billions) 35.8 1,522 7,692

Average annual growth, 2002-08 Population (%) 1. 1 1. 5 1. 2 Labor force (%) 1. 4 2 . 2 1. 6 GNI Gross per primary M ost recent estimate (latest year available, 2002-08) capita enrollment Poverty (% of population below national poverty line) 23 .. .. Urban population (% of total population) 15 30 41 Life expectancy at birth (years) 74 65 68 Infant mo rtality (per 1,000 live births) 13 5 9 4 6 Child malnutrition (% of children under 5) 21 41 26 Access to improved water source Access to an improved water source (% of population) 82 87 86 Literacy (% of population age 15+) 91 63 83 Gross primary enrollment (% of school-age population) 10 5 10 8 10 9 Sri Lanka M a l e 10 5 111 112 Lower-middle-income group Female 105 104 106

KEY ECONOM IC RATIOS and LONG-TERM TRENDS 1988 1998 2007 2008 Economic ratios* GDP (US$ billions) 7.0 15.8 32.4 40.6 Gross capital formation/GDP 22.8 25.1 27.3 27.1 Exports of goods and services/GDP 26.1 36.2 29.1 24.9 Trade Gro ss do mestic savings/GDP 9.9 19.6 16.9 13.7 Gross national savings/GDP 17.2 23.7 23.0 14.8

Current acco unt balance/GDP -5.7 -1.4 -4.3 -9.3 Interest payments/GDP 2.4 1.2 0.9 0.8 Domestic Capital savings formation Total debt/GDP 74.6 57.3 43.3 37.4 Total debt service/exports 21.7 8.5 6.9 9.3 Present value of debt/GDP .. .. 36.0 28.8 Present value of debt/exports .. .. 93.8 87.9 Indebtedness 1988-98 1998-08 2007 2008 2008-12 (average annual growth) GDP 5.2 5.0 6.8 6.0 4.8 Sri Lanka GDP per capita 4.1 4.0 6.1 5.2 4.1 Lower-middle-income group Exports of goods and services 7.7 ......

STRUCTURE of the ECONOM Y 1988 1998 2007 2008 Growth of capital and GDP (%) (% of GDP) Agriculture 26.3 21.1 11.7 13.4 9 Industry 26.7 27.5 29.9 29.4 6 M anufacturing 15.4 16.5 18.5 18.0 3 Services 47.0 51.4 58.4 57.3 0 Household final consumption expenditure 78.1 71.1 67.8 70.1 03 04 05 06 07 08 General gov't final consumption expenditure 9.8 9.8 15.3 16.2 GCF GDP Imports of goods and services 36.8 42.3 39.5 38.3

1988-98 1998-08 2007 2008 (average annual growth) Agriculture 2.0 2.0 3.4 7.5 Industry 7.0 4.8 7.6 5.9 M anufacturing 8.4 4.1 6.4 4.9 Services 5.7 5.9 7.1 5.6

Household final consumption expenditure 4.7 ...... General gov't final consumption expenditure 22.6 ...... Gro ss capital fo rmatio n 5.6 ...... Imports of goods and services 8.0 ......

Note: 2008 data are preliminary estimates. This table was produced from the Development Economics LDB database. * The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be inco mplete.

97 Sri Lanka

PRICES and GOVERNMENT FINANCE 1988 1998 2007 2008 Inflation (%) Domestic prices (% change) 25 Consumer prices 14.0 9.4 15.8 22.6 20 Implicit GDP deflato r 10.1 9.2 14.0 16.3 15 10 Government finance 5 (% of GDP, includes current grants) 0

Current revenue .. 14.4 16.6 15.6 03 04 05 06 07 08 Current budget balance .. -5.2 -0.8 -1.3 GDP deflator CPI Overall surplus/deficit -12.7 -8.4 -6.9 -7.0

TRADE 1988 1998 2007 2008 Export and import levels (US$ mill.) (US$ millions)

Total exports (fob) 1,478 4,810 7,650 8,106 15,000 Tea 387 780 1,027 1,266 Other agricultural goods and unclassified exp 117 351 482 583 12,000 M anufactures 265 2,460 3,339 3,469 9,000 Total imports (cif) 2,264 5,898 11,177 13,948 6,000 Fo o d .. 723 831 1,125 Fuel and energy .. 345 2,504 3,350 3,000 Capital goods .. 1,477 2,688 2,969 0 Export price index (2000=100) .. 92 160 166 02 03 04 05 06 07 08 Import price index (2000=100) .. 92 172 200 Exports Imports Terms of trade (2000=100) .. 100 93 83

BALANCE of PAYMENTS 1988 1998 2007 2008 Current account balance to GDP (%) (US$ millions) Exports of goods and services 1,814 5,712 9,415 10,140 0 Imports of goods and services 2,565 6,659 12,768 15,609 02 03 04 05 06 07 08 -2 Resource balance -750 -947 -3,353 -5,469 -4 Net income -172 -180 -358 -972 Net current transfers 526 900 2,311 2,666 -6

Current account balance -396 -227 -1,400 -3,775 -8

Financing items (net) 272 264 1,931 2,550 -10 Changes in net reserves 125 -37 -531 1,225

Memo: Reserves including gold (US$ millions) 232 1,984 3,644 5,467 Conversion rate (DEC, local/US$) 31.8 64.5 110.6 108.7

EXTERNAL DEBT and RESOURCE FLOWS 1988 1998 2007 2008 Composition of 2008 debt (US$ mill.) (US$ millions) Total debt outstanding and disbursed 5,207 9,048 14,003 15,154 IB RD 83 26 0 0 IDA 658 1,648 2,357 2,381 G: 2,087 B: 2,381

Total debt service 487 586 852 1,229 C: 169 IB RD 13 8 0 0 F: 1,644 IDA 7 24 66 74

Composition of net resource flows Official grants 195 115 455 520 D: 3,178 Official creditors 285 371 303 262 Private creditors -93 231 764 90 Foreign direct investment (net inflows) 46 193 603 752 Portfolio equity (net inflows) 0 0 -322 -488 E: 5,695 World Bank program Commitments 217 57 32 279 Disbursements 63 96 74 95 A - IBRD E - Bilateral Principal repayments 6 19 49 55 B - IDA D - Other multilateral F - Private C - IMF G - Short-term Net flows 57 78 25 40 I n t e r e s t p a y m e n t s 15 14 17 19 Net transfers 42 64 7 21

Note: This table was produced from the Development Economics LDB database. 12/9/09

98 Annex 15: Maps SRI LANKA: SME Development Facility Project

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